The Future of UK Development Co-operation: Phase 1: Development Finance - International Development Committee Contents


4  Lending to the public sector

Potential role for UK bilateral concessional loans

40. In this Chapter we consider the potential advantages and drawbacks of DFID providing concessional loans to partner governments. The International Development Act 2002 gives DFID the power to provide loans—a power which the UK Government used before the 1980s debt crisis—but the vast majority of UK bilateral ODA is currently provided in grant form.[87] According to a recent analysis by Development Initiatives, only a small number of donors disburse significant amounts of bilateral ODA loans, with 90% of these in 2011 coming from Japan, France and Germany, and Japan's loans being more concessional on average than those of France or Germany.[88] OECD DAC regulations stipulate that "to qualify as ODA, a loan must include a 25% "grant element", in comparison with a loan of similar nominal amount and duration carrying a 10% interest rate". The term 'concessional loan' is often used more broadly to refer to loans which have preferential terms such as a lower interest rate and/or, a longer or more flexible repayment term, and to loans for projects with higher risks which would not attract market rate loans.

POTENTIAL ADVANTAGES OF CONCESSIONAL LOANS

41. Several witnesses said that loans had potential advantages, provided that they were carefully and appropriately targeted.[89] There are many large public sector projects, particularly infrastructure projects in Africa, which require long-term financing, potentially in politically unstable countries, which is often not available, or affordable, through the market.[90] A key benefit of concessional loans is the ability to mobilise large levels of upfront financial resources, with affordable terms and conditions, for these projects.[91] Matthew Martin told us that many recipient countries were already using concessional loans and were also being pushed to fund infrastructure on much more expensive loans, such as borrowing on bond markets and doing off-budget PFI deals in an extremely high cost way. He added that the alternative of having lower cost concessional loans would probably be very welcome to them, and suggested that loans should be focussed on high-return projects, public-sector projects which had a high impact on growth and development, and where there was currently a real funding gap.[92]

42. Other arguments offered in favour of loans are that they can help recipient countries improve their debt management capabilities; they can strengthen partnership and cooperation; they offer flexibility to meet specific project needs; and they can provide a way of offering a larger volume of funding and over longer term periods.[93]

POTENTIAL DRAWBACKS OF CONCESSIONAL LOANS

43. A key drawback of loans is the risk that they can lead to an accumulation of debt which, if not managed well, can threaten the future stability of vulnerable economies. Concessional loans can however help countries reduce their exposure to indebtedness by providing an alternative to riskier and more expensive loans. The TUC pointed out that an accumulation of debt could threaten the stability of vulnerable economies, but said that it had no objections to the setting up of a separate financial institution for concessional development finance if the new institution were to provide additional finance for development. However it also argued that concessional finance could be provided more effectively by other existing financial institutions.[94] Peter Chowla, Coordinator, Bretton Woods Project, said that public-sector concessional loans "need to be carefully and strategically used for different kinds of things because of the debt-creating nature of them, the governance arrangements over how they are controlled, and potentially the purposes and strings that might be tied to them".[95] Richard Manning was of a similar view, saying that "To me, a critical issue is the proper use of these funds and whether we have a good system internationally for encouraging debt-creating flows to be used in a sustainable manner."[96] Investing in large public and private sector projects is not risk free: there are, sadly, many examples of poor use of aid in past years on private investments and large public sector infrastructure projects which failed to deliver long-term development benefits commensurate with their cost, but nevertheless left the countries concerned with high levels of development debt, which in the case of many least developed countries was eventually written off by donors.

44. Several witnesses mentioned complications with regard to the calculation of the ODA element of loans. Loan repayments count as negative ODA and so DFID would need to forecast these, as well as tracking new grants and loans, in order to monitor its total annual ODA contribution. Some experts have questioned whether the OECD DAC definition, requiring concessional loans to include a grant element of at least 25%, is applied sufficiently rigorously, and have suggested that this issue should be addressed in the ODA definition review being undertaken by the DAC Expert Reference Group on External Financing. Some question the current rule where countries which borrow at market rates in developed countries and on-lend to developing countries with a mark-up but below ODA rates, can count that finance as ODA. The TUC stated that "There is growing criticism of current methods of the degree of concessionality - grant element - of loans taken out by some developing countries from developed nations including France and Japan. In fact, the methods used by DAC tend to inflate the grant element significantly."[97] Richard Manning agreed, saying that "some countries are counting flows that are not really concessional because of how the OECD has chosen to [define ODA]".[98] Another issue raised by witnesses was the difficulty of tracking the development outcomes of loans. For example, the UK Aid Network and Bond maintain that any increase in the use of loans must be assessed against the risks which include "lack of transparency, lack of evidence of impact or very long evidence chains".[99]

