Contemporary Issues in Development Finance 0429835256, 9780429835254

Table of contents :
Contents
List of figures
List of tables
List of contributors
Acknowledgements
Chapter 1 Introduction to contemporary issues in development finance
Chapter 2 Finance, economic growth, and development
Chapter 3 Microfinance and development
Chapter 4 Private capital flows and economic growth
Chapter 5 Remittances and development
Chapter 6 Foreign aid and economic development
Chapter 7 Global financial architecture: emerging issues and agenda for reforms
Chapter 8 Sovereign wealth management
Chapter 9 Sovereign debt management
Chapter 10 Financial inclusion and economic growth
Chapter 11 Financing agriculture for inclusive development
Chapter 12 Financing sustainable development: new insights for the present and the future
Chapter 13 International trade, finance, and development
Chapter 14 Infrastructure financing and economic development
Chapter 15 Finance and economic development: the role of the private sector
Index

Citation preview

CONTEMPORARY ISSUES IN DEVELOPMENT FINANCE Contemporary Issues in Development Finance provides comprehensive and up-to-date coverage of theoretical and policy issues in development fnance from both the domestic and the external fnance perspectives and emphasizes addressing the gaps in fnancial markets. The chapters cover topical issues such as microfnance, private sector fnancing, aid, FDI, remittances, sovereign wealth, trade fnance, and the sectoral fnancing of agricultural and infrastructural projects. Readers will acquire both breadth and depth of knowledge in critical and contemporary issues in development fnance from a philosophical and yet pragmatic development impact approach. The text ensures this by carefully integrating the relevant theoretical underpinnings, empirical assessments, and practical policy issues into its analysis. The work is designed to be fully accessible to practitioners with only a limited theoretical economic background, allowing them to deeply engage with the book as useful reference material. Readers may fnd more advanced information and technical details provided in clear, concise boxes throughout the text. Finally, each chapter is fully supported by a set of review questions and by cases and examples from developing countries, particularly those in Africa. This book is a valuable resource for both development fnance researchers and students taking courses in development fnance, development economics, international fnance, fnancial development policy, and economic policy management. Practitioners will fnd the development impact, policy, and conceptual analysis dimensions insightful analysing and designing intervention strategies. Joshua Yindenaba Abor is a Professor of Finance at the Department of Finance, University of Ghana Business School, Ghana. He is also a Visiting Professor of Development Finance at the University of Stellenbosch Business School, South Africa. He has made signifcant contributions to fnancial economics literature, mainly in the areas of banking and fnance, development fnance, fnancial market development, corporate fnance and governance, international fnancial fows, and growth. Charles Komla Delali Adjasi is a Professor of Development Finance and Economics at the University of Stellenbosch Business School, South Africa. He is also a Visiting Professor at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. His research focuses on fnancial markets development, frm productivity, international trade, and household welfare. Robert Lensink is a Professor of Finance and Financial Markets at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. He is also a Professor of Finance and Development at the Development Economics Group, Wageningen University & Research, and has published widely in the area of development fnance.

“This book provides an excellent overview of the challenges of fnancial sector development in developing countries. The different chapters touch on all the relevant dimensions, including international capital fows, microfnance and fnancial inclusion. An important contribution to our feld!” – Thorsten Beck, Professor of Banking and Finance, The Business School (formerly Cass), University of London, UK “An abundance of literature exists in development fnance, but this book will be an important ‘one-stop shop’ for researchers, teachers, and policy makers. It is thematic and coherent. The underpinning is on contemporary theories and empirics linking fnance and development with emphasis on inclusive development. This is because fnancial sector development alone does not ensure inclusive fnance that is vital for inclusive development. The fnancial instruments considered are also wide ranging; so are the players who can help bridge the fnancial development gap.” – Lemma Senbet, The William E. Mayer Chair Professor of Finance, University of Maryland, USA; Immediate Past Executive Director/CEO, African Economic Research Consortium

CONTEMPORARY ISSUES IN DEVELOPMENT FINANCE Edited by Joshua Yindenaba Abor, Charles Komla Delali Adjasi and Robert Lensink

First published 2021 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2021 selection and editorial matter, Joshua Yindenaba Abor, Charles Komla Delali Adjasi and Robert Lensink; individual chapters, the contributors The right of Joshua Yindenaba Abor, Charles Komla Delali Adjasi and Robert Lensink to be identifed as the authors of the editorial material, and of the authors for their individual chapters, has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identifcation and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book has been requested ISBN: 978-1-138-32431-2 (hbk) ISBN: 978-1-138-32432-9 (pbk) ISBN: 978-0-429-45095-2 (ebk) Typeset in Palatino by Apex CoVantage, LLC

CONTENTS List of fgures vii List of tables ix List of contributors xi Acknowledgements xv

Chapter 1

Introduction to contemporary issues in development fnance 1 Joshua Yindenaba abor, Charles Komla delali adJasi, and robert lensinK

Chapter 2

Finance, economic growth, and development 20 lordina amoah, Charles Komla delali adJasi, issouf soumare, Kofi aChampong osei, Joshua Yindenaba abor, ebenezer bugri anarfo, Charles amo-YarteY, and isaaC otChere

Chapter 3

Microfnance and development 51 niels hermes and robert lensinK

Chapter 4

Private capital fows and economic growth 73 eliKplimi Komla agbloYor, alfred Yawson, and pieter opperman

Chapter 5

Remittances and development 104 hanna fromell, tobias grohmann, and robert lensinK

Chapter 6

Foreign aid and economic development 140 matthew Kofi oCran, bernardin senadza, and eriC osei-assibeY

Chapter 7

Global fnancial architecture: emerging issues and agenda for reforms 169 Joshua Yindenaba abor, angela azumah alu, david mathuva, and Joe nellis

Chapter 8

Sovereign wealth management 207 mbaKo mbo and Charles Komla delali adJasi

Chapter 9

Sovereign debt management 235 amin Karimu, vera fiador, and imhotep paul alagidede

Chapter 10 Financial inclusion and economic growth 263 Joshua Yindenaba abor, haruna issahaKu, mohammed amidu, and viCtor murinde

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Chapter 11 Financing agriculture for inclusive development 287 haruna issahaKu, edward asiedu, paul Kwame nKegbe, and robert osei Chapter 12 Financing sustainable development: new insights for the present and the future 318 gordon abeKah-nKrumah, patriCK o. assuming, patienCe aseweh abor, and Jabir ibrahim mohammed Chapter 13 International trade, fnance, and development

351

steven braKman and Charles van marrewiJK Chapter 14 Infrastructure fnancing and economic development saint Kuttu, ashenafi fanta, miChael graham, and Joshua Yindenaba abor Chapter 15 Finance and economic development: the role of the private sector 411 eliKplimi Komla agbloYor, Joshua Yindenaba abor, haruna issahaKu, and Charles Komla delali adJasi Index

435

385

FIGURES 1.1 2.1 2.2 3.1 4.1 4.2 4.3 4.4 4.5 5.1 5.2 5.3 6.1 6.2 6.3 6.4 7.1 7.2 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 8.13 9.1

Credit rationing and its implications Domestic credit by banking sector (% GDP) across income groups Domestic credit by banking sector (% GDP) by regional classifcation Microfnance services Trends in private capital fows to Africa, 2000–2016 Scatter plot between capital fows and GDP per capita, 2000–2016 Scatter plot between capital fows and CO2 emissions, 2000–2016 Scatter plot between capital fows and institutions, 2000–2016 Scatter plot between capital fows and natural resource rents, 2000–2016 Capital infows to low- and middle-income countries, in billions USD Received remittances by country-level income group, in billions current USD Remittances in percentage of GDP by country-level income group Total volume of ODA in constant 2015 prices, 1960–2016 Sub-Saharan Africa’s share of ODA, 2005–2015 The aid Laffer curve Global 2017 CPI score and ranking Representation of Article 1 of the IMF Benefts and risks of fnancial globalisation A conceptual framework for SWF Evolution of SWF over time Cumulative growth in the number of funds, 1953–2017 SWF by source of seed capital Evolution of SWFs in Asia (pre-2007/2008 fnancial crisis) Trends in the Middle East: oil prices and production Evolution of SWFs in the Middle East (pre-2007/2008 fnancial crisis) Evolution of SWFs in Africa (pre-2007/2008 fnancial crisis) Evolution of SWFs in other parts of the world (pre-2007/2008 fnancial crisis) Evolution of SWFs: the aftermath of the 2007/2008 global fnancial crisis Evolution of SWFs post-2007/2008 global fnancial crisis A typical sovereign balance sheet Components of the Santiago SWF principles Debt Laffer curve

7 33 34 55 75 78 79 86 89 105 106 107 147 148 156 160 172 194 209 210 210 212 213 214 214 215 215 216 217 224 231 241

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9.2 11.1 11.2 11.3 11.4 11.5 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 13.9 13.10 13.11 13.12 13.13 13.14 13.15 13.16 13.17 14.1 15.1 15.2

Figures

Scatter plot with a ftted line Agriculture value added per worker, constant 2010 USD Agriculture value added per worker, constant 2000 USD Employment shares by sector (% in total employment) Share of FDI to agriculture in total FDI (%), 2011 Share of agriculture credit in total credit, 2015 Swiss franc, Canadian dollar, and South African rand; daily data, 2000–2020 Real effective exchange rate and nominal exchange rate; China, 1990–2020 British pound to euro spot and three-month forward exchange rates, 2016 British pound to euro spot rate and three-month forward premium, 2009–2016 Two investment options Assumptions, interest parity, and market effciency Argentina: interest rates, growth, and infation; percent, 1994–2018 Argentina reference interest rate; 7-Day Leliq Rate, 2016–2020 The policy trilemma Overview of international monetary regimes Spider web spiral: world imports in millions US gold dollar, 1929–1933 De facto exchange rate arrangements; 30 April 2014 Proposed and rejected trade fnance transactions; by region (%), 2017 Proposed and rejected trade fnance transactions; by frm size (%), 2017 Why trade fnance proposals were rejected; % of applications, 2019 Outcome of efforts to seek alternative trade fnancing; SMEs (%), 2019 Distribution of FDI; advanced, developing, and transition countries, 1975–2014 Number of PPP projects undertaken in South Africa between 1993 and 2017 Top recipients of FDI fows in Africa (billions of dollars), 2014–2015 Remittances dependent countries in SSA, 2017

242 291 291 292 295 296 354 355 357 358 359 362 363 363 365 366 368 372 373 374 374 375 378 402 425 426

TABLES 2.1 2.2 4.1 7.1 7.2 10.1 11.1 11.2 11.3 A13.1 12.1 12.2 12.3 12.4 13.1 13.2 13.3 13.4 13.5 13.6 14.1 15.1

Stock markets in sub-Saharan Africa Average financial structures of high-income vs low-income countries, 2015 Private capital fows to Africa in 2016: best and worst performers Overview of RDBs Financial products and services addressing the SDGs Trends in fnancial inclusion: SSA and World Contribution of agriculture to GDP (%) Agricultural raw materials exports (% of merchandise exports) Commodity exchanges in Africa Agriculture value added per worker (constant 2010 USD) MDGs and SDGs Differences between SDGs and MDGs Percentage contribution of different health fnancing sources to current health expenditure in 2015 Trends in DAH from 2008 to 2017 in billions USD and component contributions in percentages Some international currency symbols Spot exchange rates on 3 December 2019 at 11:55:00 a.m. (UTC + 01:00) Cross-exchange rates; spot, 3 December 2019 at 11:55:00 a.m. (UTC + 01:00) The policy trilemma and the international economic order IMF exchange rate classifcation system Functions of international currencies Financing structure Africa-focused private equity (PE) capital raised in the past ten years by domestic manager location

37 39 102 187 204 267 289 294 305 317 323 324 342 345 352 352 355 370 371 376 396 421

CONTRIBUTORS Gordon Abekah-Nkrumah is a senior lecturer in the Department of Public Administration and Health Services Management, University of Ghana Business School, Ghana. Joshua Yindenaba Abor is a professor of fnance at the Department of Finance, University of Ghana Business School, Ghana. He is also a visiting professor of development fnance at the University of Stellenbosch Business School, South Africa. Patience Aseweh Abor is a senior lecturer in the Department of Public Administration and Health Services Management, University of Ghana Business School, Ghana. Charles Komla Delali Adjasi is a professor of development fnance and economics at University of Stellenbosch Business School, South Africa. He is also a visiting professor at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. Elikplimi Komla Agbloyor is a senior lecturer in fnance at the Department of Finance, University of Ghana Business School, Ghana. Imhotep Paul Alagidede is a professor of fnance at Wits Business School, University of the Witwatersrand, Johannesburg, South Africa. Angela Azumah Alu is a doctoral researcher in fnance at the Department of Finance, University of Ghana Business School, Ghana. Mohammed Amidu is an associate professor of accounting and fnance at the Department of Accounting, University of Ghana Business School, Ghana. Charles Amo-Yartey is a senior economist in the African Department of the International Monetary Fund, Washington, DC, USA. He was previously the IMF resident representative in Liberia. Lordina Amoah is a lecturer at the Department of Finance, University of Ghana Business School, Ghana. Ebenezer Bugri Anarfo is a senior lecturer at the Ghana Institute of Management and Public Administration, Ghana. Edward Asiedu is a lecturer at the Department of Finance, University of Ghana Business School, Ghana, and an affliate research fellow chair of development economics, University of Passau, Germany. Patrick O. Assuming is a senior lecturer in economics at the Department of Finance, University of Ghana Business School, Ghana. Steven Brakman is a professor of international economics at University of Groningen, the Netherlands.

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Contributors

Ashenaf Fanta is a senior lecturer in development fnance at University of Stellenbosch Business School, South Africa. Vera Fiador is a senior lecturer in fnance at the Department of Finance, University of Ghana Business School, Ghana. Hanna Fromell is an assistant professor of fnance at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. Michael Graham is a professor of corporate fnance and the head of development fnance programmes at University of Stellenbosch Business School, South Africa. Tobias Grohmann is a doctoral researcher at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. Niels Hermes is a professor of fnance and the chair of Department of Economics, Econometrics and Finance at the University of Groningen, the Netherlands. Haruna Issahaku is a senior lecturer in economics and fnance and the head of the Department of Economics and Entrepreneurship, University for Development Studies, Tamale, Ghana. Amin Karimu is a lecturer at the University of Ghana Business School and a researcher at the Centre for Environmental and Resource Economics (CERE), Sweden. Saint Kuttu is a  senior lecturer in fnance and risk management at the Department of Finance, University of Ghana Business School, Ghana. Robert Lensink is a professor of fnance and fnancial markets at the Department of Economics, Econometrics and Finance, University of Groningen, the Netherlands. He is also a professor of fnance and development at the Development Economics Group, Wageningen University & Research. David Mathuva is a senior lecturer, the director of the undergraduate programmes, and the academic director of the master of science in development fnance programme at Strathmore University Business School, Kenya. Mbako Mbo is a fnance practitioner specializing in development fnance institutions and a chief fnancial offcer, Botswana Development Corporation, Botswana. Jabir Ibrahim Mohammed is a doctoral researcher in fnance at the Department of Finance, University of Ghana Business School, Ghana, and a fellow at PFM-Tax NetWork Africa. Victor Murinde is an AXA professor in global fnance and the head of the School of Finance and Management at SOAS University of London, UK. Joe Nellis is a deputy dean and a professor of global economy, School of Management, Cranfeld University, UK.

Contributors

xiii

Paul Kwame Nkegbe is an associate professor of applied and agricultural economics and the dean of the Faculty of Integrated Development Studies, University for Development Studies, Tamale, Ghana. Matthew Kof Ocran is a professor of economics and deputy dean of the faculty of economic and management sciences, University of the Western Cape, Cape Town, South Africa. Pieter Opperman is a lecturer in development fnance at the University of Stellenbosch Business School, South Africa. Eric Osei-Assibey is an associate professor of economics at the Department of Economics, University of Ghana, Ghana. Kof Achampong Osei is an associate professor of fnance at the Department of Finance, University of Ghana Business School, Ghana. Robert Osei is an associate professor of economics at the Institute of Statistical, Social and Economic Research (ISSER), University of Ghana, Legon, Ghana, and also the vice dean of the School of Graduate Studies at the University of Ghana. Isaac Otchere is a professor of fnance at the Sprott School of Business, Carleton University, Ottawa, Canada. Bernardin Senadza is an associate professor of economics at the Department of Economics, University of Ghana, Ghana. Issouf Soumare is a professor of fnance and the director of the Laboratory for Financial Engineering at Laval University, Canada. Charles van Marrewijk is a professor of international economics at the Utrecht University School of Economics, the Netherlands. Alfred Yawson is a professor in corporate fnance at the University of Adelaide Business School, Australia.

ACKNOWLEDGEMENTS JOSHUA YINDENABA ABOR To my wife, Pat and our children, Ivana, Bastien and Venka for their love, support and encouragement. Also, to my parents, Abor Ndobire and Amina Tobga for their inspiration. I really appreciate my colleague co-editors Charles and Robert for the great and exceptional work in executing this book project. I actually enjoyed collaborating with them. I wish to specially thank Lordina, Issouf, Kof, Ebenezer, Charles, Isaac, Angela, David, Joe, Haruna, Mohammed, Victor, Saint, Ashenaf, Michael and Elikplimi for coauthoring some of the chapters with me.

CHARLES KOMLA DELALI ADJASI To my wife Chewe Sakha Adjasi and our boys Delali and Dalitso for their love, support, encouragement and for tolerating Daddy’s endless late nights. To my father W.O. K. Adjasi and my late mother D.A.M. Buachie (Auntie Mansah) for your blessings. I would like to thank my co-editors Joshua Yindenaba Abor and Robert Lensink for the sterling initiatives and collaborative effort in getting this book project completed. I also thank in particular Robert Lensink, Niels Hermes and Grietje Pol and the colleagues of the Department of Economics, Econometrics and Finance, University of Groningen for the wonderful accommodation during my sabbatical.

ROBERT LENSINK To my lovely daughter Myrthe. I became involved in co-editing this book during the sabbatical of Charles at the University of Groningen. I am very grateful to him and Joshua that they invited me to join the team, and look forward to new joint projects in the future. I wish to express special thanks to Hanna Fromell, Tobias Grohmann and Niels Hermes for co-authoring two chapters with me.

GENERAL The editors would like to take the opportunity to thank all contributing authors for the high quality of their chapters. A big thank you to Eva Spek for the meticulous and excellent language and technical editing. We also would like to thank our reviewers for each chapter.

CHAPTER

1

Introduction to contemporary issues in development fnance Joshua Yindenaba Abor, Charles Komla Delali Adjasi and Robert Lensink 1.1 INTRODUCTION The importance of fnance in the economic growth and development process cannot be overemphasised. The literature is replete with evidence that suggests that fnance contributes signifcantly to the economic growth and development process in any county. Although the extant literature generally supports the fact that fnance and, for that matter, the fnancial sector are necessary for spurring economic growth by mobilising savings for investments, some have argued in recent times that it can also be a cause of fragility (where regulation is ineffective), as witnessed during the global fnancial crisis, the eurozone crisis, and the banking crises observed in certain economies. When the fnancial sector does not function properly, opportunities for growth and development are lost, resulting in inequalities and in some cases crises. However, when the fnancial sector functions effciently, it provides the avenues for market players to take advantage of investment opportunities by channelling funds for production, thus driving economic growth and development. Discussions in the fnance and growth literature thus focused on the level of fnancial sector development. This was also in line with the view that the fnance–growth link is stronger in well-developed fnancial systems and led to substantial dialogue around the depth, size, effciency, and outreach of the fnancial sector. The type and the structure of the fnancial system in particular, whether bank based or market based, also became important points of debate in the fnance–growth nexus. By the mid 2000s, however, the discussion moved to fnancial inclusion and emphasised access to fnancial services by the low income. The development of mobile money as a way to increase access further boosted this literature on fnancial inclusion. Financial inclusion soon became a prominent part of growth-enhancing strategies of countries and international fnance institutions. Here the main difference between fnancial inclusion and fnancial sector development is that the former concentrates issues of access and use of fnancial services for

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the unbanked, while the latter deals with the development of the fnancial sector in general. Indeed, this difference becomes hazy because both can mean the same from a measurement point of view. Economic growth has to do with the increase in the productive capacity of an economy in a year in relation to the previous year as measured by real gross domestic product (GDP). Economic development is also concerned with the process of creating and utilising physical, fnancial, human, and social assets to improve the economic well-being and quality of life of people in a community, region, or country. Whereas economic growth is a phenomenon of market productivity and an increase in nominal or real GDP, economic development is associated mainly with the economic and social well-being of people in a community, region, or country. The economic development efforts of countries must be sustained over time in order to produce positive economic and social outcomes. In the view of Seidman (2005), the economic development process creates assets that enable the community, region, or country to sustain and recreate its desired economic and community outcomes. Unsurprisingly, the discussions in literature also moved to incorporate the need for inclusive growth. The emphasis was on the idea that growth must be benefcial to all and in particular for poverty reduction to be effective. Amid all of this has been the ever-constant debates around issues of causality: whether fnance causes economies to grow, whether it is instead growing economies that result in higher fnancial development, and whether causality goes both ways and depends on stages of a country’s development. There is also the vibrant debate on whether fnancial development can lift the welfare of poor households. These discussions, however, do not question the fact that fnancing economic growth and development, especially in developing and emerging countries through the mobilisation of domestic resource as well as an appropriate level of external capital infows, is an important issue. However, a fnancing gap develops when the fnancial system is ineffcient and ineffective and when governments are also unable to mobilise resources. Precisely, development fnance focuses on how domestic and the global fnancial systems facilitate the economic growth and development process. It also deals with structuring and reforming the fnancial system in ways that promote growth and development at both the macro level and the micro level in developing and emerging economies. At the macro level, the focus is on fnancing the design and implementation of national development strategy, which is critical to the realisation of the country’s development goals. Achieving country-specifc development goals may also be related to the global development agenda. With respect to global development, the present emphasis is on how to fnance the sustainable development goals (SDGs), which were set by the United Nations (UN) with a 2030 timeline (Biekpe, Cassimon, & Verbeke, 2017). The SDGs, otherwise known as the global goals, include 17 specifc goals, which build on the progress made with respect to the millennium development goals (MDGs) and incorporate additional goals. Some of these new goals include reducing inequity, ensuring sustainable consumption and production patterns,

Chapter 1 • Introduction to contemporary issues in development fnance

3

combatting climate change and its impact, promoting peaceful and inclusive societies, and providing justice, among others. Also, at the micro level, the concentration is on how individual households, local communities, and frms are able to access the necessary fnance to support their growth and development aspirations. However, a certain fnancing gap tends to constrain the achievement of these development targets  – hence the need to design the fnancial system to be able to support the growth and development process.

1.2 PURPOSE OF THIS BOOK This book examines issues in development fnance by focusing on how fnancial systems and innovations in fnancial resource fow can drive the economic growth and development process. This emerging discipline seems to be gaining widespread recognition and importance across the globe and in Africa in particular. The literature on development fnance is enormous. However, no recent text is available that covers the wide range of the literature in this area. The main contribution of this book is that it provides comprehensive coverage of the various critical and contemporary issues in development fnance by carefully integrating relevant theoretical underpinnings, empirical assessments, and practical policy issues. With the expansion of economic development initiatives across the globe comes an urgent need for expertise and skills in development fnance to drive, support, and manage them. The book tries to be as complete and up to date as possible regarding recent theoretical discussions in the broad feld of development fnance. Therefore, the book provides a valuable resource for development fnance researchers and for students taking courses in, for example, development fnance, fnance for development, development economics, international fnance, fnancial development policy, and economic policy management. Every chapter contains a set of review questions, which may be helpful for students to better absorb the information provided. Given that we deliberately avoid overly technical discussions in the main text – more technical details are provided in ‘boxes’ – also practitioners with only a limited theoretical economic background will fnd the book a useful reference. This frst introductory chapter provides an overview of the other chapters in the book. In different chapters, the book pays attention to the general theoretical and empirical discussion on the relationship between fnancial development and economic growth; the importance of microfnance; the role of different types of external capital fows, distinguishing between external private fows, foreign aid, and international remittance; the importance of international fnancial architecture; the role of sovereign debt and wealth management; the role of fnancing different sectors in the economy, such as medium-size enterprises, infrastructure, the agricultural sector, and the external sector; and the recent discussion on fnancial inclusion and economic growth, including issues like mobile money transfers. However, because development fnance emerged as a result of market imperfection and limited capital available, this chapter starts by discussing

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market imperfections and development fnance. It also examines development fnance interventions aimed at minimising the market imperfections and establishing development fnance institutions to provide direct fnancing in the market. Finally, the chapter briefy discusses recent developments regarding fnancial inclusion and fntech.

1.3 MARKET IMPERFECTIONS AND DEVELOPMENT FINANCE Development fnance recognises the need to fll the gaps between capital required and capital available through various interventions. The fnancing gap is a result of fnancial market imperfections or the failure of fnancial markets to provide the requisite fnance to support economic activity. Development fnance interventions are aimed at ensuring the availability of capital when fnancial markets fail to supply the needed capital. These interventions include trying to curtail the imperfections in fnancial markets and institutions in order to improve the level of effciency and establishing alternative development fnance institutions to provide direct capital in the market. At this stage, we bring up and discuss the concept of fnancial market imperfections. Financial market imperfection is concerned with the failure of fnancial markets to supply the required capital to fnance economic activity. Market imperfections or fnancial market gaps occur when capital is not allocated in the most productive manner. Microeconomic theory suggests that in perfect capital markets, capital is allocated perfectly, under the assumptions of complete markets, the perfect rationality of agents, and perfect or full information. Under these conditions, equilibrium is established when the interest rates clear the market when the supply of capital is equal to the demand for capital. However, when these assumptions are not present, market imperfections tend to occur. In the absence of perfect competition, suppliers of capital may seek to determine their own terms and may not be mindful of ensuring effcient allocation of capital. The high transaction costs and lack of information are a direct consequence of market imperfections. Transaction costs are the costs of using the price mechanism, which include the cost associated with discovering relevant prices and the cost of negotiating and concluding contracts (Coase, 1937). In the fnancial market, fnancial institutions play an important role in contributing to reducing transaction costs. Minimising transaction costs is regarded as a necessary condition but not a suffcient condition for improving fnancial and economic effciency. We now discuss how asymmetric information explains fnancial market imperfections. We also look at how imperfection in fnancial markets results in credit rationing. 1.3.1 Asymmetric information A key feature of fnancial markets that results in market imperfection is asymmetric information1 between users of fnance and providers of fnance. The application of asymmetric information to explain fnancial market

Chapter 1 • Introduction to contemporary issues in development fnance

5

incompleteness, imperfections, and credit constraint is attributed to the work of Joseph Stiglitz in the 1980s. The problem of asymmetric information or information asymmetry arises because borrowers and providers of fnance do not have equal access to information regarding the creditworthiness of the potential borrower. In more general terms, asymmetric information, sometimes referred to as information failure, describes a situation where one party to an economic transaction has better access to information than the other party does, resulting in an imbalance of power in transactions, which may cause the transaction to be skewed. The information-defcient party might make a different decision provided the information being withheld was made available. Asymmetric information may result in adverse selection and moral hazard. Adverse selection occurs when the lack of information in the fnancial market puts the lender in a position of being unable to distinguish good borrowers from bad ones. It occurs ex ante: before the lender provides a loan, or debt, contract to the borrower, on the basis of available information by the time of the event. It happens when the lender does not have the necessary tools to screen the borrower types and is thus unable to ascertain whether the borrower engages in riskier projects. For risky borrowers, there is a higher probability that projects will fail than for safe borrowers. However, if the project succeeds, the return will be higher for risky borrowers. In this situation, risky borrowers are likely willing to pay a higher interest rate than safe borrowers are. The consequence is that in case the bank increases the interest rate, safe borrowers decide not to borrow anymore, such that the bank ends up with a portfolio of only risky borrowers, a process indicated by the term ‘adverse selection’. The bank does not know who the risky borrower or the safe borrower is but realizes that an increase in interest rates may have ‘adverse selection’ effects. To avoid this, the bank may decide in times of access demand for credit not to increase the interest rate but simply to ration credit. Box 1.1 provides further discussion on credit rationing and its implications. Stiglitz and Weiss (1981) explain that the adverse selection theory of credit markets is based on two key assumptions: lenders are not able to differentiate between borrowers with different levels of risk, and the loan contracts are subject to limited liability in the sense that in the event that the project generates returns lesser than the debt obligations, the borrowers will not be responsible for paying out of pocket. The consequence of adverse selection is that fnancial markets are not effcient, in that good projects will not be funded, while bad projects will be selected.

ADVERSE SELECTION

Moral hazard results from the lack of information regarding the ex post behaviour of borrowers – that is, the behaviour of borrowers after a debt contract has been signed with a bank. In more general terms, moral hazard occurs when after entering into a contract, the incentives of the two parties involved change, to the extent that the risk associated with the contract is altered (Heffernan, 2006). It refers to the borrower’s engaging in high-risk strategies and applying the funds acquired for a purpose

MORAL HAZARD

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different from that for which they were sourced. After acquiring loans, borrowers may undertake risky projects, since they are not fully responsible for the funds, and the inability of the lender to control how the borrower applies the funds may lead to moral hazard. With increases in interest rates, the borrower is likely to be involved in such risky projects so as to increase the expected returns, and if the project is successful, the borrower gains, but if it fails, the lender assumes the default risk. The default risk is one of the conditions of an imperfect market. The borrower may be in fnancial distress or become bankrupt, thus being unable to fulfl their indebtedness. Therefore, the promise and level of commitment by the borrower plays a signifcant role in the lending arrangement. One way by which the lender can secure the loan is to request the borrower to pledge collateral. Ray, Ghosh, and Mookherjee (2000) suggest that collateral minimises the default risk (for incentive reasons) and the lender’s exposure in the event of default. In terms of reducing the default risk, the collateral makes the borrower’s expected return of selecting risky projects lower than the expected return of safer projects. Thus, the borrower has no incentive for choosing risky projects. In the case reducing the lender’s exposure, the loan contract is structured in such a way that the collateral provides the means by which the lender is able to recover all or substantial part of the loan given out in the event of default. There are, however, costs associated with the lender’s seizing the pledged assets in the event of default.

BOX 1.1 Credit rationing and its implications The concept of credit rationing has developed following the seminal papers by Jaffe and Russell (1976) and Stiglitz and Weiss (1981) and can be depicted by the market for supply and demand of loans. An interest rate r* maximizes the expected return to the bank. Excess demand can exist at this interest rate but not induce banks to increase the interest rate above r*. Under such conditions, banks cut the supply of loans (backwards-bending supply), at interest rates above r* where demand DL exceeds the supply of funds (SL). Unsatisfed borrowers bid up the interest rate until rm, which marks the beginning of credit rationing. Some individuals can acquire loans, albeit at a higher interest rate, while others cannot. However, hiking the interest rate or reducing the collateral requirement could increase the riskiness of the lender or loan portfolio of the bank, either by discouraging safer investments or by encouraging borrowers to undertake riskier investment projects, thus reducing the lender’s profts. The implication is to reduce the number of loans that the lender provides. In an extreme case, the backwards-bending supply curve touches the interest rate (vertical) axis, and there is full rationing and total exclusion for some large portion of individuals and entities.

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FIGURE 1.1 Credit rationing and its implications

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Credit rationing is a result of capital market imperfections, which are characterised by information asymmetry and its consequent adverse selection and moral hazard. Keeton (1979), Stiglitz and Weiss (1981), and Jaffe and Stiglitz (1990) provide specifc defnitions of two types of credit rationing: Type 1. Pure credit rationing happens when some individuals acquire loans, while apparently identical individuals, who are ready to borrow on exactly the same terms, are not able. Type 2. Redlining arises when some identifable groups of individuals, given a particular supply of credit, are not able to acquire loans at any interest rate, but given a larger supply of credit, they would.

1.4 DEVELOPMENT FINANCE INTERVENTIONS We mentioned that development fnance plays an important role in expanding capital availability to fnance economic growth and development, and these include, frst, minimising the imperfections in fnancial markets and institutions in order to improve on the level of effciency and, second, establishing alternative fnancial institutions or development fnance institutions to provide direct capital in the market. These two forms of interventions need to be regarded as complementary and should be used in ways that achieve the objectives of development fnance. Next, we discuss each of these interventions or strategies.

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1.4.1 Interventions for correcting market imperfections These are concerned with reducing the main sources of ineffciencies that introduce gaps in the required and available fnance. Interventions for perfecting the fnancial market include measures that aim at improving the performance and functioning of the fnancial market and institutions in ways that enhance available fnancing for development. This is crucial given the important role fnancial markets and institutions play in facilitating the supply of funds for fnancing economic activities. The following are some of the interventions aimed at improving the operation and performance of the fnancial markets and institutions: • Ensuring effective fnancial market regulation  – the regulation of fnancial markets is necessary given their complex nature and importance in the economies they operate in. The regulation of the fnancial market ensures market participants are treated fairly and has implications for the performance of various fnancial institutions. The essence of regulating fnancial markets include protecting investors, preventing securities issuers from defrauding investors and hiding important information, promoting the stability of fnancial institutions, promoting competition and fairness in the trading of fnancial securities, restricting the level of activities of foreign entities in local markets and institutions, and controlling the level of economic activity. • Introducing risk management instruments  – this includes the means by which market players share their risk with counterparties. It may involve the use of insurance contracts and fnancial derivatives such as forwards, futures, options, swaps, and swaptions. • Reducing cost of contracting and information processing  – fnancial institutions handle huge volumes of transactions and tend to enjoy economies of scale related to contracting and processing information on securities. The low costs associated with contracting and processing would beneft investors and issuers of securities. Also, the ability of fnancial institutions to obtain information concerning potential borrowers and screening out bad credit risks helps in dealing with the problems in connection with adverse selection and moral hazards. • Providing effcient payment system  – providing for payment mechanisms like cheques, electronic transfers of funds, debit cards, and credit cards enables fnancial institutions to transform certain types of assets (i.e. those that could not be used in making payments) into other forms of assets that can be used to effect payment. The fnancial market provides the means of making payments without using physical cash, and this is necessary for the effective and effcient functioning of the market. • Introducing fnancial innovation  – attempts to reduce market imperfection also involve introducing fnancial innovation to improve on the level of effciency in the fnancial market. Financial innovation entails the development of new fnancial products or services; the introduction of new processes or delivery systems that result in reducing costs and risks or providing enhanced services to meet the needs

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of market participants; and the emergence of new kinds of fnancial service providers. The fnancial innovation process involves changes in fnancial instruments, institutions, markets, and practices. More generally, fnancial innovation tends to affect the nature and composition of monetary aggregates by introducing new fnancial instruments or changing existing fnancial instruments. Financial innovations result in reducing the transaction cost associated with transferring funds from lower-yielding money instruments to higher-yielding ones. Thus, participants in the fnancial system are able to minimise their risk and maximise their returns. 1.4.2 Establishing development fnance institutions Development fnance institutions (DFIs) are alternative fnancial institutions that are concerned with providing long-term fnance (e.g. long-term loans, equity, and risk guarantee instruments) to promote private investment for economic growth and sustainable development while ensuring they remain fnancially viable. They concentrate mainly on areas that providers of conventional fnance tend to avoid and on markets, which have limited access to sources of domestic and external capital. DFIs are said to occupy the intermediary space between public aid and private investment by focusing on high-risk investments in sectors that have limited access to capital markets. They are capable of raising huge amounts of capital from the global capital markets for providing loans or equity investment on commercial and sometimes-concessional bases (Dickinson, n.d.; Abor, 2017). There are multilateral, regional, and bilateral or country-specifc DFIs (see Box 1.2).

BOX 1.2 Types of DFIs Multilateral DFIs include private sector outfts of international fnancial institutions (IFIs), which are founded by a number of countries and are subject to international law. They are generally owned by national governments but sometimes with ownership participation by international or private entities. They tend to have stronger fnancing capacity and provide the opportunity for close cooperation between governments. The regional DFIs are essentially part of multilateral DFIs, but they tend to focus on specifc regions and are owned by the governments of those regions. Bilateral or country-specifc DFIs operate mainly in developing and emerging economies and have the mandate of providing longterm capital to fnance the private sector, with particular value-added development objectives on a sustainable commercial basis. Bilateral DFIs may also include microfnance institutions, state development banks, community development fnance institutions, microenterprise funds, and revolving loan fundts.

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The traditional role of DFIs is to help address the failure or imperfections in fnancial markets. In the view of Dixit and Pindyck (1994), uncertainty signifcantly and negatively affects investment, which entails large sunk and irreversible costs and, where there is a choice, delaying the investment decision until additional information becomes available. The risks associated with such long-term investments tend to discourage private sector investors. DFI assist in correcting risk perceptions, promoting favourable environment for private investment to thrive as well as providing social infrastructure and other activities that have positive economic outcomes. They tend to focus on developing countries with limited access to local and external capital markets by providing long-term fnance for infrastructure projects in developing countries. DFIs facilitate private sector investment and provide risk guarantee that provide comfort for investors. They provide fnance that is linked to the design and implementation of capacity-building programmes adopted by governments (te Velde, 2011). DFIs also play an active role in fnancing small and medium-size enterprises (SMEs), which are often perceived as risky by other fnance providers. In that case, they take the frst mover advantage in markets with high growth potential. They often have a double bottom line: pursuing proft and pursuing development. On one hand, they invest for the purpose of generating returns, which enable them to undertake more investments. On the other hand, they facilitate the economic development of the countries they invest in (Dickinson, n.d.). DFIs contribute by adding value to the economic development process. Dalberg (2009) mentions three ways by which DFIs do this: 1 Investing in underserved projects types and settings  – the business model of DFIs is designed so that they are able to invest in highly risky projects in developing countries. They have the capacity to tolerate high risk and make long-term investments, especially in areas where private investors consider risky to commit resources to. 2 Investing in undercapitalised sectors  – they specialise in investing in sectors such as agriculture, energy, the fnancial sector, and infrastructure, which are critical to driving economic growth. 3 Mobilising other investors  – they promote sharing knowledge, setting standards, and collaboration, which helps attract other investors. Their track records enable other investors to scale up their investment, and they also build local capacity in fund management. Chapter 7 of this book provides a more comprehensive discussion of DFIs in the context of the global fnancial system.

1.5 FINANCIAL DEVELOPMENT, FINANCIAL INCLUSION, AND FINTECH2 During the past decade, the discussion about fnance and development has started to change, by focusing more specifcally on possibilities to improve fnancial inclusion  – that is, on different measures to improve access to fnance for unbanked people; see also Chapter 10 in this book. Even if

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fnancial development will lead to long-run economic growth, it is not clear at all that also poor people will gain a lot. Probably only if fnancial development operates on the so-called extensive margin, implying that it improves access to fnancial services by individuals who had no access to these services before, a process of fnancial development will be benefcial for the poor unbanked part of the society. If fnancial development operates on the intensive margin, and hence improves access to fnancial services only for those households and frms that already had access to fnance, fnancial development will not help unbanked people and will likely increase inequality, at the least in the short run. There is still an enormous lack of data regarding fnancial inclusion of poor people in the developing world. Fortunately, in 2011, the World Bank launched the Findex database, which is the world’s most comprehensive database on fnancial inclusion around the world. The dataset covers more than 140 economies around the world, drawing on survey data. The initial survey round was followed by a second one in 2014 and a third one in 2017. The study shows that currently almost 70% of adults around the world have a bank account. Moreover, the study provides promising fgures about a rise in fnancial inclusion in the last decade, also in developing countries, where bank account ownership increased from 55% to 63% between 2014 and 2017 (Demirgüç-Kunt, Leora, Dorothe, Saniya, & Jake, 2018). However, there are still considerable gaps in who has access to fnance: women are much less likely than men to have a bank account; bank ownership is still much lower in developing countries than in the developed world, and especially adults with low education and without formal jobs are still often excluded from any fnancial services. Thus, a further increase in fnancial inclusion to provide access to fnancial services for still-unbanked poor people seems important. Innovations in fntech are among the most promising developments in improving fnancial inclusion. Fintech refers to the emerging industry that uses technology to provide fnancial services. It is characteried as fnancial intermediation services delivered through mobile phones, computing devices using the internet, or cards linked to a secure digital payment system (Manyika, Lund, Singer, White, & Berry, 2016). The most widely adopted forms of fntech in developing countries, especially in sub-Saharan Africa, are mobile money and mobile fnancial services. Sub-Saharan Africa is even the only region where the share of adults with a mobile money account exceeds 10%. M-Pesa (see Box 1.3), a mobile phone–based money transfer service, launched in 2007 by VodafoneGroup plc and Safaricom in Kenya, was one of the frst mobile network operators in sub-Saharan Africa. Mobile money accounts have now spread to new parts of sub-Saharan Africa, and the share of adults with a mobile money account has now surpassed 30% in various countries, such as Côte d’Ivoire, Senegal, and Gabon. The success of M-Pesa has shown the possibility of leveraging simple non-internet-based mobile technology to extend fnancial services to large segments of unbanked poor people. It also shows the importance of designing a usage-based and low-cost transactional platform that enables lowincome customers to meet a range of payment needs. Fintech is very much associated with mobile money. Yet fntech also includes other applications,

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BOX 1.3 M-Pesa M-Pesa was a small-value payment and store of value system using ordinary mobile phones. It was designed to enable customers receive and transfer funds securely by using ordinary mobile phones. Customers can also use it to pay bills such as water and electricity and store their money. M-Pesa was an immediate success: at the end of its frst year, it had registered 1.2 million customers in Kenya and had 19 million customers by the end of 2018. M-Pesa payments consist of personto-person (P2P) payments, which form a bulk, and person-to-business (P2B), business-to-person (B2P), and recently government-to-person (G2P) and government-to-business (G2B) payments. M-Pesa opened the door to formal fnancial services for Kenya’s poor. It introduced small accessible and affordable loans, increased the scope of payment services, and created more-affordable fnancial options for the poor. M-Pesa has now expanded beyond the borders of Kenya and by the end of 2019 became Africa’s most successful mobile fnance case, with 37 million active customers and 11 billion transactions across seven countries: the Democratic Republic of Congo, Egypt, Ghana, Kenya, Lesotho, Mozambique, and Tanzania. M-Pesa has also enhanced access to other economic and social infrastructure via its associated new product developments. For instance, in Tanzania, it has been used by a nongovernmental organization (NGO) – Comprehensive Community-Based Rehabilitation – to support patients to pay for travel cost to health facilities. M-Pesa has also has enabled access to electricity for low-income households in Kenya and Tanzania. This is via a partnership-based system, M-KOPA, that allows households to acquire a solar-powered off-grid electricity kit and pay for it in small daily payments by using their M-Pesa account. Source: Vodafone

like a distributed ledger technology (blockchains), which can interact with the Internet of Things (IoT) to lower transaction costs and ease fnancing and mobile payments. In the literature, the terms ‘mobile money’, ‘mobile fnancial services’, ‘digital payments’, and ‘digital fnance’ are often used interchangeably. However, there is a crucial difference in that ‘digital’ refers to services that require access to digital devices (internet), whereas, for instance, a simple text-based mobile phone can be used without accessing the internet. Recently, a lot of research has been devoted to mobile money platforms and associated mobile wallet technologies, which enable the provision of fnancial services through a mobile phone. Initially, mobile money

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referred mainly to person-to-person money transfers. However, mobile phones and more generally digital fnancial services transacted via mobile money platforms are now also used to pay bills, save money, conduct person-to-business payments, and receive payments (wages) and for investments (Suri, 2017; Apior & Suzuki, 2018). Mobile phones are also increasingly used to send and receive international remittances. See Chapter 5 in this book for an extensive discussion on the role of international remittances. In sub-Saharan Africa, the sending and receiving of remittances has even become the main use of mobile money (Demirgüç-Kunt et al., 2018). Mobile money platforms thus potentially offer wide accessibility (Osburg & Lohrmann, 2017) and may serve as conduits for fnancing different sectors in the economy, such as SMEs and smallholder farmers. They may also help to include the unbanked in the fnancial system (Klapper, El-Zoghbi, & Hess, 2016) and induce positive effects on education, health, employment, productivity, and poverty alleviation. While the success of M-Pesa seems to provide evidence for the potentially enormous role of fntech in enhancing fnancial inclusion and raising the living standards of unbanked people in the developing world, the development of fntech in many countries in Africa, South America, and Asia has been problematic. Even a replication of M-Pesa outside Kenya was often unsuccessful, especially in countries where a more advanced banking network was already available, such as in South Africa. Overall, the fntech sector in sub-Saharan Africa remains small (Yermack, 2018). Indeed, there are several limitations and risks, which make it unlikely that fntech will in the short run induce a process of fnancial inclusion that will improve the living standards of the majority of the still-unbanked adults. An important prerequisite of a successful rapid fntech development is the availability of a sound communications infrastructure (Yermack, 2018). However, in most developing countries, only a rudimentary communications infrastructure is available, characterized by limited access to broadband internet connections and smartphone handsets. To promote adequate investments, a supportive regulatory framework is needed. Yet most African governments have so far taken a hands-off approach to fntech regulation. Even if fntech were to be widely promoted, it can ensure and promote inclusive growth only if it meets the needs of disadvantaged groups. The uptake and use of mobile fnancial services in many developing countries will be limited due to low reading literacy and digital literacy levels (Nedungadi, Menon, Gutjahr, Erickson, & Raman, 2018). There is also a risk that specifc fntech services will not be provided to poor rural communities, to save costs (Ozili, 2018). Entire geographic areas might be excluded from new technologies, and the new world of data and information, as the success of particular forms of fntech, especially if big data is involved, crucially depends on the availability of data scientists, who may not be available in several developing countries. Much more research on the potential and limitations of fntech is needed. However, fntech will not likely be a panacea for raising the living standards of the unbanked population in the developing world in the short run.

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1.6 AN OVERVIEW OF THE CHAPTERS In this section, we provide an overview of the various chapters. We have deliberately not distinguished different parts in the book, because the chapters can be combined in various ways to deal with subparts of the extant development fnance literature. For instance, Chapters 1, 2, 3, 10, and 15 deal with domestic fnance issues. Chapters 4, 5, and 6 discuss external fnance, and Chapter 7 discusses the global fnancial architecture. Chapters 8 and 9 address issues on sovereign debt and wealth management, and Chapters 11, 12, 13, 14, and 15 discuss the fnancing of specifc sectors of the economy. In Chapter 2, Lordina Amoah, Charles Komla Delali Adjasi, Issouf Soumare, Kof Achampong Osei, Joshua Yindenaba Abor, Ebenezer Bugri Anarfo, Charles Amo-Yartey, and Isaac Otchere discuss the theoretical and empirical literature regarding the role of the fnancial sector in inducing a process of economic growth. They also discuss fnancial repression, liberalization, and growth and the fnance–growth nexus, highlighting the various hypotheses underpinning this relationship. Their chapter ends with a discussion of the importance of deposit-taking fnancial institutions and capital markets in the economic growth process. In Chapter 3, Niels Hermes and Robert Lensink provide an up-to-date review of the role of microfnance in the process of development. The aim of this chapter is to discuss, in the face of the recent criticism, whether, and if so how, there is still a role to play for microfnance in promoting inclusive growth. They distinguish between the supply side of microfnance, focusing on analyses at the MFI level, and the demand side of microfnance, focusing on end users. The next four chapters deal with external fnance. These chapters discuss how various types of external capital fows (private capital fows, remittances, and foreign aid) affect growth and development. Moreover, it discusses the international fnancial architecture. In Chapter 4, Elikplimi Komla Agbloyor, Alfred Yawson, and Pieter Opperman discuss the role of international private capital fows in promoting economic growth. The chapter explains the difference between various types of private capital fows, such as foreign direct investments (FDI) and foreign portfolio investment (FPI). It examines how these components of private capital fows drive growth and assesses the interactions between private capital fows and domestic investment. In Chapter 5, Hanna Fromell, Tobias Grohmann, and Robert Lensink discuss the relationship between international remittances and development. They explain in detail the results and methodology of research that addresses international remittances from developed and developing countries. The chapter pays attention to, for example, the motivation for remittances, the impact of international remittances on economic growth, fnancial development, and inequality and poverty. The chapter ends with a discussion on policy tools to enhance the marginal impact of international remittance payments. In Chapter 6, Matthew Kof Ocran, Bernadin Senadza, and Eric OseiAssibey deal with foreign aid and development. They describe the historical

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origins of foreign aid and summarise trends in the volume of aid. The chapter also summarises the voluminous literature on aid effectiveness. The chapter concludes by discussing some alternatives for foreign aid. After three chapters on the relationship between external capital fows and development, Joshua Yindenaba Abor, Angela Azumah Alu, David Mathuva, and Joe Nellis, in Chapter 7, discuss the system of global economic and fnancial governance – the so-called global fnancial architecture – that facilitates the fow of external capital. The chapter pays attention to the role of the institutions that make up the global fnancial architecture, such as the Bretton Woods institutions, including the International Monetary Fund (IMF), the World Bank Group, the World Trade Organization, the Bank for International Settlements (BIS), and the regional development fnance institutions in developing and emerging countries. They chapter also addresses fnancial globalisation, global crises, and reform issues regarding the global fnancial architecture. The next two chapters deal with sovereign management in developing countries. A distinction is made between sovereign wealth management and sovereign debt management. In Chapter 8, Mbako Mbo and Charles Komla Delali Adjasi discuss sovereign wealth management in emerging economies. Sovereign wealth management deals with questions related to prudent public fnance management. The chapter pays attention to the evolution and changing role of sovereign wealth management and asset-liability management in emerging economies. It also looks at asset allocation and risk management for sovereign wealth funds. In Chapter 9, Amin Karimu, Vera Fiador, and Imhotep Paul Alagidede pay attention to what is known as sovereign debt management. The chapter discusses how governments in developing countries have managed their international debt, and how external debt affects economic growth. It also deals with questions related to renegotiating debt contracts, debt-relief policies, sovereign debt restructuring, and risk management frameworks. The chapter ends by analysing debt sustainability and a medium-term debt strategy. In Chapter 10, Joshua Yindenaba Abor, Haruna Issahaku, Mohammed Amidu, and Victor Murinde discuss the relationship between fnancial inclusion and economic growth. Whereas Chapter 2 pays attention to the more general discussion of fnancial development and economic growth, this chapter deals with the more recent discussion on fnancial inclusion and economic growth. Financial inclusion, in theory, differs from fnancial development: fnancial development focuses on the development of the fnancial sector in general, whereas fnancial inclusion deals with the question who actually has access to the fnancial system and to what extent access to the fnancial sector has improved for certain groups, especially the poor, in a society. However, in terms of measurement, the difference between fnancial development and fnancial inclusion is often not clear. This chapter defnes fnancial inclusion, provides a guide to its measurement, describes the trends in fnancial inclusion, discusses the determinants of and barriers to fnancial inclusion, and assesses the link between inclusive fnance

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and fnancial development. It also examines the effect of inclusive fnance on economic growth, including the importance of recent innovations like mobile phone–based money transfers. The chapter ends by discussing the roles of institutional architecture in the nexus between fnancial inclusion and economic growth. The next fve chapters deal with fnancing particular sectors in the economy and its relevance for economic development. Distinctions are made between fnancing the agricultural sector, fnancing infrastructure, fnancing sustainable development, fnancing the external sector, and fnancing the private sector, especially SMEs. In Chapter 11, Haruna Issahaku, Edward Asiedu, Paul Kwame Nkegbe, and Robert Osei discuss fnancing agriculture for inclusive development. The chapter examines how fnancing agriculture can promote inclusive development and reduce poverty and inequality. The specifc topics covered include stylised facts on agriculture development, challenges of agriculture fnancing, fnancing opportunities, innovative fnancing models for agriculture and agriculture development, and inclusive development. In Chapter 12, Gordon Abekah-Nkrumah, Patrick O. Assuming, Patience Aseweh Abor, and Jabir Ibrahim Mohammed pay attention to fnancing sustainable development. The main issues covered here are global actions for sustainable development, challenges and opportunities of sustainable development, conventional and innovative funding modes for sustainable development, and benefts derived from fnancing sustainable development. The chapter offers innovative ideas for fnancing sustainable development. In Chapter 13, Steven Brakman and Charles van Marrewijk discuss international trade, fnance, and development. This chapter covers topics such as models of trade, the political economy of trade policy, various trade agreements, and the effects of trade policy on economic growth and development. The chapter also pays attention to the main aspects of exchange rates and the related importance of forward-looking markets for understanding the power of fnancial forces. Finally, the chapter discusses issues on trade fnance and concludes with a discussion of fnance, investment, and development. In Chapter 14, Saint Kuttu, Ashenaf Fanta, Michael Graham, and Joshua Yindenaba Abor discuss infrastructure fnancing and economic development. The chapter covers challenges and opportunities for infrastructure development, economic growth and development nexus, infrastructure fnancing models, a framework for enhancing private participation in infrastructure development, and risk management in infrastructure projects. In the fnal chapter of the book, Chapter 15, Joshua Yindenaba Abor, Haruna Issahaku, Charles Komla Delali Adjasi, and Elikplimi Komla Agbloyor return to the fnance and growth discussion that started in Chapter 2. Chapter 15, however, focuses on the role of the private sector in the fnancial development and economic growth discussion. The chapter argues that addressing the fnancing constraints of the private sector, especially those for SMEs, is necessary to drive growth in developing and emerging economies. The chapter provides an overview of the discussion related to the private sector and economic development, discusses the fnancing and

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investment behaviour of frms, and examines how various forms of development fnance contribute to private sector development and economic development.

1.7 CONCLUDING REMARKS In this chapter, we have discussed the basic tenets of fnancial markets and their role in economic growth and development and pointed out the role of development fnance and DFIs in fnancing growth and development. The chapter shows that fnancial markets can be replete with bottlenecks and inherent challenges, rendering it imperfect and incomplete. If not reduced or controlled, these challenges could destabilize the economy and cause crises. Some of the key fnancial market problems that result in market imperfection are asymmetric information between borrowers and lenders of fnance and the presence of transaction costs. The asymmetric information prevents capital from being allocated in the most productive manner at an affordable cost. This creates fnancing gaps, rationing of credit, and market segmentation, rendering the fnancial market imperfect. This, coupled with signifcant transaction cost, creates market failures in fnancial markets. In the presence of these fnancial market failures, the economic growth and development process is heavily hampered and results in further gaps and developmental challenges in a country. This reiterates the importance of understanding the nature of fnancial systems and structuring appropriate interventions to fnance activities to sustain the economic development efforts of countries over time in order to produce positive economic and social outcomes. Well-functioning and well-structured fnancial systems minimise the informational gaps and transactions cost. When the fnancial sector functions effciently, it provides the avenues for market players to take advantage of investment opportunities by channelling funds for production, thus driving economic growth and development. We have also shown that the evolvement of fntechs has implications for the structure and depth of the fnancial system. In particular, fntechs provide innovative solutions by designing products that can be accessible for low-income populations and small businesses at a relatively lower cost. We do, however, note that for developing countries with low communications infrastructure, digital (internet) fntech-based solutions will be more costly to access than simple analogue fntech solutions. Development fnance deals with structuring and reforming the fnancial system in ways that promote growth and development at the macro and micro levels in developing and emerging economies. It focuses on how domestic and global fnancial systems facilitate the economic growth and development process. DFIs (be they multilateral, regional, and bilateral or country specifc in structure) carry out this role by minimising the imperfections in fnancial markets and institutions in order to improve the level of effciency and establish alternative fnancial institutions to provide direct capital in the market. DFIs therefore provide long-term fnance (including long-term loans, equity, and risk guarantee instruments) to promote private investment, economic growth, and sustainable development.

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Discussion questions 1 Discuss the issue of information asymmetry in fnancial markets. What measures can be used to reduce information asymmetry? 2 What are the necessary measures to ensure effciency and effectiveness in the operation and performance of fnancial markets? 3 What is credit rationing? What are the consequences of credit rationing? 4 Using examples from your country, discuss the issue of transaction cost in fnancial markets. 5 Examine the place of development fnance in addressing the issue of

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market imperfections in fnancial markets. Discuss how development fnance plays an important role in expanding capital availability to fnance economic growth and development. Discuss the various types of DFIs and their specifc roles. How do DFIs add value to the economic development process? How do fntechs address the issue of information asymmetry in fnancial markets? Discuss the conditions under which fntechs can enhance fnancial inclusion.

Notes 1 The market consequences of information asymmetry were popularized by George Akerlof in his article ‘The Market for Lemons: Quality Uncertainty and the Market mechanism’ in 1970. In 2001, the Nobel Memorial Prize in

Economic Sciences was awarded to George Akerlof, Michael Spence, and Joseph Stiglitz for their work on analysing markets with asymmetric information. 2 This section draws heavily on Hinson, Lensink, and Mueller (2019).

References Abor, J. Y. (2017). Entrepreneurial fnance for MSMEs: A managerial approach for developing markets. London: Palgrave Macmillan. Akerlof, G. A. (1970). The market for lemons: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500. Apiors, E., & Suzuki, A. (2018). Mobile money, individuals’ payments, remittances, and investments: Evidence from the Ashanti Region, Ghana. Sustainability, 10(5), 1409. Biekpe, N., Cassimon, D., & Verbeke, K. (2017). Development fnance and its innovations for sustainable growth. An introduction. In N. Biekpe, D.

Cassimon, & K. Verbeke (Eds.), Development fnance: Innovations for sustainable growth (pp.  1–16). London: Palgrave Macmillan. Coase, R. H. (1937). The nature of the frm. Economica, New Series, 4, 386–405. Dalberg. (2009). The growing role of the development fnance institutions in international development policy. Retrieved from www.fndevgateway. org/sites/default/fles/publications/ files/mfg-en-paper-the-growingrole-of-the-development-financeinstitutions-in-internationaldevelopment-policy-2009.pdf Demirgüç-Kunt, A., Leora, K., Dorothe, S., Saniya, A., & Jake, H. (2018). The

Chapter 1 • Introduction to contemporary issues in development fnance global fndex database 2017: Measuring fnancial inclusion and the fntech revolution. Washington, DC: World Bank. Dickinson, T. (n.d.). Development fnance institutions: Proftability promoting development. Retrieved from www. oecd.org/dev/41302068.pdf Dixit, A. K., & Pindyck, R. S. (1994). Investment under uncertainty. Princeton and New York: Princeton University Press. Heffernan, S. (2006). Modern banking. Chichester: John Wiley & Sons Ltd. Hinson, R., Lensink, R., & Mueller, A. (2019). Transforming agribusiness in developing countries: SDGs and the role of fntech. Current Opinion in Environmental Sustainability (COSUST), 41, 1–9. Jaffe, D. M., & Russell, T. (1976). Imperfect information, uncertainty, and credit rationing. Quarterly Journal of Economics, 90, 651–666. Jaffe, D. M., & Stiglitz, J. E. (1990). Credit rationing. In B. Friedman & F. Hahn (Eds.), Handbook of monetary economics (pp.  837–888). Amsterdam: Elsevier Science Publishers. Keeton, W. (1979). Equilibrium credit rationing. New York: Garland Press. Klapper, L., El-Zoghbi, M., & Hess, J. (2016). Achieving the sustainable development goals. The Role of Financial Inclusion, 23(5). Retrieved from www.ccgap.org. Manyika, J., Lund, S., Singer, M., White, O., & Berry, C. (2016). Digital fnance for all: Powering inclusive growth in

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emerging economies. New York: McKinsey Global Institute. Nedungadi, P. P., Menon, R., Gutjahr, G., Erickson, L., & Raman, R. (2018). Towards an inclusive digital literacy framework for digital India. Education+ Training, 60(6), 516–528. Osburg, T., & Lohrmann, C. (2017). Sustainability in a digital world. New York: Springer International. Ozili, P. K. (2018, December). Impact of digital fnance on fnancial inclusion and stability. Borsa Istanbul Review, 18(4), 329–340. Ray, D., Ghosh, P., & Mookherjee, D. (2000).  Credit rationing in developing countries: An overview of the theory. In D. Mookherjee & D. Ray (Eds.), A reader in development economics (pp. 283–301). London: Blackwell. Seidman, K. F. (2005). Economic development fnance. Thousand Oaks, CA: Sage. Stiglitz, J. E., & Andrew Weiss, A. (1981). Credit rationing in markets with imperfect information. American Economic Review, 71(3), 393–410. Suri, T. (2017). Mobile money. Annual Review of Economics, 9, 497–520. te Velde, D. W. (2011). The role of development fnance in tackling global challenges. London: Overseas Development Institute. Vodafone. www.vodafone.com/whatwe-do/services/m-pesa Yermack, D. (2018). Fintech in SubSaharan Africa: What has worked well, and what hasn’t. Working Papers No. 25007. Cambridge, MA: National Bureau of Economic Research.

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Finance, economic growth, and development Lordina Amoah, Charles Komla Delali Adjasi, Issouf Soumare, Kof Achampong Osei, Joshua Yindenaba Abor, Ebenezer Bugri Anarfo, Charles Amo-Yartey, and Isaac Otchere 2.1 INTRODUCTION The debate on the role of fnance in economic growth and development can be traced as far back as the 1800s (see Bagehot, 1873). At the commencement of the 20th century, Schumpeter (1912) highlighted the central role the banking system played in allocating savings to their most productive uses, hence improving productivity and ultimately economic growth. Over time, other authors, such as Gurley and Shaw (1955), Gerschenkron (1962), and Goldsmith (1969), have emphasized the importance of fnancial intermediation and resource accumulation in the economic growth process. More recently, with the advent of the endogenous growth models, the majority of the theoretical and empirical literature1 has revived the debate and continued to stress the important role of the fnancial sector in economic growth. This chapter generally provides a discussion on the theoretical and empirical issues underlying fnance, economic growth, and development phenomena. We start by overviewing some concepts and defnitions on the topic. We then discuss fnancial repression, liberalization, and growth. Next, we discuss the fnance–growth nexus, highlighting the various hypotheses underpinning the relationship. What follows is a discussion on the role of the fnancial system, accentuating how the various functions of the fnancial system spur economic growth and conclude the chapter with a discussion on fnancial intermediation and growth, emphasizing the role of deposittaking fnancial institutions and capital markets in the economic growth process.

2.2 FINANCIAL SECTOR AND FINANCIAL DEVELOPMENT: CONCEPTS AND DEFINITIONS The fnancial sector refers to the set of institutions, markets, instruments, and regulatory setup under which fnancial transactions are carried out in the fnancial system. Key players in the fnancial sector include banks, microfnance institutions (MFIs), insurance companies, investment bankers,

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mortgage companies, and stock exchanges, who provide fnancial services in the sector. Financial services encompass the assorted economic services provided by the fnancial institutions in the fnancial system. These comprise intermediation and advisory services, investment services, foreign exchange services, payment services, asset management services, risk management services, and debt resolution services, among others. The fnancial system refers to the framework within which all the aforementioned services are organized and offered. Accordingly, a better fnancial system will allow for an effcient allocation of resources in the economy. Financial systems function at frm-specifc, national, and global levels. Generally, fnancial development suggests advancement in the fnancial sector in terms of institutions, markets, and instruments/products. Empirically, fnancial sector development has been measured in various ways because of its complex nature and the dimensions it covers. Several indicators are used as proxies of fnancial sector development, depending on the issue under investigation. Typical fnancial development indicators (from the banking sector perspective) include total credit granted by fnancial intermediaries (banks and nonbank fnancial intermediaries), the private sector, gross domestic product (GDP), the liquid liabilities of the fnancial system (i.e. currency plus demand deposits and interest-bearing liabilities of banks and nonbank fnancial intermediaries) relative to GDP, and the ratio of commercial bank assets relative to commercial bank and central bank assets. Common stock market indicators of fnancial development are stock market capitalization (divided by GDP), stock market turnover, and stock market value traded. On the one hand, stock market capitalization measures the depth or relative size of the stock market. Stock market turnover (total value of domestic shares traded divided by market capitalization) and stock market value traded measure the liquidity of stock markets. These variables aid comparisons of fnancial development across countries. Financial development is measured2 in terms of depth, access, effciency, and stability. Financial depth refers to the extent of advancement and penetration of fnancial services provision to all levels of society in an economy. A relatively wider set of fnancial services gives people of various socioeconomic groups more options to choose from. Financial depth also connotes the size of the fnancial market and fnancial institutions relative to the size of the overall economy. Financial access describes the ability of individuals and businesses to obtain useful and affordable fnancial products and services that serve their interest in an economy. Hence, higher access to fnancial products and services implies a high-level fnancial inclusion. The opposite is also true: the inability of such groups to obtain fnancial services implies that they are fnancially excluded. Financial access facilitates the daily transactions of individuals and enterprises and aids in decision-making and planning over the longer term, such as access to shortand long-term fnancing and risk management instruments such as credit, insurance, and savings. Financial effciency refers to the scenario where market distortions are eliminated, where there is active competition in the market with

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information available to all stakeholders in the fnancial system such that the highest quality of fnancial services are provided at the lowest cost possible. Financial stability describes the state in which the fnancial system is resilient to economic shocks and is well capable of smoothly accomplishing its basic functions. It therefore implies the ability of the fnancial sector to consistently facilitate and boost economic processes, manage risks, and absorb shocks. The incidence of various fnancial crises, including the global fnancial crisis of 2007/2008 and the eurozone crisis of 2009, has reaffrmed the importance of maintaining fnancial stability. Further, depending on the aspect of the fnancial sector in question, different variables may be employed as indicators or proxies of fnancial development. There are clear differences between the fnancial sectors of developed and developing economies. On the one hand, the fnancial sectors of most developing countries are typically small, underdeveloped, and bank based. Some of the factors contributing to this include political instability, lack of the appropriate technological infrastructure, lack of trust and confdence in fnancial institutions, ineffcient legal systems, fnancial illiteracy, and the overregulation of government, inter alia. On the other hand, the fnancial sectors of most developed countries are far advanced in terms of depth, access, effciency, and stability and combine a good balance of intermediation that uses banks and capital markets. The composition of the fnancial sector, the fnancial structure, also differs across developed economies and developing economies. There are bank-based systems and market-based systems. In bank-based fnancial systems, banks play a prominent role in executing functions such as savings mobilization, capital allocation, diversifcation, and managing risks. In a market-based fnancial system, economic agents rely more on capital markets for their savings and borrowing. In that system, frms and governments raise funds from savers by issuing fnancial securities in the form of stocks and bonds. A fnancial system is described as bank based if the relative share (size or activities) of banks is bigger than that of the capital market. In the case of a market-based system, securities markets collaborate with banks in performing these functions, even though the capital market play the more active role, because they have a bigger market share. Examples of African countries with a bank-based fnancial system are Ghana, Nigeria, and Morocco. Other countries that have bank-based fnancial systems include Germany and Japan. Market-based fnancial systems, on the other hand, focus on the importance of the capital market. They are those in which the stock and bond markets play a critical role in the economy, by helping to raise long-term capital, infuencing corporate control, and providing opportunities for risk management. South Africa is an example of an African country with a market-based fnancial system. The US and the UK are also considered countries with market-based fnancial systems. There are differences in how banks and markets channel savings into investments. Typically, banks perform their intermediation function by mobilizing savings (predominantly deposits) for onward lending. By maintaining a close relationship between the two parties through information gathering, they are able to mitigate possible information asymmetry

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problems and adverse selection. Furthermore, banks provide the means for risk-averse savers to hold bank deposits instead of unproductive liquid assets. Banks are able to lend these deposits for use in productive investments that stimulate economic activity. On the other hand, markets provide a platform where debt and equity securities are issued and traded. Markets overcome information asymmetry problems through contract covenants and through the court system. Since the work of Gerschenkron (1962) and Goldsmith (1969), which expounded on the growth-enhancing role of fnancial structure, there has been burgeoning empirical debate3 on which fnancial structure is more effcient and growth enhancing. That is, whether bankbased fnancial systems or market-based fnancial systems spur growth faster. The bank-based view postulates that banks (or intermediaries) are better than markets at effciently allocating resources and hence propelling economic growth. For example, banks play the important role of providing fnance to small and medium-size enterprises (SMEs), which usually have limited or no access to capital markets. The market-based view argues that capital markets ensure good corporate governance and hence the optimal allocation of resources to expedite economic growth. The underlying argument is that large, liquid, and well-functioning markets help to ameliorate risk management through diversifcation and risk sharing. Capital markets are better able to fund new projects, research and development, and venture capital, which are crucial for increasing productivity in the economy.4 Notwithstanding the debate on the bank-based systems and marketbased systems, there is still a related strand of literature5 popularly referred to as the fnancial services view, which posits that bank-based systems and market-based systems are important together for economic growth because of the provision of complementary fnancial services.

2.3 FINANCIAL REPRESSION, LIBERALIZATION, AND GROWTH Financial repression describes the scenario in an economy where the government institutes laws, interventions, regulations, and other nonmarket restrictive policies in the fnancial sector. Such policies comprise capital controls; government domination of banks, credit, and interest rate ceilings; high-reserve ratios; restrictions on market entry and credit allocation; and so on. Governments of developing economies employ repressive policies as an option to tackle fscal challenges. The view is that putting such policies in place helps governments obtain rents from the fnancial system or manage public debt servicing. This phenomenon was prevalent in a number of developing economies after World War II. Indeed, in the period before the 1980s, a number of developing countries experienced serious economic and fnancial crisis. This was attributed to many factors, of which inappropriate fnancial sector policies, which were generally repressive, were primary (Kapur, 1991). Indeed, a number of studies have been conducted to examine the impact of fnancial repression on the growth of economies. A number of empirical studies support the notion of ineffcient allocation of capital during periods of fnancial repression, thereby impairing growth. The

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argument is that fnancial repression stifes the effcient functioning of the fnancial sector with concomitant adverse impact on growth. Specifcally, it leads to dampening in both saving and investment, inhibiting capital accumulation. That notwithstanding, this assertion has not been substantiated by the development trajectory of countries like Japan and South Korea, which have employed mainly repressionist policies. The challenges faced by developing economy governments that employed repressionist policies before the 1980s, coupled with increase in integration and globalization, forced these governments to rethink the system of controls. Hence, to curtail the repercussions of the crisis on their economies, governments of these economies in the early to mid 1980s embarked on extensive reforms to move from a repressive system to a market-oriented system, which gave rise to liberalization. Generally, fnancial liberalization refers to offcial government policies that focus on deregulating credit and interest rate controls, removing entry barriers for foreign fnancial institutions, privatizing fnancial institutions, or removing restrictions on foreign fnancial transactions. The free market system is allowed to interplay to set prices and thus stimulate competition. Financial liberalization has domestic and international dimensions. The suppositions of the neoclassical theory suggest that markets are effcient in allocating scarce resources. The theory posits that liberalization of fnancial markets increases the effciency with which these markets transform savings into investment, which leads to the better allocation of resources. Specifcally, the transmission mechanism may be explained as follows: 1 The onset of competition in the funds market increases interest rates on deposits, increasing the saving rate, which in turn increases the amount available for investment. 2 In the case of capital account liberalization, infows of capital in the form of debt and equity will also contribute to the increase in investment capital. All other things being equal, both scenarios imply an increase in loanable funds and hence a reduction in cost of funds or fnancing constraints of frms. This leads to increased investment and growth. 3 Financial liberalization improves risk diversifcation for fnancial institutions and international equity investors. 4 Competition, resulting from fnancial liberalization, causes fnancial institutions to become more effcient through the reduction in overhead costs, improvement in general bank management and risk management, and the offering of new products and services. These will help to improve the effciency of fnancial intermediation in a country, contribute to higher returns on investment, and ultimately increase the rate of economic growth. The seminal works of McKinnon (1973) and Shaw (1973) initiated the discussion on fnancial sector liberalization. Their work sought to criticize the repressive government policies that in their view led to excessive demand and ineffcient allocation of capital. Accordingly, governments of most developing countries in sub-Saharan Africa, in particular, adopted the

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programmes sponsored by the International Monetary Fund (IMF)/World Bank (WB) – the economic recovery programme (ERP)6 and the structural adjustment programme (SAP)  – as part of reforms aimed at salvaging their ailing economies. The fnancial sector was given special attention in these reforms. The reforms entailed price and interest rate liberalizations, the removal of credit ceilings, the privatization of state-owned frms, and the introduction of a number of measures for banking and capital market development, including fnancial regulatory schemes.7 The fnancial sector reforms resulted in an increase in the number of banks and the establishment of stock markets and other fnancial institutions. The reforms were aimed at enhancing the dynamism in the fnancial architecture of these economies to promote effciency in, competitiveness in, and a deepening of the fnancial system. Notwithstanding the evidence in support of fnancial liberalization, many authors8 do not agree on the growth-propelling role of fnancial liberalization. Their arguments include the following: 1 Financial liberalization does not necessarily solve the problem of information asymmetry, but rather liberalized markets may actually exacerbate information problems. 2 More competition as a result of increased liberalization may have adverse implications for proft margins and increase fnancial fragility. 3 Financial liberalization may increase the risk appetite of banks, which will likely increase the number of fnancial institutional failures and hence provoke bank runs. Overall, the empirical literature9 on fnancial liberalization and economic growth is inconclusive. Indeed, more recently, authors like Reinhart (2012) have argued that fnancial repression policies have returned but this time implemented by governments of developed economies as a strategy to obtain low-cost funds from the fnancial market in the aftermath of the global fnancial crisis.

2.4 THE FINANCE–GROWTH NEXUS The fnance–growth nexus, as it is popularly referred to as, has a long history in economic literature. Indeed, the theoretical and empirical studies examining this phenomenon have been numerous. Goldsmith (1969) was one of the frst to provide empirical evidence of a relationship between fnance and growth. According to Goldsmith, a country’s fnancial superstructure accelerates economic growth and improves economic performance to the extent that it facilitates the migration of funds to the best user, i.e. to the place in the economic system where the funds will yield the highest social return. (p. 400) After Goldsmith (1969), the foodgates were opened for further study of the phenomenon.10 These studies have evolved in the econometric techniques

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used to examine the phenomenon, such as time series analysis and panel data techniques. The underlying debate is predicated on whether fnance can infuence growth – that is, the nature and strength of the relationship between fnance and growth. Another strand in the literature seeks to investigate the possibility of the existence of threshold effects. This suggests that the attainment of a positive relationship between fnance and growth is preconditioned on the existence of certain parameters. Some parameters examined in the literature include the level of economic development, infation, institutions, openness, institutional investors, the growth of private credit, the legal and regulatory environment, or government size and policies.11 Hence, fnance has a positive impact on economic growth within certain parameter thresholds, and beyond that, it ceases to have an impact. The debate has also revolved around the type of fnancial structure, bankbased fnancial system versus capital market-led fnancial system, and their respective impacts on growth. 2.4.1 Finance and growth: the debate on causality The direction of causality between fnance and growth has also gained attention in the literature. A number of hypotheses have been postulated to explain the causality: whether fnancial development causes growth or growth causes fnancial development. These hypotheses include the supplyleading hypothesis, the demand-following hypothesis, bidirectional causality, and the no-causality hypothesis. These are discussed in succession. One the one hand, the supply-leading hypothesis of fnancial development suggests that fnancial development acts as a productive input of economic growth. Schumpeter (1912) frst advanced the notion that the provision of fnancial services by the fnancial sector has growth-enhancing effects. Pagano (1993) propounded the theoretical model that shows the channels through which fnance leads to growth– that is, through the increase in the marginal productivity of capital, the proportion of saving channelled into investment, and the saving rate. Overall, the hypothesis implies causality that runs from fnancial development to economic growth.12 On the other hand, contrary to the views of Schumpeter (1912), Robinson (1952) posited that instead enterprise paves the way for fnancial development. By implication, higher growth creates the impetus for increased demand for a wide range of fnancial services. Hence, the establishment of modern fnancial institutions, their fnancial assets and liabilities, and associated fnancial services happens in response to the demand for these services by savers and investors in the real economy. Ultimately, the demand-following hypothesis suggests a causal relationship that runs from economic growth to fnancial development (Kuznets, 1955; Ang and McKibbin, 2007; Odhiambo, 2008; Ono, 2017). The bidirectional causality (i.e. two-way causal relationship) was popularized by Patrick (1966). According to him, the causal relationship between fnancial development and growth may better be illustrated by using the chicken-and-egg framework or a cause-and-effect scenario, predominantly determined by the stage of economic development. According

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to Patrick (1966), at the early stage of economic development, before modern industrial growth sets in, the supply-leading fnancial development is dominant, inducing and propelling innovative-type investments. As modern industrial growth sets in and progresses, the demand-following phenomenon becomes prevalent. Largely, the view implies that fnancial sector development is a product of economic growth, which in turn feeds back as a factor of growth.13 The bidirectional hypothesis, therefore, seems to suggest a threshold effect, in that in a certain band of some variables (economic development, infation, institutions, institutional investors, legal and regulatory environment, or government size and policies), fnancial development may be a good catalyst for further growth. However, beyond a certain level of these variables, fnancial development may not infuence growth, leading to a possible nonlinear relationship (indicative of some turning point in the fnance–growth relationship). Indeed, some empirical studies have examined the possible nonlinear relationship between fnancial development and economic growth.14 According to Berthélemy and Varoudakis (1996), two scenarios are likely to occur. The frst is a virtuous cycle in which a high level of income stimulates a high level of fnancial development, which in turn facilitates economic growth. The second is a vicious cycle in which a low level of income inhibits the development of the fnancial system, which in turn slows economic growth. In the two scenarios, a two-way causality is implied, the frst indicative of a positive relationship and the second a negative one. In the no-causal relationship hypothesis, fnance is not an important determinant of economic growth. Lucas (1988) constructed a neoclassical theory of growth where he considered three models: physical accumulation and technological change; human capital accumulation through schooling; and specialized human capital accumulation through learning by doing. In his view, the importance of fnance in the attainment of economic growth is badly overstressed in popular and professional discourse, and hence, he is inclined to disregard it. Simply put, fnancial development is not an outcome of economic growth, and neither is growth an outcome of fnancial development.15 The implication of a positive signifcant effect of fnancial development on economic growth (suggested by the supply-leading hypothesis and in some empirical studies) is an impetus for appropriate legal and regulatory systems as well as policy reforms to be put in place, in order to improve the functioning of the fnancial sectors of developing economies. A weak causality should, however, not suggest otherwise, as it may be indicative of the existence of ineffciencies in the fnancial system arising from weak institutions, infrastructure development gap, restrictive government policies, or an unfavourable legal and regulatory environment. That is, as suggested by the threshold analysis, a positive relationship between fnance and growth is preconditioned on the existence of certain parameters. In sum, the debate in the fnance–growth nexus appears to have been strengthened, recent studies pointing towards a context-based or conditioning effect. In other words, fnance drives growth only in certain country contexts or under certain conditions. Two factors have driven the

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context-based-effect or condition-effect explanations. These factors are, frst, the threshold effect and, second, the fnancial structure or typology effect. As already discussed, the threshold effect shows that there is a turning point (nonlinear effect) in the relationship between fnance and growth. The threshold effect has two views. In the frst view, fnance positively drives growth only in countries with good fnancial systems, quality institutions, and high income and development levels.16 In this view, the role of fnance in growth for low-income countries comes about only after a certain threshold of fnancial development has been achieved. Below this threshold, there is no effect of fnance on growth. The second view17 almost diametrically opposes the frst. In it, although the level of fnancial development is good for the fnance growth nexus, the relationship between fnance and growth is an inverted U-shaped one. Finance increases growth but only to an extent of fnancial level development, beyond which fnance is detrimental to growth for developed countries. In this case, too much fnance will therefore harm growth – a situation also referred to as ‘the vanishing effect of fnancial development’ (Law & Singh, 2014). The fnancial structure or typology effect relates to the type of fnance, where investment, consumption, or working capital is on one side and the dimensions of the fnancial structure on the other. Investment credit and to a certain extent consumption credit beyond a certain threshold is seen as harmful for growth. According to this view,18 working capital is the only form of fnance with a positive growth effect. With respect to the dimensions effect,19 the effect of fnance on growth depends on the different dimensions (depth, effciency, stability, openness, and access to fnancial services). A stable and effcient fnancial structure increases productivity and growth universally. However, the effect of other dimensions will depend on the level of development in the country. In this view, the existence of different thresholds in the fnance–growth nexus comes when we focus on depth, openness, and access to fnancial services. In a slightly related way, another perspective20 dwells on the view that although bank fnance increases growth, this effect is more pronounced and signifcant in countries with more-developed stock markets. The idea here is that such countries exhibit more effciency and stability.

2.5 THE ROLE OF THE FINANCIAL SYSTEM In the 1990s, even though there were general postulations about the growth effects of fnancial development, Pagano (1993) became the frst to propose the theoretical model explaining the channels through which fnancial development infuences economic growth. According to Pagano (1993), the fnancial sector spurs growth through the accumulation of productive factors and increase in total factor productivity. Accordingly, the fnancial system facilitates economic growth through its ability to increase the marginal productivity of capital, the proportion of saving channelled into investment, and the saving rate. In line with Pagano (1993), Levine (1997) outlines the specifc functions of an effcient fnancial system and how the implementation or existence of these functions should help increase the

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marginal productivity of capital, the proportion of saving channelled into investment, and the saving rate. These functions are as follows: • Mobilizing and pooling savings. • Producing information about possible investments and allocating capital. • Easing the exchange of goods and services. • Facilitating the trading, diversifcation, and management of risk. • Monitoring frms and exerting corporate governance. What follows is a discussion on how these functions lead to growth through the increase in the marginal productivity of capital, the proportion of saving channelled into investment, and the saving rate. Mobilizing and pooling savings: the quantity of savings channelled to investment is critical to economic growth. An effcient fnancial system increases the amount of savings mobilized from disparate savers and channels them towards investment in economically viable projects. In so doing, the fnancial system also helps to increase the saving rate. In mobilizing savings as a fnancial intermediary, the fnancial sector reduces the costs involved in collecting funds from a wide variety of savers and overcomes information asymmetries associated with ensuring that savers are comfortable to give up control of their savings.21 Producing information about possible investments and allocating capital: individual savers may not have the wherewithal and time to collect, process, and produce information on potentially viable investments. Information costs may stife capital from being directed to its optimal use. Financial intermediaries effciently take up the costly process of gathering information on investment opportunities for others. In this way, reduced information costs lead to improved resource allocation and hence accelerated growth.22 Easing the exchange of goods and services: fnancial markets provide arrangements that reduce transaction costs and the process of exchange of goods and services. For example, the fnancial sector provides a payment system that increases the reliability and speed of exchanges. The system helps people to save time and energy, which would otherwise be lost under a barter system, thereby helping them to focus on the nuances of the production process. Ultimately, by promoting specialization and innovation, the fnancial system improves productivity and in turn growth.23 Financial technology24 (fntech) is one of the fastest growing areas, facilitating payments and other fnancial transactions. A notable innovation is the Ethiopian Commodity Exchange (ECX) (see Box 2.1). The ECX provides a payment system that eases the exchange of commodities and facilitates risk management. The ECX provides a market for futures contract trading, which helps to mitigate risk for buyers and sellers, particularly in the commodity market. In most developing countries, the commodity market is crucial. The structure or platform on which the commodities market operates is critical for fnancial intermediation in the sector; hence, the ECX is an example of effective fnancial intermediation in the commodities market. Facilitating the trading, diversifcation, and management of risk: generally, fnancial transactions involve numerous risks, such as cross-sectional,

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intertemporal, and liquidity risks. The presence of risk prevents people who are risk averse from saving and investing or entering into fnancial contracts. The fnancial system provides the platform for the sharing of crosssectional risks and helps in the smoothing of intertemporal risks and in reducing liquidity risks. Financial systems also mitigate the risks associated with individual projects, frms, industries, regions, and countries. In particular, banks, MFIs, mutual funds, and securities (stocks, bonds, and derivatives) markets provide vehicles for the trading, pooling, and diversifcation of risks, through economies of scale and lower transaction costs. For example, some high-return projects require a commitment of capital for a longer time, whereas savers fnd it diffcult to relinquish control of their funds for longer-term periods. Thus, with a liquid fnancial market, savers have the option to hold liquid assets such as equity, bonds, or demand deposits, while fnancial markets transform these assets into long-term capital investments. Hence, fnancial markets lower transaction costs and enhance risk diversifcation. By so doing, they improve the amount of savings, the savings rate, physical resource allocation, and then economic growth.25 Monitoring frms and exerting corporate governance: fnancial intermediaries have the expertise and economies of scale necessary for verifying and monitoring projects and frms. In the agency theory, borrowers may not always act in the best interest of the providers of capital. Hence, monitoring is crucial because it ensures the truthful reporting of project outcomes and helps to minimize the incidence of moral hazard. Monitoring is also a costly process, especially if carried out by individual lenders. However, fnancial intermediaries reduce the costs associated with monitoring because of the economies of scale they enjoy from dealing with a large number of borrowers and lenders. In Thadder (1995) and Dolar and Meh (2002), as information costs reduce, capital allocation is enhanced, thereby increasing productivity growth.

BOX 2.1 Enhancing fnancial intermediation in commodities markets: the ECX The ECX is a national multicommodity exchange in the fnancial system of Ethiopia. It aims at addressing the problems of a lack of access to fnance, no market structure, a lack of order in the market and its actors, low producer earnings, high contract performance risk and default, high market risk in quality, a lack of integrity and transparency in the agricultural trading system, and limited effciency in the market, among others. The ECX was established in 2006 and started its trading operations in April 2008. Commodities which are open for trade at ECX are coffee, sesame, haricot beans, wheat, and maize. The ECX enhances market effciency by operating a trading system where buyers and sellers use standardized commodity contracts by disseminating market information in real time to all market players. The ECX manages a system of daily clearing and settling of commodity

Chapter 2 • Finance, economic growth, and development

contracts. It also facilitates risk management by offering contracts for future delivery, providing sellers and buyers a way to hedge against price risk. Apart from enhancing payments of receipts of funds for commodities, the ECX helps address the agricultural marketing challenges and risks that were faced by farmers and traders, especially the rural farmers and traders. In that regard, the ECX has introduced seven electronic trading platforms in various regions in Ethiopia, and this e-trading platform enabled the ECX to trade 246,752 metric tons of commodities, mainly coffee and white beans. Since its operations in 2008, ECX has been able to achieve some its goals. Achievements of the ECX in the frst fve years of its operations include high returns to farmers through the effective payment system; improved impact on exports and trading volumes with high outreach of over three million farmers; improved warehouse capacity (57 warehouses and 300,000 metric tons warehouse storage capacity; market data (interactive voice response [IVR] had one million call-ins/month; SMS had 888,000 texts/ month; and website had 10,826 hits/month) as of 2013. The fnancial intermediation medium has borne some fruit compared to the period before the establishment of the ECX, in that there is increased access to fnance through the warehouse receipt fnance system, enhanced risk management, price discovery, and overall reduction in transaction costs.

BOX 2.2 Enhancing fnancial intermediation (or inclusion through) in mobile fnancial services: the story of M-PESA M-PESA is a mobile fnancial service promoting fnancial intermediation (inclusion) in Kenya. It is simply a technological platform that requires a transfer of digital value in the form of electronic currency using text messages (SMS) and a multitude of agents who help their subscribers deposit money into and withdraw money from their mobile money accounts. This transfer is often done by agents who are found in specialized shops popularly known as M-PESA kiosks, which are widely spread across the country. M-PESA was launched in March 2007, after one of Kenya’s leading mobile network operators, Safaricom. The conceptualization of M-PESA was born out of critical observations: the majority of mobile network subscribers’ tendency to exchange airtime to transfer money, the increasing rate of adoption of technology, and the rapid infux of mobile phones in the country. This local mobile money transfer service has become a household fnancial intermediary or monetary instrument in Kenya and is used for multiple purposes, such as payments for goods and services, transferring money to other users, saving money, and converting from and to cash. According to Global Financial Index

31

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(Findex) data, as of 2014, approximately 58% of the Kenyan adult population had mobile money accounts. Again, out of the total number of frms who were interviewed by the FinAcces Business survey in Nairobi, as many as 35% of these frms attested to accepting mobile money as a form of payment method from their customers and 32% adopted mobile money in purchasing their inputs from their suppliers. The introduction of M-PESA has created a relatively cheaper alternative of transferring money, comparable to others such as Western Union and PayPal, and reduced the risk of theft associated with sending cash via friends or bus drivers. By 2014, the number of M-PESA kiosks had increased to about 124,000 (representing annual growth of 148%), and M-PESA had about 27 million registered users and over 130,000 agents as of 2016. According to the 2017 Safaricom annual report, the customer base increased to approximately 11.8% during the year under review and the total transactions executed were valued at about Shs6.9 trillion. Currently, this concept of mobile money has moved beyond the borders of Kenya to other parts of East Africa and West Africa. Across the sub-Saharan region, mobile fnancial services play vital roles in providing fnancial services to people who have limited access to traditional fnancial institutions such as the banks, insurance companies, stock exchanges, and mortgage institutions. Data from the Global Financial Index 2017 show that the share of adults who have a mobile money account in the sub-Saharan region has roughly doubled since 2014, from 4% to about 9%. Mobile money services are also available in other parts of the world such as Haiti, Chile, Mongolia, and Turkey.

2.6 FINANCIAL INTERMEDIATION AND GROWTH The preponderance of literature (as seen in the preceding sections) point to the growth-enhancing effects of fnancial intermediation, a function performed by fnancial institutions and fnancial markets. Financial institutions and markets vary in their approach to executing the functions outlined in section 2.3, in order to propel growth. A discussion on some fnancial institutions and markets follows: specifcally deposit-taking fnancial institutions and capital markets. 2.6.1 Deposit-taking fnancial institutions and growth Deposit-taking fnancial institutions refer to fnancial institutions that are licensed to receive and manage deposits on behalf of clients. They also give out loans to their clients. By so doing, they play critical roles in the process of fnancial intermediation. There are a number of deposit-taking fnancial institutions. A discussion on some of these institutions, specifcally banks, microfnance institutions, and credit unions, follows.

Chapter 2 • Finance, economic growth, and development

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2.6.1.1 BANKS Particularly in economies with bank-based fnancial systems, banks play the critical role of formal fnancial intermediation, through the mobilization of funds from surplus units and channelling it to the most productive sectors of the economy. Apart from contributing to economic growth through their capital mobilization and allocation functions, banks encourage savings behaviour by offering savings, chequing, and time-deposit accounts to customers through branch networking; mitigate fnancial risk; facilitate payments (and hence, trade) within and beyond the borders of a country; and assist in the implementation of key macroeconomic policies (e.g. monetary policy) that ensure the stability of the overall economy and employment creation. Some empirical studies26 provide evidence that shows that banking development has a positive infuence on growth. The argument is that banks are more effcient at reducing market frictions and costs related to the mobilization and allocation of resources towards more-productive ventures. Information costs may hinder capital from being directed to its optimal use. Financial intermediaries, in this case banks, take up the costly process of gathering information on investment opportunities for others. In this way, reduced information costs lead to improved resource allocation and hence accelerate productivity growth. Singh and Weisse (1998) make a special case for banks on the basis that they foster long-term relationships with investors and thus provide a more stable source of fnance for attaining long-term growth and industrialization. Domestic credit to the private sector by the banking sector relative to gross economic output is one of the variables used in assessing the contribution of banks to an economy with regard to providing credit. Figure 2.1 shows domestic credit by the banking sector (% GDP) for the various income groups from 1973 to 2016. It shows a clear trend of a rise across all income groups. Generally, across successive years, high-income countries have recorded the highest domestic credit by the banking sector (% GDP), followed by the upper-middle income, the lower-middle income group, and then the low-income group. In terms of regional classifcation, Figure 2.2 shows that over the years from 1969 to 2017, East Asia and Asia Pacifc have

FIGURE 2.1 Domestic credit by banking sector (% GDP) across income groups Low income

Lower-middle

Upper-middle

High-income

120 100 80 60 40 20 0 1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

Source: Beck, Asli, Ross, Cihak, & Feyen, 2015 World Bank Financial Structure Dataset and authors’ computations

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FIGURE 2.2 Domestic credit by banking sector (% GDP) by regional classifcation 200 150 100 50

Sub-Saharan Africa East Asiaand Pacifc North America

Middle-east and North-Africa Europe and Central Asia

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

1973

1971

1969

0

South Asia La°n America and Caribbean

Source: Beck et al., 2015 World Bank Financial Structure Dataset and authors’ computations

recorded the highest domestic credit by banking sector. Europe and Central Asia follow after only from 200127 to 2017 and then North America. Credit associations and other fnancial cooperatives have existed for centuries. Credit unions are mutually owned fnancial cooperatives that generally provide savings and lending products to their members. Credit unions act as fnancial intermediaries, by providing credit and other fnancial services from lenders to borrowers who belong to the same community, be it a school, church, club, or a cooperative union, at relatively fair and competitive rates, usually lower than those of commercial banks. Each member is required to be a shareholder in the organization. Members usually satisfy a common bond, which may be determined by locality, employer, or religion, among others. Unlike banks, the main goal of credit unions is not to maximize profts but to provide fnancial services to its members. Each has a democratic structure, where it is owned and governed by the members, who direct the operations of the union. Unlike MFIs, credit unions provide credit to members at more competitive rates of interest. They operate with the aim of improving a standard of living to members. Surpluses generated are either ploughed back or given to members in the form of dividends or interest rebates. The concept of credit unions became common in the United States around the 1900s. It was a local strategy for fnancial inclusion for groups marginalized by race. Hence, working-class Black Americans or immigrants in the low-income class in rural households pulled their fnancial resources together by forming fnancial cooperatives in order to improve their lives. Over time, credit unions have grown around the world. The United States has the largest credit union membership around the world. There are just as many credit unions as banks in the US, with a combined asset of USD1 trillion (Pavlovskaya & Eletto, 2018). Box 2.3 is a brief illustration of how credit unions operate in Canada. Apart from providing fnancial alternatives, credit unions play a vital role in

2.6.1.2 CREDIT UNIONS

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supporting the urban populace amid stern competition from ingrained capitalist banks. One of the major benefts of credit unions is that the existence of the bond implies a reduction in information asymmetry and informationgathering costs, which facilitates the provision of fnancial services to groups which may otherwise would have been excluded from the formal banking system (McKillop & Wilson, 2011; McKillop & Quinn, 2017). Credit unions play an important role in rebuilding community and ultimately the country, on the basis of fnancial inclusion and solidarity.

BOX 2.3 Credit unions in Canada Canada has a vibrant cooperative fnancial services sector comprising credit unions (popularly called caisses populaires in French-speaking regions, meaning people’s bank). The frst successful credit union in Canada was started in Lévis, Québec, in 1900 by Alphonse Desjardins. Canada has one of the highest per capita memberships in credit unions in North America. Over 75% of the population are members of at least one credit union, and Québec has the largest membership. Credit unions in Canada are deposit-taking fnancial institutions that are provincially regulated with legislation spelling out how they can lend, borrow, and invest. Provincial regulators supervise individual credit unions in their respective provinces, and credit unions are required to meet standards and work with public agencies to ensure they are among the country’s soundest fnancial institutions. The Canadian Credit Union Association (CCUA) is the leading advocate for a successful, competitive, and growing credit union industry in Canada. The CCUA was the frst owned and governed national organization in Canada. CCUA works on behalf of its members in four key areas: 1 Advocacy and government relations to ensure that national public policy recognizes the distinctiveness and strength of credit unions. 2 National regulatory and network compliance, which includes a focus on payments network compliance. 3 Professional development and education of credit union employees and board members. 4 National awareness building, which focuses on promoting the value and importance of Canada’s credit unions in local communities and to the Canadian economy.

2.6.2 Capital markets and growth Theoretical and empirical literature concur that capital markets play important roles in stimulating economic growth. Financial securities available on the capital markets are essentially long-term in nature and consist mainly of stocks (equity) and bonds (debt). On the one hand, stocks represent an

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ownership of the issuing company. Bonds, on the other hand, are usually issued by governments and corporate bodies. In market-based fnancial systems, stock markets play the major role of fnancial intermediation, bringing together investors willing to buy and those who want to sell their shares/stocks. Indeed, the proposition that stock markets contribute positively to economic growth has gained ground.28 The channels through which effcient stock markets facilitate growth is through the provision of liquidity for investors, increased physical capital accumulation, the improved allocation of funds towards long-term investments (arising from investors monitoring frms), and risk sharing. Empirical studies29 show that countries that are more developed and enjoy macroeconomic stability tend to have deeper stock markets. In particular, the laws and enforcement mechanisms that protect the rights of minority investors promotes stock market development. Levine (1991) accentuates the importance of stock market liquidity, which is the ability to trade equity easily, to economic growth. The argument is that more-liquid markets make it possible to engage in projects that require large injections of capital for a long period of time before yielding any profts. Liquid stock markets make it easy for savers to relinquish control of their savings for such long periods by providing them with assets that can be liquidated at any time, effortlessly. This allows frms to have permanent and uninterrupted access to capital to undertake economically viable projects. Contrary to these fndings, there is also another angle to the debate that argues that stock markets could adversely infuence growth.30 Stiglitz (1985) questions the role of stock markets in improving information asymmetries. In their view, stock markets disclose information through price changes, thereby creating a free-rider problem that weakens the motivation for investors to undertake costly research. Other channels through which stock market liquidity could prevent growth is discussed in the literature.31 Arguments are made about the reduction in saving rates through the income and substitution effect. There is also the issue of stock market liquidity adversely affecting corporate governance due to investor myopia. Unlike developed economies’ stock markets, developing countries’ stock markets have typically been illiquid and segmented with overall trading and capitalization centred on a few stocks. However, the past two decades have seen a number of countries implementing capital market reforms to spur fnancial sector development. For example, the sub-Saharan Africa (SSA) region has, for the past three decades, seen a swift increase in the number of stock exchanges (see Table 2.1) after the implementation of capital market reforms. According to Allen, Otchere, and Senbet (2011), the reform has led to relative improvements in economic growth rates of the African countries. Other initiatives have also been implemented to improve the effciency of capital markets and improve participation and fnancial access in the region. One of such initiatives is the introduction of the Ghana Alternate Market (GAX). This is elaborated in Box 2.4. According to Hearn, Piesse, and Strange (2010), countries perceive the development of equity markets as a means to facilitate both foreign equity portfolio investment and 2.6.2.1 STOCK MARKETS

37

Chapter 2 • Finance, economic growth, and development TABLE 2.1 Stock markets in sub-Saharan Africa Country

Name of stock exchange

Year of establishment

Number of frms listed

Botswana Ghana Kenya Malawi Mauritius Nigeria South Africa Côte d’Ivoire Zimbabwe Namibia Swaziland Tanzania

Botswana Stock Exchange (BSE) Ghana Stock Exchange (GSE) Nairobi Securities Exchange (NSE) Malawi Securities Exchange (MSE) Stock Exchange of Mauritius (SEM) Nigerian Stock Exchange (NSE) Johannesburg Stock Exchange (JSE) Bourse Regionale des Valeurs Mobilieres33 Zimbabwe Stock Exchange (ZSE) Namibia Stock Exchange Swaziland Stock Exchange Dar es Salaam Stock Exchange

1989 1989 1954 1994 1989 1960 1887 1998 1946 1992 1990 1998

39 43 45 13 164 172 816 45 38 7 28

 

Source: Author’s compilation from various sources

foreign direct investment (FDI) through the acquisition of shares in domestic companies and hence boost the low levels of funding from domestic savings. Despite these tremendous improvements in the growth of this sector in Africa, most of these markets are characterized by problems of thin trading, small size, low liquidity, weak regulatory institutions, and infrastructural bottlenecks (Yartey & Adjasi, 2007; Mlambo & Biekpe, 2007; Kuttu, 2017). In this regard, a number of issues infuencing stock market development have been investigated:32 legal, political, and governance system; liquidity and size effects; corporate governance, and so on. For example, according to Hearn and Piesse (2010), the dissimilarities in the colonial legacy and the ensuing legal institutions explains why the size and the activity of stock markets vary across Africa. That is, the actualization of the benefts of stock markets in developing countries depends largely on well-established property rights. The existence of these will serve as a good platform for appropriate regulations to be designed to minimize transaction costs associated with searching for and verifying information. Nevertheless, these characteristics can be improved or eliminated if the determinants of the stock market in Africa, such as shareholder protections, a legal framework, institutional quality, macroeconomic stability, and the banking sector development iterated by Yartey and Adjasi (2007), are established.

BOX 2.4 Ghana Alternative Market The Ghana Alternative Market (GAX) is a parallel market operated by the Ghana Stock Exchange. The GAX was launched in 2013 to help small and medium-size enterprises (SMEs) generate funds to start their

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operations or expand their business operations. It focuses on SMEs with potential for growth. The GAX accommodates companies at various stages of their development, including start-ups and existing enterprises. Listing on the GAX helps frms gain access to long-term capital, enhance their status in the community, and improve their fnancial position. Advisory and regulatory fees involved in listing on the GAX is relatively lower compared to listings on the main Ghana Stock Exchange. Firms do not pay any application fees and do not incur any cost upon listing, as it is waived. A GAX-listed company pays an annual fee of only around USD450. A frm applying to list on the GAX must have a minimum stated capital of around USD50,000 at the time of listing. This shall be the capital after the frm’s initial public offering. The public foat of the applicant must constitute a minimum of 25% of the total number of issued shares. Admission may be granted to a start-up company if the applicant provides a three-year business plan to the GAX that shows the viability of the applicant. The company seeking admission to the GAX need not have recorded profts historically. However, it must have potential to make proft at least by the end of its third year of listing. Five companies were listed on GAX as of 2018. Source: Ghana Stock Exchange

2.6.2.2 BOND MARKETS Bonds are medium- to long-term debt securities. They may be issued by the government or corporate entities. Bond markets are alternative or complementary sources of medium- to long-term fnance for governments and corporations alike. Firms wishing to borrow for the medium to long term have the option of issuing corporate bonds. In this way, the bond market plays a key role in the effcient mobilization and allocation of fnancial resources in the economy. When bonds are issued by national governments, they are usually referred to as sovereign bonds.34 They may be denominated in governments’ domestic currency or a foreign currency. A typical example is the Eurobond. A Eurobond35 is denominated in a currency other than the home currency of the country or market in which it is issued. While literature is replete with studies on the role of banks and stock market in spurring economic growth, the same cannot be said about bond markets,36 particularly in developing countries, because bond markets in these countries are at the rudimentary stage. Hence, the market capitalization of bonds as a percentage of GDP is low. Whereas government bonds have gained some traction over the past decade, corporate bonds are relatively at the inception stage of development in these countries, due to factors such as ineffcient market infrastructure, a relatively underdeveloped regulatory framework, and a low number of market participants. There is dominance of over-the-counter (OTC) government or treasury bond markets with few bonds traded on the organized exchanges.

Chapter 2 • Finance, economic growth, and development

39

Indeed, as agents of fnancial intermediation, bond markets serve as one of the channels through which savings are transformed into capital to fnance the real sector of an economy. The funds mobilized from the issuance of bonds provide the government with extra spending money, which is used for various developmental projects, ultimately stimulating economic activity. Such long-term fnance helps in addressing the growing infrastructural defcits, particularly in the sub-Saharan region. The declining trends in aid fows give credence to the increasing number of sovereign bonds being issued recently by developing countries as an alternative means to acquiring external funds to fnance infrastructural projects. In particular, Eurobonds have become popular as a fnance tool because of the high degree of fexibility that they offer issuers. For example, it allows the issuer to choose the country of issuance on the basis of the regulatory market, interest rates, and depth of the market. They are also attractive to investors because of their small par values and high liquidity. 2.6.3 Summarized overview of fnancial structure Table 2.2 shows the average fnancial structures of low-income and highincome countries. We observe that high-income countries exhibit higher scales of bank deposit to GDP, other fnancial institutions assets to GDP, private credit by banks to GDP, stock market capitalization to GDP, and stock market turnover than those of developing countries. However, bank net interest margin, bank overhead costs to total assets, and central bank assets to GDP are higher in developing countries than they are in developed countries. The high interest margin and high bank overhead costs to total assets are a refection of the low level of effciency associated with developing countries’ fnancial systems. In terms of the high central bank assets to GDP, this is an indication of the more dominant role that the public sector plays in low-income economies. Although financial liberalization has eroded many of the structures associated with financial repression in lowincome countries, a lot more is required to improve the level of effciency in these markets.

TABLE 2.2 Average fnancial structures of high-income vs low-income countries, 2015 Variables

Low income

High income

Bank deposits to GDP (%) Bank net interest margin (%) Bank overhead costs to total assets (%) Central bank assets to GDP (%) Other fnancial institutions’ assets to GDP (%) Private credit by banks to GDP (%) Stock market capitalization to GDP (%) Stock market turnover (%)

18.01 5.05 5.27 3.85 3.06 13.18 16.89 1.44

78.91 1.88 1.67 2.12 6.57 77.95 70.00 36.79

Source: Beck et al., 2015 World Bank Financial Structure Dataset and authors’ computations

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2.7 REGULATION IN THE FINANCIAL SECTOR Because of the complex nature of the fnancial system and the role it is expected to play in the economy, governments are responsible for ensuring the effcient regulation of the fnancial system. This responsibility is provided by organizations that regulate and supervise fnancial institutions to ensure that they meet certain requirements. Such regulatory requirements aim to maintain the integrity and soundness of the fnancial system. Financial regulators are often saddled with the issue of imposing appropriate regulation aimed at ensuring the safety and soundness of the fnancial system without limiting competition and effciency. Regulating the fnancial system is aimed at protecting investors; preventing securities issuers from defrauding investors and hiding important information; maintaining the stability of fnancial markets and institutions; promoting effciency, competition, and fairness in the trading of fnancial securities; restricting the extent of participation of foreign entities in the domestic markets; and controlling the level of economic activity. There are different regulatory regimes across various countries. While some jurisdictions have different fnancial regulators responsible for regulating different aspects of the fnancial system, others have one regulator (besides the oversight role of the central bank over the banking sector) overseeing the nonbank fnancial system. For examples, countries such Ghana, Nigeria, and India have different regulators for banking, securities markets, insurance, and pensions. Until 2017, South Africa had two sector-specifc regulators, the South African Reserve Bank (SARB) for regulating the banking sector and the Financial Services Board (FSB) for overseeing the nonbanking sector. This situation has changed with the new regulatory framework that focuses on establishing two regulators: a prudential regulator (Prudential Authority) operating in the SARB will be in charge of promoting and enhancing safety and soundness of fnancial institutions and a dedicated market conduct regulator (Financial Sector Conduct Authority) responsible for supervising market conduct with the aim of protecting fnancial consumers. The South African model is similar to that of England, which after the global fnancial crisis, split the responsibilities of the Financial Services Authority in 2013 and assigned them to two organizations: the Financial Conduct Authority and the Prudential Regulation Authority of the Bank of England.

2.8 CONCLUSION The importance of the fnancial sector in an economy cannot be overemphasized. Specifc functions performed by this sector include the mobilization and pooling of savings; the production of information about possible investments and allocation of capital to best user; easing the exchange of goods and services; facilitating the trading, diversifcation, and management of risk; and enforcing corporate governance. Undeniably, the relationship between fnancial sector development and economic growth has received and continues to receive attention from policy think tanks, fnancial market practitioners, and academic researchers.

Chapter 2 • Finance, economic growth, and development

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A number of postulations have been made in both the theoretical literature and the empirical literature. This chapter provided a review of concepts and existing literature on fnancial development and economic growth and development. First, the literature points to ineffcient allocation of capital and stunted growth during periods of fnancial repression, which was a popular phenomenon after World War II. This argument gave credence and impetus to the adoption of liberalization policies in the 1980s. The objective was to propel a free market system, stimulate competition, and enhance dynamism in institutions, products, and systems in the fnancial sectors of mostly developing economies. Nonetheless, more recently, fnancial repression policies have been readopted and are being implemented by governments of developed economies as a strategy to obtain low-cost funds from the fnancial market in the aftermath of the global fnancial crisis. The debate on the relationship between fnancial sector development and economic growth and development continues unabated, even though the preponderance of the empirical literature points to the positive effects of fnancial development on growth and development. Theoretically, fnancial sector development facilitates economic growth through its ability to increase the marginal productivity of capital, the proportion of saving channelled into investment, and the saving rate. Hence, a welldeveloped fnancial system is expected to enhance physical capital accumulation and facilitate the effcient allocation of resources that will feed into economic growth. More-recent literature has also focused on examining the possibility of threshold effects in the fnance–growth nexus, thereby suggesting a nonlinear relationship. By implication, the existence or not of certain parameters may infuence the direction and extent of the relationship between fnancial sector development and economic growth. Furthermore, the debate in the literature on whether the bank-based fnancial sector or the market-based fnancial sector is more growth enhancing has still not reached a conclusion. That notwithstanding, banks are particularly important in developing countries where stock markets are relatively smaller or play a less active role in fnancial intermediation. Even so, the fnancial services view posits that both bank and market-based systems are important together for economic growth because of the provision of complementary fnancial services. Regulating the fnancial system aims to protect investors and maintain the stability of fnancial markets and institutions. There are different regulatory regimes across various countries. Some countries have different regulators responsible for regulating different aspects of the fnancial system, while others have one regulator overseeing the nonbank fnancial system. In conclusion, the importance of fnancial sector development to an economy increases the need to put appropriate policies in place to improve the functioning of the sector. As mentioned in the literature, these may include but are not limited to maintaining a stable macroeconomic environment, quality institutions and political governance, and a conducive legal and regulatory environment.

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Discussion questions 1 Financial development leads to economic growth and not the other way round. Comment on this assertion. 2 Explain the following concepts: fnancial depth, access, effciency, and stability. 3 Describe the main functions of the fnancial sector. 4 What are the channels through which the functions performed by the fnancial sector contribute to economic growth? 5 What is fnancial repression, and what are its consequences for an economy? 6 What are the differences between bank-based fnancial sectors and market-based fnancial sectors?

7 Banking sector development is more critical for developing economies than stock market development. Comment on this statement. 8 What are the mechanisms through which fnancial intermediation of banks and stock markets contribute to economic growth? 9 How does the fnancial intermediation of the various deposit-taking fnancial institutions contribute to economic growth? 10 How would you describe the African fnancial system? What policies should be put in place to facilitate improvements to the fnancial system?

Notes 1 See Pagano (1993), Levine (1997), Barro and Sala-i-Martin (1998), Montiel (2003), Arestis, Chortareas, and Magkonis (2015), Ono (2017), and Ruiz (2018). 2 More-comprehensive measures of fnancial development are contained in the World Bank’s Global Financial Development Database (GFDD). The database provides a framework for four sets of indicators depicting a well-functioning fnancial system. 3 SeeLuintel (2008), Gambacorta, Yang, and Tsatsaronis (2014), Luintel, Khan, and Leon-Gonzalez (2016), Fufa and Kim (2018). 4 SeeAllen and Gale (1999) and Luintel et al. (2016). 5 See Boyd and Smith (1998), Levine and Zervos (1998), DemirgucKunt and Levine (1999), Beck, Levine and Loayza (2000), Levine (2002), Beck and Levine (2004), and Song and Thakor (2010).

6 The ERP and the SAP refer to the set of free market policy reforms imposed on developing countries by the IMF and the WB respectively as a precondition for receiving loans to salvage their ailing economies and reverse the prolonged period of severe economic decline. While the IMF focused on setting the macroeconomic development and policy agenda, the WB provided the structural adjustment lending. 7 For an extensive exposé on these reforms, see Nissanke and Aryeetey (1998), Senbet and Otchere (2006), Honohan and Beck (2007). 8 SeeStiglitz and Weiss (1981) and Stiglitz (2000). 9 For a survey of the literature, see, for example, Eichengreen (2001), Henry (2007), Kose, Prasad, Rogoff, and Wei (2010), Hermes and Lensink (2008), Edison, Klein, Ricci, and Slok (2004), and Prasad, Rogoff, Wei, and Kose (2003).

Chapter 2 • Finance, economic growth, and development 10 See McKinnon (1973), Shaw (1973), Greenwood and Jovanovic (1990), Bencivenga and Smith (1991), Boyd and Smith (1998), King and Levine (1993a, 1993b), Levine (1997, 2005), Kugler and Neusser (1998), Demirgüç-Kunt and Maksimovic (1998), Rajan and Zingales (1998), Rousseau and Wachtel (1998), Beck et al. (2000), Acemoglu, Aghion, and Zilibotti (2003), Beck and Levine (2004), Andersen, Jones, and Tarp (2012), Adu, Marbuah, and Mensah (2013), Arestis, Chortareas, and Magkonis (2015) Otchere, Soumaré, and Yourougou (2016), Ono (2017), Durusu-Ciftci, Ispir, and Yetkiner (2017), and Ruiz (2018). 11 See Deidda and Fattouh (2002), Roija and Valev (2004), Shen and Lee (2006), Yilmazkuday (2011), Rousseau and Wachtel (2011), Law and Singh (2014), Ductor and Grechyna (2015), Adeniyi, Oyinlola, Omisakin, and Egwaikhide (2015), Samargandi, Fidrmuc, and Ghosh (2015), Ibrahim and Alagidede (2017), Ruiz (2018), and Fufa and Kim (2018). 12 See Rajan and Zingales (1998), Levine and Zervos (1998), Levine, Loayza, and Beck (2000), Beck and Levine (2004), Levine (2005), Abu-Bader and Abu-Qarn (2008), Kargbo and Adamu (2009), Masoud (2013), Adu et al. (2013), Herwartz and Walle (2014), Padhran, Arvin, Hall, and Nair (2016), Seven and Yetkiner (2016), and Bist and Read (2018). 13 Akinboade (1998) and Fowowe (2011) are among those who conducted empirical studies that support this view. 14 See Rousseau and Wachtel (2002), Yilmazkuday (2011), Adeniyi et al. (2015), and Ruiz (2018). 15 Ogun (1986) and Atindéhou, Gueyie, and Amenounve (2005) are among those who conducted empirical studies that support this assertion.

43

16 See Deidda and Fattouh (2002) and Rioja and Valev (2004). 17 See Rousseau and Wachtel (2011) and Beck, Büyükkarabacak, Rioja, and Valev (2012). 18 See Soedarmono, Hasan, and Arsyad (2017). 19 See Čihák, Demirgüç-Kunt, Feyen, and Levine (2012) and Naceur, Blotevogel, Fischer, and Shi (2017). 20 See Botev, Egert, and Jawadi (2019). 21 See Pagano (1993), Levine (1997, 2004), Acemoglu and Zilibotti (1997), and Dolar and Meh (2002). 22 See Greenwood and Jovanovic (1990), Bencivenga and Smith (1991), Berthélemy and Varoudakis (1996), and Greenwood and Smith (1997). 23 See King and Levine (1993a, 1993b), Berthélemy and Varoudakis (1996), and Montiel (2003). 24 This refers mainly to computer programmes and other technology designed to facilitate and support fnancial services. 25 See Greenwood and Jovanovic (1990), Dolar and Meh (2002), and Levine (2004). 26 See Boot and Thakor (1997), Levine and Zervos (1998), Beck and Levine (2004), Coval and Thakor (2005), and Seven and Yetkiner (2016). 27 Data is unavailable on the world development indicators for period before 2001. 28 See Levine (1991), Atje and Jovanovic (1993), Greenwood and Smith (1997), Levine and Zervos (1998), Luintel and Khan (1999), Rousseau and Wachtel (2000), Beck and Levine (2003), Kargbo and Adamu (2009), and Masoud (2013). 29 See Boyd and Smith (1998), Allen and Gale (1999), Boyd, Levine, and Smith (2001), Rajan and Zingales (2003), La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), and La Porta, Lopez de Silanes, and Shleifer (2006).

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30 See Stiglitz (1993), Shleifer and Vishny (1997), and Christopoulos and Tsionas (2004). 31 See Demirgüç-Kunt and Levine (1996) for an extensive discussion of these channels. 32 For an extensive discussion of these issues, see Hearn and Piesse (2010, 2013, 2015) and Hearn (2011, 2012). 33 This is an exchange situated in Côte d’Ivoire but serves as a common exchange for the eight francophone countries in West Africa. 34 The terms ‘sovereign bond’ and ‘sovereign debt’ are sometimes used interchangeably. But ‘sovereign debt’ encompasses a much broader stock of a country’s total outstanding government debt.

35 Issuance is usually handled by an international syndicate of fnancial institutions on behalf of the borrower. 36 Studies on bond market and economic growth include Mu, Phelps, and Stotsky (2013), Thumrongvit, Kim, and Pyun (2013). Pradan, Zaki, Maradana, Jayakumar, and Chatterjee (2015), Olabisi and Stein (2015), Fanta and Makina (2016), Presbitero, Ghura, Olumuyiwa, and Njie (2015), Duffour, Stancu, and Varottoa (2017), Coskun, Seven, Ertugru, and Ulussever (2017), Senga, Cassimon, and Essers (2018), and Bordalo, Gennaioli, Ma, and Shleifer (2018).

References Abu-Bader, S., & Abu-Qarn, A. (2008). Financial development and economic growth: The Egyptian experience. Journal of Policy Modeling, 30(5), 887–898. Acemoglu, D., Aghion, P., & Zilibotti, F. (2003). Distance to frontier, selection, and economic growth. Working Paper No. 9066. Cambridge, MA: National Bureau of Economic Growth. Acemoglu, D., & Zilibotti, F. (1997). Was prometheus unbound by chance? Risk, diversifcation, and growth. Journal of Political Economy, 105(4), 709–751. Adeniyi, O., Oyinlola, A., Omisakin, O., & Egwaikhide, F. O. (2015). Financial development and economic growth in Nigeria: Evidence from threshold modelling. Economic Analysis and Policy, 47, 11–21. Adu, G., Marbuah, G., & Mensah, J. (2013). Financial development and economic growth in Ghana: Does the measure of fnancial development matter?  Review of Development Finance, 3, 192–203. Akinboade, A. O. (1998). Financial development and economic growth

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CHAPTER

3

Microfnance and development Niels Hermes and Robert Lensink 3.1 INTRODUCTION The role and importance of microfnance in reducing poverty is one of the most heavily discussed topics among academics and practitioners studying developing economies. Until the end of the 20th century, microfnance programmes were enormously popular and success stories were emphasized, even resulting in the 2006 Nobel Peace Prize for the founding father of microfnance, Muhammed Yunus, and then the microfnance industry started to become heavily criticized. The sudden drop in popularity is partly associated with the increase in rigorous evaluations of the impact of microcredit, which suggests that effect sizes are much smaller than expected and that they are nontransformative. Moreover, the commercialization of microfnance led to serious criticism as it may lead to mission drift, a process in which wealthier clients are prioritized over poorer clients (Cull, Demirguç‐Kunt, & Morduch, 2007). As a result of commercialization, microfnance institutions (MFIs) increased interest rates. It is now common to see interest rates above 50% on a yearly basis, which has resulted in serious ethical concerns (Hudon & Sandberg, 2013). According to some commentators (e.g. Bateman, 2010), microfnance may even be an obstacle to development. The aim of this chapter is to discuss, in the face of the recent criticism, whether, and if so how, microfnance still has a role to play in promoting inclusive growth. The chapter is structured as follows. In section 3.2, we defne the concept of microfnance and discuss how it has evolved over the past decades. Next, in section 3.3, we focus on the supply side of microfnance. In particular, we discuss the two main objectives of MFIs, outreach and fnancial sustainability, and explain that reaching both objectives simultaneously may be diffcult in practice. In section 3.4, we pay attention to examples of products that MFIs are providing and whether and how they aim to improve the contribution of microfnance to fnancial inclusion. Section 3.4 focuses on MFIs, and we turn our attention the users – that is, the demand side of microfnance – in section 3.5. This section provides an overview of recent studies that have assessed the impact of microfnance. The chapter ends with a conclusion.

