CONSULTANT’S REPORT
Commonwealth Secretariat
LOWERING THE THRESHOLD
Changing private investors’ perceptions by reducing the cost and
risk of investment in least developed, small and vulnerable
economies.
London
August 2001
Attribution and Disclaimer
This report is the outcome of a consultant study commissioned in mid-2001 by
the Commonwealth Secretariat. Anthony Hughes was the lead consultant and
Havelock Brewster was the consultant covering the Caribbean.
Unless otherwise stated, views expressed in the report are those of the
consultants and do not necessarily represent the position of the Secretariat or
member Governments of the Commonwealth
Acknowledgment
The report could not have been prepared without the generous assistance of
officials of financial institutions mentioned in Appendix A, who provided
information and advice to the consultants in interviews and by e-mail during
May and June 2001. The Commonwealth Secretariat and the consultants are
most grateful for this help.
Abbreviations used in the text
ACP
African, Caribbean and Pacific states in formal association with EU
AfDB
African Development Bank
AsDB
Asian Development Bank
Caribcan Caribbean Canada Trade Agreement
CBERA
Caribbean Bas in Economic Recovery Acts (of the US Congress)
CDB
Caribbean Development Bank
DCB
a domestic commercial bank, incorporated locally or overseas
EU
European Union
EUR
Euro, the common currency of EU
FIAS
Foreign Investment Advisory Service (of IFC and MIGA)
IDB
Inter-American Development Bank
IFC
International Finance Corporation, part of the World Bank Group
IFI
an international financial institution, eg, IFC, IDB, AfDB, AsDB
IIC
Inter-American Investment Corporation
LDC
Least Developed Country
MDB
multilateral development bank, eg, AfDB, AsDB, CDB, IDB, WB
MFC
Multilateral Investment Fund, established by IDB
MFI
multilateral financial institution, similar meaning to IFI
MFN
‘most favoured nation’ , referring to equality of treatment in trade
MIGA
Multilateral Investment Guarantee Agency, part of WB Group
NGO
Non-governmental organisation
ODA
Official Deve lopment Assistance, the technical term for foreign aid
OECD
Organisation for Economic Development and Cooperation
OFC
offshore finance (or financial) centre, usually also a tax haven
SME
small or medium sized enterprise
Sparteca
non-reciprocal trade agreement among Australia and Pacific islands
SVE
small and vulnerable economies
UNCLOS
UN Convention on the Law of the Sea,1982
UNCTAD
UN Commission on Trade and Development
WB
World Bank (International Bank for Reconstruction and Development)
WTO
World Trade Organisation
NB: several other institutions mentioned only in Box F are defined there
Currency: in this report ‘ $’ means US dollars
TABLE OF CONTENTS
Page
CHAPTER 1: SUMMARY ................................................................................5
CHAPTER 2: ORIGINS AND APPROACH OF THE STUDY.................................7
EROSION OF TRADE PREFERENCES.....................................................................7
IMPACT OF COTONOU ......................................................................................8
PRIVATE INVESTMENT AND OFFICIAL AID ..............................................................9
ARRANGEMENT OF THE REPORT.........................................................................9
CHAPTER 3: DECIDING THE LOCATION OF INVE STMENTS.........................11
THE INVESTOR’S POINT OF VIEW ...................................................................... 11
THE ROLE OF TRADE PREFERENCES.................................................................. 17
THE SIGNIFICANCE OF INVESTMENT COSTS......................................................... 18
CHAPTER 4: ATTRACTING EXPORT-ORIENTED INVESTMENT .....................21
INVESTORS AND ENTERPR ISES ......................................................................... 21
IMPROVING THE INVESTMENT CLIMATE .............................................................. 24
AND THEN ? ................................................................................................ 29
CHAPTER 5: INTERVENING TO REDUCE COSTS AND RISKS .......................31
EXISTING ARRANGEMENTS............................................................................. 31
IFIS’ UNDER-PERFORMANCE ........................................................................... 34
THE DETERRENT EFFECT OF SCALE .................................................................. 36
UNEASE ABOUT AID-BASED SUBSIDIES .............................................................. 36
THE PROPER USE OF ODA ............................................................................. 40
PROPOSED AIMS AND MET HODS....................................................................... 41
CHAPTER 6 : FEASIBILITY OF AID-BASED, MARKET-DRIVEN FACILITIES ..43
A NEW FACILITY ........................................................................................... 45
COORDINATED CONVERGENCE ........................................................................ 47
CHAPTER 7: RECOMMENDATIONS..............................................................49
BOXES IN THE TEXT
A.
B.
C.
D.
E.
F.
G.
What investors want —and don’t want
Why invest in disadvantaged economies?
What host governments want —and don’t want
Doing without SME investment
The developmental role of subsidies
Existing official financial assistance to SME investment
Outline of an aid-based, market-driven facility
12
16
21
28
26
31
43
5
Chapter 1: Summary
1. The study originates in growing awareness of the problems faced by LDCs
and SVEs in attracting private investment into SMEs as trade preferences
disappear. The changes embodied in the Cotonou Agreement and issues
highlighted by the recent joint Commonwealth Secretariat/World Bank
study of small states have sharpened this concern.
2. The problems lie at the interface between the economic development policies
of LDC and SVE governments and their IFI and aid donor partners, and the
investment aims and decision criteria of domestic and foreign private
investors. Official intervention to reduce the deterrent effect of the ‘endowed
handicaps’ of LDCs and SVEs on investment decisions is clearly appropriate,
and is already taking place, but care is needed to minimise any distortionary
effects from the use of ODA to subsidise costs.
3. With few exceptions, commercial investors are seeking a minimum financial
rate of return (the threshold rate), after meeting the net additional costs of
doing business in LDC/SVEs, that justifies the additional risk of locating
there compared with possible alternatives. To do this the expected
profitability of a SME in a LDC or SVE generally needs to be 50-100%
greater than that of a similar business in a larger, more developed and less
vulnerable economy. Investors are betting that they can manage the positive
and negative factors in their business to achieve such returns. Trade
preferences have made a major contribution to their expectations of success.
4. It is possible that a combination of several ways of reducing the investor’s
costs and risks could have a comparable effect to trade preferences, though
the impact would vary according to the relative importance of capital costs
in overall financial performance. Reducing the unit cost of outside capital
increases the return available to the inside investor, while reducing the
amount of owner’s capital required reduces the size of the controlling
investor’s risk, and may reduce the threshold rate of return.
5. Governments seek investment in the export sector for its growth potential
and linkages into all other production and the build-up of all forms of
capital. Almost any successful production of traded goods will have similar
effects, whether based primarily on access to natural resources, use of
technology, or—until now—to take advantage of trade preferences.
6. Much effort by governments, aid donors and IFIs has gone into ‘improving
the investment climate’. There have been important achievements and a few
countries have made great advances, but in most countries there are still
unnecessary procedural obstacles and service deficiencies—man-made
deterrents adding to the ‘endowed handicaps’ of LDCs and SVEs.
7. Whatever improvements are made to policy and infrastructure, there are
some SVEs that are very unlikely to attract orthodox SME investment, for
reasons of their very small size, remoteness, extreme vulnerability. For them
the appropriate strategy is to exploit marketable aspects of sovereignty, and
6
develop a network of emigrant income sources. The specific case of these
SVEs supports the more general argument that it is possible for a country to
do all it reasonably can with existing tools to attract investment in SMEs,
and still attract none: the cost and risk impact of its endowed handicaps can
outweigh anything that can be done by improving policy and infrastructure.
8. There remains the possibility of directly reducing private investment costs
and risks through some form of official intervention. IFIs have developed an
impressive range of institutional tools for this, but it is generally agreed that
they are not having a significant impact on private investment in most LDCs
and SVEs. The reasons are partly in the nature of the instruments, which
are now mostly at or close to market terms and cannot offset endowed cost
handicaps, and partly in institutional sentiment that IFI interventions in
LDCs and SVEs are too costly and/or of low priority, and that the use of
ODA to reduce costs runs the risk of distorting the allocation of resources.
9. In fact the use of ODA to offset endowed handicaps is sound developmental
policy, and distortionary hazards can be minimised by appropriate system
design. Those components of investment risk that the LDC/SVE private
investor cannot avoid—the ‘least developed, small, vulnerable economy’ risk
itself, exchange risk and political risk—can be properly mitigated by a
system that makes financing available on non-LDC/SVE terms, absorbs the
exchange risk and provides packaged insurance against political risk. Such
a system would operate through domestic commercial banks on an offbalance sheet basis, and its net costs would be met by IFIs and aid donors.
10. Two ways of doing this are compared: a new facility in the form of a
dedicated and separate fund with its own procedures and criteria, owned by
existing IFIs but legally distinct from them; and a scheme of ‘coordinated
convergence’, whereby the IFIs undertake over a period to modify their
existing facilities to take on agreed key features, until the range, cost and
accessibility of assistance envisage d under the separate facility model is
achieved. The second approach appears politically more feasible and
technically capable of faster implementation
11. There are two recommendations, both for action by the Commonwealth
Secretariat and the IFIs. They are that:
•
the problem faced by LDCs and SVEs in attracting and retaining private
investment be formally recognised as deserving of greater attention and
more IFI and ODA resources than it presently receives, and
•
IFIs, aid donors and LDC/SVE governments collaborate in devising
practical ways of increasing private investment in SMEs in the smaller
and weaker economies.
A two-stage process is envisaged, starting with consultations among the IFIs
under Commonwealth Secretariat and IFC leadership to determine a
recommended course of action, followed by a wider meeting of aid donors
and governments to obtain financial and political backing.
7
Chapter 2: Origins and Approach of the Study
1. The origins of this study lie in the interplay of three factors: growing
awareness of the developmental downside of the globalisation of trade and
investment under the aegis of the World Trade Organisation; the
replacement of the long-running series of EU-ACP Lome Conventions on
trade and aid by the Cotonou Agreement; and the heightened recognition of
the special problems of least developed countries (LDCs) and small and
vulnerable economies (SVEs) as a result of work by UNCTAD, the World
Bank and the Commonwealth Secretariat.
Erosion of trade preferences
2. The opening-up of protected markets and the deregulation of cross-border
flows are intended to allow market forces to function free of policy-based
‘distortions’, so that trade and investment can flow readily to where the
risk/return calculus is most attractive. The process involves the progressive
dismantling of protective tariffs and trade quotas in all regions of the
developed and developing world. Meanwhile regional Free Trade Areas and
linked webs of MFN trade entitlements are being created as staging points
on the road to gl obalised barrier-free trade.
3. For half a century, tariff and quota barriers have provided industrialised
countries with a means of selectively tilting the trade and investment scales
in favour of developing countries, and especially LDCs and SVEs, by giving
them preferential access to export markets around or under the protective
barriers. As these artificial aids to competitiveness disappear 1, concern has
grown that without them LDCs and SVEs will, more than ever, fail to attract
the investment they need for growth, unless more effective ways can be
found of offsetting their endowed cost and risk characteristics.
4. The Commonwealth Secretariat spelled out this concern in respect of SVEs
in February 1999. In a paper to the St Lucia meeting of the Commonwealth
Secretariat/World Bank Joint Task Force on Small States 2 the Secretariat
argued that relying solely on market-oriented reforms under structural
adjustment programmes and technical assistance for niche market
development was an inadequate response to the ‘inherent or exogenous cost
disadvantages’ faced by SVEs. The paper proposed, inter alia, the
replacement of trade preferences by ‘investment preferences’, making the
point that trade preferences had always been intended to persuade
investors to locate enterprises in the preference -receiving economies. It is
that proposal that this study examines 3.
With few exceptions the existing arrangements are scheduled to be gone by 2009
The Trade Policy Implications for Small Vulnerable States of the Global Trade Regime Shift,
Commonwealth Secretariat, 1999, Chapter 3.
3 A similar idea was aired in several forums in the Pacific region in the mid-1990s, as it became
clear that trade preferences would be dismantled over the next decade, but at that time it was not
taken up outside the region.
1
2
8
Impact of Cotonou
5. At the same time as the Commonwealth Secretariat and the World Bank
were jointly studying the problems of small states 4, the European Union
(EU) was preparing to reshape its relations with the developing world. Long
and somewhat asymmetrical negotiations between the EU and the ACP
states began in 1996 with the publication of the EU’s Green Paper on future
EU-ACP relations, and culminated in the signing of the Cotonou Agreement
in June 2000. This makes substantial changes to the relationships and
institutions that had evolved over 25 years of Lome Conventions—generally
reflecting shifts in the thinking of the developed rather than the developing
countries—while explicitly trying to build on the practical lessons and more
mystical acquis of the Lome experience.
6. The Cotonou components relevant to this study relate to trade and
investment. The Lome trade arrangements revolved around preferential
access to EU markets through quotas and lower tariffs. Cotonou aims at
progressive creation of barrier-less mutual access and compliance with WTO
rules. There could hardly be a more complete change. The new regime is to
be achieved over a twenty-year period—eight years of existing trade
arrangements and twelve years of phased moves to free trade. During the
breathing–space the ACP states will create regional free trade areas among
themselves, and EU will enter into economic partnership agreements with
these groupings that will spell out jointly planned liberalisation measures,
leading to barrier-less mutual access and detailed agreement on a wide
range of trade -related issues.5
7. On the investment side Cotonou provides, within a EU25bn allocation to
ACP states for five years from 1 March 2000, an EDF ‘investment facility’ of
EU2.2bn and an EIB own-resources allocation of EU1.7bn. The Investment
Facility 6 is to provide ‘long-term financial resources including risk capital to
assist in promoting growth in the private sector’ . The conditions governing
this facility are revisited in Chapter 5 of this report. They suggest that while
the makers of Cotonou were aware of many of the issues that gave rise to
this study, they were intent on aligning their criteria and practices more
closely with market forces than had been the case under Lome IV. The
outcome was a significant hardening of the standard terms of the financing
available to private enterprises.
