House of Commons - International Development

Select Committee on International Development Fourth Report

5 FINANCING PRIVATE SECTOR DEVELOPMENT

113. Donors have a number of mechanisms at their disposal for mobilising private sector finance and funding PSD policies. As DFID acknowledged in their Memorandum, the private sector has far greater potential resources — in terms of finance, human capital and regional and international networks — than donors, and finding ways to stimulate the investment of these resources is crucial to poverty reduction. This chapter will work through a series of the methods for PSD financing used by DFID and other donors, including risk finance (and DFID's primary instrument for risk finance, CDC); microfinance; support to Small and Medium-sized Enterprises (SMEs) and business sector development; challenge funds; Public Private Partnerships (PPPs) and remittances.

Risk finance and CDC

114. A shortage of risk capital - the provision of finance for investments perceived to be risky — is holding back the potential for pro-poor growth in many countries.[235] Risk finance is particularly important to major infrastructure and extractive projects where commercial finance may be conditional upon it, and where the minimum social, ethical and environmental standards set by risk finance agencies may be called into play.[236]

115. CDC is DFID's leading risk finance instrument. Created in 1948 as the Colonial (later Commonwealth) Development Corporation to develop the resources of Britain's colonies, CDC Group PLC was comprehensively re-structured (and re-named) in 1999, becoming a public limited company and de-merging the bulk of its operational capacity into a number of separate fund management companies in 2004, chief amongst them being Actis. These fund managers negotiate and manage the investment of CDC's capital in developing countries, to fulfil its mission of "maximising the creation and growth of viable businesses in poorer developing countries, through responsible investment and the mobilisation of private finance". CDC remains wholly owned by the UK Government and retains an investment portfolio valued at some £1.5 billion.[237]

116. DFID assured us that the re-structured CDC-Actis model is, largely, working well: it is making profits and the bulk of CDC's investments remain in developing countries.[238] DFID and CDC witnesses both told the Committee that a major benefit of the re-structuring has been CDC's greater ability to trigger a 'demonstrator effect' and mobilise other money alongside its own.[239] Richard Laing, the CEO of CDC, gave the example of a US$20million fund in India:

240

117. DFID sees CDC's role as an investment pioneer as an enduring one. Gavin McGillivray, Head of International Financial Institutions at DFID, told us: "I think within our lifetimes there will still be a strong role for pioneering investment because the frontier keeps on advancing."[241] We agree that there is a continuing role for CDC as an investment pioneer and provider of risk finance. The 2004 restructuring seems to have been successful in reinforcing CDC's 'demonstrator effect' and its ability to mobilise other money alongside its own.

118. However, a number of factors affecting CDC's contribution to poverty reduction lead us to believe that CDC's continuing role must be kept under careful watch. For instance, CDC's investment in agricultural projects — the mainstay of private sector activity in many developing countries — has dropped considerably, from 18% of its portfolio five years ago to 10% now. When we visited Mozambique and Malawi in March 2006, we witnessed at first hand the difficulties that African smallholders face in accessing capital. Richard Laing attributed agriculture's declining profile within CDC's portfolio to the fact that "returns on agribusiness were quite low".[242] Yet this conflicts with his earlier statement that: "The advantage of the current structure where we are still owned by government is that we are less return-sensitive and we can direct capital to those areas where maybe we will not maximise our return."[243]He went on to admit that, "On a disaggregated basis fund by fund we will have a very clear idea what our return expectations will be."[244] The UK Government, according to Richard Laing, set an aggregated target return of 5%.[245] Whilst accepting the UK Government target of a 5% market return should be met wherever possible, we consider that returns should be balanced with directing finance where it is most needed to reduce poverty. Agricultural investment within Africa is an urgent priority, and the provision of risk finance by CDC will encourage potential investors to step in.

119. CDC's mission statement of "generating wealth, broadly shared, in emerging markets, particularly the poorest countries" has also been brought into question. For instance, through its fund manager, Actis, CDC provided a significant proportion of the equity for the The Palms Shopping Centre in Lagos, completed in December 2005. Richard Laing's defence of this investment — that it will support Nigeria's middle classes, who are themselves key to the country's economic growth — is valid up to a point.[246] CDC's portfolio of investments must continue to be carefully scrutinised for their overall contribution to poverty reduction. CDC's social and environmental record is patchy and we recommend close monitoring by DFID on where and how CDC invests. Acting as an investment catalyst is a necessary but not sufficient contribution to poverty reduction: CDC must ensure that its 'development footprint' is a wholly positive one.