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3.2 THE EVOLUTION OF MICROFINANCE: FROM MICROCREDIT TO MICROFINANCE PLUS Microfnance is a broad concept, without a strict defnition. In general, microfnance refers to fnance provided to (poor) people who are excluded from the formal fnancial sector. Traditionally, microfnance was primarily associated with small credits (on average in developing countries around USD500) to poor people who are not able to borrow from commercial banks. Microfnance is provided by MFIs, which include a variety of fnancial institutions, such as nongovernmental organizations (NGOs), credit unions, microfnance banks, and nonbank fnancial institutions. Microfnance exists all over the world, including in developed economies, but most of the biggest MFIs have their headquarters in Asia, such as BRAC, the Grameen Bank, and ASA, all of which originate in Bangladesh. Since the frst implementation of microfnance, the number of MFIs and microfnance borrowers has increased exponentially. Ever since the 1997 initiation of the Microcredit Summit Campaign,1 the number of microfnance customers has been increasing, from 13 million in 1997 to 211 million in 2013, of which more than 80% have been women and 114 million have been among the poorest (Lensink & Bulte, in press). Moreover, whereas in 1997 there were only 655 microfnance programmes, in 2016 there were more than 10,000 worldwide. The formal beginning of the microfnance movement can be dated back to 1983, when the Bangladesh government decided that the research project that Muhammed Yunus had started in 1976 to test his method of providing credit to the rural poor was authorized and established as an independent bank. Yet long before this date, poor people who were excluded from formal credit could obtain microcredits via informal rotating savings and credit associations (ROSCAs), or via credit cooperatives. Microfnance has its roots in formal and informal fnancial institutions in the 19th century (Guinnane, 2002). The antecedents of microfnance, as well as the modern microfnance movement, rely heavily on group lending systems, where borrowers selfselect into groups to discuss issues related to borrowing, saving, and repayment. The Grameen Bank strategy combined group lending with the joint liability of borrowers. With joint liability, the entire group of borrowers becomes liable (responsible) for any default of individual group members. As borrowers want to avoid having to pay the debts for others, the joint liability group lending system would, in theory, contribute to reducing adverse selection and moral hazard problems (see Box 3.1). In practice, however, the effciency of the joint liability group lending system has been questioned, among other things, due to the high transaction costs of having to attend group meetings. Moreover, most group loans are short-term loans, which need to be repaid during group meetings ever week. This makes these loans unattractive to farmers because their repayment possibilities depend heavily on crop cycles. They are also unattractive for borrowers who want to make investments in a small enterprise because the returns on their investments take time to materialize.

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BOX 3.1 Group lending with joint liability: two main systems There is a wide variety of group lending systems. The two best-known systems are the Grameen Bank Solidarity group lending system and the village bank system. In the solidarity group lending system, borrowers are asked to form groups of three to seven members. Borrowers are jointly liable and payments are due weekly and are constant over the life of the loan. If a loan is repaid, the borrower becomes eligible for a larger loan, providing a dynamic incentive to repay. Often around eight solidarity groups are federated into a larger group (a centre) to discuss payment issues with a loan offcer of the MFI. In the village bank system, 15–30 people are brought together. A single loan is given to the village bank authority, which on-lends the single loan to individual members. Loan sizes may differ among members, but all loans carry the same repayment and interest rate terms. Also in this system, there is joint liability. Although there are several differences between the two systems, they also have a lot in in common. These include self-selecting groups, regular and compulsory meetings (often weekly), joint liability, and dynamic incentives. There are two main advantages of group lending systems. First, the joint liability clause reduces informational asymmetries. Because groups self-select, people ‘screen’ each other in order to ensure that only ‘good’ borrowers become members of the group, to reduce the possibility that individual borrowers have to pay for other borrowers in the group. This process reduces adverse selection problems. Moreover, after a group has been formed, the joint liability clause induces group members to monitor each other to reduce moral hazard problems. Second, due to peer pressure in closed community groups, and the related importance of reputation, honour, and shame, repayment rates are expected to be high in a group lending system, even when there is no formal joint liability system. There is quite some evidence that peer monitoring is even more important than a formal joint liability system in guaranteeing high repayment rates. This is probably one of the reasons why, in practice, many MFIs that use group lending systems do not have a formal joint liability system, do not enforce joint liability, or are fexible with the implementation of joint liability. As a consequence of the rigid character of the traditional microfnance group lending systems and of the high transaction costs of having to regularly attend group meetings, many MFIs have switched to individual lending systems and have tried to develop new instruments to reduce defaults. A well-known example of such an instrument is the use of a progressive lending system, also known as stepped lending, in which credit limits increase over time, contingent on the full repayment of previous loans. The progressive lending system is often combined with dynamic incentives, which imply that repaying borrowers are allowed access to future credits.

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While microfnance was traditionally associated mainly with microcredit, over the past decades, MFI has started to diversify, which led to a shift from microcredit to microfnance. Many MFIs now collect savings; sell insurance products, to a lower extent; and provide transfer and payment services. Life insurance, for instance, is a popular product. Life insurance is mostly offered as part of a microcredit package, in the form of credit-life contracts. These contracts ensure that if a borrower dies, the outstanding loans will be paid off and a fxed payout will be provided to the family. MFIs have also started to develop health insurance plans and both property insurance and crop insurance, and they have started to experiment with pension schemes. These micro-pensions focus on long-term savings, to provide income security to the aged poor who have worked in the informal sector and are not covered by formal retirement schemes. With their close connections and regular meetings with low-income workers in the unorganized sector, MFIs can be ideal fnancial institutions to channel micropension products to the poor in informal sectors. In addition to providing a broader range of fnancial products, MFIs also have started to offer nonfnancial services, which is known as microfnance plus. In general, the nonfnancial services aim to strengthen the impact of the fnancial services, and in particular of microcredit, on the welfare of the microfnance clients. Microfnance plus activities consist of three types of nonfnancial services: social services, business development services, and technical assistance. Social services integrate credit with health, education (gender training), or other programmes intended to increase health consciousness, practices, and formal uses. Business development services comprise a broad range of offerings, such as fnancial literacy training, management or vocational skills training, marketing, product design, and accounting and legal services. Technical assistance differs from business services in that it directly deals with the production of goods and services; it does not focus on managerial processes. Technical assistance can be delivered through technical training workshops or provided individually by a specialist who has a one-to-one relationship with the client. Figure 3.1 summarizes the different activities that are currently employed by MFIs. In the next section, we elaborate on the product development of MFIs.

3.3 THE SUPPLY SIDE OF MICROFINANCE: MFIS AND THEIR PERFORMANCE2 The main objective of MFIs is to provide fnancial services to poor households that are excluded from the formal fnancial system. This objective is usually referred to as outreach.3 Another objective of these institutions is to provide these fnancial services in a fnancially sustainable way – that is, over the longer term, these activities should not result in loss making. In the microfnance literature, people refer to the so-called double bottom line mission of improving the lives of the poor while being independent of donor support in the long run (Armendáriz & Labie, 2011). Achieving both objectives simultaneously is referred to as the microfnance promise (Morduch, 1999). In practice, however, these two objectives may be diffcult to combine.

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FIGURE 3.1 Microfnance services

Source: Garcia and Lensink (2019)

On the one hand, providing services to the poor is usually relatively expensive. First, a substantial share of the poor live in rural areas, which increases transaction costs. Second, they usually do not have collateral, increasing the risks and costs of lending to the poor. Third, fxed costs are high, because the amount in the loans provided or savings made by the poor is relatively low. Finally, information about the creditworthiness of these borrowers is hard to get. On the other hand, while costs are high, fnancial resources for MFIs may be limited. Their funding mainly comes from donors, market-based funding such as commercial loans and equity, and savings accounts collected from clients. The share of these funding sources depends on each MFI’s formal status. NGOs usually depend more on donor funding; cooperatives receive a large part of their funding from saving clients; and commercial MFIs usually have a larger share of loans and equity. The availability of donor funding is restricted by the development aid budgets of governments and international fnancial institutions, such as the World Bank and the regional development banks in Africa, Asia, and Latin America. Savings accounts are based on the number of clients and their ability and willingness to make savings. The availability of commercial loans and equity depend on the positive returns that MFIs are able to generate from their activities. Given the high costs of providing fnancial services to the poor and given the availability of funding, MFIs may have to make a choice regarding the question whether they aim at focusing on maximizing their outreach

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to the poor given the fnancial sources available or whether they should aim at generating returns on fnancial resources given a certain level of outreach. In practice, while NGOs generally focus more on their social mission of reaching out to the poor, commercial MFIs are more likely to emphasize fnancial returns, which may confict with the cost of their outreach. The discussion about the costs of microfnance and its funding points out that there may be a trade-off between outreach and fnancial sustainability. The existence of such a trade-off has been heavily debated in the academic literature and among practitioners. Some believe that MFIs can provide services to the poor while remaining fnancially sustainable. According to this view, sometimes coined as the fnancial systems approach (Robinson, 2001) or the self-sustainability approach (Schreiner, 2002), outreach and fnancial sustainability may be compatible since reaching a large number of customers creates economies of scale, leading to lower costs. In addition, fnancially sustainable MFIs may be better able to attract funding from private investors, which may be used to improve their outreach. Finally, some argue that proft-making MFIs may reinvest in servicing poorer clients. The proponents of this view stress that if MFIs provide services to the poor while making losses, their business model will not be sustainable in the long term. Others stress that MFIs should focus on their mission of servicing the poor – if necessary, fnanced by subsidies and other outside funding. This view is referred to as the poverty-lending (Robinson, 2001) or poverty approach (Schreiner, 2002). Until the late 1990s, the poverty-lending approach dominated the thinking about microfnance and the role of MFIs. From the beginning of the 2000s, the fnancial systems approach gained prominence. Since then, emphasizing the importance of developing fnancially sustainable MFIs has become an important feature in debates about the role of microfnance as an instrument to reduce poverty. This shift from emphasizing poverty reduction to showing fnancial performance was partly due to the success of the microfnance business model. Many MFIs reported high repayment rates of close to 90%–95%. This caught the attention of institutional investors looking for opportunities to invest in socially responsible projects that showed a positive return at the same time and from commercial banks seeing microfnance as a potentially interesting way to develop new and unexplored markets to which they could sell their fnancial services. The success of the model also led to strong growth in the number of MFIs and the number of services they provided, leading to increased competition in and commercialization of the microfnance sector, accompanied by an increased focus on making proft. One of the potential consequences of the shift from focusing on poverty and outreach to fnancial sustainability is referred to as mission drift (Copestake, 2007; Armendáriz & Szafarz, 2011; Mersland & Strøm, 2010). Mission drift occurs when MFIs increase the provision of fnancial services to wealthier clients at the cost of providing these services to poorer clients. Such a shift may be necessary to reduce costs and become fnancially sustainable because providing services to wealthier clients is more proftable. Notwithstanding this shift from focusing on poverty and outreach to fnancial sustainability, nowadays many MFIs are still not fnancially

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sustainable and are therefore depending on subsidies. Cull, Demirgüç‐ Kunt, and Morduch (2018) report that only half of the MFIs listed in the so-called MIX Market dataset, a web-based platform providing data on the performance of MFIs in more than a hundred developing markets, are fnancially sustainable. D’Espallier, Hudon, and Szafarz (2013) show that only 20%–25% of MFIs do not receive any donations.4 The question whether there is a trade-off between outreach and fnancial sustainability has been studied extensively. The results of these studies do not paint a clear picture. A number of studies suggest a negative relationship between outreach and fnancial sustainability. Among these are studies by Cull et al. (2007); Hermes, Lensink, and Meesters (2011); Hartarska, Shen, and Mersland (2013); and Louis and Baesens (2013). Other studies, however, fnd no relationship or even a positive relationship between outreach and fnancial sustainability for a trade-off: see, for example, Louis, Seret, and Baesens (2013) and Adhikary and Papachristou (2014). Several studies have looked into the conditions under which a trade-off is more likely to occur. These studies show that the representation of stakeholders on boards of MFIs (Hartarska, 2005), gender diversity in the board (Hartarska, Nadolnyak, & Mersland, 2014), and loan methodology (Tchakoute-Tchuigoua, 2012) may help explain when a trade-off occurs. The most comprehensive overview of the trade-off discussion in microfnance can be found in Reichert (2018), who performed a meta-analysis of the literature. He found that the presence of a trade-off strongly depended on the measurement of outreach and fnancial sustainability used. To conclude, the literature does not provide a clear-cut answer to the question whether there is a trade-off between outreach and fnancial sustainability. The safest conclusion, therefore, is to say that it depends on the context and on the way fnancial and social goals have been measured (see Box 3.2).

BOX 3.2 Measuring outreach and fnancial sustainability of MFIs The fnancial sustainability of MFIs can be measured in various ways. In the literature, several studies use standard fnancial ratios, such as the return on equity (ROE), calculated as net operating income divided by the value of outstanding equity, and the return on assets (ROA), measured as the ratio of net operating income to the value of total assets of the MFI. Some studies use measures that are more specifc to microfnance, such as the operational self-suffciency (OSS) and the fnancial self-suffciency (FSS) of MFIs. OSS measures MFIs’ ability to cover costs with revenues by dividing total operating revenues by the sum of total fnancial expenses on attracting funding, including interest paid to depositors; interest and fees on loans from funds or other fnancial institutions and bondholders; and expenses on loan loss reserves and operations. FSS measures the adjusted total fnancial revenue divided by the sum of adjusted fnancial expenses, loan loss provisions, and operating expenses, where adjustments refer

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to correcting for the country-level infation rate and the implicit and explicit subsidies. FSS measures the extent to which MFIs are able to operate without ongoing subsidies, including soft loans and grants. Measuring outreach to the poor requires factoring in two dimensions. The breadth of outreach refers to the coverage of MFI and is generally measured by the number of clients served by the MFI. The depth of outreach refers to the type or profle of the clients served by the MFI and is measured mostly either by taking the ratio of active female borrowers to the total number of active borrowers of an MFI or by the average size of the loan divided by the GDP per capita of the country in which the MFI resides. A few studies focus on analysing organizational effciency by measuring how MFIs use resources and turn them into goods and services. These studies calculate the maximum level of outputs that can be generated given a certain quantity or costs of inputs, or they calculate the minimum quantity or the cost of inputs to generate a certain output level. The closer the organization is to producing the maximum output level or to minimizing the costs of production, the higher its effciency. Studies following this approach, in most cases, use either data envelopment analysis (DEA) or stochastic frontier analysis (SFA) to measure effciency. Examples of studies in microfnance using this approach are Caudill, Gropper, and Hartarska (2009); Hermes et al. (2011); and Servin, Lensink, and Van den Berg (2012). Fall, Akim, and Wassongma (2018) provide a meta-analysis of studies that measure the effciency of MFIs.

3.4 MICROFINANCE PRODUCTS Most fnancial services, such as savings and loan products, which are offered by MFIs, can be characterized as being simple and standardized. Microfnance loans are small and have fxed sizes, they have a fxed repayment schedule, they do not require physical collateral, and repayments already start from the frst week when the loan was obtained (i.e. the grace period is zero). Microfnance savings accounts have similar characteristics. These accounts have a fxed opening cost and allow for (and in some cases even require) small, fxed, and regular deposits, but withdrawals are usually at a relatively high cost. One reason why MFIs provide simple and standardized products is that the costs of offering such services to the poor are relatively low. In particular, loans offering simple and standardized fnancial products help customers make repayment, which reduces the risk of default for the MFI. Moreover, stimulating customers to regularly deposit savings in their accounts helps in making these deposits a proftable (or at least not a lossmaking) activity for the MFI. More importantly, however, offering simple and standardized products helps to discipline clients to make fnancial transactions. Commitments or disciplining mechanisms encourage regular payments. With strict repayment schedules, borrowers know when they have to make payments on their loan and can act accordingly by generating enough

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income or by saving up to generate the necessary funds. Savings products that require clients to regularly make deposits help customers to overcome the temptation to use funds now and instead save the money for later. Such savings products can be important because people fnd saving hard, which means trading current for future consumption. In this context, psychologists refer people’s tendency to procrastinate on a task or action that they tend to dislike. In most cases, the goals and needs of poor customers are short term. As explained by CGAP (2014, p. 16), for the poor, the ‘future is a distant concept and hard to imagine because present needs are so prominent’. Simplicity and standardization go at the cost of the fexibility of fnancial products. Not surprisingly perhaps, especially the poor may proft from their having access to more-fexible products. One of the greatest challenges the poor face is matching infows and outfows of funds, also termed ‘cashfow management’ in the literature (Collins, Morduch, Rutherford, & Ruthven, 2009). Their infows mainly come from income, savings made earlier, or loans and gifts they receive. Yet these infows are usually small, irregular, and uncertain. They need these infows to spend on basic needs (such as food and rents for housing), health payments, school fees, emergencies (such as the consequences of foods and hurricanes), and so-called big-ticket items (such as weddings and funerals). These spending categories are partly regular (basic needs, school fees) and partly unexpected or lumpy (emergencies, funerals). These characteristics of the infows and outfows of funds point out the diffculty of cashfow management that the poor face. Having access to more-fexible fnancial services facilitates cashfow management for the poor. Given the irregularity and uncertainty of their infows, having access to savings accounts and loans that allow them to use these funds whenever needed or make payments the moment infows are available makes it easier for them to match infows and outfows. Flexibility may be provided ex ante – that is, before the customer enters into the contract. In this case, the customer may choose terms at the start of the contract; no adjustments are allowed once the contract starts and sanctions; or penalties are used to commit customers to the initial terms. Another way of providing fexibility is ex post. In this case, terms may be adjusted after the contract has started, depending on the situation the customer is confronted with (e.g. droughts, foods, and illness). In case of full fexibility both ex ante fexibility and ex post fexibility are allowed. The problem for the MFI is that there is a trade-off between offering simple and standardized products versus offering products that are fexible. On the one hand, fexible products are costlier, and their use is more diffcult to monitor. Flexibility helps cashfow management, which potentially increases the repayment of loans or the depositing of savings. On the other hand, however, it may also reduce repayment and savings, because it breaks down commitment and discipline attached to standardized products. The challenge for MFIs is to develop product innovations in microfnance that aim at combining both fexibility and commitment/discipline (Labie, Laureti, & Szafarz, 2017).5 Such products would help poor customers dealing with cashfow management while reducing the risk of the nonrepayment of loans or low deposits of savings for the MFI. In recent years, MFIs

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have experimented with new product designs that try to combine these two characteristics. Some MFIs started offering loans with fexible repayment schedules or repayment schedules that are more closely linked to the fuctuations in income of their clients. In particular, MFIs lending to farmers have developed loan programmes with repayments due after the harvest season – that is, when borrowers obtain income from selling their products. For example, in Thailand, the Bank for Agriculture and Agricultural Cooperative (BAAC) offers agricultural loans with various maturities allowing for ex post fexibility. That is, if a farmer is confronted with repayment problems, the bank is willing to reschedule repayments by taking into account the projected future cashfows (Townsend & Yaron, 2002). To manage their loan portfolio with an ex post fexible contract, loan offcers of the bank regularly visit borrowers to obtain information about their repayment capacity. Confanza, a bank in Peru, offers so-called seasonal loans. These loans offer ex ante fexibility by adapting the repayment schedule and maturity to the crop cycle (Laureti & Hamp, 2011). SafeSave, a microfnance programme operating in Dahka, Bangladesh, offers full fexibility. Customers are offered a savings account that allows them to make deposits and withdrawals at any time for any amount. Moreover, active clients of the programme can also obtain loans without a fxed maturity and without a fxed repayment schedule in terms of timing and amount. SafeSave manages its operations by having loan offcers who come from the same areas where the customers live and who actively visit them to ask them to make deposits or repayments on loans (Labie et al., 2017). Some MFIs have experimented with adjusting the terms of their fnancial products. One example is an MFI called Village Financial Services, which has operations in Kolkata, India. This MFI introduced changes in the repayment structure of loans to see whether this improves the contribution loans can make to the welfare of their borrowers. One change they introduced was offering a loan with a two-month grace period. Microcredit often uses infexible repayment schemes, with repayments made twice a week starting right after the loan disbursement. This increases the probability of repayment but also makes it more diffcult for borrowers to use loans for investing in projects with a higher return, because this type of project may take more time to generate positive cashfows (Field, Pande, Papp, & Rigol, 2013). For the same reason, the MFI experimented with offering loans with monthly instead of weekly or twice-a-week repayment schemes (Field, Pande, Papp, & Park, 2012). Several other new product designs make use of so-called nudges (see Box 3.3). A nudge is an intervention aimed at changing an individual’s behaviour and decision-making in a direction that is seen as desirable by the those who developed the intervention. A nudge should stimulate people’s behaviour in a specifc direction, but it does not forbid individuals’ making their own choices (Thaler & Sunstein, 2008). Nudges in microfnance try to change customers of MFIs to make repayments on loans or deposit savings regularly and on time. Examples are the use of labelling savings accounts. By labelling a savings account for a specifc purpose such as health costs, or school fees, people may be stimulated to save more, because there is clear relationship between depositing savings and the use of the savings made

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(Dupas & Robinson, 2013). Some MFIs have introduced SMS text services to remind borrowers to make a loan repayment or to deposit savings (Karlan, McConnell, Mullainathan, & Zinman, 2016).

BOX 3.3 Using nudges in microfnance: the example of Caja de Ica, Peru In 2008, researcher Dean Karlan and colleagues (Karlan et al., 2016) teamed up with a bank in Peru, the government-owned bank Caja de Ica, to try out a number of fnancial innovations and analyse their impact on the savings behaviour of the clients of the bank. The innovations were part of the new product, Plan Ahorro, of the bank. The product had the following characteristics. First, clients could sign up for the product and open an account, selecting the period for which they committed themselves to make regular savings (between six and 12 months after opening the account), indicating a minimum amount they would deposit every month and setting a goal (which they could select from a list of 14 pre-established categories) for which they would make the savings. Clients were required to make deposits within ten days from the due date each month, to meet their commitment. Second, the bank used various nudges, such as sending clients a reminder by mail seven days before the monthly due date. It also sent another reminder whenever a client did not make a deposit three days after their scheduled deposit date. Other nudges that were used included sending some of the clients a reminder with specifc information about the goal a client was saving for, next to the regular text about reminding them to make the deposit on time. In this way, the client’s salience of why they were making savings was increased, nudging them to make savings on time. As an example of providing specifc information about the goal, a client would receive the following text in the mail: ‘[Regular text about reminding to deposit] If you miss a payment, you will lose a total of [amount] in additional interest rate incentive that you will be able to use towards your savings goal of [goal]!’ A fnal example of a nudge used by the bank was asking some clients to bring a picture of the object they were saving for, such as a motorcycle. The bank would then make a jigsaw puzzle of this picture, and on each occasion the client was depositing money in their account, they would receive a piece of the puzzle. The idea was that in this way, a client would slowly see the object that they were saving for appear, which was supposed to stimulate them to keep on saving. The researchers did fnd evidence that receiving reminders increases the likelihood that clients remain committed to saving. They also found some evidence that these reminders increased the amounts of savings made. Finally, they found support for the fact that messages containing specifc information about the savings goal were effective in making clients save. These results suggest that nudges can also be important in infuencing people’s behaviour when it comes to their making savings.

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To conclude, we have discussed the importance of cashfow management for the poor. Cashfow management refers to the diffcult process of matching small, irregular, and uncertain income, savings, and borrowing with regular spending needs and unexpected or lumpy spending needs. The effectiveness of the poor’s cashfow management depends on the design of fnancial products. Product design is a crucial dimension of fnancial services when talking about how microfnance may help the poor to improve their welfare.

3.5 THE IMPACT OF MICROFINANCE ON END USERS The enormous growth of microfnance programmes during the frst two decades after the establishment of the Grameen Bank suggests that microfnance is a great success. Indeed, until the beginning of the 21st century, many practitioners and academics argued that microfnance could play an important, maybe even crucial, role in lifting the poor out of poverty. However, more recently, the popularity of microfnance has decreased enormously, and the rosy view of microfnance has been challenged by several developments. For example, many MFIs have been accused of offering extremely high lending rates, inducing borrowers from one MFI to borrow from another MFI, to repay their debt. This process has contributed to severe debt problems among some MFI clients. The southern Indian state of Andhra Pradesh even plunged into a microcredit crisis after microfnanceinduced suicides in 2010. Do the aforementioned developments imply that microfnance is unsuccessful? To answer this question, we take a closer look at the research that can teach us something about the success of microfnance. Before doing this, it is important to realize that the answer to the question whether microfnance is a success depends very much on the objectives of microfnance that are evaluated, the microfnance service that is evaluated (credit, savings, or microfnance plus), and the data used in the research. Broadly speaking, one can consider success by focusing either on data with respect to the social and economic impacts of microfnance on end users or data on the proftability and fnancial sustainability of microfnance institutions. This section deals with the frst group of studies; section 3.3 dealt with the second group of studies. 3.5.1 Impact of microcredit There are hundreds of studies on the impact of microfnance, of which most focus exclusively on microcredit. Surveys of these impact studies are provided, among others, by Armendáriz and Morduch (2010); Bauchet et al. (2011); Duvendack et al. (2011); Duvendack and Mader (2019); and Van Rooyen, Stewart, and De Wet (2012). It is impossible to survey the entire literature in this chapter. Therefore, we pay attention to some of the most infuential studies and try to draw some general conclusions. The impact of microfnance has been studied since the 1990s. Most of the early studies suggest positive impacts of microcredit. However, the

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scientifc quality of most of them is rather weak, in that, in general, problems related to self-selection bias or programme placement bias (see Box 3.4) have not been addressed. Yet there are some exceptions worth mentioning. Pitt and Khandker (1998) in their study use an impact evaluation methodology that takes into account that the MFIs they evaluate only allow households owning less than half an acre of land to borrow. By taking into account this eligibility rule, Pitt and Khandker (1998) are able to address some selection biases. The results of their study are quite positive; especially for women, there are large marginal effects of microcredit on indicators of welfare. However, Roodman and Morduch (2014) suggest that it is diffcult, if not impossible, to replicate the fndings from Pitt and Khandker’s study. Coleman (1999) is much less positive about the impact of microcredit. His study concludes that group lending provided by village banks in northeast Thailand had no signifcant impact on variables like assets, production, healthcare, and education. The study by Coleman (1999) is noteworthy because of the innovative evaluation technique he used. By exploiting information about the expansion strategy (pipeline approach) of MFIs, he differentiates between borrowers and nonborrowers in areas where microcredit is already available and in areas where microcredit will become available in the near future. His approach, akin to a cross-sectional double-difference methodology, under some strict assumptions, enables controlling for self-selection bias and programme placement bias.

BOX 3.4 Why is evaluating a microfnance intervention so diffcult? To measure the impact of a microfnance intervention, such as providing some people with access to microcredit, on welfare, a researcher needs to try to uncover the causal effects of microcredit. That is, they need to examine whether, and to what extent, a change in welfare is due to microcredit and not due to other factors. An unbiased estimate of the impact of microcredit would be obtained by comparing welfare levels of the same group of individuals at the same point in time with and without microcredit. Obviously, this is not possible. The researcher is confronted with a missing counterfactual. In practice, several techniques have been used to deal with the missing counterfactual problem by defning a comparison or control group. However, fnding a valid comparison group for the group of people with microcredit is not an easy task. The following are some of the main problems that the researcher is confronted with: 1 Some people may deliberately decide to borrow microcredit, whereas others, even if they had the possibility to do so, may decide not to take up the credit. For instance, more-innovative people, in a group with otherwise similar characteristics, may decide to borrow. If the researcher tried to measure the impact of microcredit by comparing borrowers of microcredit with a

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comparison group of nonborrowers with the same measurable characteristics (age, education level, etc.), the estimate would probably suffer from self-selection bias. 2 The MFI may deliberately decide to open branches in villages with a better infrastructure, where it is easier for farmers to sell their products (or, in contrast, deliberately open branches in villages in remote areas). If the researcher then tries to measure the impact of microcredit by comparing microcredit borrowers from the village where the branch has been opened with a comparison group of nonborrowers in another village, the estimate will probably suffer from programme placement bias. 3 Some microfnance borrowers may after some time decide to leave the microfnance programme because they do not need credit anymore or be kicked out of the microfnance programme if they were not able to repay their debts. A researcher who tries to measure the impact of microcredit by comparing the group of extant borrowers with a comparison group may obtain a biased impact estimate due to attrition bias, because the best (or the worst) microcredit borrowers are no longer taken into account in the comparison.

More recently, impact studies on microcredit have started using better methodologies to control for self-selection and programme placement biases. Several studies have used randomized controlled trials (RCTs) to measure the impact of microcredit (see Box 3.5). With an RCT, researchers study the impact of microcredit by using randomized assignments to an intervention. That is, who will (and will not) obtain access to microcredit is determined via a lottery. In theory, this procedure should produce equivalent control and treatment groups and thereby controls for selection biases. Banerjee, Karlan, and Zinman (2015) discuss the results of six RCTs. These studies show consistent results: (access to) microcredit has a positive yet relatively small impact on people’s lives and fails to raise households out of poverty. Dahal and Fiala (2020), however, show that most recent RCTS on microcredit, including the six studies discussed by Banerjee et al. (2015), are underpowered to identify impacts, for example, due to low uptake. They conclude that we still don’t know whether microcredit is effective. Also, Garcia, Lensink, and Voors (2020), in a quasi-experimental study in Sierra Leone, fnd that microcredit provided via a group lending scheme could enhance the aspirations and hopes of borrowers and hence may improve long-term welfare by reducing internal psychological constraints. Given that most microfnance borrowers are women, microcredit may have a specifc impact on women. The provision of microcredits to female entrepreneurs arguably helps to create a stable income for women, which may be instrumental in breaking the vicious cycle of poverty. Access to microcredit would result in greater income independence for women and help improve women’s empowerment. However, over the past decades,

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several studies have criticized the assumed positive impact of microcredit on women’s empowerment. Some studies even argue that women’s involvement in microcredit programmes can result in their disempowerment (Vaessen et al., 2014). Sometimes targeting only women shifts the burden of fnancial responsibilities in the household onto women, without improving their control over expenditures (which will stay with the husband). Hansen, Huis, and Lensink (in press) provide an overview of the discussion of microfnance services and women’s empowerment. In conclusion, we don’t have unambiguous answer to the question whether microcredit has a positive impact on the welfare of the poor. The time horizon of several impact studies has likely been too short, given that impacts may take time to materialize. However, clearly there is an inverse relationship between the ‘rigour’ of the impact study and the size of the impact of microcredit on outcomes. The more a study tries to control for biases, the less positive the results seem to be. However, it also appears that the recent severe criticisms of microcredit, just like the earlier overenthusiastic claims about the potential contributions of microcredit, have been exaggerated. At the same time, access to microcredit will not be a panacea that can reduce worldwide poverty.

BOX 3.5 Randomized controlled trials: the golden standard of impact evaluations? Several quantitative research designs have been used to measure the impact of microfnance. Examples of methodologies include regression discontinuity, difference-in-difference approaches, propensityscore-matching approaches, and randomized controlled trials (RCTs). The evaluation methods differ in several respects, but they all try to deal with the problem of missing counterfactuals, by defning a comparison or control group. According to Gertler et al. (2011), a highquality impact evaluation needs to defne a control group as one that 1 Is identical to the treatment group, without intervention. 2 Reacts equally as the treatment group to the intervention. 3 Is exposed to the same set of (other) external interventions as the treatment group is. The RCT approach determines treatment and control groups by assigning (groups of) households to the intervention by lottery. This approach, under some conditions, produces equivalent control and treatment groups. In theory, RCTs provide the best opportunity to rigorously address causality questions. This is why RCTs are often seen as the gold standard of impact evaluations. However, in practice, the conditions for ideal RCTs almost never hold (Deaton, 2010) for several reasons, such as ethical concerns. The main advantage of randomization is that it removes bias, and thus, if correctly applied, RCTs lead to an impact estimate, which

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is correct on average. Yet randomization does not always produce the most useful estimator. For example, the precision of the estimator might be low, so the standard error of the unbiased estimator is high. Deaton and Cartwright (2016) argue that in some situations, a more accurate impact estimate (e.g. of microcredit) can be obtained by trading in some bias for greater precision. In other words, rather than using an RCT which avoids ‘biases’, it is sometimes better to use impact evaluation designs that improve precision (reduce variances). Notwithstanding the criticisms that RCTs have received, this methodology has been widely accepted in research nowadays, sometimes considered the golden standard of impact evaluations. In 2019, Abhijit Banerjee and Esther Dufo received the Nobel Memorial Prize for Economic Sciences for their research on evaluating programmes that aim to alleviate poverty. In their work, they extensively use RCTs, among other methods, to evaluate the impact of microfnance programmes.

3.5.2 Impact of microfnance, other than microcredit Some studies have examined the impact of microsavings. However, only a few of them focused on impacts of savings on social outcomes; most of the studies considered a specifc savings product and focused on the uptake of this product or on impacts in terms of total savings. A well-known example is the study by Ashraf, Karlan, and Yin (2006). It focused on the impact of a newly developed savings product offered by the Green Bank of Caraga, a microfnance bank in the Philippines. A specifc characteristic of the savings product, known as SEED (save, earn, enjoy, deposits), was that savers were not allowed to withdraw any of their savings before they had reached a certain goal. The study shows that the commitment savings product leads to much higher savings than does a normal savings account. Some savings studies consider the impact of microsavings on women’s empowerment. An interesting example is the study by Ashraf, Karlan, and Yin (2010), who consider the same commitment savings product as Ashraf et al. (2006) did. The study suggests that women who suffer from low bargaining power are able to improve their bargaining power substantially by using the commitment savings account. An example of a microsavings study that considers the impact on different social outcomes is Karlan, Savonitto, Thuysbaert, and Udry (2017). Using a randomized controlled trial, they examined the impact of microsavings programmes in Ghana, Malawi, and Uganda. These programmes promote and develop the (informal) Village Savings and Loan Association (VSLA). The study suggests that the savings programmes in the three countries signifcantly improved household business outcomes and women’s empowerment. However, it does not fnd positive impacts on average consumption or other livelihoods. To conclude, in general, studies suggest that savings services have a more positive impact on the poor than

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microcredit has. However, the empirical evidence is still limited and only a few focus on the effects on social outcomes, implying that the positive fndings should be considered with caution (see also Duvendack & Mader, 2019). There is also some mixed evidence on the impact of microfnance plus, especially in the impact of business trainings on microfnance clients. McKenzie and Woodruff (2014) surveyed the ‘old’ literature. Their study suggests that business training sessions do not have a big impact on economic outcomes. However, they also argue that most studies they surveyed suffer from major methodological problems. Some more-recent studies also provide mixed evidence, such as Karlan and Valdivia (2011). Other recent studies are much more positive about the impact of business training sessions. For instance, Giné and Mansuri (2014); Berge, Bjorvatn, and Tungodden (2015); and Bulte, Lensink, and Vu (2017) report substantial effects. Bulte et al. (2017) even strongly argue that investments in human capital (i.e. business trainings) may usefully complement microcredit.

3.6 CONCLUSION In this chapter, we discussed the role of microfnance in promoting inclusive growth. We started by defning the concept of microfnance and discussed how it evolved over the past decades. Next, we focused on the supply side of microfnance. We discussed their two main objectives, outreach and fnancial sustainability, and explained that reaching both objectives simultaneously may be diffcult in practice. We also surveyed the recent literature dealing with the determinants of fnancial sustainability and outreach of MFIs. Several studies have analysed whether there is a trade-off between fnancial and social goals of MFIs. Yet the literature does not provide a clear-cut answer to this question. The safest conclusion is to say that it depends on the context and on the way fnancial and social goals have been measured. We continued by discussing the importance of commitment and fexibility as the main features of fnancial products offered to the poor. Particularly for the poor, the infows and outfows of funds are sometimes diffcult to manage. Infows are small, irregular, and uncertain; outfows are sometimes regular, sometimes irregular, and sometimes lumpy. Flexible fnancial products in terms of the payment of interest costs and loan instalments and making deposits to a savings account (i.e. being able to make deposit at any time and of any size) would help the poor in better managing their infows and outfows, thereby increasing their welfare. At the same time, fnancial products that provide commitments in terms of regular interest payments, repayments of loans, or depositing savings would help the poor as well, because they are instrumental in making sure that they keep on making regular payments and savings. Finally, we turned to the demand side of microfnance by discussing what we know about the impact of microfnance on the poor’s well-being. Analysing this is generally hard, mainly because a counterfactual is not readily available: we usually have no information about what would have

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happened if no microfnance was available. However, during recent years, researchers have developed methods to get around this problem by using RCTs. Researchers using this method create treatment and control groups by randomly assigning (groups of) households to a specifc intervention, such as providing a microcredit. The random assignment, under certain conditions, produces treatment and control groups with the same, or at least very similar, characteristics. In this way, the control group can serve as the counterfactual to analyse the impact of providing microcredit to the treatment group. During the past few years, many RCTs have been carried out, and most studies have shown consistent results: (access to) microcredit has a positive yet relatively small impact on people’s lives. Therefore, microfnance fails to raise households out of poverty. The results from RCTs’ analysing the impact of savings products and microfnance plus are more positive. In particular, studies have shown that offering savings to the poor can help them to improve their lives. At the same time, however, access to microfnance will not be a panacea that can reduce worldwide poverty.

Discussion questions 1 What are the two main objectives of MFIs? What is meant by the microfnance promise (Morduch, 1999)? Why is it diffcult in practice for MFIs to combine their two main objectives? 2 In discussions about the existence of a trade-off between the two main objectives of MFIs, two views, or approaches, are prominent: the fnancial systems approach and the poverty-lending approach (Robinson, 2001; Schreiner, 2002). What is the main argument of both these views regarding the existence of a trade-off? 3 What do we mean by mission drift of MFIs? Why does this occur? 4 Why are commitment and fexibility important features of fnancial services such as savings accounts and loans for microfnance clients? Are these features more or less important for poor people visà-vis rich people? 5 In many large cities in developing economies, poor people earn income by selling food or artisanal

6 7 8 9 10 11

products on the streets. According to you, what type of fnancial services would best serve the needs of these poor people? In particular, what kind of characteristics should these services need to have? In your discussion, describe the nature of the poor’s fnancial infows and outfows, and link this description to your discussion of the fnancial services that MFIs should offer to them. What is meant by a randomized control trial? Why do some people argue that RCTS are the golden standard of impact evaluations? Do you agree? Discuss the evidence on the impact of microcredit. What does selection bias mean? Differentiate between different forms of selection bias. Why might joint liability group lending reduce adverse selection and moral hazard problems? Explain the difference between microcredit, microfnance, and microfnance plus.

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Notes 1 The Microcredit Summit Campaign is an American nonproft organization that was founded in 1997 by Muhammad Yunus (founder of Grameen Bank), Sam Daley-Harris (US-American writer and activist), and John Hatch (US-American development economist and founder of FINCA International, a nonproft microfnance organization). The organization brings together several different parties involved in microcredit, such as microcredit practitioners, academics, donor agencies, international fnancial institutions, and NGOs, to promote the use of microcredit as an instrument to reduce poverty around the globe. At the start of the organization, a campaign was launched that aimed at reaching a billion poor families and provide them access to credit by 2005. The campaign has been instrumental in getting attention for microfnance as an instrument to reduce poverty and has contributed to the growth of the use of microfnance worldwide. 2 This section is based on Hermes and Hudon (2018).

3 Outreach refers to the number of poor people that an MFI can provide services to. The outreach of microfnance is not the same as the impact of microfnance, which refers to the effect that access to services has on the welfare of poor people. The impact of microfnance will be discussed in section 5. 4 D Espallier et al. (2013) use data for one year (2010) for almost 1,100 MFIs; Cull et al. (2018) use data for 2005–2009 for 1,335 MFIs. Both studies use slightly different methods of calculating the subsidies that MFIs receive. The differences with respect to sample size, time period, and method of calculating may explain why both studies show different fndings regarding the importance of subsidies for MFIs. 5 Since most product innovation in microfnance have been introduced quite recently and have been applied only by a relatively few MFIs around the world, a comprehensive evaluation of their performance vis-à-vis the performance of standard microfnance products is currently not available.

References Adhikary, S., & Papachristou, G. (2014). Is there a trade-off between fnancial performance and outreach in South Asian microfnance institutions?  The Journal of Developing Areas, 381–402. Armendáriz, B., & Labie, M. (2011). The handbook of microfnance.  Singapore (SG): World Scientifc Publishing Co. Pte. Ltd. ISBN 139789814295659. Armendáriz, B., & Morduch, J. (2010). The economics of microfnance. Cambridge, MA: MIT Press.

Armendáriz, B., & Szafarz, A. (2011). On mission drift in microfnance institutions. In The handbook of microfnance  (pp.  341–366). Singapore: World Scientifc. Ashraf, N., Karlan, D., & Yin, W. (2006). Tying Odysseus to the mast: Evidence from a commitment savings product in the Philippines. The Quarterly Journal of Economics, 121(2), 635–672. Ashraf, N., Karlan, D., & Yin, W. (2010). Female empowerment: Impact of a

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commitment savings product in the Philippines. World Development, 38(3), 333–344. Banerjee, A., Karlan, D., & Zinman, J. (2015). Six randomized evaluations of microcredit: Introduction and further steps. American Economic Journal: Applied Economics, 7(1), 1–21. Bateman, M. (2010). Why doesn’t microfnance work? The destructive rise of local neoliberalism. London: Zed Books Ltd. Bauchet, J., Marshall, C., Starita, L., Thomas, J., & Yalouris, A. (2011). Latest fndings from randomized evaluations of microfnance. In  Access to fnance forum: CGAP, fnancial access initiative, innovations for poverty action, Abdul Latif Jameel poverty action lab (Vol. 2). Washington, DC: Consultative Group to Assist the Poor (CGAP)/The World Bank. Berge, L. I. O., Bjorvatn, K., & Tungodden, B. (2015). Human and fnancial capital for microenterprise development: Evidence from a feld and lab experiment.  Management Science, 61(4), 707–722. Bulte, E., Lensink, R., & Vu, N. (2017). Do gender and business trainings affect business outcomes? Experimental evidence from Vietnam.  Management Science, 63(9), 2885–2902. Caudill, S. B., Gropper, D. M., & Hartarska, V. (2009). Which microfnance institutions are becoming more cost effective with time? Evidence from a mixture model.  Journal of Money, Credit and Banking, 41(4), 651–672. CGAP. (2014). Insights into action: What human-centered design means for fnancial inclusion. Retrieved from file:///X:/My%20Downloads/ CGAP_Insights_into_Action_fnal%20 (1).pdf Coleman, B. E. (1999). The impact of group lending in Northeast Thailand.  Journal of Development Economics, 60(1), 105–141. Collins, D., Morduch, J., Rutherford, S., & Ruthven, O. (2009). Portfolios of the poor: How the world’s poor live on $2 a day. Princeton: Princeton University Press.

Copestake, J. (2007). Mainstreaming microfnance: Social performance management or mission drift? World Development, 35(10), 1721–1738. Cull, R., Demirguç‐Kunt, A., & Morduch, J. (2007). Financial performance and outreach: A global analysis of leading microbanks.  The Economic Journal, 117(517), F107–F133. Cull, R., Demirgüç-Kunt, A., & Morduch, J. (2018). The microfnance business model: Enduring subsidy and modest proft. World Bank Economic Review, 32(2), 221–244. Dahal, M., & Fiala, N. (2020). What do we know about the impact of microfnance? The problems of power and statistical precision. World Development, 128. Deaton, A. (2010). Instruments, randomization, and learning about development. Journal of Economic Literature, 48(2), 424–455. Deaton, A., & Cartwright, N. (2016). Understanding and misunderstanding randomized controlled trials. NBER Working Paper Series No. 22595. Cambridge, MA: National Bureau of Economic Research. D’Espallier, B., Hudon, M., & Szafarz, A. (2013). Unsubsidized microfnance institutions. Economics Letters, 120(2), 174–176. Dupas, P., & Robinson, J. (2013). Why don’t the poor save more? Evidence from health savings experiments. American Economic Review, 103(4), pp. 1138–1171. Duvendack, M., & Mader, P. (2019). Impact of fnancial inclusion in lowand middle-income countries. Campbell Systematic Reviews, 15. Duvendack, M., Palmer-Jones, R., Copestake, J. G., Hooper, L., Loke, Y., & Rao, N. (2011). What is the evidence of the impact of microfnance on the well-being of poor people? London: EPPI-Centre, Social Science Research Unit, Institute of Education, University of London. Fall, F., Akim, A. M., & Wassongma, H. (2018). DEA and SFA research on the effciency of microfnance institutions: A meta-analysis. World Development, 107, 176–188.

Chapter 3 • Microfnance and development Field, E., Pande, R., Papp, J., & Park, Y. J. (2012). Repayment fexibility can reduce fnancial stress: A randomized control trial with microfnance clients in India. PloS One, 7(9), e45679. Field, E., Pande, R., Papp, J., & Rigol, N. (2013). Does the classic microfnance model discourage entrepreneurship among the poor? Experimental evidence from India. American Economic Review, 103(6), 2196–2226. Garcia, A., & Lensink, R. (2019). Microfnance-plus: A review and avenues for research.  A Research Agenda for Financial Inclusion and Microfnance, 111. Garcia, A., Lensink, R., & Voors, M. (2020). Does microcredit increase aspirational hope? Evidence from a group lending scheme in Sierra Leone. World Development, 128. Gertler, P. J., Martinez, S., Premand, P., Rawlings, L. B., & Vermeersch, C. M. J. (2011). Impact evaluation in practice. Washington, DC: The World Bank. Giné, X., & Mansuri, G. (2014). Money or ideas? A feld experiment on constraints to entrepreneurship in rural Pakistan. Washington, DC: The World Bank. Guinnane, T. W. (2002). Delegated monitors, large and small: Germany’s banking system, 1800–1914. Journal of Economic Literature, 40(1), 73–124. Hansen, N., Huis, M., & Lensink, R. (in press). Microfnance services and women’s empowerment. In S. J. Leire, J. L. Retolaza, & L. Van Liedekerke (Eds.), International handbooks in business ethics: Handbook on ethics in fnance. New York: Springer. Hartarska, V. (2005). Governance and performance of microfnance institutions in Central and Eastern Europe and the newly independent states.  World Development,  33(10), 1627–1643. Hartarska, V., Nadolnyak, D., & Mersland, R. (2014). Are women better bankers to the poor? Evidence from rural microfnance institutions. American Journal of Agricultural Economics, 96(5), 1291–1306.

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Hartarska, V., Shen, X., & Mersland, R. (2013). Scale economies and input price elasticities in microfnance institutions.  Journal of Banking & Finance, 37(1), 118–131. Hermes, N., & Hudon, M. (2018). Determinants of the performance of microfnance institutions: A systematic review.  Journal of Economic Surveys, 32(5), 1483–1513. Hermes, N., Lensink, R., & Meesters, A. (2011). Outreach and effciency of microfnance institutions.  World Development, 39(6), 938–948. Hudon, M., & Sandberg, J. (2013). The ethical crisis in microfnance: Issues, fndings, and implications.  Business Ethics Quarterly, 23(4), 561–589. Karlan, D., McConnell, M., Mullainathan, S., & Zinman, J. (2016). Getting to the top of mind: How reminders increase saving.  Management Science, 62(12), 3393–3411. Karlan, D., Savonitto, B., Thuysbaert, B., & Udry, C. (2017). Impact of savings groups on the lives of the poor.  Proceedings of the National Academy of Sciences, 114(12), 3079–3084. Karlan, D., & Valdivia, M. (2011). Teaching entrepreneurship: Impact of business training on microfnance clients and institutions.  Review of Economics and Statistics, 93(2), 510–527. Labie, M., Laureti, C., & Szafarz, A. (2017). Discipline and fexibility: A behavioural perspective on microfnance product design.  Oxford Development Studies, 45(3), 321–337. Laureti, C., & Hamp, M. (2011). Innovative fexible products in microfnance. Savings and Development, 35(1), 97–129. Lensink, R., & Bulte, E. (in press). Can we improve the impact of microfnance? A survey of the recent literature and potential avenues for success. In A. N. Berger, P. Molyneux, & J. O. Wilson (Eds.), Oxford handbook of banking. Oxford: Oxford University Press. Louis, P., & Baesens, B. (2013). Do forproft microfnance institutions achieve better fnancial effciency and social

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impact? A generalised estimating equations panel data approach. Journal of Development Effectiveness, 5(3), 359–380. Louis, P., Seret, A., & Baesens, B. (2013). Financial effciency and social impact of microfnance institutions using self-organizing maps. World Development, 46, 197–210. McKenzie, D., & Woodruff, C. (2014). What are we learning from business training and entrepreneurship evaluations around the developing world? The World Bank Research Observer, 29(1), 48–82. Mersland, R., & Strøm, R. Ø. (2010). Microfnance mission drift?  World Development, 38(1), 28–36. Morduch, J. (1999). The microfnance promise.  Journal of Economic Literature, 37(4), 1569–1614. Pitt, M. M., & Khandker, S. R. (1998). The impact of group-based credit programs on poor households in Bangladesh: Does the gender of participants matter?  Journal of Political Economy, 106(5), 958–996. Reichert, P. (2018). A meta-analysis examining the nature of trade-offs in microfnance. Oxford Development Studies, 20, 1–23. Robinson, M. S. (2001).  The microfnance revolution: Sustainable fnance for the poor. Washington, DC: The World Bank. Roodman, D., & Morduch, J. (2014). The impact of microcredit on the poor in Bangladesh: Revisiting the evidence.  Journal of Development Studies, 50(4), 583–604.

Schreiner, M. (2002). Aspects of outreach: A framework for discussion of the social benefts of microfnance.  Journal of International Development, 14(5), 591–603. Servin, R., Lensink, R., & Van den Berg, M. (2012). Ownership and technical effciency of microfnance institutions: Empirical evidence from Latin America.  Journal of Banking & Finance, 36(7), 2136–2144. Tchakoute-Tchuigoua, H. (2012). Active risk management and loan contract terms: Evidence from rated microfnance institutions. The Quarterly Review of Economics and Finance, 52(4), 427–437. Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving decisions about health, wealth, and happiness. Yale: Yale University Press. Townsend, R. M., & Yaron, J. (2002). An Asian development bank: Credit risk contingency and the subsidy dependence index.  Savings and Development, 227–258. Vaessen, J., Rivas, A., Duvendack, M., Jones, R. P., van Gils, G., Lukach, R., . . . Huband, N. (2014). The effects of microcredit on women’s control over household spending in developing countries: A systematic review and meta‐analysis.  Campbell Systematic Reviews, 10(1), 1–205. Van Rooyen, C., Stewart, R., & De Wet, T. (2012). The impact of microfnance in sub-Saharan Africa: A systematic review of the evidence.  World Development, 40(11), 2249–2262.

CHAPTER

4

Private capital fows and economic growth Elikplimi Komla Agbloyor, Alfred Yawson, and Pieter Opperman 4.1 INTRODUCTION External fnance in the form of private capital fows have recently increased considerably to developing regions such as Africa (see Figure 4.1). The increasing trend in private capital fow levels was initially necessitated by the region’s comparatively high returns on investment compared with other regions (Asiedu, 2002), high level of poverty, and low level of income and domestic savings, and many African policymakers and developmental partners promote private capital fows to spur investment and growth. Apart from external fnance, other potential sources to fnance development include the use of income from export earnings, increasing government revenue through taxation, and domestic investment (accessing domestic savings through an effcient fnancial system). A key problem for developing countries is that most of these other potential sources for fnancing development are limited. This necessitates relying on external fnance to increase the pool of capital available for development. For example, many African countries’ export earnings are highly commodity dependent, where a slump in commodity prices adversely affects the current account balance, thus suppressing development plans. Further, a low tax base mainly because of the large informal sector in Africa hampers domestic-resourcemobilization capabilities, limiting the possibility of governments’ increasing revenue through taxation. Further, compared with other developing regions, African countries are characterized by low levels of domestic savings with underdeveloped and ineffcient fnancial systems. By attracting private capital fows, countries with insuffcient domestic savings can access an external pool of savings. Through this, countries can accomplish the following: 1 2 3 4

Resource allocation effciency can be enhanced. Technology and management transfer can be facilitated. Welfare-enabling current account imbalances can be fnanced. Portfolio diversifcation can ensue.

Increased private capital fows could also lead to indirect benefts, including fnancial sector development, enhanced trade, macroeconomic policy discipline/stability, and economic effciency (IMF, 2012). When private

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capital fows are allocated effciently through fnancial markets to fnance innovations, that may be because of technology transfer, the improved capital accumulation, and technology diffusion can promote economic growth. However, private capital infows also present a double-edged sword for host economies. Private capital infow surges cause infationary pressures and capital account defcits expose economies to external shocks. Once capital retrenchment follows, a deterioration of economic activity and welfare losses as a result of consumption volatility could ensue (Shirota, 2015). The excessive expansion of aggregate demand or overheating of the economy can occur as a result of asset price distortions resulting from signifcant private capital infows. Apart from infationary pressures and widening current account defcits, a real exchange rate appreciation, which can render a host economy’s exports less competitive, is a further concern associated with private capital infow surges. Private capital infows can result in fnancial system vulnerability. An increase in external debt and a rise in excessive bank lending can worsen maturity mismatch between bank assets and liabilities, inducing poor loan quality. Maturity mismatch occurs when bank assets become less liquid than their liabilities. When banks rely more on external fnance as opposed to their own capital, the potential withdrawal of foreign capital increases maturity mismatch and fnancial stability concerns. Debts denominated in foreign currency increases developing countries’ fnancial risks, because fnancing occurs in foreign currency. These debts infamed the impact of emerging market fnancial crises such as the 1994 Mexican tequila crisis, the 1998 Russian rouble crisis, and the late 1990s East Asian crisis (Eichengreen & Hausman, 1999). Indeed, developing countries are exposed to the phenomenon of ‘original sin’ in that they borrow in foreign currencies over which they have no control. This exposes them to exchange rate fuctuations or exchange rate risk. Important variations exist in the various components of private capital fows (foreign direct investment, foreign bank lending, and foreign portfolio investment), and lumping these fnancial fows together to examine their determinants or impact may lead to wrong policy choices. Although foreign direct investment (FDI) and portfolio equity investment differ, since the former is linked to ownership and control, both fows differ from foreign debt that creates liabilities that must be repaid. The main private capital fows also transmit through separate markets where the levels of organization and liquidity vary greatly. With fnancial instrument transactions – such as bank lending and foreign portfolio investment (FPI)  – there are usually many buyers and sellers, standardized contracts, and prices that are publicly available with a market structure often approximating perfect competition. Conversely, FDI is often not observed in fnancial markets but is rather the consequence of fnancial and industrial decisions that are internal to frms that could have real implications possibly unrelated to fnancial variables (Contessi, De Pace, & Francis, 2013). The various types of capital fow exhibit different levels of volatility and respond differently to fnancial liberalization (Neumann, Penl, & Tanku, 2009). Although global factors were signifcant determinants of the volatility of capital fows, the work of Broto, Diaz-Cassou, & Erce (2011)

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revealed conficting evidence about the infuence of domestic factors on the volatility of capital fows. In sub-Saharan Africa, global and domestic factors affected FDI and portfolio equity volatility, whereas only domestic factors affected cross-border bank lending volatility (Opperman & Adjasi, 2017). FDI volatility is, on average, less than FPI and cross-border bank lending volatility. FDI is considered more stable and permanent because of a larger initial investment and the associated fxed entry costs. In essence, FDIs are considered ‘bolted’ and cannot be easily ‘unscrewed’ or reversed. Figure 4.1 shows that FPI appears more volatile than the other capital fows and has been especially since 2010. This could be in response to global investors’ pulling their investments after the global fnancial crisis of 2007/2008. The literature shows that the differences between FDI volatility and FPI volatility are much lower in developed countries than in developing countries (Goldstein & Razin, 2006). Along with FPI, cross-border bank lending fows are considered highly volatile, infuencing the macroeconomic and fnancial stability of developing economies (Herrmann & Mihaljek, 2013). FPI and cross-border banking fows are often referred to as ‘hot money’ – that is, global fows extremely sensitive to interest rate differences, expected returns, and future growth prospects. These volatile capital fows could be induced by a small shock to the economy that worsens the shock and can disrupt the local economy. It is therefore important to consider the heterogeneous nature of different private capital fow types. FDI is defned as investment that acquires a lasting management interest (10% or more of voting stock) in an enterprise that operates in a different economy than that of the investor, and direction is classifed as either inward FDI or outward FDI. FDI by entry mode can be classifed into Greenfeld investments or cross-border mergers and acquisitions (M&As). With

FIGURE 4.1 Trends in private capital fows to Africa, 2000–2016

Source: Generated by authors on the basis of data from the World Development Indicators

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Greenfeld investments, foreign enterprises set up operations in the domestic economy from scratch (e.g. constructing new production facilities), whereas with cross-border M&As, foreign enterprises merge or acquire an existing stake in a domestic enterprise. Although M&As comprise most of FDI fows in developed countries, their uptake and importance have increased in developing regions, such as Africa (Agbloyor, Abor, Adjasi, & Yawson, 2012). FDIs by target can be classifed as either a horizontal FDI or vertical FDI. With a horizontal FDI, the investment is made in the same industry at a foreign location, thereby duplicating the production process, whereas with a vertical FDI, the different stages of production are located in different countries. Vertical FDI can be classifed as either forward vertical or backward vertical. With forward vertical, FDI takes the frm nearer to the market, whereas with backward vertical, international integration moves towards the required production inputs. The literature on FDIs by motive can be classifed as resource seeking, market seeking, effciency seeking, and strategic-asset seeking (Ajayi, 2006). Resource-seeking FDI investors pursue resources at a lower real cost abroad that is often not available at home. Resources include natural resources or low-cost labour, and resource-seeking FDIs are predominantly export oriented. Market-seeking FDIs pursue market share in target foreign markets to reduce the cost of supplying a market. Effciency-seeking FDIs attempt to establish effcient structures by producing in as few countries as possible, each country having its own distinct advantage relating to location, endowment, and government policies. The motive for strategic-asset-seeking FDIs is to locate where assets in foreign frms can be acquired that promote long-term objectives (e.g. to beneft from current and future research and development). The top countries in Africa in relation to net FDI infows in 2016 were Egypt, Nigeria, Angola, Ethiopia, Ghana, Mozambique, Morocco, South Africa, the Republic of the Congo, and Algeria (see Appendix Table 4.1). Appendix Table 4.1 also shows the countries that received the least FDI fows in 2016. The literature’s use of aggregate credit measures of bank lending has been differentiated on the basis of the origin of the bank’s nationality (domestic or foreign) and type (cross-border or affliate). Foreign bank lending by type can be defned as either cross-border bank lending (lending by foreign banks directly from abroad) or as foreign-bank-affliate lending (lending by branches and subsidiaries of foreign banks from the host economy) (Owen & Temesvary, 2014). An important component of the expansion of private capital fows to developing countries has been foreign bank lending, be it through cross-border bank lending or through bank lending by these banks’ foreign affliates (Pontines & Siregar, 2014). Past decades have witnessed an unequalled increase in cross-border bank fows, and many banks (from developed and developing economies) have ventured abroad. The increase in foreign bank presence has potentially been the most transformative change that the ongoing process of fnancial globalization has exerted on the fnancial sectors of developing economies (Cull & Peria, 2010). Nevertheless, the effect of foreign bank presence on fnancial sector development remains contentious. Foreign banks can improve the availability and quality

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of fnancial services in the host economy through increasing competition and the introduction of new lending technologies. A potential cost of increasing foreign bank presence could be incurred when foreign banks focus on the top segment of the market, so local entrepreneurs receive less access to fnancial services. The top countries in cross-border banking lending (proxied by external debt) in Africa in 2016 were Egypt, Angola, South Africa, Kenya, Ethiopia, Nigeria, Mauritius, Morocco, Ghana, and Tanzania (see Appendix Table 4.1). Various foreign banks operate in Africa (see Box 4.5). FPI is usually short-term passive investment that does not actively participate in the day-to-day operations and strategic initiatives of local frms. Investments are made in capital market assets, including bonds, debentures, and equity stocks, and investors target return maximization without having management control in the principal asset. The top countries in portfolio investments in Africa in 2016 were Mauritius, Burkina Faso, Kenya, Morocco, Mozambique, Zimbabwe, Uganda, Cameroon, Tunisia, and Seychelles (see Appendix Table 4.1). The rest of this chapter is structured as follows: section 4.2 discusses determinants of private capital fows; section 4.3 provides the benefts and costs associated with private capital fows; and section 4.4 concludes.

4.2 THE DETERMINANTS OF PRIVATE CAPITAL FLOWS The literature usually distinguishes between pull and push factors to categorize the determinants of capital fows. Pull factors are associated with the domestic policies and characteristics of host economies that pull capital into a country, refecting the host economy’s relative appeal as an investment destination. Pull factors include the domestic growth potential, low domestic infation, trade and fnancial openness, fnancial market development, infrastructural quality, institutional quality, political stability and absence of confict, domestic market size, and natural resource base. Figure 4.2 shows the correlation between institutional quality and capital fows (-0.75). Overall, it seems that capital fows go to countries with poor institutions and vice versa. Figure 4.3 also shows the relationship between natural resource rents and total capital fows. Total capital fows and natural resources are positively correlated (0.41). This implies that countries with natural resources tend to receive higher capital fows. Thus, natural resources tend to pull capital fows into host African countries. Push factors are associated with global economic conditions that drive capital fows towards countries and include global growth, global liquidity, global risk aversion, and international portfolio diversifcation. Therefore, pull factors are internal to countries that receive capital fows and push factors are external to these countries. If pull factors are the main determinant of capital fows to a recipient economy, then well-designed prudent macroeconomic policies should limit the potential negative effects that these fows can have on fnancial imbalances. However, domestic macroeconomic policies have little potential to limit the negative effects of capital fows’ arising from global push factors, because these factors are beyond the control of the recipient economy.

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FIGURE 4.2 Scatter plot between capital fows and GDP per capita, 2000–2016

Panel A: FDI, Portfolio Investments, and Institutions

Source: Generated by authors on the basis of data from the World Development Indicators Note: Correlation between FDI and institutions is -0.57; the correlation between portfolio investments and institutions is 0.05

Panel B: External Debt, Capital Flows, and Institutions

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between cross-border bank lending (proxied by external debt) and institutions is -0.73; the correlation between capital fows and institutions is -0.75

4.2.1 FDI determinants Apart from the general divide into push factors and pull factors that determine capital fows, a more specifc FDI determinants literature strand covers the following (Sánchez-Martín, de Arce, & Escribano, 2014): 1 The neoclassical economic approach. 2 The ownership, location, and internalization advantage (OLI) paradigm. 3 Horizontal and vertical FDI models.

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FIGURE 4.3 Scatter plot between capital fows and CO2 emissions, 2000–2016

Panel A: FDI, Portfolio Investments, and Natural Resource Rents

Source: Generated by authors on the basis of data from the World Development Indicators. Note: The correlation between FDI and natural resource rent is 0.67; the correlation between portfolio investment and natural resource rent is -0.07.

Panel B: External Debt, Capital Flows (Total), and Natural Resource Rents

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between cross-border bank lending (proxied by external debt) and natural resource rent is -0.01; the correlation between capital fows (total) and natural resource rent is 0.41

4.2.1.1 THE NEOCLASSICAL ECONOMIC APPROACH The standard neoclassical economic approach predicts that in the presence of perfect factor mobility, capital would fow from rich to poor countries pending the return to investments equalizing in all countries. New investment should occur in countries that exhibit low capital-to-labour ratios as implied by the law of diminishing returns to capital. The standard approach offers a preliminary

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insight regarding FDI determinants, given that the prominence of differences in factor endowments and returns to capital across countries are suggested. The seminal work of Lucas (1990) introduced the Lucas paradox, highlighting that, rather than following a ‘north–south’ pattern, capital fows follow a ‘north-north’ pattern. Lucas (1990) demonstrated that according to the neoclassical economic approach, India’s marginal product of capital should be approximately 58 times greater than that of the US, with all capital fowing to India. Notwithstanding considerable increased capital fows recently, international capital mobility remains imperfect. Some reasons put forward about why the standard neoclassical economic approach does not accurately predict international capital fow patterns include the presence of economies of scale, backward and forward linkages, differences in regulations, and systemic distortions between countries (Sánchez-Martín et al., 2014). 4.2.1.2 THE OLI PARADIGM From a microeconomic perspective, Dunning’s (1977) OLI paradigm provides an analytical framework that accommodates a variety of testable theories of FDI determinants and the international activities of multinational enterprises (MNEs). The OLI paradigm states that the degree, geography, and manufacturing structure of MNEs’ international production is determined by the interaction and combination of ownership, location, and internalization advantages. Ownership advantages are existing frm-specifc and knowledge-based assets (e.g. patents, management skills, and marketing) that provide MNEs with advantages in foreign markets over local frms. Ownership advantages therefore refer to the competitive advantages of MNEs that give them an edge over domestic counterparts in foreign markets. Location advantages are the attractions of alternative countries or regions where MNEs seek to engage in value-enhancing activities (e.g. access to protected markets, better tax treatments, favourable competition structure, institutions, political risk, and natural resources). Figure 4.2 shows a negative correlation (-0.57) between FDI and the quality of institutions. This means that countries with poor institutions receive higher FDI fows than do countries with good institutions. This is puzzling: the observed correlation may be because MNEs may be able to negotiate better terms and have more fexibility to operate (e.g. polluting the environment). On the other hand, Figure 4.3 shows that FDI is positively correlated (0.67) with natural resources in Africa. This suggests that MNEs consider the natural resource endowment of a country before they make FDI decisions. The more immobile (natural or created) endowments MNEs need to exploit, in combination with their competitive advantage that favours an international presence, the more MNEs will choose to exploit their ownership advantages through pursuing FDI (Dunning, 2000). One signifcant determinant of FDI is political risk – an extreme form being confict. Countries that are plagued by confict are likely to receive less FDI. Confict creates uncertainty in planning: most studies on the impact of confict on international business found that confict in host countries negatively impacts the economy through disruptions of production, corruption,

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and transportation (Chen, 2017). FDI may reduce the probability of confict. This is because of the economic benefts that FDI provides, such as the creation of new jobs, which reduces the probability that young men can be recruited by warlords. This suggests that there is a bicausal relationship between FDI and confict. Akomatey (2017) examines the relationship between FDI and confict in Africa. The fndings show that FDI infows signifcantly reduce the likelihood of confict among countries in sub-Saharan Africa. For instance, FDI infows to host countries help its citizens, who are destitute and unemployed, to get work, to receive income, and to be able to provide the basic needs of life for themselves and their families. This increases the opportunity cost of engaging in confict. In some cases, the presence of FDI may exacerbate the probability of confict. This may especially be when a country is endowed with natural resources (see Box 4.1) because the resources create a ‘big pot’ to fght over, since whoever gains control gains access to signifcant power and infuence. Further, the determinants of FDI may vary depending on whether a country is a classifed as a confict-prone country. Empirical evidence for Africa shows that the determinants of FDI vary in confict and nonconfict environments. Boachie-Mensah (2017) shows that the factors that determine FDI to sub-Sahara Africa differ from one country to another on the basis of whether the country is classifed as being a confict or nonconfict country. For the determinants of FDI in the full sample, she fnds that fnancial development and infrastructure had positive signifcant effects on FDI, whereas trade openness and market size had a signifcant, negative relationship with FDI. For nonconfict countries, natural resources, institutions, trade openness, infrastructure, and fnancial development had positive signifcant coeffcients, but market size had a signifcant negative coeffcient. For confict countries, natural resources had a negative impact on FDI. Trade openness and market size also exhibit a negative relationship with FDI. With internalization advantages, MNEs organize, create, and exploit their core competencies given the location advantages. Rather than export or engage in licensing, MNEs pursue international production for the net benefts of internalizing intermediate cross-border product markets (Dunning, 2000). MNEs minimize imitation risks or reputation losses and save transaction costs by pursuing international production directly in the target market (Sánchez-Martín et al., 2014). The empirical literature that tested the OLI paradigm showed FDI determinants to be a combination of ownership advantages, transport costs, market features, infrastructure, property rights, and industrial dispute mechanisms (Faeth, 2009). 4.2.1.3 HORIZONTAL AND VERTICAL FDI APPROACHES Horizontal and vertical FDI approaches emerged in the 1980s as part of new trade theories building on industrial organization models (including the OLI paradigm) to combine ownership and location advantages with technology and country characteristics. General equilibrium models in a monopolistic competition setting were used to try to explain the activities of horizontal (Markusan, 1984) and vertical FDI (Helpman, 1984), the FDI and export link being a case of a substitution relationship or a complementary relationship (Abor,

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Adjasi, & Hayford, 2008). According to Sánchez-Martín et al. (2014), the following reasons explain foreign investment in a country: • With resource-seeking activities, MNEs establish a manufacturing plant in a developing economy to gain access to raw materials to the extent to which the host economy will beneft from the foreign investment, depending on the terms of the concessionary agreement with the MNE and how local institutions manage the income. • With horizontal FDI, MNEs seek to gain access to markets to serve a large demand where transportation costs from the MNEs’ home base are high. Horizontal FDI could be used to avoid import restrictions or high tariffs, thereby substituting for global trade and possibly increasing local industry competition. • With vertical FDI, MNEs seek cheaper factor prices by establishing manufacturing plants that use labour-intensive processes in countries with low wages and appropriate transport infrastructure connections with developed countries. This type of FDI permits backward and forward linkages and is frequently export oriented. The knowledge-capital model of Markusan and Maskus (2002) allows for combinations of horizontal and vertical FDI approaches. Horizontal FDI is established where two countries are similar in size and a large market exist, whereas vertical FDI is established where countries differ in size and endowments. The empirical literature strongly supports market size and transport costs as FDI determinants; evidence remains inconclusive on whether factor endowments (supporting the vertical FDI approach) are signifcant FDI determinants (Faeth, 2009). The following groups of variables, in theory, determine FDI, ownership advantages (e.g. patents and strategic assets), locational advantages (e.g. endowments, transport costs, and trade barriers), macroeconomic factors (e.g. infation, exchange rates, labour costs, and GDP growth), and policy and institutional factors (e.g. political risk, degree of fnancial openness, and taxation benefts) (Sánchez-Martín et al., 2014).

BOX 4.1 FDI and the DR Congo (DRC) experience The Democratic Republic of the Congo (DR Congo, or DRC) is located in Central Africa and is the world’s largest copper producer. It has been plagued by several conficts in the past, and by some estimates, confict in the DRC has claimed over fve million lives. The DRC ranks low on the Mo Ibrahim Index (measures the performance of African countries in terms of governance) of African governance (35 out of 100 in 2016). The war in Rwanda spilled over into DRC as Rwandan forces pursued those who had committed genocide in Rwanda and had fed into DRC. At its height, the war in DRC embroiled several of its neighbours and other African countries (Rwanda, Uganda, South Sudan, Central African Republic, Angola, Namibia, and Zimbabwe).

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The DR Congo’s natural resources fuelled this confict after long-time despot Mobutu Sese Seko was overthrown. The family jewels (blood diamonds) became available for looting. Although statistics on FDI into the DR Congo are diffcult to come by (in terms of actual amounts), FDI into the country has been rising recently, and FDI stocks have risen sharply, especially after a lull in the confict in 2003. In 2016, on the basis of data from the WDI, DR Congo received FDI infows of about USD1.2 billion, ranking 13th for that year. Several MNEs operate in the DR Congo, and most observers believe that the DR Congo has not benefted from these investments, since the terms of the investments are regarded as far too generous. Indeed, the DR Congo has been exploited by foreigners since the Victorian era. Further reading: www.economist.com/leaders/2018/02/15/congo-is-slidingback-to-bloodshed https://mo.ibrahim.foundation/iiag

4.2.2 Foreign bank lending determinants To consider sustainability and policy responses in the wake of increased cross-border bank lending fows to recipient economies, it has become necessary to investigate their determinants. When push factors are dominant, central decisions of headquarter/home countries drive international bank lending fows. These fows could easily reverse when diffculties arise in the home country, exposing recipient countries to possible sources of domestic market vulnerability. Recipient country regulators could then restrict international banks from reallocating their funds globally by adopting liquidity regulations (‘ring-fencing’) regulations. Most ring-fencing proposals require foreign banks to have dedicated capital and liquidity resources that are subject to local control. One objective of ring-fencing regulations is to limit the potential impact of cross-border banking contagion. If domestic pull factors are dominant, international bank lending fows are more determined by total optimization decisions based on the risk-adjusted returns for each recipient destination (Shirota, 2015). The literature shows that both push factors and pull factors drive cross-border bank lending. Herrmann and Mihaljek (2013) show that riskspecifc factors of the borrower country signifcantly impact cross-border bank lending and that global risk aversion is also a signifcant determinant. Shirota (2015) reveals that global and regional common factors accounted for approximately half of cross-border bank lending fuctuations. However, much heterogeneity exists between countries, since some countries were largely affected by country-specifc pull factors; thus, appropriate policy responses to cross-border bank lending fows might vary depending on the recipient country.

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Figure 4.2 shows the relationship between cross-border bank lending (proxied by external debt fows) and institutional quality. Surprisingly, just like FDI fows, cross-border bank lending has a negative correlation (-0.73) with the quality of domestic institutions. Consequently, it appears that countries with poor-quality institutions receive higher lending. This may be because the data also include lending from multinational agencies, such as the IMF, that are more likely to lend to countries experiencing diffculty. These countries are usually characterized by poor institutions. Finally, Figure 4.3 shows the relationship between cross-border bank lending and natural resource endowment of host African countries. The correlation (-0.01) is negative but close to zero, meaning that cross-border bank lending is not infuenced much by the natural resource endowment of host countries. 4.2.3 FPI determinants Diversifcation is the foundation of the modern portfolio theory of Markowitz (1952, 1959) and has since become a central theme in the fnance literature. International fnance theory holds that FPI fows are the natural consequence of foreign investors seeking to invest across borders to help diversify portfolio risk and maximize returns. Studies have shown the benefts of diversifying across borders (e.g. Grubel, 1968; Harvey, 1991). As previously noted, the literature usually distinguishes between pull factors and push factors in categorizing the determinants of international capital fows. Some recent contributions in the literature revealed that both pull factors and push factors drive FPI. For instance, supporting the results of previous studies, Ahmed and Zlate (2014) fnd that global risk aversion, interest rate differentials, and growth differentials were signifcant FPI determinants in developing countries. Global risk aversion, as a push factor, is likely to be associated with weaker FPI fows, because an investor’s willingness to purchase riskier developing country assets is negatively impacted. A higher GDP growth rate in the domestic economy is expected to pull in FPI fows, because the higher growth rate is often seen as a proxy for the dynamism of the domestic economy. In a study investigating the determinants of portfolio bond fows to developing countries, Erduman and Kaya (2016) fnd interest rate differential and the infation rate the most signifcant pull factors, with global liquidity being an important push factor. After the global fnancial crisis, the expansionary monetary policies of the developed economies and the resultant increasing global liquidity increased investors’ search for riskier and higher-yielding developing country assets. Institutional and governance quality have also been found to be important determinants of FPI (De Santis & Lührmann, 2009; Vo, Nguyen, Ho, & Nguyen, 2017). Figure 4.2 shows that FPI exhibits a positive but low correlation with institution quality. This shows that FPIs do not rely so much on the quality of local institutions in Africa. Further, Figure 4.3 shows that FPIs exhibit a negative but low correlation with the natural resource endowment of the host nation. This suggests that natural resource endowments do not play a signifcant role in infuencing the decisions of foreign portfolio investors.

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Although pull factors therefore remain equally important as FPI drivers, along with push factors, evidence regarding FPI volatility or periods of extreme FPI movements indicate push factors as the primary drivers. Forbes and Warnock (2012) show that global risk is signifcantly related to periods of extreme FPI and that domestic characteristics are generally less important. Sarno, Tsiakas, and Ulloa (2016) fnd that over 80% of FPI variation was a result of push factors.

4.3 BENEFITS AND COSTS ASSOCIATED WITH PRIVATE CAPITAL FLOWS Private capital fows present a double-edged sword for host economies regarding benefts as well as costs. Because important variations exist regarding the various components of private capital fows, this section provides a more expansive discussion of the benefts and costs associated with FDI, foreign bank lending, and FPI. 4.3.1 Benefts of FDI With FDI, more information regarding investment fundamentals is available to foreign investors, enabling them to manage the investment more resourcefully than can FPI investors (Goldstein & Razin, 2005). Policies intended to attract FDI infows are driven by the benefts related to inward FDI identifed in the literature that include productivity gains, technology spill-over, the introduction of new management processes and employee training, international trade integration, creating backward and forward linkages through international production processes, and the advancement of a favourable business environment (Adjasi, Abor, Osei, & Nyavor-Foli, 2012; Agbloyor, Abor, Adjasi, & Yawson, 2013). Through FDIs’ impact on economic growth, poverty reduction can ensue. Figure 4.4 shows that FDI is highly correlated (0.83) with GDP per capita. This correlation is higher than the correlation between other types of capital fows (portfolio investments and cross-border bank lending – proxied by external debt) and GDP per capita. The benefts to host economies can occur as a result of FDI’s upskilling unskilled labour. By supplying scarce capital into the domestic economy, FDI helps to resolve the access to fnance problem and needs to be structured to suit the local development context. By augmenting domestic capital for exports, FDI assists frms to enter the export market (Abor et al., 2008). Through the provision of backward and forward linkages in production, FDI enables local frms to add value to their products and services, which should further translate into greater participation in regional and global trade. The related literature, however, suggests that the benefts associated with inward FDI depend on the host economy’s absorptive capacity (see Agbloyor, Gyeke-Dako, Kuipo, & Abor, 2016). For example, FDI productivity depends on a minimum level of human capital development (Borensztein, De Gregorio, & Lee, 1998) and FDI productivity is enhanced through the existence of well-functioning domestic fnancial markets

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FIGURE 4.4 Scatter plot between capital fows and institutions, 2000–2016

Panel A: FDI, Portfolio Investment, and GDP Per Capita

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between FDI and GDP per capita is 0.83; the correlation between portfolio investment and GDP per capita is 0.04

Panel B: External Debt, Capital Flows (Total), and GDP Per Capita

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between cross-border bank lending (proxied by external debt) and GDP per capita is 0.66; the correlation between capital fows (total) and GDP per capita is 0.90

(Adjasi et al., 2012; Agbloyor, Abor, Adjasi, & Yawson, 2014) and the quality of institutions (Agbloyor, Gyeke-Dako, Kuipo, and Abor, 2016). The literature describes strong institutions as those with democratic and relatively equal processes, few radical and social divisions, and ample counterbalances on political behaviour. Further, the impact of FDI may depend on the country’s confict status. That is, confict may alter the relationship

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between FDI and economic growth. This may be for several reasons. One potential explanation is that confict destroys the necessary absorptive capacity (e.g. fnancial development, infrastructure development, trade openness, human capital, institutions, and macroeconomic stability) that a country needs to beneft from FDI. Another plausible explanation could be that confict-prone countries may attract ‘bad’ FDI or FDI targeted towards natural resources. Agbloyor, Gyeke-Dako, Yawson, and Abor (2016) examine the relationship between FDI, confict, and economic growth in sub-Saharan Africa. They fnd that in the full sample of countries, FDI has no effect on economic growth. However, after dropping countries that have been plagued by confict, they fnd that FDI has a positive signifcant impact on economic growth. Alternative approaches using dummy variables to represent countries plagued by confict and the duration of the confict show that, though FDI has a positive impact on growth, the effect is lower in confict-affected countries. Agbloyor, Gyeke-Dako, Yawson, and Abor (2016) develop and test three new hypothesis to explain these fndings. These hypotheses are the good boy, bad boy, and repentant heart hypotheses. A good boy is classifed as a country that has never entered into confict. A bad boy, on the other hand, is a country that is prone to recurrent confict. Repentant hearts are countries that have entered into confict, exited confict, and have not re-entered confict for a minimum of six years. The results show that good boys beneft from FDI fows, in terms of achieving higher growth outcomes, more than their counterparts do. Repentant hearts also benefted from FDI in terms of achieving higher growth outcomes. Bad boys, however, do not beneft from FDI fows in terms of achieving higher growth outcomes. In Africa, Botswana has been a shining example of development. Botswana has been able to leverage investments into its diamond industry to catapult growth and development (see Box 4.2).

BOX 4.2 FDI and the Botswana experience Botswana gained its independence in 1966 and is often referred to as the Southern Star. It was extremely poor at independence. Today, Botswana is a shining example of development in Africa. According to an Economist article in 2002, Botswana has achieved the fastest growth in the world in income per capita over the past 35 years. This growth was faster than any Asian tiger (e.g. Singapore or South Korea) or growth in China or in the United States. Botswana has also consistently ranked highly on the Mo Ibrahim Index of African governance. Most of this wealth is due to minerals, in particular diamonds. Unsurprisingly, a lot of FDI into Botswana goes into diamond exploration. Botswana, however, does not rank highly in terms of FDI in Africa (it received only about USD129 million in 2016, the 40th in Africa) and even compared with its own exports. De Beers from South Africa is one of the most important investors in the diamond business

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in Botswana. The country recently had a 50–50 arrangement with De Beers to increase its share of the profts from exploration. Botswana has been able to harness and leverage on its diamonds for development and has avoided most of the pitfalls that have befallen other resource-rich countries in the region, such as the Democratic Republic of Congo. Several explanations have been offered for Botswana’s success. One is that the elite were enriched enough from diamonds so that further rent seeking, which could potentially escalate into war, was unnecessary. Another explanation is that the traditional society in Botswana encouraged dialogue between leaders and citizens. One key challenge for Botswana is to diversify its economy and reduce its dependence on its natural resources. Further reading: www.economist.com/finance-and-economics/2002/03/28/theafrican-exception www.economist.com/middle-east-and-africa/2018/03/10/ how-to-save-botswanas-sparkling-reputation

4.3.2 Costs of FDI FDI investors’ advantage in having more information regarding frms’ investment fundamentals as opposed to FPI investors can give rise to future asymmetric information problems between the foreign investor and future buyers (Goldstein & Razin, 2005). Information asymmetry problems could arise for FDI investors should they disinvest before investment maturity. In such a case, potential buyers would be willing to pay a lower price because they would realize that the investor has an information advantage regarding the investment fundamentals and may suspect the disinvestment arises from negative future investment prospects. FDIs may also lead to negative consequences when they are viewed not to have signifcant linkages with the domestic economy. For example, FDIs may be concentrated in the exploration of natural resources, such as oil and gas, which may have few linkages with the domestic economy (see Box 4.3). Further, FDIs may have negative consequences in the domestic market because these frms ‘outcompete’ local frms, leading to the demise of local frms with attendant losses in employment, capital, and negative social consequences because of, for example, job losses. Domestic frms may also feel that foreign frms are given more attractive investment packages to domestic frms’ detriment. When domestic frms lose market share to foreign frms, their productivity is reduced through competition effects. Should the productivity decline from a lesser market share be large enough, domestic frms’ net productivity can reduce even though technology and management transfer could have occurred because of the presence of foreign frms. The following are some of the other explanations for why the

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domestic economy might not beneft through FDI spillovers (Görg & Greenaway, 2003): • Foreign frms are able to guard their frm-specifc advantages. • The positive FDI spillovers impact only certain frms. • The positive FDI spillovers imply no intra-industry knowledge transfer. Because of global governance, institutions, and the possibility of capital fight, developing economies often try to create a conducive business environment that includes lower domestic environmental regulations compared with developed economies (Jorgenson, 2007). Developing economies are also less likely to ratify international environmental treaties. Kuznet’s (1955) economic growth inequality hypothesis addresses the link between FDI and environmental sustainability through an indirect channel: FDI positively impacts growth that leads to increased CO2 emissions (see Figure 4.5). Figure 4.5 shows that FDI is positively correlated (0.34) with CO2 emissions. This correlation is higher than the correlation between the other types of private capital fows (portfolio investment and cross-border bank lending) and CO2 emissions. A direct theory that addresses the link between FDI and environmental sustainability is the pollution havens theory (Bokpin, 2017). According to the pollution havens theory, multinational enterprises locate in developing countries with weaker environmental standards and lower regulations in order to fnance polluting and ecologically ineffcient processes (see Box  4.4). To attract additional foreign investment, developing countries intentionally undervalue their environment, becoming pollution havens. FIGURE 4.5 Scatter plot between capital fows and natural resource rents,

2000–2016

Panel A: FDI, Portfolio Investments, and CO2 Emissions

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between FDI and CO2 emissions is 0.34; the correlation between portfolio investments and CO2 emissions is 0.25

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FIGURE 4.5 (Continued)

Panel B: External Debt, Capital Flows (Total), and CO2 Emissions

Source: Generated by authors on the basis of data from the World Development Indicators Note: The correlation between cross-border bank lending (proxied by external debt) and CO2 emissions is 0.17; the correlation between capital fows and CO2 emissions is 0.39

When the environment is undervalued or considered free, a distortion in economic incentives and overuse by producers and customers ensues (Mabey & McNally, 1999). Empirical evidence has revealed that FDI infows increase environmental degradation in Africa. However, in the presence of strong government institutions, such as environmental protection agencies, FDI contributes to environmental sustainability (see Bokpin, 2017).

BOX 4.3 FDI and the Nigerian experience Nigeria is one of the largest recipients of FDI in Africa. In 2016, Nigeria received FDI infows of USD4.44 billion, ranking second in Africa. It is also one of the largest producers of oil in Africa and the world. Traditionally, FDI into Nigeria has focused mainly on the natural resource sector. A number of empirical studies have found that FDI has had a negative impact or no impact on economic growth in Nigeria (e.g. see Akinlo, 2004). These studies usually attribute this negative effect to the fact that most of the investments go into the natural resource sector, which has few linkages with the rest of the economy. The Niger Delta crises where local militants have been fghting foreign multinationals engaged in oil exploration in Nigeria probably sums up how some Nigerians feel about FDI, especially in the natural resource sector. As recently as 2016, an attack on the Shell Petroleum Development Corporation led to a halt in production. Some other studies, such as Ayanwale (2007), suggest that though overall FDI may not have an impact on growth, FDI in sectors in Nigeria such as communication has had a positive impact.

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BOX 4.4 FDI and the pollution havens hypothesis: copper mining in Zambia Signifcant FDI in the natural resource sectors of African economies has raised concerns that FDI could undermine local development where negative external costs (e.g. an increase in environmental degradation) are created but not accounted for by the foreign investor. Capacity constraints, an interventionist tradition, and a cooperative approach when engaging with industry characterizes the environmental regulatory efforts in Zambia. These characteristics have afforded MNEs signifcant latitude to remedy compliance gaps. For instance, in 2007, the Zambian parliament noted that two projects were given approval to proceed through clauses in the Environmental Act allowing the minister of environment to overrule objections from the Environmental Council of Zambia that the projects were environmentally unsound (Haglund, 2008). In 2016, Zambia received net FDI infows of USD662 million, ranking 18th in Africa. It would seem that investment risks relating to the effectiveness of local environmental regulations in Zambia have been valid. In 2017, Zambian villagers won the right to sue a Londonbased mining group and its subsidiary, in British courts, claiming a copper mine had polluted their water for years.

4.3.3 Benefts of foreign bank lending The advantages of increased foreign bank presence include foreign banks’ achieving better economies of scale and risk diversifcation, the introduction of more advanced technology and better risk management practices, importing improved supervision and regulation, and enhancing competition. In times of economic hardship, foreign affliates of global banks could be perceived as safer than domestic banks (see Box 4.6). Foreign banks may be less infuenced by the domestic political climate and less susceptible to lend to connected parties (Detragiache, Tressel, & Gupta, 2008). According to modern portfolio theory, by diversifying asset holdings, an investor can reduce portfolio risk. Similar diversifcation gains arise to banks that invest abroad through a reduction of the variance of their asset portfolio; the resultant lower asset volatility should decrease the prospect of bank failures in the home country. Apart from bank failures, diversifcation gains from cross-border banking could also reduce lending volatility in the home country, because the lower risk exposure of banks reduces their chances to cut back lending. Diversifcation gains can also arise from the presence of foreign banks in the host economy. Increased foreign bank presence enables frms in the host country to have lending relationships with both domestic and foreign banks, where the frms are able to substitute domestic lending with foreign bank fnance should domestic banks become constrained in their lending (Allen et al., 2011).

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The effect of foreign bank presence on competition in the domestic banking market can be marked in concentrated domestic markets where banks operate ineffciently. One strand of the related literature suggests competition enhances stability through the mitigation of agency problems at the borrower level. Increased competition will lower lending rates, raising borrowers’ profts, reducing risk-shifting incentives, and subsequently lowering borrower risk. Increasing borrowers’ profts lowers the chances of bankruptcy, and fewer moral hazard problems on the part of borrowers can be expected once borrowers are confronted with lower interest costs. In addition to increasing the number of market participants, foreign banks may be more effcient (e.g. use improved risk management practices), thereby forcing domestic banks to improve their effciency and thus contributing further to banking sector stability (Allen et al., 2011). Empirical evidence has shown that increased foreign bank presence is associated with a reduction in the proftability and margins of domestic banks (Claessens, Demirgüç-Kunt, & Huizinga, 2001), and barriers for bank customers are lower with increased foreign bank involvement (Beck, Demirgüç-Kunt, & Peria, 2008). Foreign bank lenders could prompt the supervisory authorities from host economies to improve regulation and supervision in answer to new activities and products, thereby indirectly contributing to fnancial stability (Beck, Fuchs, Singer, & Witte, 2014).

BOX 4.5 Foreign bank ownership in Africa On the basis of geographical origin, foreign bank ownership in Africa can be grouped into two categories (Beck et al., 2014): 1 Global banks from outside the continent (specifcally Europe), although we have also seen an increasing presence of southsouth banks from India and China – examples include Sociéte Générale (France), Citigroup (USA), Standard Chartered (UK), BNP Paribas (France), and Bank of Baroda (India), and Sociéte Générale has representation through branches and subsidiaries in 17 African countries 2 Cross-border banks from Africa predominantly incorporated in South Africa, Nigeria, and Morocco  – examples include Ecobank (Togo), UBA (Nigeria), Stanbic (South Africa), and BMCE (Morocco), and Ecobank has representation in 32 African countries. There are major discrepancies concerning foreign bank ownership across Africa, according to Claessens and Van Horen’s (2014) database on bank ownership. The banking sector of some countries is dominated by foreign banks, where foreign banks own over 80% of banking sector assets. Country examples include Benin, Madagascar, Senegal, and Zambia. In some African economies, foreign banks own between 60% and 80% of banking sector assets. Country examples

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include Botswana, Cameroon, and Ghana. Foreign bank assets among total bank assets in 2013 were lower in some countries that exhibit greater banking sector development. Country examples are Kenya (34%), South Africa (25%), and Nigeria (16%). No foreign banks operate in Ethiopia. According to Beck et al. (2014), the variation in foreign bank presence across the continent can be partly explained by historical and country-specifc factors. For example, fnancial sector reforms implemented at independence in Kenya, Morocco, and Nigeria brought about the nationalization of foreign banks, established state-owned banks, and facilitated the growth of domestic banks through low entry requirements. In South Africa, foreign bank presence declined in the 1980s as pressure mounted on foreign banks to disinvest because of the country’s apartheid regime, and domestic bank concentration remained high. In Nigeria, as a result of the minimum capital increase in 2005 that led to banking sector consolidation, foreign bank investment was initially discouraged. In Kenya, prudent management and the strong market position of the Kenya Commercial Bank, along with private sector competition, fuelled product innovation and, in the 2000s, advanced a platform for East African cross-border expansion.

BOX 4.6 Foreign bank presence, fnancial sector stability, and connected lending in Ghana The banking industry in Ghana experienced signifcant shocks in 2017 and 2018. In 2017, two domestic banks (UT Bank and Capital Bank) collapsed and were handed over to GCB Bank (a domestic bank previously wholly owned by the state) through a purchase and assumption transaction. The collapse of these banks was attributed to poor corporate governance practices and connected lending. In 2018, fve more local banks collapsed (Biege Bank, Royal Bank, Sovereign Bank, UniBank Ghana, and Construction Bank). The collapse of these banks was attributed to similar reasons. Interestingly, no foreign owned bank was affected by the fnancial crisis that occurred. Thus, some have argued that these banks were not affected, because of their higher corporate governance standards and lower propensity to engage in related party lending. 4.3.4 Costs of foreign bank lending Critics of increased foreign bank presence posit that distance constraints and information disadvantages deter foreign banks from lending to smaller, more-opaque frms that are particularly prevalent in African economies. That is, foreign banks cherry-pick the best customers, leading to reduced credit to ordinary citizens of the country. If foreign banks crowd out local banks, fnancial outreach could be negatively impacted as smaller frms

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further struggle to access fnance because foreign banks lend predominantly to the top market segment (Detragiache et al., 2008). According to the literature, foreign banks shun lending to soft information sector borrowers (e.g. small start-up frms) because of information and agency costs relating to cultural and geographical variances (Mian, 2006). The stability benefts associated with increased foreign bank presence as a result of diversifcation gains have been challenged by critics. Although increased foreign bank presence can shield a host economy from domestic shocks, foreign banks can also transmit or ‘import’ shocks into the host economy. Domestic capital is less mobile than foreign capital, and foreign banks can withdraw liquidity and reduce lending in the host economy should adverse conditions arise globally or in their home countries. Whether increased foreign bank presence results in improved regulation and supervision has been questioned, since effective regulation and supervision do not require the presence of any foreign banks but start with domestic banks. Acquiring suffcient regulatory expertise to improve oversight may take years, exposing the domestic banking sector to risks relating to new products and technologies that are not fully understood (Beck et al., 2014). 4.3.5 Benefts of FPI FPI fows provide foreign investors the opportunity to target investments across economies to diversify portfolio risk and obtain higher riskadjusted rates of return as risks are pooled by investors. FPI also caters to different portfolio preferences, expanding the available choice of fnancial instruments that vary across countries. FDI is considered more permanent because of the larger capital initial investment requirements and relatively less liquidity than FPI. Hence, institutional investors (e.g. pension funds and asset managers) prefer FPI because of the liquidity and possible information asymmetry problems associated with FDI. For developing country host economies, FPI closes the savings–investment gap, provides foreign exchange, assists in fnancing current account defcits, provides a monitoring role for the corporate sector, and facilitates resource mobilization. The depth and liquidity of local stock markets are increased, which could result in positive spillovers, including improved regulation and supervision and improved accounting and reporting standards. More-developed stock markets afford emerging companies additional fnancing options, thereby decreasing their dependence on bank fnancing that reduces the risk of credit constraints. Well-developed and integrated local bond markets provide an intermediate function to raise funding for infrastructure development. Because of FPIs’ positive impact on valuations, a reduction in the cost of capital may ensue. 4.3.6 Costs of FPI FPI investors need to factor in country and currency risk, along with other factors, before investing in an economy. FPI investors are more vulnerable to liquidity shocks, and FDI investors with FPI fows are more susceptible

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to surges and sudden stops (see Box 4.7). FPI infow surges can infuence domestic asset prices, resulting in a real estate bubble and infation; sudden stops can translate into higher interest rates, currency depreciation, and a low growth environment (Sarno et al., 2016). Increased FPI fows that positively infuence stock market liquidity may negatively impact corporate governance in that liquid stock markets could translate into investor myopia (Yartey & Adjasi, 2007). Long-term investment is constrained by investor myopia, which is defned as investors focusing only on short-run price changes over a short-time horizon. If FPI investors can readily disinvest, their motivation to adequately provide a monitoring role for the corporate sector becomes questionable. The actual operation of the pricing and turnover mechanism of stock markets can also translate into short-termism, along with decreased long-term investment, including frm-specifc human capital. With the aim of attracting more FPI investors, management can engage in actions to maximize short-term earnings and stock prices while neglecting more-effcient long-term resource allocation decisions, such as investing in frm-specifc human capital that raises worker productivity. Compared with FDI, FPI fows can depart from long-term proftability expectations relating to host economies’ fundamentals and are also infuenced by herding behaviour. For example, in the aftermath of the global fnancial crisis, the expansionary monetary policies implemented in developed countries created ample incentive for speculative FPI fows to food the stock and bond markets of developing countries. The excessive liquidity from these aggressive monetary policy actions spilled over into developing countries with little relation to the host economy’s macroeconomic fundamentals because the aim of these cross-border fows is often an attempt to earn short-term gains. The literature has also argued that investors are more inclined to herd if markets are ineffcient. If developing country fnancial markets are poorly regulated, experience frequent central bank intervention, and have poor disclosure requirements for listed securities, then foreign investors are arguably likely to exhibit herding behaviour (i.e. foreign investors mimicking each other’s actions). Herding behaviour can create a gap between a listed security’s fundamental price and the market price that can lead to a price bubble. Empirical evidence has shown that the entrance of foreign institutional investors into the capital markets of developing countries dilutes domestic fnancial price information, because these investors trade with less information. Although more access to international capital markets could beneft domestic growth prospects, information asymmetries from the side of institutional investors can negatively impact resource allocation and fnancial stability (Frenkel & Menkhoff, 2004).

BOX 4.7 FPI effects in South Africa Since the turn of the century, South Africa has primarily relied on FPI fows to support the current account defcit as a result of a shortfall in

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domestic savings. Between 2000 and 2007, FPI fows contributed over 50% of infows recorded on the fnancial account, compared with the 36% contribution of FDI. The volatility of FPI fows was demonstrated in 2008, when investor sentiment became negative and FPI outfows of 104% on the fnancial account balance was recorded, resulting in a depreciation of the local currency. The country’s reliance on FPI fows continued from 2009 to 2014, FPI fows contributing nearly 50% of infows recorded on the fnancial account. Although the local currency initially strengthened between 2009 and April 2011, severe periods of depreciation occurred from the second half of 2011. Although South Africa’s local currency developments refected both country-specifc and international developments, deteriorating global economic prospects left most emerging market economies with depreciating currencies and the effects thereof. Therefore, a concern for countries that overly rely on FPI fows is that global push factors (beyond the control of the domestic policymakers) can easily trigger a reversal of fows. For example, in 2016, South Africa recorded the largest net portfolio investments in Africa: a staggering USD16 billion. South Africa’s increasing reliance on FPI fows was highlighted as a factor for a selloff of FPI in the second half of 2018, compounded by global push factors such as looming trade wars and a strong dollar. Source: Adapted from De Beer (2015)

4.4 CONCLUSION This chapter examined various issues regarding private capital fows to Africa. Private capital fows have generally been rising. The main capital fows examined were FDI, foreign bank lending, and FPI. FDIs may be classifed as either Greenfeld or cross-border M&As, with the latter rising. In terms of motives for FDI, these have been generally classifed as resource seeking, market seeking, effciency seeking, and strategic-asset seeking. Resource-seeking FDI investors pursue resources at a lower real cost abroad that is often not available at home. Market-seeking FDIs pursue market share in target foreign markets with the goal of reducing the cost of supplying a market. Effciency-seeking FDIs attempt to establish effcient structures by producing in as few countries as possible, each country having its own distinctive advantage relating to location, endowment, and government policies. The motive for strategic-asset-seeking FDIs is to locate where assets in foreign frms can be acquired that promote long-term objectives. Several benefts from FDI fows were identifed. These include productivity gains, technology spillovers, the introduction of new management processes and employee training, international trade integration, creating backward and forward linkages through international production processes, and the advancement of a favourable business environment. These

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benefts were also found to depend on host-country characteristics, such as trade openness, human capital, confict, the quality of institutions, and fnancial development, among other variables. FDI was found to be positively correlated with GDP per capita. FDI was identifed to be associated with costs such as increased pollution and low linkages with the rest of the economy in the case of some resource-rich countries. Various theories have been proposed to explain the determinants of FDI fows to host countries. These theories include the neoclassical theory, the OLI framework, and the horizontal and vertical FDI models. FDIs were found to be more stable than the other types of private capital fows. The consequences of capital fow volatility were identifed to include intensifying economic cycles, creating weaknesses in fnancial systems, and worsening overall macroeconomic uncertainty. The fndings in the chapter indicated that FDI exhibits a negative correlation with the quality of institutions. FDIs were also found to exhibit a positive correlation with natural resources. FDIs reduce the probability of confict. In certain instances, FDIs may exacerbate the likelihood of confict. The determinants of FDI were identifed to vary by the confict status of a country. For nonconfict countries, natural resources, institutions, trade openness, infrastructure, and fnancial development had positive signifcant coeffcients, but market size had negative and signifcant coeffcients. For confict countries, natural resources were found to have a negative impact on FDI. Trade openness and market size were also found to exhibit a negative relationship with FDI. Finally, nonconfict countries and countries that have entered and exited war without returning to war benefted more from FDI than did countries prone to recurrent confict. Push (global) and pull (host-country) factors were identifed as the main factors that explain FPI fows to African countries. The push factors were identifed to be more important than the pull factors. FPIs were identifed to exhibit a low correlation with the quality of institutions in host countries. Further, FPIs were also identifed to be lowly correlated with natural resource endowments in host countries. FPIs are associated with certain benefts, such as closing the savings–investment gap, providing foreign exchange, assisting in fnancing current account defcits, providing a monitoring role for the corporate sector, and facilitating resource mobilization. Some of the costs associated with FPIs include surges in domestic asset price, resulting in a real estate bubble and infation, while sudden stops can translate into higher interest rates, currency depreciation, and a low growth environment. Push and pull factors explain cross-border bank lending, which is negatively correlated with institutions. Further, cross-border bank lending is lowly correlated with the natural resource endowments of host countries. Cross-border bank lending is associated with benefts as well, such as the ability of foreign banks to achieve better economies of scale and risk diversifcation, the introduction of more advanced technology and better risk management practices, importing improved supervision and regulation, and enhancing competition. In times of economic hardship, foreign affliates of global banks could be perceived as safer than domestic banks

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are, because they are perceived to be less infuenced by the domestic political climate and less susceptible to lending to connected parties. The withdrawal of cross-border bank lending can also impose signifcant costs on host economies.

Discussion questions 1 Why have policymakers in developing countries and international development fnance institutions promoted private capital fows in recent times? Are there any reasons why policymakers should be cautious in fashioning policies to attract FDI? 2 Explain the various types of private capital fows. Why would countries prefer certain types of private capital fows over others? 3 Discuss the implications of volatile capital fows for African countries. 4 Discuss the trends in private capital fows in Africa. What does this tell us about to the preference of countries for particular capital fows, and why is this the case? 5 Explain the various motives for FDI fows, according to Ajayi (2006). 6 There are two main forces that determine capital fows into developing countries. These are push and pull factors. What is the difference between the two? Provide examples. 7 There are various theories that explain FDI fows. Discuss these

8 9

10 11

12

theories, and what do these theories say about FDI fows? a. The neoclassical approach. b. The Dunning’s OLI framework. c. Horizontal and vertical FDI models. Discuss how FDI determinants vary depending on the confict status of a country? Theory and empirical evidence suggest that confict may lead to lower FDI fows in developing countries. However, FDI fows may also negatively affect the confict status of a country. How may FDI affect the probability of confict in developing regions like Africa? Discuss how confict may alter the relationship between FDI and economic growth. Discuss the good boy, bad boy and the repentant heart hypotheses in relation to FDI and economic growth. Discuss the potential costs and benefts of foreign direct investments, foreign portfolio investment, and foreign bank lending.

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Appendix TABLE 4.1 Private capital fows to Africa in 2016: best and worst performers Panel A: FDI and portfolio investments Top 10 recipients of FDI

Top 10 recipients of portfolio investments

Egypt, Arab Rep. 8,106,800,000.00 Nigeria 4,445,102,771.13 4,104,422,619.77 Angola 3,988,953,391.68 Ethiopia 3,485,333,369.28 Ghana 3,128,149,928.70 Mozambique 2,318,278,920.13 Morocco 2,215,307,020.40 South Africa 2,006,000,000.00 DR Congo 1,637,370,975.34 Algeria Some countries of interest Botswana 129,127,201.65 1,204,708,617.17 DR Congo 662,813,935.42 Zambia  

1 2 3 4 5 6 7 8 9 10 40 13 18

Bottom 10 recipients of FDI Equatorial Guinea Eritrea Central African Republic Swaziland Sao Tome and Principe Guinea-Bissau Comoros Burundi Gambia, The South Sudan

Mauritius 7,189,574,257.34 Burkina Faso 398,605,423.81 Kenya 383,124,984.59 Morocco 327,671,042.12 Mozambique 123,864,414.69 Zimbabwe 80,061,343.26 Uganda 66,688,232.76 Cameroon 65,104,461.95 Tunisia 56,842,693.32 Seychelles 49,612,777.20 Some countries of interest Botswana (1,801,492.01) DR Congo 15,954,430.78 Zambia (413,849,920.29) (553,701,689.77) Ghana

1 2 3 4 5 6 7 8 9 10 22 13 30 31

Bottom 10 recipients of portfolio investments

53,962,172.52 52,305,383.53 31,196,880.99

45 46 47

Angola Namibia Niger

(42,450,977.70) (54,686,219.07) (122,072,112.34)

27 28 29

27,049,949.52 23,331,087.12

48 49

Zambia Ghana

(413,849,920.29) (553,701,689.77)

30 31

14,221,700.00 8,015,631.04

50 51

(588,956,354.09) (736,100,000.00)

32 33

55,420.36 (1,526,519.34) (17,000,000.00)

52 53 54

Côte d’Ivoire Egypt, Arab Rep. Libya Nigeria South Africa

(1,443,800,000.00) (1,709,746,689.11) (16,372,515,388.73)

34 35 36

Panel B: External debt and total capital fows Top 10 recipients of external debt Egypt, Arab Rep. Angola South Africa Kenya Ethiopia Nigeria Mauritius Morocco

9,008,045,000.00 7,550,361,000.00 5,299,867,000.00 3,339,897,000.00 2,685,420,000.00 2,596,833,000.00 2,241,825,000.00 2,026,966,000.00

Top 10 recipients of capital fows 1 2 3 4 5 6 7 8

Egypt, Arab Rep. 16,378,745,000.00 Angola 11,612,332,642.07 Mauritius 9,780,817,830.92 Ethiopia 6,674,373,391.68 Nigeria 5,332,189,082.02 Morocco 4,672,915,962.25 Ghana 4,292,076,679.51 Kenya 4,116,381,405.44

1 2 3 4 5 6 7 8

Chapter 4 • Private capital fows and economic growth 103 Top 10 recipients of external debt Ghana 1,360,445,000.00 Tanzania 1,120,890,000.00 Some countries of interest Zambia 588,649,000.00   Bottom 10 recipients of external debt Central African Republic Sao Tome and Principe Guinea-Bissau Guinea Gambia Eritrea Côte d’Ivoire Sudan Botswana DR Congo

Top 10 recipients of capital fows 9 Mozambique 3,741,194,343.39 10 Tanzania 2,491,309,467.33 Some countries of interest 15 DR Congo 1,012,766,047.95 Zambia 837,613,015.13

9 10 17 22

Bottom 10 recipients of capital fows

6,988,000.00

39 Eritrea

37,502,383.53

45

2,544,000.00

40 Guinea-Bissau

32,830,700.00

46

816,000.00

41 Sao Tome and Principe 42 Botswana 43 Burundi 44 Gambia 45 South Sudan 46 Côte d’Ivoire 47 Libya 48 South Africa

26,481,057.92

47

(2,937,000.00) (11,437,000.00) (14,803,000.00) (37,597,000.00) (84,864,000.00) (102,836,000.00) (207,897,000.00)

24,489,709.64 8,469,420.36 (12,963,519.34) (17,000,000.00) (49,074,110.00) (951,244,000.00) (8,857,341,368.34)

48 49 50 51 52 53 54

CHAPTER

5

Remittances and development Hanna Fromell, Tobias Grohmann, and Robert Lensink 5.1 INTRODUCTION The most common form of migration is by people who leave their homes to improve  – in one way or the other  – their economic opportunities. This is referred to as voluntary labor migration.1 Labor migration, both domestic and international, affects not only the economic outcomes of the migrants themselves but also the economic outcomes of those left behind: frst, through migration  – that is, the outfow of people from their origin communities, countries, and labor markets  – and, second, through the fnancial transfers that migrant workers send back home. These transfers are called remittances. They are the topic of this chapter. More specifcally, we focus on international remittances: fnancial transfers made by international labor migrants sent to households in their home country. In the context of voluntary labor migration, remittances result from an active migration decision of one or more members of a household aiming to increase the household’s overall income with earnings that are higher than what they would have earned at home. The recent two decades have seen a large increase in international remittances, where especially low- and middle-income countries receive large sums in comparison to the size of their economy. At the same time, international organizations and policymakers have taken increased interest in international remittances and the fnancial systems that facilitate their fows (Brown & Jimenez-Soto, 2015). On the one hand, banks consider the handling of remittances as high risk, resulting in derisking measures, such as the closure of accounts held by monetary transfer operators and the termination of correspondent bank relationships through which banks exchange banking services. On the other hand, the number of international migrants is not high enough and that there are substantial positive gains to be realized from lowering the many migration barriers in place (Clemens, 2011). In line with such more-favorable views on the role of migration, international actors are setting international targets on how to reduce fnancial and regulatory migration barriers in order to encourage individuals to migrate and take up jobs abroad and remit money home. For instance, United Nations sustainable development goal (SDG) number ten explicitly calls to reduce the transaction costs of remittances to less than 3% and to implement wellmanaged migration policies (UN, 2015). A result of the increasing interest

Chapter 5 • Remittances and development 105

among international organizations and policymakers in the role of international migration and remittances has been an increase in resources allocated to researchers to advance knowledge in this area (Brown & Jimenez-Soto, 2015). Among academics from different disciplines, including economics, there is indeed an increasing interest in remittance research. Questions that have interested economists have concerned the underlying motives among migrants to send money home and the impact of remittances on their recipients, including their communities and on the home economy as a whole. In this chapter, we review and discuss the results and methodology of research that addresses remittances in a development context. We restrict our review to international remittance payments and focus on remittance fows from developed countries to developing countries. The remainder of this chapter is organized as follows. In section 5.2, we highlight the importance of remittances for development, by sketching the magnitude of current and past remittance fows to developing countries. Section 5.3 outlines some of the key characteristics of remittances. In section 5.4, we present research on the motivation for remittances. The subsequent three sections focus on the impact of remittances on their receivers: section 5.5 discusses the impact of remittances on economic growth; section 5.6 looks at the relationship between remittances and fnancial development in the recipient economy; and section 5.7 elaborates on the impact of remittances on inequality and poverty. Section 5.8 presents research on policy tools that either aim to facilitate remittance payments or aim to improve the marginal impact of remittance payments.

5.2 THE MAGNITUDE AND IMPORTANCE OF INTERNATIONAL REMITTANCES Remittance fows to low- and middle-income countries (LMICs) reached a record high of USD529 billion in 2018 (World Bank, 2019a). Figure 5.1 shows the amount for remittances, foreign direct investment (FDI), offcial FIGURE 5.1 Capital infows to low- and middle-income countries, in billions USD ($ billion) 900 FDI

700 500

Remittances

300 100

Portfolio debt & equity ˜ows

ODA

19 1990 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 97 19 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 0 20 6 0 20 7 0 20 8 0 20 9 1 20 0 1 20 1 1 20 2 1 20 3 1 20 4 1 20 5 16 20 1 20 7 1 20 8 19

–100

106 Hanna Fromell et al.

development assistance (ODA), and private fnancial fows (private debt and portfolio equity) received by LMICs annually since 1990 (World Bank, 2019a, p. 1). In 2018, remittances to LMICs were about three times the size of aid receipts and about as high as FDI. Moreover, remittance payments are expected to increase further in the near future. If China is taken out of the sample, then remittances have already surpassed FDI since about 2014 (ibid., p. 2). The fgure also illustrates remittances’ resilience to fnancial shocks, such as the 2007/2008 fnancial crisis to which FDI instead responded with a dramatic drop of 39.7%. Figure 5.2 plots the evolution of absolute remittance receipts for all countries, grouped by income category, in the period 1990 to 2016.2 For all income groups, we can observe an overall increase in received remittances since the early 2000s. However, the lower-middle-income countries (LMC) stand out with an especially steep increase in remittances received, while that of the low-income countries (LIC) have undergone only a meagre shift upward in comparison to the other income groups. Figure 5.3 instead plots remittances expressed in percentage of gross domestic product (GDP) by country-level income group. While remittances receipts in LICs compared unimpressively to other income groups in absolute terms, Figure 5.3 illustrates a strong positive trend in remittances as a share of GDP in low-income countries. Since around 2010, the data show a clear increase in the remittances share of GDP in LICs compared to the

FIGURE 5.2 Received remittances by country-level income group, in billions

current USD

300 250 200 150 100 50

Low income

Lower middle income

Upper middle income

High income

Source: World Bank’s database on World Development Indicators

20 16

20 14

20 12

20 10

20 08

20 06

20 04

20 02

20 00

19 98

19 96

19 94

19 92

19 90

–

Chapter 5 • Remittances and development 107 FIGURE 5.3 Remittances in percentage of GDP by country-level income group 12% 10% 8% 6% 4% 2%

Low income

Lower middle income

Upper middle income

High income

20 16

20 14

20 12

20 10

20 08

20 06

20 04

20 02

20 00

19 98

19 96

19 94

19 92

19 90

0%

Source: World Bank’s database on World Development Indicators

other income groups. Although the GDP share stagnated over the past few years, this documents the importance of remittances as a source of funding for low-income countries. In the group of low- and middle-income countries, the top receivers of remittances in 2018 in absolute terms were India, China, Mexico, the Philippines, and Egypt. The top receivers in terms of the remittances-to-GDP ratio were Tonga, the Kyrgyz Republic, Tajikistan, Haiti, and Nepal (World Bank, 2019a, p. 2).

BOX 5.1 Remittances statistics Country-level data on remittances, such as the statistics presented in section 5.2 retrieved from the World Bank’s World Development Indicator (WDI) database, are collected from each country’s balance of payments. This is an offcial record that accounts for incoming and outgoing international economic transactions, which are formally defned in the Balance of Payments and International Position Manual (BPM6, International Monetary Fund, 2009). According to this manual, remittances are a composite measure of two positions in the balance of payments: personal transfers and compensation of employees (capital transfers between households are left out). Personal transfers are cash or noncash transfers from migrants to domestic households that do not

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involve economic exchanges such as payments for provided services. (As we will see in section 5.4, this defnition assumes that remittances are paid from altruistic motives.) The compensation of employees instead refers to salaries paid to temporary workers (migrants who are residents of the host country for less than one year). This category is commonly included in the measurement of remittances because temporary workers are expected to return with their salaries to their origin country (Yang, 2011). Some researchers argue for excluding compensation for employees from the measure of remittances (Chami et al., 2008; Barajas, Chami, Fullenkamp, Gapen, & Montiel, 2009). The remittances indicator in the WDI database is itself partly an estimate based on the balance of payments data. The World Bank uses estimates when either no data or only partial data are available in the balance of payments of a country in a given period (for details, see World Bank, 2017, Annex A). Moreover, because the balances of payments capture remittances only if they fow through formal channels, such as electronic wire, they do not capture remittances that fow through informal channels, such as cash or goods carried across borders. While these informal remittance transfers may be small individually, they may make up a considerable portion of remittances received by households, because their overall number is potentially large. Therefore, offcially reported country-level remittance fows likely underestimate the actual amount for remittances in the world. Furthermore, changes in how remittances are measured can account for a large share of the increase in remittance in the period 1990–2010 (Clemens & McKenzie, 2018, see also section 5.5.2).

Several ways are available for migrants to send remittances back home. We can distinguish between formal and informal channels. Formal channels are provided by remittance service providers (RSPs), which are classifed into four groups: banks, money transfer operators (e.g. Western Union), post offces, and mobile operators. The payments that go through these channels are offcially reported and appear in the offcial statistics seen in Figures 5.1, 5.2, and 5.3. In contrast, remittances sent via informal channels (e.g. in kind or in cash through returning relatives and friends or through transport companies) are typically not included (see also Box 5.1). The World Bank also provides data on the costs of sending remittances. According to their Remittances Prices Worldwide3 database, in the frst quarter of 2019, the global average of sending remittances was at 6.94% of the remitted amount (World Bank, 2019b). To compare, in 2009, when these data were frst collected, the global average was recorded at 9.67%. This marks a decline of almost 3%. Reducing the costs of remittances is subject to many international development agreements. For example, the UN SDGs state a target of reducing the global average to under 3%.

Chapter 5 • Remittances and development 109

Given this general picture of remittances to developing countries, we next highlight some of the specifc characteristics of remittances that make them relevant in a development context.

5.3 CHARACTERISTICS OF REMITTANCES 5.3.1 Remittances are person-to-person transfers The most important difference between remittances and other sources of external funding of developing countries is that remittances are person-toperson transfers. In contrast, ODA are government-to-government transfers, and FDI are frm-to-frm transfers (Frankel, 2011; Glytsos, 2002). This suggests that remittances could be effective as stimulators of development. To see this, recall that remittances are the result of an active migration decision leading to higher earnings abroad that are shared with those left behind. Ideally, then, remittances arrive directly where they are most needed at relatively low cost and effort. Hence, they may be effective in tackling poverty and in raising the economic opportunities of their receivers. In contrast, to fully unlock the development potential of ODA, a high level of institutional quality and organization would be required (Burnside & Dollar, 2000). Ineffcient governance structures may cause portions of the aid fows to trickle away. Similarly, in order for FDI frm-to-frm transfers to raise incomes and opportunities of the poor, they need to be passed along effciently in the form of better employment opportunities and higher wages. So in virtue of their person-to-person nature, remittances have the potential to be a direct form of fnancing development. Yet whether they are more effective than ODA and FDI also depends on whether both senders and receivers of remittances have indeed better information than governments and other organizations about where funding is needed. 5.3.2 Remittances and resource allocation One important aspect to consider when investigating remittances in a development context is that they could change the spending behavior of their recipients. That is, the receipt of remittances may change the recipient household’s resource allocation: how much income the household allocates on investments vis-à-vis consumption. We present two views that are based on microeconomic theory. One view is that the receipt of remittances does not change the spending behavior of households. Here the hypothesis is that remittances are a fungible source of income and that remittances are thus just like any other source of household income (Stark, 1991). This implies that each additional dollar from remittances is spent on exactly the same proportions of consumption and investments as any additional dollar from regular income. Hence, remittances would increase consumption and investment proportionally. This implies that remittances have the potential to promote longterm economic growth in the recipient country through their positive effect on investments while reducing short-term growth fuctuations and shortterm poverty through their positive effects on consumption.

110 Hanna Fromell et al.

The contrasting view is that the receipt of remittances can change the spending behavior of households. Here the underlying assumption is that the life cycle hypothesis (LCH) holds. This means that individuals aim to even out their consumption over their life cycles. If this is the case, then there are two scenarios: the household could allocate the additional remittance income either to investments or to consumption. This depends on whether remittance payments are perceived as transitory (one-off payments) or permanent income fows. If remittances are perceived as transitory payments – that is, raising the recipient’s income only in the current period – households will spend a larger portion of their remittances on investment. This is because they save (invest) their transitory income to distribute consumption over future periods. If, however, remittances are considered permanent, recipients will increase their consumption signifcantly already in the period of the frst receipt. Some authors (Adams & Cuecuecha, 2010) believe that remittances are perceived as a transitory income, while others point to evidence that a signifcant proportion of remittances are spent on ‘status-oriented’ consumption goods (Chami, Fullenkamp, & Jahjah, 2003), which would indicate that remittances are treated as permanent income. Thus, under the assumption of the LCH, remittances could be either more effective in promoting short-term growth effects (through consumption) or more effective in driving long-term economic growth (investments). Another reason why remittances may change receiving households’ resource allocation is that they are often earmarked for nonconsumption purposes such as housing, farm equipment, or the education of younger household members (Taylor & Wyatt, 1996; Brown & Jimenez-Soto, 2015). This view implies that remittances have a positive impact on long-term economic growth because they are spent more on the margin on investment goods rather than on consumption. 5.3.3 Are remittances countercyclical? Remittances are often seen as countercyclical cashfows, meaning that remittance fows increase – or at least do not decrease – when the economic situation in the remittance-receiving country deteriorates (Spatafora, 2005; Frankel, 2011; De, Islamaj, Kose, & Yousef, 2016). If this holds true, remittance fows could serve an informal insurance against economic uncertainty for recipient households. They could provide fnancial assistance when faced with negative income shocks, such as bad harvests. This would constitute positive impacts on welfare and economic development in poorer countries. Yet the assertion that remittances are countercyclical for recipient countries is not undisputed in the literature (e.g. Ruiz & Vargas-Silva, 2014). According to theory discussed in section 5.4, countercyclicality should only hold for remittances that have been purely motivated by altruism, as opposed to self-interest. Self-interested remittances are made for investment motives only. Thus, if motivated purely by self-interest, they would stop fowing to receiving countries that are in an economic downturn simply because there are no gains to be made; the senders’ money would be

Chapter 5 • Remittances and development 111

invested more proftably elsewhere. Moreover, if motivated by self-interest, we would expect them to be largely procyclical with respect to the recipient country. If so, then the potentially benefcial impact of remittances on economic development in the poorest countries might vanish. So whether or not remittances have a positive impact on development in poor countries also seems to depend (at least to a certain degree) on the motives of their senders (De et al., 2016). What about cyclicality with respect to the remittances-sending country? If economic conditions in the host country of the migrant worsen, for example, when unemployment rises, then migrants may not be able to earn as before and reduce their remittances. So while remittances may be either procyclical or countercyclical with respect to the economic conditions in the recipient country, they are likely to be procyclical with respect to the sending country. On a macroeconomic level, however, the procyclicality of the remittance-sending country does not seem to be pronounced. For example, the data in section 5.2 suggest that remittance fows remained relatively stable over the fnancial crisis in 2007–2008.