A three-year process of research and consultation, culminating in publication of Small States:
Meeting Challenges in the Global Economy—Report of the Commonwealth Secretariat / World Bank
Joint Task Force on Small States, Commonwealth Secretariat, 2000.
5 A year after concluding the Cotonou Agreement the EU took another dramatic step towards
liberalisation by extending duty and quota-free access to LDCs for ‘everything but arms’ –the EBA
initiative—subject to a phased elimination of quotas and tariffs for bananas (2002-2006), rice
(2006-2009)and sugar (2006-2009). This effectively removes the distinction between ACP and
non -ACP LDCs, and makes the EU’s arrangements WTO-compatible.
6 Annexes I and II to the Cotonou Agreement.
4
9
Private investment and official aid
8. The study approaches the evaluation of the ‘investment preference’ concept
by placing it firmly in the context of the interaction between economic
development policies and commercial investment decisions, and by looking
at it as far as possible through the eyes of potential investors. What are LDC
and SVE governments, MFIs and aid donors trying to do? What are the
decision parameters of commercial investors? Could an ‘ investment
preference’ facility make any significant difference? If so, what form should it
take—and to what extent does it already exist?
9. Lome, Cotonou and many bilateral aid programmes demonstrate that the
use of official development assistance (ODA) as a policy tool to improve the
investment-attractiveness of LDCs and SVEs—provision of infrastructure,
training, utilities, development loans and even some forms of risk capital 7—
is well established. It remains the case that the closer the aid gets to being
actually handled and used by the commercial investor, the more concerns
are raised that its effect will be distortionary (ie, allocative decisions will be
made that are inefficient/unsustainable), commercial disciplines will be
weakened and entrepreneurial spirit undermined.
10. Those are objections to the way aid is used to promote commercial
investment, not to the idea of using it for that purpose. The study therefore
takes it as given that ODA can properly be used in a wide range of ways to
promote commercial investment in LDCs and SVEs, and examines
‘investment preference’ for its likely practical effectiveness in achieving that
aim. The recommended approach seeks to minimise the allocative
distortions that could result from use of ODA by retaining as much as
possible of the disciplines and signposts of the market, while confronting the
acknowledged imperfections of those signals in the severely handicapped
markets of LDCs and SVEs. To this end, the study has been based on
consultations not only with MFIs based in Europe, Asia and the Americas,
but also with commercial banks operating in the Caribbean and Pacific.
Arrangement of the report
11. Chapter 3 examines how and why investment decisions—particularly
location decisions—are made, so as to get a sense of the past role of trade
preferences, and the potential importance in the decision calculus of a
reduction in investment costs and risks in LDCs and SVEs. Chapter 4 looks
at why and how, in terms of their development goals, countries try to make
themselves attractive to investment by their own citizens and by foreigners,
and how far most of them have still to go. This discussion raises the
question of what happens when a country has done all it reasonably can
with existing tools to make its policies and price structures investor-friendly,
and still little or no investment takes place.
Many LDCs and SVEs have received grants and concessionary loan s for on -lending and
investment in private enterprise, usually through state-owned development banks and
investment corporations (see Box F)
7
10
12. Chapter 5 takes the questions raised by Chapters 3 and 4 as its point of
departure. It reviews the performance of past and present efforts to reduce
investment risk and cost through intervention by governments, aid donors
and international financial institutions, identifies significant weaknesses
and shortcomings in these arrangements, and finds there is a case for
supplementary initiatives involving use of ODA. Chapter 6 examines the
feasibility of a new facility that would embody elements of ODA while being
responsive to market signals and exposed to market discipline; compares
this with a more diffused and diversified ‘coordinated convergence’
approach; and identifies a number of questions that need more detailed
examination. Chapter 7 recommends more collaborative effort by IFIs, aid
donors and LDC/SVE governments to improve the access of LDCs and SVEs
to existing institutions; while the need and scope for a new, aid-based,
market-driven facility, and the related questions raised by this report, are
being canvassed widely among governments and IFIs.
11
Chapter 3: Deciding the location of investments
The investor’s point of view
1. This report is a study of how to provide a corrective bias to commercial
decisions on the location of new investments and the expansion,
restructuring and rehabilitation of existing enterprises, in favour of LDCs
and SVEs—locations that otherwise would not be sufficiently attractive to
justify the investment. The central case is
a private commercial investment intended to produce goods or services for
export, creating local employment and using local natural resources and
infrastructure in a cost and tax structure that enables the product to
compete in overseas markets, and yield a return on investment as good or
better than the next best available use of the same investment resources.
2. The scale of such an investment will normally be in the range known as
Small and Medium Enterprises, or SMEs. These may be in any sector,
employing from a few score up to a thousand or more employees, eg in
labour-intensive agriculture, wood-based manufacturing, tourism, garment
and footwear manufacturing, food-processing, electronics assembly or
data-processing operations (and financial and other services to the export
sector). Their capital costs generally 8lie in the range of a hundred thousand
to tens of millions of US dollars. Below this range lie micro-enterprises,
normally undertaken by small family firms or individual investors who have
less desire or capability to invest elsewhere —though they may decide to
emigrate with their capital and entrepreneurial talents. Above the SME
range lie large, normally transnational, enterprises, mostly in the minerals
and petroleum sectors but including some fisheries and food-processing
corporations with a global reach, with an ability to mobilise investment
funds far exceeding that of the LDCs and SVEs where they may choose to
locate an activity.
3. The target investor of this study is unlikely to be just going into business for
the first time. Total beginners are more likely to be found in the microenterprise range, and to need business advisory services alongside any
financial assistance.9 This study is mainly concerned with the established
entrepreneur who has a choice, to locate a new investment in a more
developed, larger and less vulnerable economy, or to close down an existing
enterprise and relocate it—or the resulting financial capital—elsewhere,
where the grass is greener. This part of the report looks at the investor’s
There seems to be no standard definition of a SME, as country and industry norms vary so
much, but these parameters will cover most cases.
9 Worldwide there is increasing recognition of the importance of very small and informal
enterprises in economic growth and the alleviation of poverty. A range of instruments and
approaches are being fielded by governments, aid agencies and NGOs in an endeavour to assist
such enterprises without undermining the initiative and self-discipline of individuals and
households. ODA is already being widely deployed at this level and many studies are in existence
or in preparation about its effectiveness. This report therefore does not examine this area of
development policy.
8
12
decision process, and the relative importance of trade preferences and
capital costs in the decision calculus. In Box A the stated and unstated
requirements of investors are canvassed.
Box A: What investors want—and don’t want
Investors in LDCs and SVEs may go or stay there for a variety of reasons. The
central case in this study assumes a profit motive, expressed as a target return
on investment. But for a multi-country investor the return on a particular
investment may not occur there, but in a related enterprise elsewhere, through
transfer prici ng. Trade preferences have invited location of manufacturing in
preferred states, and have gone to some lengths, mainly by ‘rules of origin’, to
insist on local value added, but cannot have wholly prevented transfer pricing
among related enterprises. Or an investment may be made not for a direct
profit—at least not immediately—but to prevent a rival from occupying that
investment space, and so to protect market share.
Moreover, investment may be made by foreign governments or state -owned
entities, openly or in disguise, for non-commercial reasons—strategic denial,
military access, electronic intelligence -gathering—and still be welcome as an
addition to domestic economic activity. Special conditions then apply. Apart
from providing a market for local goods and services, the benefits to the host
country may include aid programmes, defence agreements, access to overseas
labour markets, while the costs include the loss of some aspect of sovereignty
(see Box D). Investments of this kind exist in several of the countries covered by
this study.
For the study’s central case, surveys by FIAS and others have established, at
least to the extent that commercial investors are prepared to disclose their
minds to such inquiries, that in pursuit of their target rate of re turn they are
looking for—not necessarily in order of importance:
• clear, published rules and efficient administrative procedures for providing
information and processing investment proposals
• ‘political stability’ , which seems in practice to mean the abi lity of national
and local governments to deliver their side of the investment ‘contract’
without demanding excessive pay-offs or provoking civil strife
• freedom to manage the enterprise as they see fit, within stable and
transparent regulatory arrangements, which are nowadays expected to
include environmental conservation and ‘good corporate citizen’
requirements
• secure, bankable and transferable tenure of land—registered leaseholds up
to fifty years, with protection against unreasonable rental hikes, are
becoming the norm
• credible assurance that they will be able to sell the business on an open
market and repatriate the proceeds as and when they wish
• reliable infrastructure, utilities and public services available at competitive
cost—first-class telecommunications are now a prime requirement
• ready access to a skilled/semi-skilled workforce capable of quickly absorbing
specialised training, willing to work for lower wages than in competitor
countries and not prone to industrial disputes
• non-discriminatory access to a sound, competitively priced and well
connected financial system
13
•
a stable tax regime that allows duty-free entry of capital goods and rapid
recovery of investment outlays, and provides internationally competitive tariff
and profits tax rates after the enterprise is commercially established
It is notable that the benefit of trade preferences (low tariffs, quota shares,
supported prices) does not usually feature in the investors’ explicit wish-list—
perhaps because there is a slightly disreputable aura of market-distorting noncommerciality about it—yet there is no doubt that this has been a decisive
factor in enterprise location, particularly of clothing, garment and footwear
manufacturing and food processing investments. Somewhat similarly, inve stors
responding to surveys commonly claim not to be looking for special tax breaks,
but in practice they or others like them often ask for—and get—these and other
cost-lowering ‘incentives’ when making investment proposals.
Access to concessional finance is likewise not usually on the list, probably
because in the past this has often meant dealing with state -owned development
banks under political direction (strings of various kinds attached), and because
the finance available to manufacturing/processing/exporting enterprises
through those channels has not been particularly cheap (see further in Chapter
5 and Box F).
It is worth noting too that despite their objections in theory, in practice some
investors can apparently live with a lot of official ‘processing’ and demands for
corrupt pay-offs, if the commercial rewards are expected to be big enough. This
commonly, but not only, occurs in natural resource -based projects, and clearly
any additional costs to the investor are factored in to the finances of the
enterprise.
What investors don’t want, apart from the converse of the ‘wants’ list, includes
• unpredictability in the taxation and regulatory environment, leading to
postponement of investment decisions and inducing an increase in the
threshold rate of return to compensate for uncertainty
• a requirement for local (state or private) share -holding, directors etc.
Investors may propose this themselves, but they do not want to be forced
into it—this increases the sense of risk.
• disagreements among authorities about policy or regulatory matters, causing
costly delays, and often acting as cover for officials demanding pay-offs.
4. Here we assume that the investor’s goal is a commercial profit, defined as a
target rate of return on investment. This will be related to the alternatives
open to the owners of a privately-held business, and the earnings demands
of the major shareholders in a publicly quoted company. Investors in SMEs
employ varying degrees of formality and precision in their decisions.
Closely-held family businesses, which are immensely important in the SME
field in less developed and small vulnerable states, do not normally disclose
their investment criteria, but increasingly, key family members have
undergone formal business training and are using sophisticated computerbased aids to decision-making. Even though, as in the largest corporations
the ‘hunch’ of the top person plays a decisive role—meaning that, for
example, the location of family roots, or the quality of relations with
influential people in the government, can be worth several percentage
points in a comparative rate of return calculation—both the more formal
14
investment appraisals and the less formal family processes will cover, in
greater or lesser detail, a wide and pretty standard range of issues.
5. The cost and availability of capital certainly features in such investment
appraisals, but it takes its place—relative importance varying widely
among sectors—along with many other factors, as follows:
• market conditions, product quality required by customers, prices now
and in future, scope for market development
• political conditions, economic stability and physical security of the
proposed investment
• climatic and environmental conditions and the possibility of adverse
changes over the life of the investment
• known or assumed plans of competitors, and appropriate responses
• current and prospective production and processing technology and
design issues, and cost of adaptation, compliance with pollution and
other environmental regulations
• export and import non-tariff regulations and cost of compliance
• domestic import and export tariffs, and availability of exemptions and
drawback
• cost, reliability and frequency of sea and/or air transport of inputs and
outputs
• availability, cost and reliability/work attitude of skilled and semiskilled
workforce, scope and governance of organised labour unions
• access to and cost of land and buildings, cost and timing of construction
or rehabilitation
• availability, reliability and cost of utilities and public services
• ability to import management and higher level skilled workers
• access to domestic financial institutions on competitive (preferably,
most-favoured-customer ) terms
• favourable tax treatment of capital outlays, eg immediate full write-off
and indefinite carry-forward of losses
• enterprise financial structure, cost and availability of funds as equity,
long-term loan and short-term (working capital), and security required
by lenders
• the degree of risk attached to the assumptions made about all these
factors, leading to
• an estimate of the most probable financial performance of the
investment, as a projected cash flow, balance sheets and earnings
statement for a number of years, usually sufficient to see the
shareholders’ outlay recovered, and a target or threshold rate of return
on the investment being annually met or exceeded
6. The investor is deciding whether to commit investible resources—mainly
financial, though considerable psychological resources are also involved—
that could otherwise be held as reserves, or committed to another project,
eg real estate, or another place. The threshold rate of return that the project
must exceed, whether intuitively or technically and formally computed, is
the no-risk opportunity cost of those resources divided by the risk of
15
receiving a lower or no return. Away from the risk-infested world of LDCs
and SVEs, high-quality financial investments can be expected to provide a
real annual return of return of 5-10%, taking one year with another, and
investment in a portfolio of publicly quoted enterprises would reliably yield
a real return in that range. Allowing for some factoring in of risk associated
with starting or rehabilitating an enterprise, we can assume that the target
real rate of return for the owner-investor of a SME in a developed
economy—outside of temporarily overheated sectors such as dot-com—
would be 10-15%, but that once an investment has been established a real
return of 5-10% would suffice to keep it in place.
