Helping the poor or cooking the books: How concessional is concessional aid?

Over the next three years, the poorest countries in the world will receive less aid and better-off countries will get more. The change is modest — about 3-4 percent — but in the wrong direction. The deadline for the Millennium Development Goals approaches, and its the poorest countries that are furthest off track.

The current Organization for Economic Cooperation and Development definition of official development assistance is partly to blame, as it encourages donors to provide loans on terms that can actually turn them a profit, and which are inappropriate for poor countries. Donors are meeting in December to revise the way that ODA is defined, so you might hope that they will sort this problem. Prepare to be disappointed.

It all comes down to the rate at which loan repayments are “discounted” when assessing whether a loan counts as “concessional in character,” and so eligible for ODA. The higher the discount rate, the more concessional a loan will appear. The present rules say loans must have a grant element of at least 25 percent, calculated using a discount rate of 10 percent. This rate was reasonable when first set in the 1970s, but makes no sense when say Germany can borrow at under 1 percent. It gives creditworthy countries an incentive to offer unsubsidized “hard” loans, since these will still meet the concessionality criterion. Germany and France, in particular, are stepping up such lending.

You might think that the discount rate should reflect each donor’s borrowing costs. This is what happens for loans tied to the donor’s exports. Tied loans must have a grant element of 35 percent — 50 percent for the poorest countries — discounted at a rate that is set slightly above each country’s cost of borrowing, and which is regularly updated to reflect market conditions.

The OECD could adopt this practice, although another option might be to follow the International Monetary Fund’s rate of around 5 percent, which would also reduce the present incentive to harden loan terms.

The major loan providers argue that because the donor is carrying the risk of default, a “risk premium” should be added to the IMF rate. This would be higher for poorer recipients, where it could well end up close to 10 percent again. And it looks as if the OECD's Development Assistance Committee may well agree to this, with a few safeguards against hard lending to the poorest countries.

Does this matter? Yes, for at least two reasons:

1. It would continue to send a perverse incentive for donor countries to offer loans on hard terms, which in practice means higher flows to countries like China, Mexico or Turkey, thus disincentivizing aid to the least developed countries, which need grants and very soft loans.

2. It makes nonsense of any comparison among donors. The countries offering loans on hard terms (principally France and Germany) can boost their reported aid generosity, at least in the short term, at a financial profit. For countries that overwhelmingly provide grants and that focus on poor countries still far from achieving the MDGs, this looks a very unreasonable basis of comparison, and one which may put them under pressure to follow suit.

The OECD-DAC specifies what counts towards the target of donors providing 0.7 percent of their GNI as aid, even though the target was set by the United Nations. An OECD definition that scores barely concessional loans as aid risks undermining its credibility to validate flows towards the U.N. target in the new era of the sustainable development goals due to be agreed next year.

Non-DAC providers such as China are increasingly financiers of development, often on semi-concessional terms. An international system for accounting all official flows that support development, with a common metric of loan concessionality, is badly overdue. While only the U.N. could operate such a system, the template that the OECD sets could strongly inform it. If the OECD-DAC agrees a weak definition, it will be harder to ensure that loans from other providers meet reasonable standards, especially for the poorest countries.

So here are five things that ought to be part of the reforms agreed in December:

1. No perverse incentives for hard lending.

2. Incentives to give aid to the poorest countries, which need aid essentially in the form of grants and very soft loans.

3. Recorded ODA must allow fair comparison of genuine donor effort (costs incurred) and the treatment of loans must not allow some donors to game the system to flatter their ODA performance.

4. The system should be designed to facilitate eventual adoption by the U.N. to measure development assistance from all countries, not just OECD-DAC members.

5. The OECD must check that loans that fall below the concessionality threshold for tied aid credits are genuinely untied.

Unless donors agree these changes, we will enter the post-2015 development era with foreign aid heading in the wrong direction.

This post is based on remarks Richard Manning will be making at the Center for Aid and Public Expenditure’s 2014 CAPE conference at the Overseas Development Institute in London, on Nov. 12 from 18:00 GMT (11:00 EST). To watch the session and the conference online, please click here to register.

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