Paddy Carter
Former Research Fellow - CGD Europe
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Paddy Carter was a Research Fellow at CGD Europe. He has a PhD in the economics of foreign aid from Bristol University where he was also a British Academy Post-Doctoral Fellow. He has published in leading economics journals, including the Journal of International Economics, the IMF Economic Review, and the European Economic Review. Paddy was previously a Senior Research Fellow for development strategy and finance at ODI, where he specialised in aid allocation and the private sector development strategies of donors, particularly the role of Development Finance Institutions. Before taking his PhD, Paddy spent a decade as an equities analyst at London-based stockbrokers and a financial journalist.
Media Contact
Holly Shulman
hshulman@cgdev.org
High-res photo
March 27, 2018
Blog Post
Last year the World Bank adopted a new “cascade” approach that intended to maximise finance for development by prioritising private solutions wherever possible:
Source: World Bank
In what world would this “cascade” algorithm make sense? Without a good answer to that question, the cascade risks looking like ideology rather than sound development finance advice.
An economist explores the questionWorld Bank economist Tito Cordella has published a fascinating theoretical exploration of this question “Optimizing Finance for Development”, focused on the optimal sequencing of the three possibilities: reform, subsidies (risk mitigation), or public funding.
But as economists are wont to do, Cordella strips his model down to the bare minimum needed to analyse the question in hand. Yet his model contains some ingredients that could help us think about the cascade more broadly. Moreover, it is not always obvious how to connect his stylized model back to reality. This blog post tries to do that. Before proceeding, it should be noted that World Bank research economists do not speak for the Bank and so this is not an attempt to hoist the Bank on its own petard: what matters are the arguments being made, not who is making them.
Efficiency firstAs an economist, the first question Cordella asks is: which is more efficient, public or private? When Cordella writes that “to focus on the policy relevant trade-offs, most of the analysis features the case in which the private sector has an efficiency advantage”—that’s because for him when the public sector is more efficient the solution is trivial: the public sector should do it. That is a significant departure from, “if the private sector can do it, it should.”
But I suspect many people may feel that even basing the choice between public or private on efficiency is too reductive. Many North Americans fundamentally object to the idea of socialised medicine—for example—whilst many Europeans find the American health system equally objectionable. Societies have different ideas about fairness and equality. We could interpret “efficiency” more broadly, meaning that we want to satisfy social preferences in the most efficient manner possible. Or we could see the role of the Bank as setting out the costs of achieving various social outcomes and leaving it to the political process to decide what’s worth the price.
In Cordella’s model, public and private are assumed to have the same cost of capital but differing levels of efficiency across projects, which shows up in the form of different rates of financial return: greater efficiency means higher returns. Beneath the abstraction of a model, what do financial returns mean in the context of public provision? Some public projects charge user fees (e.g., utilities) but the government can also capture financial returns via incremental economic activity, which is taxed. Efficiency is a simple model parameter, but in reality the analysis of public versus private efficiency would (should) be complex: all else equal, perhaps public schooling is more efficient because it reaches the less well-off, and lower inequality is good for growth and tax revenues. Perhaps public roads are more efficient because they have a larger economic impact on overall economic activity than a toll road. The model also recognises that efficiency is not just about returns that can be internalised financially—projects create externalities. Cordella assumes externalities are the same under public and private provision, but that is merely because he is not interested in that aspect of the problem; the theoretical implications would be trivial: all else equal, if positive externalities are larger under public provision, the public should do it.
Cordella is focused on the set of projects where the private sector has an efficiency advantage, but the returns are not sufficient to induce investment. For these, there is an interesting problem of whether, and how, to bear the costs of overcoming that. His model introduces two helpful ideas: policy reforms that improve the commercial viability of projects can come at a social cost, and subsidies to induce private participation can be too expensive. This is a useful contribution to policy debates over “blended finance” which thus far have had little to say about when levering the private sector is not worth the trouble.
The analysis reveals that sequencing of the cascade algorithm only matters because governments are unable to perfectly fit instruments to projects. If subsidies and reforms are precise and project-specific, sequencing is irrelevant. But if the cascade approach is implemented in stages where, in effect, the “reforms department” does as much as it can with its instruments first before passing on the residual of projects to the “subsidies department,” then the sequencing is important. Cordella finds that contrary to the “cascade” it is best to apply subsidies first, and crowd-in the projects which are close to commercially viable at low cost, before turning to reforms when they come at a meaningful social cost. If reforms are cost free, the implications are trivial: do them. Cordella concludes:
The objective of maximizing private finance for development may conflict with the objective of optimizing finance for development.
A different motivationHowever, the cascade is motivated by something that does not feature in Cordella’s model: the scarcity of public funds. There is no government budget constraint in the model. It could be introduced by assuming the cost of public finance is increasing in the quantity of public projects, so that “efficiency” becomes combination of costs and returns. The effect on Cordella’s model would be to expand the set of projects where the private sector has an efficiency advantage, and thus candidates for the cascade. Presumably the cost of financing subsidies would also reflect the increasing cost of public finance and the last-resort public option would become less often feasible, so the importance of reforms would rise. Behind the cascade model lies the idea that developing countries have reached the limit of fiscal space, so choosing private solutions where they are available is the only way of getting more done.
A counter argument is that if an economy can afford to pay for a new airport, for example, via users fees high enough for a private provider to make profits, then it should also be able to afford to pay those fees to a government-run airport or to pay via taxation. If the government has a profitable investment opportunity, it should be able to raise finance without seeing its cost of capital increase. Of course, if the government would be less efficient—perhaps it faces capacity constraints that aren’t about money but are about human resources—then that would settle it. But the cascade’s “private if possible” rule makes sense if the scarcity of public funds dominates efficiency considerations, otherwise relative efficiency should be the deciding factor. And if the public sector is equally efficient, in the sense of being equally able to capture financial returns, then it should also be able to find the money. The public budget should not be regarded as fixed, irrespective of what positive return investment opportunities that the government faces.
Maybe there are too many “shoulds” in the previous paragraph. Governments may not be able to finance all their positive-return projects. The cascade could be justified as a second-best solution for a second-best world. It may also be better seen as a signal that the Bank is now more receptive to collaborating with the private sector, rather than as a rule to be followed to the letter. But even on a more sympathetic reading, a stated policy of unconditional preference for private provision may be hard to sustain.
Unconditional support for private finance is untenableOpinion in some of the Bank’s shareholder countries is turning against private finance. More importantly, citizens of partner countries are reading stories like this: the American contractor Bechtel is lobbying the Kenyan government to choose conventional public procurement for a new Nairobi-Mombasa expressway, because it claims the financing cost under a PPP will be five times higher ($15bn versus $3bn). There is no mention of World Bank involvement in this project, but it’s a useful example. Kenya is a country with public debt approaching unsustainable levels so perhaps choosing private financing for this expressway would preserve fiscal space for something else, such as an investment in public rural roads.
What’s more, straight comparisons of financing costs can be misleading, because they obscure who carries the can for cost overruns under the two models (we should not assume a construction firm has the client’s best interests at heart, especially if advocating a cost-plus over a fixed-cost contract). The right choice is not obvious, so advice from the World Bank could be useful here. A flow chart that points straight to the private sector is not.
Cordella’s model sets aside theoretical possibilities if the implications are trivial. It may seem trivial to conclude that the choice between public and private finance should juggle both public financing constraints and comparative efficiency, but the cascade doesn’t work that way. And it should.
February 9, 2018
Blog Post
Since the 2015 financing for development agreement, donor governments and their development finance institutions (DFIs) have all been singing from the same hymn sheet: we must do more to mobilize private investment. One way of measuring mobilization is simply to count how many private dollars are co-invested alongside public dollars, in each deal. The new Blended Finance Taskforce’s report—Better Finance, Better World—has compiled some “leverage ratio” estimates, which show the average development bank private sector window brings in 1.5 private dollars for every public dollar. The report calls for banks and DFIs to set themselves targets to multiply their leverage ratios.
Is that a good idea? It’s easy to think of objections. Speaking at a recent conference, Jeremy Oppenheim, Taskforce program director, made a forceful case: “Things just don’t change unless you target them. We know that from all walks of life.” But, he acknowledged, designing the right targets won’t be easy, will require nuance, and it must be done right.