7. Compared with more developed and larger economies, LDCs and SVEs are
perceived by investors as more costly and riskier locations for SMEs. Box B
discusses the dimensions of these differences. Broadly speaking, ‘less
developed’ implies more costly and less reliable infrastructure, a less skilled
workforce, and greater exposure to political interruption; ‘small and
vulnerable’ equates with high transport costs, lack of domestic economic
depth and the risk of macro-economic or climatic/environmental
instability. The higher costs, so far as they can be quantified, are built into
business plans, offset wherever possible by lower-cost factors, eg,
developing country wage rates, ready access to natural resources, subsidies
built into industrial estate charges, and—until now—the benefit of any
trade preferences expected to lift the net income from sales above openmarket levels.
8. The perceived higher level of risk—that is to say, the probability that the
investment may fail to produce a satisfactory, or indeed any, return—is
compensated by significantly raising the rate of return that the investment
has to exceed, ie the threshold rate, above that which would apply in a
more developed/larger/less vulnerable economy. There is abundant
circumstantial and anecdotal evidence for the existence of this ‘investment
risk premium’, though empirical data is scarce. The difference in target real
rates of return seems to be in the range of 5-10 percentage points, a
magnitude difference of 50-100%, suggesting that investors implicitly
assess a one in two or one in three proba bility of nil returns.
9. To accommodate a target, pre -investment, real rate of return of 15-25% and
post-establishment, going-concern rates of 10-20%, the difference between
the expected revenues and costs of the enterprise—its expected
profitability—will need to be 50-100% greater than that of a similar SME in
a larger, more developed and less vulnerable economy. Investment in
‘emerging markets’, as they are styled in international financial jargon, is
effectively a bet that the worst won’t happen and the higher than stay-athome returns will materialise more often than not.
16
Box B: Why invest in ‘disadvantaged economies’?
Entrepreneurs who choose to invest in LDCs and SVEs do so in defiance of some
obvious deterrents. By definition these economies are handicapped, and they
handicap enterprises located within them, by being either
• ‘least developed’ , that is to say, deficient in much of the economic and social
infrastructure and services found in the more developed economies with which
they must compete in international markets—these things the enterprise needs
are absolutely lacking, or the supply of them is intermittent, costly and of
doubtful quality—or
• small and vulnerable, ie, with domestic markets offering no economies of scale
or the combined challenge and comfort of a cluster of peer enterprises, and the
higher risk of economic instability and physical disruption of services that
comes with ‘economic exposure; remoteness and insularity; and proneness to
natural disasters’ 10
This is the case for both foreign and domestic investors. The foreign investor has to
overcome entry and exit barriers that the local investor does not face, but a lot of
effort in recent years has gone in to removing or reducing those barriers. The local
investor is just as much—perhaps more —exposed to most of the other investment
risks as is the foreigner; often faces the extra hazard of cultural pressures to
distribute benefits from the enterprise long before there is any surplus to distribute;
and very likely has some additional knowledge and access handicaps when trying to
develop an export business.
Investment takes place, if and when it does, because the investor believes these
structural weaknesses and institutional handicaps are more than offset by positive
factors peculiar to the economy or the enterprise, that can be managed so as to yield
a target rate of return. These factors may include
For the economy
• outstanding and unspoiled environmental and scenic features
• convenient location for air travel—far enough away to be ‘foreign’, close enough
not to be too costly
• an educated and friendly workforce able to quickly adapt to new tasks
• a particularly stable and investment-friendly political climate
• a specially attractive and accessible natural resource, eg, tuna or pearl fishery,
hardwood forest
• up to now, preferential access to developed country markets
• now, barrier-free access to weaker trading partners in a regional free trade area
For the enterprise or its controlling investor
• high level of self-confidence and energy
• robust and self-reliant production and processing technology
• knowledge of and access to a niche market, or other strong marketing
connections overseas
• good local knowledge and connections, and strong inter-personal skills, helping
to secure access to land and natural resources and retain an efficient workforce
• very good relations—not necessarily corrupt—with the government, smoothing
transactions with the bureaucracy
A Commonwealth Vulnerability Index for Developing Countries, Economic Paper No 40,
Commonwealth Secretariat, 2000.
10
17
•
•
personal and enterprise ‘bankability’, often lowering borrowing costs by several
percentage points
in the case of the local investor, ability to contain and turn to advantage kinship
ties and cultural obligations
The investor takes a calculated risk, gambling that it can manage the positive
factors to outweigh the negative. This is true of all investors , but the investor in
LDCs and SVEs is a bigger gambler, taking a greater risk, and seeking a higher
return to make the odds worthwhile.11 The existence of higher threshold rates of
return is the equivalent of a higher opportunity cost of capital—this is the market
price, the price the LDC or SVE economy has to pay for the investment. The spread
between LDC/SVE rates of return and comparable rates in better-placed economies
does not represent an economic rent, but the factor cost of capital in these more
difficult locations. The only way to lower that cost is to remove a significant part of
the gamble of investing in a LDC or SVE.
The role of trade preferences
10. Giving concrete support to the investor’s commercial gamble has been an
important part of the rationale for trade preferences. Until now, many LDCs
and small vulnerable states have been able to offer investors preferential
access to developed country markets (variously Europe, USA and Australia,
and to a much lesser extent New Zealand and Japan) in most of the sectors
where export-oriented SMEs are found. 12 The impact of the benefits has
apparently been big enough to influence the location of investments,
particularly in the case of small and vulnerable states. It follows that the
margi ns of preference have been of sufficient value not only to cover the
higher location costs but also to yield, at least in expectation, the desired
investment risk premium.
11. Striking examples of this effect are found under Lome, Sparteca, CBERA
and Caribcan—or a combined effect of more than one of these schemes—in
the garment and footwear industries of Mauritius, Fiji and certain
Caribbean and Central American States, tuna fishing and processing in the
Indian and Pacific Oceans and West Africa, out-of-season fruit and
vegetables in several Pacific and Caribbean island states and Mauritius,
and electrical or electronic assembly operations in certain Pacific, Indian
Ocean and Caribbean states. Commenting on the cost handicaps of Eastern
Caribbean States, a recent WTO report 13 observed ‘ Exports suffer from
these high costs and take place almost exclusively under preferential
conditions’. Two well-known riders to this positive record should be noted.
Financial investors and institutions have coined the expression ‘emerging markets’ to cover the
riskier and more remote reaches of their investment world. It is an up -beat label, suggestive of an
autonomous development process and incipient dynamism. Readily applicable to the more
successful LDCs, such as Bangladesh, and SVEs such as Mauritius, Trinidad and Fiji, it is
harder to apply to the smaller and more vulnerable economies without a sense of straining the
meaning of the words.
12 Tourism has not been the subject of trade preference because of the nature of the business—
an export industry whose product is consumed where it is produced, and data-processing has
been preference-free, as a post-colonial arrival in world trade with a product difficult to pin down.
13 WTO Trade Policy Review OECS-WTO Members, May 2001, WT/TPR/S/85, page viii.
11
18
12. First, trade preferences have acted to protect and sustain high-cost
industries, of which most SVE producers of sugar and bananas are famous
examples14. Without trade preferences these industries would have had to
undergo deep structural change long ago to make them competitive. The
belated attempt to reform them now is going to be costly and difficult, if
indeed it is feasible at all in the more naturally handicapped cases.
13. Second, with very few exceptions, the investments that have been made
with the benefit of trade preferences have gone to those LDCs and SVEs
that were the least handicapped by endowed high-cost characteristics. In
other words, the beneficial impact has been concentrated on those LDCs
and SVEs that were already better off—deeper, stronger and more resilient
economies—than their classmates, and where it is conceivable (because
the parameters of feasibility in these matters are both country-specific and
fuzzy) that developmentally equivalent or better investment in these or
other sectors might have taken place if trade preferences had not been
available.
14. That said, trade preferences are now on the way out, and—with the
exception of the three Micronesian states 15 that have Compacts of Free
Association with USA—are scheduled to be gone well within the expected
life of any substantial SME investment that might be made in the next few
years. There was a consensus among this study’s informants that, except
for Micronesia, trade preferences will no longer be a significant factor in the
location of the kind of investments that small and vulnerable states want to
attract. For the sectors that have benefitted from preferences, the task of
establishing the higher rate of return that SME investors in these
economies apparently require will now become that much more
problematic.
The significance of investment costs
15. Could a reduction in the investment costs of an enterprise—the ‘investment
preference’ of this study’s terms of reference—make a comparable
difference? Even if not comparable, could it make a big enough difference to
affect location decisions, and so be worth organising? The answers depend
on how important the cost of investible resources is in the expected
performance of investments, and how much of a reduction in those costs it
is reasonable to contemplate.
16. It is clear that the initial financial cost of an investment is only one of
many factors going into the decision calculus, and it is only one of several
cost factors that directly affect the profitability of the investment. Investors
Sugar in Fiji, Mauritius, Barbados and Belize, bananas in the smaller Caribbean states, have
led charmed lives under their preferential access to the EU and USA markets. A less well-known
example is the tuna processing operation in Solomon Islands, which for the last twenty years has
only been able to support Japanese-style overhead costs because of its 24% tariff advantage in its
main market, the EU, over non -ACP producers.
15 The Federated States of Micronesia, and the Republics of Palau and the Marshall Islands
14
19
can be expected to try to minimise their actual investment cost by
leveraging their own contribution with outside loans, while trying to make it
look as big as possible for public relations and taxation purposes, eg, by
overvaluing contributed assets and services. One way to get an idea of
investment costs from outside is to relate an assumed return on
investment—for which there is a lot of circumstantial evidence—to the
reported after-tax and after-debt-service profits of an enterprise in ‘going
concern’ condition.
17. A SME located in a LDC or SVE and making reasonable headway in a
competitive environment might typically earn net after-tax profits in the
range of 10% of sales. As noted above, it appears from interviews and the
consultants’ experience that target real rates of return when an investment
in a LDC or SVE is being considered—other than minerals and petroleum,
where investment costs, risks and target rates of return are higher—are in
the range of 15-25%, but that once an investment is made a lower range of
actual returns, say 10% in real terms, is enough to keep it in place. If we
assume annual inflation is perceived to be around 5%, the available 10% of
sales has to equate to a 15% current-prices return on investment. This,
together with an assumed outside borrowing equivalent to 30% of sales and
repayable over five years, suggests that the original investment by the
owner was around 70% of sales—that is to say, a typical $10m investment
in manufacturing or processing for export is financed with a 70:30 ratio of
owner’s funds to outside debt, and produces gross sales of $10m and a
current-prices return on investor’s funds of about $1m a year. These are
necessarily broad brush treatments of a key subject on which data is both
very varied and closely-held, but the conclusions chime reasonably well
with informe d opinions canvassed during this study.
18. To take this a little further, the annual total costs of a commercially
healthy SME, including interest and depreciation, are typically around 85%
of sales. Tax—after any holidays have expired—commonly takes a quarter
to a third of the surplus, the remaining 10-12% of sales being available to
repay debt and reward the investor (it being the investor’s choice to
borrow/repay debt, or self-fund the investment). The annual financial cost
of the investment is the interest paid to outside sources of investment
capital and the opportunity cost of the owner’s funds. Both the reasoning
set out above and the gist of interviews for this study suggest that these
costs will typically be in the range of 15% of the capital cost of the
enterprise, and equivalent to a similar proportion of the operation’s total
costs.
19. Given the variety of actual enterprise sizes and financial structures it is
difficult to be more precise, but this sketch provides an indication of the
scope for improving the financial performance of an investment by reducing
the cost of capital. This can be done either by reducing the unit cost of
capital or by reducing the amount needed, or both. Halving a 15% rate of
interest on outside loans in the enterprise de scribed above with a 70:30
equity:loan gearing will reduce total costs by 2-3% and increase the
investor’s surplus by 20-25%, say raising the expected return on
20
investment from 12% to 15%. An increase in the investor’s rate of return
can also be achieved by substituting lower-cost outside capital for part of
the investor’s commitment—this is the attraction of higher gearing for the
investor, if interest rates are friendly.
