CONTEMPORARY ISSUES IN
DEVELOPMENT FINANCE
Contemporary Issues in Development Finance provides comprehensive and up-to-date
coverage of theoretical and policy issues in development fnance from both the
domestic and the external fnance perspectives and emphasizes addressing the gaps
in fnancial markets.
The chapters cover topical issues such as microfnance, private sector fnancing,
aid, FDI, remittances, sovereign wealth, trade fnance, and the sectoral fnancing
of agricultural and infrastructural projects. Readers will acquire both breadth and
depth of knowledge in critical and contemporary issues in development fnance from
a philosophical and yet pragmatic development impact approach. The text ensures
this by carefully integrating the relevant theoretical underpinnings, empirical
assessments, and practical policy issues into its analysis. The work is designed to be
fully accessible to practitioners with only a limited theoretical economic background,
allowing them to deeply engage with the book as useful reference material. Readers
may fnd more advanced information and technical details provided in clear, concise
boxes throughout the text. Finally, each chapter is fully supported by a set of review
questions and by cases and examples from developing countries, particularly those
in Africa.
This book is a valuable resource for both development fnance researchers
and students taking courses in development fnance, development economics,
international fnance, fnancial development policy, and economic policy
management. Practitioners will fnd the development impact, policy, and conceptual
analysis dimensions insightful analysing and designing intervention strategies.
Joshua Yindenaba Abor is a Professor of Finance at the Department of Finance,
University of Ghana Business School, Ghana. He is also a Visiting Professor of
Development Finance at the University of Stellenbosch Business School, South Africa.
He has made signifcant contributions to fnancial economics literature, mainly in the
areas of banking and fnance, development fnance, fnancial market development,
corporate fnance and governance, international fnancial fows, and growth.
Charles Komla Delali Adjasi is a Professor of Development Finance and Economics
at the University of Stellenbosch Business School, South Africa. He is also a Visiting
Professor at the Department of Economics, Econometrics and Finance, University of
Groningen, the Netherlands. His research focuses on fnancial markets development,
frm productivity, international trade, and household welfare.
Robert Lensink is a Professor of Finance and Financial Markets at the Department
of Economics, Econometrics and Finance, University of Groningen, the Netherlands.
He is also a Professor of Finance and Development at the Development Economics
Group, Wageningen University & Research, and has published widely in the area of
development fnance.
“This book provides an excellent overview of the challenges of fnancial sector
development in developing countries. The different chapters touch on all the
relevant dimensions, including international capital fows, microfnance and
fnancial inclusion. An important contribution to our feld!”
– Thorsten Beck, Professor of Banking and Finance,
The Business School (formerly Cass), University of London, UK
“An abundance of literature exists in development fnance, but this book will be an
important ‘one-stop shop’ for researchers, teachers, and policy makers. It is thematic
and coherent. The underpinning is on contemporary theories and empirics linking
fnance and development with emphasis on inclusive development. This is because
fnancial sector development alone does not ensure inclusive fnance that is vital for
inclusive development. The fnancial instruments considered are also wide ranging;
so are the players who can help bridge the fnancial development gap.”
– Lemma Senbet, The William E. Mayer Chair Professor of Finance,
University of Maryland, USA; Immediate Past Executive
Director/CEO, African Economic Research Consortium
CONTEMPORARY ISSUES IN
DEVELOPMENT FINANCE
Edited by Joshua Yindenaba Abor,
Charles Komla Delali Adjasi and
Robert Lensink
First published 2021
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
52 Vanderbilt Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2021 selection and editorial matter, Joshua Yindenaba Abor, Charles Komla Delali
Adjasi and Robert Lensink; individual chapters, the contributors
The right of Joshua Yindenaba Abor, Charles Komla Delali Adjasi and Robert
Lensink to be identifed as the authors of the editorial material, and of the authors
for their individual chapters, has been asserted in accordance with sections 77 and
78 of the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or utilised
in any form or by any electronic, mechanical, or other means, now known or
hereafter invented, including photocopying and recording, or in any information
storage or retrieval system, without permission in writing from the publishers.
Trademark notice: Product or corporate names may be trademarks or registered
trademarks, and are used only for identifcation and explanation without intent to
infringe.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
A catalog record for this book has been requested
ISBN: 978-1-138-32431-2 (hbk)
ISBN: 978-1-138-32432-9 (pbk)
ISBN: 978-0-429-45095-2 (ebk)
Typeset in Palatino
by Apex CoVantage, LLC
CONTENTS
List of fgures vii
List of tables ix
List of contributors xi
Acknowledgements xv
Chapter 1
Introduction to contemporary issues in development
fnance 1
Joshua Yindenaba abor, Charles Komla delali adJasi,
and robert lensinK
Chapter 2
Finance, economic growth, and development 20
lordina amoah, Charles Komla delali adJasi, issouf soumare,
Kofi aChampong osei, Joshua Yindenaba abor, ebenezer bugri
anarfo, Charles amo-YarteY, and isaaC otChere
Chapter 3
Microfnance and development
niels hermes and robert lensinK
Chapter 4
Private capital fows and economic growth 73
eliKplimi Komla agbloYor, alfred Yawson, and pieter opperman
Chapter 5
Remittances and development 104
hanna fromell, tobias grohmann, and robert lensinK
Chapter 6
Foreign aid and economic development 140
matthew Kofi oCran, bernardin senadza, and eriC osei-assibeY
Chapter 7
Global fnancial architecture: emerging issues and
agenda for reforms 169
Joshua Yindenaba abor, angela azumah alu,
david mathuva, and Joe nellis
Chapter 8
Sovereign wealth management 207
mbaKo mbo and Charles Komla delali adJasi
Chapter 9
Sovereign debt management 235
amin Karimu, vera fiador, and imhotep paul alagidede
51
Chapter 10 Financial inclusion and economic growth
Joshua Yindenaba abor, haruna issahaKu,
mohammed amidu, and viCtor murinde
263
vi
Contents
Chapter 11 Financing agriculture for inclusive development 287
haruna issahaKu, edward asiedu, paul Kwame nKegbe,
and robert osei
Chapter 12 Financing sustainable development: new insights
for the present and the future 318
gordon abeKah-nKrumah, patriCK o. assuming,
patienCe aseweh abor, and Jabir ibrahim mohammed
Chapter 13 International trade, fnance, and development
steven braKman and Charles van marrewiJK
351
Chapter 14 Infrastructure fnancing and economic development
saint Kuttu, ashenafi fanta, miChael graham,
and Joshua Yindenaba abor
Chapter 15 Finance and economic development: the role of the
private sector 411
eliKplimi Komla agbloYor, Joshua Yindenaba abor,
haruna issahaKu, and Charles Komla delali adJasi
Index
435
385
FIGURES
1.1
2.1
2.2
3.1
4.1
4.2
4.3
4.4
4.5
5.1
5.2
5.3
6.1
6.2
6.3
6.4
7.1
7.2
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
9.1
Credit rationing and its implications
Domestic credit by banking sector (% GDP) across
income groups
Domestic credit by banking sector (% GDP) by regional
classifcation
Microfnance services
Trends in private capital fows to Africa, 2000–2016
Scatter plot between capital fows and GDP per capita,
2000–2016
Scatter plot between capital fows and CO2 emissions,
2000–2016
Scatter plot between capital fows and institutions,
2000–2016
Scatter plot between capital fows and natural resource
rents, 2000–2016
Capital infows to low- and middle-income countries,
in billions USD
Received remittances by country-level income group,
in billions current USD
Remittances in percentage of GDP by country-level
income group
Total volume of ODA in constant 2015 prices, 1960–2016
Sub-Saharan Africa’s share of ODA, 2005–2015
The aid Laffer curve
Global 2017 CPI score and ranking
Representation of Article 1 of the IMF
Benefts and risks of fnancial globalisation
A conceptual framework for SWF
Evolution of SWF over time
Cumulative growth in the number of funds, 1953–2017
SWF by source of seed capital
Evolution of SWFs in Asia (pre-2007/2008 fnancial crisis)
Trends in the Middle East: oil prices and production
Evolution of SWFs in the Middle East (pre-2007/2008
fnancial crisis)
Evolution of SWFs in Africa (pre-2007/2008 fnancial crisis)
Evolution of SWFs in other parts of the world
(pre-2007/2008 fnancial crisis)
Evolution of SWFs: the aftermath of the 2007/2008
global fnancial crisis
Evolution of SWFs post-2007/2008 global fnancial crisis
A typical sovereign balance sheet
Components of the Santiago SWF principles
Debt Laffer curve
7
33
34
55
75
78
79
86
89
105
106
107
147
148
156
160
172
194
209
210
210
212
213
214
214
215
215
216
217
224
231
241
viii
9.2
11.1
11.2
11.3
11.4
11.5
13.1
13.2
13.3
13.4
13.5
13.6
13.7
13.8
13.9
13.10
13.11
13.12
13.13
13.14
13.15
13.16
13.17
14.1
15.1
15.2
Figures
Scatter plot with a ftted line
Agriculture value added per worker, constant 2010 USD
Agriculture value added per worker, constant 2000 USD
Employment shares by sector (% in total employment)
Share of FDI to agriculture in total FDI (%), 2011
Share of agriculture credit in total credit, 2015
Swiss franc, Canadian dollar, and South African rand;
daily data, 2000–2020
Real effective exchange rate and nominal exchange rate;
China, 1990–2020
British pound to euro spot and three-month forward
exchange rates, 2016
British pound to euro spot rate and three-month
forward premium, 2009–2016
Two investment options
Assumptions, interest parity, and market effciency
Argentina: interest rates, growth, and infation;
percent, 1994–2018
Argentina reference interest rate; 7-Day Leliq Rate,
2016–2020
The policy trilemma
Overview of international monetary regimes
Spider web spiral: world imports in millions US gold
dollar, 1929–1933
De facto exchange rate arrangements; 30 April 2014
Proposed and rejected trade fnance transactions;
by region (%), 2017
Proposed and rejected trade fnance transactions;
by frm size (%), 2017
Why trade fnance proposals were rejected; % of
applications, 2019
Outcome of efforts to seek alternative trade fnancing;
SMEs (%), 2019
Distribution of FDI; advanced, developing, and
transition countries, 1975–2014
Number of PPP projects undertaken in South
Africa between 1993 and 2017
Top recipients of FDI fows in Africa (billions of dollars),
2014–2015
Remittances dependent countries in SSA, 2017
242
291
291
292
295
296
354
355
357
358
359
362
363
363
365
366
368
372
373
374
374
375
378
402
425
426
TABLES
2.1
2.2
4.1
7.1
7.2
10.1
11.1
11.2
11.3
A13.1
12.1
12.2
12.3
12.4
13.1
13.2
13.3
13.4
13.5
13.6
14.1
15.1
Stock markets in sub-Saharan Africa
Average financial structures of high-income vs low-income
countries, 2015
Private capital fows to Africa in 2016: best and
worst performers
Overview of RDBs
Financial products and services addressing the SDGs
Trends in fnancial inclusion: SSA and World
Contribution of agriculture to GDP (%)
Agricultural raw materials exports (% of merchandise
exports)
Commodity exchanges in Africa
Agriculture value added per worker (constant 2010 USD)
MDGs and SDGs
Differences between SDGs and MDGs
Percentage contribution of different health fnancing
sources to current health expenditure in 2015
Trends in DAH from 2008 to 2017 in billions USD and
component contributions in percentages
Some international currency symbols
Spot exchange rates on 3 December 2019 at 11:55:00 a.m.
(UTC + 01:00)
Cross-exchange rates; spot, 3 December 2019
at 11:55:00 a.m. (UTC + 01:00)
The policy trilemma and the international economic
order
IMF exchange rate classifcation system
Functions of international currencies
Financing structure
Africa-focused private equity (PE) capital raised in
the past ten years by domestic manager location
37
39
102
187
204
267
289
294
305
317
323
324
342
345
352
352
355
370
371
376
396
421
CONTRIBUTORS
Gordon Abekah-Nkrumah is a senior lecturer in the Department of Public Administration and Health Services Management, University of Ghana
Business School, Ghana.
Joshua Yindenaba Abor is a professor of fnance at the Department of
Finance, University of Ghana Business School, Ghana. He is also a visiting
professor of development fnance at the University of Stellenbosch Business
School, South Africa.
Patience Aseweh Abor is a senior lecturer in the Department of Public
Administration and Health Services Management, University of Ghana
Business School, Ghana.
Charles Komla Delali Adjasi is a professor of development fnance and
economics at University of Stellenbosch Business School, South Africa. He is
also a visiting professor at the Department of Economics, Econometrics and
Finance, University of Groningen, the Netherlands.
Elikplimi Komla Agbloyor is a senior lecturer in fnance at the Department
of Finance, University of Ghana Business School, Ghana.
Imhotep Paul Alagidede is a professor of fnance at Wits Business School,
University of the Witwatersrand, Johannesburg, South Africa.
Angela Azumah Alu is a doctoral researcher in fnance at the Department
of Finance, University of Ghana Business School, Ghana.
Mohammed Amidu is an associate professor of accounting and fnance
at the Department of Accounting, University of Ghana Business School,
Ghana.
Charles Amo-Yartey is a senior economist in the African Department of the
International Monetary Fund, Washington, DC, USA. He was previously
the IMF resident representative in Liberia.
Lordina Amoah is a lecturer at the Department of Finance, University of
Ghana Business School, Ghana.
Ebenezer Bugri Anarfo is a senior lecturer at the Ghana Institute of Management and Public Administration, Ghana.
Edward Asiedu is a lecturer at the Department of Finance, University of
Ghana Business School, Ghana, and an affliate research fellow chair of
development economics, University of Passau, Germany.
Patrick O. Assuming is a senior lecturer in economics at the Department of
Finance, University of Ghana Business School, Ghana.
Steven Brakman is a professor of international economics at University of
Groningen, the Netherlands.
xii
Contributors
Ashenaf Fanta is a senior lecturer in development fnance at University of
Stellenbosch Business School, South Africa.
Vera Fiador is a senior lecturer in fnance at the Department of Finance,
University of Ghana Business School, Ghana.
Hanna Fromell is an assistant professor of fnance at the Department of
Economics, Econometrics and Finance, University of Groningen, the
Netherlands.
Michael Graham is a professor of corporate fnance and the head of development fnance programmes at University of Stellenbosch Business School,
South Africa.
Tobias Grohmann is a doctoral researcher at the Department of Economics,
Econometrics and Finance, University of Groningen, the Netherlands.
Niels Hermes is a professor of fnance and the chair of Department of
Economics, Econometrics and Finance at the University of Groningen, the
Netherlands.
Haruna Issahaku is a senior lecturer in economics and fnance and the
head of the Department of Economics and Entrepreneurship, University for
Development Studies, Tamale, Ghana.
Amin Karimu is a lecturer at the University of Ghana Business School
and a researcher at the Centre for Environmental and Resource Economics
(CERE), Sweden.
Saint Kuttu is a senior lecturer in fnance and risk management at the
Department of Finance, University of Ghana Business School, Ghana.
Robert Lensink is a professor of fnance and fnancial markets at the Department of Economics, Econometrics and Finance, University of Groningen,
the Netherlands. He is also a professor of fnance and development at the
Development Economics Group, Wageningen University & Research.
David Mathuva is a senior lecturer, the director of the undergraduate programmes, and the academic director of the master of science in development fnance programme at Strathmore University Business School, Kenya.
Mbako Mbo is a fnance practitioner specializing in development fnance
institutions and a chief fnancial offcer, Botswana Development Corporation, Botswana.
Jabir Ibrahim Mohammed is a doctoral researcher in fnance at the Department of Finance, University of Ghana Business School, Ghana, and a fellow
at PFM-Tax NetWork Africa.
Victor Murinde is an AXA professor in global fnance and the head of the
School of Finance and Management at SOAS University of London, UK.
Joe Nellis is a deputy dean and a professor of global economy, School of
Management, Cranfeld University, UK.
Contributors
xiii
Paul Kwame Nkegbe is an associate professor of applied and agricultural
economics and the dean of the Faculty of Integrated Development Studies,
University for Development Studies, Tamale, Ghana.
Matthew Kof Ocran is a professor of economics and deputy dean of the
faculty of economic and management sciences, University of the Western
Cape, Cape Town, South Africa.
Pieter Opperman is a lecturer in development fnance at the University of
Stellenbosch Business School, South Africa.
Eric Osei-Assibey is an associate professor of economics at the Department
of Economics, University of Ghana, Ghana.
Kof Achampong Osei is an associate professor of fnance at the Department of Finance, University of Ghana Business School, Ghana.
Robert Osei is an associate professor of economics at the Institute of Statistical, Social and Economic Research (ISSER), University of Ghana, Legon,
Ghana, and also the vice dean of the School of Graduate Studies at the University of Ghana.
Isaac Otchere is a professor of fnance at the Sprott School of Business, Carleton University, Ottawa, Canada.
Bernardin Senadza is an associate professor of economics at the Department of Economics, University of Ghana, Ghana.
Issouf Soumare is a professor of fnance and the director of the Laboratory
for Financial Engineering at Laval University, Canada.
Charles van Marrewijk is a professor of international economics at the
Utrecht University School of Economics, the Netherlands.
Alfred Yawson is a professor in corporate fnance at the University of Adelaide Business School, Australia.
ACKNOWLEDGEMENTS
JOSHUA YINDENABA ABOR
To my wife, Pat and our children, Ivana, Bastien and Venka for their love,
support and encouragement. Also, to my parents, Abor Ndobire and Amina
Tobga for their inspiration. I really appreciate my colleague co-editors
Charles and Robert for the great and exceptional work in executing this
book project. I actually enjoyed collaborating with them. I wish to specially
thank Lordina, Issouf, Kof, Ebenezer, Charles, Isaac, Angela, David, Joe,
Haruna, Mohammed, Victor, Saint, Ashenaf, Michael and Elikplimi for coauthoring some of the chapters with me.
CHARLES KOMLA DELALI ADJASI
To my wife Chewe Sakha Adjasi and our boys Delali and Dalitso for their
love, support, encouragement and for tolerating Daddy’s endless late
nights. To my father W.O. K. Adjasi and my late mother D.A.M. Buachie
(Auntie Mansah) for your blessings. I would like to thank my co-editors
Joshua Yindenaba Abor and Robert Lensink for the sterling initiatives and
collaborative effort in getting this book project completed. I also thank in
particular Robert Lensink, Niels Hermes and Grietje Pol and the colleagues
of the Department of Economics, Econometrics and Finance, University of
Groningen for the wonderful accommodation during my sabbatical.
ROBERT LENSINK
To my lovely daughter Myrthe. I became involved in co-editing this book
during the sabbatical of Charles at the University of Groningen. I am very
grateful to him and Joshua that they invited me to join the team, and look
forward to new joint projects in the future. I wish to express special thanks
to Hanna Fromell, Tobias Grohmann and Niels Hermes for co-authoring
two chapters with me.
GENERAL
The editors would like to take the opportunity to thank all contributing
authors for the high quality of their chapters. A big thank you to Eva Spek
for the meticulous and excellent language and technical editing. We also
would like to thank our reviewers for each chapter.
CHAPTER
1
Introduction to
contemporary issues in
development fnance
Joshua Yindenaba Abor, Charles Komla Delali Adjasi
and Robert Lensink
1.1 INTRODUCTION
The importance of fnance in the economic growth and development process cannot be overemphasised. The literature is replete with evidence that
suggests that fnance contributes signifcantly to the economic growth and
development process in any county. Although the extant literature generally supports the fact that fnance and, for that matter, the fnancial sector are necessary for spurring economic growth by mobilising savings for
investments, some have argued in recent times that it can also be a cause
of fragility (where regulation is ineffective), as witnessed during the global
fnancial crisis, the eurozone crisis, and the banking crises observed in
certain economies. When the fnancial sector does not function properly,
opportunities for growth and development are lost, resulting in inequalities and in some cases crises. However, when the fnancial sector functions
effciently, it provides the avenues for market players to take advantage of
investment opportunities by channelling funds for production, thus driving
economic growth and development.
Discussions in the fnance and growth literature thus focused on the
level of fnancial sector development. This was also in line with the view that
the fnance–growth link is stronger in well-developed fnancial systems and
led to substantial dialogue around the depth, size, effciency, and outreach
of the fnancial sector. The type and the structure of the fnancial system
in particular, whether bank based or market based, also became important
points of debate in the fnance–growth nexus. By the mid 2000s, however,
the discussion moved to fnancial inclusion and emphasised access to fnancial services by the low income. The development of mobile money as a
way to increase access further boosted this literature on fnancial inclusion.
Financial inclusion soon became a prominent part of growth-enhancing
strategies of countries and international fnance institutions. Here the main
difference between fnancial inclusion and fnancial sector development is
that the former concentrates issues of access and use of fnancial services for
2
Joshua Yindenaba Abor et al.
the unbanked, while the latter deals with the development of the fnancial
sector in general. Indeed, this difference becomes hazy because both can
mean the same from a measurement point of view.
Economic growth has to do with the increase in the productive capacity of an economy in a year in relation to the previous year as measured
by real gross domestic product (GDP). Economic development is also concerned with the process of creating and utilising physical, fnancial, human,
and social assets to improve the economic well-being and quality of life of
people in a community, region, or country. Whereas economic growth is
a phenomenon of market productivity and an increase in nominal or real
GDP, economic development is associated mainly with the economic and
social well-being of people in a community, region, or country. The economic development efforts of countries must be sustained over time in order
to produce positive economic and social outcomes. In the view of Seidman
(2005), the economic development process creates assets that enable the
community, region, or country to sustain and recreate its desired economic
and community outcomes.
Unsurprisingly, the discussions in literature also moved to incorporate the need for inclusive growth. The emphasis was on the idea that
growth must be benefcial to all and in particular for poverty reduction to
be effective. Amid all of this has been the ever-constant debates around
issues of causality: whether fnance causes economies to grow, whether it
is instead growing economies that result in higher fnancial development,
and whether causality goes both ways and depends on stages of a country’s
development. There is also the vibrant debate on whether fnancial development can lift the welfare of poor households.
These discussions, however, do not question the fact that fnancing
economic growth and development, especially in developing and emerging
countries through the mobilisation of domestic resource as well as an appropriate level of external capital infows, is an important issue. However, a
fnancing gap develops when the fnancial system is ineffcient and ineffective and when governments are also unable to mobilise resources. Precisely,
development fnance focuses on how domestic and the global fnancial systems facilitate the economic growth and development process. It also deals
with structuring and reforming the fnancial system in ways that promote
growth and development at both the macro level and the micro level in
developing and emerging economies.
At the macro level, the focus is on fnancing the design and implementation of national development strategy, which is critical to the realisation of
the country’s development goals. Achieving country-specifc development
goals may also be related to the global development agenda. With respect to
global development, the present emphasis is on how to fnance the sustainable development goals (SDGs), which were set by the United Nations (UN)
with a 2030 timeline (Biekpe, Cassimon, & Verbeke, 2017). The SDGs, otherwise known as the global goals, include 17 specifc goals, which build on the
progress made with respect to the millennium development goals (MDGs)
and incorporate additional goals. Some of these new goals include reducing inequity, ensuring sustainable consumption and production patterns,
Chapter 1 • Introduction to contemporary issues in development fnance
3
combatting climate change and its impact, promoting peaceful and inclusive societies, and providing justice, among others. Also, at the micro level,
the concentration is on how individual households, local communities, and
frms are able to access the necessary fnance to support their growth and
development aspirations. However, a certain fnancing gap tends to constrain the achievement of these development targets – hence the need to
design the fnancial system to be able to support the growth and development process.
1.2 PURPOSE OF THIS BOOK
This book examines issues in development fnance by focusing on how
fnancial systems and innovations in fnancial resource fow can drive the
economic growth and development process. This emerging discipline seems
to be gaining widespread recognition and importance across the globe and
in Africa in particular. The literature on development fnance is enormous.
However, no recent text is available that covers the wide range of the literature in this area. The main contribution of this book is that it provides
comprehensive coverage of the various critical and contemporary issues in
development fnance by carefully integrating relevant theoretical underpinnings, empirical assessments, and practical policy issues. With the expansion of economic development initiatives across the globe comes an urgent
need for expertise and skills in development fnance to drive, support, and
manage them.
The book tries to be as complete and up to date as possible regarding recent theoretical discussions in the broad feld of development fnance.
Therefore, the book provides a valuable resource for development fnance
researchers and for students taking courses in, for example, development
fnance, fnance for development, development economics, international
fnance, fnancial development policy, and economic policy management.
Every chapter contains a set of review questions, which may be helpful for
students to better absorb the information provided. Given that we deliberately avoid overly technical discussions in the main text – more technical
details are provided in ‘boxes’ – also practitioners with only a limited theoretical economic background will fnd the book a useful reference.
This frst introductory chapter provides an overview of the other
chapters in the book. In different chapters, the book pays attention to the
general theoretical and empirical discussion on the relationship between
fnancial development and economic growth; the importance of microfnance; the role of different types of external capital fows, distinguishing
between external private fows, foreign aid, and international remittance;
the importance of international fnancial architecture; the role of sovereign
debt and wealth management; the role of fnancing different sectors in the
economy, such as medium-size enterprises, infrastructure, the agricultural
sector, and the external sector; and the recent discussion on fnancial inclusion and economic growth, including issues like mobile money transfers.
However, because development fnance emerged as a result of market
imperfection and limited capital available, this chapter starts by discussing
4
Joshua Yindenaba Abor et al.
market imperfections and development fnance. It also examines development fnance interventions aimed at minimising the market imperfections
and establishing development fnance institutions to provide direct fnancing in the market. Finally, the chapter briefy discusses recent developments
regarding fnancial inclusion and fntech.
1.3 MARKET IMPERFECTIONS AND DEVELOPMENT
FINANCE
Development fnance recognises the need to fll the gaps between capital
required and capital available through various interventions. The fnancing
gap is a result of fnancial market imperfections or the failure of fnancial
markets to provide the requisite fnance to support economic activity. Development fnance interventions are aimed at ensuring the availability of capital
when fnancial markets fail to supply the needed capital. These interventions
include trying to curtail the imperfections in fnancial markets and institutions in order to improve the level of effciency and establishing alternative
development fnance institutions to provide direct capital in the market.
At this stage, we bring up and discuss the concept of fnancial market imperfections. Financial market imperfection is concerned with the failure of fnancial markets to supply the required capital to fnance economic
activity. Market imperfections or fnancial market gaps occur when capital
is not allocated in the most productive manner.
Microeconomic theory suggests that in perfect capital markets, capital is allocated perfectly, under the assumptions of complete markets, the
perfect rationality of agents, and perfect or full information. Under these
conditions, equilibrium is established when the interest rates clear the market when the supply of capital is equal to the demand for capital. However, when these assumptions are not present, market imperfections tend to
occur. In the absence of perfect competition, suppliers of capital may seek
to determine their own terms and may not be mindful of ensuring effcient
allocation of capital. The high transaction costs and lack of information are
a direct consequence of market imperfections.
Transaction costs are the costs of using the price mechanism, which
include the cost associated with discovering relevant prices and the cost of
negotiating and concluding contracts (Coase, 1937). In the fnancial market, fnancial institutions play an important role in contributing to reducing
transaction costs. Minimising transaction costs is regarded as a necessary
condition but not a suffcient condition for improving fnancial and economic effciency. We now discuss how asymmetric information explains
fnancial market imperfections. We also look at how imperfection in fnancial markets results in credit rationing.
1.3.1 Asymmetric information
A key feature of fnancial markets that results in market imperfection is
asymmetric information1 between users of fnance and providers of fnance.
The application of asymmetric information to explain fnancial market
Chapter 1 • Introduction to contemporary issues in development fnance
5
incompleteness, imperfections, and credit constraint is attributed to the
work of Joseph Stiglitz in the 1980s. The problem of asymmetric information or information asymmetry arises because borrowers and providers of
fnance do not have equal access to information regarding the creditworthiness of the potential borrower. In more general terms, asymmetric information, sometimes referred to as information failure, describes a situation
where one party to an economic transaction has better access to information
than the other party does, resulting in an imbalance of power in transactions,
which may cause the transaction to be skewed. The information-defcient
party might make a different decision provided the information being withheld was made available. Asymmetric information may result in adverse
selection and moral hazard.
Adverse selection occurs when the lack of information in the fnancial market puts the lender in a position of being unable
to distinguish good borrowers from bad ones. It occurs ex ante: before the
lender provides a loan, or debt, contract to the borrower, on the basis of
available information by the time of the event. It happens when the lender
does not have the necessary tools to screen the borrower types and is thus
unable to ascertain whether the borrower engages in riskier projects. For
risky borrowers, there is a higher probability that projects will fail than for
safe borrowers. However, if the project succeeds, the return will be higher
for risky borrowers. In this situation, risky borrowers are likely willing to
pay a higher interest rate than safe borrowers are. The consequence is that
in case the bank increases the interest rate, safe borrowers decide not to borrow anymore, such that the bank ends up with a portfolio of only risky borrowers, a process indicated by the term ‘adverse selection’. The bank does
not know who the risky borrower or the safe borrower is but realizes that an
increase in interest rates may have ‘adverse selection’ effects. To avoid this,
the bank may decide in times of access demand for credit not to increase the
interest rate but simply to ration credit. Box 1.1 provides further discussion
on credit rationing and its implications.
Stiglitz and Weiss (1981) explain that the adverse selection theory of
credit markets is based on two key assumptions: lenders are not able to
differentiate between borrowers with different levels of risk, and the loan
contracts are subject to limited liability in the sense that in the event that
the project generates returns lesser than the debt obligations, the borrowers
will not be responsible for paying out of pocket. The consequence of adverse
selection is that fnancial markets are not effcient, in that good projects will
not be funded, while bad projects will be selected.
ADVERSE SELECTION
Moral hazard results from the lack of information regarding the ex post behaviour of borrowers – that is, the behaviour of borrowers
after a debt contract has been signed with a bank. In more general terms,
moral hazard occurs when after entering into a contract, the incentives of
the two parties involved change, to the extent that the risk associated with
the contract is altered (Heffernan, 2006). It refers to the borrower’s engaging in high-risk strategies and applying the funds acquired for a purpose
MORAL HAZARD
6
Joshua Yindenaba Abor et al.
different from that for which they were sourced. After acquiring loans, borrowers may undertake risky projects, since they are not fully responsible
for the funds, and the inability of the lender to control how the borrower
applies the funds may lead to moral hazard. With increases in interest rates,
the borrower is likely to be involved in such risky projects so as to increase
the expected returns, and if the project is successful, the borrower gains, but
if it fails, the lender assumes the default risk.
The default risk is one of the conditions of an imperfect market. The
borrower may be in fnancial distress or become bankrupt, thus being
unable to fulfl their indebtedness. Therefore, the promise and level of commitment by the borrower plays a signifcant role in the lending arrangement. One way by which the lender can secure the loan is to request the
borrower to pledge collateral. Ray, Ghosh, and Mookherjee (2000) suggest
that collateral minimises the default risk (for incentive reasons) and the
lender’s exposure in the event of default. In terms of reducing the default
risk, the collateral makes the borrower’s expected return of selecting risky
projects lower than the expected return of safer projects. Thus, the borrower has no incentive for choosing risky projects. In the case reducing
the lender’s exposure, the loan contract is structured in such a way that
the collateral provides the means by which the lender is able to recover all
or substantial part of the loan given out in the event of default. There are,
however, costs associated with the lender’s seizing the pledged assets in
the event of default.
BOX 1.1 Credit rationing and its implications
The concept of credit rationing has developed following the seminal
papers by Jaffe and Russell (1976) and Stiglitz and Weiss (1981) and
can be depicted by the market for supply and demand of loans.
An interest rate r* maximizes the expected return to the bank.
Excess demand can exist at this interest rate but not induce banks
to increase the interest rate above r*. Under such conditions, banks
cut the supply of loans (backwards-bending supply), at interest rates
above r* where demand DL exceeds the supply of funds (SL). Unsatisfed borrowers bid up the interest rate until rm, which marks the
beginning of credit rationing. Some individuals can acquire loans,
albeit at a higher interest rate, while others cannot. However, hiking
the interest rate or reducing the collateral requirement could increase
the riskiness of the lender or loan portfolio of the bank, either by discouraging safer investments or by encouraging borrowers to undertake riskier investment projects, thus reducing the lender’s profts.
The implication is to reduce the number of loans that the lender
provides. In an extreme case, the backwards-bending supply curve
touches the interest rate (vertical) axis, and there is full rationing and
total exclusion for some large portion of individuals and entities.
Chapter 1 • Introduction to contemporary issues in development fnance
7
FIGURE 1.1 Credit rationing and its implications
˜
Credit rationing is a result of capital market imperfections, which are
characterised by information asymmetry and its consequent adverse
selection and moral hazard.
Keeton (1979), Stiglitz and Weiss (1981), and Jaffe and Stiglitz
(1990) provide specifc defnitions of two types of credit rationing:
Type 1. Pure credit rationing happens when some individuals acquire
loans, while apparently identical individuals, who are ready to
borrow on exactly the same terms, are not able.
Type 2. Redlining arises when some identifable groups of individuals,
given a particular supply of credit, are not able to acquire loans at
any interest rate, but given a larger supply of credit, they would.
1.4 DEVELOPMENT FINANCE INTERVENTIONS
We mentioned that development fnance plays an important role in expanding capital availability to fnance economic growth and development, and
these include, frst, minimising the imperfections in fnancial markets and
institutions in order to improve on the level of effciency and, second, establishing alternative fnancial institutions or development fnance institutions
to provide direct capital in the market. These two forms of interventions
need to be regarded as complementary and should be used in ways that
achieve the objectives of development fnance. Next, we discuss each of
these interventions or strategies.
8
Joshua Yindenaba Abor et al.
1.4.1 Interventions for correcting market imperfections
These are concerned with reducing the main sources of ineffciencies that
introduce gaps in the required and available fnance. Interventions for perfecting the fnancial market include measures that aim at improving the performance and functioning of the fnancial market and institutions in ways
that enhance available fnancing for development. This is crucial given the
important role fnancial markets and institutions play in facilitating the supply of funds for fnancing economic activities.
The following are some of the interventions aimed at improving the
operation and performance of the fnancial markets and institutions:
• Ensuring effective fnancial market regulation – the regulation of
fnancial markets is necessary given their complex nature and importance in the economies they operate in. The regulation of the fnancial
market ensures market participants are treated fairly and has implications for the performance of various fnancial institutions. The essence
of regulating fnancial markets include protecting investors, preventing securities issuers from defrauding investors and hiding important
information, promoting the stability of fnancial institutions, promoting competition and fairness in the trading of fnancial securities,
restricting the level of activities of foreign entities in local markets and
institutions, and controlling the level of economic activity.
• Introducing risk management instruments – this includes the means
by which market players share their risk with counterparties. It may
involve the use of insurance contracts and fnancial derivatives such
as forwards, futures, options, swaps, and swaptions.
• Reducing cost of contracting and information processing – fnancial
institutions handle huge volumes of transactions and tend to enjoy
economies of scale related to contracting and processing information
on securities. The low costs associated with contracting and processing would beneft investors and issuers of securities. Also, the ability of fnancial institutions to obtain information concerning potential
borrowers and screening out bad credit risks helps in dealing with the
problems in connection with adverse selection and moral hazards.
• Providing effcient payment system – providing for payment mechanisms like cheques, electronic transfers of funds, debit cards, and
credit cards enables fnancial institutions to transform certain types
of assets (i.e. those that could not be used in making payments) into
other forms of assets that can be used to effect payment. The fnancial
market provides the means of making payments without using physical cash, and this is necessary for the effective and effcient functioning
of the market.
• Introducing fnancial innovation – attempts to reduce market imperfection also involve introducing fnancial innovation to improve on
the level of effciency in the fnancial market. Financial innovation
entails the development of new fnancial products or services; the
introduction of new processes or delivery systems that result in reducing costs and risks or providing enhanced services to meet the needs
Chapter 1 • Introduction to contemporary issues in development fnance
9
of market participants; and the emergence of new kinds of fnancial
service providers. The fnancial innovation process involves changes
in fnancial instruments, institutions, markets, and practices. More
generally, fnancial innovation tends to affect the nature and composition of monetary aggregates by introducing new fnancial instruments
or changing existing fnancial instruments. Financial innovations
result in reducing the transaction cost associated with transferring
funds from lower-yielding money instruments to higher-yielding
ones. Thus, participants in the fnancial system are able to minimise
their risk and maximise their returns.
1.4.2 Establishing development fnance institutions
Development fnance institutions (DFIs) are alternative fnancial institutions
that are concerned with providing long-term fnance (e.g. long-term loans,
equity, and risk guarantee instruments) to promote private investment for
economic growth and sustainable development while ensuring they remain
fnancially viable. They concentrate mainly on areas that providers of conventional fnance tend to avoid and on markets, which have limited access
to sources of domestic and external capital. DFIs are said to occupy the intermediary space between public aid and private investment by focusing on
high-risk investments in sectors that have limited access to capital markets.
They are capable of raising huge amounts of capital from the global capital markets for providing loans or equity investment on commercial and
sometimes-concessional bases (Dickinson, n.d.; Abor, 2017). There are multilateral, regional, and bilateral or country-specifc DFIs (see Box 1.2).
BOX 1.2 Types of DFIs
Multilateral DFIs include private sector outfts of international fnancial institutions (IFIs), which are founded by a number of countries
and are subject to international law. They are generally owned by
national governments but sometimes with ownership participation by
international or private entities. They tend to have stronger fnancing
capacity and provide the opportunity for close cooperation between
governments.
The regional DFIs are essentially part of multilateral DFIs, but
they tend to focus on specifc regions and are owned by the governments of those regions.
Bilateral or country-specifc DFIs operate mainly in developing
and emerging economies and have the mandate of providing longterm capital to fnance the private sector, with particular value-added
development objectives on a sustainable commercial basis. Bilateral
DFIs may also include microfnance institutions, state development
banks, community development fnance institutions, microenterprise
funds, and revolving loan fundts.
10
Joshua Yindenaba Abor et al.
The traditional role of DFIs is to help address the failure or imperfections in fnancial markets. In the view of Dixit and Pindyck (1994), uncertainty
signifcantly and negatively affects investment, which entails large sunk and
irreversible costs and, where there is a choice, delaying the investment decision until additional information becomes available. The risks associated
with such long-term investments tend to discourage private sector investors.
DFI assist in correcting risk perceptions, promoting favourable environment for private investment to thrive as well as providing social infrastructure and other activities that have positive economic outcomes. They
tend to focus on developing countries with limited access to local and external capital markets by providing long-term fnance for infrastructure projects in developing countries. DFIs facilitate private sector investment and
provide risk guarantee that provide comfort for investors. They provide
fnance that is linked to the design and implementation of capacity-building
programmes adopted by governments (te Velde, 2011).
DFIs also play an active role in fnancing small and medium-size enterprises (SMEs), which are often perceived as risky by other fnance providers. In that case, they take the frst mover advantage in markets with high
growth potential. They often have a double bottom line: pursuing proft and
pursuing development. On one hand, they invest for the purpose of generating returns, which enable them to undertake more investments. On the
other hand, they facilitate the economic development of the countries they
invest in (Dickinson, n.d.).
DFIs contribute by adding value to the economic development process. Dalberg (2009) mentions three ways by which DFIs do this:
1 Investing in underserved projects types and settings – the business
model of DFIs is designed so that they are able to invest in highly
risky projects in developing countries. They have the capacity to tolerate high risk and make long-term investments, especially in areas
where private investors consider risky to commit resources to.
2 Investing in undercapitalised sectors – they specialise in investing
in sectors such as agriculture, energy, the fnancial sector, and infrastructure, which are critical to driving economic growth.
3 Mobilising other investors – they promote sharing knowledge, setting standards, and collaboration, which helps attract other investors.
Their track records enable other investors to scale up their investment, and they also build local capacity in fund management.
Chapter 7 of this book provides a more comprehensive discussion of DFIs in
the context of the global fnancial system.
1.5 FINANCIAL DEVELOPMENT, FINANCIAL INCLUSION,
AND FINTECH2
During the past decade, the discussion about fnance and development has
started to change, by focusing more specifcally on possibilities to improve
fnancial inclusion – that is, on different measures to improve access to
fnance for unbanked people; see also Chapter 10 in this book. Even if
Chapter 1 • Introduction to contemporary issues in development fnance
11
fnancial development will lead to long-run economic growth, it is not clear
at all that also poor people will gain a lot. Probably only if fnancial development operates on the so-called extensive margin, implying that it improves
access to fnancial services by individuals who had no access to these services before, a process of fnancial development will be benefcial for the
poor unbanked part of the society. If fnancial development operates on
the intensive margin, and hence improves access to fnancial services only
for those households and frms that already had access to fnance, fnancial development will not help unbanked people and will likely increase
inequality, at the least in the short run.
There is still an enormous lack of data regarding fnancial inclusion of
poor people in the developing world. Fortunately, in 2011, the World Bank
launched the Findex database, which is the world’s most comprehensive
database on fnancial inclusion around the world. The dataset covers more
than 140 economies around the world, drawing on survey data. The initial
survey round was followed by a second one in 2014 and a third one in 2017.
The study shows that currently almost 70% of adults around the world have
a bank account. Moreover, the study provides promising fgures about a rise
in fnancial inclusion in the last decade, also in developing countries, where
bank account ownership increased from 55% to 63% between 2014 and 2017
(Demirgüç-Kunt, Leora, Dorothe, Saniya, & Jake, 2018). However, there are
still considerable gaps in who has access to fnance: women are much less
likely than men to have a bank account; bank ownership is still much lower
in developing countries than in the developed world, and especially adults
with low education and without formal jobs are still often excluded from any
fnancial services. Thus, a further increase in fnancial inclusion to provide
access to fnancial services for still-unbanked poor people seems important.
Innovations in fntech are among the most promising developments
in improving fnancial inclusion. Fintech refers to the emerging industry
that uses technology to provide fnancial services. It is characteried as fnancial intermediation services delivered through mobile phones, computing
devices using the internet, or cards linked to a secure digital payment system
(Manyika, Lund, Singer, White, & Berry, 2016). The most widely adopted
forms of fntech in developing countries, especially in sub-Saharan Africa,
are mobile money and mobile fnancial services. Sub-Saharan Africa is even
the only region where the share of adults with a mobile money account
exceeds 10%. M-Pesa (see Box 1.3), a mobile phone–based money transfer
service, launched in 2007 by VodafoneGroup plc and Safaricom in Kenya,
was one of the frst mobile network operators in sub-Saharan Africa. Mobile
money accounts have now spread to new parts of sub-Saharan Africa, and
the share of adults with a mobile money account has now surpassed 30% in
various countries, such as Côte d’Ivoire, Senegal, and Gabon.
The success of M-Pesa has shown the possibility of leveraging simple
non-internet-based mobile technology to extend fnancial services to large
segments of unbanked poor people. It also shows the importance of designing a usage-based and low-cost transactional platform that enables lowincome customers to meet a range of payment needs. Fintech is very much
associated with mobile money. Yet fntech also includes other applications,
12
Joshua Yindenaba Abor et al.
BOX 1.3 M-Pesa
M-Pesa was a small-value payment and store of value system using
ordinary mobile phones. It was designed to enable customers receive
and transfer funds securely by using ordinary mobile phones. Customers can also use it to pay bills such as water and electricity and store
their money. M-Pesa was an immediate success: at the end of its frst
year, it had registered 1.2 million customers in Kenya and had 19 million customers by the end of 2018. M-Pesa payments consist of personto-person (P2P) payments, which form a bulk, and person-to-business
(P2B), business-to-person (B2P), and recently government-to-person
(G2P) and government-to-business (G2B) payments. M-Pesa opened
the door to formal fnancial services for Kenya’s poor. It introduced
small accessible and affordable loans, increased the scope of payment
services, and created more-affordable fnancial options for the poor.
M-Pesa has now expanded beyond the borders of Kenya and by the
end of 2019 became Africa’s most successful mobile fnance case, with
37 million active customers and 11 billion transactions across seven
countries: the Democratic Republic of Congo, Egypt, Ghana, Kenya,
Lesotho, Mozambique, and Tanzania.
M-Pesa has also enhanced access to other economic and social
infrastructure via its associated new product developments. For
instance, in Tanzania, it has been used by a nongovernmental organization (NGO) – Comprehensive Community-Based Rehabilitation –
to support patients to pay for travel cost to health facilities. M-Pesa
has also has enabled access to electricity for low-income households
in Kenya and Tanzania. This is via a partnership-based system,
M-KOPA, that allows households to acquire a solar-powered off-grid
electricity kit and pay for it in small daily payments by using their
M-Pesa account.
Source: Vodafone
like a distributed ledger technology (blockchains), which can interact with
the Internet of Things (IoT) to lower transaction costs and ease fnancing
and mobile payments.
In the literature, the terms ‘mobile money’, ‘mobile fnancial services’,
‘digital payments’, and ‘digital fnance’ are often used interchangeably.
However, there is a crucial difference in that ‘digital’ refers to services that
require access to digital devices (internet), whereas, for instance, a simple
text-based mobile phone can be used without accessing the internet.
Recently, a lot of research has been devoted to mobile money platforms and associated mobile wallet technologies, which enable the provision of fnancial services through a mobile phone. Initially, mobile money
Chapter 1 • Introduction to contemporary issues in development fnance
13
referred mainly to person-to-person money transfers. However, mobile
phones and more generally digital fnancial services transacted via mobile
money platforms are now also used to pay bills, save money, conduct
person-to-business payments, and receive payments (wages) and for investments (Suri, 2017; Apior & Suzuki, 2018). Mobile phones are also increasingly used to send and receive international remittances. See Chapter 5
in this book for an extensive discussion on the role of international remittances. In sub-Saharan Africa, the sending and receiving of remittances has
even become the main use of mobile money (Demirgüç-Kunt et al., 2018).
Mobile money platforms thus potentially offer wide accessibility (Osburg
& Lohrmann, 2017) and may serve as conduits for fnancing different sectors in the economy, such as SMEs and smallholder farmers. They may also
help to include the unbanked in the fnancial system (Klapper, El-Zoghbi, &
Hess, 2016) and induce positive effects on education, health, employment,
productivity, and poverty alleviation.
While the success of M-Pesa seems to provide evidence for the potentially enormous role of fntech in enhancing fnancial inclusion and raising the living standards of unbanked people in the developing world, the
development of fntech in many countries in Africa, South America, and
Asia has been problematic. Even a replication of M-Pesa outside Kenya was
often unsuccessful, especially in countries where a more advanced banking
network was already available, such as in South Africa. Overall, the fntech
sector in sub-Saharan Africa remains small (Yermack, 2018).
Indeed, there are several limitations and risks, which make it unlikely
that fntech will in the short run induce a process of fnancial inclusion
that will improve the living standards of the majority of the still-unbanked
adults. An important prerequisite of a successful rapid fntech development
is the availability of a sound communications infrastructure (Yermack,
2018). However, in most developing countries, only a rudimentary communications infrastructure is available, characterized by limited access to
broadband internet connections and smartphone handsets. To promote
adequate investments, a supportive regulatory framework is needed. Yet
most African governments have so far taken a hands-off approach to fntech regulation. Even if fntech were to be widely promoted, it can ensure
and promote inclusive growth only if it meets the needs of disadvantaged
groups. The uptake and use of mobile fnancial services in many developing
countries will be limited due to low reading literacy and digital literacy levels (Nedungadi, Menon, Gutjahr, Erickson, & Raman, 2018). There is also a
risk that specifc fntech services will not be provided to poor rural communities, to save costs (Ozili, 2018). Entire geographic areas might be excluded
from new technologies, and the new world of data and information, as the
success of particular forms of fntech, especially if big data is involved, crucially depends on the availability of data scientists, who may not be available in several developing countries. Much more research on the potential
and limitations of fntech is needed. However, fntech will not likely be a
panacea for raising the living standards of the unbanked population in the
developing world in the short run.
14
Joshua Yindenaba Abor et al.
1.6 AN OVERVIEW OF THE CHAPTERS
In this section, we provide an overview of the various chapters. We have
deliberately not distinguished different parts in the book, because the chapters can be combined in various ways to deal with subparts of the extant
development fnance literature. For instance, Chapters 1, 2, 3, 10, and 15 deal
with domestic fnance issues. Chapters 4, 5, and 6 discuss external fnance,
and Chapter 7 discusses the global fnancial architecture. Chapters 8 and 9
address issues on sovereign debt and wealth management, and Chapters 11,
12, 13, 14, and 15 discuss the fnancing of specifc sectors of the economy.
In Chapter 2, Lordina Amoah, Charles Komla Delali Adjasi, Issouf
Soumare, Kof Achampong Osei, Joshua Yindenaba Abor, Ebenezer Bugri
Anarfo, Charles Amo-Yartey, and Isaac Otchere discuss the theoretical and
empirical literature regarding the role of the fnancial sector in inducing a
process of economic growth. They also discuss fnancial repression, liberalization, and growth and the fnance–growth nexus, highlighting the various
hypotheses underpinning this relationship. Their chapter ends with a discussion of the importance of deposit-taking fnancial institutions and capital
markets in the economic growth process.
In Chapter 3, Niels Hermes and Robert Lensink provide an up-to-date
review of the role of microfnance in the process of development. The aim
of this chapter is to discuss, in the face of the recent criticism, whether, and
if so how, there is still a role to play for microfnance in promoting inclusive
growth. They distinguish between the supply side of microfnance, focusing
on analyses at the MFI level, and the demand side of microfnance, focusing
on end users.
The next four chapters deal with external fnance. These chapters
discuss how various types of external capital fows (private capital fows,
remittances, and foreign aid) affect growth and development. Moreover, it
discusses the international fnancial architecture.
In Chapter 4, Elikplimi Komla Agbloyor, Alfred Yawson, and Pieter
Opperman discuss the role of international private capital fows in promoting economic growth. The chapter explains the difference between various
types of private capital fows, such as foreign direct investments (FDI) and
foreign portfolio investment (FPI). It examines how these components of
private capital fows drive growth and assesses the interactions between
private capital fows and domestic investment.
In Chapter 5, Hanna Fromell, Tobias Grohmann, and Robert Lensink discuss the relationship between international remittances and development. They explain in detail the results and methodology of research
that addresses international remittances from developed and developing
countries. The chapter pays attention to, for example, the motivation for
remittances, the impact of international remittances on economic growth,
fnancial development, and inequality and poverty. The chapter ends with
a discussion on policy tools to enhance the marginal impact of international
remittance payments.
In Chapter 6, Matthew Kof Ocran, Bernadin Senadza, and Eric OseiAssibey deal with foreign aid and development. They describe the historical
Chapter 1 • Introduction to contemporary issues in development fnance
15
origins of foreign aid and summarise trends in the volume of aid. The chapter also summarises the voluminous literature on aid effectiveness. The
chapter concludes by discussing some alternatives for foreign aid.
After three chapters on the relationship between external capital fows
and development, Joshua Yindenaba Abor, Angela Azumah Alu, David
Mathuva, and Joe Nellis, in Chapter 7, discuss the system of global economic
and fnancial governance – the so-called global fnancial architecture – that
facilitates the fow of external capital. The chapter pays attention to the role
of the institutions that make up the global fnancial architecture, such as
the Bretton Woods institutions, including the International Monetary Fund
(IMF), the World Bank Group, the World Trade Organization, the Bank for
International Settlements (BIS), and the regional development fnance institutions in developing and emerging countries. They chapter also addresses
fnancial globalisation, global crises, and reform issues regarding the global
fnancial architecture.
The next two chapters deal with sovereign management in developing countries. A distinction is made between sovereign wealth management
and sovereign debt management.
In Chapter 8, Mbako Mbo and Charles Komla Delali Adjasi discuss
sovereign wealth management in emerging economies. Sovereign wealth
management deals with questions related to prudent public fnance management. The chapter pays attention to the evolution and changing role of
sovereign wealth management and asset-liability management in emerging
economies. It also looks at asset allocation and risk management for sovereign wealth funds.
In Chapter 9, Amin Karimu, Vera Fiador, and Imhotep Paul Alagidede pay attention to what is known as sovereign debt management. The
chapter discusses how governments in developing countries have managed
their international debt, and how external debt affects economic growth. It
also deals with questions related to renegotiating debt contracts, debt-relief
policies, sovereign debt restructuring, and risk management frameworks.
The chapter ends by analysing debt sustainability and a medium-term debt
strategy.
In Chapter 10, Joshua Yindenaba Abor, Haruna Issahaku, Mohammed Amidu, and Victor Murinde discuss the relationship between fnancial
inclusion and economic growth. Whereas Chapter 2 pays attention to the
more general discussion of fnancial development and economic growth, this
chapter deals with the more recent discussion on fnancial inclusion and economic growth. Financial inclusion, in theory, differs from fnancial development: fnancial development focuses on the development of the fnancial
sector in general, whereas fnancial inclusion deals with the question who
actually has access to the fnancial system and to what extent access to the
fnancial sector has improved for certain groups, especially the poor, in a
society. However, in terms of measurement, the difference between fnancial development and fnancial inclusion is often not clear. This chapter
defnes fnancial inclusion, provides a guide to its measurement, describes
the trends in fnancial inclusion, discusses the determinants of and barriers to fnancial inclusion, and assesses the link between inclusive fnance
16
Joshua Yindenaba Abor et al.
and fnancial development. It also examines the effect of inclusive fnance
on economic growth, including the importance of recent innovations like
mobile phone–based money transfers. The chapter ends by discussing the
roles of institutional architecture in the nexus between fnancial inclusion
and economic growth.
