1

After Gleneagles: What role for loans in ODA?

Helmut Reisen, OECD Development Centre

www.oecd.org/dev/reisen

Presentation based on several joint papers with Daniel Cohen, ENS and Pierre Jacquet, AfD.

I would like to thank Xiaobao Chen for his very able research assistance.

2

EventEvent

March 2000: US Congress Report of the International Financial Institution Advisory Commission (better known as Meltzer Report)

July 2005: Gleneagles debt relief $55 billion owed by poor countries to the World Bank and the African Development Bank.

Total cancellation of poor-country debt essential; corollary: provide support in the form of performance-based grants only rather than (concessionary, or soft) loans.

18 HIPC countries will benefit immediately from $40 billion of debt relief, a further 9 should benefit over the next few years.

3

DebateDebate

Lerrick, Adam and Allan Meltzer (2002), Grants : A better way to deliver aid, Carnegie Mellon University, Quarterly International Economic Report, January.

Bulow and Rogoff (2005) “Grants versus Loans for Development Banks”, AER, P&P, June.

Loans carry perverse incentives whereas grants generate positive incentives.

Contrary to loans, grants do not contribute to the debt overhang.

Note a tendency to practice “defensive lending” as MDBs are subject to internal pressure to push loans

4

Soft loans should be thought of as an Soft loans should be thought of as an arithmetic combination between a grant and a arithmetic combination between a grant and a

market loanmarket loan

Soft Loan at 1%, no grace period, 30yr duration, annual payment

--------------------------- cash inflow = 1000 constant annuities:

38.75 AAA investor buys soft

loan at 197.4 (=38.5/.195)

=>grant element = 80.2%

Market Loan at 19.5% (4% for AAA

investor, .5% management fee, 15% default risk)

-------------------------------- grant: 802 market loan: 198 at

19.5% =>cash inflow = 1000 =>38.75 annuities, 30ys

5

ODA definitions; ODA definitions; grant element of soft loansgrant element of soft loans

World Bank: “The major drawback of the DAC methodology is that the fixed 10 percent discount rate used implies that even commercial loans could be deemed concessional given today’s low interest environment”. Is the World Bank right? Unlikely: 1) Poor borrowers pay more than 10%. 2) Donor social opportunity cost to ODA

have not fallen, they are actually rising! (ageing, higher mobility of tax bases).

=> DAC should apply WACC (weighted avg. cost of capital) in setting discount rate.

6

Size of transferSize of transfer

A switch of aid to grants could limit the financial resources to the poorest countries since it would eliminate the reflows arising from the repayment of soft loans.

However, in the presence of ‘defensive lending’, the net transfer would be higher with grants.

=> Defensive Lending is NOT a loan-intrinsic problem!

Evidence

Independent Impact of Debt Service (t-1) on New Loans (t), %

Bilateral Lenders

Multilaterals

1980s 17

40

1990s 14

78

7

IncentivesIncentives

Evidence available so far favors soft loans over grants.

loans => higher tax revenues, less government cons, higher investment rates.

in countries where institutions are weakest, any increase in grant aid would be canceled out by a reduction in public revenues (grants =>friends).

Are the social returns endogenous to grants and soft loans?

Are grants used, at least by ‘donor darlings’, to the point where their marginal utility equals their zero cost to the recipient?

Do grants undermine efforts to mobilise public revenues and thus lead to greater aid dependency?

8

Shock absorption/Shock absorption/consumption smoothingconsumption smoothing

Financial markets exclude poor countries so they suffer from liquidity constraints:

High volatility => high spreads => low borrowing capacity => projects with high social return underfinanced.

Information asymmetries, herding, leverage through carry trades, risk management systems & regulation (Basel II), late & procyclical ratings => no consumption smoothing..

Emerging Markets Spreads (Basis Points) & Developing Countries Non-Energy Commodities Price (Index), Jan 1998-June 2004

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Jan

19

98

Jun

19

98

No

v19

98

Ap

r19

99

Se

p1

99

9

Fe

b2

00

0

Jul2

00

0

De

c20

00

Ma

y20

01

Oct

20

01

Ma

r20

02

Au

g2

00

2

Jan

20

03

Jun

20

03

No

v20

03

Ap

r20

04

Bas

is P

oint

s /

Inde

x

MonthlyCommodity(Excludes Energy)Price Index ForDevelopingCountries

Monthly SpreadsIn Basis Pointsfor EmergingMarkets

Emerging market bond spreads tend to fall when raw material prices rise.

9

Proposal: Dev Banks use the grant element for Proposal: Dev Banks use the grant element for provisioning, provisioning, to be calibrated to cover risks related to natural to be calibrated to cover risks related to natural exogenous shocks. Count provisions as ODA. But lever exogenous shocks. Count provisions as ODA. But lever ODA for loans as a function of measurable country risk ODA for loans as a function of measurable country risk (CPIA).(CPIA).

Calibrate provisions to cover natural shocks.

After country risk analysis, classify countries in groups.

Better CPIA scores result in lower loan-loss provisions.

Weakest countries (low CPIA) get no loans, just grants.

Good governance raises ODA leverage and helps speed convergence.

ODA Provisions

Flows

100 25 400

100 50 200

100 75 133

100 100 100