20. From the investor’s standpoint the results of reducing the unit cost and the
amount of capital required are significantly different. Reducing the unit
cost, which usually means lowering borrowing costs, has the effect of
improving profitability and so increasing the return on whatever capital is
invested. Reducing the amount of capital the owner/controlling investor
has to contribute may marginally reduce the cost of that capital, depending
on the investor’s opportunity cost structure, but more importantly it
reduces the size of the investor’s exposure to loss—it makes the investment
risk smaller. In return for someone else sharing this risk the owner usually
has to concede some part of the control of the investment, at least in
respect of the financial structure and disposition of surpluses. Willingness
to do this depends on the investor’s corporate nature, other exposures and
strategic goals for this investment.
21. This distinction is important in designing possible capital cost
interventions: reducing the cost of outside capital increases the return
available to the inside or direct investor, while reducing the amount of
capital required from the investor reduces the size of the investor’s risk. If
the reduction in exposure is substantial it may reduce the threshold rate of
return for undertaking the investment—investors being more willing to risk
a smaller amount. Governments seeking SME investment have used many
ways of reducing the amount and/or the cost of the capital that the investor
has to find. These techniques and their limitations are reviewed in Chapter
5 of the report. It is worth noting in advance that there is a long history to
such endeavours, and that some of the most successful —eg, state -funded
industrial estates leased at below-market rates—have generally escaped
criticism as vehicles for market-distorting subsidies, perhaps because they
have been widely used by developed as well as developing countries. In
preparation for that examination of cost-reducing measures, in the next
chapter we recall why governments go to great lengths to attract investment
into the export sector .
21
Chapter 4: Attracting export-oriented investment
Investors and enterprises
1. This study is concerned particularly with promotion of investment that will
increase exports. For a LDC or SVE, investment in SMEs in the export
sector, including tourism, offers the best chance of rapidly creating jobs,
increasing national income and widening the tax base. External markets are
large enough to absorb the new output without any fall in price. Domestic
markets are by definition small and undeveloped, and at the higher—urban,
monetised—end are accustomed to internationally-traded products. New
production for export does not displace the output of existing enterprises,
and the new activity enlarges the domestic market for non-traded goods and
services. Provided product quality is maintained or improved, the demand
created by the greater volume available for export can help to reduce the
costs and improve the quality of air and sea transport and
telecommunications to the benefit of the whole economy. At the same time
the enhanced skills required of the workforce by most exporting SMEs will
rub off on skill levels generally, by putting pressure on standards and
capacities of secondary education, technical and vocational training.
2. Box C sets out what host governments are usually looking for from
investment. Promoting and facilitating investment in SMEs in the export
sector is a leading way of enlarging the economy’s capital base, drawing in
investible resources from outside the economy and retaining within it capital
that would otherwise seek safer and more profitable uses overseas. A sense
of where competent and willing investors are most likely to be found is
important in planning efforts to attract them.
Box C: What host governments want—and don’t want
Governments of LDCs and SVES are like political administrations anywhere —their top
priority is to stay in office. This aim is pursued in political and development arenas
simultaneously. In the political arena supporters are recruited and rewarded, while
opponents are outsmarted and kept out of office. In the development arena, forms of
social and economic change are espoused that can bring sustainable benefits to people
at large and for which governments can take credit, with an ensuing electoral pay-off.
Successful promotion of commercial investment plays a role in both arenas: obviously
in the latter by inducing growth of output, more subtly in the former by providing the
government with more room for manoeuvre and scope for patronage.
Economic growth in the form of increasing employment and real incomes, more local
enterprises surviving and expanding, more and better public services and utilities more
widely accessible and affordable, protection of the natural environment and repair of
damage already done—all in a context of a sound financial system, stable monetary
conditions and a sustainable balance of payments—this scenario not only makes people
feel good, but also can be expected to make democratic governments re -electable, and
autocratic governments acceptable. Such generally beneficial growth requires
investment, and with few exceptions commercial growth has been found to need private
entrepreneurial investment.
22
Governments therefore promote private, direct commercial investment with the explicit
intention that it will, in no particular order of priority:
• create jobs, particularly in areas where open unemployment is acute
• raise skill levels, leading both to higher incomes and enhanced ability to attract
further investment
• earn more foreign exchange income than it uses, by reducing imports and/or
increasing exports
• increase government revenue through direct and indirect taxation, enabling
increased public investment and better services
• justify increased infrastructure and utilities investment, and successfully demand
higher standards of service
• enlarge the markets for locally produced goods and services
• help create ‘critical mass’ for institutional development and increase human and
social capital
In some countries, as noted above, there is an implicit intention to reward political
supporters in some way from the bigger scope for patronage that increased private
investment may bring. Public pressure for transparency and competence in such
appointments may act to limit this scope.
What governments of LDCs and SVEs apparently do not want from investment, except
in a few isolated cases, is to lose control of the overall direction of their economies. This
is worth mentioning because of widespread concerns in weaker economies about
aspects of WTO-led globalisation, pa rticularly what appear to be restrictions on the
economic management powers of states, and a corresponding increase in the ability of
international business to set the trade and investment rules and determine the
direction of economic development.
When the power pendulum will start to swing back towards the state in OECD
countries is not clear—though it seems certain to do so eventually—but the small and
vulnerable states, perhaps precisely because of their smallness and vulnerability, may
have a sharper sense of the social and economic riskiness of handing over political
power to big business. So long as the public accountability of governments is strong
enough to prevent a secret sell-out, they are likely to resist being rolled up into a kind of
neo-colonial status under cover of the freeing-up of international trade.
3. A large part of—perhaps most—foreign direct investment appears to be
reinvestment16 in the upgrading and expansion of existing enterprises,
where the risks are known, there is a record of achievement and local
knowledge can be put to good use, rather than in ‘greenfield’ start-ups.
Much the same undoubtedly applies to investment by resident investors.
Existing investments are often ignored or taken for granted by governments
while they e xpend great efforts to attract new investors. The return on effort
put into encouraging reinvestment by proven investors is likely to greatly
exceed that on chasing after new ones.
4. A further important source of investment for many LDCs and SVEs is their
overseas kin—nationals of the country who have gone abroad to make their
fortune, and have succeeded well enough to be able to invest back home.
A point made often in publications of the now -defunct UN Centre on Transnational
Corporations.
16
23
Besides their own money and bankable credit rating, such entrepreneurs
often have overseas networks, market connections and technical know-how
of priceless value to the LDC or SVE, which are by definition short of all
these investment necessities. The diaspora has contributed to the success of
export investment in Bangladesh, Mauritius, Fiji and certain Caribbean
states, much as it has in Israel and China. As emigration continues from
LDCs and SVEs, and more families acquire transnational experience,
capability and capital, the potential importance of ‘return investment’ , like
retention and reinvestment, needs to be recognised by LDC and SVE
governments.
5. Within the export sector, the sub-sectors where the need and opportunity
for successful investment is most likely to be found can be reviewed in three
categories. First, the older-established natural resource -based sub-sectors,
within which important parts have survived only because of trade
preferences, and the more dynamic parts often target niche markets;
second, the newer technology-based sub-sectors; and third, the now
threatened—and in many cases already adjusting—trade-preference -based
manufacturing and assembly sub-sectors.
Natural resource -based
• Agriculture: sugar, bananas, coffee, cocoa, spices, kava, root crops, outof season or exotic fruit, market vegetables and flowers
• Fisheries: tuna fishing and processing, catching of reef and other highvalue food species, live fish and shellfish for aquariums and restaurants
• Aquaculture: farming of fish, prawns, clams, pearl oysters, seaweed
• Forestry: green-certified management of natural, regenerated and
plantation forests for logs, sawn timber and wood products and the
earning of ‘carbon credits’
• Tourism: full range of markets, resorts and supporting activities from
millionaire to backpacker grade, increasingly environment-aware and
green-certified
• Minerals: SME-scale exploitation of alluvial and mined gold and silver,
bauxite, bitumen, phosphate, production of sea-salt
Technology-based
• off-shore banking and financial services
• residential tertiary education aimed at third-country students
• medical treatment or recuperation facilities for overseas patients
• data-processing centres for, eg, airlines, banks, insurance companies
• call centres for customer-response services originating overseas
• financial, marketing, scientific, packaging and other services to exporters
Trade-preference -based
• clothing and footwear manufacture
• assembly of electrical and electronic equipment
• food processing associated with preference -eligible agriculture and
fisheries
24
Improving the investment climate
6. The physical and financial investment needs of the three categories differ
significantly—in particular the relative weight of initial capital costs in the
overall cost structure varies widely—but potential investors in them will
share most of the desiderata set out earlier in Box A. There is a primary
requirement for state-of-the art telecommunications in the technology-based
group, but it also needs political stability and security of tenure. The
resource -based group has a primary need for secure access to resources,
but nowadays those enterprises too must have first-class external
communications if they are to compete in world markets. Trade preferences
have made the crucial rate-of-return difference for SMEs in the preference receiving subsectors, but to be successful they also needed good
communications, political stability and a trainable work-force.
7. In the last decade much effort has gone into ‘getting the investment
environment right’, both from the international financial institutions and aid
donors, and—with less than whole -hearted enthusiasm in some cases—from
the LDCs and SVEs. The common ground is that LDCs and SVEs need the
jobs and export earnings of SMEs, and to obtain them conditions must be
conducive to private direct investment. The widely recommended formula for
conduciveness has two main parts: first, achieving a stable and predictable
macro-economic environment with a competitive exchange rate and interest
rate structure; and second, making the micro-economic conditions and
regulatory framework as investment-friendly, transparent and predictable as
possible.
8. The first part has been addressed by a range of policy and structural reform
programmes, with greater or lesser involvement—in some cases too much, in
some perhaps too little—by IFIs and aid donors, according to the capability
and self-confidence of the government. As one of the necessary conditions
for macro-economic stability is commonly a steady flow of private
investment, sequencing of reforms presents something of a chicken-and-egg
problem that has to be finessed or fudged. The second part, often specified
as part of an overall reform programme, has been the concern of the World
Bank Group’s Foreign Investment Advisory Service. FIAS has been providing
technical assistance to WB member countries and others, usually in the
form of a preliminary diagnostic assessment and follow -up advisory
missions, and has amassed a vast knowledge of conditions. Most LDCs and
SVEs have made use of this service, though the effectiveness of their take up of advice varies considerably, and in many cases real improvement seems
to be an extremely slow process.
9. The gist of the message of the IFIs has been that avoidable policy and
structural deterrents to investment should be removed, and marketdistorting price and non-price rigidities should be eliminated. The clear
implication is that if this is done, good things in the shape of increased
domestic and foreign investment can be expected to follow. The avoidable
deterrents include cumbersome and opaque procedures and lackadaisical
administration. Governments have generally acknowledged this, and there
25
have been some real successes in improvement of the approval process, but
all too often, according to FIAS 17, there is a large gap between benign official
policy and the obstructionist reality faced by investors.
10. The removal of ‘market distortions and rigidities in factor markets’ has
proved more difficult at the policy level, for two reasons. First, some of these
conditions exist for reasons of redistributive public and private policy based
in concepts of social and economic equity; and second, it is not clear that
even if they were removed factor prices could fall to a level that would offset
the other intrinsic cost handicaps of LDCs and SVEs—in other words, with
output prices being determined in export markets elsewhere, even if any
economic rents and payments to government were squeezed out of noncapital factor prices by rigorous structural adjustment, driving them down
to their underlying supply prices in order to increase the return to capital,
that return might still be below the investor’s threshold rate, so no new
investment would result.18
11. Governments of LDCs, for whom this is allowed under WTO rules, might
intervene in factor prices to make them more investor-friendly by applying a
subsidy, if they have the fiscal resources to do so. The discussion in Box E
aims to dispel some concerns about the use of capital and operating
subsidies in development management. Using this approach to land rents,
for example, eliminating them entirely (eg, government provides rent-free
serviced site and buildings) could improve the investor’s position
significantly by transferring even a few percentage points of the cost
structure to the available rate of return. This has been the rationale for
industrial estates and some individual factories where land costs have been
heavily subsidised by governments. Fuel and utilities may account for as
much as much as 20-30% of operating costs, eg in a fisheries enterprise, so
a subsidy of say one-third could transfer up to ten percentage points to the
investor and conceivably tip the investment decision—provided the investor
believes it will continue. The weakness of such subsidies from the investor’s
standpoint, particularly in LDCs and SVEs, is that most governments are
already under fiscal pressure and may not be able implement such
A recent FIAS report, Administrative Barriers to Investment: The Pacific , FIAS, May 2001,
observes ‘ in virtually every case (reforms)… have been accompanied by an anticipation of
increased private investment flows. Almost invariably.. these flows have not materialised…there
are two main reasons…lack of opportunity…and investment uncertainty even when opportunity
exists.’ Pointing out that administrative barriers often continue even when policy statements
suggest otherwise, the report observes ‘When a company has finally made the decision to invest,
the investor is then subjected to some of the worst treatment imaginable, sometimes from the
various agencies of that government that so actively courted him in the first place.’ News of such
experiences gets around, and neutralises vast amounts of promotional propaganda.
18 The same problem was neatly put another way in the Commonwealth Secretariat paper referred
to earlier, when it asked whether there in fact exists sufficient domestic value added in SVEs to
reimburse bare minimum factor costs and compensate investors for the cumulative cost
disadvantages of such economies. (Commonwealth Secretariat (1999), Chapter 3). The reductio ad
absurdum was expressed in consultations by the question, ‘What would you have to pay Toyota to
assemble cars in Tuvalu?’