The next fve chapters deal with fnancing particular sectors in the
economy and its relevance for economic development. Distinctions are
made between fnancing the agricultural sector, fnancing infrastructure,
fnancing sustainable development, fnancing the external sector, and
fnancing the private sector, especially SMEs.
In Chapter 11, Haruna Issahaku, Edward Asiedu, Paul Kwame
Nkegbe, and Robert Osei discuss fnancing agriculture for inclusive development. The chapter examines how fnancing agriculture can promote
inclusive development and reduce poverty and inequality. The specifc topics covered include stylised facts on agriculture development, challenges of
agriculture fnancing, fnancing opportunities, innovative fnancing models
for agriculture and agriculture development, and inclusive development.
In Chapter 12, Gordon Abekah-Nkrumah, Patrick O. Assuming,
Patience Aseweh Abor, and Jabir Ibrahim Mohammed pay attention to fnancing sustainable development. The main issues covered here are global actions
for sustainable development, challenges and opportunities of sustainable
development, conventional and innovative funding modes for sustainable
development, and benefts derived from fnancing sustainable development.
The chapter offers innovative ideas for fnancing sustainable development.
In Chapter 13, Steven Brakman and Charles van Marrewijk discuss
international trade, fnance, and development. This chapter covers topics
such as models of trade, the political economy of trade policy, various trade
agreements, and the effects of trade policy on economic growth and development. The chapter also pays attention to the main aspects of exchange
rates and the related importance of forward-looking markets for understanding the power of fnancial forces. Finally, the chapter discusses issues
on trade fnance and concludes with a discussion of fnance, investment,
and development.
In Chapter 14, Saint Kuttu, Ashenaf Fanta, Michael Graham, and
Joshua Yindenaba Abor discuss infrastructure fnancing and economic development. The chapter covers challenges and opportunities for infrastructure
development, economic growth and development nexus, infrastructure
fnancing models, a framework for enhancing private participation in infrastructure development, and risk management in infrastructure projects.
In the fnal chapter of the book, Chapter 15, Joshua Yindenaba Abor,
Haruna Issahaku, Charles Komla Delali Adjasi, and Elikplimi Komla
Agbloyor return to the fnance and growth discussion that started in Chapter 2. Chapter 15, however, focuses on the role of the private sector in the
fnancial development and economic growth discussion. The chapter argues
that addressing the fnancing constraints of the private sector, especially
those for SMEs, is necessary to drive growth in developing and emerging
economies. The chapter provides an overview of the discussion related to
the private sector and economic development, discusses the fnancing and
Chapter 1 • Introduction to contemporary issues in development fnance
17
investment behaviour of frms, and examines how various forms of development fnance contribute to private sector development and economic
development.
1.7 CONCLUDING REMARKS
In this chapter, we have discussed the basic tenets of fnancial markets and
their role in economic growth and development and pointed out the role of
development fnance and DFIs in fnancing growth and development. The
chapter shows that fnancial markets can be replete with bottlenecks and
inherent challenges, rendering it imperfect and incomplete. If not reduced
or controlled, these challenges could destabilize the economy and cause
crises. Some of the key fnancial market problems that result in market
imperfection are asymmetric information between borrowers and lenders of
fnance and the presence of transaction costs. The asymmetric information
prevents capital from being allocated in the most productive manner at an
affordable cost. This creates fnancing gaps, rationing of credit, and market
segmentation, rendering the fnancial market imperfect. This, coupled with
signifcant transaction cost, creates market failures in fnancial markets. In
the presence of these fnancial market failures, the economic growth and
development process is heavily hampered and results in further gaps and
developmental challenges in a country. This reiterates the importance of
understanding the nature of fnancial systems and structuring appropriate interventions to fnance activities to sustain the economic development
efforts of countries over time in order to produce positive economic and
social outcomes. Well-functioning and well-structured fnancial systems
minimise the informational gaps and transactions cost. When the fnancial
sector functions effciently, it provides the avenues for market players to
take advantage of investment opportunities by channelling funds for production, thus driving economic growth and development. We have also
shown that the evolvement of fntechs has implications for the structure
and depth of the fnancial system. In particular, fntechs provide innovative
solutions by designing products that can be accessible for low-income populations and small businesses at a relatively lower cost. We do, however,
note that for developing countries with low communications infrastructure,
digital (internet) fntech-based solutions will be more costly to access than
simple analogue fntech solutions.
Development fnance deals with structuring and reforming the fnancial system in ways that promote growth and development at the macro
and micro levels in developing and emerging economies. It focuses on how
domestic and global fnancial systems facilitate the economic growth and
development process. DFIs (be they multilateral, regional, and bilateral or
country specifc in structure) carry out this role by minimising the imperfections in fnancial markets and institutions in order to improve the level of
effciency and establish alternative fnancial institutions to provide direct
capital in the market. DFIs therefore provide long-term fnance (including
long-term loans, equity, and risk guarantee instruments) to promote private
investment, economic growth, and sustainable development.
18
Joshua Yindenaba Abor et al.
Discussion questions
1 Discuss the issue of information
asymmetry in fnancial markets.
What measures can be used to
reduce information asymmetry?
2 What are the necessary measures
to ensure effciency and effectiveness in the operation and performance of fnancial markets?
3 What is credit rationing? What
are the consequences of credit
rationing?
4 Using examples from your country, discuss the issue of transaction cost in fnancial markets.
5 Examine the place of development
fnance in addressing the issue of
6
7
8
9
market imperfections in fnancial
markets.
Discuss how development fnance
plays an important role in expanding capital availability to fnance
economic growth and development.
Discuss the various types of DFIs
and their specifc roles. How do
DFIs add value to the economic
development process?
How do fntechs address the issue
of information asymmetry in
fnancial markets?
Discuss the conditions under
which fntechs can enhance fnancial inclusion.
Notes
1 The market consequences of information asymmetry were popularized by George Akerlof in his
article ‘The Market for Lemons:
Quality Uncertainty and the Market mechanism’ in 1970. In 2001,
the Nobel Memorial Prize in
Economic Sciences was awarded
to George Akerlof, Michael
Spence, and Joseph Stiglitz for
their work on analysing markets
with asymmetric information.
2 This section draws heavily on Hinson, Lensink, and Mueller (2019).
References
Abor, J. Y. (2017). Entrepreneurial fnance
for MSMEs: A managerial approach for
developing markets. London: Palgrave
Macmillan.
Akerlof, G. A. (1970). The market for
lemons: Quality uncertainty and the
market mechanism. Quarterly Journal
of Economics, 84(3), 488–500.
Apiors, E., & Suzuki, A. (2018). Mobile
money, individuals’ payments, remittances, and investments: Evidence
from the Ashanti Region, Ghana. Sustainability, 10(5), 1409.
Biekpe, N., Cassimon, D., & Verbeke, K.
(2017). Development fnance and its
innovations for sustainable growth.
An introduction. In N. Biekpe, D.
Cassimon, & K. Verbeke (Eds.), Development fnance: Innovations for sustainable growth (pp. 1–16). London:
Palgrave Macmillan.
Coase, R. H. (1937). The nature of the
frm. Economica, New Series, 4, 386–405.
Dalberg. (2009). The growing role of the
development fnance institutions in
international development policy.
Retrieved from www.fndevgateway.
org/sites/default/fles/publications/
files/mfg-en-paper-the-growingrole-of-the-development-financeinstitutions-in-internationaldevelopment-policy-2009.pdf
Demirgüç-Kunt, A., Leora, K., Dorothe,
S., Saniya, A., & Jake, H. (2018). The
Chapter 1 • Introduction to contemporary issues in development fnance
global fndex database 2017: Measuring fnancial inclusion and the fntech
revolution. Washington, DC: World
Bank.
Dickinson, T. (n.d.). Development fnance
institutions: Proftability promoting
development. Retrieved from www.
oecd.org/dev/41302068.pdf
Dixit, A. K., & Pindyck, R. S. (1994).
Investment under uncertainty. Princeton and New York: Princeton University Press.
Heffernan, S. (2006). Modern banking.
Chichester: John Wiley & Sons Ltd.
Hinson, R., Lensink, R., & Mueller, A.
(2019). Transforming agribusiness in
developing countries: SDGs and the
role of fntech. Current Opinion in Environmental Sustainability (COSUST), 41,
1–9.
Jaffe, D. M., & Russell, T. (1976). Imperfect information, uncertainty, and
credit rationing. Quarterly Journal of
Economics, 90, 651–666.
Jaffe, D. M., & Stiglitz, J. E. (1990). Credit
rationing. In B. Friedman & F. Hahn
(Eds.), Handbook of monetary economics
(pp. 837–888). Amsterdam: Elsevier
Science Publishers.
Keeton, W. (1979). Equilibrium credit
rationing. New York: Garland Press.
Klapper, L., El-Zoghbi, M., & Hess, J.
(2016). Achieving the sustainable
development goals. The Role of Financial Inclusion, 23(5). Retrieved from
www.ccgap.org.
Manyika, J., Lund, S., Singer, M., White,
O., & Berry, C. (2016). Digital fnance
for all: Powering inclusive growth in
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emerging economies. New York: McKinsey Global Institute.
Nedungadi, P. P., Menon, R., Gutjahr,
G., Erickson, L., & Raman, R. (2018).
Towards an inclusive digital literacy
framework for digital India. Education+ Training, 60(6), 516–528.
Osburg, T., & Lohrmann, C. (2017). Sustainability in a digital world. New York:
Springer International.
Ozili, P. K. (2018, December). Impact of
digital fnance on fnancial inclusion
and stability. Borsa Istanbul Review,
18(4), 329–340.
Ray, D., Ghosh, P., & Mookherjee, D.
(2000). Credit rationing in developing countries: An overview of the
theory. In D. Mookherjee & D. Ray
(Eds.), A reader in development economics (pp. 283–301). London: Blackwell.
Seidman, K. F. (2005). Economic development
fnance. Thousand Oaks, CA: Sage.
Stiglitz, J. E., & Andrew Weiss, A. (1981).
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imperfect information. American Economic Review, 71(3), 393–410.
Suri, T. (2017). Mobile money. Annual
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te Velde, D. W. (2011). The role of development fnance in tackling global
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Yermack, D. (2018). Fintech in SubSaharan Africa: What has worked well,
and what hasn’t. Working Papers No.
25007. Cambridge, MA: National
Bureau of Economic Research.
CHAPTER
2
Finance, economic growth,
and development
Lordina Amoah, Charles Komla Delali Adjasi, Issouf Soumare,
Kof Achampong Osei, Joshua Yindenaba Abor, Ebenezer Bugri
Anarfo, Charles Amo-Yartey, and Isaac Otchere
2.1 INTRODUCTION
The debate on the role of fnance in economic growth and development can
be traced as far back as the 1800s (see Bagehot, 1873). At the commencement
of the 20th century, Schumpeter (1912) highlighted the central role the banking system played in allocating savings to their most productive uses, hence
improving productivity and ultimately economic growth. Over time, other
authors, such as Gurley and Shaw (1955), Gerschenkron (1962), and Goldsmith (1969), have emphasized the importance of fnancial intermediation
and resource accumulation in the economic growth process. More recently,
with the advent of the endogenous growth models, the majority of the theoretical and empirical literature1 has revived the debate and continued to
stress the important role of the fnancial sector in economic growth.
This chapter generally provides a discussion on the theoretical and
empirical issues underlying fnance, economic growth, and development
phenomena. We start by overviewing some concepts and defnitions on the
topic. We then discuss fnancial repression, liberalization, and growth. Next,
we discuss the fnance–growth nexus, highlighting the various hypotheses
underpinning the relationship. What follows is a discussion on the role of
the fnancial system, accentuating how the various functions of the fnancial
system spur economic growth and conclude the chapter with a discussion
on fnancial intermediation and growth, emphasizing the role of deposittaking fnancial institutions and capital markets in the economic growth
process.
2.2 FINANCIAL SECTOR AND FINANCIAL
DEVELOPMENT: CONCEPTS AND DEFINITIONS
The fnancial sector refers to the set of institutions, markets, instruments,
and regulatory setup under which fnancial transactions are carried out
in the fnancial system. Key players in the fnancial sector include banks,
microfnance institutions (MFIs), insurance companies, investment bankers,
Chapter 2 • Finance, economic growth, and development
21
mortgage companies, and stock exchanges, who provide fnancial services
in the sector. Financial services encompass the assorted economic services
provided by the fnancial institutions in the fnancial system. These comprise intermediation and advisory services, investment services, foreign
exchange services, payment services, asset management services, risk management services, and debt resolution services, among others. The fnancial system refers to the framework within which all the aforementioned
services are organized and offered. Accordingly, a better fnancial system
will allow for an effcient allocation of resources in the economy. Financial
systems function at frm-specifc, national, and global levels.
Generally, fnancial development suggests advancement in the fnancial sector in terms of institutions, markets, and instruments/products.
Empirically, fnancial sector development has been measured in various
ways because of its complex nature and the dimensions it covers. Several
indicators are used as proxies of fnancial sector development, depending
on the issue under investigation. Typical fnancial development indicators (from the banking sector perspective) include total credit granted by
fnancial intermediaries (banks and nonbank fnancial intermediaries), the
private sector, gross domestic product (GDP), the liquid liabilities of the
fnancial system (i.e. currency plus demand deposits and interest-bearing
liabilities of banks and nonbank fnancial intermediaries) relative to GDP,
and the ratio of commercial bank assets relative to commercial bank and
central bank assets. Common stock market indicators of fnancial development are stock market capitalization (divided by GDP), stock market
turnover, and stock market value traded. On the one hand, stock market
capitalization measures the depth or relative size of the stock market. Stock
market turnover (total value of domestic shares traded divided by market
capitalization) and stock market value traded measure the liquidity of stock
markets. These variables aid comparisons of fnancial development across
countries.
Financial development is measured2 in terms of depth, access, effciency, and stability. Financial depth refers to the extent of advancement
and penetration of fnancial services provision to all levels of society in an
economy. A relatively wider set of fnancial services gives people of various socioeconomic groups more options to choose from. Financial depth
also connotes the size of the fnancial market and fnancial institutions relative to the size of the overall economy. Financial access describes the ability of individuals and businesses to obtain useful and affordable fnancial
products and services that serve their interest in an economy. Hence, higher
access to fnancial products and services implies a high-level fnancial inclusion. The opposite is also true: the inability of such groups to obtain fnancial services implies that they are fnancially excluded. Financial access
facilitates the daily transactions of individuals and enterprises and aids in
decision-making and planning over the longer term, such as access to shortand long-term fnancing and risk management instruments such as credit,
insurance, and savings.
Financial effciency refers to the scenario where market distortions are eliminated, where there is active competition in the market with
22
Lordina Amoah et al.
information available to all stakeholders in the fnancial system such that
the highest quality of fnancial services are provided at the lowest cost possible. Financial stability describes the state in which the fnancial system is
resilient to economic shocks and is well capable of smoothly accomplishing its basic functions. It therefore implies the ability of the fnancial sector to consistently facilitate and boost economic processes, manage risks,
and absorb shocks. The incidence of various fnancial crises, including the
global fnancial crisis of 2007/2008 and the eurozone crisis of 2009, has reaffrmed the importance of maintaining fnancial stability. Further, depending on the aspect of the fnancial sector in question, different variables may
be employed as indicators or proxies of fnancial development.
There are clear differences between the fnancial sectors of developed
and developing economies. On the one hand, the fnancial sectors of most
developing countries are typically small, underdeveloped, and bank based.
Some of the factors contributing to this include political instability, lack of
the appropriate technological infrastructure, lack of trust and confdence in
fnancial institutions, ineffcient legal systems, fnancial illiteracy, and the
overregulation of government, inter alia. On the other hand, the fnancial
sectors of most developed countries are far advanced in terms of depth,
access, effciency, and stability and combine a good balance of intermediation that uses banks and capital markets.
The composition of the fnancial sector, the fnancial structure, also
differs across developed economies and developing economies. There are
bank-based systems and market-based systems. In bank-based fnancial
systems, banks play a prominent role in executing functions such as savings mobilization, capital allocation, diversifcation, and managing risks.
In a market-based fnancial system, economic agents rely more on capital
markets for their savings and borrowing. In that system, frms and governments raise funds from savers by issuing fnancial securities in the form of
stocks and bonds. A fnancial system is described as bank based if the relative
share (size or activities) of banks is bigger than that of the capital market.
In the case of a market-based system, securities markets collaborate with
banks in performing these functions, even though the capital market play
the more active role, because they have a bigger market share. Examples
of African countries with a bank-based fnancial system are Ghana, Nigeria, and Morocco. Other countries that have bank-based fnancial systems
include Germany and Japan. Market-based fnancial systems, on the other
hand, focus on the importance of the capital market. They are those in which
the stock and bond markets play a critical role in the economy, by helping to raise long-term capital, infuencing corporate control, and providing
opportunities for risk management. South Africa is an example of an African country with a market-based fnancial system. The US and the UK are
also considered countries with market-based fnancial systems.
There are differences in how banks and markets channel savings
into investments. Typically, banks perform their intermediation function
by mobilizing savings (predominantly deposits) for onward lending. By
maintaining a close relationship between the two parties through information gathering, they are able to mitigate possible information asymmetry
Chapter 2 • Finance, economic growth, and development
23
problems and adverse selection. Furthermore, banks provide the means
for risk-averse savers to hold bank deposits instead of unproductive liquid
assets. Banks are able to lend these deposits for use in productive investments that stimulate economic activity. On the other hand, markets provide
a platform where debt and equity securities are issued and traded. Markets
overcome information asymmetry problems through contract covenants and
through the court system. Since the work of Gerschenkron (1962) and Goldsmith (1969), which expounded on the growth-enhancing role of fnancial
structure, there has been burgeoning empirical debate3 on which fnancial
structure is more effcient and growth enhancing. That is, whether bankbased fnancial systems or market-based fnancial systems spur growth
faster. The bank-based view postulates that banks (or intermediaries) are
better than markets at effciently allocating resources and hence propelling
economic growth. For example, banks play the important role of providing
fnance to small and medium-size enterprises (SMEs), which usually have
limited or no access to capital markets. The market-based view argues that
capital markets ensure good corporate governance and hence the optimal
allocation of resources to expedite economic growth. The underlying argument is that large, liquid, and well-functioning markets help to ameliorate
risk management through diversifcation and risk sharing. Capital markets
are better able to fund new projects, research and development, and venture
capital, which are crucial for increasing productivity in the economy.4
Notwithstanding the debate on the bank-based systems and marketbased systems, there is still a related strand of literature5 popularly referred
to as the fnancial services view, which posits that bank-based systems and
market-based systems are important together for economic growth because
of the provision of complementary fnancial services.
2.3 FINANCIAL REPRESSION, LIBERALIZATION,
AND GROWTH
Financial repression describes the scenario in an economy where the government institutes laws, interventions, regulations, and other nonmarket
restrictive policies in the fnancial sector. Such policies comprise capital
controls; government domination of banks, credit, and interest rate ceilings;
high-reserve ratios; restrictions on market entry and credit allocation; and
so on. Governments of developing economies employ repressive policies as
an option to tackle fscal challenges. The view is that putting such policies
in place helps governments obtain rents from the fnancial system or manage public debt servicing. This phenomenon was prevalent in a number of
developing economies after World War II. Indeed, in the period before the
1980s, a number of developing countries experienced serious economic and
fnancial crisis. This was attributed to many factors, of which inappropriate fnancial sector policies, which were generally repressive, were primary
(Kapur, 1991). Indeed, a number of studies have been conducted to examine
the impact of fnancial repression on the growth of economies. A number
of empirical studies support the notion of ineffcient allocation of capital during periods of fnancial repression, thereby impairing growth. The
24
Lordina Amoah et al.
argument is that fnancial repression stifes the effcient functioning of the
fnancial sector with concomitant adverse impact on growth. Specifcally,
it leads to dampening in both saving and investment, inhibiting capital
accumulation. That notwithstanding, this assertion has not been substantiated by the development trajectory of countries like Japan and South Korea,
which have employed mainly repressionist policies.
The challenges faced by developing economy governments that
employed repressionist policies before the 1980s, coupled with increase in
integration and globalization, forced these governments to rethink the system of controls. Hence, to curtail the repercussions of the crisis on their economies, governments of these economies in the early to mid 1980s embarked
on extensive reforms to move from a repressive system to a market-oriented
system, which gave rise to liberalization. Generally, fnancial liberalization
refers to offcial government policies that focus on deregulating credit and
interest rate controls, removing entry barriers for foreign fnancial institutions, privatizing fnancial institutions, or removing restrictions on foreign
fnancial transactions. The free market system is allowed to interplay to set
prices and thus stimulate competition. Financial liberalization has domestic
and international dimensions. The suppositions of the neoclassical theory
suggest that markets are effcient in allocating scarce resources. The theory
posits that liberalization of fnancial markets increases the effciency with
which these markets transform savings into investment, which leads to the
better allocation of resources. Specifcally, the transmission mechanism may
be explained as follows:
1 The onset of competition in the funds market increases interest rates
on deposits, increasing the saving rate, which in turn increases the
amount available for investment.
2 In the case of capital account liberalization, infows of capital in the
form of debt and equity will also contribute to the increase in investment capital. All other things being equal, both scenarios imply an
increase in loanable funds and hence a reduction in cost of funds or
fnancing constraints of frms. This leads to increased investment and
growth.
3 Financial liberalization improves risk diversifcation for fnancial
institutions and international equity investors.
4 Competition, resulting from fnancial liberalization, causes fnancial
institutions to become more effcient through the reduction in overhead costs, improvement in general bank management and risk management, and the offering of new products and services.
These will help to improve the effciency of fnancial intermediation in a
country, contribute to higher returns on investment, and ultimately increase
the rate of economic growth.
The seminal works of McKinnon (1973) and Shaw (1973) initiated
the discussion on fnancial sector liberalization. Their work sought to criticize the repressive government policies that in their view led to excessive
demand and ineffcient allocation of capital. Accordingly, governments of
most developing countries in sub-Saharan Africa, in particular, adopted the
Chapter 2 • Finance, economic growth, and development
25
programmes sponsored by the International Monetary Fund (IMF)/World
Bank (WB) – the economic recovery programme (ERP)6 and the structural
adjustment programme (SAP) – as part of reforms aimed at salvaging
their ailing economies. The fnancial sector was given special attention in
these reforms. The reforms entailed price and interest rate liberalizations,
the removal of credit ceilings, the privatization of state-owned frms, and
the introduction of a number of measures for banking and capital market
development, including fnancial regulatory schemes.7 The fnancial sector
reforms resulted in an increase in the number of banks and the establishment of stock markets and other fnancial institutions. The reforms were
aimed at enhancing the dynamism in the fnancial architecture of these
economies to promote effciency in, competitiveness in, and a deepening of
the fnancial system.
Notwithstanding the evidence in support of fnancial liberalization,
many authors8 do not agree on the growth-propelling role of fnancial liberalization. Their arguments include the following:
1 Financial liberalization does not necessarily solve the problem of
information asymmetry, but rather liberalized markets may actually
exacerbate information problems.
2 More competition as a result of increased liberalization may have
adverse implications for proft margins and increase fnancial fragility.
3 Financial liberalization may increase the risk appetite of banks, which
will likely increase the number of fnancial institutional failures and
hence provoke bank runs.
Overall, the empirical literature9 on fnancial liberalization and economic
growth is inconclusive. Indeed, more recently, authors like Reinhart (2012)
have argued that fnancial repression policies have returned but this time
implemented by governments of developed economies as a strategy to
obtain low-cost funds from the fnancial market in the aftermath of the
global fnancial crisis.
2.4 THE FINANCE–GROWTH NEXUS
The fnance–growth nexus, as it is popularly referred to as, has a long history in economic literature. Indeed, the theoretical and empirical studies
examining this phenomenon have been numerous. Goldsmith (1969) was
one of the frst to provide empirical evidence of a relationship between
fnance and growth. According to Goldsmith,
a country’s fnancial superstructure accelerates economic growth
and improves economic performance to the extent that it facilitates the migration of funds to the best user, i.e. to the place in the
economic system where the funds will yield the highest social
return.
(p. 400)
After Goldsmith (1969), the foodgates were opened for further study of the
phenomenon.10 These studies have evolved in the econometric techniques
26
Lordina Amoah et al.
used to examine the phenomenon, such as time series analysis and panel
data techniques. The underlying debate is predicated on whether fnance
can infuence growth – that is, the nature and strength of the relationship
between fnance and growth. Another strand in the literature seeks to investigate the possibility of the existence of threshold effects. This suggests that
the attainment of a positive relationship between fnance and growth is
preconditioned on the existence of certain parameters. Some parameters
examined in the literature include the level of economic development,
infation, institutions, openness, institutional investors, the growth of private credit, the legal and regulatory environment, or government size and
policies.11 Hence, fnance has a positive impact on economic growth within
certain parameter thresholds, and beyond that, it ceases to have an impact.
The debate has also revolved around the type of fnancial structure, bankbased fnancial system versus capital market-led fnancial system, and their
respective impacts on growth.
2.4.1 Finance and growth: the debate on causality
The direction of causality between fnance and growth has also gained
attention in the literature. A number of hypotheses have been postulated
to explain the causality: whether fnancial development causes growth or
growth causes fnancial development. These hypotheses include the supplyleading hypothesis, the demand-following hypothesis, bidirectional causality, and the no-causality hypothesis. These are discussed in succession.
One the one hand, the supply-leading hypothesis of fnancial development suggests that fnancial development acts as a productive input of
economic growth. Schumpeter (1912) frst advanced the notion that the
provision of fnancial services by the fnancial sector has growth-enhancing
effects. Pagano (1993) propounded the theoretical model that shows the channels through which fnance leads to growth– that is, through the increase in
the marginal productivity of capital, the proportion of saving channelled
into investment, and the saving rate. Overall, the hypothesis implies causality that runs from fnancial development to economic growth.12
On the other hand, contrary to the views of Schumpeter (1912),
Robinson (1952) posited that instead enterprise paves the way for fnancial development. By implication, higher growth creates the impetus for
increased demand for a wide range of fnancial services. Hence, the establishment of modern fnancial institutions, their fnancial assets and liabilities, and associated fnancial services happens in response to the demand
for these services by savers and investors in the real economy. Ultimately,
the demand-following hypothesis suggests a causal relationship that runs
from economic growth to fnancial development (Kuznets, 1955; Ang and
McKibbin, 2007; Odhiambo, 2008; Ono, 2017).
The bidirectional causality (i.e. two-way causal relationship) was
popularized by Patrick (1966). According to him, the causal relationship
between fnancial development and growth may better be illustrated by
using the chicken-and-egg framework or a cause-and-effect scenario, predominantly determined by the stage of economic development. According
Chapter 2 • Finance, economic growth, and development
27
to Patrick (1966), at the early stage of economic development, before modern industrial growth sets in, the supply-leading fnancial development is
dominant, inducing and propelling innovative-type investments. As modern industrial growth sets in and progresses, the demand-following phenomenon becomes prevalent. Largely, the view implies that fnancial sector
development is a product of economic growth, which in turn feeds back as
a factor of growth.13 The bidirectional hypothesis, therefore, seems to suggest a threshold effect, in that in a certain band of some variables (economic
development, infation, institutions, institutional investors, legal and regulatory environment, or government size and policies), fnancial development
may be a good catalyst for further growth. However, beyond a certain level
of these variables, fnancial development may not infuence growth, leading
to a possible nonlinear relationship (indicative of some turning point in the
fnance–growth relationship). Indeed, some empirical studies have examined the possible nonlinear relationship between fnancial development and
economic growth.14 According to Berthélemy and Varoudakis (1996), two
scenarios are likely to occur. The frst is a virtuous cycle in which a high
level of income stimulates a high level of fnancial development, which in
turn facilitates economic growth. The second is a vicious cycle in which a
low level of income inhibits the development of the fnancial system, which
in turn slows economic growth. In the two scenarios, a two-way causality
is implied, the frst indicative of a positive relationship and the second a
negative one.
In the no-causal relationship hypothesis, fnance is not an important
determinant of economic growth. Lucas (1988) constructed a neoclassical
theory of growth where he considered three models: physical accumulation
and technological change; human capital accumulation through schooling;
and specialized human capital accumulation through learning by doing. In
his view, the importance of fnance in the attainment of economic growth
is badly overstressed in popular and professional discourse, and hence, he
is inclined to disregard it. Simply put, fnancial development is not an outcome of economic growth, and neither is growth an outcome of fnancial
development.15
The implication of a positive signifcant effect of fnancial development on economic growth (suggested by the supply-leading hypothesis and
in some empirical studies) is an impetus for appropriate legal and regulatory systems as well as policy reforms to be put in place, in order to improve
the functioning of the fnancial sectors of developing economies. A weak
causality should, however, not suggest otherwise, as it may be indicative of
the existence of ineffciencies in the fnancial system arising from weak institutions, infrastructure development gap, restrictive government policies, or
an unfavourable legal and regulatory environment. That is, as suggested by
the threshold analysis, a positive relationship between fnance and growth
is preconditioned on the existence of certain parameters.
In sum, the debate in the fnance–growth nexus appears to have
been strengthened, recent studies pointing towards a context-based or
conditioning effect. In other words, fnance drives growth only in certain
country contexts or under certain conditions. Two factors have driven the
28
Lordina Amoah et al.
context-based-effect or condition-effect explanations. These factors are, frst,
the threshold effect and, second, the fnancial structure or typology effect.
As already discussed, the threshold effect shows that there is a turning
point (nonlinear effect) in the relationship between fnance and growth. The
threshold effect has two views. In the frst view, fnance positively drives
growth only in countries with good fnancial systems, quality institutions,
and high income and development levels.16 In this view, the role of fnance
in growth for low-income countries comes about only after a certain threshold of fnancial development has been achieved. Below this threshold, there
is no effect of fnance on growth. The second view17 almost diametrically
opposes the frst. In it, although the level of fnancial development is good
for the fnance growth nexus, the relationship between fnance and growth
is an inverted U-shaped one. Finance increases growth but only to an extent
of fnancial level development, beyond which fnance is detrimental to
growth for developed countries. In this case, too much fnance will therefore harm growth – a situation also referred to as ‘the vanishing effect of
fnancial development’ (Law & Singh, 2014).
The fnancial structure or typology effect relates to the type of fnance,
where investment, consumption, or working capital is on one side and the
dimensions of the fnancial structure on the other. Investment credit and to
a certain extent consumption credit beyond a certain threshold is seen as
harmful for growth. According to this view,18 working capital is the only
form of fnance with a positive growth effect. With respect to the dimensions
effect,19 the effect of fnance on growth depends on the different dimensions
(depth, effciency, stability, openness, and access to fnancial services). A
stable and effcient fnancial structure increases productivity and growth
universally. However, the effect of other dimensions will depend on the
level of development in the country. In this view, the existence of different
thresholds in the fnance–growth nexus comes when we focus on depth,
openness, and access to fnancial services. In a slightly related way, another
perspective20 dwells on the view that although bank fnance increases
growth, this effect is more pronounced and signifcant in countries with
more-developed stock markets. The idea here is that such countries exhibit
more effciency and stability.
2.5 THE ROLE OF THE FINANCIAL SYSTEM
In the 1990s, even though there were general postulations about the growth
effects of fnancial development, Pagano (1993) became the frst to propose the theoretical model explaining the channels through which fnancial development infuences economic growth. According to Pagano (1993),
the fnancial sector spurs growth through the accumulation of productive
factors and increase in total factor productivity. Accordingly, the fnancial system facilitates economic growth through its ability to increase the
marginal productivity of capital, the proportion of saving channelled into
investment, and the saving rate. In line with Pagano (1993), Levine (1997)
outlines the specifc functions of an effcient fnancial system and how the
implementation or existence of these functions should help increase the
Chapter 2 • Finance, economic growth, and development
29
marginal productivity of capital, the proportion of saving channelled into
investment, and the saving rate. These functions are as follows:
• Mobilizing and pooling savings.
• Producing information about possible investments and allocating
capital.
• Easing the exchange of goods and services.
• Facilitating the trading, diversifcation, and management of risk.
• Monitoring frms and exerting corporate governance.
What follows is a discussion on how these functions lead to growth through
the increase in the marginal productivity of capital, the proportion of saving
channelled into investment, and the saving rate.
Mobilizing and pooling savings: the quantity of savings channelled
to investment is critical to economic growth. An effcient fnancial system
increases the amount of savings mobilized from disparate savers and channels them towards investment in economically viable projects. In so doing,
the fnancial system also helps to increase the saving rate. In mobilizing
savings as a fnancial intermediary, the fnancial sector reduces the costs
involved in collecting funds from a wide variety of savers and overcomes
information asymmetries associated with ensuring that savers are comfortable to give up control of their savings.21
Producing information about possible investments and allocating capital: individual savers may not have the wherewithal and time to collect, process, and produce information on potentially viable investments. Information
costs may stife capital from being directed to its optimal use. Financial intermediaries effciently take up the costly process of gathering information on
investment opportunities for others. In this way, reduced information costs
lead to improved resource allocation and hence accelerated growth.22
Easing the exchange of goods and services: fnancial markets provide
arrangements that reduce transaction costs and the process of exchange of
goods and services. For example, the fnancial sector provides a payment
system that increases the reliability and speed of exchanges. The system
helps people to save time and energy, which would otherwise be lost under
a barter system, thereby helping them to focus on the nuances of the production process. Ultimately, by promoting specialization and innovation, the
fnancial system improves productivity and in turn growth.23 Financial technology24 (fntech) is one of the fastest growing areas, facilitating payments
and other fnancial transactions. A notable innovation is the Ethiopian Commodity Exchange (ECX) (see Box 2.1). The ECX provides a payment system
that eases the exchange of commodities and facilitates risk management.
The ECX provides a market for futures contract trading, which helps to mitigate risk for buyers and sellers, particularly in the commodity market. In
most developing countries, the commodity market is crucial. The structure
or platform on which the commodities market operates is critical for fnancial intermediation in the sector; hence, the ECX is an example of effective
fnancial intermediation in the commodities market.
Facilitating the trading, diversifcation, and management of risk: generally, fnancial transactions involve numerous risks, such as cross-sectional,
30
Lordina Amoah et al.
intertemporal, and liquidity risks. The presence of risk prevents people who
are risk averse from saving and investing or entering into fnancial contracts. The fnancial system provides the platform for the sharing of crosssectional risks and helps in the smoothing of intertemporal risks and in
reducing liquidity risks. Financial systems also mitigate the risks associated
with individual projects, frms, industries, regions, and countries. In particular, banks, MFIs, mutual funds, and securities (stocks, bonds, and derivatives) markets provide vehicles for the trading, pooling, and diversifcation
of risks, through economies of scale and lower transaction costs. For example, some high-return projects require a commitment of capital for a longer time, whereas savers fnd it diffcult to relinquish control of their funds
for longer-term periods. Thus, with a liquid fnancial market, savers have
the option to hold liquid assets such as equity, bonds, or demand deposits,
while fnancial markets transform these assets into long-term capital investments. Hence, fnancial markets lower transaction costs and enhance risk
diversifcation. By so doing, they improve the amount of savings, the savings rate, physical resource allocation, and then economic growth.25
Monitoring frms and exerting corporate governance: fnancial intermediaries have the expertise and economies of scale necessary for verifying
and monitoring projects and frms. In the agency theory, borrowers may not
always act in the best interest of the providers of capital. Hence, monitoring
is crucial because it ensures the truthful reporting of project outcomes and
helps to minimize the incidence of moral hazard. Monitoring is also a costly
process, especially if carried out by individual lenders. However, fnancial
intermediaries reduce the costs associated with monitoring because of the
economies of scale they enjoy from dealing with a large number of borrowers and lenders. In Thadder (1995) and Dolar and Meh (2002), as information
costs reduce, capital allocation is enhanced, thereby increasing productivity
growth.
BOX 2.1 Enhancing fnancial intermediation in commodities
markets: the ECX
The ECX is a national multicommodity exchange in the fnancial system of Ethiopia. It aims at addressing the problems of a lack of access
to fnance, no market structure, a lack of order in the market and its
actors, low producer earnings, high contract performance risk and
default, high market risk in quality, a lack of integrity and transparency in the agricultural trading system, and limited effciency in the
market, among others. The ECX was established in 2006 and started
its trading operations in April 2008. Commodities which are open for
trade at ECX are coffee, sesame, haricot beans, wheat, and maize. The
ECX enhances market effciency by operating a trading system where
buyers and sellers use standardized commodity contracts by disseminating market information in real time to all market players. The
ECX manages a system of daily clearing and settling of commodity
Chapter 2 • Finance, economic growth, and development
contracts. It also facilitates risk management by offering contracts for
future delivery, providing sellers and buyers a way to hedge against
price risk. Apart from enhancing payments of receipts of funds for
commodities, the ECX helps address the agricultural marketing challenges and risks that were faced by farmers and traders, especially
the rural farmers and traders. In that regard, the ECX has introduced
seven electronic trading platforms in various regions in Ethiopia, and
this e-trading platform enabled the ECX to trade 246,752 metric tons
of commodities, mainly coffee and white beans. Since its operations
in 2008, ECX has been able to achieve some its goals. Achievements of
the ECX in the frst fve years of its operations include high returns to
farmers through the effective payment system; improved impact on
exports and trading volumes with high outreach of over three million
farmers; improved warehouse capacity (57 warehouses and 300,000
metric tons warehouse storage capacity; market data (interactive voice
response [IVR] had one million call-ins/month; SMS had 888,000 texts/
month; and website had 10,826 hits/month) as of 2013. The fnancial
intermediation medium has borne some fruit compared to the period
before the establishment of the ECX, in that there is increased access
to fnance through the warehouse receipt fnance system, enhanced
risk management, price discovery, and overall reduction in transaction costs.
BOX 2.2 Enhancing fnancial intermediation (or inclusion through)
in mobile fnancial services: the story of M-PESA
M-PESA is a mobile fnancial service promoting fnancial intermediation (inclusion) in Kenya. It is simply a technological platform that
requires a transfer of digital value in the form of electronic currency
using text messages (SMS) and a multitude of agents who help their
subscribers deposit money into and withdraw money from their
mobile money accounts. This transfer is often done by agents who
are found in specialized shops popularly known as M-PESA kiosks,
which are widely spread across the country. M-PESA was launched
in March 2007, after one of Kenya’s leading mobile network operators, Safaricom. The conceptualization of M-PESA was born out of
critical observations: the majority of mobile network subscribers’
tendency to exchange airtime to transfer money, the increasing rate
of adoption of technology, and the rapid infux of mobile phones in
the country. This local mobile money transfer service has become a
household fnancial intermediary or monetary instrument in Kenya
and is used for multiple purposes, such as payments for goods and
services, transferring money to other users, saving money, and
converting from and to cash. According to Global Financial Index
31
32
Lordina Amoah et al.
(Findex) data, as of 2014, approximately 58% of the Kenyan adult
population had mobile money accounts. Again, out of the total number of frms who were interviewed by the FinAcces Business survey
in Nairobi, as many as 35% of these frms attested to accepting mobile
money as a form of payment method from their customers and 32%
adopted mobile money in purchasing their inputs from their suppliers. The introduction of M-PESA has created a relatively cheaper
alternative of transferring money, comparable to others such as
Western Union and PayPal, and reduced the risk of theft associated
with sending cash via friends or bus drivers. By 2014, the number of
M-PESA kiosks had increased to about 124,000 (representing annual
growth of 148%), and M-PESA had about 27 million registered users
and over 130,000 agents as of 2016. According to the 2017 Safaricom
annual report, the customer base increased to approximately 11.8%
during the year under review and the total transactions executed
were valued at about Shs6.9 trillion. Currently, this concept of mobile
money has moved beyond the borders of Kenya to other parts of East
Africa and West Africa. Across the sub-Saharan region, mobile fnancial services play vital roles in providing fnancial services to people
who have limited access to traditional fnancial institutions such as
the banks, insurance companies, stock exchanges, and mortgage
institutions. Data from the Global Financial Index 2017 show that the
share of adults who have a mobile money account in the sub-Saharan
region has roughly doubled since 2014, from 4% to about 9%. Mobile
money services are also available in other parts of the world such as
Haiti, Chile, Mongolia, and Turkey.
2.6 FINANCIAL INTERMEDIATION AND GROWTH
The preponderance of literature (as seen in the preceding sections) point
to the growth-enhancing effects of fnancial intermediation, a function performed by fnancial institutions and fnancial markets. Financial institutions
and markets vary in their approach to executing the functions outlined in
section 2.3, in order to propel growth. A discussion on some fnancial institutions and markets follows: specifcally deposit-taking fnancial institutions and capital markets.
2.6.1 Deposit-taking fnancial institutions and growth
Deposit-taking fnancial institutions refer to fnancial institutions that are
licensed to receive and manage deposits on behalf of clients. They also give
out loans to their clients. By so doing, they play critical roles in the process
of fnancial intermediation. There are a number of deposit-taking fnancial
institutions. A discussion on some of these institutions, specifcally banks,
microfnance institutions, and credit unions, follows.
Chapter 2 • Finance, economic growth, and development
33
2.6.1.1 BANKS Particularly in economies with bank-based fnancial
systems, banks play the critical role of formal fnancial intermediation,
through the mobilization of funds from surplus units and channelling
it to the most productive sectors of the economy. Apart from contributing to economic growth through their capital mobilization and allocation
functions, banks encourage savings behaviour by offering savings, chequing, and time-deposit accounts to customers through branch networking;
mitigate fnancial risk; facilitate payments (and hence, trade) within and
beyond the borders of a country; and assist in the implementation of key
macroeconomic policies (e.g. monetary policy) that ensure the stability
of the overall economy and employment creation. Some empirical studies26 provide evidence that shows that banking development has a positive infuence on growth. The argument is that banks are more effcient
at reducing market frictions and costs related to the mobilization and
allocation of resources towards more-productive ventures. Information
costs may hinder capital from being directed to its optimal use. Financial
intermediaries, in this case banks, take up the costly process of gathering
information on investment opportunities for others. In this way, reduced
information costs lead to improved resource allocation and hence accelerate productivity growth. Singh and Weisse (1998) make a special case for
banks on the basis that they foster long-term relationships with investors
and thus provide a more stable source of fnance for attaining long-term
growth and industrialization.
Domestic credit to the private sector by the banking sector relative to
gross economic output is one of the variables used in assessing the contribution of banks to an economy with regard to providing credit. Figure 2.1
shows domestic credit by the banking sector (% GDP) for the various
income groups from 1973 to 2016. It shows a clear trend of a rise across all
income groups. Generally, across successive years, high-income countries
have recorded the highest domestic credit by the banking sector (% GDP),
followed by the upper-middle income, the lower-middle income group, and
then the low-income group. In terms of regional classifcation, Figure 2.2
shows that over the years from 1969 to 2017, East Asia and Asia Pacifc have
FIGURE 2.1 Domestic credit by banking sector (% GDP) across income groups
Low income
Lower-middle
Upper-middle
High-income
120
100
80
60
40
20
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
Source: Beck, Asli, Ross, Cihak, & Feyen, 2015 World Bank Financial Structure Dataset and authors’
computations
34
Lordina Amoah et al.
FIGURE 2.2 Domestic credit by banking sector (% GDP) by regional classifcation
200
150
100
50
Sub-Saharan Africa
East Asiaand Pacifc
North America
Middle-east and North-Africa
Europe and Central Asia
2017
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
0
South Asia
La°n America and Caribbean
Source: Beck et al., 2015 World Bank Financial Structure Dataset and authors’ computations
recorded the highest domestic credit by banking sector. Europe and Central
Asia follow after only from 200127 to 2017 and then North America.
Credit associations and other fnancial cooperatives have existed for centuries. Credit unions are mutually owned fnancial
cooperatives that generally provide savings and lending products to their
members. Credit unions act as fnancial intermediaries, by providing credit
and other fnancial services from lenders to borrowers who belong to the
same community, be it a school, church, club, or a cooperative union, at
relatively fair and competitive rates, usually lower than those of commercial banks. Each member is required to be a shareholder in the organization. Members usually satisfy a common bond, which may be determined
by locality, employer, or religion, among others. Unlike banks, the main
goal of credit unions is not to maximize profts but to provide fnancial services to its members. Each has a democratic structure, where it is owned and
governed by the members, who direct the operations of the union. Unlike
MFIs, credit unions provide credit to members at more competitive rates
of interest. They operate with the aim of improving a standard of living to
members. Surpluses generated are either ploughed back or given to members in the form of dividends or interest rebates.
The concept of credit unions became common in the United States
around the 1900s. It was a local strategy for fnancial inclusion for groups marginalized by race. Hence, working-class Black Americans or immigrants in
the low-income class in rural households pulled their fnancial resources
together by forming fnancial cooperatives in order to improve their lives.
Over time, credit unions have grown around the world. The United States
has the largest credit union membership around the world. There are just
as many credit unions as banks in the US, with a combined asset of USD1
trillion (Pavlovskaya & Eletto, 2018).
Box 2.3 is a brief illustration of how credit unions operate in Canada.
Apart from providing fnancial alternatives, credit unions play a vital role in
2.6.1.2 CREDIT UNIONS
Chapter 2 • Finance, economic growth, and development
35
supporting the urban populace amid stern competition from ingrained capitalist banks. One of the major benefts of credit unions is that the existence
of the bond implies a reduction in information asymmetry and informationgathering costs, which facilitates the provision of fnancial services to groups
which may otherwise would have been excluded from the formal banking
system (McKillop & Wilson, 2011; McKillop & Quinn, 2017). Credit unions
play an important role in rebuilding community and ultimately the country,
on the basis of fnancial inclusion and solidarity.
BOX 2.3 Credit unions in Canada
Canada has a vibrant cooperative fnancial services sector comprising
credit unions (popularly called caisses populaires in French-speaking
regions, meaning people’s bank). The frst successful credit union in
Canada was started in Lévis, Québec, in 1900 by Alphonse Desjardins.
Canada has one of the highest per capita memberships in credit unions
in North America. Over 75% of the population are members of at least
one credit union, and Québec has the largest membership. Credit
unions in Canada are deposit-taking fnancial institutions that are provincially regulated with legislation spelling out how they can lend,
borrow, and invest. Provincial regulators supervise individual credit
unions in their respective provinces, and credit unions are required
to meet standards and work with public agencies to ensure they are
among the country’s soundest fnancial institutions. The Canadian
Credit Union Association (CCUA) is the leading advocate for a successful, competitive, and growing credit union industry in Canada.
The CCUA was the frst owned and governed national organization
in Canada. CCUA works on behalf of its members in four key areas:
1 Advocacy and government relations to ensure that national
public policy recognizes the distinctiveness and strength of
credit unions.
2 National regulatory and network compliance, which includes a
focus on payments network compliance.
3 Professional development and education of credit union
employees and board members.
4 National awareness building, which focuses on promoting the
value and importance of Canada’s credit unions in local communities and to the Canadian economy.
2.6.2 Capital markets and growth
Theoretical and empirical literature concur that capital markets play important roles in stimulating economic growth. Financial securities available on
the capital markets are essentially long-term in nature and consist mainly
of stocks (equity) and bonds (debt). On the one hand, stocks represent an
36
Lordina Amoah et al.
ownership of the issuing company. Bonds, on the other hand, are usually
issued by governments and corporate bodies.
In market-based fnancial systems, stock markets
play the major role of fnancial intermediation, bringing together investors
willing to buy and those who want to sell their shares/stocks. Indeed, the
proposition that stock markets contribute positively to economic growth has
gained ground.28 The channels through which effcient stock markets facilitate growth is through the provision of liquidity for investors, increased
physical capital accumulation, the improved allocation of funds towards
long-term investments (arising from investors monitoring frms), and risk
sharing. Empirical studies29 show that countries that are more developed
and enjoy macroeconomic stability tend to have deeper stock markets. In
particular, the laws and enforcement mechanisms that protect the rights
of minority investors promotes stock market development. Levine (1991)
accentuates the importance of stock market liquidity, which is the ability to
trade equity easily, to economic growth. The argument is that more-liquid
markets make it possible to engage in projects that require large injections
of capital for a long period of time before yielding any profts. Liquid stock
markets make it easy for savers to relinquish control of their savings for
such long periods by providing them with assets that can be liquidated at
any time, effortlessly. This allows frms to have permanent and uninterrupted access to capital to undertake economically viable projects. Contrary
to these fndings, there is also another angle to the debate that argues that
stock markets could adversely infuence growth.30 Stiglitz (1985) questions
the role of stock markets in improving information asymmetries. In their
view, stock markets disclose information through price changes, thereby
creating a free-rider problem that weakens the motivation for investors
to undertake costly research. Other channels through which stock market
liquidity could prevent growth is discussed in the literature.31 Arguments
are made about the reduction in saving rates through the income and substitution effect. There is also the issue of stock market liquidity adversely
affecting corporate governance due to investor myopia.
Unlike developed economies’ stock markets, developing countries’
stock markets have typically been illiquid and segmented with overall
trading and capitalization centred on a few stocks. However, the past two
decades have seen a number of countries implementing capital market
reforms to spur fnancial sector development. For example, the sub-Saharan
Africa (SSA) region has, for the past three decades, seen a swift increase in
the number of stock exchanges (see Table 2.1) after the implementation of
capital market reforms. According to Allen, Otchere, and Senbet (2011), the
reform has led to relative improvements in economic growth rates of the
African countries. Other initiatives have also been implemented to improve
the effciency of capital markets and improve participation and fnancial
access in the region. One of such initiatives is the introduction of the Ghana
Alternate Market (GAX). This is elaborated in Box 2.4. According to Hearn,
Piesse, and Strange (2010), countries perceive the development of equity
markets as a means to facilitate both foreign equity portfolio investment and
2.6.2.1 STOCK MARKETS
Chapter 2 • Finance, economic growth, and development
37
TABLE 2.1 Stock markets in sub-Saharan Africa
Country
Name of stock exchange
Year of
establishment
Number
of frms
listed
Botswana
Ghana
Kenya
Malawi
Mauritius
Nigeria
South Africa
Côte d’Ivoire
Zimbabwe
Namibia
Swaziland
Tanzania
Botswana Stock Exchange (BSE)
Ghana Stock Exchange (GSE)
Nairobi Securities Exchange (NSE)
Malawi Securities Exchange (MSE)
Stock Exchange of Mauritius (SEM)
Nigerian Stock Exchange (NSE)
Johannesburg Stock Exchange (JSE)
Bourse Regionale des Valeurs Mobilieres33
Zimbabwe Stock Exchange (ZSE)
Namibia Stock Exchange
Swaziland Stock Exchange
Dar es Salaam Stock Exchange
1989
1989
1954
1994
1989
1960
1887
1998
1946
1992
1990
1998
39
43
45
13
164
172
816
45
38
7
28
Source: Author’s compilation from various sources
foreign direct investment (FDI) through the acquisition of shares in domestic companies and hence boost the low levels of funding from domestic savings. Despite these tremendous improvements in the growth of this sector in
Africa, most of these markets are characterized by problems of thin trading,
small size, low liquidity, weak regulatory institutions, and infrastructural
bottlenecks (Yartey & Adjasi, 2007; Mlambo & Biekpe, 2007; Kuttu, 2017).
In this regard, a number of issues infuencing stock market development
have been investigated:32 legal, political, and governance system; liquidity
and size effects; corporate governance, and so on. For example, according
to Hearn and Piesse (2010), the dissimilarities in the colonial legacy and the
ensuing legal institutions explains why the size and the activity of stock
markets vary across Africa. That is, the actualization of the benefts of stock
markets in developing countries depends largely on well-established property rights. The existence of these will serve as a good platform for appropriate regulations to be designed to minimize transaction costs associated
with searching for and verifying information. Nevertheless, these characteristics can be improved or eliminated if the determinants of the stock market
in Africa, such as shareholder protections, a legal framework, institutional
quality, macroeconomic stability, and the banking sector development iterated by Yartey and Adjasi (2007), are established.
BOX 2.4 Ghana Alternative Market
The Ghana Alternative Market (GAX) is a parallel market operated
by the Ghana Stock Exchange. The GAX was launched in 2013 to help
small and medium-size enterprises (SMEs) generate funds to start their
38
Lordina Amoah et al.
operations or expand their business operations. It focuses on SMEs with
potential for growth. The GAX accommodates companies at various
stages of their development, including start-ups and existing enterprises. Listing on the GAX helps frms gain access to long-term capital,
enhance their status in the community, and improve their fnancial position. Advisory and regulatory fees involved in listing on the GAX is relatively lower compared to listings on the main Ghana Stock Exchange.
