Successful modernization of aid

The relative weight of ODA in external financing to developing countries, 2000-11. Click to see full size.
The relative weight of ODA in external financing to developing countries, 2000-11. Click to see full size.

Today’s post is from Erik Solheim, Chair of the OECD Development Assistance Committee (DAC)

The donor countries representing well above 90% of all global development aid agreed in the Development Assistance Committee of the OECD on December 16 on a set of measures to modernize official development assistance, ODA. We will build on the historic success of aid and make it fit for the future. The goal is to provide more and better aid and support the global process of financing the post-2015 sustainable development goals.

The huge development progress over the past decades has made the world a better place to live than at any other point in human history. Extreme poverty, child mortality and malaria have been halved. The majority of people on the planet are better educated and live longer and healthier lives than ever before. But progress has been uneven. Development in states at war and in the poorest nations has been much slower. Conflict has even reversed development in some nations by 20-30 years. Extreme poverty will increasingly be found in weak states and in vulnerable groups such as indigenous communities, small scale farmers, ethnic and religious minorities, and the disabled. The majority of the very poor are women and they are living in rural areas. Global economic growth alone will not get all these people out of poverty. Specific policies targeting the most vulnerable groups and directing more resources to the least developed countries will be required to end poverty.

This is why the Development Assistance Committee has agreed to provide more development assistance to the least developed countries and other nations most in need, including small island states, land-locked countries and fragile states and nations in conflict. Those who have committed have reconfirmed the UN targets of 0.7% of national income for development assistance and at least 0.15% for the least developed countries. New agreed rules for concessional loans will give the poorest nations better access to this important source of development finance. The Development Assistance Committee agreed to modernise the reporting of concessional loans to encourage more resources on softer terms to the poorest nations while putting in place safeguards to ensure debt sustainability. The result of all this will be more and better development assistance to the poorest nations. More grants for schools and hospitals. More loans for railways, manufacturing plants and clean energy.

Development assistance is an important source of external funds for the least developed countries. But the big drivers of global development are private finances and domestic resources. Development assistance reached a record high of $135 billion last year, but foreign direct investments are almost 5 times greater. By far the biggest share of the money spent on education in the developing world comes from domestic resources. A three letter word for development is “tax”. A 1% increase in developing country tax revenues would mobilise twice as much for health, education and roads as total development assistance.

But development assistance can have a big impact on global sustainable development if used smarter to mobilize more private investments and domestic resources. $20 trillion will be invested annually across the world in the coming decades. More of this should be directed to green growth and development.

As our contributions to the global process of financing sustainable development, the OECD Development Assistance Committee will continue to develop new statistical measures to account for and mobilise more private finances. A new statistical tool measuring total official support for sustainable development will complement, not replace, official development assistance data. The purpose is to use public funds to mobilise more of those $20 trillion for green growth and development by making better use of the available financial instruments such as guarantees and equity investments. This work will be refined leading up to the third international conference on financing for development in Addis Ababa. We encourage all nations, private sector and civil society organization to work with us.

Better rules for development assistance are only relevant if it reduces poverty and has a real impact on the life of real people. More and better development assistance will help us towards eradication of extreme poverty by 2030. Our new broader measure is an additional contribution to the UN led process of shaping the sustainable development agenda and ending poverty while protecting the planet.

Useful links

DAC High-level Meeting December 2014, agenda and documents

OECD Development Co-operation Report 2014: Mobilising Resources for Sustainable Development.

Stimulating SME Equity Financing? Change The Culture

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Would you have invested in this SME?

On October 23rd, the OECD Financial Roundtable (FRT) dealt with public SME equity financing with a special focus on exchanges, platforms and players. In today’s post, Markus Schuller of Panthera Solutions gives us his personal view on the meeting.

Let’s face it: the bulk of small and medium-sized entreprises (SMEs) are still financed mainly by bank credit. However, as bank finance is harder to come by in the current post-crisis environment, fostering non-bank financing alternatives may help closing an SME financing gap. The OECD has been looking into such issues, also with input from the private sector via its Financial Roundtables. After the one held in April that discussed SME non-bank debt financing, this one, held in October, explored impediments and possibilities for public equity financing for SMEs.

Banks represented at the discussion naturally pleaded their cause, namely for debt financing, some even arguing that there is no shortage of SME debt financing, but only of risk financing. I allowed myself to add that this insight comes rather late. Too late actually, to stop the BoE and ECB in rolling out their securitisation support (asset backed securities purchase programme and covered bond purchase programme) that may be pointless if the analysis that the Eurozone suffers mainly from a demand-side problem is correct – as we have been highlighting over the last three years.