17
26
subsidies for long, so it may be wiser to discount them in an investment
decision even if they are negotiated.19
Box E: The developmental role of subsidies
The study encountered an understandable unease among IFIs, and to a much lesser
extent among governments of LDCs and SVEs, about the distortionary effects of
subsidies on the developmental process. Actually no country has developed its economy
without the use of subsidies, and they remain in developed and developing countries
alike a legitimate and valuable tool of economic management. Subsidies are nonreimbursable payments from governments to producers or suppliers with the aim of
keeping the price of a good or service below the factor cost of producing it. The effect is
to increase demand, and so production, above the unsubsidised market-determined
level—in some cases, to make private production possible at all.
There are several important points to watch when using subsidies in the development
process. As payments originating in public funds they need to be fiscally sustainable, so
as to be reliable from the producer’s standpoint. Further, they should be shown to be a
necessary part of the enterprise finances—subsidies that are not needed for commercial
viability are a waste of scarce public resources. As incentives to invest in and operate
enterprises that would not otherwise exist, they can attract or retain private resources
in inefficient uses that are not in an economy’s long-term interests. Massive
agricultural price support in the EU, USA and Japan is the most frequently cited case of
this, nicely illuminating the tension between economic and political measures of
efficiency, but there are many other examples in countries at all levels of economic
sophistication.20
Determining eligibility for subsidy, like any discretionary allocation of benefits by
officials, can easily become a market for corrupt activity. The best protection is to make
the process as mechanical and non-discretionary as possible, with regular publication
of subsidies in force and who receives them; and if demand exceeds supply and the
nature of the subsidy permits, to develop a publicly tendered bidding process to
determine who gets the available assistance.
It is generally accepted that subsidies have a place in economic management. Markets
in real life are full of imperfections as a result of structural shortcomings, internal
manipulation or the short time-horizons of participants, and market signals are only as
good as the markets generating them. Subsidies are a time-honoured way of correcting
market-induced inefficiencies in resource allocation. The trick is to intervene without
causing more problems than are being solved. Subsidies should be affordable, effective,
transparent and non-distorting in resource allocation. The ‘best practice’ way of meeting
the first three conditions is to keep the process open and transparent, regularly
reporting and accounting to parliament and the public for subsidy payments and
assessing their effectiveness.
At least, though, the investor might reasonably hope that these inputs would not be made more
expensive by the addition of tax, as has been the case of fuel for tuna fishing vessels in Solomon
Islands.
20 Domestic transport systems, strategic or defence-linked industries, infant industries,
backward-area industries, industrial estates and technology parks, agricultural services, training
institutes and more, have all been and still are the recipients of subsidies of various kinds for
widely supported reasons of public policy.
19
27
The danger of distortion should be minimised by making the eligibility categories as
broad as possible, and not trying to make investors’ judgments for them—that is, for
example, by making assistance available to the agriculture sector as a whole, not just to
one sub-sector (in a SVE this can often comprise one firm) picked out by officials or
politicians as specially deserving—and as just mentioned, wherever practicable allocate
scarce subsidy resources through a bidding process, in which competing applicants bid
by stating the lowest subsidy they consider can give them a competitive rate of return.
Distinctions between capital and operating subsidies are of limited technical
significance, but there are important differences in the way they are perceived. A
subsidy to the up-front outlays of the investor, in the form of a grant for part of the
capital cost or provision of all or part of the fixed assets at below market cost, will
reduce the accounting cost of capital to be charged against enterprise income and
increase the return available on the investment.
A similar result in terms of expected cash flow and profitability may be obtained by
subsidies for all or part of the cost of certain inputs to operations, eg, loan interest, fuel,
utilities, training costs. But in terms of investor’s risk, and so the target rate of return
applying to the project, the one-off capital subsidy may be much more valuable because
it takes place right at the start and cannot easily be taken back, and it reduces the size
of the investor’s exposure to loss. Operating subsidies, even when written into
investment agreements, are vulnerable to changes of policy, government and fiscal
conditions—so they may have to be significantly discounted by an investor assessing
the risk/return prospects of the project—and the enterprise has to survive long enough
to receive the expected benefit.
12. Skilled and semiskilled labour may account for 10-30% of costs, depending
on the nature of the enterprise. The supply price of unskilled labour in LDCs
and SVEs is usually assumed to be a ‘subsistence wage’, which is the value
of own and family output produced and consumed or sold by an
unemployed but employable person. Valuing this is difficult, but the
consultant’s observations suggest that in the Pacific islands it is close to the
de facto formal sector minimum wage (low-skilled people are still drifting to
town, but with no real hope of finding a job). Margins for skill have usually
been hard won from employers, who do not easily surrender return on
capital to return on labour, while pay differentials are an important
motivation for improvement of skills. Given the social and political
importance of a pay structure that is generally felt to be fair, there is little
scope for driving down wages to release resources to reward investment.21
13. With tariffs generally coming down, apparently heading for a common
general import tariff of 10%, and the residual revenue being of great utility
to many LDC and SVE governments, the scope for further exemptions is
limited and the potential benefit to the enterprise much less than it used to
be. Commonly, imports of a capital nature are exempt from duty during the
initial investment/rehabilitation phase of a qualifying project—which would
certainly be any export-oriented investment, and perhaps all investments—
under a general provision of the tariff law. The burden of advice aimed at
What does seem to have had a positive economic impact is the freezing of public sector or
public service pay in a number of countries undertaking adjustment and reform programmes.
This has lessened the artificial upward pressure on private sector wages, unrelated to
productivity, that erodes export-competitiveness.
21
28
transparency and predictability of taxation would be that there should not
be any discretionary additions to that. Investors can then make their plans
and evaluations on a common and reasonably firm basis.
14. Besides rents and royalties for the use of assets made available by the
government, payments to government in the nature of withholding taxes 22,
which could add 5-15% to the cost to the enterprise of its factors of
production, can be waived or refunded for a specified period or forever, by a
government anxious to secure an investment. Governments in developed as
well as developing countries sometimes go to extraordinary lengths to nail
an investment deal, particularly if the proposed location is in an area of high
unemployment, or otherwise of special economic or political significance.23
All these add-ons taken together are likely to account for less than 5% of
sales, making a useful but probably not critical addition to the other
elements of the government's investor-friendly package.
Box D: Doing without SME investment
Some LDCs, and a number of SVEs, are particularly small, remote or poorly endowed
with land-based natural resources. After trying with little success to attracting SME
investment, even at the small end of the range, they have had to look beyond the
orthodoxy of export-oriented development strategies, and make use of a less tangible
resource endowment—sovereignty, a vote in world forums, and the potential to act in
concert with other similar states.
The scope for selling military-strategic ‘friendship’, access to bases, exclusion of others,
has been mentione d earlier. The most striking examples of this are the ‘Compacts of
Free Association’ between the USA and the former US-administered trust territories of
the UN in Micronesia. In the Indian, Pacific and Atlantic Oceans (less so in the
Caribbean) UNCLOS-based 200-mile exclusive economic zones have yielded valuable
fisheries licensing and tax revenues, and in some SVEs a significant number of jobs.
The scope for sea-bed mining is as yet ill-defined, but—a bit like space travel a few
decades ago—it is certainly coming closer24 , and its theoretical implications for some
small states are awesome.
The best-known use of SVE sovereignty is the operation of off-shore finance centres.
OFCs are currently a bone of contention with OECD states who do not accept that tax
regimes are a proper field of international competition, and—less contentiously—are
concerned about the use of OFCs for money-laundering. There are signs that a
compromise will be reached that allows SVEs to continue in the OFC business, subject
to reasonable safeguards against their misuse as a haven for the proceeds of organised
crime.
Shipping registries and sale of passports, both significant revenue earners in several
LDCs and SVEs, are also contentious when they encroach on the sovereignty of bigger
Eg, on interest payments, land and building rents, payments to contractors
Many SVEs are so small and so vulnerable that any SME investment would be an event of
special significance.
24 In the next 10-30 years, according to the World Bank’s most recent biennial report on the
Pacific islands, Managing Change in Pacific Island Economies, World Bank, 2000, Vol 1, page 39.
22
23
29
and more powerful states. Less controversially, philatelists and numismatists have long
made useful contributions to SVE revenues.
Besides these uses of sovereignty (and others yet to be devised) the export of people at
all skill levels into jobs at sea or on land in better-endowed economies, provides both
an alternative and a supplement to growth through direct investment in SMEs. Many
LDCs and SVEs have a high proportion of their nationals overseas as contract workers
or emigrants, who still send money and goods to relatives back home, making a crucial
contribution to the balance of payments. 25
And then?
15. The unfortunate fact is that after taking all these cost-reducing incentives
into account the investor may still conclude that the expected return on
investment does not offset the risk involved. This is clear from the case of
the extremely small and vulnerable economies, discussed in Box D.
Whatever they do, including in effect paying the investor to invest there, it
still won’t happen. Even for the more typical LDCs and SVEs, it is agreed
among the IFIs consulted during this study that—in theory at least—it is
possible for a government to have done all that it can reasonably be
expected to do, using available knowledge and institutions, to make its
country and economy attractive to investment by domestic, emigrated or
foreign investors, and still to experience an SME investment famine.
16. The conditional note is necessary because a state of perfect investor friendliness is easier in theory than in practice. But it is acknowledged that
many are making solid progress, and a few 26 are now close to doing all they
reasonably could. To recall in brief the condition they are trying to achieve,
it comprises
•
•
•
•
•
•
•
•
political and macro-economic stability
the rule of law, and an effective legal system
simple, transparent procedures
sound development strategies
competent and honest public administration
capable work-force
reliable utilities and infrastructure
low tariffs and tax rates
If this is achieved, or can be objectively assessed as being as close to
achievement as can be reasonably expected, but still there is no significant
For some SVEs, the population of the diaspora is several times greater than the population at
home, where social and economic institutions have entirely adapted to this, as a permanent and
generally satisfactory state of affairs. Granted the differences of scale, this resembles the case of
the Overseas Chinese, or Israel’s access to Jewish capital overseas, and has potentially very
positive implications for the investment prospects of such SVEs.
25
Countries in this category include Samoa in the Pacific, Trinidad and Tobago in the Caribbean
and Mauritius in the Indian Ocean
26
30
investment, it can be concluded that the endowed and intrinsic cost
disadvantages of the country make it uncompetitive.
17. That moves the debate out of the province of the domestic government and
back into the international arena. Levelling up a fundamentally uneven
global endowment of economic and human resources is part of the rationale
of foreign aid and the existence of international financial institutions. The
endowed unattractiveness of LDCs and SVEs to commercial investment is
clearly a proper target of ODA, given the key role of aid in improving
infrastructure and other necessary conditions. The aspect of the investment
decision process that is begging for attention is the capital cost/risk/return
calculus.
18. How much and what form of intervention by ODA to affect investment
decisions is appropriate, and how could it be organised without causing
more problems than it aims to solve? The next chapter reviews the
effectiveness of past efforts to reduce the investor’s cost and risk by official
interventions of various kinds, and discusses the scope and possible
modalities for the use of ODA resources to do it more successfully.
31
Chapter 5: Intervening to reduce costs and risks
Existing arrangements
1. Of the many ways that LDCs and SVEs try to make themselves more
attractive to SME investment—none of them sufficient by itself—this chapter
focuses on measures intended to reduce financial cost and risks. These have
a long history and various sponsors, and several of them make use of ODA
in some form, usually to defray administrative costs. Box F provides a brief
taxonomy of the facilities currently available to assist with investment costs
and risks, in theory at least, in LDCs and SMEs.
2. It is accepted among the institutions listed in Box F that their facilities for
assisting private investment do not easily adapt to the degrees of endowed
disadvantage found in many LDCs and SMEs. Interviews for this study
clearly showed that. It is less generally accepted among the IFIs—most LDC
and SVE governments have a different perspective —that more needs to be
done to effect that adaptation, many IFI officials being sceptical of the
benefit that would come from attempts at further innovation.27 And there is
no agreement among IFIs and governments about what practical form any
such adaptation should take.
Box F: Existing official financial assistance to SME investment
LDC and SVE governments.
•
•
•
national development banks (NDBs): dating from a state-interventionist period
before and after achieving political independence, most are in poor shape, with
many non-performing loans on their books, largely as a result of politically
influenced lending; some have been merged with state-owned DCBs
investment corporations: also relics of the earlier interventionist period,
established to implement state ownership of ‘commanding heights’ of economy
and attract or retain foreign investment through joint ventures; most portfolios
now performing poorly, and being restructured or wound up under privatisation
programmes
credit guarantees to domestic commercial banks (DCBs): often provided by central
banks at government request, originally for trade financing/export promotion,
later broadened to general loans for indigenous enterprises short of collateral;
successful only if strongly designed and administered; now again in vogue to
support DCBs in micro-enterprise financing
This scepticism was to a significant degree shared by the interviewing consultants, and is
reflected in the circumspect—though strongly positive—assessment of the need for further
innovation taken in this report
27
32
World Bank Group
•
•
•
•
IFC: the World Bank Group’s efforts to promote private enterprise are overseen
by the International Finance Corporation. Since start-up in 1956 IFC has
committed over $30bn of investments and loans from its own funds, and
arranged over $20bn of syndications and underwriting of loans, for over 2,500
enterprises around the developing world. At FY2000 IFC had a disbursed
portfolio of $10.9bn (equity 24%, loans 76%), of which 29% was invested in
financial services sector.