Firms do not pay any application fees and do not incur any cost upon
listing, as it is waived. A GAX-listed company pays an annual fee of
only around USD450. A frm applying to list on the GAX must have a
minimum stated capital of around USD50,000 at the time of listing. This
shall be the capital after the frm’s initial public offering. The public foat
of the applicant must constitute a minimum of 25% of the total number
of issued shares. Admission may be granted to a start-up company if
the applicant provides a three-year business plan to the GAX that shows
the viability of the applicant. The company seeking admission to the
GAX need not have recorded profts historically. However, it must have
potential to make proft at least by the end of its third year of listing. Five
companies were listed on GAX as of 2018.
Source: Ghana Stock Exchange
2.6.2.2 BOND MARKETS Bonds are medium- to long-term debt securities.
They may be issued by the government or corporate entities. Bond markets are alternative or complementary sources of medium- to long-term
fnance for governments and corporations alike. Firms wishing to borrow
for the medium to long term have the option of issuing corporate bonds. In
this way, the bond market plays a key role in the effcient mobilization and
allocation of fnancial resources in the economy. When bonds are issued
by national governments, they are usually referred to as sovereign bonds.34
They may be denominated in governments’ domestic currency or a foreign
currency. A typical example is the Eurobond. A Eurobond35 is denominated
in a currency other than the home currency of the country or market in
which it is issued.
While literature is replete with studies on the role of banks and stock
market in spurring economic growth, the same cannot be said about bond
markets,36 particularly in developing countries, because bond markets in
these countries are at the rudimentary stage. Hence, the market capitalization of bonds as a percentage of GDP is low. Whereas government bonds
have gained some traction over the past decade, corporate bonds are relatively at the inception stage of development in these countries, due to factors such as ineffcient market infrastructure, a relatively underdeveloped
regulatory framework, and a low number of market participants. There is
dominance of over-the-counter (OTC) government or treasury bond markets with few bonds traded on the organized exchanges.
Chapter 2 • Finance, economic growth, and development
39
Indeed, as agents of fnancial intermediation, bond markets serve as
one of the channels through which savings are transformed into capital to
fnance the real sector of an economy. The funds mobilized from the issuance of bonds provide the government with extra spending money, which
is used for various developmental projects, ultimately stimulating economic
activity. Such long-term fnance helps in addressing the growing infrastructural defcits, particularly in the sub-Saharan region. The declining trends in
aid fows give credence to the increasing number of sovereign bonds being
issued recently by developing countries as an alternative means to acquiring external funds to fnance infrastructural projects. In particular, Eurobonds have become popular as a fnance tool because of the high degree of
fexibility that they offer issuers. For example, it allows the issuer to choose
the country of issuance on the basis of the regulatory market, interest rates,
and depth of the market. They are also attractive to investors because of
their small par values and high liquidity.
2.6.3 Summarized overview of fnancial structure
Table 2.2 shows the average fnancial structures of low-income and highincome countries. We observe that high-income countries exhibit higher
scales of bank deposit to GDP, other fnancial institutions assets to GDP,
private credit by banks to GDP, stock market capitalization to GDP, and
stock market turnover than those of developing countries. However, bank
net interest margin, bank overhead costs to total assets, and central bank
assets to GDP are higher in developing countries than they are in developed
countries. The high interest margin and high bank overhead costs to total
assets are a refection of the low level of effciency associated with developing countries’ fnancial systems. In terms of the high central bank assets to
GDP, this is an indication of the more dominant role that the public sector plays in low-income economies. Although financial liberalization has
eroded many of the structures associated with financial repression in lowincome countries, a lot more is required to improve the level of effciency in
these markets.
TABLE 2.2 Average fnancial structures of high-income vs low-income countries, 2015
Variables
Low income
High income
Bank deposits to GDP (%)
Bank net interest margin (%)
Bank overhead costs to total assets (%)
Central bank assets to GDP (%)
Other fnancial institutions’ assets to GDP (%)
Private credit by banks to GDP (%)
Stock market capitalization to GDP (%)
Stock market turnover (%)
18.01
5.05
5.27
3.85
3.06
13.18
16.89
1.44
78.91
1.88
1.67
2.12
6.57
77.95
70.00
36.79
Source: Beck et al., 2015 World Bank Financial Structure Dataset and authors’ computations
40
Lordina Amoah et al.
2.7 REGULATION IN THE FINANCIAL SECTOR
Because of the complex nature of the fnancial system and the role it is
expected to play in the economy, governments are responsible for ensuring
the effcient regulation of the fnancial system. This responsibility is provided by organizations that regulate and supervise fnancial institutions to
ensure that they meet certain requirements. Such regulatory requirements
aim to maintain the integrity and soundness of the fnancial system. Financial regulators are often saddled with the issue of imposing appropriate regulation aimed at ensuring the safety and soundness of the fnancial system
without limiting competition and effciency. Regulating the fnancial system
is aimed at protecting investors; preventing securities issuers from defrauding investors and hiding important information; maintaining the stability of
fnancial markets and institutions; promoting effciency, competition, and
fairness in the trading of fnancial securities; restricting the extent of participation of foreign entities in the domestic markets; and controlling the level
of economic activity.
There are different regulatory regimes across various countries. While
some jurisdictions have different fnancial regulators responsible for regulating different aspects of the fnancial system, others have one regulator (besides
the oversight role of the central bank over the banking sector) overseeing the
nonbank fnancial system. For examples, countries such Ghana, Nigeria, and
India have different regulators for banking, securities markets, insurance,
and pensions. Until 2017, South Africa had two sector-specifc regulators,
the South African Reserve Bank (SARB) for regulating the banking sector
and the Financial Services Board (FSB) for overseeing the nonbanking sector.
This situation has changed with the new regulatory framework that focuses
on establishing two regulators: a prudential regulator (Prudential Authority)
operating in the SARB will be in charge of promoting and enhancing safety
and soundness of fnancial institutions and a dedicated market conduct
regulator (Financial Sector Conduct Authority) responsible for supervising
market conduct with the aim of protecting fnancial consumers. The South
African model is similar to that of England, which after the global fnancial
crisis, split the responsibilities of the Financial Services Authority in 2013 and
assigned them to two organizations: the Financial Conduct Authority and
the Prudential Regulation Authority of the Bank of England.
2.8 CONCLUSION
The importance of the fnancial sector in an economy cannot be overemphasized. Specifc functions performed by this sector include the mobilization
and pooling of savings; the production of information about possible investments and allocation of capital to best user; easing the exchange of goods
and services; facilitating the trading, diversifcation, and management of
risk; and enforcing corporate governance. Undeniably, the relationship
between fnancial sector development and economic growth has received
and continues to receive attention from policy think tanks, fnancial market
practitioners, and academic researchers.
Chapter 2 • Finance, economic growth, and development
41
A number of postulations have been made in both the theoretical
literature and the empirical literature. This chapter provided a review of
concepts and existing literature on fnancial development and economic
growth and development. First, the literature points to ineffcient allocation of capital and stunted growth during periods of fnancial repression,
which was a popular phenomenon after World War II. This argument gave
credence and impetus to the adoption of liberalization policies in the 1980s.
The objective was to propel a free market system, stimulate competition,
and enhance dynamism in institutions, products, and systems in the fnancial sectors of mostly developing economies. Nonetheless, more recently,
fnancial repression policies have been readopted and are being implemented by governments of developed economies as a strategy to obtain
low-cost funds from the fnancial market in the aftermath of the global
fnancial crisis.
The debate on the relationship between fnancial sector development and economic growth and development continues unabated, even
though the preponderance of the empirical literature points to the positive effects of fnancial development on growth and development. Theoretically, fnancial sector development facilitates economic growth through
its ability to increase the marginal productivity of capital, the proportion
of saving channelled into investment, and the saving rate. Hence, a welldeveloped fnancial system is expected to enhance physical capital accumulation and facilitate the effcient allocation of resources that will feed
into economic growth. More-recent literature has also focused on examining the possibility of threshold effects in the fnance–growth nexus, thereby
suggesting a nonlinear relationship. By implication, the existence or not
of certain parameters may infuence the direction and extent of the relationship between fnancial sector development and economic growth. Furthermore, the debate in the literature on whether the bank-based fnancial
sector or the market-based fnancial sector is more growth enhancing has
still not reached a conclusion.
That notwithstanding, banks are particularly important in developing
countries where stock markets are relatively smaller or play a less active
role in fnancial intermediation. Even so, the fnancial services view posits
that both bank and market-based systems are important together for economic growth because of the provision of complementary fnancial services.
Regulating the fnancial system aims to protect investors and maintain the
stability of fnancial markets and institutions. There are different regulatory regimes across various countries. Some countries have different regulators responsible for regulating different aspects of the fnancial system,
while others have one regulator overseeing the nonbank fnancial system. In
conclusion, the importance of fnancial sector development to an economy
increases the need to put appropriate policies in place to improve the functioning of the sector. As mentioned in the literature, these may include but
are not limited to maintaining a stable macroeconomic environment, quality
institutions and political governance, and a conducive legal and regulatory
environment.
42
Lordina Amoah et al.
Discussion questions
1 Financial development leads to
economic growth and not the other
way round. Comment on this
assertion.
2 Explain the following concepts:
fnancial depth, access, effciency,
and stability.
3 Describe the main functions of the
fnancial sector.
4 What are the channels through
which the functions performed by
the fnancial sector contribute to
economic growth?
5 What is fnancial repression, and
what are its consequences for an
economy?
6 What are the differences between
bank-based fnancial sectors and
market-based fnancial sectors?
7 Banking sector development is
more critical for developing economies than stock market development. Comment on this statement.
8 What are the mechanisms through
which fnancial intermediation of
banks and stock markets contribute to economic growth?
9 How does the fnancial intermediation of the various deposit-taking
fnancial institutions contribute to
economic growth?
10 How would you describe the
African fnancial system? What
policies should be put in place
to facilitate improvements to the
fnancial system?
Notes
1 See Pagano (1993), Levine (1997),
Barro and Sala-i-Martin (1998),
Montiel (2003), Arestis, Chortareas, and Magkonis (2015), Ono
(2017), and Ruiz (2018).
2 More-comprehensive measures
of fnancial development are contained in the World Bank’s Global
Financial Development Database
(GFDD). The database provides a
framework for four sets of indicators depicting a well-functioning
fnancial system.
3 SeeLuintel (2008), Gambacorta,
Yang, and Tsatsaronis (2014),
Luintel, Khan, and Leon-Gonzalez
(2016), Fufa and Kim (2018).
4 SeeAllen and Gale (1999) and
Luintel et al. (2016).
5 See Boyd and Smith (1998), Levine
and Zervos (1998), DemirgucKunt and Levine (1999), Beck,
Levine and Loayza (2000), Levine
(2002), Beck and Levine (2004),
and Song and Thakor (2010).
6 The ERP and the SAP refer to the
set of free market policy reforms
imposed on developing countries
by the IMF and the WB respectively
as a precondition for receiving loans
to salvage their ailing economies
and reverse the prolonged period of
severe economic decline. While the
IMF focused on setting the macroeconomic development and policy
agenda, the WB provided the structural adjustment lending.
7 For an extensive exposé on these
reforms, see Nissanke and Aryeetey (1998), Senbet and Otchere
(2006), Honohan and Beck (2007).
8 SeeStiglitz and Weiss (1981) and
Stiglitz (2000).
9 For a survey of the literature, see,
for example, Eichengreen (2001),
Henry (2007), Kose, Prasad, Rogoff, and Wei (2010), Hermes and
Lensink (2008), Edison, Klein,
Ricci, and Slok (2004), and Prasad,
Rogoff, Wei, and Kose (2003).
Chapter 2 • Finance, economic growth, and development
10 See McKinnon (1973), Shaw (1973),
Greenwood and Jovanovic (1990),
Bencivenga and Smith (1991),
Boyd and Smith (1998), King and
Levine (1993a, 1993b), Levine (1997,
2005), Kugler and Neusser (1998),
Demirgüç-Kunt and Maksimovic
(1998), Rajan and Zingales (1998),
Rousseau and Wachtel (1998), Beck
et al. (2000), Acemoglu, Aghion,
and Zilibotti (2003), Beck and
Levine (2004), Andersen, Jones, and
Tarp (2012), Adu, Marbuah, and
Mensah (2013), Arestis, Chortareas,
and Magkonis (2015) Otchere, Soumaré, and Yourougou (2016), Ono
(2017), Durusu-Ciftci, Ispir, and
Yetkiner (2017), and Ruiz (2018).
11 See Deidda and Fattouh (2002),
Roija and Valev (2004), Shen and
Lee (2006), Yilmazkuday (2011),
Rousseau and Wachtel (2011),
Law and Singh (2014), Ductor and
Grechyna (2015), Adeniyi, Oyinlola, Omisakin, and Egwaikhide
(2015), Samargandi, Fidrmuc,
and Ghosh (2015), Ibrahim and
Alagidede (2017), Ruiz (2018), and
Fufa and Kim (2018).
12 See Rajan and Zingales (1998),
Levine and Zervos (1998), Levine,
Loayza, and Beck (2000), Beck
and Levine (2004), Levine (2005),
Abu-Bader and Abu-Qarn (2008),
Kargbo and Adamu (2009),
Masoud (2013), Adu et al. (2013),
Herwartz and Walle (2014),
Padhran, Arvin, Hall, and Nair
(2016), Seven and Yetkiner (2016),
and Bist and Read (2018).
13 Akinboade (1998) and Fowowe
(2011) are among those who conducted empirical studies that support this view.
14 See Rousseau and Wachtel (2002),
Yilmazkuday (2011), Adeniyi et al.
(2015), and Ruiz (2018).
15 Ogun (1986) and Atindéhou,
Gueyie, and Amenounve (2005)
are among those who conducted
empirical studies that support this
assertion.
43
16 See Deidda and Fattouh (2002) and
Rioja and Valev (2004).
17 See Rousseau and Wachtel (2011)
and Beck, Büyükkarabacak, Rioja,
and Valev (2012).
18 See Soedarmono, Hasan, and
Arsyad (2017).
19 See Čihák, Demirgüç-Kunt, Feyen,
and Levine (2012) and Naceur,
Blotevogel, Fischer, and Shi (2017).
20 See Botev, Egert, and Jawadi (2019).
21 See Pagano (1993), Levine (1997,
2004), Acemoglu and Zilibotti
(1997), and Dolar and Meh (2002).
22 See Greenwood and Jovanovic
(1990), Bencivenga and Smith
(1991), Berthélemy and Varoudakis (1996), and Greenwood and
Smith (1997).
23 See King and Levine (1993a,
1993b), Berthélemy and Varoudakis (1996), and Montiel (2003).
24 This refers mainly to computer
programmes and other technology designed to facilitate and support fnancial services.
25 See Greenwood and Jovanovic
(1990), Dolar and Meh (2002), and
Levine (2004).
26 See Boot and Thakor (1997),
Levine and Zervos (1998), Beck
and Levine (2004), Coval and Thakor (2005), and Seven and Yetkiner (2016).
27 Data is unavailable on the world
development indicators for period
before 2001.
28 See Levine (1991), Atje and Jovanovic (1993), Greenwood and
Smith (1997), Levine and Zervos
(1998), Luintel and Khan (1999),
Rousseau and Wachtel (2000),
Beck and Levine (2003), Kargbo
and Adamu (2009), and Masoud
(2013).
29 See Boyd and Smith (1998), Allen
and Gale (1999), Boyd, Levine, and
Smith (2001), Rajan and Zingales
(2003), La Porta, Lopez-de-Silanes,
Shleifer, and Vishny (1998), and
La Porta, Lopez de Silanes, and
Shleifer (2006).
44
Lordina Amoah et al.
30 See Stiglitz (1993), Shleifer and
Vishny (1997), and Christopoulos
and Tsionas (2004).
31 See Demirgüç-Kunt and Levine
(1996) for an extensive discussion
of these channels.
32 For an extensive discussion of these
issues, see Hearn and Piesse (2010,
2013, 2015) and Hearn (2011, 2012).
33 This is an exchange situated in
Côte d’Ivoire but serves as a common exchange for the eight francophone countries in West Africa.
34 The terms ‘sovereign bond’ and
‘sovereign debt’ are sometimes
used interchangeably. But ‘sovereign debt’ encompasses a much
broader stock of a country’s total
outstanding government debt.
35 Issuance is usually handled by an
international syndicate of fnancial institutions on behalf of the
borrower.
36 Studies on bond market and economic growth include Mu, Phelps,
and Stotsky (2013), Thumrongvit,
Kim, and Pyun (2013). Pradan,
Zaki, Maradana, Jayakumar, and
Chatterjee (2015), Olabisi and Stein
(2015), Fanta and Makina (2016),
Presbitero, Ghura, Olumuyiwa,
and Njie (2015), Duffour, Stancu,
and Varottoa (2017), Coskun,
Seven, Ertugru, and Ulussever
(2017), Senga, Cassimon, and Essers (2018), and Bordalo, Gennaioli,
Ma, and Shleifer (2018).
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CHAPTER
3
Microfnance and
development
Niels Hermes and Robert Lensink
3.1 INTRODUCTION
The role and importance of microfnance in reducing poverty is one of the
most heavily discussed topics among academics and practitioners studying developing economies. Until the end of the 20th century, microfnance
programmes were enormously popular and success stories were emphasized, even resulting in the 2006 Nobel Peace Prize for the founding father
of microfnance, Muhammed Yunus, and then the microfnance industry
started to become heavily criticized. The sudden drop in popularity is
partly associated with the increase in rigorous evaluations of the impact
of microcredit, which suggests that effect sizes are much smaller than
expected and that they are nontransformative. Moreover, the commercialization of microfnance led to serious criticism as it may lead to mission
drift, a process in which wealthier clients are prioritized over poorer clients
(Cull, Demirguç‐Kunt, & Morduch, 2007). As a result of commercialization,
microfnance institutions (MFIs) increased interest rates. It is now common
to see interest rates above 50% on a yearly basis, which has resulted in serious ethical concerns (Hudon & Sandberg, 2013). According to some commentators (e.g. Bateman, 2010), microfnance may even be an obstacle to
development.
The aim of this chapter is to discuss, in the face of the recent criticism,
whether, and if so how, microfnance still has a role to play in promoting
inclusive growth. The chapter is structured as follows. In section 3.2, we
defne the concept of microfnance and discuss how it has evolved over the
past decades. Next, in section 3.3, we focus on the supply side of microfnance. In particular, we discuss the two main objectives of MFIs, outreach
and fnancial sustainability, and explain that reaching both objectives simultaneously may be diffcult in practice. In section 3.4, we pay attention to
examples of products that MFIs are providing and whether and how they
aim to improve the contribution of microfnance to fnancial inclusion. Section 3.4 focuses on MFIs, and we turn our attention the users – that is, the
demand side of microfnance – in section 3.5. This section provides an overview of recent studies that have assessed the impact of microfnance. The
chapter ends with a conclusion.
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3.2 THE EVOLUTION OF MICROFINANCE: FROM
MICROCREDIT TO MICROFINANCE PLUS
Microfnance is a broad concept, without a strict defnition. In general,
microfnance refers to fnance provided to (poor) people who are excluded
from the formal fnancial sector. Traditionally, microfnance was primarily
associated with small credits (on average in developing countries around
USD500) to poor people who are not able to borrow from commercial banks.
Microfnance is provided by MFIs, which include a variety of fnancial institutions, such as nongovernmental organizations (NGOs), credit unions,
microfnance banks, and nonbank fnancial institutions. Microfnance exists
all over the world, including in developed economies, but most of the biggest MFIs have their headquarters in Asia, such as BRAC, the Grameen
Bank, and ASA, all of which originate in Bangladesh.
Since the frst implementation of microfnance, the number of MFIs
and microfnance borrowers has increased exponentially. Ever since the
1997 initiation of the Microcredit Summit Campaign,1 the number of microfnance customers has been increasing, from 13 million in 1997 to 211 million
in 2013, of which more than 80% have been women and 114 million have
been among the poorest (Lensink & Bulte, in press). Moreover, whereas
in 1997 there were only 655 microfnance programmes, in 2016 there were
more than 10,000 worldwide.
The formal beginning of the microfnance movement can be dated back
to 1983, when the Bangladesh government decided that the research project
that Muhammed Yunus had started in 1976 to test his method of providing credit to the rural poor was authorized and established as an independent bank. Yet long before this date, poor people who were excluded from
formal credit could obtain microcredits via informal rotating savings and
credit associations (ROSCAs), or via credit cooperatives. Microfnance has
its roots in formal and informal fnancial institutions in the 19th century
(Guinnane, 2002).
The antecedents of microfnance, as well as the modern microfnance
movement, rely heavily on group lending systems, where borrowers selfselect into groups to discuss issues related to borrowing, saving, and repayment. The Grameen Bank strategy combined group lending with the joint
liability of borrowers. With joint liability, the entire group of borrowers
becomes liable (responsible) for any default of individual group members.
As borrowers want to avoid having to pay the debts for others, the joint liability group lending system would, in theory, contribute to reducing adverse
selection and moral hazard problems (see Box 3.1). In practice, however, the
effciency of the joint liability group lending system has been questioned,
among other things, due to the high transaction costs of having to attend
group meetings. Moreover, most group loans are short-term loans, which
need to be repaid during group meetings ever week. This makes these loans
unattractive to farmers because their repayment possibilities depend heavily on crop cycles. They are also unattractive for borrowers who want to
make investments in a small enterprise because the returns on their investments take time to materialize.
Chapter 3 • Microfnance and development
53
BOX 3.1 Group lending with joint liability: two main systems
There is a wide variety of group lending systems. The two best-known
systems are the Grameen Bank Solidarity group lending system and
the village bank system. In the solidarity group lending system, borrowers are asked to form groups of three to seven members. Borrowers are jointly liable and payments are due weekly and are constant
over the life of the loan. If a loan is repaid, the borrower becomes eligible for a larger loan, providing a dynamic incentive to repay. Often
around eight solidarity groups are federated into a larger group (a
centre) to discuss payment issues with a loan offcer of the MFI. In the
village bank system, 15–30 people are brought together. A single loan
is given to the village bank authority, which on-lends the single loan
to individual members. Loan sizes may differ among members, but all
loans carry the same repayment and interest rate terms. Also in this
system, there is joint liability. Although there are several differences
between the two systems, they also have a lot in in common. These
include self-selecting groups, regular and compulsory meetings (often
weekly), joint liability, and dynamic incentives.
There are two main advantages of group lending systems. First,
the joint liability clause reduces informational asymmetries. Because
groups self-select, people ‘screen’ each other in order to ensure that
only ‘good’ borrowers become members of the group, to reduce the
possibility that individual borrowers have to pay for other borrowers
in the group. This process reduces adverse selection problems. Moreover, after a group has been formed, the joint liability clause induces
group members to monitor each other to reduce moral hazard problems. Second, due to peer pressure in closed community groups, and
the related importance of reputation, honour, and shame, repayment
rates are expected to be high in a group lending system, even when
there is no formal joint liability system. There is quite some evidence
that peer monitoring is even more important than a formal joint liability system in guaranteeing high repayment rates. This is probably one
of the reasons why, in practice, many MFIs that use group lending
systems do not have a formal joint liability system, do not enforce joint
liability, or are fexible with the implementation of joint liability.
As a consequence of the rigid character of the traditional microfnance
group lending systems and of the high transaction costs of having to regularly attend group meetings, many MFIs have switched to individual lending systems and have tried to develop new instruments to reduce defaults.
A well-known example of such an instrument is the use of a progressive
lending system, also known as stepped lending, in which credit limits
increase over time, contingent on the full repayment of previous loans. The
progressive lending system is often combined with dynamic incentives,
which imply that repaying borrowers are allowed access to future credits.
54
Niels Hermes and Robert Lensink
While microfnance was traditionally associated mainly with microcredit, over the past decades, MFI has started to diversify, which led to a
shift from microcredit to microfnance. Many MFIs now collect savings; sell
insurance products, to a lower extent; and provide transfer and payment
services. Life insurance, for instance, is a popular product. Life insurance
is mostly offered as part of a microcredit package, in the form of credit-life
contracts. These contracts ensure that if a borrower dies, the outstanding
loans will be paid off and a fxed payout will be provided to the family.
MFIs have also started to develop health insurance plans and both property
insurance and crop insurance, and they have started to experiment with
pension schemes. These micro-pensions focus on long-term savings, to provide income security to the aged poor who have worked in the informal
sector and are not covered by formal retirement schemes. With their close
connections and regular meetings with low-income workers in the unorganized sector, MFIs can be ideal fnancial institutions to channel micropension products to the poor in informal sectors.
In addition to providing a broader range of fnancial products, MFIs
also have started to offer nonfnancial services, which is known as microfnance plus. In general, the nonfnancial services aim to strengthen the
impact of the fnancial services, and in particular of microcredit, on the welfare of the microfnance clients. Microfnance plus activities consist of three
types of nonfnancial services: social services, business development services, and technical assistance. Social services integrate credit with health,
education (gender training), or other programmes intended to increase
health consciousness, practices, and formal uses. Business development services comprise a broad range of offerings, such as fnancial literacy training,
management or vocational skills training, marketing, product design, and
accounting and legal services. Technical assistance differs from business
services in that it directly deals with the production of goods and services;
it does not focus on managerial processes. Technical assistance can be delivered through technical training workshops or provided individually by a
specialist who has a one-to-one relationship with the client. Figure 3.1 summarizes the different activities that are currently employed by MFIs. In the
next section, we elaborate on the product development of MFIs.
3.3 THE SUPPLY SIDE OF MICROFINANCE: MFIS AND
THEIR PERFORMANCE2
The main objective of MFIs is to provide fnancial services to poor households that are excluded from the formal fnancial system. This objective is
usually referred to as outreach.3 Another objective of these institutions is
to provide these fnancial services in a fnancially sustainable way – that is,
over the longer term, these activities should not result in loss making. In the
microfnance literature, people refer to the so-called double bottom line mission of improving the lives of the poor while being independent of donor
support in the long run (Armendáriz & Labie, 2011). Achieving both objectives simultaneously is referred to as the microfnance promise (Morduch,
1999). In practice, however, these two objectives may be diffcult to combine.
Chapter 3 • Microfnance and development
55
FIGURE 3.1 Microfnance services
Source: Garcia and Lensink (2019)
On the one hand, providing services to the poor is usually relatively
expensive. First, a substantial share of the poor live in rural areas, which
increases transaction costs. Second, they usually do not have collateral,
increasing the risks and costs of lending to the poor. Third, fxed costs are
high, because the amount in the loans provided or savings made by the
poor is relatively low. Finally, information about the creditworthiness of
these borrowers is hard to get. On the other hand, while costs are high,
fnancial resources for MFIs may be limited. Their funding mainly comes
from donors, market-based funding such as commercial loans and equity,
and savings accounts collected from clients. The share of these funding
sources depends on each MFI’s formal status. NGOs usually depend more
on donor funding; cooperatives receive a large part of their funding from
saving clients; and commercial MFIs usually have a larger share of loans
and equity. The availability of donor funding is restricted by the development aid budgets of governments and international fnancial institutions,
such as the World Bank and the regional development banks in Africa, Asia,
and Latin America. Savings accounts are based on the number of clients and
their ability and willingness to make savings. The availability of commercial
loans and equity depend on the positive returns that MFIs are able to generate from their activities.
Given the high costs of providing fnancial services to the poor and
given the availability of funding, MFIs may have to make a choice regarding the question whether they aim at focusing on maximizing their outreach
56
Niels Hermes and Robert Lensink
to the poor given the fnancial sources available or whether they should
aim at generating returns on fnancial resources given a certain level of outreach. In practice, while NGOs generally focus more on their social mission
of reaching out to the poor, commercial MFIs are more likely to emphasize
fnancial returns, which may confict with the cost of their outreach.
The discussion about the costs of microfnance and its funding points
out that there may be a trade-off between outreach and fnancial sustainability. The existence of such a trade-off has been heavily debated in the
academic literature and among practitioners. Some believe that MFIs can
provide services to the poor while remaining fnancially sustainable. According to this view, sometimes coined as the fnancial systems approach (Robinson, 2001) or the self-sustainability approach (Schreiner, 2002), outreach
and fnancial sustainability may be compatible since reaching a large number of customers creates economies of scale, leading to lower costs. In addition, fnancially sustainable MFIs may be better able to attract funding from
private investors, which may be used to improve their outreach. Finally,
some argue that proft-making MFIs may reinvest in servicing poorer clients. The proponents of this view stress that if MFIs provide services to
the poor while making losses, their business model will not be sustainable
in the long term. Others stress that MFIs should focus on their mission of
servicing the poor – if necessary, fnanced by subsidies and other outside
funding. This view is referred to as the poverty-lending (Robinson, 2001) or
poverty approach (Schreiner, 2002).
Until the late 1990s, the poverty-lending approach dominated the
thinking about microfnance and the role of MFIs. From the beginning of
the 2000s, the fnancial systems approach gained prominence. Since then,
emphasizing the importance of developing fnancially sustainable MFIs has
become an important feature in debates about the role of microfnance as an
instrument to reduce poverty. This shift from emphasizing poverty reduction to showing fnancial performance was partly due to the success of the
microfnance business model. Many MFIs reported high repayment rates of
close to 90%–95%. This caught the attention of institutional investors looking
for opportunities to invest in socially responsible projects that showed a positive return at the same time and from commercial banks seeing microfnance
as a potentially interesting way to develop new and unexplored markets to
which they could sell their fnancial services. The success of the model also
led to strong growth in the number of MFIs and the number of services they
provided, leading to increased competition in and commercialization of the
microfnance sector, accompanied by an increased focus on making proft.
One of the potential consequences of the shift from focusing on poverty and outreach to fnancial sustainability is referred to as mission drift
(Copestake, 2007; Armendáriz & Szafarz, 2011; Mersland & Strøm, 2010).
Mission drift occurs when MFIs increase the provision of fnancial services
to wealthier clients at the cost of providing these services to poorer clients.
Such a shift may be necessary to reduce costs and become fnancially sustainable because providing services to wealthier clients is more proftable.
Notwithstanding this shift from focusing on poverty and outreach
to fnancial sustainability, nowadays many MFIs are still not fnancially
Chapter 3 • Microfnance and development
57
sustainable and are therefore depending on subsidies. Cull, Demirgüç‐
Kunt, and Morduch (2018) report that only half of the MFIs listed in the
so-called MIX Market dataset, a web-based platform providing data on
the performance of MFIs in more than a hundred developing markets, are
fnancially sustainable. D’Espallier, Hudon, and Szafarz (2013) show that
only 20%–25% of MFIs do not receive any donations.4
The question whether there is a trade-off between outreach and fnancial sustainability has been studied extensively. The results of these studies
do not paint a clear picture. A number of studies suggest a negative relationship between outreach and fnancial sustainability. Among these are studies
by Cull et al. (2007); Hermes, Lensink, and Meesters (2011); Hartarska, Shen,
and Mersland (2013); and Louis and Baesens (2013). Other studies, however, fnd no relationship or even a positive relationship between outreach
and fnancial sustainability for a trade-off: see, for example, Louis, Seret,
and Baesens (2013) and Adhikary and Papachristou (2014). Several studies
have looked into the conditions under which a trade-off is more likely to
occur. These studies show that the representation of stakeholders on boards
of MFIs (Hartarska, 2005), gender diversity in the board (Hartarska, Nadolnyak, & Mersland, 2014), and loan methodology (Tchakoute-Tchuigoua,
2012) may help explain when a trade-off occurs. The most comprehensive overview of the trade-off discussion in microfnance can be found in
Reichert (2018), who performed a meta-analysis of the literature. He found
that the presence of a trade-off strongly depended on the measurement of
outreach and fnancial sustainability used. To conclude, the literature does
not provide a clear-cut answer to the question whether there is a trade-off
between outreach and fnancial sustainability. The safest conclusion, therefore, is to say that it depends on the context and on the way fnancial and
social goals have been measured (see Box 3.2).
BOX 3.2 Measuring outreach and fnancial sustainability of MFIs
The fnancial sustainability of MFIs can be measured in various ways.
In the literature, several studies use standard fnancial ratios, such
as the return on equity (ROE), calculated as net operating income
divided by the value of outstanding equity, and the return on assets
(ROA), measured as the ratio of net operating income to the value
of total assets of the MFI. Some studies use measures that are more
specifc to microfnance, such as the operational self-suffciency (OSS)
and the fnancial self-suffciency (FSS) of MFIs. OSS measures MFIs’
ability to cover costs with revenues by dividing total operating revenues by the sum of total fnancial expenses on attracting funding,
including interest paid to depositors; interest and fees on loans from
funds or other fnancial institutions and bondholders; and expenses
on loan loss reserves and operations. FSS measures the adjusted total
fnancial revenue divided by the sum of adjusted fnancial expenses,
loan loss provisions, and operating expenses, where adjustments refer
58
Niels Hermes and Robert Lensink
to correcting for the country-level infation rate and the implicit and
explicit subsidies. FSS measures the extent to which MFIs are able to
operate without ongoing subsidies, including soft loans and grants.
Measuring outreach to the poor requires factoring in two dimensions.
The breadth of outreach refers to the coverage of MFI and is generally
measured by the number of clients served by the MFI. The depth of
outreach refers to the type or profle of the clients served by the MFI
and is measured mostly either by taking the ratio of active female borrowers to the total number of active borrowers of an MFI or by the
average size of the loan divided by the GDP per capita of the country
in which the MFI resides. A few studies focus on analysing organizational effciency by measuring how MFIs use resources and turn them
into goods and services. These studies calculate the maximum level
of outputs that can be generated given a certain quantity or costs of
inputs, or they calculate the minimum quantity or the cost of inputs to
generate a certain output level. The closer the organization is to producing the maximum output level or to minimizing the costs of production, the higher its effciency. Studies following this approach, in
most cases, use either data envelopment analysis (DEA) or stochastic
frontier analysis (SFA) to measure effciency. Examples of studies in
microfnance using this approach are Caudill, Gropper, and Hartarska
(2009); Hermes et al. (2011); and Servin, Lensink, and Van den Berg
(2012). Fall, Akim, and Wassongma (2018) provide a meta-analysis of
studies that measure the effciency of MFIs.
3.4 MICROFINANCE PRODUCTS
Most fnancial services, such as savings and loan products, which are offered
by MFIs, can be characterized as being simple and standardized. Microfnance loans are small and have fxed sizes, they have a fxed repayment
schedule, they do not require physical collateral, and repayments already
start from the frst week when the loan was obtained (i.e. the grace period
is zero). Microfnance savings accounts have similar characteristics. These
accounts have a fxed opening cost and allow for (and in some cases even
require) small, fxed, and regular deposits, but withdrawals are usually at a
relatively high cost. One reason why MFIs provide simple and standardized
products is that the costs of offering such services to the poor are relatively
low. In particular, loans offering simple and standardized fnancial products
help customers make repayment, which reduces the risk of default for the
MFI. Moreover, stimulating customers to regularly deposit savings in their
accounts helps in making these deposits a proftable (or at least not a lossmaking) activity for the MFI. More importantly, however, offering simple
and standardized products helps to discipline clients to make fnancial transactions. Commitments or disciplining mechanisms encourage regular payments. With strict repayment schedules, borrowers know when they have to
make payments on their loan and can act accordingly by generating enough
Chapter 3 • Microfnance and development
59
income or by saving up to generate the necessary funds. Savings products
that require clients to regularly make deposits help customers to overcome
the temptation to use funds now and instead save the money for later. Such
savings products can be important because people fnd saving hard, which
means trading current for future consumption. In this context, psychologists
refer people’s tendency to procrastinate on a task or action that they tend to
dislike. In most cases, the goals and needs of poor customers are short term.
As explained by CGAP (2014, p. 16), for the poor, the ‘future is a distant concept and hard to imagine because present needs are so prominent’.
Simplicity and standardization go at the cost of the fexibility of fnancial products. Not surprisingly perhaps, especially the poor may proft from
their having access to more-fexible products. One of the greatest challenges
the poor face is matching infows and outfows of funds, also termed ‘cashfow management’ in the literature (Collins, Morduch, Rutherford, & Ruthven, 2009). Their infows mainly come from income, savings made earlier,
or loans and gifts they receive. Yet these infows are usually small, irregular, and uncertain. They need these infows to spend on basic needs (such
as food and rents for housing), health payments, school fees, emergencies
(such as the consequences of foods and hurricanes), and so-called big-ticket
items (such as weddings and funerals). These spending categories are partly
regular (basic needs, school fees) and partly unexpected or lumpy (emergencies, funerals). These characteristics of the infows and outfows of funds
point out the diffculty of cashfow management that the poor face.
Having access to more-fexible fnancial services facilitates cashfow
management for the poor. Given the irregularity and uncertainty of their
infows, having access to savings accounts and loans that allow them to use
these funds whenever needed or make payments the moment infows are
available makes it easier for them to match infows and outfows. Flexibility may be provided ex ante – that is, before the customer enters into the
contract. In this case, the customer may choose terms at the start of the contract; no adjustments are allowed once the contract starts and sanctions; or
penalties are used to commit customers to the initial terms. Another way of
providing fexibility is ex post. In this case, terms may be adjusted after the
contract has started, depending on the situation the customer is confronted
with (e.g. droughts, foods, and illness). In case of full fexibility both ex ante
fexibility and ex post fexibility are allowed.
The problem for the MFI is that there is a trade-off between offering
simple and standardized products versus offering products that are fexible.
On the one hand, fexible products are costlier, and their use is more diffcult to monitor. Flexibility helps cashfow management, which potentially
increases the repayment of loans or the depositing of savings. On the other
hand, however, it may also reduce repayment and savings, because it breaks
down commitment and discipline attached to standardized products.
The challenge for MFIs is to develop product innovations in microfnance that aim at combining both fexibility and commitment/discipline
(Labie, Laureti, & Szafarz, 2017).5 Such products would help poor customers
dealing with cashfow management while reducing the risk of the nonrepayment of loans or low deposits of savings for the MFI. In recent years, MFIs
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Niels Hermes and Robert Lensink
have experimented with new product designs that try to combine these two
characteristics. Some MFIs started offering loans with fexible repayment
schedules or repayment schedules that are more closely linked to the fuctuations in income of their clients. In particular, MFIs lending to farmers
have developed loan programmes with repayments due after the harvest
season – that is, when borrowers obtain income from selling their products.
For example, in Thailand, the Bank for Agriculture and Agricultural Cooperative (BAAC) offers agricultural loans with various maturities allowing
for ex post fexibility. That is, if a farmer is confronted with repayment problems, the bank is willing to reschedule repayments by taking into account
the projected future cashfows (Townsend & Yaron, 2002). To manage their
loan portfolio with an ex post fexible contract, loan offcers of the bank regularly visit borrowers to obtain information about their repayment capacity.
Confanza, a bank in Peru, offers so-called seasonal loans. These loans offer
ex ante fexibility by adapting the repayment schedule and maturity to the
crop cycle (Laureti & Hamp, 2011).
SafeSave, a microfnance programme operating in Dahka, Bangladesh,
offers full fexibility. Customers are offered a savings account that allows
them to make deposits and withdrawals at any time for any amount. Moreover, active clients of the programme can also obtain loans without a fxed
maturity and without a fxed repayment schedule in terms of timing and
amount. SafeSave manages its operations by having loan offcers who come
from the same areas where the customers live and who actively visit them
to ask them to make deposits or repayments on loans (Labie et al., 2017).
Some MFIs have experimented with adjusting the terms of their fnancial products. One example is an MFI called Village Financial Services, which
has operations in Kolkata, India. This MFI introduced changes in the repayment structure of loans to see whether this improves the contribution loans
can make to the welfare of their borrowers. One change they introduced was
offering a loan with a two-month grace period. Microcredit often uses infexible repayment schemes, with repayments made twice a week starting right
after the loan disbursement. This increases the probability of repayment but
also makes it more diffcult for borrowers to use loans for investing in projects
with a higher return, because this type of project may take more time to generate positive cashfows (Field, Pande, Papp, & Rigol, 2013). For the same reason,
the MFI experimented with offering loans with monthly instead of weekly or
twice-a-week repayment schemes (Field, Pande, Papp, & Park, 2012).
Several other new product designs make use of so-called nudges (see
Box 3.3). A nudge is an intervention aimed at changing an individual’s
behaviour and decision-making in a direction that is seen as desirable by the
those who developed the intervention. A nudge should stimulate people’s
behaviour in a specifc direction, but it does not forbid individuals’ making
their own choices (Thaler & Sunstein, 2008). Nudges in microfnance try to
change customers of MFIs to make repayments on loans or deposit savings
regularly and on time. Examples are the use of labelling savings accounts.
By labelling a savings account for a specifc purpose such as health costs, or
school fees, people may be stimulated to save more, because there is clear
relationship between depositing savings and the use of the savings made
Chapter 3 • Microfnance and development
61
(Dupas & Robinson, 2013). Some MFIs have introduced SMS text services to
remind borrowers to make a loan repayment or to deposit savings (Karlan,
McConnell, Mullainathan, & Zinman, 2016).
BOX 3.3 Using nudges in microfnance: the example
of Caja de Ica, Peru
In 2008, researcher Dean Karlan and colleagues (Karlan et al., 2016)
teamed up with a bank in Peru, the government-owned bank Caja
de Ica, to try out a number of fnancial innovations and analyse their
impact on the savings behaviour of the clients of the bank. The innovations were part of the new product, Plan Ahorro, of the bank.
The product had the following characteristics. First, clients could
sign up for the product and open an account, selecting the period for
which they committed themselves to make regular savings (between six
and 12 months after opening the account), indicating a minimum amount
they would deposit every month and setting a goal (which they could
select from a list of 14 pre-established categories) for which they would
make the savings. Clients were required to make deposits within ten days
from the due date each month, to meet their commitment. Second, the
bank used various nudges, such as sending clients a reminder by mail
seven days before the monthly due date. It also sent another reminder
whenever a client did not make a deposit three days after their scheduled
deposit date. Other nudges that were used included sending some of the
clients a reminder with specifc information about the goal a client was
saving for, next to the regular text about reminding them to make the
deposit on time. In this way, the client’s salience of why they were making savings was increased, nudging them to make savings on time.
As an example of providing specifc information about the goal, a
client would receive the following text in the mail: ‘[Regular text about
reminding to deposit] If you miss a payment, you will lose a total of
[amount] in additional interest rate incentive that you will be able to use
towards your savings goal of [goal]!’ A fnal example of a nudge used by
the bank was asking some clients to bring a picture of the object they were
saving for, such as a motorcycle. The bank would then make a jigsaw puzzle of this picture, and on each occasion the client was depositing money in
their account, they would receive a piece of the puzzle. The idea was that
in this way, a client would slowly see the object that they were saving for
appear, which was supposed to stimulate them to keep on saving.
The researchers did fnd evidence that receiving reminders increases
the likelihood that clients remain committed to saving. They also found
some evidence that these reminders increased the amounts of savings
made. Finally, they found support for the fact that messages containing specifc information about the savings goal were effective in making
clients save. These results suggest that nudges can also be important in
infuencing people’s behaviour when it comes to their making savings.
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Niels Hermes and Robert Lensink
To conclude, we have discussed the importance of cashfow management for the poor. Cashfow management refers to the diffcult process of
matching small, irregular, and uncertain income, savings, and borrowing
with regular spending needs and unexpected or lumpy spending needs. The
effectiveness of the poor’s cashfow management depends on the design of
fnancial products. Product design is a crucial dimension of fnancial services when talking about how microfnance may help the poor to improve
their welfare.
3.5 THE IMPACT OF MICROFINANCE ON END USERS
The enormous growth of microfnance programmes during the frst two
decades after the establishment of the Grameen Bank suggests that microfnance is a great success. Indeed, until the beginning of the 21st century,
many practitioners and academics argued that microfnance could play
an important, maybe even crucial, role in lifting the poor out of poverty.
However, more recently, the popularity of microfnance has decreased
enormously, and the rosy view of microfnance has been challenged by several developments. For example, many MFIs have been accused of offering
extremely high lending rates, inducing borrowers from one MFI to borrow from another MFI, to repay their debt. This process has contributed to
severe debt problems among some MFI clients. The southern Indian state of
Andhra Pradesh even plunged into a microcredit crisis after microfnanceinduced suicides in 2010.
Do the aforementioned developments imply that microfnance is
unsuccessful? To answer this question, we take a closer look at the research
that can teach us something about the success of microfnance. Before
doing this, it is important to realize that the answer to the question whether
microfnance is a success depends very much on the objectives of microfnance that are evaluated, the microfnance service that is evaluated (credit,
savings, or microfnance plus), and the data used in the research. Broadly
speaking, one can consider success by focusing either on data with respect
to the social and economic impacts of microfnance on end users or data
on the proftability and fnancial sustainability of microfnance institutions.
This section deals with the frst group of studies; section 3.3 dealt with the
second group of studies.
3.5.1 Impact of microcredit
There are hundreds of studies on the impact of microfnance, of which most
focus exclusively on microcredit. Surveys of these impact studies are provided, among others, by Armendáriz and Morduch (2010); Bauchet et al.
(2011); Duvendack et al. (2011); Duvendack and Mader (2019); and Van
Rooyen, Stewart, and De Wet (2012). It is impossible to survey the entire
literature in this chapter. Therefore, we pay attention to some of the most
infuential studies and try to draw some general conclusions.
The impact of microfnance has been studied since the 1990s. Most
of the early studies suggest positive impacts of microcredit. However, the
Chapter 3 • Microfnance and development
63
scientifc quality of most of them is rather weak, in that, in general, problems
related to self-selection bias or programme placement bias (see Box 3.4) have
not been addressed. Yet there are some exceptions worth mentioning. Pitt
and Khandker (1998) in their study use an impact evaluation methodology
that takes into account that the MFIs they evaluate only allow households
owning less than half an acre of land to borrow. By taking into account this
eligibility rule, Pitt and Khandker (1998) are able to address some selection
biases. The results of their study are quite positive; especially for women,
there are large marginal effects of microcredit on indicators of welfare.
However, Roodman and Morduch (2014) suggest that it is diffcult, if not
impossible, to replicate the fndings from Pitt and Khandker’s study. Coleman (1999) is much less positive about the impact of microcredit. His study
concludes that group lending provided by village banks in northeast Thailand had no signifcant impact on variables like assets, production, healthcare, and education. The study by Coleman (1999) is noteworthy because
of the innovative evaluation technique he used. By exploiting information
about the expansion strategy (pipeline approach) of MFIs, he differentiates
between borrowers and nonborrowers in areas where microcredit is already
available and in areas where microcredit will become available in the near
future. His approach, akin to a cross-sectional double-difference methodology, under some strict assumptions, enables controlling for self-selection
bias and programme placement bias.
BOX 3.4 Why is evaluating a microfnance intervention
so diffcult?
To measure the impact of a microfnance intervention, such as providing some people with access to microcredit, on welfare, a researcher
needs to try to uncover the causal effects of microcredit. That is, they
need to examine whether, and to what extent, a change in welfare is
due to microcredit and not due to other factors. An unbiased estimate
of the impact of microcredit would be obtained by comparing welfare levels of the same group of individuals at the same point in time
with and without microcredit. Obviously, this is not possible. The
researcher is confronted with a missing counterfactual. In practice,
several techniques have been used to deal with the missing counterfactual problem by defning a comparison or control group.
However, fnding a valid comparison group for the group of
people with microcredit is not an easy task. The following are some of
the main problems that the researcher is confronted with:
1 Some people may deliberately decide to borrow microcredit,
whereas others, even if they had the possibility to do so, may
decide not to take up the credit. For instance, more-innovative
people, in a group with otherwise similar characteristics, may
decide to borrow. If the researcher tried to measure the impact
of microcredit by comparing borrowers of microcredit with a
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Niels Hermes and Robert Lensink
comparison group of nonborrowers with the same measurable
characteristics (age, education level, etc.), the estimate would
probably suffer from self-selection bias.
2 The MFI may deliberately decide to open branches in villages
with a better infrastructure, where it is easier for farmers to sell
their products (or, in contrast, deliberately open branches in villages in remote areas). If the researcher then tries to measure
the impact of microcredit by comparing microcredit borrowers
from the village where the branch has been opened with a comparison group of nonborrowers in another village, the estimate
will probably suffer from programme placement bias.
3 Some microfnance borrowers may after some time decide to
leave the microfnance programme because they do not need
credit anymore or be kicked out of the microfnance programme
if they were not able to repay their debts. A researcher who tries
to measure the impact of microcredit by comparing the group of
extant borrowers with a comparison group may obtain a biased
impact estimate due to attrition bias, because the best (or the
worst) microcredit borrowers are no longer taken into account
in the comparison.
More recently, impact studies on microcredit have started using better methodologies to control for self-selection and programme placement
biases. Several studies have used randomized controlled trials (RCTs) to
measure the impact of microcredit (see Box 3.5). With an RCT, researchers
study the impact of microcredit by using randomized assignments to an
intervention. That is, who will (and will not) obtain access to microcredit is
determined via a lottery. In theory, this procedure should produce equivalent control and treatment groups and thereby controls for selection biases.
Banerjee, Karlan, and Zinman (2015) discuss the results of six RCTs. These
studies show consistent results: (access to) microcredit has a positive yet
relatively small impact on people’s lives and fails to raise households out of
poverty. Dahal and Fiala (2020), however, show that most recent RCTS on
microcredit, including the six studies discussed by Banerjee et al. (2015), are
underpowered to identify impacts, for example, due to low uptake. They
conclude that we still don’t know whether microcredit is effective. Also,
Garcia, Lensink, and Voors (2020), in a quasi-experimental study in Sierra
Leone, fnd that microcredit provided via a group lending scheme could
enhance the aspirations and hopes of borrowers and hence may improve
long-term welfare by reducing internal psychological constraints.
Given that most microfnance borrowers are women, microcredit may
have a specifc impact on women. The provision of microcredits to female
entrepreneurs arguably helps to create a stable income for women, which
may be instrumental in breaking the vicious cycle of poverty. Access to
microcredit would result in greater income independence for women and
help improve women’s empowerment. However, over the past decades,
Chapter 3 • Microfnance and development
65
several studies have criticized the assumed positive impact of microcredit
on women’s empowerment. Some studies even argue that women’s involvement in microcredit programmes can result in their disempowerment
(Vaessen et al., 2014). Sometimes targeting only women shifts the burden of
fnancial responsibilities in the household onto women, without improving
their control over expenditures (which will stay with the husband). Hansen, Huis, and Lensink (in press) provide an overview of the discussion of
microfnance services and women’s empowerment.
In conclusion, we don’t have unambiguous answer to the question
whether microcredit has a positive impact on the welfare of the poor. The
time horizon of several impact studies has likely been too short, given that
impacts may take time to materialize. However, clearly there is an inverse
relationship between the ‘rigour’ of the impact study and the size of the
impact of microcredit on outcomes. The more a study tries to control for
biases, the less positive the results seem to be. However, it also appears that
the recent severe criticisms of microcredit, just like the earlier overenthusiastic claims about the potential contributions of microcredit, have been
exaggerated. At the same time, access to microcredit will not be a panacea
that can reduce worldwide poverty.
BOX 3.5 Randomized controlled trials: the golden standard
of impact evaluations?
Several quantitative research designs have been used to measure the
impact of microfnance. Examples of methodologies include regression discontinuity, difference-in-difference approaches, propensityscore-matching approaches, and randomized controlled trials (RCTs).
The evaluation methods differ in several respects, but they all try to
deal with the problem of missing counterfactuals, by defning a comparison or control group. According to Gertler et al. (2011), a highquality impact evaluation needs to defne a control group as one that
1 Is identical to the treatment group, without intervention.
2 Reacts equally as the treatment group to the intervention.
3 Is exposed to the same set of (other) external interventions as the
treatment group is.
The RCT approach determines treatment and control groups by
assigning (groups of) households to the intervention by lottery. This
approach, under some conditions, produces equivalent control and
treatment groups. In theory, RCTs provide the best opportunity to rigorously address causality questions. This is why RCTs are often seen
as the gold standard of impact evaluations. However, in practice, the
conditions for ideal RCTs almost never hold (Deaton, 2010) for several
reasons, such as ethical concerns.
The main advantage of randomization is that it removes bias,
and thus, if correctly applied, RCTs lead to an impact estimate, which
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Niels Hermes and Robert Lensink
is correct on average. Yet randomization does not always produce
the most useful estimator. For example, the precision of the estimator might be low, so the standard error of the unbiased estimator is
high. Deaton and Cartwright (2016) argue that in some situations, a
more accurate impact estimate (e.g. of microcredit) can be obtained
by trading in some bias for greater precision. In other words, rather
than using an RCT which avoids ‘biases’, it is sometimes better to use
impact evaluation designs that improve precision (reduce variances).
Notwithstanding the criticisms that RCTs have received, this
methodology has been widely accepted in research nowadays, sometimes considered the golden standard of impact evaluations. In 2019,
Abhijit Banerjee and Esther Dufo received the Nobel Memorial Prize
for Economic Sciences for their research on evaluating programmes
that aim to alleviate poverty. In their work, they extensively use
RCTs, among other methods, to evaluate the impact of microfnance
programmes.
