by Paddy Carter
27 July 2015
A common reaction to the UN financing for development conference in Addis Ababa last week was: nice narrative, now what? That narrative was the now-familiar beyond aid story, and we did not have long to wait for an example of what may follow: the UK’s Department for International Development has announced the first new money in 20 years for the UK’s development finance institution (DFI), CDC.
It would be no surprise to see other governments either put more money into their DFIs, bilateral private sector programmes, contributions to multilateral mechanisms like the EU blending facilities, or the three new blended finance initiatives that were announced in Addis. For some years now donors have been talking up the ‘catalytic’ role of aid, and although somewhat buried in the Addis Ababa Action Agenda itself (paragraphs 48 and 54), the preponderance of private investment-themed side-events at the conference was a clear sign of where donor enthusiasm lies.
There are lots of ways of going about stimulating private sector investment, but many of them can be rolled up under the general idea of providing a subsidy. Many DFIs have traditionally provided finance at market rates (although there may be an implicit “stamp of approval” subsidy to co-investors) but the rise of blended finance, or other forms of co-investment on concessional terms, suggest donors are going to increasingly provide explicit subsidies to private investment in their efforts to turn billions into trillions.
The justification for a public subsidy lies in having a positive impact on development, which in turn requires both subsidising an investment with good outcomes and that actually needed a subsidy to be viable. Robust empirical evidence that donors and DFIs achieve these twin goals is thin on the ground, and is likely to remain that way until somebody funds a very expensive randomised control trial (establishing a counterfactual is hideously difficult). The pick of the empirical bunch includes this systematic review from the Institute of Development Studies and some macro-econometrics from the Overseas Development Institute (ODI).
In the absence of empirical evidence, we could hope at least for a well-articulated theory of why judicious dollops of donor money could be expected to have a large impact on private investment. What matters is magnitude – when should we expect a small subsidy to have a large impact on the quantity of investment?
Ask an economist when a subsidy can be expected to have a large impact on quantity, and they will start talking about the slope of supply and demand curves. Steep curves mean it takes lots of movement in the price dimension to get anywhere in the quantity dimension. In this context we could think of the two sides of the market as money looking for projects and projects looking for money, and the price as the expected risk-adjusted return on investment. A subsidy shifts the money supply curve downwards (because investors receive the project return plus the subsidy).
In principle at least, if the returns on offer exceed those available on the global market even by a smidge, money should pour in. So we can assume the supply curve is shallow: it all comes down to the slope of the demand curve.
This simple analysis tells us three things.
First, the claim that blended finance will leverage large quantities of private investment amounts to the claim that the demand curve is shallow: that each incremental reduction in required returns will push a large number of projects over the threshold of commercial viability. This notion does not sit well with the common observation that the real constraint on investment is a lack of bankable projects.
Everybody knows that we need action on the demand side. There has been a spate of new project preparation facilities announced by development banks and the Addis outcome calls for a new Global Infrastructure Forum to coordinate these efforts. Supply and demand analysis reminds us that unless these efforts are successful, stimulating investment via subsidy will be pushing on string (to borrow a phrase John Maynard Keynes).
Secondly, this analysis shows us that without an accompanying shift on the demand side, further increases in the quantity of investment will require larger subsidies, worsening the cost-benefit picture. This also tells us something about the plausibility of high leverage ratios. There may be a few projects that only require a soupçon of subsidy, but, because demand curves slope down, as the number of co-invested projects rise we should see that less often.
Lastly, there is a lesson here about sequencing. Investments to accelerate project planning and preparation are likely to bear fruit over time, whereas blended finance facilities can be set up relatively quickly. In their desire to catalyse private investment, donors must resist pushing too hard on the supply side before the demand side starts to pull.