Optimising EU Development Finance: Mobilising More of It, on the Right Terms, and to Where It has Most Impact.

The recent Spring Meetings of the World Bank and the International Monetary Fund (IMF) shone a light on the enormous and enlarging gulf between developing countries’ needs and what high-income countries are currently offering. Already constrained by the economic aftershocks of COVID-19, low- and middle-income countries (LICs and MICs) now face a combination of soaring debt, rising interest rates and inflation.

Confronted with insufficient liquidity to respond to these challenges and unable to access global markets, LICs and MICs need additional concessional finance, in the form of grants and soft loans. However, donor countries, especially in the European Union (EU), are themselves operating under constrained budgets following an increase in energy, defence and refugee spending. We need some creative thinking to find effective ways to maximise the use of concessional finance for greater leverage and impact.

In the coming months, we will explore how the EU can best leverage development finance and deploy its financial instruments in a smarter way and provide vital support to countries in need.

On the one hand, the augmented risk of debt distress increases the need for additional grants for developing countries. One the other, there are countries which have capacity to take on additional debt, if it can be sourced at affordable rates. Looking across the EU’s range of tools, from budget support and macro-financial assistance packages, to blended finance, we argue that, by reappraising its mix of concessional and non-concessional funding, the EU could have a significant impact.

Financing needs for low-income and highly indebted countries

The world has changed dramatically in the last three years. The COVID-19 pandemic, the Russian invasion of Ukraine and the devastating and intensifying effects of climate change have fuelled inflation and protectionism, global food and energy shortages, debt crises, humanitarian and refugee crises and the resurgence of global poverty.

The shocks of the past three years have hit all countries, but they have hit LICs particularly hard, and the effects will be long-lasting. Where once interest rates were low, they have now been rising fast, driving up borrowing costs and creating waves of defaults in highly indebted countries.

With limited access to vaccines during the pandemic and smaller stimulus packages to ease the negative economic effects of COVID-19, the capacity of low- and lower-middle income countries to bounce back was severely hampered. With additional vulnerability caused by the Russian invasion of Ukraine, the World Bank now estimates that output of emerging markets and developing economies is expected to be 5.6 percent below pre-pandemic trends, compared to 2.2 percent for advanced economies. According to the IMF, 36 of 63 LICs eligible for concessional facilities are either in debt distress or at high risk of debt distress. Unmet financing needs for urgent development priorities continue to grow. Estimates by the UN Conference on Trade and Development and the IMF suggest that the SDG funding gap could reach USD 4.3 trillion per year from 2020 to 2025, an increase of USD 400 billion over OECD estimates in 2019-20. For the EU in particular, the reconstruction of Ukraine in the coming years will also require significant resources. The latest estimates of the cost of reconstruction and recovery reach USD 411 billion.

Not just grants - solutions must involve different forms of concessional finance

When countries are unable to access global markets for liquidity, the international policy response is usually a construct of “concessional” finance which provides the right countervailing incentives. Often, this is a straight interest subsidy or “blend”, that lowers the financial cost for a given purpose or country category. Similar effects can be obtained by donor governments and official institutions guaranteeing investors and/or lenders against all—or specific partial—losses.

The entire programme can also be funded as a 100 percent grant, and this is the prevailing practice for most programmes traditionally managed by many national aid agencies and the European Commission. Grants will always be necessary in fragile country contexts where there is no immediate prospect of a return to debt sustainability even using very low-interest, long-maturity loans. However, always taking the 100 percent grant route regardless of debt considerations reduces the upfront volume of resources that can be mobilised in the great majority of cases.

In addition to its grant programmes, the EU also deploys its Macro-Financial Assistance (MFA) instrument, which provides medium- and long-term concessional loans to countries to help them deal with balance-of-payments difficulties. However, the instrument is only deployed in the EU’s neighbourhood. Current beneficiaries include Albania, Bosnia-Herzegovina, Georgia, Jordan, Kosovo, Moldova, Montenegro, North Macedonia, Tunisia, and Ukraine. In 2022 and 2023, the EU designed an MFA+ instrument to provide highly concessional loans to Ukraine to address the country’s short-term financing needs.

Missed opportunities to leverage combined development finance and allocate concessional funds more fairly

While development aid from the EU Member States rose in 2022, largely because of higher in-donor refugee costs, the tense economic and political situation in 2023 offers little room for outright aid increases. This year, Official Development Assistance (ODA) from EU Member States is expected to either plateau or decrease, with countries like Sweden and Germany proposing a reduced envelope for development. In-donor refugee costs are also expected to rise among DAC members in 2023 and could reach the equivalent of 15 percent of total ODA in 2022.

With European development budgets unable to fund the “big push” the global development agenda requires solely through their own efforts, we need some creative thinking to find effective ways to maximise the use of concessional finance for greater leverage and impact.

To do this, we should explore different potential mixes of concessional and non-concessional developmental finance. The European Investment Bank is only able to lend to countries with sufficiently high credit ratings, limiting the volume of available funds to countries with weaker ones. And the European Commission supports countries with almost EUR 2 billion annually in budget support grants, independently of their credit rating or ability to repay resources. The mainstream use of 100 percent grants by the European Commission (with the exception of loans under its Macro-Financial Assistance instrument) means middle-income countries with moderate or better market access tend to get more grants (not necessarily more funding overall) than they might require. One would expect a reasonably close correlation between the debt service capacity and the volume of budget support provided, relative to population size. However, Figure 1, which shows those countries who received EU budget support in 2021 relative to their external debt payments as a percentage of government revenues, gives a different picture: highly indebted countries receive little budget support relative to those at a lower risk of debt distress. For example, Morocco, with a sustainable debt outlook and proxied here by a relatively low debt service ratio, received a commitment of EUR 231 million of budget support (EUR 2.7 per capita) in 2021. Conversely, highly indebted countries, such as Angola, received EUR 17 million of EU budget support (EUR 0.4 per capita) in 2021.

Figure 1. Government external debt payments as percentage of government revenue in 2022 and EU budget support per capita in 2021

Source: OECD CRS and Debt Justice.

Note: Countries represented are those benefiting from EU budget support in 2021. The selection excludes (i) EU candidates and potential candidate countries which receive significant amounts of budget support through the Instrument for Pre-Accession (IPA) and (ii) small islands developing states (SIDS).

The growing financing divide, the difficulties accessing capital markets and the tightening of fiscal spaces are sharply diminishing the ability of many developing countries to respond to shocks, invest in recovery, and achieve the SDGs. To prevent further defaults among LICs and MICs and put developing countries back on a track to meet the 2030 Agenda, additional concessional finance needs to be deployed under the form of grants and soft loans. With a more efficient use of budget support and macro-financial assistance, the EU could go part of the way in addressing the gap.