3.5.2 Impact of microfnance, other than microcredit
Some studies have examined the impact of microsavings. However, only a
few of them focused on impacts of savings on social outcomes; most of the
studies considered a specifc savings product and focused on the uptake of
this product or on impacts in terms of total savings. A well-known example
is the study by Ashraf, Karlan, and Yin (2006). It focused on the impact of
a newly developed savings product offered by the Green Bank of Caraga,
a microfnance bank in the Philippines. A specifc characteristic of the savings product, known as SEED (save, earn, enjoy, deposits), was that savers
were not allowed to withdraw any of their savings before they had reached
a certain goal. The study shows that the commitment savings product leads
to much higher savings than does a normal savings account. Some savings
studies consider the impact of microsavings on women’s empowerment.
An interesting example is the study by Ashraf, Karlan, and Yin (2010), who
consider the same commitment savings product as Ashraf et al. (2006) did.
The study suggests that women who suffer from low bargaining power are
able to improve their bargaining power substantially by using the commitment savings account. An example of a microsavings study that considers
the impact on different social outcomes is Karlan, Savonitto, Thuysbaert,
and Udry (2017). Using a randomized controlled trial, they examined the
impact of microsavings programmes in Ghana, Malawi, and Uganda. These
programmes promote and develop the (informal) Village Savings and Loan
Association (VSLA). The study suggests that the savings programmes in
the three countries signifcantly improved household business outcomes
and women’s empowerment. However, it does not fnd positive impacts on
average consumption or other livelihoods. To conclude, in general, studies
suggest that savings services have a more positive impact on the poor than
Chapter 3 • Microfnance and development
67
microcredit has. However, the empirical evidence is still limited and only
a few focus on the effects on social outcomes, implying that the positive
fndings should be considered with caution (see also Duvendack & Mader,
2019).
There is also some mixed evidence on the impact of microfnance plus,
especially in the impact of business trainings on microfnance clients. McKenzie and Woodruff (2014) surveyed the ‘old’ literature. Their study suggests that business training sessions do not have a big impact on economic
outcomes. However, they also argue that most studies they surveyed suffer
from major methodological problems. Some more-recent studies also provide mixed evidence, such as Karlan and Valdivia (2011). Other recent studies are much more positive about the impact of business training sessions.
For instance, Giné and Mansuri (2014); Berge, Bjorvatn, and Tungodden
(2015); and Bulte, Lensink, and Vu (2017) report substantial effects. Bulte et
al. (2017) even strongly argue that investments in human capital (i.e. business trainings) may usefully complement microcredit.
3.6 CONCLUSION
In this chapter, we discussed the role of microfnance in promoting inclusive
growth. We started by defning the concept of microfnance and discussed
how it evolved over the past decades. Next, we focused on the supply side
of microfnance. We discussed their two main objectives, outreach and
fnancial sustainability, and explained that reaching both objectives simultaneously may be diffcult in practice.
We also surveyed the recent literature dealing with the determinants
of fnancial sustainability and outreach of MFIs. Several studies have analysed whether there is a trade-off between fnancial and social goals of MFIs.
Yet the literature does not provide a clear-cut answer to this question. The
safest conclusion is to say that it depends on the context and on the way
fnancial and social goals have been measured.
We continued by discussing the importance of commitment and fexibility as the main features of fnancial products offered to the poor. Particularly for the poor, the infows and outfows of funds are sometimes diffcult
to manage. Infows are small, irregular, and uncertain; outfows are sometimes regular, sometimes irregular, and sometimes lumpy. Flexible fnancial products in terms of the payment of interest costs and loan instalments
and making deposits to a savings account (i.e. being able to make deposit
at any time and of any size) would help the poor in better managing their
infows and outfows, thereby increasing their welfare. At the same time,
fnancial products that provide commitments in terms of regular interest
payments, repayments of loans, or depositing savings would help the poor
as well, because they are instrumental in making sure that they keep on
making regular payments and savings.
Finally, we turned to the demand side of microfnance by discussing
what we know about the impact of microfnance on the poor’s well-being.
Analysing this is generally hard, mainly because a counterfactual is not
readily available: we usually have no information about what would have
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Niels Hermes and Robert Lensink
happened if no microfnance was available. However, during recent years,
researchers have developed methods to get around this problem by using
RCTs. Researchers using this method create treatment and control groups
by randomly assigning (groups of) households to a specifc intervention,
such as providing a microcredit. The random assignment, under certain
conditions, produces treatment and control groups with the same, or at least
very similar, characteristics. In this way, the control group can serve as the
counterfactual to analyse the impact of providing microcredit to the treatment group.
During the past few years, many RCTs have been carried out, and most
studies have shown consistent results: (access to) microcredit has a positive
yet relatively small impact on people’s lives. Therefore, microfnance fails
to raise households out of poverty. The results from RCTs’ analysing the
impact of savings products and microfnance plus are more positive. In particular, studies have shown that offering savings to the poor can help them
to improve their lives. At the same time, however, access to microfnance
will not be a panacea that can reduce worldwide poverty.
Discussion questions
1 What are the two main objectives
of MFIs? What is meant by the
microfnance promise (Morduch,
1999)? Why is it diffcult in practice for MFIs to combine their two
main objectives?
2 In discussions about the existence
of a trade-off between the two main
objectives of MFIs, two views, or
approaches, are prominent: the
fnancial systems approach and
the poverty-lending approach
(Robinson, 2001; Schreiner, 2002).
What is the main argument of
both these views regarding the
existence of a trade-off?
3 What do we mean by mission drift
of MFIs? Why does this occur?
4 Why are commitment and fexibility important features of fnancial
services such as savings accounts
and loans for microfnance clients? Are these features more or
less important for poor people visà-vis rich people?
5 In many large cities in developing economies, poor people earn
income by selling food or artisanal
6
7
8
9
10
11
products on the streets. According to you, what type of fnancial services would best serve the
needs of these poor people? In
particular, what kind of characteristics should these services need to
have? In your discussion, describe
the nature of the poor’s fnancial
infows and outfows, and link
this description to your discussion
of the fnancial services that MFIs
should offer to them.
What is meant by a randomized
control trial?
Why do some people argue that
RCTS are the golden standard of
impact evaluations? Do you agree?
Discuss the evidence on the
impact of microcredit.
What does selection bias mean?
Differentiate between different
forms of selection bias.
Why might joint liability group
lending reduce adverse selection
and moral hazard problems?
Explain the difference between
microcredit, microfnance, and
microfnance plus.
Chapter 3 • Microfnance and development
69
Notes
1 The Microcredit Summit Campaign is an American nonproft
organization that was founded
in 1997 by Muhammad Yunus
(founder of Grameen Bank),
Sam Daley-Harris (US-American
writer and activist), and John
Hatch (US-American development economist and founder of
FINCA International, a nonproft
microfnance organization). The
organization brings together several different parties involved in
microcredit, such as microcredit
practitioners, academics, donor
agencies, international fnancial
institutions, and NGOs, to promote the use of microcredit as
an instrument to reduce poverty
around the globe. At the start of
the organization, a campaign was
launched that aimed at reaching a
billion poor families and provide
them access to credit by 2005. The
campaign has been instrumental
in getting attention for microfnance as an instrument to reduce
poverty and has contributed to the
growth of the use of microfnance
worldwide.
2 This section is based on Hermes
and Hudon (2018).
3 Outreach refers to the number of
poor people that an MFI can provide services to. The outreach of
microfnance is not the same as
the impact of microfnance, which
refers to the effect that access to
services has on the welfare of poor
people. The impact of microfnance
will be discussed in section 5.
4 D Espallier et al. (2013) use data
for one year (2010) for almost
1,100 MFIs; Cull et al. (2018) use
data for 2005–2009 for 1,335 MFIs.
Both studies use slightly different
methods of calculating the subsidies that MFIs receive. The differences with respect to sample
size, time period, and method of
calculating may explain why both
studies show different fndings
regarding the importance of subsidies for MFIs.
5 Since most product innovation
in microfnance have been introduced quite recently and have
been applied only by a relatively
few MFIs around the world, a
comprehensive evaluation of
their performance vis-à-vis the
performance of standard microfnance products is currently not
available.
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CHAPTER
4
Private capital fows and
economic growth
Elikplimi Komla Agbloyor, Alfred Yawson, and Pieter Opperman
4.1 INTRODUCTION
External fnance in the form of private capital fows have recently increased
considerably to developing regions such as Africa (see Figure 4.1). The
increasing trend in private capital fow levels was initially necessitated
by the region’s comparatively high returns on investment compared with
other regions (Asiedu, 2002), high level of poverty, and low level of income
and domestic savings, and many African policymakers and developmental partners promote private capital fows to spur investment and growth.
Apart from external fnance, other potential sources to fnance development
include the use of income from export earnings, increasing government
revenue through taxation, and domestic investment (accessing domestic
savings through an effcient fnancial system). A key problem for developing countries is that most of these other potential sources for fnancing
development are limited. This necessitates relying on external fnance to
increase the pool of capital available for development. For example, many
African countries’ export earnings are highly commodity dependent, where
a slump in commodity prices adversely affects the current account balance, thus suppressing development plans. Further, a low tax base mainly
because of the large informal sector in Africa hampers domestic-resourcemobilization capabilities, limiting the possibility of governments’ increasing revenue through taxation. Further, compared with other developing
regions, African countries are characterized by low levels of domestic savings with underdeveloped and ineffcient fnancial systems.
By attracting private capital fows, countries with insuffcient domestic savings can access an external pool of savings. Through this, countries
can accomplish the following:
1
2
3
4
Resource allocation effciency can be enhanced.
Technology and management transfer can be facilitated.
Welfare-enabling current account imbalances can be fnanced.
Portfolio diversifcation can ensue.
Increased private capital fows could also lead to indirect benefts, including fnancial sector development, enhanced trade, macroeconomic policy
discipline/stability, and economic effciency (IMF, 2012). When private
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Elikplimi Komla Agbloyor et al.
capital fows are allocated effciently through fnancial markets to fnance
innovations, that may be because of technology transfer, the improved capital accumulation, and technology diffusion can promote economic growth.
However, private capital infows also present a double-edged sword
for host economies. Private capital infow surges cause infationary pressures and capital account defcits expose economies to external shocks.
Once capital retrenchment follows, a deterioration of economic activity
and welfare losses as a result of consumption volatility could ensue (Shirota, 2015). The excessive expansion of aggregate demand or overheating of
the economy can occur as a result of asset price distortions resulting from
signifcant private capital infows. Apart from infationary pressures and
widening current account defcits, a real exchange rate appreciation, which
can render a host economy’s exports less competitive, is a further concern
associated with private capital infow surges. Private capital infows can
result in fnancial system vulnerability. An increase in external debt and a
rise in excessive bank lending can worsen maturity mismatch between bank
assets and liabilities, inducing poor loan quality. Maturity mismatch occurs
when bank assets become less liquid than their liabilities. When banks rely
more on external fnance as opposed to their own capital, the potential withdrawal of foreign capital increases maturity mismatch and fnancial stability concerns. Debts denominated in foreign currency increases developing
countries’ fnancial risks, because fnancing occurs in foreign currency.
These debts infamed the impact of emerging market fnancial crises such as
the 1994 Mexican tequila crisis, the 1998 Russian rouble crisis, and the late
1990s East Asian crisis (Eichengreen & Hausman, 1999). Indeed, developing countries are exposed to the phenomenon of ‘original sin’ in that they
borrow in foreign currencies over which they have no control. This exposes
them to exchange rate fuctuations or exchange rate risk.
Important variations exist in the various components of private capital
fows (foreign direct investment, foreign bank lending, and foreign portfolio investment), and lumping these fnancial fows together to examine their
determinants or impact may lead to wrong policy choices. Although foreign
direct investment (FDI) and portfolio equity investment differ, since the former is linked to ownership and control, both fows differ from foreign debt
that creates liabilities that must be repaid. The main private capital fows
also transmit through separate markets where the levels of organization and
liquidity vary greatly. With fnancial instrument transactions – such as bank
lending and foreign portfolio investment (FPI) – there are usually many
buyers and sellers, standardized contracts, and prices that are publicly
available with a market structure often approximating perfect competition.
Conversely, FDI is often not observed in fnancial markets but is rather the
consequence of fnancial and industrial decisions that are internal to frms
that could have real implications possibly unrelated to fnancial variables
(Contessi, De Pace, & Francis, 2013).
The various types of capital fow exhibit different levels of volatility and respond differently to fnancial liberalization (Neumann, Penl, &
Tanku, 2009). Although global factors were signifcant determinants of the
volatility of capital fows, the work of Broto, Diaz-Cassou, & Erce (2011)
Chapter 4 • Private capital fows and economic growth
75
revealed conficting evidence about the infuence of domestic factors on the
volatility of capital fows. In sub-Saharan Africa, global and domestic factors
affected FDI and portfolio equity volatility, whereas only domestic factors
affected cross-border bank lending volatility (Opperman & Adjasi, 2017).
FDI volatility is, on average, less than FPI and cross-border bank lending
volatility. FDI is considered more stable and permanent because of a larger
initial investment and the associated fxed entry costs. In essence, FDIs are
considered ‘bolted’ and cannot be easily ‘unscrewed’ or reversed. Figure 4.1
shows that FPI appears more volatile than the other capital fows and has
been especially since 2010. This could be in response to global investors’
pulling their investments after the global fnancial crisis of 2007/2008. The
literature shows that the differences between FDI volatility and FPI volatility are much lower in developed countries than in developing countries
(Goldstein & Razin, 2006). Along with FPI, cross-border bank lending fows
are considered highly volatile, infuencing the macroeconomic and fnancial stability of developing economies (Herrmann & Mihaljek, 2013). FPI
and cross-border banking fows are often referred to as ‘hot money’ – that
is, global fows extremely sensitive to interest rate differences, expected
returns, and future growth prospects. These volatile capital fows could be
induced by a small shock to the economy that worsens the shock and can
disrupt the local economy. It is therefore important to consider the heterogeneous nature of different private capital fow types.
FDI is defned as investment that acquires a lasting management interest (10% or more of voting stock) in an enterprise that operates in a different economy than that of the investor, and direction is classifed as either
inward FDI or outward FDI. FDI by entry mode can be classifed into Greenfeld investments or cross-border mergers and acquisitions (M&As). With
FIGURE 4.1 Trends in private capital fows to Africa, 2000–2016
Source: Generated by authors on the basis of data from the World Development Indicators
76
Elikplimi Komla Agbloyor et al.
Greenfeld investments, foreign enterprises set up operations in the domestic economy from scratch (e.g. constructing new production facilities),
whereas with cross-border M&As, foreign enterprises merge or acquire
an existing stake in a domestic enterprise. Although M&As comprise most
of FDI fows in developed countries, their uptake and importance have
increased in developing regions, such as Africa (Agbloyor, Abor, Adjasi,
& Yawson, 2012). FDIs by target can be classifed as either a horizontal FDI
or vertical FDI. With a horizontal FDI, the investment is made in the same
industry at a foreign location, thereby duplicating the production process,
whereas with a vertical FDI, the different stages of production are located in
different countries. Vertical FDI can be classifed as either forward vertical
or backward vertical. With forward vertical, FDI takes the frm nearer to the
market, whereas with backward vertical, international integration moves
towards the required production inputs.
The literature on FDIs by motive can be classifed as resource seeking,
market seeking, effciency seeking, and strategic-asset seeking (Ajayi, 2006).
Resource-seeking FDI investors pursue resources at a lower real cost abroad
that is often not available at home. Resources include natural resources or
low-cost labour, and resource-seeking FDIs are predominantly export oriented. Market-seeking FDIs pursue market share in target foreign markets
to reduce the cost of supplying a market. Effciency-seeking FDIs attempt
to establish effcient structures by producing in as few countries as possible,
each country having its own distinct advantage relating to location, endowment, and government policies. The motive for strategic-asset-seeking FDIs is
to locate where assets in foreign frms can be acquired that promote long-term
objectives (e.g. to beneft from current and future research and development).
The top countries in Africa in relation to net FDI infows in 2016 were
Egypt, Nigeria, Angola, Ethiopia, Ghana, Mozambique, Morocco, South
Africa, the Republic of the Congo, and Algeria (see Appendix Table 4.1).
Appendix Table 4.1 also shows the countries that received the least FDI
fows in 2016.
The literature’s use of aggregate credit measures of bank lending has
been differentiated on the basis of the origin of the bank’s nationality (domestic or foreign) and type (cross-border or affliate). Foreign bank lending by
type can be defned as either cross-border bank lending (lending by foreign banks directly from abroad) or as foreign-bank-affliate lending (lending by branches and subsidiaries of foreign banks from the host economy)
(Owen & Temesvary, 2014). An important component of the expansion of
private capital fows to developing countries has been foreign bank lending,
be it through cross-border bank lending or through bank lending by these
banks’ foreign affliates (Pontines & Siregar, 2014). Past decades have witnessed an unequalled increase in cross-border bank fows, and many banks
(from developed and developing economies) have ventured abroad. The
increase in foreign bank presence has potentially been the most transformative change that the ongoing process of fnancial globalization has exerted
on the fnancial sectors of developing economies (Cull & Peria, 2010). Nevertheless, the effect of foreign bank presence on fnancial sector development
remains contentious. Foreign banks can improve the availability and quality
Chapter 4 • Private capital fows and economic growth
77
of fnancial services in the host economy through increasing competition and
the introduction of new lending technologies. A potential cost of increasing
foreign bank presence could be incurred when foreign banks focus on the
top segment of the market, so local entrepreneurs receive less access to fnancial services. The top countries in cross-border banking lending (proxied by
external debt) in Africa in 2016 were Egypt, Angola, South Africa, Kenya,
Ethiopia, Nigeria, Mauritius, Morocco, Ghana, and Tanzania (see Appendix
Table 4.1). Various foreign banks operate in Africa (see Box 4.5).
FPI is usually short-term passive investment that does not actively participate in the day-to-day operations and strategic initiatives of local frms.
Investments are made in capital market assets, including bonds, debentures, and equity stocks, and investors target return maximization without
having management control in the principal asset. The top countries in portfolio investments in Africa in 2016 were Mauritius, Burkina Faso, Kenya,
Morocco, Mozambique, Zimbabwe, Uganda, Cameroon, Tunisia, and Seychelles (see Appendix Table 4.1).
The rest of this chapter is structured as follows: section 4.2 discusses
determinants of private capital fows; section 4.3 provides the benefts and
costs associated with private capital fows; and section 4.4 concludes.
4.2 THE DETERMINANTS OF PRIVATE CAPITAL FLOWS
The literature usually distinguishes between pull and push factors to categorize the determinants of capital fows. Pull factors are associated with the
domestic policies and characteristics of host economies that pull capital into
a country, refecting the host economy’s relative appeal as an investment
destination. Pull factors include the domestic growth potential, low domestic infation, trade and fnancial openness, fnancial market development,
infrastructural quality, institutional quality, political stability and absence
of confict, domestic market size, and natural resource base.
Figure 4.2 shows the correlation between institutional quality and
capital fows (-0.75). Overall, it seems that capital fows go to countries
with poor institutions and vice versa. Figure 4.3 also shows the relationship
between natural resource rents and total capital fows. Total capital fows
and natural resources are positively correlated (0.41). This implies that
countries with natural resources tend to receive higher capital fows. Thus,
natural resources tend to pull capital fows into host African countries.
Push factors are associated with global economic conditions that drive
capital fows towards countries and include global growth, global liquidity,
global risk aversion, and international portfolio diversifcation. Therefore,
pull factors are internal to countries that receive capital fows and push factors are external to these countries. If pull factors are the main determinant
of capital fows to a recipient economy, then well-designed prudent macroeconomic policies should limit the potential negative effects that these fows
can have on fnancial imbalances. However, domestic macroeconomic policies have little potential to limit the negative effects of capital fows’ arising
from global push factors, because these factors are beyond the control of the
recipient economy.
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Elikplimi Komla Agbloyor et al.
FIGURE 4.2 Scatter plot between capital fows and GDP per capita, 2000–2016
Panel A: FDI, Portfolio Investments, and Institutions
Source: Generated by authors on the basis of data from the World Development Indicators
Note: Correlation between FDI and institutions is -0.57; the correlation between portfolio investments and institutions is 0.05
Panel B: External Debt, Capital Flows, and Institutions
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between cross-border bank lending (proxied by external debt) and institutions is -0.73; the correlation between capital fows and institutions is -0.75
4.2.1 FDI determinants
Apart from the general divide into push factors and pull factors that determine capital fows, a more specifc FDI determinants literature strand covers the following (Sánchez-Martín, de Arce, & Escribano, 2014):
1 The neoclassical economic approach.
2 The ownership, location, and internalization advantage (OLI) paradigm.
3 Horizontal and vertical FDI models.
Chapter 4 • Private capital fows and economic growth
79
FIGURE 4.3 Scatter plot between capital fows and CO2 emissions, 2000–2016
Panel A: FDI, Portfolio Investments, and Natural Resource Rents
Source: Generated by authors on the basis of data from the World Development Indicators.
Note: The correlation between FDI and natural resource rent is 0.67; the correlation between
portfolio investment and natural resource rent is -0.07.
Panel B: External Debt, Capital Flows (Total), and Natural Resource Rents
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between cross-border bank lending (proxied by external debt) and natural
resource rent is -0.01; the correlation between capital fows (total) and natural resource rent is 0.41
4.2.1.1 THE NEOCLASSICAL ECONOMIC APPROACH The standard neoclassical economic approach predicts that in the presence of perfect factor mobility, capital would fow from rich to poor countries pending the return to
investments equalizing in all countries. New investment should occur in
countries that exhibit low capital-to-labour ratios as implied by the law of
diminishing returns to capital. The standard approach offers a preliminary
80
Elikplimi Komla Agbloyor et al.
insight regarding FDI determinants, given that the prominence of differences in factor endowments and returns to capital across countries are suggested. The seminal work of Lucas (1990) introduced the Lucas paradox,
highlighting that, rather than following a ‘north–south’ pattern, capital
fows follow a ‘north-north’ pattern. Lucas (1990) demonstrated that according to the neoclassical economic approach, India’s marginal product of capital should be approximately 58 times greater than that of the US, with all
capital fowing to India. Notwithstanding considerable increased capital
fows recently, international capital mobility remains imperfect. Some reasons put forward about why the standard neoclassical economic approach
does not accurately predict international capital fow patterns include the
presence of economies of scale, backward and forward linkages, differences
in regulations, and systemic distortions between countries (Sánchez-Martín
et al., 2014).
4.2.1.2 THE OLI PARADIGM From a microeconomic perspective, Dunning’s
(1977) OLI paradigm provides an analytical framework that accommodates
a variety of testable theories of FDI determinants and the international
activities of multinational enterprises (MNEs). The OLI paradigm states
that the degree, geography, and manufacturing structure of MNEs’ international production is determined by the interaction and combination of
ownership, location, and internalization advantages. Ownership advantages are existing frm-specifc and knowledge-based assets (e.g. patents,
management skills, and marketing) that provide MNEs with advantages in
foreign markets over local frms. Ownership advantages therefore refer to
the competitive advantages of MNEs that give them an edge over domestic
counterparts in foreign markets.
Location advantages are the attractions of alternative countries or
regions where MNEs seek to engage in value-enhancing activities (e.g. access
to protected markets, better tax treatments, favourable competition structure, institutions, political risk, and natural resources). Figure 4.2 shows a
negative correlation (-0.57) between FDI and the quality of institutions. This
means that countries with poor institutions receive higher FDI fows than
do countries with good institutions. This is puzzling: the observed correlation may be because MNEs may be able to negotiate better terms and have
more fexibility to operate (e.g. polluting the environment). On the other
hand, Figure 4.3 shows that FDI is positively correlated (0.67) with natural
resources in Africa. This suggests that MNEs consider the natural resource
endowment of a country before they make FDI decisions. The more immobile (natural or created) endowments MNEs need to exploit, in combination
with their competitive advantage that favours an international presence, the
more MNEs will choose to exploit their ownership advantages through pursuing FDI (Dunning, 2000).
One signifcant determinant of FDI is political risk – an extreme form
being confict. Countries that are plagued by confict are likely to receive less
FDI. Confict creates uncertainty in planning: most studies on the impact of
confict on international business found that confict in host countries negatively impacts the economy through disruptions of production, corruption,
Chapter 4 • Private capital fows and economic growth
81
and transportation (Chen, 2017). FDI may reduce the probability of confict. This is because of the economic benefts that FDI provides, such as the
creation of new jobs, which reduces the probability that young men can
be recruited by warlords. This suggests that there is a bicausal relationship between FDI and confict. Akomatey (2017) examines the relationship
between FDI and confict in Africa. The fndings show that FDI infows signifcantly reduce the likelihood of confict among countries in sub-Saharan
Africa. For instance, FDI infows to host countries help its citizens, who are
destitute and unemployed, to get work, to receive income, and to be able
to provide the basic needs of life for themselves and their families. This
increases the opportunity cost of engaging in confict. In some cases, the
presence of FDI may exacerbate the probability of confict. This may especially be when a country is endowed with natural resources (see Box 4.1)
because the resources create a ‘big pot’ to fght over, since whoever gains
control gains access to signifcant power and infuence.
Further, the determinants of FDI may vary depending on whether a
country is a classifed as a confict-prone country. Empirical evidence for
Africa shows that the determinants of FDI vary in confict and nonconfict
environments. Boachie-Mensah (2017) shows that the factors that determine
FDI to sub-Sahara Africa differ from one country to another on the basis of
whether the country is classifed as being a confict or nonconfict country.
For the determinants of FDI in the full sample, she fnds that fnancial development and infrastructure had positive signifcant effects on FDI, whereas
trade openness and market size had a signifcant, negative relationship with
FDI. For nonconfict countries, natural resources, institutions, trade openness, infrastructure, and fnancial development had positive signifcant
coeffcients, but market size had a signifcant negative coeffcient. For confict countries, natural resources had a negative impact on FDI. Trade openness and market size also exhibit a negative relationship with FDI.
With internalization advantages, MNEs organize, create, and exploit
their core competencies given the location advantages. Rather than export
or engage in licensing, MNEs pursue international production for the net
benefts of internalizing intermediate cross-border product markets (Dunning, 2000). MNEs minimize imitation risks or reputation losses and save
transaction costs by pursuing international production directly in the target
market (Sánchez-Martín et al., 2014). The empirical literature that tested the
OLI paradigm showed FDI determinants to be a combination of ownership
advantages, transport costs, market features, infrastructure, property rights,
and industrial dispute mechanisms (Faeth, 2009).
4.2.1.3 HORIZONTAL AND VERTICAL FDI APPROACHES Horizontal and vertical FDI approaches emerged in the 1980s as part of new trade theories
building on industrial organization models (including the OLI paradigm) to
combine ownership and location advantages with technology and country
characteristics. General equilibrium models in a monopolistic competition
setting were used to try to explain the activities of horizontal (Markusan,
1984) and vertical FDI (Helpman, 1984), the FDI and export link being a
case of a substitution relationship or a complementary relationship (Abor,
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Adjasi, & Hayford, 2008). According to Sánchez-Martín et al. (2014), the following reasons explain foreign investment in a country:
• With resource-seeking activities, MNEs establish a manufacturing
plant in a developing economy to gain access to raw materials to the
extent to which the host economy will beneft from the foreign investment, depending on the terms of the concessionary agreement with
the MNE and how local institutions manage the income.
• With horizontal FDI, MNEs seek to gain access to markets to serve a
large demand where transportation costs from the MNEs’ home base
are high. Horizontal FDI could be used to avoid import restrictions or
high tariffs, thereby substituting for global trade and possibly increasing local industry competition.
• With vertical FDI, MNEs seek cheaper factor prices by establishing
manufacturing plants that use labour-intensive processes in countries
with low wages and appropriate transport infrastructure connections
with developed countries. This type of FDI permits backward and forward linkages and is frequently export oriented.
The knowledge-capital model of Markusan and Maskus (2002) allows for
combinations of horizontal and vertical FDI approaches. Horizontal FDI is
established where two countries are similar in size and a large market exist,
whereas vertical FDI is established where countries differ in size and endowments. The empirical literature strongly supports market size and transport
costs as FDI determinants; evidence remains inconclusive on whether factor endowments (supporting the vertical FDI approach) are signifcant FDI
determinants (Faeth, 2009).
The following groups of variables, in theory, determine FDI, ownership advantages (e.g. patents and strategic assets), locational advantages
(e.g. endowments, transport costs, and trade barriers), macroeconomic factors (e.g. infation, exchange rates, labour costs, and GDP growth), and policy and institutional factors (e.g. political risk, degree of fnancial openness,
and taxation benefts) (Sánchez-Martín et al., 2014).
BOX 4.1 FDI and the DR Congo (DRC) experience
The Democratic Republic of the Congo (DR Congo, or DRC) is located
in Central Africa and is the world’s largest copper producer. It has
been plagued by several conficts in the past, and by some estimates,
confict in the DRC has claimed over fve million lives. The DRC ranks
low on the Mo Ibrahim Index (measures the performance of African
countries in terms of governance) of African governance (35 out of 100
in 2016). The war in Rwanda spilled over into DRC as Rwandan forces
pursued those who had committed genocide in Rwanda and had fed
into DRC. At its height, the war in DRC embroiled several of its neighbours and other African countries (Rwanda, Uganda, South Sudan,
Central African Republic, Angola, Namibia, and Zimbabwe).
Chapter 4 • Private capital fows and economic growth
83
The DR Congo’s natural resources fuelled this confict after
long-time despot Mobutu Sese Seko was overthrown. The family jewels (blood diamonds) became available for looting. Although statistics on FDI into the DR Congo are diffcult to come by (in terms of
actual amounts), FDI into the country has been rising recently, and
FDI stocks have risen sharply, especially after a lull in the confict in
2003. In 2016, on the basis of data from the WDI, DR Congo received
FDI infows of about USD1.2 billion, ranking 13th for that year. Several
MNEs operate in the DR Congo, and most observers believe that the
DR Congo has not benefted from these investments, since the terms
of the investments are regarded as far too generous. Indeed, the DR
Congo has been exploited by foreigners since the Victorian era.
Further reading:
www.economist.com/leaders/2018/02/15/congo-is-slidingback-to-bloodshed
https://mo.ibrahim.foundation/iiag
4.2.2 Foreign bank lending determinants
To consider sustainability and policy responses in the wake of increased
cross-border bank lending fows to recipient economies, it has become necessary to investigate their determinants. When push factors are dominant,
central decisions of headquarter/home countries drive international bank
lending fows. These fows could easily reverse when diffculties arise in the
home country, exposing recipient countries to possible sources of domestic
market vulnerability. Recipient country regulators could then restrict international banks from reallocating their funds globally by adopting liquidity regulations (‘ring-fencing’) regulations. Most ring-fencing proposals
require foreign banks to have dedicated capital and liquidity resources that
are subject to local control. One objective of ring-fencing regulations is to
limit the potential impact of cross-border banking contagion. If domestic
pull factors are dominant, international bank lending fows are more determined by total optimization decisions based on the risk-adjusted returns for
each recipient destination (Shirota, 2015).
The literature shows that both push factors and pull factors drive
cross-border bank lending. Herrmann and Mihaljek (2013) show that riskspecifc factors of the borrower country signifcantly impact cross-border
bank lending and that global risk aversion is also a signifcant determinant.
Shirota (2015) reveals that global and regional common factors accounted
for approximately half of cross-border bank lending fuctuations. However,
much heterogeneity exists between countries, since some countries were
largely affected by country-specifc pull factors; thus, appropriate policy
responses to cross-border bank lending fows might vary depending on the
recipient country.
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Figure 4.2 shows the relationship between cross-border bank lending
(proxied by external debt fows) and institutional quality. Surprisingly, just
like FDI fows, cross-border bank lending has a negative correlation (-0.73)
with the quality of domestic institutions. Consequently, it appears that
countries with poor-quality institutions receive higher lending. This may
be because the data also include lending from multinational agencies, such
as the IMF, that are more likely to lend to countries experiencing diffculty.
These countries are usually characterized by poor institutions. Finally, Figure 4.3 shows the relationship between cross-border bank lending and natural resource endowment of host African countries. The correlation (-0.01) is
negative but close to zero, meaning that cross-border bank lending is not
infuenced much by the natural resource endowment of host countries.
4.2.3 FPI determinants
Diversifcation is the foundation of the modern portfolio theory of Markowitz (1952, 1959) and has since become a central theme in the fnance
literature. International fnance theory holds that FPI fows are the natural
consequence of foreign investors seeking to invest across borders to help
diversify portfolio risk and maximize returns. Studies have shown the benefts of diversifying across borders (e.g. Grubel, 1968; Harvey, 1991).
As previously noted, the literature usually distinguishes between
pull factors and push factors in categorizing the determinants of international capital fows. Some recent contributions in the literature revealed that
both pull factors and push factors drive FPI. For instance, supporting the
results of previous studies, Ahmed and Zlate (2014) fnd that global risk
aversion, interest rate differentials, and growth differentials were signifcant FPI determinants in developing countries. Global risk aversion, as a
push factor, is likely to be associated with weaker FPI fows, because an
investor’s willingness to purchase riskier developing country assets is negatively impacted. A higher GDP growth rate in the domestic economy is
expected to pull in FPI fows, because the higher growth rate is often seen as
a proxy for the dynamism of the domestic economy. In a study investigating the determinants of portfolio bond fows to developing countries, Erduman and Kaya (2016) fnd interest rate differential and the infation rate the
most signifcant pull factors, with global liquidity being an important push
factor. After the global fnancial crisis, the expansionary monetary policies
of the developed economies and the resultant increasing global liquidity
increased investors’ search for riskier and higher-yielding developing country assets. Institutional and governance quality have also been found to be
important determinants of FPI (De Santis & Lührmann, 2009; Vo, Nguyen,
Ho, & Nguyen, 2017).
Figure 4.2 shows that FPI exhibits a positive but low correlation with
institution quality. This shows that FPIs do not rely so much on the quality
of local institutions in Africa. Further, Figure 4.3 shows that FPIs exhibit a
negative but low correlation with the natural resource endowment of the
host nation. This suggests that natural resource endowments do not play
a signifcant role in infuencing the decisions of foreign portfolio investors.
Chapter 4 • Private capital fows and economic growth
85
Although pull factors therefore remain equally important as FPI drivers, along with push factors, evidence regarding FPI volatility or periods of
extreme FPI movements indicate push factors as the primary drivers. Forbes
and Warnock (2012) show that global risk is signifcantly related to periods
of extreme FPI and that domestic characteristics are generally less important. Sarno, Tsiakas, and Ulloa (2016) fnd that over 80% of FPI variation was
a result of push factors.
4.3 BENEFITS AND COSTS ASSOCIATED WITH PRIVATE
CAPITAL FLOWS
Private capital fows present a double-edged sword for host economies
regarding benefts as well as costs. Because important variations exist
regarding the various components of private capital fows, this section provides a more expansive discussion of the benefts and costs associated with
FDI, foreign bank lending, and FPI.
4.3.1 Benefts of FDI
With FDI, more information regarding investment fundamentals is available to foreign investors, enabling them to manage the investment more
resourcefully than can FPI investors (Goldstein & Razin, 2005). Policies
intended to attract FDI infows are driven by the benefts related to inward
FDI identifed in the literature that include productivity gains, technology
spill-over, the introduction of new management processes and employee
training, international trade integration, creating backward and forward
linkages through international production processes, and the advancement
of a favourable business environment (Adjasi, Abor, Osei, & Nyavor-Foli,
2012; Agbloyor, Abor, Adjasi, & Yawson, 2013).
Through FDIs’ impact on economic growth, poverty reduction can
ensue. Figure 4.4 shows that FDI is highly correlated (0.83) with GDP per
capita. This correlation is higher than the correlation between other types of
capital fows (portfolio investments and cross-border bank lending – proxied
by external debt) and GDP per capita. The benefts to host economies can
occur as a result of FDI’s upskilling unskilled labour. By supplying scarce
capital into the domestic economy, FDI helps to resolve the access to fnance
problem and needs to be structured to suit the local development context.
By augmenting domestic capital for exports, FDI assists frms to enter the
export market (Abor et al., 2008). Through the provision of backward and
forward linkages in production, FDI enables local frms to add value to their
products and services, which should further translate into greater participation in regional and global trade.
The related literature, however, suggests that the benefts associated with inward FDI depend on the host economy’s absorptive capacity (see Agbloyor, Gyeke-Dako, Kuipo, & Abor, 2016). For example, FDI
productivity depends on a minimum level of human capital development
(Borensztein, De Gregorio, & Lee, 1998) and FDI productivity is enhanced
through the existence of well-functioning domestic fnancial markets
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FIGURE 4.4 Scatter plot between capital fows and institutions, 2000–2016
Panel A: FDI, Portfolio Investment, and GDP Per Capita
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between FDI and GDP per capita is 0.83; the correlation between portfolio
investment and GDP per capita is 0.04
Panel B: External Debt, Capital Flows (Total), and GDP Per Capita
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between cross-border bank lending (proxied by external debt) and GDP
per capita is 0.66; the correlation between capital fows (total) and GDP per capita is 0.90
(Adjasi et al., 2012; Agbloyor, Abor, Adjasi, & Yawson, 2014) and the quality of institutions (Agbloyor, Gyeke-Dako, Kuipo, and Abor, 2016). The
literature describes strong institutions as those with democratic and relatively equal processes, few radical and social divisions, and ample counterbalances on political behaviour. Further, the impact of FDI may depend
on the country’s confict status. That is, confict may alter the relationship
Chapter 4 • Private capital fows and economic growth
87
between FDI and economic growth. This may be for several reasons. One
potential explanation is that confict destroys the necessary absorptive
capacity (e.g. fnancial development, infrastructure development, trade
openness, human capital, institutions, and macroeconomic stability) that a
country needs to beneft from FDI. Another plausible explanation could be
that confict-prone countries may attract ‘bad’ FDI or FDI targeted towards
natural resources. Agbloyor, Gyeke-Dako, Yawson, and Abor (2016)
examine the relationship between FDI, confict, and economic growth in
sub-Saharan Africa. They fnd that in the full sample of countries, FDI
has no effect on economic growth. However, after dropping countries that
have been plagued by confict, they fnd that FDI has a positive signifcant
impact on economic growth. Alternative approaches using dummy variables to represent countries plagued by confict and the duration of the
confict show that, though FDI has a positive impact on growth, the effect
is lower in confict-affected countries. Agbloyor, Gyeke-Dako, Yawson,
and Abor (2016) develop and test three new hypothesis to explain these
fndings. These hypotheses are the good boy, bad boy, and repentant heart
hypotheses. A good boy is classifed as a country that has never entered
into confict. A bad boy, on the other hand, is a country that is prone to
recurrent confict. Repentant hearts are countries that have entered into
confict, exited confict, and have not re-entered confict for a minimum
of six years. The results show that good boys beneft from FDI fows, in
terms of achieving higher growth outcomes, more than their counterparts
do. Repentant hearts also benefted from FDI in terms of achieving higher
growth outcomes. Bad boys, however, do not beneft from FDI fows in
terms of achieving higher growth outcomes.
In Africa, Botswana has been a shining example of development.
Botswana has been able to leverage investments into its diamond industry
to catapult growth and development (see Box 4.2).
BOX 4.2 FDI and the Botswana experience
Botswana gained its independence in 1966 and is often referred to
as the Southern Star. It was extremely poor at independence. Today,
Botswana is a shining example of development in Africa. According to
an Economist article in 2002, Botswana has achieved the fastest growth
in the world in income per capita over the past 35 years. This growth
was faster than any Asian tiger (e.g. Singapore or South Korea) or
growth in China or in the United States. Botswana has also consistently ranked highly on the Mo Ibrahim Index of African governance.
Most of this wealth is due to minerals, in particular diamonds.
Unsurprisingly, a lot of FDI into Botswana goes into diamond
exploration. Botswana, however, does not rank highly in terms of FDI
in Africa (it received only about USD129 million in 2016, the 40th in
Africa) and even compared with its own exports. De Beers from South
Africa is one of the most important investors in the diamond business
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Elikplimi Komla Agbloyor et al.
in Botswana. The country recently had a 50–50 arrangement with De
Beers to increase its share of the profts from exploration.
Botswana has been able to harness and leverage on its diamonds for development and has avoided most of the pitfalls that have
befallen other resource-rich countries in the region, such as the Democratic Republic of Congo. Several explanations have been offered for
Botswana’s success. One is that the elite were enriched enough from
diamonds so that further rent seeking, which could potentially escalate into war, was unnecessary. Another explanation is that the traditional society in Botswana encouraged dialogue between leaders and
citizens. One key challenge for Botswana is to diversify its economy
and reduce its dependence on its natural resources.
Further reading:
www.economist.com/finance-and-economics/2002/03/28/theafrican-exception
www.economist.com/middle-east-and-africa/2018/03/10/
how-to-save-botswanas-sparkling-reputation
4.3.2 Costs of FDI
FDI investors’ advantage in having more information regarding frms’
investment fundamentals as opposed to FPI investors can give rise to future
asymmetric information problems between the foreign investor and future
buyers (Goldstein & Razin, 2005). Information asymmetry problems could
arise for FDI investors should they disinvest before investment maturity. In
such a case, potential buyers would be willing to pay a lower price because
they would realize that the investor has an information advantage regarding the investment fundamentals and may suspect the disinvestment arises
from negative future investment prospects.
FDIs may also lead to negative consequences when they are viewed
not to have signifcant linkages with the domestic economy. For example,
FDIs may be concentrated in the exploration of natural resources, such as
oil and gas, which may have few linkages with the domestic economy (see
Box 4.3). Further, FDIs may have negative consequences in the domestic
market because these frms ‘outcompete’ local frms, leading to the demise
of local frms with attendant losses in employment, capital, and negative
social consequences because of, for example, job losses. Domestic frms
may also feel that foreign frms are given more attractive investment packages to domestic frms’ detriment. When domestic frms lose market share
to foreign frms, their productivity is reduced through competition effects.
Should the productivity decline from a lesser market share be large enough,
domestic frms’ net productivity can reduce even though technology and
management transfer could have occurred because of the presence of foreign frms. The following are some of the other explanations for why the
Chapter 4 • Private capital fows and economic growth
89
domestic economy might not beneft through FDI spillovers (Görg & Greenaway, 2003):
• Foreign frms are able to guard their frm-specifc advantages.
• The positive FDI spillovers impact only certain frms.
• The positive FDI spillovers imply no intra-industry knowledge transfer.
Because of global governance, institutions, and the possibility of capital fight, developing economies often try to create a conducive business
environment that includes lower domestic environmental regulations compared with developed economies (Jorgenson, 2007). Developing economies
are also less likely to ratify international environmental treaties. Kuznet’s
(1955) economic growth inequality hypothesis addresses the link between
FDI and environmental sustainability through an indirect channel: FDI
positively impacts growth that leads to increased CO2 emissions (see Figure 4.5). Figure 4.5 shows that FDI is positively correlated (0.34) with CO2
emissions. This correlation is higher than the correlation between the other
types of private capital fows (portfolio investment and cross-border bank
lending) and CO2 emissions.
A direct theory that addresses the link between FDI and environmental sustainability is the pollution havens theory (Bokpin, 2017). According
to the pollution havens theory, multinational enterprises locate in developing countries with weaker environmental standards and lower regulations in order to fnance polluting and ecologically ineffcient processes (see
Box 4.4). To attract additional foreign investment, developing countries
intentionally undervalue their environment, becoming pollution havens.
FIGURE 4.5 Scatter plot between capital fows and natural resource rents,
2000–2016
Panel A: FDI, Portfolio Investments, and CO2 Emissions
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between FDI and CO2 emissions is 0.34; the correlation between portfolio
investments and CO2 emissions is 0.25
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Elikplimi Komla Agbloyor et al.
FIGURE 4.5 (Continued)
Panel B: External Debt, Capital Flows (Total), and CO2 Emissions
Source: Generated by authors on the basis of data from the World Development Indicators
Note: The correlation between cross-border bank lending (proxied by external debt) and CO2
emissions is 0.17; the correlation between capital fows and CO2 emissions is 0.39
When the environment is undervalued or considered free, a distortion
in economic incentives and overuse by producers and customers ensues
(Mabey & McNally, 1999). Empirical evidence has revealed that FDI infows
increase environmental degradation in Africa. However, in the presence of
strong government institutions, such as environmental protection agencies,
FDI contributes to environmental sustainability (see Bokpin, 2017).
BOX 4.3 FDI and the Nigerian experience
Nigeria is one of the largest recipients of FDI in Africa. In 2016, Nigeria
received FDI infows of USD4.44 billion, ranking second in Africa. It is
also one of the largest producers of oil in Africa and the world. Traditionally, FDI into Nigeria has focused mainly on the natural resource sector.
A number of empirical studies have found that FDI has had a negative
impact or no impact on economic growth in Nigeria (e.g. see Akinlo,
2004). These studies usually attribute this negative effect to the fact that
most of the investments go into the natural resource sector, which has few
linkages with the rest of the economy. The Niger Delta crises where local
militants have been fghting foreign multinationals engaged in oil exploration in Nigeria probably sums up how some Nigerians feel about FDI,
especially in the natural resource sector. As recently as 2016, an attack on
the Shell Petroleum Development Corporation led to a halt in production.
Some other studies, such as Ayanwale (2007), suggest that
though overall FDI may not have an impact on growth, FDI in sectors
in Nigeria such as communication has had a positive impact.
Chapter 4 • Private capital fows and economic growth
91
BOX 4.4 FDI and the pollution havens hypothesis: copper mining
in Zambia
Signifcant FDI in the natural resource sectors of African economies has
raised concerns that FDI could undermine local development where
negative external costs (e.g. an increase in environmental degradation)
are created but not accounted for by the foreign investor. Capacity
constraints, an interventionist tradition, and a cooperative approach
when engaging with industry characterizes the environmental regulatory efforts in Zambia. These characteristics have afforded MNEs signifcant latitude to remedy compliance gaps. For instance, in 2007, the
Zambian parliament noted that two projects were given approval to
proceed through clauses in the Environmental Act allowing the minister of environment to overrule objections from the Environmental
Council of Zambia that the projects were environmentally unsound
(Haglund, 2008).
In 2016, Zambia received net FDI infows of USD662 million,
ranking 18th in Africa. It would seem that investment risks relating
to the effectiveness of local environmental regulations in Zambia have
been valid. In 2017, Zambian villagers won the right to sue a Londonbased mining group and its subsidiary, in British courts, claiming a
copper mine had polluted their water for years.
4.3.3 Benefts of foreign bank lending
The advantages of increased foreign bank presence include foreign banks’
achieving better economies of scale and risk diversifcation, the introduction of more advanced technology and better risk management practices,
importing improved supervision and regulation, and enhancing competition. In times of economic hardship, foreign affliates of global banks could
be perceived as safer than domestic banks (see Box 4.6). Foreign banks may
be less infuenced by the domestic political climate and less susceptible to
lend to connected parties (Detragiache, Tressel, & Gupta, 2008).
According to modern portfolio theory, by diversifying asset holdings,
an investor can reduce portfolio risk. Similar diversifcation gains arise to
banks that invest abroad through a reduction of the variance of their asset
portfolio; the resultant lower asset volatility should decrease the prospect
of bank failures in the home country. Apart from bank failures, diversifcation gains from cross-border banking could also reduce lending volatility in the home country, because the lower risk exposure of banks reduces
their chances to cut back lending. Diversifcation gains can also arise from
the presence of foreign banks in the host economy. Increased foreign bank
presence enables frms in the host country to have lending relationships
with both domestic and foreign banks, where the frms are able to substitute
domestic lending with foreign bank fnance should domestic banks become
constrained in their lending (Allen et al., 2011).
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Elikplimi Komla Agbloyor et al.
The effect of foreign bank presence on competition in the domestic
banking market can be marked in concentrated domestic markets where
banks operate ineffciently. One strand of the related literature suggests
competition enhances stability through the mitigation of agency problems
at the borrower level. Increased competition will lower lending rates, raising borrowers’ profts, reducing risk-shifting incentives, and subsequently
lowering borrower risk. Increasing borrowers’ profts lowers the chances
of bankruptcy, and fewer moral hazard problems on the part of borrowers can be expected once borrowers are confronted with lower interest
costs. In addition to increasing the number of market participants, foreign
banks may be more effcient (e.g. use improved risk management practices),
thereby forcing domestic banks to improve their effciency and thus contributing further to banking sector stability (Allen et al., 2011). Empirical
evidence has shown that increased foreign bank presence is associated with
a reduction in the proftability and margins of domestic banks (Claessens,
Demirgüç-Kunt, & Huizinga, 2001), and barriers for bank customers are
lower with increased foreign bank involvement (Beck, Demirgüç-Kunt, &
Peria, 2008). Foreign bank lenders could prompt the supervisory authorities from host economies to improve regulation and supervision in answer
to new activities and products, thereby indirectly contributing to fnancial
stability (Beck, Fuchs, Singer, & Witte, 2014).
BOX 4.5 Foreign bank ownership in Africa
On the basis of geographical origin, foreign bank ownership in Africa
can be grouped into two categories (Beck et al., 2014):
1 Global banks from outside the continent (specifcally Europe),
although we have also seen an increasing presence of southsouth banks from India and China – examples include Sociéte
Générale (France), Citigroup (USA), Standard Chartered (UK),
BNP Paribas (France), and Bank of Baroda (India), and Sociéte
Générale has representation through branches and subsidiaries
in 17 African countries
2 Cross-border banks from Africa predominantly incorporated
in South Africa, Nigeria, and Morocco – examples include
Ecobank (Togo), UBA (Nigeria), Stanbic (South Africa), and
BMCE (Morocco), and Ecobank has representation in 32 African
countries.
There are major discrepancies concerning foreign bank ownership across Africa, according to Claessens and Van Horen’s (2014)
database on bank ownership. The banking sector of some countries
is dominated by foreign banks, where foreign banks own over 80% of
banking sector assets. Country examples include Benin, Madagascar,
Senegal, and Zambia. In some African economies, foreign banks own
between 60% and 80% of banking sector assets. Country examples
Chapter 4 • Private capital fows and economic growth
93
include Botswana, Cameroon, and Ghana. Foreign bank assets among
total bank assets in 2013 were lower in some countries that exhibit
greater banking sector development. Country examples are Kenya
(34%), South Africa (25%), and Nigeria (16%). No foreign banks operate in Ethiopia. According to Beck et al. (2014), the variation in foreign
bank presence across the continent can be partly explained by historical and country-specifc factors. For example, fnancial sector reforms
implemented at independence in Kenya, Morocco, and Nigeria brought
about the nationalization of foreign banks, established state-owned
banks, and facilitated the growth of domestic banks through low entry
requirements. In South Africa, foreign bank presence declined in the
1980s as pressure mounted on foreign banks to disinvest because of
the country’s apartheid regime, and domestic bank concentration
remained high. In Nigeria, as a result of the minimum capital increase
in 2005 that led to banking sector consolidation, foreign bank investment was initially discouraged. In Kenya, prudent management and
the strong market position of the Kenya Commercial Bank, along with
private sector competition, fuelled product innovation and, in the
2000s, advanced a platform for East African cross-border expansion.
BOX 4.6 Foreign bank presence, fnancial sector stability, and
connected lending in Ghana
The banking industry in Ghana experienced signifcant shocks in 2017
and 2018. In 2017, two domestic banks (UT Bank and Capital Bank)
collapsed and were handed over to GCB Bank (a domestic bank previously wholly owned by the state) through a purchase and assumption transaction. The collapse of these banks was attributed to poor
corporate governance practices and connected lending. In 2018, fve
more local banks collapsed (Biege Bank, Royal Bank, Sovereign Bank,
UniBank Ghana, and Construction Bank). The collapse of these banks
was attributed to similar reasons.
Interestingly, no foreign owned bank was affected by the fnancial crisis that occurred. Thus, some have argued that these banks were
not affected, because of their higher corporate governance standards
and lower propensity to engage in related party lending.
4.3.4 Costs of foreign bank lending
Critics of increased foreign bank presence posit that distance constraints
and information disadvantages deter foreign banks from lending to smaller,
more-opaque frms that are particularly prevalent in African economies.
That is, foreign banks cherry-pick the best customers, leading to reduced
credit to ordinary citizens of the country. If foreign banks crowd out local
banks, fnancial outreach could be negatively impacted as smaller frms
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Elikplimi Komla Agbloyor et al.
further struggle to access fnance because foreign banks lend predominantly
to the top market segment (Detragiache et al., 2008). According to the literature, foreign banks shun lending to soft information sector borrowers (e.g.
small start-up frms) because of information and agency costs relating to
cultural and geographical variances (Mian, 2006).
The stability benefts associated with increased foreign bank presence
as a result of diversifcation gains have been challenged by critics. Although
increased foreign bank presence can shield a host economy from domestic shocks, foreign banks can also transmit or ‘import’ shocks into the host
economy. Domestic capital is less mobile than foreign capital, and foreign
banks can withdraw liquidity and reduce lending in the host economy
should adverse conditions arise globally or in their home countries.
