The Future of UK Development Cooperation Phase 1: Development Finance

Written evidence submitted by the Overseas Development Institute

1. The long term relevance of the 0.7% ODA target

1.1 The 0.7% target was first agreed under the auspices of the UN in 1970. It has never been a strongly evidenced target, more a political tool, which implies that discussions about changing it will be at least as much political in nature as technical. A range of factors imply that the current definition and target of ODA are no longer fit for purpose.

1.2 Studies suggest that extreme poverty is continuing to decline rapidly, although there is continued discussion about the likely future "geography of poverty" (Sumner 2010, Kharas and Rogerson 2012).

1.3 Most developing countries are increasingly moving away from reliance on aid, even in Africa (Actionaid 2012, Glennie 2008), which raises questions over whether there will still be demand for traditional aid in the future.

1.4 Amongst the broader goals (beyond poverty reduction) that future ODA could help to mobilise finance for the provision of are addressing climate change and environmental sustainability, global health challenges and security – often grouped under the heading Global Public Goods (GPGs) (Severino 2009, ODI forthcoming). The implications of a more ambitious agenda addressing GPGs alongside poverty reduction might be the need for more resources overall, and the need to focus even on countries where extreme poverty is no longer prevalent.

1.5 The growing volume of development assistance coming from Southern donors and new development cooperation actors is a crucial additional factor. ODI estimates that these flows were equivalent to at least 30% of OECD donor contributions in 2011 and are growing fast (Greenhill et al 2013). ODI’s Claire Leigh and Jonathan Glennie have proposed that all countries, even the poorest, might contribute something to global development financing in the future (Leigh and Glennie 2013).

1.6 This discussion began some time before the process of agreeing development goals to succeed the MDGs and a package of measures to pursue them (for example see Severino 2009), but has been given added impetus by this process.

1.7 There appear to be two broad scenarios. Either aid gradually declines as poverty is reduced globally and countries rely more on non-concessional flows. Or aid continues to be of importance, as objectives multiply and the unique character of public finance at a global level is considered important. In the former scenario, the 0.7% target would seem too high; in the latter it may not be sufficient.

2. The suitability of DFID’s mix of financial instruments, including its use of loans and traditional grant aid

2.1 DFID does not currently deliver any of its ODA in the form of loans, although its grant contributions to a number of multilateral institutions are lent on to developing countries. However, the share of loans in total ODA has been on a gradually increasing trend since 2007 and reached just over 20% in 2011 (Tew 2013).

2.2 There are a number of arguments commonly put forward in favour of providing ODA in the form loans rather than grants, including their ability to mobilise large levels of upfront resources for countries (an effect which is neutralised over the length of the loan due to repayments) and possible disciplining effects on the use of resource use by recipients (which is disputed in the literature) (Tew 2013).

2.3 The major downside to ODA loans is that they have to be repaid and therefore require developing countries to divert resources away from public spending towards such repayments. This issue retains major relevance in many developing countries, as debt levels have increased since the global economic crisis. Aid levels stagnated during this period and developing countries have had to rely on loans for around 40% of the resources they have raised to compensate for the falls in revenue (DFI and Oxfam 2013).

2.4 These characteristics of loans suggest that grants are more suitable for countries with lower levels of income, higher levels of inherited debt, higher risk of economic volatility and limited fiscal capacity (Baudienville et al 2009). Although countries with these characteristics tend to be those in the low income category, it would also be the case for many MICs, given the breadth of the middle income country (MIC) category (which covers countries with annual incomes between $1,026 and $12,475). Country classifications are now, in fact, a questionable tool for making such financing decisions (Glennie 2011).

2.5 Much of the impact of loans on the resources of developing countries will depend on the terms of the loan being provided. There are a range of ways in which donors can lessen this impact and ensure a loan is concessional, including charging below market interest rates, providing lengthy repayment periods and blending loans with grants. It is vital that donors use such approaches to tailor loans to country needs and challenges.

2.6 These conclusions point to the need for DFID to address any question on the use of loans and their concessionality on the basis of the portfolio of countries it wishes to provide assistance to and robust assessments of their economic and financial capacity to manage loans.

2.7 The characteristics of loans also point towards there being a stronger case for grants to fund projects that do not generate revenues (like private sector and infrastructure investments) and involve higher risks (Baudienville et al). As a result DFID’s policy on loans may also need to be informed by decisions on the mix of such activities in its portfolio.

3. Role of the UK as a provider of climate finance

3.1 The UK’s climate finance contribution is of vital importance to helping developing countries incorporate climate change into their development strategies. The UK has played a critical leadership role in global efforts to mobilise funding to this end, consistent with commitments made under the UN Framework Convention on Climate Change to scale up climate finance in the context of securing ambitious global collective action on climate change (Nakhooda et al 2012). It is crucially important for the UK to continue to deliver climate finance in support of these commitments, and to continue to make progress on options for scaling up the level of support that it is delivering, while continuing to strengthen the effectiveness of the support that it delivers.