But back to the actual Roundtable topic. The overall challenge was described as how to stimulate equity financing for a segment that is characterised by low survival rates and a large diversity of entities, the two main drivers that make it difficult to assess risk. The focus of the debate was more on analysing the current drivers of a challenging environment for SME equity financing and less on solutions.

The limitations in the ecosystem (exchanges, platforms, brokers, market-makers, advisors, equity research) necessary both for the development of SME equity finance and the maintenance of liquidity in such markets can definitely be named as impediments. Having said that, those are technicalities that can be resolved quickly by market forces, given sufficient investor interest in allocating to this segment. It appears to be a chicken or egg situation, but it isn’t. If investors are intrinsically motivated to seeking exposure in SME equity investments, the supply side will follow.

Let me focus on a more fundamental driver of an investor´s motivation to ensure a sustainable flow in SME equity investments: cultural change.

In my FRT contribution I highlighted the lack of a risk equity culture across Europe as an important obstacle. In Germany, only 13,8% of the population invests directly (7,1%, 2013) or indirectly via funds (6,7%, 2013) in listed equity securities. Compared with around 50% in the US (45% in 2008, ICI Survey / 52% in 2014, Gallup Survey). Both the US and Germany saw a slight deterioration in equity ownership from 2000 until today, explained by the long-term effects of the dot-com bubble during the 2000s and the pro-cyclical behaviour of retail and institutional investors, leading to a reduction in their exposure caused by the Great Recession.

On top of shying away from the volatility in asset pricing, equity exposure in Germany is significantly linked to the educational attainment of the individual. In 2013, investors with vocational baccalaureate diplomas achieved an exposure of 25,9%, with secondary school leaving certificate only 11,8% and secondary modern school qualification alarmingly 6,5%.

How to reverse this trend of sinking equity ownership in Germany and neighbouring countries? By reframing the question. Let’s analyse what drove the rise of equity owners in Germany from 3,9 million (1992) to 6,2 million (2000) and back to 4,5 million (2013). Two main factors can be named for the rise: pro-equity friendly sentiment in politics; and accessible home bias led to a low entry barrier for investors.

The dot-com bubble burst deformed the first. Since then politicians harvest low hanging populist points by stigmatising equity markets as too dangerous to get exposed to. The Great Recession acted as reaffirmation of their convictions. Some even enacted policies to forcefully dry up market liquidity as seen in Austria with its stock exchange tax.

The dot-com bubble also caused millions of Germans to divest their home bias. Home bias is a well-researched cognitive dissonance in behavioural finance, driven by both rational and irrational factors. Local bias in SME investments is driven by pride of local ownership; ambiguity aversion (investors are more likely to choose an option with known risks over unknown risks, and with fewer unknown elements rather than many); identification with product, service or entrepreneur; reduced information asymmetry through local knowledge.

Sourcing information globally on listed companies works well thanks to its digital distribution, identifying yourself with them doesn’t. Investors reject exposure to risk if they cannot judge the situation, or do not know the relevant risk drivers. This behavioural pattern can be traced back to the individual’s need for control (as von Nitzsch points out).

The affinity to an equity home bias for both institutional and retail investors can be used as entry point for changing the lack of equity culture in Europe.

The same cultural change was needed in Europe for SME debt financing. For corporate debt markets it needed the Great Recession and banks unwilling to or incapable of lending to trigger the change. Since then, starting with large corporations, a trickle down effect is starting – see German “Mittelstandsanleihen” and their friendly welcome by investors. In short, cultural change is possible.

A potential trigger for cultural change in equity markets can be found in the ongoing financial repression and negative interest on savings accounts. Less a carrot, more a stick.

In my profession as asset allocation advisor, I cannot recommend a home-biased portfolio as being well diversified. Scientific evidence opposes this view. My point is to only use this bias as an entry point for inducing cultural change. It needs to be followed by a further increase in sophistication levels of market participants, enabling them to properly invest in a risk factor diversified, global, multi-asset portfolio.

Which leads to my second FRT contribution, namely on calling for increased education regarding equity investments for all market constituencies (SMEs, individual investors and advisors alike). Only increased levels of sophistication allow a responsible extension of alternative equity financing options in the ecosystem – see the delicate, little plant called “crowdinvesting” for example.

As cultural changes and educational effects only pay a dividend in the medium term, I suggested at the FRT to leverage the activities of an existing EU institution, namely the European Investment Fund (EIF).