Whether increased foreign bank presence results in improved regulation
and supervision has been questioned, since effective regulation and supervision do not require the presence of any foreign banks but start with domestic
banks. Acquiring suffcient regulatory expertise to improve oversight may
take years, exposing the domestic banking sector to risks relating to new products and technologies that are not fully understood (Beck et al., 2014).
4.3.5 Benefts of FPI
FPI fows provide foreign investors the opportunity to target investments across economies to diversify portfolio risk and obtain higher riskadjusted rates of return as risks are pooled by investors. FPI also caters to
different portfolio preferences, expanding the available choice of fnancial
instruments that vary across countries. FDI is considered more permanent
because of the larger capital initial investment requirements and relatively
less liquidity than FPI. Hence, institutional investors (e.g. pension funds
and asset managers) prefer FPI because of the liquidity and possible information asymmetry problems associated with FDI.
For developing country host economies, FPI closes the savings–investment gap, provides foreign exchange, assists in fnancing current account
defcits, provides a monitoring role for the corporate sector, and facilitates
resource mobilization. The depth and liquidity of local stock markets are
increased, which could result in positive spillovers, including improved regulation and supervision and improved accounting and reporting standards.
More-developed stock markets afford emerging companies additional
fnancing options, thereby decreasing their dependence on bank fnancing
that reduces the risk of credit constraints. Well-developed and integrated
local bond markets provide an intermediate function to raise funding for
infrastructure development. Because of FPIs’ positive impact on valuations,
a reduction in the cost of capital may ensue.
4.3.6 Costs of FPI
FPI investors need to factor in country and currency risk, along with other
factors, before investing in an economy. FPI investors are more vulnerable
to liquidity shocks, and FDI investors with FPI fows are more susceptible
Chapter 4 • Private capital fows and economic growth
95
to surges and sudden stops (see Box 4.7). FPI infow surges can infuence
domestic asset prices, resulting in a real estate bubble and infation; sudden
stops can translate into higher interest rates, currency depreciation, and a
low growth environment (Sarno et al., 2016).
Increased FPI fows that positively infuence stock market liquidity
may negatively impact corporate governance in that liquid stock markets
could translate into investor myopia (Yartey & Adjasi, 2007). Long-term
investment is constrained by investor myopia, which is defned as investors focusing only on short-run price changes over a short-time horizon. If
FPI investors can readily disinvest, their motivation to adequately provide
a monitoring role for the corporate sector becomes questionable. The actual
operation of the pricing and turnover mechanism of stock markets can also
translate into short-termism, along with decreased long-term investment,
including frm-specifc human capital. With the aim of attracting more FPI
investors, management can engage in actions to maximize short-term earnings and stock prices while neglecting more-effcient long-term resource
allocation decisions, such as investing in frm-specifc human capital that
raises worker productivity. Compared with FDI, FPI fows can depart from
long-term proftability expectations relating to host economies’ fundamentals and are also infuenced by herding behaviour. For example, in the
aftermath of the global fnancial crisis, the expansionary monetary policies
implemented in developed countries created ample incentive for speculative FPI fows to food the stock and bond markets of developing countries. The excessive liquidity from these aggressive monetary policy actions
spilled over into developing countries with little relation to the host economy’s macroeconomic fundamentals because the aim of these cross-border
fows is often an attempt to earn short-term gains. The literature has also
argued that investors are more inclined to herd if markets are ineffcient. If
developing country fnancial markets are poorly regulated, experience frequent central bank intervention, and have poor disclosure requirements for
listed securities, then foreign investors are arguably likely to exhibit herding
behaviour (i.e. foreign investors mimicking each other’s actions). Herding
behaviour can create a gap between a listed security’s fundamental price
and the market price that can lead to a price bubble.
Empirical evidence has shown that the entrance of foreign institutional
investors into the capital markets of developing countries dilutes domestic
fnancial price information, because these investors trade with less information. Although more access to international capital markets could beneft
domestic growth prospects, information asymmetries from the side of institutional investors can negatively impact resource allocation and fnancial
stability (Frenkel & Menkhoff, 2004).
BOX 4.7 FPI effects in South Africa
Since the turn of the century, South Africa has primarily relied on FPI
fows to support the current account defcit as a result of a shortfall in
96
Elikplimi Komla Agbloyor et al.
domestic savings. Between 2000 and 2007, FPI fows contributed over
50% of infows recorded on the fnancial account, compared with the
36% contribution of FDI. The volatility of FPI fows was demonstrated
in 2008, when investor sentiment became negative and FPI outfows
of 104% on the fnancial account balance was recorded, resulting in a
depreciation of the local currency. The country’s reliance on FPI fows
continued from 2009 to 2014, FPI fows contributing nearly 50% of
infows recorded on the fnancial account. Although the local currency
initially strengthened between 2009 and April 2011, severe periods of
depreciation occurred from the second half of 2011. Although South
Africa’s local currency developments refected both country-specifc
and international developments, deteriorating global economic prospects left most emerging market economies with depreciating currencies and the effects thereof. Therefore, a concern for countries that
overly rely on FPI fows is that global push factors (beyond the control
of the domestic policymakers) can easily trigger a reversal of fows.
For example, in 2016, South Africa recorded the largest net portfolio investments in Africa: a staggering USD16 billion. South Africa’s
increasing reliance on FPI fows was highlighted as a factor for a selloff
of FPI in the second half of 2018, compounded by global push factors
such as looming trade wars and a strong dollar.
Source: Adapted from De Beer (2015)
4.4 CONCLUSION
This chapter examined various issues regarding private capital fows to
Africa. Private capital fows have generally been rising. The main capital
fows examined were FDI, foreign bank lending, and FPI. FDIs may be
classifed as either Greenfeld or cross-border M&As, with the latter rising. In terms of motives for FDI, these have been generally classifed as
resource seeking, market seeking, effciency seeking, and strategic-asset
seeking. Resource-seeking FDI investors pursue resources at a lower real
cost abroad that is often not available at home. Market-seeking FDIs pursue
market share in target foreign markets with the goal of reducing the cost of
supplying a market. Effciency-seeking FDIs attempt to establish effcient
structures by producing in as few countries as possible, each country having
its own distinctive advantage relating to location, endowment, and government policies. The motive for strategic-asset-seeking FDIs is to locate where
assets in foreign frms can be acquired that promote long-term objectives.
Several benefts from FDI fows were identifed. These include productivity gains, technology spillovers, the introduction of new management
processes and employee training, international trade integration, creating
backward and forward linkages through international production processes, and the advancement of a favourable business environment. These
Chapter 4 • Private capital fows and economic growth
97
benefts were also found to depend on host-country characteristics, such
as trade openness, human capital, confict, the quality of institutions, and
fnancial development, among other variables. FDI was found to be positively correlated with GDP per capita. FDI was identifed to be associated
with costs such as increased pollution and low linkages with the rest of the
economy in the case of some resource-rich countries. Various theories have
been proposed to explain the determinants of FDI fows to host countries.
These theories include the neoclassical theory, the OLI framework, and the
horizontal and vertical FDI models. FDIs were found to be more stable than
the other types of private capital fows. The consequences of capital fow
volatility were identifed to include intensifying economic cycles, creating
weaknesses in fnancial systems, and worsening overall macroeconomic
uncertainty.
The fndings in the chapter indicated that FDI exhibits a negative correlation with the quality of institutions. FDIs were also found to exhibit a
positive correlation with natural resources. FDIs reduce the probability of
confict. In certain instances, FDIs may exacerbate the likelihood of confict.
The determinants of FDI were identifed to vary by the confict status of
a country. For nonconfict countries, natural resources, institutions, trade
openness, infrastructure, and fnancial development had positive signifcant
coeffcients, but market size had negative and signifcant coeffcients. For
confict countries, natural resources were found to have a negative impact
on FDI. Trade openness and market size were also found to exhibit a negative relationship with FDI. Finally, nonconfict countries and countries that
have entered and exited war without returning to war benefted more from
FDI than did countries prone to recurrent confict.
Push (global) and pull (host-country) factors were identifed as the
main factors that explain FPI fows to African countries. The push factors
were identifed to be more important than the pull factors. FPIs were identifed to exhibit a low correlation with the quality of institutions in host
countries. Further, FPIs were also identifed to be lowly correlated with
natural resource endowments in host countries. FPIs are associated with
certain benefts, such as closing the savings–investment gap, providing foreign exchange, assisting in fnancing current account defcits, providing a
monitoring role for the corporate sector, and facilitating resource mobilization. Some of the costs associated with FPIs include surges in domestic asset
price, resulting in a real estate bubble and infation, while sudden stops can
translate into higher interest rates, currency depreciation, and a low growth
environment.
Push and pull factors explain cross-border bank lending, which is
negatively correlated with institutions. Further, cross-border bank lending
is lowly correlated with the natural resource endowments of host countries. Cross-border bank lending is associated with benefts as well, such
as the ability of foreign banks to achieve better economies of scale and risk
diversifcation, the introduction of more advanced technology and better
risk management practices, importing improved supervision and regulation, and enhancing competition. In times of economic hardship, foreign
affliates of global banks could be perceived as safer than domestic banks
98
Elikplimi Komla Agbloyor et al.
are, because they are perceived to be less infuenced by the domestic political climate and less susceptible to lending to connected parties. The withdrawal of cross-border bank lending can also impose signifcant costs on
host economies.
Discussion questions
1 Why have policymakers in developing countries and international
development fnance institutions
promoted private capital fows in
recent times? Are there any reasons why policymakers should be
cautious in fashioning policies to
attract FDI?
2 Explain the various types of private capital fows. Why would
countries prefer certain types of
private capital fows over others?
3 Discuss the implications of volatile
capital fows for African countries.
4 Discuss the trends in private capital fows in Africa. What does this
tell us about to the preference of
countries for particular capital
fows, and why is this the case?
5 Explain the various motives for FDI
fows, according to Ajayi (2006).
6 There are two main forces that
determine capital fows into
developing countries. These are
push and pull factors. What is the
difference between the two? Provide examples.
7 There are various theories that
explain FDI fows. Discuss these
8
9
10
11
12
theories, and what do these theories say about FDI fows?
a. The neoclassical approach.
b. The Dunning’s OLI framework.
c. Horizontal and vertical FDI
models.
Discuss how FDI determinants
vary depending on the confict
status of a country?
Theory and empirical evidence
suggest that confict may lead to
lower FDI fows in developing
countries. However, FDI fows
may also negatively affect the
confict status of a country. How
may FDI affect the probability of
confict in developing regions like
Africa?
Discuss how confict may alter the
relationship between FDI and economic growth.
Discuss the good boy, bad boy
and the repentant heart hypotheses in relation to FDI and economic growth.
Discuss the potential costs and
benefts of foreign direct investments, foreign portfolio investment, and foreign bank lending.
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Appendix
TABLE 4.1 Private capital fows to Africa in 2016: best and worst performers
Panel A: FDI and portfolio investments
Top 10 recipients of FDI
Top 10 recipients of portfolio investments
Egypt, Arab Rep.
8,106,800,000.00
Nigeria
4,445,102,771.13
Angola
4,104,422,619.77
Ethiopia
3,988,953,391.68
Ghana
3,485,333,369.28
Mozambique
3,128,149,928.70
Morocco
2,318,278,920.13
South Africa
2,215,307,020.40
DR Congo
2,006,000,000.00
Algeria
1,637,370,975.34
Some countries of interest
Botswana
129,127,201.65
DR Congo
1,204,708,617.17
Zambia
662,813,935.42
1
2
3
4
5
6
7
8
9
10
40
13
18
Bottom 10 recipients of FDI
Equatorial Guinea
Eritrea
Central African
Republic
Swaziland
Sao Tome and
Principe
Guinea-Bissau
Comoros
Burundi
Gambia, The
South Sudan
Mauritius
7,189,574,257.34
Burkina Faso
398,605,423.81
Kenya
383,124,984.59
Morocco
327,671,042.12
Mozambique
123,864,414.69
Zimbabwe
80,061,343.26
Uganda
66,688,232.76
Cameroon
65,104,461.95
Tunisia
56,842,693.32
Seychelles
49,612,777.20
Some countries of interest
Botswana
(1,801,492.01)
DR Congo
15,954,430.78
Zambia
(413,849,920.29)
Ghana
(553,701,689.77)
1
2
3
4
5
6
7
8
9
10
22
13
30
31
Bottom 10 recipients of portfolio
investments
53,962,172.52
52,305,383.53
31,196,880.99
45
46
47
Angola
Namibia
Niger
(42,450,977.70)
(54,686,219.07)
(122,072,112.34)
27
28
29
27,049,949.52
23,331,087.12
48
49
Zambia
Ghana
(413,849,920.29)
(553,701,689.77)
30
31
14,221,700.00
8,015,631.04
50
51
(588,956,354.09)
(736,100,000.00)
32
33
55,420.36
(1,526,519.34)
(17,000,000.00)
52
53
54
Côte d’Ivoire
Egypt, Arab
Rep.
Libya
Nigeria
South Africa
(1,443,800,000.00)
(1,709,746,689.11)
(16,372,515,388.73)
34
35
36
Panel B: External debt and total capital fows
Top 10 recipients of external debt
Egypt, Arab Rep.
Angola
South Africa
Kenya
Ethiopia
Nigeria
Mauritius
Morocco
9,008,045,000.00
7,550,361,000.00
5,299,867,000.00
3,339,897,000.00
2,685,420,000.00
2,596,833,000.00
2,241,825,000.00
2,026,966,000.00
Top 10 recipients of capital fows
1
2
3
4
5
6
7
8
Egypt, Arab Rep. 16,378,745,000.00
Angola
11,612,332,642.07
Mauritius
9,780,817,830.92
Ethiopia
6,674,373,391.68
Nigeria
5,332,189,082.02
Morocco
4,672,915,962.25
Ghana
4,292,076,679.51
Kenya
4,116,381,405.44
1
2
3
4
5
6
7
8
Chapter 4 • Private capital fows and economic growth 103
Top 10 recipients of external debt
Ghana
1,360,445,000.00
Tanzania
1,120,890,000.00
Some countries of interest
Zambia
588,649,000.00
Bottom 10 recipients of external debt
Central African
Republic
Sao Tome and
Principe
Guinea-Bissau
Guinea
Gambia
Eritrea
Côte d’Ivoire
Sudan
Botswana
DR Congo
Top 10 recipients of capital fows
9 Mozambique
3,741,194,343.39
10 Tanzania
2,491,309,467.33
Some countries of interest
15 DR Congo
1,012,766,047.95
Zambia
837,613,015.13
9
10
17
22
Bottom 10 recipients of capital fows
6,988,000.00
39 Eritrea
37,502,383.53
45
2,544,000.00
40 Guinea-Bissau
32,830,700.00
46
816,000.00
41 Sao Tome and
Principe
42 Botswana
43 Burundi
44 Gambia
45 South Sudan
46 Côte d’Ivoire
47 Libya
48 South Africa
26,481,057.92
47
(2,937,000.00)
(11,437,000.00)
(14,803,000.00)
(37,597,000.00)
(84,864,000.00)
(102,836,000.00)
(207,897,000.00)
24,489,709.64
8,469,420.36
(12,963,519.34)
(17,000,000.00)
(49,074,110.00)
(951,244,000.00)
(8,857,341,368.34)
48
49
50
51
52
53
54
CHAPTER
5
Remittances and
development
Hanna Fromell, Tobias Grohmann, and Robert Lensink
5.1 INTRODUCTION
The most common form of migration is by people who leave their homes
to improve – in one way or the other – their economic opportunities. This
is referred to as voluntary labor migration.1 Labor migration, both domestic and international, affects not only the economic outcomes of the migrants
themselves but also the economic outcomes of those left behind: frst, through
migration – that is, the outfow of people from their origin communities,
countries, and labor markets – and, second, through the fnancial transfers
that migrant workers send back home. These transfers are called remittances.
They are the topic of this chapter. More specifcally, we focus on international
remittances: fnancial transfers made by international labor migrants sent to
households in their home country. In the context of voluntary labor migration, remittances result from an active migration decision of one or more
members of a household aiming to increase the household’s overall income
with earnings that are higher than what they would have earned at home.
The recent two decades have seen a large increase in international
remittances, where especially low- and middle-income countries receive
large sums in comparison to the size of their economy. At the same time,
international organizations and policymakers have taken increased interest
in international remittances and the fnancial systems that facilitate their
fows (Brown & Jimenez-Soto, 2015). On the one hand, banks consider the
handling of remittances as high risk, resulting in derisking measures, such
as the closure of accounts held by monetary transfer operators and the termination of correspondent bank relationships through which banks exchange
banking services. On the other hand, the number of international migrants
is not high enough and that there are substantial positive gains to be realized from lowering the many migration barriers in place (Clemens, 2011). In
line with such more-favorable views on the role of migration, international
actors are setting international targets on how to reduce fnancial and regulatory migration barriers in order to encourage individuals to migrate and
take up jobs abroad and remit money home. For instance, United Nations
sustainable development goal (SDG) number ten explicitly calls to reduce
the transaction costs of remittances to less than 3% and to implement wellmanaged migration policies (UN, 2015). A result of the increasing interest
Chapter 5 • Remittances and development 105
among international organizations and policymakers in the role of international migration and remittances has been an increase in resources allocated
to researchers to advance knowledge in this area (Brown & Jimenez-Soto,
2015). Among academics from different disciplines, including economics,
there is indeed an increasing interest in remittance research. Questions that
have interested economists have concerned the underlying motives among
migrants to send money home and the impact of remittances on their recipients, including their communities and on the home economy as a whole.
In this chapter, we review and discuss the results and methodology of
research that addresses remittances in a development context. We restrict our
review to international remittance payments and focus on remittance fows
from developed countries to developing countries. The remainder of this
chapter is organized as follows. In section 5.2, we highlight the importance
of remittances for development, by sketching the magnitude of current and
past remittance fows to developing countries. Section 5.3 outlines some of
the key characteristics of remittances. In section 5.4, we present research on
the motivation for remittances. The subsequent three sections focus on the
impact of remittances on their receivers: section 5.5 discusses the impact of
remittances on economic growth; section 5.6 looks at the relationship between
remittances and fnancial development in the recipient economy; and section
5.7 elaborates on the impact of remittances on inequality and poverty. Section
5.8 presents research on policy tools that either aim to facilitate remittance
payments or aim to improve the marginal impact of remittance payments.
5.2 THE MAGNITUDE AND IMPORTANCE OF
INTERNATIONAL REMITTANCES
Remittance fows to low- and middle-income countries (LMICs) reached
a record high of USD529 billion in 2018 (World Bank, 2019a). Figure 5.1
shows the amount for remittances, foreign direct investment (FDI), offcial
FIGURE 5.1 Capital infows to low- and middle-income countries, in billions USD
($ billion)
900
FDI
700
500
Remittances
300
100
Portfolio debt &
equity ˜ows
ODA
19
1990
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
97
19
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
0
20 6
0
20 7
0
20 8
0
20 9
1
20 0
1
20 1
1
20 2
1
20 3
1
20 4
1
20 5
16
20
1
20 7
1
20 8
19
–100
106 Hanna Fromell et al.
development assistance (ODA), and private fnancial fows (private debt
and portfolio equity) received by LMICs annually since 1990 (World Bank,
2019a, p. 1). In 2018, remittances to LMICs were about three times the size of
aid receipts and about as high as FDI. Moreover, remittance payments are
expected to increase further in the near future. If China is taken out of the
sample, then remittances have already surpassed FDI since about 2014 (ibid.,
p. 2). The fgure also illustrates remittances’ resilience to fnancial shocks,
such as the 2007/2008 fnancial crisis to which FDI instead responded with
a dramatic drop of 39.7%.
Figure 5.2 plots the evolution of absolute remittance receipts for all
countries, grouped by income category, in the period 1990 to 2016.2 For all
income groups, we can observe an overall increase in received remittances
since the early 2000s. However, the lower-middle-income countries (LMC)
stand out with an especially steep increase in remittances received, while
that of the low-income countries (LIC) have undergone only a meagre shift
upward in comparison to the other income groups.
Figure 5.3 instead plots remittances expressed in percentage of gross
domestic product (GDP) by country-level income group. While remittances
receipts in LICs compared unimpressively to other income groups in absolute terms, Figure 5.3 illustrates a strong positive trend in remittances as a
share of GDP in low-income countries. Since around 2010, the data show
a clear increase in the remittances share of GDP in LICs compared to the
FIGURE 5.2 Received remittances by country-level income group, in billions
current USD
300
250
200
150
100
50
Low income
Lower middle income
Upper middle income
High income
Source: World Bank’s database on World Development Indicators
20
16
20
14
20
12
20
10
20
08
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
–
Chapter 5 • Remittances and development 107
FIGURE 5.3 Remittances in percentage of GDP by country-level income group
12%
10%
8%
6%
4%
2%
Low income
Lower middle income
Upper middle income
High income
20
16
20
14
20
12
20
10
20
08
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
0%
Source: World Bank’s database on World Development Indicators
other income groups. Although the GDP share stagnated over the past few
years, this documents the importance of remittances as a source of funding
for low-income countries. In the group of low- and middle-income countries, the top receivers of remittances in 2018 in absolute terms were India,
China, Mexico, the Philippines, and Egypt. The top receivers in terms of
the remittances-to-GDP ratio were Tonga, the Kyrgyz Republic, Tajikistan,
Haiti, and Nepal (World Bank, 2019a, p. 2).
BOX 5.1 Remittances statistics
Country-level data on remittances, such as the statistics presented
in section 5.2 retrieved from the World Bank’s World Development
Indicator (WDI) database, are collected from each country’s balance
of payments. This is an offcial record that accounts for incoming and
outgoing international economic transactions, which are formally
defned in the Balance of Payments and International Position Manual
(BPM6, International Monetary Fund, 2009). According to this manual,
remittances are a composite measure of two positions in the balance of
payments: personal transfers and compensation of employees (capital
transfers between households are left out). Personal transfers are cash
or noncash transfers from migrants to domestic households that do not
108 Hanna Fromell et al.
involve economic exchanges such as payments for provided services.
(As we will see in section 5.4, this defnition assumes that remittances
are paid from altruistic motives.) The compensation of employees
instead refers to salaries paid to temporary workers (migrants who are
residents of the host country for less than one year). This category is
commonly included in the measurement of remittances because temporary workers are expected to return with their salaries to their origin
country (Yang, 2011). Some researchers argue for excluding compensation for employees from the measure of remittances (Chami et al.,
2008; Barajas, Chami, Fullenkamp, Gapen, & Montiel, 2009).
The remittances indicator in the WDI database is itself partly
an estimate based on the balance of payments data. The World Bank
uses estimates when either no data or only partial data are available
in the balance of payments of a country in a given period (for details,
see World Bank, 2017, Annex A). Moreover, because the balances of
payments capture remittances only if they fow through formal channels, such as electronic wire, they do not capture remittances that
fow through informal channels, such as cash or goods carried across
borders. While these informal remittance transfers may be small individually, they may make up a considerable portion of remittances
received by households, because their overall number is potentially
large. Therefore, offcially reported country-level remittance fows
likely underestimate the actual amount for remittances in the world.
Furthermore, changes in how remittances are measured can account
for a large share of the increase in remittance in the period 1990–2010
(Clemens & McKenzie, 2018, see also section 5.5.2).
Several ways are available for migrants to send remittances back
home. We can distinguish between formal and informal channels. Formal
channels are provided by remittance service providers (RSPs), which are
classifed into four groups: banks, money transfer operators (e.g. Western
Union), post offces, and mobile operators. The payments that go through
these channels are offcially reported and appear in the offcial statistics
seen in Figures 5.1, 5.2, and 5.3. In contrast, remittances sent via informal
channels (e.g. in kind or in cash through returning relatives and friends or
through transport companies) are typically not included (see also Box 5.1).
The World Bank also provides data on the costs of sending remittances. According to their Remittances Prices Worldwide3 database, in the
frst quarter of 2019, the global average of sending remittances was at 6.94%
of the remitted amount (World Bank, 2019b). To compare, in 2009, when
these data were frst collected, the global average was recorded at 9.67%.
This marks a decline of almost 3%. Reducing the costs of remittances is subject to many international development agreements. For example, the UN
SDGs state a target of reducing the global average to under 3%.
Chapter 5 • Remittances and development 109
Given this general picture of remittances to developing countries, we
next highlight some of the specifc characteristics of remittances that make
them relevant in a development context.
5.3 CHARACTERISTICS OF REMITTANCES
5.3.1 Remittances are person-to-person transfers
The most important difference between remittances and other sources of
external funding of developing countries is that remittances are person-toperson transfers. In contrast, ODA are government-to-government transfers,
and FDI are frm-to-frm transfers (Frankel, 2011; Glytsos, 2002). This suggests
that remittances could be effective as stimulators of development. To see this,
recall that remittances are the result of an active migration decision leading to
higher earnings abroad that are shared with those left behind. Ideally, then,
remittances arrive directly where they are most needed at relatively low cost
and effort. Hence, they may be effective in tackling poverty and in raising the
economic opportunities of their receivers. In contrast, to fully unlock the development potential of ODA, a high level of institutional quality and organization
would be required (Burnside & Dollar, 2000). Ineffcient governance structures
may cause portions of the aid fows to trickle away. Similarly, in order for
FDI frm-to-frm transfers to raise incomes and opportunities of the poor, they
need to be passed along effciently in the form of better employment opportunities and higher wages. So in virtue of their person-to-person nature, remittances have the potential to be a direct form of fnancing development. Yet
whether they are more effective than ODA and FDI also depends on whether
both senders and receivers of remittances have indeed better information than
governments and other organizations about where funding is needed.
5.3.2 Remittances and resource allocation
One important aspect to consider when investigating remittances in a
development context is that they could change the spending behavior of
their recipients. That is, the receipt of remittances may change the recipient
household’s resource allocation: how much income the household allocates
on investments vis-à-vis consumption. We present two views that are based
on microeconomic theory.
One view is that the receipt of remittances does not change the spending behavior of households. Here the hypothesis is that remittances are a
fungible source of income and that remittances are thus just like any other
source of household income (Stark, 1991). This implies that each additional
dollar from remittances is spent on exactly the same proportions of consumption and investments as any additional dollar from regular income.
Hence, remittances would increase consumption and investment proportionally. This implies that remittances have the potential to promote longterm economic growth in the recipient country through their positive effect
on investments while reducing short-term growth fuctuations and shortterm poverty through their positive effects on consumption.
110 Hanna Fromell et al.
The contrasting view is that the receipt of remittances can change
the spending behavior of households. Here the underlying assumption
is that the life cycle hypothesis (LCH) holds. This means that individuals
aim to even out their consumption over their life cycles. If this is the case,
then there are two scenarios: the household could allocate the additional
remittance income either to investments or to consumption. This depends
on whether remittance payments are perceived as transitory (one-off payments) or permanent income fows. If remittances are perceived as transitory
payments – that is, raising the recipient’s income only in the current period –
households will spend a larger portion of their remittances on investment.
This is because they save (invest) their transitory income to distribute consumption over future periods. If, however, remittances are considered permanent, recipients will increase their consumption signifcantly already in
the period of the frst receipt. Some authors (Adams & Cuecuecha, 2010)
believe that remittances are perceived as a transitory income, while others
point to evidence that a signifcant proportion of remittances are spent on
‘status-oriented’ consumption goods (Chami, Fullenkamp, & Jahjah, 2003),
which would indicate that remittances are treated as permanent income.
Thus, under the assumption of the LCH, remittances could be either more
effective in promoting short-term growth effects (through consumption) or
more effective in driving long-term economic growth (investments).
Another reason why remittances may change receiving households’
resource allocation is that they are often earmarked for nonconsumption
purposes such as housing, farm equipment, or the education of younger
household members (Taylor & Wyatt, 1996; Brown & Jimenez-Soto, 2015).
This view implies that remittances have a positive impact on long-term economic growth because they are spent more on the margin on investment
goods rather than on consumption.
5.3.3 Are remittances countercyclical?
Remittances are often seen as countercyclical cashfows, meaning that
remittance fows increase – or at least do not decrease – when the economic
situation in the remittance-receiving country deteriorates (Spatafora, 2005;
Frankel, 2011; De, Islamaj, Kose, & Yousef, 2016). If this holds true, remittance fows could serve an informal insurance against economic uncertainty
for recipient households. They could provide fnancial assistance when
faced with negative income shocks, such as bad harvests. This would constitute positive impacts on welfare and economic development in poorer
countries.
Yet the assertion that remittances are countercyclical for recipient
countries is not undisputed in the literature (e.g. Ruiz & Vargas-Silva, 2014).
According to theory discussed in section 5.4, countercyclicality should
only hold for remittances that have been purely motivated by altruism, as
opposed to self-interest. Self-interested remittances are made for investment motives only. Thus, if motivated purely by self-interest, they would
stop fowing to receiving countries that are in an economic downturn simply because there are no gains to be made; the senders’ money would be
Chapter 5 • Remittances and development 111
invested more proftably elsewhere. Moreover, if motivated by self-interest,
we would expect them to be largely procyclical with respect to the recipient country. If so, then the potentially benefcial impact of remittances on
economic development in the poorest countries might vanish. So whether
or not remittances have a positive impact on development in poor countries
also seems to depend (at least to a certain degree) on the motives of their
senders (De et al., 2016).
What about cyclicality with respect to the remittances-sending country? If economic conditions in the host country of the migrant worsen, for
example, when unemployment rises, then migrants may not be able to earn
as before and reduce their remittances. So while remittances may be either
procyclical or countercyclical with respect to the economic conditions in the
recipient country, they are likely to be procyclical with respect to the sending country. On a macroeconomic level, however, the procyclicality of the
remittance-sending country does not seem to be pronounced. For example,
the data in section 5.2 suggest that remittance fows remained relatively
stable over the fnancial crisis in 2007–2008.
5.4 MOTIVATIONS TO REMIT
Given remittances’ substantial share of total capital infows in many developing countries, we look into what motivates migrants to remit. We here
present some of the motivations behind remittances frequently discussed in
the literature. For each of the motivations, we introduce a bit of theory from
which empirical hypotheses can be derived. We then also point to studies
that have tested these hypotheses empirically. One challenge for the literature is to disentangle observable outcomes such that motives to remit can
be derived from them. This is because motivations to remit should not be
seen as mutually exclusive; migrants may well have mixed motives to remit
(section 5.4.5). But as we will see, with careful formulations of hypotheses,
different motivations for remitting money back home can have different
implications for the behavior of the remittance-sending migrant and the
remittance-receiving household.
5.4.1 Altruism
Perhaps the most apparent reason why migrants remit is that they care
about the well-being of the people in their home country, such as family and
community members, and prefer to share some of their income with these
recipients. In other words, their remittances are altruistically motivated.
Using a mutual altruism framework, in which the migrant as well
as the recipient care for each other’s well-being, Rapoport and Docquier
(2006) show analytically how the volume of the altruistic remittance transfer
depends on the altruistic preferences of migrant and recipient as well as on
their respective incomes. First, the transfer increases with the altruistic preference of the migrant. That is, the higher the transfer, the more the migrant
cares about the well-being of those left behind. This is a result that we
would expect from transfers under altruism. Second, maybe surprisingly,
112 Hanna Fromell et al.
the transfer decreases with the altruistic preferences of the recipient. The
intuition is that because the migrant knows that the recipient cares about the
migrant’s well-being and is therefore harmed when the migrant has to transfer money, there will be lower transfers. In other words, the recipient allows
the migrant to keep more of the earnings. Hence, the more the recipient cares
about the well-being of the migrant, the lower the required transfers. Third,
the altruistic remittances transfer increases with the migrant’s income. The
intuition is that if there is more to share on part of the migrants, then the
additional income will be shared, depending, of course, on how much they
care about those left behind. Fourth, the altruistic transfer decreases with
the recipient household’s income. The intuition is that migrants have an a
priori preference for a certain distribution of consumption between themselves and their family. They use both their own income and the nonremittance income of the recipient household to ensure this distribution. Thus, if
they see that income at home (in the recipient household) increases, they do
not feel compelled to remit as much as before, because they assume that the
consumption needs are satisfed.
Since altruistic preferences of migrants and recipients are not directly
observable, the literature has tested the two implications regarding increases
of the migrant’s income and regarding increases of the recipient’s income.
However, because the hypothesis that remittance transfers increase when
migrant incomes go up is consistent with many other motivations to remit
(e.g. insurance; see section 5.4.3), reliable evidence for altruistic remittances
can be found by testing the hypothesis that the migrant should remit less
if the recipient’s income increases. In contrast to this prediction, much evidence speaks against the pure altruism hypothesis, since the distribution of
consumption indeed varies with the distribution of income. For example,
an early study in Botswana by Lucas and Stark (1985) shows that receipts
of remittances are not higher among households with a lower pretransfer
income than among richer households, holding the level of income of the
remitting party constant. Yet Agarwal and Horowitz (2002) fnd that remittances are lower for households who receive remittances from more than
one migrant. They interpret this as evidence consistent with altruism given
that additional remittances from others should increase income and lower
the needs for remittances by any single migrant.
5.4.2 Exchange
Another studied motive for remitters is that of exchange, whereby migrants
remit money to pay for services, such as taking care of young family members and elderly family members or maintaining their property. Rapoport
and Docquier (2006) show in a simple model for such motivations that
remittances are expected to increase with the amount of services required,
but that there is no clear prediction about their response to a change in the
recipient’s income (see Box 5.2). Yet the maximum amount that the migrant
would be willing to remit increases with the migrant’s income, similar to the
altruism motive. An increase in the recipient’s income should increase their
opportunity cost of providing services for the migrant. This implies that they
Chapter 5 • Remittances and development 113
require a higher payment for providing services, thus increasing the minimum amount that the recipient would be willing to accept from the migrant.
This also means that an increase in the recipient’s income may decrease
the probability of receiving remittances while increasing the amount of
received remittances. Notably, this is in contrast to what is predicted by an
altruistic model, according to which an increase in the recipient’s income
always decreases both the probability of receiving and the received amount.
Moreover, according to the exchange model, an increase in the employment rate in the remittance-receiving country would increase the recipient’s
bargaining power and thereby increase the amount received. That is, the
recipient at home would have higher opportunity costs (e.g. through better
employment opportunities) and would require higher remittances to offset
these. The opposite prediction would instead be made if migrants’ motives
were formed as described by the model of pure altruism. In this case, the
recipient’s income rises through better employment and their consumption
increases. As discussed earlier, this leads the remitting migrant to reduce
the amount of remittances sent.
Evidence for the exchange hypothesis is provided by Lucas and Stark
(1985), who conducted a study in Botswana. They found that sons remit
greater amounts to families with large herds, which could be because the
sons pay family members at home to look after their cattle. These fndings are also consistent with a motive to inherit, which is discussed in section 5.4.4. However, the altruism motive cannot be ruled out, because the
larger remittances were possibly a cause of – rather than a response to –
large herds held by the household at home.
BOX 5.2 Modeling exchange-driven motivations
The model explaining remittances as a result of exchange-driven motivations presented by Rapoport and Docquier (2006) uses a framework
in which remittances are regarded as a means to pay for services,
denoted X, that the recipient household provides to the migrant. Such
services could be taking care of younger or older family members or
maintaining property at home. The migrant and the recipient household each has a utility function given by U i (C i ,X), where i = m,h; here
m is the migrant and h is the recipient household. Since the services
generate utility for the migrant but are costly in terms of exerted effort
to the recipient household, the marginal effect of services on utilities
˜V h
˜V m
> 0 . For the recipient house> 0 and
can be defned as
˜X
˜X
hold, with a given pretransfer income, Ih, to be willing to provide the
requested number of services, the offered transfer, T, must be such that
V h ( I h +T , X ) ˝ V h ( I h , 0).
That is, the recipient’s utility obtained from providing the service
in exchange for payment must be at least as high as the utility that they
114 Hanna Fromell et al.
can obtain from declining. This participation constraint can be solved
for T: the minimum payment required for the recipient household to
be willing to provide the requested services depends on the size of the
services and on the recipient’s pretransfer income. It then follows that
˜T <
˜T
˙ 0 and
> 0. Remittances are thus predicted to increase with
h >
˜X
˜I
the number of services required, but there is no clear prediction about
their response to a change in the recipient’s income.
5.4.3 Insurance for household at home
Remittance payments could also be motivated by an insurance, where the
transfers from the migrant insure the recipient household against negative income shocks. In such an arrangement, one would expect a negative
relationship between remittances and income fuctuations of the recipient.
De la Brière, Sadoulet, Janvry, and Lambert (2002), who study remittances
to households in the Dominican Republic, fnd some support for an insurance contract between female migrants and their parents, where remittances increase when parents experience a loss in number of working days.
Further evidence consistent with the insurance motive comes from studies designed to address problems associated with potential endogeneity
(e.g. reverse causality and omitted variables). This is because an insurance
motive can only be identifed if the relationship between remittance transfers and domestic income shocks can be separated from other factors that
affect both in the same direction. For example, remittances could fund productive investments and lead to increased income, or as discussed earlier,
they might also reduce domestic income by reducing the recipients’ labor
force participation. Such factors should be excluded in order to identify the
negative relationship between remittances and income that is predicted by
an insurance motive. Clarke and Wallsten (2003) address reverse causality
by using panel data techniques, and Yang and Choi (2007) use variations in
rainfall as an instrumental variable (IV) for income variation. Both fnd evidence that suggests an insurance motive for remittance payments. On the
other hand, the fnding from Agarwal and Horowitz (2002) that remittances
vary depending on whether the household receives remittances from more
than one migrant are inconsistent with the insurance motive. The fnding is
indeed also inconsistent with exchange motives, in which remittances function to pay for services or pay back a loan.
5.4.4 Investment for bequests
Because motives such as exchange and insurance build on informal agreements between households and migrated household members, a problem
of moral hazard arises, whereby the migrant has an incentive to deviate
from their promise to remit. The threat of depriving the migrant from their
inheritance rights may thus work as an enforcement mechanism (Rapoport
Chapter 5 • Remittances and development 115
& Docquier, 2006). De la Brière et al. (2002) present evidence that migrants
remit for bequest purposes, by showing that there is a positive association
between the remitted amount and land assets of households: migrants from
wealthier families tend to remit more than migrants from poorer families.
5.4.5 Mixed motive
While most of the literature discussing the motivation to remit strive toward
fnding the one motive that best explains remittances, there is widespread
recognition that several motives can simultaneously drive a given migrant
to send money home. For example, Cox, Eser, and Jimenez (1998) allow for
remitters to be driven by both altruism and exchange motives. They suggest that the enforcement of the repayment of a loan could partly be solved
through the loyalty and guilt aversion of the remitter toward the recipient.
The exchange of money for services can refer to past services, namely
any assistance or loans received that served to aid in the process to migrate.
The household and the migrant member of the household would then enter
into an informal contract in which the migrant takes a loan from the other
household members to fnance the expenses necessary to migrate. Cox et
al. (1998) use data from a Peruvian household survey and fnd evidence for
a bargaining-cum-altruism framework (mixed motive; see section 5.4.5), in
which a member of the household (the prospective migrant) takes a loan
from another member of the household to allow for the smoothening of
consumption over time and where remittances are used to repay the loan.
In this framework, the recipient’s pretransfer income can have a positive
impact on the received remittances for lower levels of income and a negative impact at higher income levels. The rationale is that the recipient’s
income positively affects their ability to sustain themselves without borrowing money from the sender, which improves their relative bargaining
power over the terms of these loans and causes a positive impact from the
recipient income on the transfer amount. On the other hand, increased pretransfer income eases the liquidity constraint of the recipient, making them
less in need of the money transfer. For lower levels of recipient pretransfer
income, the effect of improved bargaining power dominates that of becoming less in need of additional income, producing an initial positive relationship between income and remittances.
5.5 REMITTANCES AND GROWTH
The previous sections already anticipated that remittances may have a positive impact on economic growth in the recipient country. This section deals
specifcally with the impact of remittances on economic growth. In section
5.5.1, we describe, theoretically, the various channels through which remittance infows may potentially impact growth. In section 5.5.2, we discuss
how empirical studies have tried to identify the effects of remittances on
growth and which methodological challenges they face. As will become
apparent, the empirical literature has so far been unsuccessful to deliver
unambiguous results regarding remittances’ impact on economic growth.
116 Hanna Fromell et al.
5.5.1 Theory4
To structure our discussion of the various channels through which remittances may affect overall economic growth, we use a standard growth
accounting framework. In this framework, the output growth of an economy is broken down into separate contributions of the two main production
factors: capital and labor. The residual growth of the economy, which is not
accounted for by growth in capital or labor, is attributed to technological
progress, expressed by total factor productivity: how effectively the economy uses its production factors. This theory section is divided into three
parts, each representing a separate channel through which remittances may
affect economic growth:
1 Capital accumulation (physical and human).
2 Labor force growth.
3 Total factor productivity.
Remittances may affect the rate at which an economy invests in economically productive goods (physical capital) and in the skills, knowledge,
and experience of its labor force (human capital). There are at least three
potential mechanisms through which remittances can alter physical capital
growth. First, remittances may directly impact physical capital growth simply by providing additional resources for investments. The assumption here
is that income from remittances is saved by the remittance-receiving households. Thus, private savings in the economy increase, which means that
in our standard growth accounting framework investments also increase
(cf. savings–investment identity). Investments are assumed to be spent on
productive goods, and in this way, the economy grows. This requires that
households spend part of the received remittances on saving or investment and thus perceive them as transitory income (see section 5.3.2). Second, there is a potential indirect effect of remittances on investment via an
increase in total income and collateral. This may improve the creditworthiness of remittance-receiving households and ultimately increase their ability to invest in economically productive projects. Third, remittances may
have a positive effect on macroeconomic stability and thus shape a positive
economic climate for investment.
Yet remittances do not obviously have a positive impact on investments and thus on economic growth. As discussed in section 5.3.2, if remittances are not perceived as one-off payments (i.e. transitory income), but
rather as a permanent infow of additional income, they may stimulate consumption rather than investment – even in the presence of credit constraints
(recall that the second mechanism operates through creditworthiness).
Remittances may therefore have a relatively small impact on long-term
national aggregate output but a larger impact on reducing short-term output fuctuations and short-term poverty (see section 5.7.2).
Remittances may also affect human capital accumulation. Keeping the
size of the labor force constant, remittances may raise the effectiveness of
labor, such as by improving sanitary conditions, facilitating healthier lifestyles, making healthcare possible, and creating educational opportunities.
Chapter 5 • Remittances and development 117
Remittances may also indirectly affect human capital accumulation by reducing the need for child labor, which, for households in developing countries,
is often a way to generate more income. If children are sent to work in order
to generate more household income, they usually abandon school at relatively young ages and forgo educational opportunities. By increasing household income, remittances may also reduce the need for child labor, increase
educational attainment, improve health, and so increase human capital.
Remittances may affect economic growth through their impact on
labor force participation, which alters the size of the economy’s labor force.
Here the impact of remittances is likely to be negative, because the receipt
of remittances may create disincentives for receivers to supply labor (see
Chami et al. [2003] for a formal model). The labor supply reduction can be
explained by an income effect as well as by a substitution effect (AmuedoDorantes, 2014). To see this, consider that labor supply decisions arise from a
trade-off between allocating time on leisure versus allocating time on work.
Remittances are a form of nonlabor income and thus increase the income of
the receiving households and raise their reservation wage. That is, they call
for a higher price for their labor and demand higher wages. If there are no
jobs with that wage, then receivers increase the time they allocate to leisure
and reduce the time they allocate to work; this is the income effect.
On the other hand, under the assumption of altruistic remittances,
moral hazard and asymmetric information problems may arise. That is,
receivers may be incentivized to purposefully reduce their labor supply in
order to continue receiving the remittance payments from the remitter; this
is the substitution effect. The assumption of altruistic remittances is important here because the remitted amount is tied to the income of the receiving
household at home (see section 5.4.1). The moral hazard is that the cost of
the risky decision to reduce labor supply is covered by the remitter; the
receiver can afford to reduce labor supply, because remittance fows come
in. This situation arises because the remitter has incomplete information
about the labor supply decisions of the members of the receiving household.
Finally, remittances may also impact economic growth in the receiving
country by affecting total factor productivity (TFP) growth. This can occur
if remittances alter the quality and effciency of the fnancial system with
respect to fnancial intermediation and the allocation of capital (see Barajas et al., 2009). Yet it is not certain whether such TFP effects are positive
or negative. For example, if remittances are used by the remitter to invest
capital in the receiving country, then remittances could either increase or
decrease the quality of fnancial intermediation. That is, if the person making the investment has an informational advantage (disadvantage) over
domestic formal intermediaries, the quality of fnancial intermediation
would increase (decrease) in the recipient country, and TFP growth would
increase (decrease). By increasing the size of capital fows in the receiving
country’s banking system, remittances could also lead to positive economies
of scale. That is, because an increased productivity of the fnancial sector
would lower the costs of fnancial intermediation, remittances could spur
TFP growth. Remittances may also increase the fnancial literacy of their
recipients, as they learn about fnancial products. This could have a positive
118 Hanna Fromell et al.
impact on their investment decisions, leading to investments into moreproductive activities. Yet remittances may also hinder TFP growth and have
negative effects on economic growth in the long run through Dutch-disease
effects (see Box 5.3)
5.5.2 Empirical evidence
The theoretical arguments in the previous section provide ambiguous predictions regarding the impact of remittances on home-country growth; the
effect could be positive (e.g. via investments) or negative (e.g. via labor
force participation). Moreover, various mechanisms could offset each other.
Consequently, researchers have tried to empirically determine the effect of
remittances on economic growth. The literature in this feld typically implements cross-sectional or panel data in a standard growth regression framework to determine the impact of international remittances on economic
growth. Remittances are then included as the explanatory variable of interest among a standard set of growth variables. For example, a cross-sectional
specifcation of such a growth regression could take the following form:
ˇyi = ˜0 + ˜1 y0i + ˜2 REMi + ˜3 Xi + °i ,
where ˇyi is the growth rate of economic output in country i, measured by
the log of real GDP per capita; y0i is the initial value of yi; REMi is remittances
received by country i; and Xi is a set of control variables that account for determinants of economic growth other than remittances. Some studies choose to
replace REMi – that is, the current level of remittance infows – with ˇREMi,
the change in received remittances between the initial and fnal period. This
is to better capture the dynamic nature of remittance fows. Xi , the set of control variables, may include variables such as domestic investment, education,
net private cashfows, exchange rate changes, and measures for institutional
quality or fnancial development. Usually, REMi and Xi are expressed in their
ratio to GDP to account for the size of the recipient economy.
One of the frst studies that investigates the impact of remittances on
economic growth in a large cross-country study, rather than a single-country
study, is Chami et al. (2003). Before their study, constraints on data availability made studying the impact of remittances on a larger sample of countries
infeasible. Chami et al. (2003) use cross-section and panel estimations on a
dataset with 113 countries in the period 1970–1998. They regress growth in
real GDP per capita on (the change of) the remittances-to-GDP ratio. Their
results suggest a negative effect of remittances on economic growth.
BOX 5.3 Dutch disease
Remittances may affect economic growth of the recipient country by affecting the real exchange rate in the economy. Such effects
are called Dutch-disease effects. Assuming that the receipt of remittances increases consumption and that prices in the traded sector are
Chapter 5 • Remittances and development 119
exogenously given on the global market, higher remittance infows
lead to higher relative prices on nontradable goods. This leads to a shift
of resources towards the nontradable sector. Moreover, an increase in
relative prices of nontradable goods corresponds to an appreciation of
the real exchange rate, which reduces the competitiveness of the economy in international markets and ultimately causes a contraction of
the traded sector. Since the traded sector generates positive externalities for the nontraded sector, this may ultimately result in a reduction
in the competitiveness of the nontraded sector as well. This results in
a loss of overall TFP growth in the economy and has negative impacts
on long-term economic growth.
A study by Lartey, Mandelman, and Acosta (2012) substantiates the Dutch-disease effects of remittances, by estimating whether
remittances have an impact on the real exchange rate of remittancereceiving countries. To do this, they estimate the following function:
p
RERit =
˛ REM
j=0
j
it−j
+ ˜2 Xit + (˝i + ˙t + °it ),
where RERit is the real exchange rate in country i at time t,
REM remittances, Xit a set of control variables, ˝i time-invariant
country-specifc effects, ˙t time-specifc effects and °it an idiosyncratic
p
˛ allows for longer lags of remiterror term. The expression
j=0 j
tances in order to capture the delayed effects of remittances on the real
exchange rate.
Using dynamic panel estimators on a panel of 109 developing
and transitioning countries from 1990 to 2003, Lartey et al. (2012) fnd
evidence for a Dutch-disease effect of remittance by showing that
remittances lead to an appreciation of the real exchange rate. AmuedoDorantes and Pozo (2004) fnd similar evidence. Lartey et al. (2012)
also show that an increase in received remittances leads to a shift from
the tradable to the nontradable sector and a decline in the output share
of the manufacturing sector, while the output share of the service sector increases. Both of these symptoms serve as further evidence for
the Dutch-disease effects of remittances in developing countries.
Although Lartey et al. (2012) do not investigate the effects on economic
growth or welfare in their sample, their fndings lend credibility to the
hypothesis that remittances can lead to a decrease in economic growth
through a reduction of TFP via Dutch-disease effects.
Chami et al. (2003) formalize a model that predicts moral hazard problems
under asymmetric information when remittances payments are understood as
altruistic transfers. This serves to formulate testable hypotheses regarding the
impact of remittances on economic growth. Recall from the theory in section
5.5.1 that altruistically motivated remittances can create incentives to reduce
120 Hanna Fromell et al.
labor force participation. Their model, therefore would predict a negative
impact of remittances on economic growth in remittance-receiving countries.
Although the authors do not test this model explicitly, because they lack data
on the labor force participation of migrant versus nonmigrant households in
all the countries, they provide indirect evidence for the two main predictions of
their model. First, they fnd that remittances are countercyclical: they increase
with negative economic growth in the receiving country. Chami et al. (2003)
take this as evidence for altruistic transfers. Second, their results suggest that
remittances have a negative impact on economic growth in recipient countries.
Together, these two results can be taken as indirect evidence that the receipt of
remittances reduces labor force participation. The reason is that only the labor
force participation channel is consistent with these two fndings.
One of the central methodological challenges in empirical remittance
research is to control for the potential endogeneity of remittance fows. Of
most concern to researchers is endogeneity due to reverse causality. To see
this, consider not only that remittances may affect economic growth but also
that economic growth affects the occurrence and size of remittance fows.
This is true for countercyclical remittances and procyclical remittances: in
both cases, remittance infows depend on the economic conditions in the
receiving country. Moreover, recall that the initial migration decision of
labor migrants is typically based on the expected economic outcomes faced
by potential migrants at home and abroad. So the mere fact that people are
able to send remittances as migrants depends on the economic output of
their origin (and destination) countries. Additionally, it seems impossible (or
excessively costly) to control for all potential factors that impact both remittances (migration) and growth. Thus, the relationship between remittances
and growth appears to be riddled with potential sources of endogeneity.
Chami et al. (2003) address these endogeneity concerns by using
an instrumental variable (IV) strategy. More specifcally, they use lagged
income ratios and lagged interest rate ratios between remittance-receiving
countries and the US to instrument remittance fows. The US is taken as a
general proxy for all remittance-sending countries. The idea behind this IV
strategy is that while the income gaps and interest rate gaps to remittancesending countries may generate remittance transfers (relevance), they do
not determine the economic performance in the recipient country (exclusion) (Chami et al., 2003, pp. 19–21; for more on IV in remittances and migration research, see Box 5.4).5
BOX 5.4 Instrumental variables in remittance (and migration)
research
As mentioned several times earlier in this chapter, remittance (and
migration) research faces serious endogeneity issues. A popular, and
potentially powerful, remedy to endogeneity issues is to use IV regression. If you are unfamiliar with the terms ‘endogeneity’ and ‘instrumental variables’, please refer to standard econometric textbooks.
Chapter 5 • Remittances and development 121
Two commonly used instruments in remittances and migration
research are distance (e.g. from migrant origin to residence at destination) and migrant networks (e.g. the number of migrants from the
same origin that already reside at destination). Both these instruments
appear relevant, but there are major concerns regarding their exclusion restriction.
The intuition behind the distance instrument is that the greater
the distance between origin and destination, the fewer people who will
migrate because of associated migration costs. Indeed, there seems
to be an inverse relationship between distance and migration fows.
Hence, distance should predict migrations – and therefore remittance
fows – reasonably well. However, arguing that the distance between
origin and destination does not affect (or correlate with) outcomes
either at origin or at destination is diffcult. For example, the distance
between developing African countries and the destination regions of
Europe and North America is certainly indicative not only of migrant
fows but also of trade fows, colonial ties, and investment fows, all of
which affect income, poverty, and education differences between those
countries. Thus, distance affects outcomes not only through migration
but also through other channels. Exclusion has most likely not been
satisfed. See our discussion of the instruments used by Adams and
Page (2005) in section 5.7.2.
