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In his post, John Simon, a former CGD visiting fellow, politely disagreed with our suggestion that donors are mainly using the wrong instrument to support private-sector investment. John made some excellent points (which we urge you to read in full). And, as we stressed in our first post, we all agree that private investment is crucial for delivering social returns in developing countries.

However, we still believe that donors should work with the private sector by using contracts that reward success, instead of instruments like guarantees, soft loans, or equity stakes. Those instruments work best if DFIs have better information than the private sector about risks and rewards and can choke off competition by picking winners.

Below, we summarise what seem to be John’s main arguments (our takeaways) and then reply to them based on our paper.

Information advantages

Our takeaways from John’s post
DFIs have better information than the private sector because they get information from their government’s diplomatic corps or intelligence agencies, and — particularly in frontier markets — because they specialise in markets where the private sector has not made a similar effort to understand the terrain.

Our replies
Most DFIs don’t get this kind of privileged information. In any case, there are many private sector firms that provide the same edge.

If donors really do know about profitable investment opportunities in emerging economies, wouldn’t publishing it be cheaper (and better for competition) than setting up a DFI to try and trade on it?

De-risking

Takeaways
DFIs’ investments are ‘safer’. Because they’re attached to powerful governments, other parties involved in deals with DFIs are less likely to default or renege.

Replies
This may be true in some cases. But it isn’t a feature of DFIs — it’s a subsidy they get from the reputation of the governments that fund them.

More generally, governments often use their power on behalf of national firms to push their overseas partners to honour a contract, without participating in their deals. (We’re not saying this is good or fair).

Since it’s not something DFIs do themselves (or can bring to bear equally for all their deals), we don’t think it’s an argument for or against which kind of financial instruments donors should use.

Transaction costs

Takeaways
Writing pay-for-success contracts is much more expensive for donors or DFIs than issuing loans and guarantees.

Replies
The costs of “paying for success” will go down as donors do it more often.

And since paying for success means that donors won’t need to evaluate business plans in advance, the total costs may well end up being lower than other instruments.

As the effort by donors shifts from rowing the boat to steering it, in the long run, the transactions costs could well turn out to be equal, or even lower.

Profitability

Takeaways
As John says, OPIC in the United States and CDC in the United Kingdom both do well financially, so there is no question of needing a public subsidy. So too does the IFC, the World Bank’s private lending arm.

Since DFIs are generally profitable, not loss-making, the question of public subsidy does not arise. Moreover, their record of financial success in markets where private investors are scarce is proof they do add value in finding and promoting profitable investments in these tough environments — investments the private sector often misses.

Replies
We wish these organisations — and their investees — well.

But if DFIs were always profitable, it casts doubt on how much they are crowding in additional investment, so much as displacing private investment.

And if DFIs create additional investment by offering cheaper financing or better terms, they are subsidising the private sector.

We argue that ‘paying for success’ is a better way to allocate that subsidy.

* * *

There’s already long list of white elephant projects in development. Paying for success doesn’t eliminate the chance we’ll fund these kinds of projects, but it does mean taxpayers are less likely to bear the costs of donors’ irrational exuberance. It also makes it easier to use subsidies that encourage competition, rather than “picking winners.”

Our paper and blog post are not intended as an attack on DFIs. Far from it: we strongly believe that there should be more private investment in developing countries. But we continue to believe that donors must be thoughtful about how they do this: not only to get the best possible value for public investment, but also to have the biggest possible impact on growth and jobs in developing countries, and to do the best we can to help the world’s poor. John’s defence of DFIs does not shake our conviction that donors could be doing this better.

Disclaimer

CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.