5.4 MOTIVATIONS TO REMIT Given remittances’ substantial share of total capital infows in many developing countries, we look into what motivates migrants to remit. We here present some of the motivations behind remittances frequently discussed in the literature. For each of the motivations, we introduce a bit of theory from which empirical hypotheses can be derived. We then also point to studies that have tested these hypotheses empirically. One challenge for the literature is to disentangle observable outcomes such that motives to remit can be derived from them. This is because motivations to remit should not be seen as mutually exclusive; migrants may well have mixed motives to remit (section 5.4.5). But as we will see, with careful formulations of hypotheses, different motivations for remitting money back home can have different implications for the behavior of the remittance-sending migrant and the remittance-receiving household. 5.4.1 Altruism Perhaps the most apparent reason why migrants remit is that they care about the well-being of the people in their home country, such as family and community members, and prefer to share some of their income with these recipients. In other words, their remittances are altruistically motivated. Using a mutual altruism framework, in which the migrant as well as the recipient care for each other’s well-being, Rapoport and Docquier (2006) show analytically how the volume of the altruistic remittance transfer depends on the altruistic preferences of migrant and recipient as well as on their respective incomes. First, the transfer increases with the altruistic preference of the migrant. That is, the higher the transfer, the more the migrant cares about the well-being of those left behind. This is a result that we would expect from transfers under altruism. Second, maybe surprisingly,

112 Hanna Fromell et al.

the transfer decreases with the altruistic preferences of the recipient. The intuition is that because the migrant knows that the recipient cares about the migrant’s well-being and is therefore harmed when the migrant has to transfer money, there will be lower transfers. In other words, the recipient allows the migrant to keep more of the earnings. Hence, the more the recipient cares about the well-being of the migrant, the lower the required transfers. Third, the altruistic remittances transfer increases with the migrant’s income. The intuition is that if there is more to share on part of the migrants, then the additional income will be shared, depending, of course, on how much they care about those left behind. Fourth, the altruistic transfer decreases with the recipient household’s income. The intuition is that migrants have an a priori preference for a certain distribution of consumption between themselves and their family. They use both their own income and the nonremittance income of the recipient household to ensure this distribution. Thus, if they see that income at home (in the recipient household) increases, they do not feel compelled to remit as much as before, because they assume that the consumption needs are satisfed. Since altruistic preferences of migrants and recipients are not directly observable, the literature has tested the two implications regarding increases of the migrant’s income and regarding increases of the recipient’s income. However, because the hypothesis that remittance transfers increase when migrant incomes go up is consistent with many other motivations to remit (e.g. insurance; see section 5.4.3), reliable evidence for altruistic remittances can be found by testing the hypothesis that the migrant should remit less if the recipient’s income increases. In contrast to this prediction, much evidence speaks against the pure altruism hypothesis, since the distribution of consumption indeed varies with the distribution of income. For example, an early study in Botswana by Lucas and Stark (1985) shows that receipts of remittances are not higher among households with a lower pretransfer income than among richer households, holding the level of income of the remitting party constant. Yet Agarwal and Horowitz (2002) fnd that remittances are lower for households who receive remittances from more than one migrant. They interpret this as evidence consistent with altruism given that additional remittances from others should increase income and lower the needs for remittances by any single migrant. 5.4.2 Exchange Another studied motive for remitters is that of exchange, whereby migrants remit money to pay for services, such as taking care of young family members and elderly family members or maintaining their property. Rapoport and Docquier (2006) show in a simple model for such motivations that remittances are expected to increase with the amount of services required, but that there is no clear prediction about their response to a change in the recipient’s income (see Box 5.2). Yet the maximum amount that the migrant would be willing to remit increases with the migrant’s income, similar to the altruism motive. An increase in the recipient’s income should increase their opportunity cost of providing services for the migrant. This implies that they

Chapter 5 • Remittances and development 113

require a higher payment for providing services, thus increasing the minimum amount that the recipient would be willing to accept from the migrant. This also means that an increase in the recipient’s income may decrease the probability of receiving remittances while increasing the amount of received remittances. Notably, this is in contrast to what is predicted by an altruistic model, according to which an increase in the recipient’s income always decreases both the probability of receiving and the received amount. Moreover, according to the exchange model, an increase in the employment rate in the remittance-receiving country would increase the recipient’s bargaining power and thereby increase the amount received. That is, the recipient at home would have higher opportunity costs (e.g. through better employment opportunities) and would require higher remittances to offset these. The opposite prediction would instead be made if migrants’ motives were formed as described by the model of pure altruism. In this case, the recipient’s income rises through better employment and their consumption increases. As discussed earlier, this leads the remitting migrant to reduce the amount of remittances sent. Evidence for the exchange hypothesis is provided by Lucas and Stark (1985), who conducted a study in Botswana. They found that sons remit greater amounts to families with large herds, which could be because the sons pay family members at home to look after their cattle. These fndings are also consistent with a motive to inherit, which is discussed in section 5.4.4. However, the altruism motive cannot be ruled out, because the larger remittances were possibly a cause of  – rather than a response to  – large herds held by the household at home.

BOX 5.2 Modeling exchange-driven motivations The model explaining remittances as a result of exchange-driven motivations presented by Rapoport and Docquier (2006) uses a framework in which remittances are regarded as a means to pay for services, denoted X, that the recipient household provides to the migrant. Such services could be taking care of younger or older family members or maintaining property at home. The migrant and the recipient household each has a utility function given by U i (C i ,X), where i = m,h; here m is the migrant and h is the recipient household. Since the services generate utility for the migrant but are costly in terms of exerted effort to the recipient household, the marginal effect of services on utilities ˜V h ˜V m > 0 . For the recipient house> 0 and can be defned as ˜X ˜X hold, with a given pretransfer income, Ih, to be willing to provide the requested number of services, the offered transfer, T, must be such that V h ( I h +T , X ) ˝ V h ( I h , 0). That is, the recipient’s utility obtained from providing the service in exchange for payment must be at least as high as the utility that they

114 Hanna Fromell et al.

can obtain from declining. This participation constraint can be solved for T: the minimum payment required for the recipient household to be willing to provide the requested services depends on the size of the services and on the recipient’s pretransfer income. It then follows that ˜T < ˜T ˙ 0 and > 0. Remittances are thus predicted to increase with h > ˜X ˜I the number of services required, but there is no clear prediction about their response to a change in the recipient’s income.

5.4.3 Insurance for household at home Remittance payments could also be motivated by an insurance, where the transfers from the migrant insure the recipient household against negative income shocks. In such an arrangement, one would expect a negative relationship between remittances and income fuctuations of the recipient. De la Brière, Sadoulet, Janvry, and Lambert (2002), who study remittances to households in the Dominican Republic, fnd some support for an insurance contract between female migrants and their parents, where remittances increase when parents experience a loss in number of working days. Further evidence consistent with the insurance motive comes from studies designed to address problems associated with potential endogeneity (e.g. reverse causality and omitted variables). This is because an insurance motive can only be identifed if the relationship between remittance transfers and domestic income shocks can be separated from other factors that affect both in the same direction. For example, remittances could fund productive investments and lead to increased income, or as discussed earlier, they might also reduce domestic income by reducing the recipients’ labor force participation. Such factors should be excluded in order to identify the negative relationship between remittances and income that is predicted by an insurance motive. Clarke and Wallsten (2003) address reverse causality by using panel data techniques, and Yang and Choi (2007) use variations in rainfall as an instrumental variable (IV) for income variation. Both fnd evidence that suggests an insurance motive for remittance payments. On the other hand, the fnding from Agarwal and Horowitz (2002) that remittances vary depending on whether the household receives remittances from more than one migrant are inconsistent with the insurance motive. The fnding is indeed also inconsistent with exchange motives, in which remittances function to pay for services or pay back a loan. 5.4.4 Investment for bequests Because motives such as exchange and insurance build on informal agreements between households and migrated household members, a problem of moral hazard arises, whereby the migrant has an incentive to deviate from their promise to remit. The threat of depriving the migrant from their inheritance rights may thus work as an enforcement mechanism (Rapoport

Chapter 5 • Remittances and development 115

& Docquier, 2006). De la Brière et al. (2002) present evidence that migrants remit for bequest purposes, by showing that there is a positive association between the remitted amount and land assets of households: migrants from wealthier families tend to remit more than migrants from poorer families. 5.4.5 Mixed motive While most of the literature discussing the motivation to remit strive toward fnding the one motive that best explains remittances, there is widespread recognition that several motives can simultaneously drive a given migrant to send money home. For example, Cox, Eser, and Jimenez (1998) allow for remitters to be driven by both altruism and exchange motives. They suggest that the enforcement of the repayment of a loan could partly be solved through the loyalty and guilt aversion of the remitter toward the recipient. The exchange of money for services can refer to past services, namely any assistance or loans received that served to aid in the process to migrate. The household and the migrant member of the household would then enter into an informal contract in which the migrant takes a loan from the other household members to fnance the expenses necessary to migrate. Cox et al. (1998) use data from a Peruvian household survey and fnd evidence for a bargaining-cum-altruism framework (mixed motive; see section 5.4.5), in which a member of the household (the prospective migrant) takes a loan from another member of the household to allow for the smoothening of consumption over time and where remittances are used to repay the loan. In this framework, the recipient’s pretransfer income can have a positive impact on the received remittances for lower levels of income and a negative impact at higher income levels. The rationale is that the recipient’s income positively affects their ability to sustain themselves without borrowing money from the sender, which improves their relative bargaining power over the terms of these loans and causes a positive impact from the recipient income on the transfer amount. On the other hand, increased pretransfer income eases the liquidity constraint of the recipient, making them less in need of the money transfer. For lower levels of recipient pretransfer income, the effect of improved bargaining power dominates that of becoming less in need of additional income, producing an initial positive relationship between income and remittances.

5.5 REMITTANCES AND GROWTH The previous sections already anticipated that remittances may have a positive impact on economic growth in the recipient country. This section deals specifcally with the impact of remittances on economic growth. In section 5.5.1, we describe, theoretically, the various channels through which remittance infows may potentially impact growth. In section 5.5.2, we discuss how empirical studies have tried to identify the effects of remittances on growth and which methodological challenges they face. As will become apparent, the empirical literature has so far been unsuccessful to deliver unambiguous results regarding remittances’ impact on economic growth.

116 Hanna Fromell et al.

5.5.1 Theory4 To structure our discussion of the various channels through which remittances may affect overall economic growth, we use a standard growth accounting framework. In this framework, the output growth of an economy is broken down into separate contributions of the two main production factors: capital and labor. The residual growth of the economy, which is not accounted for by growth in capital or labor, is attributed to technological progress, expressed by total factor productivity: how effectively the economy uses its production factors. This theory section is divided into three parts, each representing a separate channel through which remittances may affect economic growth: 1 Capital accumulation (physical and human). 2 Labor force growth. 3 Total factor productivity. Remittances may affect the rate at which an economy invests in economically productive goods (physical capital) and in the skills, knowledge, and experience of its labor force (human capital). There are at least three potential mechanisms through which remittances can alter physical capital growth. First, remittances may directly impact physical capital growth simply by providing additional resources for investments. The assumption here is that income from remittances is saved by the remittance-receiving households. Thus, private savings in the economy increase, which means that in our standard growth accounting framework investments also increase (cf. savings–investment identity). Investments are assumed to be spent on productive goods, and in this way, the economy grows. This requires that households spend part of the received remittances on saving or investment and thus perceive them as transitory income (see section 5.3.2). Second, there is a potential indirect effect of remittances on investment via an increase in total income and collateral. This may improve the creditworthiness of remittance-receiving households and ultimately increase their ability to invest in economically productive projects. Third, remittances may have a positive effect on macroeconomic stability and thus shape a positive economic climate for investment. Yet remittances do not obviously have a positive impact on investments and thus on economic growth. As discussed in section 5.3.2, if remittances are not perceived as one-off payments (i.e. transitory income), but rather as a permanent infow of additional income, they may stimulate consumption rather than investment – even in the presence of credit constraints (recall that the second mechanism operates through creditworthiness). Remittances may therefore have a relatively small impact on long-term national aggregate output but a larger impact on reducing short-term output fuctuations and short-term poverty (see section 5.7.2). Remittances may also affect human capital accumulation. Keeping the size of the labor force constant, remittances may raise the effectiveness of labor, such as by improving sanitary conditions, facilitating healthier lifestyles, making healthcare possible, and creating educational opportunities.

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Remittances may also indirectly affect human capital accumulation by reducing the need for child labor, which, for households in developing countries, is often a way to generate more income. If children are sent to work in order to generate more household income, they usually abandon school at relatively young ages and forgo educational opportunities. By increasing household income, remittances may also reduce the need for child labor, increase educational attainment, improve health, and so increase human capital. Remittances may affect economic growth through their impact on labor force participation, which alters the size of the economy’s labor force. Here the impact of remittances is likely to be negative, because the receipt of remittances may create disincentives for receivers to supply labor (see Chami et al. [2003] for a formal model). The labor supply reduction can be explained by an income effect as well as by a substitution effect (AmuedoDorantes, 2014). To see this, consider that labor supply decisions arise from a trade-off between allocating time on leisure versus allocating time on work. Remittances are a form of nonlabor income and thus increase the income of the receiving households and raise their reservation wage. That is, they call for a higher price for their labor and demand higher wages. If there are no jobs with that wage, then receivers increase the time they allocate to leisure and reduce the time they allocate to work; this is the income effect. On the other hand, under the assumption of altruistic remittances, moral hazard and asymmetric information problems may arise. That is, receivers may be incentivized to purposefully reduce their labor supply in order to continue receiving the remittance payments from the remitter; this is the substitution effect. The assumption of altruistic remittances is important here because the remitted amount is tied to the income of the receiving household at home (see section 5.4.1). The moral hazard is that the cost of the risky decision to reduce labor supply is covered by the remitter; the receiver can afford to reduce labor supply, because remittance fows come in. This situation arises because the remitter has incomplete information about the labor supply decisions of the members of the receiving household. Finally, remittances may also impact economic growth in the receiving country by affecting total factor productivity (TFP) growth. This can occur if remittances alter the quality and effciency of the fnancial system with respect to fnancial intermediation and the allocation of capital (see Barajas et al., 2009). Yet it is not certain whether such TFP effects are positive or negative. For example, if remittances are used by the remitter to invest capital in the receiving country, then remittances could either increase or decrease the quality of fnancial intermediation. That is, if the person making the investment has an informational advantage (disadvantage) over domestic formal intermediaries, the quality of fnancial intermediation would increase (decrease) in the recipient country, and TFP growth would increase (decrease). By increasing the size of capital fows in the receiving country’s banking system, remittances could also lead to positive economies of scale. That is, because an increased productivity of the fnancial sector would lower the costs of fnancial intermediation, remittances could spur TFP growth. Remittances may also increase the fnancial literacy of their recipients, as they learn about fnancial products. This could have a positive

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impact on their investment decisions, leading to investments into moreproductive activities. Yet remittances may also hinder TFP growth and have negative effects on economic growth in the long run through Dutch-disease effects (see Box 5.3) 5.5.2 Empirical evidence The theoretical arguments in the previous section provide ambiguous predictions regarding the impact of remittances on home-country growth; the effect could be positive (e.g. via investments) or negative (e.g. via labor force participation). Moreover, various mechanisms could offset each other. Consequently, researchers have tried to empirically determine the effect of remittances on economic growth. The literature in this feld typically implements cross-sectional or panel data in a standard growth regression framework to determine the impact of international remittances on economic growth. Remittances are then included as the explanatory variable of interest among a standard set of growth variables. For example, a cross-sectional specifcation of such a growth regression could take the following form: ˇyi = ˜0 + ˜1 y0i + ˜2 REMi + ˜3 Xi + °i , where ˇyi is the growth rate of economic output in country i, measured by the log of real GDP per capita; y0i is the initial value of yi; REMi is remittances received by country i; and Xi is a set of control variables that account for determinants of economic growth other than remittances. Some studies choose to replace REMi  – that is, the current level of remittance infows – with ˇREMi, the change in received remittances between the initial and fnal period. This is to better capture the dynamic nature of remittance fows. Xi , the set of control variables, may include variables such as domestic investment, education, net private cashfows, exchange rate changes, and measures for institutional quality or fnancial development. Usually, REMi and Xi are expressed in their ratio to GDP to account for the size of the recipient economy. One of the frst studies that investigates the impact of remittances on economic growth in a large cross-country study, rather than a single-country study, is Chami et al. (2003). Before their study, constraints on data availability made studying the impact of remittances on a larger sample of countries infeasible. Chami et al. (2003) use cross-section and panel estimations on a dataset with 113 countries in the period 1970–1998. They regress growth in real GDP per capita on (the change of) the remittances-to-GDP ratio. Their results suggest a negative effect of remittances on economic growth.

BOX 5.3 Dutch disease Remittances may affect economic growth of the recipient country by affecting the real exchange rate in the economy. Such effects are called Dutch-disease effects. Assuming that the receipt of remittances increases consumption and that prices in the traded sector are

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exogenously given on the global market, higher remittance infows lead to higher relative prices on nontradable goods. This leads to a shift of resources towards the nontradable sector. Moreover, an increase in relative prices of nontradable goods corresponds to an appreciation of the real exchange rate, which reduces the competitiveness of the economy in international markets and ultimately causes a contraction of the traded sector. Since the traded sector generates positive externalities for the nontraded sector, this may ultimately result in a reduction in the competitiveness of the nontraded sector as well. This results in a loss of overall TFP growth in the economy and has negative impacts on long-term economic growth. A study by Lartey, Mandelman, and Acosta (2012) substantiates the Dutch-disease effects of remittances, by estimating whether remittances have an impact on the real exchange rate of remittancereceiving countries. To do this, they estimate the following function: p

RERit =

 ˛ REM j=0

j

it−j

+ ˜2 Xit + (˝i + ˙t + °it ),

where RERit is the real exchange rate in country i at time t, REM remittances, Xit a set of control variables, ˝i time-invariant country-specifc effects, ˙t time-specifc effects and °it an idiosyncratic p ˛ allows for longer lags of remiterror term. The expression j=0 j tances in order to capture the delayed effects of remittances on the real exchange rate. Using dynamic panel estimators on a panel of 109 developing and transitioning countries from 1990 to 2003, Lartey et al. (2012) fnd evidence for a Dutch-disease effect of remittance by showing that remittances lead to an appreciation of the real exchange rate. AmuedoDorantes and Pozo (2004) fnd similar evidence. Lartey et al. (2012) also show that an increase in received remittances leads to a shift from the tradable to the nontradable sector and a decline in the output share of the manufacturing sector, while the output share of the service sector increases. Both of these symptoms serve as further evidence for the Dutch-disease effects of remittances in developing countries. Although Lartey et al. (2012) do not investigate the effects on economic growth or welfare in their sample, their fndings lend credibility to the hypothesis that remittances can lead to a decrease in economic growth through a reduction of TFP via Dutch-disease effects.



Chami et al. (2003) formalize a model that predicts moral hazard problems under asymmetric information when remittances payments are understood as altruistic transfers. This serves to formulate testable hypotheses regarding the impact of remittances on economic growth. Recall from the theory in section 5.5.1 that altruistically motivated remittances can create incentives to reduce

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labor force participation. Their model, therefore would predict a negative impact of remittances on economic growth in remittance-receiving countries. Although the authors do not test this model explicitly, because they lack data on the labor force participation of migrant versus nonmigrant households in all the countries, they provide indirect evidence for the two main predictions of their model. First, they fnd that remittances are countercyclical: they increase with negative economic growth in the receiving country. Chami et al. (2003) take this as evidence for altruistic transfers. Second, their results suggest that remittances have a negative impact on economic growth in recipient countries. Together, these two results can be taken as indirect evidence that the receipt of remittances reduces labor force participation. The reason is that only the labor force participation channel is consistent with these two fndings. One of the central methodological challenges in empirical remittance research is to control for the potential endogeneity of remittance fows. Of most concern to researchers is endogeneity due to reverse causality. To see this, consider not only that remittances may affect economic growth but also that economic growth affects the occurrence and size of remittance fows. This is true for countercyclical remittances and procyclical remittances: in both cases, remittance infows depend on the economic conditions in the receiving country. Moreover, recall that the initial migration decision of labor migrants is typically based on the expected economic outcomes faced by potential migrants at home and abroad. So the mere fact that people are able to send remittances as migrants depends on the economic output of their origin (and destination) countries. Additionally, it seems impossible (or excessively costly) to control for all potential factors that impact both remittances (migration) and growth. Thus, the relationship between remittances and growth appears to be riddled with potential sources of endogeneity. Chami et al. (2003) address these endogeneity concerns by using an instrumental variable (IV) strategy. More specifcally, they use lagged income ratios and lagged interest rate ratios between remittance-receiving countries and the US to instrument remittance fows. The US is taken as a general proxy for all remittance-sending countries. The idea behind this IV strategy is that while the income gaps and interest rate gaps to remittancesending countries may generate remittance transfers (relevance), they do not determine the economic performance in the recipient country (exclusion) (Chami et al., 2003, pp. 19–21; for more on IV in remittances and migration research, see Box 5.4).5

BOX 5.4 Instrumental variables in remittance (and migration) research As mentioned several times earlier in this chapter, remittance (and migration) research faces serious endogeneity issues. A popular, and potentially powerful, remedy to endogeneity issues is to use IV regression. If you are unfamiliar with the terms ‘endogeneity’ and ‘instrumental variables’, please refer to standard econometric textbooks.

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Two commonly used instruments in remittances and migration research are distance (e.g. from migrant origin to residence at destination) and migrant networks (e.g. the number of migrants from the same origin that already reside at destination). Both these instruments appear relevant, but there are major concerns regarding their exclusion restriction. The intuition behind the distance instrument is that the greater the distance between origin and destination, the fewer people who will migrate because of associated migration costs. Indeed, there seems to be an inverse relationship between distance and migration fows. Hence, distance should predict migrations – and therefore remittance fows – reasonably well. However, arguing that the distance between origin and destination does not affect (or correlate with) outcomes either at origin or at destination is diffcult. For example, the distance between developing African countries and the destination regions of Europe and North America is certainly indicative not only of migrant fows but also of trade fows, colonial ties, and investment fows, all of which affect income, poverty, and education differences between those countries. Thus, distance affects outcomes not only through migration but also through other channels. Exclusion has most likely not been satisfed. See our discussion of the instruments used by Adams and Page (2005) in section 5.7.2. The intuition behind the network instrument is that the greater the number of people who already live at destination, the lower the costs associated with migration. Prospective migrants do not have to organize their move on their own but rather can rely on networks and even institutionalized channels that help them move and settle in. So relevance is usually satisfed, but the exclusion restriction requires some arguing: the reason why some people have different networks than others is exogenous. Are there omitted variables that would explain both the network and the outcome? The education levels of ancestors, which often are unknown, can affect historical migrations (more educated people are more likely to migrate) and income inequality (people from more educated families are more likely to be richer). Hence, the reason that some have better networks than others is not exogeneous but rather endogenously determined by past education levels. Thus, the exclusion restriction is violated. The previous examples illustrate how diffcult fnding good instruments in migration research is. The following could work as a general rule of thumb to fnd an instrument that satisfes the exclusion restriction: if the outcome variable is measured at migrant origin (e.g. incomes of remaining household members), then as an instrument for migration or remittances, use a variable measured at destination (e.g. migrant network); in contrast, if the outcome variable is measured at destination (e.g. earnings of migrants), use an instrument measured at origin (e.g. rainfall shocks at home). If one is worried that migrant

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networks do not predict remittance fows well enough, then the instrument could be constructed, for example, as network * employment at destination. This would also capture the economic conditions at destination, including the ability of migrants to fnd (well-paying) jobs, and thus capture the migrants’ ability to send remittances. The foregoing rule of thumb can make easier fnding instruments that do not affect the outcome directly but only through migration and remittances. So chances are higher to satisfy the exclusion restriction. However, we recommend paying close attention to justifying the IVs properly, because experienced researchers excel at questioning the validity of instruments.

Since the study by Chami and others (2003), numerous other studies have attempted to estimate the effect of remittances on economic growth in the recipient countries (Spatafora, 2005; Faini, 2007; Acosta, Calderón, Fajnzylber, & Lopez, 2008; Chami et al., 2008; Mundaca, 2009; Lartey, 2013; Acosta, Lartey, & Mandelman, 2009; Lartey et al., 2012; Imai, Gaiha, Ali, & Kaicker, 2014, 2016; Feeny, Iamsiraroj, & McGillivray, 2014; Giuliano & Ruiz-Arranz, 2009). These studies differ with respect to their choice of remittance measure, estimation technique, IVs, study period, and selections for countries to study. Despite all these attempts, we don’t know whether the receipt of remittances increases or decreases a country’s long-term growth. Hence, we cannot conclude on their macroeconomic impact on development in cross-country studies. We conclude this section by discussing how to interpret the ambiguous results in the literature. For example, Clemens and McKenzie (2018) argue that the reported ambiguous empirical results are due to problems that are more fundamental than the issues regarding specifcation, sample choice, and instrumentation strategy typically mentioned in the literature. They offer three explanations for the ambiguous results in the literature. First, they argue that the observed increase of remittance payments in macro data (e.g. balance of payments; see Box 3.1) does not concord with the growth of remittances observed in micro data (e.g. household surveys). They show in their paper that only 21% of the growth in remittances observed between 1990 and 2010 can be attributed to the actual growth of the migrant stocks and migrant earnings. The remaining 79% are attributable to changes in the measurement of remittances. So if remittance growth that we observe in macro data is illusory rather than genuine, then it is also not surprising that we cannot detect consistent effects on growth. Second, they show that, even if the macro data was correct, growth regressions (as discussed earlier) lack the statistical power to even detect any effects on economic growth. And third, they argue that even if there were detectable effects of remittances on home-country GDP growth, they would likely be offset by reduction of the labor force in the home country through migration itself. A similar issue returns when estimating the impact of remittances in micro data on

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household incomes (see section 5.7). Yet their third argument highlights an important issue for remittance research: whenever we want to establish an effect of remittances on indicators in the origin communities of migrants, we should do so while taking into account that remittances always occur in conjunction with (or as a consequence of) migration itself. Remittance fows are always preceded by migration fows in the opposite direction. But does this mean that empirical studies into the development effects of remittances are futile altogether? Concluding that it does would be too quick. As Clemens and McKenzie (2018) argue, although currently available macro data on remittances may display the shortcomings addressed earlier, data become more available in better quality through research and legislation efforts, such that growth regression studies may become feasible in the future after all. Moreover, it may be more important in the development context to know whether remittances can help receivers to overcome hardship and to escape poverty than to know that remittances incite domestic investment and economic growth.6 As mentioned earlier, remittances may have other crucial benefcial effects on receiving households and communities. Following this line of thought, we address such effects in the remainder of this chapter. In section 5.6, we discuss the relationship between remittances and fnancial development. In section 5.7, we present research on the impact of remittances on household incomes  – especially with respect to income inequality and poverty. In section 5.8, we also discuss potential policy tools available to policymakers that may help to increase the benefcial effects of remittances on their receivers.

5.6 REMITTANCES AND FINANCIAL DEVELOPMENT In this section, we look at the relationship between remittances and fnancial development in a remittance-receiving country. On the one hand, the development of the fnancial system of the remittances-receiving country may be a catalyst for the impact of remittances on economic growth. On the other hand, remittances may directly improve fnancial development and so contribute to mitigating poverty and inequality in the receiving country. We discuss both options in turn. It seems almost obvious that better fnancial development, expressed as the ratio of credits provided by the banking sector (the depth of fnancial system), facilitates the impact of remittances on economic growth. This is because a more developed fnancial sector may enhance the effcient allocation of remittance infows toward proftable investments. Thus, remittances may have a greater impact in countries with more-developed fnancial sectors. However, this need not be the case. Instead, remittances to developing countries could provide funding for frms and households that do not have access to formal credit markets and so stimulate economic growth. This implies that remittances substitute for credit and would have a greater impact on growth in countries with a less developed fnancial system. A well-known study testing the extent to which the impact of remittances on growth depends on fnancial sector development is that of

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Giuliano and Ruiz-Arranz (2009). Using a sample of about a hundred countries for the 1975–2002 period, they estimate the following equation by using ordinary least squares (OLS) as well as system GMM: GDPit = ˜0 + ˜1GDPi ,t−1 + ˜2 REMit + ˜3 FINDEVit +˜4 REMit * FINDEVit + ˜5 Xit + µt + ˙i + °it Here GDP denotes GDP; REM denotes remittances over GDP; FINDEV denotes the measure for fnancial development (measured in four ways); and X is a vector of controls. The last three terms refer to a time-fxed effect, a country-specifc fxed effect, and an error. The coeffcient of interest is β4: a positive (negative) signifcant β4 indicates that the marginal impact of remittances on growth positively (negatively) depends on the development of the fnancial sector. The study fnds strong support for a negative interaction between remittances and the development of the fnancial sector. In other words, the marginal impact of remittances on growth decreases with fnancial development. Moreover, the study also fnds that remittances increase economic growth. Thus, the results in Giuliano and Ruiz-Arranz (2009) support the hypothesis that remittances are used as substitutes for credit and that remittances help provide an alternative way to fnance investment. To corroborate this fnding, they also show that remittances seem to drive investments in the less fnancially developed countries. Hence, as suggested earlier, remittances seem to have benefcial effects on households; they appear to lift credit constraints on investments. Another, more substantial group of literature argues that remittances may enhance fnancial inclusion and via this channel may improve inclusive growth and reduce poverty. Thus, in contrast to the frst group of literature that argues that impacts of remittances on growth depend on the development of the fnancial sector, this literature claims that remittances affect the development of the fnancial sector. Development benefts from fnancial inclusion can be substantial and diverse since access to fnancial products may help poor households reduce their level of poverty and deal with shocks. For instance, access to savings accounts enables households to build up a fnancial safety net, which may induce income-generating activities and thus reduce poverty. In general, fnancial services can encourage people to accumulate savings and spend more on necessities, such as nutritious foods, education, and farming equipment and other business investments (Demirgüç-Kunt, Klapper, Singer, Ansar, & Hess, 2018). The growing body of research that points at the enormous development benefts of fnancial inclusion makes necessary determining whether and to what extent remittances are able to increase fnancial inclusion. The frst step towards fnancial inclusion is owning a bank account. Thus, the relationship between remittances and fnancial inclusion seems clear: many migrant households – that is, the migrants and their relatives back home – open and use bank accounts to send and receive remittances. Hence, sending and receiving remittances facilitates fnancial inclusion at home and abroad. However, there are several additional reasons why

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remittances may cause fnancial inclusion, both via the demand side and via the supply side of fnancial products. On the demand side, remittance infows may encourage remittance receivers to demand fnancial products if the remittances are channeled through a bank account and thus induce the receiver to interact with a bank. The established relationship with a bank may lead to demand for additional fnancial products, such as savings, credit, and insurance products. Remittances may also increase fnancial inclusion via the supply side: commercial banks have realized that the remittance channel can be used to promote fnancial services among lowincome individuals. Also, credit unions have started to develop remittance services by allowing members and nonmembers to send money electronically. Bridging remittance senders and receivers, credit unions often offer other fnancial services, such as savings accounts (Grace, 2005). In addition, due to remittance infows, fnancial institutions can build a fnancial history of poor people who haven’t had access to the fnancial sector before. Thus, remittance infows enable poor people to build a sound fnancial history with a fnancial institution, which reduces informational asymmetries and improves access to credit. As mentioned earlier, remittance infows may function as a substitute for a job and a regular income. Many migrated family members regularly send money home to sustain their family, such that this remittance infow becomes comparable to regular income. The remittance infow informs the bank about income and expected future funds of the remittance receivers, which may be used to repay loans, and hence provides information about creditworthiness. Becauase remittance infows are often countercyclical – that is, remittance infows often increase during adverse circumstances at home – remittances may also improve the risk profle of the remittance receiver. Related to this, remittances allow banks to build a relationship with new clientele (relationship lending; see Berger & Udell, 2002). Finally, (potential) bank clients can use current and future remittance infows as collateral, which will lower bank risk and thus may induce banks to provide credit. Therefore, it seems likely that on the one hand receivers of remittances become more interesting clients for banks and on the other hand they are also induced to make more use of banking services. Yet the potential positive impact of remittances on fnancial inclusion ultimately depends on the ability and willingness of banks to adapt. Banks need to expand their offering of fnancial products to poor people to accommodate the transfer of remittances and to induce fnancial inclusion of those who don’t already have access to fnancial services. However, banks and private sector businesses in general may simply underestimate market opportunity at the ‘bottom of the pyramid’ (Prahalad, 2004) and refrain from offering new fnancial products. Also, governments may play an important role in enhancing the effect of remittances on fnancial inclusion by, for example, removing taxes on incoming remittances and by relaxing exchange and capital controls. Moreover, migrant identifcation requirements need to be addressed. Migrants without legal status abroad need to be allowed to use formal channels to remit a valid immigration status but lack identifcation to open a bank account; consequently, they need

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to rely on money transfer organizations (MTOs) or informal networks to remit. Moreover, governments need to ensure that appropriate regulations and consumer protection safeguards are in place, and banks must ensure that fnancial services are tailored to the needs of disadvantaged groups to ensure that poor people beneft from fnancial inclusion (Demirgüç-Kunt et al., 2018). One of the earliest papers on the impact of remittances on fnancial inclusion is Toxopeus and Lensink (2008). They use a cross-sectional dataset on approximately 60 countries for 2005 and use the following equation (with OLS and a median regression technique): FININLi = ˜0 + ˜1REMi + ˜2 Xi + °i Here FININLi is the proxy for fnancial inclusion (measured by percentage of population that has access to a bank account in country i). Toxopeus and Lensink (2008) provide strong support for a positive signifcant effect of remittances on fnancial inclusion. They also consider the impacts of remittances on growth, via the fnancial inclusion channel, using a three-stage least squares (3sls) technique. This analysis indeed suggests that remittances positively affect growth by enhancing fnancial inclusion.7 A much more elaborate and rigorous analysis of the impact of remittances on fnancial development is that by Aggarwal, Demirgüç-Kunt, and Martínez Peria (2011) .8 The paper uses a panel of developing countries for the period 1975–2007 and applies cross-country regressions and system GMM regressions for a dynamic panel. Their main regression equation is specifed as follows: FININLi ,t = ˜0 + ˜1REMi ,t−1 + ˜2 Xi ,t−1 + °i ,t The paper provides strong evidence of a positive signifcant and robust link between the infow of remittances and fnancial development in developing countries.

5.7 REMITTANCES AND HOUSEHOLD INCOMES Whereas the previous sections focused on the impact of remittances on economic growth and fnancial sector development, this section focuses on the impact of remittances on household incomes. In theory, we expect that remittances to have positive effects on household incomes at home. If prospective migrants make well-informed migration decisions, then the earnings that they receive abroad should offset the costs associated with migration and thus increase the overall income available to the household at home.9 Rising incomes through remittances may impact poverty levels as well as inequality levels in the origin communities of migrants. On the one hand, we expect that remittances can lift receiving households out of poverty and thus have negative effects on poverty levels at origin. On the other hand, it is not clear a priori whether remittances would reduce or increase income inequality. Remittances could increase inequality if remittances were to reach only those few households that can afford migration in the frst place.

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Yet if migration were available to poorer households as well, they could reduce inequality at home. In the empirical literature, the effects on inequality and poverty have been studied by using both micro-level data (e.g. on the household level) and aggregate-level data (e.g. on the municipality or country level). Given that most of the studies are based on household-level data, we focus primarily on these but also consider aggregate-level studies when appropriate. 5.7.1 Remittances and inequality We begin with the impact of remittances on inequality. Inequality is typically measured with the Gini coeffcient – sometimes at the local, village level (Stark, Taylor, & Yitzhaki, 1986; Barham & Boucher, 1998) and sometimes at the country level (Adams & Page, 2005; Brown & Jimenez, 2008).10 Thus, the research question is by how much the receipt of remittances changes the Gini coeffcient in the migrants’ origin community. Two strands of literature have developed on this topic. They use different identifcation strategies and may, even if applied to the same sample, arrive at different conclusions on the impact of remittances on inequality. We describe both methods in turn. We believe that looking at both methods enhances our understanding of how remittance transfers may impact receiving households and their communities. (Box 5.5 discusses the underlying assumptions of the two approaches.) The Gini decomposition method proceeds in two steps. First, total observed village income is decomposed into different sources: home earnings and earnings from remittances. Second, the Gini coeffcient of the observed overall income distribution in the sample is compared with the Gini coeffcient of the home earnings of nonmigrant households. If the latter is greater than the former, then remittances have reduced income inequality. Thus, the Gini decomposition method can answer the extent to which income from remittances changes the distribution of total income in the village. The Gini decomposition method was introduced by Stark et al. (1986). In their study on two Mexican villages, the authors fnd that international remittances (from the US) reduce inequality. That is, they fnd that the Gini coeffcient of total income, including remittances, was lower than the Gini coeffcient of the nonremittance income. However, they fnd that the inequality-reducing effect was more pronounced in the village which had a longer migration history to the US than in the village with a shorter migration history. So it seems that the more migrants migrated over time, the more benefcial was the impact of remittances on income inequality.

BOX 5.5 Remittances: exogenous or endogenous transfer payments? As mentioned in section 5.7.1, the literature has developed two methods to identify the effect of remittances on income inequality: the Gini decomposition method and the counterfactual incomes method. The

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identifcation strategies should be chosen on the basis of whether the remittances are exogenous transfers or endogenous transfers. The Gini decomposition method must make the simplifying assumption that the receipt of remittances is independent of household characteristics. That is, it assumes substantial differences between migrant and nonmigrant households with respect to receiving remittances and assumes that the allocation of remittances across households in the origin community is almost random. This assures the identifcation of the impact of remittances on income inequality: the difference between the Gini of nonmigrant households and the Gini of all households in the sample equals the effect that remittances have on income inequality. Crucially, if one assumes that remittances are independent of household characteristics, then they are exogenous transfers to household income. They are an additive component to household income. As such, remittances’ impact on recipient household income is positive by construction: because remittance fows are never negative (they are either zero or positive), they can also never reduce household income. Yet the assumption of exogenous transfers and, consequently, the implication of nonnegative impact on household income are implausible according to the advocates of the counterfactual incomes method. They argue that remittances necessarily follow from migration and that their effects should always be evaluated in conjunction with the decision to migrate. As explained in section 5.1, household income may decrease after migration even when remittances are paid (e.g. Acosta, Fajnzylber, & Humberto Lopez, 2007). This is possible when migrant earnings abroad are lower than respective home earnings or when household members at home reduce their labor force participation. If this is the case, then remittances are endogenous transfers in the sense that they are substitutes of home earnings rather than an additive source of household income. Hence, receiving remittances depends on household characteristics after all – most importantly on the decision to migrate and to substitute home earnings with earnings abroad. Thus, the counterfactual incomes method identifes the impact of remittances on inequality as the difference between the Gini of the full sample of households (including remittances) and the Gini of a counterfactual scenario where the household incomes of the sample are calculated as if no one had migrated. So the counterfactual incomes method asks what the gains from migrating and remitting are compared to staying and generating income at home. For further discussion, see Brown and Jimenez-Soto (2015).

In fact, this second result has become one of the central fndings in the literature on the impact of remittances on inequality. The general idea is that there exists a nonlinear relationship between remittances and income

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inequality, meaning that the effect of a marginal increase in remittances depends on the absolute size of the remittances. In fact, also other studies fnd that for (initially) low levels, remittances increase community-level inequality and that inequality decreases only once remittances have reached a certain threshold (McKenzie & Sasin, 2007; Shen, Docquier, & Rapoport, 2010; McKenzie & Rapoport, 2007). The literature explains this inverse effect with the maturity of the migration history in the origin community. In the beginning, only a few have the means to migrate abroad, either because they are wealthier than others or because they already have networks abroad that facilitate migration. At this stage, the level of received remittances is low and the transfers beneft only a few, presumably richer, households. This leads to an increase in inequality in the community. However, as emigration from the community continues, migration becomes more affordable also for the poorer households, due to better-established networks at home and abroad. This means that the total number of remittances increases in the community, where more and more remittances go to households at the lower end of the income distribution. The process of a gradual maturing of the migration history of the community therefore leads to a reversal of the effect of remittances on inequality. The Gini decomposition method has been extended to account for the general equilibrium effects of remittances on incomes in a community at large, both migrant households and nonmigrant households. Hence, it can capture not only the direct but also the potential indirect effects of remittances on inequality (Taylor, 1992; Taylor & Wyatt, 1996). Indirect effects occur when remittances affect either the income of nonmigrant households or other sources of income for the migrant household. For example, remittances may raise the recipient’s budget constraint and free up funds for investment. This may increase the income of the recipient household as well as the income of other households through further employment opportunities (e.g. shopkeeping and kettle herding). On the other hand, remittances may negatively impact the labor supply decision of the remaining members of the migrant household. These indirect effects parallel those that we discussed in section 5.5 on economic growth. Despite the advantage of being able to account for the general equilibrium effects of remittances, the Gini decomposition technique has an important shortcoming: it does not account for the migration decision and the associated opportunity costs of migration. That is, it does not account for the fact that migrant households make an active decision to forgo income at home and to substitute it with remittances from earnings abroad. For the  Gini decomposition method, remittances are a separate, additional source of income for the household and the migration decision does not play a role in it (for further details, see Box 5.5). To address this shortcoming, the second strand of literature has taken a different methodological route. To determine the impact of remittances as substitutes of household income on poverty and inequality, this literature compares the actual earnings of migrant households with what these households would have earned had none of their members migrated. This requires estimating the income of migrant households in a counterfactual

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nonmigration scenario. This method is therefore called the counterfactual income method. Studies using this method differ with respect to the construction of the counterfactual nonmigration scenario. Some impute the counterfactual incomes by using data from nonmigrant households; some use the Heckman selection model to construct the counterfactual; and others use propensity score matching. Several studies use the counterfactual incomes method (Jimenez-Soto & Brown, 2012; Adams & Cuecuecha, 2013). We briefy present the strategy and results of a seminal study by Barham and Boucher (1998) to exemplify the counterfactual incomes method and to contrast it with the Gini decomposition method. Barham and Boucher investigate the effect of remittances on income inequality on a sample of migrant and nonmigrant households in Bluefelds, Nicaragua. They construct a counterfactual nonmigration scenario by estimating the incomes of migrant households had none of the members migrated.11 Their general strategy is to compare the Gini coeffcient of the actual incomes in the observed migration scenario with the Gini coeffcient in the counterfactual nonmigration scenario. If the Gini in the actual, observed scenario is lower than the Gini in the counterfactual scenario, then migration and remittances would have had an inequalityreducing effect on incomes in the community. More specifcally, the authors compare two counterfactual scenarios with the actual scenario. For the frst counterfactual scenario, they estimate the nonmigration incomes of the migrants and add these counterfactual incomes to the actual incomes of nonmigrants. For the second counterfactual scenario, they also estimate the counterfactual incomes of the nonmigrant members of migrant households, because the migration decision affects not only the migrants but also those left behind. As discussed earlier, nonmigrant members of migrant households may make labor force participation decisions conditional on whether another household member decides to migrate. Hence, migration may not only change the migrants’ but also the nonmigrants’ contributions to household income. The results show that the Gini coeffcient in the actual (observed) migration scenario is signifcantly higher than it is in both counterfactual nonmigration scenarios: by 7.5% and by 12%. Because a higher Gini coeffcient means higher inequality, remittances have increased income inequality in the sample. Furthermore, when Barham and Boucher use the Gini decomposition method on the same Bluefelds sample, they fnd the opposite result: remittances reduce inequality. That is, if remittances are considered exogenous transfers in this sample, then they reduce inequality. The Barham and Boucher (1998) study suggests that it appears diffcult to empirically determine the effect of remittances on inequality in remittance-receiving communities. The results are ambiguous across different methodologies. 5.7.2 Remittances and poverty In contrast to the ambiguous results on the link between remittances and inequality, there appears to be more consensus that remittances lift the receiving households out of poverty (Adams, 2004; Yang & Martínez, 2006;

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Gupta, Pattillo, & Wagh, 2009; Akobeng, 2016; Acosta et al., 2007). As we wrote earlier, these positive results can be expected in the case of successful labor migration. Migration is successful in this sense if migrants achieve what they intend with their migration decision – improving their and their families’ economic outcomes at home by migrating to places where they can fnd work and earn more money. At least with respect to poverty reduction, migrants seem to make economically rational decisions. The results seem to be robust across different methodological approaches. For example, Jimenez-Soto and Brown (2012) use the counterfactual incomes method to estimate the effect of remittances on poverty by using household survey data from Tonga. They use propensity score matching to construct the counterfactual scenario to estimate nonmigration household incomes. By measuring poverty in different way, they fnd that remittances can reduce poverty. For example, remittances reduce the poverty headcount ratio, which measures the extent of poverty, by 31% and reduce the poverty gap ratio, which measures the depth of poverty, by 49%. Using a cross-sectional approach, Adams and Page (2005) evaluate the direct effect of international remittances on poverty in 71 developing countries. They use a growth-poverty model (Ravallion, 1997; Ravallion & Chen, 1997) given by log Pit = ˜1 log yit + ˜2 log git + ˜3 log REMit + ˝i + °it , where Pit is a poverty measure, yit is per capita income, g is the Gini coefit fcient, REMit represents remittances, ˝i is time-invariant country-specifc effects and °it is an idiosyncratic error term. After instrumenting for the potential endogeneity of remittances, they fnd a statistically signifcant negative coeffcient for remittances. This means that remittances reduced poverty in their sample. However, concerns could be raised regarding the IV strategy used in this study. In particular, Adams and Page do not discuss the exclusion restriction of the three instruments that they use to address the endogeneity of the remittance variable. For example, they use the distance between the remittance-sending area (US, EU, or Gulf) and the recipient country as their frst instrument. While they rightly argue that distance may be a good predictor of remittances (migration is typically negatively correlated with the distance between origin country and destination country), they do not discuss the exclusion restriction at all. So it is not obvious why distance would not affect poverty in remittances-receiving countries – for example, through trade, FDI, or colonial ties. Thus, it seems that distance is not a good instrument for remittances, and since similar considerations apply to their other two instruments, their study cannot conclusively identify a causal effect of remittances on poverty (see also Box 5.4).

5.8 POLICY TOOLS AND INTERVENTIONS Since much of the empirical literature on the impact of remittances suggests a positive impact on several welfare indicators, some researchers have investigated how policy reform could be used to infuence migrants’ remittances

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decisions. One questions of particular relevance for policy is how remittances can be allocated in the most productive way. Great attention has been paid to whether remittances are used mainly for consumption or for investment. Which one would be the optimal use for a given household is not obvious. Furthermore the evidence diverges on whether remittances tend to be spent more on investments or more on consumption (Yang, 2011). For example, Yang (2008) and Yang and Martínez (2006) exploit sudden changes in exchange rates between the host country of migrants and their origin country, which are used as IV for changes in remittances. Signifcant increases in investments and an increased likelihood of exiting poverty are identifed among the remittance-receiving households. Another question that has been given a lot of attention is how remittances could be further increased. Most of the literature discussed in this section provides evidence about the factors that infuence the use of remittances and their magnitude. 5.8.1 Financial literacy programs If remittances are not spent optimally, imperfect knowledge about fnancial products on the part of the recipients appears as one plausible explanation. Studies have been conducted in which migrants or the household members left at home receive training in fnancial literacy to verify whether this has positive effects on remittances and their productivity. Doi, McKenzie, & Zia (2014) fnd positive effects from providing training both to the household members left at home and to the migrant, before migration. However, they fnd no positive impact from giving fnancial training to only the migrant or only the household members left at home. Financial literacy training has also been offered to migrants after their move to the host country. The fndings of such training have been mixed, where Seshan and Yang (2014) fnd increased savings and remittances among migrants working in Qatar, while Gibson et al. (2013) fnd no impact on remittances sent home from offering fnancial training to immigrants in Tonga, East Asia, and Sri Lanka. 5.8.2 Migrant control over the use of remittances If a migrant has a different opinion over how the household should spend the money from that of the household, the migrant may be more inclined to remit more if given greater control over how remittances are spent. Evidence supporting this possibility is provided by Ashraf, Aycinena, Martinez, and Yang (2011), who offer savings accounts with varying degrees of migrant control over savings in the home country and fnd that migrants accumulate the most savings when they are given the highest level of control. Further evidence for the importance of being in control among migrants is offered by Chin, Karkoviata, and Wilcox (2011). 5.8.3 Costs As mentioned earlier, the costs associated with international remittances have become the target of international development agreements. Recall that these

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costs are often substantial, amounting to a global average of about 7% of the amount remitted (World Bank, 2019a), and there are often relatively high fxed costs per transaction. Nevertheless, remittances have been observed to be relatively frequent and small in size (Yang, 2011), resulting in relatively high fees paid relative to remitted amounts. One potential reason for why migrants choose to remit so often rather than sending larger amounts more seldom is a problem of self-control. Migrants may, for example, anticipate that the recipient will be tempted to spend too much of the remittances as soon as they have been received if a larger amount that is intended to last for a longer period is sent all at once (Yang, 2011). As the costs paid to remit are substantial, scholars have investigated whether a reduction in such costs would enable the supply of remittances to rise. Ambler, Aycinena, and Yang (2015) run a randomized control trial in which they offered migrants living in the US the chance to send money to fund the education of a student of their choice living in El Salvador. They contrast two policy interventions: in the frst, migrants’ contributions were matched by an additional USD3 for each USD1 submitted, and in the second, the cost to remit were reduced by half. The results show that migrants were more than twice as likely to allocate money through the matching program compared to the cost reduction program. Further illustrating this high price elasticity of demand, they fnd that no allocations were made when no matching was offered. A high sensitivity in the cost to remit is also confrmed by Ambler, Aycinena, and Yang (2014), who fnd that the large positive effects in remitted amounts persist even 20 weeks after the discount on costs ceased to apply. The authors fnd suggestive evidence that this may be because the recipients continue to demand the increased amounts received even after the discount period. Other studies confrm that recipients seem to have some infuence over the remittances they receive. In a lab-in-the-feld experiment, Ambler (2015) fnds that if a migrant earns unexpected windfall money and household members at home learn about this, the migrant is willing to remit more than if the household members do not learn about the windfall. 5.8.4 Channel remittances to specifc purposes Migrants who are concerned about the productive use of their remittances and who care not only about their family members but also about the community as a whole may be more willing to send money home if their money can be earmarked for specifc purposes. Several programs have been designed with such a purpose, where remittances are earmarked for the education of students. For example, the study mentioned earlier, by Ambler et al. (2015), allowed migrants to fund the payment of a selected student in El Salvador. The success of this product is limited in so far as there was no demand for channeling money through this program when there was no matching of money by the program on top of what was offered by the migrant. However, De Arcangelis, Joxhe, McKenzie, Tiongson, and Yang (2015) fnd evidence for positive demand among migrants to fund the education of students in their origin country. Interestingly the authors fnd a signifcant increase, of 15%, in remittances when they are labeled as intended for education but where it is still possible for the recipient to use the money

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for other purposes. Imposing a hard form of commitment by channeling the money directly to the school only adds another 2.2% on top of the remittances sent when the money has been labeled.

5.9 CONCLUSION This chapter showed that international remittances, the fnancial transfers made by labor migrants to their families and relatives at home, have the potential to exert positive effects on economic output, fnancial development, poverty levels, and income inequality in developing recipient countries. In this sense, their role vis-à-vis other forms of development fnance – for example, via offcial development assistance (ODA) or foreign direct investments (FDI) – cannot be understated and should be further investigated. This chapter also highlighted the importance of understanding the motivations of migrants to transfer money home as they shape the special characteristics of remittances that set them apart from other forms of development fnance. Such an understanding facilitates the assessment of the development effects of remittances and improves any endeavor to eventually unlock their presumed development potential. While the empirical literature on the development effects of remittances is growing in number and quality, we maintain that consumers should be aware of the various weaknesses regarding data availability and research methodology exhibited by the literature. We also highlighted throughout the chapter that the potentially benefcial effects of remittances should always be investigated in conjunction with migration decisions. Remittances never occur without migration, and therefore, who receives remittances is highly dependent on who can afford to migrate. Future research in the feld should therefore account for this selectivity and aim to improve the methods that are used to measure the effect of remittances on development (e.g. McKenzie, Stillman, & Gibson, 2010; Gibson, McKenzie, & Stillman, 2013). We also described ways that policymakers could infuence the remitting behavior of international labor migrants. Supporting the strategies adopted by recent international agreements on migration and remittance policies, a reduction in the costs of remitting smaller amounts promises higher volumes of remittance fows.

Discussion questions 1 Which theoretical considerations explain a change in the receivers’ spending behavior towards consumption and which towards investment goods? Consider the permanent income hypothesis and different motivations to remit. 2 What are the effects of remittances from refugees on communities at

home? Would they differ from labor migrants’ remittances? 3 What could explain the ambiguous empirical results on the impact of remittances? 4 Do you fnd the choice of instrumental variables in Chami et al. (2003) convincing? Why or why not?

Chapter 5 • Remittances and development 135 5 Consider the role of the fnancial sector in the impact of remittances on growth. In your opinion, does the fnancial sector play a moderating or a mediating role? Read up on moderators and mediators in econometric research. How would you design a study to investigate either of the two roles?

6 Given what you have learned, how would you design a program to enhance entrepreneurship through the receipt of remittances in the recipient community? 7 What are social remittances, and what would their impact on economic growth, fnancial inclusion, poverty and inequality be? How would you assess their impact?

Notes 1 Voluntary labor migration differs from so called forced migration, or displacement, that occurs when people have to leave their homes due to threats to their safety and security. Forced migration is smaller in size and typically generates smaller remittance fows. It has therefore not received much attention in the literature and is not discussed in this chapter. 2 This totaled 216 countries: 31 low-income countries, 53 lowermiddle-income countries, 56 upper middle-income countries and 76 high-income countries. 3 The World Bank, Remittance Prices Worldwide, available at http:// remittanceprices.worldbank.org. 4 This section draws from Chami et al. (2008), Barajas et al. (2009), and Amuedo-Dorantes (2014). 5 In our study questions, we ask you to evaluate the quality of the Chami et al. instruments. See also Box 5.4. 6 Brown and Jimenez-Soto (2015) argue along similar lines. 7 The 3sls analysis assumes that remittances affect growth only via fnancial inclusion. However, remittances likely also affect growth via other channels, implying that the implicit exclusion restriction used in the 3sls approach conducted by Toxopeus and Lensink (2008) will not hold.

8 Gupta, Pattillo, and Wagh (2009) use a similar approach to that of Aggarwal, Demirgüç-Kunt, and Martínez Peria (2011). However, Gupta, Pattillo, and Wagh (2009) focus on sub-Saharan Africa. Most importantly, they fnd strong support for a positive and signifcant impact of remittances on fnancial development. 9 Recall that we focus on labor migration where one household member leaves their family behind to work abroad. So the decision to migrate is deliberate and not coerced. Of course, if we were to investigate other types of migrations, such as forced migration, then we could not expect that their earnings abroad would necessarily exceed their home earnings. 10 The Gini coeffcient is the most popular measure of inequality in a population. It measures how far a population’s income distribution deviates from a perfectly equal distribution. A Gini coeffcient of 0 expresses perfect equality, while a value of 1 expresses maximal inequality. 11 The study uses a double-selection Heckman model (Heckman, 1979) to control for the migration decision of migrating household members and the labor force decisions of nonmigrant household members.

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Theory and evidence. KNOMAD Working Paper 11. Retrieved from https:// www.knomad.org/publication/ remittances-over-business-cycletheory-and-evidence Demirgüç-Kunt, A., Klapper, L., Singer, D., Ansar, S., & Hess, J. (2018). The global fndex database 2017: Measuring fnancial inclusion and the fntech revolution. Washington, DC: World Bank. Doi, Y., McKenzie, D., & Zia, B. (2014). Who you train matters: Identifying combined effects of fnancial education on migrant households. Journal of Development Economics, 109, 39–55. Faini, R. (2007). Migration and remittances. The impact on the countries of origin. Revue d’économie Du Développement, 15(2), 153–182. Feeny, S., Iamsiraroj, S., & McGillivray, M. (2014). Remittances and economic growth: Larger impacts in smaller countries? Journal of Development Studies, 50(8), 1055–1066. Frankel, J. (2011). Are bilateral remittances countercyclical? Open Economies Review, 22(1), 1–16. Gibson, J., McKenzie, D., & Stillman, S. (2013). Accounting for selectivity and duration-dependent heterogeneity when estimating the impact of emigration on incomes and poverty in sending areas. Economic Development and Cultural Change, 61(2), 247–280. Giuliano, P., & Ruiz-Arranz, M. (2009). Remittances, fnancial development, and growth. Journal of Development Economics, 90, 144–152. Glytsos, N. P. (2002). The role of migrant remittances in development: Evidence from mediterranean countries. International Migration, 40(1), 5–26. Grace, D. C. (2005). Exploring the credit union experience with remittances in the Latin American market. In S. Munzele Maimbo & D. Ratha (Eds.), Remittances: Development impact and future prospects (pp.  159–74). Washington, DC: World Bank. Gupta, S., Pattillo, C. A., & Wagh, S. (2009). Effect of remittances on poverty and

138 Hanna Fromell et al. fnancial development in Sub-Saharan Africa. World Development, 1, 104–115. Heckman, J. J. (1979). Sample selection bias as a specifcation error. Econometrica, 47(1), 153–161. Imai, K. S., Cheng, W., Malaeb, B., & Bresciani, F. (2016). Remittances, growth and poverty reduction in Asia -a critical review of the literature and the new evidence from cross-country panel data. Discussion Paper Series DP2016–28. Retrieved from https:// www.rieb.kobe-u.ac.jp/academic/ ra/dp/English/DP2011-30.pdf Imai, K. S., Gaiha, R., Ali, A., & Kaicker, N. (2014). Remittances, growth and poverty: New evidence from Asian countries. Journal of Policy Modeling, 36, 524–538. International Monetary Fund. (2009). Balance of payments and international investment position manual. 6 (BPM6). Washington, DC: International Monetary Fund. Jimenez-Soto, E., & Brown, R. P. C. (2012). Assessing the poverty impacts of migrants’ remittances using propensity score matching: The case of Tonga*. Economic Record, 88(282), 425–439. La Brière, B. D., Sadoulet, E., Janvry, A. D., & Lambert, S. (2002). The roles of destination, gender, and household composition in explaining remittances: An analysis for the dominican sierra. Journal of Development Economics, 68. Lartey, E. K. K. (2013). Remittances, investment and growth in SubSaharan Africa. Journal of International Trade and Economic Development, 22(7), 1038–1058. Lartey, E. K. K., Mandelman, F. S., & Acosta, P. A. (2012). Remittances, exchange rate regimes and the dutch disease: A panel data analysis. Review of International Economics, 20(2), 377–395. Lucas, R. E. B., & Stark, O. (1985). Motivations to remit: Evidence from botswana. Journal of Political Economy, 93(5), 901–918. McKenzie, D., & Rapoport, H. (2007). Network effects and the dynamics of migration and inequality: Theory

and evidence from Mexico. Journal of Development Economics, 84, 1–24. McKenzie, D., & Sasin, M. J. (2007). Migration, remittances, poverty, and human capital: Conceptual and empirical challenges. World Bank Policy Research Working Paper Series 4272. Washington, DC: World Bank. McKenzie, D., Stillman, S., & Gibson, J. (2010). How important is selection? Experimental vs. non-experimental measures of the income gains from migration. Journal of the European Economic Association, 8(4), 913–945. Mundaca, B. G. (2009). Remittances, fnancial market development, and economic growth: The case of Latin America and the caribbean. Review of Development Economics, 13(2), 288–303. Prahalad, C. K. (2004). The fortune at the bottom of the pyramid. Upper Saddle River: Wharton School Publishing. Rapoport, H., & Docquier, F. (2006). The economics of migrants’ remittances. In Handbook of the economics of giving, altruism and reciprocity (Vol. 2, pp. 1135– 1198). North Holland: Elsevier. Ravallion, M. (1997). Can high-inequality developing countries escape absolute poverty? Economics Letters, 56, 51–57. Ravallion, M., & Chen, S. (1997). What can new survey data tell us about recent changes in distribution and poverty? The World Bank Economic Review, 11(2), 357–382. Ruiz, I., & Vargas-Silva, C. (2014). Remittances and the business cycle: A reliable relationship? Journal of Ethnic and Migration Studies, 40(3), 456–474. Seshan, G., & Yang, D. (2014). Motivating migrants: A feld experiment on fnancial decision-making in transnational households. Journal of Development Economics, 108, 119–127. Shen, I. L., Docquier, F., & Rapoport, H. (2010). Remittances and inequality: A dynamic migration model. The Journal of Economic Inequality, 8(2), 197–220. Spatafora, N. 2005. Workers’ remittances and economic development. In World economic outlook: Globalization and external imbalances (pp.  69–107).

Chapter 5 • Remittances and development 139 Washington, DC: International Monetary Fund. Stark, O. (1991). The migration of labor. Cambridge, MA and Oxford: Basil Blackwell. Stark, O., Taylor, J. E., & Yitzhaki, S. (1986). Remittances and inequality. The Economic Journal, 96(383), 722–740. Taylor, J. E. (1992). Remittances and inequality reconsidered: Direct, indirect, and intertemporal effects. Journal of Policy Modelling, 14(2), 187–208. Taylor, J. E., & Wyatt, T. J. (1996). The shadow value of migrant remittances, income and inequality in a household‐farm economy. Journal of Development Studies, 32(6), 899–912. Toxopeus, H. S., & Lensink, R. (2008). Remittances and fnancial inclusion in development. In Development fnance in the global economy (pp. 236– 263). New York: Springer. UN. (2015). Transforming our world: The 2030 agenda for sustainable development. A/Res/70/1. Retrieved from https://www.un.org/en/development/ desa/population/migration/general assembly/docs/globalcompact/A_ RES_70_1_E.pdf World Bank. (2017). Migration and remittances – recent developments and outlook.

Special topic: Global compact on migration. Migration and Development Brief 27. Washington, DC: Author. World Bank. (2019a). Migration and remittances: Recent developments and outlook. Migration and Development Brief, 31. World Bank. (2019b). Remittances prices worldwide. An Analysis of Trends in Costs of Remittances Services, 29(2). Yang, D. (2008). International migration, remittances and household investment: Evidence from philippine migrants’ exchangerate shocks. The Economic Journal, 118, 591–630. Yang, D. (2011). Migrant remittances. Journal of Economic Perspectives, 25(3), 129–152. Yang, D., & Choi, H. (2007). Are remittances insurance? Evidence from rainfall shocks in the philippines. The World Bank Economic Review, 21(2), 219–248. Yang, D., & Martínez, C. A. (2006). Remittances and poverty in migrants’ home areas: Evidence from the philippines. In Çağlar Özden & Maurice Schiff (Eds.), International migration, remittances, and the brain drain (pp. 81–122). Basingstoke and New York: Palgrave Macmillan.

CHAPTER

6

Foreign aid and economic development Matthew Kof Ocran, Bernardin Senadza, and Eric Osei-Assibey 6.1 INTRODUCTION Overseas development assistance (ODA) is an expression that was frst conceived of in 1969by the Development Assistance Committee (DAC) to measure aid. The DAC defnes ‘aid’ as resource fow from offcial agencies to stimulate economic development. According to the DAC, for a resource fow to be considered as aid, it must be offered on concessional terms with at least a 25% grant1 component. The resource may be fnancial, technical assistance or in the form of agricultural commodities. Humanitarian aid is also considered aid. While donations, military equipment, or technical assistance offered on concessionary terms are considered aid by some countries, the DAC excludes them in its description of aid. Thus the DAC invariably separates ‘offcial development assistance’ from other ‘offcial fows’ (OECD, 2006). For example, aid in support of antiterrorism efforts is excluded from the measurement of aid. The question regarding the role of foreign aid in fostering economic development has attracted considerable attention in the literature over the past six decades. Despite the huge volume of literature on the topic, there appears to be no unanimity on whether foreign aid has had a positive effect on economic development. What has been become clear, though, is that the motivation for providing aid to developing countries is often driven by reasons other than altruistic ones. This chapter examines the historical origins of foreign aid, the rationale behind the provision of aid, and trends in the volume of aid. We also examine the question of aid effectiveness, by examining the literature on aid and economic growth on one hand and aid and poverty on the other. The last section of chapter proposes options that can enable developing countries to look beyond aid.

6.2 EVOLUTION OF FOREIGN AID The historical origins of formal attempts aimed at providing foreign assistance can be traced to the US Congress’s Act for Relief of the Citizens of Venezuela, which was passed in 1812 after a devastating earthquake in Venezuela in March of that year (Hjertholm & White, 1998). Later on in the 20th century, the United Kingdom’s Colonial Development Act 1929 was

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promulgated. The Act sought to provide for loans in support of agriculture and industry in a number of British colonies and territories in a bid to promote commerce or industry in the United Kingdom. In 1933, the US, through the Agricultural Adjustment Act, provided shipments of agricultural surpluses to needy countries as relief and to create new markets for US agricultural output. The beginning of multilateral efforts in the provision of aid was heralded by the formation of the United Nations in 1945 following the Bretton Woods conference in 1944. A year earlier, the United Nations Relief and Rehabilitation Administration (UNRRA) was formed. Instructively, the immediate postwar efforts of multilateralism spearheaded by the United States were all aimed at supporting Europe, whose countries’ economies had been decimated by the war, to fnd its feet.2 CARE and OXFAM,3 which are among the leading international NGOs in the developing world today, were all formed to support the poor in Europe. The European Recovery Plan, commonly known as the Marshall Plan was backed by the United States’ Foreign Assistance Act of 1948. The plan was frst made public by George Marshall, the then US secretary of state, during a speech at Harvard University in 1947. The Marshall Plan is probably the most remarkable bilateral aid effort in the chronology of foreign aid. The plan was aimed at assisting the reconstruction of the European countries that had been destroyed by the Second World War. The European countries also faced the increasing threat of dictatorial communism and worsening economic outcomes. The devastation of the war and the accompanied collapse of physical infrastructure across the countries in Europe made recovery without foreign aid diffcult for European economies (Weissman, 2013). The aid under the Marshall Plan was in the form of fuel, raw materials, capital goods, loans, food, and technical assistance to help rebuild infrastructure such as transport systems. Later on, the US made direct fnancial investments in European companies. After barely four years after the inception of the Marshall Plan, European economies began to see phenomenal rebound. The United States also benefted immensely from the economic stimulus it had provided to Europe. For instance, the US industries recorded strong growth in domestic production and proft as they sought to meet the demand for goods and services from Europe after the support from the US government. Another outcome of the support was the construction of new democratic institutions in Europe and the fostering of the US economic paradigm of the free market and the ‘Americanization’ of Western Europe. Under the plan, Europe was encouraged to produce a plan for reconstruction that the United States could fund. The Europeans asked for USD22 billion; the US Congress instead approved USD17 billion, out of which the US government disbursed more than USD13 billion. The Marshall Plan was not entirely for altruistic purposes, though. In addition to helping Western Europe recover from the debilitating effect of the Second World War, it was meant to beneft the American economy and contain Soviet expansion into Europe. Thus, despite the virtues of the Marshall Plan, it was also intended to achieve political objectives (Leffer, 1988).

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In 1950, the Colombo Plan for Cooperative Economic and Social Development in Asia and the Pacifc (i.e. the Colombo Plan) was launched, like the Marshall Plan in Europe. The motivation was to create a platform to coordinate resource fow for the reconstruction of Asian countries that were badly affected by the Second World War. The Colombo Plan was also partly aimed at containing Soviet expansion into the newly independent countries in the Asia Pacifc region. This was undoubtedly the frst, most signifcant multilateral effort aimed at promoting economic development in any part of the world. The plan led to the creation of a regional organization based on the idea of collective intergovernmental efforts to stimulate economic and social development in countries of the Asia Pacifc region. The idea for the Colombo Plan emerged during a Commonwealth conference on foreign affairs in Colombo, Sri Lanka. There were seven founding signatory countries. Among these were donors and recipients. The group included Britain, New Zealand, Australia, Canada, Sri Lanka (formerly Ceylon), India, and Pakistan. The developed countries among the group provided physical capital and human resource development to better leverage the fnancial aid for economic development. Thus, the thrust of the Colombo Plan was self-help and mutual assistance (Curtin, 1954). In the 1950s, donors focused on the notion of community development and the types of aid that were in vogue were largely in the form of food aid and project support. However, the dominant donor in the 1950s was partly motivated by its anticommunist stance. After the successes of the Marshall Plan, the US promulgated the Mutual Security Act of 1951, which had a much broader development assistance mandate. Through the Act, the US provided both economic and military aid to both European countries and developing countries. The old Soviet Union, through its Molotov Plan sought to assist other countries. The Molotov Plan had two overarching objectives: a set of maximum aims and a set of minimum aims. The maximum aims sought to gain economic and political control of Europe, to attract European economies into its orbit of infuence, and to turn the continent into a source of industrial production for the Soviet Union and a market for its surplus production. On the other hand, the minimum aims were geared toward obtaining consumer goods from Europe for its people and to make sure friendly governments were in charge across countries in Europe (Berger, 1948). The cold contestation between the Soviet Union and the United States dominated the development aid environment. In the 1960s, many bilateral programs were established by Western European countries whose economies had by then recovered from the war. The 1960s also saw the establishment of regional development banks (African Development Bank in 1964; Asian Development Bank in 1966; and the Caribbean Development Bank in 1969). More importantly, against the background of the Cold War between East and West, the developed countries of the world formed the DAC in 1960 under the auspices of the Organization for Economic Cooperation and Development (OECD) in Europe. The primary motivation of the DAC was to coordinate aid from the rich Western countries in pursuance of poverty alleviation in developing countries. Also in the 1960s, a number of Western countries set up specialized development

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assistance entities such as the Canadian International Development Agency (CIDA). During the 1970s, multilateralism in the provision of aid gained more traction; poverty alleviation anchored on basic human needs  – education, healthcare, sanitation, and sustainable livelihood – was adopted as a key consideration in the provision of aid. The DAC decided to pay particular attention to the least developed countries and to prioritize the more disadvantaged countries in the distribution of aid. The idea here was that economic growth had failed to considerably reduce poverty in developing countries; therefore, measures that directly targeted the poor needed to be pursued more vigorously. The 1980s were characterized by unfavorable economic outcomes in the developed world: high unemployment and high infation rates. These challenges in turn dampened global demand for commodities. The slump in commodity prices, deterioration in terms of trade, and the high debt levels in Africa, Latin America, and Western Asia were partly a result of weak economic prospects in the developed world. The Bretton Woods institutions’ policy response was a fscal consolidation as far as economic development in the developing world was concerned. Consequently, the institutions introduced structural adjustment program loans to help reduce fscal imbalances and to help economies in the developing world adjust to their long-term growth paths. Among the policy positions that were pushed by Western donors in the 1980s was market deregulation in developing countries (UNDESA, 2017). There was a big increase in the number of NGOs in the 1980s, all in an effort to help developing countries that were facing poverty and strife as a consequence of the poor economic conditions. After the collapse of the Berlin Wall, the 1990s saw the former Soviet Union and its satellite states becoming recipients of aid. More importantly, the DAC High Level Meeting came out with a policy document that informed the fow of aid, Development Cooperation in the 1990s. The thrust of the policy was threefold. First, efforts were to be geared toward the promotion of sustainable economic growth. Second, they were to broaden the participation of all people in the productive processes and the pursuance of equity in the sharing of the benefts of growth. The last pillar of the policy was to ensure environmental sustainability and to slow population growth in countries where it is too high to impede sustainable development. The aim of the new policy underpinning ODA was to highlight and link high population growth, poverty, malnutrition, illiteracy, and environmental degradation, which were still the plight of most developing countries (OECD, 2006). At the turn of the 21st century, the DAC High Level Meeting pushed for greater emphasis on people-centered development, local ownership of development initiatives, global integration, and the forging of development partnerships between developing countries and developed countries. The DACs strategy was adopted by the OECD and the Group of Seven (G7). These ideas culminated in the adoption of the Millennium Development Goals (MDGs) that were approved by the United Nations after the Millennium Summit in 2000, which then gained universal commitment and subsequently immense global importance. The objectives of the MDGs were woven around the promotion of economic well-being, social development,

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and environmental sustainability. The sustainable development goals (SDGs) replaced the MDGs, which lapsed in 2015. The SDGs emanated from the Agenda 2030. Again, the SDGs cover a wide range of social and economic development objectives that are represented by 17 goals. The goals are then operationalized with the aid of 169 targets. The SDGs call for a global effort to end poverty, protect the planet, and ensure that there is peace and prosperity across the globe. The other signifcant development in the aid architecture in the frst decade of the 2000s was the emergence of China and some leading developing countries, such as India, Brazil, and Turkey, among others, as donors. However, the volume of China’s foreign aid dwarfs that of the other emerging donors (UNDP, 2016).

6.3 RATIONALE FOR AID Importantly, aid is not provided by donors entirely for altruistic reasons. And aid is not provided as a result of concerns for global social justice or the recipient’s needs. Indeed, two clear strands can be identifed in the literature on the motivation for providing foreign aid: those around strategic national policy and those associated with philanthropic concerns. While the motivations for providing foreign aid by rich developed countries, including the United States and the United Kingdom, have evolved over time, the thrust of the motivations have remained unchanged: strategic and humanitarian. Assuming that aid in itself can alter the socioeconomic conditions in developing countries in any meaningful way is therefore patently naïve. Morgenthau (1962) is one of the earlier authors who argues that aid is unable to turn the fortunes of poor countries around. After 50 years, this reality has become increasingly clear. The literature suggests that the poorest countries of the world are not necessarily the largest recipients of aid.4 Indeed, the desperate attempts by countries that are not developed to provide aid to developing countries is ample demonstration of the extent of ‘soft power’ that a country can wield as a donor. Quirk (2014) states in no uncertain terms that the motivations of the new non-DAC donors are just like the established DAC donors (the US and Europe): ‘doling out development aid to advance their political,5 security, and economic interests’. Empirical studies in the late 1970s (McKinlay & Little, 1977, 1978) suggest that donor interest trumped recipient interest at least for the United States and the United Kingdom. For instance, Alesina and Dollar (2000) fnd a pattern in giving aid that is motivated by politics and strategy. These outcomes are consistent with the conclusions reached by McKinlay and Little (1977, 1978). The authors further argue that while France’s foreign aid largely goes to its former colonies that it has stronger political ties with, the United States’ pattern of aid is greatly connected to its interests in the Middle East. Berthélemy and Tichit (2004) suggest that former colonies are better placed to receive disproportionate amounts of aid from their former colonial powers. Alesina and Dollar (2000, p. 33) further assert that ‘an ineffcient, economically closed, mismanaged nondemocratic former colony politically friendly to its former colonizer receives more foreign aid than another country with similar levels of poverty, a superior policy stance but without a past as a colony’.

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Dudley and Montmarquette (1976) suggest that donor’s expectations are that by providing foreign aid, the recipient country should reciprocate by supporting the donor’s interests, perhaps in the area of international politics. For instance, in 2017, when many developing countries voted against the United States’ recognition of Jerusalem as capital of Israel at the United Nations General Assembly, the US threatened to cut aid to ‘unfriendly countries’ that voted against the US (Beaumont, 2017). Trump, the US president, said, ‘They take hundreds of millions and even billions of dollars, and then they vote against us’ and went on to say, ‘Let them vote against us. We’ll save a lot. We don’t care’ (Tawfk, 2017). Again, to underscore this point, Quirk (2014) points out that one of the important reasons underlying India’s interest in providing aid to developing countries is to obtain support for its bid to have a permanent seat on the UN Security Council. Japan’s foreign aid has also gone largely to countries that share their international political interests, according to their UN voting pattern (Alesina & Dollar, 2000). News media’s coverage of natural disasters in the receiving country and the associated dividends that accrues to leaders for acting in a humanitarian manner is another clear motivation for providing foreign aid to distressed countries (Drury, Olson, & Van Belle, 2005; Strömberg, 2007; Porter & Van Belle, 2009). The massive spike in international aid to Ethiopia during the 1983–1985 famine and Haiti after the 12 January 2010 earthquake that left almost a third of a million of people dead are classic examples of instances where news coverage encourages donors to provide additional support. There are many other instances where news coverage has garnered aid for countries in facing misery as a result of natural disasters. Again, news coverage may also motivate citizens of rich countries to encourage their governments to make aid allocations for humanitarian purposes. Aid may also be traded for policy concessions (Mesquita & Smith, 2007). From the donor’s perspective, the policy concession could be in the form of favorable terms for access to natural resources in the recipient country by frms in the donor country. Thus, the donor country obtains some utility from the receiving country in terms of higher wages, dividends, and taxes. The economic interest in providing foreign aid may be seen in the provision of tied aid. Tied aid refers to foreign aid that requires that goods and services associated with the aid be obtained from the donor country. OXFAM has long argued that tied aid results in making aid ‘round trip’. Many countries tie foreign aid to something. OXFAM argued that the US tied its aid more than any other country (Oxfam, n.d.). And the US’s food aid program is arguably the worst form of tied aid. The food must be produced in the US and packaged in the US, and at least 75% of it must be transported by US-owned vessels. As another example, most of the foreign aid aimed at infrastructure development offered by China is often undertaken by Chinese labor;6 this has caused a level of discontent (Lamido, 2013).7 Much of the Chinese aid to Africa, for example, is aimed at securing natural resources from Africa for China’s own development. Recipients may also become trading partners of donors as their economies get connected to that of their donors through aid. Thus, donors also use aid to foster trade with

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recipient countries. A strand of the literature on aid provides ample evidence that foreign aid is in part motivated by trade interest (Nath & Sobhee, 2007; Hoeffer & Outram, 2011, Dietrich, 2012). In sum, the motivation for international is varied. Most of the geopolitical and strategic reasons why countries provide foreign aid do not necessarily coincide with the idiosyncratic needs of aid-recipient countries. No wonder why the outcomes of the massive fow resources in terms of aid to developing countries, particularly over the past six decades, have been mixed.

6.4 AID ARCHITECTURE, VOLUMES, AND TRENDS Many countries often provide development assistance to other countries, but the 30-member Development Assistance Committee8 (DAC) has been the major donor over the past fve decades. There are also non-DAC and emerging donor countries that are increasingly becoming considerable sources of foreign aid. These donors fall under four categories (IDA, 2007) 1 OECD members outside the DAC – Korea, Mexico, a large number of European countries, and Turkey. 2 New European Union member states that are not members of the OECD. 3 Middle Eastern and OPEC countries, such as, Kuwait, Saudi Arabia, and Iran. 4 non-OECD countries that are outside all three foregoing groupings, such as China, India, Brazil, and Russia. At the apex of the foreign aid architecture are offcial bilateral donors. The offcial bilateral donors include both DAC members and non-DAC members. The bilateral donors constitute the most important source of funds for aid in the developing world. The offcial bilateral donors provide resources to the multilaterals: regional development banks, UN agencies, and the International Development Association (IDA).9 In addition to providing the resources required by the multilaterals for their foreign aid disbursements, the bilateral donors also provide aid directly to recipient countries. The aid architecture also involves the fow of resources to the various donors in the form of refows following gross disbursements. These refows represent the payment of the principal and interests for the loan components of aid. Although the importance of the DAC members as a major source of external assistance has reduced from a high of 77% in 2005 to 62% in 2015, it is by far the major source of assistance. The non-DAC group has more than tripled its contribution, from just about 3% in 2005 to 11% in 2015. Multilateral institutions have also increased their support from 21% to 27% over the period under discussion (OECD, 2018). The total value of international development assistance has risen from USD108.5 billion in 2005 to USD152.7 billion (see Figure 6.1). Between 1960 and 1980, the volume of aid remained fairly steady as some of the major recipients, such as Turkey, Chile, and Brazil, became affuent and saw huge reductions in their aid fows. After the collapse of the

Chapter 6 • Foreign aid and economic development 147 FIGURE 6.1 Total volume of ODA in constant 2015 prices, 1960–2016 160 140

US$/billions

120 100 80 60 40 20 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

0

Source: Data from OECD DAC website

Berlin Wall and the subsequent transitions of the hitherto countries in the orbit of the former Soviet Union into market economies, aid fows spiked. From the peak in 1992, the volume of aid dropped substantially and bottomed out in 1997. The reduction in aid in the 1990s has also been attributed to the decline in the brisk competition between proponents of communist politico-economic ideologies and capitalist politico-economic ideologies. Coupled with the reduction in the ideological competition was the rapid development recorded in parts of Asia at the same time. The recent spike in aid fows seen in 2005–2006 is reckoned to have been as a result of the debt relief afforded to Nigeria and Iraq (OECD, 2017). Sub-Saharan Africa has been the largest regional benefciary of aid from the DAC. The proportion of aid that went to the region peaked at 39% in 2006 and then fell to less than 30% by 2015 (see Figure 6.2). Whereas other countries have had improved economic outcomes over the past 30 years and thus are becoming less and less reliant on aid, the same cannot be said of sub-Saharan African countries. Even though there was stronger growth in the 1990s, most countries have come from a low economic base, and it would take much stronger and sustainable growth rates to become less reliant on aid. Also, the share of ODA that goes to sub-Saharan Africa has declined steadily since 2005, from a peak of almost 40% in 2006 to less than 30% as of 2013. The non-DAC donor group is not a heterogeneous group in terms of each country’s stage of development. The group includes upper-middleincome and even lower-middle-income countries, such as Pakistan. Some of the countries are in Europe but do not belong to the OECD’s DAC group. Another well-defned group is Middle Eastern oil-producing countries such as Saudi Arabia, Kuwait, and Qatar. BRIC countries – Brazil, Russia, India, China, and South Africa – are also increasingly becoming a signifcant source of aid fow to the developing world. Chinese contributions are well documented. Turkey is another non-DAC donor that provides considerable support to developing countries.

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180.0

45%

160.0

40%

140.0

35%

120.0

30%

100.0

25%

80.0

20%

60.0

15%

40.0

10%

20.0

5%

0.0

ODA ratio

US$ billion

FIGURE 6.2 Sub-Saharan Africa’s share of ODA, 2005–2015

0% 2005

2006

2007

2008

2009

All developing countries

2010

2011

2012

Sub Saharan Africa

2013

2014

2015

SSA Share

Source: OECD (2018)

The most important non-DAC donor group of countries includes China, Turkey, India, Brazil, and Saudi Arabia. Although the exact volume of aid from China to developing countries is diffcult to determine, because of the nature of China’s aid statistics, the available data suggest that it is considerable. The aid that has been provided to 90 countries across the world has led to exponential growth over the period 2001–2011. From a low of USD1.7 billion in 2001, it increased to USD189 billion in 2011 (Quirk, 2014). Turkey’s foreign aid is also reckoned to have increased immensely over the ten-year period 2002–2012. This has soared from USD86 million to USD2.5 billion as the country has prospered. India has been a donor of foreign aid since the 1990s. It receives foreign aid with one hand and gives foreign aid with the other hand. Indeed, the British newspaper the Telegraph reported in 2016 that Britain still gives hundreds of millions of dollars in aid to India and China (Swinford, 2016). Saudi Arabia’s development assistance totaled USD289 million in 2015 (Saudi Aid Platform, 2020). And between 2005 and 2011, Brazil provided development assistance to the tune of USD1.4 billion in total, to 70 countries (Huber, 2012). The motivation behind these and many middle-income countries’ efforts at providing foreign aid to developing countries needs to be explained.

6.5 AID EFFECTIVENESS 6.5.1 Aid and growth The convention of extending aid, particularly after the Second World War, was principally aimed at assuaging the economic diffculties of wardistraught economies and to occasion auspicious channels toward economic rejuvenation. The scope of concentration, however, has evolved in

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recent times to refect the general economic concerns of the developing and underdeveloped world, after the end of the Cold War in 1989 (Ccheang, 2009). Thus, foreign aid is now targeted at engendering rapid and palpable growth in regions typifed by severe macroeconomic instability and often dealing with the twin challenges of low domestic savings and reduced foreign exchange infows (Basnet, 2013). In an economy where neither domestic savings nor export-fnanced imports are fully capable of satisfying investment demand, foreign aid could assist in bridging the savings–investment gap and the foreign exchange gap: the conventional two-gap approach to an aid-development analysis. The growth-enhancing mechanisms of aid would thus include augmenting the levels of human and physical capital and bolstering an economy’s capacity to import capital goods while limiting conditions that incite declines in investments or savings (Morrissey, 2001). The ability of foreign aid to effectively achieve its prescribed objective remains a contentious issue in the policy arena and the academic arena. Whereas the prevailing view in the 1990s (e.g. see Boone, 1994, 1996) was that aid did not instigate growth in developing countries, the 2000s have witnessed a drift in perspective, signaling that ‘aid works’. Panel-based empirical studies10 have yielded evidence supporting the hypothesis of a positive aid effect on growth (Dalgaard, Hansen, & Tarp, 2004). The argument is far from conclusive; nevertheless, the idea that aid is universally effective is unfounded. For instance, while micro-based evaluations (Cassen & Associates, 1986) affrm the premise that ‘aid works’ in most scenarios, macro-based analyses have yielded largely equivocal outcomes, often fnding no signifcant aid effects on growth. Mosley (1986) terms the given dichotomy ‘the micro-macro paradox’. Dalgaard and Hansen (2001), however, attempts to resolve the paradox by estimating aggregate or macro returns on aid, in comparison to estimates of micro returns on individual investment projects. Aid investment productivity exceeds domestic investment productivity in relative terms. The evident disparity in fndings has been ascribed to a number of factors, including the distribution and quality of data found, sample size used, econometric methodologies employed, and the model of growth adopted (Doucouliagos & Paldam, 2009). Many inquires into the aid–growth framework either predate or fail to capture newer developments in growth theory. Many of these dated studies correlate negative growth with aid fows, without taking into account the direction of causation, the overall system of variables determining growth, or the aid counterfactuals (Addison, Morrissey, & Tarp, 2017). Thus, ‘aid’ must be incorporated into a system of robust growth specifcations if it is to yield any determinative effects on growth (Doucouliagos & Paldam, 2009). In the theoretical purview, the idea that aid yields ambiguous effects on growth is easily shown, as observed by Burnside and Dollar (2000). In a standardized neoclassical growth framework, steady-state effects are explained to depend not only on the type and amount of aid but also on how effciently aid is used by the recipient economy and the kinds of distortions it incites, if any (Karras, 2006). Employing a similar growth specifcation, Obstfeld (1999) explains that a country’s output, or steady-state capital stock, remains unaffected by lump-sum external aid; the latter only speeds

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up the adjustment to a steady state. For aid to yield nonzero steady-state effects on output, however, Obstfeld (1999) suggests making modifcations to the model. One such modifcation is espoused by Dalgaard et al. (2004), where the theoretical ambiguity of the aid effect on steady-state capital or output is affrmed in a simple overlapping-generations model. Clearly, the uncertainty surrounding the aid–growth relationship is resolvable only empirically, and as indicated earlier, an empirical consensus seems to be emerging in recent years. For instance, the notion that aid is largely ineffective (as earlier empirical studies suggest) is qualifed in the seminal paper by Burnside and Dollar (2000), who argue that aid, when combined with good trade, fscal, and monetary policies, could have positive effects on growth. In support, Holmgren, Kasekende, Atingi-Ego, and Ddamulira (1999) show that in the scenario of structural reforms and sound policies, aid has a strong positive effect on a country’s economic growth outcome. Real-world evidence of the given perspective is refected in the experiences of Ghana and Uganda. During the 1980s, when many developing countries pursued economic reforms to rehabilitate their striving economies, Ghana and Uganda were the most successful reformers and prominent aid recipients as well. In that era, macroeconomic indicators had plummeted distressingly, the culprit being gross economic mismanagement, exacerbated by civil war in Uganda (Rodrik, 1998). Grappling with severe economic diffculties, both economies recovered with continual growth, in the face of exponential increases in aid infows from both bilateral sources and multilateral sources (Tsikata, 1999; Holmgren et al., 1999; Aryeetey & Tarp, 2000). Montinola (2010) employing data on 67 developing countries, however, observes that although aid promotes fscal reform, the given impact is more pronounced in democratic economies, where the positive effect of aid on reforms rises with higher levels of democracy. Hansen and Tarp (2001), Dalgaard and Hansen (2001), and Jensen and Paldam (2003), however, present evidence suggesting that aid could have positive effects even in countries fraught with unfavorable policy environments. Thus, a positive impact of aid on growth does not depend on optimal policies, as prescribed by studies such as those by Burnside and Dollar (2000), Collier and Dollar (2002), and McGillivray, Feeny, Hermes, and Lensink (2006). A few studies also affrm that aid is ineffective at increasing economic performance, such as those byGriffn (1970), Griffn and Enos (1970), Weisskopf (1972), Easterly (2003), Easterly (2007a, 2007b) and Rajan and Subramanian (2008). Here aid is believed to have the following characteristics (Alemu & Lee, 2015): 1 It is fully exhausted. 2 It substitutes rather than complements domestic resources in the receiving country. 3 It interferes with domestic income distribution. 4 It incites the import of unimportant technology. 5 It generates greater ineffciencies and corruption in the governments of developing countries. Knack (2004) and Brautigam and Knack (2004) assert that, aid may actually worsen the effcacy of democratic institutions. Thus, large infusions of

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aid maybe undesirable. Another strand of literature – by Mosley (1980) and Mosley, Hudson, and Horrell (1987) – suggests that aid has had no impact on economic performance and growth. 6.5.2 Aid and poverty The developing world is signifcantly mired in chronic poverty, even after nearly six decades of continual aid infows. Currently, more than half of the world’s population subsists on less than USD2 a day, with limited access to good sanitary conditions; an approximate half of these estimated three billion people are in abject poverty, subsisting on less than UDS1 a day, and lacking access to potable water (Azam, Haseeb, & Samsudin, 2016). In subSaharan Africa, for instance, the extreme poor have persistently accounted for about 41% to 48% of the population, (Barrett, 2008). The controversies surrounding the effcacy of aid have been partly substantiated by these astounding fgures, as the principal objective of most external aid fows (particularly into the developing regions of the world) have been inclined towards poverty alleviation and growth. The original aid-development theory was premised on the hypothesis that aid infows into developing economies serve to relax the capital and investment constraints characteristic of countries in these regions. Aid, thus, enables these economies to reach their optimal or steady-state growth levels faster than they would otherwise. The continual growth creates avenues for continued poverty reduction (Ravallion & Chen, 1997). There is the possibility, however, of aid’s spurring growth without its necessarily translating into declining levels of poverty (Fosu, 2017). The alternate scenario is possible too, where aid could augment the standards of living of a given population (as poverty declines) but with no meaningful impact on the overall growth of the economy (Arvin & Barillas, 2002). That notwithstanding, there is a seeming swing in the focus of the international development community in recent times, where poverty alleviation is emphasized, as opposed to growth, in the economic development discourse (Asra, Estrada, Kim, & Quibria, 2005). For most donors now, growth in the developing world is valuable only if it can be construed as favorable to the poor (Mosley, Hudson, & Verschoor, 2004). Sachs and McArthur (2001) show that aid is effective at mitigating poverty and can translate into growth and development. Connors (2012) indicates that aid’s overarching objective of poverty reduction has good prospects of fueling economic growth and enhancing institutional reform, in addition to its fundamental goal of poverty mitigation. Riddell (2014) argues that aid, where extended directly or indirectly, could be instrumental in improving the lives of the people who are in most need of it. This contemporary perspective was well refected in the UN’s Millennium Development Goals (MDGs) and the sustainable development goals (SDGs). The World Bank, for instance, envisages a world devoid of poverty – an overarching view shared by its regional extensions, comprising the African Development Bank, the Asian Development Bank, the Inter-American Development Bank, and the International Monetary Fund (IMF). After the inception of

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the MDGs, some signifcant reductions in poverty have been recorded in some developing countries. In 2014, for instance, about 74 countries met the target of halving their poverty rates. Specifcally, the global proportion of extreme poverty dropped from 47% in 1990 to 22% in 2014, and the number of extremely poor people decreased from 1.92 billion in 1990 to 1.01 billion in 2010 (Wells, 2015). However, a noteworthy fraction of aid recipients presents limited evidence of economic development: poverty reduction, declining rates of unemployment, and stable income growth (Azam et al., 2016). Evidence suggests that rising external aid infows into these developing countries have been accompanied by increasing poverty and unemployment (Oduor & Khainga, 2009). In Africa, for example, over USD450 billion in external aid has been extended since the 1960s – commensurate to about six Marshall Plans – and yet they have yielded negligible outcomes in alleviating poverty (Sachs & Ayittey, 2009). Notwithstanding the positives of the MDGs, nearly one in fve people still survives on less than USD1.25 a day in developing countries, often fraught with vulnerable and politically fragile economic environments (Wells, 2015). These statistics quite validate the fact that the issue of extreme poverty has barely been surmounted. The Organization for Economic Cooperation and Development’s (OECD) review of the aid impact on economic development over a period of 25 years indicates that external aid has provided a minimal measurable contribution to mitigating extreme poverty, especially in the world’s rural regions (OECD, 1985). This was ascribed to the fact that external aid is often directed at countries dealing with highly challenging and intractable economic diffculties, including emergency conditions arising from conficts, natural disasters, and refugee infuxes and not necessarily at countries with high investment returns or prospects. In a similar vein, Connors (2012) discloses that, in practice, external aid has been largely ineffective at reducing poverty or occasioning market-based improvements in developing regions. Sachs and Ayittey (2009), therefore, stress the need to view aid as a supplement to market-led development and not as a substitute for the forces of supply and demand, especially in poor economies lacking in income, infrastructure, and creditworthiness. Ijaiya and Ijaiya (2004), in examining the aid–poverty relationship on a cross-country sample of sub-Saharan African economies, fnd no signifcant impact from aid on poverty reduction. The low income levels in these countries are believed to be contingent on the weak macroeconomic management condition in the region, as evidenced in the forms of bad governance, corruption, and political and economic instability. To improve the effectiveness of aid, however, some donors have adopted a selectivity arrangement, where aid agreements seemingly favor only those economies whose policy environments are in some sense already acceptable (Mosley et al., 2004). It is quite diffcult, however, to directly examine the aid effect on poverty across countries, as comparative cross-country data on poverty over time are scarce (Gomanee, Morrissey, Mosley, & Verschoor, 2005). Additionally, many poverty measures are income based, with limited cross-country comparability. Some studies in the literature have adopted

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indirect approaches with variables that strongly correlate with poverty, observing how they respond in the circumstance of aid. For instance, Gomanee et al. (2005) tests the hypothesis that aid contributes to increasing aggregate welfare, measured by infant mortality and the human development index (HDI), in 104 recipient countries over the period 1980–2000. The results show positive aid effects on the welfare indicators and even greater effects in low-income economies. Asra et al. (2005), however, obtain regression outcomes suggesting that on average, aid has been effective at mitigating poverty, under a variety of settings (in terms of both the policy atmosphere and the quality of governance), in an assortment of developing countries. Quite uncommonly, their study adopts poverty reduction as the metric for measuring aid effectiveness, as opposed to growth, in a panel model framework. The fndings signal the effectiveness of aid when it is relatively moderate, and an eventual decline in aid effectiveness when the volume of aid surpasses the critical value specifed by the absorptive capacity of the country. Collier and Dollar (2002) compare actual aid allocations to estimated poverty-effcient aid allocations, derived using the headcount, poverty-gap, and squared poverty-gap measures of poverty, to ascertain the allocation of aid that has maximum poverty-reducing effects. This optimal allocation depends on the quality of policies and the level of poverty. Collier and Dollar (2002) observe a disparity between the poverty-effcient allocation of aid and actual aid allocations. With respect to the countries studied, present (actual) aid allocations are observed to move an approximate ten million people out of poverty, annually. In the circumstance of poverty-effcient aid allocations, however, impacts such allocation are projected to be twice as effective. Sachs and Ayittey (2009), nevertheless, staunchly believe that developing regions, especially Africa, do not need foreign aid to assuage their economic diffculties, because, evidently, these regions have had minimal successes with aid-led development. To these authors, the idea of pumping more external aid into developing countries needs to be crucially reassessed. The plausibility of aid generating palpable declines in poverty is largely contingent on which meaningful reforms accompany the given aid infow. A more auspicious mechanism to ensure the effectiveness of aid would be one that empowers economic agents at the micro level (i.e. civil society and community-based groups) to monitor aid infows and engender reform from within (Sachs & Ayittey, 2009). 6.5.3 Aid and domestic resource mobilization Increasingly, domestic resource mobilization (DRM) is rightly becoming a development instrument for generating resources to fund long-term and inclusive economic development efforts. This is because the dwindling and the unpredictability of development assistance or aid in recent times mean that countries in developing countries must look inward for resources to support their economies. The surest way, therefore, for developing countries to reduce aid dependency cycle is to develop their respective capacities to mobilize enough domestic resources to fnance public goods and

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other developmental needs. Thus, developing countries must increase the amount of their own funds available for development fnance (i.e. DRM), in particular by increasing tax revenues. This remains a major challenge for low-income countries (LICs), where revenue/GDP ratios are signifcantly lower than those in developed countries, largely because of weak tax efforts, weak tax administrations, and low taxpayer morale, corruption, and poor governance (OECD, 2014). The key question, however, is whether LICs dependent on aid will encourage or discourage their tax efforts and thus have any infuence on domestic revenue mobilization. While there is no straightforward answer to this question, theory shows that although there are many ways that aid can have indirect effects on tax revenue, the direct effects arise because aid and tax are alternative sources of revenue and political economy factors infuence the choices made by governments (Morrissey, 2015). In general, the theoretical literature outlines three channels in which aid may have effects on tax revenue. First, aid can have indirect effects on revenues in that aid has macroeconomic effects and in that tax revenues are affected by macroeconomic performance. For example, if aid is effective in supporting growth, then revenue should increase in line with an expanding tax base (indicating growth-enhanced tax revenue or the buoyancy of the tax system). Second, aid may have direct effects on fscal revenues in that most aid fnances public goods and services, and therefore, it may substitute for efforts to raise tax revenue or, for a given level of tax, support a higher level of government spending. In this view, such direct effects relate to the amount of aid relative to the level of taxation. Third, technical advice on policy reforms and conditionalities associated with aid that underlines the broader donor–recipient relationship can affect tax revenue. This viewpoint contends that providing support for tax administration or policy reform may increase revenue; however, other policy reforms, such as tariff reductions as part of trade reforms, may reduce revenue, at least in the short term (Morrissey, 2015). Although some empirical studies (Osei, Morrissey, & Lloyd, 2005; Moore, 2014; Ahlerup Baskaran, & Bigsten, 2015) have found that grants or aid were associated with increased tax revenue through tax reforms that reduce the bureaucratic costs of taxation, others (such as Gupta, Clemens, Pivovarsky, & Tiongson, 2004; Carter, 2013; Benedek, Crivelli, Gupta, & Muthoora, 2012) have empirically found that aid reduces tax efforts and tax revenues, largely because it increases pervasive incentives. However, Morrissey (2015) argues that this negative effect of aid on tax efforts is because developing countries often receive aid or grants not because they have a low tax base and relatively low revenue but because they are poor – hence the observed correlation between high aid and low tax. According to this viewpoint, theoretical considerations show that any effect of aid on tax refects a revenue choice that will vary across countries depending on political economy factors. Expanding on the previous point, Morrissey (2015) observes that the effect of aid on tax varies from one country to another, which depends on

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the nature of political economy that pertains in the country. For example, Morrissey and Torrance (2015) contend that the effect depends on how a government values autonomy, accountability, and bureaucratic costs associated with aid as well as administrative costs of tax reforms. In this regard, a government that values autonomy and wants to be less dependent on aid will choose more tax effort. This is because the requirements of being accountable to donors and negotiating conditionality reduce the autonomy of aid recipients by limiting their policy discretion; even limited conditionality is a constraint on policy action (if only because effort has to be expended to avoid or circumvent the conditions) (Morrissey, 2015). Governments can therefore be expected to prefer greater autonomy and reduce ‘donor capture’ by taking steps to reduce aid dependency. Moreover, Altincekic and Bearce (2014) argue that because aid is subject to conditionality and is less fungible than oil resource revenues in particular, governments are more likely to raise domestic resource revenues than aid if they want control over how revenues are managed. The literature seems to suggest that there is an aid Laffer curve. Lensink and White (2001), comparing aid fows in the 1990s with those from the 1970s, make clear that there are now many more countries receiving what may be termed ‘high aid’ (in excess of 30% of GNP) and that a group of countries that receive very high aid has emerged. In their view, such high aid may do more harm than good, a notion which they captured as an aid Laffer curve. Their elaborate empirical paper also presents an endogenous growth model, which exhibits negative returns to aid at high aid levels and offers some additional reasons why such a phenomenon may exist. Their result is quite similar and consistent with a conclusion reached by Griffn (1970), who argued that aid would reduce the productivity of investment such that if this effect were suffciently large, then aid would reduce growth. The difference here is that unlike the Lesinki and White model, Griffn (1970) suggest a general nonlinear relationship between aid and growth. According to them, the diminishing returns to aid-fnanced government expenditure in the production function means that the negative effect becomes present only after some threshold value has been surpassed. Box 6.1 contains more about the Lensink and White aid Laffer curve.

BOX 6.1 The aid Laffer curve Lensink and White (2001) explored the possibility that aid may not have merely decreasing returns (a proposition that everyone would surely accept) but that after a certain level the returns to further aid inflows are negative. The idea that a country can get ‘too much aid’ can be shown by an aid Laffer curve (see Figure 6.3). The horizontal axis measures aid and the vertical beneficial effects. The curve is an inverted U; that is, after a certain threshold, more

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FIGURE 6.3 The aid Laffer curve Beneÿcal effects

Aid Source: Lensink and White (2001)

aid is detrimental rather than beneficial, so the country would be better off with less aid. The paper begins by illustrating that the number of countries receiving high aid infows (measured in relation to either their GNP or their population) has increased over time and draws the following conclusion: some countries are now quite clearly ‘very high aid recipients’, which was not so clear in the 1970s. Is all this aid a good thing? More specifcally, is it possible that there is a point at which a country would be better off with less aid rather than more? That this may be so is a notion we embody in the aid Laffer curve. Moreover, both the incorporation of aid fows into an endogenous growth model, and an examination of existing literature on aid effectiveness, give grounds for thinking that mechanisms may well exist which would cause an aid Laffer curve to be observed in practice. Our empirical estimation bears this out. The policy conclusions of our analysis may seem very clear: place a ceiling at aid around the top of the aid Laffer curve. Any country receiving more should lose this excess, which should be redistributed to countries in which aid will be effective. However, while we have sympathy with this conclusion, we would urge some caution in that attention should also be paid to special circumstances (e.g. short periods of high emergency aid or debt relief), the type of aid, and the possibilities of increasing aid effectiveness at all levels of aid. Lensink and White (2001)

According to most multilateral donor agencies, such as the World Bank and the IMF, the revenue generation potential in LICs, such as in some

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countries in Africa, has not been suffciently tapped by revenue authorities, which explains their overreliance on aid. Not only have these donors directly provided technical assistance, but also their consultation missions have issued several country assessment reports and recommended measures such as tax policy reforms, revenue administration measures, spending controls, and improved cash management, all aimed at improving the countries’ respectively capacities to collect eligible taxes to fnance their respective national budgets. In June 2012, the IMF Fiscal Affairs Department (FAD), which assessed the implementation status of tax administration reforms in Ghana, made several recommendations: modernization of governance, policy and program designs and monitoring, taxpayer selfassessment, and compliance management. In sum, although the effect of development assistance on long-term domestic revenue mobilization is uncertain, there is now a consensus that that aid must also be aimed at supporting the recipient country’s domestic tax mobilization effort. And continued reliance on aid in the long term may have negative repercussions on DRM (IMF, 2011). 6.5.4 Aid uncertainties and conditionalities While much of the aid-effectiveness literature has focused on the aid– growth relationship, recent studies have pointed out that the relationship is not straightforward and that the potency of aid in driving growth to a large extent depends on how stable or predictable aid is. Lensink and Morrissey (2000) posit that it is not the level of aid fows per se but rather the stability of such fows that determines the impact of aid on economic growth. They point out that such uncertainty in aid fow infuences the relationship between aid and investment; infuences how recipient governments respond to aid; and therefore infuences how aid affects growth. Estimating a standard cross-country growth regression, including accounting for the level of aid and aid uncertainty (which is negative and signifcant), they fnd that aid has a signifcant positive effect on growth. This suggests that aid will only positively infuence growth and will be effective if it is stable. While evidence in support of the negative effect of unpredictability of aid on aid management by recipient countries is overwhelming, few studies have also argued that such a signifcant share of such unpredictability patterns can be associated with factors that are close proxies for major changes in a country’s environment and therefore justify, if not necessitate, some degree of unpredictability in donor behavior. For example, Celasun and Walliser (2007) argue that while low predictability always results from donors’ not delivering on their original promises (i.e. the ‘donors never live up to their commitments’ view) country conditions that need to prevail for aid to be used effectively also explain the extent of unpredictability and explain why fckle donor behavior may be just one cause of commitment deviations or projection deviations from actual outcomes. The changing conditionalities attached to aid also matter. Montinola (2010), defning ‘aid conditionality’ as the setting of policy goals in exchange

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for access to aid, investigates whether aid conditionality promotes reform and whether the recipient regime type matters. Focusing on the impact of IMF and World Bank aid on fscal reform in 68 countries, he argues that conditional aid is effective but that its effcacy depends on recipient countries’ level of democracy. This is because the value of aid to governments depends on the degree to which it helps them maintain power, and recent work shows that the marginal impact of aid on political survival increases with the level of democracy (Montinola (2010). Aid conditionality may not necessarily result in policy reforms because governments are often unwilling to carry out the required policy changes – because they view the conditions to be inappropriate or fear that the reforms may endanger the political support they get from society (Hermes & Lensink, 2001). In most cases, recipient governments agree on adhering to the conditions ex ante to obtain the fnancial aid without really supporting the contents of these programs. According to Hermes and Lensink (2001), this is the result of the fact that the contents are being set by World Bank representatives or donors without the active involvement of recipient governments and civil society, so these governments do not own the reforms. Box 6.2 contains the other causes for the nonimplementation of conditionality or why it may not infuence reforms suggested in the literature.

BOX 6.2 Aid, conditionality, and good governance Aid conditionality has been the normal practice for the past decades. Bilateral as well as multilateral donors aim at achieving specifc objectives and outcomes when giving aid. The idea is that setting conditions related to the disbursement of aid should provide incentives to the recipient government to stimulate them to take actions or to carry out policies that increase the probability of obtaining these objectives and outcomes. In other words, conditionality should help to increase the effectiveness of giving aid. Yet conditionality has been disputed. Especially since the early 1980s, when the IMF and World Bank started to provide structural adjustment loans conditional on changes in government policies, conditionality has come under scrutiny, largely because the outcomes of the structural lending programs were rather disappointing and, according to some observers, even harmful to economic development. The initial reaction of the IMF and World Bank to the lack of success of conditionality was to increase the number of conditions in the program and to shorten the period over which the program was to be executed and evaluated. The aim of such a redefnition of conditions was to further stimulate recipient governments to carry out the required reforms. Yet the results of policy reforms remained bleak in most cases. Most observers do not criticize the principle of imposing conditions on aid as such. What they criticize is the nature of the conditions imposed on recipient governments and the way donors decide on selecting these conditions

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(Killick, 1996, 1997; Hermes & Schilder, 1997; White & Morrissey, 1997; Dijkstra, 1999). Several critics point out that the main reason for the failure of aid to be effective is that recipient governments in practice do not adhere to the conditions. One of the main causes for the nonimplementation of conditionality suggested in the literature is that failure is only rarely penalized, for instance by suspending or even stopping aid disbursements. Donors have their own incentives to continue disbursing aid, even when reforms have not been carried out. For instance, donors may feel pressured to give aid to prevent further macroeconomic deterioration or defaults on loans and debt services. Moreover, inappropriate incentives to staff of donor organizations may reward high funding levels or punish nondisbursement by reducing next year’s budgets. Such incentives reduce the donors’ credibility and will undermine the incentives of recipient governments to implement policies. Hermes and Lensink (2001)

6.5.5 Aid and corruption Another issue that has engaged the attention of researchers and donor community is whether aid fuels the incidence of corruption in aid-recipient countries.11 This question remains relevant in development economics discourse because, despite a large body of writings that has emerged on the corrosive effect of corruption that undermines the effectiveness of aid, the empirical literature is inconclusive, and the direction of causation remains unresolved. Anecdotal evidence from available cross-country data appears to suggest that LICs that have received the most aid had scores that are way lower on the transparency international corruption perception index than those countries receiving less aid. A cursory look at Figure 6.4 in Box 6.3 appears to support this point.

BOX 6.3 Global 2017 CPI score and ranking The corruption perception index (CPI)  – which orders 180 countries and territories by their apparent levels of public sector corruption according to knowledgeable people and people in commerce with the aid and scores using a 0 to 100 scale, where 0 denotes highly corrupt and 100 clean – suggests that corruption is highly associated with poverty-stricken and underdeveloped countries, most of which are recipients of large amounts of aid. Figure 6.4 indicates that over 90% of countries in sub-Saharan Africa are ranked above 80 or higher in the global CPI ranking of countries.

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FIGURE 6.4 Global 2017 CPI score and ranking 2017 Ranking

CPI Score 178

57 41

85 16

NZL SGP GBR AUT EST BTN TWN POL VCT GEO KOR SVK ROU HUN BGR TUN GHA BEN ALB BRA THA TZA PHL NER TGO MWI IRN HND PRY LBN NIC CAF KHM ERI PRK YEM

200 89 180 160 140 120 100 80 60 40 20 0

100 90 80 70 60 50 40 30 20 10 0

Source: Authors’ creation, on the basis of data from Transparency International

Morrissey (2015) contends that although the question whether aid affects corruption is not easy to address, donor technical support and institutional interventions for monitoring tax and public expenditure are intended to reduce corruption in public fnance but may be most effective for aid funds. The study further posits that aid may lessen corruption on the basis that aid is least attractive for corrupt people, because it is subject to greater monitoring by donors; corruption involving donor funds is more likely to be observed and investigated. Furthermore, some study fndings have concluded that aid might beneft governance by reducing corruption as it might not only possibly help recipient countries implement far-reaching institutional reforms but also help increase the salaries of civil servants (Alesina & Weder, 2002; Tavares, 2003; Charron, 2011). Providing empirical insights into the impact of foreign aid on corruption levels in SSA countries, Mohamed, Kaliappan, Ismail, and Azman-Saini (2015) support this standpoint by concluding that foreign aid reduces the corruption levels of SSA countries. According to them, although aid from different bilateral sources has different effects on corruption, the effect is likely to be greater in nations that experience a higher level of corruption. On the contrary, while empirical studies such as that by De la Croix and Delavallade (2014) suggest that aid infuences corruption in recipient countries, studies such as that by Mernard and Weill (2016) fnd no correlation between aid and corruption. Despite these fndings, recent review studies by Quibria (2017) point out that the negative impact of aid on corruption appears to enjoy greater support in recent literature because of the strong desire of the international development community to improve the development impact of foreign aid, and it has therefore taken a frm stance against corruption. This review suggests that these measures have had a substantial impact on combatting corruption in aid-recipient countries. Key among some of these measures is performance-based lending, where the multilateral development banks (MDBs), such as the World Bank, base their aid allocation in part on

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indicators of corruption. Bilateral donors, such as the Millennium Challenge Corporation of the United States government, have made anticorruption central to their aid-allocation process. Another important measure that donors have adopted is improving the transparency and accountability of recipients. In addition to addressing their own accountability, bilateral and multilateral agencies have sought to improve the transparency and accountability of recipients (Quibria, 2017). These activities include support for creating anticorruption commissions, building investigative and judicial institutions, implementing new public procurement systems, and improving public fnancial management practices.

6.6 CONCLUSION The considerable volume of foreign development assistance aimed at stimulating economic development, particularly in sub-Saharan Africa, has not been entirely effective. Indeed, the aid-effectiveness literature reports mixed results. The role of foreign aid in alleviating poverty and facilitating longterm growth has been largely disappointing over the past fve decades. We provide a number of suggestions to go beyond aid. Here the argument is that developing countries, and mostly those in sub-Saharan Africa, cannot continue to expect or rely on foreign assistance to engender economic growth and development, given the dismal development outcomes over the past fve decades. We suggest that countries re-double their efforts to mobilize domestic resources to generate the capital required for funding investment. The reality, though, is that domestic tax bases are often small because a considerable portion of the economies are outside the formal sector. The low output and productivity of the informal sectors makes the cost of tax administration aimed at bringing the sector into the tax net quite exorbitant. Such countries need to transform the informal sector into a formal sector. Innovative development fnance options that are increasingly becoming available need to be harnessed to generate funds to support domestic economic development efforts. Institutional reforms and the creation of new and progressive institutions that support development ought to be encouraged as well. The illicit outfow of capital from the developing world and renewed efforts aimed at fghting corruption would all contribute to increasing the pool of resources required to fund development.

Discussion questions 1 Discuss the argument for and against aid given by developed countries to developing countries. Do you support the critics’ view that aid has worsened poverty levels of aid-recipient countries rather than alleviated them?

2 Explain the arguments for and against external aid. What policy and implement reforms are relevant to an effcient aid package? 3 ‘Political and strategic considerations more than economic development underlie donor’s aid

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4 5

6

7

allocation’. How valid is this statement in light of the effectiveness of aid in developing countries? Why does predictability matter in aid effectiveness and growth? To what extent has foreign aid succeeded in assuaging the economic diffculties of the developing world? In recent times, how has foreign aid fared in combatting the twin challenges of low domestic savings and reduced foreign exchange infows in developing countries? Some recent studies have indicated that aid works in a sound macroeconomic environment. Discuss the economic conditions needed for aid to thrive. Are there any real-world examples of

countries that have experienced palpable growth in the face of aid, complemented by structural reforms and sound policies? 8 Increasing external aid infows to developing regions has not translated into declining poverty and unemployment. What are some possible reasons for the observed situation? 9 What are the indicators of an economy’s absorptive capacity, which determines how much aid is enough to yield effective results? Is there a threshold after which additional infows of aid yield ineffective results? 10 Is there an amount of aid that yields maximal poverty-reducing effects? How do we ascertain this threshold? Is it country specifc?

Notes 1 Although the loan component of ODA is payable over time at favorable interest rates, which are often considerably lower than market rates, grants are not payable. 2 CARE  – Cooperative for American Remittances to Europe, which was later rechristened the Cooperative and Relief for People Everywhere  – was formed in 1945 to provide humanitarian assistance to countries in postwar Europe. It did not begin operations in Africa until the 1960s. 3 OXFAM  – Oxford Committee for Famine Relief  – was formed in 1942. Initially, the group focused on mobilizing relief to support starving women and children in enemy-occupied Greece, which was facing a British naval blockade during the war. 4 The top three recipients of US foreign aid are Afghanistan, Israel, and Egypt. Afghanistan is the top now because of the antiterrorism

5

6

7

8

war being fought in the country. Historically, Israel and Egypt have been the top recipients in per capita terms, for US strategic interests. A recipient country of Chinese aid cannot have a diplomatic relationship with Taiwan or recognize the Dalai Lama as the spiritual leader of the Tibetan people. The number of Chinese workers in Africa in 2014 was estimated at 252,000 by offcial Chinese sources, as quoted by the AfricaChinese Research Initiative. Lamisi Solido, the one-time governor of the Nigerian central bank, admonished African countries: ‘China is capable of the same forms of exploitation as the West. . . . Africa is now willingly opening itself up to a new form of imperialism’. Members include Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, European Union, Finland, France, Germany,

Chapter 6 • Foreign aid and economic development 163 Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Slovenia, Sweden, Switzerland, the United Kingdom, and the United States. 9 The IDA is the development fnance institution of the World Bank that focuses on the poorest countries of the world. 10 See Dowling and Hiemenz (1983), Singh (1985), Levy (1988), Hadjimichael et al. (1995), Burnside and Dollar (1997), Burnside and

Dollar (2000), and Hansen and Tarp (2001). 11 Corruption may mean different things to different people, organizations, and countries. Transparency International, a global anticorruption coalition, defnes it simply as ‘the abuse of entrusted power for private gain’. The World Bank, however, provides a slightly more detailed defnition: a form of deceit by people occupying positions of infuence, in an effort to amass wealth.