Microfinance

120. Microfinance is defined as credit, savings, insurance and money transfer services for relatively poor people.[247] Successful microfinance institutions (MFIs) have been proven to contribute to poverty reduction in multiple ways, helping poor people to increase incomes, build assets and save and insure themselves against times if increased vulnerability.[248] Microfinance has also been linked to increased access to education, improved women's and children's health and the empowerment of women (it has been estimated that 8 out of every 10 clients are women).[249]

121. Following the successful model famously pioneered by the Grameen Bank in Bangladesh, the last decade has seen a remarkable proliferation of MFIs. The Year of Microcredit in 2005 raised the profile of microfinance and brought banks, multilaterals and public sector bodies together.[250] DFID's continuing commitment to microfinance was recognised by witnesses. The Department's support for the Consultative Group to Assist the Poor (CGAP) at the World Bank, which has been a leader on the microfinance sector, was welcomed.[251] DFID extends support to a number of financial sector development initiatives, such as the FinMark Trust, that relate closely to microfinance.[252] But, as Citibank pointed out, the amounts that DFID contributes to microfinance — approximately £30 million per year — are relatively small in terms of global finance.[253]

122. With the exceptions of Bangladesh and Bolivia, microfinance has not reached an inclusive, sustainable level. Large-scale sustainable microfinance is best achieved when financial services for poor people are successfully integrated into the broader financial systems of developing countries.[254] Commercial banks continue to under-serve large swathes of the populations of developing countries: as Citibank admitted to us, banks have to find ways of reaching larger numbers of people in an affordable way.[255] DFID has worked towards this by combining the skills of the microfinance and commercial banking sectors, and in doing so has set itself apart from other donors' microfinance work.[256]

123. But there are risks to using donor funds to promote commercialised MFIs.[257] Using funds in this way could produce a bias towards more accessible geographical areas where economic activity is greater. It could risk compromising the 'social mission' of microfinance — for instance, the training traditionally carried out by NGOs and small MFIs that often goes beyond business to health, equality and community issues. DFID must continue to engage with banks and the not-for-profit financial sector to increase their reach to the poorest sectors of society. However, integrating microfinance into the commercial system requires care: efforts must be made to go beyond accessible, commercially-rewarding areas to reach the poorest, and to retain the 'social mission' of microfinance. DFID's annual expenditure on microfinance work remains limited and part of DFID's increasing budget could be usefully spent in expanding microfinance projects beyond their currently very limited range, embedded in a broader strategy of deepening financial markets. This could include partnership with the banking sector in providing business case evaluated unsecured loans to small businesses whose principals have few assets of land or other security.

124. A crucial determinant of the ability of MFIs to contribute to pro-poor growth is the regulatory environment in which they operate. Jay Naidoo, Chairman of the Development Bank of Southern Africa, described the problems experienced in South Africa whereby MFIs have taken advantage of unregulated environments. Charging high interest rates, these MFIs caused large numbers of poor people to become saddled with high debts, until the Government intervened and started to regulate more tightly.[258] Evidence from Bolivia and Mexico shows that competition helps to reduce interest rates in microfinance.[259] Microfinance institutions have to operate in a regulated environment, otherwise poor people are liable to be exploited. In parallel with its support to microfinance, DFID must seek to build policy environments that provide appropriate levels of regulation and competition.

Supporting SMEs and business sector development

125. Small and Medium-sized Enterprises (SMEs) are the backbone of private sector activity in most countries. Typically, they provide the overwhelming majority of jobs and — when operating in the formal sector — are large contributors to tax revenue and economic growth. SMEs can provide opportunities for employees to gain and use new skills and technology.[260]

126. Yet SMEs are also more vulnerable than multinational corporations to closure, exit, failure and economic shocks.[261] In certain sectors, such as agriculture, the vulnerability of SMEs is made more acute by climatic and seasonal variations such as droughts and floods. Start-up, survival and growth in SMEs is undermined by factors such as macro-economic turbulence; institutional weaknesses in legal and regulatory systems and resource constraints such as personnel, managerial know-how and finance.[262]

