Financing Options for Low-Income Countries

The global narrative on development finance centers on enabling all countries to achieve the Sustainable Development Goals (SDGs) by 2030. This cascades into a set of questions about how much financing is needed, how it should be mobilized, and how it will be used. While the SDGs motivate action and have a reasonable prospect of being met in middle-income developing countries, achieving the SDGs in low-income countries (LICs), which have further to travel and more binding resource and institutional constraints, will be harder. The challenge will be most acute in Africa, where pockets of absolute poverty are increasingly concentrated and environmental degradation and conflict add to state fragility.  

The IMF estimates that in order to meet the SDGs, LICs will need to spend an additional half a trillion dollars annually by 2030. For many, that represents an additional 15.4 percentage points of GDP. Ramping up spending at this pace poses a number of challenges—institutional capacity, governance, and skills to name a few—but the availability of the necessary finance is foremost among them.

Given the scale of the challenge, hard choices loom on spending priorities and tradeoffs across different sources of financing. And yet, too much of the current discussion on financing for development in LICs is based on wishful thinking rather than realistic planning. It is good to approach the problem with a degree of optimism, but it is not helpful to base spending plans and commitments on unrealistic expectations about the availability of domestic or external financing.

The development community’s approach to these issues must shift from idealistic to realistic. We need to understand what resources will likely be available to LICs, either through public or private channels, and how they can best be deployed to make substantial progress toward sustainable development objectives.

How far and how fast can additional domestic resources be mobilized? 

Many developing countries have seen an increase in domestic resource mobilization (DRM) and there is scope for more in others. In sub-Saharan Africa, tax revenue has increased from 13 percent of GDP in 2000 to 17 percent in 2016. And there is clearly room to go further in the longer term as LICs move closer to the OECD average tax revenue-to-GDP ratio of 35 percent.

The IMF has estimated that in order to meet the SDGs in five thematic areas, LICs will need to increase their tax-to-GDP ratio by 5 percent by 2030. How feasible is this target? For many, a sustained half percentage point per year increase in tax-to-GDP ratios is an ambitious goal for several reasons.

First, in fragile states and other LICs with limited institutional capacity, ramping up tax revenues requires a longer-term perspective. The IMF finds that in these countries, targeting fiscal technical assistance is necessary to achieve stability and secure elastic revenues. And the approach to technical assistance will differ depending on the state of fragility. For example, in regions immediately post-conflict or post-disaster, the focus should be on collecting tax revenue, whereas in relatively more stable regions, the emphasis shifts to modernizing fiscal institutions.

Second, some countries have the institutional capability but their progress on raising tax revenues has been stymied by the political economy of DRM. Simply put, the coalition of interests that could and should pay more taxes in these countries is powerful enough to thwart repeated attempts to enhance and rationalize tax collection. It is in these countries that international efforts to provide technical assistance for DRM has been least successful because the nature of the problem is political rather than technical. For that reason, one strand of work we are pursuing at CGD focuses on drawing lessons from the political economy of countries that have the necessary technical advice but are still unable to increase DRM.

Finally, the drive to raise tax-to-GDP ratios should be implemented in a way that doesn’t exacerbate the burden on the poor. Recent work by the Commitment to Equity Institute (summarized by my colleagues Charles Kenny and Justin Sandefur here) suggests that while tax and transfer systems reduce inequality in rich countries, they sometimes exacerbate poverty in the poorest countries. This is because in many of the poorest countries, revenue authorities tend to rely more on indirect taxes that fall on consumers. Any tax reform in LICs must recognize that good DRM looks at poverty impact and the extent to which taxes are viewed as fair. One near-term commitment—for both LIC policymakers and international agencies—would be to ensure that individuals below the national poverty line in each country are net recipients, not payers, into the fiscal system.

What is a realistic trajectory for mobilizing private financing for LICs?

The “billions to trillions” narrative for financing the SDGs depends heavily on mobilizing private capital for financing development programs. Almost every official development finance institution has made catalyzing private capital one of its primary goals.

This is laudable, but the evidence to date suggests that realizing the goal of “billions to trillions” faces difficult operational, institutional, and behavioral hurdles. Multilateral development finance institutions commit about $40 billion per year in finance for the private sector but only catalyze $60 billion in private finance. Contrast this with annual financing gaps for SDG-related investments estimated in the trillions. Blended finance from multilateral DFIs—joint deployment of market-oriented and concessional finance to mobilize private capital—amounted to only about $9 billion in 2017, or 22 percent of the total $40 billion. And the share of low-income countries in multilateral DFI blended finance is only about 6 percent, while the share of private finance mobilized by blended finance that goes to low-income countries is an even lower 4 percent. So, to date, relatively little blended finance has been deployed to mobilize private finance, and of that, very little goes to LICs. 

For infrastructure in particular, we see little evidence of successful mobilization of private finance. The volume of infrastructure finance transactions that include some private finance has dropped about 40 percent since 2012, for both developing countries and for the poorest (IDA) countries. So here too, we do not observe a “billions to trillions” upward trend.

This is not to say that LICs are not capable of attracting private finance. In fact, private capital inflows (especially foreign direct investment) constitute a significant source of LIC investment capital, reaching over 6 percent of GDP in 2017.