The intuition behind the network instrument is that the greater
the number of people who already live at destination, the lower the
costs associated with migration. Prospective migrants do not have
to organize their move on their own but rather can rely on networks
and even institutionalized channels that help them move and settle in. So relevance is usually satisfed, but the exclusion restriction
requires some arguing: the reason why some people have different
networks than others is exogenous. Are there omitted variables that
would explain both the network and the outcome? The education levels of ancestors, which often are unknown, can affect historical migrations (more educated people are more likely to migrate) and income
inequality (people from more educated families are more likely to be
richer). Hence, the reason that some have better networks than others
is not exogeneous but rather endogenously determined by past education levels. Thus, the exclusion restriction is violated.
The previous examples illustrate how diffcult fnding good
instruments in migration research is. The following could work as a
general rule of thumb to fnd an instrument that satisfes the exclusion
restriction: if the outcome variable is measured at migrant origin (e.g.
incomes of remaining household members), then as an instrument for
migration or remittances, use a variable measured at destination (e.g.
migrant network); in contrast, if the outcome variable is measured at
destination (e.g. earnings of migrants), use an instrument measured
at origin (e.g. rainfall shocks at home). If one is worried that migrant
122 Hanna Fromell et al.
networks do not predict remittance fows well enough, then the instrument could be constructed, for example, as network * employment at
destination. This would also capture the economic conditions at destination, including the ability of migrants to fnd (well-paying) jobs, and
thus capture the migrants’ ability to send remittances.
The foregoing rule of thumb can make easier fnding instruments
that do not affect the outcome directly but only through migration and
remittances. So chances are higher to satisfy the exclusion restriction.
However, we recommend paying close attention to justifying the IVs
properly, because experienced researchers excel at questioning the
validity of instruments.
Since the study by Chami and others (2003), numerous other studies
have attempted to estimate the effect of remittances on economic growth
in the recipient countries (Spatafora, 2005; Faini, 2007; Acosta, Calderón,
Fajnzylber, & Lopez, 2008; Chami et al., 2008; Mundaca, 2009; Lartey, 2013;
Acosta, Lartey, & Mandelman, 2009; Lartey et al., 2012; Imai, Gaiha, Ali,
& Kaicker, 2014, 2016; Feeny, Iamsiraroj, & McGillivray, 2014; Giuliano &
Ruiz-Arranz, 2009). These studies differ with respect to their choice of remittance measure, estimation technique, IVs, study period, and selections for
countries to study. Despite all these attempts, we don’t know whether the
receipt of remittances increases or decreases a country’s long-term growth.
Hence, we cannot conclude on their macroeconomic impact on development in cross-country studies.
We conclude this section by discussing how to interpret the ambiguous results in the literature. For example, Clemens and McKenzie (2018)
argue that the reported ambiguous empirical results are due to problems
that are more fundamental than the issues regarding specifcation, sample
choice, and instrumentation strategy typically mentioned in the literature.
They offer three explanations for the ambiguous results in the literature.
First, they argue that the observed increase of remittance payments in
macro data (e.g. balance of payments; see Box 3.1) does not concord with the
growth of remittances observed in micro data (e.g. household surveys). They
show in their paper that only 21% of the growth in remittances observed
between 1990 and 2010 can be attributed to the actual growth of the migrant
stocks and migrant earnings. The remaining 79% are attributable to changes
in the measurement of remittances. So if remittance growth that we observe
in macro data is illusory rather than genuine, then it is also not surprising
that we cannot detect consistent effects on growth. Second, they show that,
even if the macro data was correct, growth regressions (as discussed earlier) lack the statistical power to even detect any effects on economic growth.
And third, they argue that even if there were detectable effects of remittances
on home-country GDP growth, they would likely be offset by reduction
of the labor force in the home country through migration itself. A similar
issue returns when estimating the impact of remittances in micro data on
Chapter 5 • Remittances and development 123
household incomes (see section 5.7). Yet their third argument highlights an
important issue for remittance research: whenever we want to establish an
effect of remittances on indicators in the origin communities of migrants,
we should do so while taking into account that remittances always occur in
conjunction with (or as a consequence of) migration itself. Remittance fows
are always preceded by migration fows in the opposite direction.
But does this mean that empirical studies into the development effects
of remittances are futile altogether? Concluding that it does would be too
quick. As Clemens and McKenzie (2018) argue, although currently available
macro data on remittances may display the shortcomings addressed earlier,
data become more available in better quality through research and legislation efforts, such that growth regression studies may become feasible in the
future after all.
Moreover, it may be more important in the development context to
know whether remittances can help receivers to overcome hardship and to
escape poverty than to know that remittances incite domestic investment
and economic growth.6 As mentioned earlier, remittances may have other
crucial benefcial effects on receiving households and communities. Following this line of thought, we address such effects in the remainder of this
chapter. In section 5.6, we discuss the relationship between remittances and
fnancial development. In section 5.7, we present research on the impact
of remittances on household incomes – especially with respect to income
inequality and poverty. In section 5.8, we also discuss potential policy tools
available to policymakers that may help to increase the benefcial effects of
remittances on their receivers.
5.6 REMITTANCES AND FINANCIAL DEVELOPMENT
In this section, we look at the relationship between remittances and fnancial development in a remittance-receiving country. On the one hand, the
development of the fnancial system of the remittances-receiving country
may be a catalyst for the impact of remittances on economic growth. On the
other hand, remittances may directly improve fnancial development and so
contribute to mitigating poverty and inequality in the receiving country. We
discuss both options in turn.
It seems almost obvious that better fnancial development, expressed
as the ratio of credits provided by the banking sector (the depth of fnancial
system), facilitates the impact of remittances on economic growth. This is
because a more developed fnancial sector may enhance the effcient allocation of remittance infows toward proftable investments. Thus, remittances
may have a greater impact in countries with more-developed fnancial sectors. However, this need not be the case. Instead, remittances to developing countries could provide funding for frms and households that do not
have access to formal credit markets and so stimulate economic growth.
This implies that remittances substitute for credit and would have a greater
impact on growth in countries with a less developed fnancial system.
A well-known study testing the extent to which the impact of remittances on growth depends on fnancial sector development is that of
124 Hanna Fromell et al.
Giuliano and Ruiz-Arranz (2009). Using a sample of about a hundred countries for the 1975–2002 period, they estimate the following equation by using
ordinary least squares (OLS) as well as system GMM:
GDPit = ˜0 + ˜1GDPi ,t−1 + ˜2 REMit + ˜3 FINDEVit
+˜4 REMit * FINDEVit + ˜5 Xit + µt + ˙i + °it
Here GDP denotes GDP; REM denotes remittances over GDP; FINDEV
denotes the measure for fnancial development (measured in four ways);
and X is a vector of controls. The last three terms refer to a time-fxed effect,
a country-specifc fxed effect, and an error. The coeffcient of interest is β4: a
positive (negative) signifcant β4 indicates that the marginal impact of remittances on growth positively (negatively) depends on the development of the
fnancial sector. The study fnds strong support for a negative interaction
between remittances and the development of the fnancial sector. In other
words, the marginal impact of remittances on growth decreases with fnancial development. Moreover, the study also fnds that remittances increase
economic growth. Thus, the results in Giuliano and Ruiz-Arranz (2009)
support the hypothesis that remittances are used as substitutes for credit
and that remittances help provide an alternative way to fnance investment.
To corroborate this fnding, they also show that remittances seem to drive
investments in the less fnancially developed countries. Hence, as suggested
earlier, remittances seem to have benefcial effects on households; they
appear to lift credit constraints on investments.
Another, more substantial group of literature argues that remittances
may enhance fnancial inclusion and via this channel may improve inclusive
growth and reduce poverty. Thus, in contrast to the frst group of literature
that argues that impacts of remittances on growth depend on the development of the fnancial sector, this literature claims that remittances affect the
development of the fnancial sector.
Development benefts from fnancial inclusion can be substantial and
diverse since access to fnancial products may help poor households reduce
their level of poverty and deal with shocks. For instance, access to savings
accounts enables households to build up a fnancial safety net, which may
induce income-generating activities and thus reduce poverty. In general,
fnancial services can encourage people to accumulate savings and spend
more on necessities, such as nutritious foods, education, and farming equipment and other business investments (Demirgüç-Kunt, Klapper, Singer,
Ansar, & Hess, 2018). The growing body of research that points at the enormous development benefts of fnancial inclusion makes necessary determining whether and to what extent remittances are able to increase fnancial
inclusion.
The frst step towards fnancial inclusion is owning a bank account.
Thus, the relationship between remittances and fnancial inclusion seems
clear: many migrant households – that is, the migrants and their relatives
back home – open and use bank accounts to send and receive remittances.
Hence, sending and receiving remittances facilitates fnancial inclusion
at home and abroad. However, there are several additional reasons why
Chapter 5 • Remittances and development 125
remittances may cause fnancial inclusion, both via the demand side and
via the supply side of fnancial products. On the demand side, remittance
infows may encourage remittance receivers to demand fnancial products
if the remittances are channeled through a bank account and thus induce
the receiver to interact with a bank. The established relationship with a
bank may lead to demand for additional fnancial products, such as savings, credit, and insurance products. Remittances may also increase fnancial inclusion via the supply side: commercial banks have realized that the
remittance channel can be used to promote fnancial services among lowincome individuals. Also, credit unions have started to develop remittance
services by allowing members and nonmembers to send money electronically. Bridging remittance senders and receivers, credit unions often offer
other fnancial services, such as savings accounts (Grace, 2005).
In addition, due to remittance infows, fnancial institutions can build
a fnancial history of poor people who haven’t had access to the fnancial
sector before. Thus, remittance infows enable poor people to build a sound
fnancial history with a fnancial institution, which reduces informational
asymmetries and improves access to credit. As mentioned earlier, remittance
infows may function as a substitute for a job and a regular income. Many
migrated family members regularly send money home to sustain their family, such that this remittance infow becomes comparable to regular income.
The remittance infow informs the bank about income and expected future
funds of the remittance receivers, which may be used to repay loans, and
hence provides information about creditworthiness. Becauase remittance
infows are often countercyclical – that is, remittance infows often increase
during adverse circumstances at home – remittances may also improve the
risk profle of the remittance receiver. Related to this, remittances allow
banks to build a relationship with new clientele (relationship lending; see
Berger & Udell, 2002). Finally, (potential) bank clients can use current and
future remittance infows as collateral, which will lower bank risk and thus
may induce banks to provide credit. Therefore, it seems likely that on the
one hand receivers of remittances become more interesting clients for banks
and on the other hand they are also induced to make more use of banking
services.
Yet the potential positive impact of remittances on fnancial inclusion ultimately depends on the ability and willingness of banks to adapt.
Banks need to expand their offering of fnancial products to poor people
to accommodate the transfer of remittances and to induce fnancial inclusion of those who don’t already have access to fnancial services. However,
banks and private sector businesses in general may simply underestimate market opportunity at the ‘bottom of the pyramid’ (Prahalad, 2004)
and refrain from offering new fnancial products. Also, governments may
play an important role in enhancing the effect of remittances on fnancial
inclusion by, for example, removing taxes on incoming remittances and by
relaxing exchange and capital controls. Moreover, migrant identifcation
requirements need to be addressed. Migrants without legal status abroad
need to be allowed to use formal channels to remit a valid immigration status but lack identifcation to open a bank account; consequently, they need
126 Hanna Fromell et al.
to rely on money transfer organizations (MTOs) or informal networks to
remit. Moreover, governments need to ensure that appropriate regulations
and consumer protection safeguards are in place, and banks must ensure
that fnancial services are tailored to the needs of disadvantaged groups to
ensure that poor people beneft from fnancial inclusion (Demirgüç-Kunt
et al., 2018).
One of the earliest papers on the impact of remittances on fnancial
inclusion is Toxopeus and Lensink (2008). They use a cross-sectional dataset on approximately 60 countries for 2005 and use the following equation
(with OLS and a median regression technique):
FININLi = ˜0 + ˜1REMi + ˜2 Xi + °i
Here FININLi is the proxy for fnancial inclusion (measured by percentage
of population that has access to a bank account in country i).
Toxopeus and Lensink (2008) provide strong support for a positive signifcant effect of remittances on fnancial inclusion. They also consider the
impacts of remittances on growth, via the fnancial inclusion channel, using
a three-stage least squares (3sls) technique. This analysis indeed suggests
that remittances positively affect growth by enhancing fnancial inclusion.7
A much more elaborate and rigorous analysis of the impact of remittances on fnancial development is that by Aggarwal, Demirgüç-Kunt, and
Martínez Peria (2011) .8 The paper uses a panel of developing countries for
the period 1975–2007 and applies cross-country regressions and system
GMM regressions for a dynamic panel. Their main regression equation is
specifed as follows:
FININLi ,t = ˜0 + ˜1REMi ,t−1 + ˜2 Xi ,t−1 + °i ,t
The paper provides strong evidence of a positive signifcant and robust link
between the infow of remittances and fnancial development in developing
countries.
5.7 REMITTANCES AND HOUSEHOLD INCOMES
Whereas the previous sections focused on the impact of remittances on economic growth and fnancial sector development, this section focuses on the
impact of remittances on household incomes. In theory, we expect that remittances to have positive effects on household incomes at home. If prospective
migrants make well-informed migration decisions, then the earnings that
they receive abroad should offset the costs associated with migration and
thus increase the overall income available to the household at home.9
Rising incomes through remittances may impact poverty levels as well
as inequality levels in the origin communities of migrants. On the one hand,
we expect that remittances can lift receiving households out of poverty and
thus have negative effects on poverty levels at origin. On the other hand, it
is not clear a priori whether remittances would reduce or increase income
inequality. Remittances could increase inequality if remittances were to
reach only those few households that can afford migration in the frst place.
Chapter 5 • Remittances and development 127
Yet if migration were available to poorer households as well, they could
reduce inequality at home.
In the empirical literature, the effects on inequality and poverty have
been studied by using both micro-level data (e.g. on the household level)
and aggregate-level data (e.g. on the municipality or country level). Given
that most of the studies are based on household-level data, we focus primarily on these but also consider aggregate-level studies when appropriate.
5.7.1 Remittances and inequality
We begin with the impact of remittances on inequality. Inequality is typically measured with the Gini coeffcient – sometimes at the local, village level
(Stark, Taylor, & Yitzhaki, 1986; Barham & Boucher, 1998) and sometimes at
the country level (Adams & Page, 2005; Brown & Jimenez, 2008).10 Thus, the
research question is by how much the receipt of remittances changes the Gini
coeffcient in the migrants’ origin community. Two strands of literature have
developed on this topic. They use different identifcation strategies and may,
even if applied to the same sample, arrive at different conclusions on the
impact of remittances on inequality. We describe both methods in turn. We
believe that looking at both methods enhances our understanding of how
remittance transfers may impact receiving households and their communities. (Box 5.5 discusses the underlying assumptions of the two approaches.)
The Gini decomposition method proceeds in two steps. First, total
observed village income is decomposed into different sources: home earnings and earnings from remittances. Second, the Gini coeffcient of the
observed overall income distribution in the sample is compared with the
Gini coeffcient of the home earnings of nonmigrant households. If the latter
is greater than the former, then remittances have reduced income inequality. Thus, the Gini decomposition method can answer the extent to which
income from remittances changes the distribution of total income in the village. The Gini decomposition method was introduced by Stark et al. (1986).
In their study on two Mexican villages, the authors fnd that international
remittances (from the US) reduce inequality. That is, they fnd that the
Gini coeffcient of total income, including remittances, was lower than
the Gini coeffcient of the nonremittance income. However, they fnd that
the inequality-reducing effect was more pronounced in the village which
had a longer migration history to the US than in the village with a shorter
migration history. So it seems that the more migrants migrated over time,
the more benefcial was the impact of remittances on income inequality.
BOX 5.5 Remittances: exogenous or endogenous transfer
payments?
As mentioned in section 5.7.1, the literature has developed two methods to identify the effect of remittances on income inequality: the Gini
decomposition method and the counterfactual incomes method. The
128 Hanna Fromell et al.
identifcation strategies should be chosen on the basis of whether the
remittances are exogenous transfers or endogenous transfers.
The Gini decomposition method must make the simplifying
assumption that the receipt of remittances is independent of household characteristics. That is, it assumes substantial differences between
migrant and nonmigrant households with respect to receiving remittances and assumes that the allocation of remittances across households in the origin community is almost random. This assures the
identifcation of the impact of remittances on income inequality: the
difference between the Gini of nonmigrant households and the Gini of
all households in the sample equals the effect that remittances have on
income inequality.
Crucially, if one assumes that remittances are independent of
household characteristics, then they are exogenous transfers to household income. They are an additive component to household income.
As such, remittances’ impact on recipient household income is positive
by construction: because remittance fows are never negative (they are
either zero or positive), they can also never reduce household income.
Yet the assumption of exogenous transfers and, consequently, the
implication of nonnegative impact on household income are implausible according to the advocates of the counterfactual incomes method.
They argue that remittances necessarily follow from migration and
that their effects should always be evaluated in conjunction with the
decision to migrate. As explained in section 5.1, household income
may decrease after migration even when remittances are paid (e.g.
Acosta, Fajnzylber, & Humberto Lopez, 2007). This is possible when
migrant earnings abroad are lower than respective home earnings or
when household members at home reduce their labor force participation. If this is the case, then remittances are endogenous transfers in the
sense that they are substitutes of home earnings rather than an additive
source of household income. Hence, receiving remittances depends on
household characteristics after all – most importantly on the decision to
migrate and to substitute home earnings with earnings abroad.
Thus, the counterfactual incomes method identifes the impact
of remittances on inequality as the difference between the Gini of the
full sample of households (including remittances) and the Gini of a
counterfactual scenario where the household incomes of the sample
are calculated as if no one had migrated. So the counterfactual incomes
method asks what the gains from migrating and remitting are compared to staying and generating income at home. For further discussion, see Brown and Jimenez-Soto (2015).
In fact, this second result has become one of the central fndings in the
literature on the impact of remittances on inequality. The general idea is
that there exists a nonlinear relationship between remittances and income
Chapter 5 • Remittances and development 129
inequality, meaning that the effect of a marginal increase in remittances
depends on the absolute size of the remittances. In fact, also other studies fnd that for (initially) low levels, remittances increase community-level
inequality and that inequality decreases only once remittances have reached
a certain threshold (McKenzie & Sasin, 2007; Shen, Docquier, & Rapoport,
2010; McKenzie & Rapoport, 2007). The literature explains this inverse effect
with the maturity of the migration history in the origin community. In the
beginning, only a few have the means to migrate abroad, either because they
are wealthier than others or because they already have networks abroad
that facilitate migration. At this stage, the level of received remittances is
low and the transfers beneft only a few, presumably richer, households.
This leads to an increase in inequality in the community. However, as emigration from the community continues, migration becomes more affordable
also for the poorer households, due to better-established networks at home
and abroad. This means that the total number of remittances increases in
the community, where more and more remittances go to households at the
lower end of the income distribution. The process of a gradual maturing of
the migration history of the community therefore leads to a reversal of the
effect of remittances on inequality.
The Gini decomposition method has been extended to account for the
general equilibrium effects of remittances on incomes in a community at
large, both migrant households and nonmigrant households. Hence, it can
capture not only the direct but also the potential indirect effects of remittances on inequality (Taylor, 1992; Taylor & Wyatt, 1996). Indirect effects
occur when remittances affect either the income of nonmigrant households
or other sources of income for the migrant household. For example, remittances may raise the recipient’s budget constraint and free up funds for
investment. This may increase the income of the recipient household as well
as the income of other households through further employment opportunities (e.g. shopkeeping and kettle herding). On the other hand, remittances
may negatively impact the labor supply decision of the remaining members
of the migrant household. These indirect effects parallel those that we discussed in section 5.5 on economic growth.
Despite the advantage of being able to account for the general equilibrium effects of remittances, the Gini decomposition technique has an important shortcoming: it does not account for the migration decision and the
associated opportunity costs of migration. That is, it does not account for
the fact that migrant households make an active decision to forgo income
at home and to substitute it with remittances from earnings abroad. For
the Gini decomposition method, remittances are a separate, additional
source of income for the household and the migration decision does not
play a role in it (for further details, see Box 5.5).
To address this shortcoming, the second strand of literature has taken
a different methodological route. To determine the impact of remittances
as substitutes of household income on poverty and inequality, this literature compares the actual earnings of migrant households with what these
households would have earned had none of their members migrated. This
requires estimating the income of migrant households in a counterfactual
130 Hanna Fromell et al.
nonmigration scenario. This method is therefore called the counterfactual
income method. Studies using this method differ with respect to the construction of the counterfactual nonmigration scenario. Some impute the
counterfactual incomes by using data from nonmigrant households; some
use the Heckman selection model to construct the counterfactual; and others use propensity score matching.
Several studies use the counterfactual incomes method (Jimenez-Soto
& Brown, 2012; Adams & Cuecuecha, 2013). We briefy present the strategy
and results of a seminal study by Barham and Boucher (1998) to exemplify
the counterfactual incomes method and to contrast it with the Gini decomposition method. Barham and Boucher investigate the effect of remittances
on income inequality on a sample of migrant and nonmigrant households
in Bluefelds, Nicaragua. They construct a counterfactual nonmigration
scenario by estimating the incomes of migrant households had none of the
members migrated.11 Their general strategy is to compare the Gini coeffcient of the actual incomes in the observed migration scenario with the
Gini coeffcient in the counterfactual nonmigration scenario. If the Gini in
the actual, observed scenario is lower than the Gini in the counterfactual
scenario, then migration and remittances would have had an inequalityreducing effect on incomes in the community.
More specifcally, the authors compare two counterfactual scenarios
with the actual scenario. For the frst counterfactual scenario, they estimate
the nonmigration incomes of the migrants and add these counterfactual
incomes to the actual incomes of nonmigrants. For the second counterfactual
scenario, they also estimate the counterfactual incomes of the nonmigrant
members of migrant households, because the migration decision affects not
only the migrants but also those left behind. As discussed earlier, nonmigrant members of migrant households may make labor force participation
decisions conditional on whether another household member decides to
migrate. Hence, migration may not only change the migrants’ but also the
nonmigrants’ contributions to household income.
The results show that the Gini coeffcient in the actual (observed)
migration scenario is signifcantly higher than it is in both counterfactual
nonmigration scenarios: by 7.5% and by 12%. Because a higher Gini coeffcient means higher inequality, remittances have increased income inequality in the sample. Furthermore, when Barham and Boucher use the Gini
decomposition method on the same Bluefelds sample, they fnd the opposite
result: remittances reduce inequality. That is, if remittances are considered
exogenous transfers in this sample, then they reduce inequality. The Barham
and Boucher (1998) study suggests that it appears diffcult to empirically
determine the effect of remittances on inequality in remittance-receiving
communities. The results are ambiguous across different methodologies.
5.7.2 Remittances and poverty
In contrast to the ambiguous results on the link between remittances and
inequality, there appears to be more consensus that remittances lift the
receiving households out of poverty (Adams, 2004; Yang & Martínez, 2006;
Chapter 5 • Remittances and development 131
Gupta, Pattillo, & Wagh, 2009; Akobeng, 2016; Acosta et al., 2007). As we
wrote earlier, these positive results can be expected in the case of successful labor migration. Migration is successful in this sense if migrants achieve
what they intend with their migration decision – improving their and their
families’ economic outcomes at home by migrating to places where they can
fnd work and earn more money. At least with respect to poverty reduction,
migrants seem to make economically rational decisions.
The results seem to be robust across different methodological approaches.
For example, Jimenez-Soto and Brown (2012) use the counterfactual incomes
method to estimate the effect of remittances on poverty by using household
survey data from Tonga. They use propensity score matching to construct
the counterfactual scenario to estimate nonmigration household incomes.
By measuring poverty in different way, they fnd that remittances can reduce
poverty. For example, remittances reduce the poverty headcount ratio, which
measures the extent of poverty, by 31% and reduce the poverty gap ratio,
which measures the depth of poverty, by 49%.
Using a cross-sectional approach, Adams and Page (2005) evaluate the
direct effect of international remittances on poverty in 71 developing countries. They use a growth-poverty model (Ravallion, 1997; Ravallion & Chen,
1997) given by
log Pit = ˜1 log yit + ˜2 log git + ˜3 log REMit + ˝i + °it ,
where Pit is a poverty measure, yit is per capita income, g is the Gini coefit
fcient, REMit represents remittances, ˝i is time-invariant country-specifc
effects and °it is an idiosyncratic error term. After instrumenting for the
potential endogeneity of remittances, they fnd a statistically signifcant
negative coeffcient for remittances. This means that remittances reduced
poverty in their sample.
However, concerns could be raised regarding the IV strategy used
in this study. In particular, Adams and Page do not discuss the exclusion
restriction of the three instruments that they use to address the endogeneity
of the remittance variable. For example, they use the distance between the
remittance-sending area (US, EU, or Gulf) and the recipient country as their
frst instrument. While they rightly argue that distance may be a good predictor of remittances (migration is typically negatively correlated with the
distance between origin country and destination country), they do not discuss the exclusion restriction at all. So it is not obvious why distance would
not affect poverty in remittances-receiving countries – for example, through
trade, FDI, or colonial ties. Thus, it seems that distance is not a good instrument for remittances, and since similar considerations apply to their other
two instruments, their study cannot conclusively identify a causal effect of
remittances on poverty (see also Box 5.4).
5.8 POLICY TOOLS AND INTERVENTIONS
Since much of the empirical literature on the impact of remittances suggests
a positive impact on several welfare indicators, some researchers have investigated how policy reform could be used to infuence migrants’ remittances
132 Hanna Fromell et al.
decisions. One questions of particular relevance for policy is how remittances can be allocated in the most productive way. Great attention has
been paid to whether remittances are used mainly for consumption or for
investment. Which one would be the optimal use for a given household
is not obvious. Furthermore the evidence diverges on whether remittances
tend to be spent more on investments or more on consumption (Yang, 2011).
For example, Yang (2008) and Yang and Martínez (2006) exploit sudden
changes in exchange rates between the host country of migrants and their
origin country, which are used as IV for changes in remittances. Signifcant
increases in investments and an increased likelihood of exiting poverty are
identifed among the remittance-receiving households. Another question
that has been given a lot of attention is how remittances could be further
increased. Most of the literature discussed in this section provides evidence
about the factors that infuence the use of remittances and their magnitude.
5.8.1 Financial literacy programs
If remittances are not spent optimally, imperfect knowledge about fnancial
products on the part of the recipients appears as one plausible explanation.
Studies have been conducted in which migrants or the household members
left at home receive training in fnancial literacy to verify whether this has
positive effects on remittances and their productivity. Doi, McKenzie, & Zia
(2014) fnd positive effects from providing training both to the household
members left at home and to the migrant, before migration. However, they
fnd no positive impact from giving fnancial training to only the migrant
or only the household members left at home. Financial literacy training has
also been offered to migrants after their move to the host country. The fndings of such training have been mixed, where Seshan and Yang (2014) fnd
increased savings and remittances among migrants working in Qatar, while
Gibson et al. (2013) fnd no impact on remittances sent home from offering
fnancial training to immigrants in Tonga, East Asia, and Sri Lanka.
5.8.2 Migrant control over the use of remittances
If a migrant has a different opinion over how the household should spend
the money from that of the household, the migrant may be more inclined to
remit more if given greater control over how remittances are spent. Evidence
supporting this possibility is provided by Ashraf, Aycinena, Martinez, and
Yang (2011), who offer savings accounts with varying degrees of migrant
control over savings in the home country and fnd that migrants accumulate
the most savings when they are given the highest level of control. Further
evidence for the importance of being in control among migrants is offered
by Chin, Karkoviata, and Wilcox (2011).
5.8.3 Costs
As mentioned earlier, the costs associated with international remittances have
become the target of international development agreements. Recall that these
Chapter 5 • Remittances and development 133
costs are often substantial, amounting to a global average of about 7% of the
amount remitted (World Bank, 2019a), and there are often relatively high fxed
costs per transaction. Nevertheless, remittances have been observed to be
relatively frequent and small in size (Yang, 2011), resulting in relatively high
fees paid relative to remitted amounts. One potential reason for why migrants
choose to remit so often rather than sending larger amounts more seldom is a
problem of self-control. Migrants may, for example, anticipate that the recipient will be tempted to spend too much of the remittances as soon as they have
been received if a larger amount that is intended to last for a longer period is
sent all at once (Yang, 2011). As the costs paid to remit are substantial, scholars
have investigated whether a reduction in such costs would enable the supply of remittances to rise. Ambler, Aycinena, and Yang (2015) run a randomized control trial in which they offered migrants living in the US the chance
to send money to fund the education of a student of their choice living in El
Salvador. They contrast two policy interventions: in the frst, migrants’ contributions were matched by an additional USD3 for each USD1 submitted, and
in the second, the cost to remit were reduced by half. The results show that
migrants were more than twice as likely to allocate money through the matching program compared to the cost reduction program. Further illustrating this
high price elasticity of demand, they fnd that no allocations were made when
no matching was offered. A high sensitivity in the cost to remit is also confrmed by Ambler, Aycinena, and Yang (2014), who fnd that the large positive
effects in remitted amounts persist even 20 weeks after the discount on costs
ceased to apply. The authors fnd suggestive evidence that this may be because
the recipients continue to demand the increased amounts received even after
the discount period. Other studies confrm that recipients seem to have some
infuence over the remittances they receive. In a lab-in-the-feld experiment,
Ambler (2015) fnds that if a migrant earns unexpected windfall money and
household members at home learn about this, the migrant is willing to remit
more than if the household members do not learn about the windfall.
5.8.4 Channel remittances to specifc purposes
Migrants who are concerned about the productive use of their remittances
and who care not only about their family members but also about the
community as a whole may be more willing to send money home if their
money can be earmarked for specifc purposes. Several programs have been
designed with such a purpose, where remittances are earmarked for the
education of students. For example, the study mentioned earlier, by Ambler
et al. (2015), allowed migrants to fund the payment of a selected student
in El Salvador. The success of this product is limited in so far as there was
no demand for channeling money through this program when there was
no matching of money by the program on top of what was offered by the
migrant. However, De Arcangelis, Joxhe, McKenzie, Tiongson, and Yang
(2015) fnd evidence for positive demand among migrants to fund the education of students in their origin country. Interestingly the authors fnd a signifcant increase, of 15%, in remittances when they are labeled as intended
for education but where it is still possible for the recipient to use the money
134 Hanna Fromell et al.
for other purposes. Imposing a hard form of commitment by channeling the
money directly to the school only adds another 2.2% on top of the remittances sent when the money has been labeled.
5.9 CONCLUSION
This chapter showed that international remittances, the fnancial transfers
made by labor migrants to their families and relatives at home, have the
potential to exert positive effects on economic output, fnancial development,
poverty levels, and income inequality in developing recipient countries.
In this sense, their role vis-à-vis other forms of development fnance – for
example, via offcial development assistance (ODA) or foreign direct investments (FDI) – cannot be understated and should be further investigated.
This chapter also highlighted the importance of understanding the
motivations of migrants to transfer money home as they shape the special
characteristics of remittances that set them apart from other forms of development fnance. Such an understanding facilitates the assessment of the
development effects of remittances and improves any endeavor to eventually unlock their presumed development potential.
While the empirical literature on the development effects of remittances
is growing in number and quality, we maintain that consumers should be
aware of the various weaknesses regarding data availability and research
methodology exhibited by the literature. We also highlighted throughout the
chapter that the potentially benefcial effects of remittances should always
be investigated in conjunction with migration decisions. Remittances never
occur without migration, and therefore, who receives remittances is highly
dependent on who can afford to migrate. Future research in the feld should
therefore account for this selectivity and aim to improve the methods that are
used to measure the effect of remittances on development (e.g. McKenzie,
Stillman, & Gibson, 2010; Gibson, McKenzie, & Stillman, 2013).
We also described ways that policymakers could infuence the remitting behavior of international labor migrants. Supporting the strategies
adopted by recent international agreements on migration and remittance
policies, a reduction in the costs of remitting smaller amounts promises
higher volumes of remittance fows.
Discussion questions
1 Which theoretical considerations
explain a change in the receivers’ spending behavior towards
consumption and which towards
investment goods? Consider the
permanent income hypothesis
and different motivations to remit.
2 What are the effects of remittances
from refugees on communities at
home? Would they differ from
labor migrants’ remittances?
3 What could explain the ambiguous empirical results on the
impact of remittances?
4 Do you fnd the choice of instrumental variables in Chami et al.
(2003) convincing? Why or why
not?
Chapter 5 • Remittances and development 135
5 Consider the role of the fnancial
sector in the impact of remittances on growth. In your opinion, does the fnancial sector
play a moderating or a mediating role? Read up on moderators
and mediators in econometric
research. How would you design
a study to investigate either of the
two roles?
6 Given what you have learned, how
would you design a program to
enhance entrepreneurship through
the receipt of remittances in the
recipient community?
7 What are social remittances, and
what would their impact on economic growth, fnancial inclusion,
poverty and inequality be? How
would you assess their impact?
Notes
1 Voluntary labor migration differs
from so called forced migration,
or displacement, that occurs when
people have to leave their homes
due to threats to their safety and
security. Forced migration is
smaller in size and typically generates smaller remittance fows. It
has therefore not received much
attention in the literature and is
not discussed in this chapter.
2 This totaled 216 countries: 31
low-income countries, 53 lowermiddle-income
countries,
56
upper middle-income countries
and 76 high-income countries.
3 The World Bank, Remittance Prices
Worldwide, available at http://
remittanceprices.worldbank.org.
4 This section draws from Chami et
al. (2008), Barajas et al. (2009), and
Amuedo-Dorantes (2014).
5 In our study questions, we ask
you to evaluate the quality of the
Chami et al. instruments. See also
Box 5.4.
6 Brown and Jimenez-Soto (2015)
argue along similar lines.
7 The 3sls analysis assumes that
remittances affect growth only
via fnancial inclusion. However, remittances likely also
affect growth via other channels,
implying that the implicit exclusion restriction used in the 3sls
approach conducted by Toxopeus
and Lensink (2008) will not hold.
8 Gupta, Pattillo, and Wagh (2009)
use a similar approach to that of
Aggarwal, Demirgüç-Kunt, and
Martínez Peria (2011). However,
Gupta, Pattillo, and Wagh (2009)
focus on sub-Saharan Africa. Most
importantly, they fnd strong support for a positive and signifcant
impact of remittances on fnancial
development.
9 Recall that we focus on labor
migration where one household
member leaves their family behind
to work abroad. So the decision
to migrate is deliberate and not
coerced. Of course, if we were to
investigate other types of migrations, such as forced migration,
then we could not expect that their
earnings abroad would necessarily
exceed their home earnings.
10 The Gini coeffcient is the most
popular measure of inequality in a
population. It measures how far a
population’s income distribution
deviates from a perfectly equal
distribution. A Gini coeffcient of
0 expresses perfect equality, while
a value of 1 expresses maximal
inequality.
11 The study uses a double-selection
Heckman model (Heckman, 1979)
to control for the migration decision of migrating household
members and the labor force decisions of nonmigrant household
members.
136 Hanna Fromell et al.
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CHAPTER
6
Foreign aid and economic
development
Matthew Kof Ocran, Bernardin Senadza, and Eric Osei-Assibey
6.1 INTRODUCTION
Overseas development assistance (ODA) is an expression that was frst
conceived of in 1969by the Development Assistance Committee (DAC) to
measure aid. The DAC defnes ‘aid’ as resource fow from offcial agencies
to stimulate economic development. According to the DAC, for a resource
fow to be considered as aid, it must be offered on concessional terms with
at least a 25% grant1 component. The resource may be fnancial, technical
assistance or in the form of agricultural commodities. Humanitarian aid
is also considered aid. While donations, military equipment, or technical assistance offered on concessionary terms are considered aid by some
countries, the DAC excludes them in its description of aid. Thus the DAC
invariably separates ‘offcial development assistance’ from other ‘offcial
fows’ (OECD, 2006). For example, aid in support of antiterrorism efforts is
excluded from the measurement of aid.
The question regarding the role of foreign aid in fostering economic
development has attracted considerable attention in the literature over the
past six decades. Despite the huge volume of literature on the topic, there
appears to be no unanimity on whether foreign aid has had a positive effect
on economic development. What has been become clear, though, is that the
motivation for providing aid to developing countries is often driven by reasons other than altruistic ones. This chapter examines the historical origins
of foreign aid, the rationale behind the provision of aid, and trends in the
volume of aid. We also examine the question of aid effectiveness, by examining the literature on aid and economic growth on one hand and aid and
poverty on the other. The last section of chapter proposes options that can
enable developing countries to look beyond aid.
6.2 EVOLUTION OF FOREIGN AID
The historical origins of formal attempts aimed at providing foreign assistance can be traced to the US Congress’s Act for Relief of the Citizens of
Venezuela, which was passed in 1812 after a devastating earthquake in Venezuela in March of that year (Hjertholm & White, 1998). Later on in the
20th century, the United Kingdom’s Colonial Development Act 1929 was
Chapter 6 • Foreign aid and economic development 141
promulgated. The Act sought to provide for loans in support of agriculture and industry in a number of British colonies and territories in a bid
to promote commerce or industry in the United Kingdom. In 1933, the US,
through the Agricultural Adjustment Act, provided shipments of agricultural surpluses to needy countries as relief and to create new markets for US
agricultural output.
The beginning of multilateral efforts in the provision of aid was heralded by the formation of the United Nations in 1945 following the Bretton
Woods conference in 1944. A year earlier, the United Nations Relief and
Rehabilitation Administration (UNRRA) was formed. Instructively, the
immediate postwar efforts of multilateralism spearheaded by the United
States were all aimed at supporting Europe, whose countries’ economies
had been decimated by the war, to fnd its feet.2 CARE and OXFAM,3 which
are among the leading international NGOs in the developing world today,
were all formed to support the poor in Europe.
The European Recovery Plan, commonly known as the Marshall Plan
was backed by the United States’ Foreign Assistance Act of 1948. The plan
was frst made public by George Marshall, the then US secretary of state,
during a speech at Harvard University in 1947. The Marshall Plan is probably the most remarkable bilateral aid effort in the chronology of foreign
aid. The plan was aimed at assisting the reconstruction of the European
countries that had been destroyed by the Second World War. The European countries also faced the increasing threat of dictatorial communism
and worsening economic outcomes. The devastation of the war and the
accompanied collapse of physical infrastructure across the countries in
Europe made recovery without foreign aid diffcult for European economies (Weissman, 2013).
The aid under the Marshall Plan was in the form of fuel, raw materials,
capital goods, loans, food, and technical assistance to help rebuild infrastructure such as transport systems. Later on, the US made direct fnancial
investments in European companies. After barely four years after the inception of the Marshall Plan, European economies began to see phenomenal
rebound. The United States also benefted immensely from the economic
stimulus it had provided to Europe. For instance, the US industries recorded
strong growth in domestic production and proft as they sought to meet
the demand for goods and services from Europe after the support from the
US government. Another outcome of the support was the construction of
new democratic institutions in Europe and the fostering of the US economic
paradigm of the free market and the ‘Americanization’ of Western Europe.
Under the plan, Europe was encouraged to produce a plan for reconstruction that the United States could fund. The Europeans asked for USD22
billion; the US Congress instead approved USD17 billion, out of which the
US government disbursed more than USD13 billion. The Marshall Plan was
not entirely for altruistic purposes, though. In addition to helping Western
Europe recover from the debilitating effect of the Second World War, it was
meant to beneft the American economy and contain Soviet expansion into
Europe. Thus, despite the virtues of the Marshall Plan, it was also intended
to achieve political objectives (Leffer, 1988).
142 Matthew Kof Ocran et al.
In 1950, the Colombo Plan for Cooperative Economic and Social Development in Asia and the Pacifc (i.e. the Colombo Plan) was launched, like
the Marshall Plan in Europe. The motivation was to create a platform to
coordinate resource fow for the reconstruction of Asian countries that were
badly affected by the Second World War. The Colombo Plan was also partly
aimed at containing Soviet expansion into the newly independent countries
in the Asia Pacifc region. This was undoubtedly the frst, most signifcant
multilateral effort aimed at promoting economic development in any part
of the world. The plan led to the creation of a regional organization based
on the idea of collective intergovernmental efforts to stimulate economic
and social development in countries of the Asia Pacifc region. The idea for
the Colombo Plan emerged during a Commonwealth conference on foreign
affairs in Colombo, Sri Lanka. There were seven founding signatory countries. Among these were donors and recipients. The group included Britain,
New Zealand, Australia, Canada, Sri Lanka (formerly Ceylon), India, and
Pakistan. The developed countries among the group provided physical capital and human resource development to better leverage the fnancial aid for
economic development. Thus, the thrust of the Colombo Plan was self-help
and mutual assistance (Curtin, 1954).
In the 1950s, donors focused on the notion of community development and the types of aid that were in vogue were largely in the form of
food aid and project support. However, the dominant donor in the 1950s
was partly motivated by its anticommunist stance. After the successes of the
Marshall Plan, the US promulgated the Mutual Security Act of 1951, which
had a much broader development assistance mandate. Through the Act, the
US provided both economic and military aid to both European countries
and developing countries. The old Soviet Union, through its Molotov Plan
sought to assist other countries. The Molotov Plan had two overarching
objectives: a set of maximum aims and a set of minimum aims. The maximum
aims sought to gain economic and political control of Europe, to attract
European economies into its orbit of infuence, and to turn the continent
into a source of industrial production for the Soviet Union and a market for
its surplus production. On the other hand, the minimum aims were geared
toward obtaining consumer goods from Europe for its people and to make
sure friendly governments were in charge across countries in Europe (Berger,
1948). The cold contestation between the Soviet Union and the United States
dominated the development aid environment.
In the 1960s, many bilateral programs were established by Western
European countries whose economies had by then recovered from the war.
The 1960s also saw the establishment of regional development banks (African Development Bank in 1964; Asian Development Bank in 1966; and the
Caribbean Development Bank in 1969). More importantly, against the background of the Cold War between East and West, the developed countries of
the world formed the DAC in 1960 under the auspices of the Organization
for Economic Cooperation and Development (OECD) in Europe. The primary motivation of the DAC was to coordinate aid from the rich Western
countries in pursuance of poverty alleviation in developing countries. Also
in the 1960s, a number of Western countries set up specialized development
Chapter 6 • Foreign aid and economic development 143
assistance entities such as the Canadian International Development Agency
(CIDA).
During the 1970s, multilateralism in the provision of aid gained more
traction; poverty alleviation anchored on basic human needs – education,
healthcare, sanitation, and sustainable livelihood – was adopted as a key consideration in the provision of aid. The DAC decided to pay particular attention
to the least developed countries and to prioritize the more disadvantaged countries in the distribution of aid. The idea here was that economic growth had
failed to considerably reduce poverty in developing countries; therefore, measures that directly targeted the poor needed to be pursued more vigorously.
The 1980s were characterized by unfavorable economic outcomes in
the developed world: high unemployment and high infation rates. These
challenges in turn dampened global demand for commodities. The slump in
commodity prices, deterioration in terms of trade, and the high debt levels
in Africa, Latin America, and Western Asia were partly a result of weak economic prospects in the developed world. The Bretton Woods institutions’
policy response was a fscal consolidation as far as economic development in
the developing world was concerned. Consequently, the institutions introduced structural adjustment program loans to help reduce fscal imbalances
and to help economies in the developing world adjust to their long-term
growth paths. Among the policy positions that were pushed by Western
donors in the 1980s was market deregulation in developing countries (UNDESA, 2017). There was a big increase in the number of NGOs in the 1980s,
all in an effort to help developing countries that were facing poverty and
strife as a consequence of the poor economic conditions.
After the collapse of the Berlin Wall, the 1990s saw the former Soviet
Union and its satellite states becoming recipients of aid. More importantly,
the DAC High Level Meeting came out with a policy document that informed
the fow of aid, Development Cooperation in the 1990s. The thrust of the
policy was threefold. First, efforts were to be geared toward the promotion
of sustainable economic growth. Second, they were to broaden the participation of all people in the productive processes and the pursuance of equity
in the sharing of the benefts of growth. The last pillar of the policy was to
ensure environmental sustainability and to slow population growth in countries where it is too high to impede sustainable development. The aim of the
new policy underpinning ODA was to highlight and link high population
growth, poverty, malnutrition, illiteracy, and environmental degradation,
which were still the plight of most developing countries (OECD, 2006).
At the turn of the 21st century, the DAC High Level Meeting pushed
for greater emphasis on people-centered development, local ownership of
development initiatives, global integration, and the forging of development
partnerships between developing countries and developed countries. The
DACs strategy was adopted by the OECD and the Group of Seven (G7).
These ideas culminated in the adoption of the Millennium Development
Goals (MDGs) that were approved by the United Nations after the Millennium Summit in 2000, which then gained universal commitment and subsequently immense global importance. The objectives of the MDGs were
woven around the promotion of economic well-being, social development,
144 Matthew Kof Ocran et al.
and environmental sustainability. The sustainable development goals
(SDGs) replaced the MDGs, which lapsed in 2015. The SDGs emanated
from the Agenda 2030. Again, the SDGs cover a wide range of social and
economic development objectives that are represented by 17 goals. The
goals are then operationalized with the aid of 169 targets. The SDGs call
for a global effort to end poverty, protect the planet, and ensure that there
is peace and prosperity across the globe. The other signifcant development
in the aid architecture in the frst decade of the 2000s was the emergence of
China and some leading developing countries, such as India, Brazil, and
Turkey, among others, as donors. However, the volume of China’s foreign
aid dwarfs that of the other emerging donors (UNDP, 2016).
6.3 RATIONALE FOR AID
Importantly, aid is not provided by donors entirely for altruistic reasons.
And aid is not provided as a result of concerns for global social justice or the
recipient’s needs. Indeed, two clear strands can be identifed in the literature
on the motivation for providing foreign aid: those around strategic national
policy and those associated with philanthropic concerns. While the motivations for providing foreign aid by rich developed countries, including the
United States and the United Kingdom, have evolved over time, the thrust
of the motivations have remained unchanged: strategic and humanitarian.
Assuming that aid in itself can alter the socioeconomic conditions in
developing countries in any meaningful way is therefore patently naïve.
Morgenthau (1962) is one of the earlier authors who argues that aid is unable
to turn the fortunes of poor countries around. After 50 years, this reality has
become increasingly clear. The literature suggests that the poorest countries
of the world are not necessarily the largest recipients of aid.4
Indeed, the desperate attempts by countries that are not developed to
provide aid to developing countries is ample demonstration of the extent of
‘soft power’ that a country can wield as a donor. Quirk (2014) states in no
uncertain terms that the motivations of the new non-DAC donors are just
like the established DAC donors (the US and Europe): ‘doling out development aid to advance their political,5 security, and economic interests’.
Empirical studies in the late 1970s (McKinlay & Little, 1977, 1978) suggest that donor interest trumped recipient interest at least for the United
States and the United Kingdom. For instance, Alesina and Dollar (2000) fnd
a pattern in giving aid that is motivated by politics and strategy. These outcomes are consistent with the conclusions reached by McKinlay and Little
(1977, 1978). The authors further argue that while France’s foreign aid largely
goes to its former colonies that it has stronger political ties with, the United
States’ pattern of aid is greatly connected to its interests in the Middle East.
Berthélemy and Tichit (2004) suggest that former colonies are better placed to
receive disproportionate amounts of aid from their former colonial powers.
Alesina and Dollar (2000, p. 33) further assert that ‘an ineffcient, economically closed, mismanaged nondemocratic former colony politically friendly to
its former colonizer receives more foreign aid than another country with similar levels of poverty, a superior policy stance but without a past as a colony’.
Chapter 6 • Foreign aid and economic development 145
Dudley and Montmarquette (1976) suggest that donor’s expectations
are that by providing foreign aid, the recipient country should reciprocate
by supporting the donor’s interests, perhaps in the area of international politics. For instance, in 2017, when many developing countries voted against
the United States’ recognition of Jerusalem as capital of Israel at the United
Nations General Assembly, the US threatened to cut aid to ‘unfriendly countries’ that voted against the US (Beaumont, 2017). Trump, the US president,
said, ‘They take hundreds of millions and even billions of dollars, and then
they vote against us’ and went on to say, ‘Let them vote against us. We’ll
save a lot. We don’t care’ (Tawfk, 2017). Again, to underscore this point,
Quirk (2014) points out that one of the important reasons underlying India’s
interest in providing aid to developing countries is to obtain support for its
bid to have a permanent seat on the UN Security Council. Japan’s foreign
aid has also gone largely to countries that share their international political
interests, according to their UN voting pattern (Alesina & Dollar, 2000).
News media’s coverage of natural disasters in the receiving country
and the associated dividends that accrues to leaders for acting in a humanitarian manner is another clear motivation for providing foreign aid to distressed countries (Drury, Olson, & Van Belle, 2005; Strömberg, 2007; Porter
& Van Belle, 2009). The massive spike in international aid to Ethiopia during the 1983–1985 famine and Haiti after the 12 January 2010 earthquake
that left almost a third of a million of people dead are classic examples of
instances where news coverage encourages donors to provide additional
support. There are many other instances where news coverage has garnered
aid for countries in facing misery as a result of natural disasters. Again,
news coverage may also motivate citizens of rich countries to encourage
their governments to make aid allocations for humanitarian purposes.
Aid may also be traded for policy concessions (Mesquita & Smith,
2007). From the donor’s perspective, the policy concession could be in the
form of favorable terms for access to natural resources in the recipient
country by frms in the donor country. Thus, the donor country obtains
some utility from the receiving country in terms of higher wages, dividends, and taxes.
The economic interest in providing foreign aid may be seen in the provision of tied aid. Tied aid refers to foreign aid that requires that goods
and services associated with the aid be obtained from the donor country.
OXFAM has long argued that tied aid results in making aid ‘round trip’.
Many countries tie foreign aid to something. OXFAM argued that the US
tied its aid more than any other country (Oxfam, n.d.). And the US’s food
aid program is arguably the worst form of tied aid. The food must be produced in the US and packaged in the US, and at least 75% of it must be transported by US-owned vessels. As another example, most of the foreign aid
aimed at infrastructure development offered by China is often undertaken
by Chinese labor;6 this has caused a level of discontent (Lamido, 2013).7
Much of the Chinese aid to Africa, for example, is aimed at securing natural
resources from Africa for China’s own development. Recipients may also
become trading partners of donors as their economies get connected to that
of their donors through aid. Thus, donors also use aid to foster trade with
146 Matthew Kof Ocran et al.
recipient countries. A strand of the literature on aid provides ample evidence that foreign aid is in part motivated by trade interest (Nath & Sobhee,
2007; Hoeffer & Outram, 2011, Dietrich, 2012).
In sum, the motivation for international is varied. Most of the geopolitical and strategic reasons why countries provide foreign aid do not necessarily coincide with the idiosyncratic needs of aid-recipient countries. No
wonder why the outcomes of the massive fow resources in terms of aid
to developing countries, particularly over the past six decades, have been
mixed.
6.4 AID ARCHITECTURE, VOLUMES, AND TRENDS
Many countries often provide development assistance to other countries,
but the 30-member Development Assistance Committee8 (DAC) has been
the major donor over the past fve decades. There are also non-DAC and
emerging donor countries that are increasingly becoming considerable
sources of foreign aid. These donors fall under four categories (IDA, 2007)
1 OECD members outside the DAC – Korea, Mexico, a large number of
European countries, and Turkey.
2 New European Union member states that are not members of the
OECD.
3 Middle Eastern and OPEC countries, such as, Kuwait, Saudi Arabia,
and Iran.
4 non-OECD countries that are outside all three foregoing groupings,
such as China, India, Brazil, and Russia.
At the apex of the foreign aid architecture are offcial bilateral donors.
The offcial bilateral donors include both DAC members and non-DAC members. The bilateral donors constitute the most important source of funds for
aid in the developing world. The offcial bilateral donors provide resources
to the multilaterals: regional development banks, UN agencies, and the
International Development Association (IDA).9 In addition to providing the
resources required by the multilaterals for their foreign aid disbursements,
the bilateral donors also provide aid directly to recipient countries. The aid
architecture also involves the fow of resources to the various donors in the
form of refows following gross disbursements. These refows represent the
payment of the principal and interests for the loan components of aid.
Although the importance of the DAC members as a major source of
external assistance has reduced from a high of 77% in 2005 to 62% in 2015,
it is by far the major source of assistance. The non-DAC group has more
than tripled its contribution, from just about 3% in 2005 to 11% in 2015.
Multilateral institutions have also increased their support from 21% to 27%
over the period under discussion (OECD, 2018). The total value of international development assistance has risen from USD108.5 billion in 2005 to
USD152.7 billion (see Figure 6.1).
