Sir Bob Geldof, the charity pop star, has long championed the cause of debt cancellation. He has dubbed the Live Aid rock concert, first held 20 years ago and now recast as Live 8, as a "consciousness-raising exercise" ahead of the Group of Eight (G8) summit in Scotland in July 2005. The aim was to increase the pressure on the summit to ratchet up aid and debt relief for Africa.
The international community has examined this question too. In March 2000, an influential US Congress Report of the International Financial Institution Advisory Commission–better known as the Meltzer Report–had concluded that total cancellation of poor-country debt was essential for development. A corollary to this conclusion was the recommendation that multilateral development banks should henceforth provide support in the form of performance-based grants only, rather than concessionary or soft loans.
Both Sir Bob and the Meltzer Report have clearly been vindicated for their recommendation to cancel debt, at least to the HIPC countries. The agreement on debt relief reached by the G-8 Finance Ministers in mid-June cancelled $56.5 billion in loans owed to the World Bank, African Development Bank and International Monetary Fund.
Fourteen countries in Africa and four in Latin America are eligible for immediate debt forgiveness under the plan. The nations are part of the World Bank's Heavily Indebted Poor Country Initiative (HIPC), in which countries commit to good governance, meet an IMF-endorsed financial plan and root out corruption.
This is all very well, except that grants, rather than soft loans, are likely to be favoured from now on. This might not be as good for development as many think.
Certainly, individual countries–the bilateral donors–have increasingly favoured grants over loans during the past three decades, as our graph shows. In recent years, this preference has been spread to the multilateral aid agencies too, like the World Bank.
The trouble is, whatever can be said about the relative merits of grants and soft loans, the rising share of grants in aid has not reduced poverty incidence in the developing world. In fact, where poverty has been reduced–namely in East Asia–the share of grants in official development assistance (ODA) has been lower than elsewhere, and falling.
By contrast, in Africa, which is the subject of so much political effort at present, both grants as a percentage of ODA disbursements and poverty incidence have risen, but so has poverty. There may be several reasons for this, and underdevelopment cannot be entirely blamed on financing sources. But the pattern suggests that debt relief and grants alone will not do an effective job of eradicating poverty.
Consider these three principles. First, aid is a transfer that helps finance trade and savings deficits in recipient countries. A shift from concessional loans to grants could reduce the present value of the resource transfer if the face value of the grants were small relative to that of the loans. One reason: repayments by successful developing countries would cease to refinance other soft-loan schemes.
This is a much-overlooked advantage of loans over grants: at least in theory, a given aid dollar can be leveraged over time, as repayments from the first borrower help fund a loan for a second borrower, and so on. It is in this virtuous way that formerly poor Asian countries have contributed to replenishing the resources of the multilateral International Development Association, for instance.
What weakens the case of this loan argument is the temptation to engage in “defensive lending”, as multilateral banks lend back to the same indebted countries the resources which are supposedly due for repayment. Our evidence shows that defensive lending to many African countries was common in the 1990s, but not in the 1980s. Perhaps debt was too high in the 1990s to be repaid, though this is not an intrinsic feature of soft loans.
A second and more widely acknowledged factor is how efficiently the transfer is used. This, more than anything, will determine the recipient’s welfare. The modality of aid influences budget discipline, including how spending is allocated. As grants do not require repayment, they might reduce incentives and undermine development efforts. This could lead to greater aid dependency. On the other hand, frequent debt forgiveness and persistent defensive lending can have the same effect, so in the end, borrower governments may have come to perceive concessionary loans as equivalent to grants.
Nevertheless, the evidence available backs soft loans over grants: overall, they have been utilised more efficiently than grants over the past three decades, despite repeated debt crises. A study from UN WIDER, a development research institute, finds that grants, particularly in least developed countries, stimulate the financing and implementation of projects that miss usual efficiency criteria. Add to this an IMF finding that grants disappear as tax gifts to influential groups in the most corrupt countries, and they become hard to defend as tools for stimulating growth, especially if recipients are to co-finance projects, as suggested by the Meltzer Report.
There is a third factor to consider, and that is risk. Aid allows poor countries to manage consumption to suit different circumstances, what economists call “smoothing”; the poorest countries benefit most from this aspect as they are more shock-prone than the others and lack access to private finance.
In fact, private lending has been shown to accentuate, rather than to reduce, consumption variability, be it as commercial bank lending or through bond portfolio flows. In other words, more lending comes through when times are better, but tends to be withdrawn when times are worse. This gives official development finance one clear advantage.
By contrast, grants can be set up as counter-cyclical devices, rising when a country is hit by external shocks like a collapse in commodity prices, and falling in tranquil periods. But the delay between the start of the crisis and the grant disbursement may simply be too long to be really effective. In fact, they either come too late or kick in when the economy is already recovering.
Lines of credit instead may prove to be a more timely way to deal with shocks, as they can be drawn upon rapidly, and potentially repaid quickly too. What if a country suffers a sequence of bad draws that make its debts unsustainable? One of the merits of public lending is precisely the fact that public creditors are more willing to take a hit than private ones.
The conclusion is simple. Both loans and grants have their role in concessionary finance. But rather than the usual divisive debate between debt relief and grants on the one hand or less debt relief and more loans on the other, there is another way of looking at the problem. Rich countries can choose to be generous with debt relief in order to be able to keep making soft loans in the future.
Smart development finance should be built on an aid architecture that manages to make debt bearable and sustainable, providing debt cancellation when needed, to manage shocks for instance. But donors should not turn their back entirely on soft loans in favour of grants. At a time when infrastructure deals and new loans are being provided by non-OECD donors to poor countries, we should remember that beyond charity, well-managed soft loans can spur development, too.
Reisen, Helmut (2004), "Innovative Approaches to Funding the Millennium Development Goals", OECD Development Centre Policy Brief No. 24, Paris.
Reisen, Helmut (2004), “Funding the fight against global poverty”, in OECD Observer No 244, available at www.oecdobserver.org, see below
Walkenhorst, Peter (2003) "Trade, debt and development: Does reform pay off?" in OECD Observer No 237, May
OECD/African Development Bank (2005), African Economic Outlook, Paris.
©OECD Observer No 250, July 2005