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Hjertholm, P., & White, H. (1998, October 9–10). Survey of foreign aid: History, trends and allocation. A paper presented at the Foreign aid and development: Lessons of experience and directions for the future. Institute of Economics, University of Copenhagen, Copenhagen. Hoeffer, A., & Outram, V. (2011). Need, merit, or self-interest: What determines the allocation of aid? Review of Development Economics, 15(2), 237–250. Holmgren, T., Kasekende, L., AtingiEgo, M., & Ddamulira, D. (1999). Aid and reform in Uganda: Country case study. Research Series 23. Kampala: World Bank. Huber, E. (2012). Offcial development assistance: Emerging outreach. Retrieved February 14, 2020, from www.dandc. eu/en/article/brazil-emergingdonor-development-aid IDA. (2007, February). Aid architecture: An overview of the main trends in offcial development assistance fows. International Development Association, Resource Mobilization. Washington, DC: World Bank. Ijaiya, G. T., & Ijaiya, M. A. (2004). Foreign aid and poverty reduction in sub-Saharan Africa: A cross-country investigation. South African Journal of Economic and Management Sciences, 7(3), 542–552. IMF. (2011). Revenue mobilization in developing countries (p. 5). Fiscal Affairs Department. Retrieved from www.imf.org/ external/np/pp/eng/2011/030811. pdf Jensen, P. S., & Paldam, M. (2003). Can the new aid-growth models be replicated? Working Paper No. 2003–17. Aarhus: Institute for Economics. Karras, G. (2006). Foreign aid and long‐run economic growth: Empirical evidence for a panel of developing countries. Journal of International Development, 18(1), 15–28. Killick, T. (1996). Principals, Agents and the Limitations of BWI Conditionality’, The World Economy, 19(2), 211–29. Killick, T. (1997). Principals, Agents and the Failings of Conditionality’,

166 Matthew Kof Ocran et al. Journal of International Development, 9(4), 83–95. Knack, S. (2004). Does foreign aid promote democracy? International Studies Quarterly, 48, 251–266. Lamido, S. (2013, March 11). Africa must get real about Chinese ties. The Financial Times. Retrieved from www. ft.com/content/562692b0-898c-11e2ad3f-00144feabdc0 Leffer, M. P. (1988). United States and the strategic dimensions of the Marshall plan. Diplomatic History, 12(3), 277–306. Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. Journal of Development Studies, 36, 31–49. Lensink, R., & White, H. (2001). Is there aid Laffer curve? Credit Research Paper No. 99/6. Nottingham: University of Nottingham. Levy, V. (1988). Aid and growth in subSaharan Africa: The recent experience. European Economic Review, 32, 1777–1795. McKinlay, R., & Little, R. (1977). A foreign policy model of US bilateral aid allocations. World Politics, XXX(1), 58–86. McKinlay, R., & Little, R. (1978). A foreign policy model of the distribution of British bilateral aid, 1960–70. British Journal of Political Science, 8(3), 313–331. McGillivray, M., Feeny, S., Hermes, N., & Lensink, R. (2006). Controversies over the impact of development aid: It works; it doesn’t; it can, but that depends ... . Journal of International Development, 18(7), 1031–1050. Mernard, A. R., & Weill, L. (2016). Understanding the link between aid and corruption: A causality analysis. Economic Systems, 40(2), 260–272. Mesquita, B. B., & Smith, A. (2007). Foreign aid and policy concessions. Journal of Confict Resolution, 51(2), 251–284. Mohamed, M., Kaliappan, S., Ismail, N., & Azman-Saini, W. (2015). Effect of foreign aid on corruption: Evidence

from sub-Saharan African countries. International Journal of Social Economics, 42(1), 47–63. Montinola, R. G. (2010). When does aid conditionality work? Studies in Comparative International Development, 45(3), 358–382. Moore, M. (2014). Revenue reform and statebuilding in anglophone Africa. World Development, 60, 99–112. Morgenthau, H. (1962). A political theory of foreign aid. American Political Science Review, 56(2), 301–309. Morrissey, O. (2001). Does aid increase growth? Progress in Development Studies, 1(1), 37–50. Morrissey, O. (2015). Aid and domestic resource mobilisation with a focus on sub-Saharan Africa. Oxford Review of Economic Policy, 31(3–4), 447–461. doi:10.1093/oxrep/grv029 Morrissey, O., & Torrance, S. (2015). Aid and taxation. In B. M. Avin & B. Lew (Eds.), Handbook on the economics of foreign aid (Ch. 31). Cheltenham: Edward Elgar. Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79–95. Mosley, P. (1986). Aid‐effectiveness: The micro‐macro paradox. IDS Bulletin, 17(2), 22–27. Mosley, P., Hudson, J., & Horrell, S. (1987). Aid, the public sector and the market in less developed countries. Economic Journal, 97(387), 616–641. Mosley, P., Hudson, J., & Verschoor, A. (2004). Aid, poverty reduction and the new conditionality. The Economic Journal, 114, F217–F243. Nath, S., & Sobhee, S. K. (2007). Aid motivation and donor behavior. American Review of Political Economy, 5(1), 1–13. Obstfeld, M. (1999). Foreign resource infows, saving, and growth. In K. Schmidt-Hebbel & L. Serven (Eds.), The economics of saving and growth: Theory, evidence, and implications for policy (pp.  107–146). Cambridge: Cambridge University Press. Oduor, J., & Khainga, D. (2009). Effectiveness of foreign aid on poverty reduction

Chapter 6 • Foreign aid and economic development 167 in Kenya. GDN Working Paper Series, Working Paper No. 34. Retrieved from www.gdn.int/sites/default/ files/WP34-Kenya-Foreign_AidPoverty_009.pdf OECD. (1985). Twenty fve years of development cooperation: A review (p.  18). Paris: OECD Publishing. OECD. (2006). DAC in dates: The history of OECDs development assistance committee. Paris: Development Assistance Committee. Retrieved March 14, 2018, from www.oecd.org/ dac/1896808.pdf OECD. (2014). Development co-operation report 2014: Mobilising resources for sustainable development. Paris: Author. doi:10.1787/dcr-2014-en OECD. (2017).DAC database. Retrieved February 5, 2017, from www.oecd.org/dac/ financing-sustainable-development/ development-fnance-data OECD. (2018). Total offcial and private fows (indicator). Paris: Author. Retrieved February 28, 2018. doi:10.1787/ 52c1b6b4-en Osei, R., Morrissey, O., & Lloyd, T. (2005). The fscal effects of Aid in Ghana. Journal of International Development, 17(8), 1037–1054. OXFAM. (n.d.). Smart development practice  – the tied aid ‘round trip’. Retrieved from www.oxfamamerica. org/static/media/files/aidnowtiedaidroundtrip.pdf Porter, D. M., & Van Belle, D. A. (2009). News coverage and Japanese foreign disaster aid: A comparative example of bureaucratic responsiveness to the news media. International Relations of the Asia-Pacifc, 9(2), 295–315. Quibria, M. J. (2017). Foreign aid and corruption. Georgetown Journal of International Affairs, 18(2), 10–17. Quirk, P. W. (2014). (Re)emerging aid donors in the reshaping world order: How to calibrate U.S. and European foreign assistance to secure transatlantic interests. 2013–2014 Paper Series No. 5. Washington, DC: Transatlantic Academy.

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CHAPTER

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Global fnancial architecture Emerging issues and agenda for reforms Joshua Yindenaba Abor, Angela Azumah Alu, David Mathuva, and Joe Nellis 7.1 INTRODUCTION In this chapter, we discuss the global economic and fnancial system and the governance structure that facilitates the fow of external capital in it. This is known as the global fnancial architecture or international fnancial architecture. Global fnancial policies and international institutions are an important part of this framework, which ensures the provision of development fnance. The global fnancial architecture is the collective of governance arrangements at the global level for safeguarding the effective functioning (or the stability) of the global fnancial system (Elson, 2010). It is the worldwide framework of global economic and fnancial governance, including legal agreements, institutions, and economic actors that work together to facilitate the international fows of capital for fnancing investments and trade. It is composed of the Bretton Woods institutions, including the International Monetary Fund (IMF), the World Bank Group, the World Trade Organization (WTO), the Bank for International Settlements (BIS), and the regional development fnance institutions in developing and emerging countries. It also involves those institutions and mechanisms that have evolved with the responsibility of preventing, managing, and resolving fnancial crises at the global level. The prevention and the management of fnancial crises are signifcant parts of the global fnancial governance process and for that matter the global fnancial architecture. Financial governance is a key requirement for the provision of fnancial resources for development. Issues regarding reforms of international institutions are also important in the global fnancial architecture discourse. In this chapter, we examine the institutions that make up the global fnancial architecture. We frst discuss international fnancial institutions and examine the evolution, structure, and functions of the various Bretton

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Woods institutions. We also examine other global fnancial institutions by discussing their roles and challenges. Then, we look at fnancial globalisation, global crises, and reform issues regarding the global fnancial architecture. We also look briefy at the G7/G10 and G20 and the UN sustainable development goals (SDGs).

7.2 INTERNATIONAL FINANCIAL INSTITUTIONS International fnancial institutions (IFIs) are fnancial institutions that are set up by two or more countries with the aim of fnancing the social and economic development of different countries and promoting international economic cooperation and stability. IFIs are involved in providing advice on development projects, fnancing them, and assisting with the implementation of these projects. IFIs are different from local fnancial institutions in one main respect: IFIs have an international presence and are therefore subject to international law. IFIs include the IMF, the World Bank Group, and other multilateral fnance institutions, including multilateral development banks and regional development banks (RDBs). Although RDBs are part of the multilateral fnancial institutions, they tend to focus on specifc regions of the world. Whereas the Bretton Woods institutions have an international orientation, the RDBs tend to focus on a single or specifc region. The multilateral fnancial institutions are seen as mainly multilateral development fnance institutions (DFIs), and the regional development banks are regarded as regional DFIs. We frst discuss the Bretton Woods institutions and then examine the other global DFIs, including multilateral development banks, multilateral fnancial institutions, and the RDBs. 7.2.1 The Bretton Woods institutions The Bretton Woods system emerged after 1944, when the UN Monetary and Financial Conference took place in Bretton Woods, New Hampshire. After the Second World War, the Bretton Woods system was established and named after the New Hampshire town where they drew up the agreements. This was with the aim of setting up an international economic and fnancial system that would reduce instability (with respect to competitive currency devaluation and trade restrictions) and support development. It established an international basis for which one currency could be exchanged for another. Although the Bretton Woods system came into being following the Great Depression and after the Second World War, it dealt with the global challenges that started during the First World War, including trade restrictions, currency devaluation, defation, and the depression that characterised the global economy of the 1930s. The process also led to the establishment of the three Bretton Woods institutions by representatives of the 44 countries. Bretton Woods institutions included the IMF, the International Bank for Reconstruction and Development (IBRD) (now the World Bank), and the General Agreement on Trade and Tariffs (GATT), which metamorphosed into the WTO. Two economists,

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John Maynard Keynes from the United Kingdom and Harry Dexter White from the United States, played critical roles in the negotiations and process of establishing these institutions. The US and the UK were therefore the key stakeholders in these negotiations. Each of these institutions was tasked to perform specifc functions under the new global economic and fnancial governance system. The IMF was established with the objective of monitoring foreign exchange rates and providing lending on reserve currencies to countries with trade defcits. The IBRD (now World Bank) was supposed to provide underdeveloped countries with the required capital, while the GATT (now WTO) was established to focus on international economic cooperation. Over the years, the roles of these institutions have changed, and we discuss these developments later. The IMF, which has its headquarters in Washington, DC, was established in 1945 with the intent of creating a stable environment for international trade. This was to be achieved by coordinating member countries’ monetary policies and ensuring stability in exchange rates. The fund’s role in ensuring exchange rate stability involved setting a fxed exchange rate system that had other currencies pegged to the US dollar, which was also pegged to gold at USD35 per troy ounce. The IMF was therefore required to offer short-term fnancial support to countries that had diffculties with their balance of payment (BOP). The IMF came into formal existence on 27 December 1945, when 29 countries signed its Articles of Agreement. Member countries were supposed to contribute funds through a quota system to fnance the IMF’s activities, and the size of the quota assigned to each country was based on the country’s gross domestic product (GDP). The quota for each country determined how much IMF fnancing it could access in addition to its voting rights in the fund. Member countries had 250 ‘basic votes’, each in addition to one more vote for each USD100,000 of quota (later changed to 100,000 special drawing rights [SDRs]). The allocation of the basic votes was intended for ensuring that smaller member countries had a say in the fund’s decision-making processes (Spratt, 2009). The board of governors currently govern the IMF and is made up of one governor and one alternate governor, representing their respective member countries. Two important committees (the International Monetary and Financial Committee and the Development Committee) advise the board of governors. The International Monetary and Financial Committee, which has a membership of 24, is in charge of monitoring developments with respect to global liquidity and the transfer of resources to developing countries. The Development Committee has a membership of 25 and a mandate of advising on critical development matters and providing recommendations on fnancial resources needed for promoting economic development in developing countries. It also has the responsibility of advising on issues regarding trade and environment. The IMF has a managing director who serves as the head of the staff and as the chair of the 24-member executive board. The managing director has a number of deputies, including the frst deputy-managing director and three other deputy-managing directors.

7.2.1.1 INTERNATIONAL MONETARY FUND (IMF)

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The IMF is accountable to the 189 member countries. It currently has 31 Articles of Agreement covering a range of issues: purposes, membership, quotas and subscriptions, obligations regarding exchange arrangements, operations and transaction of the fund, capital transfers, the general obligations of members, organisation and management, SDRs, the withdrawal from membership, emergency provisions, and amendments. Since its establishment in 1945, the Articles of Agreement have gone through a series of revisions. However, Article I, which mentions the purposes of the IMF, has not been changed and includes the following objectives:1 1. To promote international monetary cooperation through a permanent institution that provides the machinery for consultation and collaboration on international monetary problems. 2. To facilitate the expansion and balanced growth of international trade and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy. 3. To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. 4. To assist in the establishment of a multilateral system of payments in respect to current transactions between members and in the elimination of foreign exchange restrictions, which hamper the growth of world trade. 5. To give confdence to members by making the general resources of the fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without their resorting to measures destructive to national or international prosperity. 6. In accordance with the foregoing objectives, to shorten the duration and lessen the degree of disequilibrium in members’ international balances of payments. FIGURE 7.1 Representation of Article 1 of the IMF

(I) To promote internaonal monetary cooperaon through a permanent instuon which provides the machinery for consultaon and collaboraon on internaonal monetary problems.

(II) To facilitate the expansion and balanced growth of internaonal trade, and to contribute thereby to the promoon and maintenance of high levels of employment and real income and to the development of the producve resources of all members as primary objecves of economic policy.

(III)To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid compeve exchange depreciaon.

(IV) To assist in the establishment of a mullateral system of payments in respect of current transacons between members and in the eliminaon of foreign exchange restricons, which hamper the growth of world trade.

(V) To give confdence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorng to measures destrucve of naonal or internaonal prosperity.

(VI) In accordance with the above, to shorten the duraon and lessen the degree of disequilibrium in the internaonal balances of payments of members.

Source: Authors’ construction

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The IMF’s role has evolved over time. At the time of its establishment, it focused on ensuring that the fxed exchange rate system introduced by the Bretton Woods system was maintained to facilitate international trade. After the breakdown of the fxed exchange rate regime in the early 1970s, fresh justifcation needed to be made for the continuous existence of the IMF. The IMF metamorphosed into an organization charged with managing BOP problems and global fnancial crises. It contributes to improving the economies of member countries through such activities as surveying, gathering statistics and analysis, surveilling members’ economic and fnancial performance, and demanding particular policies. The IMF’s surveillance entails overseeing the global monetary and fnancial system and monitoring the economic and fnancial policies of the member countries. It also focuses on providing technical assistance and training for countries, upon request. The IMF also serves as a ‘lender of last resort’ when a borrowing country has exhausted all other funding sources. The assistance given by the IMF usually proceeds in stages. There is an initial stopgap loan with strict rules, infamously known as an IMF conditionalities After that, consultations decide on what fscal and monetary policies the country must follow. The IMF usually advocates for the removal of state subsidies, the privatisation of state industries, the liberalisation of trade and foreign investment policies, reforms in the banking sector, and reforms in the tax laws of the country. In its assessment, the IMF notes the country’s trade balance, current account balance, real domestic demand, consumer price levels, and real GNP or GDP. For instance, as discussed in some detail in Box 7.1, Ghana entered into an IMF programme involving a three-year USD918 million extended credit facility (ECF) from the IMF in April 2015.

BOX 7.1 IMF three-year extended credit facility to Ghana In April 2015, Ghana received approval from the IMF for a three-year USD918 million extended credit facility (ECF) to support a reform programme with the aim of restoring Ghana’s debt sustainability and macroeconomic stability, in order to promote faster growth and job creation and at the same time to protect social spending. Before signing up to the IMF programme, the government of Ghana had, since 2013, pursued a fscal consolidation drive but experienced several imbalances in fscal and external positions, resulting in consistent declines in growth. The IMF programme was needed to stabilise the economy following the worsening growth and developmental challenges. On the basis of the agreement reached with the IMF, Ghana’s economy was expected to receive the credit facility, to be disbursed in eight tranches. To begin with, the IMF’s executive board approved the disbursement of the frst tranche of about USD114.8 million. To achieve fscal consolidation that could promote high growth and development, the IMF recommended strictly containing

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expenditure on wage bills and subsidies. The government needed to mobilise more revenue in order to create additional social spending space and investment in infrastructure (particularly in the energy sector). It also needed to adopt a prudent borrowing strategy to ensure that debt is secured at the lowest possible cost. On the basis of the third review of the programme, the executive board approved USD116.2 million, which brought the total disbursement under the programme to USD464.6 million. In the course of the review, adjustments were made to the programme to ensure that the economy would stay on track and to enhance its prospects for success. This involved the executive board’s granting waivers, including minor deviations in a few programme targets. The IMF’s assessment of Ghana’s implementation of the ECF remained broadly satisfactory, but the economic outlook remained discouraging. Progress had been made in stabilising the macroeconomic situation and reducing fnancial imbalances, but the fscal risks had increased. The IMF again approved a further disbursement of USD94.2 million after the fourth review, bringing the total disbursements under the programme to USD565.2 million, and the rest of the funds were tied to the remaining reviews. The executive board also approved the country’s request to waivers of the nonobservance of performance criteria and a further extension of the programme by another year, ending in 2018. The IMF commended the new government for bringing the programme back on track after the large fscal slippages in 2016. The executive board, however, observed that the country was experiencing long-standing challenges, including exposure to external shocks, budget rigidities, and economic ineffciencies, which intensifed the impact of past policy slippages on domestic and external imbalances. The board stressed that strong implementation of programme policies and reforms are crucial to addressing the risks and securing macroeconomic stability. The board also cautioned the country regarding programme implementation risks, given that it underperformed in its revenue generation in the frst half of the year, and urged the authorities to promptly adopt the necessary corrective measures to preserve the programme targets. Source: www.imf.org/en/news 2015–2017

7.2.1.2 WORLD BANK The World Bank (originally consisting of only the IBRD), was also created at the 1944 Bretton Woods Conference and then became functional in 1946. It is headquartered in Washington, DC, and was created with the goal of reducing poverty and providing loans to countries for capital programmes. According to its Articles of Agreement, all decisions of the World Bank need to be guided by a commitment to promote foreign investment and international trade and need to facilitate capital investment.

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The World Bank is currently made up of two institutions: the IBRD and the International Development Association (IDA), which is the concessionary arm of the Bank. The IBRD and the IDA are collectively referred to as the World Bank because they have the same leadership and staff. The World Bank is also part of the World Bank Group, a constituent of the United Nations system. However, unlike the UN General Assembly, which operates a one member, one vote system, the Bretton Woods institutions are designed as private entities, and the proportion of ‘shares’ that each member country holds translates into voting rights. When the World Bank was set up, the US received 35.07% of the voting rights while the UK had 14.52% (the two countries controlled about 50% of the voting rights in the World Bank). As the number of shareholders increased, a dilution of the voting power among the founding members ensued. However, due to the high majority required for decisions to be passed (initially 80% but now 85%), the US still has veto power and thus a frm grip on World Bank policy. Traditionally, the US nominates the president of the World Bank. The World Bank Group is governed by the boards of governors and is composed of one governor and one alternate governor representing each member country. The boards of governors, which has been vested with all powers, also delegates such powers to the boards of directors or executive directors apart from those stated in the Articles of Agreement. The president of the group chairs the boards of directors, which currently consists of 25 executive directors. The president of the World Bank is also the president of the World Bank Group, who chairs the board of directors. The president is assisted by two executive vice-presidents, three senior vice-presidents, and 24 vice-presidents. The bank’s role has also evolved over time. From its initial aim to reconstruct Western Europe, it shifted its focus to guaranteeing bond issues from developing countries. Doing so with the aim of again facilitating private capital fows from advanced economies to developing ones, which dipped signifcantly during the Great Depression and were eliminated during the Second World War. However, it became apparent that the private sector was not interested in such investments, and in 1947, the bank decided to change its focus to providing direct loans (Culpeper, 1997). This necessitated the establishment of the International Finance Corporation (IFC) in 1956, with the mandate of lending to the private sector in developing countries without government guarantees, thus complementing the World Bank’s lending efforts to governments. The revision of IFC’s Charter in 1961 also permitted it to provide equity capital in addition to other reforms in its structure and operations. We provide some detail of the IFC in Box 7.2.

BOX 7.2 International Finance Corporation The IFC was established in 1956 to represent the World Bank Group’s private sector arm with the objective of advancing economic

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development through investment in commercially viable projects and ventures in order to reduce poverty and promote development. It aims to create an enabling environment for people to fee poverty by providing resources for private businesses. It’s headquartered in Washington, DC, and is considered the largest global development fnance institution with a focus on providing support for private sectors in developing economies. The IFC provides three main services: investment services, asset management services, and advisory services. The idea of establishing the IFC was proposed by Robert L. Garner when the World Bank employed him in 1947 as a senior executive. He believed that private business had a signifcant role to play in global development. Robert L. Garner and some of his colleagues in 1950 mooted the idea of creating a new fnancial institution that would focus on promoting private sector investments in the developing countries that the World Bank served. The US government supported this idea of a new international institution to work closely with the World Bank to support investments in private enterprises without demanding government guarantees, without direct participating in the management of these enterprises, and by collaborating with other investors. In 1956, the IFC was offcially established and began operations with Robert L. Garner as its frst leader. It made its frst investment in 1957 by advancing a loan facility of USD2 million to an affliate of Siemens & Haiske (Siemens AG), based in Brazil. It has subsequently increased its investments in many developing and emerging countries. The IFC has 184 member countries as its owners and is governed by a board of governors, composed of one governor from member country. Each member country is also expected to appoint one alternate governor in addition to the governor. The board of governors is vested with all corporate powers, which in turn has delegated most of such powers to a 25-member board of directors chaired by the president of the World Bank Group. The board of directors is responsible for reviewing and making decisions on investments and providing overall strategic direction to IFC’s executive leadership, made up of the CEO of the IFC, the CEO of the Asset Management Company, and nine vice-presidents. The IFC’s core areas of operation include providing investment services (consisting of  equity, investment loans, syndicated loans, trade fnance, structured and securitised fnance, treasury and liquidity management, and client risk management services), advisory services (supporting corporate decision-making with regard to business, environment, social impact, and sustainability), and asset management, which is done through its wholly owned subsidiary, IFC Asset Management Company. Since 2009, it has focused on some developmental projects that aim to improve education and health, increase sustainability in agriculture, increase access to fnancing for micro and

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small enterprises, help small businesses to grow revenues, invest in climate health, and support infrastructure development. The IFC has, however, come under criticism from the NGO society for being unable to track its funds, because it invests through fnancial intermediaries. For instance, OXFAM (2015) reported that the IFC was not carrying out its necessary due diligence and was not ensuring proper risk management in the fnancial intermediaries that it has investments in. The report indicated that the IFC has little accountability for investments worth billions of US dollars into banks, hedge funds, and other fnancial intermediaries and that this has resulted in projects that are causing human rights abuses across the world. Another area of concern is that the IFC seems to focus mainly on large companies or wealthy individuals who are in the position to fnance their own investments and may not require external funding. Therefore, investing in such large companies or wealthy individuals presupposes that IFC investments have not had signifcantly positive development impacts. One example frequently cited is the fnancing provided by the IFC to the Saudi Prince for the construction of the fvestar Mövenpick Hotel in Ghana (see Einhorn, 2013). The World Bank is a triple-A credit-rating institution; this enables it to borrow at cheaper rates from the international capital markets, but its ‘hard’ loans to governments are generally given at commercial terms. However, many of the poorest countries could not service and repay the loans on commercial terms. These countries were therefore not eligible for the World Bank support under those loan conditions. Subsequently, the World Bank established the IDA in 1960, to provide ‘soft’ lending, including grants and concessionary loans with long maturities, to these poor countries. IDA obtains its funds for soft lending from donors. The World Bank also introduced the structural adjustment programmes (SAPs) in 1980, enabling it to have considerable infuence over the internal politics and policies of borrowing countries. The SAP was a key requirement for qualifying for fnancial support from the World Bank. Developing countries were required to subscribe to an agreed package of structural reforms and the regular support was contingent on borrowing countries’ satisfying these requirements. The SAPs were implemented in quite a number of African countries, and the effect of these programmes on Africa remains an issue of debate in the extant literature. Some empirical works have suggested that, with the exception of Uganda and Ghana, the SAPs have had insignifcant impacts on the growth of African economies (see Mosley, Harrigan, & Toye, 1995; Easterly, 2000; Klasen, 2003). Other studies have also indicated that the SAPs have enhanced growth and poverty reduction in some African countries  – especially those that had successfully implemented the programmes (see World Bank, 1994, 2000; Christiaensen, Demery, & Paternostro, 2001). We discuss some lessons on the implementation of the SAP in Uganda in Box 7.3.

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The SAP took various forms over the years, focused mainly on issues of poverty and human development. The Bretton Woods institutions were criticised for imposing these policies with no inputs from the borrowing countries. In recent times, however, much emphasis is being laid on the need for countries to own these reform programmes. Borrowing countries are now expected to draw up their own programmes with much consultation from various organisations, including civil society organisations (CSOs). This approach is used to give credence and to ensure that governments abide by their own reform programmes.

BOX 7.3 Structural adjustment in Uganda Background When Uganda gained independence in 1962, its economy was considered one of the most promising economies in sub-Saharan Africa. Its agricultural exports including coffee and cotton; it as a mining sector and a transportation system; and its developing local industries were in good shape and performing well. However, political instability and economic sanctions on the Baganda in the late 1960s caused the economy to start declining. Consequently, Idi Amin toppled the government of Milton Obote in a coup d’état in 1971. During the reign of Idi Amin (1971–1979), the Ugandan economy was characterised by a three-month economic war against Asians in 1972, leading to losses in its skilled workforce, fscal defcits averaging USh14.4 million per annum, rising infation, an 8.5% decline in exports, and cutbacks in donor support, resulting from sanctions. These led to, among others, balance of payment problems and a decline in economic growth from 5.2% in the 1960–1970 period to 1.6% in the 1970–1980 period. Idi Amin was overthrown in April 1979, and Milton Obote took over as president for the second time a year later, a time when the war pushed the Ugandan economy into crisis and damaged infrastructure. Due to these conditions, the Obote-led government resorted to an economic recovery programme in 1981. Structural Adjustment Programme (1981–1984) Under this programme, an IMF/World Bank economic reform package was introduced in 1981. The goals of the programme were to stimulate economic growth, control infation, restructure credit, reduce the defcit, stimulate exports, and improve the balance of payments position. The programme was able to achieve most of its goals. The government increased the producer prices of major export commodities to boost exports. For instance, the price of robusta coffee rose to USh130.8 per kilo in 1984, up from USh35 per kilo in 1981. During the 1980–1984 period, coffee exports increased by 21% and cotton exports spiralled by 191%, contributing to a 23% increase in export revenue. Infation fell from 111% in 1981 to 25% in 1983. The budget defcit also reduced

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from 2.8% of GDP to 0.6% of GDP over the same period, and the Ugandan shilling was devalued signifcantly. GDP grew by 7.2% in 1982 and 5.4% in 1983. However, total external debt rose from USD728.9 million in 1981 to USD1.065 billion in 1984. Similarly, debt servicing as a percentage of exports increased from 39.8% to 40.6%. This indicated the deteriorating position of some economic indicators at the time, which violated the programme’s conditionality. These violations, coupled with the poor management of the auction system of the Ugandan shilling, the abolition of import rationing, the absence of skilled personnel to run the programme, worsening standards of living and other challenges, led to the collapse of the programme in 1984. Amid these conditions, the second Obote government was overthrown in a coup d’état in 1984, resulting in another economic crisis and chaos. The economic recovery programme (ERP) of 1987 Shortly after the cancellation of the IMF programme and the coup d’état of 1984, the National Resistance Movement (NRM) assumed power and formed a new government. At that time, public infrastructure was in a deplorable state, black marketeering boomed, productivity fell, corruption was widespread, foreign exchange was hard to fnd, and infation had exceeded 150%. These and other factors made the NRM government turn to the Bretton Woods institutions for fnancial support in 1987, when the East African country ran out of foreign exchange but did not have the creditworthiness to borrow from the global fnancial market. The new policy package was put in an ERP and introduced in May 1987. It aimed to restore fscal discipline and monetary stability and rehabilitate infrastructure. Many measures were implemented to achieve these aims. Specifcally, subsidies to ineffcient public entities were reduced drastically, university professors received special allowances, a new currency conversion rate of 1 to 100 was introduced, interest rates were reduced, the Ugandan shilling was devalued from USh1,400 to USh6,000, and the tax system was reformed. The enhanced structural adjustment facility policy framework, 1998/1999–2000/2001 The government had been implementing macroeconomic adjustment programmes and structural reforms since 1987, mainly to sustain high economic growth, which allowed everyone to participate. During the 1997/1998 period, the government signifcantly cut the size of the public service and reduced the number of ministries from 22 to 17. In 1998, the IMF and IDA agreed that Uganda had fulflled the necessary conditions under the Heavily Indebted Poor Countries (HIPC) Initiative, making Uganda the frst country to complete the processes under the initiative. The government introduced the Poverty Eradication Action Plan (PEAP), a policy that focused on poverty reduction through the

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development of physical and human resources. In addition, the public investment programme focused on road transport and infrastructural development. Over that period, economic policy also aimed to achieve trade liberalisation, public enterprise restructuring, privatisation, and pension and tax reform. Measures were put in place to improve revenue mobilisation and ensure fscal sustainability. Moreover, efforts were made to enforce good governance, decentralisation, public service reform, and the rule of law. The recapitalisation of the Bank of Uganda (BOU) was in the last legal stages, and the main objective of monetary policy was low, stable infation. The government also sought to increase exports, diversify the export base, and encourage foreign direct investment to achieve a sustainable balance of payments position. Sources: IMF (1998), Baffoe (2000)

We examined how the roles of both the IMF and the World Bank have changed over time. Similar to what we discussed earlier in terms of the evolution of the IMF’s role, the focus of the World Bank has also evolved over time. We mentioned that the IMF’s role originally focused on maintaining a fxed exchange rate system. However, with the collapse of this system and the dynamics in the global economy, including increased fnancial rigidity, the IMF’s attention has expanded to consider much broader issues in carrying out its functions. In a similar fashion, the World Bank’s initial role of ensuring economic growth has expanded to incorporate the objective of achieving poverty alleviation. The attention of the World Bank has shifted to also focus more on social issues as important determinants of achieving growth. Although the World Bank continues to focus on economic issues, it also considers investments in human capital development (i.e. education and health) as important in enhancing growth and alleviating poverty. The expanded roles of both the IMF and the World Bank, aimed at achieving economic stability and poverty alleviation, require some reforms in the economies of borrowing countries. Apart from the World Bank, which comprises of the IBDR and the IDA, the World Bank Group is also made up of other members: the IFC, the Multilateral Guarantee Agency (MIGA), and the International Centre for Settlement of Investment Disputes (ICSID). The IFC was already discussed in greater detail in Box 7.2, and we now provide some brief background on the MIGA and the ICSID. The MIGA provides political risk insurance and guarantees to enable investors to protect their investments against noncommercial risks. The ICSID focuses on the settlement of international investment disputes. Each of these institutions plays various critical roles in achieving the World Bank Group’s mission of ending extreme poverty within a generation and boosting shared prosperity. 7.2.1.3 WORLD TRADE ORGANIZATION (WTO) The WTO is the sole global intergovernmental organisation that operates a system of international trade rules. Its Secretariat is located in Geneva, Switzerland It is a forum

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that enables governments to enter into trade agreement negotiations and settle trade disputes. Its main goal is to increase trade openness for the good of all. It was established on 1 January 1995 under the Marrakesh Agreement of 15 April 1994 and signed by 123 countries. The creation of the WTO replaced the GATT, formed immediately after World War II, which became operational in January 1948. The precursor to the GATT was the International Trade Organization (ITO), though successfully negotiated, never came into being. It was initially intended to be a specialised agency of the UN with the goals of reducing barriers to trade and addressing trade-related issues, such as investment, commodity agreements, restrictive business practices, and employment. However, the US and other signatories did not approve the ITO treaty, so it was not implemented. The single multilateral instrument for governing international trade from 1946 onwards was the GATT. This lasted until 1995, when the WTO was created. Although efforts were made in the mid 1950s and 1960s to establish an institutional mechanism to facilitate international trade, the GATT continued in operation as a provisional semi-institutionalised multilateral treaty regime for almost half a century. The WTO regulates trade among member countries. It provides a set of rules and guidelines that are needed in negotiating trade agreements and in the resolution of disputes. This framework is to ensure that WTO member countries adhere to the WTO agreements, which have been signed by representatives of governments of the member countries and ratifed by their respective parliaments. The Uruguay Round (1986–1994) provides the basis for most of the issues that the WTO seeks to address. Over the past six decades, a strong and vibrant trading system has been created with the help of the WTO. This has undoubtedly led to unprecedented growth in the global economy. As of 2018, the membership of the WTO was 164 countries, of which 117 from the developing world or separate customs regions. The WTO is headed by the director-general with the support of about 700 staff members at the Secretariat. A consensus of the entire membership is required in making decisions for the organisation. The apex institutional body is the Ministerial Conference, whose meetings are held twice a year. The conference brings the entire membership of the WTO together and is empowered to make decisions regarding issues that arise under any of the multilateral trade agreements. The conduct of the business of the WTO is placed in charge of the General Council. All members of the WTO constitute the General Council as well as the Ministerial Conference. Specialised subsidiary bodies (councils, committees, subcommittees), also made up of all member countries, have the responsibility of administering and monitoring the implementation of the various WTO agreements by member countries. The WTO engages in a myriad of activities, including negotiating the reduction or complete elimination of trade obstacles, such as import tariffs. It works on reaching consensus on rules that govern international trade practices, such as antidumping, subsidies, and product standards. The WTO also engages in the administration and monitoring of the implementation of

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the agreed rules of the WTO with respect to trade in goods and services as well as trade-related intellectual property rights. Additionally, it monitors and reviews trade policies of member countries while ensuring transparency in the agreements of regional and bilateral trade. The WTO also resolves disputes among member countries in the area of the proper interpretation and application of the agreements. It makes efforts to improve the capabilities of government offcials of developing countries in matters of international trade. The WTO also provides assistance to a number of countries that are yet to become part of the WTO by carrying out economic research and both gathering and disseminating trade-related data. This to provide support to the WTO’s primary activities and educate the public about the organisation’s mission and activities. The guiding principle of the WTO is the pursuit of open borders. In November 2001, the Doha Development Round, which is the current round of negotiations, was launched by the WTO during the fourth Ministerial Conference in Doha, Qatar. The objective of these negotiations was to bring about a more inclusive globalisation process and assist the poor by reducing barriers to trade and farming subsidies in developed countries. The initial agenda comprised both the furtherance of trade liberalisation and the making of new trade rules with the commitment to increase substantial assistance to developing countries. There have been serious contentions in the negotiation processes with strong disagreements over a number of important issues, such as agricultural subsidies. There was a breakdown in the 2008 Ministerial Conference meeting due to a disagreement between countries that export agricultural bulk commodities and those that had a high number of subsistence farmers on the specifc terms of a special protective measure to safeguard farmers from increases in imports. The WTO has, since its establishment, made signifcant strides and can be accredited with some achievements. One is the fact that greater market orientation is now the general rule in international trade. Second, there has been a decline in the use of restrictive measures in addressing BOP problems. Trade in services has also been included in the trade in goods-dominated multilateral system. Subsequently, either unilaterally or through regional or multilateral negotiations, a signifcant number of countries opened their markets to trade and investment. In addition, tariff-based protection has become the general practice instead of the exception in international trade. A process of continually monitoring developments in trade policy has been created by the review of trade policy. Finally, the WTO succeeded in having an agreement with members in reducing industrial goods-based import tariffs, on the basis of a ‘Swiss formula’. A Swiss formula is a nonlinear formula whereby tariffs, which are initially higher, are required to have proportionally higher tariff cuts. For instance, a country that has a product with an initial tariff of 25% should cut the tariffs much more than should a country that has the same product with an initial tariff of 15%. There are, however, several other issues for the WTO. First, the process of trade reforms remains incomplete in a signifcant number of countries. An example is the presence of high tariffs for which there are ongoing

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negotiations at various levels, particularly in the felds of fnancial services and telecommunications. Also, the overall trade liberalisation process seems to have suffered a number of setbacks and retrogressions in a number of developing countries. There are instances of much stronger antidumping measures and selective tariff increases. Third, the WTO has not responded well enough to developing nontariff barriers to imports, including antidumping duties from developing countries. It appears the interests of multinational companies supersede those of local industries and policies even if such actions pose serious health and security risks to the local population. Also, several serious implementation-related concerns require the implementation of measures in relation to asymmetries in trade-related investment measures (TRIMS), trade-related intellectual property rights (TRIPS), antidumping, and the movement of people, among others. The WTO also needs to pay specifc attention to issues related to textiles, agriculture, industrial tariffs (e.g. peak tariffs), and services. Lastly, developing countries are being required to accept trade policies and guidelines favourable to developed countries. This approach is a one-size-fts-all approach posing a signifcant challenge to countries in the developing world. In summary, the WTO has been instrumental in promoting global trade and investment. If member countries commit to addressing the challenges confronting the WTO, the expected benefts in increased trade and investments among member countries would be largely realised.

7.3 THE BANK FOR INTERNATIONAL SETTLEMENTS (BIS) AND THE BASEL COMMITTEE ON BANKING SUPERVISION (BCBS) The Bank for International Settlements (BIS), owned by its 60-member central banks, is an international fnancial institution meant to foster international monetary and fnancial cooperation and serve as a bank for central banks. Its headquarters are in Basel, Switzerland; it also has representative offces in Hong Kong SAR and in Mexico City. Currently, it has 35 member countries in Europe, 13 member countries in Asia, fve members in South America, three in North America, two in Oceania, and two in Africa. The bank is the frst international fnancial institution and was set up in 1930 by an agreement between Germany, Belgium, France, the United Kingdom, Italy, Japan, the United States of America, and Switzerland. Operations started on 17 May 1930. It was initially set up as a clearinghouse for German war reparations imposed by the Treaty of Versailles but evolved into a forum for cooperation and a counterparty for transactions among central banks. The bank works to promote international cooperation among monetary and fnancial authorities. It conducts economic research and analysis on policy issues to inform policymakers, academics, and the general public. It also provides banking services to the central bank community and other international organisations. The BIS carries out its work through meetings, programmes, and the Basel Process – hosting international groups pursuing global fnancial stability and facilitating their interaction.

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A number of committees and associations are involved in fnancial stability and have their secretariats at the BIS. These include the Basel Committee of Banking Supervision, the Committee on Payments and Market Infrastructures, the Committee on the Global Financial System, the Markets Committee, the Central Bank Governance Group, and the Irving Fisher Committee on Central Bank Statistics. For these groups, being located in the same place facilitates communication and collaboration. Their location also makes it easy for interactions with policymakers, makes it easier to coordinate efforts, and prevent overlaps and gaps in various work programmes. Some associations also have their secretariats at the BIS but have their own separate legal identity and governance structure and report to their members. These are the Financial Stability Board, the International Association of Deposit Insurers, and the International Association of Insurance Supervisors. The BIS contributes to the international fnancial architecture by promoting reserve transparency in central bank operations and regulating capital adequacy. The Basel Committee on Banking Supervision, which is hosted at the BIS, is in charge of setting capital adequacy requirements. Ensuring capital adequacy is critical for central banks since speculative lending on the basis of inadequate underlying capital and widely varying liability rules can cause economic crises; as Gresham’s law states, ‘bad money drives out good money’. In addition, the Basel Committee on Banking Supervision, which is hosted by the BIS, played an important role in creating the Basel Capital Accords, the Basel II framework, and the Basel III framework. 7.3.1 The Basel Committee on Banking Supervision (BCBS) The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters. Its 45 members comprise central banks and bank supervisors from 28 jurisdictions. The BCBS was set up by the central bank governors of the G10 countries in 1974. It provides a medium for regular cooperation on banking supervisory matters. Its objective is to improve the understanding of important supervisory issues and improve the quality of bank supervision all over the world. The following are some of the frameworks that the committee has created: 1 International standards on capital adequacy. 2 Core principles for effective banking supervision. 3 Concordat on cross-border banking supervision. The committee’s secretariat is situated at the Bank for International Settlements in Basel, Switzerland. However, it has its own governance arrangements, reporting lines, and agenda overseen by the central bank governors of the G10 countries. The BCBS works primarily as an informal medium for developing policy solutions and standards. Along with the International Organisations of Securities Commissions and the International Association of Insurance Supervisors, they form the joint forum of international fnancial

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regulators. It also has subgroups that work on specifc issues: the Standards Implementation Group (SIG), the Policy Development Group (PDG), the Accounting Task Force (ATF), and the Basel Consultative Group (BCG). The committee agrees on nonbinding principles for bank capital, liquidity, and funding. Member countries are expected to create opportunities for implementation, such as by enacting relevant domestic regulation.

7.4 OTHER GLOBAL DEVELOPMENT FINANCE INSTITUTIONS Other global development fnance institutions are made up of multilateral development banks (MDBs), multilateral fnancial institutions (MFIs), and regional development banks. 7.4.1 Multilateral Development Banks (MDBs) and Multilateral Financial Institutions (MFIs) MDBs are fnancial institutions that are established by various countries in order to support development activities through long-term loans and grants. They mostly provide lending at low or no interest and sometimes grants to fnance projects in areas that promote development. In more specifc terms, the fnancing provided by MDBs takes the following forms: 1 Long-term loans usually have up to 20 years’ maturity, and their interest rates are based on market rates. MDBs typically acquire funds from the global capital markets and in turn on-lend them to developing countries’ governments. 2 Very-long-term loans are also termed ‘credits’, and they usually have maturity between 30 and 40 years with interest rates pegged below market interest rates. Funding for such loans are from direct contributions made by the governments of donor countries. 3 Grant fnancing is typically for technical assistance, advisory services, and project preparation. MDBs have huge memberships, which contain both developed countries (which serve as donors) and developing countries (which are the borrowers). They are global in their scope, and examples include European Bank for Reconstruction and Development (EBRD), European Investment Bank (EIB), Inter-American Bank Group (IDB, IADB), Development Bank of Latin America (CAF), Asian Development Bank (ADB), African Development Bank (AfDB), Islamic Development Bank (IsDB), Asian Infrastructure Investment Bank (AIIB), and International Fund for Agricultural Development (IFAD). There are also subregional MDBs with membership comprising only borrowing countries. MDBs tend to raise fnance from the global capital markets at lower costs and on-lend to their members. Examples include the Central American Bank for Economic Integration (CABEI), Caribbean Development Bank (CDB), Black Sea Trade and Development Bank (BSTDB), Development Bank of Southern Africa (DBSA), West African Development

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Bank (BOAD), East African Development Bank (EADB), Eurasian Development Bank (EDB), Economic Cooperation Organisation Trade and Development Bank (ETDB), and New Development Bank (NDB) (formerly BRICS Development Bank). MDBs are generally similar to MFIs except that MFIs have morelimited memberships and mostly concentrate on fnancing specifc activities. Some examples are the International Fund for Agricultural Development (IFAD), International Investment Bank (IIB), International Finance Facility for Immunisation (IFFI), European Commission (EC), OPEC Fund for International Development (OFID), Nordic Investment Bank (NIB), and Arab Bank for Bank for Economic Development in Africa (BADEA). 7.4.2 Regional development banks Regional development banks (RDBs) are regional DFIs that focus on fnancing development activities in particular geographical areas. They are also regarded as part of MDBs and MFIs, but they operate in specifc regions of the world. The shareholders of these institutions are mainly the regional countries and other major donor countries. RDBs are considered ‘clones’ of the World Bank in terms of their structure, functions, and operations, but they tend to have a specifc focus. The main regional development banks are the Inter-American Development Bank (IDB), African Development Bank (AfDB), Asian Development Bank (ADB), Central American Bank for Economic Integration, and the European Bank for Reconstruction and Development (EBRD). Other regional development banks include the Central American Bank for Economic Integration, Islamic Development Bank (CABEI), Islamic Development Bank (IsDB), Development Bank for Latin America (CAF), Council of Europe Development Bank (CEB), West African Development Bank (BOAD), East African Development Bank (EADB), and Development Bank of Central African States. Among the fve main RDBs, the IDB for Latin America was the frst to be established in 1959. This was followed by the setting up of the Central American Bank for Economic Integration in 1960, the African Development Bank in 1964, the Asian Development Bank in 1966, and then the European Bank for Reconstruction and Development in 1991. As mentioned earlier, the RDBs have similar structures and functions to those of the World Bank, though they are different in some other respects. For instance, both the RDBs and the World Bank have ‘hard’ and ‘soft’ lending facilities, where the terms under the hard lending facility are similar in all the institutions and the soft lending is funded directly by donors. As mentioned earlier, the World Bank’s soft lending is provided through the IDA. Soft lending programmes by IDB, AfDB, and ADB, for instance, are conducted through the Fund for Special Operation (FSO), African Development Fund (ADF), and Asian Development Fund (AsDF) respectively. Hard lending takes the form of loans on market-based terms, while soft lending takes the form of grants and concessional loans, which are associated with longer repayment periods and lower interest rates. Most loans typically have a maturity of between 25 and 40 years. In terms of their governance

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structure, both the World Bank and the RDBs are governed by boards of governors, of which every member country is supposed to have a representation of one governor and one alternate governor. The boards of governors, which are the highest authority of the institutions, in turn appoint and delegate the exercise of most of their powers to the boards of directors, which provide general direction to the entities. One major challenge faced by regional development banks is that donor governments prefer to channel resources through the World Bank rather than through the regional development banks. This also means that borrowing countries tend to place more importance on their relationship with the World Bank than with their specifc RDBs. We next provide an overview of the main RDBs in Table 7.1.

TABLE 7.1 Overview of RDBs Regional development Area banks

Year Headquarters founded

Inter-American Development Bank (IDB)

Latin American, Caribbean

1959

Central American Bank for Economic Integration (CABEI) African Development Bank (AfDB)

Central America

1960

Africa

1964

Asian Development Asia and Pacifc Bank (ADB) region

1966

1991 European Bank for Central and Eastern Reconstruction Europe and and Development Central Asia (EBRD)

Main goal

Promoting poverty reduction, social equity, environmentally sustainable economic growth Promoting Tegucigalpa integration and (Honduras) development San Salvador among its (El Salvador)  member countries Abidjan (Côte Spurring sustainable economic D’Ivoire) development and social progress in its regional member countries (RMCs), thus contributing to poverty reduction Fostering economic Manila growth and (Philippines) cooperation in the region London, United Promoting transition to Kingdom market-oriented economies in the Central and Eastern European and Central Asian countries. Washington, DC (USA)

188 Joshua Yindenaba Abor et al. 7.4.2.1 INTER-AMERICAN DEVELOPMENT BANK The IDB, which was created in 1959, has its headquarters in Washington, DC. It is the oldest RDB to be established, and it represents the largest source of multilateral development fnancing for supporting socioeconomic development, institutional development projects, trade, and regional integration programmes in Latin America and the Caribbean. The IDB has 48 countries as its owners, which are made up of 26 Latin American and Caribbean states, 16 European countries, the US, Canada, Israel, China, Japan, and Korea. The 26 Latin American and Caribbean states are the borrowing member countries that regularly acquire loans from IDB, and the others constitute nonborrowing member countries. The idea of creating a DFI for the Latin American region was initially proposed during the earliest efforts to establish an inter-American system at the First American Conference in 1890. The IDB came into fruition under an initiative, which was proposed by the then president of Brazil, Juscelino Kubitshek. The IDB was offcially set up on 8 April 1959, the Organisation of American States drafting the Articles of Agreement to establish the bank. The main goals of the IDB involve promoting poverty reduction, social equity, and environmentally sustainable economic growth. It focuses on the following priority areas in the attainment of these goals:

• Fostering competitiveness by supporting policies and programmes that enhance a country’s potential for development in the global marketplace. • Modernising the state by enhancing the level of effciency and transparency in public sector institutions. • Investing in social programmes that are capable of expanding opportunities for the poor. • Promoting regional economic integration by fostering relations among countries in order to develop bigger markets for their commodities. It also helps regional initiative efforts by providing information and knowledge to aid policy discourse and funding for technical cooperation in order to strengthen regional integration. It supports governments with technical assistance on issues regarding trade and regional integration and also undertakes public outreach programmes and activities targeted at promoting such integration. IDB uses its FSO to provide concessional lending. The Central American Bank for Economic Integration (CABEI) is an RDB founded in 1960 to promote integration and development among its member countries. It currently has two headquarters, one located in Tegucigalpa (Honduras) and the other in San Salvador (El Salvador), in addition to national offces in each Central American country. Its membership is as follows:

7.4.2.2 CENTRAL AMERICAN BANK FOR ECONOMIC INTEGRATION

• Its fve founding countries are made up of Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. These were the countries that signed the Founding Covenant establishing the CABEI. • It has two non-founding regional countries – Dominican Republic and Panama. • Its fve nonregional countries are made up of Argentina, Colombia, Mexico, Spain, and Taiwan. They joined the CABEI to have a

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permanent regional presence, thereby enhancing their global projection by supporting development in the founding countries. • It also has benefciary countries; in addition to regional countries, Belize joined the CABEI to acquire loans and guarantees. However, unlike the other member countries, Belize does not hold any shares of CABEI. Argentina and Colombia also beneft from receiving loans and guarantees from CABEI. The process of Central American regional economic integration began on 13 December 1960 with the signing of the General Treaty on Central America Economic Integration. The signing of the treaty then resulted in the establishment of the CABEI, which has become the fnancial arm for the integration and development of Central America. As a regional DFI, CABEI provides support for the public and private sectors of the economy. It focuses on acquiring funds and channelling these into promoting investments in its cores areas, including energy, infrastructure, industry, agricultural and rural development, human development, urban development and services for competitiveness, and fnancial trading and development fnance. 7.4.2.3 AFRICAN DEVELOPMENT BANK The AfDB, or Banque Africaine de Development (BAD), was founded in 1964, headquartered in Abidjan, Côte d’Ivoire (but in 2003, the headquarters temporarily moved to Tunis, Tunisia, because of the Ivorian war and then returned in September 2014). Its owners are made up of 81 member countries (shareholders), comprising 54 African countries and 27 non-African countries. Two other entities are under the African Development Bank Group: the African Development Fund and the Nigeria Trust Fund. The growing desire for more unity in the continent, after the colonial period in Africa, resulted in the creation of two draft charters, for establishing the Organisation of African Unity (founded in 1963 and replaced later by the African Union) and an RDB. An agreement for establishing the AfDB was prepared in 1963, and this materialised on 10 September 1964. The Bank was formally established under the auspices of the Economic Commission for Africa but started its operations in 1966. Although the bank initially had only African countries as members, a number of non-African countries have been allowed to join since 1982. The overall objective of the AfDB Group is to spur sustainable economic development and social progress in its regional member countries (RMCs), thus contributing to poverty reduction. The AfDB Group focuses on mobilising resources and allocating them for investments in the RMCs. It also provides policy advice and technical assistance to support the development efforts of the RMCs. It serves the following primary functions:

• Making loans and equity investments for the economic and social advancement of the RMCs. • Providing technical assistance for the development projects and programmes of the RMCs. • Promoting the investment of public and private capital for development. • Assisting in organising the development policies of RMCs.

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The AfDB is also expected to pay particular attention to national and multinational projects that are required to promote and facilitate regional integration. Its main sources of fnancing include subscribed capital, reserves, borrowed funds, and accumulated net income. Its shareholding is structured in such a way that the two-thirds of the total capital is held by the RMCs, while one-third is held by nonregional members. AfDB is also a triple-A-rated institution, allowing it to borrow from the international capital markets on favourable terms. It provides fnance to governments of African countries and private companies that invest in the RMCs. AfDB lends on a nonconcessional basis at market interest rates. It also provides development fnance on concessional terms through the African Development Fund to its lowincome member countries that do not qualify to obtain loans on nonconcessional terms. Funds for concessionary loans are typically obtained from the 27 nonregional members, which come in the form of grant contributions. 7.4.2.4 ASIAN DEVELOPMENT BANK The ADB was founded in 1966 with its headquarters based in Manila, the capital of the Philippines. With initial membership of 31 countries at its establishment, ADB is currently owned by 67 member countries, which are made up of 48 countries in the Asian and the Pacifc regions and 19 from other parts of the world. The idea for establishing the ABD was considered at the beginning of the 1960s. The proposal was to establish a fnancial institution that was Asian in nature to focus on fostering economic growth and cooperation in the region. In 1963, a resolution was subsequently passed to provide clear direction for establishing the Bank United. This was done at the frst Ministerial Conference on Asian Economic Cooperation, which was held by the United Nations Economic Commission for Asia and the Far East. The bank was eventually set up on 19 December 1966. The ADB served a predominantly agricultural region by providing assistance mainly in the areas of food production and rural development during the 1960s. ADB focuses on promoting social and economic development in Asia and the Pacifc through inclusive growth, environmentally sustainable growth, and regional integration. It is concerned with helping its member countries, specifcally the developing countries, to pursue poverty reduction and improvement in the quality of life of citizens through equity investments, loans, guarantees, grants, technical assistance, and policy dialogue. Its core areas of interest include infrastructure (energy, ICT, transport, water, and urban development), environment, regional cooperation and integration, fnancial sector development, education, health, agriculture and natural resources, and public sector management. Its main sources of fnance include bond issues, recycled repayments on its loans, and member countries’ contributions. A signifcant percentage of the cumulative lending it gives is from its ordinary capital. The concessional lending it provides to its developing member countries is done through the African Development Fund. It also manages a number of trust funds and assists in channelling grants from bilateral donor partners to the recipient countries. 7.4.2.5 EUROPEAN

BANK

FOR

RECONSTRUCTION

AND

DEVELOPMENT

The EBRD is the youngest among the fve main RDBs and was established in 1991 with its headquarters in London. The EBRD was established to

Chapter 7 • Global fnancial architecture 191

promote a transition to market-oriented economies in the Central and Eastern Europe and Central Asia countries. Its owners are made up of 65 countries and two intergovernmental institutions – the European Union and the European Investment Bank. The EBRD was founded during the period of the dissolution of the Soviet Union and communism in Central and Eastern Europe, and these countries required support to develop a new private sector. The bank was set up after reaching agreements regarding its charter, size, and the share of power among the shareholders. The EBRD is also a triple-A-rated institution, which allows it to borrow from international capital markets at favourable market rates. In spite of its public sector shareholders, the EBRB focuses its investments largely on private enterprises in collaboration with commercial entities. It is committed to developing democracies and building market economies in some Central European and Central Asian countries through its investments. The EBRD provides loans and equity fnance, trade fnance, project fnance, leasing facilities, guarantees, and professional development through its support programmes. The EBRD also supports publicly owned companies in their privatisation efforts and is committed to promoting environmentally sound and sustainable development. Importantly, apart from the multilateral and regional DFIs, bilateral DFIs are also established typically by developed countries to fnance development projects in developing and emerging counties. In Chapter 1, we identifed examples of bilateral DFIs that operate worldwide, targeting developing and emerging markets to include AFD/Proparco (France), Belgian Investment Company for Developing Countries (BIO), BMI-SBI (Belgium), CDC Group (UK), CDP/SIMEST (Italy), COFIDES (Spain), Finnfund (Finland), German Investment and Development Company (DEG), IFU (Denmark), Netherlands Development Finance Company (FMO), Norfund (Norway), OeEB (Austria), Overseas Private Investment Corporation (OPIC) in the US, SOFID (Portugal), Swedfund (Sweden), and Swiss Investment Fund for Emerging Markets (SIFEM).

7.5 FINANCIAL GLOBALISATION AND GLOBAL CRISIS Before discussing fnancial globalisation and the global fnancial crisis, we frst look at the dynamics of fnancial globalisation and the general benefts and risks with respect to fnancial globalisation. 7.5.1 The dynamics of fnancial globalisation Financial globalisation (FG), viewed as the totality of all global linkages through cross-border capital fows, has become an increasingly important aspect for emerging economies as they integrate with more-developed economies. FG is seen as the net fnancial fows measured as the aggregate of foreign assets and foreign liabilities to GDP ratio (Lane & Milesi-Ferretti, 2007). FG is relevant to an emerging economy for a number of reasons: •  The changing composition of the national balance sheets, whereby the foreign fnancial assets either exceed or fall below the foreign fnancial liabilities.

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•  The role of FG in the transmission of shocks caused by global fnancial crises. •  The contribution of FG to the economic development of a nation. •  International risk management (through sharing) and smoothing business cycles. •  The overall implication of FG effects on the macroeconomic and prudential policies at national, regional, and global levels. Yeyati and Williams (2014) argue that despite the common notion that fnancial globalisation (also referred to as the IFI ratio) has been increasing in emerging economies since the mid 1980s with an acceleration in the 2000s, there has only been a marginal growth, and international portfolio diversifcation has been limited and on the decline over time. Using an FG proxy controlled for fnancial market deepening and relative price effects, Yeyati and Williams revealed a more stable FG pattern during the 2000s. Lund et al. (2017) fnd that developing countries are becoming more and more fnancially globalised and that the share of foreign assets of developing countries rose from 8% to 14% in the last decade. Cross-border capital fows have dropped by 65% since the global fnancial crisis (GFC). This is potentially because global banks took strict measures such as retrenchment. The decline could also be due to the stability of the FG, which seems to be emerging over time (Lund et al., 2017). An interesting observation is that despite the retrenchment by global banks and a cut in diaspora remittances, FG still continues. During the period 2006–2007, FG seemed to be strong and was creating more robust fnancial linkages across the globe. Advanced economies benefted more from this, while emerging economies adopted a more cautious approach. This disparity in the experiences of FG by both advanced and emerging economies would later be tested by the GFC, which was sparked in 2008 and which highlighted the properties of FG in a real setting. In 2007, the global inventory of foreign investments stood at USD103 trillion, which had increased to USD132 trillion by 2016. There is also evidence of vibrancy in the fnancial and capital markets globally, with 31% of the bonds owned by foreign investors, up from 18% in 2000. There is a notable increase in China’s total stock of foreign bank lending, FDI, and portfolio equity and bond investments. Although FG is expected to affect asset prices, the economic performance of any nation depends on the actual intensity and sensitivity of cross-border capital fows despite existing controls and restrictions. Many closely regulated economies act as important recipients and sources of foreign capital fows. They are therefore more fnancially globalised and are even more exposed to any global fnancial crisis that may hit them. However, liberal economies are regarded as risky by international investors, who tend to avoid them. These economies become locked out of the global market swings and trends. This explains the mixed effect of the 2008 GFC on various economies: some are most affected (e.g. the US, Venezuela, Iceland) and others are least affected (e.g. the United Arab Emirates, Armenia, Morocco).

Chapter 7 • Global fnancial architecture 193

7.5.2 The benefts and risks of fnancial globalisation The new dispensation of FG presents interesting challenges and opportunities. FG is benefcial for an emerging economy. However, it can also be costly for emerging economies. First, FG is responsible for the fnancial deepening of local markets by way of availing credit to the private sector and equity. FG can also help in risk sharing by countries in the long term. FG can serve as a useful tool in international risk sharing as a way of hedging consumption against local income shocks emanating from a specifc nation. Some of the positives of the new era of FG include the following: •  There is a remarkable increase in FDI and equity fows, which command a higher share of gross annual fnancial fows than they did during the precrisis period. •  Global current, fnancial, and capital account imbalances have reduced signifcantly from 2.5% of world GDP in 2007 to 1.7% in 2016. This means the global fnancial system is less vulnerable to shocks, which led to the GFC of 2008. This, coupled with the dramatic reduction in the huge US defcit and Chinese surplus, has contributed to a reduction of the potential impact that a small spark can have in the global fnancial space. •  Financial institutions across the world have improved cushions to offset future losses. Most banks now have stronger risk management systems. Despite the benefts that FG presents in the postcrisis period, there are risks that come with it. Some of the risks presented by the new dispensation of FG: •  The volatility of gross foreign capital fows increased. According to Lund et al. (2017), over 60% of the countries experience a huge decline, surge, recovery, or reversal of lending yearly. This has led to volatility in exchange rates and has led to diffculties in managing macroeconomic fundamentals. •  A potential bubble in equity market valuations may emerge. This is due to the increased valuations on equity markets in some markets. •  Financial contagion risk is now becoming immanent because more and more countries are participating in the global fnancial architecture. The risk may be more prevalent in developing and emerging economies, which are characterised by insuffcient transparency and liquidity in their fnancial markets. The response to the new dynamics in FG can be met by embracing technologies in banking to increase effciency, improve customer experience, and innovate. The use of big data analytics and machine learning algorithms may help in understanding the risks much better in an international market context. Domestic banks must also remain alert to being de-risked in the wake of closer scrutiny and transparency requirements in the global fnancial services space. This also translates into looking again into the international

194 Joshua Yindenaba Abor et al. FIGURE 7.2 Benefts and risks of fnancial globalisation Benefits of Financial Globalisation • Increase in FDI and equity flows • Global current, financial and capital account imbalances have reduced • Financial institutions globally have improved cushions to offset future losses.

Risks of Financial Globalisation • Increased volatility of gross foreign capital flows • A potential bubble in equity market valuations may emerge. • Financial contagion risk is now becoming immanent

Source: Authors’ construction

strategies adopted by the banks that should foster long-term sustainability. Regulators are also expected to build systemic risk-monitoring capabilities with real-time react capabilities to any economic shocks originating from inside or outside the nation’s borders. Innovative tools for managing capital market volatility and reducing the imbalance between capital and fnancial accounts need to be devised. 7.5.3 Financial globalisation and the global fnancial crisis The question whether fnancial globalisation materially contributed to the GFC remains debatable. Did the rise in cross-border capital fows exacerbate the GFC? What role did FG play in the aftermath of the crisis? When the global fnancial crisis happened, it was a litmus test for the fnancial globalisation model. Since fnancial globalisation operates through a determination of asset prices and responsiveness of funds fows to shocks, any foreign capital fows may be affected by any shocks in the market. Arguably, the participation of foreign investors, mainly foreign banks, fuelled the crisis. This was more so with the growth of asset-backed securities markets in the US, which were pivotal to the precrisis experiences in 2007–2008. Bernanke, Bertaut, DeMarco, and Kamin (2011) note that the fnancial institutions, especially banks in Europe, were the major purchasers of asset-backed securities. They would obtain large dollar funding from the US money market. The immanent risk in these transactions was the exposure of European parent banks to any volatility in case a small spark arose in the global fnancial services. FG led to the speedy growth of the balance sheets of many banks. Globally active banks grew rapidly in size and complexity. This made it even more diffcult for national regulators and central banks to suffciently monitor their risk profles. Credit growth plummeted in most countries due to the ability of local banks to lend owing to an upsurge in the cross-border capital fows. Emerging markets growth may have fuelled the buildup of weaknesses in global credit markets. This may have led to a securitisation

Chapter 7 • Global fnancial architecture 195

boom. Given all these factors, credit markets became vulnerable that occasioned the GFC. In a way, FG magnifed the impact of the possible causes of the crisis, such as weaknesses in credit market regulation and the upsurge of fnancing activities, which were largely unregulated. In the aftermath of the crisis, global productivity slowed down. Several proposals have been made to reform the global fnancial architecture, focusing more on the two Bretton Woods institutions – the IMF and the World Bank. The next section discusses these proposed reforms in the global fnancial architecture.

7.6 REFORMING THE GLOBAL FINANCIAL ARCHITECTURE The global fnancial architecture in the 1980s and 1990s operated largely in an unorganised manner, one in which institutions, especially the Bretton Woods institutions, came under serious criticisms from both the left and the right of the political spectrum. The conditional, policy-based lending at the time was central to these criticisms from the left. Spratt (2009) identifed the major criticisms of these institutions: • The Bretton Woods institutions, particularly the frst two (i.e. the IMF and the World Bank), were dominated by developed countries, which tended to infuence the policies with respect to lending programmes of these institutions. • The so-called Washington Consensus of economic policy prescriptions (mostly seen as neoliberal policies) were regarded as serving the interests of Western countries. Box 7.4 explains the Washington Consensus. • The two Bretton Woods institutions seem to have a one-size fts-all method for addressing issues in developing countries. They were accused of using the same template for all countries, irrespective of the economic conditions. • The infuence that the IMF and the World Bank wielded gave them much power to compel countries to implement these reforms, since they were conditional to qualify for fnancial support. The Bretton Woods institutions seemed to have no consideration for the concerns of citizens of these countries and the social implications of their reforms. • The Bretton Woods institutions’ lending programmes led to developing countries’ carrying high levels of debt. These left-wing critics contend that policies of the IMF and the World Bank have contributed to the high poverty levels in developing countries, especially in regions like Latin America and sub-Saharan Africa that implemented these reforms. Asia seemed to have been least affected by the conditionality associated with SAP, and therefore, the poverty reduction that the region experienced could not be attributed to the reform policies the IMF and the World Bank prescribed.

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BOX 7.4 The Washington Consensus The Washington Consensus consists of ten economic policy prescriptions, which are considered to constitute the ‘standard’ reform package to address fnancial crises and determine policy to ensure economic development in Latin America, Southeast Asia, and other developing countries. The term was originally used by John Williamson, the English economist, at a conference at the Institute of Development Studies in 1989. Williamson’s use of the term ‘Washington Consensus’ was meant to capture the common understanding among policy advice by Washington-based institutions, particularly the IMF, the World Bank, and the US Treasury Department. The Washington Consensus was meant to promote free trade, foating exchange rates, free markets, and macroeconomic stability and became the basis of the SAPs and for that matter the lending conditions by the IMF and the World Bank. The general principles originally stated by Williamson (1990) in 1989, included ten specifc policy areas: 1 Fiscal discipline (with avoidance of large fscal defcits relative to GDP). 2 The redirection of public expenditure priorities (‘especially indiscriminate subsidies’) toward broad-based provision of key pro-growth, pro-poor services like primary education, primary healthcare and infrastructure investment. 3 Tax reform (broaden the tax base and adopt moderate marginal tax rates). 4 Interest rate liberalisation (interest rates that are market determined and positive but moderate) in real terms. 5 Competitive exchange rates. 6 Trade liberalisation (liberalisation of imports – emphasising the elimination of quantitative restrictions, such as licensing – and any trade protection to be provided by low and relatively uniform tariffs). 7 The liberalisation of foreign direct investment infows. 8 The privatisation of state-owned enterprises. 9 Deregulation (i.e. abolition of regulations that impede market entry or restrict competition, except for those justifed on safety, environmental, and consumer protection grounds, and prudential oversight of fnancial institutions). 10 Legal security for property rights. After publishing the list of policy prescriptions, advocates of neoliberalism deployed the term  ‘Washington Consensus’  for their own purposes. Williamson (1999) recognised that the term was being used according to a different interpretation from the original prescription he provided. He opposed the alternative use of the term that became commonly known as ‘neoliberalisation’ in Latin America or ‘market fundamentalism’.

Chapter 7 • Global fnancial architecture 197

Williamson (2000) realised that his 1989 policy design was fawed in the sense that it ignored fnancial supervision, without which fnancial liberalisation could result in poor lending and ultimately crisis, requiring the taxpayers to bear the costs. He argued that looking beyond the policy prescriptions based on the Washington Consensus was necessary, by focusing on the important role of institutions in addition to policies that promote equity in income distribution as well as rapid growth in income.

There have also been strong arguments made by the right that criticise the Bretton Woods institutions. These institutions arguably tend to represent some form of pseudo-world government in the making and have no legitimacy. The IMF in particular prescribes policies that seem to be counterproductive. Again, according to right-wing critics, the presence of the IMF encourages moral hazard among borrowing countries and the lending institutions. Both borrowing countries and lending institutions may engage in irresponsible and careless behaviour, knowing that in the event of a crisis, the IMF will be present to provide a bailout plan (Spratt, 2009). These were some of the issues that invited a number of proposals and recommendations for reforming the global fnancial architecture, after the Asian crisis. In spite of the recommendations for reform, the global fnancial crisis that was set off in 2008 brought to the force major weaknesses in the precrisis global fnancial architecture that was meant to prevent, manage, and resolve crises in the international fnancial system. We discuss some of these proposals for reform made before and after the global fnancial crisis. 7.6.1 Earlier proposals on reform First, the Bretton Woods Committee Report (1997) suggested that the Bretton Woods institutions, particularly the IMF and the World Bank, need to be more transparent regarding information about their operations and also pay particular attention to addressing legitimate public concerns. Second, the UN Report (1999) made a number of recommendations for reforming the global fnancial architecture: • The need for improved consistency (and complementarity) of macroeconomic policies at the international level, including public scrutiny of the policies and operations of the central banks and the IMF. • Reforming the IMF to be able to provide for adequate international liquidity in times of crisis. • The adoption of improved codes of conduct and fnancial supervision at both the national level and the international level, in the interests of borrowers and creditors. • The preservation of relative autonomy of capital account issues in developing countries for the appropriate regulation of short-term capital fows or avoidance of sudden capital reversals.

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• Providing time-bound and time-focused debt rescheduling, where and when necessary, rather than protracted and chaotic debt renegotiations that aggravate the costs of a debt crisis to borrower countries. The International Financial Institution Advisory (‘Meltzer’) Commission, appointed by the US Congress in 1998, which submitted its report in 1999, also made certain recommendations. The Meltzer Commission Report (1999) noted that the operations of the World Bank were associated with high cost and low effectiveness. The IMF also paid little attention to the fnancial structure of developing countries, as its short-term crisis management was considered costly. Its responses were considered too slow, its advice inappropriate, and its efforts at infuencing policy and practice intrusive (Rao, 2003). The Meltzer Report focused on eliminating moral hazard associated with the IMF, which was considered as the main cause of reckless borrowing. The commission proposed several reforms, specifcally to the functioning of the IMF, to address these problems, though the report also considered the role of the World Bank, the RDBs, the WTO, and the BIS. The role of the IMF in particular was seen as relevant to avoiding fnancial crises and resolving crises that may occur. Other reports included the Geneva Report (1999) and the Overseas Development Council Report (2000). Williamson (2000) reviewed the fndings of these various reports and made the following recommendations: • The IMF should narrow its activities and focus more on its core competencies in the areas of surveillance and ensuring macroeconomic stability among member countries. • The IMF’s surveillance should take the form of surveilling the world economy its member countries. • The IMF should focus on the role of being a lender of last resort to member countries affected by crisis, and countries should have to ‘prequalify’ for assistance, instead of the conditionality, which is linked to IMF lending. • The World Bank and the RDBs need to concentrate on providing technical assistance and public goods and facilitating private sector fows to middle-income countries. They should replace loans going to developing countries with grants, with the condition that the recipient countries have a good record of delivery. 7.6.2 Proposals on reform after the global fnancial crisis The global fnancial and economic crisis of 2007–2010 exposed the faws in the precrisis global fnancial architecture in terms of its implementation and structure. Looking back, the warning signs were quite clear, given the policy lapses and wrong judgements. Schinasi and Truman (2010) argue that the global fnancial architecture, in terms of structure and implementation, was not effective in advancing corrective measures at the national, regional, continental, or global level until the global fnancial system was affected by a full-scale global crisis. Elson (2017) suggests that the global fnancial crisis has raised questions regarding the effectiveness of the global fnancial

Chapter 7 • Global fnancial architecture 199

architecture’s crisis-prevention capabilities, and clear defects can be identifed in its international guidelines for fnancial regulation, international policy coordination, the oversight of global fnancial stability, and the global fnancial safety net. Even though some improvements have been made in reforming the global fnancial architecture as well as the Financial Stability Board (FSB), a signifcant number of reforms are still needed to enhance the ability to safeguard global fnancial stability and address global crises. The FSB, as an international body, exists to promote global fnancial stability by ensuring that the development of regulation and the formulation fnancial sector policies are well coordinated. Box 7.5 provides a profle of the FSB.

BOX 7.5 Financial Stability Board The Financial Stability Board (FSB) was founded in April 2009 and is responsible for monitoring and providing advice concerning the global fnancial system. It was created to succeed the Financial Stability Forum (FSF), which was established in 1999 by the G7 ministers of fnance and governors of central banks in line with the recommendations that Dr Hans Tietmeyer, president of the Deutsche Bundesbank, gave. Dr Tietmeyer was commissioned by the G7 to propose new structures to enhance cooperation among the various international and national supervisory bodies and IFIs in order to ensure the promotion of global fnancial system stability. He recommended the setting up of a FSF that was endorsed in February 1999 at a meeting by G7 ministers and governors in Bonn. The frst FSF was convened in Washington, DC, in April 1999. In November 2008, the G20 countries’ leaders asked for an expansion of the FSF to enhance its effectiveness. The membership of the FSF was expanded and re-established as the FSB. This was announced at the G20 Leaders’ Summit in April 2009. The FSB was established to specifcally carry out the following functions: • Assessing vulnerabilities affecting the global fnancial system and identifying and reviewing, on a timely and ongoing basis in a macro prudential perspective, the regulatory, supervisory, and related actions needed to address these vulnerabilities and their outcomes, promoting coordination and information exchange among authorities responsible for fnancial stability. • Monitoring and providing advice on market developments and their implications for regulatory policy • Monitoring and providing advice with regard to best practice in meeting regulatory standards • Undertaking joint strategic reviews of the international standard setting bodies and coordinating their respective policy

200 Joshua Yindenaba Abor et al.

• • • •

development work to ensure this work is timely, coordinated, focused on priorities and addresses gaps. Setting guidelines for establishing and supporting supervisory colleges. Supporting contingency planning for cross-border crisis management, particularly with regard to systemically important frms. Collaborating with the IMF to conduct early warning exercises. Promoting member jurisdictions’ implementation of agreed commitments, standards, and policy recommendations, by monitoring the implementation and through peer review and disclosure.

It is composed of a Steering Committee and three Standing Committees, (i.e. Standing Committee on Supervisory and Regulatory Cooperation [SRC)], Standing Committee on Assessment of Vulnerabilities [SCAV], and Standing Committee on Standards Implementation [SCSI]). The FSB certainly has a signifcant role to play to promote stability in the global fnancial system. Strict adherence to and implementation of the international standards by members of the FSB is critical to achieving the overarching objective of international fnancial stability. Source: www.fsb.org/about/

Schinasi and Truman (2010) identifed six principal areas to consider in reforming the global fnancial architecture: • Regulatory requirements for capital, liquidity, and leverage and the potential benefts/costs of systemic-risk taxes. • Perimeters or boundaries of fnancial regulation, supervision, and infrastructures. • The regulation and surveillance of global money and fnancial markets. • Systemically important fnancial institutions or the ‘too big to fail’ (TBTF) problem • Crisis management, rescue, and resolution. • Effective management of volatile capital fows.

7.7 OTHER NOTEWORTHY ORGANISATIONS/GROUPS 7.7.1 The Group of Seven (G7), Group of Ten (G10) and Group of 20 (G20) The G7, G10, and G20 all play crucial roles in the global fnancial architecture due to the infuence they wield and the impact their decisions have on other countries. The G7 serves as a forum for the major industrial nations to discuss economic and fnancial issues among themselves.

7.7.1.1 THE GROUP OF SEVEN (G7)

Chapter 7 • Global fnancial architecture 201

It was formed in 1975 after the collapse of the exchange rate system in 1971, the 1970s energy crisis and the recession that followed, and during the time of the Nixon shock. The main aim was to expedite shared macroeconomic plans and activities. The member countries are Canada (joined in 1976), France, Germany, Italy, Japan, the United Kingdom, and the United States. The presidents of the European Council, the European Commission, and the managing director of the IMF also participate in G7 meetings. Russia was a member from 1997 until it was suspended in 2014 after its annexation of Crimea; Russia withdrew in 2017. When Russia was a member, it was known as the G8. In addition to the yearly meeting of heads of states, since 1987, the fnance ministers and Central Bank governors of the G7 nations have met at least every half-year to review and assess economic happenings and policies. The presidency of the group operates on a rotating basis annually, a new term commencing on 1 January of the year. The order is as follows: France, the United States, the United Kingdom, Germany, Japan, Italy, and Canada. The G7 is important in the global fnancial architecture because of the wealth and importance of its member countries. However, critics have argued that the G7 no longer represents the world’s most powerful economies since China is not a member. The following are some of the initiatives that the G7 has launched: 1 The G7 launched an initiative for 42 heavily indebted poor countries (HIPC) in 1996. 2 In 1999, the G7 got more directly involved in the management of the international monetary system through the Financial Stability Forum, which was formed earlier in 1999, and the G20, which was set up after the summit to improve discourse between major industrial and emerging market countries. The G7 also announced their plan to cancel 90% of bilateral and multilateral debt for the HIPC, totalling USD100 billion. 3 In 2005, the G7 decided to reduce debts by up to a 100% on a situation by situation basis. 4 In 2008, the G7 met twice in Washington, DC, and in Rome in February 2019 to deliberate on the global fnancial crisis. The G10 refers to a group of 11 countries that agreed to play a part in a supplementary borrowing arrangement for the IMF. This is known as the General Arrangements to Borrow (GAB), and it allows the countries to offer support when the IMF’s resources are found to be less than what a member country, and in some exceptional cases a nonmember country, needs. This GAB was formed in 1962 by the governments of eight IMF members and the central banks of two others: Germany and Sweden. Although Switzerland joined in 1962, the name G10 was maintained. After it was formed, it broadened its engagement with the IMF, which led to the creation of the Special Drawing Right (SDR) in 1969. The G10 was also the medium for the discussions that led to the Smithsonian Agreement after the collapse of the Bretton Woods system. Due to the importance of its activities, the Bank for International Settlements (BIS), the European

7.7.1.2 THE GROUP OF 10 (G10)

202 Joshua Yindenaba Abor et al.

Commission, the IMF, and the OECD are offcial observers of the activities of the G10. The members of the G10 are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. The Basel Committee on Banking Supervision (BCBS) was set up by central bank governors of the G10 countries in 1974. The G20 is a group made up of counties with both advanced and emerging economies. The members are Argentina, France, Japan, South Africa, Australia, Germany, the Republic of Korea, Turkey, Brazil, India, Mexico, the United Kingdom, Canada, Indonesia, Russia, the United States, China, Italy, Saudi Arabia, and the European Union. The G20 was created in 1999 to improve policy coordination between its members, stimulate fnancial stability, and reform the international fnancial architecture following the 1990s fnancial crisis. Membership in the G20 includes the heads of state and government, fnance ministers, and central bank governors of the G7, 12 other key countries, the European Union, and the European Central Bank. The managing director of the IMF and the president of the World Bank, plus the chairs of the IMFC and the Development Committee, also participate in G20 meetings on an ex offcio basis. The IMF works closely with the G20, particularly on issues related to global economic growth and international monetary and fnancial stability. The IMF’s work often provides a platform for G20 deliberations; vice versa, agreements reached at the G20 level are taken into consideration in the IMF’s decision-making process, even though such agreements have no legal status or binding effects at the IMF. The G20 works closely with the OECD, which is profled next.

7.7.1.3 THE GROUP OF 20 (G20)

7.7.2 The Organisation for Economic Cooperation and Development (OECD) The OECD is an intergovernmental economic organisation with 36 members. It was formed in 1961 to kindle international trade and economic growth. The OECD’s member countries and partners collaborate on global issues at local, national, and regional levels. Its headquarters are in Paris, France. The OECD works with government policymakers and citizens to set international norms and fnd solutions to social, economic, and environmental issues. Some of the issues they work on include improving economic performance, creating jobs, improving education, and battling international tax evasion. All of this is done through data and analysis, the exchange of experiences, best practice sharing, and advice on public policies and global standard setting. The OECD works through a secretariat. The Secretariat’s work is oriented by OECD members whose representatives participate in OECD committees and working parties. There are some committees with each directorate or department supporting one or more committees. There are also some committee working parties and subgroups. The OECD has a well-being index based on 11 topics: housing, income, jobs, community,

Chapter 7 • Global fnancial architecture 203

education, environment, civic engagement, health, life satisfaction, safety, and work–life balance. The OECD has acted as a strategic advisor and is an active partner to the G20. The OECD participates in G20 working group meetings and provides data, analytical reports, and proposals on specifc topics, sometimes in collaboration with other international organisations. The OECD contributes to all stages of preparation of G20 summits. The G20 does not have a secretariat but relies on the support of established international organisations. As a result, the OECD secretariat has evolved into a quasi-secretariat of the G20. For example, the OECD and G20 countries worked together for two years to develop new international tax standards and measures, addressing issues like preventing treaty shopping, country-by-country reporting, and fghting harmful tax practices.

7.8 THE UN SUSTAINABLE DEVELOPMENT GOALS (UN SDGS) The SDGs consist of 17 goals and 169 targets adopted by the United Nations in 2015 to replace the Millennium Development Goals (MDGs). The goals relate to development and empowerment and include issues such as poverty, hunger, women’s empowerment, affordable and clean energy, taking care of the environment, decent work, clean water and sanitation, and quality education. Given the worldwide scale of the SDGs, meeting the SDGs is expected to lead to more development overall. The United Nations Conference on Trade and Development (UNCTAD) in 2015 estimated that about USD5–7 trillion would be required annually until 2030 in order to achieve the SDGs. This funding gap is enormous and may require the support of fnancial institutions. The SDG fnancing gap arguably represents a tremendous opportunity for fnancial institutions. Weber (2018) argues that fnancial institutions have a critical role to play in fnancing the SDGs through various fnancing options. He outlines different types of banking as well as fnancial products and services that might address the SDGs, including conventional banking. These include socially responsible investing (SRI), impact investing, social banking, green and social impact bonds, development banking, project fnance, and green lending. Schmidt-Traub and Sachs (2015) point out that multilateral development banks (MDBs) have the requisite structures and mechanisms to fnance the SDGs because of their mandate to support development-related programmes, expertise of their staff, and track record in managing complex projects, among other strengths. However, they posit that the conservative loan approach of MDBs is a constraining factor on their increasing their lending activities. Wiek and Weber (2014) posit that the fnancial sector can both be the source of sustainability problems and the solution to those problems through their fnancing choices. Some MDBs fnance climate-change-mitigation

204 Joshua Yindenaba Abor et al. TABLE 7.2 Financial products and services addressing the SDGs Goal

Goal detail

Suggested fnancial product for fnancing

1

No poverty

2 3 4 5

No hunger Good health and well-being Quality education Gender equality

6

Clean water and sanitation

7 8

Affordable and clean energy Decent work and economic growth

9

Industry innovation and infrastructure

Private international development fnance through impact investing Microfnance for smallholder farmers Healthcare investments Philanthropic donations to schools Microfnance and lending to women and female entrepreneurs Socially responsible mutual funds investing in water Renewable energy investment General investments into the real economy Project fnance and commercial lending integrating social and environmental criteria for lending decisions Fair payment of fnancial sector employees Mortgage lending Socially responsible investing

10

Reduced inequalities

11 12

Sustainable cities and communities Responsible consumption and production Climate action Life below water Life on land Peace, justice, and strong institutions

13 14 15 16

Climate fnance Financing ecological services Financing ecological services Lending to public institutions

Source: Weber (2018)

and climate-change-adaptation projects while fnancing coal power plants (Ghio, 2015; Yang & Cui, 2012).

7.9 CONCLUSION This chapter has provided an extensive review of the wide range of institutions that make up the global fnancial architecture. There has been signifcant expansion and development of the global fnancial architecture since the end of the Second World War and especially in more-recent decades with the unprecedented growth in global capital fows and the globalisation of trade. We have paid particular attention to the events that have led up to and that have emerged since the eruption of the global fnancial crisis in 2008. Since the 1970s, there has clearly been a marked shift in the focus of global and national fnancial regulation away from product and price controls and towards stronger prudential regulation and supervision. Global competition has never been more intense, but more-recent events have exposed the extent to which fnancial institutions are vulnerable to greater risks in the context of a rapidly evolving global fnancial framework.

Chapter 7 • Global fnancial architecture 205

Discussion questions 1 Describe the global fnancial architecture and the key features of the international fnancial system? 2 Consider any country of your choice and examine the structural adjustment programme implemented in that country. Evaluate the success or otherwiseof the programme. 3 Discuss the role of regional development banks in fnancing development projects.

4 What is fnancial globalisation? Examine the relevance and benefts of fnancial globalisation and the risks associated with it. 5 Discuss the dynamics of fnancial globalisation. In what ways did fnancial globalisation contribute to the global crisis? 6 Evaluate some of the proposals on reform after the global fnancial crisis.

References Baffoe, J. K. (2000). Structural adjustment and agriculture in Uganda. Working Paper 149. Geneva: International Labour Offce. Bernanke, B. S., Bertaut, C., DeMarco, L. P., & Kamin, S. (2011). International capital fows and the returns to safe assets in the United States, 2003– 2007. Banque de France Financial Stability Review, 15, 13–26. Christiaensen, L. J., Demery, L., & Paternostro, S. (2001). Growth, distribution and poverty in Africa: Messages from the 1990s. Washington, DC: World Bank. Culpeper, R. (1997). The multilateral development banks: Titans or Behemoths? Boulder, CO: Lynne Rienner; Ottawa: The North-South Institute. Easterly, W. (2000). The effect of IMF and World Bank programs on poverty. Mimeo. Washington, DC: World Bank. Einhorn, C. S. (2013). Can you fght poverty with a fve-star hotel? Foreign Policy. Retrieved from https:// foreignpolicy.com/2013/01/02/canyou-fight-poverty-with-a-five-starhotel/ Elson, A. (2010, March). The current fnancial crisis and reform of the global fnancial architecture. The International Spectator, 45(1), 17–36. Elson, A. (2017). The role of the international fnancial architecture prior to

and since the global fnancial crisis. In The global fnancial crisis in retrospect. New York: Palgrave Macmillan. Ghio, N. (2015). New report once again shows danger of MDB fnancing for large fossil fuel projects. The Huffington Post. Retrieved from www. huffpost.com/entry/new-report-onceagain-sho_b_7102638 IMF. (1998). Uganda-enhanced structural adjustment facility policy framework paper 1998/99–2000/01. Washington, DC: Author. Klasen, S. (2003). What can Africa Learn from Asian development successes and failures? Review of Income and Wealth, 49(3), 441–451. Lane, P. R., & Milesi-Ferretti, G. M. (2007). The external wealth of nations Mark II: Revised and extended estimates of foreign assets and liabilities, 1970–2004. Journal of International Economics, 55, 263–294. Lund, S., Windhagen, E., Manyika, J., Harle, P., Woetzel, J., & Goldshtein, D. (2017). The new dynamics of fnancial globalization. McKinsey Global Institute. Retrieved from www.mckinsey. com/industries/financial-services/ our-insights/the-new-dynamics-offnancial-globalization Mosley, P., Harrigan, J., & Toye, J. (1995). Aid and power: The World Bank and

206 Joshua Yindenaba Abor et al. policy-based lending (2nd ed.). London: Routledge. OXFAM. (2015). Billions in ‘out of control’ IFC investments into third parties causing human rights abuses around the world. OXFAM International. Retrieved December 3, 2017, from www.oxfam. org/en/pressroom/pressreleases/ 2015-04-02/billions-out-control-ifcinvestments-third-parties-causinghuman-rights-abuses Rao, P. K. (2003). Development fnance. Berlin: Springer Science & Business Media. Schinasi, G. J., & Truman, E. M. (2010). Reform of the global fnancial architecture. Peterson Institute for International Economics, Working Paper Series, WP10-14. Retrieved from https:// ideas.repec.org/p/iie/wpaper/wp1014.html Schmidt-Traub, G., & Sachs, J. D. (2015). Financing sustainable development: Implementing the SDGs through effective investment. Retrieved from https:// www.semanticscholar.org/paper/ Financing-Sustainable-Development% 3A-Implementing-the-SchmidtTraub-Sachs/ca9af2d591bdc06d855 abbdfa874a39964f8bdd2 Spratt, S. (2009). Development fnance: Debates, dogmas and new directions. New York: Routledge. Weber, O. (2018, November). The fnancial sector and the SDGs interconnections and future directions. Centre for International Governance and Innovation

CIGI Papers No. 201. Washington, DC: World Bank. Wiek, A., & Weber, O. (2014). Sustainability challenges and the ambivalent role of the fnancial sector. Journal of Sustainable Finance & Investment, 4(1), 9–20. Williamson, J. (1990). What Washington means by policy reform. In J. Williamson (Ed.), Latin American adjustment: How much has happened? Washington, DC: Institute for International Economics. Williamson, J. (1999). Implication of the East Asian crisis for debt management. In mimeo. Coventry: University of Warwick. Williamson, J. (2000). What should the World Bank think about the Washington consensus? The World Bank Research Observer, 15, 251–264. World Bank. (1994). Adjustment in Africa: Reforms, results, and the road ahead. New York: Oxford University Press. World Bank. (2000). Can Africa claim the 21st century? New York: Oxford University Press. Yang, A., & Cui, Y. (2012). Global coal risk assessment: Data analysis and market research. Working Paper. World Resources Institute. Retrieved from https://pdf.wri.org/global_coal_risk_ assessment.pdf Yeyati, E. L., & Williams, T. (2014). Financial globalization in emerging economies: Much ado about nothing? Economia, 14(2), 91–131.

CHAPTER

8

Sovereign wealth management Mbako Mbo and Charles Komla Delali Adjasi 8.1 INTRODUCTION Sovereign wealth management centres on prudent public fnance management, wherein the need to plan for economic shocks and taking care of excess liquidity (arising mainly from monetised natural resources), have historically motivated a conscious approach to managing sovereign wealth. In essence, current wealth accruing to the state is partly saved up for the future. Countries endowed with natural resources periodically experience excess liquidity, particularly corresponding to periods of global economic boom, but quite commonly too, recessions do occur. Thus, the effects of economic recessions are substantially diluted by calling up on fnancial wealth accumulated during periods of excess liquidity. Countries beneft from their natural resources in a number of ways; Chile, which opted to nationalise its copper mines, benefts directly from fnancial returns from these mines, just as the state-owned oil companies among the Persian Gulf countries have been at the forefront of sovereign wealth creation in that region. Botswana, a country frequently cited as an African example of how natural resources can transform a nation, has not nationalised its diamond and other mines (although it holds a stake), but rather benefts through distributions, royalties, and taxes. Although natural resources dominate the original sources of allocations made towards sovereign wealth accumulation by governments, with oil and gas in the lead at 56% of the cases,1 the Wharton Leadership Centre lists other common sources as balance of payment surpluses, offcial foreign currency operations, the proceeds of privatizations, fscal surpluses, and receipts resulting from commodity exports.2 Although countries have held reserves in one form or another for centuries, the concept of managing sovereign wealth in a fund setup is a recent one, commonly associated with funds that evolved alongside the Persian Gulf States oil strikes in the 1950s. Successive waves of similar types of funds continued to emerge almost throughout the decades that followed, corresponding mainly to booms in oil and other natural resources in countries like South Korea, UAE, Saudi Arabia, and Iran. With the proliferation and success of sovereign wealth funds (SWFs)3 since the 1950s, the objectives of sovereign wealth management have been interestingly expanding, particularly so in emerging economies. The

208 Mbako Mbo and Charles Komla Delali Adjasi

increasing pressures on traditional sources for domestic infrastructure development funds in particular have forced governments to seriously look into the diversifcation and externalisation of revenue streams. In 2007 the International Monetary Fund (IMF)4 offered a broad categorisation of funds involved in sovereign wealth management, on the basis of their stated objectives: 1 2 3 4 5

Stabilization funds. Savings funds. Reserve investment funds. Development funds. Contingent pension reserve funds.

The expanding objectives and focus of sovereign wealth management have reshaped the approach to it and its position in the global economy, fnancial markets in particular. In this chapter, we look at the evolution and overview of sovereign wealth management, the changing role of sovereign wealth managers, asset-liability management in emerging economies, asset allocation and risk management for sovereign wealth funds, and the challenges and opportunities of sovereign wealth funds.

8.2 THE CONTEXT OF SOVEREIGN WEALTH MANAGEMENT The existence of failed economies around the world epitomises the reality that sovereign states, just like corporations, can fall into positions where they have no resources with which to fulfl their sociopolitical and national defence objectives. Unfortunately, failed economies are not always a result of a lack of economic resources, and causes extend to poor governance and sheer lack of economic foresight; in all probability, this situation is avoidable. For example, in ‘Conceptualising the Causes and Consequences of Failed States’, John (1998) cites countries like Venezuela, Tanzania, Ghana, and Zambia as some of the countries that faced the imminent failure of the economy at some point. This is despite a wide range of economic resources that these countries have been endowed with – for example, the diamonds and natural gas in Venezuela, copper in Zambia, and forestry and wildlife resources in Tanzania. Ghana has since emerged as one of the fastest growing economies across the African continent, posting an impressive gross domestic product (GDP) growth Awanzam and Okudzeto (2018). However, good governance and sociopolitical unrest on their own are not enough; countries heavily dependent on natural resources in particular are prone to both resource depletion and moderate to severe economic shocks. A case in point is what transpired in the oil-rich Middle East as an aftermath on the 2007/2008 global fnancial crises. Aggregate GDP growth rates for Golf Cooperation Council (GCC) economies dropped from 7.2% to a mere 0.8%, and housing prices plummeted by as much as 62% in Kuwait (Salah, 2010). Although the role of the government in the global economy has gradually neutralised over time, albeit at different scales across geographies, private wealth is yet to demonstrate its ability to avert, its willingness to avert, or even an active relevance in averting state economic failures. On the contrary, we have seen state bailouts and private capital fight during times of economic hardship; the 2007/2008 fnancial crises saw the US federal

Chapter 8 • Sovereign wealth management 209

government approve a USD700 billion rescue plan for corporations that were facing total collapse as a result of an economic downturn. Otherwise, capital outfow patterns displayed some negative response to the fnancial crises (Cheung, Steinkamp, & Westermann, 2013). Clearly, good economic governance should embody foresight, and an average economy must be able to withstand severe but plausible economic shocks, at least over a period of time. With such in place, a sovereign will maintain socioeconomic stability, which is also critical for retaining private capital. Private capital is simply not widely available for the rescue of sovereigns facing economic troubles; it is for the creation of private wealth. Consequently, SWF management needs to become a prominent feature of good economic management.

8.3 THE ANALYTICAL FRAMEWORK To put the discussions of this chapter into context, we use the analytical framework in Figure 8.1. FIGURE 8.1 A conceptual framework for SWF BODY OF THEORY

Trade Surpluses

Evolution of Sovereign Wealth Management

˜ Lessons Learnt (Economic

˜

downturns)

˜ Strategic Control

Theories of Economics International Trade Theory Financial Management Theories

Sovereign Wealth Funds (SWFs)

˜

Set-up

Funding

˜ ˜

Management

˜

Commercialized Public Entity Outsourced Management Level of Political control Board Structures

Corporate Governance The

more

“Traditional Funds by role/type o Stabilization o Savings o Reserves & Pensions o Development A policy Tool

Roles”

The Role of Sovereign Wealth Funds

The emerging Roles

An international Economic Cooperation Tool

Opportunities Capital availability Public Private Partnerships Patient Capital

Challenges risk/return Information Asymmetry Threats to financial stability adjustment, role of Government

Capital

flow

patterns,

Asset Price distortions

210 Mbako Mbo and Charles Komla Delali Adjasi

8.4 EVOLUTION AND OVERVIEW OF SOVEREIGN WEALTH MANAGEMENT SWF management gained momentum from the 1950s with the setting up of funds focused on sovereign wealth investment, which progressively got dotted the globe, as depicted in Figure 8.2. Even though the term ‘sovereign wealth fund’ is believed to have been coined as recently as 2005, funds involved in the management of sovereign wealth have been emerging over several decades, particularly since the 1950s. In Figure 8.3, we show the trends in the building up of these funds over the years, which for now we shall not necessarily refer to as sovereign wealth funds. FIGURE 8.2 Evolution of SWF over time

FIGURE 8.3 Cumulative growth in the number of funds, 1953–2017 90 80 70 60 50 40 30 20

0

1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

10

Chapter 8 • Sovereign wealth management 211

For the purposes of our discussion, the proliferation of funds involved in the management of sovereign wealth (see Dixon, 2016) shall be considered in three distinct phases; before the 1970s, before the fnancial crisis of 2007/2008, and the period following the 2007/2008 global fnancial crisis. 8.4.1 Before the 1970s According to the Sovereign Wealth Fund Institute, only three sovereign wealth–focused funds were in existence as of the fall of 1970, domiciled in the US and the Persian Gulf regions. It is widely believed that the Kuwait Investment Board, founded in 1953 (now the Kuwait Investment Authority) was the world’s frst investment vehicle to be given a sovereign wealth management mandate, followed three years later by the Revenue Equalisation Reserve Fund in the pacifc island of Kiribati. The genesis of Kuwait’s massive wealth potential came with the oil discovery in 1938, although no large-scale exploration activities were carried out until after World War II. By 1951 Kuwait had begun signifcant oil trading activities, realising massive exports leading to an impressive sovereign wealth accumulation trend. This growth in wealth then triggered the setting up of a sovereign wealth– focused fund in 1953. Around the same time, the geographically isolated pacifc island of Kiribati (then Gilbert), which had traditionally relied on tax and royalty revenues linked to phosphate mining, was forecasting a decline in national income. The Revenue Equalisation Reserve fund was thus set up in 1956 to diversify sources of government revenues from phosphate-mining activities. Alongside Kuwait, Saudi Arabia discovered massive oil deposits, although its exploration work and actual trading began much earlier. The kingdom experienced a large infux of foreign currency from its oil-related exports as from the late 1930s prompting the king, under the advice from some US offcials, to set up a central bank of some sort. Thus, the SAMA Foreign Holdings was formed in 1952, but initially not with a specifc sovereign wealth management mandate like that of the Kuwait Investment Board. SAMA, or the Saudi Arabian Monetary Authority, has since evolved to be the kingdom’s fully fedged central bank, with just under USD500 billion in assets under management (AUM) by February 2018. The concept of managing sovereign wealth gained recognition during the early 1950s, driven by two primary variables: excess wealth accumulating from monetised oil resources (Kuwait and Saudi Arabia) and the need to diversify the economy from overrelying on a single commodity (Kiribati). According to the Sovereign Wealth Fund Institute, no further funds came into being until the mid 1970s, when another wave was experienced, lasting into the 2000s. This phase is considered in the next section. 8.4.2 Before the fnancial crisis of 2007/2008 The Sovereign Wealth Fund Institute lists 37 funds with mandates related to sovereign wealth management that emerged between 1974 and 2006, a

212 Mbako Mbo and Charles Komla Delali Adjasi

year before the global fnancial crisis of 2007/2008. Oil and other natural resources continued to dominate the origins of the funds, but other sources began to emerge, including surpluses on balance of trade accounts and general budget surpluses. The regional dominance by oil-rich territories began to dilute as well, and Asia took the lead in funds emerging as of 1969 and until 2006, funded from sources other than oil. The historically central role played by oil production in the evolution of sovereign wealth management cannot be underplayed. The average OPEC oil price (crude) per barrel experienced signifcant downwards pressure as from the mid 1980s, remaining relatively subdued at below USD20 per barrel until two decades later, when the price recovered to an average USD27.6 per barrel in 2000. Corresponding to this is a signifcant drop in the emergence of sovereign funds, particularly outside Asia were only three funds were registered in Norway (Government Pension Fund–Global in 1990), Botswana (Pula Fund in 1994), and Abu Dhabi (Mubadala Investment Company in 2002 and Abu Dhabi Investment Council in 2007). Similarly, unlike the Persian Gulf countries, the advent of sovereign wealth management in Eastern and South Eastern Asian countries was not predominantly driven by oil production. Most sovereign wealth– focused funds in these countries emerged after 1970, alongside a wave of industrialisation among the Asian Tigers (Singapore, Hong Kong, Taiwan, and South Korea). A signifcant rise in economic performance was also being registered in Southeast Asia as from the late 1960s into the next few decades, driven mainly by the ability to export agricultural produce and processed food. Oil regained its position as a signifcant driver of sovereign wealth, with an upsurge of oil surplus originated funds between 2000 and 2007 in oil-rich states in Asia once again, but particularly in the Middle East. This is a period characterised by a steadily rising price of crude oil, which improved from an average of USD28 per barrel in 2000 to USD69 per barrel in 2007 and up to USD94 in 2008, before a dramatic drop to USD61 per barrel a year later.

FIGURE 8.4 SWF by source of seed capital Original Sources of funds emerging between 1970 and 2006

Non oil sources

South Amercia Africa & Europe Middle East

Other sources Asia

Oil

Chapter 8 • Sovereign wealth management 213 FIGURE 8.5 Evolution of SWFs in Asia (pre-2007/2008 fnancial crisis)

Asia

1970–1979 1980–1989 1990–1999 2000–2007

Temasek Holdings (Singapore)   Hong Kong Monetary Authority Investment Portfolio Khazanah Nasional (Malaysia) Brunei Investment Agency Singapore Investment Corporation Hong Kong Monetary Authority Investment Portfolio SAFE Investment company (China) Kazakhstan National Fund (Kazakhstan) State oil fund (Azerbaijan) Korea Investment Corporation Timor Leste Petrolium Funds (East Timor) State Capital Investment Corporation (Vietnam)

The Middle East region has been the pioneer of sovereign wealth management, driven mainly by accumulating oil-linked fscal surpluses. The oil surpluses were supported by steady to rising oil production on the back of a strong recovery of global crude oil prices. Figure 8.6 depicts crude oil production and price trends between 1998 and 2008. During this period, seven sovereign funds came into being, four of which in the United Arab Emirates (UAE), where the average daily oil production grew by 16% from 1999 levels to exceed three million barrels per day in 2007. Production in Bahrain and Oman remained fairly stagnant between 1999 and 2007, with marginal oscillations, while Qatar registered an impressive 75% jump in daily oil production in the same period. The evolution of sovereign wealth management in Africa continued, but at a more noticeable pace only from the early 2000s. Oil-rich nations like Libya, Gabon, and Algeria had lagged behind for geopolitical and economic reasons. Libya, for one, emerged from heavy sanctions imposed on it frst by the US in 1978 initially targeting military supplies but later extending to oil trade in 1982. The United Nations (UN) and the European Union (EU) also came up with their own sets of sanctions against Libya in 1992, thereby compounding the trade complications. Not until 2004 did the US lift its sanctions, followed shortly by the EU and UN. This opened new trade possibilities between Libya and rest of the world, coming at a time when the oil price was on a speedy recovery, exceeding USD50 per barrel for the frst time in history in 2005. Surpluses began to soar, and the Libyan Investment Authority was born in 2006. Algeria joined the bandwagon in 2000, after successfully arresting its own economic woes, which included crippling amounts of public debt, widening fscal defcits and arguably, limited trading partners (until then,

214 Mbako Mbo and Charles Komla Delali Adjasi FIGURE 8.6 Trends in the Middle East: oil prices and production 12,000

100

1,000 barrels per day

80 70

8,000

60 50

6,000

40

4,000

30 20

2,000 -

USD/barrel of crude oil

90

10,000

10 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Iran

Iraq

Kuwait

Qatar

Saudi Arabia

United Arab Emirates

Other Middle East

Oil Prices

-

FIGURE 8.7 Evolution of SWFs in the Middle East (pre-2007/2008 fnancial crisis)

Middle East

1970–1979 1980–1989 1990–1999 2000–2007

Abu Dhabi Investment Authority Saudi   Arabia Public Investment Fund State General Reserve Fund (Orman) Abu Dhabi investment Council Mubadala Investment Company (Abu Dhabi) Investment Corporation if Dubai Orman Investment Fund Mumtalaka Holding (Bahrain) Qatar Investment Authority RAK Investment Authority – UAE

 

 

 

Algeria had remained too reliant on France, and the ties between the two countries remain strong to date). Other nations like Gabon, where a sovereign wealth fund came into being in 1998, and Equatorial Guinea, where the Future Generations Fund was incepted in 2002, had previously limited their international trading avenues through their own laws and regulations. Gabon, after joining the WTO in 1995, introduced a new and relatively progressive investment code in 1998, which was seen as conforming, in all material respects, to the Central African Economic and Monetary Community (CEMAC) investment regulations. This facilitated domestic trade but more importantly, from sovereign wealth perspective, Gabon’s ability to partake foreign investment. Equatorial Guinea made its large oil discovery in 1996, but its recorded sovereign wealth management activity began in 2002, when reserves accumulated to signifcant growth, driven by increasing production supported by improving prices of crude.

Chapter 8 • Sovereign wealth management 215 FIGURE 8.8 Evolution of SWFs in Africa (pre-2007/2008 fnancial crisis)

Africa

1970–1979 1980–1989 1990–1999 2000–2007

Revenue Regulation Fund (Algeria)   Gabon Sovereign Wealth Fund National Fund for Hydrocarbon Reserves (Mauritania) Fund for Future Generations (Equatorial Guinea) Pula Fund (Botswana) Libyan Investment Authority

 

 

FIGURE 8.9 Evolution of SWFs in other parts of the world (pre-2007/2008

fnancial crisis)

Other

1970–1979 1980–1989 1990–1999 2000–2007

  Alaska Permanent Fund (US) Social and Economic Stabilisation fund (Chile) New Zealand Superannuation Fund Future Fund (Australia) Government Pension Fund–Global (Norway)

 

 

 

Like in the period leading to 1970, the evolution of sovereign wealth management into the 21st century was driven predominantly by fscal surpluses, although the dominance of oil as the major contributor to such surpluses somewhat declined between 1980 and 1999, mainly as a result of depressed oil prices. Industrialisation and commodity-led international trade boosted the accumulation of surpluses among the Asian Tigers (Singapore, Hong Kong, Taiwan, and South Korea) and the high-performance economies in Southeast Asia. The signifcant and sustained recovery of global crude oil prices in the early years of the 21st century propelled fscal prosperity in oilrich states, particularly in Middle East but also, interestingly, in Africa, where economic reforms were being undertaken alongside improving geopolitical dynamics in countries such as Libya, Gabon, Algeria, and Guinea-Bissau. 8.4.3 Period succeeding 2007/2008 global fnancial crisis The majority of countries around the world experienced a major economic downturn due to the 2007/2008 fnancial crises, which affected both advanced and emerging economies. The genesis of these crises has been traced to the US subprime lending, which is estimated to have swelled up to

216 Mbako Mbo and Charles Komla Delali Adjasi

a trillion dollars by 2007, representing a signifcant 7% of overall outstanding mortgages in the US. Perhaps two main features made the subprime mortgage prominently problematic: 1 Low credit quality (i.e. the borrowers in this instance were generally those with ultra-low credit scores). 2 The loan-to-value ratios were high. As fate would have it, the housing market collapsed, and borrowers defaulted and could not release the bonded assets primarily, because market conditions were not supportive. Credit losses among individual banks swelled up to drastically affect the collective banking market (see Shabbir, 2009), the ability to extend new credit lines shrunk, and the fow of money that was needed to propel economic growth dried up. The activity levels of creating, buying, and selling new assets hit historic lows, and international trade slumped, leading to reducing trade surpluses, forcing countries to turn to reserves. All this happened when the level of the integration of the world economy had advanced, with trade dependency on the historically isolated China estimated to be over 65%. This precipitated the rate at which the fnancial crises spread from the US to rest of the world. The reduced world economic activity, on the other hand, was affecting the global demand for oil, leading to a 33% slump in price of crude to average at USD61 per barrel during 2009. For sovereign wealth management, the surpluses that had, at this point, driven the evolution of sovereign funds were dwindling and in fact became a thing of the past in some jurisdictions. The two main drivers of these fscal surpluses had taken a hit: favourable trade balances and ‘healthy’ oil prices. Surprisingly, a total of seven sovereign funds came into being at the pick of the fnancial crises, four of which were funded from oil-related fscal surpluses (Saudi Arabia Public Investment Fund, Russia National Welfare Fund, Samruk-Kazyna JSC, and Turkmensistan Stabilisation Fund). Seemingly, important lessons were learnt from the effects of the fnancial crisis, as a historic 18 sovereign funds came into being within the frst

FIGURE 8.10

Evolution of SWFs: the aftermath of the 2007/2008 global fnancial crisis 2008–2009 2010–2016

Saudi Arabia Public Investment Fund Russia National Welfare Fund Samruk-Kazyna JSC: Kazakhstan Sovereign Fund of Brazil Turkmenistan Stabilisation Fund Sharjah Asset Management- UAE Russian Reserve Fund

Chapter 8 • Sovereign wealth management 217

six years after the pick of the crisis in 2008/2009. The naming conversion of some of the funds that came into being post fnancial crisis are refective of lessons learnt from the dangers of depleting reserves: North Dakota Legacy Fund, Colombia Savings and Stabilisation Fund, Western Australia Future Fund, Mongolia Future Stability Fund, West Virginia Future Fund, and Luxembourg Intergenerational Fund. Thus, instead of being seen primarily as a surplus driven vehicle, nations, perhaps from the lessons of the crises, began to comprehend the idea of actively seeking to create reserves for the future. Angola is also a case in point; in 2012, the government set up a USD5 billion SWF known as the Fundo Soberano de Angola (FSDEA) with a specifc mandate to safeguard existing wealth for future generations. Its investment philosophy was to target low-risk non-oil industries that would then diversify future wealth prospects away from oil. Despite a signifcant recovery of oil prices as from 2010 continuing until 2013, oil once again lost its dominance as an originator of sovereign wealth funds, and only seven of the 18 funds originated from oil-linked fscal surpluses. Natural resources, initially oil but later other resources like minerals, have supported the growth of global trade and attendant surpluses. SWM gained popularity: no fewer than 80 sovereign wealth funds dotted the globe5 by early 2018. The SWFI estimates its member SWF to have held a combined USD7.7 trillion in AUM at the end of February 2018.

FIGURE 8.11 Evolution of SWFs post-2007/2008 global fnancial crisis

2008–2009 2010–2016 National Development Fund of Iran Russia Direct Investment Fund North Dakota Legacy Fund–US Colombia Savings and Stabilisation Fund Kazakhstan National Investment Corporation Bayelsa Development and Investment Corporation-Nigeria Nigerian Sovereign Investment Authority Fondo de Ahorro de Panama FINPRO- Bolivia Senegal FONSIS Ghana Petroleum Funds Western Australia Future Fund Mongolia Future Stability Fund Papua New Guinea Sovereign Wealth Fund West Virginia Future Fund Fondo Mexicano del Petroleo Luxembourg Intergenerational Fund Turkey Sovereign Wealth Fund

218 Mbako Mbo and Charles Komla Delali Adjasi

8.5 SWF FUNDING, MANAGEMENT, AND GOVERNANCE 8.5.1 Funding As we highlighted in earlier sections, SWFs are born out of an intention to prepare for the future, be it to shield national revenues from volatility or saving for future generations. Invariably, governments allocate substantial amounts as seed capital for SWF formation; an example includes Angola’s FSDEA USD5 billion in 2012 (World bank, 2013). After its formation, funding modalities for SWFs differed, including a purely self-funding arrangement and some formula-based allocation from state revenues. SWFs like Mubadala of Abu Dabhi, Botswana’s Pula Fund, and Temasek of Singapore are examples of state-backed SWFs with no regular government funding. At the other end of the spectrum, the Funds for Future Generations in Equatorial Guinea has a commitment from the government for a stipulated 0.5% annual allocation from oil revenues. In between the continuum exist some SWF whose continuing state support is contingent on certain conditions or the occurrence of certain events. A perfect example in this case is the Economic and Social Stabilisation Fund of Chile, which from its inception had an entitlement to an allocation from a state budget devised when copper revenues were optimal. How an SWF is supported by a sponsoring government from time to time can be seen as linked to its broad objective or simply its type. Saving funds and stabilisation funds typically get a one-off but substantial capital and thereafter self-fund from a little portion of their returns: the portion that does not get reinvested. By contrast, development and future generations’ funds typically get additional allocations for incremental investments. 8.5.2 Governance and management structures The governance and management structures of SWFs are predominantly infuenced by investment strategy, investment approaches, and risk appetite. The setup normally ranges from institutional arrangements supported wholly by management and governance structures of a sponsoring institution (a ministry of fnance or a central bank), to a fully fedged institution with its own staff, management, and board. The former is typical with stabilisation and saving funds, which normally carry a low risk appetite, investing only in premium securities. Such an approach to investment does not call for fully fedged investment teams, because there is little monitoring beyond analysis and reporting; neither do they pursue any implementation of investment projects. Botswana’s Pula Fund is an example: it was set up by the central bank (Bank of Botswana), which manages and controls it under its regular management structures. The fund is essentially a longterm investment portfolio aiming to preserve part of diamond income for future generations through global investments in low-risk instruments. On the other end of the spectrum, we fnd Temasek, the Singaporean SWF. Temasek is a fully fedged corporation employing over six hundred personnel across its ten offces in different parts of the world. The SWF is

Chapter 8 • Sovereign wealth management 219

governed by a fully fedged 14-member board, with a team of 25 senior executives leading the operations. Again, the relevance of such a structure stems from Temasek’s approach to investment and from the risk appetite; it is an active investor that buys and holds stakes in subsidiaries and associate companies and spends time assessing other risky investments of higher long-term returns. Between these two extremes other variants may exist, typically involving a skeletal caretaker team hosted by the sponsoring government or central bank, where such a team would be involved in outsourcing asset management services to third-party frms not owned by a government. For instance, external managers administer the equity and corporate fxed-income portfolios of Chile’s SWF.

8.6 THE CHANGING ROLE OF SOVEREIGN WEALTH MANAGERS Traditionally, sovereign wealth management seems to have concerned itself with saving up current and trade surpluses for the future. Perhaps a more structured approach to defning the role of sovereign wealth managers can be borrowed from the IMF’s Global Financial Stability Report produced in October 2007, at the start of the US subprime crises. The report provides the following taxonomy: stabilisation funds, savings funds, reserve funds, development funds, and pension reserve funds. 8.6.1 Stabilisation funds These are set up to cater for effects on inadequate diversifcation of national revenue sources, typically by countries endowed with natural resources. Surpluses from the trade of the natural resources are saved and called upon when national revenues decline, usually due to depressed commodity markets. A perfect example is the Economic and Social Stabilisation Fund (ESSF) of Chile, established in 2007 to provide fscal spending stabilisation by reducing dependency on the global economic and copper trading cycles. The ESSF is funded from the fscal surplus, net of allocations to the Pension Reserve Fund, and any residual public debt obligations. Periodically, budgetary constraints imposed by economic downturns are mitigated by a partial call from the fund, thus avoiding the accumulation of national debt. 8.6.2 Savings funds These are ‘intergenerational funds’ that are based on monetising existing natural resources for the beneft of both present generations and future generations. As observed by the IMF, these funds effectively transfer nonrenewable assets into a diversifed portfolio of international fnancial assets to provide for future generations or other long-term objectives. An example in this case is the Equatorial Guinea’s Fonds de Réserves pour Générations Futures (Funds For Future Generations) formed in 2002. While a full picture

220 Mbako Mbo and Charles Komla Delali Adjasi

on the fund’s performance remains largely obscure, the government’s pronounced intention at the fund’s inception was to commit transferring to it 0.5% of its oil revenues for the beneft of the future generations. 8.6.3 Reserve funds Unlike the surplus-driven funds, which have tended to stabilise government budgets during times of constrained revenue infows, reserve funds are set up to pursue savings objectives, usually with increased latitude to actively pursue higher returns but still within the scope of a conservative risk appetite. According to the IMF, assets held under reserve funds count towards total fscal reserves and can be liquidated in times of need. A typical example is Botswana’s Pula Fund – established in 1994 and managed by the central bank of Botswana. The fund manages foreign exchange reserves that are more than what is expected to be needed in the medium term. Signifcant calls were made from the fund in 2001, when a Public Offcers’ Pension Fund was set up, and in 2008, due to a slump in national revenues that was induced by the global fnancial crisis of that time. 8.6.4 Development funds These are mostly development corporations, set up to pursue socioeconomic objectives. Typically, these corporations invest in projects with demonstrable development outcomes and in industries and sectors that do not have adequate private sector participation (mainly due to high risk but low returns). Increasingly, development funds are becoming vehicles for public–private partnership (PPP) transactions. Dubai Investment Capital (DIC), a subsidiary of Dubai Holding, is a corporate SWF with an investment strategy that incorporates well the concept of looking beyond fnancial returns for wider socioeconomic development. DIC played, and continues to play, a pivotal role in the development of the boating and marine sector in the UAE region through its investment in ART Marine Holdings. The company is also at the forefront of importing aerospace technology from the world into Dubai, through its investments. 8.6.5 Pension reserve funds These funds cater for pension liabilities, and the objective is often to ensure that pension liabilities always remain below funded assets without having to resort to some politically unacceptable mechanisms, for example cutting back on pension entitlements. The largest known SWF that can be classifed into this category is the Norwegian Government Pension Fund–Global, set up in 1990 to invest surpluses driven by a well-performing petroleum sector. Its stated mission is ‘to safeguard and build fnancial wealth for future generations’, and its AUM had accumulated an estimated USD1 trillion by early 2018. Therefore, the original objective of sovereign wealth management has really been to put aside, and grow over time, some fnancial assets to

Chapter 8 • Sovereign wealth management 221

cater for a future occurrence. However, the evolution of sovereign wealth management has by itself infuenced a gradual evolution of objectives and consequently the role of sovereign wealth managers. Rapid wealth accumulation by SWF in surplus economies, which is at times way beyond precautionary levels, has attracted attention of critics given the transparency concerns around some of the larger SWFs. Modern-day sovereign wealth managers’ tasks are much broader, and they aremore proactive in nature; although traditionally SWFs have evolved in reaction to fscal surpluses, today SWFs proactively pursue the socioeconomic (and sometimes geopolitical) ambitions of their respective countries. Next we explore a suite of newer objectives of sovereign wealth managers, and this does not that claim any of the older objectives has been subordinated or replaced. 8.6.6 A role in the capital and fnancial markets Sovereign funds quite often have opportunities to operate a lean cost structure not riddled with debt issuance, service costs, and expected returns from equity holders. This is because SWFs are generally funded from state funds. In addition to this, sovereign funds are seldom operating companies; most take the form of investment-holding companies with lean operational structures. Compared to other fnancial institutions, the substantially lean cost structure of SWFs brings two possibilities, among others. First, a lower cost base allows SWFs to accept lower returns and sometimes in riskier investments that would ordinarily fnd it diffcult to attract purely private capital. Thus, SWFs are increasingly becoming an important source of capital for strategic or even risky investments with a huge potential on the upside. Second, SWFs generally do not have operational cashfow pressures, as a direct result of a low-cost base. This enables them to provide the much-needed capital in projects with a long payback profle. These are typically much-needed infrastructure projects in developing economies, and SWFs occasionally support these under some form of bilateral agreements. Third, sovereign wealth funds typically hold excessive relative liquidity, with increased capacity to withstand credit losses. This, coupled with the fact that SWFs have ‘patient capital’ (i.e. can invest in longer-term horizons for conservative returns), makes them crucial sources of liquidity in the wake of credit crunches and widespread fnancial crisis. What we saw in the aftermath of the 2007/2008 fnancial crisis is a case in point; when severe credit losses, combined with a slump in property prices, threatened the existence of large fnancial institutions, and consequently the global fnancial markets themselves, SWFs came to the rescue. Between 2007 and 2008, in the US alone, a total of 30 rescue transactions were recorded, wherein SWFs invested a combined USD40 billion in capital into fnancial institutions. SWFs such as Kuwait Investment Authority, Abu Dhabi Investment Authority, and Temasek injected capital, thereby acquiring stakes in banks like Merrill Lynch and Citigroup.

222 Mbako Mbo and Charles Komla Delali Adjasi

8.6.7 A policy tool In a rather controversial emerging practice by some nations, SWFs are gradually playing a policy role. Some SWFs have in recent times been relied on as vehicles through which countries adopt a carrot-and-stick approach to achieve their broader policy objectives, a practice that has attracted some scepticism and heightened calls for transparency. In 2008, the Chinese government, acting through its own SWF the State Administration of Foreign Exchange (SAFE), invested USD300 million of government bonds issued by Costa Rica. Following a constitutional court case, the Costa Rican government was compelled to release documents, initially meant to be confdential, that were widely interpreted to mean that China was investing in Costa Rican bonds, in order to open diplomatic relations between the two nations, in return for which Costa Rica was to cease its recognition of Taiwan. Interestingly, the purchase of the bonds was followed by Costa Rica’s swiftly cutting its long-standing diplomatic ties with Taiwan. Often geopolitical concerns seem to arise when SWFs act with less transparency, particularly with respect to their intentions. For policy intentions to be achieved, it is almost preconditional that the two or more nations involved are fully agreeable and all suspicion is erased. In 2006, Dubai Ports World (DP World, or DPW) attempted to acquire a British-owned company, which held seaport management contracts for six major ports in the US. Despite the US’s having been presumably comfortable with the ports remaining under a British-owned management company, the US Congress blocked the planned takeover, citing security concerns over the unknown intentions of the UAE. 8.6.8 Bilateral and multilateral international economic cooperation Despite the scepticism and geopolitical concerns that emerge when SWFs are projected as tools for policy objectives, documented cases show mutual benefts between nations whose SWFs engage in strategic cross-border investments. In fact, SWFs can perfectly enhance bilateral economic and development cooperation instead of igniting political apprehension and uncertainties. A well-cited case is the role of SWFs in the South–South cooperation, a phenomenon seen as a real game changer in replacing North– South Overseas Development Assistance (ODA) and foreign aid fows to south–south investments for mutual beneft. Under the auspices of the South–South cooperation, the China–Africa Development Fund (CAD), a Chinese sovereign fund, was formed in 2007 with an investment focus on Africa. As of 2018, CAD held no fewer than USD10 billion available for additional African investments. The fund’s existing portfolio, as of March 2018, was spread across 36 African countries in sectors that include energy, agriculture, manufacturing, and infrastructure. From this arrangement, CAD will achieve portfolio diversifcation, value growth for Chinese enterprises, and growth in exports. While otherwise, at least in theory, African states are to beneft from improved infrastructure, a gradual transfer of skills, and the importation of technologies.