MIGA: established in 1988 as a separate legal entity withi n the World Bank
Group, the Multilateral Investment Guarantee Agency tackled head-on the
problem of insuring private investments against political risk. By FY2000 it had
extended guarantees worth $7.1bn to projects in 75 of its 130 developing
country membe rs. MIGA also provides investment-related IT and other services
to its members.
FIAS: the Foreign Investment Advisory Service, set up jointly by MIGA and IFC,
provides analytical, advisory and technical assistance to developing countries in
the improvement of the legal and administrative environment for foreign
investment
IFC’s decentralised instruments for promoting private investment
• Caribbean Project Development Facility (CPDF), Africa Project Development
Facility (APDF), Africa Management Services Company (AMSCO) and the
Africa Enterprise Fund (AEF): the first three provide assistance direct to
entrepreneurs in the Caribbean and Africa in business planning, feasibility
studies and financing proposals. AEF makes equity, quasi-equity and loan
investments in SMEs on ‘bankability’ criteria similar to those of IFC itself but
at smaller scale.
• South Pacific Project Facility (SPPF) and the Pacific Islands Investment Fund
(PIIF): SPPF provides technical assistance direct to SMEs to help them
prepare bankable investment proposals for projects ranging from $0.1m to
$5m. SPPF has also managed the PIIF, a fund within IFC aimed at Pacific
island SMEs. This has proved procedurally cumbersome, and hard to justify
when SPPF has generally been able find commercial sources of financing for
its clients. PIIF is likely to be phased out.
Regional MDBs
The Regional Multilateral Development Banks have developed a range of
instruments for assisting investment in LDCs and SVEs, with broadly similar
aims but different institutional arrangements. They try to apply commercial
standards of viability but they are drawn by their charters into less-thancommercial exposures. They all provide or support advisory and TA services and
have contributed to the funding of the NDBs in their region. They lend to private
investors in their own name or through an associated institution, directly or
through an intermediary DCB.
33
They can and do provide non-controlling equity and quasi-equity funding to
private enterprises and they all subscribe to regional and national venture
capital funds. They see themselves as catalysts, aiming at sectors and projects
where their institutional clout can make a positive difference, their input will
‘leverage’ others, they will not be displacing private capital, and for equity
positions there is a clearly perceived exit route. And they all report that doing
these things in LDCs and—especially—SVEs presents immensely difficult
problems of scale economies, pricing of risk and sheer practicality.
African Development Bank (AfDB)
• AfDB makes policy-based loans to governments in support of investmentfriendly structural adjustment, and can lend and invest directly in private
sector projects. In the three years 1998-2000 about 6% of the Bank’s total
approvals were for private sector loans and equity investments.
• AfDB provides lines of credit to NDBs in member countries, and makes
grants to APDF and AMSCO (see above)
• the Bank subscribes to national and regional venture capital funds—most
recently in Zambia and the Indian Ocean—see below under private funds.
Asian Development Bank (AsDB)
• AsDB’s Private Sector Group is institutionally part of the Bank. Through its
operations AsDB provides risk capital, quasi -equity and loans to private sector financial institutions, utilities and infrastructure enterprises, eg as
part of a privatisation programme, and participates in national and regional
venture capital funds. These activities now account for 3% of AsDB’S assets,
but little of this has so far reached LDCs and SVEs
• by agreement with the World Bank and EDF, AsDB has been the chief
source of finance and institutional support for national development banks
in the region’s SVEs
• the Bank has invested in the Kula Fund (see below) and expects soon to
invest in the Samoa Venture Capital Fund, now in preparation
Caribbean Development Bank
• More than 90% of CDB’s lending has been to public sector borrowers,
including NDBs. A Micro-finance Guarantee Programme has been launched,
and plans to increase the Bank’s loan and equity exposure to the private
sector are being considered.
Inter-American Development Bank
• the Bank aims to support ‘the hemisphere’s 65 million micro-entrepreneurs’
28 by direct lending and TA programmes under its Micro-enterprise Strategy
adopted in 1997
• the Multilateral Investment Fund (MIF) created within the IDB in 1993
provides TA and investment funds aimed at strengthening SME and microenterprise, through a wide range of interventions—financial sector
improvements, business and IT training, ISO-based quality management
• the Inter-American Investment Corporation was established in 1986 by IDB’s
shareholders to focus on the development of SMEs and capital markets. It
provides medium-term USD loans at market-based rates, makes equity
investments. IIC terms targets SMEs with high developmental impact but
with limited access to market finance, and participates in investment funds
that also target them. IIC provides appraisal services to MIF.
IDB’s Sustainable Development Department report, IDB Group Support to the Micro-enterprise
Sector, February 2001
28
34
European Union (EU)
• European Development Fund (EDF): The Cotonou Agreement establishes an
Investment Facility with an allocation of EUR2.2bn from EDF, more than double
the corresponding Lome IV amount. This is not restricted to any sub-group of
ACP states, and there are no a priori country or sector allocations. The IF’s rules
provide considerable versatility of direct and indirect intervention, including
‘apex loans’ to central banks for reticulation to DCBs, but significantly less
concessionality from market terms than was available under Lome.
• European Investment Bank (EIB): though the great bulk of EIB’s operations lie
within the EU, EIB is also the EU’s lender to developing countries. Under
Cotonou, EIB will manage the Investment Facility, plus EUR1.7bn of its own
long-term resources available for ACP projects.
• Centre for Develoment of Enterprise (CDE): formerly the Centre for Development
of Industry (CDI), CDE provides feasibility, market and partner search and
advisory services on request to investment agencies and enterprises. It will now
manage a new EU facility—
• Proinvest: now being established to strengthen investment promotion agencies
and intermediary organisations assisting investment
Commonwealth Private Investment Initiative (CPII) 29
•
•
•
•
Commonwealth Africa Investment Fund (COMAFIN): established in 1996, fully
invested in 1999 in 16 projects totalling $63m.
Second fund under
consideration.
Kula Fund: established in 1997 at $16.9m to operate in Pacific region. Now fully
invested in 11 projects, all in PNG or Fiji. Second fund under consideration.
South Asia Regional Fund: established in 1998, aiming for investment of
$108m, about one-third invested.
Tiona Fund: established 1999 at $21.5m, aiming at investment in sixteen
Caribbean states. Slow performance, $5m invested.
Privately-sponsored investment funds
There is a large and growing number of regional and country investment funds
aimed at SMEs generally or in specific sectors. Some of these are fully invested,
with portfolio companies publicly floated and profits taken, others are still looking
for the right kind of investment openings. Many have IFI participation, which is
generally felt to have helped to bring in other investors. The expectations of such
funds are typified by the highly-focused $20m Indian Ocean Regional Fund, aimed
at investment opportunities in the rapidly-adjusting economies of Mauritius and
Madagascar. Its rules restrict it to investments that are expected to have real
internal rates of return in excess of 25% annually.
IFIs’ under-performance
3. There is a gap between the stated intentions of the IFIs and their actual
performance in respect of LDCs and SVEs. All the IFIs now have policy
statements that eloquently embrace the world’s poor and recognise the
These funds are all managed by CDC Capital Partners, formerly the Commonwealth
Development Corporation. The latest progress report is expected to be made by CDC to
Commonwealth Finance Ministers in September 2001.
29
35
importance of SMEs in poverty-alleviating economic growth, but they have
yet to find ways of engaging effectively with SMEs in the poorest and
weakest economies. There are some successes, but they are almost all in the
economically less handicapped countries—SVEs such as Mauritius, Fiji and
Belize that are far from being LDCs, or Bangladesh which belies its LDC
status by its economic depth and dynamism. The bulk of the LDCs and
SVEs lag far behind the rest of the developing world in their use of existing
IFI facilities, despite the explicit aims of governments and IFIs to help them
catch up. There is a range of reasons for this.
4. Some SVEs are just too small and remote for orthodox commercial
investment (see Box D) and must depend on seizing any unorthodox,
probably sovereignty-based, investment opportunity when it occurs. They
need to know that when that does happen they can make use of IFI
assistance to bring it to reality—not be laughed out of court, or rejected for
unorthodoxy.
5. Some LDCs and larger SVEs are grappling with particularly difficult
circumstances arising from past publ ic under-investment, economic
mismanagement, fiscal excesses and in several cases the effects of
insurrection or civil war. They need to be able to fast-track the promotion of
private investment, in parallel with the restoration of economic stability
rather than subsequent to its verified achievement. Indeed a strong flow of
private investment will often be required to help restore stability and growth,
as Fiji has shown twice in fifteen years, and as is the case for, among others,
Angola, Ethiopia, Senegal and Solomon Islands. These countries need access
to IFI private sector facilities as soon as they can show that they are set on a
course of policy and structural adjustment that is expected—by the World
Bank or a regional MDB—to lead to economic stability.
6. Many LDCs and SVEs simply tend to be in the IFIs’ too-difficult box for
reasons of distance, poor communications, weak bureaucracy, lack of data,
absence of economic and social infrastructure (precisely the characteristics
that make them LDCs and SVEs) and so unable to compete effectively for
the attention of IFI staff, let alone private investors. Some IFI staff borrow
the language of the commercial investment banks to justify an admitted lack
of institutional involvement in poorer , weaker economies—there are not the
potential returns for the effort involved, the ‘deal flow’ just isn’t there —
perhaps forgetting that IFIs are set up precisely to do what the commercial
investment houses will not do, albeit to do it as cost-effectively as possible.30
These countries need either a sharper and more dedicated allocation of IFI
Investment funds supported by IFIs but also involving private institutional subscribers, such
as the CPII-sponsored funds mentioned in Box F, must adhere to investment standards stringent
enough to attract and retain the private subscriptions. These funds are close to pure commercial
investment and once launched carry their own management costs, with no significant element of
ODA or cross-subsidy in their finances. The level of returns sought by private commercial
investors is highlighted by the Indian Ocean Regional Fund cited in Box F. The CPII funds have
found investible projects in a small number of the stronger LDCs and SVEs by dint of
considerable effort by CDC and IFI staff assigned to them. The risk that an aid-based facility
could undercut such funds is discussed below.
30
36
intellectual attention, innovative skills and financial resources, or a separate
and special facility aimed explicitly at the more seriously disadvantaged
economies—the notion raised by the Commonwealth Secretariat under the
label of ‘investment preference’ , the feasibility of which is examined in
Chapter 6.
The deterrent effect of scale
7. Real and unavoidable problems of small scale and high unit cost are
associated with operations in LDCs and SVEs. As earlier discussed, the
prospective investor knows this, and expects to be able to offset these
handicaps by other cost/price advantages such as proximity to unique
natural resources, favourable climate, and access to niche markets. It seems
illogical for IFIs, bent on assisting investment in LDCs and SVEs, to be
deterred by scale factors if the private investor is not. These are factors that
investors and host governments cannot abolish, though they can alleviate
some of them. External economies can be achieved in a range of ways, some
of them involving further private investment in provision of financial,
commercial, quality assurance and marketing services to an expanding
private sector. But finally costs will tend to be higher in LDCs and SVEs
than in larger and deeper economies.
8. Meeting the additional costs of extending IFI services to the smallest and
weakest economies is an appropriate use of ODA, either by explicit grant
funding of the administrative costs, or by cross-subsidy within the IFI. There
are examples of this in practice, such as the multi-donor funding of IFC’s
regional project preparation facilities and the EU’s funding of the
‘investment extension’ work of CDE. But it remains the case that high unit
costs are frequently quoted by IFIs as a leading reason why they are not
more active in LDCs and SVEs—the potential ‘deal flow’ is insufficient to
support the costs of a more substantial presence.31
Unease about aid-based subsidies
9. There are noticeable reservations in IFIs about the distortionary effects of
aid-based subsidies on the direction and volume of investment, and
specifically about the use of ODA to reduce investment costs. These
concerns were mentioned earlier in this report. The use of subsidies in
economic management 32 to counter market imperfections is a widespread
Among the IFI/MDBs consulted for this study the Caribbean Development Bank (CDB) is both
the smallest and the closest to its clients, politically and psychologically, being almost entirely
staffed by nationals of its borrowing members. CDB has many of the same problems as the bigger
MDBs, but operates on an altogether smaller scale. It is keen to develop ways of responding more
quickly and flexibly to SME investment needs, and is experimenting with operations through
DCBs in the Caribbean, where weakness of DCB balance sheets needs to be taken into account. If
these efforts bear fruit, CDB offers a potential ‘point of decentralisation’ for IDB, EIB and IDC
resources as those IFIs seek to engage more effectively in SME investment in the Caribbean.
32 The biggest—and arguably the most distorting—subsidies in the world are those paid to
agriculture in the EU, USA and Japan. That aside, the consultants had thought that the internal
aid programmes of the EU to parts of Europe that are ‘lagging behind’, some of which
programmes target SMEs, might have useful lessons for this study. In discussions EC officials felt
31
37
and ‘technically legitimate’ practice so long as it is open, transparent and
accountable, part of its accountability being an assessment of the impact of
the subsidy on economic activity, welfare and income distribution. In an
economy attracting almost no investment into the traded goods sector it is
hard to describe measures designed to create such a flow as distortionary.
10. The use of subsidies to promote investment is legitimate internationally so
long as it does not infringe WTO rules. These allow the use of subsidies by
LDCs to promote export enterprises. Non-LDC SVEs need to avoid specific
export-oriented subsidies, but that presents few problems. Almost all
production of goods and services in small open economies is either for
export or replacement of imports. Economy-wide assistance to reduce
investment costs and risks will benefit the traded goods sector without
infringing WTO rules.