45. Diana Noble, Chief Executive Officer, CDC, cautioned against any rapid change of focus for DFID, saying that "It really takes time to scale up teams and strategies. The history of CDC shows that the biggest disasters happened when CDC rushed into a market too quickly, without really understanding what worked at small scale and before accelerating investment over time. One of the big challenges will be to resist the temptation to give a new team a big pot of money and incentivise them to spend it quickly."[100] Owen Barder argued against any major change of approach for DFID, saying that it should continue to focus on providing grants to the very poorest:

    We have learned lessons about how to deliver aid effectively over the last 50 years. That means we should continue to do that, and not follow the new donors into less effective ways of giving aid. The fact that there are more people giving hard and concessional loans should focus us on the areas where aid can make most difference in grant form. I think we should resist the tendency to be pulled into doing more of what everybody else is doing, because if aid does not focus on the very poorest, most marginalised people, who will?[101]

46. The Secretary of State agreed that there was a need for greater clarity of the OECD DAC definition of concessional loans, and also for the accounting of other instruments such as guarantees.[102] However, she expressed reservations about the option of UK bilateral loans in the immediate future saying that:

    We do not have any plans to do any concessional loans directly to governments bilaterally. Our sense is that a more sensible route is to work with multilateral agencies, which often have the scale and reach, and can pull in not only other donor investment ... but also the private sector.[103]

The Secretary of State suggested that a multilateral approach was particularly appropriate for many of the infrastructure projects in Africa because "these are very big projects that no donor country could finance on its own or would want to finance on its own".[104] However, she indicated that DFID might consider providing bilateral loans on a case-by-case basis, and said that "there is a range of different mechanisms we can use in order to carry out investment. It is about finding the right one for the project".[105]

47. There are many large public sector projects in the developing world which require finance. Concessional loans are one way of supporting such projects which have potential economic benefits for developing countries. They can offer benefits to donors in terms of recycling finance and leveraging additional finance; and to recipients in terms of offering a less expensive option to market loans. For concessional loans to be effective, donors need to have the appropriate skills and expertise to ensure that loan finance works properly and is used appropriately, so that projects are fully implemented and achieve the desired development impact; that the debt sustainability of the recipient country is not threatened; and that the loan is repaid.

48. The Secretary of State told us that DFID would continue to provide concessional loans where necessary through multilaterals, but that it had no immediate plans to start offering bilateral concessional loans. She also said that DFID might consider providing bilateral loans on a case by case basis. This ambiguity could be confusing.

49. We believe that there is a strong case for providing concessional loans, especially to lower Middle Income Countries. For example, DFID is working with the Indian Government on a programme to support the transition from a grant aid based relationship to one of mutual cooperation on trade and economic development. We believe that DFID should consider the scope for providing loans to regional governments within India as part of this transition programme, in order to support public sector projects in those regions which continue to have high levels of extreme poverty. This could provide a model for the transition arrangements for other middle income countries.

50. We recommend that DFID sets out criteria which it can use to judge whether it still has the most appropriate multilateral and bilateral instruments. Given the rapidly changing context, it should actively consider introducing new finance instruments, or it will risk reducing its effectiveness. We recommend that DFID includes an assessment of the following issues in its finance strategy:

·  Is there a demand for bilateral concessional loans for public sector projects, and if so, from which countries and sectors?

·  What additional skills and expertise would DFID need to provide and manage bilateral loans? What additional processes would it need to introduce?

·  What are the relative merits of providing loans through multilaterals, and bilaterally? In what circumstances and for what projects would DFID consider providing bilateral loans?


87   Ev 88 Back

88   Ev w48 Back

89   Eg Ev 92, Ev w10, Ev w5 Back

90   Ev w 48 Back

91   Ev 114 and Q29 Back

92   Q 30 Back

93   Note on development banks, Dirk Willem te Velde, Annex 2 Back

94   Ev w1 Back

95   Q 28 Back

96   Q 2 Back

97   Ev w1 Back

98   Q 20 Back

99   Ev w10 Back

100   Q 177 Back

101   Q 42 Back

102   Q 231 Back

103   Q 235 Back

104   Q 236 Back

105   Q 246 Back


 
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Prepared 13 February 2014