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Finance for Sustainable Development

This policy brief covers a discussion on finance for sustainable development held during a full day conference at the Stockholm School of Economics on May 11, 2015. The event was organized jointly by the Stockholm Institute of Transition Economics (SITE) and the Swedish Ministry for Foreign Affairs, and was the fifth installment of Development Day – a yearly development policy conference. With the Millennium Development Goals (MDGs) expiring in 2015, the members of the United Nations are now in the process of defining a post-2015 development agenda. The Sustainable Development Goals (SDGs) build on the eight anti-poverty targets in the MDG but also include a renewed emphasis on environmental and social sustainability. Whatever targets or goals will be agreed upon in the end, we know for certain that reaching the objectives will require substantial financial resources, far beyond the current levels of official development assistance (ODA). To discuss this issue, the conference brought together a distinguished and experienced group of policy-oriented scholars and practitioners from government agencies, international organizations, civil society and the business community.

The Millennium Development Goals (http://www.un.org/millenniumgoals/) were established in year 2000. At that time about half of the UN assembly were middle-income countries. Today, the share has grown to two thirds. If this positive development is continued, only five percent of the world’s population is estimated to live in poverty by 2030. Although remarkable progress has been made in many respects, the achievements vary significantly across countries and regions. In Asia, many countries have experienced high economic growth and achieved a large reduction of the proportion of people living in poverty. In Africa, on the other hand, the greatest improvements can be found in terms of lower child mortality.

Furthermore, the financial landscape of developing countries has changed dramatically during the last decade. While the relative share of ODA from OECD-DAC members has diminished (although not necessarily for all recipient countries), foreign direct investments (FDI), remittances, south-to-south financial flows, and private aid have become more important. Thus, in the coming negotiations of the post-2015 development agenda, the challenge is to make sure that these diverse flows contribute to a development agenda, and that they do not all go to the same destinations leaving citizens in more challenged environments to fight for themselves. It is also important that credible commitments are made at the international as well as the domestic level, and by both public and private actors.

Private Aid

Foreign aid was for a long time almost exclusively associated with bilateral aid from a small set of OECD countries, and multilateral aid from large International Finance Institutions (IFIs) such as the World Bank. This picture is quickly changing as new bilateral donors, multilateral funds (e.g. the BRICs New Development Bank and the Asian Infrastructure Bank), and private donations are growing in significance. While it is difficult to know exactly how much private development assistance (PDA) is being disbursed, estimates suggest that some 45-65 US billion dollars were disbursed in 2014. This can be compared to the World Bank’s commitment of 40.8 US billion dollars. Moreover, if we restrict attention to what is referred to as country programmable aid, then PDA and OECD-DAC aid are in comparable amounts.

The new actors in development finance offer new sources of revenues and (at least the private actors) have been found to make more use of local knowledge, and to have lower overhead and administrative costs. PDA is also believed to be less susceptible to leakage as it often can bypass public sectors in recipient countries, and do not tend to allocate aid based on country strategic alliances.

However, there are also challenges with PDA. The presence of more actors creates a risk of increased duplication costs, aid volatility and competing agendas. It is therefore important that the PDA community develops its own agreements on effectiveness, commitments, targets and indicators, and that a global initiative is taken to gather, analyze and map private-aid flows and their impacts.

Incentivizing Private Investment in Developing Countries

With the current discussion of a new post-2015 development agenda, a lot of attention is given to the question of how to attract more private capital into development finance, particularly in the areas of infrastructure, and social sectors such as education and health. The question is what kind of instruments and incentives can attract private companies and institutional investors into what are largely public goods and services, in relatively high-risk environments.

During the conference, it was argued that one of the reasons that we see underinvestment in these sectors in developing countries is that the risk-adjusted returns are too low. To create incentives for more private investments, the public sector and aid agencies arguably have two options: they can (i) shoulder part of the risk of these investments, or (ii) reduce the costs through subsidies.

An example of an instrument that lowers the financial risk of an investment is credit guarantees. This is used by for example the Swedish International Development Cooperation Agency (Sida), and means that Sida steps in as a guarantor for commercial loans taken by a partner for a certain investment. Aside from lowering the financial risk, guarantees allow for a utilization of the partner country’s own capital market, which can contribute to development and strengthening of this market to better meet local needs. The problem is that the aggregate risk is only reduced if we believe that the public sector is better informed than the private sector about the investment’s likelihood of success. If this is not the case, the risk is simply shifted from the local loan provider to the guarantor’s taxpayers.