Here I will argue that setting leverage targets in isolation might not get us what we want: more investment in developing countries. Overall investment volumes in chosen markets may make a better target, but any incentives must be soft to minimize the temptation to put public money where it is not needed.
Getting incentives rightThe problem of incentives within DFIs is not new. World Bank president Jim Yong Kim, who is trying to transform the institution from a lender and investor into a facilitator of private investment, acknowledged in a speech last year that DFIs have all too often “competed with each other to finance projects—especially, the low-hanging fruit that the private sector, with a little help, could finance on commercial terms.” He recognizes that his staff face incentives to get large loans agreed, so when they involve private investors in projects they are often “working against their own interests.” The development banks have between them agreed a way to define and attribute mobilization. Kim said the bank is “working to change the incentives . . . so we can reward every effort to crowd in private financing,” but so far leverage ratio targets have not been announced.
The most obvious concern with targeting leverage ratios is that it will bias DFIs towards middle-income countries where it is easier to attract private co-investors. Or maybe I should say, further bias. Oppenheim and his colleagues see this danger clearly and argue the bias can be offset by other incentives within DFIs to reward doing deals in difficult places.
Targeting mobilization may also further tempt DFIs to participate in projects that would have gone ahead without them. A high leverage ratio can be reported by contributing a small sum to a large private project that has no need of it. A new OECD report, Making Blended Finance Work for the SDGs, found that of all the instruments they track, guarantees appear to have mobilized the greatest quantity of private investment, but that just raises the question of whether the private participation can really be attributed to those guarantees. No private lender would turn away generously discounted credit risk insurance, but that does not mean they only invested because of it.
Not all dollars are equalThere is also a more fundamental problem with how leverage is measured. The way it is currently done uses the face value of public and private contributions, which makes little sense. We want to know how much private investment we are getting per dollar of public money, but the cost to the public sector of contributing a $10m grant is not the same as of contributing a $10m loan. Similarly, whilst blended finance instruments are intended to raise risk-adjusted returns over the threshold where private financiers are willing to invest, the value of such instruments to private investors is not measured by their face value (it would be measured by how much private investors would be willing to pay for it).
Yes, leverage targets could be differentiated by instrument, guarantees, subordinated debt, and so forth. But to the extent that DFIs are able to vary the terms of any given instrument, a leverage target could tilt them towards greater concessionality where the reported leverage ratio would be higher, but not necessarily the biggest bang for public buck. In principle leverage ratios should be calculated after first re-basing the public contribution as a grant equivalent; in practice that may be too hard to do.
A better measure of the cost to the public sector would also help with value-for-money questions. Sometimes the price we may have to pay to induce the private sector to participate in commercially unappealing projects may be too high. A price might be worth paying if, for example, the private investors learn something that leads to subsequent investments without public assistance. But in some cases, all they may learn is not to touch certain types of project without generous public support. It is hard to see why aid should be diverted simply to induce private participation in investments, if that’s all that would be achieved. Thus far the debate on blended finance has had very little to say about when mobilizing the private sector is too expensive.
Misleading metricsPerhaps the greatest problem with leverage targets was identified in a classic management studies paper, written in 1975, called “On the folly of rewarding A, while hoping for B.” We hope to increase the total quantity of investment in the service of development, but what we are measuring is the ratio of public and private capital within a set of transactions that have public involvement. These are not the same thing. If we succeed in changing the ratio of public and private money in each DFI deal, what have we achieved? Nothing if the total quantity of investment has not changed. In principle making greater use of private money in each project could free up public money to take on more projects elsewhere, but the audience at two recent blended finance conferences in Paris were repeatedly told that money is not the problem, investment opportunities are. Especially in Africa.
It is tempting to conclude that because what we are really trying to achieve is more investment, then that is what DFIs should target. If we knew, for example, that the global set of DFIs is only capable of investing $50bn annually off their own balance sheets, then if we set them a target of $200bn total deal volume (including private contributions) that would implicitly target a 1:3 leverage ratio. Targets could be set for each DFI and differentiated by market or sector. This approach is instrument agnostic, leaving DFIs to figure out which instruments offer the greatest value for money.
Sadly, it too suffers from the rewarding A hoping for B problem. We hope for additionality, we’d reward any investment that combines public and private investors. Pressure to “get money out the door” is bad enough already. If additionality is observable at all, it is tacit knowledge inside DFIs. Nobel prizes in economics have been awarded for research into the performance of contracts when the desired outcome is partially unobservable. In such circumstances contract theory says high-powered incentives can be inefficient. That suggests it may be better to try to reward staff when they are informally “known” to have created additional investments with private participation, rather than explicitly reward metrics that can be gamed.
So where does this leave us? The Blended Finance Taskforce is certainly right that the incentives within DFIs must change, to turn competition with private investors into collaboration. And that change should manifest itself as higher leverage ratios. Explicit leverage ratio targets are problematic, but so is the status quo; the priority is to improve on it, not to attain perfection. Soft incentives that reward increased overall investments with greater private participation, where we want it, are needed, but the incentives must not be strong enough to bulldozer those within DFIs whose job it is to hold the line on additionality.
November 21, 2017
Blog Post
Development finance institutions (DFIs) have long resisted the idea that they ought to support coordinated national development strategies in the countries that they invest in, but if conversations around private roundtables at the recent World Bank/IMF meetings are anything to go by, that’s where they may be heading. And if so, it may be the private sector itself that leads them there.
The buzzword of this year’s meetings was “transformative.” The new IFC 3.0 strategy of “making markets” reflects criticism of its traditional transactional model, with each deal seen in isolation. One shareholder at the meetings asked: If we are not being transformative, what’s the point?
Hopes of achieving the Sustainable Development Goals (SDGs) rest on diverting some of the trillions of wealth held in rich countries towards investments in poor countries, but DFIs know that simply increasing their deal volumes will not be enough. DFIs have set themselves the goal of being transformative, because they know that unless they can set investment booms in motion that go way beyond their own projects, the SDGs will not be achieved.
This is true. So is the observation that if I jump out the office window, I will die unless I learn to fly. But let’s not dwell on the realism of the ambition, and look instead at where it may take DFIs.
Some transformative ideas are on the supply side. Most DFIs operate a buy-and-hold business model, and ask the private sector to participate in their investments. But the perception is that most private investors too often find co-investing with DFIs more trouble than it’s worth. One much-discussed proposal is for DFIs to move towards an originate-to-distribute model, and to see their job as creating a diversified pool of assets, packaged in a way that a larger set of private investors find easy to buy. That would increase the supply of money looking for projects, but not the supply of projects looking for money. Development finance is already experiencing something of a supply shock, with many governments allocating more money to DFIs, and complaints about the lack of bankable projects are commonplace. One thing is certain: transforming the supply side will have a greater impact if complemented by something equally dramatic on the demand side. And this is what may take DFIs in some surprising directions.
Civil society has long urged DFIs to follow the principle of country ownership and to collaborate with host governments’ national development strategies. DFIs have always shied away from that suggestion, emphasizing the (ideally) decentralized and entrepreneurial nature of the private sector, and the risks of getting investment tangled up in politics, particularly in countries prone to clientelism. But around private roundtables at the recent World Bank and IMF annual meetings, private investors were heard calling for more “programmatic” investments, by which they meant coordinated investment plans. To give a simple example, a private investor can build a hospital but they want somebody else to build the reliable power supply it needs.
The Blended Finance Breakthrough Taskforce, convened to approach the problem from the perspective of the private sector, also presented some emerging findings at the meetings, including the desirability of projects “ideally linked to sectoral development plans and policy frameworks.” A star of the meetings was the Colombian development bank FDN, which is majority owned by the government but also has the World Bank’s IFC as a shareholder. FDN is governed like a private actor but has benefited from being connected to government for matters such as land acquisition and licensing in the construction of a national highways network. This combination of public and private has attracted investments from bulge bracket Wall Street banks. The idea that national development banks may have a more important role to play was subject of much discussion at the fall meetings.
Programmatic investments also have the potential for a bigger bang for each blended finance buck. That can happen if there are complementarities in production—the hospital is more likely to succeed if the power plant exists, and vice versa. If the success of one project relies on the success of others, private actors may not undertake investments unless they know that all the required complementary inputs will be created. Kaushik Basu, former World Bank chief economist, has written about how generous state guarantees can induce private investors to undertake projects they would not otherwise, and if these are coordinated then the likelihood of the guarantees being called falls.