Chapter 8 • Sovereign wealth management 223

8.7 ASSET-LIABILITY MANAGEMENT IN EMERGING ECONOMIES A fundamental objective of sovereign asset-liability management (SALM) is to align investment strategies for identifed asset classes to characteristics of all known and contingent liabilities of the state, with particular attention to the characteristics of associated payment obligations. Sovereign wealth management should be considered an integral part of SALM; sovereign wealth management concerns itself with the excess of sovereign assets over short-term obligations (including development budgets), wherein such excess should be invested within a framework that supports the characteristics of medium- to long-term explicit and contingent liabilities. While it is prudent to maximize returns through sovereign wealth management, of course in well-defned and accepted risk parameters, it is equally key to ensure that resources are seamlessly available to meet budgetary obligations at minimal costs. Different sovereigns approach SALM in a number of evolving ways, but falling mainly under either a full or a partial SALM implementation. According to International Monetary Fund6 guidance, a partial approach to SALM would typically entail matching currency mix and durations of portions of their portfolios with the aim of reducing currency and interest rate risks. A full approach to SALM is more integrated in nature, where a sovereign balance sheet is created as the centre, and hence focus, of ALM, on sovereign risk management practice. This is often referred to as the balance sheet approach to ALM. The challenges faced by emerging economies in sovereign asset and liability management make the balance sheet approach both appropriate and diffcult to implement at the same time, symbolising the amount of work needed by such economies to achieve optimal ALM. Although registering some improvements in the recent past, emerging economies have been riddled with inadequately disclosed sectorial interdependences, undiversifed and volatile revenue streams, the inadequate disclosure of liabilities, weak fnancial management controls, and a lack of reliable data on the value of unexplored natural resources – a key driver of wealth. Classical cases of weak fnancial controls and inadequately disclosing liabilities were widely reported in Malawi (2013) and Mozambique (2014) respectively. The credibility of government fnancial reports was under a spotlight in Malawi after the discovery of the looting of cash resources by government employees and private companies in September 2013. A British government–sponsored investigative audit revealed that for the six months covered, an estimate USD32 million was syphoned from government accounts, including substantial amounts claimed by private entities for works not done or goods and services not supplied. In 2013 and 2014, public managers in Mozambique issued sovereign guarantees worth over USD2 billion to Credit Suisse and VTB Bank to cover loans to state-linked companies Ematum, Proindicus, and Mozambique Asset Management. These guarantees, which made the loans possible were later ruled to have been illegally issued and thus labelled illicit because they violated budget law guarantee ceilings. In April 2018, there were mounting

224 Mbako Mbo and Charles Komla Delali Adjasi

fears that although the Zambian government was disclosing a fgure of USD8.7 billion as its external debt, the correct fgure could be double that amount, prompting an audit by the IMF, according to a Bloomberg7 release. The inadequate disclosure of public assets, surprisingly, is a growing concern among emerging economies. The major source of such concerns is the subject of this topic: sovereign wealth funds. For instance, the SWFI adopts the Linaburg–Maduell transparency index  to gauge transparency among its members, and a worrying number of them score 5 or below out of 10, and many of them have no scores assigned to them, because they just don’t provide information on the assets they own. These and many others are real issues that continue to undermine the strength of the balance sheet approach to SALM and demonstrate the need for genuine political commitment in optimising a risk-based approach to the management of sovereign assets and liabilities. Nonetheless, in this chapter, we centre our SALM discussion on the balance sheet approach. Table 8.1 is an outline of a typical balance sheet of an emerging economy sovereign.

FIGURE 8.12 A typical sovereign balance sheet

Assets

Liabilities

Financial assets Deposits and cash balances – Local currency – Foreign currency Securities (bonds, stocks and treasury bills) Loans issued Long term investments – Reserves – Sovereign wealth funds – Pension funds Receivables & profits – Interest on loans – Taxes – Fees & commissions – Seigniorage – Royalties – Dividends

Financial Liabilities Statutory expenditures – Public service emoluments – Other public Administrative expenditure – Loan service repayments (including interest payments) Development expenditure Balances – Bonds and Loans – Monetary Base (multiple currencies) – Pension liabilities 

Nonfnancial assets Infrastructure Real estate State-owned enterprises

Contingent Liabilities Guarantees issued Insurance, pension, and derivative liabilities Natural disaster relief

Contingent assets Insurance Guarantees in favour Unexplored natural resources

Net worth    

Chapter 8 • Sovereign wealth management 225

As mentioned earlier, SALM is really an integrated approach to managing sovereign fnancial risk, and in his approach to crafting a conceptual sovereign balance sheet based on a framework proposed by Merton (2007), Mr Andre Proite,8 then investor relations manager at the Brazilian National Treasury, identifes facets of a sovereign balance sheet that introduce certain classes of risk: • Foreign currency risk – currency deposits, currency payables, and loan balances. • Interest rate risk – infrastructure/developments, loans, and bonds outstanding. • Infation risk – seigniorage (and government administration). • Aging population risk – pension liabilities. Having dissected a typical sovereign balance sheet and highlighted typical risk classes, we next consider some practical implications of a conscious approach to managing the assets and liabilities of a sovereign. 8.7.1 Managing sovereign assets – issues to consider Managing sovereign assets requires an integrated risk-based approach that among other things synchronises investment objectives to characteristics and profles of liabilities. An important balance to strike is that of maximising returns on the asset portfolio in a given risk appetite but still minimising the cost of funding budgetary needs of the state. Given the risk intricacies inherent in portfolio structuring, including asset allocation as well as fnancing government liabilities in a long-term horizon, a lot of risk simulation goes along with the management of sovereign assets in order to achieve an optimised portfolio structure. Approaches to optimising portfolio structures are evolving, alongside lessons learnt from economic downturns. However, the mean-variance approach (Markowitz, 1952) continues to be a corner stone for variants in building optimal portfolio structures for both sovereigns and nonsovereigns. The mean-variance approach simulates maximum possible returns in certain risk variables and policy constraints like liquidity, balance of payment targets, and capital protection. Complementing the mean-variance approach is the value at risk (VaR), which extends the outcomes from the former by building in simulations of volatility embedded in targeted portfolio returns. As we stated earlier in this chapter, volatility is of a great concern in managing targets around portfolio returns more so that negative returns might as well positively correlate with economic downturns – hence the wide adoption of the VaR approach to portfolio structuring. Equally important, liquidity targets and respective timing approaches should not be too stringent as to introduce unnecessary opportunity costs. Unnecessarily high liquidity thresholds may also induce certain risks, particularly where foreign currency balances are involved. Liquid assets in a sovereign asset portfolio should be held in consideration of liabilities of commensurate tenures, and care is always given to ensure government budgetary

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needs are met at minimal costs. In this regard, the cost-at-risk approach is used normally as a supplement to the mean-variance approaches adopted in optimising debt profles, which is carried out in a SALM approach, hence having a signifcant bearing of the profle of the asset portfolio. The cost-atrisk is a gross measure (i.e. it includes both the cost of risk itself and the costs incurred because of a crystallised risk event). Risk governance and the strength of public fnancial management controls are variables never to be downplayed in managing sovereign assets. There are the broader issues of risk appetite and how it is arrived at, political commitment to full disclosure, commitment to transparency, and in some cases acts of criminality. The reality is, a substantial part of a given pool of sovereign assets will typically be of a long-term horizon spanning through political cycles and administrations. Uncoordinated and inconsistent changes to risk appetite, investment strategies, and liability priorities arising from evolutions in administration may easily have signifcant bearing on portfolio performance. Lack of full disclosure at times of exchanging political power can also easily upset SALM implementation, as was with the Mozambican case we cited earlier. 8.7.2 Managing sovereign liabilities – issues to consider A signifcant portion of sovereign liabilities is often debt (i.e. government borrowings). Debt levels are often capped at a certain level, although a debate still rages on concerning what this level should be. Most importantly from a SALM perspective, a good debt management strategy should entail a trade-off between low cost of debt and level of risk (various types), and the cost-at-risk approach discussed earlier applies here. Debt is generally acquired primarily to take care of a budget defcit, typically to fund development budgets. However, there are other objectives that SALM technocrats ought to be aware of. A sovereign may opt to borrow in local currency (which is often pricier in emerging economies) just to support the development of local capital markets. Local bonds, for instance, are often referred to when setting pricing benchmarks for private issuances and a sovereign may feel the need to consistently maintain issuances to establish reliable price curves for various tenures. On the other hand, the need to raise signifcant amounts of debt in local currency may be met by an insuffcient debt capital market depth – a common feature in emerging economies, particularly low-income and medium-income countries. These intricacies extend the environment of managing sovereign debt beyond asset considerations to include other policy objectives. An integrated approach to SALM should ensure that in managing a pool of sovereign assets and value accretion thereof, there is a constant projection of growth in liabilities, both explicit and contingent (see Maziad & Skancke, 2014). The risk being managed here is a situation wherein value of asset portfolio falls short of accrued liabilities over time, net of targeted reserve thresholds. The biggest setback in incorporating contingent liabilities in a SALM environment, as we stated earlier in this chapter, is assigning a reasonable value to them. Despite this, a number of countries have begun actively accounting and fully disclosing contingent liabilities by using the

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best reliable estimates, the most common being the practice of accounting for debt guarantees issued by government as part of government borrowings, and counting these towards debt/GDP statutory thresholds (Chile, Mozambique, Turkey, Botswana, and South Africa). Some contingent liabilities are explicit in that the state becomes legally bound to make good of them once a particular event happens; examples are debt guarantees issued and obligations under insurance contracts, typically trade and export credit. A prudent approach is to factor in maximum possible payout into the total liability pool. However, there are also some liabilities, which are implicit in nature, normally those that governments are bound due to either policy consequences or a moral duty to make good on. Examples are disaster relief, corporate bailouts to avert wider economic impacts of market failures, and the assumption of liabilities sitting with state-owned enterprises (SOEs) (typically privatisation targets). It is not uncommon for countries to set up funds against some of the implicit liabilities, but such funds must be managed as part of sovereign pool of assets to permit full disclosure, although this is not always the case.

8.8 ASSET ALLOCATION AND RISK MANAGEMENT FOR SOVEREIGN WEALTH FUNDS The modern portfolio theory, or MPT (Markowitz, 1952), is often a good starting point in discussing the construction of an investment portfolio through a risk conscious approach to asset allocation. MPT assumes that returns and volatility can be optimised and minimised respectively if an investment portfolio is effciently diversifed. However, the extent to which MPT holds true, particularly beyond one period, has been under the spotlight in recent times, as data from the real world does not necessarily correspond to MPT-based simulations. Portfolio construction in an SWF is often not a straightforward undertaking. SWFs invest for extended time horizons, often seeking value accretion beyond aggregated short-term returns (Chee, 2011). In addition, SWF objectives may not necessarily be all return based; earlier in this chapter, we pointed out the following as some of the common broader objectives pursued by SWFs: stabilisation, development, equalisation, policy and political strategies, and bilateral cooperation. All these factors have a signifcant bearing on asset allocations by SWFs, and diversifcation motivated under the MPT is often fawed. For example, a state may decide to hold onto some strategic investments through SOEs, which then results in a signifcantly skewed portfolio. Similarly, the China–Africa Development Fund we mentioned will never, by design, achieve a truly geographically diversifed investment portfolio typical of an international investor. Further, some ‘investment’ decisions by SWFs are reactionary in nature, often taken in the interest of wider economic and market concerns, just as SWFs are used as vehicles for corporate bailouts and market stabilisations. In the working paper ‘Optimal Asset Allocation for Sovereign Wealth Funds: Theory and Practice’, Bondie and Brière (2013) attempted to show that an ‘an optimal composition of sovereign wealth should involve a performance seeking portfolio and three hedging demand terms for the

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variability of fscal surplus and external and domestic debt’. Such a view underscores the broader nature of sovereign wealth investment objectives. Simulating past trends on SWF investment portfolio performance, as well as their structures, currently proves a nearly impossible task given the secrecy around their investment decisions. Real risk taken by SWFs and losses incurred are not suffciently appreciated. However, some cases tend to demonstrate the intricacies involved in SWF asset allocation. The Norway Pension Fund–Global (GNPFG), as an SWF, made a signifcant 26% return on its portfolio for 2009. This was after a 2007 decision to take up more risk, signifed by an increase of equity component of GNPFG’s benchmark portfolio from 60% to 70%. In a study on GNPFG’s asset allocation, Papaioannou and Rentsendorj (2015) cast doubt on its effciency, on the basis of the effcient frontier expectations, although they accepted a broad conformity to Markowitz’s single-period model. Quite usefully, the authors point out two key features that can be attributable to GNPFG’s portfolio performance: fexibility in asset allocation decisions and the ability to design a countercyclical portfolio. The issue of fexibility is almost embedded as a need rather than a reality in the case of SWFs. We have highlighted cases where a reaction is expected from an SWF to ‘save’ the economy or markets, as was the default position with Western banks bailed out by Asian SWFs at the height of the 2007/2008 fnancial crisis. This is achieved with a suffcient degree of fexibility. As demonstrated by GNPFG’s case, a countercyclical portfolio plays a key role in some of the SWF core mandates, particularly for those that aim for the stabilisation of revenues and the diversifcation of revenue sources. Finally, it remains diffcult for SWFs to evade some real constraints in achieving an optimal asset allocation in an ordinary sense of return-focused investments. To start with, an SWF-specifc effcient frontier is diffcult to ascertain given the lack of transparency and information asymmetry concerns around SWFs; a benchmark is almost impossible to agree on. Referring to nonsovereign investments for benchmarking is often possible but undermined by the reality that the acceptability of assets, risk levels, and geographies in the case of SWF investments is a decision beyond pure economics. Ultimately, a countercyclical portfolio, with regular assessments supported by adequate periodic assessment and rebalancing could achieve better results.

8.9 CHALLENGES AND OPPORTUNITIES OF SOVEREIGN WEALTH FUNDS SWFs are faced with a plethora of signifcant challenges, mostly pointing to inadequate transparency and political undertones. The political uncertainties tend to correspond to the disruptive nature of SWFs to the ‘normal’ world economic order, mainly as SWFs continue to penetrate markets of core economies. This could potentially give rise to geopolitical tensions. In an address to the International Centre for Monetary and Banking Studies, in Geneva, in December 2007, Mr Philipp Hildebrand, the then vice-chair of the governing board of the Swiss National Bank discussed what he terms a ‘vicious cycle of fnancial protectionism’. Mr Hildebrand associated such a cycle with a policy reaction that would generally be aimed at protecting the

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world economic order as we know it, but facing the disruptive variant that SWFs are, mainly due to three main occurrences: 1 The reversal of gains made in diluting government’s role in world economy – the gains have been in the strength of a gradual liberalisation and deregulation of global economic structures. Large statebacked SWFs are seen as largely confusing an evolving (and perhaps desired) pattern of capital fows based on economic forces. 2 The long-held rational view that capital fows in search of optimal riskadjusted returns is challenged – SWFs have made capital allocation decisions involving investments that tend to challenge the notion that the maximisation of returns (within set risk parameters) underpins the free fow of capital. Blurred transparency only exacerbates the problem, more so that SWF investments are mostly in foreign territories, and intentions are not necessarily declared publicly. One question that has been asked, and that remains inadequately addressed is, why did the Norwegian Investment Fund short sell bonds of banks in Iceland? 3 SWFs change the traditional pattern of capital fows, which has been from core regions of the world to the peripherals; the IMF and World Bank in particular have been conduits for the fow of capital from the developed countries to emerging economies, including poor states. Among other forms of fows, developmental loans and relief funds have been channelled mainly to Africa, Latin America, and parts of Asia to develop infrastructure, support social amenities, and make economic reforms. However, in the advent of SWFs, this is changing, with signifcant capital fows from emerging economies into advanced ones. SWFs in Southeast Asia and Middle East, among others, have wellknown investments in the US. Beyond the reversal of the norm of capital fows from the core to peripherals, SWFs are becoming an important vehicle for the fow of capital between the peripherals themselves. The South-South cooperation involves a lot of capital and technology fows between countries formerly viewed as peripherals, wherein a Chinese SWF, the CAD, plays a pivotal role in the fow of capital from China to Africa. The BRICS bank could be viewed in the same light as well. The challenges of SWFs are not limited to the economic and fnancial protectionism possibilities; as we outlined earlier, there are other problems of signifcance surrounding them, perceived or real. 8.9.1 Information asymmetry SWFs are still seen as largely lacking in transparency, particularly with respect to the areas of capital fows, investment objectives, and intentions given their state backing. This has come under the spotlight when investments were made, but with no obvious fnancial returns, as would be expected under cross boarder capital fows norms. Elsewhere in the chapter, we cited cases involving DP World and Norwegian Investment Fund, among the many investments that raised suspicion. The Linaburg–Maduell transparency index is a tool adopted by the Sovereign Wealth Funds Institute

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to issue periodic rankings of member SWFs’ transparency, measured by the level of information disclosure. This came about amid concerns of perceived unethical agendas. 8.9.2 A threat to fnancial stability SWFs generally cause the fow of funds across global economies, chasing investments with longer-term horizons. This means that their cumulatively signifcant investment at the global scale can absorb short-term market shocks and lead to longer-term stability in market prices. However, the Financial Stability Forum9 observes a problem on the fip side of the coin: SWFs are largely opaque in their structures, objectives, and performance. With little to no level of public accountability (Wong, 2009), the IMF argues that SWFs may change their governance structures and investment policies, including asset allocation decisions, just to conceal their failures. Given the volumes that SWFs deal with, serious instability in the global fnancial market may ensue (Jory, Perry, & Hemphill, 2010). 8.9.3 Market and asset pricing distortions Two distinct variables make SWFs a threat to market stability and rationality in asset pricing: the sheer size of their investment fows, backed by state funds, and their tendency to make investments at prices not determined by market forces. As observed by Anthony Wong in the Brooklyn Journal of International Law in 2009, under the theme ‘Ruling the World: Generating International Legal Norms’, SWFs operate with limited liabilities and usually face inadequate calls for accountability. It may then follow that SWFs tend to have an increased latitude to take up disproportionate risks in investments of scale, with a potentially large impact to the markets (Wong, 2009). Unfortunately, the artifcially set asset prices for a given risk scale would then infuence key decisions in the larger markets, wherein return chasing investments become wrongly priced.

8.10 THE SANTIAGO PRINCIPLES SWFs have historically attracted controversy, critics expressing a lack of transparency, inadequate accountability, and obscured governance structures. Heightened scepticism derive from the decisions of some of the world’s leading SWFs during the 2007/2008 fnancial crises, which involved their buying into foreign fnancial institutions, among others. In response to the growing concerns, the IMF convened a working group specifcally to address the transparency, governance, and accountability of SWFs. However, the principles are a set of what can be seen as generally accepted code and are voluntary in nature. The implementation of them is left entirely up to the subscribing SWFs, with no real consequences for not implementing them. The principles aim to offer a reference point for the adopting SWF’s, guiding them towards operations and investment decisions that seek to optimise risk-adjusted returns. This then deals with concerns surrounding questionable investment decision typically seen as being politically motivated. The 24 principles are grouped into three parts, as shown in Figure 8.13.

Chapter 8 • Sovereign wealth management 231 FIGURE 8.13 Components of the Santiago SWF principles

 

Brief description

Part A Legal framework, objectives, and coordination with macroeconomic policies Part B Institutional framework and governance structure

Member SWF are guided to publicise their legal structures and framework, their policy mandate, and their funding arrangements.

Part C Investment and risk management framework

Member SWFs are required to set up sound governance structures, clearly articulating the division of roles and accountability among stakeholders. At the centre of these provisions is an expectation that government, as the owner, should limit its interference in the operations and investment decisions of SWFs. SWFs are required to have in place robust investment and risk management frameworks and to disclose their investment policies. They are also expected to disclose their strategic-asset allocations and any investment decisions that are not based on economic and financial considerations.

8.11 CONCLUSION The concept of managing sovereign wealth in a fund setup dates back to the 1950s, with its genesis commonly traced to oil-rich states in the Persian Gulf region. Trade surpluses, mainly linked to oil exports, have traditionally remained the key source for ‘seed capital’ among governments that set up SWFs. However, as the concept gained popularity over years, nations started seeing sovereign wealth funds, as they became known from the early 2000s, as a real opportunity to either stabilise national revenues or diversify them. Apart from revenue stabilisation (or equalisation), SWFs also take the form of development, saving, or reserving funds, and oil no longer dominates as the major source of seed capital, although natural resources and minerals still do. Institutional arrangements among SWFs differ, including a fully fedged institution with its own governance and management structures and a desk-based operation hosted by a sponsoring government ministry or a central bank. The precise structure depends on the mandate, approach to investment, and risk appetite, whereby SWFs with a mandate to implement investment projects as part of their mandate and carry a higher risk appetite in return for chasing higher returns would typically have fully fedged institutional structures. However, SWFs with no implementing

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mandates and lower risk appetites and return targets would normally be hosted in the institutional setup of a hosting government ministry or central bank. SWFs have their own signifcant challenges, mainly cantered on geopolitical themes, including the reversal of gains made in diluting the role of governments in the world economy, the backwards fow of funds from core to peripheral economies of the world, and information asymmetry related to investments made on no apparent economic and fnancial considerations. Beyond geopolitics, SWFs are frequently criticised for distorting market asset prices and generally considered a threat to global fnancial stability. Perhaps the manifestation of SWF challenges lies with their perceived lack of transparency and weak accountability obligations, and in response to these, an IMF-convened working group concluded a set of 24 Generally Accepted Principles and Practices in 2008. The principles aim to offer a reference point for the adopting SWFs, guiding them towards operations and investment decisions that seek to optimise risk-adjusted returns. The principles offer comprehensive guidance on three broad areas: 1 Legal framework, objectives, and coordination with macroeconomic policies. 2 Institutional framework and governance structure. 3 Investment and risk management framework. To a great extent, these principles can be seen as dealing with concerns around the possibilities of politically motivated investment decisions.

Discussion questions 1 ‘Historically, SWFs have predominantly been a result of a reactive approach by governments with surpluses of one form or another, but this has since changed’. Please discuss, with examples. 2 The 2007/2008 global fnancial crises brought to the fore the fundamental challenges SWFs pose to the global geopolitical economy. Certain transactions left many with more questions than answers. Please elaborate. 3 The Santiago Principles aim to address fundamental concerns on governance and transparency of SWFs, and they are divided into

4

5 6 7

three distinct parts. Please discuss any two principles, under each part with examples. Outline and fully discuss, with practical examples, various forms of SWFs and how governments use them as vehicles for economic advancement. Why are SWFs criticized for distorting market asset prices and global fnancial markets? Discuss any three emerging roles of SWFs. What are the key considerations for SWFs that are making assetliability management decisions?

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Notes 1 Sovereign Wealth Fund Institute. 2 Wharton Leadership Centre: ‘The Brave New World of Sovereign Wealth Funds’. 3 The term ‘sovereign wealth fund’ is associated with the work of Andrew Rozanov, a senior manager, Official Institutions Group at State Street Global Advisors. 4 International Monetary Fund (2007, October). Global fnancial stability report 2007. Washington, DC: Author. 5 The Sovereign Wealth Funds Institutes lists 78 members as of February 2018, but there are other (typically smaller) funds that are not members of the SWFI.

6 IMF Sovereign Asset Liability Management Guidance for resource-rich economies, 2014. 7 Bloomberg (April 2018). Zambia’s ‘Unknown’ Debts Face Scrutiny After Mozambique Scandal. 8 A. Proite Asset Liability Management in Developing Countries: A Balance Sheet Approach 2014 (A modifed from a UNCTAD sponsored original article ‘Strengthening Capacity for Effective Asset and Liability Management’. 9 Financial Stability Forum (19 May2007). Update of the FSF report on highly leveraged institutions. Basel: Bank for International Settlements. Retrieved from www. fsforum.org/publications/.

References Awanzam, T., & Okudzeto, E. (2018). Africa economic outlook (2018 ed.). African Development Bank. Retrieved from https://www.afdb.org/fleadmin/uploads/afdb/Documents/ Generic-Documents/country_notes/ Ghana_country_note.pdf Bondie, Z., & Brière, M. (2013). Optimal asset allocation for sovereign wealth funds: Theory and practice.  Amundi Working Paper. Paris: Dauphine University, Université Libre de Bruxelles. Chee, F. P. (2011). Portfolio construction and risk management for sovereign wealth funds. Toronto: CFA Institute, CFA Society. Cheung, Y. W., Steinkamp, S., & Westermann, F. (2013). China’s capital fight: The pre- and post-crisis experiences. Unpublished manuscript. Retrieved from www.cb.cityu.edu.hk/ef/doc/ 2 0 1 5 % 2 0 C o n f e re n c e % 2 0 o n % 2 0 the%20New%20Normal/Frank%20 Westermann(1).pdf

Dixon, A. D. (2016). The rise, politics, and governance of African sovereign wealth funds. The Brown Capital Management Africa Forum Paper No. 3. Washington, DC: Wilson Centre. John, J. D. (1998). Conceptualising the causes and consequences of failed states: A critical review of the literature. Working Paper No. 25. Crisis States Research Center. Retrieved from https://www. fles.ethz.ch/isn/57427/wp25.2.pdf Jory, S. R., Perry, M. J., & Hemphill, T. A. (2010). The role of sovereign wealth funds in global fnancial intermediation. Hoboken, NJ: Wiley Periodicals. Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 77–91. Maziad, S., & Skancke, M. (2014). Sovereign asset-liability management- guidance for resource -rich economies. Washington, DC: International Monetary Fund. Merton, R. C. (2007, November). Observations on sovereign wealth fund,

234 Mbako Mbo and Charles Komla Delali Adjasi reserve, and debt management: A country risk management perspective. Luncheon Address at the First IMF Annual Roundtable of Sovereign Asset and Reserve Managers, Washington, DC. Papaioannou, M. G., & Rentsendorj, B. (2015). Sovereign wealth fund asset allocations – some stylized facts on the Norway Pension Fund–Global. Procedia Economics and Finance, 195–199. Salah, I. (2010). The effects of fnancial crisis on the middle East. The Global Law Review, 99. Retrieved from https://engagedscholarship.csuohio.edu/gblr/vol1/iss1/7 Shabbir, T. (2009). Role of the middle Eastern sovereign wealth funds in

the current global fnancial crisis. Topics in the Middle Eastern and African Economies, 11. Wong, A. (2009). Sovereign wealth funds and the problem of asymmetric information: The Santiago principles and international regulations. Brooklyn Journal of International Law, 1081, 1098–1102. World Bank. (2013). Economic developments and issues shaping Angola’s future. Angola Economic Update 1. Luanda: Author. Retrieved February 15, 2020, from www.opec.org/ opec_web/en/data_graphs/40.htm; www.swfinstitute.org/profiles/ sovereign-wealth-fund.

CHAPTER

9

Sovereign debt management Amin Karimu, Vera Fiador, and Imhotep Paul Alagidede 9.1 INTRODUCTION Generally, governments all over the world fnance their expenditures via a menu of sources, which include tax revenues, seigneuries from the central bank, charges and fees on publicly provided goods, and services such as tolls, profts from state enterprises, rents from natural resources, and borrowing from both internal and external fnancial markets. Over the 1970s and 1980s, most developing countries, including those in Africa, increased their external debts,1 which was as a result of many factors, including the emergence of the Eurodollar market2 due to the surplus revenue generated from high oil prices by oil-rich countries, low interest rates, and a generally favourable world environment. Shortly, the accumulated external debt levels started increasing and rose to high levels for most African countries that have taken too much debt without a prudent debt management3 plan. This, coupled with the rising interest rates during this period, implies higher cost of debt servicing,4 which further increased the debt levels of these countries to a crisis level (Abrego & Ross, 2001; Barro, 1989; Clements, Bhattacharya, & Nguyen, 2003). The high levels of debt accumulated by many developing countries in the early 1990s resulted in two debt-relief programmes: the Heavily Indebted Poor Countries Initiative and the Multilateral Debt Relief Initiative. These programmes, by the end of 2008, helped reduce the debt level, especially for countries in sub-Saharan Africa (SSA), by about two-thirds, which helped some of the countries, such as Ghana, to start experiencing good and appreciable levels of growth in the short term. The gains from the debt-relief programme is fast eroding for the subcontinent (SSA) after the 2008 fnancial crisis. For instance, available statistics from the IMF (2018) indicate that gross government debt to gross GDP (gross domestic product) for SSA in 2000 was 68%, which reduced to 23% by 2008, helped by the relief programme. Since 2008, the ratio of debt to GDP has be rising, and in 2016, it doubled the 2008 value, rising to 44%. This fast-rising debt level has almost wiped out half of the reduction from 2000 to 2008. In percentage terms, the 2016 debt-to-GDP ratio over the 2008 value is about 91%, within a period of just nine years, implying that the average debt level is rising by 2.3% per year, which is far more than the average GDP per capita growth of 1.2%

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over the same period, on the basis of statistics from the World Bank Word Development Indicators (2018). The reasons for the high debt problems in the 1990s and in recent years are multifaceted, driven generally by the improper management of borrowed funds and poor domestic resource mobilization. The focus of this chapter is on the borrowing component of government fnance, especially the external borrowing component with regard to its effcient and effective management in order to avoid issues such as insolvency (a state in which the central government is unable to pay its debts on time as stipulated in the borrowing contract) of the central government, particularly for developing and emerging countries. Over the years, available statistics from the IMF have shown that governments in developing countries, especially those in Africa, tend to spend signifcantly on nonproductive sectors relative to productive sectors. For instance, government expenditure on the component denoted ‘other’, which includes government spending on fuel and energy, mining, manufacturing, construction, subsidies, and general administration account for more than 50% on average, whereas in the case of agriculture, it is less than 7% over the past two decades (Fan, Omilola, & Lambert, 2009). According to Fan et al. (2009), a bulk of the expenditure in the ‘other’ component typically goes to government subsidies and expenses relating to general administration. This, among other things, suggests that the increasing share of this component may be crowding out spending on more-productive sectors, such as agriculture, education, and infrastructure development. These sectors are likely to promote growth and development, which make it easier to repay the borrowed funds. Additionally, most developing countries tend to have fewer domestic-income-generating sources for fnancing capital-intensive investment projects that require long-term debt fnancing sources if the country does not have the required reserves to fnance such projects. This is due to the less developed capital markets in these countries, implying that they rely mostly on external borrowing to fnance such projects. Such debt fnancing becomes an issue for the overall debt stock if a signifcant proportion of the overall public debt comes from external debt. In most cases for most of the developing countries, such debts generally attract interest rates above the world interest rate, due to a combination of factors, such as poor macroeconomic fundamentals, poor external assets, volatile commodity prices, and the level of accumulated debt. The structure of the chapter is as follows. The next section presents a brief overview of debt management in developing countries; the link between external debt and economic growth is presented in section 9.3; and in section 9.4, the institutional framework for government debt management is presented. Furthermore, section 9.5 provides a discussion on renegotiating debt contracts, before moving on to discuss debt-relief policies in section 9.6, designing incentives in section 9.7, sovereign debt restructuring in section 9.8, and a risk management framework for a government debt portfolio in section 9.9. The chapter concludes with a section on debt sustainability analysis and medium-term debt strategy (section 9.10).

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9.2 OVERVIEW OF DEBT MANAGEMENT To run a country effciently, the government needs money to fnance its expenditures. The source of government funding is mainly from taxes. However, when government expenditure outweighs the income received from taxes, it runs into defcits. To avoid this, it has to either increase taxes or reduce expenditures. Both of these options have serious implications for the economy. A third option is for government to borrow from both internal and external investors or grants from other countries. This perhaps is the most likely option for most governments in the developing world, since they are able to borrow to support their fnancing gap due to the low domestic-resource-mobilization5 possibilities. Borrowing from external investors mirrors the concept of external debt. External borrowing thus permits a country to produce and consume far beyond the constraints of its current domestic resources. This in effect accelerates the development of a country if well managed by investing in projects that generate enough returns to fnance the borrowed funds. The downside to this is that once a country borrows externally, it has to be wary of debt management as a creeping policy concern, especially if the funds are mismanaged. Sovereign debt6 management, in simple terms, covers how to ensure that the level and growth rate of public debt is sustainable. This, among other things, implies the ability to service the debt under a varied range of circumstances, such as increasing the cost of servicing the loans due to worsening domestic currency against foreign debt-denoted currencies, exposure to fnancial risk from foreign countries, and interest rate risk.7 A key objective of debt management is sustain public debt related to fnancing government activities in the economy, in ways that the source of raising the needed fnance, including both domestic borrowing and foreign borrowing, does not generate excessive cost and risk that creates problems in the domestic economy. The adverse effects of borrowing with regard to debt management is of prime interest. This is because most of a government’s expenditures are used in providing social services, which do not readily offer monetary returns. Thus, there is a high tendency for the government to default in payment of debt if the menu for servicing the debts are not planned and executed according to established guidelines. This means that a government is obliged to engage in further excessive borrowing. The consequence implies surges in interest rates, which of course burdens government with additional responsibilities. Obviously, these responsibilities include paying the increased outstanding debt and the need to boost local production capacity and increase exports in order to curtail such debts (both internal and external). The tendency of such defaults is high with small open economies that have limited sources to raise fnance and that are highly dependent on raw materials and nature for their economic growth8 and development. The varied nature of economic growth, coupled with the limited sources of generating revenue, suggests a high-risk premium for such countries borrowing from the international capital market, which, among other consequences, increases the cost of their public debt.

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Heavily indebted countries are most vulnerable to these shocks (interest rate shocks); consequently, affrmative actions in renegotiating and restructuring debt contracts or in some other circumstances are needed, to provide debt relief for defaulting countries. With regard to sovereign debt, the absence of collateral – or perhaps the diffculty to take hold of such collateral – requires that some alternative threat be mandated to incite or create incentives to repay the debt. More importantly, it requires measures that will reduce the risk exposure of public debt to various macroeconomic and political shocks.

9.3 EXTERNAL DEBT AND ECONOMIC GROWTH One of the key components of public debt is the share of external debt in total debt. In the early 1970s, after the frst oil crisis, many countries considered external borrowing, both from bilateral sources and from multilateral sources, as a cheap and prudent way for countries with low domestic fnancial capacity to fnance big capital projects in the quest to grow and develop their respective countries. Most developing countries tend to have low domestic fnancial capability and require high capital-intensive projects to facilitate economic development. The high levels of debt accumulated by many developing countries in the early 1990s resulted in an increase in research on external debt and economic growth, especially after the Mexico peso crisis in 1994, which sparked several questions: 1 At what level does external debt become a concern for economic growth? 2 What is the nature of the relationship between economic growth and external debt? 3 What are the channels via which external debt impacts growth? We will present the discussion along these questions, where we try to answer them by providing previous empirical studies to support the discussions. 9.3.1 External debt and economic growth At what level external debt becomes a concern for economic growth depends on three broad factors: level of external debt–to-GDP ratios, low primary surplus,9 and varying borrowing cost, which are supported by the debt-overhang hypothesis. 9.3.1.1 EXTERNAL DEBT–TO-GDP RATIOS In general, the ratio of government debt to GDP above 60% is considered problematic for most countries and even considered dangerous if it is above 100%. These numbers, however, vary depending on how the market thinks about a country’s risk of insolvency and consequently the cost of the debt via the interest rate charge as a refection of the risk level. For instance, in the case of countries in the EU, public debt close to 100% of GDP is considered high risk, and markets will react by increasing the interest rates for supplying debt to such countries.

Chapter 9 • Sovereign debt management 239

Whereas in the case of Japan, even at ratios above 200%, the market does not consider Japan to be at high risk of insolvency and is still willing to supply debt at lower interest rates. For most developing countries, the ratio of debt to GDP that fnancial markets consider to be a high risk level of insolvency is even lower, more so for external debt. This suggests that the ratio of external debt to GDP that is considered a problem for growth depends on a country’s macroeconomic fundamentals, such as external asset level, fscal space, the saving culture, the willingness to buy government bonds at lower interest rates by the country nationals, and the perception of the country’s fnancial markets’ risk of insolvency. Japan, with huge external assets and individual Japanese people willing to buy government bonds at low interest rates rather than consumption, attracts a more favourable perception by the fnancial markets on its risk of insolvency than does Greece, for instance, irrespective of the high debt-to-GDP ratio recorded in Japan (250%) relative to Greece (177%) provided by the IMF (IMF, 2017). 9.3.1.2 LOW PRIMARY SURPLUS The sovereign debt of a country is generally considered unsustainable if the debt-to-GDP ratio is projected to grow without limits, given the country’s current policies and economic fundamentals, summarised by the primary surplus of the country. The primary surplus is infuenced by three key factors: the amount of revenue the government receives, interest rate at which the government can borrow, and the types of expenditures. The levels of these three aspects of the primary surplus determine the level of the surplus and whether that level is consistent with the level needed to stabilise the debt-to-GDP ratio. 9.3.1.3 VARYING BORROWING COST The cost of the debt is another factor that determines the likelihood of exposure to debt crisis. The cost of borrowing varies across countries and across time. These variations determine the likely risk a country will face with respect to fscal crisis and consequently debt crisis relative to other countries and over time. There are two key determinants of the variation in borrowing cost across countries and over time. The frst factor is the interest rate paid on government bonds and loans, and the second is the maturity of the loans. These two factors are also infuenced by the country’s macroeconomic fundamentals and assets. Countries with good macroeconomic fundamentals are likely to borrow at favourable world interest rates, which implies a lower burden on current growth with regard to debt servicing. The relatively favourable interest rates are infuenced by the lower default risk that the good macroeconomic fundamentals reveal to the fnancial markets. For instance, Spain can borrow at interest rates that are much lower relative to Ghana, due to the difference in repayment risk, which is infuenced by the country’s fundamentals, external assets position, fscal space, and perception of the fnancial markets. The maturity period of the loans also infuences the risk of default; for instance, short-term loans increase the vulnerability of government to changes in investor’s sentiments, especially if the sentiments are against the government that have a high proportion of their debt in the short term. In

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such a case, the need to refnance a signifcant share of the debt in short periods increases, which puts more pressure on the debtor. The cost of the borrowing therefore increases due to the need to refnance the debt in short periods, but at the same time because the coupon on such short-term loans are lower, the cost also reduces by that effect. The overall effect on the cost of the loan therefore depends on the strength of these two opposing effects of short-term loans. 9.3.2 The relationship between economic growth and external debt The relationship between economic growth and external debt depends on what the debt is used for, the level of debt ratio, and the quality of institutions and policies. In the frst case, if the indebted country managed the loans prudently by investing in growth-enhancing projects, then the debtoverhang hypothesis will not apply, because the projects fnanced with the debt will generate enough returns to service the debt in the medium term. Contrarily, the debt-overhang hypothesis applies when the country is indebted but lacks good policies and institutions. In such a case, the rise in indebtedness will eventually result in the country’s experiencing debt overhang, where higher debt ratios are deteriorating to growth. In such a situation, debt-relief programmes are likely the best option for creditors to undertake to reduce future defaults by the highly indebted countries. This hypothesis led to the introduction of the debt Laffer curve,10 which was frst introduced by Jeffrey Sachs (1988) and formalised by Paul Krugman (1988). The key idea underlying the debt Laffer curve is that at low indebtedness, a country’s ability to repay the debt is high due to a positive association between the debt and economic growth. However, as the debt level increases to a crisis level, the debt becomes a drag on economic growth and consequently has a negative effect on growth. This negative effect of the debt on growth increases the risk level of default of the indebted country, which may reduce the market value of the debt, due to the risk its not repaying the debt (see Figure 9.1). In Figure 9.1, there is a clear linear relationship between the face value of debt and its market value up to point A, which suggests that a percent increase in the face value of the debt of a country results in an equivalent increase in the market value of the debt up to point A. As the face value of the debt increases beyond the level depicted by point A, we see a divergence between market value and face value of the debt, where the market value tends to increase more slowly relative to the increase in the face value of the debt. A reason for this is that at high debt levels, it becomes diffcult for a country to fnance the debt due to the increasing burden of the debtservicing obligations. The debt-servicing requirement tends to act like a tax on any activity that the indebted country undertakes, which requires an upfront cost in exchange for future benefts such as investments (Pattillo, Poirson, & Ricci, 2002). Consequently, the marginal returns on debt to the right of point A in Figure 9.1 decrease as more debt is accumulated.

Chapter 9 • Sovereign debt management 241

market vakue of debt

FIGURE 9.1 Debt Laffer curve

45°

debt overhang B

A

face value of debt Source: Krugman (1988)

Point B is the threshold point where the absolute increase in the face value of the debt is more than the marginal decrease in the market value of the debt. In such an instance, a country experiencing this is classifed as suffering from a debt overhang – hence the debt-overhang hypothesis. Figure 9.1 is generally divided into three regions: a region up to point A, a region between point A and point B, and a region above point B. If the debt level is beyond point A in Figure 9.1, there are two possibilities: the debt level is such that the country lies either to the left of point B, which is referred to as the ‘correct’ side of the debt Laffer curve, or to right of point B, which is the ‘wrong’ side of the debt Laffer curve (i.e. debt overhang). On the correct side of the debt Laffer curve, debt forgiveness will not increase the market value of the debt, whereas in a case where a country lies in the wrong side of the curve, debt forgiveness will reduce the face value of the debt and lead to a rise in the market value of the debt. Another way to practicalize the debt Laffer curve is to think of it in terms of the relationship between debt ratio and growth as demonstrated by Clements et al. (2003). If the debt ratio is at a level where there is a positive relationship between the two, then the country is on the correct side of the debt Laffer curve, but it is on the wrong side if there is negative relationship between debt ratio and growth. One the one hand, using available data from WDI (2019) for developing countries, a scatter plot with a ftted line presented in Figure 9.2 revealed a negative relationship between debt and economic growth for

242 Amin Karimu et al. FIGURE 9.2 Scatter plot with a ftted line Debt to GDP ratio above the 50% threshold

Debt to GDP ratio above the 50% threshold

200

50

EI Salvador

Congo, Dem. Rep. Cote d’lvoire

Georgia

Ukraine

Moldova

40 Zambia

100 Pakistan

Sri Lamka Egypt, Arab Rep.

Debt to GDP ratio (%)

Debt to GDP ratio

150 Burundi

Micronesia, Fed. Sts. Vanuatu

0

10

0

5

10

Bangladesh

30

20

–5

Malawi Indonesia

50

–10

Liberia

Solomon Islands

–1

Real GDP growth Debt to GDP ratio

Rwanda

Congo, Rep.

0

1

2

3

4

Real GDP growth Fitted values

Debt to GDP ratio

Fitted values

Source: Authors’ computation using data from WDI (2019)

debt levels above the 50% threshold (suggested by the IMF). On the other hand, there is a positive relation between debt and economic growth for countries with debt levels below the 50% threshold, supporting the debt Laffer curve. The empirical literature provided some evidence on indebted developing countries and growth relationship – for instance, a study by Pattillo et al. (2002) for a large panel of developing countries, in which the authors focused on the potential nonlinear relations as postulated by the debt-overhang hypothesis. Findings from their study provided evidence of a nonlinear relationship. Specifcally, there is negative impact associated with high debt-to-GDP ratios above the bracket (35%–40%) and, in the case of debt-to-exports ratio, the threshold above which debt has a negative effect range between 160% and 170%. These values show some signifcant variation of the turning point for the debt effect on growth, which may refect the heterogeneity in countries’ economic conditions, policies, assets level among others, suggesting that the level of debt that is problematic for a country is country specifc and context specifc rather than general. Clements et al. (2003) found the threshold for a panel of 55 low-income countries to be above 50% for external debt-to-GDP ratio and above 100%– 105% for the net present value of external debt–to-exports ratio. Moreover, the authors found the following the channels through which external debt affects growth for the sampled countries: via the effciency of resources used

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by the indebted country and via the indirect effect on public investment through the debt-servicing obligation. In contrast, Cordella, Ricci, and RuizArranz (2010) found that for a panel of developing countries, the threshold to be above 15%–30% of GDP, which they classifed as intermediate debt range. Furthermore, the debt-overhang threshold tends to be infuenced by policies and institutions, where bad polices and institutions reduce the threshold values. The general take from the brief empirical literature reviewed suggests, in general, that there is a nonlinear relationship between the level of accumulated external debt ratios and growth, but the level of the threshold beyond which a debt overhang occurs varies with countries and with the type of ratio used. The variations seem to be infuenced by country characteristics, the type of ratio, institutions, policies, the effcient (or not) use of resources, and the level to which debt service crowds out public investment. 9.3.3 The channels via which external debt impacts growth Both the empirical (Pattillo et al., 2002; Clements et al., 2003; Cordella et al., 2010) and the theoretical (Sachs, 1988; Krugman, 1988) literature on debt and economic growth suggests a nonlinear relationship between these two indicators. The channels via which debt affects growth are discussed under two themes: a difference in the marginal product of capital and cost of capital and a high effective marginal tax on returns on investment. 9.3.3.1 DIFFERENCE IN THE MARGINAL PRODUCT OF CAPITAL AND THE COST OF CAPITAL The frst channel is where a capital-scarce country is able to

borrow at world interest rates that are relatively lower than the marginal product of capital, as a consequence of a low level of debt, which makes the capacity for repayment high and therefore reduces the risk premium that the creditor charges (Eaton, 1993; Cohen, 1991). This positive effect of low debt on economic growth also depends on the type of capital that is fnanced with the loan, how effciently resources are used, and the soundness policies and institutions. However, even if the marginal product of capital is higher than the cost of capital but the borrowing country invests in a low productive sector, with bad policies and institutions, such growth effects become diffcult to be realized. The second channel is when the loan-servicing obligation for a highly indebted country on current production is high, which can be seen as a tax on current investment activities in the indebted country. The high debt-servicing requirement becomes a disincentive for investment in such a country. There is therefore likely to be capital fight from the highly indebted country to a low indebted country. This is due to the implied tax differential imposed by the level of indebtedness, which consequently will have a negative effect on productivity and growth, as suggested by the debt-overhang theories (Sachs, 1988; Krugman, 1988).

9.3.3.2 HIGH TAX ON RETURN ON INVESTMENT

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9.4 INSTITUTIONAL FRAMEWORK FOR GOVERNMENT DEBT MANAGEMENT The institutional framework within which government debt is managed is crucial in the overall management of public debt given the risks and cost objectives on one hand and the long-term goal of debt sustainability on the other. Most countries manage their public debt by having a unit either in the ministry of fnance (MoF) or separate from the ministry to be responsible for managing public debt. These units are generally referred as debt management offces (DMOs), which were traditionally located in the ministries of fnance before the early 1990s. In the early 1990s, some OECD countries separated their respective DMOs from their ministries of fnance and provided them with more independence in the operation of the overall debt management strategy, with less infuence on monetary policy. One reason for this separation of the DMO from the MoF is to ensure that incentive-compatibility contracts can be offered to attract highly skilled staff to manage government debt, which was not easily possible within the civil service pay structure of n MoF. According to Currie, Dethier, and Togo (2003), there are generally four major characteristics of debt exhibited by developing and emerging market economies: a less developed domestic debt market, problems of coordination between debt management and monetary policy, and problems in managing the impact of debt servicing on the budget and in controlling contingent liabilities. This highlights the need for an effective institutional framework that will incorporate the four key features just presented, in a way that that more effciently manages debt for such countries. 9.4.1 Effective governance The government structure for the DMO should be well defned regarding who is legally responsible for issuing new debt, invest, represent government in undertaking transactions regarding debt management, and clarifying rules regarding the principal–agent relationship. In OECD countries such as Sweden, the minister of fnance is ultimately responsible for government borrowing and for approving a debt management strategy, but typically, the responsibility of the day-to-day operation of debt management is delegated to a DMO. A clear and transparent governance structure makes it easy to support a sound and a credible fnancial system, which is supported by assurances of a well-designed governance structure, which bring confdence to the markets that the government debt portfolio is being managed effectively. 9.4.2 Effective organizational structure The organizational framework for debt management must be clearly specifed, and mandates and roles clearly articulated to key players within the debt management framework as suggested in the World Bank guideline for public debt management (World Bank & IMF, 2001). The institutional

Chapter 9 • Sovereign debt management 245

arrangement for locating sovereign debt management functions are many as pointed out by the World Bank guideline, which includes the MoF, central bank of a country, and the independent debt management agency. In most cases, however, it is mostly located in the MoF or an independent DMO, separate from the MoF. Irrespective of the institutional arrangement that is chosen, an important factor is to ensure that the organizational framework surrounding debt management is characterised by clearly specifed mandates and roles, strong coordination, and sharing information among different players within the framework. In most developing countries, the economy is generally more exposed to fnancial shocks and therefore more vulnerable to crises in public debt management (Currie  et al., 2003). This means that public policy aspects of risk reduction should be emphasized in debt management. As a consequence, these aspects should be incorporated into institutional arrangements: measures that will promote some elements of public policy into debt management. Some of such elements of public policy include facilitating coordination with monetary and fscal policy, the development of the domestic debt market, and the control of the possible impact of risky debt structures on the budget. 9.4.3 Effective operational structure An ineffective and inadequate operational structure within the debt management framework can impose serious operational risks,11 which could negatively impact debt management plans and consequently the sustainability of a country’s sovereign debt. Operational risks in debt management are generally high when there are no well-articulated responsibilities given to debt management staff, clear monitoring and control policies that increase the principal–agent problem, and well-structured reporting arrangements. Effective operational structure in debt management requires that the operational responsibility for debt management be subdivided into three units with clearly specifed tasks and responsibilities, but with effcient communication across the units for effcient information sharing. The three units are the front offce, the back offce, and the middle (risk management) offce. The front offce is responsible for executing and managing transactions in the fnancial markets. The back offce is responsible for the settlements of transactions and maintenance of fnancial records. The middle offce is in charge of providing risk analysis, monitoring and reporting on portfoliorelated risks, and assessing the performance of debt managers against any strategic benchmarks. 9.4.4 Effective management of information systems Effective and effcient management of information across the various units in the debt management organizational framework is crucial to keeping track of all transactions to produce timely debt data, promptly paying debt service, improving the quality of budgetary reporting, ensuring transparency in government fnancial accounts and helping in risk analysis, and

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managing debt. Effective recordkeeping and data management are crucial for debt management processes, especially for risk analysis and the timely payment of debt service to avoid unnecessary costs for delays in payment of the debt service. The data management is not free, and storing huge amounts and sensitive data is expensive. Therefore, the costs associated with the management of the information system should be considered in line with the debt management operational needs as suggested by the World Bank debt management guideline (World Bank & IMF, 2001). 9.4.5 Staff recruitment and monitoring Debt management requires staff with strong skills in fnancial markets, public policy, and accounting. Without such competently skilled staff, the debt management process will be ineffective even if the governance, organizational, operational, and information management systems are effcient. Regardless of the institutional structure of the DMO, the ability to attract and retain skilled debt management staff is crucial for mitigating operational risk. This is a problem for developing and emerging countries, where it is diffcult to separate the DMO from the MoF, due to the less developed debt market, which suggests that monetary policy and debt management are interlinked and that therefore the DMO should be kept in the MoF. Keeping the DMO in the MoF suggests that the civil service salary scheme would generally apply to DMO staff, which makes it diffcult to offer incentive-compatible contracts to attract such skills and retain them, since their skills are highly demanded in the private sector too but with better salary structures. One possibility that is often used to attract skilled staff into the DMOs is to offer them training packages. The problem with this approach is how to keep them after they have acquired all the skills from the various training programmes and have become even more competitive in the job market. Beyond the staff recruitment and retention problem, there is also a need to provide code-of-conduct and confict-of-interest guidelines that will help separate staff personal fnancial affairs from sound debt management practices.

9.5 RENEGOTIATING DEBT CONTRACT Sovereign debts are complex to deal with in cases of default. This is especially so because collaterals cannot easily be seized to defray debts. Rather, the terms and conditions of the debt contracts can be renegotiated. Thus, renegotiating debt contracts can be seen as an instrument that both a borrowing country and a lending country can use to improve the terms of the debt contract. In many cases, renegotiation is most preferred in instances where lending countries strictly enforce their rights to seize the borrower’s assets. Reports from Aguiar and Gopinath (2007) show that, on average, lending countries take a loss of 40% due to post-default debt negotiations. Yue (2010) models the interaction between default and debt renegotiation within a dynamic borrowing framework. The conclusion was that

Chapter 9 • Sovereign debt management 247

recovery rates decrease with indebtedness that affects the country’s incentive to default, ex ante. Also, in equilibrium, sovereign bonds are priced such that they compensate crediting countries for the associated risks of default and restructuring. They add that the model predicts interest rates and reductions in the stated value of an asset to increase with the level of debt. Also, results demonstrate that the changes in bargaining power have a great impact on debt recovery rates and on the sovereign bond spreads, thereby shedding light on the policy implications of sovereign debt restructuring procedures. With regard to collective action and sovereign debt renegotiation, bondholders’ incentives to renegotiate might not be aligned if lenders are large in number. According to Weinschelbaum and Wynne (2005), if each bondholder possesses a small fraction of the debt, each will have little incentive to forgive, because they can only marginally affect the government’s incentives to repay. Since the probability of being paid is basically independent of an individual’s actions, they will always fnd it incentive compatible to hold to the pre-existing debt rather than cooperate in the renegotiation process. Bai and Zhang (2012) highlight the effect of information frictions on renegotiation delays vis-à-vis the role of the secondary market in reducing these delays. When renegotiating with creditors to restructure debt, the government might prefer to have costly delays if the reservation value of the creditors is private information. Although a low restructuring proposal might cause costly delays in reaching agreements, it might also increase the government payoff if the creditors turn out to have a low reservation value. The more severe the information friction, the longer the maximum renegotiation duration. The presence of a secondary market might then reduce the renegotiation duration by lessening the information friction through price revelation. This implication is consistent with the empirical fnding that sovereign debt renegotiations are on average much shorter for liquid bonds than for illiquid bank loans. Finally, their model also reveals that to achieve higher welfare and more-effcient allocations, the creditors have to receive a certain level of renegotiation payoff. Using game theory, Gromb (1994) shows how a crediting country can rather be a prisoner to the borrower. However, the fact that the investor always fears subsidizing an already-rich entrepreneur makes the threat of terminating the development phase more credible. Arellano and Bai (2013) compare a decentralized Nash bargaining protocol with one designed by a benevolent planner. In the decentralized model, a default in one country increases the likelihood of default for the second country because recoveries are lower when both countries renegotiate together with the lender. In the planning solution, in contrast, the defaults of each country are independent of the other country. The planner simply decides on recoveries that induce default or repayment from each country, trading off the deadweight costs and the redistribution benefts of default. Benjamin and Wright (2009) fnd that longer defaults are correlated with larger reductions in the stated value of an asset and that there is a modest tendency for countries to enter default when output is relatively low

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and to emerge from default once output has recovered to reach its trend. They also establish that longer defaults and larger reductions in the stated value of an asset are more likely when economic conditions in the defaulting country are weak at the time of default. With respect to sovereign debt restructuring, on average it takes a long time for creditors and a sovereign government to reach an agreement. Lengthy renegotiations are costly: during renegotiation, governments cannot resume international borrowing, and creditors cannot realize their investment returns. Thus, understanding the causes of renegotiation delays better is important for both academic and policy purposes. Alternatively, Rose (2005) shows that it is logical for sovereign countries to fear default, since default is strongly associated with reduced trade. This is demonstrated by using a large panel dataset covering over two hundred trading partners and over 50 years of data to estimate a model of trade. Results show that debt renegotiation is associated with a decline in bilateral trade that is both economically and statistically signifcant, adding up to a year’s worth of trade, although the effect is spread over 15 years.

9.6 DEBT-RELIEF POLICIES Debt relief is granted to borrowing countries that face a situation of debt overhang, which is a situation where a country’s existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself. Debt relief can be granted by creditor countries by writing off debts to the level where a borrowing country will not face harsh economic instability. However, opponents of debt relief argue that some borrowing countries deliberately incur further debt with the belief that the debts will be cancelled in the future. In fact, they argue that this situation is not fair to developing countries that manage their debts creditably. Thus, they encourage developing countries to spend beyond their current budgets in order to merit debt relief. Of course, others argue that the granting of debt relief widens the dependence gap between the rich and the poor. When debt is seen to be unsustainable, there are a number of ways of giving out debt relief. The Heavily Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI) are compensation schemes that are given by the IMF and World Bank to grant debt relief to qualifying countries. The whole purpose of the HIPC Initiative is to curtail sovereign countries’ debts to those levels believed to be sustainable by giving them relief of debts held by creditor countries. To be eligible, borrowing countries must pursue structural reform programmes and strategies for debt reduction. The MDRI is another debt-relief programme, which is implemented to help defaulting countries graduating from the HIPC Initiative stage enjoy the privileges of full debt cancellation. That said, the MDRI was set up to assist qualifying countries to get a step closer to the Millennium Development Goals (MDGs). Also, the decision to seek debt relief is one for the defaulting country to make.

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9.7 DESIGNING INCENTIVES Effective sovereign debt management irrespective of the institutional framework under which it operates requires an effective and effcient incentive design to ensure incentive partibility between the principal’s objectives and that of the agent in minimizing the cost of public debt, given the risk exposure of such debt. The academic literature contains several incentive designs for organizations. A major issue in the economies of organizations around the world is that of designing the appropriate compensation and incentive systems, as shown in Posner’s (2010) work for CEO compensation. As Roberts (2010) rightly points out, the problem with designing the appropriate incentive systems should not be limited to the top level of organization but rather include all levels of the organization. The issue of designing the right incentive system is even more relevant to DMOs, since they play a crucial operational role in the overall debt management of the public, where the strategic objective of the principal should be in line with that of the agent for the prudent management of public debt. But what is the right incentive system that should be designed to ensure incentive compatibility between the principal and the agent in public debt management? Should the design be focused on strong incentives or weak incentives? People generally respond to incentives, but what is usually not clear is whether the designed incentives are able to appropriately capture the right interests and all the interests of the principal for the agent to respond as desired. In the context of debt management, whether we should resort to designing strong incentives relative to weak incentives or vice versa depends on fve key situations, as outlined by Roberts (2010): 1 Whether there are available good measures of the agent’s efforts or performance. 2 Whether there are available good measures for a particular activity and whether multitasking is important. 3 Whether cooperation among different agents is desired. 4 Whether encouraging experimentation is important. 5 Whether inducing obedience from agents who disagree with the principal about the right course of action is important. In all fve cases, the weak incentive scheme is recommended as the optimal incentive design relative to the strong, as demonstrated by Roberts (2010) on the basis of earlier studies (Posner, 2010; Holmstrom & Milgrom, 1991; Raith & Friebel, 2008; Van den Steen, 2007). In the case where there are poor measures for agent’s performance, poor measures for at least one task in a multitasking activity, poor measures for cooperation and experimentation, and the principal and agent fundamentally disagree about the right way to do things (detailed explanation is in Roberts, 2010), the weak incentive scheme is more appropriate. In the context of debt management, it is important to assess whether the overall strategic objective of the principal of minimizing the cost of public debt, given the risk, can be addressed by a single task or multiple

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tasks that are required by the agent to meet this objective, whether there is the need for coordination of tasks across different agents, and whether the agent needs to experiment to achieve the strategic objective of the principal. In all this, it is important to determine whether there are excellent measures for incentives to suggest whether a strong or weak incentive scheme should be implemented. The tasks of the DMO are generally many, requiring multitasking rather than working on only a single task. For instance, front offce staff are required to be able to handle tasks that include managing auctions, other forms of borrowing, and all sorts of funding operations. These different tasks are not easily measured by any performance measure to be able to use in creating a strong incentive scheme. The second related important thing to consider in designing the appropriate incentive systems for the DMO is the fact that not only do staff perform multiple of tasks, but more so, their tasks must be well coordinated, as the front offce activities affect the back offce and the middle offce activities, and vice versa. This, among other things, suggests the need for a weak form of incentive scheme, such that agents do not respond strongly to bad but strong incentives.

9.8 SOVEREIGN DEBT RESTRUCTURING Debt restructuring refers to an exchange of outstanding debt instruments like loans and bonds, for new instruments or cash through a legal process (Das, Papaioannou, & Trebesch, 2012; European Parliamentary Research Service, 2017). It involves either or a combination of debt rescheduling, which refers to an extension of repayments into the future paired with the possibility of lower interest, and debt relief, which entails the reduction of the nominal debt. Restructurings may be pre-emptive, coming before a default or after a default. The restructurings done thus far have been under four channels: the Paris club, which is a group of creditor governments; the London club, which is a group of private creditor committees; multilateral fnancial institutions (MFIS); and exchange offers for dispersed bondholders (Brooks & Lombardi, 2015). Data show that since the 1950, there have been more than six hundred individual cases of debt restructuring arising from defaults (Das et al., 2012). Debt restructuring has gained traction in the past few years, for good reason. The lack of a proper statutory approach anchored in law like in the case of corporations has limited the options available for sovereign restructuring. This has brought about the overreliance on the contractual approach mainly using collective action clauses (CACs) to restructure. However, CACs also come with limitations, as was witnessed recently under the Argentinian case and the recent Greek debt restructuring. Holdout problems limit the speedy attainment of a solution while affecting the outcome of the restructuring outcomes. This is made more complex by rulings that sometimes end up confusing international practice, rulings from litigations by parties in different jurisdictions. The Greek case demonstrated how the requirement for a supermajority in CACs might fail to be suffcient to make binding commitments as

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minority creditors successfully held out notwithstanding the CACs. Greece had tried to restructure €206 billion of debt, of which €21.6 billion was subject to foreign law. Of these foreign law bonds, 50% failed to achieve the share needed to activate a collective action clause (CAC) (usually at 75%), resulting in €6.5 billion of the bonds not being restructured. In this case, Greece was forced to pay out the holdouts in full, because those who had agreed to the CACs had their debt reduced by up to 75% in net present value terms (Nieminen & Picarelli, 2017). On one hand, the Greek debt debacle with its resultant contagion effects in Europe revealed the black box in policy that debt restructuring is, and how much it can evolve into a nightmare. On the other hand, the recent debt forgiveness process for heavily indebted poor nations also revealed how unsustainable debt can weaken a nation’s growth and development. 9.8.1 Stylized facts In recent years, debt restructuring has emerged as one of the main solutions of steering debt-ridden countries out of distress. Although there has not been an established systematic way of handling it, some common characteristics have been identifed. According to Trebesch and Kolb (2011), four major insights can be assigned to a majority of countries that eventually turn out to be candidates of a restructuring; 1 Most debt crises yield more than one debt restructuring and more than one debt renegotiation. For example, the Algeria debt crisis (1991–1996) had two restructurings, the Brazil debt crisis (1980–1990) had fve restructurings, and the Russian debt crisis (1998–2000) had three restructurings. 2 There is wide variation among the durations for sovereign debt restructuring. Between 1980 and 2007, it took an average of 30 months; and from 2008 and 2010, the restructuring period decreased to an average of 17.3 months. The duration of restructuring has generally been falling over time. The highest individual country restructuring durations include Serbia and Montenegro 2000 to 2004, which lasted 43 months; Argentina 2001 to 2005, which took 42 months; and among the shortest was Uruguay’s restructuring, which took two months. 3 Over the past few decades, it took longer to restructure bank debt than it took to restructure sovereign bonds. Sovereign bonds took on average 13 months, while bank restructurings took on average 30 months. 4 Holdouts due to creditors and prerestructuring litigation are rare and occur only in a minority of cases. Creditor legal action is restricted to less than 30% of the total cases. 9.8.2 When are debts restructured? Sovereign debt restructuring is associated with a period of debt overhang where the debt has already grown big enough for the lenders to view it as

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unpayable in full. The analysis of when a country has fallen in this state has been carried out using the debt Laffer curve, as mentioned earlier. The curve was originally used for tax optimization to limit the growth of the budget defcit but has since evolved into an important tool to evaluate the solvency of a country. Countries that have reached a point of debt unserviceability are said to be on the wrong side of the debt Laffer curve (Figure 9.1), where restructuring is the only way out. Data from 68 countries Cruces and Trebesch (2013) demonstrate that restructuring involving higher reductions in the stated value of an asset are associated with signifcant higher subsequent bond yields spreads and longer periods of capital market exclusions. 9.8.3 The debt restructuring process According to Panizza (2008) and Wright (1944), unlike debt from individuals or corporate entities, where laws can be enforced to declare bankruptcy and legal enforcement, sovereign debt is a bit complicated. There is a special status enjoyed by a country in the form of sovereign immunity, which leaves little room for creditor attachment to a debtor country’s assets. Furthermore, a sovereign is assumed an unlikely candidate for bankruptcy, which limits its default to only being illiquid. This arises from the assumption that a country can easily repay the debt through a cocktail of fscal consolidation measures, which may include increasing its revenue sources and decreasing its expenditure, among other measures. Creditors faced with a default are seldom willing to accept a repudiation of the debt. They hinge their hopes on the assumption that countries may not be willing to risk market exclusion, embargoes, sanctions, and costs in the form of reputation, borrowing rate increase, or asset confscation to encourage the debtors to stick to the terms of the loan (Eaton & Gersovitz, 1981; Megliani, 2014). Furthermore, international treaties commit the defaulting countries to making full compensation for resultant losses arising from wrong acts, as established in international treaties. Several studies, such as Trebesch and Kolb (2011), Megliani (2014), and European Parliamentary Research Service, 2017, conclude that the process of debt restructuring can generally be summarized into three phases. In the frst place, the debtor is obligated to declare the debt unsustainable and in need of restructuring. This is the longest part of the restructuring process, which can take months or years. Second, the country’s debt profle is evaluated and categorized into foreign and domestic and then by creditor type. Third, debt exchange occurs where the restructuring offer is made, and the creditors then decide whether to accept or reject it. According to European Parliamentary Research Service (2017), a minimum threshold must be reached in terms of accepting creditors for the restructuring process to proceed. According to Schwarcz (2004) and Nieminen and Picarelli (2017), the restructuring itself takes two approaches. First, a contractual approach, also called the private law approach, regulates the process by use of, among others, CACs. The contractual approach using CACs is employed mainly in international bonds and allows the supermajority of creditors to modify the

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bond’s earlier fnancial conditions. Next the statutory approach, also called the public law approach, involves the application of laws that govern the process of restructuring. This would require the use laws between states such as the sovereign debt restructuring mechanism (SDRM) of the International Monetary Fund (IMF). This process is rarely used in a sovereign context because of a lack of a properly laid-out legal framework. Although this process seems to be straightforward, the negotiation process is fraught with many complications. The process may vary from creditor to creditor, and this has seen debt market seriously agitating for a harmonization of a process to which each participant can commit. Although the foregoing process generalizes the restructuring process, the nature of debt determines the process, such that commercial banks, multilateral and bilateral suppliers, trade creditors, and bondholders may have different negotiation processes, because different interests motivate them. 9.8.4 Methods of debt restructuring The method of debt restructuring used depends on various aspects of the loan, especially on the parties involved, the nature and outcomes of the negotiations, and the needs of the debtor nation. According to Megliani (2014), the nature of the default determines the method of resolution, which can take either one of four forms: 1 2 3 4

Submitting to arbitration. The borrower’s making a unilateral determination. Arriving at a consensus between the parties involved. Taking recourse to diplomatic means.

Debtors commonly enter into negotiations. The main determinant of the method which debt restructuring takes depends on the jurisdiction in law (or lack thereof) that anchors the debt issue. There are two main jurisdictions in international debt, namely English law and New York law. Other jurisdictions include German law, Luxembourg law, and so on. The law upon which a debt instrument is based determines the jurisdiction in law, which will decide in case the restructuring ends in court and will determine the clauses that can be inserted into the debt instrument with regard to certain aspects. A major aspect is the fraction of creditors required to amend aspects of an instrument. Whereas New York law may require near-unanimous agreement among creditors, English law requires a lower threshold – twothirds or three-quarters of the creditors – to make an amendment (Arora & Caminal, 2003). On the basis of the law anchoring the bond agreement or lack thereof, restructuring arrangements are either statutory (based on law) or contractual.

9.9 RISK MANAGEMENT FRAMEWORK FOR GOVERNMENT DEBT PORTFOLIO To mitigate a sovereign country’s vulnerabilities from shocks, it needs a policy framework that integrates government debt and risk management.

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Structural weaknesses in developing markets create volatility in the macroeconomy. Thus, the more unstable an economy, the more important it is to have a comprehensive policy framework for government debt risk management. The risks inherent in the structure of the government’s debt should be carefully monitored and evaluated. Generally, risk management policies are approved by a country’s MoF, but there are separate agencies that are responsible for the actual risk management operations. Common risks that are likely to be managed are credit risk,12 liquidity risk,13 and market risks.14 According to Blommestein (2005), risk management policy framework mirrors the vital connection between the formulation and the implementation of debt management decisions and should be based on benchmarks. The strategic benchmark to that end is a management tool that requires a government to specify its risk tolerance and portfolio preferences on the trade-off between risks and expected costs. Debt managers should be able to ascertain how a portfolio is structured with respect to cost against risk criteria. This helps to hedge against various forms of shock. This means a government’s choice of debt instrument issued depends on the economy’s structure, the nature of economic shocks, and investor preferences. A strategic benchmark has two key roles: 1 It provides guidance for management of costs and risk. 2 It defnes a framework for assessing portfolio performance on cost, risks, and return. To guide borrowing decisions and lessen government risks, debt managers should take into consideration fscal and other risky features of a government’s cashfow. Theoretically, all governments have balance sheets that show their cashfows. Factoring in these cashfows vis-à-vis fnancial and other inherent risks provides in-depth insight for debt managers into managing risks associated with government debt portfolio. In addition, a fnancial analysis of a government’s balance sheet will form a basis for measuring the costs and risks of more-viable policies and programmes aimed at managing a government’s debt portfolio. Some countries have extended this approach to include other government assets and liabilities. For example, in certain countries where foreign exchange reserves are funded by foreign currency debts, debt managers have lessened government’s balance sheet risk by ensuring that the currency composition of the debt supporting the reserves refects the currency composition of the reserves after factoring in derivatives and hedging transactions. Countries where debt managers are in charge of managing liquid assets have been adopted a multipronged method for credit risk management. In other countries where credit ratings are available, debt managers should limit their investments to those that have credit ratings from independent creditrating agencies that meet a predetermined minimum requirement. Of course, credit risks can also be managed by diversifying a portfolio across a number of fnancial counterparties and through collateral agreements. A government should set its risk exposure limits for counterparties to factor in its actual and contingent consolidated fnancial exposures to that counterparty that arises from debt and operations of foreign exchange reserves management.

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Foreign exchange reserves play a role in granting government the fexibility to manoeuvre in times of shocks. The level of foreign exchange reserves should be aligned with government access to capital markets, the cost of carrying the reserves, and the exchange rate regime, among others. Governments that are unable to secure access to the international markets should consider holding reserves that align with their countries’ short-term external debt. In addition, debt managers should consider indicators that are of interest to debt management, such as ratios of debt to GDP and to tax revenue, average interest rates, debt service ratios, maturity indicators, and indicators of debt composition. Contingent liabilities are potential fnancial claims against government which have yet to materialize but can trigger a frm fscal obligation under certain circumstances. Contingent liabilities may include government insurance against natural disasters. Debt managers in managing risks should factor in the impact of contingent liabilities on a government’s fnancial position. Contingent liabilities come with some level of risks unlike government fnancial obligations. This is because they can be used only when certain events take place. Also, the size of the payout depends largely on the structure of the undertaking. Governments can reduce the contingent liabilities risks by strengthening provident supervision and regulation, introducing appropriate deposit insurance schemes, undertaking sound governance reforms of public sector enterprises, and improving the quality of their macroeconomic and regulatory policies. It is important also that a government monitor the risk exposures they enter into through contingent liabilities and make sure that they are fully aware of the risks involved in such liabilities. It is necessary also that the government be well informed about the conditions that are likely to trigger continent liabilities, such as policy distortion. Notably, some governments have found it useful to centralize this monitoring function. Nonetheless, the debt managers should be aware of the contingent liabilities undertaken by a government. It is also important that debt managers make budget allowances in anticipation of expected losses from contingent liabilities. It is expedient for debt managers to critically assess and manage risks that emanate from foreign currency and short-term or foating-rate debt. When a government overly relies on a debt management strategy that features foreign currency or short-term debts, this situation may be risky. This holds true in times when capital markets become volatile and exchange rates depreciate. Also, short-term debts that may seem less costive can create substantial rollover risk for the government. In other instances, it may limit the central bank from raising interest rates to confront issues of infation or perhaps support the exchange rate. A number of governments from emerging market countries have considerable amounts of short-term and foating-rate debt. Yet relying too much on longer-term fxed rate fnancing also has its associated risks as it entices the government to devalue the debt in real terms by initiating surprise infation. Such concerns would be refected in both current and future borrowing costs. Also, unexpected devaluation would increase debt-servicing burdens. This could create strains in countries and lead to the payment of higher risk premium given

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the already-heavy debt burden. Governments seeking to build benchmark issues often hold liquid fnancial assets, spread the maturity profle of the debt portfolio, and use domestic debt buybacks or swaps of older issues with new issues to manage the associated rollover risks. Another way to manage risk is to have a cost-effective management policy in place to cater for cases of unplanned expenditure. In situations where government fnds it diffcult to secure access to capital markets, liquid fnancial assets can provide fexibility and ease in debt and cash management operations in times of temporal fscal market distortions. They make it easy for the government to absorb shocks where it is nearly impossible to borrow in capital markets or perhaps expensive to. Sound cost-effective cash management needs to be supported by an effcient infrastructure for payments and settlements. Identifying and managing market risk involves examining the fnancial features of the revenues and other cashfows available to the government to service its borrowings and choosing a portfolio of liabilities that matches these as much as possible. Where cash and debt management functions are separately managed, such as by the central bank and ministry of fnance respectively, short-run discrepancies between debt and monetary operations are avoided. Clearly demarcating institutional responsibilities between the central bank and debt management offcials promotes sound cash management practices. The IMF (2017) provided ten guiding principles for managing sovereign risk, which due to space, will not be discussed here.

9.10 DEBT SUSTAINABILITY ANALYSIS AND MEDIUM-TERM DEBT STRATEGY The issue of debt sustainability in developing countries is an issue that often comes up in debates and discussions among policymakers and international organizations, especially in recent years after the 2008 fnancial crisis. Equally important is the concept of medium-term debt management strategy (MTDS), which is closely linked to debt sustainability. 9.10.1 Debt sustainability analysis According to the IMF, in developing countries, debt is considered to be unsustainable if the following two conditions hold: •  External debt is unsustainable. •  Debt-servicing problems occur. External debt is unsustainable when it cannot be serviced without needing exceptional fnancing, such as debt relief. This means that when a country is unable to honour his external debt service obligation without a debt-relief support, the external debt of such a country is said to be unsustainable. There are various indicators that are generally used to assess whether a country’s external debt is likely to be unsustainable or not, which will be discussed later in this section.

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Developing countries are considered to be facing debt-servicing problems or challenges when there is lack of suffcient loans or grants from external creditors (e.g. international organizations or governments) to fnance a country’s primary defcit, and when the cost of servicing domestic debt is high. This means that a country with a lower cost of domestic debt may reduce its possibility of a debt-servicing problem relative to one with a high cost of domestic debt. In the context of facing the two conditions just presented regarding debt sustainability, it becomes necessary to conduct DSA annually as recommended by the IMF to form a clear picture of what future commitment can be made in regard to debt management and public investment. DSA can be broadly defned as an assessment of how a country’s current level of debt, and new borrowing affects its ability to honour debt service obligations in the future. This, among other things, suggests that a country with a huge accumulated debt stock, but with fewer resources to support the debt, and yet it continues to accumulate new debt, which runs the risk of its not being able to honour the service obligations of the debt in the future. This risk is higher for countries with poor policies and institutions, which could serve as a check to wasteful use of the borrowed money. 9.10.2 How DSA are conducted The DSA is made up of two parts: a preparing part and an assessing part (World Bank, 2005). In the preparation part, three key steps are taken: 1 The country involved in consultation with the IMF determines the schedule for preparation, which is generally a year but could be less or more frequent than a year, depending on the level of debt stability of the country. When debt levels are more stable, less-frequent updates are required. However, in a case of countries with less-stable debt levels, frequent updates are required. 2 The country works with the IMF and the World Bank develop a macroeconomic framework. 3 The country consults key creditors for information on their lending plans. The second part, which is the assessment section of the DSA, involves the following steps (World Bank, 2005): • Link the low-income countries’ (LICs) templates for DSA to macroeconomic projections and debt data. • Calculate current and future debt-burden indicators under the baseline. The baseline scenario is based on a set of macroeconomic projections, which refects the government’s intended policies. • Design alternative scenarios and stress tests to identify the countryspecifc factors to be included in the DSA. • Produce relevant tables and charts as provided by the LIC templates. • Form a view regarding how debt-burden indicators evolve over time, and assess their vulnerability to exogenous shocks.

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• Compare external debt-burden indicators to appropriate indicative debt-burden thresholds. • Assess whether and how other factors, such as the evolution of domestic debt or contingent liabilities, affect a country’s capacity of servicing future debt service payments. • Classify a country according to its probability of debt distress in collaboration with the IMF. • Determine a country’s appropriate borrowing strategy, and identify adequate policy responses. The results from the DSA can then be used in conjunction with countries’ macroeconomic fundamentals, quality of instructions, policies, and history of debt management to determine the warning signs and how-to response appropriately, to correct them before their occurrence. 9.10.3 Medium-term debt strategy The primary objective of sovereign debt management is to raise the required funding required at the least cost over a medium term to a long term, one that is consistent with a reasonable level of risk. This suggests that effective debt management and how it is designed and implemented depend to a large extent on the macroeconomic and institutional contexts. There is a two-way interlinkage between prudent debt management and macroeconomic policy. Generally, sound debt management is critical to macro and fnancial stability and vice versa. An effcient debt management requires an effective debt management strategy (DMS), which can be broadly defned as a plan in managing public debt portfolio over time, in line with the strategic management objective conditional on the constraints imposed by government preferences with regard to cost–risk trade-offs. There are clear guidelines provided by the World Bank and IMF on how to develop a good and effective medium-term debt management strategy (MTDS). The guideline, which contains eight steps, is as follows (February 2009): 1 Identify the objectives for public debt management and scope of the MTDS. 2 Identify the current debt management strategy, and analyse the cost and risk of the existing debt. 3 Identify and analyse potential funding sources, including their cost and risk characteristics. 4 Identify baseline projections and risks in key policy areas – fscal, monetary, external, and market. 5 Review key longer-term structural factors. 6 Assess and rank alternative strategies on the basis of the cost–risk trade-off. 7 Review the implications for candidate debt management strategies with fscal and monetary policy authorities and for market conditions. 8 Submit and secure an agreement on the MTDS.

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In practice, the debt management team does not necessarily have to follow the steps in a systematic order as presented. However, all steps should be followed, because they serve various purposes in the debt management process.

CONCLUSION Debt levels for most developing countries are fast rising even after the two debt-relief programmes: the Heavily Indebted Poor Countries Initiative and Multilateral Debt Relief Initiative. These programmes, by the end of 2008, helped reduced the debt level for many developing countries. For instance, in SSA, the debt-relief programmes helped reduced the debt level by about two-thirds. The gains from the debt-relief programmes seem to have been short-lived, since the debt levels for most developing countries are getting close to a crisis threshold. Since 2008, the ratio of debt to GDP has been rising, and in 2016, it doubled the 2008 value, to 44%. This fast-rising debt level has almost wiped out half of the reduction from 2000 to 2008. In 2016, out of 46 SSA African countries with available statistics, more than half (24 countries) of them have a debt-to-GDP ratio at or above the 50% threshold considered a concern. Countries such as Capo Verde, Gambia, and the Republic of Congo have debt-to-GDP ratios above 100%, and about 15 SSA have debt-to-GDP ratios in the 60%–98% bracket. The question that keeps coming up in recent discussions is whether the debt-overhang threshold in many of the developing countries has been crossed or has come close to being crossed once again. Why are the causes of the fast-rising debt levels in developing countries? Are the current debt levels in the developing world sustainable? This chapter provided insights into the debt situations in developing countries, the growth implications, institutional framework for debt management, incentive structure for staff in debt management offces, and debt restructuring, among others, to help us better understand the effective management of debt in developing countries. The fscal space for most developing countries are clearly too narrow to support their respective growth and development pathways, and as a consequence, they tend to rely signifcantly on external debt to close the public fnancing gap. More importantly, the borrowed money is in most cases not prudently spent on projects that can generate funds to repay the debt and its servicing requirement. These call for countries to better manage public debts by introducing an effcient institutional framework for debt management, resource debt management offces, and excellent debt sustainability analysis procedures.

Discussion questions 1 Explain, with examples, why at a certain threshold of debt, it is prudent to implement debt forgiveness.

2 Give three scenarios that can result in debt crisis and provide solutions to address each of the scenarios.

260 Amin Karimu et al. 3 Explain to a policymaker why debt forgiveness can lead to an increase in the market value of debt for the creditor. 4 What is debt management? Outline the various guidelines to promote debt sustainability in a developing country. 5 Briefy outline the processes involve in conducting debt sustainability analysis (DSA) for a prudent debt management.

6 In the context of debt management, whether we should resort to designing strong incentives relative to weak incentives, or vice versa, depends on fve key situations, as outlined by John Roberts (2010). Present and discuss these fve situations in designing the appropriate incentive scheme for a developing country.

Notes 1 External debt is the portion of a country’s debt owed to nonresidents, and it is the standing amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point in the future. 2 ‘Eurodollar market’ is a term that refers to US-dollar-denominated deposits at foreign banks or at the overseas branches of American banks. 3 Debt management refers to the processes to minimize the fnancial cost of the public debt while maintaining the market and operational risks at an acceptable level, given the general objectives of the fscal and monetary policies. 4 Debt servicing is the requirement of paying the principal and interest on outstanding loans. 5 Domestic resource mobilization refers to the generation of government revenue from domestic resources, such as revenue generated from taxes or nontax sources (royalties, licences, levies, or other income). 6 Sovereign debt refers to the central government’s debt. It is debt issued by the national government in a

7

8

9

10

11

12

foreign currency in order to fnance the issuing country’s growth and development. Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected fuctuations in interest rates. Economic growth is the sustained increase in the production of goods and services over a period of time. Primary surplus refers to current government spending, which is less than current income from taxes excluding interest payments on government debt. A debt Laffer curve is a curve that shows the relationship between the face value and market value of debt, where market value is determined by the market price of debt. The curve shows when debt reduction can be benefcial to a country if the country is on the wrong side of the curve. Operational risk refers to the probability of loss occurring from the internal inadequacies of an organisation. Credit risk is the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

Chapter 9 • Sovereign debt management 261 13 Liquidity risk is the potential that a frm is unable to meet its short-term debt obligations, thereby incurring exceptionally large losses.

14 Market risk refers to the risk that an investment may face due to fuctuations in the  market, such that it cannot be eliminated through diversifcation.

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of Globalization and Development, 6(2), 287–318. Clements, B., Bhattacharya, R., & Nguyen, T. Q. (2003). External debt, public investment, and growth in lowincome countries. IMF Working Paper No. 03/249. Washington, DC: International Monetary Fund. Cohen, D. (1991). Private lending to sovereign states: A theoretical autopsy. Cambridge, MA: MIT Press. Cordella, T., Ricci, L., & Ruiz-Arranz, M. (2010). Debt-overhang or debt irrelevance? Revisiting the debt growth link (Vol. 57). IMF Staff Papers. Washington, DC: International Monetary Fund. Cruces, J. J., & Trebesch, C. (2013). Sovereign defaults: The price of haircuts. American Economic Journal: Macroeconomics, 5(3), 85–117. Currie, E., Dethier, J. J., & Togo, E. (2003).  Institutional arrangements for public debt management  (Vol. 3021). Washington, DC: World Bank. Das, U. S., Papaioannou, M. G., & Trebesch, C. (2012).  Sovereign debt restructurings 1950–2010: Literature survey, data, and stylized facts (p. 12). Washington, DC: International Monetary Fund. Eaton, J. (1993). Sovereign debt: A primer. World Bank Economic Review, 7(2), 137–172. Eaton, J., & Gersovitz, M. (1981). Debt with potential repudiation: Theoretical and empirical analysis. The Review of Economic Studies, 48(2), 289–309. European Parliamentary Research Service. (2017). Sovereign debt restructuring main drivers and mechanism. Retrieved from www.europarl. europa.eu/thinktank/en/

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Financial inclusion and economic growth1 Joshua Yindenaba Abor, Haruna Issahaku, Mohammed Amidu, and Victor Murinde 10.1 INTRODUCTION There are at least three motivations for examining the effects of fnancial inclusion on growth: the low level of fnancial inclusion in countries that need economic growth most (low-income countries), the lacklustre growth in sub-Saharan Africa (SSA) in recent times, and a realisation of the role of fnancial inclusion in accomplishing the United Nations Sustainable Development Goals (SDGs). Each motivation is substantiated in chronological order. First, while fnancial inclusion (particularly, account ownership) has almost reached a saturation point in high-income countries, low-income countries have yet to make any signifcant progress in ensuring fnancial inclusion. Meanwhile, these low-income economies need fnancial inclusion the most in order to jumpstart inclusive development. On the basis of the Findex data provided by Demirgüç-Kunt, Klapper, Singer, and Oudheusden (2015), about 90.6% of adults in high-income countries and 94% in highincome OECD countries own a bank account, while only 27.4% of adults in low-income countries own a bank account. Similarly, while 75.1% and 79.7% respectively of adults in high-income and high-income OECD countries have a debit card, only 6.6%% of adults have a debit card in low-income countries. This means that immerse opportunities exist in poor countries for extending fnancial inclusion for economic development. Second, on the basis of International Monetary Fund (IMF) data (IMF, 2018), in 2016, SSA, the poorest region in the world, experienced its lowest growth in over 20 years. From 3.4% in 2015, growth in the region fell considerably to 1.4% in 2016. Notwithstanding the fact that growth picked up in 2017 (2.7%), it was still jaded. This appalling growth is attributable to falling commodity prices, unsupportive global economic environment, and structural bottlenecks in some countries in the region. In particular, resource reliant economies such as Angola, Nigeria, and South Africa have bowed to the repercussions of low crude oil prices as revenues have been severely affected. Inopportunely, these are the three largest economies in the subregion, and for that matter, their weaknesses spill over into other countries in the subregion. These three economies respectively grew by 0.0%, -1.5%, and

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0.3% in 2016. Some non-oil-dependent economies are, however, performing impressively by experiencing growth in excess of 6%. These include Côte d’Ivoire, Ethiopia, Kenya, and Senegal. Clearly, fnancial inclusion has a role to play in accelerating growth in the SSA region. Third, fnancial inclusion is indispensable to the attainment of the SDGs. Consequently, fnancial inclusion has been integrated into the SDGs, where it features prominently as a target in eight of the 17 SDGs: SDG 1 – eradicating poverty. SDG 2 – ending hunger, achieving food security, and promoting sustainable agriculture. SDG 3 – improving health and well-being. SDG 5 – achieving gender equality and economic empowerment of women. SDG 8 – promoting economic growth and jobs. SDG 9 – supporting industry, innovation, and infrastructure. SDG 10 – reducing inequality. SDG 17 – strengthening the means of implementation. As an example, one of the targets of SDG 8 is to ‘strengthen the capacity of domestic fnancial institutions to encourage and expand access to banking, insurance and fnancial services for all’. This means that the future of the world depends so much on our ability to extend a wide range of fnancial services to the poor and marginalised. In this way, a more succinct understanding and vigorous pursuit of fnancial inclusion will be a vital contribution towards attaining these lofty global goals (SDGs). The rest of the chapter is structured as follows. Section 10.2 defnes fnancial inclusion and provides a guide to its measurement. Section 10.3 describes the trends in fnancial inclusion. Section 10.4 discusses the determinants of and barriers to fnancial inclusion. Section 10.5 assesses the link between inclusive fnance and fnancial development. Section 10.6 examines the effect of inclusive fnance on economic growth. Section 10.7 discusses the roles of institutional architecture in the fnancial inclusion–economic development nexus. Section 10.8 concludes the chapter.

10.2 CONCEPTUALISING FINANCIAL INCLUSION ‘Financial inclusion’, an antidote to fnancial exclusion, has become a buzzword in policy, academic, and practitioner circles. However, conceptualising fnancial inclusion remains an unsettled matter. While there is almost a consensus on the defnition of ‘fnancial inclusion’, the issue of measurement remains unsettled. Allen, Demirgüç-Kunt, Klapper, and Peria (2016) defne ‘fnancial inclusion’ simply as the ‘usage of formal fnancial services’ (p. 2). The World Bank defnes ‘fnancial inclusion’ as the case where ‘individuals and businesses have access to useful and affordable fnancial products and services that meet their needs – transactions, payments, savings, credit and insurance – delivered in a responsible and sustainable way’ (www.worldbank.org/en/topic/fnancialinclusion). For the African Development Bank (AfDB, 2012), ‘fnancial inclusion’ means ‘all initiatives that

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make formal fnancial services Available, Accessible and Affordable to all segments of the population’ (p. 26). According to the Centre for Financial Inclusion, fnancial inclusion is a ‘state in which everyone who can use them has access to a full suite of quality fnancial services, provided at affordable prices, in a convenient manner, with respect and dignity’ (www.centerforfnancialinclusion.org/). Diniz, Birochi, and Pozzebon (2012) view fnancial inclusion as making formal fnancial services accessible and affordable to all individuals, especially those with low incomes. On the basis of the foregoing defnitions, we present a broad (‘consensus’) defnition for fnancial inclusion as follows. ‘Financial inclusion’ can be defned as eliminating obstacles to fnancial products and services (such as credit, investment, savings, insurance, fnancial technology, and payments) for everybody in the economy (rich or poor, all adults, rural or urban dweller, educated or uneducated) and establishing a platform, or framework, or a system which produces low-cost, fair, convenient, safe, quality, and sustainable fnancial services and products and facilitates access to and the usage of these products and services by all, at all times. The conceptualisations suggest that fnancial inclusion can be viewed as a state concept or as a process concept. Financial inclusion as a state pertains if all the ideals of fnancial inclusion (ingredients) are present in fxed measures. Should there be a change in any of the ideals, then the state of fnancial inclusion changes. In this light, an individual can be described as being fnancially included or excluded. In addition, there are degrees of exclusion and inclusion that describe various states of fnancial inclusion or exclusion. However, fnancial inclusion as a process entails the mechanism or path followed to change fnancial inclusion from one state of equilibrium to another. Thus, the process leads to the state. In terms of measurement, most empirical studies measure fnancial inclusion by using one or more single-variable measures, such as the ownership of bank account, number of accounts per 1000 adults, number of bank branches per 100,000 adults, savings capacity, and insurance penetration, among others. However, these single-variable measures have been criticised for being too narrow to convey the multidimensional nature of fnancial inclusion. Now, the trend in the literature is to construct a fnancial inclusion index on the basis of some identifed dimensions. Sarma (2012) constructs a fnancial inclusion index with three main dimensions, namely the penetration of fnancial services, the availability of fnancial services, and the usage of fnancial services. In a similar vein, the Financial Inclusion Data Working Group of the Alliance for Financial Inclusion (2011) has proposed three dimensions of fnancial inclusion: 1 Access refers to availability of formal fnancial services in terms of physical proximity and affordability. 2 Quality entails designing and customising fnancial services to the satisfaction of consumers. 3 Usage refers to the regularity, frequency, and duration of using fnancial services.

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A more succinct (and universal) view of fnancial inclusion in three-dimensional form was provided by Hall (2014). The components of Hall’s threedimensional view of fnancial inclusion (FI3D) are fnancial participation, fnancial capability, and fnancial well-being. Each dimension embodies several subdimensions: 1 Financial participation refers to the affordability of, having access to, and the usage of formal fnancial services and products (accounts, credit, deposits, investment, insurance, fnancial technology, and payments). 2 Financial capability measures the deployment of fnancial inclusion to enhance the capability of the individual to effectively participate in the formal fnancial system. It entails the ability of the individual to make prudent fnancial decisions, effectively undertake fnancial planning and budgeting, and be fnancially literate and keep up to date with fnancial innovations and trends. 3 Financial well-being measures the degree to which fnancial inclusion has improved the quality of life and well-being of the individual. It measures fnancial inclusion–induced improvements in fnancial quality of life, amelioration of hardship, curtailment of over-indebtedness, fnancial self-suffciency, and livelihood sustainability. Thus, Hall’s conceptualisation collapses the three elements of fnancial inclusion proposed by Alliance for Financial Inclusion Financial Inclusion Data Working Group (2011) (access, quality, and usage) into one broad dimension: fnancial participation.

10.3 TRENDS IN FINANCIAL INCLUSION Compared to the rest of the world, fnancial inclusion is low in SSA (Table 10.1). However, the trend shows improvement. The percentage of adults who had any form of bank account in 2017 was 68.5% globally, compared to 42.6% in SSA. Again, while 62% of adults aged 15 and above had some form of account in 2014 globally, only 34.2% had an account in SSA in the same period. Globally, the percentage of adults with an account increased from 50.6% in 2011 to 68.5% in 2017. Similarly, in SSA, the percentage of adults with an account increased from 23.2% in 2011 to 42.6% in 2017. Unfortunately, vulnerable groups such as women, the unemployed, and the poor have the lowest incidence of fnancial inclusion (in terms of owning a bank account), both in the world and in SSA. The incidence of fnancial inclusion is lower with respect to accounts with formal fnancial institutions. While the percentage of adults with an account in a formal fnancial institution increased from 50.6% in 2011 to 67.1% in 2017 worldwide, in the case of SSA, the same increased from 23.9% in 2011 to 32.8% in 2017. This highlights that the growth in global trend in formal account ownership is faster than that of SSA. Thus, efforts have to be doubled to extend basic fnancial accounts to the unbanked in the region. In the academic, policy, and practitioner circles, more value is placed on using an account than on the mere owning of account, as somebody may

Chapter 10 • Financial inclusion and economic growth 267 TABLE 10.1 Trends in fnancial inclusion: SSA and world Financial inclusion measure

SSA

World

Account (%, age 15+) All adults, 2017 All adults, 2014 All adults, 2011 Financial institution account (% age 15+) All adults, 2017 All adults, 2014 All adults, 2011

  42.6 34.2 23.2   32.8 28.8 23.2

  68.5 62 50.6   67.1 61.2 50.6

Mobile money account (% age 15+) All adults, 2017 All adults, 2014

  20.9 11.6

  4.4 2.1

Account, by individual characteristics (% age 15+), 2017 Women Adults belonging to the poorest 40% Adults out of the labour force Adults living in rural areas

  36.9 31.9 31.4 39.5

  64.8 60.5 59.3 66

Digital payments in the past year (% age 15+) Made or received digital payments, 2017 Made or received digital payments, 2014 Used an account to pay utility bills, 2017 Used an account to receive private sector wages, 2017 Used an account to receive government payments, 2017 Used the internet to pay bills or to buy something online, 2017 Used a mobile phone or the internet to access an account, 2017 Used a debit or credit card to make a purchase, 2017

  34.4 26.9 7.7 5.7 7.3 7.6 20.8 7.5

  52.3 41.5 22.3 15.9 16.3 29 24.9 32.6

  5.5 7.1

  13.4 13.7

Domestic remittances in the past year (% age 15+), 2017 Sent or received domestic remittances through an account Sent or received domestic remittances through an OTC service Sent or received domestic remittances through cash only

  22.7 11 9.4

  .. .. ..

Saving in the past year (% age 15+) Saved at a fnancial institution, 2017 Saved at a fnancial institution, 2014 Saved at a fnancial institution, 2011 Saved using a savings club or person outside the family, 2017 Saved any money, 2017 Saved for old age, 2017

  14.9 15.8 14.3 25.3 54.4 10.3

  26.7 27.3 22.6 .. 48.4 20.6

Credit in the past year (% age 15+) Borrowed from a fnancial institution or used a credit card, 2017 Borrowed from a fnancial institution or used a credit card, 2014 Borrowed from family or friends, 2017 Borrowed any money, 2017 Credit in the past year (%, age 15+), 2017

  8.4 7.5 31 45.7 4.7

  22.5 22.3 25.8 47.5 11.2

Inactive account in the past year (% age 15+), 2017 No deposit and no withdrawal from an account No deposit and no withdrawal from a fnancial institution account

Source: Demirgüç-Kunt et al. (2015, 2018) Note: Except when otherwise indicated, all statistics relate to 2017

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have an account but the account has been dormant for months or years. SSA has a lower proportion of adults with a dormant account than that of the global average. The percentage of adults who neither deposited into nor withdrew from a fnancial institution account in 2017 was 13.7% for the world and 7.1% for SSA. There is an upsurge in the use of digital fnancial services. Globally, the proportion of adults who received or made digital payments increased from 41.5% (26.9%) in 2014 to 52.3% (34.4%) in 2017, an increase of about 10.8% (7.5%) over the four-year period. Generally, SSA lags behind the global average with respect to account usage indicators such as the receipt of wages and government transfers through a formal account, the use of an account to pay bills, and making online transactions. This is largely due to the relatively large informal sector in the region, which encourages payments through informal channels. The share of Africa’s informal sector in GDP is 38% compared to 24% of the GDP for Europe. This means that formalisation can be a key driver of fnancial inclusion. One of the important indicators of fnancial inclusion is savings. The Harod–Domar model highlights how the accumulation of savings can help a nation realise its growth potentials. Savings is important because it is the building block of investment. Moreover, without investment, no signifcant economic progress can occur. Globally, the proportion of adults who save in a fnancial institution is low, and the trend is showing stagnation. Worldwide, the percentage of adults who saved with a fnancial institution increased from 22.6% in 2011 to 27.4% in 2014 but dropped to 26.7% in 2017. Meanwhile, in SSA the percentage of adults who saved with a fnancial institution increased marginally from 14.3% in 2011 to 15.9% in 2014 and declined slightly to 14.9% in 2017. Thus, though the formal savings rate in SSA lags behind the global fgures, the savings rate is stagnating both worldwide and in SSA. Some barriers to formal savings include distance to a fnancial institution and low interest rates on savings. Formal savings are emphasised, as opposed to informal savings, because of the many risk involved in informal savings mechanisms and the ability for formal savings to generate several other deposits through the deposit multiplier. Although credit is indispensable to the growth of enterprises, access to credit remains an intractable problem worldwide. Globally, the percentage of adults who borrowed from a formal fnancial institution or used a credit card was 22.5% in 2017, up from 22.3% in 2014. Similarly, in SSA, the percentage of adults who borrowed from a formal fnancial institution was 8.4% in 2017, up from 7.5% in 2014. Informal sector frms suffer the most when it comes to accessing fnance due to a wide range of issues, including, but not limited to, a lack of usable collateral, a lack of valid business registration documents, the distance to fnancial institutions, and a low level of fnancial literacy.

10.4 DETERMINANTS OF AND BARRIERS TO FINANCIAL INCLUSION Determinants of and barriers to fnancial inclusion can be usefully categorised into demand-side factors and supply-side factors. On the one hand, demand-side factors entail forces, circumstances, and characteristics from

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the side of the consumer which affect or impede the uptake of fnancial inclusion. On the other hand, supply-side factors involve constraints that arise from market failures, which affect or constrain the provision of fnancial services. 10.4.1 Supply factors Infrastructure such as transportation, energy, communications, and fnance are needed to provide quality fnancial services to a large number of people. Meanwhile, these types of infrastructure are either lacking, inadequate, or in poor condition in most developing countries and in rural areas in particular. Financial institutions are unwilling and unable to set up outlets in areas where such key infrastructure facilities are lacking. That is why it is unsurprising that fnancial inclusion rates are lowest in rural and economically disadvantaged settlements. Globally, the amount needed to meet infrastructure needs by 2040 is estimated at USD94 trillion (Global Infrasturture Hub, 2017). Although Asia has the largest investment need (needing about 50% of overall global infrastructure), Africa and the Americas are forecasted to have the largest infrastructure gap. The infrastructure investment gap in these regions are estimated at 28% and 32% respectively. Africa’s infrastructure investment gap widens to 43% when infrastructure needed to meet the SDGs are incorporated. Putting in place supportive infrastructure will help extend fnancial inclusion to millions. The costs of obtaining information and enforcing contracts are prohibitive in a number of poor countries. Financial institutions often fnd it expensive to provide fnancial services to poor individuals who are located in deprived areas, where transaction costs are high. The poor state of infrastructure or the lack of it exacerbates transaction costs. Banks and other fnancial institutions are therefore more comfortable dealing with rich individuals, large frms, and the government than with the poor, who are often classifed as ‘unbankable’. Digital fnance provides an avenue for reducing the cost of extending fnance to the poor. Mobile payments can lower the cost of providing fnancial services by 80% to 90%, enabling providers to serve lower-income customers proftably (McKinsey & Company, 2016). Among transaction costs factors, fxed costs are of signifcant consequence when it comes to extending fnancial inclusion to the poor. Beck and de la Torre (2007) have discussed these fxed costs to include clientlevel and transaction-level fxed costs, such as the costs of maintaining an account for an individual client and the costs of processing a transaction, which are partly independent of the value, number, and size of transactions respectively. At the fnancial institution level, fxed costs include physical infrastructure such as headquarters and a branch network; ICT infrastructure; and legal, accounting, and security services (these being independent of the value and volume of transactions processed or the number of clients served). At the fnancial system level, fxed costs include regulatory costs and costs of settlement and payments facilities, which are partly independent of the number of fnancial institutions regulated or involved in the payment space. The scale diseconomies arising from these fxed costs make

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it unviable to extend fnancial services and payment systems unless these diseconomies can be captured in some form or the other. Settlements in rural and less-populated areas are often dispersed, and this increases the cost of providing fnancial services to these areas relative to return on the capital employed. Fixed costs in particular become more binding in rural and less-populated communities where the market size is unproftably small. Weighing the size of the market against the fxed costs, a fnancial institution is usually reluctant to set up a branch or network in an area with a small and dispersed population, especially when the demand for fnancial services in urban areas is surging. Banks have often had to close branches in areas that they initially thought would be promising for business but where the reality proved different. SSA has the lowest population density in the world, with an average population per square kilometre of 40 overall and 14 in rural areas (World Bank, 2014). This could increase the cost of extending fnancial services in the region. Thus, if governments are not willing to capture these costs, fnancial inclusion will remain a dream to many in the region. Regulation can affect fnancial inclusion in several ways. First, regulations can serve as a disincentive to fnancial inclusion. The quest to quell money laundering and terrorism fnancing has forced central banks to put up stringent measures to enable the detection and interception of illicit fnancial fows. Such stringent regulatory measures can serve as signifcant stumbling blocks for the poor. For instance, ‘know your customer’ requirements, which demand overly elaborate disclosure and documentation, may discourage the poor from opening bank accounts and from using formal fnancial services. This is because, the poor usually do not have the proper identifcation documents, land titles, and evidence of bills payments, among other documents, required to access formal fnancial services. Second, weak regulatory oversight can lead to the collapse of fnancial institutions and roll back the clock of time on fnancial inclusion. Third, suboptimal regulation can lead to the underproduction of fnancial services in the economy by leading to and reinforcing ineffciencies in the fnancial system. Lastly, overregulation can hinder fnancial innovation by either stifing, being unreceptive to, or penalising fnancial frms that seek to introduce new fnancial services and technologies into the regulatory environment. 10.4.2 Demand-side factors Although there have been improvements in literacy on the whole, about 774 million adults cannot read and write, representing one-ffth of the global population (Carr-Hill & Pessoa, 2008). This represents a waste of potential human capital and economic productivity capacity. Most of these nonliterate adults are concentrated in South and West Asia, SSA, East Asia and the Pacifc. In terms of gender, they are mostly women. In terms of geography, they are mostly located in rural areas. Such high levels of illiteracy dovetail into poor decision-making and lack of capacity to take advantage of opportunities, including fnancial inclusion–related opportunities. Even though fnancial literacy is more of a problem to the nonliterate, it is a problem for

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the literate as well. A low level of fnancial literacy leads to poor fnancial choices, poor fnancial planning, unnecessary risk taking, and using fnancial services and products less, among others. Accessing and using fnancial services often do not come free or cheap. For instance, some minimum amount is often required to open an account even though now some banks have instituted no-frill accounts. In terms of digital fnance, at least one must be able to afford a phone or other electronic device to enjoy digital fnancial services. This means that in areas where poverty is prevalent, fnancial inclusion is likely to suffer. Unsurprisingly, fnancial inclusion penetration rates are lowest in low-income countries rather than in high-income countries. Thus, reducing poverty can remove an important roadblock to fnancial inclusion. The Findex Database 2018 shows that, in all cases and in all regions of the word, adults belonging to the poorest 40% of the population are on average less likely to own a bank account. For instance, while 70.6%, 65.3%, 54.4%, 43.5%, 69.6%, 42.6% of all adults, respectively in East Asia and Pacifc, Europe and Central Asia, Latin America and the Caribbean (LAC), the Middle East and North Africa, South Asia, and SSA has any form of account, 59.3%, 56.3%, 41.9%, 35.3%, 65.6%, 31.9% of the poorest 40% respectively has an account in these regions. Behavioural economics points to some cognitive predispositions which can lead to suboptimal decisions and outcomes. These cognitive tendencies can affect the degree of fnancial inclusion at various levels and fronts. For instance, cognitive biases that tend to favour the present ahead of the future (present bias) can lead to undersaving and investment (Karlan, Ratan, & Zinman, 2014). These behavioural biases may be in the form of preferences (costly self-control, loss aversion), expectations (overconfdence), price preferences (underestimating compound interest), and diffculty in making complex and contingent decisions (planning fallacies, limited attention, inability or unwillingness to save, problem with numbers, and mental accounting). For a comprehensive review of the impact of behavioural biases on savings, see Karlan et al. (2014). Cognitive biases affect fnancial inclusion in several ways. Loss aversion is often invoked to limit borrowing; present bias leads to undersaving and a greater focus on current consumption; overconfdence in future cashfows can lead to undersaving in the current period; underestimating compound interest can lead to high loan default rates; and biases in problem-solving can lead to suboptimal decisions, which can affect various fnancial inclusion indicators. Apart from the determinants just discussed, there are some individual level characteristics and societal level factors that impede fnancial inclusion. At the individual level, these include age and gender (women are less likely to be fnancially included). At the societal level, factors include religion, culture, and law and order. Other barriers to fnancial inclusion include documentation requirements and trust issues. Dasgupta (2009) summarises the causes of fnancial exclusion as follows: 1 Geographical – that is, nonexistence of branches in an area. 2 Access exclusion – that is, restricted access because of bank’s risk assessment process.

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3 Condition exclusion – that is, conditions related to products failing to meet needs. 4 Price exclusion – that is, charges associated with products or services are high. 5 Marketing exclusion – that is, strategic exclusion of certain products. 6 Self-exclusion – that is, some sections of the population refuse to approach banks, believing that any request will be turned down (p. 41).

10.5 INCLUSIVE FINANCE AND FINANCIAL DEVELOPMENT In recent times, the emphasis of economic policy has been on fnancial inclusion. Not only is fnancial inclusion good for welfare, but it also has the capacity to promote fnancial development, particularly fnancial stability. Financial inclusion enables the poor and low-income earners, who have more stable savings and borrowing appetite, to participate in the formal fnancial system. In times of crises, deposits from retail clients serve as a more stable funding source for banks in contrast to wholesale funding sources, which cease during crises periods (Neaime & Gaysset, 2018). Furthermore, fnancial inclusion enables banks and other fnancial institutions to discover new business areas by reaching out to a vast majority of the unbanked and underbanked in developing countries. In this regard, fnancial inclusion enables banks to diversify across locations, fnancial products and services, and income groups. This enhances the resilience of fnancial markets and institutions. Again, fnancial inclusion increases the effciency of monetary policy by increasing the number of participants in the formal fnancial system, thereby increasing the scope for monetary policy. A more fnancially included economic environment ensures that monetary policy signals are effectively transmitted to the real sector. This is contrasted with fnancial development, where few people are in the formal fnancial system impeding the fow of monetary signals to the real sector. Also, by bringing a lot of previously unbanked and underbanked customers closer to the formal fnancial system, fnancial inclusion ameliorates information asymmetry, allowing banks to roll out cost-effective fnancial models (Ahamed & Mallick, 2017). This reduction in information asymmetry mitigates fnancial vulnerability by improving loan recovery while reducing a bank’s bad loan portfolios. The empirical literature supports the fnancial sector’s stabilising role of fnancial inclusion. Ahamed and Mallick (2017) studied the impact of fnancial inclusion in 2,600 banks across 86 economies over the period 2004–2012. They found that fnancial inclusion promotes fnancial stability, especially in banks that have signifcant customer deposit profles and those with smaller marginal costs of delivering fnancial services and in banks operating in countries with better institutional quality. In a sample of the Middle East and North Africa (MENA) region over the period 2002–2015, Neaime and Gaysset (2018) found fnancial inclusion to boost banking sector resilience by stabilising the deposit-funding base in the region. Using a panel of 97 countries over the period 2004–2012, Rasheed, Law, Chin, and

Chapter 10 • Financial inclusion and economic growth 273

Habibullah (2016) similarly found fnancial inclusion to positively infuence two indicators of fnancial development: credit to private sector and stock market turnover ratio. Thus, the empirical evidence largely dispels one of the notions that banks have, which prevents them from extending fnance to the poor: fnancial inclusion will disrupt the soundness of the fnancial system. Notwithstanding the evidence in support of the ability of fnancial inclusion to foster fnancial development, there is still a section of the literature that argues that fnancial inclusion can increase the vulnerability of the fnancial system by bringing into the banking system those individuals and businesses that are high-risk borrowers (see Box 10.1 for more on this argument).

BOX 10.1 The dark side of fnancial inclusion ‘So far, we have focused on the ‘bright side’ of fnancial inclusion. Unfortunately, there can be a ‘dark side’ too. Partly in response to the global fnancial crisis – and also inspired by Raghu Rajan’s, 2005 Jackson Hole paper – a growing body of research questions whether fnance is always good for growth, suggesting that ‘too much’ or ‘too fast’ fnance can plant the seeds of future fnancial crises (Arcand, Berkes, & Panizza, 2015; Gourinchas & Obstfeld, 2012; Mian & Suf, 2014; Schularick & Taylor, 2012). This vulnerability is not an exclusive feature of fnancial markets in advanced economies. During the microcredit crisis in India in 2010, the state government of Andhra Pradesh, worried about widespread overborrowing and alleged abuses by microfnance collection agents, issued an emergency ordinance, bringing microfnance activities in the state to a complete halt. This large contraction in microcredit supply translated into large negative effects on the labour market and on consumption (Breza & Kinnan, 2018). More recently, the assessment of the JDY programme in India presented by Agarwal et al. (2018) also shows evidence of an increase in loan defaults in areas more exposed to the programme, pointing to a trade-off between inclusion and stability’. Beck, Peria, Obstfeld, and Presbitero (2018)

10.5 INCLUSIVE FINANCE AND ECONOMIC GROWTH We frst look at the fnancial inclusion–economic growth transmission channels and then discuss the empirical literature on the fnancial inclusion and inclusive growth and development nexus. 10.6.1 The fnancial inclusion–economic growth transmission channels Theoretically, fnancial inclusion can promote economic growth and development through the following channels: capital accumulation, innovation and entrepreneurship, income and employment, opportunities for diversifcation, productivity, and fnancial security.

274 Joshua Yindenaba Abor et al.

Financial inclusion promotes the accumulation of savings in the banking system and in other fnancial intermediaries. These savings serve as capital for investment in productive ventures. Again, these savings deposits are transformed into loans and other fnancial products to support the investment plans of defcit spending units. The savings triggered by fnancial inclusion are broad based and ensure the mobilisation of resources from economic units (rural and poor households) that were otherwise considered unable to save. The quality of human capital is an indisputable precursor to economic growth. Meanwhile, the quality of human capital determines the degree of innovation and entrepreneurship in an economy. Financial resources are critical to the training and capacity development of human capital. Households and small and medium-size enterprises (SMEs) that are fnancially included are more able to fnd the fnancial resources to fund their education and training needs than their counterparts who are excluded from the formal fnancial system. Even in situations where individuals cannot pay education fees out of pocket, an inclusive fnancial system will enhance access to affordable credit and other avenues of support, be they private or governmental. Financial inclusion provides new, affordable, and convenient means of paying school fees. A well-trained workforce is able to generate inventions and bring innovative solutions to societal problems. Such new inventions and innovations bring about drastic increases in output and economic growth. Financial inclusion spurs entrepreneurship by providing access to capital, stimulating fnancial literacy, and imparting business management skills to individuals who otherwise would have been deprived of opportunities to live their dreams, because of fnancial exclusion. Financial inclusion provides business and employment opportunities for individuals, households, fnancial institutions, and governments. Financial inclusion provides both direct and indirect employment. The indirect jobs provided by fnancial inclusion are more diffcult to estimate but are likely to be greater in number than the direct jobs. Financial inclusion affords banks and other fnancial intermediaries opportunities to reach out to the untapped unbanked population through the development of innovative fnancial services and delivery mechanisms for the poor. In doing so, these fnancial institutions create new job openings, enhance their proftability, and strengthen their position in the fnancial system. Entrepreneurship is facilitated in these new locations, leading to improvements in the performance of SMEs. In a nutshell, fnancial inclusion engenders job creation both directly and indirectly and yields income to benefciaries therefrom. By making funds available to a wide range of investors, fnancial inclusion increases the range of economic choices available to individuals, households, and businesses, leading to economic diversifcation. By helping poor people and SMEs to save and borrow, build assets, insure against the unforeseen, and make and receive payments with ease, fnancial inclusion enables the production of diverse goods and services, access to various markets (locally and internationally), and the diversifcation of income sources. This increases the economic resilience of benefciary individuals,

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households, and businesses and subsequently cascades into a more resilient and stable macroeconomy. Through diversifcation, fnancial inclusion serves as a risk management mechanism, reducing borrowers’ reliance on vulnerable sources of output, markets, and income. Many economic agents are not as productive as they should be, because of fnancial exclusion, which makes them unable to provide the needed inputs at the required quantities at the right time to support production or take advantage of promising opportunities. With access to fnance, rational economic agents can employ the right quantities of labour, capital, technology, and other factors in order to boost productivity. By spurring innovation and entrepreneurship, fnancial inclusion extends the frontier of production, helping economic agents attain new productivity heights. Financial inclusion opens up the range of fnancial choices available to the poor, enables the poor to accumulate capital over the long run, facilitates long-range investment and consumption planning, and enhances the capacity of households to absorb economic and fnancial shocks. From a theoretical perspective, fnancial inclusion promotes economic growth and inclusive development by enabling capital accumulation, stimulating entrepreneurship and innovation, generating direct and indirect job opportunities, promoting economic diversifcation, boosting productivity, and ensuring fnancial security. 10.6.2 Empirical evidence on fnancial inclusion and inclusive growth and development At least since Schumpeter (1912), fnancial development has been closely linked to economic growth. However, empirical evidence on the real effects of broad-based access to fnance on growth is relatively nascent. The empirical evidence generally supports a positive impact of fnancial inclusion on growth and development, though the impact varies from no impact, to moderate, to large. Evidence from India supports the claim that broad-based fnancial access fosters growth. In a study conducted between 2004 and 2013 and using vector auto regression (VAR) and the Granger causality test, Sharma (2016) concluded that various dimensions of fnancial inclusion promoted economic growth in that country. The Granger causality test revealed bidirectional causality between the geographic outreach of banks and economic growth; unidirectional causality between the number of deposits/ loan accounts and the amount of growth; and no causality between using bank services and economic growth. Another study in India by Lenka and Sharma (2017) using data from 1980 to 2014 showed that fnancial inclusion has a positive effect on economic growth in both the short run and long run. This study, unlike the previous ones, found a unidirectional causality running from fnancial inclusion to economic growth. Swamy (2014) examined the economic impact of fnancial inclusion in India from a gender perspective. Using panel data from 2007 to 2012, Swamy found a positive gender premium effect in fnancial inclusion on income in favour of women. Specifcally, fnancial inclusion programmes

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were found to increase incomes (after adjusting for infation) of women by 8.40%, compared to 3.97% for men. Swamy explained that women had better awareness of fnancial inclusion instruments, used fnancial inclusion to improve household savings, and employed fnancial inclusion in ways that improved welfare. Recent evidence from 55 Organisation of Islamic Cooperation (OIC) countries by Kim, Yu, and Hassan (2018) confrmed a positive impact of fnancial inclusion on growth using supply-side fnancial inclusion measures such as number of ATMs per hundred thousand, bank branches per hundred thousand, number of borrowers from commercial banks per one thousand, and life insurance premium volume to GDP. The study covered the period 1990–2013. In line with Sharma (2016) but unlike Lenka and Sharma (2017), Kim et al. (2018) found bidirectional causality between fnance and economic growth. Demand-side data from Ghana support a positive effect of fnancial inclusion on inclusive growth. First, on the basis of the Ghana Living Standard Survey data (GLSS 6), Abor, Amidu, and Issahaku (2018) documented positive effects of mobile telephony (ownership and usage) and fnancial inclusion (access to a bank account, savings, credit, and insurance) on inclusive growth measures such as poverty and real per capita consumption. However, unlike Swamy (2014), Abor et al. (2018) did not fnd the effect of fnancial inclusion on inclusiveness of growth to be more pronounced in women-headed households than in men-headed households. Again, they did not fnd the impact to be greater in rural households than in urban households. Using the same dataset, Abu and Issahaku (2017) highlighted a positive impact of fnancial inclusion on agricultural commercialisation (see Box 10.2 for more exposition of the fnancial inclusion success story in SSA). Evidence from randomised control trials offers less-optimistic results of the impact of fnancial inclusion on development.2 For instance, as an introduction to the 2015 American Economic Journal issue on microcredit experiments, Banerjee, Karlan, and Zinman (2015) arrived at the conclusion that the most consistent fnding from most studies is that the real effects of microcredit on poverty are modest but not transformative, even in the case of women’s empowerment. Borrower heterogeneity is offered as the reason for this less enthusiastic result. In line with this, Banerjee, Breza, Dufo, and Kinnan (2018) have recently shown that while microcredit had a persistent effect on business activity and consumption for individuals who already had business before the intervention, the impact on beginner entrepreneurs was negligible. Another recent study in the MENA region found that while fnancial inclusion reduced inequality, it had no signifcant impact on poverty reduction in that region (Neaime & Gaysset, 2018). Further, a review by Clark, Harris, Biscaye, Gugerty, and Anderson (2015) of seven RCTs on impacts of credit interventions in various African countries produced mixed results. The RCT by Ashraf, Giné, and Karlan (2009) in Kenya produced positive signifcant impact of credit on production, but no signifcant impact on income/wealth; the RCT by Beaman, Karlan, Thuysbaert, and Udryet (2014)  in Mali showed a positive signifcant impact on production; another RCT in Kenya by Burke (2014) showed no

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signifcant impact of credit on income/wealth and consumption/food security; the RCT by Fink, Jack, and Masiye (2014) in Zambia revealed positive impacts on income/wealth and resilience and mixed impacts on consumption/food security; the RCT in Morocco by Crépon, Devoto, Dufo, and Pariente (2014) produced mixed impacts on income/wealth and nonsignifcant impacts on consumption/food security; the RCT by Kim et al. (2009) in South Africa found mixed impacts on consumption/food security; and the RCT by Tarozzi et al. (2015) in Ethiopia showed no signifcant impacts on income/wealth and a negative impact on consumption/food security. Evidence from quasi-natural experimental studies offers moreencouraging results. On the basis of Mexican data, Bruhn and Love (2014) found fnancial inclusion in the form of branch expansion by banks to have a considerable impact on labour market activity and income of deprived individuals and people who lived in locations that hitherto had low bank outreach. Similarly, Burgess and Pande (2005) found that branch expansion by rural banks could explain between 14 and 17 percentage point decreases in headcount poverty in rural India.