Between 1960 and 1980, the volume of aid remained fairly steady as
some of the major recipients, such as Turkey, Chile, and Brazil, became
affuent and saw huge reductions in their aid fows. After the collapse of the
Chapter 6 • Foreign aid and economic development 147
FIGURE 6.1 Total volume of ODA in constant 2015 prices, 1960–2016
160
140
US$/billions
120
100
80
60
40
20
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
0
Source: Data from OECD DAC website
Berlin Wall and the subsequent transitions of the hitherto countries in the
orbit of the former Soviet Union into market economies, aid fows spiked.
From the peak in 1992, the volume of aid dropped substantially and bottomed out in 1997. The reduction in aid in the 1990s has also been attributed
to the decline in the brisk competition between proponents of communist
politico-economic ideologies and capitalist politico-economic ideologies.
Coupled with the reduction in the ideological competition was the
rapid development recorded in parts of Asia at the same time. The recent
spike in aid fows seen in 2005–2006 is reckoned to have been as a result of
the debt relief afforded to Nigeria and Iraq (OECD, 2017).
Sub-Saharan Africa has been the largest regional benefciary of aid from
the DAC. The proportion of aid that went to the region peaked at 39% in
2006 and then fell to less than 30% by 2015 (see Figure 6.2). Whereas other
countries have had improved economic outcomes over the past 30 years and
thus are becoming less and less reliant on aid, the same cannot be said of
sub-Saharan African countries. Even though there was stronger growth in the
1990s, most countries have come from a low economic base, and it would take
much stronger and sustainable growth rates to become less reliant on aid.
Also, the share of ODA that goes to sub-Saharan Africa has declined steadily
since 2005, from a peak of almost 40% in 2006 to less than 30% as of 2013.
The non-DAC donor group is not a heterogeneous group in terms of
each country’s stage of development. The group includes upper-middleincome and even lower-middle-income countries, such as Pakistan. Some
of the countries are in Europe but do not belong to the OECD’s DAC group.
Another well-defned group is Middle Eastern oil-producing countries
such as Saudi Arabia, Kuwait, and Qatar. BRIC countries – Brazil, Russia,
India, China, and South Africa – are also increasingly becoming a signifcant
source of aid fow to the developing world. Chinese contributions are well
documented. Turkey is another non-DAC donor that provides considerable
support to developing countries.
148 Matthew Kof Ocran et al.
180.0
45%
160.0
40%
140.0
35%
120.0
30%
100.0
25%
80.0
20%
60.0
15%
40.0
10%
20.0
5%
0.0
ODA ratio
US$ billion
FIGURE 6.2 Sub-Saharan Africa’s share of ODA, 2005–2015
0%
2005
2006
2007
2008
2009
All developing countries
2010
2011
2012
Sub Saharan Africa
2013
2014
2015
SSA Share
Source: OECD (2018)
The most important non-DAC donor group of countries includes
China, Turkey, India, Brazil, and Saudi Arabia. Although the exact volume
of aid from China to developing countries is diffcult to determine, because
of the nature of China’s aid statistics, the available data suggest that it is considerable. The aid that has been provided to 90 countries across the world
has led to exponential growth over the period 2001–2011. From a low of
USD1.7 billion in 2001, it increased to USD189 billion in 2011 (Quirk, 2014).
Turkey’s foreign aid is also reckoned to have increased immensely over the
ten-year period 2002–2012. This has soared from USD86 million to USD2.5
billion as the country has prospered.
India has been a donor of foreign aid since the 1990s. It receives foreign aid with one hand and gives foreign aid with the other hand. Indeed,
the British newspaper the Telegraph reported in 2016 that Britain still gives
hundreds of millions of dollars in aid to India and China (Swinford, 2016).
Saudi Arabia’s development assistance totaled USD289 million in 2015
(Saudi Aid Platform, 2020). And between 2005 and 2011, Brazil provided
development assistance to the tune of USD1.4 billion in total, to 70 countries (Huber, 2012). The motivation behind these and many middle-income
countries’ efforts at providing foreign aid to developing countries needs to
be explained.
6.5 AID EFFECTIVENESS
6.5.1 Aid and growth
The convention of extending aid, particularly after the Second World
War, was principally aimed at assuaging the economic diffculties of wardistraught economies and to occasion auspicious channels toward economic rejuvenation. The scope of concentration, however, has evolved in
Chapter 6 • Foreign aid and economic development 149
recent times to refect the general economic concerns of the developing and
underdeveloped world, after the end of the Cold War in 1989 (Ccheang,
2009). Thus, foreign aid is now targeted at engendering rapid and palpable
growth in regions typifed by severe macroeconomic instability and often
dealing with the twin challenges of low domestic savings and reduced foreign exchange infows (Basnet, 2013). In an economy where neither domestic
savings nor export-fnanced imports are fully capable of satisfying investment demand, foreign aid could assist in bridging the savings–investment
gap and the foreign exchange gap: the conventional two-gap approach to
an aid-development analysis. The growth-enhancing mechanisms of aid
would thus include augmenting the levels of human and physical capital
and bolstering an economy’s capacity to import capital goods while limiting
conditions that incite declines in investments or savings (Morrissey, 2001).
The ability of foreign aid to effectively achieve its prescribed objective remains a contentious issue in the policy arena and the academic arena.
Whereas the prevailing view in the 1990s (e.g. see Boone, 1994, 1996) was
that aid did not instigate growth in developing countries, the 2000s have
witnessed a drift in perspective, signaling that ‘aid works’. Panel-based
empirical studies10 have yielded evidence supporting the hypothesis of a
positive aid effect on growth (Dalgaard, Hansen, & Tarp, 2004). The argument is far from conclusive; nevertheless, the idea that aid is universally
effective is unfounded. For instance, while micro-based evaluations (Cassen & Associates, 1986) affrm the premise that ‘aid works’ in most scenarios, macro-based analyses have yielded largely equivocal outcomes, often
fnding no signifcant aid effects on growth. Mosley (1986) terms the given
dichotomy ‘the micro-macro paradox’. Dalgaard and Hansen (2001), however, attempts to resolve the paradox by estimating aggregate or macro
returns on aid, in comparison to estimates of micro returns on individual
investment projects. Aid investment productivity exceeds domestic investment productivity in relative terms. The evident disparity in fndings has
been ascribed to a number of factors, including the distribution and quality of data found, sample size used, econometric methodologies employed,
and the model of growth adopted (Doucouliagos & Paldam, 2009). Many
inquires into the aid–growth framework either predate or fail to capture
newer developments in growth theory. Many of these dated studies correlate negative growth with aid fows, without taking into account the direction of causation, the overall system of variables determining growth, or the
aid counterfactuals (Addison, Morrissey, & Tarp, 2017). Thus, ‘aid’ must be
incorporated into a system of robust growth specifcations if it is to yield
any determinative effects on growth (Doucouliagos & Paldam, 2009).
In the theoretical purview, the idea that aid yields ambiguous effects
on growth is easily shown, as observed by Burnside and Dollar (2000). In
a standardized neoclassical growth framework, steady-state effects are
explained to depend not only on the type and amount of aid but also on
how effciently aid is used by the recipient economy and the kinds of distortions it incites, if any (Karras, 2006). Employing a similar growth specifcation, Obstfeld (1999) explains that a country’s output, or steady-state capital
stock, remains unaffected by lump-sum external aid; the latter only speeds
150 Matthew Kof Ocran et al.
up the adjustment to a steady state. For aid to yield nonzero steady-state
effects on output, however, Obstfeld (1999) suggests making modifcations
to the model. One such modifcation is espoused by Dalgaard et al. (2004),
where the theoretical ambiguity of the aid effect on steady-state capital or
output is affrmed in a simple overlapping-generations model. Clearly, the
uncertainty surrounding the aid–growth relationship is resolvable only
empirically, and as indicated earlier, an empirical consensus seems to be
emerging in recent years. For instance, the notion that aid is largely ineffective (as earlier empirical studies suggest) is qualifed in the seminal paper by
Burnside and Dollar (2000), who argue that aid, when combined with good
trade, fscal, and monetary policies, could have positive effects on growth.
In support, Holmgren, Kasekende, Atingi-Ego, and Ddamulira (1999) show
that in the scenario of structural reforms and sound policies, aid has a strong
positive effect on a country’s economic growth outcome. Real-world evidence of the given perspective is refected in the experiences of Ghana and
Uganda. During the 1980s, when many developing countries pursued economic reforms to rehabilitate their striving economies, Ghana and Uganda
were the most successful reformers and prominent aid recipients as well. In
that era, macroeconomic indicators had plummeted distressingly, the culprit
being gross economic mismanagement, exacerbated by civil war in Uganda
(Rodrik, 1998). Grappling with severe economic diffculties, both economies
recovered with continual growth, in the face of exponential increases in aid
infows from both bilateral sources and multilateral sources (Tsikata, 1999;
Holmgren et al., 1999; Aryeetey & Tarp, 2000).
Montinola (2010) employing data on 67 developing countries, however, observes that although aid promotes fscal reform, the given impact
is more pronounced in democratic economies, where the positive effect
of aid on reforms rises with higher levels of democracy. Hansen and Tarp
(2001), Dalgaard and Hansen (2001), and Jensen and Paldam (2003), however, present evidence suggesting that aid could have positive effects even
in countries fraught with unfavorable policy environments. Thus, a positive
impact of aid on growth does not depend on optimal policies, as prescribed
by studies such as those by Burnside and Dollar (2000), Collier and Dollar
(2002), and McGillivray, Feeny, Hermes, and Lensink (2006). A few studies
also affrm that aid is ineffective at increasing economic performance, such
as those byGriffn (1970), Griffn and Enos (1970), Weisskopf (1972), Easterly
(2003), Easterly (2007a, 2007b) and Rajan and Subramanian (2008). Here aid
is believed to have the following characteristics (Alemu & Lee, 2015):
1 It is fully exhausted.
2 It substitutes rather than complements domestic resources in the
receiving country.
3 It interferes with domestic income distribution.
4 It incites the import of unimportant technology.
5 It generates greater ineffciencies and corruption in the governments
of developing countries.
Knack (2004) and Brautigam and Knack (2004) assert that, aid may actually worsen the effcacy of democratic institutions. Thus, large infusions of
Chapter 6 • Foreign aid and economic development 151
aid maybe undesirable. Another strand of literature – by Mosley (1980) and
Mosley, Hudson, and Horrell (1987) – suggests that aid has had no impact
on economic performance and growth.
6.5.2 Aid and poverty
The developing world is signifcantly mired in chronic poverty, even after
nearly six decades of continual aid infows. Currently, more than half of the
world’s population subsists on less than USD2 a day, with limited access
to good sanitary conditions; an approximate half of these estimated three
billion people are in abject poverty, subsisting on less than UDS1 a day, and
lacking access to potable water (Azam, Haseeb, & Samsudin, 2016). In subSaharan Africa, for instance, the extreme poor have persistently accounted
for about 41% to 48% of the population, (Barrett, 2008). The controversies
surrounding the effcacy of aid have been partly substantiated by these
astounding fgures, as the principal objective of most external aid fows
(particularly into the developing regions of the world) have been inclined
towards poverty alleviation and growth. The original aid-development
theory was premised on the hypothesis that aid infows into developing
economies serve to relax the capital and investment constraints characteristic of countries in these regions. Aid, thus, enables these economies to
reach their optimal or steady-state growth levels faster than they would
otherwise. The continual growth creates avenues for continued poverty
reduction (Ravallion & Chen, 1997). There is the possibility, however, of
aid’s spurring growth without its necessarily translating into declining levels of poverty (Fosu, 2017). The alternate scenario is possible too, where
aid could augment the standards of living of a given population (as poverty declines) but with no meaningful impact on the overall growth of the
economy (Arvin & Barillas, 2002).
That notwithstanding, there is a seeming swing in the focus of the
international development community in recent times, where poverty
alleviation is emphasized, as opposed to growth, in the economic development discourse (Asra, Estrada, Kim, & Quibria, 2005). For most donors
now, growth in the developing world is valuable only if it can be construed
as favorable to the poor (Mosley, Hudson, & Verschoor, 2004). Sachs and
McArthur (2001) show that aid is effective at mitigating poverty and can
translate into growth and development. Connors (2012) indicates that aid’s
overarching objective of poverty reduction has good prospects of fueling economic growth and enhancing institutional reform, in addition to
its fundamental goal of poverty mitigation. Riddell (2014) argues that aid,
where extended directly or indirectly, could be instrumental in improving the lives of the people who are in most need of it. This contemporary
perspective was well refected in the UN’s Millennium Development Goals
(MDGs) and the sustainable development goals (SDGs). The World Bank,
for instance, envisages a world devoid of poverty – an overarching view
shared by its regional extensions, comprising the African Development
Bank, the Asian Development Bank, the Inter-American Development
Bank, and the International Monetary Fund (IMF). After the inception of
152 Matthew Kof Ocran et al.
the MDGs, some signifcant reductions in poverty have been recorded in
some developing countries. In 2014, for instance, about 74 countries met
the target of halving their poverty rates. Specifcally, the global proportion of extreme poverty dropped from 47% in 1990 to 22% in 2014, and the
number of extremely poor people decreased from 1.92 billion in 1990 to
1.01 billion in 2010 (Wells, 2015).
However, a noteworthy fraction of aid recipients presents limited
evidence of economic development: poverty reduction, declining rates of
unemployment, and stable income growth (Azam et al., 2016). Evidence
suggests that rising external aid infows into these developing countries
have been accompanied by increasing poverty and unemployment (Oduor
& Khainga, 2009). In Africa, for example, over USD450 billion in external
aid has been extended since the 1960s – commensurate to about six Marshall
Plans – and yet they have yielded negligible outcomes in alleviating poverty
(Sachs & Ayittey, 2009). Notwithstanding the positives of the MDGs, nearly
one in fve people still survives on less than USD1.25 a day in developing
countries, often fraught with vulnerable and politically fragile economic
environments (Wells, 2015). These statistics quite validate the fact that the
issue of extreme poverty has barely been surmounted. The Organization
for Economic Cooperation and Development’s (OECD) review of the aid
impact on economic development over a period of 25 years indicates that
external aid has provided a minimal measurable contribution to mitigating
extreme poverty, especially in the world’s rural regions (OECD, 1985). This
was ascribed to the fact that external aid is often directed at countries dealing with highly challenging and intractable economic diffculties, including
emergency conditions arising from conficts, natural disasters, and refugee infuxes and not necessarily at countries with high investment returns
or prospects. In a similar vein, Connors (2012) discloses that, in practice,
external aid has been largely ineffective at reducing poverty or occasioning market-based improvements in developing regions. Sachs and Ayittey
(2009), therefore, stress the need to view aid as a supplement to market-led
development and not as a substitute for the forces of supply and demand,
especially in poor economies lacking in income, infrastructure, and creditworthiness. Ijaiya and Ijaiya (2004), in examining the aid–poverty relationship on a cross-country sample of sub-Saharan African economies, fnd no
signifcant impact from aid on poverty reduction. The low income levels in
these countries are believed to be contingent on the weak macroeconomic
management condition in the region, as evidenced in the forms of bad governance, corruption, and political and economic instability. To improve
the effectiveness of aid, however, some donors have adopted a selectivity
arrangement, where aid agreements seemingly favor only those economies
whose policy environments are in some sense already acceptable (Mosley
et al., 2004).
It is quite diffcult, however, to directly examine the aid effect on
poverty across countries, as comparative cross-country data on poverty
over time are scarce (Gomanee, Morrissey, Mosley, & Verschoor, 2005).
Additionally, many poverty measures are income based, with limited
cross-country comparability. Some studies in the literature have adopted
Chapter 6 • Foreign aid and economic development 153
indirect approaches with variables that strongly correlate with poverty,
observing how they respond in the circumstance of aid. For instance,
Gomanee et al. (2005) tests the hypothesis that aid contributes to increasing aggregate welfare, measured by infant mortality and the human development index (HDI), in 104 recipient countries over the period 1980–2000.
The results show positive aid effects on the welfare indicators and even
greater effects in low-income economies. Asra et al. (2005), however, obtain
regression outcomes suggesting that on average, aid has been effective at
mitigating poverty, under a variety of settings (in terms of both the policy
atmosphere and the quality of governance), in an assortment of developing countries. Quite uncommonly, their study adopts poverty reduction
as the metric for measuring aid effectiveness, as opposed to growth, in a
panel model framework. The fndings signal the effectiveness of aid when
it is relatively moderate, and an eventual decline in aid effectiveness when
the volume of aid surpasses the critical value specifed by the absorptive
capacity of the country. Collier and Dollar (2002) compare actual aid allocations to estimated poverty-effcient aid allocations, derived using the
headcount, poverty-gap, and squared poverty-gap measures of poverty,
to ascertain the allocation of aid that has maximum poverty-reducing
effects. This optimal allocation depends on the quality of policies and the
level of poverty. Collier and Dollar (2002) observe a disparity between the
poverty-effcient allocation of aid and actual aid allocations. With respect
to the countries studied, present (actual) aid allocations are observed to
move an approximate ten million people out of poverty, annually. In the
circumstance of poverty-effcient aid allocations, however, impacts such
allocation are projected to be twice as effective. Sachs and Ayittey (2009),
nevertheless, staunchly believe that developing regions, especially Africa,
do not need foreign aid to assuage their economic diffculties, because,
evidently, these regions have had minimal successes with aid-led development. To these authors, the idea of pumping more external aid into
developing countries needs to be crucially reassessed. The plausibility of
aid generating palpable declines in poverty is largely contingent on which
meaningful reforms accompany the given aid infow. A more auspicious
mechanism to ensure the effectiveness of aid would be one that empowers
economic agents at the micro level (i.e. civil society and community-based
groups) to monitor aid infows and engender reform from within (Sachs
& Ayittey, 2009).
6.5.3 Aid and domestic resource mobilization
Increasingly, domestic resource mobilization (DRM) is rightly becoming a
development instrument for generating resources to fund long-term and
inclusive economic development efforts. This is because the dwindling and
the unpredictability of development assistance or aid in recent times mean
that countries in developing countries must look inward for resources to
support their economies. The surest way, therefore, for developing countries to reduce aid dependency cycle is to develop their respective capacities to mobilize enough domestic resources to fnance public goods and
154 Matthew Kof Ocran et al.
other developmental needs. Thus, developing countries must increase the
amount of their own funds available for development fnance (i.e. DRM),
in particular by increasing tax revenues. This remains a major challenge for
low-income countries (LICs), where revenue/GDP ratios are signifcantly
lower than those in developed countries, largely because of weak tax efforts,
weak tax administrations, and low taxpayer morale, corruption, and poor
governance (OECD, 2014).
The key question, however, is whether LICs dependent on aid will
encourage or discourage their tax efforts and thus have any infuence on
domestic revenue mobilization. While there is no straightforward answer to
this question, theory shows that although there are many ways that aid can
have indirect effects on tax revenue, the direct effects arise because aid and
tax are alternative sources of revenue and political economy factors infuence the choices made by governments (Morrissey, 2015).
In general, the theoretical literature outlines three channels in which
aid may have effects on tax revenue. First, aid can have indirect effects on
revenues in that aid has macroeconomic effects and in that tax revenues are
affected by macroeconomic performance. For example, if aid is effective in
supporting growth, then revenue should increase in line with an expanding
tax base (indicating growth-enhanced tax revenue or the buoyancy of the
tax system). Second, aid may have direct effects on fscal revenues in that
most aid fnances public goods and services, and therefore, it may substitute
for efforts to raise tax revenue or, for a given level of tax, support a higher
level of government spending. In this view, such direct effects relate to the
amount of aid relative to the level of taxation. Third, technical advice on
policy reforms and conditionalities associated with aid that underlines the
broader donor–recipient relationship can affect tax revenue. This viewpoint
contends that providing support for tax administration or policy reform
may increase revenue; however, other policy reforms, such as tariff reductions as part of trade reforms, may reduce revenue, at least in the short term
(Morrissey, 2015).
Although some empirical studies (Osei, Morrissey, & Lloyd, 2005;
Moore, 2014; Ahlerup Baskaran, & Bigsten, 2015) have found that grants
or aid were associated with increased tax revenue through tax reforms that
reduce the bureaucratic costs of taxation, others (such as Gupta, Clemens,
Pivovarsky, & Tiongson, 2004; Carter, 2013; Benedek, Crivelli, Gupta, &
Muthoora, 2012) have empirically found that aid reduces tax efforts and tax
revenues, largely because it increases pervasive incentives. However, Morrissey (2015) argues that this negative effect of aid on tax efforts is because
developing countries often receive aid or grants not because they have a low
tax base and relatively low revenue but because they are poor – hence the
observed correlation between high aid and low tax. According to this viewpoint, theoretical considerations show that any effect of aid on tax refects a
revenue choice that will vary across countries depending on political economy factors.
Expanding on the previous point, Morrissey (2015) observes that the
effect of aid on tax varies from one country to another, which depends on
Chapter 6 • Foreign aid and economic development 155
the nature of political economy that pertains in the country. For example,
Morrissey and Torrance (2015) contend that the effect depends on how a
government values autonomy, accountability, and bureaucratic costs associated with aid as well as administrative costs of tax reforms. In this regard,
a government that values autonomy and wants to be less dependent on
aid will choose more tax effort. This is because the requirements of being
accountable to donors and negotiating conditionality reduce the autonomy
of aid recipients by limiting their policy discretion; even limited conditionality is a constraint on policy action (if only because effort has to be expended
to avoid or circumvent the conditions) (Morrissey, 2015). Governments can
therefore be expected to prefer greater autonomy and reduce ‘donor capture’ by taking steps to reduce aid dependency. Moreover, Altincekic and
Bearce (2014) argue that because aid is subject to conditionality and is less
fungible than oil resource revenues in particular, governments are more
likely to raise domestic resource revenues than aid if they want control over
how revenues are managed.
The literature seems to suggest that there is an aid Laffer curve. Lensink and White (2001), comparing aid fows in the 1990s with those from the
1970s, make clear that there are now many more countries receiving what
may be termed ‘high aid’ (in excess of 30% of GNP) and that a group of countries that receive very high aid has emerged. In their view, such high aid
may do more harm than good, a notion which they captured as an aid Laffer
curve. Their elaborate empirical paper also presents an endogenous growth
model, which exhibits negative returns to aid at high aid levels and offers
some additional reasons why such a phenomenon may exist. Their result
is quite similar and consistent with a conclusion reached by Griffn (1970),
who argued that aid would reduce the productivity of investment such that
if this effect were suffciently large, then aid would reduce growth. The difference here is that unlike the Lesinki and White model, Griffn (1970) suggest a general nonlinear relationship between aid and growth. According
to them, the diminishing returns to aid-fnanced government expenditure
in the production function means that the negative effect becomes present
only after some threshold value has been surpassed. Box 6.1 contains more
about the Lensink and White aid Laffer curve.
BOX 6.1 The aid Laffer curve
Lensink and White (2001) explored the possibility that aid may
not have merely decreasing returns (a proposition that everyone
would surely accept) but that after a certain level the returns to
further aid inflows are negative. The idea that a country can get
‘too much aid’ can be shown by an aid Laffer curve (see Figure 6.3).
The horizontal axis measures aid and the vertical beneficial effects.
The curve is an inverted U; that is, after a certain threshold, more
156 Matthew Kof Ocran et al.
FIGURE 6.3 The aid Laffer curve
Beneÿcal
effects
Aid
Source: Lensink and White (2001)
aid is detrimental rather than beneficial, so the country would be
better off with less aid.
The paper begins by illustrating that the number of countries receiving high aid infows (measured in relation to either their GNP or their
population) has increased over time and draws the following conclusion:
some countries are now quite clearly ‘very high aid recipients’, which was not so clear in the 1970s. Is all this aid a good
thing? More specifcally, is it possible that there is a point at
which a country would be better off with less aid rather than
more? That this may be so is a notion we embody in the aid
Laffer curve. Moreover, both the incorporation of aid fows
into an endogenous growth model, and an examination of existing literature on aid effectiveness, give grounds for thinking
that mechanisms may well exist which would cause an aid
Laffer curve to be observed in practice. Our empirical estimation bears this out. The policy conclusions of our analysis may
seem very clear: place a ceiling at aid around the top of the
aid Laffer curve. Any country receiving more should lose this
excess, which should be redistributed to countries in which
aid will be effective. However, while we have sympathy with
this conclusion, we would urge some caution in that attention
should also be paid to special circumstances (e.g. short periods
of high emergency aid or debt relief), the type of aid, and the
possibilities of increasing aid effectiveness at all levels of aid.
Lensink and White (2001)
According to most multilateral donor agencies, such as the World
Bank and the IMF, the revenue generation potential in LICs, such as in some
Chapter 6 • Foreign aid and economic development 157
countries in Africa, has not been suffciently tapped by revenue authorities, which explains their overreliance on aid. Not only have these donors
directly provided technical assistance, but also their consultation missions
have issued several country assessment reports and recommended measures such as tax policy reforms, revenue administration measures, spending controls, and improved cash management, all aimed at improving the
countries’ respectively capacities to collect eligible taxes to fnance their
respective national budgets. In June 2012, the IMF Fiscal Affairs Department (FAD), which assessed the implementation status of tax administration reforms in Ghana, made several recommendations: modernization of
governance, policy and program designs and monitoring, taxpayer selfassessment, and compliance management.
In sum, although the effect of development assistance on long-term
domestic revenue mobilization is uncertain, there is now a consensus that
that aid must also be aimed at supporting the recipient country’s domestic
tax mobilization effort. And continued reliance on aid in the long term may
have negative repercussions on DRM (IMF, 2011).
6.5.4 Aid uncertainties and conditionalities
While much of the aid-effectiveness literature has focused on the aid–
growth relationship, recent studies have pointed out that the relationship is not straightforward and that the potency of aid in driving growth
to a large extent depends on how stable or predictable aid is. Lensink
and Morrissey (2000) posit that it is not the level of aid fows per se but
rather the stability of such fows that determines the impact of aid on
economic growth. They point out that such uncertainty in aid fow infuences the relationship between aid and investment; infuences how recipient governments respond to aid; and therefore infuences how aid affects
growth. Estimating a standard cross-country growth regression, including
accounting for the level of aid and aid uncertainty (which is negative and
signifcant), they fnd that aid has a signifcant positive effect on growth.
This suggests that aid will only positively infuence growth and will be
effective if it is stable.
While evidence in support of the negative effect of unpredictability of
aid on aid management by recipient countries is overwhelming, few studies have also argued that such a signifcant share of such unpredictability patterns can be associated with factors that are close proxies for major
changes in a country’s environment and therefore justify, if not necessitate,
some degree of unpredictability in donor behavior. For example, Celasun
and Walliser (2007) argue that while low predictability always results from
donors’ not delivering on their original promises (i.e. the ‘donors never live
up to their commitments’ view) country conditions that need to prevail for
aid to be used effectively also explain the extent of unpredictability and
explain why fckle donor behavior may be just one cause of commitment
deviations or projection deviations from actual outcomes.
The changing conditionalities attached to aid also matter. Montinola
(2010), defning ‘aid conditionality’ as the setting of policy goals in exchange
158 Matthew Kof Ocran et al.
for access to aid, investigates whether aid conditionality promotes reform
and whether the recipient regime type matters. Focusing on the impact of
IMF and World Bank aid on fscal reform in 68 countries, he argues that
conditional aid is effective but that its effcacy depends on recipient countries’ level of democracy. This is because the value of aid to governments
depends on the degree to which it helps them maintain power, and recent
work shows that the marginal impact of aid on political survival increases
with the level of democracy (Montinola (2010).
Aid conditionality may not necessarily result in policy reforms because
governments are often unwilling to carry out the required policy changes –
because they view the conditions to be inappropriate or fear that the reforms
may endanger the political support they get from society (Hermes & Lensink, 2001). In most cases, recipient governments agree on adhering to the
conditions ex ante to obtain the fnancial aid without really supporting the
contents of these programs. According to Hermes and Lensink (2001), this is
the result of the fact that the contents are being set by World Bank representatives or donors without the active involvement of recipient governments
and civil society, so these governments do not own the reforms. Box 6.2 contains the other causes for the nonimplementation of conditionality or why it
may not infuence reforms suggested in the literature.
BOX 6.2 Aid, conditionality, and good governance
Aid conditionality has been the normal practice for the past decades.
Bilateral as well as multilateral donors aim at achieving specifc objectives and outcomes when giving aid. The idea is that setting conditions related to the disbursement of aid should provide incentives to
the recipient government to stimulate them to take actions or to carry
out policies that increase the probability of obtaining these objectives
and outcomes. In other words, conditionality should help to increase
the effectiveness of giving aid. Yet conditionality has been disputed.
Especially since the early 1980s, when the IMF and World Bank started
to provide structural adjustment loans conditional on changes in government policies, conditionality has come under scrutiny, largely
because the outcomes of the structural lending programs were rather
disappointing and, according to some observers, even harmful to economic development. The initial reaction of the IMF and World Bank
to the lack of success of conditionality was to increase the number of
conditions in the program and to shorten the period over which the
program was to be executed and evaluated.
The aim of such a redefnition of conditions was to further stimulate recipient governments to carry out the required reforms. Yet the
results of policy reforms remained bleak in most cases. Most observers
do not criticize the principle of imposing conditions on aid as such.
What they criticize is the nature of the conditions imposed on recipient
governments and the way donors decide on selecting these conditions
Chapter 6 • Foreign aid and economic development 159
(Killick, 1996, 1997; Hermes & Schilder, 1997; White & Morrissey, 1997;
Dijkstra, 1999). Several critics point out that the main reason for the
failure of aid to be effective is that recipient governments in practice
do not adhere to the conditions.
One of the main causes for the nonimplementation of conditionality suggested in the literature is that failure is only rarely penalized, for instance by suspending or even stopping aid disbursements.
Donors have their own incentives to continue disbursing aid, even
when reforms have not been carried out. For instance, donors may feel
pressured to give aid to prevent further macroeconomic deterioration
or defaults on loans and debt services. Moreover, inappropriate incentives to staff of donor organizations may reward high funding levels or
punish nondisbursement by reducing next year’s budgets. Such incentives reduce the donors’ credibility and will undermine the incentives
of recipient governments to implement policies.
Hermes and Lensink (2001)
6.5.5 Aid and corruption
Another issue that has engaged the attention of researchers and donor community is whether aid fuels the incidence of corruption in aid-recipient
countries.11 This question remains relevant in development economics discourse because, despite a large body of writings that has emerged on the
corrosive effect of corruption that undermines the effectiveness of aid, the
empirical literature is inconclusive, and the direction of causation remains
unresolved. Anecdotal evidence from available cross-country data appears
to suggest that LICs that have received the most aid had scores that are way
lower on the transparency international corruption perception index than
those countries receiving less aid. A cursory look at Figure 6.4 in Box 6.3
appears to support this point.
BOX 6.3 Global 2017 CPI score and ranking
The corruption perception index (CPI) – which orders 180 countries
and territories by their apparent levels of public sector corruption
according to knowledgeable people and people in commerce with
the aid and scores using a 0 to 100 scale, where 0 denotes highly corrupt and 100 clean – suggests that corruption is highly associated with
poverty-stricken and underdeveloped countries, most of which are
recipients of large amounts of aid. Figure 6.4 indicates that over 90%
of countries in sub-Saharan Africa are ranked above 80 or higher in the
global CPI ranking of countries.
160 Matthew Kof Ocran et al.
FIGURE 6.4 Global 2017 CPI score and ranking
2017 Ranking
CPI Score
178
57
41
85
16
NZL
SGP
GBR
AUT
EST
BTN
TWN
POL
VCT
GEO
KOR
SVK
ROU
HUN
BGR
TUN
GHA
BEN
ALB
BRA
THA
TZA
PHL
NER
TGO
MWI
IRN
HND
PRY
LBN
NIC
CAF
KHM
ERI
PRK
YEM
200
89
180
160
140
120
100
80
60
40
20
0
100
90
80
70
60
50
40
30
20
10
0
Source: Authors’ creation, on the basis of data from Transparency International
Morrissey (2015) contends that although the question whether aid
affects corruption is not easy to address, donor technical support and institutional interventions for monitoring tax and public expenditure are intended
to reduce corruption in public fnance but may be most effective for aid
funds. The study further posits that aid may lessen corruption on the basis
that aid is least attractive for corrupt people, because it is subject to greater
monitoring by donors; corruption involving donor funds is more likely to
be observed and investigated. Furthermore, some study fndings have concluded that aid might beneft governance by reducing corruption as it might
not only possibly help recipient countries implement far-reaching institutional reforms but also help increase the salaries of civil servants (Alesina &
Weder, 2002; Tavares, 2003; Charron, 2011).
Providing empirical insights into the impact of foreign aid on corruption levels in SSA countries, Mohamed, Kaliappan, Ismail, and Azman-Saini
(2015) support this standpoint by concluding that foreign aid reduces the
corruption levels of SSA countries. According to them, although aid from
different bilateral sources has different effects on corruption, the effect is
likely to be greater in nations that experience a higher level of corruption.
On the contrary, while empirical studies such as that by De la Croix and
Delavallade (2014) suggest that aid infuences corruption in recipient countries, studies such as that by Mernard and Weill (2016) fnd no correlation
between aid and corruption.
Despite these fndings, recent review studies by Quibria (2017) point
out that the negative impact of aid on corruption appears to enjoy greater
support in recent literature because of the strong desire of the international
development community to improve the development impact of foreign
aid, and it has therefore taken a frm stance against corruption. This review
suggests that these measures have had a substantial impact on combatting corruption in aid-recipient countries. Key among some of these measures is performance-based lending, where the multilateral development
banks (MDBs), such as the World Bank, base their aid allocation in part on
Chapter 6 • Foreign aid and economic development 161
indicators of corruption. Bilateral donors, such as the Millennium Challenge
Corporation of the United States government, have made anticorruption
central to their aid-allocation process.
Another important measure that donors have adopted is improving
the transparency and accountability of recipients. In addition to addressing
their own accountability, bilateral and multilateral agencies have sought to
improve the transparency and accountability of recipients (Quibria, 2017).
These activities include support for creating anticorruption commissions,
building investigative and judicial institutions, implementing new public procurement systems, and improving public fnancial management
practices.
6.6 CONCLUSION
The considerable volume of foreign development assistance aimed at stimulating economic development, particularly in sub-Saharan Africa, has not
been entirely effective. Indeed, the aid-effectiveness literature reports mixed
results. The role of foreign aid in alleviating poverty and facilitating longterm growth has been largely disappointing over the past fve decades. We
provide a number of suggestions to go beyond aid. Here the argument is that
developing countries, and mostly those in sub-Saharan Africa, cannot continue to expect or rely on foreign assistance to engender economic growth
and development, given the dismal development outcomes over the past
fve decades. We suggest that countries re-double their efforts to mobilize
domestic resources to generate the capital required for funding investment.
The reality, though, is that domestic tax bases are often small because a considerable portion of the economies are outside the formal sector. The low
output and productivity of the informal sectors makes the cost of tax administration aimed at bringing the sector into the tax net quite exorbitant. Such
countries need to transform the informal sector into a formal sector. Innovative development fnance options that are increasingly becoming available need to be harnessed to generate funds to support domestic economic
development efforts. Institutional reforms and the creation of new and progressive institutions that support development ought to be encouraged as
well. The illicit outfow of capital from the developing world and renewed
efforts aimed at fghting corruption would all contribute to increasing the
pool of resources required to fund development.
Discussion questions
1 Discuss the argument for and
against aid given by developed
countries to developing countries.
Do you support the critics’ view
that aid has worsened poverty
levels of aid-recipient countries
rather than alleviated them?
2 Explain the arguments for and
against external aid. What policy
and implement reforms are relevant to an effcient aid package?
3 ‘Political and strategic considerations more than economic
development underlie donor’s aid
162 Matthew Kof Ocran et al.
4
5
6
7
allocation’. How valid is this statement in light of the effectiveness
of aid in developing countries?
Why does predictability matter in
aid effectiveness and growth?
To what extent has foreign aid
succeeded in assuaging the economic diffculties of the developing world?
In recent times, how has foreign aid fared in combatting the
twin challenges of low domestic savings and reduced foreign
exchange infows in developing
countries?
Some recent studies have indicated that aid works in a sound
macroeconomic
environment.
Discuss the economic conditions
needed for aid to thrive. Are
there any real-world examples of
countries that have experienced
palpable growth in the face of
aid, complemented by structural
reforms and sound policies?
8 Increasing external aid infows to
developing regions has not translated into declining poverty and
unemployment. What are some
possible reasons for the observed
situation?
9 What are the indicators of an
economy’s absorptive capacity,
which determines how much
aid is enough to yield effective
results? Is there a threshold after
which additional infows of aid
yield ineffective results?
10 Is there an amount of aid that
yields maximal poverty-reducing
effects? How do we ascertain this
threshold? Is it country specifc?
Notes
1 Although the loan component of
ODA is payable over time at favorable interest rates, which are often
considerably lower than market
rates, grants are not payable.
2 CARE – Cooperative for American Remittances to Europe, which
was later rechristened the Cooperative and Relief for People Everywhere – was formed in 1945 to
provide humanitarian assistance
to countries in postwar Europe. It
did not begin operations in Africa
until the 1960s.
3 OXFAM – Oxford Committee for
Famine Relief – was formed in
1942. Initially, the group focused
on mobilizing relief to support
starving women and children in
enemy-occupied Greece, which
was facing a British naval blockade during the war.
4 The top three recipients of US foreign aid are Afghanistan, Israel,
and Egypt. Afghanistan is the top
now because of the antiterrorism
5
6
7
8
war being fought in the country.
Historically, Israel and Egypt
have been the top recipients in
per capita terms, for US strategic
interests.
A recipient country of Chinese aid
cannot have a diplomatic relationship with Taiwan or recognize the
Dalai Lama as the spiritual leader
of the Tibetan people.
The number of Chinese workers
in Africa in 2014 was estimated
at 252,000 by offcial Chinese
sources, as quoted by the AfricaChinese Research Initiative.
Lamisi Solido, the one-time governor of the Nigerian central bank,
admonished African countries:
‘China is capable of the same forms
of exploitation as the West. . . . Africa
is now willingly opening itself up
to a new form of imperialism’.
Members include Australia, Austria, Belgium, Canada, the Czech
Republic, Denmark, European
Union, Finland, France, Germany,
Chapter 6 • Foreign aid and economic development 163
Greece, Hungary, Iceland, Ireland,
Italy, Japan, Korea, Luxembourg,
the Netherlands, New Zealand,
Norway, Portugal, Slovenia, Sweden, Switzerland, the United Kingdom, and the United States.
9 The IDA is the development
fnance institution of the World
Bank that focuses on the poorest
countries of the world.
10 See Dowling and Hiemenz (1983),
Singh (1985), Levy (1988), Hadjimichael et al. (1995), Burnside
and Dollar (1997), Burnside and
Dollar (2000), and Hansen and
Tarp (2001).
11 Corruption may mean different
things to different people, organizations, and countries. Transparency International, a global
anticorruption coalition, defnes it
simply as ‘the abuse of entrusted
power for private gain’. The
World Bank, however, provides a
slightly more detailed defnition: a
form of deceit by people occupying positions of infuence, in an
effort to amass wealth.
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CHAPTER
7
Global fnancial
architecture
Emerging issues and agenda
for reforms
Joshua Yindenaba Abor, Angela Azumah Alu,
David Mathuva, and Joe Nellis
7.1 INTRODUCTION
In this chapter, we discuss the global economic and fnancial system and
the governance structure that facilitates the fow of external capital in it.
This is known as the global fnancial architecture or international fnancial
architecture. Global fnancial policies and international institutions are an
important part of this framework, which ensures the provision of development fnance.
The global fnancial architecture is the collective of governance arrangements at the global level for safeguarding the effective functioning (or the
stability) of the global fnancial system (Elson, 2010). It is the worldwide
framework of global economic and fnancial governance, including legal
agreements, institutions, and economic actors that work together to facilitate the international fows of capital for fnancing investments and trade. It
is composed of the Bretton Woods institutions, including the International
Monetary Fund (IMF), the World Bank Group, the World Trade Organization (WTO), the Bank for International Settlements (BIS), and the regional
development fnance institutions in developing and emerging countries.
It also involves those institutions and mechanisms that have evolved
with the responsibility of preventing, managing, and resolving fnancial
crises at the global level. The prevention and the management of fnancial
crises are signifcant parts of the global fnancial governance process and
for that matter the global fnancial architecture. Financial governance is a
key requirement for the provision of fnancial resources for development.
Issues regarding reforms of international institutions are also important in
the global fnancial architecture discourse.
In this chapter, we examine the institutions that make up the global
fnancial architecture. We frst discuss international fnancial institutions
and examine the evolution, structure, and functions of the various Bretton
170 Joshua Yindenaba Abor et al.
Woods institutions. We also examine other global fnancial institutions by
discussing their roles and challenges. Then, we look at fnancial globalisation, global crises, and reform issues regarding the global fnancial architecture. We also look briefy at the G7/G10 and G20 and the UN sustainable
development goals (SDGs).
7.2 INTERNATIONAL FINANCIAL INSTITUTIONS
International fnancial institutions (IFIs) are fnancial institutions that are
set up by two or more countries with the aim of fnancing the social and
economic development of different countries and promoting international
economic cooperation and stability. IFIs are involved in providing advice
on development projects, fnancing them, and assisting with the implementation of these projects.
IFIs are different from local fnancial institutions in one main respect:
IFIs have an international presence and are therefore subject to international law. IFIs include the IMF, the World Bank Group, and other multilateral fnance institutions, including multilateral development banks and
regional development banks (RDBs). Although RDBs are part of the multilateral fnancial institutions, they tend to focus on specifc regions of the
world. Whereas the Bretton Woods institutions have an international orientation, the RDBs tend to focus on a single or specifc region.
The multilateral fnancial institutions are seen as mainly multilateral
development fnance institutions (DFIs), and the regional development
banks are regarded as regional DFIs. We frst discuss the Bretton Woods
institutions and then examine the other global DFIs, including multilateral
development banks, multilateral fnancial institutions, and the RDBs.
7.2.1 The Bretton Woods institutions
The Bretton Woods system emerged after 1944, when the UN Monetary and
Financial Conference took place in Bretton Woods, New Hampshire. After
the Second World War, the Bretton Woods system was established and
named after the New Hampshire town where they drew up the agreements.
This was with the aim of setting up an international economic and fnancial
system that would reduce instability (with respect to competitive currency
devaluation and trade restrictions) and support development. It established an international basis for which one currency could be exchanged for
another. Although the Bretton Woods system came into being following the
Great Depression and after the Second World War, it dealt with the global
challenges that started during the First World War, including trade restrictions, currency devaluation, defation, and the depression that characterised
the global economy of the 1930s.
The process also led to the establishment of the three Bretton Woods
institutions by representatives of the 44 countries. Bretton Woods institutions
included the IMF, the International Bank for Reconstruction and Development (IBRD) (now the World Bank), and the General Agreement on Trade
and Tariffs (GATT), which metamorphosed into the WTO. Two economists,
Chapter 7 • Global fnancial architecture 171
John Maynard Keynes from the United Kingdom and Harry Dexter White
from the United States, played critical roles in the negotiations and process
of establishing these institutions. The US and the UK were therefore the
key stakeholders in these negotiations. Each of these institutions was tasked
to perform specifc functions under the new global economic and fnancial
governance system. The IMF was established with the objective of monitoring foreign exchange rates and providing lending on reserve currencies to
countries with trade defcits. The IBRD (now World Bank) was supposed
to provide underdeveloped countries with the required capital, while the
GATT (now WTO) was established to focus on international economic
cooperation. Over the years, the roles of these institutions have changed,
and we discuss these developments later.
The IMF, which has its
headquarters in Washington, DC, was established in 1945 with the intent of
creating a stable environment for international trade. This was to be achieved
by coordinating member countries’ monetary policies and ensuring stability
in exchange rates. The fund’s role in ensuring exchange rate stability involved
setting a fxed exchange rate system that had other currencies pegged to the
US dollar, which was also pegged to gold at USD35 per troy ounce. The IMF
was therefore required to offer short-term fnancial support to countries that
had diffculties with their balance of payment (BOP). The IMF came into formal existence on 27 December 1945, when 29 countries signed its Articles of
Agreement. Member countries were supposed to contribute funds through a
quota system to fnance the IMF’s activities, and the size of the quota assigned
to each country was based on the country’s gross domestic product (GDP).
The quota for each country determined how much IMF fnancing it could
access in addition to its voting rights in the fund. Member countries had 250
‘basic votes’, each in addition to one more vote for each USD100,000 of quota
(later changed to 100,000 special drawing rights [SDRs]). The allocation of the
basic votes was intended for ensuring that smaller member countries had a
say in the fund’s decision-making processes (Spratt, 2009).
The board of governors currently govern the IMF and is made up
of one governor and one alternate governor, representing their respective
member countries. Two important committees (the International Monetary
and Financial Committee and the Development Committee) advise the
board of governors. The International Monetary and Financial Committee,
which has a membership of 24, is in charge of monitoring developments
with respect to global liquidity and the transfer of resources to developing countries. The Development Committee has a membership of 25 and a
mandate of advising on critical development matters and providing recommendations on fnancial resources needed for promoting economic development in developing countries. It also has the responsibility of advising on
issues regarding trade and environment.
The IMF has a managing director who serves as the head of the staff
and as the chair of the 24-member executive board. The managing director
has a number of deputies, including the frst deputy-managing director and
three other deputy-managing directors.
7.2.1.1 INTERNATIONAL MONETARY FUND (IMF)
172 Joshua Yindenaba Abor et al.
The IMF is accountable to the 189 member countries. It currently has
31 Articles of Agreement covering a range of issues: purposes, membership,
quotas and subscriptions, obligations regarding exchange arrangements,
operations and transaction of the fund, capital transfers, the general obligations of members, organisation and management, SDRs, the withdrawal
from membership, emergency provisions, and amendments. Since its establishment in 1945, the Articles of Agreement have gone through a series of
revisions. However, Article I, which mentions the purposes of the IMF, has
not been changed and includes the following objectives:1
1. To promote international monetary cooperation through a permanent
institution that provides the machinery for consultation and collaboration on international monetary problems.
2. To facilitate the expansion and balanced growth of international trade
and to contribute thereby to the promotion and maintenance of high
levels of employment and real income and to the development of the
productive resources of all members as primary objectives of economic policy.
3. To promote exchange stability, to maintain orderly exchange
arrangements among members, and to avoid competitive exchange
depreciation.
4. To assist in the establishment of a multilateral system of payments in
respect to current transactions between members and in the elimination of foreign exchange restrictions, which hamper the growth of
world trade.
5. To give confdence to members by making the general resources of the
fund temporarily available to them under adequate safeguards, thus
providing them with opportunity to correct maladjustments in their
balance of payments without their resorting to measures destructive
to national or international prosperity.
6. In accordance with the foregoing objectives, to shorten the duration
and lessen the degree of disequilibrium in members’ international
balances of payments.
FIGURE 7.1 Representation of Article 1 of the IMF
(I) To promote internaonal monetary
cooperaon through a permanent
instuon which provides the machinery
for consultaon and collaboraon on
internaonal monetary problems.
(II) To facilitate the expansion and
balanced growth of internaonal trade,
and to contribute thereby to the
promoon and maintenance of high levels
of employment and real income and to
the development of the producve
resources of all members as primary
objecves of economic policy.
(III)To promote exchange stability, to
maintain orderly exchange arrangements
among members, and to avoid
compeve exchange depreciaon.
(IV) To assist in the establishment of a
mullateral system of payments in
respect of current transacons between
members and in the eliminaon of foreign
exchange restricons, which hamper the
growth of world trade.
(V) To give confdence to members by
making the general resources of the Fund
temporarily available to them under
adequate safeguards, thus providing them
with opportunity to correct
maladjustments in their balance of
payments without resorng to measures
destrucve of naonal or internaonal
prosperity.
(VI) In accordance with the above, to
shorten the duraon and lessen the
degree of disequilibrium in the
internaonal balances of payments of
members.
Source: Authors’ construction
Chapter 7 • Global fnancial architecture 173
The IMF’s role has evolved over time. At the time of its establishment,
it focused on ensuring that the fxed exchange rate system introduced by
the Bretton Woods system was maintained to facilitate international trade.
After the breakdown of the fxed exchange rate regime in the early 1970s,
fresh justifcation needed to be made for the continuous existence of the
IMF.
The IMF metamorphosed into an organization charged with managing BOP problems and global fnancial crises. It contributes to improving
the economies of member countries through such activities as surveying,
gathering statistics and analysis, surveilling members’ economic and fnancial performance, and demanding particular policies. The IMF’s surveillance
entails overseeing the global monetary and fnancial system and monitoring
the economic and fnancial policies of the member countries. It also focuses
on providing technical assistance and training for countries, upon request.
The IMF also serves as a ‘lender of last resort’ when a borrowing country has exhausted all other funding sources. The assistance given by the
IMF usually proceeds in stages. There is an initial stopgap loan with strict
rules, infamously known as an IMF conditionalities After that, consultations
decide on what fscal and monetary policies the country must follow. The
IMF usually advocates for the removal of state subsidies, the privatisation of
state industries, the liberalisation of trade and foreign investment policies,
reforms in the banking sector, and reforms in the tax laws of the country. In
its assessment, the IMF notes the country’s trade balance, current account
balance, real domestic demand, consumer price levels, and real GNP or
GDP. For instance, as discussed in some detail in Box 7.1, Ghana entered
into an IMF programme involving a three-year USD918 million extended
credit facility (ECF) from the IMF in April 2015.
BOX 7.1 IMF three-year extended credit facility to Ghana
In April 2015, Ghana received approval from the IMF for a three-year
USD918 million extended credit facility (ECF) to support a reform
programme with the aim of restoring Ghana’s debt sustainability and
macroeconomic stability, in order to promote faster growth and job
creation and at the same time to protect social spending. Before signing up to the IMF programme, the government of Ghana had, since
2013, pursued a fscal consolidation drive but experienced several
imbalances in fscal and external positions, resulting in consistent
declines in growth. The IMF programme was needed to stabilise the
economy following the worsening growth and developmental challenges. On the basis of the agreement reached with the IMF, Ghana’s
economy was expected to receive the credit facility, to be disbursed in
eight tranches. To begin with, the IMF’s executive board approved the
disbursement of the frst tranche of about USD114.8 million.
To achieve fscal consolidation that could promote high
growth and development, the IMF recommended strictly containing
174 Joshua Yindenaba Abor et al.
expenditure on wage bills and subsidies. The government needed to
mobilise more revenue in order to create additional social spending
space and investment in infrastructure (particularly in the energy sector). It also needed to adopt a prudent borrowing strategy to ensure
that debt is secured at the lowest possible cost.
On the basis of the third review of the programme, the executive
board approved USD116.2 million, which brought the total disbursement under the programme to USD464.6 million. In the course of the
review, adjustments were made to the programme to ensure that the
economy would stay on track and to enhance its prospects for success. This involved the executive board’s granting waivers, including
minor deviations in a few programme targets. The IMF’s assessment
of Ghana’s implementation of the ECF remained broadly satisfactory,
but the economic outlook remained discouraging. Progress had been
made in stabilising the macroeconomic situation and reducing fnancial imbalances, but the fscal risks had increased.
The IMF again approved a further disbursement of USD94.2 million after the fourth review, bringing the total disbursements under the
programme to USD565.2 million, and the rest of the funds were tied to
the remaining reviews. The executive board also approved the country’s request to waivers of the nonobservance of performance criteria
and a further extension of the programme by another year, ending
in 2018. The IMF commended the new government for bringing the
programme back on track after the large fscal slippages in 2016. The
executive board, however, observed that the country was experiencing long-standing challenges, including exposure to external shocks,
budget rigidities, and economic ineffciencies, which intensifed the
impact of past policy slippages on domestic and external imbalances.
The board stressed that strong implementation of programme policies
and reforms are crucial to addressing the risks and securing macroeconomic stability. The board also cautioned the country regarding
programme implementation risks, given that it underperformed in its
revenue generation in the frst half of the year, and urged the authorities to promptly adopt the necessary corrective measures to preserve
the programme targets.
Source: www.imf.org/en/news 2015–2017
7.2.1.2 WORLD BANK The World Bank (originally consisting of only the
IBRD), was also created at the 1944 Bretton Woods Conference and then
became functional in 1946. It is headquartered in Washington, DC, and was
created with the goal of reducing poverty and providing loans to countries
for capital programmes. According to its Articles of Agreement, all decisions
of the World Bank need to be guided by a commitment to promote foreign
investment and international trade and need to facilitate capital investment.
Chapter 7 • Global fnancial architecture 175
The World Bank is currently made up of two institutions: the IBRD
and the International Development Association (IDA), which is the concessionary arm of the Bank. The IBRD and the IDA are collectively referred
to as the World Bank because they have the same leadership and staff.
The World Bank is also part of the World Bank Group, a constituent of the
United Nations system. However, unlike the UN General Assembly, which
operates a one member, one vote system, the Bretton Woods institutions are
designed as private entities, and the proportion of ‘shares’ that each member country holds translates into voting rights. When the World Bank was
set up, the US received 35.07% of the voting rights while the UK had 14.52%
(the two countries controlled about 50% of the voting rights in the World
Bank). As the number of shareholders increased, a dilution of the voting
power among the founding members ensued. However, due to the high
majority required for decisions to be passed (initially 80% but now 85%), the
US still has veto power and thus a frm grip on World Bank policy. Traditionally, the US nominates the president of the World Bank.