So how do multilateral DFIs adapt so that they can unlock much larger flows of private finance, especially in LICs? Four fundamental changes are necessary. DFIs need to

1. focus on becoming mobilizers rather lenders for their own account

2. take more risk (here I would argue the constraint is as much their shareholders as their business model)

3. break down their internal silos and bring their policy/institutional reform and project finance tools together for more impact

4. work together as a system for greater scale, a point stressed by the recent report of the G20-sponsored Eminent Persons Group  

And DFIs should also continue their traditional role of helping to improve macro fundamentals and the business environment, which remains the key to making these countries more attractive for private investors.

How much will new donors add to official development finance?

On average, total lending commitments from traditional lenders such as the World Bank, the African Development Bank, and the OECD’s DAC rose steadily from the early 2000s until the global financial crisis in 2008, when commitments increased substantially followed by a plateau. For example, commitments from DAC countries have doubled since the turn of the century, reaching an all-time high of $142 billion in 2016, in part due to increases in in-donor refugee costs. IDA, the World Bank’s concessional lending arm, has also grown steadily over the last decade, and annual commitments have increased and averaged about $20 billion over the last three years.

Alongside these developments is the emergence of nontraditional donors, many of whom were previous recipients of international financial assistance. The most prominent new donor is, of course, the People’s Republic of China, which has become the largest development financier for a number of LICs; China’s claims on developing countries are probably as large as the outstanding $300 billion of all the Paris Club creditors. China has also been a leading force in the creation of two new MDBs: the New Development Bank, which China created with the other BRICS in 2014, and the Asian Infrastructure Investment Bank, created in 2015. This ramping up of development finance by Chinese agencies and banks is linked with the Belt and Road Initiative, a multi-trillion-dollar infrastructure and connectivity program that covers some five dozen countries and has the potential to shape the economic geography of large sections of the globe for decades to come.

A special focus of interest for many in the development community is the dramatic increase in China’s lending to Africa. Between 2000 and 2017 China disbursed $143 billion in loans to Africa, and at the Beijing Forum on China-Africa Cooperation Summit in 2018, it committed an additional $60 billion over the next three years. 

While the increased role of China in the development space has brought many benefits, it has also created issues. First, while most recipients of Chinese development finance continue to welcome it, there has been growing concern in countries such as Malaysia, Pakistan, and Sierra Leone about the feasibility of some projects that were financed from these loans, as well as the terms of the finance itself.

Second, the ramp-up in borrowing from China has contributed to the emergence of debt sustainability concerns in a significant number of LICs. A much-cited study by CGD researchers found that China’s Belt and Road Initiative creates the potential for increased debt sustainability problems in at least eight countries, but that overall the risk of debt distress is not widespread. As a group, China’s role as creditor to LICs is modest in relation to other creditors. But, China’s role as creditor has increased dramatically in the last 10 years in post-HIPC countries with debt difficulties.

For these reasons, as well as the likely changes in China’s own economy, it would be imprudent to assume that development finance from China to LICs will continue to grow at the same pace in the future as in the past decade. China will remain a major development partner for LICs, bringing both new opportunities and new challenges, but it will not make up the financing gap in LICs as is needed to reach the SDGs.   

Debt sustainability

Finally, financing for LICs will be constrained by debt sustainability concerns. A worrying feature of today’s LIC financing landscape is the growing number of countries that are in, or at high risk of, debt distress. The most recent country debt sustainability analyses produced by the World Bank and IMF indicate that 31 of the 70 LICs eligible for support through the Poverty Reduction and Growth Trust fall into this category. The causes and implications of this growing debt problem are a subject for elsewhere; here, the point is that the bulk of high debt countries should follow an approach of fiscal consolidation and caution in taking on additional public sector liabilities. In these circumstances, it would be imprudent to plan for a major increase in debt-based finance for these countries, and they would need to rely disproportionately on grants or private-to-private funding for progressing towards the SDGs.

The bottom line

Resources will remain scarce and maximizing the return on them requires careful project selection, prioritization of needs, and effective implementation. This is the sometimes-boring part of the development finance agenda but the need for it is greater than ever.

It is also important to recognize that generating a pipeline of “bankable” projects in LICs is itself a major task that international financial institutions (IFIs) are well placed to support. The focus on revamped and expanded “country platforms” is an encouraging development in this regard.

The implication for traditional donors—both bilateral and multilateral—is the need to maintain or increase their own volumes of concessional support for LICs. At a time when development assistance is under pressure on many fronts, it is tempting—but wrong—to assume that innovative financial flows can meet the bulk of development needs in LICs. They can play a valuable additional role but progress towards the SDGs in these countries will continue to require substantial concessional support from traditional sources. It is also worth re-examining the strict eligibility criteria for access to non-concessional funding windows of traditional IFIs by LICs with the capacity to take on more debt. Denying them this access has sometimes pushed the countries to borrow at much higher cost from commercial sources, leading to debt sustainability pressures down the road.

In sum, it is time for the development community to have realistic conversations about the specific challenges LICs face in the coming years and how best to support them in progressing towards the SDGs while being mindful of debt burdens.

I am grateful to Kelsey Ross for research assistance and Sanjeev Gupta, Nancy Lee, Scott Morris, and Mark Plant for insightful comments.