11. For reasons just cited and argued earlier in the report, the use of ODA to
promote investment, even by directly reducing capital costs and risks,
should not present conceptual problems or objections of principle —specific
hazards should be identified and dealt with in system design—but IFIs and
aid donors still balk at it. The EU and its ACP partners have worked through
this most recently and in the most detail during the making of the Cotonou
Agreement. This is of particular interest both because it results from
negotiations between developed and developing countries 33, and because it
comprises at once a large ODA programme 34 through EDF and a much
smaller lending and investment commitment mainly through EIB. So the
opportunity existed here more than anywhere to use ODA resources to make
loan and investment resources more accessible to the poorer and weaker
economies.
12. The Cotonou outcome is in several ways less accommodating than Lome IV.
The indirect use of ODA in a multitude of ways to reduce the cost and risks
of investments is promoted through the EU’s extensive development finance
and technical assistance programme—which includes a nod to the departing
Stabex scheme in case of fluctuating export earnings. But the direct and
specific use of ODA in this crucial area is now limited to a more tightly
circumscribed interest subsidy scheme as part of the Investment Facility
and EIB’s own–funds lending, and the EDF funding of CDE and other
promotional and TA arrangements.
13. Under Lome an automatic 4% interest rate subsidy applied to EIB direct
and indirect lending to public and private sector projects in ACP states,
that there was insufficient similarity of circumstance to be useful, and that in any case the EU’s
internal programmes so far had had very limited success in promoting sustainable economic
activity.
33 Of the 76 ACP states 39 are LDCs and 41 are landlocked or island states.
34 Internationally it is a large programme, but to put it in EU perspective, the Cotonou Agreement
allocates EUR25bn to the ACP states for a five-year period, of which EUR9.9bn is a re-vote of
unspent Lome Convention allocations. By comparison, the EU spends EUR100bn annually on
domestic agricultural subsidies, and has allocated EUR213bn over five years to its internal
development efforts through Structural Funds.
38
subject to the limitation that the rate after subsidy should not be less than
3%. Under Cotonou 35 lending by EIB from its own resources to public sector
projects is ‘in principle’ eligible for a 3% subsidy, but private sector loans
are eligible for subsidy only if they are part of a privatisation programme or
have ‘substantial and clearly demonstrable social or environmental benefits’.
Lending and other operations of the new Investment Facility are to be on
‘market-related terms and conditions’ , except for ordinary loans to
infrastructure projects in LDCs and ‘post-conflict countries’ , which will
receive a 3% interest subsidy, and the possibility of an interest subsidy of
up to 3% to certain categories of private sector loans (the same categories as
for EIB’s own-funds rule just cited). There is an overall funding limit to
Cotonou interest subsidies of EUR195m, equivalent to 5% of the EIB and IF
available resources.36
14. With the EU so recently—and with full knowledge of growing concerns
about the asymmetrical impact of globalisation—turning away from the
opportunity to soften the terms of assistance to private investment in the
weakest economies, it is not surprising that the other IFIs, with less of a
negotiated contractual relationship with their LDC and SVE members, show
little sign of easing their terms. The arrangements now in place among the
IFIs for assisting private investment in the larger, deeper and stronger
developing countries are better than they have ever been, and they are
notching up real successes—including the alleviation of poverty. But there is
no perceptible recognition of the case for ‘special and differential treatment’
for LDCs and SVEs. Most of these states are economically unimportant.
Their exclusion from this area of international cooperation is not
handicapping global trade and investment to any noticeable extent.
15. Any move to soften ‘market terms’ must be prepared to invoke the use of
ODA in some form. There is significant IFI and donor resistance to
redirection of ODA to this purpose even though much aid is acknowledged to
be wasted through orthodox channels. The reasons commonly put forward
for not directing ODA in direct support of private investment are
• aid is intended for poverty alleviation—if scarce ODA is used to help
private investors it means less aid for the poor
• private investors do not need aid—there are many sources of private
capital and commercial finance available, and ODA would be wasted here
• subsidies distort investment decisions—artificially reducing costs/risks in
specific sectors will draw into them private resources that would be more
efficiently used elsewhere
• aid-based funding would undercut market-based sources—projects that
otherwise might have successfully approached existing investment funds
or banks will be attracted to lower-cost/risk financing
16. The first objection fails in the case of SMEs in LDC and SVE investment.
Research by IFIs and donors themselves shows that such investments are
Cotonou Agreement, Annex II, Terms and Conditions of Financing, Articles 2-4
An imaginative feature of these subsidies under Cotonou is that they can be capitalised and
paid up front to the beneficiary, or used to pay for relevant TA services to the enterprise.
35
36
39
effective in poverty alleviation: hence their energetic promotion in the ‘easier’
locations. The arguments in favour are even stronger in the more difficult
economies. The second objection similarly disregards the facts of the
situation, at least as seen by investors. The terms imposed by existing
sources of finance on the grounds of their costs and risks—arising from the
economy’s endowed characteristics—contribute to denying already costly
and risky projects an adequate return on investment.37
17. The third and fourth objections relate to distortionary effects. These can be
avoided by making cost/risk reducing assistance available across the whole
range of private commercial investment, so that there is no ‘elsewhere’ (these
are LDCs and SVEs, by definition looking for any feasible, productive and
legitimate project 38), and by limiting it to enterprises that are certified by a
participating financial institution to be ineligible for market-priced
financing.
18. Some concern was expressed that intervening to reduce capital costs could
cause distortion by favouring more capital-intensive projects, or biasing
project design towards greater use of capital, in circumstances where greater
economic benefit could be had from no intervention or from subsidising
labour costs. This concern seems more theoretical than real, given the likely
nature of SME investment in LDCs and SVEs. In agriculture, fisheries,
manufacturing and processing a certain level of capital intensity, often in
the form of second-hand machinery and equipment and now with an
increasing IT content, is inevitable. Decisions to buy or not buy such
equipment are driven by its availability—perhaps relocating from a related
enterprise—on advantageous terms, and by the product specifications
demanded by export markets.
19. For example, garment and footwear markets require standards of finish and
price that can only be achieved by a fairly well-established combination of
computer-controlled equipment and skilled workers; food processors must
meet exacting phyto-sanitary standards that unavoidably require
substantial capital outlays but also need the sensory skills of trained
workers; and IT-based enterprises have no choice but to invest in IT
equipment. The balance between capital and labour, which in any case
varies considerably among subsectors, is unlikely to be affected by the form
and extent of assistance with investment costs contemplated by this study.39
If intervention succeeds in inducing investment, it will inevitably create
employment.
Furthermore, to the extent that the conditions attaching to IFI facilities approximate those of
commercial lenders, they are competing with them, something they were not established to do—
the IFIs were set up to go where the commercial lenders are not (yet) prepared to go.
38 Everything but arms, that is.
39 A possible exception is the choice in the surface-swimming tuna fishery between capitalintensive purse-seining and labour-intensive pole-and line technology. But even here industry
trends, problems of access to bait fish resources and rising labour costs are driving out pole-andline operations.
37
40
The proper use of ODA
20. This report argues that offsetting the endowed high-cost and high-risk
characteristics of LDCs and SVEs, which reduce the profitability and drive
up the threshold return that investors require of SME investment, is a
legitimate use of ODA. Of course there are many causes of cost and risk that
are not endowed. They are caused by acts or omissions of governments or
other economic actors susceptible to government influence, and ODA plays
an important role in programmes to reduce them in virtually all LCDs and
SVEs. Those non-endowed, policy-susceptible costs and risks have to be
dealt with, or be convincingly seen to be in the process of rectification, for an
LDC or SVE to be eligible for ‘special and differential treatment’ by access to
a facility that can reduce the remaining, endowed, costs and risks to more
competitive levels.
21. If ODA is to be applied to investment cost and risks, how far should it go,
and what modalities would be appropriate? An indication of the size of the
‘risk premium’ demande d by lenders that drives up the cost of funds to the
investor —while doing the same to the investor’s own threshold rate of
return—is found in the lending rates applied to SMEs by commercial banks
in LDCs and SVEs, and the rates and other conditions applied by offshore
lenders to such SMEs. Typically these rates exceed the lender’s cost of funds
by a very large margin. Some borrowers are in individually weak positions
and pay for that weakness, but even relatively strong SMEs in Caribbean
and Pacific LDC-SVEs are paying interest rates very much higher40 than
their overseas competitors, and their controlling investors are similarly
burdened. To the extent that this risk premium relates to endowed rather
than policy-susceptible risk, reducing it will be a legitimate use of ODA.
22. The nature of the financial risk can be split into
•
business risk, which relates to the commercial probability of the
enterprise achieving its financial objectives, and is the area where the
appraisal expertise of commercial banks should operate to good effect
•
LDC/SVE risk , comprising those risks that arise from a low level of
economic and social development, small size, remoteness and
vulnerability to economic and climatic shocks
•
exchange risk , which applies only to foreign-currency or cross-border
investment or financing, and is related but not confined to LDC/SVE risk
•
political risk, such as can in principle be insured against with MIGA, but
for SMEs in these countries practically never is, being borne willy-nilly by
the investor and influencing the threshold rate of return
Only the first of these risk categories, business risk , can be significantly
affected by the investor through the way the business is set up and
40
At least double, in most SVEs.
41
operated. The others are external to the business, but are priced directly or
indirectly into its costs, in the amount the business has to pay for finance. It
is here that ODA may properly be used to reduce the ‘endowed penalties’ of
an LDC or SVE location.
Proposed aims and methods
23. The aim would be to use the financial strength of the existing IFIs to provide
loan and investment capital, shift the financial penalty of the ‘endowed
handicap’ off the SMEs and onto the IFIs and aid donors—who are also the
IFIs’ shareholders—and minimise the risk of new hazards, moral or
otherwise, arising from the use of ODA.
The proposed system would be designed to
•
•
•
•
•
make loans and related investment-financing facilities available at the
rates that apply to sovereign borrowers from the funding IFI’s
ordinary capital resources
relieve the SME of the cost effects of foreign exchange risk by
denominating all loans in domestic currency (ie, the funding IFI
carries the risk and does not charge borrower for it)
offer insurance for political risk at a specially low rate through a
modified MIGA facility
bundle these facilities together in an off-balance-sheet package 41
available, with certain other services, through participating DCBs in
return for a fee paid by the managing IFI
meet the costs of these arrangements, over and above the payments
made by the beneficiary SME, from IFI income and aid donor funds
24. The ‘other services’ required from participating DCBs would include
•
•
•
•
•
•
•
actively seeking suitable SME users of the facility
assessing the business plans of the SME and recommending
assistance
certifying that without the assistance the enterprise is not viable
acting as the conduit and monitor for the IFI financing, through an
off-balance sheet funding process
undertaking to provide all normal banking facilities, overdrafts, trade
finance, etc, to clients of the facility at ‘most favoured customer’ rates
in the case of a guarantee from the facility for a bank loan, providing
a minimum portion of the loan without guarantee
full accounting and regular reporting
As stated earlier in the report, the active participation of DCBs (and the
non-participation of governments, at the operational level anyway) would
be critical to the success of such an arrangement, by making sure that it
Off-balance-sheet, fee-earning business presents fewer prudential and regulatory problems and
more reliable net income prospects for participating banks, some of whose balance sheets—
particularly in the Caribbean —have been weakened by past loan losses.
41
42
was both market-friendly and reasonably hard-nosed. Discussions
during the preparation of this report indicated that most DCBs would be
ready to give serious and positive consideration to such a proposal.
25. Those arrangements would go some way towards meeting the needs of SMEs
in the smaller and weaker economies for capi tal on terms that would assist
them to compete with the rest of the world, without eroding entrepreneurial
spirit, commercial judgement and the ‘discipline of the market’. The
resulting borrowing costs would be lower than they are in most non-LDC
developing economies, but would still be a real cost to the enterprise. The
psychological effect of this degree of ‘investment preference’ would not be to
‘force -feed investors’—as one of the study’s collocutors put it—but to offset
some at least of the cost handicaps facing LDC and SMEs as they seek out
potential SME investment. Once investors believed it was here to stay, it
could be expected to reduce the threshold rate of return by significantly
reducing the risks of LDC and SVE investment.
26. If there is IFI and government support for the concept, how should it be
taken forward? The next chapter examines the feasibility of establishing a
separate dedicated facility for this purpose, described in a model form in Box
G, and compares it with a scheme of ‘ coordinated convergence’, in which
existing facilities retain their separate identity but are progressively modified
to take on the key characteristics of the model.
43
Chapter 6 : Feasibility of aid-based, market-driven facilities
1. The feasibility of possible solutions has to be tested against both political
and technical criteria, as follows:
•
on the political side, is there enough support for it, and if not, could such
support be created? Who are the likely winners and losers, and how
influential are they? How does the proposal connect to and affect other
trends and shifts in power and allegiance? What is at risk, and for
whom?
•
on the technical side, are the objectives clear, the resources available and
the constraints identified? Are the proposed internal actions technically
do-able at acceptable cost, and how likely are they to produce the
expected benefits? Is competent management available, and are the
assumptions about external conditions realistic? What risks are
identified and how are they to be contained?