It acts under the umbrella of the European Investment Bank (EIB). The EIF is a specialist provider of risk finance to benefit SMEs across Europe, including equity financing via more than 350 privately managed private equity funds. Its equity activity encompasses the main stages of SME development. In total it runs a book of EUR 5.6 billion in outstanding commitments, leveraging EUR 20,7 billion from other investors. In 2013, the EIF committed EUR 1.5 billion to mobilize EUR 7.1 billion in other resources.

In its announcement of a EUR 300 billion stimulus package for EU28, the Juncker commission should increase the EIF allocation power by a multiple. Positive real economic effects are guaranteed.

Useful links

OECD work on financial markets

Financial Market Trends OECD Journal

In my view: Development depends on realising the potential of taxation

Nigeria govtToday’s post from Ngozi Okonjo-Iweala, Co-ordinating Minister for the Economy and Minister of Finance, Nigeria, concludes a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development. The Report is being launched today in London with the Overseas Development Institution, and you can watch the event by registering here.

Developing country governments would do well to strengthen their tax systems so they can mobilise the domestic resources they need to finance their own development. This is particularly true for African countries, where the recent trend of decreasing ODA shows no sign of reversing.

In developing countries in general, revenue administration is often hampered by weak organisational structures, low capacity of tax officials and a lack of modern, computerised, risk-management techniques. The value-added tax “gap” alone is estimated at around 50-60% in developing countries, compared with only 13% in developed countries. The International Monetary Fund (IMF) estimates that for many low-income countries, an increase in tax revenues of about 4% of GDP is attainable.

Since the 1990s, many African countries have made progress in improving their domestic tax capacities and receipts. Despite these improvements, however, there are still many revenue leaks that need to be plugged.

In Nigeria, we are making concerted efforts. Following the recent revision of our GDP to USD 510 billion, our tax-to-GDP ratio declined from 20% to about 12%, several points below the 15% tax-to-GDP threshold recommended by the IMF for satisfactory tax performance. Yet with our increasingly diversified economy, there is room to greatly improve our tax administration capacity and increase our tax revenues.

A recent diagnostic exercise to examine the bottlenecks in our tax collection processes revealed some interesting findings. For example, about 75% of our “registered” firms were not in the tax system! Moreover, about 65% of Nigeria’s registered taxpayers had not filed their tax returns over the past two years. With the support of external consultants, we are introducing remedial measures to improve tax performance and estimate that we can raise an additional USD 500 million in non-oil tax revenues in 2014.

The international community has an important role to play in supporting such efforts by developing countries, and evidence shows that this can yield impressive returns (see also Chapter 14). The OECD has found that every USD 1 of official development assistance (ODA) spent on building tax administrative capacity can generate as much as USD 1 650 in incremental tax revenues (Chapter 14). Yet to date, only limited funds have been targeted at improving tax institutions and tax policies.

To support the broader goal of mobilizing financing for the post-2015 development agenda, ODA can also be used in many other creative ways, for instance to leverage private financial resources (Chapter 11).

In my view, realising the full potential of domestic resource mobilisation in developing countries – and in Africa in particular – is central to discussions on financing the post-2015 development agenda. It will be particularly important to deploy a greater proportion of ODA in low-income countries to support their tax administration efforts. Realising this potential will require strong commitment and leadership from developing country policy makers, as well as the support of the international community.

Useful links

Find out more about the Development Co-operation Report 2014: Mobilising resources for sustainable development here and follow #DCR2014 for live coverage of the launch events on Twitter.

Development finance: hundreds of billions more available

DCR 2014Today sees the launch of the OECD Development Co-operation Report 2014: Mobilising Resources for Sustainable Development. In today’s post, Erik Solheim, Chair of the OECD Development Assistance Committee (DAC) argues that hundreds of billions more could potentially be mobilized for poverty alleviation and sustainable development over and above the $134 billion in development assistance donated last year.

The enormous development progress seen over the past 20 years has been unprecedented in human history. Extreme poverty has been halved and 600 million people were brought out of poverty in China alone. The mortality rate for children under age five has been almost halved, saving 17,000 children every day. Economic growth and better government policies explain much of the progress. But official development assistance (ODA) has also been a great success and contributed to global improvements. However, much more and better financing will be required to eradicate extreme poverty and promote green growth.

Official Development Assistance is increasing and has never been higher. The main donors in the OECD Development Assistance Committee increased development assistance by 6.1% last year, reaching an all-time high of 134.8 billion dollars. Additionally, emerging and increasingly important donors like China, Turkey and Arab nations provided around 15 billion dollars. On top of that, Development banks such as the World Bank and Asian and African Development Banks, granted 40 billion dollars in more market-based loans not considered development assistance.