Such ideas are not new. If this is the future, it is a return to the past of big push theories of development that dominated thinking in the 1950s and 1960s. These ideas fell out of favour because they were observed not to work. The evidence still suggests that surges in public investment tend not to create sustainable growth (although public investment remains one of the most effective ways of crowding-in the private sector. World Bank economists Maya Eden and Aaart Kraay have shown that on average across 39 low-income countries, “an extra dollar of government investment raises private investment by roughly two dollars, and output by 1.5 dollars”).
Optimists will say we have learnt from history and need not repeat it. Scholars such as Dani Rodrik have articulated a vision of Industrial Policy for the Twenty-First Century, with more emphasis on experimentation and less on top-down planning. We have learnt more about how to build markets starting from an unpromising institutional environment (and one might also say that China is showing the way with more programmatic investments around the developing world). None of this sits well with DFI’s traditional, demand-led business model. Of course, much of what DFIs do involves smaller businesses where these ideas are less relevant, and some of the smaller bilateral DFIs may be more effective in other niches. But to my mind, greater cooperation with host governments and national development banks is where the ambition to be transformative is likely to lead DFIs. There are hard questions to answer about the conditions under which attempts at coordinated investment in collaboration with government are likely to succeed, and what the alternatives are in other cases, but in the face of demand from the very private investors DFIs want to attract, they must rediscover the art of activist industrial policy.
November 9, 2017
Blog Post
Ian Mitchell et al.
Penny Mordaunt has been confirmed as the UK’s new Secretary of State for International Development. Coming fresh to an agenda can be a major asset, but it can be hard to pick out the things that really matter. As civil servants dust off their detailed briefs, we try to stand back and identify five points that we think are important to understand about the UK’s role in global development on Day 1 in the job.
Development is much more than aid. You’ll be told that to achieve the sustainable development goals (SDGs) will mean a leap in financing from “billions to trillions”—but the pathway to achieving the SDGs is not just aid, nor even just financial. It’s about a whole set of policies, national and international, from increasing trade with the poorest countries to tackling climate change, and from supporting our world-class research and development institutions to tightening up the international tax system. Migration is, and will continue to be, a major driver of development. As labour moves to areas with higher capital, it increases its ability to produce and earn. Not only do workers contribute to the economy of their new “home,” they usually send money back to their families. These remittances now outweigh aid flows. Targeted aid can help reduce forced migration from conflict, persecution, or disasters, but some pressures from migration are probably irresistible. Even as the Government is committed to reducing net migration, it can promote policies to make existing migration work for development. Lasting development depends on private finance and taxation. DFID has already positioned itself to help countries catalyse private investment and raise more tax. And there are genuine win-wins, so that investment will benefit the UK and development together. But beware: there are pitfalls. Remember Pergau Dam, where development money was misspent? Mordaunt can commit DFID to a broader vision of global development being in the national interest, and avoid a narrower conception of our commercial or strategic interests. Overseas aid has a very strong mandate. The commitment to 0.7 percent of GDP on aid was supported by all the main political parties at the 2016 election, and amounts to under £220 per person in the UK per year. It is critical that aid is spent well, and DFID is a world leader in making aid effective. But beware: demanding immediate short-term results can undermine long-term success. And smart people need the flexibility to make adjustments and experiment with new solutions without getting approval from HQ at every turn. Mordaunt must be prepared to take risks and withstand attacks from ideological opponents of international development. Some failure is unavoidable in the world’s poorest contexts. Many friends of DFID say that the UK has stepped back from its leadership role on global development and humanitarian assistance. Though the UK has world-class NGOs, some of the best university research, and strong political support for aid from the main political parties, it is up to the Government to lead on bold new initiatives. Despite its commitments to a global Britain, the UK is perceived by the US, European partners, and others to have given up its leadership role. China and other emerging market economies are poised to become dominant players through their support of “South-South” development. There are excellent UK initiatives like the Smart Rules on better aid programmes, and a push improvements to the multilateral system including on humanitarian response. These have wider relevance to all development actors but will need Mordaunt’s support. The UK can and should step forward, not back, in shaping and bringing new ideas to the development discussion.
The new Secretary of State, who will be supported by a new Permanent Secretary, has a strong platform on which to build. Mordaunt can make the most of DFID and the UK’s strong reputation abroad, making the case to the British public and international partners that effective development is important to the UK’s future in its own right.
DFID is not merely an aid department: it should also be a development ministry, working effectively with and across government, and with international partners, to support policies and programmes that accelerate the realisation of a more peaceful, prosperous, and sustainable world.
October 31, 2017
Blog Post
Development Finance Institutions (DFIs) exist to promote development by investing in the poorest, least developed countries. They often route those investments via holding companies or private equity funds domiciled in tax havens. On the face of it, that seems absurd: tax havens are widely seen as a drain on development, depriving cash-strapped governments of billions of dollars in public revenue. Should the shareholders of DFIs demand a stop to this practice, as civil society urges?
In a new paper I argue that whilst widespread opposition to DFIs investing via tax havens is understandable, it is misguided. Banning the use of tax havens would do more harm than good. The argument rests on the answers to two questions: what do DFIs use tax havens for, and what are the alternatives to using them? The short answers are that tax havens are used to compensate for shortcomings in the legal systems of the countries that DFIs invest in, and that if DFIs stopped using tax havens, they would use onshore financial centres in rich countries instead. And that would not help developing countries one jot.
Why should DFIs continue to use tax havens?To simplify matters, let’s say we care about two things: the amount of tax that developing countries raise from foreign investors and the quantity of investment in capital-scarce countries. We care because taxes pay for public services and investment creates better jobs and produces goods such as renewable energy.
Most of what we hear about tax havens has to do with multinational corporations shifting profits to low-tax jurisdictions. But in the context of where investors put their holding companies, what matters more are bilateral tax treaties. These are what determine whether investors pay a reduced rate on dividends or are exempt from capital gains tax, for example. Only a few tax havens have advantageous tax treaty networks, but established financial centres like London and Amsterdam have extensive networks. So as a rule, swapping a tax haven for an onshore financial centre would not help developing countries gather more tax.
A case in point is a recent accusation that a structure that CDC has invested in, via the fund manager Actis, has deprived the Ugandan government of £38m in capital gains tax by using holding companies based in Mauritius. As it happens, the UK also has a tax treaty with Uganda, so if Actis had put its holding companies in London, no capital gains taxes on the sale of equity would have been due in Uganda (and interest on the shareholder loans would have been taxed in London, not Uganda).
How about requiring DFIs to invest directly, without using holding companies or fund managers? Holding companies and funds should be “tax neutral” in the sense that their use does not result in investors paying more tax than they would when investing directly—this is why they will always be domiciled in specialist financial centres that allow for that (and meet legal and regulatory requirements). DFIs say they invest directly when they can, but that holding companies are sometimes useful for legal reasons and delegation to specialist fund managers works better when trying to invest in small businesses. The Ugandan power generator Umeme was once part of a multinational group, so some sort of cross-border holding company was inevitable. Less investment would reach developing countries if DFIs stopped using holding companies and delegating to funds.
Instead of avoiding tax havens, we need to reform tax treaty networks in favour of poor countriesAt this point you may have two reactions: Why not regard London and Amsterdam as tax havens too? And how do we know the claims DFIs make, that the use of tax havens typically does not deprive developing countries of tax revenues but serves a useful purpose, are true?
The fact that problems with treaty networks and secrecy extend beyond stereotypical tax havens points towards the need for broader systemic reforms. Blacklisting a handful of islands is not the goal—raising standards however investments are structured, is. Multinational initiatives like the Global Forum on Transparency and Exchange of Information for Tax Purposes and the Common Reporting Standard are addressing problems around secrecy, but the points of leakage in bilateral tax treaty networks have not yet been fully addressed. To widespread acclaim, the OECD has introduced something called the “multilateral instrument” (MLI) to simultaneously update multiple tax treaties, and has used it to address certain weaknesses that enable “treaty shopping.” To really fix the problems that lie beneath routing investments via third-party jurisdictions, we need a “development MLI” to focus on the needs of the poorest countries, including minimum tax rates on dividends, interest, and capital gains.