The second option through which the public sector can create incentives for private investment is to reduce the costs of investments. This can be achieved by for example offering concessional loans. This instrument carries costs to the donor country’s taxpayers, just as guarantees, but has the benefit of avoiding moral hazard in project selection, and creating incentives for better performance management.

A third alternative that was discussed at the Development Day conference is the funding model referred to as pay for success (PFS). This means that the funder (e.g. a development agency or an IFI) and its project partner enter an agreement in which the project partner is rewarded financially if it achieves some agreed-upon targeted outcomes, rather than benefitting from reduced costs irrespective of achievement. Thereby, this instrument has the potential of achieving better targeting, promoting contestability, and of reducing monitoring and evaluation costs. At the same time, the negative risk remains with the partner and is not transferred to the donor country’s taxpayers.

Fragile States

Another challenge discussed at the event was development finance in fragile states. A fragile state is typically defined as a low-income country characterized by weak state capacity and/or weak state legitimacy leaving citizens vulnerable to a range of shocks. It is true that most poor people now live in middle-income countries such as India and Nigeria, but according to projections made by the OECD, most of the extremely poor will soon live in fragile states. Hence, if we want to eliminate extreme poverty, securing development finance to fragile states is crucial. Unfortunately, this is also very challenging, as private commercial capital and private foundations have been said to shun fragile and conflict-ridden environments, while domestic capacity to raise revenues tends to be limited. ODA can fill part of this void, but not all.

A more promising source of finance to fragile states, then, is remittances. These flows have been increasing in relative importance, and are now comparable in magnitude to FDI and exceed ODA (an estimated 436 billion US dollar in 2014). Remittances are typically sent with great regularity, and allow receiving households to increase their consumption, invest in human capital and small businesses, and can serve as an insurance against negative economic shocks.

The question is how to stimulate migrants to remit even more, and how to leverage its development impact. Moreover, the decentralized nature of remittances poses a challenge for policy. However, recent research suggests that providing migrants with a certain degree of control, and an opportunity to monitor their remittances, can have a positive effect on how much migrants remit. Other alternatives that have proven effective include providing financial literacy training to the migrants and their families, and reducing the costs of remitting by either providing subsidies or increase competition among the financial wire transfer providers.

While remittances are an important flow of capital to some fragile states, they generally tend to be concentrated to the most populous countries, and come from migrants who have migrated voluntarily. Migrants from fragile states, however, have often left their countries for other reasons than to seek better labor-market opportunities, which means that for many fragile states, ODA remains the most important source of development finance. The problem is that development assistance to fragile states tends to be allocated in the same manor as in other developing countries – ignoring the fact that the most pressing challenges for fragile states may be very different than for other developing countries. It was therefore recommended at the conference, that development agencies focus more attention on programs oriented towards providing peace and security, as well as improving institutional quality. To achieve long-term improvements in living conditions, including reductions in poverty and improvements in health and education, development assistance to fragile states may initially have to be shifted away from these sectors and instead focused on establishing peace and justice.

Conclusion

The need for development financing is large. For the post-2015 development agenda to be credible, commitments must be made at both international and domestic levels. During the Development Day conference, several participants stressed that there is a great need for more cooperation and coordination between different actors – public as well as private, donors as well as partner countries. Moreover, development agencies can serve as a bridge between partner countries and the private sector in the developed world, by channeling information about commercial opportunities and by providing incentive schemes such as guarantees and concessional loans, or by paying for success.

Participants at the Conference

  • Torbjörn Becker, SITE
  • John McArthur, Brookings Institution
  • Raj Desai, Georgetown University and Brookings Institution
  • Adis Dzebo, Stockholm Environment Institute
  • Helen Eduards, Ministry for Foreign Affairs
  • Charlotte Petri Gornitzka, Sida
  • Sadia Hassanen, Mångkulturellt Centrum
  • Kerstin Hessius, Tredje AP Fonden
  • Anneli Rogeman, We Effect
  • Per-Ola Mattson, Ministry for Foreign Affairs
  • Gary Milante, SIPRI
  • Kathryn Nwajiaku-Dahou, IDPS-OECD
  • Anders Olofsgård, SITE
  • Jolanda Profos, OECD
  • Annika Sundén, Sida
  • Amadou Sy, Brookings Institution
  • Theo Talbot, Centre for Global Development
  • Dean Yang, University of Michigan

Presentations from the conference and interviews with some of the speakers are available at SITE’s homepage: hhs.se/site/.

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