Introducing Five Principles for the Use of Aid in Subsidies to the Private Sector

Development finance institutions like the International Finance Corporation and the UK’s CDC Group use public finance to support private investments in developing countries. At their best they can help create new markets and invest in the delivery of vital goods and services, creating good jobs and entrepreneurial opportunity along the way. They have been rapidly expanding over the past few years. One estimate by Dan Runde of CSIS suggests DFIs have grown from almost $12 billion in annual investments in 2000 to $87 billion in 2017.

While supporting this expansion, the donors that undergird DFIs have also pushed the institutions to focus more on poorer countries and fragile states. The IFC has committed to delivering at least 15 percent of its lending to low-income and fragile and conflict-affected states by 2030. The CDC is meant to invest purely in low and lower middle-income countries. Legislation creating the new United States Development Finance Corporation mandates concentration in the same set of economies.

Many DFIs (although not the USDFC) have accepted this mandate as part of a quid pro quo: a greater focus on more complex markets in return for aid resources that allow them to subsidize lending costs or accept risks they would not take on as part of their normal operations. The argument was that without this effective or direct subsidy, a lot of projects in ‘frontier’ markets would remain ‘risk-prohibitive’ and it would be impossible to increase investment volumes.

Certainly, DFIs have struggled to expand their operations in low and lower middle-income countries, facing severe constraints in terms of suitable firms and bankable investments despite a considerable ramp-up of technical assistance designed to expand the project pipeline.

But the use of aid to subsidize private firms through DFIs raises significant concerns because their traditional model is not well designed to maximize the impact of government subsidy. In a paper published today, I discuss the problems faced by DFIs in the use of subsidies and, based on that analysis, propose five principles on how to use aid more effectively to finance private companies. These five principles are:

1. The choice of (and level of) subsidy should be based on public policy priorities because scarce aid resources should be used to achieve the maximum development impact, not allocated to private firms on a first-come, first-served basis.
2. The norm for subsidy allocations should be competitive approaches or open offers because negotiated approaches are less efficient, more likely to lead to rents and crowding out, and subsidies in response to unsolicited proposals could result in competition between DFIs on the basis of subsidy level.
3. Non-competitive subsidies should only support market making because they should be prioritized on grounds of providing information spillovers, not the level of private sector interest in attracting below market finance.
4. The level of bespoke subsidy provided to an individual investment on the grounds of information spillovers/industrial policy should be capped, on the grounds that the larger the subsidy, the less likely similar investments will be possible without subsidy, and the lower any spillover benefits from the project.
5. Subsidy terms should be transparent because: (i) information on subsidy levels will help create market interest/knowledge; (ii) aid transparency is important for governance—taxpayers and beneficiaries have the right to know who is getting how much for what; (iii) transparency will help reduce the risk of subsidy competition.

Some commentators have suggested the principles may lock DFIs out of some deals. This is possibly true, but the deals it would lock DFIs out of are deals DFIs shouldn’t be doing. And this raises a broader question about the outsized expectations being placed on development finance institutions. Donors may have to accept they are asking too much when demanding a whole range of DFIs each considerably expand their operations in the poorest countries where only a small part of the private sector in those countries lends itself to the institutions’ traditional investment model. Introducing subsidies does not significantly relieve this constraint, while it does add the risk of wasting aid. It is time for a broader discussion as to what donors want out of development finance institutions working in poorer economies: more deals, or better deals?

Read the paper now.