127. Donor support towards the development of SMEs has traditionally been in the form of direct intervention and provision of inputs such as business support services and finance. But this approach carries the risk of causing market distortions, as Bob Fitch, Project Director of the Financial Deepening Challenge Fund, pointed out: "The real challenge in SME development […] is how you foster their development without really disrupting the market."[263] Hence donors are now seeking to channel their support at the systemic level as well as ensuring direct assistance to businesses.[264] This sub-section will not re-explore the range of investment climate interventions employed by donors (see Chapter 3), but will focus on how DFID is seeking to directly support SMEs.

128. Donors provide Business Development Services — in the form of advice, consultancy, training, provision of market intelligence and other information, development of business linkages and building networks — to improve the quality and performance of SMEs.[265] Such services are crucial to 'the missing middle', a sector for which donors are sometimes criticised for paying insufficient attention[266], and one that DFID admits it is only "beginning to" engage with (for instance, through its 'Start and Improve Your Own Business' programme in China).[267] But as Alaric Fairbanks of Durham University highlighted, business development services are chiefly targeted towards larger companies; most transition and developing countries have little history of SME support services.[268]

129. To a large degree, business support services should be provided not by donors or governments but by business itself.[269] Ann Grant of Standard Chartered Bank told us, "If you can get banking people to help with business plans and with financial literacy [...] that is probably more efficient than setting up some kind of DFID-led super structure."[270] But an idealised notion that 'the market will provide' must not stand in the way of SMEs in undeveloped or missing markets receiving urgently needed basic assistance, which can be supplied and funded, to an extent, by donors and governments. Support to SMEs in the form of free business development advice and technical assistance is largely absent from transition and developing countries. Whilst any return to large-scale market intervention must be avoided by donors, DFID should not proceed to the other extreme and focus exclusively on investment climate work where SME growth is concerned.

130. SME growth has a number of linked concerns that donors and governments need to monitor. SMEs are often over-represented in sectors with high environmental impacts, and they may not be subject to the same regulatory codes as large companies.[271] Equally, SMEs are more likely to evade or be unaware of international labour standards. Less emphasis has been placed on Corporate Social Responsibility (CSR) issues for SMEs than for large business.[272] Whilst such codes should be driven by the SMEs and Southern stakeholders themselves, rather than donors, engendering dialogue on CSR can be usefully done by donors. DFID and other donors must be sure to include and prioritise SMEs in their dialogue with the private sector about social and environmental impacts. In their efforts to address SME growth, donors must concurrently pursue routes to improved adherence to international labour standards and codes on social and environmental abuses.

Challenge funds

131. Challenge funds are a form of public-private partnership that allocates public funds through a competitive process to meet specific objectives. Challenge funds are considered to have potentially important 'demonstrator' effects — that is, demonstrating the viability of a market opportunity and 'jump-starting' markets that are slow or fail to deliver without public sector assistance. DFID maintains that: "Whilst improving the environment and investment climate for business is seen as crucial, there is still a vital role for a mechanism that can engage more directly with the private sector, and stimulate or catalyse businesses to act in a certain way that is pro-poor."[273]

132. DFID is increasing its use of challenge funds within PSD. The management of these funds tend to be out-sourced to consultancies. Bob Fitch of Enterplan, the consultancy managing the Financial Deepening Challenge Fund (FDCF), believes this arrangement is sensible: "We can do it on a far more cost-effective basis than [DFID] could do it in-house [...] we are better able to talk and interface with private sector about business issues because we are a private sector business as well."[274] DFID's use of challenge funds was generally supported by witnesses, who praised the funds' ability to bring companies, NGOs, donors and multilaterals together and credited DFID's use of this "bottom-up" initiative in conjunction with "top-down" strategies regarding enabling environment issues.[275]

133. Witnesses pointed out the respective strengths of different challenge funds supported by DFID. The South African not-for-profit company SBP commended the Business Linkages Challenge Fund (BLCF), a £15million grant scheme aimed at building business linkages and improving competitiveness, as a "proactive instrument" for creating linkages within markets and "engaging directly with the private sector to help businesses develop their supply chains."[276] The FinMark Trust valued the FDCF for its "innovation in a sector which is notorious for 'upwards innovation' (aimed at serving existing clients better) rather than the 'disruptive innovation' that new markets demand."[277]

