New rules give donors too great an incentive to invest in the private sector

30 March 2016
Articles and blogs

What counts as aid? Part of the answer is spending on certain things, the other part is certain types of spending. Lending money at a profit is not aid; giving money away is. In jargon, we want to record donor fiscal ‘effort’.

This principle was recently made clear by changes to the rules governing how loans are scored as Official Development Assistance (ODA), so that only the ‘grant element’ of a loan gets counted, rather than the full face value of qualifying loans, to present ‘a fairer picture of provider effort.’

These rules matter, because the ‘rewards’ donors receive from recognition as ODA can influence spending decisions. What gets counted must reflect the true costs incurred by donors otherwise some forms of spending will be more attractive than others. 

Equity investments are a problem, from this perspective, because it is hard to estimate grant equivalence. For loans, that can be done with the help of a simple formula and some assumptions about things like ‘discount rates’ (although donors still don’t know in advance whether loans will be repaid).  

Last month the OECD Development Assistance Committee published new guidelines for aid to the private sector, which now allow donors to record the full value of money they give to development finance institutions (who actually do the investing) as aid.

This change was made for good a reason – the previous system, of counting a positive when equity is invested and a negative when sold, perversely penalised donors for successful investments – but it still doesn’t square with the principle of counting donor effort.

Donors must find a way of measuring the subsidies they provide

The recent shift by donors towards the private sector is potentially a good thing. The only road from poverty to plenty is via investment, and developing countries have long criticised Western donors for neglecting private sector development. Nonetheless there is a clear difference between investing and giving: making money in a country may be helpful, but it is not aid. Private equity funds are not charities.

Development finance institutions (DFIs) are there to make investments happen that would not if the private sector was left to its own devices; that means they make equity investments on terms that private investors would not.

The grant equivalence of that investment is to be found in the gap between the valuation implied by the terms of the DFI’s investment and the value that private investors would put on that enterprise, accounting for risk. The basic idea is that if you are paying £30 for something worth £20, you are giving away £10.

Estimating the grant equivalence of each deal upfront, and recording it as ODA, would avoid the perverse incentive created by scoring negative ODA when investments are sold. It might appear that treating the size of the subsidy that the donor is providing to private investors as ODA would give them an incentive to give unjustifiably large subsidies, but donors are always ‘rewarded’ in terms of ODA recognition when they spend more money. That is true for traditional aid via the public sector and NGOs too. ODA recognition is about what is spent, not what impact that spending has on development.

How do we know private sector development represents good value for money?

It is impossible to evaluate value for money without knowing how much donors are spending on supporting private sector investment.

ODI is hosting an event on the topic of evaluating development impact when public money is invested in private projects. Obtaining evidence of development impact is extremely difficult in this context, and there is a real challenge of striking the right balance between realism and accountability. But however that balance is struck, it will only ever be half the picture without information on the true cost to the public purse.

Development finance institutions might even benefit from providing more explicit information about subsidies and by framing the debate in terms of development impact per dollar spent – some DFIs attract criticism for funding luxury hotels, but perhaps the grant equivalent of those investments is zero (or negative). 

What this means for the UK

The UK recently decided to give £735m to its development finance institution CDC, over three years, and count that as ODA. That money will be used to acquire assets, largely equity in companies and projects in Africa and South Asia. CDC’s main objective is to promote development by supporting businesses, but it also aims to generate financial profits from its investments.

There is an argument that, because CDC will keep the money invested for the foreseeable future, it makes sense to treat the money as sunk: money invested and only coming back in the distant future is not terribly different to money gone for good.

But DFIs also want to encourage long-term investors like pension funds to invest in developing countries – we do not tell pension funds that money invested for the long-term is effectively sunk.

This issue extends beyond contributions to CDC. HM Treasury has set the DFID  target of £692 million of ‘non-fiscal’ expenditure in 2015-16. As the Independent Commission for Aid Impact notes, ‘The advantage to HM Treasury is that non-fiscal expenditure does not impact net public sector debt.’ Because DFID operates under a pre-determined ODA budget of 0.7 per cent of GNI, accounting details like this matter – in years when the face value of investments (or contributions to intermediaries) are counted as ODA, there’s less money for traditional aid.

Nothing here amounts to a criticism of the UK’s decision to invest more in stimulating private investment and less on traditional aid. But if ODA recognition was based on estimated upfront grant equivalence the UK could have done this without squeezing the remaining ODA budget to the same extent.

We need a better system for recognising private sector investments

We are living though a protracted period of austerity – circumstances which are likely to make governments particularly responsive to the incentives built into the rules for ODA recognition. But perhaps more importantly, as donors increasingly base their strategies around mobilising private investment, greater clarity about what they are really spending would benefit everybody.

Agreeing a methodology for estimating the subsidy implied by equity investments won’t be easy – this isn’t the place to go into details – but is a challenge worth taking on.

The idea of subsidising the private sector is politically awkward, but if donors are going to do it, they should be upfront about it. Often the subsidy they provide is small, making it easier to demonstrate value for money. Counting the full sum as ODA makes that harder.