How Should UK Development Finance Count as Aid?

The UK Secretary of State for International Development Penny Mordaunt spoke powerfully last week about the opportunities for expanding investment in developing countries, including through CDC, the UK’s development finance institution.

But a new proposal to count the reinvestment of returns on development finance towards the aid target would contradict the principle underpinning the rules on measuring aid, reduce the UK’s aid effort, and create volatility for other aid (and HM Treasury). CDC is a sound long-term investment of UK taxpayer funds—a fact which is obscured when the Secretary of State for Development gives the impression that she sees it as just a ruse to hit the aid target at the lowest cost to the taxpayer.

Here we look at the proposal on aid rules and argue that the UK should avoid the aid target limiting the Government’s investment ambitions.

“Capital and Compassion”

Last week, Penny Mordaunt gave a speech in which she set out her vision for the future of UK aid after Brexit. There was much to admire here—a genuine understanding of the mutual benefit of development investment; recognition of the role of the city; encouraging asset allocation to shift towards Africa; and highlighting the launch of the World Benchmarking Alliance (to measure and incentivise businesses on social impacts). More generally, Penny Mordaunt emphasised that Brexit was “never about withdrawing from the world, it was about engaging with it more and more directly.”

Still, the UK tabloid press trailed her speech as slashing billions from the UK aid budget and replacing it with private investment. This related to a new proposal to change international aid rules so that returns made on investments by CDC would contribute towards the UK’s 0.7 percent spending target. But is that what the proposal would actually do?

What are the aid rules for?

The purpose of having a common definition of official aid is to ensure comparability between donors’ efforts. Getting these definitions right is important—they need to accurately reflect the true cost of aid so that everyone has trust that other countries are not free-riding on their generosity, in a way that does not distort countries’ decisions away from giving aid through the most effective channels.

CDC investment does not count towards the Government’s borrowing (see our report with the IFS). Excluding CDC from government borrowing is technically correct, because CDC is an investment, not spending; but the government should take care to avoid creating a bias towards using more of the 0.7 percent aid target on CDC than is justified on the merits.

The story so far on development finance as aid

The debate on how to measure loans and other finance to developing countries in estimates of aid effort dates back to the first discussions of the OECD Development Assistance Committee (DAC) in 1966, even before Official Development Assistance (ODA) was fully defined in 1972. In 2014, the DAC made a historic agreement to only count the grant element of concessional loans, rather than entire face value.

In the latest episode of this debate, my former colleague Paddy Carter outlined the two main approaches to scoring development finance to the private sector as aid. The first, approach—known as the “instrument method”—involves calculating the grant-element of each loan separately once they are made (with a negative impact on ODA if returns are not reinvested). The second, which the UK lobbied for, is to count the full value of finance when it is transferred to an equity finance institution (like CDC) on the assumption that it will eventually all be used concessionally—the “institutional method” (with a negative impact on ODA if and when the capital and any returns are transferred back). This definition was also important because it enabled the UK government to score immediately its contribution to CDC, enabling it to scale up reported spending to meet the 0.7 percent target.

The OECD and DAC’s rules on private finance permit either approach. Neither method is perfect. Indeed, a key shortcoming is that both have a crude approach to the level of risk being taken in the lending, which may not give enough credit for higher-risk loans.

Should CDC profit count as new ODA?

The short answer is no. The Secretary of State’s proposal is that:

in future years as the amount of funding coming back into our own development financial instruments increases we should be open to using these profits to count towards the 0.7% and I’m exploring the scope to reinvest those funds with the [OECD] DAC

Under the “instrument method,” if CDC made profits on its investments then, when it used those profits to provide further loans, those additional (concessional) investments would count as ODA. However, under the “institutional method” the UK uses, by counting the total face-value of the transfer to CDC, it has already assumed that the entire value will be used concessionally at some point. The “return” earned on that is just the materialisation of the opportunity cost (or interest forgone) the UK gave up when it transferred the funds to CDC.

So, under the UK’s preferred method, additionally counting profits as Penny Mordaunt proposes would double count investment in CDC, exaggerate the “effort” through this channel, and so create artificial incentives to favour it. The DAC rules permit switching to the alternative “instrument method”—with a lock-in period to avoid double-counting—but are yet to define how.

Practical implications

Perhaps more concerning to most people than the arguments of principle above are the practical consequences. There would be at least three big foreseeable impacts if the UK succeeded in altering the rules.

1. First, the proposed change would mean less UK support overall to developing countries. Under current plans, the Government has announced an additional £3.5 billion in CDC over the period 2018-2022. If CDC continues to generate positive returns in line with its target of 3.5 percent this would, by 2022, generate some £260 million from its portfolio to reinvest each year, or twice that if CDC continues to achieve 7 percent growth. If the Government continues to implement the 0.7 percent target as a ceiling, this would mean £260 million less would be available for development through other channels relative to the current rules. Of course, this money might be spent on other public services—but it seems odd for the Secretary of State for Development to make a proposal to substantially reduce the resources to pursue the poverty reduction objectives she is responsible for.

2. Second, the proposal would introduce significant volatility into the aid budget. Since 2012, CDC’s annual returns have varied between 22.6 percent and -0.7 percent. But as any investment disclaimer will tell you, your capital is at risk—and CDC is increasingly investing in risky places. If CDC lost money, then under the proposed rule change, this would mean a negative impact on ODA. Even if CDC doesn’t lose any money and achieves its target return over 10 years of 3.5 percent per year, that could easily have an uneven profile (such as nine years of 8 percent compounded, followed by a collapse of 32 percent). Based on the expected size of the portfolio in 2022, that would mean HM Treasury having to find some £2.7 billion extra for ODA in that single year.

3. Finally, these effects could apply not just to all UK financial institutions (PIDG, GIF, AgDevCo) but potentially to all global donors’ development finance. Simon Maxwell at ODI identified this issue, and noted that with billions of assets under management globally, this would mean returns on those portfolios—already invested in developing countries—would newly count as ODA. Taking the United States as an example, if it followed suit with its new International Development Finance Corporation (USIDFC), and it met the CDC's target for returns with its $60 billion portfolio, this would artificially add $1.8 billion a year to global aid. If other countries take the UK approach of applying a ceiling to ODA, this could substantially reduce global aid.

Don’t let the aid ceiling limit investment ambition

The focus on the limitations of the ODA rules can be a distraction from the real business of accelerating development. However, the proposed DAC rule change contradicts the principle of the rules, and would result in materially less UK aid going to developing countries. Regardless of the mode then, it’s difficult for anyone that believes in the value of development aid to support that. On the rules, the UK could instead focus on ensuring they give proper credit for investment risk, which would legitimately favour CDC’s commitment to poorer countries.

More generally, the Secretary of State is right to draw attention to the investment opportunities that exist, and the strong possible returns. If the Government really believed in those returns, it would be strange to limit investment in them just because it interprets the aid target as a ceiling. CDC is a sound long-term investment of UK taxpayer funds: the Government should not behave as if it is just a ruse to hit the aid target.

We’re grateful for comments on an earlier draft of this blog post from Jesse Griffiths at ODI, Owen Barder, and Arthur Baker. All views and any errors are the authors.