How Development Finance Institutions Can Help in a Time of Aid Austerity

Aid agencies across Europe and North America are seeing their budgets slashed. Replenishments to multilateral agencies from the International Development Association (IDA) through Gavi to the Global Fund are under threat. The countries most at risk are those most reliant on foreign assistance to fund investments in areas from infrastructure through health and education: the least developed countries where aid has traditionally accounted for more than six percent of GNI but (even before the recent cuts) that has dropped closer to four percent.

The squeeze has been made worse by increasing climate commitments. Even prior to the tripling of promised volumes at last year’s COP conference in Baku, “climate finance” was coming at the considerable cost of spending on development projects in the poorest countries (and with an utterly arguable impact on reducing emissions). The new $300 billion climate finance target will considerably extend the pressure to switch out grant support to the poorest countries for partial investments in anything-that-can-be-called-climate-finance in richer countries (gelato, anyone?).

At the same time, the private sector investment vehicles funded by official development assistance (ODA) have been rapidly expanding over the past decade. But while these development finance institutions (DFIs) have grown, they are no replacement for grant aid. That’s especially true in the poorest countries, where they have largely failed to deliver: despite a considerable increase in the subsidy rate on its lower-income investments (subsidies that suck up ODA), the World Bank Group’s DFI, IFC, only invests about eight percent of its financing in low-income countries, a share that is shrinking. European DFIs are investing ever less in low-income countries as well—down to 12 percent by 2023. In particular, the role of international private finance in infrastructure, health, and education in low-income countries remains (extremely, increasingly) marginal.

It is also worth noting that the track record of development impact of the projects DFIs do support in poorer countries is weak compared to public-sector projects: only 36 percent of IFC project outcomes in IDA countries (i.e., low- and some lower-middle-income countries) are rated satisfactory, compared to 82 percent for public-sector projects funded by IDA itself. None of this should come as a surprise: poorer countries have very few large firms that can absorb significant investment and meet the governance and accounting standards required by DFIs. And most multinational investors suggest they would need extremely large subsidies and extensive guarantees to enter such markets.

In short, development finance institutions control a large amount of ODA as capital, which is of limited use to the poorest countries where aid cuts most threaten development prospects. Nonetheless, they could play a very valuable role in shoring up ODA flows to the poorest countries if they stopped absorbing ODA and instead focused on what they are good at: large-scale, profitable investments in richer developing countries. Those profits could then be used to shore up ODA to the poorest countries, with the added benefit that some of the investments DFIs make might also count toward climate finance targets without absorbing (yet) more ODA.

DFIs could be freed from investment targets in the poorest countries (targets they frequently fail to meet anyway). Working more in richer developing countries would allow them to lower reserve ratios. To ease large, low-transaction-cost investments, they should also be encouraged to provide profitable sovereign or sub-sovereign lending (particularly for net-zero infrastructure investments), also financing national development banks. Again, rather than additional capital injections, DFIs should make their existing capital go further: those that are not set up to leverage through borrowing should be allowed to do so. And the profits from leveraged, large-scale, low-transaction-cost, near- or at-market lending in richer developing countries should be funneled toward public sector grants for the poorest countries.

To take two examples:

1. We’ve seen the IFC increasing the use of subsidies in a failed attempt to do more business in low-income countries. This is part of an unfortunate reversal of financial flows between the IFC and IDA driven in part by the use of IDA resources to finance a Private Sector Window (PSW) designed to provide guarantees and subsidies to IFC projects in IDA countries. The desire for IDA to deliver on the “largest replenishment ever” last year despite declining donor grant commitments has added to the pressure to expand the PSW because it is easier to use borrowed funds to support PSW operations that are less subsidized than standard IDA programs. But the World Bank Group should resist that temptation, and leave the PSW with the resources it has—especially as the window isn’t working to deliver either volumes or impact. Instead, the IFC should move into large-scale operations in support of subnational borrowing, including to parastatals and national development banks, potentially as well as private sector clean infrastructure projects in the large middle-income countries where they can be profitable (and which are responsible for most developing country emissions). This strategy could potentially provide billions in that could be channeled to the next IDA replenishment.
2. The UK’s DFI, British International Investment (BII), has been the recipient of considerable new capitalizations over the past ten years. But it doesn’t currently leverage its capital, so one dollar of capital and retained earnings gets you only 76 cents of portfolio. At the IFC, one dollar of capital and retained earnings translates into $1.35 of portfolio—and would be able to generate more if it followed the middle-income sub-sovereign strategy. BII is authorized to borrow from the government and should do so. It should also be given the authority to lend to sovereign borrowers and released from commitments to focus on low and lower middle-income countries. Similar to the IFC, this should allow for the considerable expansion of large, profitable operations in richer developing countries, potentially with a partial focus on low-carbon investments. The profits from BII could flow back to the UK’s Foreign, Commonwealth, and Development Office, potentially legislated to be used in low-income countries.

It isn’t that all lending restrictions should go in the scramble for profits. Indeed, given the appalling track record of DFIs—including the IFC—in backing non-competitive, untransparent, overpriced energy deals that leave countries paying billions for power they can’t use (for example), there’s probably a role for greater oversight to ensure DFI deals are actually in the public interest. And the model wouldn’t work for all DFIs. The US International Development Finance Corporation (DFC), for example, is completely independent from the beleaguered USAID, and it is extremely unlikely that any DFC profits would be used to increase grantmaking to poorer countries. The approach would also come with potential costs: perhaps (even) less work in low-income countries, perhaps (even) less risk taking and additionality in the quest for profits.

But in an era of constrained resources, these potential costs are surely worth it. Where DFIs are actually controlled by a development agency, there is a role for them to step up and finance development where it is needed most by investing in development where it is most rewarding to do so, helping to meet climate finance commitments in the meantime.

Thanks for helpful comments (and disagreements!) from Clemence Landers, Ian Mitchell and Nancy Lee.