Development finance institutions can contribute to poverty reduction by supporting the growth of a vibrant private sector in developing countries. Subsidies can play a role in encouraging the private sector to invest in high-risk infrastructure projects, but may interfere with competition.  

A paper from the Overseas Development Institute, in the UK, examines whether subsidies used by development finance institutions (DFIs) are being used effectively in private sector infrastructure (comprising water and sanitation, transport, telecoms, and energy) projects.

A subsidy is a transfer from the public sector (including donor countries) to the private sector (including developing country firms and funds). These transfers can go directly to the private sector or indirectly, by affecting the conditions under which DFIs operate. This study covers both aspects, with a focus on the latter.

DFIs such as the International Finance Corporation and the European Bank for Reconstruction and Development provide loans, equity, guarantees and other financial products to the private sector. While they differ in scale, distribution and operation, DFIs support financially viable enterprises and mobilise additional capital. They also promote sustainable development. DFIs are also mandated to help the private sector invest in projects featuring aspects of public goods, such as infrastructure, which have considerable investment risks.

DFI finance is considerable – US$45 billion from the 12 main DFIs in 2005, half to the private sector – and growing. DFIs are able to provide funds for more high-risk projects in developing countries or frontier regions mostly because of their high levels of liquidity: that is, they have access to assets and cash.

A variety of subsidies apply to the operations of DFIs:

• States make capital or guarantees available to DFIs, encouraging credit rating agencies to give them triple A ratings.
• These are used by some DFIs to raise capital more cheaply than the private sector would be able to, for an investment portfolio with the same risk profile.
• DFIs do not always need to pay dividends to shareholders and most are exempt from corporate taxes, so they can take more risks such as giving out loans with longer maturities.
• Subsidies can be delivered through technical assistance (TA) to develop skills and resources to DFIs and their clients.
• DFIs can have direct or indirect access to grants, either managing Overseas Development Aid directly or co-financing projects with donors.

Despite this access to subsidies and high liquidity, which suggests DFIs can take greater risks, it is not evident that they are at an optimum level of risk. The researchers also find that DFI operations lack transparency, particularly in the use of technical assistance. There is no detailed data for TA used or provided by DFIs, which would be useful for better management and reform in the DFI sector. Other findings include:

• Aid and DFI finance could be combined in high-risk, low-return frontier markets, but DFI grant management for infrastructure co-financing is currently not transparent.
• More transparency is also required in disclosing the terms of past deals, especially to deal with possible concerns over subsidised interest rates.
• Not enough is known in the development community about the extent of DFI operations.
• Shareholders should discuss the amount of risk acceptable for DFIs, and ensure that the operations become more transparent.

Source(s):
‘The Use of Subsidies by Development Finance Institutions in the Infrastructure Sector’, Overseas Development Institute Working Paper 283, ODI: London, by Dirk Willem te Velde and Michael Warner, 2007 (PDF) Full document.
‘The Use of Subsidies by Development Finance Institutions in the Infrastructure Sector’, Overseas Development Institute Project Briefing 2, ODI: London, by Dirk Willem te Velde and Michael Warner, 2007 (PDF) Full document.

Funded by: Department for International Development (UK)

id21 Research Highlight: 27 April 2008

Further Information:
Dirk Willem te Velde
Overseas Development Institute
111 Westminster Bridge Road
London, SE7 1JD
UK

Tel: +44 20 79220300
Fax: +44 20 79220399
Contact the contributor: dw.tevelde@odi.org.uk

Overseas Development Institute, UK

Other related links:
'Infrastructure is vital for pro-poor growth in East Asia'

'Infrastructure is the key to poverty reduction in Africa'

'Freeing up competition to finance infrastructure efficiently'