The Bill & Melinda Gates Foundation and other private foundations provided around 30 billion for development, while organizations like the Red Cross and World Vision International raised more than 30 billion dollars from the public. Remittances sent home to their families by overseas workers added 350 billion dollars to the flow of finances into developing countries. Foreign direct investments, by far the largest source of external finances to developing countries, amounted to 600 billion dollars.

Together, this adds up to more than one thousand billion dollars of external financing for poverty reduction, schools, hospitals, infrastructure and jobs in developing countries.

Several additional thousands of billions of dollars could potentially be made available for poverty eradication and green growth, and development assistance can help unlock these resources. Domestic resources such as taxes are the most important source of financing for developing, even in many of the poorest countries. For example, more than 1300 billion dollars is spent on education in developing countries every year but only 15 billion of this comes from development assistance.

Yet, while OECD countries collect on average 34% of their gross domestic product as tax, developing countries achieve only half this rate. The combined GDP of the developing world is over 30,000 billion dollars and adding a mere 1% increase in tax mobilization in the developing world could add 300 billion dollars for public services, schools and hospitals. The OECD has rolled out two programmes – Tax for Development and Tax Inspectors without Borders – to improve tax revenue generation. A pilot project assisting Kenya’s tax administration returned an incredible 1650 dollars in taxes for every dollar invested.

About 5000 billion dollars annually will be required for infrastructure investment to green our economies and support a future population of 9 billion people. The private sector will need to finance most of the required investments in roads, railroads, sustainable agriculture and green energy infrastructure. But development assistance can help mobilize such private investments.

Using financial instruments such as public guarantees, development assistance can help alleviate some of the risks associated with investing in developing countries and mobilize more private finances. New and innovative financing mechanisms like social impact bonds only mobilise 2 billion dollars out of the more than 600 billion dollars that the UN estimates potentially could be mobilized. Institutional investors such as pension funds and sovereign wealth funds are sitting on a staggering 83,000 billion dollars in assets in OECD countries alone. But their investments in infrastructure only represent around 1% of those 83,000 billion.

Encouraging leadership, improving the regulatory environment and using development assistance to alleviate risk would make it easier for institutional investors to finance roads and green energy generation in developing countries. An extraordinary 830 billion dollars would be mobilized for infrastructure investments in developing countries just by directing an additional 1% of our wealth and pension funds to this purpose.

Billions could be mobilized for global development by turning bad investments into good investments. Developing countries lose more to illicit capital outflows such as corruption, money laundering and tax evasion than they receive as inflows from aid and private investments. Poor countries are losing as much as one thousand billion dollars a year to illicit capital flows. These billions are invested in crime and lavish lifestyles rather than schools and hospitals. Illicit flows can be stopped by sharing information and streamlining regulations while prosecuting and jailing financial criminals in developed and developing countries alike.

Global development would improve if we directed more investments from public bads to global public goods. The 544 billion dollars spent on fossil fuel subsidies would do more good if invested in green energy. Any portion of the 1700 billions of defence expenditures would provide security and save lives if directed to peace instead of war. Better rules facilitating global trade could benefit everyone and raise global output by more than 400 billion.

Development assistance has been a huge success. But more and better financing for development is needed to eradicate poverty and support green growth. Traditional and emerging providers of development assistance must work with private investors and developing partners to mobilize more private investments and domestic resources.

Useful links

Find out more about the Development Co-operation Report 2014: Mobilising resources for sustainable development here and follow #DCR2014 for live coverage of the launch events on Twitter.

In my view: Any developing country can undergo dynamic structural transformation, starting now

Peking UniversityToday’s post from Justin Yifu Lin, Honorary Dean at the National School of Development (NSD), Peking University, and former Chief Economist of The World Bank, is one in a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development.

Any developing country – even those with poor infrastructure and a weak business environment – can start on a path to dynamic structural transformation and growth today. How? By facilitating technological innovation and development in industries where it has a comparative advantage.

Take China. At the time of its transition to a market economy in 1979, the business environment was poor, infrastructure was very bad and China lacked the capacity to take advantage of its cheap labour market to produce goods for export. To overcome these obstacles, the Chinese government – at all levels and in all regions – encouraged foreign investment in special economic zones and industrial parks. This enabled China to rapidly develop labour-intensive light manufacturing and become the world’s factory.