The lack of evidence around the tax impact of using offshore vehicles is a thorny problem. The question of whether poor countries are deprived of tax revenues cannot be answered without specifying a realistic alternative, and that requires more than data—it requires informed but subjective judgements. But if it is wrong to ask DFIs to stop using tax havens, it is right to ask them to do more to enable public scrutiny of those investments. DFIs must invest effort into defining the tax implications of the offshore structures they use, and make that information public.
October 19, 2017
Blog Post
Last week we published a new paper, Can Africa Be A Manufacturing Destination?, that highlights the persistence of high labor costs in many countries in sub-Saharan Africa. This led to a lively debate on Twitter, initiated by Chris Blattman at the University of Chicago.
Blattman writes:
This to me is the biggest, most important, least understood issue in African dvpt: high level of industrial wages relative to productivity https://t.co/dCxOaURwX3
— Chris Blattman (@cblatts) October 17, 2017
And adds:
If you are looking for a dissertation topic this one is huge.
— Chris Blattman (@cblatts) October 17, 2017
Several bloggers and academics responded to Blattman’s tweet, sharing their views as to why labor costs are so high. Tom Westland at the University of Cambridge writes:
possible theory: wages were high and workers bargained for strong protections when land-labour ratio was high,...
— Tom Westland (@tomwestland) October 17, 2017
..and the institutional protections may be even stickier than wages in the LR
— Tom Westland (@tomwestland) October 17, 2017
& of course, high public sector wages can have positive effects (eg ↑ investment in human K so as to compete for limited pool of jobs)
— Tom Westland (@tomwestland) October 17, 2017
To which Blattman responds:
In Africa I think it may have more to do with: (1) high cost base of economy, (2) distortions in labor markets from large aid/public sector
— Chris Blattman (@cblatts) October 17, 2017
Dani Rodrik also weighs in:
Is this not explained by the high resource rents/foreign transfers and the correspondingly high level of demand for services? https://t.co/c3CWWUo6fv
— Dani Rodrik (@rodrikdani) October 18, 2017
Agree this plays a role in slowing mftg growth but I don't know that it explains high real wages. https://t.co/5dtzqusTi1
— Chris Blattman (@cblatts) October 18, 2017
As long as nontradables (services) are more labor intensive, which they are in LICs, the real exchange rate and the real wage move together. https://t.co/fwS8Z6DENg
— Dani Rodrik (@rodrikdani) October 18, 2017
Johan Fourie at Stellenbosch University has a different view:
Urban, formal-sector labour played large role in independence movements. Was awarded with high wages despite little improv in productivity.
— Johan Fourie (@JohanFourieZA) October 17, 2017
To which economist Grieve Chelwa responds:
(1/N) So the forces driving wage formation have persisted till today?
— Grieve Chelwa (@gchelwa) October 18, 2017
(2/N) If so that would be interesting given that today's manufacturing firms aren't the firms of the immediate post-independence period.
— Grieve Chelwa (@gchelwa) October 18, 2017
(3/N) In between then and now manufacturing (or industrialisation broadly) has receded and then made a small resurgence recently.
— Grieve Chelwa (@gchelwa) October 18, 2017
(4/N) Also, the power of unions to influence wages and to influence political outcomes has dwindled precipitously in btwn then & now
— Grieve Chelwa (@gchelwa) October 18, 2017
Our colleague Paddy Carter chimes in:
Empirical attempts to identify aid=>real exchange rate tend not to. So what's aid=>high wages mechanism (outside aid sector itself)
— Paddy Carter (@CarterPaddy) October 17, 2017
Pseudoerasmus, a prolific blogger, reminds everyone that unit labor costs could look very different from wages or total labor costs. He says:
my wager: ratio of output per worker-hour Bangladesh-Kenya >>> ratio of real wages Bangladesh-Kenya
— Pseudoerasmus (@pseudoerasmus) October 18, 2017
… and concludes in response to data posted by Asif Dowla:
nonetheless the problem is clearly both high wages & low productivity, & it seems more feasible to raise productivity than reduce wages...
— Pseudoerasmus (@pseudoerasmus) October 18, 2017
Howard French, an expert on China at Columbia University, comments on the story in Quartz Africa on our paper:
There will be no next China, in Africa, or anywhere else. China's takeoff is bound up in unique set of historical circumstances. https://t.co/OGdX4a1vDd
— Howard French (@hofrench) October 15, 2017
African transformation will depend on much more mixed model of services, plus some opportunistic manufacturing. Intra-African trade is key.
— Howard French (@hofrench) October 15, 2017
And Neil Gregory from the International Finance Corporation wrote in an email about gender disparities:
Bangladesh, the key comparator, is notable for very high female participation in manufacturing. If there are cultural/economic barriers to such participation in Africa, that would drive up wages as women may not be available for hire to the same extent. You could look at differences in female labor force participation to estimate this effect.
Our Response
We have tried to look at some of these hypotheses in the context of Purchasing-Power-Parity. Using the 2011 ICP data, Gelb and Diofasi confirm that African countries tend to be more costly than countries with similar incomes in other parts of the world. Aid inflows and a negative current account balance are correlated with higher price levels (the latter less strongly), while FDI and remittances are not. But even though aid dependence is associated with a higher PPP price level, this does not seem to account for the “Africa effect.”
Another possibility is that the Africa effect reflects widespread underestimation of income levels. The recent upwards revisions of GDP in several countries, including Ghana (60%), Nigeria (89%), Kenya (25%), and Zambia (25%) suggest that this could be the case for many countries on the continent. Taking a linear approximation to the relationship between the logs of income and PPP, an illustrative 30 percent increase in income per head would correspond to a 5.3 percent increase in the PPP price variable. This could account for as much as a third of the Africa effect.
Turning to structural features, another possible cause that we considered was low agricultural productivity and weak domestic supply chains. Food is relatively costly in the PPP bundle in poorer countries, and particularly so in many African countries. On average, the food price level is about 50 percent higher in low- and middle income countries than the overall price level in the economy. As shown in the recent ACET report, agricultural imports have been rising with urbanization. Much urban food is imported; this makes it harder to support a low-cost labor platform for manufacturing.
And the point on gender may be very relevant. The Asian countries have been excellent in drawing on the young female labor force. Among other things this requires a degree of operating and transit security, especially for shift work.
We would like to thank all of the researchers who shared their views on this topic! We will be continuing our work in this area and we hope that others will also try to answer the question of why industrial labor costs are so high in many countries in Africa.
October 2, 2017
Blog Post
In 2014, Mark Lowcock, then head of the UK’s Department for International Development, pulled off an unexpected coup: securing an agreement between donor governments on new rules for counting official loans as aid. Some neat diplomatic footwork is needed again now, because negotiations over extending this agreement to donors’ investments in the private sector are threatening to fall apart. Among the consequences could be that the UK walks away from using internationally agreed standards for measuring aid and starts to create its own statistics. Other countries may follow.
A better measurement system for unbiased aid allocationConsistent aid data has intrinsic value, and the details of disagreements between countries are interesting, but the bigger picture is this: using aid to mobilize private finance is one half of the globally-agreed strategy for financing the Sustainable Development Goals (the other half is domestic revenue mobilization in developing countries). If donor governments do not get enough recognition for putting money into the private sector, they may allocate too little, and if aid statistics are inflated, they may allocate too much. The world needs an accurate system of measurement so that allocation decisions are undistorted and driven by expected development impact alone. And besides quantities, quality matters too: governments are also disagreeing over safeguards intended to protect the developmental nature of aid and, crucially, ensure that it does not become a means of providing state aid to domestic firms by the back door. But there is also a risk of imposing constraints on development finance institutions (DFI) that will limit their positive impact.
This is a complex topic with much for governments to disagree about, but negotiations are stuck on square one: how to count loans as aid. This new CGD note lays out all the gory details—here we present the nub of it. It should be stressed that negotiations are ongoing and these proposals are subject to change.
Where we are nowGovernments are stuck between a rock and a hard place. The rock is the 2014 deal for loans to the official sector (sovereigns, municipalities, state-owned enterprises) which has set a benchmark that some countries refuse to undermine. The hard place is the regulated system of official export credits and lending rates observed in private markets, which define loans that should not be counted as aid. The problem is that, at least in the current low interest rate environment, the 2014 benchmark implies some loans made by export credit agencies, and sometimes private financiers, could count as aid.
