GREAT insights Magazine

International private finance for development: Risky business?

September 2015

Romero, M.J. 2015. International private finance for development: Risky business? GREAT Insights Magazine, Volume 4, Issue 5. August/September 2015.

Policy debates on development finance have been dominated by how to ‘leverage’ international private capital flows for development projects, even though existing mechanisms do not have a great track record.

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The landscape of development finance has changed substantially over the past decade. Private finance has replaced aid at the centre of global and national development initiatives, for both governments and international bodies. This was evident in the run-up to the Third International Conference on Financing for Development, which took place 13-16 July 2015 in Addis Ababa. Private finance initiatives will continue to feature prominently in discussions around the soon to be agreed Sustainable Development Goals. This reflects both the growing need to mobilise all types of resources to lift people out of poverty, as well as growing pressure among donors to link their commercial interests with development policy. While domestic private financial resources are far larger and, most would argue, more important for investment in developing countries, much attention has instead focused on international private finance.

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Looking at the full picture: risks and rewards of private finance

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Foreign private capital flows can help foster sustainable economic growth. They have the capacity to create decent jobs, facilitate technology transfer and generate domestic resources through taxation. But these flows also carry significant risks and must be carefully managed. As Eurodad’s recent report “Financing for development: Key challenges for policy makers” shows, the contribution of these flows to sustainable development deserves a detailed analysis. The employment impacts of foreign investment can vary greatly. Extractive industries, which dominate foreign capital flows to many developing countries, employ relatively few people despite large investments. According to a recent ECDPM presentation, extractives account for 60–90% of Foreign Direct Investment (FDI) to low-income countries, yet generate only 1–2% of total employment. The resource extraction sector can also have huge social, environmental and human right impacts, and may increase macroeconomic problems. For example, economies that become dependent on a small number of commodities are highly vulnerable to changes in commodity prices. In addition, developing countries are earning far less in tax than they could do, in part because of special tax deals that multinational companies negotiate before they invest. Foreign investors often put pressure on national governments to introduce favourable conditions including tax exemptions and lighter labour, social and environmental regulations, which can have damaging impacts both directly and through creating an unfair playing field with national private sector actors, particularly small and medium-sized enterprises. For example, based on extrapolating from a study of 16 countries, a research report by ActionAid International estimates that “over $138 billion is likely given away by governments every year, just in statutory corporate income tax exemptions”. Unfortunately, policy debates on development finance have been dominated by how to ‘leverage’ international private capital flows to developing countries, even though existing mechanisms do not have a great track record. For example, a recent study for the European Parliament, which Eurodad co-authored, detailed the limitations of efforts to incentivise and subsidise private capital flows to developing countries. These included:

• Difficulties in designing programmes that work for medium, small and micro enterprises in low-income countries
• Little success in generating ‘additional’ private sector investment, with external evaluations showing that many publicly backed investments replace or supplant pure private sector investments
• Unproven performance in leveraging private investment in developing countries
• Low developing country ownership over the institutions and programmes of development finance institutions
• Significant problems in providing adequate transparency and accountability
• Increasing debt risks, and very expensive financing

Therefore, the critical issue is the quality and the development contribution of private flows, which matters just as much, if not more, than their quantity.

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Promoting controversial tools?

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Public-private Partnerships (PPPs) also featured prominently in the Financing for Development agenda and will continue to be ubiquitous in discussions around the post-2015 development agenda. PPPs are agreements through which private financiers essentially replace governments as providers and funders of traditional public services such as schools, hospitals, water, roads and electricity. In the past decade, their use in developing countries has increased substantially; currently European institutions, donor governments and financial institutions, such as the European Commission, the United Kingdom, the World Bank and the European Investment Bank, are promoting multiple initiatives to provide advice and finance to PPP projects. Proponents of PPPs would argue that enabling the participation of the private sector has the capacity to deliver high-quality investment in infrastructure and reduce the need for the state to raise funds upfront, thus increasing the chances of getting more investment for much-needed public services. Yet, as Eurodad’s recent report “What lies beneath?” demonstrates, PPPs are problematic:

• PPPs are usually the most expensive method of delivering development projects. For instance, a 2015 review by the UK’s National Audit Office finds that the cost of financing a PPP project can be twice as expensive for the public purse as if the government had borrowed from private banks or issued bonds directly:
• PPPs can pose a huge risk to the public sector. Such was the case for the Queen Mamohato Memorial hospital in Lesotho, one of the poorest countries in the world. Although the World Bank reports some satisfactory results, the reality is that the hospital swallows up more than half of the country’s health budget, while giving a return of 25% to the private sector provider. This has diverted much-needed public funds from rural hospitals, where three-quarters of the population live. The government remains locked into this agreement until 2027.
• PPPs are typically very complex to negotiate and implement and are all too often renegotiated, which entails important costs for the public sector. According to IMF staff, 55% of all PPPs get renegotiated, on average every two years, and an increase in tariffs occurred in 62% of all renegotiations.
• The impact of PPPs on development outcomes are mixed and vary greatly across sectors. PPPs often build user-fee funded services, which eventually exclude the poor from access.
• PPPs suffer from low transparency and limited public scrutiny, which undermines democratic accounta-ility and offers greater opportunities for corruption.

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The way forward

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After a long preparatory process, the Financing for Development agenda was agreed in mid-July. It includes the means of implementation for the Sustainable Development Goals. Much of the debate was dominated by how to ‘leverage’ more international private capital flows to developing countries using public institutions and public financing or guarantees, even though strong guidelines for financial, social and environmental accountability of private finance were missing.

As a result, key issues were transferred to the follow up of the Addis Ababa conference. Then, it would be better to focus attention on measures that are needed to help developing countries reduce risks and manage foreign investment to maximise its development potential; including removing obstacles found in trade and investment agreements that prevent developing countries from managing private capital flows to reduce risks, and embracing a new international initiative on responsible financing standards with strong implementation mechanisms.

About the author

María José Romero is Eurodad’s Policy and Advocacy Manager.

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Photo: Unilever Côte d’Ivoire. Credits: Abdallahh, flickr.com.

This article was published in GREAT Insights Volume 4, Issue 5 (August/September 2015).