3.2 There is substantial interest in how climate finance can be used to enable fundamental transitions to climate compatible development in developing countries. There is particularly interest in the role that climate finance can play in mobilizing private sector investment in low carbon and climate resilient approaches (Whitley 2012). There is an important role for public climate finance in supporting public sector institutions to explore and implement necessary changes and improvements to underlying policies and regulatory frameworks that will make climate compatible development more viable (Nakhooda 2013). Such support may be usefully delivered through grants that support the budgets of key institutions and capacity building initiatives. There may also an important role for grants in supporting research and engagement with non-governmental institutions within countries that can support and inform more ambitious and effective action on climate change within developing countries (Whitley 2011, Nakhooda 2013).

3.3 Different interventions to support climate change entail different costs, risks, and different actors can play different roles. There is a strong case to be made for tailoring instruments to the particular risks and needs that a climate related intervention entails (Nakhooda 2013). By mobilising climate finance contributions as grants and capital grants, implementing agencies can use this funding in a discretionary way to address these risks in a tailored fashion. We observe that the decisions of some countries to capitalize multilateral climate funds such as the Clean Technology Fund with low cost loans has in some cases significantly constrained the risks that the fund is able to bear (for example, in some cases the risks associated with local currency lending for clean energy projects in developing countries were seen as too high for the loan capitalization to bear). There is a need to continue to ensure that climate finance can be used to bear a diversity of risks and costs, and to allow flexible and innovative approaches to program design.

4. Whether the UK should establish a new, independent development finance institution to offer concessional loans?

4.1 Development finance institutions (DFIs) play an important role in the international cooperation system through their provision of support to the private sector, catalysing private investment, providing counter cyclical funding during economic crises and delivering technical assistance (te Velde 2011). In providing this type of support DFIs have been found to contribute to increases in foreign direct investment (te Velde and Warner 2007), productivity, employment and economic growth (Jouanjean and te Velde 2013).

4.2 The establishment of a new independent UK development finance institution to offer concessional loans would be a major undertaking by the UK Government, and it is therefore vital that a number of important questions are addressed before such a decision is made.

4.3 Firstly, it will be important that any decision is informed by an assessment of the financing needs of the UK’s development partners and how / whether such an institution will address these needs. As highlighted in section 2 this should in part be based on assessing the degree to which these partners require and are in a position to manage the financial consequences of loans. This should also involve understanding the degree to which its partners require the types of financing tools that DFIs commonly provide, including loans, guarantees and equity investments.

4.4 Assuming that the UK’s development partners would benefit from greater access to the type of support provided by DFI’s it will be important to establish what the value added of establishing such an institution will be in comparison to other bodies – both in the UK and beyond - that are currently operating in this space, including multilateral agencies, development finance institutions and private sector actors. If these actors are better equipped to respond to these challenges and are motivated to and likely to be successful in scaling-up their efforts then channelling support through them would likely be preferable.

5. DFID’s balance between provision of bilateral and multilateral aid?

5.1 DFID’s Multilateral and Bilateral Aid Reviews have made an important contribution to the UK Government’s (and broader donor) efforts to assess the performance of these aid delivery channels and to inform decisions allocating aid across them. However, IDC will be well aware of the results of these reviews, so this section of our submission will focus on highlighting some additional insights relevant to questions, especially on the relative performance of multilateral aid agencies.

5.2 There has rightly been increasing attention on the administration costs of the various multilateral agencies, but it is important to recognise that the cost effectiveness of these organisations goes beyond this relatively narrow element. Multilateral agencies have some inherent characteristics that contribute to promoting cost effectiveness. These include reducing the aid management burdens for recipients by coordinating support from a number of donors, their delivery of untied aid and their potential to achieve economies of scale in managing aid programmes.

5.3 There have been a number of attempts beyond the MAR to assess the effectiveness of multilateral aid agencies, including ones that judge them relative to bilateral agencies. These suggest that multilateral aid agencies perform at least as well as bilateral aid agencies in relation to the Paris Declaration on Aid Effectiveness principles and commitments (OECD 2011) and may well be outperforming bilateral agencies in relation to an even broader set of criteria (Easterly and Pfutze 2008, CGD 2011).

5.4 In relation to the value added of regional development banks an important aspect of their functioning revealed by a 2007 survey by ODI was a perception by recipient countries that their closer role in the governance of these agencies has helped to shape their greater sense of ownership of their programmes (Burrall 2007).

5.5 Recent research by ODI has also illustrated how developing countries value the speed of response and delivery of some emerging donors (Greenhill et al 2013), which highlights the need for multilateral agencies to address obstacles to delivering their assistance more rapidly.

5.6 Finally, an element of the value added of multilateral agencies that is becoming more prominent and may give them renewed significance in the coming years is that relating to their response to GPGs. Addressing needs relating to GPGs benefits from the ability of multilateral agencies to pool contributions from a large range of actors in support of a coordinated response to development challenges (ODI forthcoming). Multilateral agencies are already playing such a role in relation to climate change, where bodies such as the Climate Investment Funds are leading global efforts to support country efforts to adapt and mitigate the effects of climate change.

5.7 It is important that future assessments of the performance of multilateral agencies that feed into aid allocation decisions take into account all relevant factors, including their evolving role in the international cooperation system.

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June 2013

Prepared 21st June 2013