A further twist is that there are actually two proposed methods for counting private sector aid: the “institutional” method, which counts the full face-value of money governments give to their DFIs; and the “instrument” method, which calculates a number for aid—known as the ‘grant element’ of a loan—in every transaction between a DFI and a private enterprise. The deal currently on the table deviates from the 2014 official-sector deal, using a “private sector surcharge” to push down the ODA content of some shorter-term loans in the instrument method, in attempt to minimise inconsistency with the market, and export credits. Those countries which do a lot of lending and intend to use the instrument method feel unfairly treated by others who intend to use the institutional method which they, in turn, regard as an egregious scheme for inflating aid numbers.
The truth is that there is no perfect answer. Even if donors carefully calculated aid using parameters tailored to each transaction, there would still be disagreement over what those parameters should be and no objective means of resolution. But an administrative system for creating aid data needs to be simpler, and compute aid by sorting investments into several boxes. There is a danger of getting hung up on a few transactions that might look wrong and forgetting the bulk. Export credits are not always the right comparator because DFIs often lend to riskier enterprises. Plus, the current low interest rate environment will not last forever. A deal should be struck that meets holdouts halfway on the quantitative side of instrument method, to be followed by qualitative safeguards to isolate transactions stray close to state aid, and ensure that only those with a clear development rationale, and which private investors would not finance themselves, get counted as aid.
The path forwardI have suggested two options for reaching a reasonable compromise:
a system that deviates from the 2014 deal by identifying sectors where lending to a private enterprise is notably more or less risky than lending to the state; or, a more finely differentiated system of private sector risk premia that looks less like the 2014 official sector deal but which creates scope for giving the holdouts some of what they want, but not everything.Although not currently the sticking point in negotiations, the proposals for equity need revising too. The introduction of a cap on negative ODA in the instrument method threatens to transform equity investing into an ODA pump. If I had my way, the institutional method would also be revised so that governments report an ex-ante grant element estimate when they inject capital into their DFIs, based on the institution’s targeted rates of financial return and its geographic coverage. But that may be too much to ask.
A last word on transparencyA compromise is worthwhile on the assumption that most reported PSI will be genuine aid, even if somewhat inflated. This assumption needs to be verified. As things stand some DAC member governments want to retain the right to redact some transaction level data for PSIs on the grounds of confidentiality. The DAC must find a way to permit public scrutiny of how much aid is being claimed from what investments on what terms in what places, even if based on averages at some level of aggregation. DFIs should also publish the development rationale for each investment they make. Secrecy will only strengthen suspicions that ODA is being misused.
October 2, 2017
Publications
Disagreement over how investments in the private sector are counting to aid is threatening to overwhelm the OECD Development Assistance Committee. There are no perfect solutions here; governments must find the least-bad compromise. We point the way forward.
Pages
October 19, 2017
Blog Post
Last week we published a new paper, Can Africa Be A Manufacturing Destination?, that highlights the persistence of high labor costs in many countries in sub-Saharan Africa. This led to a lively debate on Twitter, initiated by Chris Blattman at the University of Chicago.
Blattman writes:
This to me is the biggest, most important, least understood issue in African dvpt: high level of industrial wages relative to productivity https://t.co/dCxOaURwX3
— Chris Blattman (@cblatts) October 17, 2017
And adds:
If you are looking for a dissertation topic this one is huge.
— Chris Blattman (@cblatts) October 17, 2017
Several bloggers and academics responded to Blattman’s tweet, sharing their views as to why labor costs are so high. Tom Westland at the University of Cambridge writes:
possible theory: wages were high and workers bargained for strong protections when land-labour ratio was high,...
— Tom Westland (@tomwestland) October 17, 2017
..and the institutional protections may be even stickier than wages in the LR
— Tom Westland (@tomwestland) October 17, 2017
& of course, high public sector wages can have positive effects (eg ↑ investment in human K so as to compete for limited pool of jobs)
— Tom Westland (@tomwestland) October 17, 2017
To which Blattman responds:
In Africa I think it may have more to do with: (1) high cost base of economy, (2) distortions in labor markets from large aid/public sector
— Chris Blattman (@cblatts) October 17, 2017
Dani Rodrik also weighs in:
Is this not explained by the high resource rents/foreign transfers and the correspondingly high level of demand for services? https://t.co/c3CWWUo6fv
— Dani Rodrik (@rodrikdani) October 18, 2017
Agree this plays a role in slowing mftg growth but I don't know that it explains high real wages. https://t.co/5dtzqusTi1
— Chris Blattman (@cblatts) October 18, 2017
As long as nontradables (services) are more labor intensive, which they are in LICs, the real exchange rate and the real wage move together. https://t.co/fwS8Z6DENg
— Dani Rodrik (@rodrikdani) October 18, 2017
Johan Fourie at Stellenbosch University has a different view:
Urban, formal-sector labour played large role in independence movements. Was awarded with high wages despite little improv in productivity.
— Johan Fourie (@JohanFourieZA) October 17, 2017
To which economist Grieve Chelwa responds:
(1/N) So the forces driving wage formation have persisted till today?
— Grieve Chelwa (@gchelwa) October 18, 2017
(2/N) If so that would be interesting given that today's manufacturing firms aren't the firms of the immediate post-independence period.
— Grieve Chelwa (@gchelwa) October 18, 2017
(3/N) In between then and now manufacturing (or industrialisation broadly) has receded and then made a small resurgence recently.
— Grieve Chelwa (@gchelwa) October 18, 2017
(4/N) Also, the power of unions to influence wages and to influence political outcomes has dwindled precipitously in btwn then & now
— Grieve Chelwa (@gchelwa) October 18, 2017
Our colleague Paddy Carter chimes in:
Empirical attempts to identify aid=>real exchange rate tend not to. So what's aid=>high wages mechanism (outside aid sector itself)
— Paddy Carter (@CarterPaddy) October 17, 2017
Pseudoerasmus, a prolific blogger, reminds everyone that unit labor costs could look very different from wages or total labor costs. He says:
my wager: ratio of output per worker-hour Bangladesh-Kenya >>> ratio of real wages Bangladesh-Kenya
— Pseudoerasmus (@pseudoerasmus) October 18, 2017
… and concludes in response to data posted by Asif Dowla:
nonetheless the problem is clearly both high wages & low productivity, & it seems more feasible to raise productivity than reduce wages...
— Pseudoerasmus (@pseudoerasmus) October 18, 2017
Howard French, an expert on China at Columbia University, comments on the story in Quartz Africa on our paper:
There will be no next China, in Africa, or anywhere else. China's takeoff is bound up in unique set of historical circumstances. https://t.co/OGdX4a1vDd
— Howard French (@hofrench) October 15, 2017
African transformation will depend on much more mixed model of services, plus some opportunistic manufacturing. Intra-African trade is key.
— Howard French (@hofrench) October 15, 2017
And Neil Gregory from the International Finance Corporation wrote in an email about gender disparities:
Bangladesh, the key comparator, is notable for very high female participation in manufacturing. If there are cultural/economic barriers to such participation in Africa, that would drive up wages as women may not be available for hire to the same extent. You could look at differences in female labor force participation to estimate this effect.
Our Response
We have tried to look at some of these hypotheses in the context of Purchasing-Power-Parity. Using the 2011 ICP data, Gelb and Diofasi confirm that African countries tend to be more costly than countries with similar incomes in other parts of the world. Aid inflows and a negative current account balance are correlated with higher price levels (the latter less strongly), while FDI and remittances are not. But even though aid dependence is associated with a higher PPP price level, this does not seem to account for the “Africa effect.”
Another possibility is that the Africa effect reflects widespread underestimation of income levels. The recent upwards revisions of GDP in several countries, including Ghana (60%), Nigeria (89%), Kenya (25%), and Zambia (25%) suggest that this could be the case for many countries on the continent. Taking a linear approximation to the relationship between the logs of income and PPP, an illustrative 30 percent increase in income per head would correspond to a 5.3 percent increase in the PPP price variable. This could account for as much as a third of the Africa effect.