134. Challenge funds, however, are subject to criticism for failing to tackle broader systemic issues. As the ODI's submission noted, the short-term injections of finance that challenge funds provide could risk distorting indigenous markets by focusing on a small number of firms without adequate attention to sustainability and replicability once the grant period ends.[278] But Bob Fitch of the FDCF told us that, whilst earlier challenge fund work lacked strategic thought and clear linkages to other policies and the wider enabling environment, efforts to redress this were now being made — for instance, operating the new Africa Enterprise Challenge Fund (a $100million multi-donor initiative to be launched in November 2006) in tandem with the Investment Climate Facility (although Bob Fitch thought that "much more could be done" by DFID in terms of these integrated strategies).[279]

135. Mr Fitch, whilst positive about the lessons that have been learnt from previous challenge fund experiences[280], emphasised the need for coherent development programming in the use of challenge funds. He told us that, "The funding for the FDCF actually came to a halt in 2004, so we are staring at a three to four year funding gap for the market place and the danger there is that we are losing the momentum we built up."[281]Challenge funds are a useful tool for direct engagement with the private sector and can help to catalyse market activity where it is slow or non-existent. For reasons of sustainability and coherence, however, it is vital that DFID embeds challenge funds in wider PSD programmes — not least to prevent gaps in funding. The linkage of the African Enterprise Challenge Fund with the ICF is a promising sign that DFID is aware of this need to integrate grant funding with systemic enabling environment improvements.

Public Private Partnerships

136. One of the guiding principles for PSD set out in DFID's recent policy paper, 'Working with the Private Sector', is "recognising that partnership is the best approach to development".[282] Partnerships — especially Public Private Partnerships (PPPs) — were recognised throughout this inquiry as a major tool by which donors can finance and implement PSD.[283]

137. Private and public sector witnesses alike spoke positively of their experiences of PPPs. Petter Matthews of Engineers Against Poverty stated, "I think we have been through the myopic approaches that public is best and private is best and now we have a more nuanced understanding of bringing together the relative strengths of the different sectors."[284] Walter Gibson of Unilever described the Global Partnership for Handwashing with Soap as, "A wonderful thing because there is actually a shared vision at the heart of it [...] The private sector interest is the increased use of soap will expand the market; the public sector interest is promoting health."[285]

138. Several PPPs were put forward as models for success, including the Global Alliance for Improved Nutrition (GAIN), a partnership created to fight vitamin and mineral deficiency, whose partners include USAID, the Canadian International Development Agency, Unilever, UNICEF and the World Bank. GAIN's particular strength, according to its Chair, Jay Naidoo, is its ability to establish self-sustaining, market-driven programmes that become self-financed after initial donor funding.[286] Another success story is SABMiller's Eagle Lager project, a PPP between SABMiller (a large brewing company), the Ugandan Government and a local Ugandan NGO, Afro-Kai. Eagle Lager has been produced from locally-produced sorghum in Uganda since 2002 and is now Nile Brewery's top brand with a market share of around 50%. 8,000 local Ugandan farmers are benefiting from contracts to grow sorghum at guaranteed prices and this number is expected to grow as demand increases. Sue Clark, Director of Corporate Affairs for SABMiller, told us, "The partnership point of view is very important: this was a government/NGO/business partnership and all three actors in that played a very significant role."[287] Debswana, the diamond company held in equal parts by De Beers and the Government of Botswana and another successful PPP, told the Committee of how "the state in full partnership with the extractive industry" has helped to ensure Botswana's diamonds have paid developmental dividends as well as financial profit.[288]

139. The health sector, in particular, has seen a recent proliferation of PPPs, set up to develop new medicines, drugs, vaccines or diagnostics relevant to developing countries. These include Global Alliance for Vaccines and Immunisation (GAVI), the Global Fund to fight AIDS, TB and Malaria, the Stop TB partnership and Roll Back Malaria. The UK Government has provided both financial and technical support to these PPPs, and has also developed the International Finance Facility for Immunisation (IFFI) to leverage finance from capital markets to develop vaccines and vaccination programmes through GAVI.[289]

