After Gleneagles: What role for loans in ODA

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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.
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Event

• 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.

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Debate

• 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, PP, 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

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Soft loans should be thought of as an arithmetic
combination between a grant and a market 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)
• gtgrant 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
• gtcash inflow 1000
• gt38.75 annuities, 30ys

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ODA definitions grant 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 todays 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).
• gt DAC should apply WACC (weighted avg. cost of
  capital) in setting discount rate.

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Size 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.
• gt Defensive Lending is NOT a loan-intrinsic
  problem!

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

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Incentives

• Evidence available so far favors soft loans over
  grants.
• loans gt 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 gtfriends).

• 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?

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Shock absorption/consumption smoothing

• Financial markets exclude poor countries so they
  suffer from liquidity constraints
• High volatility gt high spreads gt low
  borrowing capacity gt projects with high social
  return underfinanced.
• Information asymmetries, herding, leverage
  through carry trades, risk management systems
  regulation (Basel II), late procyclical
  ratings gt no consumption smoothing..

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

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