Turning to structural features, another possible cause that we considered was low agricultural productivity and weak domestic supply chains. Food is relatively costly in the PPP bundle in poorer countries, and particularly so in many African countries. On average, the food price level is about 50 percent higher in low- and middle income countries than the overall price level in the economy. As shown in the recent ACET report, agricultural imports have been rising with urbanization. Much urban food is imported; this makes it harder to support a low-cost labor platform for manufacturing.
And the point on gender may be very relevant. The Asian countries have been excellent in drawing on the young female labor force. Among other things this requires a degree of operating and transit security, especially for shift work.
We would like to thank all of the researchers who shared their views on this topic! We will be continuing our work in this area and we hope that others will also try to answer the question of why industrial labor costs are so high in many countries in Africa.
November 9, 2017
Blog Post
Ian Mitchell et al.
Penny Mordaunt has been confirmed as the UK’s new Secretary of State for International Development. Coming fresh to an agenda can be a major asset, but it can be hard to pick out the things that really matter. As civil servants dust off their detailed briefs, we try to stand back and identify five points that we think are important to understand about the UK’s role in global development on Day 1 in the job.
Development is much more than aid. You’ll be told that to achieve the sustainable development goals (SDGs) will mean a leap in financing from “billions to trillions”—but the pathway to achieving the SDGs is not just aid, nor even just financial. It’s about a whole set of policies, national and international, from increasing trade with the poorest countries to tackling climate change, and from supporting our world-class research and development institutions to tightening up the international tax system. Migration is, and will continue to be, a major driver of development. As labour moves to areas with higher capital, it increases its ability to produce and earn. Not only do workers contribute to the economy of their new “home,” they usually send money back to their families. These remittances now outweigh aid flows. Targeted aid can help reduce forced migration from conflict, persecution, or disasters, but some pressures from migration are probably irresistible. Even as the Government is committed to reducing net migration, it can promote policies to make existing migration work for development. Lasting development depends on private finance and taxation. DFID has already positioned itself to help countries catalyse private investment and raise more tax. And there are genuine win-wins, so that investment will benefit the UK and development together. But beware: there are pitfalls. Remember Pergau Dam, where development money was misspent? Mordaunt can commit DFID to a broader vision of global development being in the national interest, and avoid a narrower conception of our commercial or strategic interests. Overseas aid has a very strong mandate. The commitment to 0.7 percent of GDP on aid was supported by all the main political parties at the 2016 election, and amounts to under £220 per person in the UK per year. It is critical that aid is spent well, and DFID is a world leader in making aid effective. But beware: demanding immediate short-term results can undermine long-term success. And smart people need the flexibility to make adjustments and experiment with new solutions without getting approval from HQ at every turn. Mordaunt must be prepared to take risks and withstand attacks from ideological opponents of international development. Some failure is unavoidable in the world’s poorest contexts. Many friends of DFID say that the UK has stepped back from its leadership role on global development and humanitarian assistance. Though the UK has world-class NGOs, some of the best university research, and strong political support for aid from the main political parties, it is up to the Government to lead on bold new initiatives. Despite its commitments to a global Britain, the UK is perceived by the US, European partners, and others to have given up its leadership role. China and other emerging market economies are poised to become dominant players through their support of “South-South” development. There are excellent UK initiatives like the Smart Rules on better aid programmes, and a push improvements to the multilateral system including on humanitarian response. These have wider relevance to all development actors but will need Mordaunt’s support. The UK can and should step forward, not back, in shaping and bringing new ideas to the development discussion.
The new Secretary of State, who will be supported by a new Permanent Secretary, has a strong platform on which to build. Mordaunt can make the most of DFID and the UK’s strong reputation abroad, making the case to the British public and international partners that effective development is important to the UK’s future in its own right.
DFID is not merely an aid department: it should also be a development ministry, working effectively with and across government, and with international partners, to support policies and programmes that accelerate the realisation of a more peaceful, prosperous, and sustainable world.
August 11, 2017
Blog Post
Here we are, deep in the throes of summer, which hopefully means you have finished your planned holiday books and are in need of another good read or two! But what should you choose? We asked CGD experts to share their recommendations. Check out the list below to find what fits your mood, whether that's a deep dive into migration policy, a surprising look into Machiavelli's life, or a techno-utopian, time-traveling adventure (I know what gets my vote!).
If you'd like to get more reading recommendations from CGD, you can also sign up for our weekly Friday "What We're Reading" newsletter.
This Earth of Mankind, by Pramoedya Ananta Toer"A love story set amidst the colonial evils of Dutch-ruled Indonesia. Transcribed from stories the author told his fellow inmates while a political prisoner in the 1970s, and beautifully translated. At once vivid historical fiction and haunting social commentary." – Jonah Busch
The Erast Fandorin novels, by Boris Akunin
"Fabulously entertaining and fantastical sleuthing set in 19th century Russia. If ideally situated in a hammock or sun-lounger, you may be able to consume one a day." – Paddy Carter
The New Odyssey: The Story of Europe's Refugee Crisis, by Patrick Kingsley
"This book makes the migration policy crisis comprehensible through the epic journalistic feat of personally accompanying one Syrian man from Egypt all the way to Sweden. If you have policy ideas about how to address the crisis, see if they survive reading Kingsley's deeply engaged account." – Michael Clemens
Empire of Cotton: A Global History, by Sven Beckert
"Beckert explores the early stages of globalization and the industrial revolution through the lens of the cultivation, processing, and trade of cotton and cotton textiles. He also focuses on the links to the slave trade in the early days of the cotton trade, and the changing fortunes of India, China, and other developing countries as their roles in the 'cotton empire' shifted over the centuries." – Kimberly Ann Elliott
All Our Wrong Todays, by Elan Mastai
"I'm not normally a fan of sci-fi, so I wasn't expecting to get into this time-travel/alternate-reality book, but I did. In this novel, Tom Barren runs into a time-travel mishap when he leaves his techno-utopian, idealistic 2016 world of flying cars and moving sidewalks behind and changes history so that he ends up stranded in our 2016. Mastai's piece is a thought-provoking, funny, and entertaining novel that's a perfect read for any vacation." – Rebecca Forman
Some Faces in the Crowd: Short Stories, by Budd Schulberg
"Fictional short stories about people haunted by abrupt failure in the wake of rapid success. The most famous story concerns Lonesome Rhodes, who rises from itinerant Arkansas guitar picker to local media rabble-rouser to TV superstar and political king-maker. Whether you read the book or not, you must see the movie, A Face in the Crowd, directed by the amazingly talented Elia Kazan, which underscores the role of the media in electing our most prominent politicians and invites viewers to draw parallels to the current situation in the United States." – John Hurley
Secondhand Time: The Last of the Soviets, by Svetlana Alexievech
"Alexievech documents ordinary Russia after the fall of the Soviet Union and their experience with revolution, capitalism, and Putin. It reads less like a history book and more like an oral history—unassuming, frank, and raw. It's a fascinating investigation into modern Russia, and it contains all these insightful nuggets on democracy, capitalism, and revolution that are surprisingly relevant for American politics." – Jared Kalow
Be Like the Fox: Machiavelli in His World, by Erica Benner
"A fascinating account of Machiavelli's life and lifelong struggle to restore Florence as a republic. He emerges as a more complex figure than you might think from reading The Prince—as interested in justice, freedom, and the rule of law as in power. On his deathbed, he is said to have claimed he'd rather be in hell with Plato, Plutarch, and Tacitus than in a heaven that banished them." – Nancy Lee
Podcast: Revisionist History, by Malcolm Gladwell
"This podcast has a new season right now and started off with an excellent take down of golf and golf courses, which I agree are a waste of a nice park, and hideously elitist." – Rajesh Mirchandani
The Force, by Don Winslow
"If you liked The Cartel, about Mexican drug lords, then you'll love Winslow's new epic crime thriller about corruption in the NYPD." – Todd Moss
Born a Crime: Stories from a South African Childhood, by Trevor Noah
"The late-night TV host tells the stories of his childhood in the slums of Johannesburg where, being racially mixed, he belonged to no group. He finds his way through to his teenage years through tenacity, the unwavering support of his mother, and a preternatural sense of the absurdity of societal norms. It is a very funny and touching book. I listened to the book, rather than read it. Noah himself narrates and his theatrical vocal presence was the icing on the cake. Great for a long car trip!" – Mark Plant
In a Dark Wood Wandering: A Novel of the Middle Ages, by Hella S. Haasse
"Haasse tells the remarkable story of Charles d'Orléans, a celebrated medieval French poet and prominent nobleman. Head of a family caught up in bitter dynastic strife at thirteen, English prisoner of war at twenty-one, Charles spends much of his life struggling against forces far beyond his control. And yet, even as his life's joys are snatched from him and his freedom denied for 25 years, the poet finds a way to live his life with dignity and grace. A stunning meditation on nothing less than the meaning of life itself, Haasse's work presents the vibrant, tumultuous world of the later Middle Ages with rare compassion and understanding." – Mallika Snyder
We hope you enjoy these summer selections! For more reading recommendations from CGD, subscribe to our weekly "What We're Reading" newsletter.