140. Two submissions expressed concern about the lack of donor and government funding for health sector PPPs. The George Institute were critical of the fact that health industry PPPs working on Research & Development (R&D) for neglected diseases receive very limited public sector support.[290]Dr Valerie Curtis of the London School of Hygiene and Tropical Medicine made a similar point in her written evidence: that donors should develop and make widely available the means to support R&D for health goods such as cost-effective soap formulations, water purifiers, sanitation solutions, primary health care facilities, schools and offices.[291] Numerous successful examples support the use of PPPs as a means to finance and implement PSD. The UK Government has shown innovation in spearheading the International Finance Facility for Immunisation and should explore other creative funding models for PPPs such as the self-financing Global Alliance for Improved Nutrition. In addition, the UK Government should engage with governments and donors to address the funding problems experienced by the growing body of PPPs working on healthcare R&D, especially those working on neglected diseases.

Remittances

141. 175 million people live outside their home country[292] and many of them regularly send funds back home.[293] Global remittance flows to developing markets were estimated at £73 billion in 2004; this value has grown by 13% annually since 2000. Migration and remittance experts argue that the unofficial transfers could be as large as formal flows. This could represent to a total annual flow to developing countries of £146 billion.[294]

142. World Bank research indicates that a 10% increase in international remittances for each individual migrant will lead to a 3.5% decline in the share of people living in poverty.[295] In order to maximise the potential contribution of remittances to poverty reduction, the barriers to increased flows must be addressed. Many of these barriers are linked to the private sector, for instance, the high charges imposed by banks for money transfers. As the previous Committee said in its Migration and Development Report, published in June 2004, if transaction costs are to be reduced, then the market for remittance services needs to work better so that service providers compete harder, to offer better and cheaper services.[296] Citibank acknowledged that "Banks have done a pretty poor job intermediating remittances", and that currently there was a tendency to treat remitters as transactors rather than as clients.[297] Seeing remittances as part of a client package will encourage banks to push transaction costs lower.[298]

143. It is more likely that improving competition will be the factor that drives down the costs of remitting. As the UK Money Transmitters Association told us, "One of the major weaknesses of the UK money remittance arena is that the market is not fully competitive [...] The UK money transfer market is dominated by two large money transfer companies creating, in effect, an oligopoly." The Association suggests one straightforward way to take action on this monopoly would be to extend the Post Office's current exclusive agreement beyond one large money transfer company.[299] Encouraging commercial banks to better facilitate remittance flows is a key example of how DFID can influence the private sector in contributing to development outcomes. To help increase remittance flows, banks must reduce transaction costs. The UK Government should engage with banks to encourage cheaper and more competitive services.

144. DFID runs a number of remittance programmes at country level, for instance the Bangladesh remittance country partnership launched in 2005.[300] The Department also funds the UK Remittances Taskforce, a private sector-led initiative, and the Sending Money Home website, which include market data and price comparisons for companies sending remittances from the UK. According to the UK Money Transmitters Association, some doubts remain as to whether money transfer customers (as opposed to industry specialists) find this website useful.[301]

145. AfricaRecruit emphasised that inward investment flows from the diaspora go beyond remittances. Many members of the diaspora invest in their home countries in other ways, and efforts should be channelled into facilitating these flows. For instance, the private sector could help to create health insurance schemes for extended family in Africa, mortgage packages and investments in overseas stock exchanges.[302] We consider that, as part of its dialogue with diaspora organisations, DFID should explore existing diaspora practices regarding remittances and other inward investment schemes and help engage the private sector to find additional ways — beyond remittances — to channel investment into home countries.

235 Ev 162 Back

236 Ev 183 Back

237 Ev 161 Back

238 Q 68 [Gavin McGillivray]. An Investment Policy agreed with the UK Government requires that 70% of CDC's new investments must be in poorer developing countries and 50% must be in sub-Saharan Africa or South Asia. Back

239 Q 69 [Gavin McGillivray] and Q 95 [Richard Laing]. Back

240 Q 95 and Q 96 [Richard Laing] Back

241 Q 70 [Gavin McGillivray] Back

242 Q 99 [Richard Laing] Back

243 Q 98 [Richard Laing] Back

244 Q 135 [Richard Laing] Back

245 Q128 [Richard Laing] Back

246 Q 115 [Richard Laing] Back