BOX 10.2 Financial inclusion is a sub-Saharan success story ‘In 2014, the US-based think tank Brookings Institution launched its fnancial and digital inclusion project to examine access to and usage of secure, affordable, formal fnancial services among the underserved populations of the world. The project has since reported twice annually on the nature and extent of fnancial inclusion. In its 2016 report, it scores best practice in terms of country commitment, mobile capacity, regulatory environment, and level of actual adoption. It fnds once more that sub-Saharan Africa is well represented in the top ten: Kenya (84%), Uganda (78%), South Africa (78%), Rwanda (76%), and Nigeria (72%) account for half of the top ten. Indeed, Kenya takes the number one slot for the second year running, thanks to its mobile money revolution. The Brookings Institution report does not cover countries such as the US that are affuent generally. However, it points out that about 8% of households in the US do not have a bank account and that these households suffer extra costs and burdens as a result, just as nonaccount holders do in the developing world. Sub-Saharan Africa’s people have achieved better fnancial inclusion mainly because of the widespread availability of cheap mobile phone networks and the adoption of mobile money platforms. The mobile operator body GSMA estimates that another 168 million Africans will be connected by mobile phone and money networks over the next fve years, with the total reaching 725 million by 2020. Innovations such as the M-Pesa mobile phone–based money transfer system in Kenya, which has revolutionised the lives of both the rural and urban poor, offer people alternatives that did not exist

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only a short while ago. Today, a phone can not only let people get hold of money in a remote rural setting, at any time of the day or night, but also let them borrow and lend, settle utility bills and loans, receive their salary, make deposits, buy goods, and view detailed statements of transactions – all in much the same way as happens with traditional banks. The latest innovation is that Kenyans can directly pay for government services such as the renewal of licences and permits by using their mobile phones. Mobile phones have also empowered women and reduced poverty by allowing social networks to be leveraged so people at the poorest level of society can borrow, help, and support each other. Current trends in the mobile money industry should improve fnancial inclusion in this region further: • Interoperable platforms allow individuals to use their mobile money across different operator platforms. • New technologies such as near feld payment modules allow more people to use their phones in new ways to make and receive money. With 725 million Africans expected to be able to connect and carry out transactions with each other by 2020, there will be substantial new internal opportunities for business as well as personal enrichment for many individuals. Rural farmers, for example, can now receive income from farming as well as the information they need for a better harvest next time, directly via their phones. The fnancial inclusion of the poor thus offers new opportunities for everyone’. Source: www.accaglobal.com/us/en/member/member/accounting-business/2016/1112/insights/success-story1.html

RCTs on savings have actually shown a somewhat more robust impact on well-being and even entrepreneurial growth. For instance, Brune, Giné, Goldberg, and Yang (2015) performed an RCT on savings clubs in Malawi. In this trial, farmers were randomly assigned to one of three groups: a control group where there was no facilitation to save, a treatment group where savings facilitation was offered in the form of an ordinary savings account, and treatment group where savings assistance is offered for the provision of access to an ordinary savings account and an additional savings account with commitment devices. The results showed that the treatment group that had savings accounts with commitment devices experienced signifcant expansion in land under cultivation, input use, and crop yield and profts over the control group. The treatment group provided with only ordinary savings accounts saw only gains in land under cultivation over the control group, but not in the other indicators. In a natural experiment on savings, based on Indian data spanning from 1977 to 1990, Burgess and Pande (2005) found that a 1% increase in the share of savings held by rural banks leads to a 2.22%

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reduction in rural poverty. Other feld experiments by Ashraf, Karlan, and Yin (2010), Dupas and Robinson (2013), and Prina (2013) collectively point to signifcant positive impacts of savings on various welfare indicators. While the literature is clear on how fnancial inclusion affects growth, it does not clearly explain how economic growth stimulates fnancial inclusion. Although no adequate explanation has been given as to how growth stimulates fnancial development, it is not hard to fathom how this happens. Four explanations are offered here. First, economic growth increases the capacity of the government to provide the infrastructure required for broad-based access to fnancial services. Second, a growing economy provides the business case for banks and other fnancial institutions to reach out to the unbanked. Third, economic growth increases the fnancial capacity of banks to set up new branches and outlets and to develop and roll out new fnancial services to a large segment of the population. Fourth, broadbased economic growth enhances the capacity of the citizenry, including the poor, to demand various fnancial services to enable them meet their fnancial needs and plans and to take advantage of economic opportunities.

10.7 FINANCIAL INCLUSION AND ECONOMIC DEVELOPMENT: ROLE OF INSTITUTIONS This subsection discusses how institutions moderate the impact of inclusive fnance on economic development. Do institutions play any role in making fnancial inclusion more effective for broad-based development? Since North’s (1990) infuential book Institutions, Institutional Change and Economic Performance, development economists have come to better appreciate the role of institutions in economic development. According to North (1990), ‘institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction’ (p. 3). Institutions are vital because they provide incentives for human actions and because of the nature of these interactions and the benefts that ensue therefrom. Therefore, institutions can determine the nature and extent of the impact of fnancial inclusion on economic growth. Some of the institutional imperatives which can enhance the growth impact of inclusive fnance include strong mechanisms for control of corruption, transparent and accountable governance, protection of property rights, entrenchment of a strong merit system, effective enforcement of law and order, effcient bureaucracies, political stability, and protection of freedoms and human rights, alongside a wide array of progressive habits, norms, and civic values. There are at least four channels through which institutions can enhance the effect of fnancial inclusion on economic development: reducing transaction costs and increasing the effciency of exchange, determining the rate of return on investment, providing the environment for innovation and creativity, and establishing the environment for the effective collaboration and mobilisation of social capital. Reducing transaction costs and increasing the effciency of exchange: institutions ameliorate transaction costs associated with information, transportation, decision-making, and bargaining. Strong institutions ensure

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transparency and accountability, which reduce information asymmetries associated with transactions. Institutions establish uniform standards and procedures to reduce red tape and facilitate economic decision-making. Furthermore, institutions facilitate the settling of disputes arising from economic and social transactions, which enable peaceful coexistence and the containment of fraud in transactions. Strong institutions ensure that funds meant for road construction (to reduce transportation cost) and such other fnancial infrastructure are not diverted for private gain. On the contrary, ‘societies with weak institutions can be trapped in a low growth equilibrium fuelled by information asymmetry, coordination failures and other market imperfections’ (Issahaku, Abor, & Amidu, 2018, p. 30). Determining the rate of return on investment: institutions infuence the rate of investment as well as return on investment by reducing the risk and uncertainty involved in economic transactions (by providing stable norms, standards, and procedures), ensuring property rights, and providing protection for investors. For instance, research has shown that when farmers have legal title to land, investment in the land and output increase (see Pande & Udry, 2005). In a number of cases, land and other productive resources have been left idle due to prolonged and wobbly dispute resolution systems perpetuated by weak institutions. Some investors have relocated from certain economies due to the inability of the system to provide protection for them and their properties, thus lowering investment. In some cases, investors do not relocate, but they reduce the amount of investment as a way of mitigating losses. The point being made here is that a household or an investor may have access to funds but may be unwilling to invest, due to institutional constraints, or may invest but the return on the investment is reduced through institutional lapses. Moreover, weak institutions reduce the rate of return on investment by increasing systematic risks and for that matter reducing opportunities for diversifcation and the spreading of risks. Providing the environment for innovation and creativity: creativity and innovation are critical fuels for human prosperity and welfare. Institutions promote creativity and innovation by providing the necessary environment for innovation and creativity to thrive. Institutions unlock creative and innovative potential by establishing the freedom to innovate and be creative, providing protection for intellectual property, promoting investment in human capital, and ensuring the evolution of an educational system that focuses on creativity and innovation. With the suitable atmosphere provided by institutions for creativity and innovation, fnancial inclusion can then ensure the mobilisation of resources for investment in the generation of new ideas, new products, and new services, thereby fostering entrepreneurship, growth, productivity, and development. Establishing the environment for effective collaboration and mobilisation of social capital: institutions are either extractive or inclusive in nature, depending on whether they hinder or foster growth (Acemoglu & Robinson, 2012). Inclusive institutions promote growth, while extractive institutions thwart growth. Inclusive institutions encourage collaborations, networking, and information sharing, which enable the pooling of resources, ideas, and people for the general good of society. Strong institutions

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facilitate the formation of clubs, joint ventures and partnerships, and other such mobilisations of social capital for the promotion of social good. These strong social networks and partnerships established by quality institutions can help unlock the potentials of individuals, and groups and cause them to optimise the benefts from fnancial inclusion products and services.3 We now turn to the empirical support for the foregoing arguments. Recounting the role of institutions in fnance, Qian and Strahan (2007) showed how institutions determine the shape and form of fnancial contracts. According to the study, in economies with strong protections for creditor rights, loan durations are longer and interest rates are lower. Foreign bank ownership shares are shown to decline as creditor protection decreases. Demetriades and Law (2006) assessed how institutions intermediate the fnance–growth nexus and produced some interesting fndings. First, a strong institutional framework magnifes the growth effect of fnance. Second, not many growth dividends end up in poor countries with more fnance but weak institutions. Third, the growth magnifying effect of institutions is highest in middle-income countries endowed with quality institutions. Fourth, though the effect of fnance on growth is lower in high-income countries, this impact improves even in these countries when the fnancial system is rooted in sound institutions. In sum, the study found that fnance promotes long-term growth in countries endowed with quality institutions. On the contrary, in countries where the fnancial system is subsumed by weak institutions, improvements in fnancial systems produce negligible benefts. In a similar vein, Gazdar and Cherif (2015) demonstrate that while fnance variables on their own may sometimes affect growth adversely, institutions turn any negative effect of fnance on growth into a positive one. Specifcally, banking sector advancement promotes growth in countries with strong law and order, low bureaucracy, and a good investment pedigree. Compton and Giedeman (2011) disagree; they fnd banking sector development and institutions to be substitutes in growth, while stock markets are neither substitutes nor complements to institutions in growth. Despite the contradictory fndings, on the balance of empirical evidence and theoretical plausibility, we conclude that institutions play complementary roles to fnance in growth.

10.8 CONCLUSION The main aim of this chapter was to examine the role of fnancial inclusion in promoting economic growth. The areas covered include the conceptualisation of fnancial inclusion, trends in fnancial inclusion, the determinants of and barriers to fnancial inclusion, links between inclusive fnance and fnancial development, the effect of inclusive fnance on economic growth, and the role of institutional architecture in the fnancial inclusion–economic development nexus. It discussed capital accumulation, innovation and entrepreneurship, income and employment, opportunities for diversifcation, productivity, and fnancial security as the main channels through which fnancial inclusion positively affects growth. The chapter identifed

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an inadequate and a lack of supportive infrastructure, high transaction costs, regulatory barriers, behavioural biases, a low level of general literacy and fnancial literacy, high poverty rates, and a dispersed population as the factors that limit access to and the usage of fnancial services. Institutions are discussed as being crucial for economic development and improving the growth impact of fnancial inclusion. This is because institutions reduce transaction costs while increasing effciency in exchanges, determine the rate of return on investment, provide the environment for innovation and creativity, and establish the environment for the effective collaboration and mobilisation of social capital. Going forward, developing countries must prioritise fnancial inclusion in policy decisions and implementation to fully reap its benefts. Financial inclusion should be mainstreamed into social protection programmes so that the poor, the marginalised, and the hard-to-reach segments of the population will be roped into the formal fnancial stream. A large informal sector and unbanked population reduces the effcacy of monetary policy, because a greater proportion of the economy will be outside the infuence of the policy authorities. A strong infrastructure backbone is key to the advancement of fnancial inclusion. Due to the cost involved in setting up infrastructure, governmental leadership and support are key factors. Governmental infrastructure plans should incorporate fnancial inclusion. Apart from that, governments should mobilise monetary and nonmonetary resources from banks, other fnancial institutions, telecommunication companies, development partners, and other stakeholders in support of the fnancial inclusion drive. Key infrastructure which must be provided, especially in the hinterlands, to advance fnancial inclusion include electricity, roads and transport, telecommunications network, water and sanitation, and fnancial infrastructure such as credit reference bureaus, banks, other fnancial institutions, and regulatory bodies. Furthermore, digital fnancial services can be leveraged to reduce the cost of providing fnancial inclusion to the poor. Digital fnancial services such as mobile money services, mobile banking, internet banking, biometric payment systems, automated teller banking, and fnancial technology (fntech), among others, must be promoted to ensure the convenient, effcient, safe, and cost-effective delivery of fnancial services. For digital fnancial services to thrive well, a comprehensive and robust regulatory framework that strikes a fne balance between promotion of fnancial innovation and amelioration of fnancial risk and fraud is imperative. Related to this is the issue of consumer protection, which entails safeguarding users of fnancial services from Ponzi schemes, fraud, and exploitation. Regulatory frameworks that cover transparent disclosure, fair treatment, dispute resolution, and fnancial education and costs will help foster consumer protection. The high level of fnancial illiteracy in the world and in developing countries in particular calls for concern. Mainstreaming fnancial literacy in educational curricula will be a good step towards creating an awareness of fnancial inclusion and enlightening the population on fnancial matters. Broad-based fnancial literacy will promote fnancial planning and prudent fnancial decision-making at the individual, household, and frm levels.

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Discussion questions 1 Provide at least three motivations for studying the impact of fnancial inclusion on economic growth. 2 Discuss the role of fnancial inclusion in attaining the UN Sustainable Development Goals. 3 How does sub-Saharan Africa compare with the rest of the world in terms of fnancial inclusion? 4 Is fnancial inclusion compatible with fnancial stability?

5 Thoroughly evaluate the channels through which financial inclusion promotes growth. 6 Trace the channels through which institutions affect economic development. 7 How can institutions make fnancial inclusion effective for economic growth? 8 Discuss the ‘dark side’ of fnancial inclusion.

Notes 1 This chapter is part of the research project ‘Delivering Inclusive Financial Development & Growth’ and received funding from DFID and ESRC under the DFID-ESRC Growth Research Programme Call 3.

2 Read more at https://voxeu.org/ article/fnancial-inclusion-driversand-real-effects. 3 Read more about the importance of institutions at www.e-ir. info/2012/09/19/the-importanceof-institutions-to-economicdevelopment/.

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Agarwal, S., Alok, S., Ghosh, P., Ghosh, S. K., Piskorski, T., & Seru, A. (2018). Banking the unbanked: What do 255 million new bank accounts reveal about fnancial access? Working Paper. Retrieved from http:// eprints.exchange.isb.edu/1023/ Ahamed, M. M., & Mallick, S. K. (2017). Is fnancial inclusion good for bank stability? International evidence. Journal of Economic Behavior and Organization. doi:10.1016/j.jebo.2017.07.027 Allen, F., Demirgüç-Kunt, A., Klapper, L., & Peria, M. S. M. (2016). The foundations of fnancial inclusion: Understanding ownership and use of formal accounts. Journal of Financial Intermediation, 27, 1–30.

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crisis. NBER Working Paper No. 24329. Cambridge, MA: National Bureau of Economic Research. Brune, L., Giné, X., Goldberg, J., & Yang, D. (2015). Facilitating savings for agriculture: Field experimental evidence from Malawi (No. w20946). Cambridge, MA: National Bureau of Economic Research. Bruhn, M., & Love, I. (2014). The real impact of improved access to fnance: Evidence from Mexico. Journal of Finance, 69(3), 1347–1376. Burgess, R., & Pande, R. (2005). Do rural banks matter? Evidence from the Indian social banking experiment. American Economic Review, 95(3), 780–795. Burke, M. (2014). Selling low and buying high: An arbitrage puzzle in Kenyan villages. Retrieved from http://web. stanford.edu/~mburke/papers/ Carr-Hill, R., & Pessoa, J. (2008). International literacy statistics: A review of concepts, methodology and current data. Montreal: UNESCO Institute for Statistics. Clark, C., Harris, K. P., Biscaye, P., Gugerty, M. K., & Anderson, C. L. (2015). Evidence on the impact of rural and agricultural fnance on clients in sub-Saharan Africa: A literature review (pp.  1–51). EPAR Brief No. 307, Learning Lab Technical Report No. 2. Retrieved from https://www.raflearning.org/sites/ default/files/epar_2_w_edits_final. pdf?token=PI9pLrEO Compton, R. A., & Giedeman, D. C. (2011). Panel evidence on fnance, institutions and economic growth. Applied Economics, 43(25), 3523–3547. doi:10.1080/00036841003670713 Crépon, B., Devoto, F., Dufo, E., & Pariente, W. (2014). Estimating the impact of microcredit on those who take it up: Evidence from a randomized experiment in Morocco (No. w20144). Cambridge, MA: National Bureau of Economic Research. Dasgupta, R. (2009). Two approaches to fnancial inclusion. Economic and Political Weekly, 41–44.

Chapter 10 • Financial inclusion and economic growth 285 Demetriades, P., & Law, S. H. (2006). Finance, institutions and economic development. International Journal of Finance and Economics, 11(3), 245e260. Demirgüç-Kunt, A., Klapper, L., Singer, D., Ansar, S., & Hess, J. (2018). The global fndex database 2017: Measuring fnancial inclusion and the fntech revolution. Washington, DC: World Bank. Demirgüç-Kunt, A., Klapper, L., Singer, D., & Oudheusden, P. V. (2015). The global fndex database 2014: Measuring fnancial inclusion around the world. Policy Research Working Paper 7255. Washington, DC: World Bank. Diniz, E., Birochi, R., & Pozzebon, M. (2012). Triggers and barriers to fnancial inclusion: The use of ICT-based branchless banking in an Amazon county. Electronic Commerce Research, 11(5), 484–494. Dupas, P., & Robinson, J. (2013). Savings constraints and microenterprise development: Evidence from a feld experiment in Kenya. American Economic Journal: Applied Economics, 5, 163–192. Fink, G., Jack, B. K., & Masiye, F. (2014). Seasonal credit constraints and agricultural labor supply: Evidence from Zambia (No. w20218). Cambridge, MA: National Bureau of Economic Research. Gazdar, K., & Cherif, M. (2015). Institutions and the fnance – growth nexus: Empirical evidence from MENA countries. Borsa Istanbul Review, 15(3), 137–160. Global Infrastructure Hub. (2017). Global infrastructure outlook: A G20 initiative. Oxford: Oxford Economics. Gourinchas, P. O., & Obstfeld, M. (2012). Stories of the twentieth century for the twenty-frst. American Economic Journal: Macroeconomics, 4, 226–265. Hall, T. (2014). Measuring fnancial inclusion: Thinking 3 dimensional. New York: Citi Foundation. IMF. (2018, January). World economic outlook update. Washington, DC: International Monetary Fund. Issahaku, H., Abor, J. Y., & Amidu, M. (2018). The effects of remittances

on economic growth: Reexamining the role of institutions. The Journal of Developing Areas, 52(4), 29–46. Karlan, D., Ratan, A. R., & Zinman, J. (2014). Savings by and for the poor: A research review and agenda. Review of Income and Wealth, 60(1), 1–43. Kim, D. W., Yu, J. S., & Hassan, M. K. (2018). Financial inclusion and economic growth in OIC countries. Research in International Business and Finance, 43, 1–14. Kim, J., Ferrari, G., Abramsky, T., Watts, C., Hargreaves, J., Morison, L., & Pronyk, P. (2009). Assessing the incremental effects of combining economic and health interventions: The IMAGE study in South Africa. Bulletin of the World Health Organization, 87(11), 824–832. Lenka, S. K., & Sharma, R. (2017). Does fnancial inclusion spur economic growth in India? The Journal of Developing Areas, 51(3), 215–228. McKinsey and Company. (2016). Digital fnance for all: Powering inclusive growth in emerging economies. McKinsey Global Institute. Retrieved from www.mckinsey.com/mgi Mian, A., & Suf, A. (2014). House of debt: How they (and you) caused the great recession, and how we can prevent it from happening again. Chicago: University of Chicago Press. Neaime, S., & Gaysset, I. (2018). Financial inclusion and stability in MENA: Evidence from poverty and inequality. Finance Research Letters, 24, 230–237. North, D. C. (1990). Institutions, institutional change and economic performance. Cambridge: Cambridge University Press. Pande, R., & Udry, C. (2005). Institutions and development: A view from below. Discussion Paper No. 928. New Haven, CT: Yale University Economic Growth Center. Prina, S. (2013). Banking the poor via savings accounts: Evidence from a feld experiment. Case Western Reserve University, Weatherhead School of Management

286 Joshua Yindenaba Abor et al. Working Paper. Retrieved from http:// faculty.weatherhead.case.edu/prina/ pdfs/prina_savingsaccounts_2013.pdf Qian, J., & Strahan, P. E. (2007). How laws and institutions shape fnancial contracts: The case of bank loans. The Journal of Finance, 62(6), 2803–2834. Rajan, R. (2005). Has fnancial development made the world riskier? NBER Working Paper No. 11728. Cambridge, MA: National Bureau of Economic Research. Rasheed, B., Law, S. H., Chin, L., & Habibullah, M. S. (2016). The role of fnancial inclusion in fnancial development: International evidence. Abasyn University Journal of Social Sciences, 9. Sarma, M. (2012). Index of fnancial inclusion: A measure of fnancial sector inclusiveness. Working Paper No. 07/2012. Berlin: Working Papers on Money, Finance, Trade and Development. Schularick, M., & Taylor, A. (2012). Credit booms gone bust: Monetary

policy, leverage cycles, and fnancial crises, 1870–2008. American Economic Review, 102(2), 1029–1061. Schumpeter, J. A. (1912). The Theory of Economic Development. Stanford University Press, 1969 (Reprint). Sharma, D. (2016). Nexus between fnancial inclusion and economic growth: Evidence from the emerging Indian economy. Journal of Financial Economic Policy, 8(1), 13–36. Swamy, V. (2014). Financial inclusion, gender dimension, and economic impact on poor households. World Development, 56, 1–15. Tarozzi, A., Desai, J., & Johnson, K. (2015). The impacts of microcredit: Evidence from Ethiopia. American Economic Journal: Applied Economics, 7(1), 54–89. World Bank. (2014). Economic indicators. Retrieved October 15, 2015, from http://data.worldbank.org/indicator/ NY.GDS.TOTL.ZS

CHAPTER

11

Financing agriculture for inclusive development Haruna Issahaku, Edward Asiedu, Paul Kwame Nkegbe, and Robert Osei 11.1 INTRODUCTION At the heart of the current global development policy is how to sustainably ensure that there is enough food with the necessary nutrients available, accessible, and affordable to the world’s seven billion people. This agenda is emphasized in United Nations (UN) Sustainable Development Goal 2 (SDG 2), which seeks to end hunger, achieve food security and improved nutrition, and promote sustainable agriculture by 2030. However, this goal cannot be realized without suffcient funding, particularly for smallholder agriculture. The UN recognizes that this goal can be achieved by, among other things, doubling agricultural productivity and smallholder incomes, making agricultural markets functional, and scaling up investments in agriculture to improve rural infrastructure, agriculture technology, and agricultural research and extension services. Thus, agriculture fnancing is crucial to the attainment of sustainable development. However, conventional funding models bewildered with credit market imperfections cannot provide the funding required to take agriculture development to the next level. Traditional bank fnance is known not to reach the people who need it most (the poorest of the poor). The fnancial system in most developing countries remains inaccessible, ineffcient, and lacking in depth. Taking sub-Saharan Africa (SSA) as an example, the average private credit provided by deposit money banks as a percentage of gross domestic product (GDP) over the period 2011–2014 was 16.3% compared to a global average of 40% over the same period. Bank accounts per a thousand people in the region was 150.3 compared to a global average of 511.7, while bank net interest margin was an average of 5.7% in the region compared to a world average of 3.7%, over the period 2011 to 2014. Thus, both the SSA averages and global averages point to the inadequacy of conventional fnance for private sector development in general. Globally, and recently, the discussion has turned towards innovative fnancing models. The fnancing gap among smallholder farmers alone is projected at USD430 billion to USD440 billion worldwide (USAID, 2016). Innovative fnancing models are needed to bridge this fnancing gap and reach the poorest segments of the population with a wide range of affordable

288 Haruna Issahaku et al.

fnancial services and products at improved terms and conditionalities. In line with this thinking, this chapter discusses innovative ways of fnancing global agriculture to enhance its ability to deliver not just growth but inclusive or pro-poor development. It is important that inclusive development be distinguished from inclusive growth. While inclusive development focuses on ‘social wellbeing and protecting the ecosystem services of nature through redefning political priorities’ (Pouw & Gupta, 2017, p. 1), the inclusive growth perspective is ‘confned to market participation (by creating jobs for the poor) and effciency (of economic processes, policies, institutions), and builds further upon an economic paradigm that does not assign value to social or environmental sustainability in its growth models’ (Pouw & Gupta, 2017, p. 2). Thus, whereas inclusive development relates to social, economic, ecological, and political inclusiveness, inclusive growth relates mainly to social, economic, and political inclusiveness with less emphasis on ecological indicators. The aim of this chapter is to discuss ways that agriculture can be fnanced to ensure inclusive development. The chapter is structured as follows. First, we discuss some stylized facts on global agriculture. Second, we overview the challenges to accessing agricultural fnance and then the fnancing opportunities in agriculture. Next, we discuss key innovative fnancing models for agriculture, and roles that could be played by banks, fnancial institutions, development agencies, and government. The penultimate section discusses how agriculture leads to inclusive development. We end the chapter with some concluding remarks.

11.2 STYLIZED FACTS ON AGRICULTURE DEVELOPMENT Globally, agriculture has gone through many shifts in terms of its contribution to economic growth, employment, productivity growth, and exports. This subsection explores some stylized regularities about agriculture development across the globe. Although these stylised facts do not necessarily establish causality, they are essential in shaping a research agenda and policy discourses (Christiaensen, 2017). 11.2.1 Stylized fact 1 Agriculture is more important to the economies of developing and poor countries than it is to the economies of developed and wealthy nations, but generally, its contribution to the economy is declining across the globe. Even though this is a well-known fact (see Johnston & Mellor, 1961), the data behind this fact are often not presented alongside the claim. In Europe and Central Asia (ECA), agriculture plays a less prominent role in economic development, agriculture’s share in GDP falling from 3.3% in 2000 to 2.4% in 2006 (Table 11.1) before stagnating at 2.2% in each year from 2012 onwards. This region is constituted by some European economic giants such as the United Kingdom, Germany, France, and Spain, whose economies are driven largely by services. For example, in the European Union in 2014, services constituted 73.9% of the GDP, industry 24.4%, and agriculture 1.7%.1

50.4

32.7 60.9

10.1 10.4 19.3 19.9 40.1

50.6

80.8

40.5 34.5 N/A NA.

20.0 N/A 29.9 23.4 N/A

12.6 1.9 24.1 19.6 5.2

60.0 20.4

13.4 70.9 N/A 30.3

90.9 10.4 19.3 19.8 40.0

31.8 60.7

50.5

50.8 20.3 50.4

50.7 20.1

2009

50.4

50.7 20.2

90.9 10.4 18.9 20.3 40.0

90.9 10.3 18.9 21.3 30.9

90.6 10.4 19.3 17.8 30.9

90.6 10.5 19.1 17.2 40.0

32.1 50.5

50.4

50.7 20.3

2010 2011

32.7 33.0 32.6 N/A N/A 50.9

50.6

50.8 20.2

2000 2006 2007 2008

Source: World Development Indicators (2017)

East Asia & Pacifc Europe & Central Asia Latin America & Caribbean Low income Middle East & North Africa Middle income High income South Asia Sub-Saharan Africa World

1990

TABLE 11.1 Contribution of agriculture to GDP (%)

90.4 10.5 18.7 18.1 30.9

33.0 50.7

50.2

50.6 20.2

90.4 10.6 18.9 17.8 40.0

31.8 60.2

50.3

50.5 20.2

90.3 10.5 18.5 17.3 30.9

30.8 60.2

50.4

50.4 20.2

90.2 10.4 18.0 17.4 30.8

30.2 60.9

50.2

50.2 20.2

90.6 10.4 18.9 18.7 30.9

32.1 60.3

50.4

50.6 20.2

90.9 10.4 19.2 19.8 40.0

32.6 60.5

50.4

50.8 20.3

90.4 10.5 18.6 17.6 30.9

31.6 60.1

50.3

50.5 20.2

2012 2013 2014 2015 10-year 5-year 5-year average average average (2006–2015) (2006–2010) (2011–2015)

Chapter 11 • Financing agriculture 289

290 Haruna Issahaku et al.

In contrast to ECA are South Asia (SA) and sub-Saharan Africa (SSA), where agriculture still plays a pivotal role in economic development. The share of agriculture in GDP fell from 29.9% to 24.1% over the decade 1990s in SA before falling to 18.0% by 2015. Similarly, in SSA the contribution of agriculture to GDP fell from 23.4% in 1990 to 19.6% in 2000 and then fell further to 17.4% by 2015. Notwithstanding the declining shares, agriculture’s contribution to GDP is still signifcant in these two regions of the world. Interestingly, these two regions play host to the bulk of the world’s poor population, who often eke out a living from subsistence agriculture. Over the past decade (2006 to 2015), SA had the largest share of agriculture in GDP (18.9%), followed closely by SSA (18.7%). For the rest of the regions, the share of agriculture in GDP is far less significant: 6.3% in Middle East and North Africa (MENA), 5.6% in East Asia and Pacific (EAP), 5.4% in Latin America and the Caribbean (LAC), and 2.2% in ECA. The correlation between agriculture’s share in economic growth and a poverty profle is seen clearly when the analysis is done on the basis of income categorization. The average contribution of agriculture to the GDP of low-income countries (LICs) over the last decade was 32.1%, compared to 9.2% in middle-income countries (MICs) and just 1.4% in high-income countries (HICs). Again, even on the basis of income groups, the share of agriculture in growth has declined over the decades. Thus, the poor are dependent on agriculture, but their dependence is declining gradually as they seek alternative livelihoods in nonfarming enterprises. 11.2.2 Stylized fact 2 Although there are diversities in agricultural productivity and agricultural productivity growth across the regions of the world, agricultural value added per worker (productivity) is generally ascending. Not only is agricultural productivity higher in ECA, LAC, and MENA, but it also increases faster in these regions (see Figure 11.1, Table 11.1) relative to EAP, SSA, and SA. ECA is the most productive region in the world, followed by LAC, and SA is the least productive region, followed closely by SSA. Agricultural productivity has been twice as fast in ECA than it has in SA over the last 15 years (2000–2015). In ECA, agriculture value added per worker increased from USD8,801.8 in 2000 to USD14,309.1 in 2015, an increase of about 63% over the period. In SA, agriculture value added per worker increased from USD871.7 in 2000 to USD1,131.7 in 2015, an increase of about 30% over the 15-year period. Thus, not only is agricultural value added per worker higher in relatively wealthy regions of the world, but it also grows faster in these regions, showing a correlation between productivity and welfare status. The link between agricultural productivity and poverty is seen clearly in Figure 11.2, where the trend line for agriculture value added per worker for HICs is not only far above those of MICs and LICs but is

Chapter 11 • Financing agriculture 291 FIGURE 11.1 Agriculture value added per worker, constant 2010 USD 16,000.00 14,000.00

East Asia & Pacific

12,000.00

Europe & Central Asia Latin America & Caribbean

10,000.00 8,000.00

Middle East & North Africa

6,000.00

South Asia

4,000.00

Sub-Saharan Africa World

2,000.00

Linear (Sub-Saharan Africa)

0.00 2000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: World Development Indicators (2017)

FIGURE 11.2 Agriculture value added per worker, constant 2000 USD

45000 40000 35000 30000 25000 20000 15000 10000 5000 0

2000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Low income

Middle income

High income

Source: World Development Indicators (2017)

also the only line trending upwards. Thus, a substylized fact is that poor economies have both low agricultural productivity and low agricultural productivity growth relative to rich economies. The implication of this stylized regularity is that substantial welfare gains can be made in poor countries by simultaneously increasing both agriculture productivity and productivity growth.

292 Haruna Issahaku et al.

11.2.3 Stylized fact 3 Although agriculture remains an important employer of the labour force, especially in economies outside ECA, for most regions of the world, the services sector is by far the largest employer of the workforce (SA and SSA being the exceptions). According to Figure 11.3, in 2014 the services sector had the largest share in total employment (69.5%) in LAC, followed by industry (22.8%) and agriculture (13.9%). Next to LAC is ECA in terms of the size of the contribution of the service sector to employment. In ECA, the services sector (66.5%) was the largest contributor to employment, followed by industry (24.8%) and agriculture (8.3%) in 2014. In EAP, the agriculture sector’s share in employment has been larger than that of the industry sector’s contribution but lower than that of the services sector. Figure 11.3 further reveals that as structural shifts occur in the economy, the share of agriculture in employment declines over time, while the employment shares of industry and services rise. SA and SSA break the dominance of the services sector in total employment. Agriculture has remained the largest employer over the years in SA even though the sector’s employment share is declining with time, whereas the service sector is picking up. On the basis of a series of reports from the United Nations Survey of Asia and the Far East, agriculture’s share in the SA region declined from 70% in 1970 to 51% in 2010, while the services share increased from 20% to 35% over the same period. Thus, agriculture’s share is a little over half of total employment in SA. Among all the regions of the world, SSA has the most dominant agricultural sector in terms of contributions to employment. This dominance

FIGURE 11.3 Employment shares by sector (% in total employment)

80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0

Agricu Industr Service Agricu Industr Service Agricu Industr Service lture y s lture y s lture y s (EAP) (EAP) (EAP) (ECA) (ECA) (ECA) (LAC) (LAC) (LAC) 2012 31.5 27.6 41.0 9.0 25.1 41.0 15.0 22.8 41.0 2013 29.9 27.3 42.9 8.8 24.8 66.0 14.8 22.4 69.1 2014 28.2 27.3 44.5 8.3 24.8 66.5 13.9 22.8 69.5 2012

2013

Source: World Development Indicators (2017)

2014

Chapter 11 • Financing agriculture 293

is prevalent in both LICs and HICs in the region. According to Fox, Thomas, and Cleary (2017), agriculture contributed 68.5% and 57.5% to employment in LICs and HICs respectively in SSA in 2010. Household enterprises are the next most signifcant contributor to employment in SSA (18.2% for LICs and 29.1% for HICs in SSA). These household enterprises are often capital-constrained micro and small enterprises. Wage employment in services and industry form a small proportion (13%) of total employment in the region, an indication of the region’s large informal sector. 11.2.4 Stylized fact 4 Agricultural raw materials exports’ share in merchandise exports is small and generally quite stagnant. In all the regions of the world, the share of agricultural raw material exports in total merchandise exports was below 3% in 2015 (Table 11.2). This might not be a bad statistic so long as there is a corresponding increase in the exports of processed goods. Understandably, SSA (3.7%), the poorest region of the world, has been more reliant on agricultural raw material exports over the last decade than any other region has. This is followed by LAC (2.1%), South Asia (1.6%), EAP (1.3%), and ECA (1.3%). The reliance of SSA and poor countries in general on raw material revenues has been of concern to policymakers in this region, but not much progress has been realized in terms of policies aimed at adding value to exports. Relying on raw material exports is a source of economic vulnerability because raw material outputs and prices are highly volatile. Agriculture raw material exports as a percentage of merchandise exports grew from 3.4% over the fve-year period of 2006–2010 to 4.0% in the subsequent fve-year period, 2011–2015. This was the largest growth over the period. Marginal growth in agricultural raw material exports’ share in merchandise export was recorded over the same period in EAP, ECA, and LAC, while no growth was recorded in MENA and SA. The MENA region is the least reliant on agriculture raw material exports, ostensibly due to huge foreign exchange revenues from crude oil exports. 11.2.5 Stylized fact 5 GLOBALLY, FOREIGN DIRECT INVESTMENT (FDI) TO AGRICULTURE IS SMALL According to the data available for 43 countries around the globe,

the average FDI to agriculture was only 2.7% of total FDI in 2011. This supports the widely held belief that the agricultural sector is generally underfunded and is less attractive to investors than are industry and services (IFC, 2012; Ruete, 2015). The outliers include Malawi (18.86%), Uruguay (15.27%), Ghana (15.75%), Cambodia (13.7%), and Lao PDR (12.3%), where agriculture’s share for each in total FDI exceeds 10% (see Figure 11.4). At least the outlier countries are all developing countries that have a real need for FDI to unlock the potentials of the agriculture sector. Thus,

10.4 10.7 20.9

00.4

10.4 50.3 10.8

30.3 20.2 30.5

N/A

40.8 N/A 30.1

10.7 30.5 10.6

00.3

10.3 10.4 20.0

2006

Source: World Development Indicators (2017)

East Asia & Pacifc Europe & Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa World

2000

1990

20.0 30.4 10.5

00.2

10.3 10.4 20.2

2007

10.7 40.0 10.4

00.1

10.3 10.2 20.0

2008

10.3 30.0 10.4

00.2

10.2 10.3 20.0

2009

20.1 30.0 10.6

00.3

10.5 10.4 20.0

2010

10.9 50.2 10.8

00.2

10.8 10.4 10.9

2011

TABLE 11.2 Agricultural raw materials exports (% of merchandise exports)

20.0 50.5 10.6

00.2

10.5 10.4 20.0

2012

20.1 30.3 10.6

00.2

10.5 10.4 20.0

2013

10.6 20.2 10.5

00.2

10.3 10.4 20.3

2014

10.6 N/A 10.5

N/A

10.3 10.3 20.7

2015

10.8 30.7 10.6

00.2

10.4 10.4 20.1

10-year average 2006–2015

10.8 30.4 10.5

00.2

10.3 10.3 20.1

5-year average 2006–2010

10.8 40.0 10.6

00.2

10.5 10.4 20.2

5-year average 2011 2015

294 Haruna Issahaku et al.

Chapter 11 • Financing agriculture 295 FIGURE 11.4 Share of FDI to agriculture in total FDI (%), 2011 18

16.86

15.75

16

15.27

13.7

14

12.34

12 10

6 4 2 0 -1

8.83

8.21

8

7.18

6 4.21 1.42 0.52 1.07 0.31 0.49 -0.03

3.93 1.64

0.33 0

0.06 0.27 -0.12

-0.24

2.01

1.79 0.05 -0.06

0.48 0.22 0.11

1.62

0.66 0.26 0.22 0.24

1.55 0.88 0.2 0.14

1.88

-0.39

-2

Source: FAO (2017)

overall, poor countries have a higher share of agriculture FDI in total FDI than do rich countries. According to Figure 11.4, the share of advanced countries’ (e.g. France, Greece, Hungary, and Spain) agriculture FDI in total FDI is minuscule. 11.2.6 Stylized fact 6 GLOBALLY, THE AGRICULTURE SECTOR RECEIVES MARGINALLY LESS PRIVATE SECTOR CREDIT THAN IT DESERVES The share of agriculture sector

credit in total credit is almost insignifcant. On the basis of data available for 103 countries across the globe (see Figure 11.5), the average private sector credit to agriculture was only 4.5% of total credit in 2015. The corresponding agriculture orientation index2 is 97.8%, which means that credit to the agriculture sector is marginally below the contribution of the sector to economic growth (i.e. agriculture sector receives marginally less credit than it deserves). Although the agriculture orientation index gap is not that big, the funding gap that this entails can be of signifcant consequence to the sector. There are signifcant cross-country variations in agriculture credit ratios across the world. On the one hand, we have countries with high agriculture credit ratios: agriculture shares of credit of at least 15% (e.g. Kyrgyzstan, Zambia, Sudan, and New Zealand). On the other hand, there are countries with infnitesimal agriculture shares of credit (e.g. UAE, Turkey, Trinidad and Tobago, Togo, Oman, and Niger). Clearly, however, countries congregate towards low credit ratios.

296 Haruna Issahaku et al. FIGURE 11.5 Share of agriculture credit in total credit, 2015

Zambia 0.17 0.10 Uruguay 0.15 0.01 United Republic of Tanzania 0.08 0.00 Ukraine 0.07 0.10 Turkey 0.00 0.05 Trinidad and Tobago 0.00 0.00 Timor-Leste 0.04 0.01 Tajikistan 0.11 0.03 Sudan 0.16 0.09 Singapore 0.01 0.03 Serbia 0.07 0.00 0.02 Saint Vincent and the Grenadines 0.01 Saint Kitts and Nevis 0.00 0.02 Republic of Moldova 0.08 0.01 Peru 0.05 0.02 Panama 0.04 0.10 Oman 0.00 0.03 Niger 0.00 0.16 0.05 Nepal 0.05 Mozambique 0.03 0.04 Montserrat 0.00 0.03 0.03 Mali 0.03 0.06 Malaysia 0.07 Lebanon 0.01 0.19 Kenya 0.04 0.05 Jordan 0.01 0.02 Italy 0.05 0.01 Iraq 0.03 0.10 India 0.13 0.06 Honduras 0.06 0.09 Guinea-Bissau 0.00 0.02 0.04 Ghana 0.04 Georgia 0.02 0.04 France 0.06 0.08 Estonia 0.05 0.03 Egypt 0.01 0.04 0.00 Dominica 0.01 Czechia 0.02 0.04 Costa Rica 0.04 0.02 Cambodia 0.10 0.03 Burkina Faso 0.02 0.04 Brazil 0.01 0.02 Bosnia and Herzegovina 0.02 0.10 Bhutan 0.05 0.03 Belize 0.12 0.03 Belarus 0.11 0.00 Bangladesh 0.00 0.05 Austria 0.00 0.07 Aruba 0.00 0.07 Argentina 0.00 0.09 Anguilla 0.00 0.05 Albania 0.02 0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 Source: FAO (2017)

Chapter 11 • Financing agriculture 297

11.3 CHALLENGES OF AGRICULTURAL FINANCING There are some major constraints peculiar to agriculture perceived as the source of the diffculty for the sector to attract fnancing. Some of these challenges as outlined by the International Finance Corporation (IFC) (2012) include seasonality, high exposure to undiversifable risk, limited availability of usable collateral, prohibitive information and transaction costs, competing priorities of banks and other fnancial institutions, and inadequate access to long-term funding. Seasonality: agricultural activities in most developing countries are seasonal in nature and are characterized by long gestation periods. This means cashfows from the sector tend to be unpredictable and clustered around certain times of the year. From a banking perspective, the erratic cashfows make liquidity management diffcult and impose an additional cost, since customized products will have to be designed in unfamiliar territory. High exposure to undiversifiable risk: most agricultural activities are highly exposed to undiversifiable risks, such as drought, floods, fire, and prices. Since most agricultural production activities face the same risks, true diversification is difficult to attain, and this increases the risk of loan default in the sector. This is further compounded by the fact that there is a lack of a well-developed insurance market for agriculture. Limited availability of usable collateral: most farmers do not have suitable collateral such as real estate, automobiles, and titled land. Because of legal and sociocultural barriers, most of the assets of agricultural households such as land and housing are not properly titled. Therefore, for the banker, what could be offered as collateral by the farmer provides poor protection against default risk. Prohibitive information and transaction costs: poor infrastructure, dispersed population, and settlements make the information and transaction costs in agriculture high. Rural areas often lack good road network, potable water, electricity, and telecommunications infrastructure. These factors combined make it diffcult for banks and other fnancial institutions to establish viable branches in agricultural settlements. Competing priorities of banks and other fnancial institutions: banks have several competing priorities, involving reaching out to more frms in the metropolitan areas, establishing new branches in densely populated urban areas, and investing in new technology. Given the promise that the aforementioned areas have, the agriculture sector is often placed at the bottom of the pecking order of bank business. Inadequate access to long-term funding: all over the world, only a handful of businesses have access to long-term fnance. This is even worse in developing countries, particularly for agriculture, mainly because long-term funds are expensive and are complicated by maturity mismatch.

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11.3.1 Funding challenges of plantation and animal agriculture For plantation farming in particular, funding challenges which require attention include high initial capital required to establish a plantation, high capital cost and accumulation due to the long period between initial planting and harvesting time, prohibitive biological and economic risks, and unattractive and inappropriately designed investment incentives by governments in the past (FAO, 2019). Similarly, animal agriculture is plagued by some peculiar challenges/risks, including being viewed as a major source of pollution, being associated with the deforestation and degradation of rangelands, being viewed as a preserve of the rich and not pro-poor, and being thought of as competing with humans for grains (Steinfeld & Mack, 2019). Other risks in the sector include a lack of funding for research, the scarcity of land and water resources, trade barriers, health challenges such as infectious diseases, a weak regulatory framework and weak regulatory oversight, and global environmental changes related to climate, habitat, and feedstock (National Research Council, 2015).

11.4 FINANCING OPPORTUNITIES IN AGRICULTURE Banks and other fnancial institutions are increasingly recognizing the agricultural sector as potentially proftable. The fnancing opportunities in agriculture are evident in the expanding demand for food, the diversifcation opportunities offered by agriculture, the need to manage sector-specifc risk with fnancial innovations such as index insurance, the low level of fnancial inclusion in agriculture, and worsening climate change (IFC, 2012). The exact nature of these opportunities is explained next. The ever-expanding demand for food is driven by a growing population and changes in dietary habits. Global food demand growth is projected to reach 50% by 20303 and 70% by 2050. To meet this growing food demand, farmers will need funds to purchase or invest in inputs such as certifed seeds, fertilizers, and agrochemicals. The increasing demand for inputs will also have a ripple effect on fnancing requirements for input suppliers. On the other side of the value chain will be the need for warehouses, storage facilities, and agro-industries to process the agricultural outputs. All these different players will need more fnancing to meet the increased food demand. The agriculture sector provides an opportunity for fnancial institutions to broaden and diversify their portfolios. As an example, in the heat of the global fnancial crises in 2008, agricultural prices soared and almost doubled across the world. A study conducted by the International Finance Corporation in 2012 showed that countries with a large share of agriculture in GDP had declining nonperforming loans (NPLs) during the crises, while the reverse was the case for countries with a lower share of agriculture in GDP. The risky nature of agriculture in terms of production, price, and market risks marks an opportunity for fnancial institutions to design risk mitigation products and services for the sector. The sector is confronted with

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foods, droughts, fres, and livestock disease outbreaks such as swine fu, which represent both challenges and opportunities. These risks present opportunities for designing risk-mitigating products such as forwards and futures contracts as well as weather insurance. The large number of unbanked people, especially in the agriculture sector, marks an opportunity for fnancial institutions to rope in this underserved segment into the mainstream fnancial system. Worsening climate change implies that sustainable means of production must be explored. In addition, this marks an opportunity for fnancial institutions to develop and tailor fnancial products and services to sustainable production systems that are consistent with climate-change-adaptation strategies.

11.5 INNOVATIVE FINANCING MODELS FOR AGRICULTURE4 Due to high information asymmetries, poor track record, unpredictable weather conditions, and the absence or low quality of the collateral, it is important that fnancing strategies for the agriculture sector be designed to reduce credit risk. We now turn the discussion to the various innovative ways that agriculture can be fnanced. 11.5.1 Financing farmers and agricultural entrepreneurs Farmers and agricultural entrepreneurs require funding for inputs, production, transportation, processing, packaging, and storage. Farmers and agricultural entrepreneurs can funded by direct fnancing (retail model) (Ruete, 2015) or indirect fnancing (wholesale model) by channelling fnancial services through cooperatives or farmer-based organizations (IFC, 2012). On the one hand, the advantage of the direct approach is that the fnancial institution gets up close to benefciaries to understand their circumstances and to be able to extend a variety of fnancial services beyond credit. It also allows the fnancial institution to collect deposits directly from farmers. A success story5 in direct lending is the case of Equity Bank in Kenya, where the bank partnered with Alliance for a Green Revolution in Africa (AGRA), the International Fund for Agricultural Development (IFAD), and the Kenyan government to provide loans to the tune of USD50 million to 2.5 million farmers and 15,000 agriculture input dealers with little or no collateral requirements. The bank gave the loans to farmers at 12% instead of the 18% interest charged other borrowers. Equity Bank reduced risk exposure by limiting the maximum amount a farmer will take and by using a group-based lending approach. As of June 2008, Equity Bank had disbursed USD18.75 million to 37,000 benefciaries. Equity Bank touts this as a success story because it helped in transforming smallholder food insecure farmers into semi-commercial farmers (IFC, 2012). On the other hand, the indirect lending approach has the advantage of signifcantly reducing the risk of default since the lending is done through

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a farmer-based organization. A success story of indirect lending is the case of the Zambia National Commercial Bank Plc (Zanaco). Zanaco provided lending through District Farmer Associations duly registered with the Zambian National Farmers Union (IFC, 2012). The facility was called the Munda credit facility. Before the farming season commences, District Farmer Associations assess the input needs of farmers and submit the list to the Zambian National Farmers Union for onwards submission to the bank. The bank requires 50% cash collateral from the District Farmer Associations. Upon harvesting, farmers sell proceeds to designated processors who pass on the money to the bank. The bank then deducts loan principal and interest and crop insurance premiums and returns any outstanding amount to farmers through the District Farmer Associations. Any District Farmer Association that fails to meet payment schedules is dropped from the scheme. The principle is ‘all for one, one for all’. The scheme served 25 District Farmer Associations in the 2010/2011 farming season, covering 4,026 farmers, from six hundred farmers in the previous farming season. Under the Munda scheme, the productivity of maize farmers rose from 1.5 metric tons per hectare to 3 metric tons per hectare due to improved access to and use of fertilizer, improved seeds, and other modern technology (IFC, 2012). The suite of products that could be extended to farmers and agricultural SMEs via the direct and indirect approaches include savings account– linked input fnance, inclusive fnance, leasing and factoring, trade fnance, weather-based insurance, and credit guarantee schemes. 11.5.2 Financing movable assets Given the diffculty in getting usable collateral from the agriculture sector, fnancing movable assets, which can themselves serve as collateral, is a viable alternative. Financing can be provided for movable assets such as machinery and equipment, small infrastructure, warehouse receipts, commodities, and even livestock (IFC, 2012). Some of the products under this fnancing model are as follows: •  In equipment fnancing, banks closely collaborate with equipment manufacturers to supply farm equipment such as tractors, irrigation facilities, combine harvesters, and factory equipment, among others, to farmers. Benefciaries take the equipment after minimum initial deposits and then use the equipment to generate cashfows to defray the loan. The equipment serves as collateral and is repossessed by the fnancial institution upon default. •  In cattle banking, banks lend to farmers, take live cattle from the farmers, and keep them in their custody as collateral. •  By leasing agriculture machinery and automobiles, farmers get to these inputs for a given period in exchange for determined payments. At the end of the contract, the farmer may have the option to purchase. Leasing has been employed successfully by some frms in Uganda (see Box 11.1). •  In warehouse receipt fnancing, secured lending is provided to owners of commodities that are stored in warehouses assigned to the

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lending institution. With warehouse receipts, agriculture products can be stored to serve as collateral; to be traded for cash; or to be used in futures and forwards contracts (Giovannucci, Varangis, & Larson, 2000). The National Microfnance Bank of Tanzania is a success story of warehouse receipts for cashews and coffee. •  In collateral management agreement (CMA) fnancing, an agreement is reached between a collateral manager, an owner or a depositor of a commodity, and a bank. The commodity is kept in the custody of the collateral manager and stored in a warehouse. The commodity is released only once the custodian has received notice from the bank that the commodity owner has fully repaid the loan. In the event of default, the commodity is sold to repay the loan. CMAs are quite expensive and may be better suited for agricultural SMEs than smallholder farmers (IFC, 2012).

BOX 11.1 Development Finance Company Uganda: leasing Development Finance Company Uganda (DFCU) is a leading commercial bank in Uganda. DFCU is listed on the Uganda Stock Exchange and operates 29 branches throughout the country. Of the bank’s credit portfolio, 5% is in the agricultural sector. The frst three rural branches (in Mbarara, Mbale, and Hoima) were opened in 2000 as part of a project funded by the U.S. Agency for International Development (USAID). DFCU has since started leasing operations in other towns, like Lira and Arua, using its own funds. DFCU specializes in providing fnance leases to SMEs for agricultural machinery – particularly tractors, milk equipment, harvesters, and agro-processing equipment. Typically, DFCU fnances 60% of the asset purchase, while the client fnances the additional 40%. The client share, however, may range from 10% to 50%. DFCU retains full ownership during the life of the lease, though the asset is transferred to the client or sold to a third party after the lease terminates. Although DFCU’s interest rates are similar to those of banks, their leases are more attractive to SMEs because they typically offer longer payment periods (three to fve years compared to around two years), provide fexible lease payment schedules that match enterprise cashfows, and recognize the leased asset as primary collateral. Additional security is requested only in specifc circumstances. Cashfows are evaluated through documentation on income sources, three to fve years of audited fnancial statements, and the company’s history and business plan. It is the borrower’s obligation to select the equipment and submit an inspection report with an invoice. The asset must be insured during the entire life of the lease; the DFCU Insurance Premium Financing facility is available and may be tied to lease payments. DFCU staff engineers regularly monitor assets, and lease offcers supervise clients in delinquency. Out of the 231 leases that DFCU facilitated in 2011 (valued at 18.3 million), 19 of these were agricultural (2.2 million). Roughly 20% of

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the bank’s agricultural credit occurs through their leasing operations. DFCU reports 32% portfolio growth for leasing in the previous year, with nonperforming assets (NPAs) limited to 1% and write-off at 0.4%. Key success factors include technical and agricultural expertise to offer leasing products that meet consumer needs and quick turnaround time to permit equipment use during the current season. Source: IFC (2012)

11.5.3 Financing agriculture value chains One fnancing approach that mitigates costs and risks in extending support to farmers and agriculture SMEs is agriculture value chain fnancing. It offers a comprehensive way of fnancing agriculture instead of the segmented and disintegrated way of supporting individuals and specifc segments of the sector. Agriculture value chain entails successive linkages through which raw materials and resources are turned into fnal products for consumption. The value chain may comprise production, processing, packaging, storage, transportation, and distribution. To quote Miller and Jones (2010, p. 2), agriculture value chain fnance (AVCF) is any or all of the fnancial services, products and support services fowing to and/or through a value chain to address the needs and constraints of those involved in that chain, be it a need to access fnance, secure sales, procure products, reduce risk and/or improve effciency within the chain. The comprehensive design of the AVCF approach requires a thorough analysis and full understanding of the chain in its entirety for the approach to succeed. Value chains can be fnanced from within (internal fnance) or from without (external fnance) (Miller & Jones, 2010). Internal value chain fnancing comes from the actors in the value chain itself, actors who have built relationships among themselves, such as a fertilizer supplier providing fertilizer to a farmer on credit to be paid upon harvest. The fnancing approach may entail product fnancing, input supplier credit, trade fnance, lead frm fnancing, and marketing company credit. External value chain fnancing is provided by actors outside the value chain on the basis of established relationships and frameworks. An example is a microfnance institution’s providing a loan to a producer on the basis of an agreement with a buyer. Financial instruments under this approach entail trade receivables fnance, loan guarantees, factoring, and forfaiting. 11.5.4 Financing agriculture by using capital market vehicles There are three main vehicles for fnancing agriculture through the capital market. These are debt, equity, and derivative instruments. The capital market is particularly important because it provides long-term funds. A

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common problem in the African banking system is the inadequacy or in most cases unavailability of long-term loans longer than fve years. Nevertheless, for plantation crops, fve years may not even be long enough for harvesting to begin (from planting). Thus, there is a mismatch between farmers’ investment horizons and the tenure of funds. The capital market can reduce this mismatch by providing avenues for agricultural ventures to raise long-term funds by issuing stocks and bonds. Debt fnancing through bonds: large-scale and commercial agricultural ventures can raise long-term capital by issuing bonds of various tenures to investors. Such bonds can either be listed on an organized exchange (listed bonds), or they may be privately placed through sales to selected institutional investors. Some of the types of bonds that could be issued by agribusinesses include corporate bonds, project bonds, infrastructure bonds, or green bonds. Equity fnancing: agribusinesses may seek equity participation and through that raise funds for investment. Agricultural sector companies can issue shares to the investing public to raise funds for investment in long-term projects with positive net present values. Equity fnancing can be obtained either through a listing on an organized exchange or through private placement. Through the formal listing procedure, an agricultural company with the help of an underwriter can go through an initial public process to sell its shares to the general public and raise funds. In this case, the ownership of the company is diluted, enabling greater participation in the management and decision-making processes of the business. If the agribusiness concern does not want to go through the formal listing procedure, it can privately arrange to sell the shares to some target entities and individuals, usually institutional investors such as pension funds, insurance companies, and mutual funds. Shares bought via private placement can only be traded over the counter and not on an organized exchange. Organized Stock Exchanges: agricultural sector companies that are well established can get listed on the organized stock market by following the prescribed listing procedures. The listing requirements for stock exchanges are usually stringent, making it diffcult for SMEs and start-ups to meet such requirements. The capital requirement alone may be out of the reach of most agricultural sector companies in developing countries. Thus, this route of fnancing is suitable for large-scale agribusinesses with long track records of viability. This avenue offers businesses the opportunity to raise large amounts of money for long-term investments. Alternative Exchange for SMEs: the current trend is to establish a parallel capital market for only SMEs and start-ups. Such alternative exchanges usually have less-stringent listing requirements compared to the main bourse. The alternative stock exchange provides access to relatively cheap long-term capital for SMEs, including those in the agricultural sector. Few African countries have an alternative market for SMEs, and in those countries that have such a facility uptake by SMEs in general, and agriculture sector SMEs in particular, is low. The alternative exchanges in Africa include Alternative Exchange (AltX) (run by the Johannesburg Stock Exchange), the Ghana Alternative Market (GAX) (run by Ghana

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Stock Exchange), Alternative Securities Market (run by the Nigeria Stock Exchange), and the Growth Enterprise Market Segment (run by the Nairobi Securities Exchange). Use of derivatives to fnance agriculture: much of the risk in agriculture can be managed by derivatives. A derivative is a fnancial instrument whose value depends on the value of an underlying asset. In this particular context, the underlying asset can be agricultural commodities such as arable crops (e.g. maize, sorghum, wheat, rice, millet, and soybean) or commercial and plantation crops (e.g. cocoa, coffee, rubber, and cashews). Some derivative instruments available for use in agriculture include spot contracts, forwards, futures, options, exchange-traded funds, and swaps. Agricultural commodity derivatives can trade on general commodity exchanges, exchanges developed purposely for agricultural commodities, and overthe-counter exchanges. The development of agricultural and international commodity markets in developing countries will provide a signifcant boost to agriculture. Agricultural and international commodity markets: the development of agricultural and international commodity markets will help promote agriculture in a number of ways. Agricultural commodity markets can reduce transaction costs and risks, make prices and other information available for prudent decision-making, provide instruments for managing various risks in agriculture, facilitate market access, reduce market margins, and indirectly encourage banks and other fnanciers to fnance agricultural value chains (Jayne, Sturgess, Kopicki, & Sitko, 2014). About 14 commodity exchanges are in Africa, at various stages of development. These are shown in Table 11.3. Integrating these exchanges will create a larger and more robust commodity market for the development of Africa’s agriculture. Such integration efforts may begin at the subregional or trade bloc level and then be scaled up to the African Union (AU) level. Developing countries, particularly African countries without agricultural commodity markets, should not rush to establish commodity exchanges (CEs) but should instead ensure that the right conditions are frst put in place. These preconditions have been identifed by Jayne et al. (2014, p. 7) as follows: 1 A pre‐existing vibrant spot market. 2 The potential to achieve suffcient volume traded across the exchange to cover its fxed costs. 3 The presence of ancillary marketing services being offered to enable a commodity exchange to be instituted at relatively low cost. 4 Modes of institutional governance and appropriate incentives suffcient to motivate rapid learning on the part of the CE’s management and a commitment from a government to desist unpredictable and discretionary forms of intervention in commodity markets. Apart from agricultural commodity exchanges, general international commodity exchanges such as the Chicago Board of Exchange, the Chicago Board of Trade, Intercontinental Exchange (Atlanta, USA), Central Japan Commodity Exchange, Deutsche Börse/Eurex, and Saint-Petersburg

Chapter 11 • Financing agriculture 305 TABLE 11.3 Commodity exchanges in Africa Name

Abbreviation

City

Commodity types

Ghana Commodity Exchange Africa Mercantile Exchange Egyptian Commodities Exchange Nairobi Coffee Exchange Ethiopia Commodity Exchange Mercantile Exchange of Madagascar East Africa Exchange Agricultural Commodity Exchange for Africa Auction Holding Commodity Exchange Bourse Africa (previously GBOT) South African Futures Exchange (part of JSE Limited) Abuja Securities and Commodity Exchange Lagos Commodities and Futures Exchange AFEX Commodities Exchange Limited

GCX

Accra, Ghana

Agricultural

AfMX

Nairobi, Kenya

Agricultural, energy

EGYCOMEX

Cairo, Egypt

Agricultural, energy

NCE ECX

Nairobi, Kenya Addis Ababa, Ethiopia Antananarivo, Madagascar Kigali, Rwanda Lilongwe, Malawi Lilongwe, Malawi Ebene City, Mauritius Sandton, South Africa

Coffee Agricultural

ASCE

Abuja, Nigeria

Agricultural products

LCFE

Lagos, Nigeria

AFEX Nigeria

Abuja, Nigeria

Agricultural products, Oil and gas, currency Agricultural products

MEX EAX ACE AHCX

JSE

Agricultural, metals, energy Agricultural Agricultural Agricultural Metals, forex Agricultural

Source: Wikipedia (2019)

International Mercantile Exchange, among others, accommodate the trading of agricultural commodities. This opens a bigger market for the trading of agricultural commodities worldwide. 11.5.5 Risk management Agriculture is saddled with a lot of risks, and these risks also present fnancing opportunities for fnancial institutions. Some of the risks faced by farmers arise from unpredictable weather leading to foods or droughts, pest and disease outbreaks, price volatility, long gestation periods, impeded access to credit, and inputs and markets. An innovative approach to fnancing agricultural risk is to incorporate insurance into a credit scheme. For example, NMB Bank Tanzania and Basix in India make life insurance a compulsory component of their loans (IFC, 2012). This way, one of the risk components that could cause the farmer to default on the loan is taken care of. Examples of innovative risk management fnancing instruments are presented in the following subsections.

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Some examples are credit-weather insurance, credit-health insurance, production insurance, and index-based insurance products; because of the seeming reluctance of individual insurance companies to invest in agriculture, there is the need to create a platform that pools a number of insurance companies to design innovative insurance packages for the sector. This reluctance to insure agriculture production may be due to a lack of expertise to understand the peculiarities of the sector, inadequate funds, and a lack of innovation. When several insurance companies come together, these challenges are ameliorated, enabling them to design customized insurance products for various clients in the sector. The Ghana Agricultural Insurance Pool (GAIP) is one initiative that could be replicated in other African countries. It is made of 19 insurance companies that pool their funds and expertise to develop various agricultural insurance products for the Ghanaian market. The following are some of the innovative agricultural products provided by GAIP:

INSURANCE INSTRUMENTS

•  Drought index insurance – this product is designed specifcally for small-scale farmers who are many and scattered throughout the country. This insurance package covers the three phases of plant growth – that is, germination, vegetative growth, and fowering/maturity. Payout is based on validated weather reading from a ground weather station or satellite. This type of insurance is suitable for crops such as maize, millet, groundnut, sorghum, and vegetables. •  Area yield insurance – claims are paid to the insured farmers when their yield falls below the average yield in a defned geographical area, such as the district where the farm is located. Although the product can be applied to various categories of crops, it is most suitable for cocoa cooperatives and cocoa commercial farmers. •  Multi-peril crop insurance – this package is designed for commercial farmers and investors in the agricultural value chain, such as aggregators, banks, off-takers, input dealers, and processors. A key qualifying criterion is that the product be designed for a minimum farm size of 50 acres. This package allows a client to insure against as many hazards as deemed appropriate. •  Poultry insurance – this package is designed for a wide range of domestic and foreign poultry, including chicken, turkey, guinea fowl, and duck reared intensively. Some of the perils insured against include diseases (with the exception of avian infuenza), pests, fooding, thunder damages, and theft. MARKET-BASED INSTRUMENTS Market-based price risk management products such as forwards, futures, options contracts, and exchange-traded swaps can be deployed to manage different kinds of risk in agriculture. Emerging economies like Brazil, Argentina, China, India, and South Africa have markets that help manage price risk for players in agriculture. The Bagsa Agricultural Commodity Exchange in Nicaragua facilitates bilateral cash and forwards contracts in the agriculture sector as well as auction services. Bagsa has about 180 shareholders and 36 brokers. The total value

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traded on the exchange in 2013 alone amounted to USD720 million.6 Some of the commodities traded on the exchange include live cattle, meat, milk products, paddy rice, beans, and coffee. 11.5.6 Financing agriculture through savings Agricultural frms and households stand to beneft greatly from massive savings mobilization drives. According to Höllinger (2011), savings enable individuals and frms to self-insure and to build capital for investment in business activities, education, health, and asset building. In addition, savings assuage the collateral burden by increasing savers’ access to collateral in the form of built assets (assets and properties acquired through savings) and accumulated capital: the amount saved can serve as collateral for a loan (Brune, Giné, Goldberg, & Yang, 2015; Schaner, 2015). Savings can be promoted at the individual level or group level. Individual savings products entail normal savings products, no-frills savings accounts, and subsidized savings accounts. The normal savings accounts provided by banks and allied fnancial institutions often require a minimum balance in accounts at all times and impose limits on withdrawals. In some cases, the interest paid on such accounts is minimal. This often makes such savings products unattractive to farmers. This is where no-frills accounts come in. No-frills accounts, also known as zero balance accounts, waive minimum balance requirements on savings accounts. Also, the cost charged per transaction on no-frills accounts is lower than the per unit transaction cost of conventional savings accounts. The promotion of no-frill accounts should enable a large number of the unbanked to be roped into the formal fnancial system. In cases where no-frills accounts products are not available, savings accounts could be subsidized such that government or an enabling institution bears the cost of minimum balance requirements and other bank charges for farmers. This should reduce the cost of saving for farm households. The available empirical evidence on the benefts of individual savings in the agricultural sector is encouraging. In a study conducted in Kenya on 779 couples who opened bank accounts in 2009, Schaner (2015) examined the impact of subsidized savings in the form of removing the minimum savings balance and making temporary interest payments to account holders. The fndings revealed that the savings subsidy enhanced account penetration while increasing the income of benefciaries. Men who received higher subsidies reported higher incomes, asset ownership, and entrepreneurial activity two and half years after the intervention. Similar benefts were not reported for women. Using data collected in the Tanzania National Panel Survey (TZNPS), Bandara, Dehejia, and Lavie (2014) reveal that bank account ownership by a household is linked with a reduction of eight to ten child labour hours per month. Group savings products are suitable for societies where cooperation and social bonds are valued and encouraged. This is usually so in the rural areas of developing countries. The limited availability of formal savings products in agriculture and rural areas has popularised group savings

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mechanisms such as village savings and loan associations (VSLAs) or rotating credit and savings associations (ROSCAs). A typical VSLA comprises a group of 15 to 25 self-selected individuals who bring their savings together and issue small loans to members on the basis of the savings. The activities of the group run in cycles of one year, after which the savings and profts realized from the small loans are distributed back to members.7 In a typical ROSCA, members pool their savings into a common fund, usually on a monthly basis, such that at the beginning of each cycle, a single member withdraws a lump sum. Each member takes their turn to withdraw a lump sum. This system of continuous contribution and rotation of funds continues for as long as the group survives.8 The empirical evidence shows positive effects of group savings schemes. In a randomized impact evaluation of VSLA establishments in 80 villages in Burundi, Annan, Armstrong, and Bundervoet (2013) found that while the incidence of poverty increased by 10% among households in control villages, it reduced by 14% among treatment households. A similar impact evaluation of ROSCAs in Mali revealed that participating households experienced a reduction in poverty and food insecurity (BARA & IPA, 2013). 11.5.7 Financing agriculture through foreign direct investment (FDI) The insuffciency of savings and other domestic fnancing sources to satisfy the funding needs of agriculture in developing countries mean that they will have to look elsewhere to fll this gap. FDI is one source of capital infow that can help bridge the funding gap in agriculture. To attract more FDI to the agriculture sector, developing countries must understand the factors that drive FDI fows to the sector. The literature shows that factors that draw FDI to the agricultural sector include the size of the economy (the larger the better), trade openness (the more open the better), infrastructure (the more endowed the better), forest land share (the larger the better), size of agricultural market (the larger the better), agriculture value added (the larger the better), and poverty (the lower the better) (Farr, 2017; Abdul Rashid, Abu Bakar, & Abdul Razak, 2016). Agricultural sectors in developing countries stand to beneft a lot from FDI. Some of the benefts of FDI have been discussed extensively in the literature. FDI increases agricultural production, productivity, employment; lowers prices (Gerlach & Liu, 2010); and has positive technological spillover effects (Tondl & Fornero, 2010). Chaudhuri and Banerjee (2010) found that FDI in agricultural land improves welfare and also reduces unemployment among both skilled labour and unskilled labour. However, the benefts of FDI must be counterbalanced against the negatives. FDI can hurt the health of households and degrade and pollute the environment (Ben Slimane, Huchet-Bourdon, & Zitouna, 2016). Of recent interest is FDI in agricultural lands, a phenomenon called land grabbing. So far, the literature on the impact of FDI in agricultural land on food security is scanty and controversial. In a qualitative study in Africa, Cotula,

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Vermeulen, Leonard, and Keeley (2009) concluded that foreign investors in agricultural land are simply land ‘grabbers’ that hinder local development and increase food insecurity by exploiting water resources and using certain fertilizers and other chemicals which are harmful to the environment. On the contrary, Sliman et al. (2016) found that agricultural FDI leads to improvements in food security. The authors, however, found that FDI in the secondary and tertiary sectors leads to food insecurity. Santangelo (2018) has advocated an analysis of the impact of land grabbing in developing countries on the basis of the origin of FDI infows. On the one hand, the author found that FDI in land from developed country investors in addition to positive spillovers enhances food security by increasing land used for crop production due to home institutional pressure for the respect of human rights and responsible farming practices. On the other hand, FDI in land from developing country investors, in addition to negative spillovers, leads to food insecurity by displacing farmlands owing to home-country institutional pressure to align with ‘national interests’ and ‘government objectives’. 11.5.8 Digital fnancial and agricultural development Conventional fnancing mechanisms have not been able to satisfy the fnancing needs of agriculture, particularly the needs of smallholder farmers. Indeed, access to fnance has become a common and intractable problem in developing country agriculture. Meanwhile, 80% of the world’s population is fed by smallholder farmers who total about 1.5 billion people (USAID, 2016). Again, smallholder farmers form the largest proportion of the world’s poor who live on less than USD2 a day (Grossman & Tarazi, 2014). The fnancing shortfall among smallholder farmers is estimated to be USD430 billion to USD440 billion (USAID, 2016). Thus, smallholder farmers are by far the group that needs fnancial inclusion the most, but unfortunately, they are also among the most diffcult to reach. The potentials of digital fnancial services (DFS) can be harnessed to jumpstart fnancial inclusion among all categories of farmers and those who are hard to reach in general. DFS refers to gaining access to or using fnancial services and products through digital channels such as mobile phones, tablets, computers, point-of-sale devices, and electronic cards (debit cards, credit cards, and key fobs). Digital fnancial instruments can be used to access credit, subscribe to insurance, transfer money, make purchases, access information without the need for face-to-face contact with the parties in the transaction, unlike conventional brick and mortar banking. According to the World Development Report 2016, digital fnance can be harnessed to promote fnancial inclusion, increase the effciency of fnancial service delivery, and drive fnancial innovation. Digital payments (e.g. mobile payments) can break access barriers and bring fnancial services to the doorsteps of the poor. Digital fnance lowers the cost of fnancial transactions and the delivery cost of fnancial services. This is because digital fnance allows for the unbundling of fnancial services and products and enables the automation of fnancial service delivery at any scale: small, medium, and large. Digital fnance offers limitless

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possibilities for fnancial innovation. These innovations can range from process automation to the development of new and customized products and services at a reduced cost in an effcient manner. USAID (2016) outlines some roadblocks in smallholder agriculture and indicates how fnancial digitization can remove them. These roadblocks include diffculty in getting the right fnancial products for smallholder farmers, the low competitiveness of smallholders in agriculture value chains, women’s lack of a voice in decision-making in agriculture, poor post-harvest management and inability to speculate for higher prices for products, low savings capacity, diffculties in managing weather risks, and high cost of inputs. Digital fnancial services can be used to remove these roadblocks by reducing the cost of delivering fnancial services, reducing price opacity, encouraging inventory-based credit, reducing risk in the delivery of fnancial services and increasing access of the poor, including women, to a wide range of fnancial services, such as credit, savings, crop insurance, weather insurance, and payments. There are four main innovations in digital fnance (Bank of England, 2014): 1 Wrappers provide a digital interface with a bank account or credit card. With the help of wrappers, one can receive SMS alerts when a transaction is done with a bank account by use of either cheque or credit card. 2 Mobile money systems store mostly local currency as a credit on the smart card or in the books of the service provider and enable transactions online or through a mobile phone. Mobile money services, especially those mediated by mobile phones, have become popular among the unbanked and underbanked in Africa. Various telecommunication companies have rolled out mobile money services to help the poor gain access to fnancial services – speedily, at reduced cost, and at greater convenience. Farmers are able to make and receive payments through their mobile phones. This means they can easily sell farm products and access farm inputs. Farmers can also purchase investment products, save money, and access funds via their mobile phones. Increasingly, mobile money services are being linked to the formal fnancial system, such that it is now possible to transfer money from a bank account to a mobile money wallet and vice versa. Some common mobile money services include M-Pesa, MTN mobile money, TigoCash, and Airtel money. 3 Credits and local digital currencies are alternative units of account denominated in foreign currency aimed at promoting spending in a local economy or as a way of exchanging game proceeds. 4 Digital currency is a new type of currency that is available only in digital form and not in physical paper currency or coin currency form. Digital currencies can be transferred only electronically. Many countries are still sceptical about the use of digital currency. Some recent empirical studies have provided support for the importance of mobile technology and digital fnancial services in promoting agricultural

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development. Information and communications technology (ICT) has been found to boost extension services delivery (Fu & Akter, 2016), agribusiness (Tadesse & Bahiigwa, 2015), land management (Jordan, Eudoxie, Maharaj, Belfon, & Bernard, 2016), and productivity (Issahaku, Abu, & Nkegbe, 2017). In particular, Issahaku et al. (2017) showed that mobile phone use increased the productivity of maize farmers by at least 261.20 kg/ha per production season. The authors found that mobile phone use affected productivity through three main channels: extension services, the adoption of modern technology, and market participation. Already, there are success stories about the application of digital fnancial services to promote agricultural development along agricultural value chains. For instance, USAID’s/Ghana’s Agricultural Development and Value Chain Enhancement (ADVANCE) II project is using a digital fnancial system (mainly mobile phone mediated) to establish and strengthen linkages among smallholder farmers, markets, fnance, large-scale farmers, traders, and input and equipment suppliers. Under ADVANCE II, farmers receive payments for their harvest via mobile money; the capacities of mobile money agents have been built to serve farmers well; farmers are encouraged to save. The government of Nigeria implemented a pilot programme, an e-voucher system, for the distribution of fertilizer subsidies in 2011. By 2013, the system was scaled up to the entire country and served over 4.3 million small-scale famers. Under this system, each farmer had a mobile phone e-wallet with a unique personal identifcation number (PIN) to access fertilizer subsidies. This has drastically reduced corruption in the distribution of subsidized fertilizer in Nigeria (USAID, 2016).

11.6 OVER-INDEBTEDNESS IN AGRICULTURE Rising debt among farmers and agriculture-related companies has become of great concern to agricultural sector players. Davydoff et al. (2008) have conceptualized over-indebtedness as a high debt service that pushes an individual or household below the poverty line. The causes of unsustainable debts in agriculture are many and varied. A review by Datta, Tiwari, and Shylajan (2016) identifed the causes of high indebtedness in agriculture as unproductive uses of the loan (for marriages, funerals, and other social ceremonies), erratic rainfall, foods and drought, declining production and productivity, overreliance on noninstitutional sources of credit (money lenders), persistent losses, and rising costs of inputs. Some other causes of over-indebtedness include a lack of coordination among debtors due to a lack of information on the credit history of borrowers, pests and diseases, and high levels of fnancial illiteracy. Thus, any farm policy intended to curtail unsustainable debts in agriculture should incorporate these factors. Furthermore, debtors and policymakers need to establish debt thresholds that lead to over-indebtedness for various farming communities and households. In a study in South Africa, Ntsalaze and Ikhide (2017) found that exceeding a debt-to-income ratio of 42.5% leads to declines in household welfare.

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Over-indebtedness has both direct effects and indirect effects on poverty (Ntsalaze & Ikhide, 2017). In terms of the direct effects, the high debt service burden reduces the availability of resources for agricultural households to meet their needs. The indirect effects arise from the fact that high debt subdues growth due to a reduction in farm investments. Other consequences of over-indebtedness include stigmatization, legal consequences, insolvency, and perpetual penury.

11.7 AGRICULTURE FINANCE PLUS Complementarities are crucial in agricultural fnancing. In this regard, agricultural fnancing must come in a full package in order to be effective. Agricultural credit and other fnancing programmes must have an education and training component that teaches farmers how to effectively apply the credit to good effect. Apart from fnancing needs, farmers and agriculture companies need training on which breed of animal or seed to plant, when to start the business, how to keep records, and customer care, among others. If these other needs are not properly taken care of, it will be diffcult for farmers and agricultural sector companies to meet their fnancial obligations when they fall due. Thus, agricultural fnancing programmes should incorporate education, training, and fnancial literacy. This is called agriculture fnance plus. Agriculture fnance plus should help improve the use of funds and thus reduce the risk of default in the sector.

11.8 ROLE OF GOVERNMENT IN AGRICULTURAL FINANCING The state has a critical role to play in providing funding and creating an enabling environment for agriculture to thrive. The roles of government could range from establishing the legal and regulatory framework, infrastructure fnance, research and development (R&D) fnance, and establishing loan guarantee funds. Legal and regulatory frameworks: fnancial regulation is important for ensuring the optimal allocation of fnancial resources, reducing information and transaction costs, and the development of sustainable fnancial markets and institutions. Financial regulation must protect farmers from Ponzi schemes and provide some fexibility for innovative products to be designed for the sector. Infrastructure fnance: according to Ruete (2015), a fourishing agriculture sector requires supporting infrastructure such as road networks linking farms to market centres, irrigation schemes to reduce farmers’ overreliance on nature, storage infrastructure to stem post-harvest losses, telecommunications to facilitate transactions, water for household and agro-industrial use, and electricity to power agro-industries. Infrastructure fnance can be a collaborative effort between the government, fnancial institutions, and private partners. R&D fnance: innovation and knowledge are crucial to the transformation of agriculture. However, fnancing R&D in agriculture is often not

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attractive to the private sector. This means the government must take the lead. More funding should be channelled to the various agriculture research institutions and universities to drive agricultural innovation. Loan guarantee funds: governments may provide loan guarantees schemes to reduce the default risk in the agriculture sector in order to encourage more fnancial institutions to participate in agriculture fnancing.

11.9 CONCLUSION The agriculture sector, although beset by a lot of risks, still has a lot of fnancing opportunities that can be explored to position it as a key tool for poverty reduction both in the short term and in the long term. To achieve these ends, it will take a collaborative effort between governments, fnancial institutions, development fnance institutions, and other actors in the value chain to provide the needed fnancing for the sector. Going forward, there must be a departure from funding agriculture in a piecemeal fashion to adopting a more holistic approach to agricultural fnancing. This chapter, therefore, provides an assessment of potential fnancing models of agriculture with a view to better understanding what can work to support the growth of the sector for inclusive development. First, and in line with Agar (2011), we advocate an integrated approach to fnancing agriculture. Such fnancing must encompass agriculture value chain, nonfarm enterprise, and the household. This integrated approach is necessitated by the fungible nature of money. It would not be enough to make funding available to farmers only for production purposes. The consumption needs of farmers are linked to their production needs and to their nonfarm activities. Thus, if farmers know that they can get funding only for farming and not for their health, educational, and other needs, they will still go for loans for farming purposes but divert them to meet their survival and other most pressing needs. Thus, a holistic approach to funding agriculture that addresses both agricultural and nonagricultural needs is the way to go. Second, we note that fnancial inclusion and fnancial innovation are critical channels by which fnancial products and services can be brought to the doorsteps of the rural population. In the spirit of that, we argue that digital fnancing services such as mobile banking, mobile payments, and branchless banking services should be pursued by fnancial institutions and fnancial sector actors in this regard. Third, an enabling environment for business generally is also good for agriculture fnancing and agriculture growth. In particular we argue that improving the effciency of the judiciary and the courts, consolidating land and property rights, and investing in infrastructure such as transport, telecommunications, electricity, and water in agricultural areas will affect agriculture not only directly but also indirectly, by making fnancing for agriculture more accessible. Finally, capacity-building programmes are needed in order to strengthen the capacities of agricultural fnancial institutions and imbue farmers and agriculture entrepreneurs with the requisite knowledge to make the right fnancing decisions.

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Discussion questions 1 Discuss how poor countries can reduce their reliance on raw material exports. How will this reduce economic vulnerabilities? 2 Discuss agriculture sector-specifc risks, teasing out the fnancing opportunities that belie such risks. 3 How can the different risks in agriculture be mitigated by using various fnancial instruments?

4 To what extent can movable asset fnancing be used to ease collateral constraints in smallholder agriculture? 5 Discuss how digital fnance can solve some identifed constraints in the agriculture sector. 6 Discuss the various capital fnancing mechanisms for agriculture.

Notes 1 Read more at http://marketrealist.com/2015/12/analyzing-european-unions-gdp-composition/. 2 This is computed as the agriculture share of credit, over the agriculture share of GDP. 3 Read more details at www. un.org/waterforlifedecade/food_ security.shtml. 4 The discussion in this section is adapted mainly from International Finance Corporation (2012) and then Miller and Jones (2010) and Ruete (2015).

5 The cases used to support the discussion in this presentation were drawn mainly from the International Financial Corporation (2012). 6 Read more at www.centralamericadata.com/en/article/home/ Nicaragua_Agricultural_Exchange_ Traded_720_million_in_2013. 7 Read more about VSLAs at www. vsla.net/aboutus/vslmodel. 8 Read more about ROSCAs at www. investopedia.com/terms/r/rotatingcredit-and-savings-association. asp.

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Annan, J., Armstrong, M., & Bundervoet, T. (2013). Urwaruka Rushasha: A randomized impact evaluation of village savings and loans associations and family-based interventions in Burundi. Evaluation Brief. New York: International Rescue Committee. Gerlach, Ann-Christin, A., & Liu, P. (2010). Resource-seeking foreign direct investment in African agriculture: A review of country case studies. FAO Commodity and Trade Policy Research Working Paper No. 31. Rome: Trade and Markets

Chapter 11 • Financing agriculture 315 Division of the Food and Agriculture Organization of the United Nations (FAO). Bandara, A., Dehejia, R., & Lavie, S. (2014). Impact of income and nonincome shocks on child labour. New York: World Institute for Development Economics Research, United Nations University. Bank of England. (2014). Innovations in payment technologies and the emergence of digital currencies. Quarterly Bulletin 2014, Q3. Retrieved from https://www.bankofengland. co.uk/quarterly-bulletin/2014/q3/ innovations-in-payment-technologiesa n d - t h e - e m e rg e n c e - o f - d i g i t a l currencies BARA (Bureau of Applied Research in Anthropology), & IPA (Innovations for Poverty Action). (2013). Final impact evaluation of the saving for change program in Mali, 2009–2012. Bureau of Applied Research in Anthropology, University of Arizona, and Innovations for Poverty Action. Evaluation commissioned by OXFAM America and Freedom from Hunger. Retrieved from https://mangotree.org/Resource/ Report-Summary-Final-evaluationfor-the-Saving-for-Change-Programin-Mali-2009-2012 Slimane, Ben M., Huchet-Bourdon, M., & Zitouna, H. (2016). The role of sectoral FDI in promoting agricultural production and improving food security. International Economics, 145, 50–65. Brune, L., Giné, X., Goldberg, J., & Yang, D. (2015). Facilitating savings for agriculture: Field experimental evidence from Malawi (No. w20946). Cambridge, MA: National Bureau of Economic Research. Chaudhuri, S., & Banerjee, D. (2010). FDI in agricultural land, welfare and unemployment in a developing economy. Research in Economics, 64, 229–239. Christiaensen, L. (2017). Agriculture in Africa – telling myths from facts: A synthesis. Food Policy, 67, 1–11.

Cotula, L., Vermeulen, S., Leonard, R., & Keeley, J. (2009). Land grab or development opportunity? Agricultural investment and international land deals in Africa. London and Rome: IIED, FAO, IFAD. Datta, S., Tiwari, A. K., & Shylajan, C. S. (2016). An empirical analysis of nature, magnitude and determinants of farmers’ indebtedness in India. International Journal of Social Economics. doi:10.1108/IJSE-11-2016-0319 Davydoff, D., Naacke, G., Dessart, E., Jentzsch, N., Figueira, F., Rothemund, M., .  .  . Finney, A. (2008). Towards a common operational European defnition of over-indebtedness. Brussels: European Communities, Directorate-general for Employment, Social Affairs and Equal Opportunities European Commission. FAO. (2017). Database -FAOSTAT. Retrieved from www.fao.org/faostat/en/#home FAO. (2019). Constraints and challenges in forest plantations. Retrieved June 29, 2019, from www.fao.org/3/y7209e/ y7209e06.htm Farr, F. (2017). Determinants of foreign direct investment and foreign direct investment in agriculture in developing countries. Manhattan: Master of Agribusiness, Department of Agricultural Economics, Kansas State University. Fox, L., Thomas, A., & Cleary, H. (2017). Structural transformation in employment and productivity: What can Africa hope for? Washington, DC: International Monetary Fund. Fu, X., & Akter, S. (2016). The impact of mobile phone technology on agricultural extension services delivery: Evidence from India. Journal of Development Studies, 52(11), 1561–1576. Giovannucci, D., Varangis, P., & Larson, D. (Eds.). (2000). Warehouse receipts: Facilitating credit and commodity markets. Retrieved from http://ssrn.com/ abstract=952596 Grossman, J., & Tarazi, M. (2014). Serving smallholder farmers: Recent developments in digital fnance. Washington,

316 Haruna Issahaku et al. DC: CGAP (Consultative Group to Assist the Poor). Höllinger, F. (2011). Agricultural fnance – trends, issues and challenges. Eschborn: GIZ. International Finance Corporation (IFC). (2012). Innovative agricultural SME fnance models. Washington, DC: Author. Issahaku, H., Abu, B. M., & Nkegbe, P. K. (2017). Does the use of mobile phones by smallholder maize farmers affect productivity in Ghana? Journal of African Business, 19(3), 302–322. doi:1 0.1080/15228916.2017.1416215 Jayne, T. S., Sturgess, C., Kopicki, R., & Sitko, N. (2014). Agricultural commodity exchanges and the development of grain markets and trade in Africa: A review of recent experience. FoodTrade East and Southern Africa. Retrieved from https:// www.researchgate.net/publication/ 272744447_agricultural_commodity_ exchanges_and_the_development_of_ grain_markets_and_trade_in_africa_a_ review_of_recent_experience Johnston, B. F., & Mellor, J. W. (1961). The role of agriculture in economic development. The American Economic Review, 51(4), 566–593. Jordan, R., Eudoxie, G., Maharaj, K., Belfon, R., & Bernard, M. (2016). Agrimaps: Improving site-specifc land management through mobile maps. Computers and Electronics in Agriculture, 123, 292–296. Miller, C., & Jones, L. (2010). Agricultural value chain fnance: Tools and lessons. Rome: Food and Agriculture Organization, Practical Action Publishing. National Research Council. (2015). Critical role of animal science research in food security and sustainability. Washington, DC: The National Academies Press. doi:10.17226/19000 Ntsalaze, L., & Ikhide, S. (2017). The threshold effects of household indebtedness on multidimensional poverty. International Journal of Social Economics, 44(11), 1471–1488.

Pouw, N., & Gupta, J. (2017). Inclusive development: A multi-disciplinary approach. Current Opinion in Environmental Sustainability, 24, 104–108. Ruete, M. (2015). Financing for agriculture: How to boost opportunities in developing countries. Investment in Agriculture Policy Brief No. 3. Winnipeg: International Institute for Sustainable Development. Santangelo, G. D. (2018). The impact of FDI in land in agriculture in developing countries on host country food security. Journal of World Business, 53(1), 75–84. Schaner, S. (2015). The persistent power of behavioral change: Long-run impacts of temporary savings subsidies for the poor. Documento de trabajo. Hanover, NH: Dartmouth College. Steinfeld, H., & Mack, S. (2019). Livestock development strategies. Retrieved June 29, 2019, from www.fao.org/3/ V8180T/v8180T0a.htm Tadesse, G., & Bahiigwa, G. (2015). Mobile phones and farmers’ marketing decisions in Ethiopia. World Development, 68, 296–307. Tondl, G., & Fornero, J. A. (2010). Sectoral productivity and spillover effects of FDI in Latin America: Sectoral productivity and spillover effects of FDI in Latin America. FIW Working Papers. FIW – Kompetenzzentrum Forschungsschwerpunkt Internationale Wirtschaft. Retrieved from https://www.econstor.eu/ handle/10419/121055?locale=de USAID. (2016). Guide to the use of digital fnancial services in agriculture. USAID. Retrieved from https://www.usaid. gov/digitalag/documents/digitalfnancial-services-agriculture-guide Wikipedia. (2019). List of commodity exchanges. Retrieved July 4, 2019, from https://en.wikipedia.org/wiki/List_ of_commodities_exchanges World Development Indicators. (2017). World development indicators. Washington, DC: World Bank.

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

06_15

06_10

11_15

Source: World Development Indicators (2017)

East Asia & 1,088.9 1,285.4 1,322.4 1,389.8 1,427.7 1,466.5 1,528.0 1,591.3 1,649.4 1,712.7 1,766.9 1,514.0 1,378.3 1,649.7 Pacifc Europe & 8,801.8 10,448.2 10,570.4 11,336.3 11,664.6 11,444.7 12,470.7 12,336.3 13,128.5 13,774.3 14,309.1 12,148.3 11,092.8 13,203.8 Central Asia Latin 4,541.2 5,676.4 5,975.2 6,205.5 5,951.5 6,427.4 6,679.2 6,655.5 7,107.6 6,912.8 7,228.3 6,481.9 6,047.2 6,916.7 America & Caribbean Low income 401.1 422.8 455.5 462.5 472.4 482.1 479.0 494.1 490.7 500.7 504.1 476.4 459.1 493.7 Middle East 3,803.4 4,829.1 4,723.4 4,403.6 4,770.5 4,972.9 5,193.4 5,296.7 5,635.0 5,792.3 5,938.5 5,155.5 4,739.9 5,571.2 & North Africa Middle 1,211.2 1,478.9 1,519.9 1,566.1 1,592.5 1,661.2 1,731.9 1,773.1 1,853.5 1,886.6 1,920.0 1,698.4 1,563.7 1,833.0 income High income 22,419.8 27,489.4 28,024.6 30,422.9 32,277.6 32,099.7 33,240.6 32,997.5 36,405.7 37,959.9 39,256.7 33,017.5 30,062.8 35,972.1 South Asia 871.7 946.3 990.7 984.2 989.8 1,048.5 1,083.4 1,093.8 1,135.8 1,130.2 1,131.7 1,053.4 991.9 1,115.0 Sub-Saharan 776.3 994.6 1,028.8 1,081.1 1,092.0 1,120.6 1,130.5 1,174.1 1,184.8 1,209.6 1,223.3 1,123.9 1,063.4 1,184.4 Africa World 1,557.5 1,778.2 1,812.2 1,872.0 1,905.6 1,953.5 2,011.9 2,027.9 2,122.8 2,152.9 2,179.2 1,981.6 1,864.3 2,098.9

2000

TABLE A13.1 Agriculture value added per worker (constant 2010 USD)

Appendix

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CHAPTER

12

Financing sustainable development New insights for the present and the future Gordon Abekah-Nkrumah, Patrick O. Assuming, Patience Aseweh Abor and Jabir Ibrahim Mohammed 12.1 INTRODUCTION Sustainable development has been a long-standing issue since the 1980s, and several conferences have been held to discuss issues pertaining to sustainable development. Sustainable development serves as the key idea around which environment and development goals are structured. It also serves as the principal goal of many more institutions in development than in previous times. The United Nations established an independent group of 22 people drawn from member states in 1984, taken from both developing countries and developed countries. The main aim of the group was to identify longterm environmental strategies for the international community. In 1987, the World Conference on Environment and Development (WCED) published a report titled Our Common Future. This report is often referred to as the Brundtland Report, named after its chair, the prime minister of Norway, Gro Harlem Brundtland (Brundtland, 1985). The report used the term ‘sustainable development’, which is widely defned as ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’ (p. 43). This report highlighted the argument that economic inequities will lead to the overexploitation of resources and that economic growth is needed especially in poorer countries in order to satisfy their basic human needs. The report further states that this kind of development must follow a ‘new pathway’ that does not entail environmental destruction. They report that this renewed pathway for achieving sustainable economic growth and the equitable redistribution of wealth can be achieved only through political participation. The proclivity of sustainability in the words of John Robinson and Jon Tinker hinges on three key elements: ecological, economic, and social imperatives. They argue that most sustainable theorists and practitioners mostly expand on the dimensions of the social imperatives to include both

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intergenerational and intragenerational equity. The argument is that a sustainable world must provide for the basic needs of all people living today (intragenerational equity) without compromising the ability of future generations to meet their needs (intergenerational equity). For the current generation to be able to provide for the basic needs of all people living today without precluding future generations from meeting their needs, rigorous mechanisms for fnancing sustainable development that cate for the present and the future needs of humanity will be needed. The Intergovernmental Committee of Experts on Sustainable Development Financing (ICESDF), for instance, suggests that suffcient funds exist internationally to achieve sustainable development, but this requires strong political commitment to structural reforms, coupled with new and innovative fnancing mechanisms in order to make tangible progress. The outcome of the Third Conference on Financing for Development (FfD) held in Addis Ababa in July 2015 represents a critical contribution to the post-2015 sustainable development agenda and the drive for implementation. We defne ‘sustainable development fnance’ as a fnancing mechanism that provides clean and innovative blended sources of fnance to meet the needs of current and future generations. The concerted mechanism of fnance may be obtained from both domestic and international sources, including public funds and private funds, such as environmental fnance, private sector fnance, and innovative fnance for sustainable development. In this chapter, we examine fnancing for sustainable development. We frst provide an overview of sustainable development by looking at the Millennium Development Goals (MDGs) and the Sustainable Development Goals (SDGs). We also discuss the challenges and benefts of fnancing sustainable development, bring up the sources of fnancing for sustainable development, and fnally make concluding remarks.

12.2 OVERVIEW OF SUSTAINABLE DEVELOPMENT Sustainable development is concerned with development that meets the needs of the current without sacrifcing the future generations’ ability to meet their needs. The modern use of the term ‘sustainable development’ is derived mainly from the Brundtland Report (1987). It contains two key concepts: frst, the concept of ‘needs’, in particular the essential needs of the world’s poor, to which overriding priority should be given, and, second, the idea of limitations imposed by the state of technology and social organization on the environment’s ability to meet present and future needs (Brundtland, 1987). The meaning of the concept of sustainable development has evolved over time. The initial focus of sustainable development was on sustainable forest management and environmental issues. However, as the concept evolved, the focus shifted towards economic and social development as well as protecting the environment for future generations. We provide the evolution of the concept of sustainable development in Box 12.1.

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BOX 12.1 The evolution of the concept of sustainable development The United Nation Education Scientifc and Cultural Organization (UNESCO), at a conference on the biosphere, initially launched the idea of sustainable development in 1968. The concept of sustainable development received its frst major international recognition in 1972 at the UN Conference on Human Environment held in Stockholm. The term was not referred to as sustainable development, though the international community decided that development should address the needs of the environment without causing adverse effects to the inhabitants, so that it is maintained and passed on to future generations while being managed in a mutually benefcial way. Again, the United Nations Conference on Environment and Development (also called the Earth Summit) held in Rio de Janeiro in 1992, re-echoed the need for sustainable development. The summit was the initial international attempt to develop action plans and strategies to achieve a more sustainable pattern of development. In 2002, ten years after the summit in Rio de Janeiro, the World Summit on Sustainable Development was held in Johannesburg and attended by 191 national governments, UN agencies, multilateral fnancial institutions, and other major groups to assess progress since the conference in Rio de Janeiro. The main areas of commitment during the summit were sustainable consumption and production, water and sanitation, and energy. Source: www.sd-commission.org.uk/pages/history_sd.html

The term ‘sustainability’ is derived from the Latin root sus-tinere, meaning to under-hold or hold up from underneath, which implies robustness and durability over time. Sustainability also depicts a paradigm that protects the planet’s life support system to ensure the longevity of humans and other species. While ‘sustainability’ is viewed as humanity’s target for human–ecosystem equilibrium (homeostasis), ‘sustainable development’ is concerned with the holistic approach and temporal processes that result in the end point of sustainability (Shaker, 2015). At the global level, reference is currently being made to the SDGs in the attainment of specifc sustainable development outcomes by 2030. The SDGs build on the MDGs, which were set in 2000. We provide some brief discussion on the MDGs and the SDGs. 12.2.1 The Millennium Development Goals In 2000, all 191 member states of the United Nations and at least 22 international organizations made a commitment to achieve eight international development goals by the year 2015. These goals were referred to as the MDGs. The MDGs were essentially antipoverty goals born out of the need

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to put in place a mechanism to implement the Millennium Declaration. The Millennium Declaration considered certain fundamental values – freedom, equality (of individuals and nations), solidarity, tolerance, respect for nature, and shared responsibility – to be essential in international relations in the 21st century. The MDGs, along with 21 specifc targets, encapsulated the objects of development as understood at the time, as well as key enablers for achieving them. Thus, the goals centred on human capital, infrastructure, and human rights, to improve living standards. The MDGs galvanized unprecedented levels of concerted efforts of a broad coalition of individuals and organizations working in development: academics, governments, intergovernmental organizations, nongovernmental organizations (NGOs), and other members of civil society. The MDGs consequently became the standard for judging the success of development programmes around the world. After 15 years of MDGs, signifcant progress was made in several areas. One of the major achievements is the reduction in poverty. Globally, the number of people living in extreme poverty (i.e. people living on less than USD1.25 per day) declined by more than 50%, and the global target of halving extreme poverty was achieved ahead of time in 2010 (UN, 2015). In addition, the proportion of workers in vulnerable employment also fell, although 45% were still working in vulnerable conditions (National Development Planning Commission [NDPC], 2015). With regard to achieving universal primary education, signifcant progress was made towards it in developing regions of the world. The net enrolment rate (NER) in primary education increased from 83% in 2000 to 90% in 2012 (NDPC, 2015). Signifcant progress has also been made towards gender equality in primary education and the participation of women in political activities in developing regions. However, progress towards improving gender equality in labour markets remains slow. Substantial progress was made in improving child and maternal healthcare even though the target was not achieved by 2015. Under-fve mortality declined from 90 to 43 deaths per 1,000 live births between 1990 and 2015, despite population growth in developing regions. Similarly, maternal mortality declined by about 45% worldwide, though this reduction was still below the target. Further, the incidence of HIV at the global level reduced by 40% between 2000 and 2013. Malaria-related mortality rates fell by 42% globally between 2000 and 2012 due to improvements in malaria interventions. Between 2000 and 2015, over 6.2 million malaria deaths were averted, 97% of whom were young children (UN News Centre, 2015). Also, over 2.3 billion more people gained access to improved sources of drinking water, representing 89% of the world’s population by 2012 (NDPC, 2015). Finally, a signifcant improvement was recorded in offcial development assistance (ODA). ODA from developed economies grew by 66% in real terms from 2000 to 2014 (UN News Centre, 2015). The debt burden of developing countries has also fallen dramatically, and there has been a substantial increase in internet access worldwide (NDPC, 2015).

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However, the substantial global progress masked progress across the regions and countries of the world. First, in spite of the progress made, a large number of people still live in poverty. An estimated 800 million people around the world still live in extreme poverty, hunger, and deprivation. Moreover, over 160 million children under fve years of age are too short for their age, due to insuffcient food, while 57 million children of school-going age are not in school. Second, in spite of progress made, huge gaps in socioeconomic status and economic opportunities exist between rural households and urban households. For instance, around the world, those in the rural population who do not use improved drinking water sources is four times that of the urban population (UN, 2015). Third, in most parts of the world, gender inequalities persist, as many women are discriminated against in the areas of economic opportunities and participation in private and public decisionmaking. Finally, in terms of climate change and the environment, environmental degradation and the negative effects of climate change persist, the poor bearing a disproportionate share of the consequences. 12.2.2 From MDGs to SDGs The foregoing analyses indicate that while signifcant progress has been made, concerted and focused global efforts are needed to address extreme hardship and deprivation. Uneven progress made on the MDG targets meant that large sections of the population in low-income countries, particularly those in Africa, are without access to basic services. In addition, efforts on some of the MDGs also remained off-track, especially those that relate to child and maternal healthcare. Moreover, there has been an increasing recognizing that several key emerging issues in development were not captured under the MDGs and that therefore the 2030 Agenda required an expanded range of goals and outcomes. The idea for SDGs was conceived at the United Nations Conference on Sustainable Development in Rio de Janeiro, Brazil, 20–22 June 2012. The aim was to come out with a set of universal goals that meet the urgent environmental, political, and economic challenges facing our world. Thus, the SDGs came as a bold commitment to fnish what was started and address other, more-challenging issues the world is facing. It builds on the MDGs and aims to fll in the gaps in the objectives and achievements of the MDGs, particularly reaching the most vulnerable. The SDGs are also known as the 2030 Agenda as the deadline for achieving the goals is 2030. The goals are interconnected, so success in one would invariably lead to success in others. Hence, the scope of the SDGs goes far beyond the MDGs, to include a wider range of economic, social, and environmental objectives. More importantly, it defnes the means of implementing SDGs. The main focus of the MDGs was poverty reduction, and they didn’t consider the various complications of global poverty. This lack is important to point out because the world’s social, economic, and environmental landscape is constantly changing, which affects the poor. The SDGs thus seek to address issues underpinning poverty and employ an approach that interconnects all the three aspects of sustainable development: economic, social, and environmental.

Chapter 12 • Financing sustainable development 323 TABLE 12.1 MDGs and SDGs MDGs

SDGs

1 Eradicate extreme poverty and hunger.  

1 End poverty in all its forms everywhere 2 End hunger, achieve food security and improved nutrition, and promote sustainable agriculture. 3 Ensure inclusive and equitable quality education and promote life-long learning opportunities for all. 4 Achieve gender equality and empower all women and girls. 5 Ensure healthy lives and promote wellbeing for all at all ages. 6 Ensure healthy lives and promote wellbeing for all at all ages. 7 Ensure healthy lives and promote wellbeing for all at all ages. 8 Ensure availability and sustainable management of water and sanitation for all. 9 Strengthen the means of implementation and revitalize the global partnership for sustainable development. 10 Ensure access to affordable, reliable, sustainable, and modern energy for all. 11 Promote sustained, inclusive, and sustainable economic growth, full and productive employment, and decent work for all. 12 Build resilient infrastructure, promote inclusive and sustainable industrialization, and foster innovation. 13 Reduce inequality in and among countries. 14 Make cities and human settlements inclusive, safe, resilient, and sustainable. 15 Ensure sustainable consumption and production patterns. 16 Take urgent action to combat climate change and its impacts. 17 Conserve and sustainably use the oceans, seas, and marine resources for sustainable development. 18 Protect, restore, and promote the sustainable use of terrestrial ecosystems, sustainably manage forests, combat desertifcation, and halt and reverse land degradation and halt biodiversity loss. 19 Promote peaceful and inclusive societies for sustainable development, provide access to justice for all, and build effective, accountable, and inclusive institutions at all levels.

2 Achieve universal primary education.   3 Promote gender equality and empower women. 4 Reduce child mortality. 5 Improve maternal health.   6 Combat HIV/AIDS, malaria, and other diseases. 7 Ensure environmental sustainability. 8 Global partnership for development.      

             

 

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The MDGs came about largely through a top-down approach. The goals were largely determined by OECD countries and international donor agencies. However, the SDGs came about through extensive consultations. Civil society organizations, citizens, scientists, academics, and the private sector were all consulted in the process of formulating the SDGs. According to Coonrod (2014), the MDGs’ targets were aimed at accomplishing at least half the targets. However, the SDGs aim at fully accomplishing the goals, thus setting zero-based goals (reaching the statistical zero on the targets like poverty, hunger, and child and maternal mortality). Thus, more focus is placed on reaching all players involved in reaching the goals. In addition, while the MDGs addressed each of the goals in isolation, the SDGs employ a more integrative approach. All the 17 SDGs are interconnected, so success in one would lead to success in the others (Boucher, 2015). The SDGs brought together all three aspects of sustainable development – that is, economic, social, and environmental – in a more integrative manner. In terms of funding, the MDGs envisaged a substantial role for international aid. Goal eight of the MDGs included targets for substantial amounts of offcial development assistance (ODA) from developed to developing countries. The onset of the 2008–2009 global fnancial crises and the economic crisis that followed led to sharp falls in ODA, and this may have played a role in the inability to achieve a number of the goals and targets. The SDGs take a slightly different approach, by focusing on sustainable and inclusive economic development that emphasizes self-revenue-generating capacities (Coonrod, 2014). TABLE 12.2 Differences between SDGs and MDGs MDGs

SDGs

1 The MDGs are made up of eight 1 The SDGs include 17 goals, 169 targets, and 304 indicators to measure compliance. goals, 21 targets, and 63 indicators. 2 The SDGs came about through extensive 2 The MDGs came about largely worldwide grass root consultation through a top-down approach. 3 The MDGs targets were such that 3 The SDGs aim at full accomplishment, thus setting zero-based goals (reaching the accomplishing at least half the statistical zero on the targets like poverty, targets was acceptable. hunger, and child and maternal mortality). 4 The SDGs employ a more integrative 4 The MDGs addressed each of approach (all the 17 SDGs are interconnected, the goals in isolation. thus success in one would lead to success in others). 5 The SDGs cuts across every single country in 5 The MDGs’ main focus was on the world, emphasizing that no one should developed countries’ granting be left behind. Thus, it looks at poverty aid to developing countries eradication in every country in the world. through ODA. 6 In the MDGs, hunger and poverty 6 The SDGs address this shortcoming by treating hunger and poverty as separate were lumped together, making issues. it look like solving one would automatically solve the other. 7 With the SDGs, sustainable and inclusive 7 The MDGs were anticipated economic development was put at the forefront to be funded by aid from of the goals so that countries could improve developed countries, but that their self-revenue-generating capacities. proved a challenge.

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In sum, the SDGs are universal zero goals, aimed at achieving the unmet MDGs and more. The processes that led to the fnalization of the SDGs were more consultative and inclusive, involving broad consultations with a cross-section of civil society and grassroots organizations. This resulted in a more broad-based set of goals and targets. One important aspect in which the MDGs differ from the SDGs is that in terms of funding, the former placed greater emphasis on aid from advanced countries to developing economies, while the latter makes no such explicit expectation of donor funding but emphasizes inclusive growth through improving revenue-generating capacities to ensure sustainability.

12.3 CHALLENGES OF FINANCING SUSTAINABLE DEVELOPMENT The Rio de Janerio conference highlighted a wide range of interlinked challenges that call for priority attention. These challenges include decent jobs, energy, sustainable cities, food security and sustainable agriculture, clean water, clean oceans, and disaster readiness. Among these challenges, the Department of Economic and Social Affairs (DESA, 2013) under the United Nations, conducted a survey on the challenges of sustainable developments and highlighted four of these areas: 1 2 3 4

Sustainable cities. Food security, nutrition, and sustainable agriculture. Energy sustainability. Decent jobs.

12.3.1 Sustainable cities The world’s urban population continues to grow partly because of new opportunities that urbanization presents to millions of people who live in urban communities. This has contributed partly to the eradication of extreme poverty among rural and urban people. Despite the immense contributions (e.g. access to safe drinking water, jobs, health) that urbanization brings to people, it has also contributed greatly to the world’s urban problems, such as increased pressure on existing resources and increased demand for essential goods such as energy, water, sanitation, public services, education, and healthcare (Polèse, 2009; Satterthwaite, 1992). More than half of the world’s population have lived in urban areas since 2007, and it is estimated that this proportion will reach 70% by 2050 and will account for 80% of those living in the developing world, especially cities in Africa and Asia. For instance, 1.3 billion people were added to small cities in the world for the period 1950–2010, which has been estimated to be more than double the 632 million people who were added to medium cities or the 570 million added to large cities (DESA, 2013). The rise in population growth calls for urgent policy initiatives, especially for developing countries, to help address this challenge within the next 15–20 years. Most developing countries will need additional resources to be able to contain the rapid urbanization that they are experiencing now. The rapid mobility of people from the rural areas to seek better opportunities in

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urban cities, especially in developing countries, is increasingly becoming a serious issue of concern. Most of these movements contribute to slums, pressure on energy resources, public transport, education, healthcare, water and heavy sanitation challenges, and more recently climate change problems, which put serious pressure on the adaptive capacity of the poor in urban areas. Financing cities requires taking a multifaceted approach that involves a mixture of several fnancing mechanisms. This concerns raising money from capital markets, such as issuing municipal bonds, bank bonds (without central government support), green bonds, and offcial development assistance. In this regard, local, and national authorities need a close partnership in order to raise sustainable fnance for the development of their cities. Cities in most developed countries have the capacity to raise municipal bonds directly from the capital market and loans from banks, unlike poor countries, where these mechanisms are limited. Poor countries need international support and resources to be able to support green technology adaptation and capacity development. They also need both technical and fnancial support to provide effcient public transportation, housing, water and sanitation, electricity, healthcare, and education. Investments in infrastructure require upfront fnance, the beneft of which will only be reaped in the medium to long term. Rich cities need to enact policies that encourage renewable energy and reduce ineffciency and wasteful consumption. To achieve this, regulatory strategies must be put in place to support the determination of the pricing structures, taxes, and subsides for both household and industries for development. 12.3.2 Food security and nutrition A strong and healthy workforce is needed to drive the socioeconomic progress of the world, more particularly progress in poorer nations. Nutritious food is needed to ensure that people are healthy and work towards their development. It is against this background that governments of developing countries see it as a major priority to fnance food security and nutrition, since developing countries are mostly affected by food insecurity. Since 1970, about one billion people in the world have been affected by basic food insecurity (DESA, 2013). However, there has been an improvement among people who are undernourished. The proportion of people who were under nourished in 1990–1992 were 20%, and this has declined to 15% in 2008–2010. Among those most affected with food insecurity were from sub-Saharan Africa and South Asia. This negatively affected the region’s ability to meet the 2015 deadline for the MDGs. Additionally, there is low diversity in the available food and low quality in food. This makes the challenge of malnutrition even broader than the issue of hunger and undernourishment. In 2013, it was estimated that more than 2.8 million adults die each year as a result of obesity and overweight, partly because of the high consumption of calories by adults in both developing and developed countries (DESA, 2013).

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It is also estimated that food production will have to increase by 70% globally in order to feed an additional 2.3 billion people by 2050. To meet this target, investment in agriculture needs to increase in order to boost livestock and diary production, cereals, and fruits and vegetables, among others. This will put a lot of pressure on land, water, and biodiversity resources. Additionally, resource constraints pose a signifcant challenge to meeting the ever-increasing demand for food. Currently, greenhouse gas emissions arising from agricultural practices are reducing soil fertility and leading to water pollution. There is also the problem of climate change arising from the volatility of weather patterns, thereby affecting crop yields and income levels from agricultural produce. Economically, disadvantaged people are mostly affected as a result of an increase in land used for biofuels. This constrains the supply of food products, which can lead to price hikes. In addition, demand for land for housing as a result of urbanization accelerates the diversion of land meant for agricultural purposes to urban use. To address this challenge, there is the need to enhance social safety net policies targeted at rural development, and strategic development plans need to reach out to disadvantaged and marginalized households. These social safety nets will empower the most vulnerable against short-term economic shocks and enhance long-term resilience through the facilitation of smallholders’ access to food, help them manage risk, and adopt new technologies to increase food production. Finally, food waste is a serious challenge. It is estimated that, globally, 32% of food produced is wasted. We can have a sustainable food system only if we are able to reduce food waste. This implies the need for a strong policy framework to help address food waste if we intend to improve food security. 12.3.3 Energy transformation Energy transformation should be a core element of the sustainable development goals in order to improve living standards. To ensure that the environment is clean, there has been a global move to focus more attention on renewable energy rather than on fossil fuels, which tends to pollute the environment. Recent estimates confrm that emission trends will lead to temperature increases with potential catastrophic consequences. Researchers have argued that even if more emission- mitigating policies were implemented, including expansion in the use of renewable energy sources and improvement in energy effciency, a stabilization of greenhouse gas emissions at 450 parts per million (ppm) will not be achieved by 2050. The OECD (2012c) projected that emission concentrations might reach between 650 and 700 ppm of carbon dioxide equivalent (CO2e) by 2050 and between 800 and 1,300 ppm of CO2e by 2100. This will lead to an increase in the global average temperature of 2°C–3°C by 2050 and 3.7°C–5.6°C by 2100. Due to this increase, multiple pathways towards sustainable energy have been identifed. The world can follow a large number of energy pathways towards sustainable development, which require ambitious policies, improved international cooperation, improved implementation,

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behavioural changes, and unprecedented levels of investment. The scenario results indicate that, in the absence of additional targeted pro-poor energy policies, by 2030, some 2.4 billion people will still rely on solid fuels for cooking. The implementation of highly ambitious policies in order to address the energy–poverty nexus has the potential to ensure access to modern energy for an additional 1.9 billion people. There is the need for good fnancing vehicles to be put in place to cover the upfront costs of enabling access to modern energy and purchase of appliances with a 50% fuel subsidy in relation to market prices. With this effort, there are still over 500 million people without access to modern energy in which most of these people are found in rural Africa and remote areas. This means that there is the need for concerted efforts from national, bilateral, and multilateral sources to fnance clean and affordable energy for all. 12.3.4 Decent jobs Unemployment is a serious threat to global peace. Globally, the world’s population consists of a signifcant share of young people, and the lack of decent jobs for them can be challenging. Currently, there are over 1.2 billion young people in the world and the majority of them are found in developing countries. The share of the working population in developing countries is beginning to rise as a result of a lower fertility rate and increased longevity. As the working population is rising, developing countries, for instance, need to put in place proactive measures to create decent and productive jobs for the growing population. According to the International Labour Organization (ILO) statistics, there are about 74 million unemployed youth in the world and some who are even underemployed. Most young people living in developing countries are often underemployed or work in the informal sector. According to the ILO, in several low-income and middle-income countries, nearly half of youth in developing countries are not achieving their full economic potential, which is a further hindrance to development in those countries. The ILO not only considered standard labour market indicators in its analysis but went further to include issues such as irregular employment and underutilization, job quality and satisfaction, and the transition of young people into the labour market. These are the conditions that force the majority of the youth in developing countries out of their homes. This means developing countries need to explore all options available to create decent jobs. This can be done through a balanced policy agenda: upgrading skills for better employment, an increase in productive investment, and increased access to fnance. With respect to upgrading skills, the right training and educational investments need to be undertaken, and this can help youth match their skills with the requirements of the job market. Strong relationships between academia and industry can be explored to improve skills acquisition by students. Finally, developing countries need to deploy macroeconomic and growth-inducing policies that encourage economic diversifcations and development of the various sectors of the economy for the purposes of job creation. Also,

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governments should provide a window of opportunity for youth by providing and guaranteeing loan facilities for young people who have better business ideas to boost entrepreneurship. 12.3.5 Other fnancing challenges In spite of the key challenges identifed and the progress made so far, enormous challenges still remain in terms of raising the necessary funds from identifed sources and other innovative sources to fnance sustainable development. Some of these challenges include tax systems, weak fnancial systems, confict between proft and sustainable development, lifestyles, and human attitudes. Developing countries are those most affected by unsustainable development practices. They are generally said to have weak tax systems, and even those with relatively strong tax laws do not have the capacity to enforce them. As a result, tax contributes a small portion of total revenues relative to developed countries. For instance, tax revenue in developing countries on average makes up only 17% of GDP, compared to more than 30% in developed countries. This heavily undermines the ability of countries to raise the necessary domestic revenue to meet the fnancing needs of sustainable development. Corruption has a negative and adverse effect on revenue mobilization. This is due to poor fnancial management. Generally, developing countries have weak fnancial management systems, and this situation allows for seepages. Therefore, funds that should go into fnancing sustainable development end up in private pockets. Similarly, procurement systems are also weak, and this makes for a safe haven for the siphoning of public resources for private gain. Unless these gaps are sealed, developing countries will continue to rely on the insuffcient external and private funding to meet their nationally framed SDGs and other developmental projects. To meet the fnancing needs of the sustainable development goals, governments will have to optimize the use of funds from all sources, including public, private, and international. At the domestic level, however, the inherent confict between public fnance and private fnance affects the ability of governments to leverage private capital for sustainable development. While private fnance gravitates towards proft with a focus on risk and return, public fnance is concerned with the provision of public goods and investments with a long-term horizon. The capacity to reconcile private interest with public appeal is lacking in developing countries. Therefore, the potential of private fnance for public interest in many developing countries remains untapped. And many developing countries may not be able to maximize the synergies of different sources of fnance to meet the demands of sustainable development. Unsustainable consumption and production patterns are rapidly undermining the ability of countries to raise the needed fnancing to meet the targets set by SDGs. The effort to mobilize resources must be complemented by sustainable lifestyles, especially in the developed world. As long as the problem keeps escalating, resources will never be adequate to address them. It will be like ‘fetching water with a basket’: for every dollar made, a

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dollar or half a dollar in fresh damage is caused. In developed countries, the per capita greenhouse gas emissions are 20 to 40 times greater than what is needed to stabilize the atmospheric greenhouse gas concentration (IFC, 2015). This unsustainable lifestyle, which evolved in the developed world, is increasingly being emulated by high-income households in the developing world. There is the need to have comprehensive regulation that discourages unsustainable lifestyles that threaten to reverse any progress made on the SDGs.

12.4 BENEFITS OF FINANCING SUSTAINABLE DEVELOPMENT Sustainable development fnance comes with many benefts to nations and the world as a whole. In this section, we discuss a number of benefts of fnancing sustainable development. Synergy in fnancing sources helps with raising funds from multiple sources in both developing and developed countries. Funds for sustainable development are raised from many sources, including private, government, and international bodies. Investments in renewable energy, biodiversity and the ecosystem, green bonds, and education and health have increased astronomically over the years. For instance, the Frankfurt School-UNEP (2018) report noted that investment in renewable energy has continued to increase each year since 2004; the world has invested USD2.9 trillion in green energy sources; and the investment was largely driven by developing countries. Again, the funding sources used for these areas had backward and forward linkages for other sectors of the economy. Well-fnanced sustainable development through funds generated for a green economy helps to reduce greenhouse gas emissions. The best way to address climate change is to drastically reduce greenhouse gas emissions such as methane and carbon dioxide. Money that is charged through a carbon tax and issuances of green bonds can be used to fnance the reduction in greenhouse gas emissions. Another beneft of synergy in fnancing sources is economic growth. Sustainable development supports current and future generations, so mechanisms put in place to fnance it must be driven by growth. Investing in sustainable cities helps to improve the infrastructure of those cities, which in turn improves the economic activities of those countries and facilitates economic growth. Additionally, renewable energy investment is a sure way to provide clean energy sources for industrial and economic growth. When energy is made clean and reliable and when factories are able to have a constant supply of energy, output increases. Financing sustainable development will help to improve the employment fortunes of Africa’s youth and women. In addition, 80% of employment in Africa is driven by the natural resource–based sectors, such as agriculture, mineral resources, forestry, and fsheries. Similarly, the tourism industry in Africa employs over 6.3 million people, and this sector also relies primarily on the continent’s natural and cultural wealth (World Travel & Tourism Council, 2009). All these sectors need support in enhancing the

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green economy, which will create sustainable jobs and improve people’s livelihood. Therefore, sustainable development fnancing from private and public sources can help to create much-needed jobs. Another beneft of fnancing sustainable development is to ensure that there is food security for all. Financing food security to reduce postharvest losses will help to reduce the over 33%–35% malnourished population in Africa. Funding issues of environmental degradation, poor soil and water management will rapidly improve crop yield of farmers and help to make quality food available. Also, forest conservation through fnancing to replace falling trees and controlling illegal logging and overgrazing will help to make food growth in those areas more secure for human consumption. This means that climate change fnancing is important for the African continent.