The same approach can work in other developing countries. For instance, in August 2011 the late Ethiopian Prime Minister Meles Zenawi visited China. Aware of Ethiopia’s labour cost advantages and China’s plans to relocate its shoe industry because of rising wages, he invited Chinese shoe manufacturers to invest in Ethiopia. Managers of Huajian, a designer shoe manufacturer, visited Addis Ababa in October 2011 and – convinced of the opportunity – opened a shoe factory near Addis in January 2012, employing 550 Ethiopians. Huajian more than doubled Ethiopia’s shoe exports by the end of 2012 and by December 2013, the workforce had expanded to 3 500 (by 2016 it is expected to reach 30 000).

Before this, like almost all other African countries, Ethiopia had found it difficult to attract export-oriented foreign direct investment in light manufacturing. The immediate success of the Huajian shoe factory transformed foreign investors’ impression of Ethiopia, helping them to see it as a potential manufacturing base for exports to global markets. Over just three months in 2013, 22 factory compounds in the new industrial park of Bole Lamin were leased to export-oriented factories.

As long as it is carefully embedded within the broader economy so as to avoid creating isolated ‘enclaves’ of productivity and growth, this type of investment can help to fuel modern economic growth, funding improvements in infrastructure and institutions as well as structural changes in technology and industries to reduce costs of production and increase output values. In any country, these enhancements in labour productivity can fuel a continuing increase in per capita income.

In my view, development finance can have the largest possible impact on accelerating a developing country’s structural transformation, job generation and poverty reduction when the country uses these flows to remove infrastructure bottlenecks and develop industries that draw on the country’s comparative advantages. This pragmatic approach will allow these countries to capture China’s relocation of 85 million labour-intensive manufacturing jobs, allowing them too to grow as dynamically as the East Asian economies.

Useful links

Getting Globalization Right: China Marches to its Own Beat by Dani Rodrik, Professor of International Political Economy at the John F. Kennedy School of Government, Harvard University, on OECD Insights.

In my view: The Structural Gap approach offers a new model for co-operation with middle-income countries

ECLACToday’s post from Alicia Bárcena, Executive Secretary of the Economic Commission for Latin America and the Caribbean (ECLAC), is one in a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development.

Middle-income countries differ widely in their reliance on official development assistance (ODA). While for some, ODA represents less than 1% of their gross national income, for others it is more than 30%. This divergence reflects countries’ differing capacity to access financial resources and capital markets.

The DAC List of ODA Recipients shows all countries and territories eligible to receive official development assistance. The list includes low and middle-income countries, as well as the least developed countries, defined according to their gross national income (GNI) per capita. As we review the future of ODA, we need to ask: Is per capita income the best criterion for allocating official development assistance? And how can we deal with the heterogeneity of middle-income countries?

The use of income per capita as an allocation criterion relies on two assumptions: that as countries increase their income per capita they will be able to mobilise a larger pool of international and domestic resources to finance their development needs and become less dependent on ODA; and that income levels reflect a given stage of social and economic development.

Evidence shows that a country’s capacity to access external resources depends on many factors besides income per capita. These include conditions outside their control, such as country risk ratings and perceptions, external demand for the products from that country and country size (i.e. population). Similarly, domestic resource mobilisation depends on numerous factors, including levels of savings, development and strength of financial markets, and the capacity and willingness of the government to levy taxes and collect duties (Chapter 7 and 14). Evidence also shows that despite similar income levels, countries may have different development realities. For example, people may vary widely in their access to social protection mechanisms, formal financial institutions and quality education, as well as in their resilience to economic and social shocks.

Far from being a homogeneous category, middle-income countries are a widely heterogeneous social and economic grouping with a large diversity of needs. For example, in 2012 income per capita in these countries ranged from $1006 to $12,275.

As a way forward, ECLAC proposes the Structural Gap approach as an alternative criterion to that of per capita income. This approach is based on the premise that there is no single classification criterion applicable to all countries and underscores the fact that income level cannot be equated with development level. It identifies key areas where there are obstacles to sustained, equitable and inclusive growth in middle-income countries (or “gaps”): equality and livelihoods, investment and savings, productivity and innovation, infrastructure, education, health, taxation, gender and the environment. Countries themselves are responsible for identifying the main gaps that hamper their social and economic development.

In my view, the debate on the future of ODA can benefit from the Structural Gap approach, which offers a basis for inclusive and egalitarian co-operation. It should be part of the post-2015 framework, helping to reorient co-operation away from the “donor-recipient” dichotomy towards a new model of co-operation among equals, following the principle of common-but-differentiated responsibilities.

Useful links

OECD work on external financing for development