Using aid to catalyse private investment: rhetoric vs reality

8 July 2015
Articles and blogs
The Addis Ababa Accord that will be announced next week will be the outward manifestation of financing for development debates that have been rumbling on for months. Everybody agrees on the need to transform development finance from billions to trillions but there has been less consensus on how.

Rich country governments do not want to cough up more money – instead they want to use aid to ‘catalyse’ finance from other sources. One way of doing that is to use small quantities of aid to ‘unlock’ much larger private financial flows, through a process known as blending or leveraging (blending also sometimes refers to one arm of the public sector subsidising another).

Developing countries are less enamoured with the idea, which is probably why the Accord will be rather noncommittal on the subject – the draft merely notes that aid can be ‘used to unlock additional finance through blended or pooled financing and risk mitigation’ that supports private sector development. But the enthusiasm of donors remains undimmed and this looks set to be a growth industry, post-2015.

Catalytic aid: rhetoric vs reality

The basic idea is that many investments in developing countries do not look sufficiently lucrative in private sector eyes, but with some help from donors to either raise returns or mitigate risk, the money will start flowing.

This catalytic role for aid has become the mantra in official circles (examples here from the UN, EU, OECD, and World Bank). But this enthusiasm for leveraging the private sector overlooks an inconvenient fact: it actually does little to increase the amount of money available to finance development.

If a donor has $10m of grant money to spend, it can already offer a concessional bilateral loan for a much greater sum on terms that would also cost the taxpayer $10m (known as the ‘grant equivalent’ of the loan). We are told donors need to leverage private finance to increase the quantity of available finance, but in the context of blended finance this makes no sense: if a donor has grant money to spend on blending then in principle it can afford to provide the loan itself.

Giving away a $10m grant to ‘unlock’ $90m of private market-rate loans is financial alchemy – it has the appearance of transforming a small sum into a larger one. Leveraging private finance is sold as a necessity, but it is actually a choice, which is being obscured by the rhetoric around the need to ‘mobilise more finance’.

Good reasons for using aid to leverage private sector investment…

This isn’t to say there aren’t good reasons to use aid to catalyse private finance by other means, for example by promoting an enabling environment that is conducive to investment. And there is a potential ‘learning-by-doing’ argument for blending: using subsidies to introduce private financiers to certain geographies or markets in the hope that unsubsidised finance will follow.

It is also important to distinguish between financial investment (just putting up money) and real investments (building businesses). Blending a private sector loan with a public grant is just about arranging finance. There are good reasons to subsidise private real investment, but donors can do that without using grants to boost returns on private financial investment.

Finally, while in principle donors do not achieve much by using the private sector to create concessional loans, in practice they may face political, budgetary and organisational constraints that mean blending public grants with private loans is an open door whilst others are closed. Donor governments may face gross borrowing constraints even though financing a concessional loan adds no more to the national debt than the grant equivalent.

…And a few less good reasons

There are also less creditable potential explanations for the embrace of blended finance.

It could be a means of side-stepping more stringent safeguard procedures and bureaucratic processes that govern public development finance (and arguably throttle demand for it).

It could also be a way of attaining recognition as official development assistance for the grant element, when the resulting loan would not meet the concessionality thresholds.

If there are good reasons for blending grants with private loans they are being hidden under the fig leaf of mobilising more finance. When development ministers return home from this year’s run of conferences, they must look past the hype about leveraging private finance and take a clear-eyed look at what it actually achieves.