12.5 SOURCES OF FINANCING SUSTAINABLE DEVELOPMENT In this section, we discuss the various sources available for fnancing sustainable development. Here, we focus on environmental fnance, private sector fnance, and innovative sources of fnancing sustainable development. These fnancing mechanisms are important in addressing the challenges raised in section 12.3. 12.5.1 Environmental fnance The environment is an important dimension when it comes to addressing the sustainable development goals. Thus, environmental fnance is critical for the success of the SDGs. Some of the environmental issues are climate change, biodiversity and the ecosystem, and renewable energy. The sources of fnance required to address these environmental issues are important. Environmental fnance is concerned with the impact of environmental issues on fnancing decisions. There are a number of ways that the environment can be fnanced. These include climate fnance, fnance for biodiversity and the ecosystem, renewable energy fnance, and green fnance. We discuss them in turn. Climate change is one of the key issues to be considered when it comes to meeting the sustainable development goals. This is because anthropogenic climate change presents an unprecedented challenge to the well-being of humans and threatens economic growth in both rich countries and poor countries. To tackle climate change problems, long-term private and public investments are required. Therefore, climate fnance covers a wide range of investment vehicles that are required to reduce excessive greenhouse gas emissions. To this end, there is a clear difference between development fnance and climate fnance. While development fnance provides resources for global public goods and public investments that cannot be fnanced by the poorest countries, climate fnance focuses mainly on greenhouse gas emissions. Progress has been made regarding

12.5.1.1 CLIMATE FINANCE

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donor partners’ pledge for climate fnance. At the Copenhagen Conferences of Parties (COP) 15, the developed countries agreed to commit USD30 billion as a fast start programme for 2010–2012 and committed to provide USD100 billion annually by 2020 to fnance climate change mitigation. Schmidt-Traub and Sachs (2015) argued that to properly fnance climate change mitigation, investment in the following areas is required: • Infrastructure – low-carbon energy and transmission, effcient buildings, low-carbon industrial plants, sea walls to protect against rising sea levels, climate-resilient cities, and water management infrastructure. • Agriculture – low-carbon agriculture and animal husbandry, droughtresistant farming practices and infrastructure, improved water management infrastructure, soil-erosion control, climate-resilient livestock management practices, and improved food storage facilities. • Biodiversity and ecosystem services – improved monitoring systems, reduced deforestation, and integrated water resource management. • Research, development, demonstration, and deployment (RDD&D) – providing climate-resilient technologies for energy, agriculture, water management, and healthcare; providing cutting-edged research to identify new ideas in energy technology, water resource management, agriculture and health, particularly for Africa. On such investment, the success story of Woodlot management in Tanzania can provide great lessons. See Box 12.2 for the story.

BOX 12.2 African success stories: Woodlot management for climate change adaptation in Tanzania In the Makete District of the United Republic of Tanzania, forest, woodland, and grassland resources are essential to the local economies. They also play a crucial role in protecting the watersheds that are vital for the conservation of the environment for agriculture and livestock production. Tanzanian authorities and local communities, working together and sustained by international support, have improved smallholder livelihoods through woodlots management practices as a strategy for climate change adaptation while creating a new stream of income for local communities and revenues for the city. Following an assessment of smallholder woodlot management practices and the marketing of timber, user groups were assisted in developing their own woodlot operational plans and harvesting rules, in setting rates and prices for products, and in determining how surplus income would be distributed or spent. This produced signifcant improvements in the conservation of woodlots in area and density and helped enhance soil and water management. This improved knowledge has allowed producers to increase their incomes, and it has enabled the Makete District government to achieve a 64% increase in council revenue for 2009/2010, following the

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collection of royalties from timber sales. The creation of new sources of income triggered the setting up of community savings and credit societies that provide fnancial credits to low-income earners, using their woodlots as sources of collateral. This has promoted inclusive growth, enhanced the number of savings and credit operations among members, and enabled the provision of loans to fnance income-generating activities. What is more, the concrete evidence of these benefts has increased the national government’s interest in expanding climatechange-adaptation measures that improve rural livelihoods and the economy as a whole. Source: UNEP/UNDP Climate Change Adaptation and Development Initiative (CC DARE) – ccdare.org and United Nation (2012)

Biodiversity and its associated ecosystem provide a wide range of services to society that underpin human health, well-being, and economic growth. The OECD (2013) projected a 10% loss in biodiversity by 2050. The OECD (2013) identifed six innovative fnancing mechanisms capable of mitigating these losses:

12.5.1.2 BIODIVERSITY AND ECOSYSTEM FINANCING

• Environmental fscal reforms involve shifting the tax burden from a desirable economic activity onto activities that entail negative environmental externalities. They involve taxation that can broaden fscal revenue while working towards meeting environmental goals. These include taxes charged on natural resources, pollution, and rents that are harmful to the environment. Some of the taxes recently charged include taxes on pesticides, fertilizers, and other sources of emissions (such as NOX, SO2, and CO2 emissions); natural resource extraction; wastewater discharges; and entrance fees to natural parks. • Payments for ecosystem services (PESs) are voluntary programmes that provide incentives to enhance the provision of ecosystem services. PESs provide compensations for individuals and communities whose land use or other resource management decisions infuence the provision of ecosystem services for the additional cost of providing these services. Globally, more than three hundred programmes have been implemented on PESs. Out of this number, about fve PES programmes channel more than USD6 billion per annum. • Biodiversity offsets are instruments designed to allow for the continuation of project development that is found in an overall objective of no net loss of biodiversity. This is done in order to offset or compensate for signifcant adverse effects arising from biodiversity impacts from projects that have been undertaken. This is expected to be carried out at the fnal stage of environmental impact mitigation. • Markets for green products are fnancing sources developed for the sustainable use of biodiversity and the ecosystem (ecotourism and bio-trade). This means that goods have to be produced in a way that

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has a low impact on biodiversity – for instance, timber produced from reduced-impact logging and goods, whose environmental impact is low as a result of reduced pollution load (biodegradable). The idea is that some consumers may decide to buy and even pay premiums to companies that have green products, and this will push such companies and many others to adopt sustainable production methods. In recent times, markets for such products have witnessed considerable growth. • Biodiversity in climate change funding emphasizes how to leverage biodiversity benefts, with huge amounts of funding fowing to climate change mitigation and adaptation. Policymakers can harness mechanisms for reducing emission for deforestation and degradation as well as ecosystem-based adaptations. • Biodiversity in international development fnance provides policymakers with the opportunity to harness synergies and better mainstream biodiversity in broader development objectives. When policymakers are able to brainstorm and provide quality solutions to improve fnance for biodiversity management and conservation, it will contribute more broadly to SDGs, which are crucial to reducing poverty and protecting rural livelihoods. Renewable energy is energy derived from resources that are continually replenished, such as wind, solar energy, and tides. Renewable energy fnance is capital intensive and thus risky for many investors to venture into its production and supply. Because electricity is not generated and stored, its production must be matched by corresponding demand. Most countries or electricity generators use renewable energy sources only in periods of peak demand. Globally, countries are moving from subsidy regimes in both fossil fuels and renewable energy to auctions where the market is allowed to interact with supply and demand forces. Also, corporate bodies wishing to buy green electricity have various options, including installing photovoltaic (PV) panels on their warehouses roofs or in some countries buying renewable energy certifcates, thereby boosting revenues for clean energy plants. According to Frankfurt SchoolUNEP Centre (2017, pp. 33–41), a number of fnancing options are available for renewable energy:

12.5.1.3 RENEWAL ENERGY FINANCE

• Utility-scale renewable power projects are usually fnanced either on balance sheet by a utility, energy company, or large developer or with a mixture of equity and debt provided directly to the project itself. • Institutional investors have become key sources of equity fnance for projects, particularly in recent times, such as by using direct investment by institution in project equity and indirect investment through a pooled vehicle such as a yieldco. For instance, the direct investment institutions such as pension funds and insurance companies have invested an estimated of USD2.8 billion in European renewable energy projects in 2016. Africa and other developing countries provide huge opportunities for renewable energy investment since the population is

Chapter 12 • Financing sustainable development 335

expanding and many more people are drifting towards lower-middleincome status. Investors in renewable energy should take advantage of this development and invest in developing countries. A success story of energy feed-in tariffs in Kenya is illustrated in Box 12.3. This is another story of the energy investment potential in Africa. • Debt consists of the majority of the capital required for renewable energy projects that are funded through project fnance. In developed markets, the project debt level is about 75% to 80% of the cost of an onshore wind installation, and the remainder is through equity fnance. Similarly, a solar project may meet the same debt proportion, while biomass and offshore wind projects will typically get less (i.e. 65% to 70% debt) because of the higher perceived risk.

BOX 12.3 African success stories Renewable energy feed-in tariffs in Kenya Kenya adopted a renewable energy feed-in tariff (REFIT) in 2008, a policy it revised in January 2010. The REFIT aims to stimulate market penetration for renewable energy technologies by making it mandatory for energy companies or utilities to purchase electricity from renewable energy sources at a predetermined price. This price is set at a level high enough to stimulate new investment in the renewable sector. This in turn ensures that those who produce electricity from renewable energy sources have a guaranteed market and an attractive return on investment. Aspects of a REFIT include access to the grid, long-term power purchase agreements, and a set price per kilowatt-hour (kWh). Kenya REFIT covers electricity generated from wind, biomass, small hydro, geothermal, solar, and biogas, with a total electricity generation capacity of 1,300 MW. This policy has the following advantages: 1 It ensures environmental integrity, including the reduction of greenhouse gas emissions. 2 It enhances energy supply security, reducing the country’s dependence on imported fuels and helping it cope with the global scarcity of fossil fuels and its attendant price volatility. 3 It improves economic competitiveness and creates jobs. As Kenya’s greatest renewable energy potential is in rural areas, the effects of the feed-in tariff policy are expected to trickle down and stimulate rural employment. Additional investments could be attracted towards renewable energy in Kenya if the feed-in tariff policy in Kenya acquired a more solid legal status (AFREPEN/WP, 2009). For more information, visit www.unep.org/greeneconomy/ SuccessStories/FeedintariffsinKenya/tabid/29864/Default.aspx.

336 Gordon Abekah-Nkrumah et al.

Loans for solar water heaters in Tunisia The solar water heater market in Tunisia showed a dramatic increase when low interest loans were made available to householders, with repayments collected through regular utility bills. This reduced the risk for local banks while showing borrowers the impact of solar heating on their electricity bills. Prosol – a joint initiative of Tunisia National Agency for Energy Conservation, UNEP, and the Italian Ministry for the Environment, Land and Sea – has helped more than 105,000 Tunisian families get their hot water from the sun, based on loans of over USD60 million, a substantial leverage on Prosol’s initial USD2.5 million cost. Its success has led the Tunisian government to set an ambitious target of 750,000 m2 of solar panels for 2010–2014, a goal that represented solar coverage comparable to that in Spain or Italy, countries with populations several times larger than Tunisia’s. Many jobs have been created, as 42 suppliers and more than a thousand installation companies have sprung up to service the solar market. The tourism and industry sectors are also involved, with 47 hotels engaged as of late 2009, and there are plans to encourage the industry sector to make greater use of the sun’s energy. A project is underway to make photovoltaic energy available to a further ffteen thousand households through a similar loan and repayment scheme. For more information, visit www.unep.org/unite/30ways/ story.aspx?storyID=49. Source: United Nation (2012)

12.5.1.4 GREEN BONDS Green bonds are differentiated from regular bonds by their label, which signifes a commitment to use the fund exclusively to fnance projects, assets, or business activities (ICMA, 2015). Therefore, a green bond is a bond that is issued for fnancing green infrastructure and for green investments. According to the OECD (2017) and Inderst, Kaminker, and Stewart (2012), a green infrastructure system can be considered low carbon and climate resilient (LCR). The green bond market is rapidly growing, with an annual issuance of green bond tripled from USD11 billion in 2013 to reach USD36.6 billion as of 2014. According to the OECD (2017), green bonds are categorised into six distinct forms that can be issued by different entities:

• Corporate bond – a ‘use of proceeds’ bond issued by a corporate entity with recourse to the issuer in the case of default on interest payments or on return of principal. This category includes bonds issued by ‘yieldco’ vehicles (an investment vehicle formed by a parent company to own operating assets). They are known as synthetic Master limited partnerships (MLPs). Yieldco vehicles pay corporate-level taxes, unlike MLPs, which get a tax pass to fnance asset acquisitions.

Chapter 12 • Financing sustainable development 337

• •

•

• •

Yieldco vehicles are often issued in the energy sector to raise more funds to fnance renewable energy activities. Project bond – a bond backed by single project or multiple projects for which the investor has direct exposure to the risk of the project, with or without recourse to the bond issuer. Asset-backed security (ABS) – a bond collateralised by one or more specifc projects, usually providing recourse only to the assets, except in the case of covered bonds (included in this category). For covered bonds, the primary recourse is to the issuing entity, with secondary recourse to an underlying cover pool of assets, in the event that the issuer defaults. Supranational, subsovereign, and agency (SSA) bond – a bond issued by international fnancial institutions (IFIs) such as the World Bank or the European Investment Bank (i.e. ‘supranational issuers’). SSA bonds have features similar to a corporate bond relating to ‘use of proceeds’ and recourse to the issuer. Agency bonds are included in this category (e.g. issuance by export-import banks), as are subsovereign national development banks (e.g. the German KfW). Municipal bond – a bond issued by a municipal government, region, or city. A national government entity could theoretically also issue a ‘sovereign’ bond; no green sovereign bonds have been issued to date. Financial sector bond – a type of corporate bond issued by a fnancial institution specifcally to raise capital to fnance on-balance sheet lending (i.e. to provide loans) for green activities (e.g. ABN AMRO or Agricultural Bank of China).

12.5.2 Private sector fnance Private sector fnance is the type of fnance obtained from private sector sources of fnance. These fnancing sources are drawn and used to fnance development projects, and they include responsible private fnance and blended fnance. PRIVATE FINANCE The essence of responsible fnance is to outline standards to ensure that lending and investments actively deliver positive development outcomes. In a responsible fnance, there are three key primary actors that work together to ensure that responsible fnance is achieved in any economy. These include the government, which provides consumer protection and regulation; fnancial intermediaries; and clients themselves, who need to possess a certain degree of fnancial literacy.  The Great Recession of the 1930s and the recent global fnancial crises of 2008–2009 left lasting scars on the global fnancial system and have had protracted impacts on the poor across the world. Financial infows to developing countries are increasing, as are the outfows. This calls for urgent attention that needs the work of the government, fnancial intermediaries, and clients as a whole. For instance, fnancial infows from developing countries for responsible fnance include net FDI to developing countries, new loans to developing countries, developing countries migrant remittances,

12.5.2.1 RESPONSIBLE

338 Gordon Abekah-Nkrumah et al.

and global ODA. Also, outfows include developing countries debt service, proft remittances on FDI, and illicit fnancial fows (Molina, 2011). Blended fnance is one of the complementary tools used by the International Finance Corporation (IFC) to create markets and foster development impact. According to the IFC (2017), ‘blended fnance refers to a fnancing package comprised of concessional funding provided by the development partners and commercial funding provided by IFC and co-investors’. These types of funding are provided for projects with a high-impact factor, especially to society, the environment, and the ecosystem. This is because such projects do not attract funding on a commercial basis, given that the returns from these projects are not commensurate with the level of risk. Since development projects need different funds at various stages of their completion, it is prudent to use blended fnance to avoid the risk of delay in fnancing the projects. The IFC uses a number of fnancial instruments for blended fnance. These include risk mitigations/ guarantees, concessional debt (senior and mezzanine), equity (direct investments and private equity), and performance-based incentives. The IFC (2017) had earmarked four priority areas for blended fnance, which follow:

12.5.2.2 BLENDED FINANCE

• The Global Agriculture and Food Security Program (GAFSP) is a private sector window that targets countries with the highest rates of poverty and hunger. The essence of this programme is to provide support in the form of short-term and long-term loans, credit guarantees, and equity to support smallholder farmers and small and medium enterprises (SME) farmers so as to enhance productivity growth, create, and deepen links in the market space and increase the capacity and technical skills of these business owners. • Blended climate fnance includes investment in renewable energy, energy effciency, climate-smart agriculture, clean technology, and adaptation that would otherwise not be funded by the private sector. The private sector will view this kind of investment as too risky to venture into. The concessional fnancing vehicle paves the way for fnancing on complete commercial terms because the viability of these projects will make it a proftable venture for the private sector to engage in. • The Global SME Finance Facility supports SMEs that are women based. They include SMEs from fragile and confict areas, those in education and healthcare and companies that are located in the rural markets. IFC uses blended fnancing to increase access to fnance for marginalized businesses in the form of loan guaranteeing as well as deepening fnancial intermediation in those markets. • The IDA 18 IFC-MIGA Private Sector Window (IDA-PSW) is a new fnancing tool used for crowding in private sector investment in the lowest-income, post-confict, and fragile states that do not have a commercial solution or where no other IFC or MIGA tool can be used. For instance, an allocation of USD2.5 billion from World Bank support will enable private sectors working with IFC or MIGA to take risks at a level that is commensurate with returns to promote sustainability. A three-year pilot has been earmarked that started 1 July 2017 and goes

Chapter 12 • Financing sustainable development 339

until July 2020. The aim is to increase private sector capital investments in large-scale infrastructure and public–private partnerships and across all sectors, such as manufacturing, education and health, SMEs, climate fnance, and technology. The fnancial instruments used include loans, equity, guarantees, and local currency solutions. 12.5.3 Innovative sources of fnance for sustainable development Apart from the various sources discussed, there are different innovative sources of fnancing sustainable development. These include international fnance facility, IMF special drawings rights, global lottery, and global taxes. International fnance facility (IFF) was frst proposed by the Her Majesty’s Treasury (HM Treasury), also referred to as the exchequer, in conjunction with the Department for International Development of the UK. IFF was designed to frontload aid to help MDGs. In this facility, bonds were issued to the global capital markets against the security of government guarantees in order to maintain future aid fows, which will be used to buy back the bonds over a long period of time. This idea was used by France and other European countries in 2006 to fnance immunization in the International Finance Facility for Immunization (IFFm). It was initiated to rapidly accelerate the availability and predictability of funds for immunization. The IFFIm sells bonds, offcially called the vaccine bonds, to raise funds on the capital markets for the GAVI Alliance, a public–private partnership, which works to save children’s lives and protect people’s health by increasing access to vaccination in developing countries.  Box 12.4 describes the detailed information regarding how GAVI raises funds through the use of IFFIm.

12.5.3.1 INTERNATIONAL FINANCE FACILITY

BOX 12.4 GAVI Vaccine Alliance IFFIm GAVI, the Vaccine Alliance, fnances vaccine programmes in low-income countries. In 2006, GAVI recognized that to reach high vaccine coverage levels as soon as possible, signifcantly more funds were needed than were available. In response, the British Department for International Development, the Gates Foundation, United Nations Children’s Fund, and the fnancial services industry created the independent charity, the International Finance Facility for Immunization (IFFIm). Between 2000 and 2015, two-thirds of GAVI’s funding (i.e. USD11.6 billion), came from donations by governments. Every fve years, governments pledged to donate a certain amount and then make regular payments to GAVI. IFFIm enables governments to make a legally binding long-term commitment to IFFIm – for example, an annual payment of USD20 million for 20 years, instead of donating directly to GAVI. Next, IFFIm creates bonds – that is, a type of long-term loan to the value of the total amount committed by governments (in this example,

340 Gordon Abekah-Nkrumah et al.

USD400 million). International investors then buy these bonds, thus immediately providing IFFIm with USD400 million. GAVI will have access to these funds by applying to IFFIm. IFFIm pays back bondholders over time with the annual payments from the governments. The proposed beneft of IFFIm was to make the money from future donations available immediately, so that vaccine programmes could be scaled up to reach the goal of herd immunity earlier. However, there are two costs involved in this fnancing mechanism. First, the administration costs of IFFIm have been estimated at between 4.1% and 4.6% of the pledged amount over the 20-year duration of the current commitments. Between 2010 and 2014, these costs averaged USD115 million per year, the World Bank acting as treasury manager. The second cost is the payment of interest to bondholders, which is diffcult to calculate because it depends on currency and market conditions. Between 2006 and 2014, IFFIm has received in total USD6.5 billion of long-term commitments from ten donor governments and has raised USD5 billion for GAVI through selling bonds (the difference of USD1.5 billion is held by IFFIm to reduce fnancial risk). Thus, IFFIm has provided around a third of GAVI’s funding to date. GAVI also receives funding (USD1.5 billion) from the advanced market commitment, which was an agreement by GAVI donors to pay for the creation of a new pneumococcal vaccine. In the January 2015 pledging event to secure funds for GAVI for 2016–2020, GAVI requested USD1 billion to be committed through IFFIm. However, only USD252 million in new commitments were made by France and the Netherlands. In contrast, GAVI received all the USD7.5 billion that it had requested, through direct donations. The change in funding profle compared to the last round reduction of funds pledged through IFFIm has been described by credit ratings agencies as a result of the diminishing policy importance of IFFIm for the future fnancing of GAVI’s immunization programmes. Source: Crocker-Buque and Mounier-Jack (2016)

12.5.3.2 IMF SPECIAL DRAWING RIGHTS Special drawing rights (SDRs) are international reserve assets created by the IMF in 1969 to supplement its member countries’ offcial reserves. In other words, it is like a global currency maintained by the IMF. As of September 2017, 204.2 billion SDRs (equivalent to about USD291 billion) had been created and allocated to members (IMF, 2017). SDRs can be exchanged for freely usable currencies. The value of the SDR is based on a basket of fve major currencies: the US dollar, the euro, the Chinese renminbi (RMB), the Japanese yen, and the British pound sterling (IMF, 2017). The IMF borrows money at 0.05% from member countries and lends at 1.05% to member countries that need the funds. Since the IMF accumulates the funds through the interest payments, a special account can be created from this fund to support fnancing

Chapter 12 • Financing sustainable development 341

sustainable development goals. Countries normally leverage on SDR for the purpose of export so that they can help their export partner countries’ currencies appreciate by buying a corresponding amount of SDR in their currency. This helps their exporters receive a good deal for their export commodities. The IMF can charge extra fees on this kind of arrangement to support sustainable development fnance. Additionally, developing countries are the countries that most suffer climate change problems. SDRs will serve as a lower cost reserve for them. The gain could be used to fnance sustainable development, because countries would not have to borrow from other countries or the international fnancial markets at a higher cost so as to shore up their reserves. Furthermore, developed countries could take the SDRs they receive and donate it to nongovernmental organization (NGO) programmes that support sustainable development and climate change– related activities (Herman, 2013). The development SDRs would be grants that the awarded NGOs would convert into hard currency at their national central bank, whose SDR holdings would thus increase at the expense of the hard currency paid to the NGOs (Soros, 2002, pp. 181–186). This is a corporation which designs and markets lottery and pari-mutual systems to government, lottery operators and parimutual operators worldwide. There are three categories of draw-based games. These are instant games, sports games (pari-mutual), and sports games (fxed odds). Huge revenues can be mobilized from lottery to sustainable development fnance. Also, the World Lottery Association (WLA, 2014) should vote on part of this revenue to fnance climate change and other biodiversity and ecosystem activities. We argue that if on an incremental basis, the lottery amount could continue to increase by approximately 4%, such a percentage should be charged for sustainable development fnance on the total lottery amount generated.

12.5.3.3 GLOBAL LOTTERY

12.5.3.4 GLOBAL TAXES Taxes are an important source of revenue generation for countries. In recent times, a number of innovative taxes have come on stream to help fnance government expenditure. In most developed countries, innovative taxes such as a currency transaction tax, a carbon tax, an international air transport tax, and an arms export tax serve as key sources of raising fnance (Kapoor, 2004; Brzoska, 2017). In scaling up fnancing mechanisms for fnancing sustainable development, developed countries need to allocate part of these funds to the developing world to help fnance sustainable development.

12.5.4 Financing health We here discuss mechanisms that are specifc to fnancing health. Both domestic and international sources of funds will play a crucial role in achieving the health-related SDGs. For a long time, the health systems of many developing countries relied on international sources of funds for supporting the delivery of health services. However, in many countries, domestic resources make a major contribution to the fnancing of healthcare. For example, data available from the World Development Indicators (WDI) suggest that domestic general

342 Gordon Abekah-Nkrumah et al.

government health expenditure as a percentage of current health expenditure in low-income countries (LICs) was 19.61% in 2015, a reduction of 8.75% from the 2000 fgure of 28.36%. For the same period, domestic private health expenditure as a percentage of current health expenditure reduced by 8.22% from the 2000 fgure of 58.78% to 50.56% in 2015. This implies that domestic resources contributed 87.14% and 70.17% to total health expenditure in 2000 and 2015 respectively. The reality in LICs is not entirely different from that of lower-middle-income countries (LMICs). Data available from WDI equally indicate that the contribution of domestic resources (domestic general government health expenditure as a percentage of current health expenditure and domestic private health expenditure as a percentage of current health expenditure) to total health expenditure was 97.12% in 2000 and 96.42% in 2015. Domestic resources come from one revenue or a combination of general revenues, social health insurance (SHI) voluntary private health insurance (VPHI), community health insurance schemes (CHIS), and out of pocket payments (OOPP). The contributions of the various sources as a percentage of the total current health expenditure vary depending on the nature and income level of a particular country, as shown in Table 12.3.

TABLE 12.3 Percentage contribution of different health fnancing sources to current health expenditure in 2015 Country

SHI%

VFM%

Benin Burkina Faso Cabo Verde Central African Republic Côte d’Ivoire Ethiopia Ghana Kenya Nigeria Rwanda Bolivia Guatemala Honduras Egypt Morocco Kyrgyzstan Moldova Bangladesh India Indonesia Myanmar Mongolia Philippines Vietnam

2 – 19 – 1 – 9 4 1 3 28 16 12 5 11 6 40 – 3 14 – 19 14 22

53 47 26 77 79 55 45 61 74 42 31 66 55 70 56 54 51 82 75 68 76 43 68 50

VPHI% 5 3 1 1 9

– –

3

– –

3 4 5 1 1

– –

8 5 4

– – 13 1

OOPP% 40 36 19 40 36 52 36 54 72 26 26 56 49 62 53 48 46 72 65 65 74 39 54 43

Source: Data from the WHO National Health Account (NHA) for 2015 Note: SHI is short for social health insurance; VFM is short for voluntary fnancing mechanism

Chapter 12 • Financing sustainable development 343

• General revenues generally come from taxes (income and proft taxes, value-added and sales taxes, taxes on imports, and taxes on  profts from the sale of natural resources) that may either be direct or indirect and paid to the national treasury and disbursed through the budget system to provide social services such as health. The mix of taxes deployed in each country is a matter of choice and also based on the circumstance of each country. Also, the revenue-raising capacity of taxes is correlated with income levels and the structure of the economy. Thus, LMICs with relatively large informal sectors tend to raise less from taxes than do high-income countries (HICs) with a large formal sector. The contribution of tax revenue to total health expenditure depends on the contribution of taxes to aggregate income. The informal nature of the economy of developing countries implies relatively lower contribution of taxes to general government revenue and therefore allocation to the health sector. For example, data from WDI suggest that tax revenue as a percentage of GDP in LMICs was 12.03% in 2015 compared to 15.31% for HICs. • Social health insurance (SHI) is a fnancing mechanism that is based on a defned contribution (premium) for a specifed package of benefts for a specifed period. The uniqueness of social health insurance is the fact that enrolment and payment of premium constitute a social contract between the enrolee and the social health insurance organization, the terms of which are coded in law and therefore cannot be changed. As a result, SHI funds are mostly earmarked and therefore not mixed with general government revenue. Unlike private health insurance, SHI is often compulsory and administered by either the government or a government agency. An advantage of SHI is that it has a greater potential to provide effective risk coverage, in addition to the fact that the intended transparency can improve potential contributors’ willingness to contribute to the fund. The downside of SHI is that it may not cover the entire population, especially those outside of the formal sector and the fact that it may increase real labour cost, especially if employers treat the SHI premium as a labour cost. Given that SHI tends to be treated as some form of tax and collected using formal channels, the contribution of SHI to overall health spending tends to be related to the structure (formal versus informal) of the economy. Thus, the contribution of SHI to the health budget tends to be low in LICs (see Table 12.3). • Under a voluntary private health insurance (VPHI) scheme, individuals voluntarily buy a health insurance policy from private organizations that operate in a competitive market and at a price (premium) that refects the risk of the buyer rather than the ability of the buyer to pay. The advantage of VPHI is that it constitutes an additional to revenue generated either through general revenues or SHI. Major challenges associated with VPHI include the possibility of risk selection, higher cost of operation (leading to increased premiums), and the possibility that it will cover fewer people than SHI will. The size of VPHI in developing countries tends to be small given that VPHI premiums

344 Gordon Abekah-Nkrumah et al.

tend to be high compared to average income levels in developing countries. The data in Table 12.3 confrm the relatively low levels of VPHI’s contribution to total health spending. • Community-based health insurance (CBHI) schemes are seen as alternatives that deal with the shortcomings of other fnancing mechanisms, such as VPHI and SHI, which have the tendency to focus on the higher cost but less frequent use of health services. CBHI schemes are normally operated and fnanced by community members who voluntarily make defned contributions for a package of health services (primary as well as higher-level care). Providers of health services within CBHI schemes are normally entities hired by the community or NGOs that are in the business of providing healthcare services. The advantage of the CBHI schemes is that the community control of the scheme can engender transparency and accountability and hence motivate community members to enrol in the scheme. The downside, however, is that the voluntarily nature may mean that fewer people enrol and may create viability and sustainability issues for such small risk pools. • Out of pocket payments (OOPPs) or user fees are direct payments made by individuals or groups using health services, which are not reimbursable. Out of pocket payment may range from offcial fees (payment for services, medications, deductibles, and copayments) to unoffcial payments for services that may not be available at the healthcare facility visited by the user. OOPPs normally constitute a large proportion of funds available for providing health services in LICs. The poor nature of health systems and health fnancing mechanisms in developing countries makes OOPPs a major option in many countries. According to Table 12.3, OOPPs tend to contribute a substantial proportion of the total current spending on health. Besides domestic resources, external sources of funds normally referred to as development assistance for health (DAH), though relatively small compared to domestic resources, still play a crucial role in the delivery of healthcare in developing countries. The levels of DAH to developing countries have evolved over the last two decades. Estimates from the Institute for Health Metrics and Evaluation (IHME) suggest that the period from 1990 to 2017 saw an increase in DAH from USD7,554 million in 1990 to USD37,421.62 million in 2017 in nominal terms. The estimates in Table 12.4 show trends in DAH over the last decade. • Bilateral agencies represent nation states and are used as channels to disburse external resources to recipient countries. Examples of such agencies include USAID, DFID, DANIDA, JICA, CIDA, GTZ, for the United States, United Kingdom, Denmark, Japan, Canada, and Germany respectively. The United States tends to be the biggest bilateral contributor to DAH. The estimates in Table 12.4 for bilateral agencies represents contributions from some 24 countries, including contributions from the European Union as an agency. Among the 24 countries, the United States is the largest contributor to DAH. The estimates

70.757 41.06 12.94 11.46 27.66 40.46 20.41

Total DAH (USD billions) Bilateral agencies (%) United Nations (%) PPPs (%) NGOs & foundations (%) World Bank (%) Regional dev. banks (%)

90.368 35.14 13.07 12.33 31.15 60.11 20.20

2009 11.666 28.93 13.73 13.05 34.45 80.26 10.57

2010 12.390 31.63 13.53 11.25 34.81 70.54 10.23

2011 12.866 30.76 11.88 14.67 36.23 50.37 10.09

2012 14.001 29.36 12.01 15.61 34.99 50.88 20.14

2013 13.322 30.61 12.96 13.21 36.73 30.71 20.77

2014

Note: *2017 fgures are preliminary estimates; PPPs is short for public–private partnerships

Source: Constructed by authors from data from Micah, Dieleman, and Chang (2017) Financing Global Health database

2008

 

12.782 26.35 15.46 14.95 35.71 40.59 20.94

2015

TABLE 12.4 Trends in DAH from 2008 to 2017 in billions USD and component contributions in percentages

12.416 30.06 13.57 14.25 35.10 40.42 20.60

2016

11.959 29.00 13.46 16.14 35.44 40.16 10.80

2017*

Chapter 12 • Financing sustainable development 345

346 Gordon Abekah-Nkrumah et al.

•

•

•

•

also suggest that the contribution of bilateral agencies to total DAH is declining but remains the largest proportion of DAH. Multilateral organizations have become channels through which countries transfer DAH. Although these agencies constitute channels for delivering DAH, in some instances they also play actives roles in the implementation of programmes and interventions. Examples of multilateral agencies include United Nations agencies such the World Health Organization (WHO), United Nations Children’s Fund (UNICEF), United Nations Population Fund (UNFPA), and World Food Programme (WFP). In 2012, UNICEF and UNFPA alone contributed around USD2.8 billion to DAH through the UN system. The estimates from Table 12.4 suggest that multilateral agencies make the third largest contribution to DAH after bilateral agencies, NGOs, and foundations. Public–private partnerships (PPPs) are contribution channels developed out of collaborations from private and public institutions and are thus referred to as public–private partnerships. Major institutions in this space are the Global Alliance for Vaccines and Immunization (GAVI) and the Global Fund for HIV/AIDS, Tuberculosis, and Malaria (GFATM). The contribution of these two organizations to total DAH has increased steadily from 11.46% in 2008 to 16.14 %in 2017. NGOs and foundations are international NGOs and foundations of private individuals and corporations such as the Bill and Melinda Gates Foundation and the Clinton Foundation. Within the past ten years, a major contributor in this space has been the Bill and Melinda Gates Foundation. The estimates in Table 12.4 suggest that contributions from NGOs and foundations are the second-largest contributors to total DAH, after those from bilateral agencies. World Bank and regional development banks also contribute to DAH. Regional development banks include the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA) as well as other regional development banks such as the African Development Bank and the Asian Development Bank. Contributions from these banks come in the form of loans or grants to recipient governments, either for capacity or for infrastructure development. The World Bank and the other regional development banks make the least contribution to total DAH, as per estimates available for the past ten years. Unlike the other DAH channels, the contributions of the World Bank and the other development banks have been fuctuating.

12.6 CONCLUSION The MDGs constituted a concrete practical attempt to bring meaning to the United Nations charter, which in principle seeks to promote development in peace, on the basis of respect for human rights and the rule of law. The eight goals constituted an important frst step that galvanized the

Chapter 12 • Financing sustainable development 347

nations of the world towards a common purpose and the belief that a good international formula/solution also has benefts. Clearly, a lot of progress was made in developing countries with respect to the attainment of the eight MDGs, especially in the areas of poverty and education in regions such as sub-Saharan Africa and Asia. Notwithstanding the progress made with the MDGs, it is equally the case that a lot of work needs to be done to ensure broad-based development, especially in areas such as maternal health, energy environment, transportation, urbanization, migration, agriculture, and industrialization. Thus, the SDGs, the successor of the MDGs, are a more broad-based, comprehensive, and ambitious attempt to move the wheels of development towards the vision of development in peace with respect for human rights and the rule of law. The realization of the SDGs will depend on the extent to which nation states, especially developing ones, are able to operationalize and refect actions aimed at achieving the goals in their respective development plans. This will require an inclusive and broad-based participatory approach involving strong leadership from government and the participation of knowledgeable citizens, civil society, academia, the private sector, and international partners that understand the goals and can advocate for and insist on practical actions to achieve them. Even more important is the issue of how to fnance the implementation of the SDGs. Traditionally, development fnancing has emphasized the use of ODA. However, current ODA levels (estimated to be USD135 billion per annum) are way below what is needed to fnance the SDGs. Besides, the current levels of ODA may even reduce due to budgetary constraints arising from contraction in the economies of those countries most likely to give ODA. There must therefore be a shift of emphasis from the reliance on ODA as a major source of fnancing development to public resources and private fnancing. It is indeed a challenge to advocate for additional public resources for development in countries such as those in SSA and South Asia, where budgets are fnanced mainly by ODA. However, for some developing countries, especially those in the middle-income bracket (lower-middle and upper-middle income), there are opportunities to improve domestic resource mobilization through the implementation of reforms that will improve the effectiveness of revenue mobilization systems and the effciency (allocative and technical) of resource use. At the revenue mobilization level, emphasis should be on reforms that will help to formalize the large informal sector and therefore help to identify such operators for the purposes of raising tax revenues from their operations. In many developing countries especially those in SSA and South Asia, a reliable and effective national identifcation and public system is important to move closer to formalizing the informal sector. Additionally, rapid innovations in mobile telephony could be a solution to formalizing transactions that take place in the informal economy. These measures could go a long way to broadening the tax net and thereby increasing domestic public resources available for development. In countries where the tax depth is low, there could be opportunities to increase the effective tax rate. This

348 Gordon Abekah-Nkrumah et al.

option may, however, not be popular among policymakers, given that it may incur serious political costs, especially for the ruling coalition. On the issue of effciency, reforms that seek to tighten and close loopholes in public procurement and fnancial management and administration can reduce corrupt practices, and savings therefrom can be channelled into fnancing development. Besides public resources, the private sector can play a major role not only in the capital they can make available but also in the innovative solutions they can bring to the overall strategy for the implementation of the SDGs, as indicated in the Addis Ababa Action Agenda. The emphasis on private capital is even more important given that there are large pools of private capital in the developed world that hardly yield decent returns at a time when there is the need for capital for long-term investments in developing countries. The argument that has been made in the development discourse is that the excess supply of private capital in the developed world and the demand for this in developing countries create a unique opportunity for the fow of private capital to developing countries to fnance projects that will yield decent returns. The challenge, however, is that the level of risk in most of these developing countries is so high and may therefore constrain the fow of private capital. ODA can play a major role in this direction not just in providing development fnance but also in unlocking private capital by leveraging the risk that owners of private capital face in developing countries. Additionally, multilateral development banks, such as the World Bank, IMF, and regional development banks can develop new approaches that will help leverage risk in developing countries and thereby improve the capacity of developing countries to mobilize the needed resources for fnancing development. The success of both the implementation and fnancing of frameworks will depend on the level of inclusiveness and strong coordination and collaboration among governments, think thanks, academia, the scientifc community, civil society, the private sector, the United Nations, and MDBs.

Discussion questions 1 Provide an overview of sustainable development, detailing the evolution of the concept of sustainable development. 2 Discuss the challenges that affect fnancing for sustainable development? In your opinion discuss the opportunities available to address these challenges? 3 There are a number of fnancing mechanisms available for sustainable development. What are some of these fnancing mechanisms?

What are some of the weakness with these fnancing vehicles? 4 In which ways can these fnancing vehicles be used to address the challenges identifed? 5 What benefts do you think developing countries can derive from using innovative sources of fnancing for sustainable development? 6 Discuss the sources of fnancing health in developing countries.

Chapter 12 • Financing sustainable development 349

References AFREPEN/WP. (2009, September). The role of feed-in tariff policy in renewable energy development in developing countries. Retrieved from https://agoraparl.org/node/8953 Boucher, L. (2015). Sustainable development goals vs. millennium development goals: What you need to know. Retrieved from https://populationeducation. org/sustainable-development-goalsvs-millenniumdevelopment-goalswhat-you-need-know/ Brundtland, G. H. (1985). World commission on environment and development.  Environmental Policy and Law, 14(1), 26–30. Brundtland, G. H. (1987). Our common future. World Commission on Environment and Development (The Brundtland Report). Oxford: Oxford University Press. Brzoska, M. (2017). Core issues of an arms trade tax. Retrieved from www.sipri. org/sites/default/files/201709/participant_refection_arms_trade_tax.pf Coonrod, J. (2014, August 8). MDGs to SDGs: Top 10 differences. Retrieved from https://advocacy.thp.org/2014/ 08/08/mdgs-to-sdgs/ Crocker-Buque, T., & Mounier-Jack, S. (2016). The international fnance facility for immunisation: Stakeholders’ perspectives. Bulletin of the World Health Organization, 94(9), 687. DESA. (2013). Sustainable development challenges. World Economic and Society Survey. Retrieved from https:// sustainabledevelopment.un.org/content/documents/2843WESS2013.pdf Frankfurt School-UNEP Centre. (2017). Global trends in renewable energy investment. Retrieved from http://fsunepcentre.org/sites/default/fles/ publications/globaltrendsinrenewableenergyinvestment2017.pdf Frankfurt School-UNEP Centre. (2018). Global trends in renewable energy investment. Retrieved from www.google. com/search?client=safari&rls=en&q= global+trends+in+renewable+energy

+investment+2018+report&ie=UTF-8 &oe=UTF-8 Herman, B. (2013). Half a century of proposals for ‘innovative’ development fnancing. New York: United Nations, Department of Economic and Social Affairs. ICMA. (2015, March). Green bond principles: Voluntary process guidelines for issuing green bonds. Retrieved from https://www.icmagroup.org/greensocial-and-sustainability-bonds/ green-bond-principles-gbp/ IFC. (2015). Blending donor funds for climate-smart investments. Retrieved from www.ifc.org/climatebusiness IFC. (2017). Blended fnance at international fnance corporation. Retrieved from www.ifc.org/wps/wcm/connect/4 5c23d804d9209fab2f8b748b49f4568/ Blended-fnance-Factsheet-May2017. pdf?MOD=AJPERES IMF. (2017). Special drawings right (SDR). Retrieved from www.imf.org/external/np/exr/facts/sdr.htm Inderst, G., Kaminker, C., & Stewart, F. (2012). Defning and measuring green investments: Implications for institutional investors’ asset allocations. OECD Working Papers on Finance, Insurance and Private Pensions No. 24. Paris: OECD Publishing. doi:10.1787/ 5k9312twnn44-en Kapoor, S. (2004). The currency transaction tax: Enhancing fnancial stability and fnancing development.  Tobin Tax Network. Retrieved from https://www. stampoutpoverty.org/wf_library_ post/the-currency-transaction-taxenhancing-financial-stability-andfnancing-development/ Micah, A., Dieleman, J., & Chang, A. (2017). Financing global health 2017: Funding universal health coverage and unfnished HIV/AIDS agenda. Retrieved from www.healthdata.org/policy-report/ fnancing-global-health-2017 Molina, N. (2011). Responsible Finance Charter. https://slettgjelda.no/assets/ docs/Eurodad-Responsible-FinanceCharter-2011.pdf

350 Gordon Abekah-Nkrumah et al. National Development Planning Commission. (2015). Ghana millennium development goals 2015 report. Retrieved from https://www.gh.undp.org/ content/ghana/en/home/library/ poverty/2015-ghana-millenniumdevelopment-goals-report.html OECD. (2012c). The OECD Environmental Outlook to 2050. Key Findings on Climate Change. https:// www.oecd.org/env/cc/Outlook%20 to%202050_Climate%20Change%20 Chapter_HIGLIGHTS-FINA-8pagerUPDATED%20NOV2012.pdf OECD. (2013). Scaling-up fnance mechanisms for biodiversity. Retrieved from www.oecd.org/env/resources/OECD% 20Finance%20for%20Biodiversity% 20[f]%20[lr]%20WEB%20SM.pdf OECD. (2017). Green bonds; mobilising the debt capital markets for a lowcarbon transition. Policy Perspectives. Retrieved from www.oecd.org/environment/cc/Green%20bonds%20 PP%20[f3]%20[lr].pdf Polèse, M. (2009). The wealth and poverty of regions: Why cities matter. Chicago: The University of Chicago Press. Satterthwaite, D. (1992, October). Sustainable cities: Introduction. Environment and Urbanization, 4(2), 3–8. Schmidt-Traub, G., & Sachs, J. (2015). Financing sustainable development: Implementing the SDGs through effective investment strategies and partnerships. United Nations Sustainable Development Solutions Network (UNSDSN). Retrieved from http://unsdsn.org/ wp-content/uploads/2015/04/ 150619-SDSN-Financing-SustainableDevelopment-Paper-FINAL-02.pdf Shaker, R. R. (2015). The spatial distribution of development in Europe and its underlying sustainability correlations. Applied Geography, 63, 304–314. doi:10.1016/j.apgeog.2015.07.009 Soros, G. (2002). George Soros on globalization. New York: Public Affairs. Sustainable Development Goals. (n.d.). Retrieved June 18, 2018, from www.

undp.org/content/undp/en/home/ sustainable-development-goals/ background.html United Nation. (2012). Green economy in the context of sustainable development and poverty eradication: What are the implications for Africa? Retrieved from https:// www.greengrowthknowledge.org/ sites/default/files/downloads/ resource/Green_Economy_What_Are_ The_Implications_For_Africa_UNEP_ UNECA.pdf UN News Centre. (2015, December 30). Sustainable development goals kick off with start of new year. Retrieved from www. un.org/sustainabledevelopment/ blog/2015/12/sustainable-development-goals-kick-off-with-start-of-newyear/ World Lottery Association. (2014). The WLA global lottery data compendium: An annual review of the lottery industry based on data from WLA members. Retrieved from http://eldiario.deljuego.com. ar/images/stories/Notas/00__2014/ WLA_Compendium_2014.pdf World Travel and Tourism Council. (2009). Travel and tourism economic impact, sub-Saharan Africa. London: Author.

Online sources www.greengrowthknowledge.org/ sites/default/files/downloads/ resource/Green_Economy_What_ Are_The_Implications_For_Africa_ UNEP_UNECA.pdf www.oecd.org/env/cc/Outlook%20 to%202050_Climate%20Change%20 Chapter_HIGLIGHTS-FINA-8pagerUPDATED%20NOV2012.pdf www.sd-commission.org.uk/pages/ history_sd.html www.unep.org/greeneconomy/SuccessStories/FeedintariffsinKenya/ tabid/29864/Default.aspx www.unep.org/unite/30ways/story. aspx?storyID=49

CHAPTER

13

International trade, fnance, and development Steven Brakman and Charles van Marrewijk 13.1 INTRODUCTION When (developing) countries trade with other countries, they are confronted about fnancial interactions and forces that affect the way they do business and limit the possibilities and effectiveness of certain types of policies. The power of these fnancial forces is enormous. According to the Bank of International Settlements (BIS, 2019), the daily turnover on fnancial markets for all instruments on a net-net basis in April 2019 was USD6.6 trillion, which is equivalent to about 8% of the total world income in one year.1 In this chapter, we briefy discuss the main interactions, forces, limitations, and possibilities of trade with other countries. We start in section 13.2 by discussing the main aspects of exchange rates, the price of one currency in terms of another. In section 13.3, we emphasize the importance of forward-looking markets for understanding the power of fnancial forces. These aspects are combined in section 13.4, where we discuss covered and uncovered interest rate parity, which is crucial for understanding the possibilities and limitations of monetary policy, as explained in section 13.5. Using this theoretical basis, in section 13.6 we review the main policy choices made in recent history up to this day. Next, we turn our attention in section 13.7 to the practical issues of trade fnancing and trade fnancing gaps. Section 13.8 covers the practical issues of international (vehicle) currencies. We conclude in section 13.9 with a brief discussion of fnance, investment, and development and provide a summary in section 13.10.

13.2 EXCHANGE RATES In international trade fows, the exporters and importers at some point in time are confronted with exchange rates when they have to exchange goods or services valued in one currency in exchange for another currency. An exchange rate is a price, namely the price of one currency in terms of another currency. This price is determined simply by supply and demand in the foreign exchange market. As there are many countries with convertible currencies, there are many exchange rates, such as the exchange rate

352 Steven Brakman and Charles van Marrewijk

of a Singapore dollar in terms of European euros or the exchange rate of a Japanese yen in terms of British pounds. Since the exchange rate is a price, a rise in the exchange rate indicates that the item being traded has become more expensive, just like any other price rise indicates. Therefore, if the exchange rate of a Singapore dollar in terms of European euros rises, this indicates that the Singapore dollar has become more expensive. Various specialized symbols have been introduced to identify specifc currencies, such as US$ to denote (US) dollars, € to denote European euros, £ to denote (British) pounds, and ¥ to denote Japanese yen or Chinese yuan. Table 13.1 lists some of these international currency symbols and the three-letter international standard (ISO) code to identify the currencies. As will be discussed later on, there are various types of exchange rates, but we frst focus on the spot exchange rate, the price of buying or selling a particular currency at this moment. Table 13.2 lists some spot exchange rates as recorded on 3 December 2019, at 11:55:00 a.m. (UTC + 01:00).2 The fact that we have to be so precise by listing not only the day on which the spot exchange rates were recorded but also the exact time and the time zone TABLE 13.1 Some international currency symbols Country

Currency

Symbol

ISO code

Australia Canada China EMU countries India Iran Japan Kuwait Mexico Saudi Arabia Singapore South Africa Switzerland United Kingdom United States

dollar dollar yuan euro rupee rial yen dinar peso riyal dollar rand franc pound dollar

A$ C$ ¥ € Rs RI ¥ KD Ps SR S$ R SF £ US$

AUD CAD CNY EUR INR IRR JPY KWD MXP SAR SGD ZAR CHF GBP USD

Source: Van Marrewijk (2012), table 20.1

TABLE 13.2 Spot exchange rates on 3 December 2019 at 11:55:00 a.m. (UTC + 01:00) Price of

Bid spot rate

Ask spot rate

Currency

Country

Spread %

USD1 USD1 USD1

1.32993 0.98960 14.66009

1.33007 0.98976 14.66686

CAD CHF ZAR

Canada Switzerland South Africa

0.0105 0.0162 0.0462

Source: www.oanda.com

Chapter 13 • International trade 353

signals an important general property of exchange rates; they are extremely variable. The website from which the information was taken updates every fve seconds. Real-time transactions are updated even more frequently. This makes exchange rates rather special prices, as the variability in the quoted prices is much higher than for those for goods and services traded in the marketplace (such as the price of diapers at the supermarket), although generally of the same order of magnitude as many other prices in fnancial markets. Table 13.2 lists the exchange rate of the US dollar relative to three countries, namely Canada, Switzerland, and South Africa. There are actually two rates quoted: the bid rate – that is, the price at which banks are willing to buy USD1 (what they are bidding for USD1) –and the ask rate – that is, the price at which the banks are willing to sell USD1 (what they are asking to sell you USD1). These quotes are for large amounts only. The difference between the buying and selling rate is called the spread. It generates revenue for the currency-trading activities of the banks. In practice, the spread is quoted relative to the bid price. Therefore, on the basis of Table 13.2, a Swiss bank might quote USD0.98960–76, indicating the bank is willing to buy dollars at 0.98960 and willing to sell dollars at 0.98976. Obviously, banks from other countries can also buy and sell US dollars for Swiss francs: trading in these currencies is not limited to only Swiss banks and US banks. Note that the spread between the bid price and the ask price, the margin for the banks, is small. For the US dollar–Canadian dollar in our example, it is only 0.0105%. As shown in Table 13.2, the spread is slightly bigger for trade in the US dollar–Swiss franc (0.0162%) and substantially larger for trade in the US dollar–South African rand (0.0462%). In general, the spread decreases with the intensity with which the two currencies involved are traded. Since the spread is so small, we henceforth assume that the bid price is equal to the ask price (such that the spread is zero) and refer to the exchange rate of the US dollar in terms of Canadian dollars, Swiss francs, or South African rands. For fnancial trading, however, the spread is crucial. Figure 13.1 illustrates the variability of exchange rates for a longer period (2000–2020) for the exchange rate of the US dollar in Canada, South Africa, and Switzerland using daily data. There are clearly big differences in the price of the US dollar over time and big differences in variability between countries. In Canada, for example, the US dollar exchange rate varied from a low of 0.9168 on 7 November 2007 to a 76% higher value of 1.6128 on 18 January 2002. In South Africa, the US dollar exchange rate varied from a low of 5.615 on 24 December 2004 to a value three times higher, 16.8845, on 20 January 2016. Over the period as a whole, the US dollar depreciated relative to the Swiss franc, meaning that it has become less expensive for the Swiss to purchase US dollars. Initially, there was also a depreciation of the US dollar relative to the Canadian dollar, but that trend reversed to an appreciation (US dollar becomes more expensive) around 2008 and 2013, such that the net effect over a 20-year period is small. Relative to the South African rand, the US dollar has appreciated over this time, with large fuctuations over time and peaks in 2002, 2009, and 2016.

354 Steven Brakman and Charles van Marrewijk FIGURE 13.1 Swiss franc, Canadian dollar, and South African rand; daily data,

2000–2020

18

2

(

)

9

1

0 2000

2005

2010

2015

0 2020

Source: www.federalreserve.gov Note: CHF = Swiss franc; CAD = Canadian dollar; ZAR = South African rand (on right-handside vertical axis); exchange rates relative to US dollar

We have seen that exchange rates vary considerably over time, even within one day. The same is not true for the exchange rate at different locations for a given point in time. Since currencies are homogenous goods (a yen is a yen, no matter where it comes from) and the spreads are small, if the Japanese yen exchange rate were high in one location, say New York, and low in another location, say London, at the same point in time, traders could make a proft by (electronically) rapidly buying yen in London (where they are cheap) and selling them in New York (where they are dear). As a result of this arbitrage activity, the price of yen would rise in London and fall in New York. Proft opportunities exist until the price is equal in the two locations. In view of the small spreads, large funds swiftly move around the globe electronically, and the huge trading volume equality occurs almost instantaneously. This holds not only for direct arbitrage for a particular exchange rate but also for so-called triangular arbitrage for different pairs of exchange rates – which is illustrated in Table 13.3. Suppose we know the price of one US dollar in terms of Canadian dollars (1.3300), Swiss francs (0.9897), and South African rands (14.6635). In view of arbitrage opportunities, this suffces to calculate all cross-exchange rates as given in Table 13.3. We know, for example, that one Swiss franc must cost 14.8164 South African rands, because 14.6635 rands are worth one US dollar, and one US dollar is worth 0.9897 Swiss francs, so one Swiss franc is worth148164 rands (14.6635 ÷ 0.9897 = 148164 rands). Similar treatment is given to the other table entries. Box 13.1 briefy discusses arbitrage in connection to Donald Trump’s claims of Chinese currency manipulation in 2016.

Chapter 13 • International trade 355 TABLE 13.3 Cross-exchange rates; spot, 3 December 2019 at 11:55:00 a.m. (UTC + 01:00) Price of 1

(Country)

CAD

CHF

USD

ZAR

CAD CHF USD ZAR

(Canada) (Switzerland) (United States) (South Africa)

1.0000 1.3439 1.3300 0.0907

0.7441 1.0000 0.9897 0.0675

0.7519 1.0104 1.0000 0.0682

11.0252 14.8164 14.6635 1.0000

Source: See Table 13.2; for ISO code, see Table 13.1; it is based on av. bid & ask price of USD

BOX 13.1 China: arbitrage, real exchange rates, and currency manipulation? Arbitrage ensures that goods cost the same in different countries if currencies refect their real value. Suppose a hamburger costs USD4 in the US. If you exchange this to Chinese yuan at an exchange rate of CNY7 per USD, you receive CNY28 and should be able to buy a similar hamburger in China. If, instead, the hamburger costs CNY35 in China, the dollar is undervalued. Suppose S is the nominal spot exchange rate, P is the average price of US goods, and P* is the average price of Chinese goods; then the real exchange rate RER can be defned as RER = SP*/P. If the ratio is larger than 1, Chinese yuan are overvalued. If arbitrage works, the ratio should move towards 1. Since in practice nations trade with many countries, we apply the real exchange rate concept to all trading partners (using trade shares as weight) to determine the real effective exchange rate, which provides a summary of a currency’s value relative to all trading partners. Figure 13.2 depicts the nominal exchange of Chinese yuan relative to the US dollar, as well as the real effective exchange rate (index; 2010 = FIGURE 13.2 Real effective exchange rate and nominal exchange rate; 14

120

12

)

10

/

(

)

140

80

8

(

(

, 2010 = 100)

China, 1990–2020

60

6

100

(

40

)

2

20 0 1990

4

1995

2000

2005

2010

2015

Source: Created by using World Bank Development Indicators data Notes: xrate = exchange rate; nominal = offcial rate

0 2020

356 Steven Brakman and Charles van Marrewijk

100) for the period 1990–2020. We can use it, for example, to evaluate Donald Trump’s claim during the US presidential elections in 2016 that China is a currency manipulator.3 If true, this suggests that China artifcially infuenced the value of the yuan to boost its competitive position, thus creating an undervalued currency. Note that the nominal dollar exchange rate rose sharply from about CNY4.8 to CNY8.6 in 1994 (a depreciation of the yuan) and then remained stable at about CNY8.3 for a long time, until 2004 (pegged to the US dollar), after which it started to decline to about CNY6.1 in 2014 (an appreciation of the yuan) and rise to CNY7.0 at the end of 2019 (a depreciation of the yuan). The real effective exchange rate takes currency changes and price changes relative to all of China’s trade partners into consideration. It was 100 by construction in 2010 and also in 1990. The latter might be taken as an ‘equilibrium’ year because China’s current account balance switched from a defcit in 1989 to a surplus in 1990.4 The real effective exchange rate is below 100 for the period 1991–2008 and has been rising substantially above 100 since then. Although we should not be too dramatic about minor deviations, if anything, this suggests that the Chinese yuan has been overvalued rather than undervalued since about 2013. Trump’s claim of currency manipulation during the presidential election in 2016 was therefore not valid, although it might have been valid around 1994.

13.3 FORWARD-LOOKING MARKETS The large variability of exchange rates illustrated in Figure 13.1 potentially poses problems for agents active on the foreign exchange market. Suppose, for example, that you represent a Japanese frm and have sold a thousand watches for delivery and payment in France in three months at a total price of €150,000. At the current exchange rate of ¥133.49 per euro, the payment of €150,000 is worth ¥20,023,500. Since the total cost of producing and delivering the watches for your company is about ¥19 million, you stand to make a proft of about ¥1 million on this transaction, so your boss will be pleased. However, payment (in euro) takes place only three months later. To your surprise and dismay, the euro turns out to have considerably depreciated relative to the Japanese yen in this period, such that three months later, the spot exchange rate for the euro is only ¥120.49. The payment of €150,000 is now worth only ¥18,051,000, which means that your company took a loss of about ¥1 million, rather than a proft of ¥1 million. Your boss will not be pleased. Could you have avoided the ¥1 million loss? Yes, you could have, but it required you to take action three months earlier on a forward-looking market by using a forward-looking instrument. In this case, for example, you could have sold the €150,000 on the forward exchange market three months earlier at a then agreed-on forward price of, say, ¥131.24 per euro. This would have guaranteed you a revenue of ¥19,686,000 upon payment and ensured a proft

Chapter 13 • International trade 357

of about 700,000 Japanese yen. That is, you could have hedged your foreign exchange risk exposure on the forward exchange market. Since many other economic agents face exposure to similar or opposite foreign exchange risks (which they would like to hedge too) and other economic agents would like to take a gamble (speculate) on the direction and size of changes in the exchange rate, many forward-looking markets have developed, accompanied by rather exotic terminology. We can distinguish, for example, between three so-called plain vanilla instruments, namely forwards, swaps, and options. According to the BIS (2002, p. 34), the term ‘plain vanilla’ refers to instruments that are ‘traded in generally liquid markets according to more or less standard contracts and market conventions’. Combinations of the basic instruments can then be used to construct tailormade fnancial instruments, such as currency swaptions (options to enter into a currency swap contract). The spot exchange rate is the price at which you can buy or sell a currency today. The forward exchange rate is the price at which you agree on today to buy or sell an amount of a currency at a specifc date in the future.5 A swap involves the simultaneous buying and selling of an amount of currency at some point in the future and a reverse transaction at another point in the future. A currency swap applies this to a stream of profts. Finally, an option gives you the right to buy or sell a currency at a given price during a given period. Figure 13.3 illustrates the movement of the spot rate and the threemonth forward exchange rate of the British pound relative to the euro

FIGURE 13.3 British pound to euro spot and three-month forward exchange

rates, 2016

0.82

spot

0.73 2016

3Mfor

2016

Source: Based on Datastream data Note: daily data from 1 January to 24 May 2016 (average rates); 3Mfor is short for three-month forward rate; vertical scale does not start at zero

358 Steven Brakman and Charles van Marrewijk

from 1 January to 24 May 2016 (the fgure depicts the price of €1 in British pounds). Obviously, the forward rate and the spot rate move, in general, quite closely together (note that the scale on the vertical axis does not start at zero). Over the period 2009–2016, the forward rate of the euro was mostly higher than the spot rate (about 77% of the time): the euro was selling at a premium. If the opposite holds – that is, if the forward rate is below the spot rate – then the currency is said to be selling at a discount. The existence of a forward premium is driven by an expected appreciation of the currency, while a forward discount is driven by an expected depreciation of the currency. To get a better (and comparable) view of the degree to which the euro was selling at a premium or a discount in this period, we can calculate the annualized forward premium for different maturities. Let S denote the spot exchange rate, let F denote the forward rate, and let the duration be measured in months: forword premium | annual,%=

(F − S) / S duration / 12

(13.1)

Figure 13.4 illustrates the forward premium for the three-month forward rate since 2009 (right-hand scale) as well as the spot rate of the euro (left-hand scale). It shows that the changes from one period to the next can be quite large and that the predicted percentage change of appreciation or depreciation (as measured by the forward premium) can be substantial (almost +10%, such as on 30 April 2010, which is clearly outside the scale in the fgure). FIGURE 13.4

British pound to euro spot rate and three-month forward premium, 2009–2016

5

1.0 spot

0.5

0

3-month forward premium (right scale) 0.0 2009

-5 2010

2011

2012

2013

2014

2015

2016

Source: Based on Datastream data Note: daily data from 1 January 2009 to 24 May 2016 (average rates); three-month forward premium annualized, in percentages

Chapter 13 • International trade 359

13.4 INTEREST RATE PARITY When you have a large sum of money to invest, you are interested in the return on your investment from different opportunities. When these opportunities are located in different countries, the exchange rate plays an important role in determining where to invest. This evaluation leads to the interest rate parity condition, which is crucial for international money markets. There are two types of interest rate parity conditions: covered and uncovered. We start with the former and then discuss the latter. Suppose you live in Europe and want to invest in government bonds. For simplicity, we consider just two options: European bonds and US bonds. We assume that the two assets are perfect substitutes, implying in particular that there is no difference in perceived riskiness of one asset relative to the other. You have a large sum L of euros to invest for one period and care only about the return in euros. Figure 13.5 shows two possible investment options. • Option 1: you can purchase a European bond. If the European interest rate is equal to iEU, you will receive (1 + iEU)L euros by the end of the period. • Option 2: you can purchase a US bond. Since these are denominated in dollars, you will have to be active on the foreign exchange market – frst by exchanging your L euros on the spot market for L/S US dollars, where S is the spot exchange rate of the US dollar (its price in euros) and second by investing these L/S dollars in US bonds. If the American interest rate is equal to iUS, you will receive (1 + iUS) (L/S) dollars by the end of the period. You are, however, not interested in the return in dollars, but only in the return in euros, so you will have to convert these dollars at the end of the period back to euros. This FIGURE 13.5 Two investment options

invest in European bonds euro to invest

exchange euro to dollar

invest dollar in American bonds

receive (1 + euro

)

compare revenue

exchange (1 + for 1 +

S )(S )

dollar

euro

receive (1 + S )( ) dollar S

360 Steven Brakman and Charles van Marrewijk

poses a problem because at the moment you are making your investment decision (option 1 or option 2), you do not yet know what the future spot exchange rate of the dollar is going to be. This is where the forward exchange market provides a solution. Since you know exactly how many dollars you will receive one time period from now if you choose option 2 (namely (1 + iUS) (L/S) dollars), you will also know exactly how many euros you will receive if you sell these dollars before making your investment decision at the forward exchange rate, F, on the forward exchange market, namely (1 + iUS) (F/S) euros. In short, you know exactly the return to your investment if you choose option 1 and the return to your investment if you choose option 2. Obviously, many other economic agents make similar calculations as you do (possibly trying to beneft from arbitrage opportunities), and all of you will invest in the asset with the highest return. If the two assets are perfect substitutes and both are held in equilibrium, the return to the two assets must therefore be the same to ensure that the market does not prefer one asset over the other – that is, we have the following equilibrium condition: F(1+ iUS ) S

L = (1 + iEU ) L 

F 1+ iEU = S 1+ iUS

(13.2)

Obviously, the time frame for equation 13.2 must be consistent, so if F is, for example, the three-month forward rate, then iES and iUS must be threemonth interest rates. Except for interest rates, we will use the convention that lowercase letters refer to the natural logarithm of uppercase letters. The second equality of the condition of equation 13.2 can be written more tersely by taking the natural logarithm and using the approximation. In (1 + X) ≈ X (where the symbol ≈ should be read as ‘is approximately equal to’), f − s  iEU − iUS .

(13.3)

Equation 13.3 states that the logarithmic difference between the forward rate and the spot rate must be equal to the difference between the domestic interest rate and the foreign interest rate. It is known as the covered interest parity condition, because you have fully covered your return in foreign currency on the forward exchange market. It provides a powerful and crucial empirical relationship between interest rates and (spot and forward) exchange rates in international money and fnance analysis. Under the given circumstances, there are more options available to you. One of these options (called option 3) is not to hedge your risk on the forward exchange market. For clarity of exposition, it is better to now explicitly add a subindex, t, to denote time. Let us compare your revenue from option 1 – that is, buy the European bond – with the revenue from option 3: buy the US bond and do not hedge on the forward exchange market. Nothing has changed for option 1, so the following is true: • Revenue from buying European bond – (1 + iEU,t) L

Chapter 13 • International trade 361

Before you can purchase the US bond, you have to convert your euros to dollars at the exchange rate, St, which will give you L/St dollars. In the next period, your revenue will therefore be (1 + iUS,t) (L/St) dollars. You have decided not to hedge your foreign exchange risk, so in the next period, you will have to exchange your currency on the spot exchange market. In this period, when you have to make your investment decision, you obviously do not know the next period’s spot exchange rate. To make your decision, you will therefore have to form some expectation today about the future spot exchange rate. This can be a simple (single number) or a complicated (distribution function) expectation. Let us denote the expected value of your forecasting process by Ste+1 . Then we conclude the following: • Expected revenue from buying US bond –

e St+ 1 (1 + iUS ,t )

St

L

We cannot draw immediate conclusions from comparing these two revenues, because you know the return to investing in the European bond for sure, whereas the return to investing in the US bond is uncertain. Only under the additional assumption of risk neutral economic agents, hypothesizing that agents focus onlyon the expected value of the return and do not care at all about the underlying distribution of risk, should the sure return to the European bond be equal to the expected return of the US bond. Under that assumption, and after a similar logarithmic transformation and approximation as discussed earlier, we arrive at the uncovered interest parity condition: e St+1 − St  iEU ,t − iUS ,t

(13.4)

Equation 13.4 says that the difference between home interest rates and foreign interest rates must be equal to the expected appreciation of the foreign currency. Thus, the equation is pretty useless for empirical testing because it contains the expectation of the future exchange rate, and expectations cannot be directly measured.6 Alternatively, you can view it as a simple method to defne these expectations under the assumption of risk neutrality. In combination with the covered interest parity condition 13.3, however, it is trivial to see that the forward exchange rate should be equal to the expected value of the future spot exchange rate: e f = St+1

(13.5)

Equation 13.5 still does not give us a testable hypothesis, unless we are willing to go one step further, namely by assuming rational expectations. Under rational expectations, economic agents make no systematic forecast errors. They will, of course, not be able to exactly predict the future exchange rate, but their prediction should refect all information available to them at the time they are making the prediction. Any forecast errors must therefore be uncorrelated with (i.e. not systematically related to) the information set available at the time of the prediction. Under the additional assumption of rational expectations, the uncovered interest parity condition can therefore

362 Steven Brakman and Charles van Marrewijk FIGURE 13.6 Assumptions, interest parity, and market effciency

arbitrage

covered interest parity =

arbitrage + risk neutrality

uncovered interest parity

arbitrage + risk neutrality + rational expectations + information set

testable uncovered interest parity hypothesis = 0+ 1 + 1

= 1;

uncorrelated with info

be tested by estimating a regression similar to the following (see Frenkel, 1976):7 St+1 = ˇ 0 + ˇ1 ft + °t

(13.6)

Here εt is the (forecast) error term. Under the hypothesis of risk neutrality and rational expectations, we expect the parameter γ1 to be equal to unity and the forecast error to be uncorrelated with the information available at time t. Empirical estimates of equations like 13.6 are frequently called tests of market effciency. There are different types of market effciency, where the joint hypothesis of risk neutrality and rational expectations is dubbed the simple effciency hypothesis by Sarno and Taylor (2002, p. 10). Figure 13.6 schematically summarizes our discussion. Box 13.2 illustrates some of the economic and fnancial connections associated with interest rates, infation, currencies, capital controls, and economic growth for Argentina.

BOX 13.2 Argentina: interest rates, infation, and capital controls Infation rates in Argentina have been high in the 20th century. The average infation rate in the period 1975–1990, for example, was about 550% per year, which implies that prices rise by about 40% per month.8 The peak of infation in 1989 was at more than 3,000%. As Figure 13.7 illustrates, after a period of free market reform and privatization, the infation rate became low or negative until 2001 and combined with an exacerbating economic crisis starting in 1998, eventually leading to a large contraction of about 11% in 2002. A series of deposit runs forced the Argentinian authorities to impose a deposit freeze (capital controls) in December 2001, combined with partial default and abandoning convertibility. The Argentinian peso lost most of its value, and in 2002, infation rose to 31% and the interest rate to 52%, while unemployment rose sharply. Economic growth returned under the guidance of Roberto Lavagna (minister of the economy), who moderated infation and stabilized the exchange rate, with the help of a commodity price boom. Under the

Chapter 13 • International trade 363

Kirchner presidencies (frst Néstor and then his wife, Cristina Fernández) infation rates crawled back up despite price and capital controls, with a slowdown of the economy and a second default in 2014. On the basis of this legacy, Mauricio Macri became president in 2015, released exchange restrictions, and lifted price and capital controls. The subsequent rise in infation rate was accompanied by rising interest rates (to 40% and 37% in 2018, respectively). Despite negative real interest rates, economic growth was halted and turned negative (-3%) in FIGURE 13.7 Argentina: interest rates, growth, and infation; percent,

1994–2018

52

% 45

40 37

31

30

15

0 1994

1998

2002

2006

2010

-3 2018

2014

-11

-15

Source: Created by using World Development Indicators data Note: infation is GDP defator; growth is GDP growth

FIGURE 13.8 Argentina reference interest rate; 7-Day Leliq Rate, 2016–2020 Argentina; 7 day Leliq rate % 80

60

40

20

2016

2017

2018

2019

2020

Source: Created by using Central Bank of Argentina data (tradingeconomics.com)

364 Steven Brakman and Charles van Marrewijk

2018. As the interest rate developments since then (see Figure 13.8) show, the situation became unstable in August 2018 (see the Economist, 2018). The peso depreciated sharply as fnancial markets started to worry that the government would struggle to refnance its debt and get re-elected in view of the required high interest rates to attract creditors that might repel voters. These worries became reality in October 2019, when Alberto Fernandez rather than Maurizio Macri, was elected. Interest rates rose sharply as Argentina tightened capital controls (reintroduced in September 2019) substantially: savers can buy only USD200 per month, rather than USD2,000 per month (Do Rosario & Millan, 2019).

13.5 THE POLICY TRILEMMA In theory, we can distinguish between two types of exchange rate regimes: fxed exchange rates and fexible exchange rates. In practice, there is a sliding scale (with associated colourful typology) from one hypothetical extreme to the other. As the names suggest, the difference between fxed exchange rates and fexible exchange rates is the extent to which the exchange rate is allowed to change, in response to market pressure. Under fxed exchange rates, the central bank of a country has set the exchange rate at a particular level, and it will not allow the currency to appreciate or depreciate relative to that level. To maintain the fxed exchange rate, the central bank must be ready to intervene in the foreign exchange market by buying or selling reserves or by increasing or decreasing the interest rate (see van Marrewijk, 2012). Under fexible exchange rates, the central bank does not intervene in the foreign exchange market and allows the currency to freely appreciate or depreciate in response to changes in market supply and demand. The history of the international economic order on exchange rate regimes and capital market integration is closely connected; on this, see Mundell (1968), Eichengreen (1996), and Obstfeld and Taylor (2003). To better explain this connection, we distinguish between three possible policy objectives that a nation might try to achieve:9 1 Monetary policy independence. 2 A fxed exchange rate. 3 International capital mobility. The frst objective is desirable in that it allows a country to determine its monetary policy independently of other countries, on the basis of its own economic circumstances. The second objective is desirable in that it provides price stability for international transactions and a clear point of reference. The third objective is desirable in that it allows for the spreading of investment risks and access to the most proftable projects internationally. It turns out that only two of these three policy objectives can be achieved at any one point in time, at the expense of the third objective. Focusing on the EU and the US, this can be illustrated most effectively by

Chapter 13 • International trade 365

recalling the uncovered interest rate parity condition with transaction costs (using a zero-risk premium; see equation 13.7): e iEU ,t = iUS ,t + (St+1 − St ) + transaction cos ts ,

(13.7)

where the subindex t denotes time, iEU,t is the EU interest rate, iUS,t is the US interest rate, St is the (log) US dollar exchange rate (price of USD1 in terms of euros), and Ste+1 is the (log) expected value of the next period’s US dollar exchange rate. If there is complete international capital mobility (objective 3 holds), the transaction costs are low, such that equation 13.7 reduces to the uncove ered interest parity condition itself: iEU ,t = iUS ,t + (St+1 −St ). This implies that expected changes in the exchange rate are the only reason for an interest rate differential between the EU and the US. With full international capital mobility, policymakers must therefore choose between monetary policy independence (reaching objective 1, as measured by a possible deviation between EU interest rates and US interest rates) and a fxed exchange rate (reaching objective 2). If, for example, they decide to fx the exchange e rate (such that St+ 1 − St = 0), this automatically implies iEU ,t = iUS , t , making monetary policy independence impossible. Similarly, if they decide to strive for monetary policy independence, this automatically makes a fxed e i  iUS , t . The only way exchange rate impossible, since St+ 1  St when EU ,t that objectives 1 and 2 can be achieved simultaneously is by giving up objective 3, in which case equation 13.7 with fxed exchange rates reduces to iEU ,t = iUS ,t + transaction cos ts. A country can then steer its own interest rate (retain policy autonomy) and have a fxed exchange rate at the cost of immobile capital, which prevents portfolio investors from directing capital fows to or from the EU so as to beneft from the interest rate differential. Although intermediate solutions are possible for monetary policy independence and capital controls (some capital controls buy you some monetary independence; see also Table 13.4), this does not hold for fxed exchange rates. Figure 13.9 illustrates how satisfying two policy objectives (squares) necessarily implies sacrifcing the third policy objective (circle).

FIGURE 13.9 The policy trilemma capital mobility

policy independence

fixed exchange rate

fixed exchange rate

capital mobility

policy independence

policy independence

fixed exchange rate

capital mobility

366 Steven Brakman and Charles van Marrewijk

The incompatibility between objectives 1–3 was pointed out by Nobel laureate Robert Mundell in the early 1960s. It is called the incompatible trinity, incompatible triangle, or policy trilemma and provides us with a categorization scheme that helps us to understand changes in the international economic order over time. Figure 13.9 illustrates the trilemma. In each triangle of the fgure, the two squares indicate the objectives pursued by the government, whereas the circle at the top of the triangle indicates the policy objective that cannot be met. The trilemma indicates that there is a price to pay for policymakers when they want to achieve full capital mobility, fxed exchange rates, or policy autonomy. Box 13.2 illustrates the connections for a real-world case, such as Argentina.

13.6 EXCHANGE RATE POLICY We now briefy explain how the choices have changed over time by focusing on the most recent main international monetary regimes; see also Eichengreen (1996) and Obstfeld and Taylor (2003).10 Figure 13.10 overviews these regimes, their duration, and the main characteristics: • • • •

Gold standard (±1870–1914) World wars and recession (1914–1945) Bretton Woods (1945–1971) Floating rates (1971–present)

13.6.1 Gold standard (±1870–1914) Towards the end of the 19th century, when the United Kingdom was the world’s leading economy and London the undisputed global fnancial centre, an increasing share of the world economy moved to the gold standard. This was a stable and credible fxed exchange rate regime in which countries valued their currency in terms of gold. It started in Britain in 1844, when the Bank Charter Act established that Bank of England notes, fully backed by gold, were the legal standard. It became an international standard in 1871, when Germany established the mark on a strict gold standard, soon followed by many other European nations and eventually by Japan (1897), India (1898), and the US (1900). With countries’ issuing bank notes directly backed by gold and by allowing gold to be freely

FIGURE 13.10 Overview of international monetary regimes Gold Standard ˜ixed exchange rate regime, currencies pegged to gold, global capital market (London)

1870

World Wars and Recession gold standard broken, beggar-thyneighbour, capital controls 1914

Bretton Woods

Floating Rates

˜ixed exchange rates (pegged to USD, pegged to gold), initial capital controls

managed ˜loating and some pegging, capital market liberalization

1945

1971

now

Chapter 13 • International trade 367

imported and exported across borders according to the gold standard rules, the exchange rates between the currencies became fxed. Suppose, for example, that the Federal Reserve pegs the price of gold at $35 per ounce and the Bank of England at £7, then the exchange rate of the British Pound in terms of US dollars must be 35/7 = 5; otherwise, proftable arbitrage opportunities arise. In practice, by taking the costs of shipping and insuring gold in transit into consideration, the exchange rates could fuctuate within narrow margins called gold points. The gold standard functioned as a disciplining device for countries, which led to a convergence of interest rates and a global capital market centred in London, in exchange for a reduction in policy autonomy. The gold standard worked quite well at the end of the 19th century and the beginning of the 20th century, but there are also several drawbacks to the gold standard. First, although currency backed by gold generally leads to relatively stable prices, the rate of infation is determined not only by macroeconomic conditions but also by the random discoveries of new gold supplies. There have been considerable fuctuations linked to these events; see Cooper (1982). Second, the international payments system requires gold as reserves. As economies are growing, central banks strive for an increase in the buffer stock of their gold reserves (otherwise, there would be defation). Simultaneous competition for gold by central banks might bring about unemployment through a reduction in their money supply. Third, the gold standard gives countries with a large gold supply, such as Russia and South Africa, the ability to infuence the world’s macroeconomic conditions by selling gold. Fourth, and perhaps most importantly, the gold standard puts undue restrictions on the use of monetary policy as a means of fghting unemployment under special circumstances, such as a worldwide recession (this is true for any fxed exchange rate regime). 13.6.2 World wars and recession (1914–1945) The pillars of the international economic system – the gold standard, multilateral trade, and the interchangeability of currencies – crumbled down one by one during the First World War (1914–1918), the Second World War (1939–1945), and particularly during the Great Depression, which started in October 1929 and lasted throughout the 1930s. To fnance its war efforts, Britain ended the convertibility of Bank of England notes in 1914. Nations printed more money than could be redeemed in gold, hoping to win the First World War and redeem the excess out of reparations payments. Losing the war, Germany was required by the Treaty of Versailles to pay large punitive damages, of which in the end it could only effectively transfer a fraction; see Brakman and Van Marrewijk (1998, ch. 1). To deal with these diffculties, the Bank for International Settlements was established in 1930 under the Young Plan. Many nations, including the US and the UK, instituted capital controls to prevent the movement of gold. Britain returned to the gold standard at the prewar gold price in 1925, which entailed a signifcant defation for the economy, much to the dismay of British economist John Maynard Keynes, who called the gold standard a ‘barbarous relic’.

368 Steven Brakman and Charles van Marrewijk

The credibility of the gold standard was broken by the First World War, such that countries were no longer willing to give up their policy autonomy for a well-functioning international economic system, focusing instead on domestic political goals. Consequently, when the Great Depression hit in 1929, many countries engaged in noncooperative, competitive beggar-thyneighbour devaluations and instituted capital controls. This greatly exacerbated the crisis, caused the international trade system to collapse and put millions of people out of a job, with unemployment rates of more than 30%. Both the punitive damages required from Germany in the Treaty of Versailles and the economic consequences of the nationalistic policies imposed during the Great Depression are seen as major contributing factors in causing the outbreak of the Second World War. While the war was raging, politicians and advisors started to work on a plan to prevent this from happening again. During the Great Depression in the 1930s, the beggar-thy-neighbour policies, in which each country tried to transfer its economic problems to other countries by depreciating its own currency and imposing high tariffs (e.g., see the Hawley–Smoot Act of the US in 1930), led to an almost complete collapse of the international trade system, further exacerbating and prolonging the economic crisis. The impact of the beggar-thy-neighbour policies on international trade is aptly illustrated by the ‘spider web spiral’, measuring the size of world imports in each month by the distance to the origin; see Figure 13.11. In a period of only four years, world trade FIGURE 13.11 Spider web spiral: world imports in millions US gold dollar,

1929–1933

January February

December

March

November

April

October

September

May

August July

June

Source: League of Nations (1933) Note: Values in January (1929–1933) – 2,998; 2,739; 1,839; 1,206; and 992 respectively

Chapter 13 • International trade 369

fows dropped to one-third of their previous level (from January 1929 to January 1933, world imports fell from 2,998 to 992 million US gold dollars per month). 13.6.3 Bretton Woods (1945–1971) The foundations for a new international economic order were laid at the Mount Washington hotel in Bretton Woods, New Hampshire, when the delegates of 44 allied nations signed the Bretton Woods Agreement in July 1944. The delegates set up a system of rules, institutions, and procedures and established the International Monetary Fund and the World Bank. Planning for the new order had been underway some three years since US President Franklin Roosevelt and UK Prime Minister Winston Churchill signed the Atlantic Charter in August 1941. There was no question towards the end of the Second World War that the balance of power had shifted towards the United States, politically, economically, and militarily. This meant that although there was some compromise towards the UK plan designed by John Maynard Keynes, the structure of the Bretton Woods system was based on the plans designed by US-American Harry Dexter White, who would remain a powerful initial infuence at the IMF as the frst US executive director. The pillar of the US vision for the postwar economic order was free trade and a prevention of beggar-thy-neighbour policies. William Clayton, the assistant secretary of state for economic affairs, apparently summed up this point: ‘we need markets – big markets – around the world in which to buy and sell’. Free trade involved lowering tariffs and other trade barriers, a task for the General Agreement on Tariffs and Trade and World Trade Organization, and a stable international monetary system to foster the development of trade and capital fows. To do this, the gold standard was re-established indirectly through the role of the US dollar as international reserve currency. The US government fxed the price of gold at USD35 per ounce and made a commitment to convert dollars to gold at that price (for foreign governments and central banks). In conjunction with the strength of the US economy, this made dollars even better than gold as international reserves, since dollars earned interest and gold did not. Other countries pegged their currency to the US dollar at a par value and would buy and sell dollars to keep exchange rates within a band of plus or minus 1% of parity. To avoid the beggar-thy-neighbour devaluation problem, member countries could change their par value only with IMF approval, which required a decision by the IMF that the balance of payments was in ‘fundamental disequilibrium’. A decrease in the value of a currency was called a devaluation, an increase a revaluation. This terminology still holds for all fxed exchange rate regimes. For foating regimes, we use appreciation and depreciation respectively. 13.6.4 Floating rates (1971–present) Increasing pressure on the Bretton Woods system during the 1960s and early 1970s caused its collapse. Massive sales of gold by the Federal Reserve and

370 Steven Brakman and Charles van Marrewijk

European central banks led to the instalment of a two-tier gold market on 17 March 1968. Private traders could buy and sell gold at a price determined by market forces on the London gold market, while central banks would continue to transact with one another at the (lower) offcial gold price of USD35 per ounce. The latter was used only to a limited amount. Speculation against the dollar forced the German Bundesbank to purchase USD1 billion during a single day on 4 May 1971, and another USD1 billion during the frst hour of the next trading day alone; see Krugman and Obstfeld (2003, p. 560). Germany gave up and allowed the mark to foat. It became clear that the dollar had to be devalued. This was, however, diffcult under the Bretton Woods system, because it implied that all other currencies, which were pegged to the dollar, had to be revalued with approval from the IMF and all other countries, many of whom were reluctant to do so. Richard Nixon, the then US president, forced the issue on 15 August 1971 by formally ending the convertibility of US dollars to gold and imposing a 10% tax on all imports into the US until an agreement had been reached. Although this Smithsonian Agreement to devalue the dollar by about 8% came in December of 1971 (at the Smithsonian Institution in Washington, DC), it was unable to save the Bretton Woods system. After renewed speculative attacks, there was another 10% devaluation of the dollar on 12 February 1973, followed by a decision of a foating exchange rate of the US dollar relative to the most important international currencies on 19 March 1973. Table 13.4 summarizes the policy choices made by most countries concerning the policy trilemma explained in section 13.5 for each of the four most recent international monetary systems. During the gold standard, there was a broad consensus to give up on policy autonomy in exchange for capital mobility and maintaining fxed exchange rates. This broke down during the world wars and recession era, as most countries pursued activist monetary policies to try to solve domestic problems at the cost of either imposing large capital controls or giving up on fxed exchange rates. In the Bretton Woods era, there was again broad consensus to maintain fxed

TABLE 13.4 The policy trilemma and the international economic order  

Resolution of trilemma – countries choose to sacrifce:

 

fxed exchange notes policy capital rate autonomy mobility broad consensus few few Gold standard most capital controls most several World wars and few especially in Central recession Europe, Latin America broad consensus few most Bretton Woods few some consensus; many few Floating rates few currency boards, dollarization, etc. Era

Source: Obstfeld and Taylor (2003)

Chapter 13 • International trade 371

exchange rates, this time by sacrifcing capital mobility (which was limited directly after the Second World War and then gradually increased). With regard to the foating rates era, Table 13.5 depicts the more recent policy choices as they have evolved over time, in which many countries have been willing to give up on fxed exchange rates in return for policy autonomy and capital mobility. TABLE 13.5 IMF exchange rate classifcation system Hard pegs    

  No separate legal tender Currency board arrangements

Soft pegs Conventional   pegged arrangement  

Stabilized arrangement

 

Crawling peg

 

Crawl-like arrangement

 

Pegged exchange rate within horizontal bands

Floating arrangements Floating    

Free foating

Residual Other managed   arrangement

The currency of another country circulates as the sole legal tender (formal dollarization). A monetary regime based on an explicit commitment to exchange domestic currency for a specifed foreign currency at a fxed exchange rate. The domestic currency will be issued only against (fully backed) foreign exchange.   The country formally (de jure) pegs its currency at a fxed rate to another currency or a basket of currencies. The exchange rate may fuctuate within narrow margins. A spot market exchange rate that remains within a margin of 2% (except for outliers) for six months or more and is not foating. The currency is adjusted in small amounts at a fxed rate or in response to changes in selected indicators. The exchange rate remains in a narrow margin of 2% relative to a statistically identifed trend for six months or more and is not foating. The exchange rate is maintained within margins of at least +1% around a central rate.   The exchange rate is largely market determined, without an ascertainable or predictable path for the rate. Exchange rate intervention occurs only exceptionally and aims to address disorderly market conditions.   A residual category if the exchange rate regime does not meet the criteria of any of the other categories.

Source: IMF (2014, Table 13.1) and Habermeier et al. (2009) Note: System used since 2009

372 Steven Brakman and Charles van Marrewijk FIGURE 13.12 De facto exchange rate arrangements; 30 April 2014

Nigeria

Other managed arr. Free foang Floang

USA; Euro India Tonga

Pegged rate with bands Crawl-like arrangement

China Botswana

Crawling peg Stabilized arrangement Convenonal peg Currency board No separate legal tender

Vietnam S Arabia (USD); Denmark (Euro) Hong Kong Ecuador 0

10

20

30

40

Source: IMF (2014, Table 2) Note: # of countries; selected countries for each regime; see also Table 13.5

13.6.5 Current exchange rate regimes Although the present international monetary system is called the foating rates era, this does not mean that all currencies are freely determined by market forces. On the contrary, almost all countries at some time or another engage in some type of foreign exchange market intervention, through either their legal framework, direct intervention, or interest rate policy. As summarized in Table 13.5, the IMF currently identifes ten exchange rate regimes. Figure 13.12 shows the number of countries in each of the ten categories as identifed on April 2014, with some selected countries in each category for illustration purposes. It indicates that many countries have opted for a foating or free-foating arrangement, whereas many other countries are engaged in various forms of fxed and managed exchange rate regimes.

13.7 TRADE FINANCE Compared to domestic trade, cross-border trade activities are riskier, which raises costs as frms learn about foreign markets, regulations, and product customization; see Foley and Manova (2015). In addition, traders experience a longer delay between production and payment, while banks screen traders more carefully, which raises the costs of credit; see Ahn, Amiti, and Weinstein (2011). Trade fnance is credit (including open-account, cash-in-advance, and bank-intermediated instruments) that banks offer to frms to facilitate global trade. The payment contract is infuenced by export market and import market characteristics, costs, timing, and default risk. As a result of the foregoing properties, trade fnance has characteristics that differ from other types of

Chapter 13 • International trade 373

credit; see DiCaprio and Yao (2017). These characteristics include short tenor (the amount of time left for repayment or until a contract expires), availability (not all banks have the expertise to offer trade fnance), and stability (the frst line of credit to be pulled in case of a liquidity shortage). Historically, attention to diffculties that traders encounter when they want to fnance their activities rises in times of a credit crunch (such as the Great Recession, which started in 2008) as a way to explain the exacerbation of a crisis since banks transfer the shock (their shortage of funds) to their borrowers (credit rationing). In contrast, since 2013 the Asian Development Bank (ADB) has been collecting information on trade fnance diffculties during regular times as an obstacle in the development process. These efforts now seem to lead to a twice annual Trade Finance Gaps, Growth and Jobs Survey, which we use as our source of information for this section. It is suitable that the ADB became active in this area since the dominant bankintermediated trade fnance instruments are letters of credit, for which Asia Pacifc is by far the dominant region; see DiCaprio and Yao (2017). The global regional distribution of proposed and rejected trade fnance transactions is reasonably stable and depicted for 2017 in Figure 13.13. Ordered by proposed transactions, Europe is the largest region (1%), followed by the Americas (North and South, 18%). At the continent level, Asia is dominant (close to 50%), but in the fgure, it is subdivided into many subregions (advanced Asia, developing Asia, China, and India), while the Middle East is combined with Africa. Relative to their share in proposed FIGURE 13.13 Proposed and rejected trade fnance transactions; by region (%),

2017

18

Europe Americas Adv Asia

13

China

7

India

7

Dev Asia

6

Russia - CIS

6

4 1

Pacifc 0

23

18 18

13

ME Africa

19

14

12 9 9 rejected

proposed

3 5

10

15

20

Source: Created by using ADB (2017) data Note: Adv Asia = Advanced Asia (Hong Kong, Japan, S. Korea, and Singapore); ME = Middle East; Dev Asia = Developing Asia, excl. China and India; CIS = Commonwealth of Independent States (Azerbaijan, Belarus, Kazakhstan, Kyrgyzstan, Armenia, Moldova, Russia, Tajikistan, and Uzbekistan)

374 Steven Brakman and Charles van Marrewijk

transactions, the share of rejected transactions is large in the Americas, advanced Asia, the Middle East and Africa, and in the Commonwealth of Independent States. It is relatively low in the other regions. Figure 13.14 focuses on the distribution of proposed and rejected transactions by frm size. Multinationals and large corporations take care of almost half of the proposed transactions and only a quarter of the rejected transactions. In contrast, micro and small- and medium-size enterprises take care of only 12% of the proposed transactions and almost double that (22%) of rejected transactions. The midcap frms are in between. The probability of a rejected transaction is thus substantially larger for smaller frms. In subsequent work, the ADB analysed some of the causes and consequences of rejected trade fnance transactions. Figure 13.15 starts with FIGURE 13.14 Proposed and rejected trade fnance transactions; by frm size (%),

2017

26

Multnatonals

48

52

Midcap 39

22

Micro and SMEs 12 0

10

20

rejected

proposed

40

50

30

Source: Created by using ADB (2017) data Note: multinationals include large corporations; SMEs = small and medium-size enterprises

FIGURE 13.15 Why trade fnance proposals were rejected; % of applications,

2019

Lacked additonal collateral

20

Completely unsuitable for support

19

Serious know your customer concerns

18

Poorly presented and had insufficient informaton

17

Not profitable enough to process

15

Not profitable to process due to regulatory capital constraints

11 0

Source: Created by using ADB (2019) data

5

10

15

20

Chapter 13 • International trade 375

the causes of rejection and shows that many projects lack additional collateral or are simply unsuitable for support. Other important reasons for rejection are the inability of banks to really know their customers, poor presentation, and insuffcient information. Less common reasons are a lack of proftability of the fnance transaction and regulatory capital constraints. In most cases, the consequence of rejected trade fnance proposals is that the transaction does not take place. An imperfect indication is provided in Figure 13.16, which lists respondents’ outcomes after they sought alternative fnance. In almost half of the cases (47%), respondents were not able to fnd appropriate alternative fnance, while in 18% of the cases, they found alternative, informal, or digital fnance (in 10%, 7%, and 1% of the cases, respectively) but opted not to use it. Hence, about 65% of the rejected trade fnance transactions failed to materialize. The remaining projects were fnanced eventually, about 18% through informal fnancing, 16% through alternative formal fnancing, and 1% through digital fnancing. ADB (2019) estimates that the global trade fnance gap is large but stable at USD1.5 trillion. The global regional distribution is fairly stable, but the gap is particularly large for smaller frms. This shortage in trade fnance needs continues to hamper international trade, particularly for the smallest frms in developing countries. ADB (2019) fnds no evidence that improved technology is reducing the gap.

FIGURE 13.16 Outcome of efforts to seek alternative trade fnancing; SMEs (%),

2019

Unable to find appropriate alternatve financing

47

Used informal financing

18

Used formal alternatve financing successfully Found formal alternatve financing but opted not to use it Found informal financing but opted not to use it

16 10 7

Used digital finance successfully

1

Found digital finance but opted not to use it

1 0

10

20

Source: Created by using ADB (2019) data Note: % of respondents; SMEs = small and medium-size enterprises

30

40

50

376 Steven Brakman and Charles van Marrewijk

13.8 INTERNATIONAL CURRENCIES We noted in section 13.6 that the dollar performs the role of an international currency. In this section, we briefy look at the consequences of this characteristic of the world economy. International currencies perform the same roles as national currency but also are used outside the country of origin. Table 13.6 presents a widely accepted typology. International currencies act as a medium of exchange just as a national currency would, but on a larger scale. These are the so-called vehicle currencies that facilitate currency exchanges. If businesses need to exchange, for example, the Bhutan ngultrum into the Rwandan franc, the US dollar is in the middle and two exchanges take place because there is no market that exchanges both currencies directly. So the ngultrum is exchanged into dollars, and dollars into francs. The US dollar is the main currency in this respect. According to the Bank of International Settlements (BIS, 2019), 88% of all trades in April 2019 involved the US dollar. Closely related to this function is that these currencies are a safe store of value in unstable local markets. It protects private actors against extreme infation, and the trust in the US government can be higher than that in a local government. In fnancial markets, there is a home-market effect, which means that investors have a bias in favour of investments in the home-market currency. For international currencies, this is different. US frms – even if they are small – can easily borrow money from foreign investors because foreign investors have little diffculty lending in US dollars. This gives US borrowers an advantage that frms in other countries – for example, developing countries with a less developed fnancial market – do not have. This is partly an explanation of one of the Obstfeld and Rogoff (2000) puzzles. The special position of international currencies and in particular of the US dollar is also refected in the denomination of securities and invoice share of these international currencies. Gopinath (2016) documents that for many countries a large share of imports and exports is denominated by the US dollar. If trade is denominated by a particular currency, traders can reduce the exchange rate risk by also holding funds and securities in the same currency. TABLE 13.6 Functions of international currencies Sector

Functions

 

Medium of exchange

Store of value

Unit of account

Private sector

Vehicle currency Liquid and safe asset markets

Denomination of securities Trade invoicing

Offcial sector

Intervention currency Lender of last resort

Nominal securities issuance Banking and cash hoarding Reserves

Source: Gourinchas, Rey, and Sauzet (2019)

Exchange rate peg

Chapter 13 • International trade 377

For central banks – the offcial sector – the special role of international currencies implies that if they have to intervene in currency markets, it is effcient to do so using a currency that most market players use – that is, an international currency. As a consequence, holding reserves in these currencies is a precaution for when the need arrives to intervene. A reserve currency gives the country of origin, the hegemon, an advantage. Exchange rate risks are in general not as severe as for other countries; running a current account defcit for extended periods of time is not as problematic as it is for other countries (a defcit is needed to provide the world with enough of the reserve currency); and it has easier access to global capital markets than do other countries. For unstable countries with governments that are unable to handle the economy, such a currency provides a safe haven. But what are the disadvantages? It turns out that an appreciation of the dollar is transmitted in import and export prices throughout the world while insulating the US from these price changes. Gopinath et al. (2019) fnd that a 1% appreciation of the dollar results in a 0.6%–0.8% decline in (world) trade. The special position of the reserve currency also affects the discussion of the trilemma in section 13.5; see Rey (2016). As discussed in section 13.5, a fexible exchange rate should allow a country to perform independent monetary policy, but a strong reserve on which a country relies interferes with this because monetary conditions are sensitive to monetary policies in the hegemon country, in practice the US. So reserve currencies enable unstable countries to fnd safe havens but also make them dependent on the policies of another country, in practice the US.

13.9 FINANCE, INVESTMENT, AND DEVELOPMENT Foreign direct investments (FDIs) are important sources of investment for many countries. If a foreign investor acquires a controlling stake in a frm, it is an FDI.11 If the investment does not result in a controlling stake in the frm, it is called a portfolio or equity investment. The threshold to qualify as FDI is in practice 10% or higher. FDI can be a greenfeld investment – that is, the construction of a new production facility – or a merger & acquisition (M&A) – that is, a takeover of an existing frm. Most FDI is in the form of a M&As; see Antràs and Yeaple (2014). The distribution of the stock of FDI is shown in more detail in Figure 13.17 for 166 countries, classifed in global regions. Panel A shows inward FDI (the countries as destinations of FDI) and panel B shows outward FDI (the countries as sources of FDI). There are fve main regions active in FDI (certainly as a source): Europe, North America, East Asia, Southeast Asia, and the Pacifc. The role of other regions in global FDI is minimal, particularly as a source. The importance of Hong Kong and Singapore in global FDI, both as source and as destination, is noteworthy. The largest net source FDI countries (measured as the difference in the percentage of global outward FDI and the percentage of global inward FDI) are the US (4.9%), Germany (3.3%), Japan (3.2%), and France (2.0%). The largest net destinations FDI countries (measured similarly) are Brazil (-1.8%), China (-1.5%), Singapore (-1.5%), and Mexico (-1.0%).

378 Steven Brakman and Charles van Marrewijk FIGURE 13.17 Distribution of FDI; advanced, developing, and transition countries,

1975–2014

Source: Van Marrewijk (2017) Note: data in 1975 are based on a fve-year moving average for 1971–1975, and the others follow this fve-year model; the small area in between advanced countries and developing countries is for transition countries; ‘developing countries’ excludes fnancial centres in the Caribbean

Why do investors engage in FDI? (see also Chapter 4 of this book). The literature distinguishes between two main forces: a horizontal motive and a vertical motive. With horizontal FDI, a frm copies the production facility at home in the foreign market in order to serve customers in that market – hence the term ‘horizontal’. With vertical FDI, a frm establishes a foreign branch that produces an intermediate step in the production process for the fnal product – hence the term ‘vertical’. With horizontal FDI, a frm is looking for interesting markets, such as a market with suffciently many wealthy customers to buy a certain type of product. For this type of investment, low costs in the foreign market are less important than those in a developed market. For vertical FDI cost differences tend to be most important. This includes, for example, low local wages for labour-intensive parts of the production process but can also be based on other types of cost advantages. In practice, one fnds combinations of both motives. The horizontal versus vertical typology structures the discussion on FDI. Figure 13.17 shows that most FDI takes place between advanced countries, which suggests that the dominant motive for FDI is that frms are looking not for low-cost destinations to set up an establishment but for interesting markets. This observation does not imply that the vertical FDI motive is absent; many FDI fows are between developing countries and advanced countries. For these fows, the vertical FDI motive is usually important. What is striking in Figure 13.17 is that developing countries increasingly participate in FDI. But why do forms not simply export and import and instead go to the trouble to set up a foreign establishment? Dunning (1981) describes the main aspects of multinational ownership in his famous OLI framework. The o stands for ownership advantages and

Chapter 13 • International trade 379

indicates that a frm has expertise that other frms do not have, like patents, technology and management practices. The l stands for location advantages in the foreign market. A foreign market might have advantages such as low wages or large markets that compensate for the additional cost of setting up an additional facility. Finally, the i stands for internalization advantages and indicates that because of transaction frictions, it is benefcial to produce something in-house rather than to outsource. All three advantages are necessary to explain the existence of multinational frms. What are the effects of FDI on the destination markets? These investments can contribute to further development by increasing capital in the host markets. There is, however, also a risk of crowding out; if FDI is fnanced locally, it could make investments for domestic frms more diffcult if lenders prefer FDI over local frms. The effects of FDI on economic growth in the host countries is also ambiguous. Multinational frms – on average – pay higher wages, are more innovative and skill intensive than local frms, but the effects are positive only when FDI is accompanied by a mature fnancial sector; see Alfaro, Chanda, Kalemli-Ozcan, and Sayek (2004). FDI can also have positive effects on local frms through knowledge spillovers that increase productivity in local frms. Furthermore, local frms can beneft from multinational activity through forward and backward linkages. Forward linkages refer to the supply of high-quality intermediate products by multinationals. Backward linkages refer to the demand for local inputs by multinationals. Of course, there are also negative effects of multinational production. The additional demand for fnance might crowd out local frms; they can monopolize local markets and raise wages such that the most qualifed workers are no longer available to local frms. The net effects of FDI are not clear-cut; see Alfaro and Chauvin (2020) for a recent survey.

13.10 CONCLUSIONS In this chapter, we highlighted the interrelations between countries through trade and fnance and illustrated some of the policy consequences. We presented a short history of exchange rate regimes, illustrated international vehicle currencies, and discussed capital and investment fows. A key link between a country and the rest of the world is through the exchange rate. Prices in one country have to be translated into another’s currency. As trade takes time (order now, pay later), expectations about exchange rates become important, which establishes a link between the exchange rate and interest rates; the covered and uncovered interest parity conditions. This link between exchanges is crucial for understanding the possibilities and limitations of monetary policy and fnance opportunities for frms that are internationally active. Firms in more-unstable countries have a more diffcult time fnancing their international operations. International fnancial relations also limit policy choices for a government. This is the so-called policy trilemma. One can choose only two out of the following three policy preferences: monetary policy independence, a fxed exchange rate, full international capital mobility. The case of Argentina shows how diffcult this choice is (Box 13.2).

380 Steven Brakman and Charles van Marrewijk

The key lesson of this chapter is that trade, fnance and government policies are fundamentally interrelated.

Notes 1 This uses World Bank Development Indicators online GDP income for 2018 as a reference. 2 UTC = universal time coordinated, successor to Greenwich mean time. 3 www.staradvertiser.com/2016/ 12/29/breaking-news/what-itmeans-if-trump-names-china-acurrency-manipulator/. 4 Since 1994, China’s current account balance remained a surplus. It reached a peak in relative terms in 2007 (9.9% of GDP) and has almost disappeared since then (0.4% of GDP in 2018). 5 The futures market is slightly different from the forwards market in that only a few currencies are traded, with standardized contracts at certain locations (such as

6 7 8 9 10

11

the Chicago Mercantile Exchange, the largest futures market) and specifc maturity dates. We can, of course, get indirect measures from surveys, consensus forecasts, and so on. For econometric reasons, the actual test is usually in deviation from St. Based on World Bank Development Indicators online GDP defator. See Beugelsdijk, Brakman, Garretsen, and van Marrewijk (2013) for a similar analysis. General historical information in this section is based on that on Wikipedia; http://en.wikipedia. org. See also Chapter 4 of this book for a more extensive discussion.

References ADB. (2017, September). Trade fnance gaps, growth, and jobs survey. Manila: Asian Development Bank. ADB. (2019, September). Trade fnance gaps, growth, and jobs survey. Manila: Asian Development Bank. Ahn, J., Amiti, M., & Weinstein, D. (2011). Trade fnance and the great trade collapse. American Economic Review, 101(3), 298–302. Alfaro, L., Chanda, A., Kalemli-Ozcan, S., & Sayek, S. (2004). FDI and economic growth: The role of local fnancial markets. Journal of International Economics, 64, 89–112. Alfaro, L., & Chauvin, J. (2020). Foreign direct investment, fnance, and economic development. In M. Spatareanu (Ed.), Encyclopedia of international economics and global trade, vol. 3:

Foreign direct investment and the multinational enterprise (Ch. 10). Singapore: World Scientifc. Antràs, P., & Yeaple, S. R. (2014). Multinational frms and the structure of international trade. Handbook of International Economics, 4, 55–130. Beugelsdijk, S., Brakman, S., Garretsen, H., & van Marrewijk, C. (2013). International economics and business: Nations and frms in the global economy (2nd ed.). Cambridge: Cambridge University Press. BIS. (2002, March). Triennial central bank survey: Foreign exchange and derivatives market activity in 2001. Basel: Bank for International Settlements. BIS. (2019, September). Triennial central bank survey, foreign exchange turnover in April 2019. Basel: Bank for International Settlements.

Chapter 13 • International trade 381 Brakman, S., & van Marrewijk, C. (1998). The economics of international transfers. Cambridge: Cambridge University Press. Cooper, R. N. (1982). The gold standard: Historical facts and future prospects. Brookings Papers on Economic Activity, 1, 1–45. DiCaprio, A., & Yao, Y. (2017). Drivers of trade fnance gaps. Working Paper Series 678. Tokyo: Asian Development Bank Institute. Do Rosarion, J., & Millan, C. (2019). Argentina tightens currency controls after Fernandez Victory. Bloomberg. Retrieved from www.bloomberg.com/news/ articles/2019-10-28/argentina-tightenscurrency-controls-after-fernandezvictory Dunning, J. (1981). International production and the multinational enterprise. London and Boston: Allen & Unwin. The Economist. (2018, September 1). Go fund me: Markets bash Argentina’s and Turkey’s currencies again. Retrieved from www.economist.com/finance-andeconomics/2018/09/01/markets-bashargentinas-and-turkeys-currenciesagain Eichengreen, B. J. (1996). Globalizing capital: A history of the international monetary system. Princeton, NJ: Princeton University Press. Foley, F., & Manova, K. (2015). International trade, multinational activity, and corporate fnance. Annual Review of Economics, 7, 119–146. Frenkel, J. A. (1976). A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence. Scandinavian Journal of Economics, 78, 200–224. Gopinath, G. (2016). The international price system. Jackson Hole Symposium Proceedings. Retrieved from https:// scholar.harvard.edu/gopinath/ publications/international-pricesystem Gopinath, G., Boz, E., Casas, C., Diez, F., Gourinchas, P. O., & Plagborg-Moller,

M. (2019). Dominant currency paradigm. NBER Working Paper No. 22943. Cambridge, MA: National Bureau of Economic Research. Gourinchas, P. O., Rey, H., & Sauzet, M. (2019). The international monetary and fnancial system. Annual Review of Economics, 11, 859–893. Advanced Access. Habermeier, K., Kokenyne, A., Veyrune, R., & Anderson, H. (2009). Revised system for the classifcation of exchange rate arrangements. IMF Working Papers 09/211. Retrieved from https:// www.imf.org/external/pubs/ft/ wp/2009/wp09211.pdf IMF. (2014). Annual report on exchange arrangements and exchange restrictions 2014. Washington, DC: Author. Krugman, P. R., & Obstfeld, M. (2003). International economics: Theory and policy (6th ed.). New York: AddisonWesley. League of Nations (1933), World Economic Survey, 1932–33, Geneva, League of Nations. Mundell, R. A. (1968). International economics. New York: Palgrave Macmillan. Obstfeld, M., & Rogoff, K. (2000). The six major puzzles in international macroeconomics: Is there a common cause? NBER Macroeconomics Annual, 15, 339–390. Obstfeld, M., & Taylor, A. M. (2003). Sovereign risk, credibility, and the gold standard: 1870–1913 versus 1925– 31. The Economic Journal, 113(487), 241–275. Rey, H. (2016). International channels of transmission of monetary policy and the Mundellian trilemma. IMF Economic Review, 64(1), 6–35. Sarno, L., & Taylor, M. P. (2002). The economics of exchange rates. Cambridge: Cambridge University Press. van Marrewijk, C. (2012). International economics: Theory, application, and policy (2nd ed.). Oxford: Oxford University Press. van Marrewijk, C. (2017). International trade. Oxford: Oxford University Press.

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Questions for chapter 13: international trade, fnance, and development QUESTION 13.1 Suppose you want to buy a car. You want to buy either a Chevrolet for USD23,000, a Volkswagen for €15,900, a Honda for ¥2.2 million, or a Hyundai for ₩22 million. The following exchange rates are given.

 

Foreign currency per dollar

Foreign currency per euro

US dollar Euro Japanese yen Korean won

1.0 0.8 106.0 1120.9

1.3 1.0 135.9 1437.1

13.1A 13.1B 13.1C 13.1D

Which car is cheapest when all prices are expressed in US dollars? Do relative prices change when expressed in euros? Explain why this is the case. Which currency has to appreciate for the cheapest car to become more expensive? Which currencies have to depreciate for the cheapest car to become more expensive?

QUESTION 13.2 Imagine you have €100.000 and want to invest it in the foreign exchange market. After conducting an extensive analysis, you conclude what the exchange rates will be one year ahead. The following table gives both the spot exchange rate of the amount of foreign currency per euro and the expected exchange rate in one year.

 

Spot rate

Expected future rate

Australian dollar British pound Japanese yen US dollar

1.71 0.69 135.2 1.27

1.77 0.72 130.0 1.24

13.2A 13.2B

Explain in which currency you want to invest. How many euros do you expect to have in one year?

Suppose you own a car assembly line in Mexico. The different parts of the car are imported from the United States and the assembled cars are exported back to the United States.

QUESTION 13.3

13.3A 13.3B

What happens to the price of the imports when the Mexican peso depreciates? Does your car become more or less attractive to US consumers when the Mexican peso depreciates? Explain.

Chapter 13 • International trade 383

13.3C

As a Mexican producer, do you think the depreciation of the Mexican peso is a good thing?

QUESTION 13.4 On Monday, 1 November 2004, the dollar/euro exchange rate was 1.2748 and the dollar/euro 12 months forward exchange rate was 1.2717.

13.4A 13.4B 13.4C

Calculate the annual forward premium of the euro and the dollar. Explain whether the forward premium indicates that investors expect the euro to appreciate or depreciate in the future. If you expect that the euro will appreciate, should you buy or sell a forward euro contract?

An investor in London has two investment opportunities. They can invest in two-year UK government bonds with an annual nominal interest rate of 4.5%, or they can invest in two-year US government bonds with an annual nominal interest rate of 2.6%. Currently the spot exchange rate is 1.8 US dollar/UK pound, and the two-year forward exchange rate is 1.7 US dollar/UK pound.

QUESTION 13.5

13.5A 13.5B

Should the investor hold their money in UK or US government bonds? Does the covered interest parity hold? Do you think this situation will exist for a long time?

QUESTION 13.6 The covered and uncovered interest parity condition constitutes a powerful tool to predict exchange rate movements. The following is a list of a number of events. Predict with the covered or uncovered interest parity condition what will happen with the euro/US dollar spot exchange rate.

13.6A 13.6B 13.6C 13.6D

The US Federal Reserve announces that the discount rate will be lowered. GDP fgures of the euro area turn out to be better than expected, raising expectations that the European economy is coming sooner out of its slump. The ECB president hesitates before he says ‘strong euro’. Most large US companies unexpectedly raise their proft prospects.

QUESTION 13.7 13.7A A nation might try to achieve three main policy objectives: monetary policy independence, a fxed exchange rate, and international capital mobility. What are the merits of each of these objectives? Why are they desirable?

13.7B

Since the year 2000, US policymakers have grown concerned about the exchange rate between the US dollar and the Chinese yuan. Effectively, the yuan was fxed to the dollar at a rate they considered to be inappropriate. Moreover, China was able to maintain some monetary independence. What does this imply for capital mobility?

384 Steven Brakman and Charles van Marrewijk

13.7C

13.7D

The buoyant growth of the Chinese economy in the 21st century has attracted a lot of capital to China. Given that capital restrictions are hard to enforce perfectly, Chinese money growth has been rapid. What does this imply for monetary policy independence? As the Chinese economy integrates ever more tightly into the global economic system, capital restrictions will become ever harder to enforce. What policy options do the Chinese monetary authorities have in light of this development?

CHAPTER

14

Infrastructure fnancing and economic development Saint Kuttu, Ashenaf Fanta, Michael Graham, and Joshua Yindenaba Abor 14.1 INTRODUCTION Infrastructure is, without a doubt, one of the key determinants of economic growth. According to the World Bank, 1994 World Development Report (pp. 2–4, 13–16), most studies on economic development, though plagued by the econometric problem of endogeneity, fnd that infrastructure investment is associated with one-for-one percentage increases in gross domestic product (GDP). The United Nations Sustainable Development Goals (SDGs) capture the importance of infrastructure to economic growth in SDG 9. Specifcally, SDG 9, among other things, aims at developing regional and cross-border quality, reliable, sustainable, and resilient infrastructure to support economic development and human well-being. Furthermore, SDG 9 aims to facilitate sustainable and resilient infrastructure development in developing countries, particularly in Africa and other less-developed countries. Infrastructure is at the core of inclusive growth (SDG 10) for creating jobs, reducing inequalities, and offering opportunities to African citizens. African countries cannot achieve SDG 4 of expanding education opportunities for youth and SDG 8 of providing jobs without providing access to electricity, broadband, and connectivity. SDGs 1 and 2, improving food security and agricultural value chain development, cannot be achieved without providing access to reliable transport infrastructure that will help reduce postharvest losses. SDG 11 of sustainable cities and communities cannot be achieved without clean water, adequate sanitation, a reliable and affordable electricity supply, and mass transit systems to make Africa’s growing cities habitable. Infrastructure can be broadly classifed into economic infrastructure and social infrastructure (Simpson & Zimmermann, 2012). One the one hand, economic infrastructure is the combination of basic facilities that underpin economic development. These encompass, for instance, telecommunication, electricity, transportation, and energy. On the other hand, social infrastructure is the combination of basic facilities that are essential for human development. These include health, education, and housing. For

386 Saint Kuttu et al.

the overall development of Africa, economic and social infrastructure are necessary and must complement each other. However, the infrastructural defcit of sub-Saharan Africa (SSA) is substantial. The World Bank (2011) report on infrastructure indicates that the equivalent of 15% of the continent’s GDP is required annually to raise infrastructure in SSA to a reasonable level. The World Bank (2011) argues that one approach to addressing the challenge posed by inadequate funding is to facilitate an increase in the private provision of public infrastructure through public–private partnerships. However, we contend that the most plausible approach that can sidestep the inadequate funding conundrum and thus reduce the infrastructural defcit in SSA, is fnancing infrastructure though project fnance. This argument hinges on the premise that using project fnance will make the servicing of funds for the infrastructure project nonrecourse or limited recourse. Given the high sovereign debt levels in SSA, borrowing to augment the capital to fnance infrastructure will add to the unsustainable sovereign debt stock, which will negatively affect the sovereign debt rating. With the project fnance approach, where the project fnancing is legally and economically self-contained, cross-contaminating toxic debt is not possible, because the project is ring fenced from the sponsors, which include the host government. To give the presentation in this chapter contemporary relevance, we structure the discussions around the following questions: 1 What are the challenges and opportunities for infrastructure development on the African continent? 2 How does infrastructure development, in general, affect Africa’s development? 3 What are the traditional ways of fnancing infrastructure development on the continent? 4 Are there other innovative means through which Africa can fnance the needed infrastructure development to close the signifcant infrastructure gap? 5 What are the risks accompanying infrastructure projects, and how can they be managed? The rest of the chapter proceeds as follows. Section 14.2 presents the development challenges that Africa faces due to a lack of social and economic infrastructure and the opportunities that have emerged as a result of the discovery of natural resources in some countries. Section 14.3 discusses the multiplier effects of infrastructure on economic development. In Section 14.4, we present the various ways of fnancing infrastructure development on the continent, focusing on public–private partnerships. This is followed by a discussion on the institutional framework and the legal framework required to promote PPPs, in sections 14.5 and 14.6, respectively. Section 14.7 presents risk management in infrastructure projects, and section 14.8 concludes.

Chapter 14 • Infrastructure fnancing 387

14.2 CHALLENGES AND OPPORTUNITIES FOR INFRASTRUCTURE DEVELOPMENT 14.2.1 Challenges One of the topmost developmental challenges in SSA is the shortage of economic and social infrastructure. Economic infrastructure covering transportation, power, and communication facilitates growth, and social infrastructure, including water supply, sanitation, sewage disposal, education, and health, has a direct impact on the quality of life. Inadequate transport, communication, water, and power infrastructure stifes it even more. The African Development Bank (2018) estimates that Africa needs between USD130 billion and USD170 billion per year to fund the infrastructure gap in the continent’s economic activity, reduce effciency, and decrease competitiveness. Most international investors who are eager to do business in Africa fnd it diffcult to access the markets, especially in the interior, due to inadequate and poor infrastructure.1 Nonetheless, there are some challenges inhibiting infrastructure development in Africa, and we enumerate a few here. First, management capacity and the technical expertise required to develop nonexistent multinational projects. The paucity of expertise often results in projects that are of poorer quality and higher cost. Second, inadequate data and lack of programmes and plans present major challenges to the provision of infrastructure in Africa. The fast, steady, and continuous growth in household demand for infrastructure stemming from Africa’s high population growth and the fast increase in the urbanisation rates of these populations contribute to fuelling the demand for infrastructure. With competing priorities, governments in Africa become completely helpless when it comes to proving adequate infrastructure. Third, inadequate funding for infrastructure development is another challenge facing the provision of infrastructure in Africa. The puzzling paradox is that politicians seem to be ahead of academics and many international donors in recognising that infrastructure development is relevant for growth and poverty alleviation, yet they end up allocating a declining level of resources, both in absolute terms and in relative terms, to infrastructure development (Estache, 2006). Fourth, political risk and corruption have stifed foreign investors’ making infrastructure investments in Africa. Political interference, policy uncertainty, delays in passing laws, bureaucratic delays in decision-making, policy changes, and endemic corruption are some of the contributors to the lack of investment in infrastructure development. Project sponsors, developers, and operators, along with investors, often lack clarity around contracting, government regulation, contracting arbitration, the policy and process for procurement, planning, and tariff setting. Nigeria, for instance, suffers from high levels of corruption. Companies operating in the country also face the threat of an unstable security situation, especially in the Niger Delta area, and in the north, where militant group Boko Haram is known to target international workers.