October 2, 2017
Publications
Disagreement over how investments in the private sector are counting to aid is threatening to overwhelm the OECD Development Assistance Committee. There are no perfect solutions here; governments must find the least-bad compromise. We point the way forward.
October 31, 2017
Blog Post
Development Finance Institutions (DFIs) exist to promote development by investing in the poorest, least developed countries. They often route those investments via holding companies or private equity funds domiciled in tax havens. On the face of it, that seems absurd: tax havens are widely seen as a drain on development, depriving cash-strapped governments of billions of dollars in public revenue. Should the shareholders of DFIs demand a stop to this practice, as civil society urges?
In a new paper I argue that whilst widespread opposition to DFIs investing via tax havens is understandable, it is misguided. Banning the use of tax havens would do more harm than good. The argument rests on the answers to two questions: what do DFIs use tax havens for, and what are the alternatives to using them? The short answers are that tax havens are used to compensate for shortcomings in the legal systems of the countries that DFIs invest in, and that if DFIs stopped using tax havens, they would use onshore financial centres in rich countries instead. And that would not help developing countries one jot.
Why should DFIs continue to use tax havens?To simplify matters, let’s say we care about two things: the amount of tax that developing countries raise from foreign investors and the quantity of investment in capital-scarce countries. We care because taxes pay for public services and investment creates better jobs and produces goods such as renewable energy.
Most of what we hear about tax havens has to do with multinational corporations shifting profits to low-tax jurisdictions. But in the context of where investors put their holding companies, what matters more are bilateral tax treaties. These are what determine whether investors pay a reduced rate on dividends or are exempt from capital gains tax, for example. Only a few tax havens have advantageous tax treaty networks, but established financial centres like London and Amsterdam have extensive networks. So as a rule, swapping a tax haven for an onshore financial centre would not help developing countries gather more tax.
A case in point is a recent accusation that a structure that CDC has invested in, via the fund manager Actis, has deprived the Ugandan government of £38m in capital gains tax by using holding companies based in Mauritius. As it happens, the UK also has a tax treaty with Uganda, so if Actis had put its holding companies in London, no capital gains taxes on the sale of equity would have been due in Uganda (and interest on the shareholder loans would have been taxed in London, not Uganda).
How about requiring DFIs to invest directly, without using holding companies or fund managers? Holding companies and funds should be “tax neutral” in the sense that their use does not result in investors paying more tax than they would when investing directly—this is why they will always be domiciled in specialist financial centres that allow for that (and meet legal and regulatory requirements). DFIs say they invest directly when they can, but that holding companies are sometimes useful for legal reasons and delegation to specialist fund managers works better when trying to invest in small businesses. The Ugandan power generator Umeme was once part of a multinational group, so some sort of cross-border holding company was inevitable. Less investment would reach developing countries if DFIs stopped using holding companies and delegating to funds.
Instead of avoiding tax havens, we need to reform tax treaty networks in favour of poor countriesAt this point you may have two reactions: Why not regard London and Amsterdam as tax havens too? And how do we know the claims DFIs make, that the use of tax havens typically does not deprive developing countries of tax revenues but serves a useful purpose, are true?
The fact that problems with treaty networks and secrecy extend beyond stereotypical tax havens points towards the need for broader systemic reforms. Blacklisting a handful of islands is not the goal—raising standards however investments are structured, is. Multinational initiatives like the Global Forum on Transparency and Exchange of Information for Tax Purposes and the Common Reporting Standard are addressing problems around secrecy, but the points of leakage in bilateral tax treaty networks have not yet been fully addressed. To widespread acclaim, the OECD has introduced something called the “multilateral instrument” (MLI) to simultaneously update multiple tax treaties, and has used it to address certain weaknesses that enable “treaty shopping.” To really fix the problems that lie beneath routing investments via third-party jurisdictions, we need a “development MLI” to focus on the needs of the poorest countries, including minimum tax rates on dividends, interest, and capital gains.
The lack of evidence around the tax impact of using offshore vehicles is a thorny problem. The question of whether poor countries are deprived of tax revenues cannot be answered without specifying a realistic alternative, and that requires more than data—it requires informed but subjective judgements. But if it is wrong to ask DFIs to stop using tax havens, it is right to ask them to do more to enable public scrutiny of those investments. DFIs must invest effort into defining the tax implications of the offshore structures they use, and make that information public.
March 27, 2018
Blog Post
Last year the World Bank adopted a new “cascade” approach that intended to maximise finance for development by prioritising private solutions wherever possible:
Source: World Bank
In what world would this “cascade” algorithm make sense? Without a good answer to that question, the cascade risks looking like ideology rather than sound development finance advice.
An economist explores the questionWorld Bank economist Tito Cordella has published a fascinating theoretical exploration of this question “Optimizing Finance for Development”, focused on the optimal sequencing of the three possibilities: reform, subsidies (risk mitigation), or public funding.
But as economists are wont to do, Cordella strips his model down to the bare minimum needed to analyse the question in hand. Yet his model contains some ingredients that could help us think about the cascade more broadly. Moreover, it is not always obvious how to connect his stylized model back to reality. This blog post tries to do that. Before proceeding, it should be noted that World Bank research economists do not speak for the Bank and so this is not an attempt to hoist the Bank on its own petard: what matters are the arguments being made, not who is making them.
Efficiency firstAs an economist, the first question Cordella asks is: which is more efficient, public or private? When Cordella writes that “to focus on the policy relevant trade-offs, most of the analysis features the case in which the private sector has an efficiency advantage”—that’s because for him when the public sector is more efficient the solution is trivial: the public sector should do it. That is a significant departure from, “if the private sector can do it, it should.”
But I suspect many people may feel that even basing the choice between public or private on efficiency is too reductive. Many North Americans fundamentally object to the idea of socialised medicine—for example—whilst many Europeans find the American health system equally objectionable. Societies have different ideas about fairness and equality. We could interpret “efficiency” more broadly, meaning that we want to satisfy social preferences in the most efficient manner possible. Or we could see the role of the Bank as setting out the costs of achieving various social outcomes and leaving it to the political process to decide what’s worth the price.
In Cordella’s model, public and private are assumed to have the same cost of capital but differing levels of efficiency across projects, which shows up in the form of different rates of financial return: greater efficiency means higher returns. Beneath the abstraction of a model, what do financial returns mean in the context of public provision? Some public projects charge user fees (e.g., utilities) but the government can also capture financial returns via incremental economic activity, which is taxed. Efficiency is a simple model parameter, but in reality the analysis of public versus private efficiency would (should) be complex: all else equal, perhaps public schooling is more efficient because it reaches the less well-off, and lower inequality is good for growth and tax revenues. Perhaps public roads are more efficient because they have a larger economic impact on overall economic activity than a toll road. The model also recognises that efficiency is not just about returns that can be internalised financially—projects create externalities. Cordella assumes externalities are the same under public and private provision, but that is merely because he is not interested in that aspect of the problem; the theoretical implications would be trivial: all else equal, if positive externalities are larger under public provision, the public should do it.
Cordella is focused on the set of projects where the private sector has an efficiency advantage, but the returns are not sufficient to induce investment. For these, there is an interesting problem of whether, and how, to bear the costs of overcoming that. His model introduces two helpful ideas: policy reforms that improve the commercial viability of projects can come at a social cost, and subsidies to induce private participation can be too expensive. This is a useful contribution to policy debates over “blended finance” which thus far have had little to say about when levering the private sector is not worth the trouble.
