Should the EU Provide Policy-based Lending?

As more developing countries reach middle-income status, the European Commission is exploring the idea of adding “policy-based lending” to its existing arsenal of development finance instruments. This raises some questions: what is policy-based lending and how does it differ from budget support? Why is the Commission contemplating policy-based lending? What value-add will the Commission bring to the table? We address each of these below.

Policy-based lending is a means of providing budget finance flexibly and at scale, with fewer eligibility assessments, reporting requirements, and performance conditions than the EU’s existing budget support grants. This flexibility makes it better suited to more advanced developing countries, which are increasingly able to attract cheap private capital to finance their public reforms. The Commission hopes that the instrument will allow it to maintain a presence and a degree of policy influence in countries that are transitioning away from grant-based aid. But because the Commission has limited ability to issue loans outside of the EU, it would need to partner with European development finance institutions (DFIs) to blend its grants with their policy-based loans. Currently, Germany’s KfW and France’s Agence Francaise de Développement (AFD) are the main pioneers of policy-based lending among European development actors. Yet, it remains unclear what value the Commission brings to the table, raising serious concerns that it will simply be subsiding what others are already doing with its scarce grant resources.

1. How does policy-based lending differ from EU budget support?

Policy-based lending is a means of financing policy reform in developing countries. At first glance, it looks rather like the EU’s existing budget support modality. Both involve the provision of funds directly to the budgets of recipient governments. And both accompany financial support with a package of policy dialogue, technical assistance, and conditionality. However, the instruments differ substantially in three key respects: (i) contract size and duration, (ii) eligibility criteria and assessment, and (iii) nature of the conditions.

The EU is the largest provider of non-reimbursable budget support, contributing 70 percent of total disbursements by DAC donors. In 2017, the average value of EU budget support contracts ranged from €14 million in the Overseas Countries and Territories to €82 million in West and Central Africa, and was €47 million overall. While the European DFIs do not publish comparable figures for their policy-based lending operations, their programme “case studies” suggest that contract sizes are an order of magnitude larger. For example, KfW has committed policy-based soft loans worth €300 million and €600 million to finance reform of Tunisia’s water sector and Indonesia’s public financial management respectively, while AfD has issued a trio of loans totaling €800 million in support of Indonesia’s climate change mitigation policies. Policy-based lending commitments are also shorter than the typical budget support operation. According to KfW, a project usually lasts one to three years to allow “easy exit” from non-performing reforms. By contrast, EU general and sector budget support contracts have a duration of three to six years.

A further difference between the instruments is the process and criteria for assessing eligibility. EU budget support contracts are subject to four eligibility criteria that are assessed both when a programme is approved and before each disbursement of funds. These include:

1. relevant and credible public policies,
2. stable macroeconomic framework,
3. satisfactory public financial management, and
4. budget transparency and oversight.

Recipient governments are encouraged to provide progress reports against these criteria for each assessment, though the final decision on their continued eligibility rests with the Commission.

The process for assessing eligibility for policy-based lending is comparatively simple. The main criterion is that the partner country be an advanced developing or emerging economy with a strong commitment to reform. Eligibility is assessed only once, during contract approval, and reporting requirements are deliberately kept to a minimum to ensure low transaction costs for recipients.

Finally, the nature of the conditions attached to budget support and policy-based loans are different. EU budget support contracts are divided into fixed and variable tranches, with the former disbursed conditional on the four eligibility criteria described above and the latter disbursed proportional to programme performance or results. According to the EU’s Budget Support Guidelines, programme performance should ideally be measured using three to ten induced output or outcome indicators, though process indicators may be more appropriate in certain contexts. While there is no hard-and-fast rule regarding the ratio of fixed to variable tranches, in practice the EU has gradually increased the share of budget support that is conditional on results, from an average of 30 percent in 2007-13 to 50 percent in 2017. This was likely in response to growing concerns over the fiduciary risks of budget support, such as misallocation of funds to non-poverty relevant sectors, that has led many bilateral donors to curtail their operations.

Policy-based lending, on the other hand, conditions disbursement on pre-agreed reforms or policy actions. Usually, the entire value of the contract is disbursed in a “single shot” once the conditions are met. KfW explains that this approach ensures that “reforms can be implemented quickly and comprehensively.”

2. Why is the Commission contemplating policy-based lending?

Developing countries, particularly those that have transitioned to middle-income status, are increasingly able to finance their public spending by borrowing from international markets, often at low interest rates. This looks likely to reduce demand for EU budget support grants, which offer governments smaller amounts with more conditions than international investors. Policy-based lending, with greater scale, fewer eligibility assessments, and less stringent performance requirements, is a more attractive proposition. The instrument would therefore allow the EU to maintain a presence and influence in middle-income countries, albeit with a lighter touch.

3. What is the Commission’s value-add in policy-based lending?

The introduction of policy-based lending would continue the EU’s existing trend of providing an increasing share of its aid as blended finance (see here), thereby reducing the size of the pot for traditional forms of development assistance, including budget support grants. This poses various risks.

First, the evidence base for blending instruments is far weaker than that for better-established instruments. EU budget support programmes, in particular, have been evaluated extensively with strongly positive results for aid effectiveness and development outcomes. Second, like other blending operations, policy-based lending focuses on middle-income economies and thus has the potential to divert resources away from poorer countries where development needs are greatest. Finally, it remains unclear whether and how the EU adds value to DFIs’ existing operations via blending partnerships, raising concerns that it may simply be subsiding others’ “business-as-usual.”

Given these risks, it is incumbent on the Commission to demonstrate how the anticipated benefits of policy-based lending for development outcomes will outweigh potential costs.