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After Gleneagles: What role for loans in ODA?

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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After Gleneagles: What role for loans in ODA?

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  1. After Gleneagles: What role for loans in ODA? Helmut Reisen, OECD Development Centre www.oecd.org/dev/reisen Presentation based on several jointpapers with Daniel Cohen, ENS and Pierre Jacquet, AfD. I would like to thank Xiaobao Chen for his very able research assistance.

  2. 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. Event

  3. 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, P&P, 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 Debate

  4. 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) =>grant 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% =>cash inflow = 1000 =>38.75 annuities, 30ys Soft loans should be thought of as an arithmetic combination between a grant and a market loan

  5. 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 today’s 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). • => DAC should apply WACC (weighted avg. cost of capital) in setting discount rate.

  6. A switch of aid to grantscould 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. => Defensive Lending is NOT a loan-intrinsic problem! Evidence Independent Impact of Debt Service (t-1) on New Loans (t), % Size of transfer

  7. Evidence available so far favors soft loans over grants. loans => 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 =>friends). 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? Incentives

  8. Shock absorption/consumption smoothing • Financial markets exclude poor countries so they suffer from liquidity constraints: High volatility => high spreads => low borrowing capacity => projects with high social return underfinanced. Information asymmetries, herding, leverage through carry trades, risk management systems & regulation (Basel II), late & procyclical ratings => no consumption smoothing.. • Emerging market bond spreads tend to fall when raw material prices rise.

  9. 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.

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