The analysis reveals that sequencing of the cascade algorithm only matters because governments are unable to perfectly fit instruments to projects. If subsidies and reforms are precise and project-specific, sequencing is irrelevant. But if the cascade approach is implemented in stages where, in effect, the “reforms department” does as much as it can with its instruments first before passing on the residual of projects to the “subsidies department,” then the sequencing is important. Cordella finds that contrary to the “cascade” it is best to apply subsidies first, and crowd-in the projects which are close to commercially viable at low cost, before turning to reforms when they come at a meaningful social cost. If reforms are cost free, the implications are trivial: do them. Cordella concludes:
The objective of maximizing private finance for development may conflict with the objective of optimizing finance for development.
A different motivationHowever, the cascade is motivated by something that does not feature in Cordella’s model: the scarcity of public funds. There is no government budget constraint in the model. It could be introduced by assuming the cost of public finance is increasing in the quantity of public projects, so that “efficiency” becomes combination of costs and returns. The effect on Cordella’s model would be to expand the set of projects where the private sector has an efficiency advantage, and thus candidates for the cascade. Presumably the cost of financing subsidies would also reflect the increasing cost of public finance and the last-resort public option would become less often feasible, so the importance of reforms would rise. Behind the cascade model lies the idea that developing countries have reached the limit of fiscal space, so choosing private solutions where they are available is the only way of getting more done.
A counter argument is that if an economy can afford to pay for a new airport, for example, via users fees high enough for a private provider to make profits, then it should also be able to afford to pay those fees to a government-run airport or to pay via taxation. If the government has a profitable investment opportunity, it should be able to raise finance without seeing its cost of capital increase. Of course, if the government would be less efficient—perhaps it faces capacity constraints that aren’t about money but are about human resources—then that would settle it. But the cascade’s “private if possible” rule makes sense if the scarcity of public funds dominates efficiency considerations, otherwise relative efficiency should be the deciding factor. And if the public sector is equally efficient, in the sense of being equally able to capture financial returns, then it should also be able to find the money. The public budget should not be regarded as fixed, irrespective of what positive return investment opportunities that the government faces.
Maybe there are too many “shoulds” in the previous paragraph. Governments may not be able to finance all their positive-return projects. The cascade could be justified as a second-best solution for a second-best world. It may also be better seen as a signal that the Bank is now more receptive to collaborating with the private sector, rather than as a rule to be followed to the letter. But even on a more sympathetic reading, a stated policy of unconditional preference for private provision may be hard to sustain.
Unconditional support for private finance is untenableOpinion in some of the Bank’s shareholder countries is turning against private finance. More importantly, citizens of partner countries are reading stories like this: the American contractor Bechtel is lobbying the Kenyan government to choose conventional public procurement for a new Nairobi-Mombasa expressway, because it claims the financing cost under a PPP will be five times higher ($15bn versus $3bn). There is no mention of World Bank involvement in this project, but it’s a useful example. Kenya is a country with public debt approaching unsustainable levels so perhaps choosing private financing for this expressway would preserve fiscal space for something else, such as an investment in public rural roads.
What’s more, straight comparisons of financing costs can be misleading, because they obscure who carries the can for cost overruns under the two models (we should not assume a construction firm has the client’s best interests at heart, especially if advocating a cost-plus over a fixed-cost contract). The right choice is not obvious, so advice from the World Bank could be useful here. A flow chart that points straight to the private sector is not.
Cordella’s model sets aside theoretical possibilities if the implications are trivial. It may seem trivial to conclude that the choice between public and private finance should juggle both public financing constraints and comparative efficiency, but the cascade doesn’t work that way. And it should.
November 21, 2017
Blog Post
Development finance institutions (DFIs) have long resisted the idea that they ought to support coordinated national development strategies in the countries that they invest in, but if conversations around private roundtables at the recent World Bank/IMF meetings are anything to go by, that’s where they may be heading. And if so, it may be the private sector itself that leads them there.
The buzzword of this year’s meetings was “transformative.” The new IFC 3.0 strategy of “making markets” reflects criticism of its traditional transactional model, with each deal seen in isolation. One shareholder at the meetings asked: If we are not being transformative, what’s the point?
Hopes of achieving the Sustainable Development Goals (SDGs) rest on diverting some of the trillions of wealth held in rich countries towards investments in poor countries, but DFIs know that simply increasing their deal volumes will not be enough. DFIs have set themselves the goal of being transformative, because they know that unless they can set investment booms in motion that go way beyond their own projects, the SDGs will not be achieved.
This is true. So is the observation that if I jump out the office window, I will die unless I learn to fly. But let’s not dwell on the realism of the ambition, and look instead at where it may take DFIs.
Some transformative ideas are on the supply side. Most DFIs operate a buy-and-hold business model, and ask the private sector to participate in their investments. But the perception is that most private investors too often find co-investing with DFIs more trouble than it’s worth. One much-discussed proposal is for DFIs to move towards an originate-to-distribute model, and to see their job as creating a diversified pool of assets, packaged in a way that a larger set of private investors find easy to buy. That would increase the supply of money looking for projects, but not the supply of projects looking for money. Development finance is already experiencing something of a supply shock, with many governments allocating more money to DFIs, and complaints about the lack of bankable projects are commonplace. One thing is certain: transforming the supply side will have a greater impact if complemented by something equally dramatic on the demand side. And this is what may take DFIs in some surprising directions.
Civil society has long urged DFIs to follow the principle of country ownership and to collaborate with host governments’ national development strategies. DFIs have always shied away from that suggestion, emphasizing the (ideally) decentralized and entrepreneurial nature of the private sector, and the risks of getting investment tangled up in politics, particularly in countries prone to clientelism. But around private roundtables at the recent World Bank and IMF annual meetings, private investors were heard calling for more “programmatic” investments, by which they meant coordinated investment plans. To give a simple example, a private investor can build a hospital but they want somebody else to build the reliable power supply it needs.
The Blended Finance Breakthrough Taskforce, convened to approach the problem from the perspective of the private sector, also presented some emerging findings at the meetings, including the desirability of projects “ideally linked to sectoral development plans and policy frameworks.” A star of the meetings was the Colombian development bank FDN, which is majority owned by the government but also has the World Bank’s IFC as a shareholder. FDN is governed like a private actor but has benefited from being connected to government for matters such as land acquisition and licensing in the construction of a national highways network. This combination of public and private has attracted investments from bulge bracket Wall Street banks. The idea that national development banks may have a more important role to play was subject of much discussion at the fall meetings.
Programmatic investments also have the potential for a bigger bang for each blended finance buck. That can happen if there are complementarities in production—the hospital is more likely to succeed if the power plant exists, and vice versa. If the success of one project relies on the success of others, private actors may not undertake investments unless they know that all the required complementary inputs will be created. Kaushik Basu, former World Bank chief economist, has written about how generous state guarantees can induce private investors to undertake projects they would not otherwise, and if these are coordinated then the likelihood of the guarantees being called falls.
Such ideas are not new. If this is the future, it is a return to the past of big push theories of development that dominated thinking in the 1950s and 1960s. These ideas fell out of favour because they were observed not to work. The evidence still suggests that surges in public investment tend not to create sustainable growth (although public investment remains one of the most effective ways of crowding-in the private sector. World Bank economists Maya Eden and Aaart Kraay have shown that on average across 39 low-income countries, “an extra dollar of government investment raises private investment by roughly two dollars, and output by 1.5 dollars”).
Optimists will say we have learnt from history and need not repeat it. Scholars such as Dani Rodrik have articulated a vision of Industrial Policy for the Twenty-First Century, with more emphasis on experimentation and less on top-down planning. We have learnt more about how to build markets starting from an unpromising institutional environment (and one might also say that China is showing the way with more programmatic investments around the developing world). None of this sits well with DFI’s traditional, demand-led business model. Of course, much of what DFIs do involves smaller businesses where these ideas are less relevant, and some of the smaller bilateral DFIs may be more effective in other niches. But to my mind, greater cooperation with host governments and national development banks is where the ambition to be transformative is likely to lead DFIs. There are hard questions to answer about the conditions under which attempts at coordinated investment in collaboration with government are likely to succeed, and what the alternatives are in other cases, but in the face of demand from the very private investors DFIs want to attract, they must rediscover the art of activist industrial policy.
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