388 Saint Kuttu et al.

Fifth, project delays and budget overruns are pervasive in SSA. Large and inherently risky projects with many interconnected parts, resources, and contractors require complex stakeholder management. Project developers in Africa often face additional distinctive problems. These include different legal standards, a greater likelihood of political interference, and diffculty in accessing supporting infrastructure such as power, water, housing, airports, and healthcare. They sometimes need to import skilled labour, equipment, and materials. The impact of delays can extend beyond the project itself and may affect internal problems (e.g. inadequate pre-engineering, weak project management, poor planning, and weak governance), fnancing (e.g. capital rationing and delays in the release of funds), governmental complications (e.g. legal and regulatory requirements, delays in approvals, and changes in policy), and diffculties in the supply chain into the organisation. Economic factors (e.g. infation, currency depreciation, and currency exchange controls) and technical factors (e.g. a lack of project cost estimation, commercial management and project management skills, poor planning, poor technical decision-making, inadequate risk assessments, lack of proper controls, and the inadequate monitoring of projects) may sometimes contribute to budget overruns. 14.2.2 Opportunities Opportunities for infrastructure development in transportation, oil, gas, power, and water sectors abound in Africa. Despite some level of investment in road infrastructure in most African countries, the quality of roads and railroad networks still lags far behind much of the rest of the world. Many roads remain unpaved, and most rail lines, which were constructed during the colonial period, are in poor condition and outdated. As African economies develop, a solid transportation network is critical to linking economic zones and resource-rich centres with seaports, airports, and the global economy. Rundown and ineffcient transportation infrastructure increases the costs of moving goods, reduces the competitiveness of businesses, and impacts intracountry and intercountry trade. As a consequence, the African Development Bank (2018) has reported that high transport costs increase the price of goods in Africa by about 75%. With the increase in exciting discoveries of oil and gas being made in many parts of Africa, international investors are looking to participate in the next frontline of oil and gas development. The recent fnds in Mozambique, Tanzania, Kenya, and Uganda have renewed interest in Africa’s hydrocarbons. To monetise these resources, spending on infrastructure will be critical. Nigeria is the leading oil exporter in Africa and also has the largest natural gas reserves on the continent, and Angola is the continent’s secondlargest oil producer. Due to insuffcient infrastructure for the extraction, processing, and storage of these commodities, neither can currently take full advantage of their resource reserves. Electric power remains one of Africa’s greatest infrastructure challenges, with limited electricity access and frequent power outages across the region; electricity supply is recurrently unreliable. The generators and the

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transmission infrastructure have passed their shelf lives and need replacement. As a result, there has been an increased reliance on self-generation and temporary solutions. With the growing demand for power, greater investment in generation and transmission infrastructure are needed to keep up with the growing demand. There is abundant availability of energy resources in the form of coal, oil, gas, hydropower, solar, and geothermal potential, which remain underexploited as a result of underinvestment. Power generation is a high priority in the National Development Plan of South Africa. In the plan, spending is projected to increase at an average annual rate of over 20% between now and 2025 to total more than USD120 billion. Also, in Nigeria, a 10% average annual growth rate in spending is expected across the electricity sector. This hinges on solid government revenue growth from oil receipts. Angola is aiming to increase the country’s power production capacity from the current level of 1,800MW to 9,000MW by 2025 through the construction of 15 new power plants, while in Gabon, the government is focusing on the development of the nonhydropower capacity to improve the reliability of supply. Ghana plans to expand its thermal capacity through investment in gas-fred generation and in solar power. Another area plagued by underinvestment in infrastructure in Africa is the water sector. This manifests itself in service backlogs, ageing infrastructure, and vulnerability to hydrological variances. Signifcant proportions of the population are without access to basic water supply and dignifed sanitation. Hence, signifcant investment in water and sanitation infrastructure is needed to address the problem. As a consequence of limited funding, many countries are faced with trade-offs. They either maintain the existing infrastructure or expand the network to unserved people. Such tradeoffs often result in countries’ underinvesting in the maintenance of existing infrastructure, which manifests in unreliable and poor-quality service and operational ineffciencies

14.3 MULTIPLIER EFFECTS OF INFRASTRUCTURE DEVELOPMENT ON ECONOMIC DEVELOPMENT The positive economic impact of infrastructure has long been recognised, and without a robust infrastructure, achieving the other United Nations SDGs will be diffcult. In the short term, infrastructure stimulates demand and creates employment in construction and related industries, and in the long term, infrastructure boosts supply and enhances an economy’s productive capacity. For example, a new road may facilitate more trade, and it would likely support even more jobs long after the project’s completion. César and Luis (2004) observe that infrastructure development can have a disproportionate impact on the human capital of the poor and hence on their job and income prospects. They argued that for infrastructure to reduce income inequality, it must result in improved access and enhanced quality, particularly for low-income households. They also found that infrastructure made a relatively modest improvement in inequality in SSA due to the region’s lack of progress on the quality infrastructure over the sample period.

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Investment in infrastructure could become a strategic tool for poverty reduction and economic development. Infrastructure investment in Africa is particularly important because the continent ranks at the bottom of all developing regions in nearly all dimensions of performance. Kodongo and Ojah (2016) argue that spending on infrastructure and increments in the access to infrastructure infuence economic growth and development in SSA. Further, they posit that these signifcant associations, especially those of infrastructure spending, are more important for lesser-developed economies in the region than for the relatively more developed economies. Clearly better infrastructure such as telecommunication infrastructure, roads, rail, and ports will unlock many of the bottlenecks and stimulate intra-African trade. Specifcally, reducing the cost and improving the quality of transport services is central to facilitating the movement of goods and services. Also, given the housing defcit in Africa, the current form of fnancing housing in Africa where commercial investment banks rely mostly on short-term deposits to fund long-term housing loans naturally presents banks with a balance sheet mismatch problem and limits the number of mortgages they can offer. Ncube (2010) argues that multilateral agencies, such as the World Bank and the African Development Bank, have an opportunity to develop, participate in, and provide longer-term funds for on-lending for affordable housing in Africa. Some of the opportunities would include the provision of long-term loan facilities to local banks for on-lending for affordable housing ownership, taking equity ownership in mortgage fnance institutions established by various African countries, purchasing some of the mortgage-backed securities, and providing a fnancial guarantee to banks for loans provided for the affordable housing sector. Infrastructure is a key element of poverty alleviation. It often acts as a catalyst to development and enhances the impact of interventions to improve the poor’s access to other assets – for example, human, social, fnancial, and natural assets. Its impact is felt on both the economic sectors and the social sectors. Without roads, the poor are not able to sell their output on the market. The most devastating famines experienced in Africa were not primarily the result of inadequate production but inadequate entitlement to food. In infrastructure terms, entitlement translates into access. For the poor, the most dramatic impact of inadequate infrastructure may be less the result of a lack of infrastructure per se and more the result of a lack of access to that infrastructure. The 2016 survey by the polling frm Afrobarometer, a nonpartisan research network, found that more than 20 countries in Africa have improved economic growth and living conditions with active government spending on infrastructure. The survey shows the importance of developing roads, electrical grids, health clinics, and other forms of infrastructure for promoting development and reducing poverty. Ogun (2010) unequivocally fnds that infrastructural development leads to poverty reduction. Results also show that although infrastructure, in general, reduces poverty, social infrastructure explains a higher proportion of the forecast error in poverty indicators relative to physical infrastructure.

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14.4 FINANCING INFRASTRUCTURE DEVELOPMENT 14.4.1 Traditional versus private investment No doubt, the cost of fnancing large and complex public infrastructure projects is considerable. Traditionally, national governments have been the prominent fnanciers of such projects around the world (see, e.g., BriceñoGarmendia, Smits, & Foster, 2009). This dominance has been attributed to the public goods attributes of public infrastructure and the positive externalities generated by such investments. Among the funding options used by governments to fnance public infrastructure projects are taxes and rents on the extraction of resources, loans contracted, and grants received from donors. Dwindling public capital committed to infrastructure development, accentuated by increasing public debt–to-GDP ratios, public defcits, and a narrow tax base has, however, left the infrastructure needs of many countries and regions unattended to. For example, the African Development Bank (2018) estimates that Africa needs between USD130 billion and USD170 billion per year to fund the infrastructure gap on the continent.2 Given the contribution of infrastructure to economic growth, a defcit in public infrastructure fnancing places a signifcant hurdle in its facilitating role in achieving positive national outcomes, thereby perpetuating an observed conundrum. That is, it is relatively more diffcult to improve and expand on the compulsory and unrequited payments into government coffers to fnance infrastructure without economic growth. Economic growth, in turn, is dependent on the elimination of logjams brought about by inadequate infrastructure. Given the limited availability of public funds to fnance infrastructure projects, private sector investment is seen as vital in closing the estimated infrastructure gap. We can categorise private sector participation in fnancing infrastructure as follows: projects that are commissioned by the national government but that are, at least partially, fnanced by the private sector and projects that are fully owned and operated by the private sector. The private sector may self-fund infrastructure projects that are deemed fnancially viable (with acceptable risk returns) that do not need government concession to undertake. An example is the resource sector and its ability to self-fund rail and ports (see PwC, 2011). Private sector participants in infrastructure provision typically source loans from banks (bank-syndicated loans) or via bond issuance in capital markets. Over the past decade or so, private sector infrastructure fnancing has increasingly taken the form of project fnance, a deal structure that involves the setting up of a special purpose vehicle (SPV) that becomes the centre of a complex network of contracts. In this arrangement, private sector fnancing comes in the form of equity and debt fnancing. The equity fnancing is provided mostly by corporate sponsors and developers, who may be either primary or secondary equity providers. Primary equity providers, unlike the secondary equity investors, are involved in decisions regarding the construction of the infrastructure asset. Debt fnancing usually forms a hefty percentage of infrastructure fnancing. The proportion of private debt fnancing is, however, dependent on the stability and predictability of income fows from the respective projects.

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Although private sector fnancing is important in fnancing global infrastructure development, there are bounds that can be accomplished by the sector. This is clear in projects that have high social but low fnancial returns (e.g. areas of rural infrastructure). There is, therefore, the need for collaborative efforts by the public and private sectors to institute innovative fnancing modes to address the infrastructure gap (see Atta-Mensah, 2004; Kothari, 2006; Brixiova, Mutambatsere, Ambert, & Etienne, 2011; Hughes, 2011). 14.4.2 Various fnancial instruments A consequence of the recent global fnancial crisis is that there are now more-stringent regulations on banks and their lending requirements. For this reason, infrastructure projects can no longer depend solely on traditional debt sourced from banks. Also, infrastructure are long-term assets, and banks with large short-term liabilities are ill-suited to hold infrastructure assets on their balance sheets. Thus, closing the noted infrastructure gap would also entail implementing other innovative fnancing resources. In this section, we discuss some of such fnancing mechanisms. Sovereign bonds, debt instruments issued by national governments, offer options in raising capital to fnance long-term capital like infrastructure. These bonds are characterised by relatively low risk compared to equities and are attractive to institutional investors with long-term liabilities. The resilience of many emerging regions during the recent global fnancial crisis is expected to increase the attractiveness of these bonds to institutional investors. There has been a growth in the number of developing countries and parastatals.

SOVEREIGN BONDS

LOCAL CURRENCY INFRASTRUCTURE BONDS Infrastructure is currently seen by many market participants as an asset class of its own. As such, a signifcant upsurge in resource allocation by institutional investors and other fund managers to this investment class can be expected. For that reason, issuing longterm infrastructure bonds can be seen as an ideal and viable debt-funding avenue to obtain fnancing for infrastructure projects. These debt instruments may be subject to tax exemptions as national governments encourage infrastructure development and investments through these bonds. In particular, issuing infrastructure bonds denominated in the local currency has merits for many countries. On the one hand, revenues derived from infrastructure projects are denominated in local currency. On the other hand, foreign banks lend in foreign currency. This results in a currency mismatch with signifcant implications for countries with volatile currencies. In this context, local currency bonds serve as an alternative way for infrastructure fnancing and help plug the fnancing gap for long-term infrastructure projects. COMMODITY-BACKED BONDS Commodity-backed bonds are long-term debt securities whose returns are linked to the performance of an underlying

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commodity. In this sense, they differ from a conventional bond regarding the payoffs to the bearer of the bond. The nominal return of the conventional bond held to maturity is known with certainty. That is, the bearer of the bond receives contractual fxed coupon payments during the life of the bond and the principal at maturity. In contrast, the principal of a commodity-linked bond is paid in either the physical units of a reference commodity (e.g. gold, silver, oil) or its equivalent monetary value. Likewise, the coupon payments may also be in units of the commodity to which the bond is indexed. Thus, the nominal return of a commodity-backed bond is unknown. For commodity-exporting countries, issuing debt securities backed by commodities can be benefcial, raising funds as well as providing a hedge against unexpected and signifcant declines in commodity prices. Migrant remittances offer a way, through securitisation, to borrow in hard currencies to fnance infrastructure development. By securitising the remittances, the bank’s receipt of the money transfers is separated from its responsibility to pay the third party to whom the remittance was sent. Unlike other forms of securitisation, where the infow is an income, securitising the future fow of remittances is essentially securitising cashfows. The loans in hard currency are fnanced with remittance fows, and the resultant liability to pay recipients in domestic currency is cleared by a local remittance bank out of its domestic resources. Thus, it enables countries to tap into the foreign exchange (hard currency) element of remittances, without disrupting the actual transfer. In this structure, the originating bank gives up its rights to collect remittances in hard currency, and all future remittances through the bank do not enter the issuing bank’s domestic country. An offshore special purpose vehicle (SPV) is created to receive the remittance in hard currency to repay investors. Consequently, with remittance securitisation, income is not matched with debt service, but rather, there is a matching of infows and debt services.

SECURITISING REMITTANCES

DIASPORA BONDS Diaspora bonds present an inexpensive way for governments to raise funds. A diaspora bond is a debt security issued by a sovereign country aimed at investors that have emigrated to other countries and the relatives of those emigrants. This alternative way of raising funds taps into the patriotic desires of emigrants to contribute to the progress in their country of origin. Investors at home may also hold such bonds. The appeal of a diaspora bond as an investment pool is obvious: many investors with personal links to a country tend to be loyal to the country and may be more willing to risk their investment capital in the local currency of such countries, often at relatively lower yields. Dilip Ratha of the World Bank refers to this as the patriotic discount. Such patriotism may see the investors’ persisting with their investment and not cashing out in periods of crisis. Many countries, including Ethiopia, India, Israel, and Sri Lanka have issued diaspora bonds. Thus, diaspora bonds are would-be avenues of longer-term fnancial resources for infrastructure, complementing remittance fows that typically fnance social expenditures.

394 Saint Kuttu et al. PRIVATE EQUITY FUNDS Private sector participation in infrastructure fnancing has also increased due to the increasing presence of private equity funds (PEFs), funds formed by investors interested in directly investing in other companies (by buying the whole company) rather than buying shares. Investors in PEFs may include development fnance institutions, pension funds and endowments, and high-net-worth individual investors. PEFs use a mix of fnancing instruments (e.g. mezzanine fnance) to invest in various infrastructure sectors. They provide much-needed foreign currency fnancing and longer tenors. The investment community distinguishes between traditional PEFs and infrastructure PEFs because of some salient characteristics of infrastructure (e.g. low risk, strong cash yield, providing a hedge, and low correlation with other assets).3 Specialised infrastructure funds, a scheme that invests primarily in the securities of infrastructure companies, infrastructure capital companies, and infrastructure projects, were pioneered by established infrastructure frms such as Macquarie Group. Currently, numerous specialised infrastructure funds have mobilised billions of US dollars in direct fnancing for greenfeld and brownfeld infrastructure projects.

The savings rate – that is, disposable income plus the change in net equity of households in pension funds minus fnal consumption expenditure (see OECD, 2020 for Data) – differs across the world. Given the fundamental macroeconomic identity that savings equal investment (physical investments), it can be understood that the varying saving rates would have important implications for longterm investment patterns. This is because household saving is the foremost domestic source of fnancing for long-term projects. Countries with low saving rates therefore need to institute policies to attract capital fow, especially private capital fows, as sources of funds to fnance infrastructure (capital) investment. Economic agents in high saving countries are looking for riskconsistent proftable opportunities. A concerted effort to match excess savings and investment opportunities across national borders may offer an effective way to fnance capital investments. Low-saving-rate countries may also target emerging partners, like Chinese, Arab, and Islamic funding institutions, as sources of fnancing infrastructure projects.

TAPPING RESERVES IN EXCESS-SAVINGS COUNTRIES

SOVEREIGN WEALTH FUNDS Sovereign wealth funds (SWFs) are a mechanism through which countries make investments. There are currently 60 SWFs in operation. They are established from, among other things, the balance of payment excesses, government transfer payments, fscal surpluses, and receipts from resource exports. SWFs can be an important source for fnancing infrastructure development, particularly in resource-rich countries. Assets under management (AUM) by existing SWF has topped USD7 trillion.4 This is signifcant in the context of fnancing infrastructure because many SWFs are authorised to assist with developing local economies and because infrastructure investment is a viable conduit for that purpose. Unsurprisingly, the proportion of sovereign wealth funds investing in infrastructure has reached 62% of total assets under management, according to

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the 2016 Preqin Sovereign Wealth Fund Review. Infrastructure investments are, generally, attractive to SWFs because they offer long-term stable yields and their capacity to endure illiquidity makes them particularly well suited to the infrastructure asset class. Importantly, further growth in investment in the infrastructure asset class is predicted. 14.4.3 Public–private partnership fnancing structures A public–private partnership (PPP) involves collaboration between a private entity and a government (or government entity) in a joint venture, each party applying their respective strengths in developing a project more effciently than the government would achieve alone. PPP arrangements may take difference forms – for example, a situation where the private entity brings in the funding to fnance government infrastructure project and assumes some form of ownership subject to oversight role and approval by the government. The structures may differ in the way the government entity and private entity share responsibilities, risks, and rewards related to the infrastructure project (Winch, Onishi, & Schmidt, 2012; Rosnani, Suhaiza, & Julia, 2018). Finnerty (2013) identifes some PPP fnancing models available for the fnancing of typical infrastructural projects. The main fnancing models include the build-operate-transfer (BOT) model, build-transfer-operate (BTO) model, buy-build-operate (BBO) model, lease-develop-operate (LDO) model, perpetual franchise model, wraparound addition, temporary privatisation, speculative development, value capture, and use-reimbursement model. Each fnancing model differs in the contributions from, responsibilities for, and rewards for each partner (public or private venture). Finnerty (2013) suggests that determining the most appropriate fnancing model requires addressing the following key issues: • • • •

Whose role is to design and construct the project? Whose role is to provide funding? Whose role is to arrange fnancing? Who has legal ownership of the projects and its assets and to what extent? • Who bears all risks and liabilities? • Whose role is to operate the facility? • Who is responsible for generating revenue from the project? The choice of PPP fnancing model would be based on the extent to which each party does what in the project. Next, we discuss each of the PPP fnancing models. The BOT model is the commonest form of PPP fnancing structure. It entails the private sector entity’s committing to construct and build a commercial structure or infrastructure and run or operate it for a stipulated number of years, after which its ownership reverts to the local government. With this type of agreement, ownership rests in the hands of the private operations from the time the

14.4.3.1 BUILD-OPERATE-TRANSFER (BOT) MODEL

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project is started and fnished, and some years it is operated by the private entity. After a stipulated future date, ownership reverts to the government or elected governmental bodies. This arrangement allows for ample time for the private entity to recoup its capital investments, after which ownership transfers to the government or public entity. The private entity fully fnances the project only for ownership transfer to occur at a later date. This model is quite common in developing economies because of governments’ fscal constraints. It may be diffcult for such projects to come to fruition if the government is left to do it alone. On the part of the private investors, it is a win-win situation, because they are also able to make satisfactory returns on their investment. A typical example is a construction of highways by private entities, after which the private entity collects tolls for some years and then transfers ownership to the government entity (Laishram & Satyanarayana, 2009). Box 14.1 provides details of a healthcare project that used a BOT model.

BOX 14.1 Lesotho public–private investment partnership The government of Lesotho and Tsepong (Pty) Ltd (a private consortium) in 2008 entered into a healthcare PPP to rebuild the national referral hospital and associated clinics in the capital city of Maseru in Lesotho. The duration of the contract is 18 years (2008 until 2026), and the government and Tsepong established the project structure on the 1 October 2008 over the 18-year period for USD256.8 million. The construction is jointly financed by 37.7% of public funds and 62.3% of private funds. The project aims to design, build, and construct a 425-bed hospital (made up of 390 public and 35 private beds) and refurbish and re-equip three urban clinics. The hospital was to be operated and managed by Tsepong for the 18-year period. The hospital and the clinic constructed a health district for supporting the application of integrated care to ensure improvements in efficiency and expand healthcare access for the people of Maseru and all of Lesotho. The funding structure of the project is shown in Table 14.1. TABLE 14.1 Financing structure Source of capital

Public capital investment (USD)

Private capital investment (USD)

Total (USD)

Funding %

Debt Equity Total

94.9m* 0.47m 95.4m

47.5m 10.2m 57.7m

142.4m 10.7m 153.1m

93.01% 6.99%

Source: Downs, Montagu, da Rita, Brashers, and Feachem (2013) Note: m = million

Chapter 14 • Infrastructure fnancing 397 14.4.3.2 BUILD-TRANSFER-OPERATE (BTO) MODEL The BTO model involves the private entity’s initiating and building a project only to transfer it to the government entity upon completion. The government entity then operates the facility or can lease it back to the private entity for a fxed term. If the infrastructure is leased back to the private entity, it is at liberty to make fnancial gains from it, and this is normally the case. If the government entity operates the structure, it still has the option to hire the private entity to manage the project on its behalf. Under this model, the chunk of the fnancial commitment falls on the private entities; the government makes little fnancial commitment. An example of a PPP project that could employ this model is private–public collaboration to build a government hospital for a district.

Under the BBO model, the private entity acquires an existing government structure or building, modernises it, and then operates it. In this arrangement, the title or ownership of the property transfers to the private entity after purchase. The private entity after purchasing the property can repair, expand, or improve the property and can monetise it. This model is often applied in government privatisation schemes. Usually, the government cannot turn things around concerning these properties so giving them to private management is the best option for it. This model of fnancing is also quite popular in developing economies. An example of partnerships where this model could be used isthe privatisation of government buses for private usage and management.

14.4.3.3 BUY-BUILD-OPERATE (BBO) MODEL

In the LDO model, the government leases a public property with the accompanying land to a private institution to use and manage for an agreed term. In the model arrangement, ownership of the property is retained by the government entity while the right to use and manage the property is given to the private entity. This arrangement works well in a situation where the private entity is not able to make a full payment for the acquisition of the property, unlike they can in the case of a BBO model. It means the cost of the lease is much lower than an outright purchase of the property. Also, the risk from the project is not borne by the private entity alone but shared between the two parties. This could be an advantage to both parties. Also, the LDO model gives the government right to some of the profts from the project after it has been leased. An example of a project that could be fnanced using the LBO model is the lease of government land to be used as a transport yard.

14.4.3.4 LEASE-DEVELOP-OPERATE (LDO) MODEL

Concerning perpetual fnance model, the private entity obtains a ‘perpetual franchise’ to operate the project or structure for the foreseeable future. This ‘perpetual franchise’ is obtained from the local government. Funding is provided by the entity, and the ownership and title of the project’s assets reside with the private owners. The way that governments come in is by regulating the project. The government has the right to regulate the quality of the project’s output, pricing, profts, safety, level of output, and more. The government or public institution does not retain any of the profts that accrue from such

14.4.3.5 PERPETUAL FRANCHISE MODEL

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infrastructural investment. A good example where this model may apply is a government’s providing land for a private investor to construct a compost plant. The government offers the land while the private entity provides the necessary accoutrements to build the plant. Further, the government can regulate the pricing of the compost and infuence whom it should or should not be sold to. 14.4.3.6 WRAPAROUND ADDITION In this fnancial model, the government gives the private entity the right to expand and use up a property. The private entity undertakes to upgrade and use the government property. In this case, the title of the core property remains in the hands of the government entity. The private entity retains ownership of the extra upgrade or additions it brings. This model has a risk and proft-sharing mechanism just like the LDO. In most cases, the private entity would be the one running the operations of the whole structure. An example of a project that could use this fnancial model is a government warehouse converted and developed into a factory by a private entity. A real example where this fnancing model is used is the Azura Power West Africa Ltd in Edo Nigeria, where for a 2.5% minority stake in the project, the government provided 100 hectares of land (see https://azuraedo.com/about/). 14.4.3.7 TEMPORARY PRIVATISATION The temporary privatisation model is similar in some respects to BOT model in that the private entity operates the property for only a stipulated amount of time. Here the private entity obtains the right to use the property from the government. The private entity then develops or repairs it, then operates it for a predetermined period. In this case, the ownership of the property does not transfer to the private entity. The government signs some lease agreements with the private entity. Normally the property will need some form of upgrading, and the private entity then commits to upgrade it and operate it for a period to recoup its investments. Here all the risk is transferred to the private entity in the period of operation. The term given to the private entity is usually long enough for it to recoup all its investments and make suffcient returns. The private sector entity is also not required to share profts with the government entity. After the time allotted has elapsed, the right of operation is then reverted to the government. An example, in this case, would be the repairs and operation of a bridge or railway by a private entity for an agreed period. 14.4.3.8 SPECULATIVE DEVELOPMENT This model is speculative in the sense that a private entity identifes a public need that has not been met. It ascertains whether it could monetise it and then performs all the necessary groundwork with the knowledge of government after obtaining the necessary permission. When the private entity can make measurable progress, the government comes to provide fnancial and nonfnancial support. In this model, ownership usually remains in private hands, although it could be joint ownership in some cases. The main risk from the project inception rests with the private entity until the government comes in to offer some

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assistance. Due to the speculative nature of the project, it could also easily go bust. However, in cases where the project becomes successful, the private entity can rake in more profts. An example of a project that would use this fnancing model is the setting up of an amusement park on government property. 14.4.3.9 VALUE CAPTURE This model is sometimes referred to as the involuntary partnership model. In this model, the value created by the existence of a project is taxed to generate revenue to complete the project. An infrastructural project like the building of a railway or highway will generate externalities to those affected, which could be monetised. When a railway passes through a town, there are many externalities created; property values appreciate, ease of transport improves demand for housing close to the rail, and commercial enterprises have access to a bigger market, among others. These externalities enhance revenue generation to the entities involved. Because of these positive externalities, the value created could be captured and monetised to generate revenue for the project. Value capture imposes special taxes on those the project would affect, to generate revenue to run the project. Revenue collection agencies would be set up to collect these taxes and channel them directly to the project. In cases where the revenue fows are regular and predictable, bonds could be issued on them to generate additional fnance to complete the project quickly. As alluded to earlier, a typical project that could use the value capture method is railway construction. 14.4.3.10 USE-REIMBURSEMENT MODEL In this model, the project company enters a utilisation contract with the public or private entity. This contract requires the public or private entity to make periodic payments to the project company to cover all debt accrued to the establishment of the structure. This method works particularly well in a situation where the funds for the project were borrowed from an external source and repayment has to be made after the project has been completed and is in operation. So revenue generated from the structure is used to defray the debt. The loan is usually guaranteed by the government, thus exposing the government to credit risk. After completion and subsequent operation, the loan has to be repaid whether the structure generates proft or loss. Again, the loan repayment structure is usually standardised and regular. An example of a project that could fall under this category is the construction of a cluster of schools by private contractors for the government.

14.5 INSTITUTIONAL FRAMEWORK FOR PRIVATE PARTICIPATION IN INFRASTRUCTURE DEVELOPMENT Ensuring sustainable private participation in public sector projects requires enabling a legal, regulatory, and institutional framework (see, e.g., Chong & Poole, 2013). The institutional framework and legal environment that encourage private sector involvement in infrastructure projects are needed

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to minimise the likelihood of corruption and must be suffciently reliable to promote private participation and investment. In the absence of a wellfunctioning legal and judicial system, private sector participants will see the project as unpredictable and highly risky. This can also increase the cost of a PPP contract because private sector participants factor the risk into their project-pricing model. Similarly, assurances must be made that the laws and the contract will be honoured and can be enforced in the courts through arbitration, when necessary. This requires setting up an independent regulatory organ in the government, and it can also be useful to embed regulatory principles in the contract. Although the degree of specifcity in the terms and conditions of a PPP contract may depend on the legal regime prevalent in a particular jurisdiction, highly specifc contract terms that establish duties, performance targets, tariff level and structure, rules for changing tariffs, and dispute resolution procedures allow the private sector to better predict the proftability of the venture and decide whether the contract is worth bidding on. The institutional framework required for PPP contracts mainly includes a PPP unit and dispute resolution mechanisms. The PPP unit can bring coordination and effciency gains, and it can be located at the ministry of fnance/treasury. PPP units at a central level can improve coordination and effciency and bring a clustering of relevant skills to a single place. For instance, as presented in Box 14.1, the PPP unit in South Africa is located in the National Treasury. When located at a high level, PPP units can ensure buy-in from key decision makers. However, this approach has risks in that it can tie PPPs to individual leaders rather than embed them in the bureaucratic system, and it can thus lead to lack of involvement across government departments in later stages of PPP cycles. An effcient dispute resolution process is important to assure private sector participants that they will receive fair legal treatment should a dispute materialise. Dispute resolution procedures can be embedded into a PPP agreement, prescribing specifc steps that must be followed in the event a dispute arises. For example, in South Africa, the resolution of frst instance disputes should be made through discussions between private party liaison offcers and public sector project offcers and disputes that are not resolved at this level can be referred to an accounting offcer/authority of the public sector institution and the chief executive offcer of the private party. If PPP agreements cannot be reached at this level either, the matter is referred to an independent mediator to determine the outcome. Disputes are referred to the court only if they remain unresolved after all the formal and informal procedures have been exhausted.

14.6 LEGAL FRAMEWORKS AND INVESTMENT INCENTIVES The legal framework for PPP lays the foundation of private sector participation, and specifc provision depends on the legal system of a country: common law or civil law. The main consideration about the freedom of negotiation in both systems is whether the relevant procurement processes

Chapter 14 • Infrastructure fnancing 401

restrain the ability of the contracting parties to negotiate and revise the terms of a PPP contract issued as part of a tender process and whether any amendments might result in procurement challenges or allegations of corruption. In a common law system, parties typically have freedom of contract, and few provisions are implied into a contract by law. Judicial decisions set precedents, which will be followed in the determination of contractual disputes and therefore influence contractual drafting. A consequence of this freedom is that the terms of any contractual arrangements should be expressly set out in the relevant contract. In a PPP contract, arrangements that govern the relationship between the parties, therefore, need to be explicitly set out in the contract itself. In a common law system, everything is permitted that is not expressly prohibited by law or by contract. If a government is embarking on a PPP programme, it may, therefore, wish to ensure that certain protections are enshrined in applicable legislation and built into PPP contracts for public policy reasons. For example, it may wish to expressly prohibit the service provider from cutting off the water or electricity supply of delinquent payers or limit the toll or tariff that a private partner can charge users, to reflect governmental obligations under relevant international treaties. It may also wish to expressly require that certain documents related to the transaction be disclosed under freedom of information legislation. In contrast, a civil law system is a codifed system of law that is generally more prescriptive than a common law system. Basic rights and duties are enshrined in an overarching constitution under which specifc legal codes are promulgated (such as administrative and commercial legal codes). Also, in many civil law jurisdictions, underlying principles of good governance and other administrative law rules affect public sector parties, and broad obligations such as ‘good faith’ have an important impact on contract performance. Broadly speaking, legislative enactments are considered binding for all, as opposed to judicial decisions as in common law jurisdictions. Codifed provisions and underlying principles may be implied into civil law contracts without being expressly included. As a result, less importance is generally placed on expressly setting out all the terms governing contractual parties’ relationships because gaps or ambiguities can be remedied or resolved by operation of law. Accordingly, a civil law contract is often less detailed than an equivalent common law contract.

BOX 14.1 Legal and institutional frameworks for PPPs in South Africa: a benchmark for other African countries Six pioneering PPP projects were undertaken in South Africa from 1997 to 2000, at national and provincial levels. However, the legal and institutional framework for PPP projects came into being in 2000 after the Treasury Regulations for PPPs were issued following the Public Finance Management Act (Act 1 of 1999). PPPs on the national and provincial level are regulated according to Treasury Regulation 16, issued in 2004 to the Public Finance Management Act (1999). The government

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has also, through the Public Finance Management Act, issued a series of National Treasury PPP Practice Notes. These notes constitute a PPP manual and standardised practice notes that government departments and provinces use to guide them through the project life cycle of a PPP. Municipal PPPs operate under the Municipal Public–Private Partnership Regulations, issued in 2005 after the Municipal Finance Management Act of 2003. A PPP unit was set up at the National Treasury to facilitate private participation in public sector projects by promoting an enabling environment for PPPs. The PPP unit also serves as a centre of excellence, so it is also mandated to provide technical assistance to public institutions through project feasibility, procurement, and management for projects in sectors such as health, energy, water, transport, information and communications technology (ICT), tourism, waste, accommodation, and education. Today, South Africa is at the top of the Infrascope ranking, where the environment for PPPs in 15 African nations was compared. Countries are grouped into four categories – nascent, emerging, developed, or matured – on the basis of their PPP environment, measured according to six important dimensions: legal and regulatory framework, institutional framework, operational maturity, investment climate, fnancial facilities, and subnational adjustments. As shown in Figure 14.1, South Africa has had the most PPP projects since 1993, and the projects were implemented after the legal and institutional framework for PPPs was established. Most of the PPP projects in South Africa are in the power sector related to renewable energy generation and awarded to independent power producers (IPPs), and as such, the projects were designed in the build-operate-own (BOO) model. The country has 79 active PPP projects as of 2018, either under construction or in operation, with a total investment value of USD21.22 billion.

FIGURE 14.1 Number of PPP projects undertaken in South Africa

between 1993 and 2017

93

53

35

South Africa

Nigeria

Uganda

33

Tanzania

Source: Based on data from PPI database

29

Kenya

29

Senegal

28

Ghana

23

20

Côte d'Ivoire Mozambique

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One unique characteristic of the legislative framework of PPPs in South Africa is the attention accorded to Black economic empowerment (BEE), which has been formalised in the Code of Good Practice for BEE in PPPs issued in 2004 under the Public Financial Management Act. PPP contracts are therefore required to meet a minimum threshold of BEE about equity, management and employment, subcontracting, and local socioeconomic impact. Source: National Treasury (n.d.)

To tap into the fnancial capability and technical expertise of the private sector, governments must provide incentives to attract private investment in infrastructure: a tax holiday, which exempts the project entity from income tax for a specifed number of years; assurance as to the availability of raw materials or power at prices no higher than competitive rates; support in arranging fnancing of the project at concessionary interest rate; provision of loan guarantee services; or assurance as to the availability of hard currency to make project debt service payments. The types of incentive schemes provided should be carefully designed, and the number of incentives given to investors should be determined on the basis of the value of the incentives in attracting private investment. A misplaced incentive will only increase the cost of infrastructure projects. Besides, considerations need to be given to whether a scheme is appropriate to a given private sector. For instance, the provision of support in the form of concessionary interest rate may work for private sector investors that fnance the project by using a signifcant amount of debt, but the same incentive may not be of value to those that mainly use equity. At the same time, the government should carefully plan incentives because of their fscal implications. For instance, a prolonged tax holiday means that a government revenue plan will not be completed, and hence, its fscal consequences should be recognised, and adequate planning must be done in advance. Before providing incentive schemes, governments must conduct a cost–beneft analysis to ensure the cost of the incentives do not exceed the potential benefts from the project.

14.7 RISK MANAGEMENT OF INFRASTRUCTURE PROJECTS Although the magnitude and chance of risk may vary from one activity to the other, it is inherent in any economic activity. The amount of risk and its likelihood tends to be high in long-term investment projects due to such activities’ extending into many years, increasing the uncertainty. In infrastructure projects fnanced through a PPP contract, the risk management framework must be devised such that the risk is effectively shared between the contracting parties: the public sector entity and the private partner. Failure to identify potential risk and effective allocation to the party that can best manage the risk can increase the chance of project termination, or it

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may lead to the project’s costing the public sector more than what was initially anticipated. 14.7.1 Idiosyncratic risks to infrastructural development in developing countries Risk can be systemic or nonsystematic. Systematic risk arises from changes in the overall political, social, and economic environment of a country. Such risks affect all economic activities in a given jurisdiction and hence are less amenable to diversifcation. The other types of risks are project-specifc risks (i.e. idiosyncratic risks) that arise from the way the project is designed. This section focuses mainly on idiosyncratic risks emphasising the types of risks and their allocation among contracting parties. The degree of risk exposure of infrastructure projects may vary depending on, among others, the nature of the project, its term, and the way fnancing is structured. We present in the next section what has been identifed by Global Infrastructure Hub (2016) as the most common risk categories that affect infrastructure projects. However, we admit that the list should by no means be considered exhaustive, and our aim is to enable readers to understand the main risk classes and the potential mitigating techniques needed to address them. Land purchase and site risk refer to the risk of acquiring title to the land to be used for a project, the selection of that site, and the geophysical conditions of that site. Such a risk can be mitigated when the public sector entity undertakes detailed ground, environmental, and social assessments and discloses such information to the private partner as part of the bidding process. Such an assessment should consider any easements and covenants that may encumber the land.

LAND PURCHASE AND SITE RISK

This is the risk that the project has not been designed adequately for the purpose required. Mistakes may be discovered in the design of public infrastructure that require subsequent modifcations that entail added costs in time and money. Such risks are borne by the private partner, due to its responsibility for ensuring the adequacy of the design of the system and its compliance with the output or performance specifcation. The public sector agency may retain some design risk in certain aspects of the system or related works, depending on how prescriptive the public sector agency is in the output specifcation.

DESIGN RISK

CONSTRUCTION RISK This includes risks associated with time delays, noncompliance with legal and performance-related standards, additional building costs, increments of supplies costs, technical defects, and negative external effects. DEMAND RISK This risk arises from the usage of incorrect demand projections or the fuctuation of demand due to factors unrelated to their actions. Such factors can be variations in the economic cycle, changing market trends, new direct sources of competition, or obsolescence.

Chapter 14 • Infrastructure fnancing 405 OPERATION PERFORMANCE RISKS These are associated with the performance of the service to be rendered. They can happen due to lack of performance of the operator or other causes. This is a breach of the contract that may imply penalties on the operator or deductions on revenues if the private party is paid on performance. Incurring any of them leads to a reduction of revenues that will affect the overall business. COMPLETION RISK Completion risk refers to the risk of commissioning the asset on time and on budget and the consequence of missing either of those two criteria. The principal risks arising out of delay are the loss of expected revenue, the ongoing costs of fnancing construction, holding costs of other contractors, and extended site costs.

Force majeure risk refers to the risk that unexpected events occur that are beyond the control of the parties and delay or prohibit performance. Typical events include war, armed confict, terrorism, or acts of foreign enemies; nuclear or radioactive contamination; chemical or biological contamination; and the discovery of any species at risk, fossils, or historic or archaeological artefacts that require the project to be abandoned or delayed.

FORCE MAJEURE RISK

Exchange rate risks involve changes in the rate of exchange that decreases the value of the part of the investment made in foreign currency. Concessions regularly affect the capital provided by investors and, in some cases, debt acquired in international markets.

EXCHANGE RATE RISKS

Insurance risk refers to the risk that insurance for a particular risk is or becomes unavailable. This can happen when a risk event occurs so frequently that the insurance industry no longer desires to cover the risk.

INSURANCE RISK

INFLATION RISK

than expected.

This risk arises when the costs of the project increase more

FINANCING RISK This relates to risks associated to the funding arrangements of the project, including, but not limited to, arranging the necessary funding, refnancing, and interest rate fuctuations that endanger the repayment of the fnancial obligations. POLITICAL AND REGULATORY RISK This is the risk of government intervention discrimination, the total or partial expropriation or nationalisation of the asset, or the termination of the contract, without justifed cause and in exchange for insuffcient compensation. In general, actions by government bodies or by public authorities that can negatively affect a project’s viability or proftability or that can limit or prevent recovery of the invested capital or obtained benefts are classifed as political or regulatory risks. ENVIRONMENTAL RISK Environmental risk includes the risk of the existing latent environmental conditions affecting the project and the subsequent

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risk of damage to the environment or local communities. Laws and regulations can impose environmental liabilities and constraints on a project. SOCIAL RISK The risk of local stakeholders opposing the project or instability of any kind can cause lower earnings or jeopardise the conditions under which the project was framed. DISRUPTIVE TECHNOLOGY RISK This is the risk that a new, emerging technology unexpectedly displaces an established technology used in the sector.

14.7.2 Risk analysis and risk mitigation strategies Risk identifcation is the frst step in risk management, and risk analysis is conducted to understand the magnitude of loss and the chance that a risk event may occur. Risk events can be grouped into four categories: high probability and high magnitude; high probability and low magnitude; low probability and high magnitude; and low probability and low magnitude. A rational choice concerning economic activities that involve high probability and high magnitude risk is to abandon them, while activities with low probability and low magnitude risk events are managed through risk prevention techniques. For low probability and high magnitude risks, an appropriate insurance policy should be acquired. However, the insurance industry may not underwrite policies for all risks in this category, due to the low commercial value of such policies. This implies that contracting parties must put in place all the necessary preventive measures to ensure the risk does not occur or to minimise the loss should it occur. Risk mitigation can be done at different stages of the contracting process. Essentially, most risk events can be addressed at a feasibility study stage by explicitly factoring them into the analysis. For instance, land purchase and site risk can be mitigated by conducting detailed ground, environmental, and social assessments and by disclosing such information to the private partner as part of the bidding process. Similarly, conducting the necessary due diligence to ascertain the environmental ftness of the site and disclosing all known environmental issues to the private partner can address environmental risk. Additional measures can be embedded into the overall contract management process. This is the case particularly for completion risks that arise due to the private partner’s failing to deliver on time. To minimise such a risk, the public sector entity must implement a multistaged completion process to ensure that the private partner begins receiving payment for its design and construction services once signifcant components of the project have been substantially completed. This can help increase cashfow during construction, reduce the private partner’s fnancing costs, and incentivise the phasing of construction works to ensure critical components are completed on time. Moreover, fnancial penalties and liquidated damages can help enforce construction deadlines. For force majeure events, project insurance is be a key mitigating tool for physical damages and loss of revenue.

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While the risk-mitigating tools presented earlier are necessary for ensuring the project will be completed according to the initial schedule without substantial additional cost, fnanciers of infrastructure projects may require additional measures in the form of credit guarantee and insurance. These measures can help mobilise commercial debt and private equity when governments or local infrastructure entities lack the creditworthiness or track record to attract fnance on their own. The risk mitigation instruments are important in mobilising private capital to supplement limited public resources. They allow offcial agencies to leverage their fnancial resources and facilitate the development of commercial and sustainable fnancing mechanisms for infrastructure development. A credit guarantee transfers the risk of default to third parties, including offcial agencies (multilateral or bilateral) or private institutions. Insurance contracts ensure payments to the holder once the claims have been evaluated and liability established by the insurance company. Credit guarantees and insurance are crucial in increasing the bankability of infrastructure contracts.

14.8 CONCLUSION Infrastructure plays a vital role in economic development through various channels. Primarily, infrastructure services such as electricity, water, telecommunications, and transport are critical inputs in the production process, and hence, the lack thereof constrains output. Also, infrastructure services contribute to national output by increasing the productivity of factors of production. Infrastructure is also important in ensuring inclusive growth – people without access to basic infrastructure services are likely to be excluded from social and economic activities. That is why building resilient infrastructure is part of the SDGs, and other SDGs, such as reducing inequality, ensuring access to water and sanitation for all, and ensuring access to affordable, reliable, and sustainable energy for all, are unlikely to be met in the absence of adequate infrastructure. Poor infrastructure and lack of access to basic infrastructure services are typical characteristics of many African economies. Africa faces the twin challenges of a massive infrastructure gap and a fnancing gap. Access to infrastructure in the continent is one of the lowest in the world, and most of the investment in infrastructure is fnanced by the public sector. However, the weak fnancial capacity of the public sector means the infrastructure gap is bound to persist unless alternative fnancing techniques are used. Alternative fnancing techniques such as sovereign bonds, local currency bonds, commodity-backed bonds, securitising remittances, diaspora bonds, private equity funds, reserves in excess-saving countries, sovereign wealth funds, and PPP are proposed to help economies narrow infrastructure fnancing gaps. Although most infrastructure services exhibit characteristics of a public good, their provision can involve private sector entities. Partnerships between private sector investors and public sector entities can be forged to tap into the fnancial capabilities and technical expertise of the private sector. Governments must, therefore, design various incentive packages to entice private sector entities to participate in infrastructure projects.

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Incentives can include, among others, a tax holiday, provision of loan guarantee, and assurances as to the availability of hard currency. The incentive packages should be designed such that they are suitable to attract targeted private sector frms while keeping their impact on government fnances to the minimum. The effective participation of the private sector in infrastructure projects also hinges on the existence of legal and institutional frameworks. A strong legal and institutional framework is crucial in attracting private sector partners and also in getting value for money from the partnership. The participation of private sector partners is driven mainly by a proft maximisation motive, and as a result, the decision to participate is determined by their perception of a risk, in which a legal and institutional framework plays a signifcant role. Conducive legal and institutional frameworks increase investor confdence and hence reduce their perception of a risk. Lack of a risk management capability in the public sector can render promising PPP projects worthless. Idiosyncratic infrastructure project risks, such as land purchase risk, design risk, construction risk, operational performance risk, demand risk, and force majeure risk, must be identifed, and proper risk allocation must be done before commissioning the project.

Questions 1 Discuss the economic and social infrastructure challenges in Africa. 2 Beside transportation, oil, gas, power, and water sectors, discuss fve other sectors where infrastructure is need to spur economic development in Africa. 3 Explain why a legal and institutional framework is needed to successfully implement infrastructure

projects using public–private partnerships (PPPs). 4 Discuss the pros and cons of locating the PPP unit at the highest level of government. 5 Identify fve of the most important risks in infrastructure projects and discuss the possible mitigating techniques for each.

References African Development Bank. (2018). African economic outlook 2018. Abidjan: Author. Atta-Mensah, J. (2004). Commodity-linked bonds: A potential means for less developed countries to raise foreign capital. Bank of Canada Working Paper 2004–20. Retrieved from https:// econpapers.repec.org/paper/bcabocawp/04-20.htm

Briceño-Garmendia, C., Smits, K., & Foster, V. (2009). Financing public infrastructure in sub-Saharan Africa: Patterns and emerging issues. Washington, DC: World Bank. Brixiova, Z., Mutambatsere, E., Ambert, C., & Etienne, D. (2011). Closing Africa’s infrastructure gap: Innovative fnancing and risks. Africa Economic Brief, 2(1).

Chapter 14 • Infrastructure fnancing 409 César, C., & Luis, S. (2004). The effects of infrastructure development on growth and income distribution. Policy Research Working Paper No. 3400. Washington, DC: World Bank. Chong, S., & Poole, E. (2013, September). Financing infrastructure: A spectrum of country approaches (pp.  65–76). RBA Bulletin, Reserve Bank of Australia. Retrieved from https://www.rba. gov.au/publications/bulletin/2013/ sep/8.html Downs, S., Montagu, D., da Rita, P., Brashers, E., & Feachem, R. (2013). Health system innovation in Lesotho: Design and early operations of the Maseru public-private integrated partnership. Healthcare Public – Private Partnerships Series No. 1. SanFrancisco: The Global Health Group, Globalhealth Sciences, University of California and PwC. Estache, A. (2006, February). Africa’s infrastructure: Challenges and opportunities. In Highlevel seminar: Realizing the potential for proftable investment in Africa. Tunis, Tunisia: IMF Institute and the Joint Africa Institute. Finnerty, J. D. (2013). Project fnancing: Asset-based fnancial engineering. Hoboken, NJ: Wiley. Global Infrastructure Hub. (2016). Allocating risks in public-private partnership contracts. Global Infrastructure Hub Ltd. Retrieved May 2, 2018, from https://ppp.worldbank.org/public-private-partnership/sites/ppp. worldbank.org/files/documents/ GIHub_Allocating_Risks_PPP_Contracts_EN_2016.pdf Hughes, H. (2011, December 1). Understanding the securitization of worker remittances. WCL Research Paper No. 2008–39. American University. SSRN. Retrieved from https://ssrn.com/ abstract=1096700 or http://dx.doi. org/10.2139/ssrn.1096700 Kodongo, O., & Ojah, K. (2016). Does infrastructure really explain economic growth in sub-Saharan Africa? Review of Development Finance, 6(2), 105–125.

Kothari, V. (2006). Securitization: The fnancial instrument of the future. Hoboken, NJ: Wiley. Laishram, B. S., & Satyanarayana, N. K. (2009). Criteria infuencing debt fnancing of Indian PPP road projects: A case study. Journal of Financial Management of Property and Construction, 14(1), 34–60. National Treasury. (n.d.). PPP project cycle: Refecting treasury regulation 16 to the public fnance management act, 1999. Retrieved March 2, 2020, from www. gtac.gov.za/Publications/1160PPP%20Manual.pdf Ncube, M. (2010). Financing and managing infrastructure in Africa Journal of African Economies, 19(1), i114– i164. OECD. (2020). Household savings (indicator). doi: 10.1787/cfc6f499-en (Accessed on 04 November 2020). Ogun, T. P. (2010). Infrastructure and poverty reduction: Implications for urban development in Nigeria. Urban Forum, 21(3), 249–266. PPI Database, World Bank, & PPIAF. Retrieved April 24, 2020, from https:// datacatalog.worldbank.org/dataset/ private-participation-infrastructure Preqin sovereign wealth fund review. (2016). Sovereign wealth funds investing in infrastructure. Retrieved from https://docs.preqin.com/newsletters/ra/Preqin-RASL-May-16-Feature-Article.pdf PWC. (2011). Funding infrastructure: Time for a new approach? Retrieved from https://www.pwc.com/gx/en/ psrc/pdf/time-for-a-new-approach. pdf Rosnani, M., Suhaiza, I., & Julia, M. S. (2018). Performance indicators for public–private partnership (PPP) projects in Malaysia. Journal of Economic and Administrative Sciences, 34(2), 137–152. Simpson, R., & Zimmermann, M. (Eds.). (2012). The economy of green cities: A world compendium on the green urban economy. Berlin: Springer Science & Business Media.

410 Saint Kuttu et al. Winch, G., Onishi, M., & Schmidt, S. (2012). Summary of research report 126: Taking stock of PPP and PFI around the world. Certifed Accountants Educational Trust. Retrieved from https:// study.sagepub.com/sites/default/ files/ACCA%20on%20PPPs%20 around%20the%20world.pdf

World Bank. (1994). World development report: Infrastructure for development. New York: Oxford University Press. World Bank. (2011). Towards better infrastructure: Conditions, constraints, and opportunities in fnancing public-private partnerships. Washington, DC: World Bank.

CHAPTER

15

Finance and economic development The role of the private sector Elikplimi Komla Agbloyor, Joshua Yindenaba Abor, Haruna Issahaku, and Charles Komla Delali Adjasi 15.1 INTRODUCTION The importance of fnance in economic growth and development follows the works of Schumpeter (1934), Goldsmith (1969), McKinnon (1973), and Shaw (1973). Extant literature suggests three main channels through which fnancial development can infuence economic growth, including the level of fnancial intermediation, composition, and effciency by which fnance is allocated to productive activities to stimulate economic growth. However, without effective regulation, fnancial systems can become unstable and trigger crises that devastate the real economy. The ongoing repercussions of the global fnancial crises signal how large these effects can be (Spratt, 2013). The effects of fnancial markets on economic growth may be either transient or lasting, depending on the theoretical framework used. In the traditional growth theories, the effects are transient, suggesting that they are present only during the transition to an economy’s steady-state growth path. In new theories of endogenous growth, the effects can be lasting, meaning they can permanently lift the economy to a higher growth path (Deabes, 2004). The fnancial system may, therefore, infuence growth permanently in one of the following ways: 1 Improving the average productivity of capital. 2 Facilitating the fow of investment funds to frms in the intermediation process. 3 Accruing savings. 4 Reallocating resources into productive sectors. The fnancial sector can be growth inducing and growth induced. This suggests fnance is important in ensuring the growth of an economy, at both the macro level and the micro level, and that growth is a driver of fnancial sector development. Both domestic resource mobilisation and a suitable level of external capital infows are necessary to fnance growth and development. This is the focus of development fnance. An important issue

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to consider is the means by which fnance affects the private sector, which is considered the engine of growth and development. However, the issue of fnancing has been a major constraint to private sector growth and economic development in Africa and other developing regions of the world. The private sector in developing economies is confronted with less-developed fnancial markets, thus limiting access to fnance. This situation is more severe in the case of small and medium-size enterprises (SMEs) that often lack the requisite qualifcation to obtain formal fnance. Financial systems in developing countries are said to be small, shallow, and costly, with limited outreach. This is refected not only in the aggregate fnancial development indicators but also in the frm and household data gauging the use of formal fnancial services (Beck & Cull, 2014a). The problem of fnancing a developing country’s private sector thus raises a number of issues worthy of policy consideration. As mentioned earlier, it is imperative to consider the issue of fnancing the private sector, which is regarded as the engine of economic growth. Thus, addressing the fnancing constraints of the private sector, especially SMEs, is necessary to drive growth in developing and emerging economies. This chapter examines the role of fnance in private sector development. The chapter is organised as follows. We overview private sector and economic development in the next section. This is followed by the fnancing and investment behaviour of frms. We then examine how various forms of development fnance contribute to private sector development and economic development. The fnal section concludes.

15.2 OVERVIEW OF PRIVATE SECTOR AND ECONOMIC DEVELOPMENT This section discusses prominent features of developing countries’ and Africa’s private sector, its contribution to development, and the challenges it faces. 15.2.1 Features of Africa’s private sector Africa’s private sector has at least three characteristic features: its relatively large size, its highly informal nature, and the dominance of micro and small frms in the formal sector. According to African Development Bank (AfDB, 2011) estimates, the private sector in Africa accounts for more than 80% of production, 68% of total investment, and 75% of total credit in the economy. Furthermore, it offers employment to 90% of the working population in the continent. The large size of Africa’s private sector implies that interventions geared towards bolstering the sector will have wide-ranging impacts. On the one hand, the informal sector is broadly characterised as consisting of units engaged in the production of goods or services, with the primary objective of generating employment and incomes to the people concerned. On the other hand, the formal sector encompasses all jobs with normal hours and regular wages and is recognized as an income source on which income taxes must be paid (International Labour Offce, 2000).

Chapter 15 • Finance and economic development 413

Beyond its large size, Africa’s private sector is highly informal in nature. With the exception of Latin America and the Caribbean (LAC), Africa has the largest informal sector in the world. According to estimates by Medina, Jonelis, and Cangul (2017), from 2010 to 2014, Africa’s informal sector constitutes about 38% of its GDP. In LAC, the informal sector constitutes about 40% of GDP, while in South Asia and Europe, the informal sector’s share in GDP is 34% and 24% respectively. Africa’s largest informal sectors are concentrated in fragile states, and lowincome countries (AfDB, 2011). This relatively large private sector in Africa presents opportunities as well as challenges: opportunities in the sense that if it could unleash the potential of this large sector through policy reform, the impact on accelerated growth would be massive and challenges in the sense that a large informal sector connotes low productivity and lower revenues from taxes, since a lot of the activities are outside the tax net. Even Africa’s relatively small formal sector is dominated by micro and small businesses with a few large frms, which are mostly foreign owned. Compared to other parts of the world, Africa has little representation in medium-size and large enterprises. Medium-size and large enterprises constitute a little over 30% of all enterprises in Africa (AfDB, 2011). Thus, Africa’s private sector has a ‘missing middle’ where the economy has a large share of micro and small enterprises relatively to its size (GDP). These micro enterprises are often encumbered by volatile revenues, red tape, poor technical knowledge, and low managerial competence, while the medium-size enterprises are hindered by inadequate access to capital, technology, and electricity (Fjose, Grünfeld, & Green, 2010). These characteristics of Africa’s private sector are akin to what pertains in the private sector of other developing regions of the world. 15.2.2 The role of the private sector in economic development Worldwide, the private sector is pivotal in the economic development process. Some of the contributions of the private sector to economic development include income and growth, employment and job creation, productivity, access to fnance, and revenue mobilisation. One of the key contributions of the private sector is that it is a crucial driver of economic growth. Economic growth is important because it forms the basis for the generation and broad-based distribution of resources. Although, economic growth does not necessarily lead to poverty reduction, in areas of the world where poverty has declined signifcantly over the years, this has been associated with high levels of growth. Thus, economic growth is imperative for widespread reductions in poverty and inequality. SMEs (both formal and informal) contribute between 60% and 70% of the global GDP (Ayyagari, Beck, & Demirgüç-Kunt, 2003). With the right distribution policies and mechanisms in place, this growth can translate into income, job opportunities, and prosperity for the vast majority of the population, leading to a reduction in poverty and inequality.

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Self-employment or earning a wage or salary employment is one of the surest means to exit poverty. In developing countries and in Africa as well, the private sector is responsible for creating about 90% of all jobs (Australian Government, 2014). An analysis based on African data shows that frms with over a hundred workers employ about 50% of the workforce in the formal sector; medium-size enterprises (20–99 employees) employ 27% of the labour force; small frms employ the remaining 23% of the labour force (Page & Söderbom, 2015). Thus, large frms are the leading employment category, followed by medium-size and small frms respectively. Generally, in the developing world, small frms create a disproportionate share of new jobs. As the private sector expands and transitions from informal to formal employment, it is important to put in place the right legal and institutional mechanisms that will ensure decent employment and provide job security for the weak and marginalised. Generally, privately owned frms are considered to be more productive (effcient) than public sector frms (Atkinson & Halvorsen, 1986). Thus, the private sector contributes to economic development through the effective use of scarce resources to produce goods and services. International Labour Organisation (ILO) estimates based on World Bank Enterprise Surveys show that, on the whole, large frms are more productive than SMEs. This is because large frms proft from economies of scale; invest more in machinery, skilled workers, research and development; and outsource some of their activities (ILO, 2015). Large frms are therefore more likely to churn out new innovations and new products than are SMEs. Small frms tend to be the least productive. In Africa, the large informal sector complicates the productivity problem. Evidence shows that in Africa, the productivity of small formal frms is 120% higher than that of informal frms, while wages are about 130% higher (La Porta & Shleifer, 2011). Another way that the private sector promotes economic development is through the provision of revenue for the central government. The World Bank estimates that the private sector accounts for over 80% of government revenue in low- and middle-income countries. The sources of these revenues are taxes, resource rents, and income tax on employees. These revenues, when applied judiciously in the provision infrastructure such as roads and transport, electricity, banking and fnance, water and sanitation, and education will bring about drastic improvements in the livelihood of a large section of the population. 15.2.3 Obstacles to private sector development As indispensable as the contribution of the private sector is to economic growth, the private sector cannot succeed without strong support from the public sector. The public sector plays a critical role in providing public services such as health, roads, transportation, electricity, and education. It also leads the way in safeguarding the environment, providing security, seeing to law and order, and providing a conducive economic, institutional, regulatory, and operating environment for private businesses to thrive in. Indeed, in the Asian Tigers (and China), the public sector has been instrumental in

Chapter 15 • Finance and economic development 415

catalysing growth and private sector development. The degree to which the public sector plays its role determines the scope and scale of the constraints that the private sector is faced with, which in turn determine how effectively the private sector can contribute to economic progress. The World Bank Enterprise Survey datasets contain information on the ranking of 15 obstacles by frms in 98 countries. These 15 obstacles are access to fnance; access to land; business licensing and permits; corruption; courts; crime; customs and trade regulations; electricity; inadequately educated workforce; labour regulations; political instability; practices of competitors in the informal sector; theft and disorder; tax administration; and tax rates and transport. Kushnir, Mirmulstein, and Ramalho (2010) analysed this dataset and found electricity and access to fnance to be the top two constraints faced by frms in developing countries. The top six constraints are electricity, access to fnance, practices of the informal sector, tax rates, political instability, and corruption. The severity of these constraints varies with frm size. Small frms are more likely to cite access to fnance as an obstacle (Dai, Ivanov, & Cole, 2017; Cenni, Monferrà, Salotti, Sangiorgi, & Torluccio, 2015), while large frms are more likely to cite political stability as a constraint. Small and medium-size frms are more likely to lack high-value collateral and less likely to have consistent cashfows and the necessary documentation to facilitate access to credit in the formal credit circuit than are large frms. The inadequate access to credit prevents micro, small, and medium-size frms from moving to the next phase of their development owing to underinvestment and inability to take advantage of viable investment opportunities. Lack of suffcient investment and ineffciencies in the power sector lead to a situation where many frms in developing countries lack access to an affordable and stable electricity supply (Grainger & Zhang, 2019). Firms in the manufacturing sector are hit the hardest in an environment with energy shortfalls. If developing countries must unleash the creative potential of the private sector, then they must actually bring about energy self-suffciency. Competition from the informal sector (Purnama & Subroto, 2016; Bali, McKiernan, Vas, & Waring, 2016), erratic power supply (Grainger & Zhang, 2019), tax rates (Ameyaw, Korang, Twum, & Asante, 2016), political instability (Rahman, Uddin, & Lodorfos, 2017), and corruption (Mendoza, Lim, & Lopez, 2015) are also cited among the obstacles hindering the development of formal sector frms. The private sector in developing countries is encumbered by high tax rates, request for bribes from tax offcials, and the pressure to make and receive informal payments to ‘get things done’ (bribery and corruption). These tendencies erode the little capital that the private sector has to work with. The lack of a merit system and the lack of entrenchment of a set of mores and core values lead to a situation where a number of contracts are awarded without regard to due procedure, while the lack of innovative ideas on the part of the fscal authorities leads to a situation where formal frms are overtaxed to fund ineffcient state bureaucracies. Democracy and good governance are not well established in a number of developing countries. As a result, civil wars and politically related

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disturbances still occur in some parts of the region, making it diffcult for frms to have the peaceful environment needed to nurture and grow their businesses.

15.3 WHAT EXPLAINS FIRMS’ FINANCING AND INVESTMENT BEHAVIOUR? 15.3.1 Factors infuencing fnancing behaviour A frm’s fnancing behaviour is related to its capital structure, and before we look at fnancing options available to the private sector, we need to discuss the capital structure of frms. Capital structure is the specifc mixture of debt and equity a frm uses to fnance its operations. Capital structure may be explained by a number of theories, including the life cycle theory, the pecking-order theory, the static trade-off theory, the dynamic trade-off theory, and the signalling theory. The life cycle theory suggests that a frm’s access to fnance depends on its stage of development. Newer frms tend to rely on owners’ capital because, at the initial stages, they may not be in the position to present an attractive investment avenue to attract funding. If they survive the dangers of undercapitalisation, they may then be able to make use of other sources of fnance (Chittenden, Hall, & Hutchinson, 1996; Berger & Udell, 1998). The pecking-order theory (POT) indicates that frms will initially rely on internally generated funds, where there is no existence of information asymmetry, then they will turn to debt if additional funds are needed, and fnally they will issue external equity to cover any remaining capital requirements. The notion of asymmetric information suggests a hierarchy of frms’ preferences with respect to fnancing. The order of preferences refects the relative costs of various fnancing options. Clearly, frms would prefer internal sources over costly external fnance (Myers & Majluf, 1984). Thus, according to the pecking-order theory, frms that are proftable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings. In the case of SMEs, they seem to face a more extreme version of the POT, described as a ‘constrained’ POT by Holmes and Kent (1991) and a ‘modifed’ POT by Ang (1991), because of the diffculty in raising external equity from the capital market. Therefore, they simply rely on retained earnings, additional investment by the owner, and to some extent bank loans and loans from microfnance institutions. With respect to the static trade-off theory, fnancial managers often think of the frm’s debt-equity decisions as a trade-off between interest tax shields and the costs of fnancial distress (Myers, 2001). According to Kim and Sorensen (1986), less debt is used when the expected cost of bankruptcy is higher than the tax shields or other benefts of using debt. This theory recognizes the fact that the choice of debt and the choice of equity vary from one frm to another and over time. The general reasoning behind the tradeoff theory is that frms will borrow up to the point where the marginal value of tax shields on additional debt is offset by the present value of possible costs of fnancial distress (Myers, 2001). This means that frms seek debt

Chapter 15 • Finance and economic development 417

levels that balance the tax advantage of additional debt against the cost of possible fnancial distress. The dynamic trade-off theory holds that frms allow their leverage ratios to fuctuate within an optimal range. Thus, frms adjust current leverage ratios towards a target debt ratio. Signalling theory also suggests that if a frm raises debt fnance, the frm has an investment opportunity that will require more funds beyond the internally generated funds. Therefore, employing more debt in the frm’s capital structure often serves as a signal to outsiders about the current situation of the frm as well as the managerial expectations concerning future earnings. Generally, the debt offering is believed to reveal information that the frm has identifed positive net present value projects and as such will require more external debt fnance to fnance such projects (Eckbo, 1986). The capital structure of frms is determined by a number of conventional factors: • Age of the frm – older frms are believed to have a good track record and thus are able to access debt more easily than are newer frms, which have no track record or credit history. Firms that make it beyond the survival stage (in the venture life cycle – from start-up to survival to rapid growth to maturity) would have overcome a number of challenges that make them more attractive to lenders because in essence the risk of the enterprise has reduced. That is, older frms are expected to have a good reputation that they have built over the years, which is understood by the market and which has observed its ability to meet its obligations in a timely manner (Diamond, 1989). • Size of the frm – relatively bigger frms are more diversifed and are perceived as having lower risk. Thus, they are capable of attracting more debt, especially long-term debt. However, smaller frms have diffculty in attracting long-term debt because of the severe information asymmetry problems between owner-managers of the small frms and potential lenders. Also, long-term debt is likely to be proportionally more expensive for small frms because of the fxed transaction cost. The information asymmetries and transaction costs therefore limit the attractiveness of debt, in particular longterm debt. • Asset structure – a frms’ asset structure plays a signifcant role in determining its capital structure. The degree of asset tangibility infuences the liquidation value (Titman & Wessels, 1988; Harris & Raviv, 1991). Pledging the frm’s assets as collateral reduces the costs associated with adverse selection and moral hazard, and this enhances the frm’s access to debt fnance at a lower cost. • Proftability – proftable frms rely more on internal resources, in line with the ‘POT’, while less-proftable frms require external debt fnancing. This is because proftable frms are able to generate enough internal resources and therefore rely less on external sources of fnance. • Growth – high-growth frms are able to attract debt fnance. Firms with high-growth opportunities require more external debt fnance to fnance the growth.

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• Tax effect – tax has an effect on a frm’s capital structure decisions. Corporate taxes allow frms to deduct interest on debt in computing taxable profts. This means that tax advantages derived from debt lead frms to be fnanced through debt. This beneft is created by the fact that the interest payments associated with debt are tax deductible, while payments associated with equity, such as dividends, are not tax deductible. Thus, this tax effect encourages debt use by the frm, as more debt increases the after-tax proceeds to the owners (Modigliani & Miller, 1963; Miller, 1977). • Macroeconomic environment – macroeconomic stability is associated with the use of more equity and less debt (Baum, Caglayan, & Rashid, 2017). Firms in countries which experience macroeconomic instability in the form of high infation and interest rates tend to use less debt. If they employ debt, this is usually short term. • Legal environment – frms in countries that have weak legal regimes tend to employ mainly short-term debt. • Institutional investing – countries that have bank-based fnancial systems tend to have companies with more debt, especially short-term debt. Whereas countries with institutional investors, such as pension funds and life insurance companies, tend to have frms with more equity in their capital structure. SMEs’ capital structures and fnancing may be infuenced by some heterodox factors (see Green, Kimuyu, Manos, & Murinde, 2002; Abor, 2008): • Ownership structure – SMEs with a high percentage of managerial shareholders depend less on short-term debt. • Industry – access to debt fnancing varies across industry groups. Firms in the high-technology sector with few tangible assets have been known to rely more on equity than on debt fnancing. • Location of the frm – SMEs located outside a capital city encounter greater diffculty in acquiring debt, especially long-term fnance, than do their counterparts located in a capital city. • The entrepreneur’s educational background – the educational background of the entrepreneur is associated with access to debt fnance, implying that better-educated owners do have greater possibilities of borrowing. Better-educated owners fnd it easier to present a plausible case for a loan to an outside body. • The gender of the entrepreneur – men-owned SMEs have easier access to debt fnance than do women-owned SMEs. Women-owned businesses are less likely to use debt, for a variety of reasons, including discrimination, greater risk aversion, and ineffective networking (Brush, 1992; Scherr, Sugrue, & Ward, 1993; Aryeetey, Baah-Nuakoh, Duggleby, Hettige, & Steel, 1994). • Form of business – limited liability companies have been observed to rely more on long-term debt fnance than do sole proprietorships. • Export status – exporting frms are better able to obtain debt because of the fact that they are more diversifed and tend to exhibit better and stabler cashfows (in line with achieving global diversifcation and lower

Chapter 15 • Finance and economic development 419

systematic risk) compared with nonexporting frms. Further, access to bank fnance has been shown to promote exports (see Abor, Agbloyor, & Kuipo, 2014). This increases their ability to fulfl their debt obligations on time, thus increasing their access to more long-term credit. 15.3.2 Factors infuencing investment behaviour Factors infuencing investment behaviour are numerous and vary across contexts. Specifcally, factors infuencing investment behaviour can be grouped as investor-related factors, industry-related factors, social-related factors, and macroeconomic-related factors. For instance, Borges, Bergseng, Eid, and Gobakken (2015) show that social factors infuenced investment behaviour in the United States between 2004 and 2012. Specifcally, they report local politics and religion as key infuencers of investment behaviour. Similarly, Salem (2019) posits that risk tolerance, investment confdence, investment literacy levels, and herding behaviour were the critical factors that shaped the investment behaviour of Arab women. Zhao, Chen, and Hao (2018) also posit that investment information diffusion is crucial in shaping investment behaviour. Thus, they show that providing or diffusing investment information helps guide investors to select their investment portfolios. Dominant and key infuencers of investment behaviour are presented and discussed as follows: • Cost of investment (interest rate) (Drobetz, El Ghoul, Guedhami, & Janzen, 2018) – investment is fnanced out of savings or by borrowing. This requires compensation for the saver or lender for deferring current consumption. Therefore, investment is strongly infuenced by interest rates, which are the cost of investment (debt component). Higher levels of interest rate discourage investment activities, while lower interest rates encourage investment activities. • Economic growth (Sunde, 2017) – economic growth shapes the behaviour of investments. That is, if economic growth prospects improve, frms will increase their investments given that expected future demand will rise. Similarly, the accelerator theory states that investment depends on the rate of change of economic growth. • Investor confdence (Shahid & Abbas, 2019; Hoffmann & Post, 2016) – investment involves some level of riskiness and uncertainty. Hence, the investors invest only when they are confdent about costs, demands, and economic conditions. Following the Keynes model, the ‘animal spirits of businesspeople are a crucial determinant of investments’. This may be fuelled by the political climate and interest rates. • Infation (Mkaouar, Prigent, & Abid, 2019; Farooq & Ahmed, 2018) – in the long term, infation affects the value of investments, which tends to determine the behaviour of investments. Infation creates instability and confusion in the costs of investment and erodes the value of investments. Thus, prolonged and instable infationary periods and environments lead to lower levels of investment, due to fear of losing the value of the investment.

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• Productivity of capital (technology) (Alshubiri, Elheddad, & Doytch, 2019; Boonman, Hagspiel, & Kort, 2015) – advancements in technology can help shape investment behaviour. Since technology improves the quality and quantity of goods and lowers the cost of production, frequent changes in technology may require additional investment in order to keep up the change trends in technology. • Government policies and regulations – policies and regulations shape investment behaviour (Zhao et al., 2018). For instance, where tax policies (Sineviciene & Railiene, 2015) favour capital gain yields at the expense of dividend yields, investments move towards instruments that provide capital gain return.

15.4 DEVELOPMENT FINANCE, PRIVATE SECTOR DEVELOPMENT, AND ECONOMIC DEVELOPMENT We now discuss the various sources of development fnance and innovative fnancing and how these could anchor private sector development. 15.4.1 Private equity and venture capital fnancing Private equity is a source of investment capital provided by high-networth individuals and high-net-worth institutions with the aim of investing equity in businesses.  Private equity frms seek to raise funds and manage these funds in order to generate returns for their investors. Private equity includes buyout, venture capital, growth, turnaround, private equity secondaries, mezzanine fnance, private equity fund of funds, angel investments, and other private equity. Venture capital, which is an important aspect of private equity, involves the provision of private equity to innovative businesses that have a high growth potential. Venture capital is regarded as patient capital, since the venture capitalist is usually willing to invest in the enterprise for a longer period before harvesting their investment. Venture capital frms also provide management and technical assistance that can add value to the investee frms. There are, however, some problems associated with venture capital fnancing. Many SMEs tend to shy away from any form of fnancing that requires giving up an equity interest and ceding some control over decision-making. Accessing venture capital is often diffcult, and the success rate is low in Africa. Although the contribution of private equity frms in fnancing the private sector is currently limited in Africa, this is gradually picking up over time. Table 15.1 shows that a total of USD13.6 billion private equity, including venture capital, was raised over the last decade by the top 12 domestic fund manager locations. The bulk of private equity was raised by equity funds located in South Africa (USD6.8 billion), followed by those in Egypt (USD2.7 billion), Mauritius (USD1.1 billion), and Nigeria (USD1.0 billion). The average amount of private equity raised by Africa-focused PEFs per year is USD1.36 billion per annum.

Chapter 15 • Finance and economic development 421 TABLE 15.1 Africa-focused private equity (PE) capital raised in the past ten years by domestic manager location Domestic manager location South Africa Egypt Mauritius Nigeria Tunisia Kenya Morocco Ghana Togo Botswana Senegal Ivory Coast Total

PE capital raised (bn* USD) 6.8 2.7 1.1 1.0 0.7 0.5 0.4 0.1 0.1 0.1 0.1 0.1 13.6

Average PE capital raised per year (bn USD) 0.68 0.27 0.11 0.10 0.07 0.05 0.04 0.01 0.01 0.01 0.01 0.01 1.36

Source: Preqin (2016) Note: * bn = billion

Private equity and venture capital can be important sources of enterprise fnancing. There is ample evidence to suggest that enterprises with venture capital investment tend to perform better than those without venture capital fnancing (see Dushnitsky & Lenox, 2006; Smolarski & Kut, 2011). However, a lot more needs to be done to increase the capacity of the venture capital and private equity industry to support enterprise development in Africa and other developing regions of the world. 15.4.2 Structured trade fnance Structured trade fnance (STF) is an alternative approach to enterprise fnance, which focuses on transaction-based lending. It is a cross-border means of fnance in emerging markets provided outside the traditional fallback on securities; the focus shifts from the strength of the borrower to the underlying cashfow and structures that enhance safe fnancing. Each STF deal is tailored to meet the individual borrower’s needs. The facility is useful for businesses that do not have strong balance sheets but have an underlying transaction that is self-liquidating. The technique originated from the Latin American fnancial crisis in the mid 1980s and has since been seen as an innovative means of fnancing international trade by not relying on balance sheet analysis, government guarantee, and tangible assets as collateral but rather relying on the potential sale of the commodity for payment. STF is particularly benefcial to developing countries, which may not be able to access straight commercial fnance; while STF constitutes about 80% of loans to noninvestment-grade borrowers that of investment grade borrowers is 20%–40% (Spratt, 2008). Examples are the African Export-Import Bank (Afreximbank) based in Egypt and the Ghana EXIM Bank, which provide fnance through STF

422 Elikplimi Komla Agbloyor et al.

deals. Given the important contributions of Afreximbank in supporting STF in Africa, we provide details of its STF programme in Box 15.1. It would be useful to encourage banks and other lending institutions in Africa and other developing countries to consider STF in addition to traditional methods of balance sheet fnancing, which excludes most enterprises with viable trade transactions (Abor, Issahaku, & Agbloyor, 2019). This is necessary to facilitate and boost international trade. Lending institutions and banking corporations provide a variety of services to exporters, importers, and trading corporations to carry out trade effciently, and these services are collectively referred as structured trade fnance services (Broer, 2018; Ghent, Torous, & Valkanov, 2017). These services are highly specialized in nature and dedicated to the fnancing of high-value exports and imports. Trade fnance products play a pivotal role in the free fow of commodities and capital goods from one country to another.

BOX 15.1 African Export-Import Bank and structured trade fnance The African Export-Import Bank (Afreximbank) was established in Abuja, Nigeria, in October 1993 by African governments, African private and institutional investors, and non-African fnancial institutions and private investors for the purpose of fnancing, promoting, and expanding intra-African and extra-African trade. The bank is one of the entities under the African Development Bank Group and is headquartered in Cairo, Egypt. Afreximbank has various classes of shareholders: class A shareholders consist of African governments, central banks, African regional and subregional institutions, including the African Development Bank; class B shareholders consist of African private investors and fnancial institutions; class C shareholders are made up of non-African fnancial institutions, export credit agencies, and private investors; and class D shareholders include other institutions and individuals. The bank’s governance structure includes the general meeting, which consists of shareholders or their representatives and is the highest decision-making organ of the bank. It also has a board of directors, with representations from all classes of shareholders. The president of the bank is assisted by a senior executive vice-president, and executive vice-presidents in the day-to-day management of the bank. The bank offers a number of products and services, including structured trade fnance (STF), factoring, an export development programme, project-related fnancing programme, and a guarantee programme related to obtaining large contracts. Afreximbank’s STF programme covers both exports and imports and is composed of programmes and facilities designed to address the market and product diversifcation problems that Africa faces. It is intended to remove bottlenecks to the trading of products already produced or near production and able to enter trade. Facilities under this

Chapter 15 • Finance and economic development 423

scheme are organised under dual and non-dual recourse programmes. Programmes under the dual recourse (DR) category are those in which the bank lends to a corporate against the guarantee or aval of an acceptable bank or another creditworthy corporate. This category of programmes helps the bank rely on the nearness of local banks to the underlying borrowers in monitoring the loans it makes and therefore helps mitigate the risk of lending to next-generation exporters that have replaced the dismantled commodity boards and the broader emerging African private sector. It also helps in dealing with the impediments to extending fnancing to certain countries when problems arise from high documentary taxes and when the bank’s special tax-exempt privileges do not apply because they are not nonparticipating states. By using DR structures, the bank extends recourse to all the parties in a deal mitigating the risk of possible impairment of other collateral it may have taken on such a deal. Programmes in the non-dual recourse (NDR) category are operated with direct recourse to one obligor. This involves lines of credit, direct fnancing, syndications, and special risks programmes. Such deals are done with established corporatons and banks or where the legal regime allows for the proper perfection of securities. Since Afreximbank’s establishment in 1993, it has provided over USD41 billion in credit facilities for African businesses. Most of the loans were STF facilities, funded either directly by the bank or in syndicates. The bank provided about USD15.4 billion through STF deals between 2012 and 2016. Afreximbank plays a signifcant role in providing capital, facilitating international trade, economic recovery, and stability to the African region. Source: https://afreximbank.com/

15.4.3 Project fnance for infrastructure development Project fnance for infrastructure development is another important development fnance tool, given that infrastructure development is critical for enterprise growth. For developing countries to move from being consumerbased economies to investment-driven economies, they need infrastructure. The private sector can thrive in an environment of solid infrastructure in the areas of transportation, water, information and communications technology (ICT), energy, and power. However, in many developing countries, a large and growing infrastructure ‘gap’ continues to constitute a key constraint to private sector growth. For instance, the World Economic Forum’s Global Competitive Index (GCI) 2015–2016 indicates that about 75% of the 20 least competitive countries in the world are found in sub-Saharan Africa, due in large part to the region’s deep infrastructure defcit (World Economic Forum, 2015). According to a study by the World Bank (2010), the continent needed USD93 billion per year to plug the infrastructure gap (Ghana alone will require USD1.5 billion per annum over the next decade). Africa’s power

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sector alone has been experiencing a fnance shortfall of USD40–45 billion every year since achieving universal access to electricity and requires an investment of about USD55 billion per year until 2030. The fscal constraints, coupled with underdeveloped capital markets, constitute a major challenge to fnancing infrastructural development in Africa. As a result, there is a global trend to seek alternative means of fnancing infrastructural projects that were traditionally fnanced primarily by governments and banks. Project fnance is therefore necessary in this regard. It is a new fnancial discipline that has developed rapidly over the past two and half decades. It involves raising long-term fnance for major projects through project fnancial engineering, on the basis of fnancing against cashfows generated by the project alone. However, not much has been done in this area in Africa. Between 2003 and 2013, the World Bank reported that only 158 project fnance deals valued at USD59 billion (representing a mere 3% of the 5,000 deals globally valued at USD2 trillion) have been closed in sub-Saharan Africa. The few deals either have been wrongly priced or have had poor value for money analysis. Project fnance through a public–private partnership (PPP) can help deal with the issues of pricing and with issues from risk sharing and rewards between the public and private partners in a manner that is mutually acceptable. For example, countries like Brazil, Colombia, Chile, Mexico, China, and India have made huge progress on infrastructure development, mainly through PPP deals. African countries can consider such a fnancing model for major infrastructure development in order to support private sector growth, but this should require the proper regulation and governance of these arrangements. 15.4.4 External capital infows External capital infows in the form of foreign direct investment (FDI), debt infows, foreign portfolio investment, and remittances are considered important sources of economic growth in many countries. While fnancing fows often proved volatile and prone to recurrent misallocation, FDI, for instance, is sought by many countries because of the large positive externalities they are expected to carry with them (Asiedu, 2002; Alfaro, Chanda, Kalemli-Ozcan, & Sayek, 2004; Abor, Adjasi, & Hayford, 2008; Abor & Harvey, 2008). Remittances have also become a preferred source of development fnance due to their countercyclical nature and the fact that they do not constitute debt to the host economy (Issahaku, Abor, & Amidu, 2016, Issahaku, Abor, & Harvey, 2017). Figure 15.1 shows FDI infows among top recipient countries in Africa. In 2015, out of the USD764.67 billion FDI infows into all developing countries, Africa received only 7% (USD54.08 billion), with Ghana (USD3.19 billion), Angola (USD8.68 billion), Egypt (USD6.89 billion), Mozambique (USD3.71 billion), and Morocco (USD3.16 billion) as the top fve FDI recipients in Africa. Total FDI infows into Africa in 2014 were USD53.9 billion, with South Africa, the Congo (Democratic Republic), Mozambique, Egypt, and Nigeria as the top fve FDI recipients (UNCTAD, 2015, 2016).

Chapter 15 • Finance and economic development 425 FIGURE 15.1 Top recipients of FDI fows in Africa (billions of dollars), 2014–2015 (x)=2014 ranking

3.2

Morroco (6)

3.6 3.2

Ghana (7)

3.4 3.7

Mozambique (3)

4.9 6.9

Egypt (5)

4.6 8.7

Angola (11)

1.9 0

1

2

3

4 2015

5

6

7

8

9

10

2014

Source: UNCTAD (2015, 2016)

Although the importance of FDI is recognised, a key issue that requires serious policy attention is whether FDI necessarily leads to growth at both the micro level and the macro level. Recent empirical studies recognise that the effects of FDI on growth may depend on the size of FDI, the absorptive capacity of domestic frms, and the role of the local fnancial market (Abor, 2010; Adjasi, Abor, Osei, & Nyavor-Foli, 2012). That is, countries have to achieve a certain minimum level of human development, fnancial market development, trade openness, macroeconomic stability, institutional quality, and infrastructural development to beneft from FDI. The contribution of remittances to economic development in developing countries is becoming apparent. World Bank (2018) estimates show that remittance fows to low- and middle-income countries reached a new high of USD466 billion in 2017, a growth of about 8% from the 2016 fgure of USD429 billion. In absolute dollar terms, the top six remittance recipients in 2017 were India, China, Philippines, Mexico, Nigeria, and Egypt. In terms of share of remittances in total GDP, the top six recipients in 2017 were the Kyrgyz Republic, Tonga, Tajikistan, Haiti, Nepal, and Liberia. Remittances now exceed three times the size of foreign aid, and with the exception of China, remittances exceed FDI infows to low- and middle-income countries. Formal remittances to the sub-Saharan Africa (SSA) region reached USD34 billion in 2016 and rose to USD38 billion in 2017. These understate the number of remittances received in Africa, since a signifcant number of remittances are sent through informal channels. Nigeria, the largest remittance recipient in dollar terms, received USD22 billion in 2017. Senegal and Ghana, which are next to Nigeria, each received only USD2.2 billion in 2017. In terms of the size of remittances relative to the size of the economy, Liberia is the most remittent-dependent country in the region, with remittances as a percentage of GDP reached 27.1 in 2017 (see Figure 15.2). Comoros and Gambia follow, with remittances as a share of GDP exceeding 20%.

426 Elikplimi Komla Agbloyor et al. FIGURE 15.2 Remittances dependent countries in SSA, 2017

Country

Top 10 Remittance Receipients in SSA (Percentage of GDP, 2017) Nigeria Mali Guinea Bissau Togo Cabo Verde Senegal Lesotho Gambia, The Comoros Liberia

5.6 6.9 8 8.4

0

5

10

12.8 13.9 15.2

15 Percentage

20.8 21 20

27.1 25

30

Source: World Development Indicators (2018)

15.4.5 Other innovative sources of fnancing Other innovative sources of fnancing private sector development could be explored, including crowdfunding, green bonds, and leasing and factoring. 15.4.5.1 CROWDFUNDING Crowdfunding entails raising money to start a business venture or to support an existing venture or charity through an online platform, particularly social media. The issuer taps into a network of social media users who offer their contributions in support of the business idea in exchange for a promised return. Examples of crowdfunding applications include Crowdfunder, Indiegogo, and Kickstarter. The platform allows the fundraiser to set up and launch a public campaign to solicit funds from the general public. This campaign will give details of the business venture for which funding is needed, the amount required, any promised return, and the duration of the fundraising campaign. Crowdfunding offers an opportunity for the entrepreneur to raise external funds from a large cross-section of individuals (a ‘crowd’) instead of relying on a single fnancing source or a small group of complicated investors. After evaluating a sample of 48,500 crowdfunded projects with a combined value of USD 237 million, Mollick (2013) found that the success of crowdfunding depends on the fundraiser’s network and the quality of the underlying project. The study further found that the majority of fundraisers fulfl their obligations to funders, though about 75% of fundraisers delay in the delivery of their products. Lack of awareness, inadequate technological infrastructure, lack of regulatory framework, and other constraints have hindered the adoption of crowdfunding in developing countries. The

Chapter 15 • Finance and economic development 427

Crowdfunding Centre (2014) reports that the best-performing countries in terms of successful projects include advanced countries like the US, the UK, Canada, Germany, France, Australia, and Italy. Developing countries must build a strong internet backbone and a robust regulatory framework and launch a spirited public campaign in order to popularise the adoption and use of crowdfunding as a means of reducing the fnancing constraints of their funding-starved private sector. 15.4.5.2 GREEN, SOCIAL, AND SUSTAINABILITY BONDS (GSSBS) Globally, there is a rising cadre of investors who have a high level of environmental and societal consciousness. Such investors screen projects and select projects that optimise the use of resources in a sustainable manner. The private sector can take advantage of this intergenerational and social consciousness to issue GSSBs. GSSBs are debt securities issued with the proceeds applied solely to environmental or social projects. Worldwide, there is a rising concern about the devastating consequences of climate change and the sustainability of resources. The private sector can seize the opportunity to raise funds to apply them in projects that satisfy the triple bottom line (proft, people, and planet). The green bond principles (GBPs) and social bond principles (SBPs) and the sustainability bond guidelines (SBGs), generally called the principles have become the leading framework for GSSBs. The International Capital Market Association (ICMA) is the secretariat for providing guidance and governance of the principles. The principles are aimed at ensuring integrity of the GSSBs market by providing guidelines that ensure transparency, disclosure, and accurate reporting. Each of these principles has four components (ICMA, 2018a):

1 2 3 4

Use of proceeds. Process for project evaluation and selection. Management of proceeds. Reporting.

Green bonds are debt instruments where the funds/proceeds are applied solely to fnance or refnance either in full or in part a new project or an existing project that has environmental benefts (ICMA, 2018a). Some eligible green bond project categories include renewable energy, energy effciency, the prevention and control of pollution, the environmentally sustainable management of living natural resources and land use, biodiversity conservation, clean transportation, sustainable water and wastewater management, climate change adaptation, and green buildings. Social bonds are debt securities where the funds/proceeds are applied solely to fnance or refnance either in full or in part a new project or an existing project that has social benefts (ICMA, 2018b). Some eligible projects that can be fnanced through the issuance of social bonds include projects that promote or provide affordable basic infrastructure (clean water, sewage, sanitation, health, and energy), affordable housing, food security, and employment generation and those targeted at alleviating the suffering of people below the poverty line, the unemployed, and the vulnerable in general (ICMA, 2018b).

428 Elikplimi Komla Agbloyor et al.

Sustainability bonds are debt securities where the funds/proceeds are applied solely to fnance or refnance either in full or in part a mix of green and social projects (ICMA, 2018c). Thus, sustainability bonds fnance or refnance projects with social cobenefts and environmental cobenefts. Some social projects may have environmental cobenefts while some green projects may have social cobenefts. Whether a bond is classifed as green or social or sustainability depends on the underlying objectives of the project. GSSBs are sometimes linked to the UN Sustainable Development Goals (SDGs) in which case they are SDG-themed bonds. The private sector can innovatively raise fnance by aligning their business models with the SDGs. 15.4.5.3 LEASING AND FACTORING Leasing as a fnancing option involves a contractual arrangement, in which one party (lessor) gives the right to use an asset for a given period to another party (lessee). Lease fnancing is considered a form of debt fnancing where the lessee makes periodic lease payments for the use of the asset. Effcient leasing can help frms acquire the needed machinery and equipment to enhance production. Factoring, however, entails a frm’s handing over its debt collection responsibility to a specialist institution – the factor or factoring house. The factor or factoring house provides fnancing by means of advances and uses the frm’s accounts receivable balances as security. Factoring provides the means by which frms can outsource their sales function, smooth cashfows, and enhance fnancial planning. Lease fnancing and factoring can make signifcant contributions to fnancing private sector development in Africa.

15.5 CONCLUSION The private sector is often recognised as the bedrock of economic development in both developing countries and developed countries. Some of the contributions of the private sector to economic development include income and growth, employment and job creation, productivity, access to fnance, and revenue mobilisation. However, some constraints hinder the private sector in developing countries from maximising its potential to contribute optimally to economic development. These constraints revolve around access to fnance; access to land; business licensing and permits; corruption; courts; crime; customs and trade regulations; electricity; an inadequately educated workforce; labour regulations; political instability; the practices of competitors in the informal sector; theft and disorder; tax administration; tax rates; and transportation. Chief among these constraints is access to fnance. Private sector frms lack access to formal credit to enable them expand or take advantage of business opportunities. This constraint is more pervasive among small and medium-size frms than among large frms. We have to move beyond traditional bank fnancing in order to alleviate the funding constraints in

Chapter 15 • Finance and economic development 429

the private sector. Some innovative fnancing models that can improve access to fnance for the private sector include microfnance, mobile money systems, private equity and venture capital fnancing, alternative capital markets for SMEs, structured trade fnance, project fnance for infrastructure development, and external capital infows such as FDI and international remittances. For small firms, in particular, mobile money systems hold a lot of promise. Mobile money systems are affordable, convenient, reliable, and accessible. But the promotion of this financial innovation requires a strong and resilient telecommunication infrastructure and a robust regulatory framework. There are still wide geographical spans in Africa and other developing countries without a reliable telecommunication system. Further, regulations on mobile money are still evolving around the globe. A wide range of services can be extended through mobile money systems, including credit, savings, insurance, investment, and payments. On the capital market front, an alternative capital market for start-ups and SMEs is likely to make it easier for frms to access funding through the capital markets. Already, some African countries like Ghana, South Africa, Nigeria, and Kenya, among others, have taken the lead in this direction. But, so far, the response from the private sector to this opportunity has not been as good as expected. More incentives in the form of waiving listing fees, fexible continuous registration processes, and reduced underwriting costs, among other measures that can reduce the cost of listing and continuous listing, can improve the uptake of alternative markets by private sector frms. Other African and developing countries without capital markets or alternative markets should explore this avenue as an alternative source of providing funding for the private sector. Other sources of innovative fnance that the private sector can explore include crowdfunding; green, social and sustainability bonds (GSSBs); and leasing and factoring. Crowdfunding enables entrepreneurs to tap into their network and raise funds to support their business ideas. With the SDGs’ taking centre stage in global development circles, the private sector can take advantage and issue SDG-themed bonds or issue securities to fnance or refnance green or social or sustainability projects. GSSBs allow frms to align traditional proft-making objectives to global and societal objectives relating to the environment and society. Clearly, a lot of the obstacles faced by the private sector are in the domain and hence control of the public sector. A functional public sector will inevitably yield a functional private sector, which is the engine of growth. The public sector can lighten the burdens of the private sector by providing the necessary policies and infrastructure to anchor systems and structures relating to health, roads, transportation, telecommunications, taxation, electricity, banking and fnance, the environment, education, and law and order. Thus, the public sector must provide the conducive economic, institutional, regulatory, and operating environment needed for private businesses to thrive and prosper.

430 Elikplimi Komla Agbloyor et al.

Discussion questions 1 Through what channels does fnance impact economic growth? 2 Describe the characteristic features of the private sector in developing countries. 3 Critically evaluate the contribution of the private sector to economic development. 4 Critically appraise the slogan that the private sector is the engine of growth. 5 Discuss three theories underlying the capital structure decisions of frms.

6 Enumerate and explain fve factors that determine the capital structure of frms. 7 Explain four heterodox factors that affect the capital structure of SMEs. 8 Discuss fve innovative sources of development fnance for the private sector. 9 Critically evaluate how the following funding sources could be unlocked for private sector development: a. Crowdfunding. b. Green, social and sustainability bonds. c. Leasing and factoring.

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INDEX Note: Page numbers in italic indicate a fgure and page numbers in bold indicate a table on the corresponding page. advanced countries 295, 325, 378–379, 378, 427; see also specifc countries adverse selection 5 Africa 3, 11–13, 412–414, 420–422, 428–429; Africa-focused PE capital raised 421; capital market 429; commodity exchanges in 305; FDI fows in 424–425, 425; and fnancial inclusion 263–265, 268–269, 276–278; and fnancing agricultural 299, 303–304, 306, 308, 310; and fnancing sustainable development 322, 325–326, 328, 330–331, 334–335; and foreign aid 143, 145, 151–153, 157; foreign bank ownership in 92–93; and global fnancial architecture 177–179, 183; and infrastructure fnancing 385–391, 407; and international trade 373–374; and microfnance 55; ODA 148; and private capital fows 73–77, 80–84, 87–88, 90–93, 96–97, 102–103; and remittances 121; and sovereign debt management 235–236; and sovereign wealth management 207–208, 213–215, 222; SWFs 215; trends in private capital fows to 75; see also African Development Bank; African Development Fund; African Export-Import Bank; Middle East and North Africa (MENA) region; sub-Saharan Africa; and specifc countries African Development Bank (AfDB) 151, 346, 412–413, 422; and fnancial inclusion 264–265; and global fnancial architecture 185–186, 189–190; and infrastructure fnancing 387–388, 390 African Development Fund 189–190 African Export-Import Bank (Afreximbank) 421–423 Agbloyor, Elikplimi Komla 87 agricultural commodity markets 304–305 agricultural development 309–311 agricultural entrepreneurs: fnancing 299–300 agricultural fnancing 312; challenges of 297–298; and derivatives 304; role of government in 312–313 agricultural raw materials 293–294, 294 agriculture: and capital market vehicles 302–305; contribution to GDP 289; credit 296; and FDI 293–295, 295, 308–309; fnancing opportunities in 298–299; overindebtedness in 311–312; and private

sector credit 295; and savings 307–308; value added per worker 291, 317; see also agricultural fnancing; agricultural raw materials; agriculture development; agriculture value chains agriculture development 287–296 agriculture value chains 302 aid Laffer curve 155–156, 156 allocating capital 29 alternative trade fnancing 375 altruism 111–112 Amidu, Mohammed 276 animal agriculture 298; see also agriculture arbitrage: China 355–356 Argentina 188–189, 202, 250–251, 306; international trade 362–364, 362–363, 366, 379 Asia 13, 33–34, 52, 55, 74, 413–414; evolution of SWFs in 213; fnancial inclusion 269–271; fnancing agriculture 288–294; fnancing sustainable development 325–326, 346–347; foreign aid 142–143; global fnancial architecture 183, 185–186, 195–197; international trade 373–374, 377; sovereign wealth management 212–213, 228–229; see also Asian Development Bank; Asian Tigers; Central Asia; East Asia and Pacifc; Europe and Central Asia; South Asia; and specifc countries Asian Development Bank (ADB) 142, 151, 185–186, 190, 346, 373–375 Asian Tigers 87, 212, 215, 414 asset allocation: sovereign wealth funds 227–228 asset-backed security (ABS) 337 asset-liability management see sovereign asset-liability management asset pricing: SWFs 230 assumptions 361–362, 362 asymmetric information 4–6 bank-based fnancial systems 22 Bank for International Settlements (BIS) 183–185 banks 33–34; priorities of 297 Banque Africaine de Development (BAD) see African Development Bank Basel Committee on Banking Supervision (BCBS) 183–185 bequests: investment for 114–115

436 Index bidirectional causality 26–27 bilateral agencies 344–346 bilateral international economic cooperation 222 biodiversity: and ecosystem fnancing 333–334 blended climate fnance 338 blended fnance 338–339 bond markets 38–39 bonds: debt fnancing through 303; see also asset-backed security; commodity-stacked bonds; corporate bonds; diaspora bonds; fnancial sector bonds; green bonds; green, social, and sustainability bonds; local currency infrastructure bonds; municipal bonds; project bonds; sovereign bonds; supranational, subsovereign, and agency (SSA) bonds borrowing cost 239–240 Botswana: and FDI 87–88 Brazil 225, 251, 306, 322, 377, 424; foreign aid 144, 146–148; global fnancial architecture 176, 188, 202 Bretton Woods 369 Bretton Woods institutions 170–171; International Finance Corporation 175–177; International Monetary Fund 171–174, 178–180; World Bank 174–180; World Trade Organization 180–183; see also specifc institutions by name BRICS 147, 229; see also Brazil; China; India; Russia; South Africa British pound: exchange rates 357–358, 357–358 build-operate-transfer (BOT) model 395–396 build-transfer-operate (BTO) model 397 buy-build operate (BBO) model 397 Caja de Ica 61 Canada 34–35, 344, 427; foreign aid 142–143; global fnancial architecture 188, 201–202; international trade 352–355, 352, 354 Canadian dollar 353–354, 354 capital see allocating capital; capital controls; capital fows; capital infows; capital market vehicles; capital markets; cost of capital; external capital infows; private capital fows; product of capital; seed capital capital controls: Argentina 362–364 capital fows: and CO2 emissions 79, 89, 90; and GDP per capita 78, 85, 86; and institutions 86; and natural resource rents 77, 89; see also capital infows; private capital fows capital infows 74, 105, 111, 424–425 capital markets: and growth 35–37; and sovereign wealth managers 221

capital market vehicles 302–305 causality 26–28 Central American Bank for Economic Integration (CABEI) 188–189 Central Asia 34, 191, 271, 288 China 414, 424–425; global fnancial architecture 188, 192, 201–202; fnancing agriculture 306; foreign aid 144–148, 162n7; international trade 355–356, 373, 377, 383–384; microfnance 87, 92; remittances 106–107; sovereign wealth management 216, 222, 227, 229 cities: sustainable 325–326 climate change adaptation 332–333 climate fnance 331–332; blended 338 CO2 emissions 79, 89, 89–90, 333 collaboration 280–281 collateral 297 commodities markets: fnancial intermediation in 30–31 commodity-backed bonds 392–393 commodity exchanges 304–306, 305 community-based health insurance (CBHI) 344 completion risk 405 conditionality: and foreign aid 158–159 connected lending: Ghana 93 construction risk 404 consumption patterns 329–330 contracting: cost of 8 copper mining: Zambia 91 corporate bonds 336–337 corporate governance 30 corruption: and foreign aid 159–161 corruption perception index (CPI) 159–160, 160 cost of capital: and marginal product of capital 243 costs: information costs 29–30, 33, 297; international remittances 132–133; see also cost of capital; transaction costs country-level income group 106–107, 106–107 CPI see corruption perception index creativity 280 credit: share of agriculture credit ratios 295–296, 296; see also credit rationing; domestic credit credit rationing 6–7, 7 credit unions 34–35; in Canada 35 cross-exchange rates 354–355, 355 crowdfunding 426–427 currencies see currency manipulation; international currencies currency manipulation: China 355–356 debt see debt contract; debt fnancing; debt management; debt-relief policies; debt sustainability analysis; external debt;

Index 437 government; medium-term debt strategy; over-indebtedness; sovereign debt management debt contract: renegotiating 246–248 debt fnancing 303 debt Laffer curve 240–242, 241, 252, 260n10 debt management: overview of 237–238; see also sovereign debt management debt-relief policies 248 debt sustainability analysis (DSA) 256–258: and medium-term debt strategy 256–259 demand-following hypothesis 26 demand risk 404 demand-side factors 270–272 Democratic Republic of the Congo (DR Congo, or DRC) 82–83 deposit-taking fnancial institutions 14; and growth 32–35 derivatives: fnancing agriculture 304 design risk 404 developing countries 412, 414–415, 421–423, 426–429; contemporary issues in development fnance 10–11, 13–15, 17; distribution of FDI 378, 378; fnance, economic growth, and development 22–25, 29, 36–39, 41; fnancial inclusion 269, 272, 282; fnancing agriculture 287, 293, 297, 303–304, 307–308; fnancing sustainable development 318, 321, 324–330, 334–338, 341–344, 347–348; foreign aid 140, 142–150, 152–154, 161; global fnancial architecture 171, 175–177, 182–185, 190–192, 195–198; idiosyncratic risks to infrastructural development in 404–406; infrastructure fnancing 385; international trade 375–376, 378; microfnance 52; private capital fows 74–76, 84, 89, 95; remittances 105, 109, 117, 119, 126; sovereign debt management 235–236, 238–239, 242–243, 245, 248, 256–257, 259; see also specifc countries development assistance for health (DAH) 344–346, 345 development fnance 4–6, 420–428 Development Finance Company Uganda (DFCU) 301–302 development fnance institutions (DFIs): establishing 9–10; types of 9 development fnance interventions 7–10; for correcting market imperfections 8–9 development funds 220 diaspora bonds 393 digital fnancial development 309–311 disruptive technology risk 406 domestic credit 33–34, 33–34 domestic resource mobilization: and foreign aid 153–155 Dutch-disease effects 118–119

East Asia and Pacifc (EAP) 220, 271, 290, 292–293 economic development 420–428; and fnancial inclusion 279–281; multiplier effects of infrastructure development on 389–390; obstacles to private sector development 414–416; and private sector 412–416; role of private sector in 413–414 economic growth: and external debt 238–243; fnancial inclusion–economic growth transmission channels 273–275; and inclusive fnance 273–279 ecosystem fnancing 333–334 ECX 30–31 effciency of exchange 279–280 emerging economies: sovereign assetliability management in 223–227 empirical evidence: remittances 118–123 employment 292–293, 292 end users: impact of microfnance on 62–67 energy transformation 327–328 environmental fnance 331 environmental risk 405–406 equity fnancing 303 euro: exchange rates 356–359, 357–358 European Bank for Reconstruction and Development (EBRD) 190–191 Europe and Central Asia (ECA) 34, 191, 271, 288, 290, 292–293 excess-savings countries 394 exchange 112–113; modeling exchangedriven motivations 113–114; see also effciency of exchange exchange rate 351–356; de facto arrangements 372; IMF classifcation system 371; see also cross-exchange rates; exchange rate policy; exchange rate regimes; exchange rate risks; foating rates; nominal exchange rate; real effective exchange rate; spot exchange rate; threemonth forward exchange rate exchange rate policy 366–372 exchange rate regimes 372 exchange rate risks 405 exports: agricultural raw materials 293–294, 294 extended credit facility (ECF): Ghana 173–174 external capital infows 424–425 external debt: the channels via which external debt impacts growth 243; and economic growth 238–243 external debt-to-GDP ratios 238–239 factoring 428 farmers: fnancing 299–300 fnance 377–379; and causality 26–28; innovative sources of 339; see also

438 Index blended climate fnance; blended fnance; climate fnance; environmental fnance; infrastructure fnance; private fnance; private sector fnance; public fnance; R&D fnance; structured trade fnance; trade fnance fnance–growth nexus 25–28 fnancial access 21 fnancial crisis of 2007/2008: and fnancial globalisation 194–195; sovereign wealth management after 215–217; sovereign wealth management before 211–215; SWFs 216–217 fnancial depth 21 fnancial development 10–13; concepts and defnitions 20–23; and inclusive fnance 272–273; and remittances 123–126 fnancial effciency 21–22 fnancial globalisation (FG): benefts and risks of 193–194, 194; dynamics of 191–192; and global crisis 191–195; and the global fnancial crisis 194–195 fnancial inclusion 10–13; conceptualising 264–266; the dark side of 273; determinants of and barriers to 268–272; and economic development 279–281; and economic growth 273–279; empirical evidence 275–279; and fnancial development 272–273; fnancial inclusion–economic growth transmission channels 273–275; mobile fnancial services 31–32; SSA and world 267; sub-Saharan Africa 277–278; trends in 266–268 fnancial innovation 8–9 fnancial institutions see banks; deposittaking fnancial institutions; global development fnance institutions; international fnancial institutions fnancial instruments 392–395 fnancial intermediation: commodities markets 30–31; and growth 32–39; mobile fnancial services 31–32 fnancial liberalization 23–25 fnancial literacy programs 132 fnancial management 329 fnancial market regulation 8 fnancial markets: and sovereign wealth managers 221 fnancial products: addressing SDGs 204 fnancial repression 23–24 fnancial sector: concepts and defnitions 20–23; regulation in 40 fnancial sector bonds 337 fnancial sector stability: Ghana 93 fnancial services 21–23; addressing SDGs 204; see also mobile fnancial services Financial Services Board (FSB) 40, 199–200

fnancial services view 23 fnancial stability 22; and SWFs 230 Financial Stability Board (FSB) 199–200 fnancial structures 22, 39 fnancial sustainability 56–57; of MFIs 57–58 fnancial system 21; role of 28–30 fnancing: agriculture 299–311; agriculture value chains 302; and capital market vehicles 302–305; farmers and agricultural entrepreneurs 299–300; through FDI 308–309; health 341–346; infrastructure development 391–399; innovative sources of 426–428; movable assets 300–301; risk management 305–307; through savings 307–308; sustainable development 325–331; see also debt fnancing; ecosystem fnancing; equity fnancing; fnancing behaviour; fnancing opportunities; fnancing structure; renewal energy fnance fnancing behaviour 416–420; factors infuencing 416–419 fnancing opportunities in agriculture 298–299 fnancing structure 396; summarized overview 39, 39 fntech 10–13 foating rates 369–372 food security: and nutrition 326–327 force majeure risk 405 foreign aid: the aid Laffer curve 155–156; architecture, volumes, and trends 146–148; conditionality and good governance 158–159; and corruption 159–161; and domestic resource mobilization 153–157; evolution of 140–144; and growth 148–151; and poverty 151–153; rationale for 144–146; uncertainties and conditionalities 157–158 foreign bank lending: benefts of 91–92; costs of 93–94; determinants 83–84 foreign bank ownership: Africa 92–93 foreign bank presence: Ghana 93 foreign direct investment (FDI) 295; and agriculture 293–295, 308–309; benefts of 85–87; and Botswana 87–88; costs of 88–90; determinants 78–82; distribution of 378; and the DRC 82–83; horizontal and vertical approaches 81–82; and Nigeria 90; top recipients in Africa 425; and Zambia 91 foreign portfolio investment (FPI): benefts of 94; costs of 94–95; determinants 84–85; effects in South Africa 95–96 forward-looking markets 356–358 foundations 346 funding: plantation and animal agriculture 298; SWF 218; see also long-term funding

Index 439 G7 see Group of Seven G10 see Group of Ten G20 see Group of 20 GAVI 339–340 general revenues 343 Ghana 12, 22, 36–38, 40, 423–425, 429; fnancial inclusion 276; fnancing agriculture 293, 296, 303–306, 311; foreign aid 150, 157; global fnancial architecture 177; IMF three-year extended credit facility to 173–174; infrastructure fnancing 389; microfnance 66; private capital fows 76–77, 93; sovereign debt management 235, 239; sovereign wealth management 208 Ghana Alternative Market (GAX) 36–38, 303 Ghana Stock Exchange (GSE) 37, 37–38 Global Agriculture and Food Security Program (GAFSP) 338 global development fnance institutions 185–191 global fnancial architecture: reforming 195–197 globalisation see fnancial globalisation global lottery 341 Global SME Finance Facility 338 global taxes 341 gold standard 366–367 good governance: and foreign aid 158–159 goods and services 29 governance 244; and management structures 218–219 government: role in agricultural fnancing 312–313 government debt: institutional framework for management of 244–246; risk management framework for 253–256 green bonds 336–337 green, social, and sustainability bonds (GSSBS) 427–428 group lending 53 Group of 20 (G20) 202 Group of Seven (G7) 200–201 Group of Ten (G10) 201–202 growth 23–25; and aid 148–151; Argentina 363; and capital markets 35–39; and causality 26–28; the channels via which external debt impacts growth 243; and deposit-taking fnancial institutions 32–35; and fnancial intermediation 32–39; and remittances 115–123 health: fnancing 341–346 health expenditure 342, 342 health fnancing 342 Hermes, Niels 158 high-income countries 39, 39

household: insurance for 114 household incomes: and remittances 126–131 IDA 18 IFC-MIGA Private Sector Window (IDA-PSW) 338–339 impact evaluations 65–66 imports 368–369, 368 incentives 249–250 inclusive development 275–279 inclusive fnance see fnancial inclusion inclusive growth 275–279 income groups 33, 33; see also country-level income group India 40, 424–425; fnancial inclusion 273, 275, 277, 278; fnancing agriculture 305–306; foreign aid 142, 144–148; global fnancial architecture 202; infrastructure fnancing 393; international trade 366, 373; microfnance 60, 62; private capital fows 80, 92; remittances 107 inequality: and remittances 127–130 infation: Argentina 362–364, 363 information 29 information asymmetry 229–230 information costs 29–30, 33, 297 information processing 8 information systems: effective management of 245–246 infrastructure development: challenges for 387–388; fnancing 391–399; idiosyncratic risks to 404–406; institutional framework for private participation in 399–400; multiplier effects on economic development 389–390; opportunities for 388–389; and project fnance 423–424 infrastructure fnance 312 infrastructure projects: risk management of 403–404 innovation 280 institutional framework: for government debt management 244–246; PPPs in South Africa 401–403; for private participation in infrastructure development 399–400 instrumental variables: in remittance research 120–122 insurance: for household at home 114; see also insurance instruments; insurance risk insurance instruments 306 insurance risk 405 Inter-American Development Bank (IDB) 188 interest parity condition 360–362, 362 interest rate parity 359–362 interest rates: Argentina 362–364, 363; see also reference interest rates international commodity markets 304–305 international currencies 376–377; functions of 376; symbols 352

440 Index international economic cooperation 222 international economic order 364, 366, 369, 370 international fnance facility (IFF) 339 International Finance Facility for Immunization (IFFIm) 339–340 International Finance Moment (IFC) 175–177 international fnancial institutions (IFIs) see Bretton Woods institutions; regional development banks; and specifc institutions International Monetary Fund (IMF) 171–173; Article 1 172; exchange rate classifcation system 371; special drawing rights 340–341; three-year extended credit facility to Ghana 173–174 international monetary regimes 366, 366 international remittances 105–109 investment 29, 359, 377–379; for bequests 114–115; traditional versus private 391–392; see also foreign direct investment; foreign portfolio investment; investment behaviour; investment incentives; return on investment investment behaviour 416–420; factors infuencing 419–420 investment incentives: and legal frameworks 400–403 Issahaku, Haruna 276, 311 jobs 328–329 joint liability 53 Kenya 11–13, 31–32, 429; fnancial inclusion 264, 276–278; fnancing agriculture 299, 307; infrastructure fnancing 388; private capital fows 77, 93; renewable energy feed-in tariffs in 335 Laffer curve see aid Laffer curve; debt Laffer curve land purchase and site risk 404 lease-develop-operate (LDO) model 397 leasing 428; DFCU 301–302 legal frameworks 312; and investment incentives 400–403; PPP in South Africa 401–403 lending see connected lending; foreign bank landing; group lending Lensink, Robert 64–65, 126, 155–156, 157–158 Lesotho 12, 396, 426 loan guarantee funds 313 loans: solar water heaters in Tunisia 336 local currency infrastructure bonds 392 long-term funding 297 low- and middle-income countries (LMICs) 104–106, 105 low-income countries (LIC) 39, 105, 106–107

management structures 218–219 marginal product of capital 243 market-based fnancial systems 22 market-based instruments 306–307 market effciency 362, 362 market imperfections 4–7; interventions for correcting 8–9 market pricing 230 MDGs 319–326, 323–324 medium-term debt strategy 258–259 MENA region see Middle East and North Africa (MENA) region microcredit 52–54; impact on end users 62–67 microfnance 52–54, 55; impact on end users 62–67; and nudges 61; supply side of 54–57 microfnance institutions (MFIs) 54–57; outreach and fnancial sustainability of 57–58; performance of 54–57 microfnance intervention: evaluation of 63–64 microfnance plus 52–54 microfnance products 58–62 Middle East 144, 208, 212–215, 214, 229, 234, 373–374; see also Middle East and North Africa Middle East and North Africa (MENA) region 271–272, 276, 290, 293 migrants: migrant control over the use of remittances 132 migration: instrumental variables in migration research 120–122 Millennium Development Goals (MDGs) 320–322; achievements and challenges 321–322; and SDGs 322–325 mixed motive 115 mobile fnancial services 31–32 monetary regimes see international monetary regimes monitoring frms 30 moral hazard 5–6 motivations: mixed motive 115; modeling exchange-driven motivations 113–114; remittances 111–115 movable assets 300–301 M-Pesa 12, 31–32 multilateral development banks (MDBs) 185–186 multilateral fnancial institutions (MFIs) 185–186 multilateral international economic cooperation 222 multilateral organizations 346 multiplier effects 389–390 municipal bonds 337 natural resource rents 77, 79, 89 neoclassical economic approach 79–80

Index 441 NGOs 346 Nigeria 40, 420–422, 424–426, 429; fnancial inclusion 263, 277; fnancing agriculture 304, 311; foreign aid 147; global fnancial architecture 189; infrastructure fnancing 387–389, 398; private capital fows 76–77, 90, 92–93 no-causal relationship 27–28 nominal exchange rate: China 355, 355 nudges 61 nutrition: and food security 326–327 offcial development assistance (ODA) 147–148 oil prices 213–217, 214 oil production 212–213, 214 OLI paradigm 80–81 operational structure 245 operation performance risks 405 Organisation for Economic Cooperation and Development (OECD) 202–203 organizational structure 244–245 Organized Stock Exchanges 303 Otchere, Isaac 36 out of pocket payments (OOPPs) 344 outreach 57–58 over-indebtedness 311–312 payment system 8 pension reserve funds 220–221 perpetual franchise model 397–398 person-to-person transfers 109; see also remittances Peru see Caja de Ica plantation agriculture 298 policy see debt-relief policies; exchange rate policy; policy tools and interventions; policy trilemma policy tools and interventions 131–134; SWFs 222 policy trilemma 364–366, 365, 370 political risk 405 pollution havens hypothesis 91 poverty: and aid 151–153; and remittances 130–131 primary surplus 239 private capital fows: to Africa 75, 102–103; benefts and costs associated with 85–96; determinants of 77–85 private equity (PE) capital 420–421, 421 private equity funds (PEFs) 394 private fnance 329; responsible 337–338 private investment: traditional versus 391–392 private participation: infrastructure development 400–401 private sector: in Africa 412–413; and economic development 412–416; obstacles

to development 414–416; role in economic development 413–414 private sector credit: and agriculture 295 private sector development 420–428 procurement systems 329 production patterns 329–330 project bonds 337 project fnance 423–424 public fnance 329 public–private partnerships (PPPs) 346, 395–399; Lesotho 396; South Africa 401–403, 402 purpose 133–134 R&D fnance 312–313 randomized controlled trials 65–66 real effective exchange rate: China 355–356, 355 recession 367–369 reference interest rates 363–364, 363 reform: earlier proposals on 197–198; global fnancial architecture 195–200; proposals after the global fnancial crisis 198–200 regional classifcation 33–34, 34 regional development banks (RDBs) 170, 186–191, 187, 346 regulation 40 regulatory frameworks 312 regulatory risk 405 remittances 106–107; characteristics of 109–111; as counter cyclical 110–111; and fnancial development 123–126; and growth 115–123; and household incomes 126–131; and inequality 127–130; instrumental variables in research 120–122; migrant control over the use of 132; motivations 111–115; and poverty 130–131; purposes 133–134; remittance-dependent countries in SSA 426; and resource allocation 109–110; see also international remittances; securitising remittances renegotiating debt contract 246–248 renewable energy feed-in tariffs (REFIT) 335 renewal energy fnance 334–335 reserve funds 220 resource allocation: and remittances 109–110 restructuring: methods of 253; process of 252–253; sovereign debt 250–253 return on investment 280; tax on 243 risk: idiosyncratic risks to infrastructural development in developing countries 404–406; undiversifable 297; see also risk analysis; risk mitigation risk, diversifcation of 29–30 risk, management of 29–30 risk, trading of 29–30 risk analysis 406–407

442 Index risk management 305; government debt portfolio 253–256; infrastructure projects 403–407; sovereign wealth funds 227–228 risk management instruments 8 risk mitigation 406–407 Russia 74, 146–147, 201–202, 216, 251, 367 Santiago Principles 230–231, 232n3 savings 29; fnancing agriculture 307–308 savings funds 219–220 seasonality 297 securitising remittances 393 seed capital 212, 218, 231 small and medium-size enterprises (SMEs) 375; alternative exchange for 303–304 social capital 280–281 social health insurance (SHI) 343 social risk 406 solar water heaters: loans for 336 South Africa 22, 40, 147, 277; debt-to-income ratio 311–312; exchange rates 353–355, 354, 355; FPI effects in 95–96; National Development Plan of 389; PPPs in 400–403, 402; see also Financial Services Board; G20; South African Reserve Bank; sub-Saharan Africa South African rand 353–354, 354 South African Reserve Bank (SARB) 40 South Asia (SA) 271, 290, 292–293, 326, 347, 413 sovereign asset-liability management (SALM): in emerging economies 223–227; issues to consider 225–227 sovereign assets see sovereign asset-liability management sovereign balance sheet 223–225, 224 sovereign bonds 392 sovereign debt 250–253 sovereign liabilities see sovereign assetliability management sovereign wealth funds (SWFs) 394–395; challenges and opportunities for 228–230; conceptual framework 209; evolution in Africa 215; evolution in Asia 213; evolution in the Middle East 214; evolution in other parts of the world 215; evolution over time 210; funding 218; governance and management structures 218–219; post2007/2008 global fnancial crisis 216–217; Santiago principles 231; by source of seed capital 212 sovereign wealth management: analytical framework 209; context of 208–209; evolution and overview of 210–217 sovereign wealth managers 219–222 special drawing rights (SDRs) 340–341 speculative development 398–399

spider web spiral 368–369, 368 spot exchange rate 352, 352, 355–361, 355, 357–358 stabilisation funds 219 staff recruitment and monitoring 246 stock markets 36–37; sub-Saharan Africa 37; see also Organized Stock Exchanges structural adjustment 178–180 structured trade fnance (STF) 421–422; and African Export-Import Bank 422–423 stylized facts 25, 251, 288–296 sub-Saharan Africa (SSA) 11, 13, 24–25, 36–39, 423–426; DAC aid 147; debt-relief programmes 235; and fnancial inclusion 263–264, 266–268, 267, 270–271, 276–177; fnancial sector liberalization 24–25; and fnancing agricultural 287, 290, 292–293; and fnancing sustainable development 326, 347; and foreign aid 151–152, 160–161; global CPI ranking 159, 160; and infrastructure fnancing 386–390; mobile fnancial services 32; and private capital fows 81, 87; remittance recipients in 426; share of ODA 148; and sovereign debt management 235, 259; stock markets in 37; volatility of capital fow 75; see also specifc countries supply factors 269–270 supply-leading hypotheses 26 supply side 54–57 supranational, subsovereign, and agency (SSA) bonds 337 sustainable cities 325–326 sustainable development 319–325; benefts of fnancing 330–331; environmental fnance 331–337; evolution of the concept of 320; fnancing 325–330; fnancing health 341–346; global lottery 341; global taxes 341; and IMF special drawing rights 340–341; innovative sources of fnance for 339; and international fnance facility 339; private sector fnance 337–339; sources of fnancing 331–346 Sustainable Development Goals see UN Sustainable Development Goals Swiss franc 353–354, 354 Tanzania 12, 77, 208, 388; climate change adaptation 332–333; fnancing agriculture 301, 305, 307 taxes 341; general revenues 343; on return on investment 243 tax systems 329 temporary privatisation 398 theory 116–118 three-month forward exchange rate 357–358

Index 443 trade fnance 372–375; see also structured trade fnance trade fnance transactions 373–375, 373–374 trade fnancing see alternative trade fnancing; trade fnance transactions transaction costs 279–280, 297 transition countries 378 Tunisia 77, 189, 336

Vaccine Alliance 339–340 value added: agriculture 290–291, 291, 317 value capture 399 value chains 302 venture capital fnancing: and private equity 420–421 voluntary private health insurance (VPHI) 343–344

Uganda 150, 177, 277, 388; fnancing agriculture 300–301; microfnance 66; private capital fows 77, 82; structural adjustment 178–180 undiversifable risk 297 UN Sustainable Development Goals (UN SDGs) 203–204, 204, 323–324; fnancial products and services addressing 204; and MDGs 322–325, 323–324 use-reimbursement model 399

war 367–369 Washington Consensus 196–197 woodlot management 332–333 World Bank 174–180, 346 World Trade Organization (WTO) 180–183 wraparound addition 398 Yawson, Alfred 87 Zambia 91–92, 208, 224, 277, 295, 300