2. While ‘do nothing’ is always there as the default option, this study has taken
the Commonwealth Secretariat and World Bank view that in the case of the
LDCs and SVEs doing nothing is, as a rule, a poor choice. This chapter
therefore compares two approaches to the reduction of investment costs and
risks by official intervention: first, a new facility on the lines of the model
described in Box G; and second, a scheme of ‘coordinated convergence’, in
which existing facilities are progressively modified by their sponsors to take
on as many of the key features of the model as possible, without losing their
separate institutional identity and financial autonomy.
Box G: Outline of an aid-based, market-driven facility
This box describes a new, separate financial instrument aimed at the needs described
in earlier chapters. For effective intervention, it should be well funded, readily and
promptly accessible, flexible to varying situations and needs, under decentralised
management, operating transparently unde r clear and stable conditions and strong
accountability, dynamic and risk-taking but with effective safeguards against waste.
The model is a subscribed and substantially paid-up fund, called for the purposes of
discussion the Investment Preference Fund (IPF).
IPF would be established on a joint and tripartite basis by the World Bank Group
(represented by IFC), the European Union (represented by EIB), and the regional
multilateral development banks (MDBs)—including the Caribbean Development Bank—
with responsibility for the provision of capital divided among them in three equal parts.
The one -third share of the MDBs would be further allocated among them according to
the economic weight of their IPF-eligible members.
44
The purpose of IPF would be to assist private investment in the production of traded
goods and services (start-up, acquisition, restructuring or rehabilitation) in eligible
states. It would do so by providing domestic-currency loans, quasi-equity investment
capital and guarantees to qualifying enterprises at rates and maturities and on other
terms broadly equivalent to those provided by its sponsoring IFIs to mainstream LDC
sovereign borrowers from their ordinary capital resources. It would also ‘retail’ a
specially simplified form of MIGA cover for political risk.
For their resident SMEs to be eligible for IPF assistance, states would have to be
members in good standing of one of the regional MDBs and of the World Bank, and be
currently rated by both the relevant IFI as being in a satisfactory condition of macroeconomic stability or in the process of implementing policy and structural reforms
expected to lead to such a condition within a short period—say three years. They would
also have to be rated as LDCs and/or SVEs by an agreed rating system—probably a
combination of classifications in use or presently under development by the UN and the
Commonwealth Secretariat, and endorsed by the World Bank.
The ‘marketing’, enterprise evaluation, processing, disbursement, monitoring and aftercare of IPF-funded loans and investments would be undertaken by participating
domestic commercial banks (DCBs) in each country, under contract to the appropriate
IFI, as off-balance-sheet business in return for a fee paid by the IFI that included a
performance-based component. Any qualified DCB would be eligible for IPF contract if it
so wished. To qualify, a DCB would have to be in good standing with all relevant
banking supervisory authorities, ie, not in breach of any statutory requirements or
prudential or other administrative directions of such authority, be represented in all
main centres of population and economic activity and have a substantial part of its
existing banking business in the export sector.
Participating DCBs would undertake to provide all normal commercial banking and
trade financing facilities to enterprises receiving IPF funds or guarantees, on terms
(interest rates, grace periods and maturities, collateral security) as good as or better
than the best of those available to comparable enterprises, subject to the DCB’s overriding right to withdraw or curtail facilities on prudential grounds after notifying all
concerned. The DCB would contractually agree that in the event of such an event, or
other enterprise stress or failure necessitating re structuring or winding up, IPF-funded
loans would rank equally for recovery with the DCB’s own-funds lending.
Enterprise eligibility rules for IPF assistance would include
• enterprise is formally incorporated and holds all necessary investment
approvals, licences, land leases etc
• will produce traded goods and/or services without special tariff protection or
special government subsidy to enterprise operating costs/revenues, ie, generally
applicable tariffs, utilities costs etc will apply to the enterprise
• IPF assistance will go into start-up investment or substantial expansion,
restructuring or rehabilitation of existing enterprise
• enterprise is rated by participating DCB as a bankable credit risk with the
proposed IPF assistance (copy of the bank’s formal evaluation, including
assessment of financial structure and expected performance, production
technology, management capability and market prospects, to be provided to the
regional IFI) but not otherwise —ie the DCB asserts that IPF assistance is
necessary for the investment to proceed
45
•
IPF facilities, including the amount of any loan funds covered by IPF guarantee,
would normally constitute not more than 50% of the capital finances of the
enterprise, with an upper limit in exceptional circumstances of 67%
Assistance available from IPF would include
• long term loans in local currency reticulated through the participating DCB at
no on-cost 42 , the DCB obtaining its reward from the contracted management fee
and the enhanced commercial banking activity induced by the IPF funding.
• quasi-equity investments, eg, non-dividend-earning shares with an agreed buyout time and profit-sharing price, or participating loans free of interest until an
agreed (and verifiable) level of profitability is reached, to be made and managed
by the DCB as agent for the IPF (full cost and risk is for IPF)
• non-controlling ordinary equity investments
• guarantees for loans from the participating DCB and/or other commercial
lenders, subject to the terms being on most-favoured-borrower terms, the
guarantee not covering more than an agreed portion of the lender’s risk, ie, the
lender must retain a significant exposure, and the lender taking all reasonable
steps to recover the loan in full before calling on the guarantee.
• retailing of MIGA insurance for political risk (see below)
Formal and enforceable contracts governing the details of these arrangements would
exist between: IPF and the regional IFIs; IFIs and DCBs; DCBs and beneficiary
enterprises. Funds owed or belonging to IPF would have the same exchange control
status as other funds of IFIs.
The operating costs and any foreign exchange and lending-related or investment losses
of IPF, over and above the interest and fees paid to IPF by beneficiary enterprises
through the DCB, would be for the account of IPF, to be met from its treasury income
from financial reserves invested in OECD markets, and grant contributions to IPF for
this purpose from its aid donor shareholders.
Arrangements would be developed with MIGA such that a simplified and circumscribed
form of MIGA coverage against political risk could be retailed by IPF through DCBs as
an optional, for-payment part of the assistance package offered to SMEs.
There would be no direct LDC and SVE government involvement in the working of this
process, apart from issue of the necessary investment approvals. The process would be
overseen by the IFIs, in which governments have full membership rights to information
and participate in policy formulation through Board representation.
A new facility
3. The political feasibility of a new facility is heavily conditioned by the prior
existence of a number of institutions whose stated aims appear to occupy
much of the same ground. Box F has given a quick overview of these
institutions. None of them embodies all the features of the model single
facility, but many of them are in principle capable of providing most of its
main services—equity investment, loans, quasi-equity, guarantees—albeit
The effect would be a reduction of 5-15 percentage points in most LDCs and SVEs, a cut of 5075% in the lending rates presently faced by investors. Consultations for this study in the
Caribbean region indicated that this would significantly improve the viability of existing SMEs,
and the same is expected to apply elsewhere.
42
46
on terms that are intended to reflect the additional risk of LDC and SVE
operations. The problem is, first, that this capability is not translated into a
significant level of activity in the weaker economies, for reasons explored
earlier; and second, that the pricing-in and ‘conditioning-in’ of LDC and SVE
risk adds to the already high costs and risks of the private investor who
might want to use these facilities if he could access them.
4. In consultations for this study there was, understandably enough, no
enthusiasm among the IFIs for the creation of a new facility. The gist of most
responses was either that the existing facilities are up to the job but they
just haven’t yet got round to dealing with LDCs and SVEs; or that their
terms and conditions do need further review to fit the situation of the
weaker economies but they have the intellectual resources to do this, and it
is best done through existing review processes—with the implication that
there are so many other reasons why investment doesn’t take place in LDCs
and SVEs that such a review is not a high priority.
5. As private sector operations in LDCs and SVEs are a tiny part of IFI activity
and few institutional careers are being built on its success, there may not be
much opposition based on fear of job loss or ‘turf encroachment’ . Any IFI
opposition would more likely be based on the argument that the required
human and financial resources are scarce, allocations to a new facility
would have to be taken from some other part of the aid-and-IFI basket, and
resources are more efficiently used in economies where the hassle factor is
smaller and the unit cost of operations lower.43
6. Governments of LDCs and SVEs were not specifically consulted for this
study, but judging by many years of policy statements and interventions at
IFI annual meetings they could be expected to support any practical
measure that could improve their chances of attracting private investment,
provided that aid for other forms of development was not reduced. Political
support for a new facility would depend on the perceived political costs and
benefits in a many-sided context of aid relationships, and of course on what
alternative paths to the same ends were available.
7. The technical feasibility of the separate facility would revolve around the
costing of a set of activities and an assumed growth path, including prudent
assumptions about the expected level of foreign exchange and
credit/investment losses, with clear prescriptions for decentralised
management and accountability, linked to the securing of IFI and donor
support to underwrite a given level of activity. Final political approval would
no doubt depend on a satisfactory technical assessment and an affordable
level of expected costs, but the decision in principle to commit ODA
resources to this purpose would need to be taken before a comprehensive
technical study was launched.
The objection that a new aid-based facility would undercut market-based facilities was
mentioned earlier. It can be dealt with by restricting the new facility to SMEs that are not able to
access market-priced facilities.
43
47
Coordinated convergence
8. The alternative course of action against which a new facility should be
compared appears to be a scheme of ‘coordinated convergence’ among IFIs
and their facilities that are intended to assist SMEs in the weaker
economies. Under such a scheme the IFIs would agree on a destination—a
broadly similar set of aid-based facilities available to SMEs in all LDCs and
SVEs, somewhat on the lines sketched in this report—and a route to get
there, by progressively modifying their existing facilities, marching more or
less in step, until the agreed set of ‘global’ standards prevailed.
9. To do this, the IFIs, interested aid donors and—in some manageable form—
representatives of LDC and SVE governments, would need jointly to
•
resolve to make substantial adjustments to the facilities available to
SMEs in the weaker economies broadly on the lines advocated in this
report
•
agree on the specific characteristics and standards of facilities that
are to be achieved
•
set up a planning , coordinating and monitoring body to drive and
report on the process
•
periodically review progress and clear matters referred by the
coordinating body
10. If this study’s argument for improvement of facilities is accepted in principle,
the political feasibility of the ‘coordinated convergence’ route is less
problematic than that of a ‘new facility’ . Convergence has the advantage of
leaving policy-making with the existing institutions, not threatening any
institutional turf or professional careers—it enhances them, actually—and
offering the prospect of much faster implementation than could conceivably
be achieved with the ‘new facility’ approach.
11. The crucial issue of financing the overhead and operating costs and
providing against potential foreign exchange, credit and investment losses
from outside the operating revenues of the enhanced LDC/SVE facilities
remains to be dealt with. But this too may be more readily addressed and
resolved within each existing institution, among aid-donor shareholders
and managements with known records of prudence and a high level of interpersonal confidence, than in the context of a new institution with new
management venturing untried into risk-strewn territory. The technical
feasibility of the coordinated convergence route would thus be examined
within each participating IFI and ideas pooled through the coordinating
mechanism already mentioned.
48
12. On balance, and in the light of the consultations for this study, the
‘coordinated convergence’ approach appears to be politically more feasible
and almost certainly faster to produce results, than the creation of a new
and distinct facility. It is quite conceivable that after a period of successful
pursuit of the convergence strategy the IFIs and their shareholders might
decide that institutional changes amounting to the creation of a new facility
were both desirable and feasible. For the present, coordinated convergence
looks a more practicable way of achieving what needs to be done.
49
Chapter 7: Recommendations
1. Based on the foregoing argument, the report makes two recommendations.
They are directed to Commonwealth Secretariat and the IFIs whose officials
provided such ready, helpful and comprehensive information and advice
during the study’s consultations.
2. The first recommendation is that
the special problem faced by LDCs and SVEs in attracting private
investment be formally recognised as one deserving of greater attention
and more resources than it is presently receiving.
There is in the IFIs a tendency both to treat the problem as too difficult—and
it is genuinely difficult—and to justify inaction in compensating for endowed
handicaps by pointing out, with some truth, that there is still much to be
done to eliminate man-made obstacles to investment.
3. This report has discussed many of the components of the problem’s difficult
nature with the aim of making them less of a deterrent to action. The fact
that many policy-based obstacles remain should not preclude intensive work
on ways of further reducing the investor’s costs and risks: access by SMEs
to those enhanced facilities should then be conditional on the host LDC or
SVE having a clean bill of health on the policy and regulatory front.
4. The second recommendation is that
IFIs, interested aid donors and governments should collaborate in devising
ways of increasing private sector investment in LDCs and SVEs
There is a great amount of relevant experience and insight available within
individual IFIs and their specialised offshoots that is not being shared with
other IFIs and with governments, partly because of a natural disinclination
to do so, partly for lack of a suitable forum in which to do it. To a large
extent this report is aiming to create an agenda and an environment for
collaboration, as much as it is trying to identify specific solutions.
5. A two-stage process to create a collaborative forum may be best. The first
stage might be a meeting of IFIs jointly convened by the Commonwealth
Secretariat and the IFC, somewhat in the way the Secretariat and the World
Bank collaborated over the small states exercise. Such a meeting might
consider and comment on this report, among other material, and propose
such course of action as it saw fit—a new facility, coordinated convergence,
or another approach altoge ther, with recommended machinery of
implementation. At a second stage, aid donors and LDC/SVE governments
might also join, to consider the outcome of the first meeting and if they saw
fit, to adopt it and make supportive commitments of ODA and political
backing there and in other forums.