The World Bank Group is governed by the boards of governors and
is composed of one governor and one alternate governor representing each
member country. The boards of governors, which has been vested with all
powers, also delegates such powers to the boards of directors or executive
directors apart from those stated in the Articles of Agreement. The president of the group chairs the boards of directors, which currently consists of
25 executive directors. The president of the World Bank is also the president
of the World Bank Group, who chairs the board of directors. The president
is assisted by two executive vice-presidents, three senior vice-presidents,
and 24 vice-presidents.
The bank’s role has also evolved over time. From its initial aim to
reconstruct Western Europe, it shifted its focus to guaranteeing bond issues
from developing countries. Doing so with the aim of again facilitating private capital fows from advanced economies to developing ones, which
dipped signifcantly during the Great Depression and were eliminated during the Second World War. However, it became apparent that the private
sector was not interested in such investments, and in 1947, the bank decided
to change its focus to providing direct loans (Culpeper, 1997).
This necessitated the establishment of the International Finance Corporation (IFC) in 1956, with the mandate of lending to the private sector in
developing countries without government guarantees, thus complementing the World Bank’s lending efforts to governments. The revision of IFC’s
Charter in 1961 also permitted it to provide equity capital in addition to
other reforms in its structure and operations. We provide some detail of the
IFC in Box 7.2.
BOX 7.2 International Finance Corporation
The IFC was established in 1956 to represent the World Bank
Group’s private sector arm with the objective of advancing economic
176 Joshua Yindenaba Abor et al.
development through investment in commercially viable projects and
ventures in order to reduce poverty and promote development. It aims
to create an enabling environment for people to fee poverty by providing resources for private businesses. It’s headquartered in Washington, DC, and is considered the largest global development fnance
institution with a focus on providing support for private sectors in
developing economies. The IFC provides three main services: investment services, asset management services, and advisory services.
The idea of establishing the IFC was proposed by Robert L. Garner when the World Bank employed him in 1947 as a senior executive. He believed that private business had a signifcant role to play
in global development. Robert L. Garner and some of his colleagues
in 1950 mooted the idea of creating a new fnancial institution that
would focus on promoting private sector investments in the developing countries that the World Bank served. The US government supported this idea of a new international institution to work closely with
the World Bank to support investments in private enterprises without demanding government guarantees, without direct participating
in the management of these enterprises, and by collaborating with
other investors. In 1956, the IFC was offcially established and began
operations with Robert L. Garner as its frst leader. It made its frst
investment in 1957 by advancing a loan facility of USD2 million to an
affliate of Siemens & Haiske (Siemens AG), based in Brazil. It has subsequently increased its investments in many developing and emerging
countries.
The IFC has 184 member countries as its owners and is governed
by a board of governors, composed of one governor from member
country. Each member country is also expected to appoint one alternate governor in addition to the governor. The board of governors is
vested with all corporate powers, which in turn has delegated most of
such powers to a 25-member board of directors chaired by the president of the World Bank Group. The board of directors is responsible
for reviewing and making decisions on investments and providing
overall strategic direction to IFC’s executive leadership, made up of
the CEO of the IFC, the CEO of the Asset Management Company, and
nine vice-presidents.
The IFC’s core areas of operation include providing investment
services (consisting of equity, investment loans, syndicated loans,
trade fnance, structured and securitised fnance, treasury and liquidity management, and client risk management services), advisory services (supporting corporate decision-making with regard to business,
environment, social impact, and sustainability), and asset management, which is done through its wholly owned subsidiary, IFC Asset
Management Company. Since 2009, it has focused on some developmental projects that aim to improve education and health, increase
sustainability in agriculture, increase access to fnancing for micro and
Chapter 7 • Global fnancial architecture 177
small enterprises, help small businesses to grow revenues, invest in
climate health, and support infrastructure development.
The IFC has, however, come under criticism from the NGO
society for being unable to track its funds, because it invests through
fnancial intermediaries. For instance, OXFAM (2015) reported that
the IFC was not carrying out its necessary due diligence and was
not ensuring proper risk management in the fnancial intermediaries
that it has investments in. The report indicated that the IFC has little
accountability for investments worth billions of US dollars into banks,
hedge funds, and other fnancial intermediaries and that this has
resulted in projects that are causing human rights abuses across the
world. Another area of concern is that the IFC seems to focus mainly
on large companies or wealthy individuals who are in the position to
fnance their own investments and may not require external funding.
Therefore, investing in such large companies or wealthy individuals
presupposes that IFC investments have not had signifcantly positive
development impacts. One example frequently cited is the fnancing
provided by the IFC to the Saudi Prince for the construction of the fvestar Mövenpick Hotel in Ghana (see Einhorn, 2013).
The World Bank is a triple-A credit-rating institution; this enables it
to borrow at cheaper rates from the international capital markets, but its
‘hard’ loans to governments are generally given at commercial terms. However, many of the poorest countries could not service and repay the loans
on commercial terms. These countries were therefore not eligible for the
World Bank support under those loan conditions. Subsequently, the World
Bank established the IDA in 1960, to provide ‘soft’ lending, including grants
and concessionary loans with long maturities, to these poor countries. IDA
obtains its funds for soft lending from donors.
The World Bank also introduced the structural adjustment programmes (SAPs) in 1980, enabling it to have considerable infuence over
the internal politics and policies of borrowing countries. The SAP was a
key requirement for qualifying for fnancial support from the World Bank.
Developing countries were required to subscribe to an agreed package of
structural reforms and the regular support was contingent on borrowing
countries’ satisfying these requirements. The SAPs were implemented in
quite a number of African countries, and the effect of these programmes
on Africa remains an issue of debate in the extant literature. Some empirical works have suggested that, with the exception of Uganda and Ghana,
the SAPs have had insignifcant impacts on the growth of African economies (see Mosley, Harrigan, & Toye, 1995; Easterly, 2000; Klasen, 2003).
Other studies have also indicated that the SAPs have enhanced growth and
poverty reduction in some African countries – especially those that had
successfully implemented the programmes (see World Bank, 1994, 2000;
Christiaensen, Demery, & Paternostro, 2001). We discuss some lessons on
the implementation of the SAP in Uganda in Box 7.3.
178 Joshua Yindenaba Abor et al.
The SAP took various forms over the years, focused mainly on issues
of poverty and human development. The Bretton Woods institutions were
criticised for imposing these policies with no inputs from the borrowing
countries. In recent times, however, much emphasis is being laid on the
need for countries to own these reform programmes. Borrowing countries
are now expected to draw up their own programmes with much consultation from various organisations, including civil society organisations
(CSOs). This approach is used to give credence and to ensure that governments abide by their own reform programmes.
BOX 7.3 Structural adjustment in Uganda
Background
When Uganda gained independence in 1962, its economy was considered one of the most promising economies in sub-Saharan Africa. Its agricultural exports including coffee and cotton; it as a mining sector and a
transportation system; and its developing local industries were in good
shape and performing well. However, political instability and economic
sanctions on the Baganda in the late 1960s caused the economy to start
declining. Consequently, Idi Amin toppled the government of Milton
Obote in a coup d’état in 1971. During the reign of Idi Amin (1971–1979),
the Ugandan economy was characterised by a three-month economic
war against Asians in 1972, leading to losses in its skilled workforce,
fscal defcits averaging USh14.4 million per annum, rising infation, an
8.5% decline in exports, and cutbacks in donor support, resulting from
sanctions. These led to, among others, balance of payment problems
and a decline in economic growth from 5.2% in the 1960–1970 period to
1.6% in the 1970–1980 period. Idi Amin was overthrown in April 1979,
and Milton Obote took over as president for the second time a year later,
a time when the war pushed the Ugandan economy into crisis and damaged infrastructure. Due to these conditions, the Obote-led government
resorted to an economic recovery programme in 1981.
Structural Adjustment Programme (1981–1984)
Under this programme, an IMF/World Bank economic reform package was introduced in 1981. The goals of the programme were to stimulate economic growth, control infation, restructure credit, reduce the
defcit, stimulate exports, and improve the balance of payments position. The programme was able to achieve most of its goals. The government increased the producer prices of major export commodities to
boost exports. For instance, the price of robusta coffee rose to USh130.8
per kilo in 1984, up from USh35 per kilo in 1981. During the 1980–1984
period, coffee exports increased by 21% and cotton exports spiralled
by 191%, contributing to a 23% increase in export revenue. Infation
fell from 111% in 1981 to 25% in 1983. The budget defcit also reduced
Chapter 7 • Global fnancial architecture 179
from 2.8% of GDP to 0.6% of GDP over the same period, and the Ugandan shilling was devalued signifcantly. GDP grew by 7.2% in 1982
and 5.4% in 1983. However, total external debt rose from USD728.9
million in 1981 to USD1.065 billion in 1984. Similarly, debt servicing as
a percentage of exports increased from 39.8% to 40.6%. This indicated
the deteriorating position of some economic indicators at the time,
which violated the programme’s conditionality. These violations, coupled with the poor management of the auction system of the Ugandan
shilling, the abolition of import rationing, the absence of skilled personnel to run the programme, worsening standards of living and other
challenges, led to the collapse of the programme in 1984. Amid these
conditions, the second Obote government was overthrown in a coup
d’état in 1984, resulting in another economic crisis and chaos.
The economic recovery programme (ERP) of 1987
Shortly after the cancellation of the IMF programme and the coup d’état
of 1984, the National Resistance Movement (NRM) assumed power and
formed a new government. At that time, public infrastructure was in a
deplorable state, black marketeering boomed, productivity fell, corruption was widespread, foreign exchange was hard to fnd, and infation
had exceeded 150%. These and other factors made the NRM government turn to the Bretton Woods institutions for fnancial support in
1987, when the East African country ran out of foreign exchange but
did not have the creditworthiness to borrow from the global fnancial
market. The new policy package was put in an ERP and introduced
in May 1987. It aimed to restore fscal discipline and monetary stability and rehabilitate infrastructure. Many measures were implemented
to achieve these aims. Specifcally, subsidies to ineffcient public entities were reduced drastically, university professors received special
allowances, a new currency conversion rate of 1 to 100 was introduced,
interest rates were reduced, the Ugandan shilling was devalued from
USh1,400 to USh6,000, and the tax system was reformed.
The enhanced structural adjustment facility policy framework,
1998/1999–2000/2001
The government had been implementing macroeconomic adjustment
programmes and structural reforms since 1987, mainly to sustain high
economic growth, which allowed everyone to participate. During the
1997/1998 period, the government signifcantly cut the size of the public service and reduced the number of ministries from 22 to 17. In 1998,
the IMF and IDA agreed that Uganda had fulflled the necessary conditions under the Heavily Indebted Poor Countries (HIPC) Initiative,
making Uganda the frst country to complete the processes under the
initiative. The government introduced the Poverty Eradication Action
Plan (PEAP), a policy that focused on poverty reduction through the
180 Joshua Yindenaba Abor et al.
development of physical and human resources. In addition, the public
investment programme focused on road transport and infrastructural
development. Over that period, economic policy also aimed to achieve
trade liberalisation, public enterprise restructuring, privatisation, and
pension and tax reform. Measures were put in place to improve revenue mobilisation and ensure fscal sustainability. Moreover, efforts
were made to enforce good governance, decentralisation, public service reform, and the rule of law. The recapitalisation of the Bank of
Uganda (BOU) was in the last legal stages, and the main objective of
monetary policy was low, stable infation. The government also sought
to increase exports, diversify the export base, and encourage foreign
direct investment to achieve a sustainable balance of payments position.
Sources: IMF (1998), Baffoe (2000)
We examined how the roles of both the IMF and the World Bank have
changed over time. Similar to what we discussed earlier in terms of the evolution of the IMF’s role, the focus of the World Bank has also evolved over
time. We mentioned that the IMF’s role originally focused on maintaining a
fxed exchange rate system. However, with the collapse of this system and
the dynamics in the global economy, including increased fnancial rigidity,
the IMF’s attention has expanded to consider much broader issues in carrying out its functions. In a similar fashion, the World Bank’s initial role
of ensuring economic growth has expanded to incorporate the objective of
achieving poverty alleviation. The attention of the World Bank has shifted
to also focus more on social issues as important determinants of achieving
growth. Although the World Bank continues to focus on economic issues,
it also considers investments in human capital development (i.e. education
and health) as important in enhancing growth and alleviating poverty. The
expanded roles of both the IMF and the World Bank, aimed at achieving
economic stability and poverty alleviation, require some reforms in the
economies of borrowing countries.
Apart from the World Bank, which comprises of the IBDR and the
IDA, the World Bank Group is also made up of other members: the IFC, the
Multilateral Guarantee Agency (MIGA), and the International Centre for
Settlement of Investment Disputes (ICSID). The IFC was already discussed
in greater detail in Box 7.2, and we now provide some brief background
on the MIGA and the ICSID. The MIGA provides political risk insurance
and guarantees to enable investors to protect their investments against
noncommercial risks. The ICSID focuses on the settlement of international
investment disputes. Each of these institutions plays various critical roles
in achieving the World Bank Group’s mission of ending extreme poverty
within a generation and boosting shared prosperity.
7.2.1.3 WORLD TRADE ORGANIZATION (WTO) The WTO is the sole global
intergovernmental organisation that operates a system of international
trade rules. Its Secretariat is located in Geneva, Switzerland It is a forum
Chapter 7 • Global fnancial architecture 181
that enables governments to enter into trade agreement negotiations and
settle trade disputes. Its main goal is to increase trade openness for the good
of all. It was established on 1 January 1995 under the Marrakesh Agreement of 15 April 1994 and signed by 123 countries. The creation of the WTO
replaced the GATT, formed immediately after World War II, which became
operational in January 1948.
The precursor to the GATT was the International Trade Organization
(ITO), though successfully negotiated, never came into being. It was initially
intended to be a specialised agency of the UN with the goals of reducing
barriers to trade and addressing trade-related issues, such as investment,
commodity agreements, restrictive business practices, and employment.
However, the US and other signatories did not approve the ITO treaty, so it
was not implemented.
The single multilateral instrument for governing international trade
from 1946 onwards was the GATT. This lasted until 1995, when the WTO
was created. Although efforts were made in the mid 1950s and 1960s to
establish an institutional mechanism to facilitate international trade, the
GATT continued in operation as a provisional semi-institutionalised multilateral treaty regime for almost half a century.
The WTO regulates trade among member countries. It provides a set
of rules and guidelines that are needed in negotiating trade agreements and
in the resolution of disputes. This framework is to ensure that WTO member
countries adhere to the WTO agreements, which have been signed by representatives of governments of the member countries and ratifed by their
respective parliaments. The Uruguay Round (1986–1994) provides the basis
for most of the issues that the WTO seeks to address.
Over the past six decades, a strong and vibrant trading system has
been created with the help of the WTO. This has undoubtedly led to unprecedented growth in the global economy. As of 2018, the membership of the
WTO was 164 countries, of which 117 from the developing world or separate customs regions.
The WTO is headed by the director-general with the support of about
700 staff members at the Secretariat. A consensus of the entire membership
is required in making decisions for the organisation. The apex institutional
body is the Ministerial Conference, whose meetings are held twice a year.
The conference brings the entire membership of the WTO together and is
empowered to make decisions regarding issues that arise under any of the
multilateral trade agreements.
The conduct of the business of the WTO is placed in charge of the
General Council. All members of the WTO constitute the General Council as
well as the Ministerial Conference. Specialised subsidiary bodies (councils,
committees, subcommittees), also made up of all member countries, have
the responsibility of administering and monitoring the implementation of
the various WTO agreements by member countries.
The WTO engages in a myriad of activities, including negotiating the
reduction or complete elimination of trade obstacles, such as import tariffs. It works on reaching consensus on rules that govern international trade
practices, such as antidumping, subsidies, and product standards. The WTO
also engages in the administration and monitoring of the implementation of
182 Joshua Yindenaba Abor et al.
the agreed rules of the WTO with respect to trade in goods and services as
well as trade-related intellectual property rights. Additionally, it monitors
and reviews trade policies of member countries while ensuring transparency in the agreements of regional and bilateral trade.
The WTO also resolves disputes among member countries in the area of
the proper interpretation and application of the agreements. It makes efforts
to improve the capabilities of government offcials of developing countries
in matters of international trade. The WTO also provides assistance to a
number of countries that are yet to become part of the WTO by carrying
out economic research and both gathering and disseminating trade-related
data. This to provide support to the WTO’s primary activities and educate
the public about the organisation’s mission and activities.
The guiding principle of the WTO is the pursuit of open borders. In
November 2001, the Doha Development Round, which is the current round
of negotiations, was launched by the WTO during the fourth Ministerial
Conference in Doha, Qatar. The objective of these negotiations was to bring
about a more inclusive globalisation process and assist the poor by reducing
barriers to trade and farming subsidies in developed countries. The initial
agenda comprised both the furtherance of trade liberalisation and the making of new trade rules with the commitment to increase substantial assistance to developing countries.
There have been serious contentions in the negotiation processes with
strong disagreements over a number of important issues, such as agricultural subsidies. There was a breakdown in the 2008 Ministerial Conference
meeting due to a disagreement between countries that export agricultural
bulk commodities and those that had a high number of subsistence farmers
on the specifc terms of a special protective measure to safeguard farmers
from increases in imports. The WTO has, since its establishment, made signifcant strides and can be accredited with some achievements. One is the
fact that greater market orientation is now the general rule in international
trade. Second, there has been a decline in the use of restrictive measures in
addressing BOP problems. Trade in services has also been included in the
trade in goods-dominated multilateral system. Subsequently, either unilaterally or through regional or multilateral negotiations, a signifcant number of countries opened their markets to trade and investment. In addition,
tariff-based protection has become the general practice instead of the exception in international trade.
A process of continually monitoring developments in trade policy has
been created by the review of trade policy. Finally, the WTO succeeded in
having an agreement with members in reducing industrial goods-based
import tariffs, on the basis of a ‘Swiss formula’. A Swiss formula is a nonlinear formula whereby tariffs, which are initially higher, are required to have
proportionally higher tariff cuts. For instance, a country that has a product
with an initial tariff of 25% should cut the tariffs much more than should a
country that has the same product with an initial tariff of 15%.
There are, however, several other issues for the WTO. First, the process of trade reforms remains incomplete in a signifcant number of countries. An example is the presence of high tariffs for which there are ongoing
Chapter 7 • Global fnancial architecture 183
negotiations at various levels, particularly in the felds of fnancial services
and telecommunications. Also, the overall trade liberalisation process seems
to have suffered a number of setbacks and retrogressions in a number of
developing countries. There are instances of much stronger antidumping
measures and selective tariff increases. Third, the WTO has not responded
well enough to developing nontariff barriers to imports, including antidumping duties from developing countries. It appears the interests of multinational companies supersede those of local industries and policies even if
such actions pose serious health and security risks to the local population.
Also, several serious implementation-related concerns require the
implementation of measures in relation to asymmetries in trade-related
investment measures (TRIMS), trade-related intellectual property rights
(TRIPS), antidumping, and the movement of people, among others. The
WTO also needs to pay specifc attention to issues related to textiles, agriculture, industrial tariffs (e.g. peak tariffs), and services. Lastly, developing
countries are being required to accept trade policies and guidelines favourable to developed countries. This approach is a one-size-fts-all approach
posing a signifcant challenge to countries in the developing world.
In summary, the WTO has been instrumental in promoting global
trade and investment. If member countries commit to addressing the challenges confronting the WTO, the expected benefts in increased trade and
investments among member countries would be largely realised.
7.3 THE BANK FOR INTERNATIONAL SETTLEMENTS
(BIS) AND THE BASEL COMMITTEE ON BANKING
SUPERVISION (BCBS)
The Bank for International Settlements (BIS), owned by its 60-member central banks, is an international fnancial institution meant to foster international monetary and fnancial cooperation and serve as a bank for central
banks. Its headquarters are in Basel, Switzerland; it also has representative
offces in Hong Kong SAR and in Mexico City. Currently, it has 35 member
countries in Europe, 13 member countries in Asia, fve members in South
America, three in North America, two in Oceania, and two in Africa.
The bank is the frst international fnancial institution and was set up in
1930 by an agreement between Germany, Belgium, France, the United Kingdom, Italy, Japan, the United States of America, and Switzerland. Operations started on 17 May 1930. It was initially set up as a clearinghouse for
German war reparations imposed by the Treaty of Versailles but evolved
into a forum for cooperation and a counterparty for transactions among central banks.
The bank works to promote international cooperation among monetary and fnancial authorities. It conducts economic research and analysis
on policy issues to inform policymakers, academics, and the general public.
It also provides banking services to the central bank community and other
international organisations. The BIS carries out its work through meetings,
programmes, and the Basel Process – hosting international groups pursuing
global fnancial stability and facilitating their interaction.
184 Joshua Yindenaba Abor et al.
A number of committees and associations are involved in fnancial stability and have their secretariats at the BIS. These include the Basel Committee
of Banking Supervision, the Committee on Payments and Market Infrastructures, the Committee on the Global Financial System, the Markets Committee, the Central Bank Governance Group, and the Irving Fisher Committee
on Central Bank Statistics. For these groups, being located in the same place
facilitates communication and collaboration. Their location also makes it
easy for interactions with policymakers, makes it easier to coordinate efforts,
and prevent overlaps and gaps in various work programmes. Some associations also have their secretariats at the BIS but have their own separate legal
identity and governance structure and report to their members. These are the
Financial Stability Board, the International Association of Deposit Insurers,
and the International Association of Insurance Supervisors.
The BIS contributes to the international fnancial architecture by promoting reserve transparency in central bank operations and regulating capital adequacy. The Basel Committee on Banking Supervision, which is hosted
at the BIS, is in charge of setting capital adequacy requirements. Ensuring
capital adequacy is critical for central banks since speculative lending on the
basis of inadequate underlying capital and widely varying liability rules can
cause economic crises; as Gresham’s law states, ‘bad money drives out good
money’. In addition, the Basel Committee on Banking Supervision, which
is hosted by the BIS, played an important role in creating the Basel Capital
Accords, the Basel II framework, and the Basel III framework.
7.3.1 The Basel Committee on Banking Supervision (BCBS)
The Basel Committee on Banking Supervision (BCBS) is the primary global
standard setter for the prudential regulation of banks and provides a forum
for regular cooperation on banking supervisory matters. Its 45 members
comprise central banks and bank supervisors from 28 jurisdictions.
The BCBS was set up by the central bank governors of the G10 countries in 1974. It provides a medium for regular cooperation on banking
supervisory matters. Its objective is to improve the understanding of important supervisory issues and improve the quality of bank supervision all over
the world.
The following are some of the frameworks that the committee has
created:
1 International standards on capital adequacy.
2 Core principles for effective banking supervision.
3 Concordat on cross-border banking supervision.
The committee’s secretariat is situated at the Bank for International Settlements in Basel, Switzerland. However, it has its own governance arrangements, reporting lines, and agenda overseen by the central bank governors
of the G10 countries. The BCBS works primarily as an informal medium
for developing policy solutions and standards. Along with the International
Organisations of Securities Commissions and the International Association
of Insurance Supervisors, they form the joint forum of international fnancial
Chapter 7 • Global fnancial architecture 185
regulators. It also has subgroups that work on specifc issues: the Standards
Implementation Group (SIG), the Policy Development Group (PDG), the
Accounting Task Force (ATF), and the Basel Consultative Group (BCG).
The committee agrees on nonbinding principles for bank capital,
liquidity, and funding. Member countries are expected to create opportunities for implementation, such as by enacting relevant domestic regulation.
7.4 OTHER GLOBAL DEVELOPMENT FINANCE
INSTITUTIONS
Other global development fnance institutions are made up of multilateral
development banks (MDBs), multilateral fnancial institutions (MFIs), and
regional development banks.
7.4.1 Multilateral Development Banks (MDBs)
and Multilateral Financial Institutions (MFIs)
MDBs are fnancial institutions that are established by various countries
in order to support development activities through long-term loans and
grants. They mostly provide lending at low or no interest and sometimes
grants to fnance projects in areas that promote development. In more specifc terms, the fnancing provided by MDBs takes the following forms:
1 Long-term loans usually have up to 20 years’ maturity, and their interest rates are based on market rates. MDBs typically acquire funds
from the global capital markets and in turn on-lend them to developing countries’ governments.
2 Very-long-term loans are also termed ‘credits’, and they usually have
maturity between 30 and 40 years with interest rates pegged below
market interest rates. Funding for such loans are from direct contributions made by the governments of donor countries.
3 Grant fnancing is typically for technical assistance, advisory services,
and project preparation.
MDBs have huge memberships, which contain both developed countries
(which serve as donors) and developing countries (which are the borrowers). They are global in their scope, and examples include European Bank
for Reconstruction and Development (EBRD), European Investment Bank
(EIB), Inter-American Bank Group (IDB, IADB), Development Bank of
Latin America (CAF), Asian Development Bank (ADB), African Development Bank (AfDB), Islamic Development Bank (IsDB), Asian Infrastructure
Investment Bank (AIIB), and International Fund for Agricultural Development (IFAD).
There are also subregional MDBs with membership comprising only
borrowing countries. MDBs tend to raise fnance from the global capital
markets at lower costs and on-lend to their members. Examples include
the Central American Bank for Economic Integration (CABEI), Caribbean
Development Bank (CDB), Black Sea Trade and Development Bank (BSTDB),
Development Bank of Southern Africa (DBSA), West African Development
186 Joshua Yindenaba Abor et al.
Bank (BOAD), East African Development Bank (EADB), Eurasian Development Bank (EDB), Economic Cooperation Organisation Trade and Development Bank (ETDB), and New Development Bank (NDB) (formerly BRICS
Development Bank).
MDBs are generally similar to MFIs except that MFIs have morelimited memberships and mostly concentrate on fnancing specifc activities.
Some examples are the International Fund for Agricultural Development
(IFAD), International Investment Bank (IIB), International Finance Facility
for Immunisation (IFFI), European Commission (EC), OPEC Fund for International Development (OFID), Nordic Investment Bank (NIB), and Arab
Bank for Bank for Economic Development in Africa (BADEA).
7.4.2 Regional development banks
Regional development banks (RDBs) are regional DFIs that focus on fnancing development activities in particular geographical areas. They are also
regarded as part of MDBs and MFIs, but they operate in specifc regions of
the world. The shareholders of these institutions are mainly the regional
countries and other major donor countries. RDBs are considered ‘clones’ of
the World Bank in terms of their structure, functions, and operations, but
they tend to have a specifc focus. The main regional development banks
are the Inter-American Development Bank (IDB), African Development
Bank (AfDB), Asian Development Bank (ADB), Central American Bank
for Economic Integration, and the European Bank for Reconstruction and
Development (EBRD). Other regional development banks include the Central American Bank for Economic Integration, Islamic Development Bank
(CABEI), Islamic Development Bank (IsDB), Development Bank for Latin
America (CAF), Council of Europe Development Bank (CEB), West African
Development Bank (BOAD), East African Development Bank (EADB), and
Development Bank of Central African States.
Among the fve main RDBs, the IDB for Latin America was the frst to
be established in 1959. This was followed by the setting up of the Central
American Bank for Economic Integration in 1960, the African Development
Bank in 1964, the Asian Development Bank in 1966, and then the European
Bank for Reconstruction and Development in 1991.
As mentioned earlier, the RDBs have similar structures and functions
to those of the World Bank, though they are different in some other respects.
For instance, both the RDBs and the World Bank have ‘hard’ and ‘soft’ lending facilities, where the terms under the hard lending facility are similar
in all the institutions and the soft lending is funded directly by donors. As
mentioned earlier, the World Bank’s soft lending is provided through the
IDA. Soft lending programmes by IDB, AfDB, and ADB, for instance, are
conducted through the Fund for Special Operation (FSO), African Development Fund (ADF), and Asian Development Fund (AsDF) respectively. Hard
lending takes the form of loans on market-based terms, while soft lending
takes the form of grants and concessional loans, which are associated with
longer repayment periods and lower interest rates. Most loans typically
have a maturity of between 25 and 40 years. In terms of their governance
Chapter 7 • Global fnancial architecture 187
structure, both the World Bank and the RDBs are governed by boards of
governors, of which every member country is supposed to have a representation of one governor and one alternate governor. The boards of governors,
which are the highest authority of the institutions, in turn appoint and delegate the exercise of most of their powers to the boards of directors, which
provide general direction to the entities.
One major challenge faced by regional development banks is that
donor governments prefer to channel resources through the World Bank
rather than through the regional development banks. This also means that
borrowing countries tend to place more importance on their relationship
with the World Bank than with their specifc RDBs.
We next provide an overview of the main RDBs in Table 7.1.
TABLE 7.1 Overview of RDBs
Regional development Area
banks
Year
Headquarters
founded
Inter-American
Development
Bank (IDB)
Latin
American,
Caribbean
1959
Central American
Bank for
Economic
Integration
(CABEI)
African
Development
Bank (AfDB)
Central
America
1960
Africa
1964
Asian Development Asia and
Pacifc
Bank (ADB)
region
1966
1991
European Bank for Central and
Eastern
Reconstruction
Europe and
and Development
Central Asia
(EBRD)
Main goal
Promoting poverty
reduction,
social equity,
environmentally
sustainable
economic growth
Promoting
Tegucigalpa
integration and
(Honduras)
development
San Salvador
among its
(El Salvador)
member countries
Abidjan (Côte Spurring sustainable
economic
D’Ivoire)
development and
social progress
in its regional
member countries
(RMCs), thus
contributing to
poverty reduction
Fostering economic
Manila
growth and
(Philippines)
cooperation in
the region
London, United Promoting
transition to
Kingdom
market-oriented
economies in
the Central and
Eastern European
and Central
Asian countries.
Washington,
DC (USA)
188 Joshua Yindenaba Abor et al.
7.4.2.1 INTER-AMERICAN DEVELOPMENT BANK The IDB, which was created
in 1959, has its headquarters in Washington, DC. It is the oldest RDB to be
established, and it represents the largest source of multilateral development
fnancing for supporting socioeconomic development, institutional development projects, trade, and regional integration programmes in Latin America
and the Caribbean. The IDB has 48 countries as its owners, which are made
up of 26 Latin American and Caribbean states, 16 European countries, the
US, Canada, Israel, China, Japan, and Korea. The 26 Latin American and
Caribbean states are the borrowing member countries that regularly acquire
loans from IDB, and the others constitute nonborrowing member countries.
The idea of creating a DFI for the Latin American region was initially
proposed during the earliest efforts to establish an inter-American system
at the First American Conference in 1890. The IDB came into fruition under
an initiative, which was proposed by the then president of Brazil, Juscelino
Kubitshek. The IDB was offcially set up on 8 April 1959, the Organisation
of American States drafting the Articles of Agreement to establish the bank.
The main goals of the IDB involve promoting poverty reduction, social
equity, and environmentally sustainable economic growth. It focuses on the
following priority areas in the attainment of these goals:
• Fostering competitiveness by supporting policies and programmes
that enhance a country’s potential for development in the global
marketplace.
• Modernising the state by enhancing the level of effciency and transparency in public sector institutions.
• Investing in social programmes that are capable of expanding opportunities for the poor.
• Promoting regional economic integration by fostering relations among
countries in order to develop bigger markets for their commodities.
It also helps regional initiative efforts by providing information and knowledge to aid policy discourse and funding for technical cooperation in order
to strengthen regional integration. It supports governments with technical assistance on issues regarding trade and regional integration and also
undertakes public outreach programmes and activities targeted at promoting such integration. IDB uses its FSO to provide concessional lending.
The Central American Bank for Economic Integration (CABEI) is an RDB founded in
1960 to promote integration and development among its member countries.
It currently has two headquarters, one located in Tegucigalpa (Honduras)
and the other in San Salvador (El Salvador), in addition to national offces in
each Central American country. Its membership is as follows:
7.4.2.2 CENTRAL AMERICAN BANK FOR ECONOMIC INTEGRATION
• Its fve founding countries are made up of Costa Rica, El Salvador,
Guatemala, Honduras, and Nicaragua. These were the countries that
signed the Founding Covenant establishing the CABEI.
• It has two non-founding regional countries – Dominican Republic and
Panama.
• Its fve nonregional countries are made up of Argentina, Colombia, Mexico, Spain, and Taiwan. They joined the CABEI to have a
Chapter 7 • Global fnancial architecture 189
permanent regional presence, thereby enhancing their global projection by supporting development in the founding countries.
• It also has benefciary countries; in addition to regional countries,
Belize joined the CABEI to acquire loans and guarantees. However,
unlike the other member countries, Belize does not hold any shares of
CABEI. Argentina and Colombia also beneft from receiving loans and
guarantees from CABEI.
The process of Central American regional economic integration began on 13
December 1960 with the signing of the General Treaty on Central America
Economic Integration. The signing of the treaty then resulted in the establishment of the CABEI, which has become the fnancial arm for the integration and development of Central America.
As a regional DFI, CABEI provides support for the public and private
sectors of the economy. It focuses on acquiring funds and channelling these
into promoting investments in its cores areas, including energy, infrastructure, industry, agricultural and rural development, human development,
urban development and services for competitiveness, and fnancial trading
and development fnance.
7.4.2.3 AFRICAN DEVELOPMENT BANK The AfDB, or Banque Africaine de
Development (BAD), was founded in 1964, headquartered in Abidjan, Côte
d’Ivoire (but in 2003, the headquarters temporarily moved to Tunis, Tunisia,
because of the Ivorian war and then returned in September 2014). Its owners
are made up of 81 member countries (shareholders), comprising 54 African
countries and 27 non-African countries. Two other entities are under the
African Development Bank Group: the African Development Fund and the
Nigeria Trust Fund.
The growing desire for more unity in the continent, after the colonial
period in Africa, resulted in the creation of two draft charters, for establishing the Organisation of African Unity (founded in 1963 and replaced later
by the African Union) and an RDB. An agreement for establishing the AfDB
was prepared in 1963, and this materialised on 10 September 1964. The Bank
was formally established under the auspices of the Economic Commission
for Africa but started its operations in 1966. Although the bank initially had
only African countries as members, a number of non-African countries have
been allowed to join since 1982.
The overall objective of the AfDB Group is to spur sustainable economic development and social progress in its regional member countries
(RMCs), thus contributing to poverty reduction. The AfDB Group focuses
on mobilising resources and allocating them for investments in the RMCs. It
also provides policy advice and technical assistance to support the development efforts of the RMCs. It serves the following primary functions:
• Making loans and equity investments for the economic and social
advancement of the RMCs.
• Providing technical assistance for the development projects and programmes of the RMCs.
• Promoting the investment of public and private capital for development.
• Assisting in organising the development policies of RMCs.
190 Joshua Yindenaba Abor et al.
The AfDB is also expected to pay particular attention to national and multinational projects that are required to promote and facilitate regional integration.
Its main sources of fnancing include subscribed capital, reserves, borrowed funds, and accumulated net income. Its shareholding is structured in
such a way that the two-thirds of the total capital is held by the RMCs, while
one-third is held by nonregional members. AfDB is also a triple-A-rated
institution, allowing it to borrow from the international capital markets on
favourable terms. It provides fnance to governments of African countries
and private companies that invest in the RMCs. AfDB lends on a nonconcessional basis at market interest rates. It also provides development fnance
on concessional terms through the African Development Fund to its lowincome member countries that do not qualify to obtain loans on nonconcessional terms. Funds for concessionary loans are typically obtained from the
27 nonregional members, which come in the form of grant contributions.
7.4.2.4 ASIAN DEVELOPMENT BANK The ADB was founded in 1966 with
its headquarters based in Manila, the capital of the Philippines. With initial
membership of 31 countries at its establishment, ADB is currently owned by
67 member countries, which are made up of 48 countries in the Asian and
the Pacifc regions and 19 from other parts of the world.
The idea for establishing the ABD was considered at the beginning
of the 1960s. The proposal was to establish a fnancial institution that was
Asian in nature to focus on fostering economic growth and cooperation in
the region. In 1963, a resolution was subsequently passed to provide clear
direction for establishing the Bank United. This was done at the frst Ministerial Conference on Asian Economic Cooperation, which was held by the
United Nations Economic Commission for Asia and the Far East. The bank
was eventually set up on 19 December 1966. The ADB served a predominantly agricultural region by providing assistance mainly in the areas of
food production and rural development during the 1960s.
ADB focuses on promoting social and economic development in Asia
and the Pacifc through inclusive growth, environmentally sustainable
growth, and regional integration. It is concerned with helping its member
countries, specifcally the developing countries, to pursue poverty reduction and improvement in the quality of life of citizens through equity investments, loans, guarantees, grants, technical assistance, and policy dialogue.
Its core areas of interest include infrastructure (energy, ICT, transport,
water, and urban development), environment, regional cooperation and
integration, fnancial sector development, education, health, agriculture
and natural resources, and public sector management.
Its main sources of fnance include bond issues, recycled repayments on
its loans, and member countries’ contributions. A signifcant percentage of the
cumulative lending it gives is from its ordinary capital. The concessional lending it provides to its developing member countries is done through the African
Development Fund. It also manages a number of trust funds and assists in
channelling grants from bilateral donor partners to the recipient countries.
7.4.2.5 EUROPEAN
BANK
FOR
RECONSTRUCTION
AND
DEVELOPMENT
The EBRD is the youngest among the fve main RDBs and was established
in 1991 with its headquarters in London. The EBRD was established to
Chapter 7 • Global fnancial architecture 191
promote a transition to market-oriented economies in the Central and Eastern Europe and Central Asia countries. Its owners are made up of 65 countries and two intergovernmental institutions – the European Union and the
European Investment Bank.
The EBRD was founded during the period of the dissolution of the
Soviet Union and communism in Central and Eastern Europe, and these
countries required support to develop a new private sector. The bank was
set up after reaching agreements regarding its charter, size, and the share of
power among the shareholders.
The EBRD is also a triple-A-rated institution, which allows it to borrow
from international capital markets at favourable market rates. In spite of its public sector shareholders, the EBRB focuses its investments largely on private enterprises in collaboration with commercial entities. It is committed to developing
democracies and building market economies in some Central European and
Central Asian countries through its investments. The EBRD provides loans
and equity fnance, trade fnance, project fnance, leasing facilities, guarantees,
and professional development through its support programmes. The EBRD also
supports publicly owned companies in their privatisation efforts and is committed to promoting environmentally sound and sustainable development.
Importantly, apart from the multilateral and regional DFIs, bilateral DFIs are also established typically by developed countries to fnance
development projects in developing and emerging counties. In Chapter 1,
we identifed examples of bilateral DFIs that operate worldwide, targeting developing and emerging markets to include AFD/Proparco (France),
Belgian Investment Company for Developing Countries (BIO), BMI-SBI
(Belgium), CDC Group (UK), CDP/SIMEST (Italy), COFIDES (Spain), Finnfund (Finland), German Investment and Development Company (DEG),
IFU (Denmark), Netherlands Development Finance Company (FMO), Norfund (Norway), OeEB (Austria), Overseas Private Investment Corporation
(OPIC) in the US, SOFID (Portugal), Swedfund (Sweden), and Swiss Investment Fund for Emerging Markets (SIFEM).
7.5 FINANCIAL GLOBALISATION AND GLOBAL CRISIS
Before discussing fnancial globalisation and the global fnancial crisis, we
frst look at the dynamics of fnancial globalisation and the general benefts
and risks with respect to fnancial globalisation.
7.5.1 The dynamics of fnancial globalisation
Financial globalisation (FG), viewed as the totality of all global linkages
through cross-border capital fows, has become an increasingly important
aspect for emerging economies as they integrate with more-developed
economies. FG is seen as the net fnancial fows measured as the aggregate
of foreign assets and foreign liabilities to GDP ratio (Lane & Milesi-Ferretti,
2007). FG is relevant to an emerging economy for a number of reasons:
• The changing composition of the national balance sheets, whereby the
foreign fnancial assets either exceed or fall below the foreign fnancial
liabilities.
192 Joshua Yindenaba Abor et al.
• The role of FG in the transmission of shocks caused by global fnancial
crises.
• The contribution of FG to the economic development of a nation.
• International risk management (through sharing) and smoothing
business cycles.
• The overall implication of FG effects on the macroeconomic and prudential policies at national, regional, and global levels.
Yeyati and Williams (2014) argue that despite the common notion that
fnancial globalisation (also referred to as the IFI ratio) has been increasing in emerging economies since the mid 1980s with an acceleration in the
2000s, there has only been a marginal growth, and international portfolio
diversifcation has been limited and on the decline over time. Using an FG
proxy controlled for fnancial market deepening and relative price effects,
Yeyati and Williams revealed a more stable FG pattern during the 2000s.
Lund et al. (2017) fnd that developing countries are becoming more and
more fnancially globalised and that the share of foreign assets of developing countries rose from 8% to 14% in the last decade.
Cross-border capital fows have dropped by 65% since the global
fnancial crisis (GFC). This is potentially because global banks took strict
measures such as retrenchment. The decline could also be due to the stability of the FG, which seems to be emerging over time (Lund et al., 2017). An
interesting observation is that despite the retrenchment by global banks and
a cut in diaspora remittances, FG still continues.
During the period 2006–2007, FG seemed to be strong and was creating
more robust fnancial linkages across the globe. Advanced economies benefted more from this, while emerging economies adopted a more cautious
approach. This disparity in the experiences of FG by both advanced and
emerging economies would later be tested by the GFC, which was sparked
in 2008 and which highlighted the properties of FG in a real setting.
In 2007, the global inventory of foreign investments stood at USD103
trillion, which had increased to USD132 trillion by 2016. There is also evidence of vibrancy in the fnancial and capital markets globally, with 31%
of the bonds owned by foreign investors, up from 18% in 2000. There is a
notable increase in China’s total stock of foreign bank lending, FDI, and
portfolio equity and bond investments.
Although FG is expected to affect asset prices, the economic performance of any nation depends on the actual intensity and sensitivity of
cross-border capital fows despite existing controls and restrictions. Many
closely regulated economies act as important recipients and sources of foreign capital fows. They are therefore more fnancially globalised and are
even more exposed to any global fnancial crisis that may hit them. However, liberal economies are regarded as risky by international investors,
who tend to avoid them. These economies become locked out of the global
market swings and trends. This explains the mixed effect of the 2008 GFC
on various economies: some are most affected (e.g. the US, Venezuela, Iceland) and others are least affected (e.g. the United Arab Emirates, Armenia,
Morocco).
Chapter 7 • Global fnancial architecture 193
7.5.2 The benefts and risks of fnancial globalisation
The new dispensation of FG presents interesting challenges and opportunities. FG is benefcial for an emerging economy. However, it can also be
costly for emerging economies. First, FG is responsible for the fnancial
deepening of local markets by way of availing credit to the private sector
and equity. FG can also help in risk sharing by countries in the long term.
FG can serve as a useful tool in international risk sharing as a way of hedging consumption against local income shocks emanating from a specifc
nation.
Some of the positives of the new era of FG include the following:
• There is a remarkable increase in FDI and equity fows, which command a higher share of gross annual fnancial fows than they did during the precrisis period.
• Global current, fnancial, and capital account imbalances have reduced
signifcantly from 2.5% of world GDP in 2007 to 1.7% in 2016. This
means the global fnancial system is less vulnerable to shocks, which
led to the GFC of 2008. This, coupled with the dramatic reduction in
the huge US defcit and Chinese surplus, has contributed to a reduction of the potential impact that a small spark can have in the global
fnancial space.
• Financial institutions across the world have improved cushions to
offset future losses. Most banks now have stronger risk management
systems.
Despite the benefts that FG presents in the postcrisis period, there are
risks that come with it. Some of the risks presented by the new dispensation of FG:
• The volatility of gross foreign capital fows increased. According to
Lund et al. (2017), over 60% of the countries experience a huge decline,
surge, recovery, or reversal of lending yearly. This has led to volatility
in exchange rates and has led to diffculties in managing macroeconomic fundamentals.
• A potential bubble in equity market valuations may emerge. This is
due to the increased valuations on equity markets in some markets.
• Financial contagion risk is now becoming immanent because more
and more countries are participating in the global fnancial architecture. The risk may be more prevalent in developing and emerging
economies, which are characterised by insuffcient transparency and
liquidity in their fnancial markets.
The response to the new dynamics in FG can be met by embracing technologies in banking to increase effciency, improve customer experience, and
innovate. The use of big data analytics and machine learning algorithms
may help in understanding the risks much better in an international market
context. Domestic banks must also remain alert to being de-risked in the
wake of closer scrutiny and transparency requirements in the global fnancial
services space. This also translates into looking again into the international
194 Joshua Yindenaba Abor et al.
FIGURE 7.2 Benefts and risks of fnancial globalisation
Benefits of Financial
Globalisation
• Increase in FDI and equity
flows
• Global current, financial and
capital account imbalances
have reduced
• Financial institutions globally
have improved cushions to
offset future losses.
Risks of Financial Globalisation
• Increased volatility of gross
foreign capital flows
• A potential bubble in equity
market valuations may
emerge.
• Financial contagion risk is
now becoming immanent
Source: Authors’ construction
strategies adopted by the banks that should foster long-term sustainability.
Regulators are also expected to build systemic risk-monitoring capabilities
with real-time react capabilities to any economic shocks originating from
inside or outside the nation’s borders. Innovative tools for managing capital
market volatility and reducing the imbalance between capital and fnancial
accounts need to be devised.
7.5.3 Financial globalisation and the global fnancial crisis
The question whether fnancial globalisation materially contributed to
the GFC remains debatable. Did the rise in cross-border capital fows
exacerbate the GFC? What role did FG play in the aftermath of the crisis? When the global fnancial crisis happened, it was a litmus test for
the fnancial globalisation model. Since fnancial globalisation operates
through a determination of asset prices and responsiveness of funds
fows to shocks, any foreign capital fows may be affected by any shocks
in the market.
Arguably, the participation of foreign investors, mainly foreign banks,
fuelled the crisis. This was more so with the growth of asset-backed securities markets in the US, which were pivotal to the precrisis experiences in
2007–2008. Bernanke, Bertaut, DeMarco, and Kamin (2011) note that the
fnancial institutions, especially banks in Europe, were the major purchasers
of asset-backed securities. They would obtain large dollar funding from the
US money market. The immanent risk in these transactions was the exposure of European parent banks to any volatility in case a small spark arose
in the global fnancial services.
FG led to the speedy growth of the balance sheets of many banks.
Globally active banks grew rapidly in size and complexity. This made it
even more diffcult for national regulators and central banks to suffciently
monitor their risk profles. Credit growth plummeted in most countries due
to the ability of local banks to lend owing to an upsurge in the cross-border
capital fows. Emerging markets growth may have fuelled the buildup of
weaknesses in global credit markets. This may have led to a securitisation
Chapter 7 • Global fnancial architecture 195
boom. Given all these factors, credit markets became vulnerable that occasioned the GFC. In a way, FG magnifed the impact of the possible causes of
the crisis, such as weaknesses in credit market regulation and the upsurge
of fnancing activities, which were largely unregulated. In the aftermath of
the crisis, global productivity slowed down.
Several proposals have been made to reform the global fnancial architecture, focusing more on the two Bretton Woods institutions – the IMF and
the World Bank. The next section discusses these proposed reforms in the
global fnancial architecture.
7.6 REFORMING THE GLOBAL FINANCIAL
ARCHITECTURE
The global fnancial architecture in the 1980s and 1990s operated largely in
an unorganised manner, one in which institutions, especially the Bretton
Woods institutions, came under serious criticisms from both the left and the
right of the political spectrum. The conditional, policy-based lending at the
time was central to these criticisms from the left. Spratt (2009) identifed the
major criticisms of these institutions:
• The Bretton Woods institutions, particularly the frst two (i.e. the IMF
and the World Bank), were dominated by developed countries, which
tended to infuence the policies with respect to lending programmes
of these institutions.
• The so-called Washington Consensus of economic policy prescriptions (mostly seen as neoliberal policies) were regarded as serving
the interests of Western countries. Box 7.4 explains the Washington
Consensus.
• The two Bretton Woods institutions seem to have a one-size fts-all
method for addressing issues in developing countries. They were
accused of using the same template for all countries, irrespective of
the economic conditions.
• The infuence that the IMF and the World Bank wielded gave them
much power to compel countries to implement these reforms, since
they were conditional to qualify for fnancial support. The Bretton
Woods institutions seemed to have no consideration for the concerns of citizens of these countries and the social implications of their
reforms.
• The Bretton Woods institutions’ lending programmes led to developing countries’ carrying high levels of debt.
These left-wing critics contend that policies of the IMF and the World Bank
have contributed to the high poverty levels in developing countries, especially in regions like Latin America and sub-Saharan Africa that implemented these reforms. Asia seemed to have been least affected by the
conditionality associated with SAP, and therefore, the poverty reduction
that the region experienced could not be attributed to the reform policies
the IMF and the World Bank prescribed.
196 Joshua Yindenaba Abor et al.
BOX 7.4 The Washington Consensus
The Washington Consensus consists of ten economic policy prescriptions, which are considered to constitute the ‘standard’ reform package
to address fnancial crises and determine policy to ensure economic
development in Latin America, Southeast Asia, and other developing
countries. The term was originally used by John Williamson, the English economist, at a conference at the Institute of Development Studies in 1989. Williamson’s use of the term ‘Washington Consensus’ was
meant to capture the common understanding among policy advice by
Washington-based institutions, particularly the IMF, the World Bank,
and the US Treasury Department. The Washington Consensus was
meant to promote free trade, foating exchange rates, free markets, and
macroeconomic stability and became the basis of the SAPs and for that
matter the lending conditions by the IMF and the World Bank.
The general principles originally stated by Williamson (1990) in
1989, included ten specifc policy areas:
1 Fiscal discipline (with avoidance of large fscal defcits relative
to GDP).
2 The redirection of public expenditure priorities (‘especially
indiscriminate subsidies’) toward broad-based provision of key
pro-growth, pro-poor services like primary education, primary
healthcare and infrastructure investment.
3 Tax reform (broaden the tax base and adopt moderate marginal
tax rates).
4 Interest rate liberalisation (interest rates that are market determined and positive but moderate) in real terms.
5 Competitive exchange rates.
6 Trade liberalisation (liberalisation of imports – emphasising the
elimination of quantitative restrictions, such as licensing – and
any trade protection to be provided by low and relatively uniform tariffs).
7 The liberalisation of foreign direct investment infows.
8 The privatisation of state-owned enterprises.
9 Deregulation (i.e. abolition of regulations that impede market
entry or restrict competition, except for those justifed on safety,
environmental, and consumer protection grounds, and prudential oversight of fnancial institutions).
10 Legal security for property rights.
After publishing the list of policy prescriptions, advocates of neoliberalism deployed the term ‘Washington Consensus’ for their own
purposes. Williamson (1999) recognised that the term was being used
according to a different interpretation from the original prescription
he provided. He opposed the alternative use of the term that became
commonly known as ‘neoliberalisation’ in Latin America or ‘market
fundamentalism’.
Chapter 7 • Global fnancial architecture 197
Williamson (2000) realised that his 1989 policy design was fawed
in the sense that it ignored fnancial supervision, without which fnancial liberalisation could result in poor lending and ultimately crisis,
requiring the taxpayers to bear the costs. He argued that looking
beyond the policy prescriptions based on the Washington Consensus
was necessary, by focusing on the important role of institutions in
addition to policies that promote equity in income distribution as well
as rapid growth in income.
There have also been strong arguments made by the right that criticise
the Bretton Woods institutions. These institutions arguably tend to represent some form of pseudo-world government in the making and have no
legitimacy. The IMF in particular prescribes policies that seem to be counterproductive. Again, according to right-wing critics, the presence of the
IMF encourages moral hazard among borrowing countries and the lending
institutions. Both borrowing countries and lending institutions may engage
in irresponsible and careless behaviour, knowing that in the event of a crisis,
the IMF will be present to provide a bailout plan (Spratt, 2009).
These were some of the issues that invited a number of proposals and
recommendations for reforming the global fnancial architecture, after the
Asian crisis. In spite of the recommendations for reform, the global fnancial
crisis that was set off in 2008 brought to the force major weaknesses in the
precrisis global fnancial architecture that was meant to prevent, manage,
and resolve crises in the international fnancial system. We discuss some of
these proposals for reform made before and after the global fnancial crisis.
7.6.1 Earlier proposals on reform
First, the Bretton Woods Committee Report (1997) suggested that the Bretton Woods institutions, particularly the IMF and the World Bank, need to
be more transparent regarding information about their operations and also
pay particular attention to addressing legitimate public concerns. Second,
the UN Report (1999) made a number of recommendations for reforming
the global fnancial architecture:
• The need for improved consistency (and complementarity) of macroeconomic policies at the international level, including public scrutiny
of the policies and operations of the central banks and the IMF.
• Reforming the IMF to be able to provide for adequate international
liquidity in times of crisis.
• The adoption of improved codes of conduct and fnancial supervision
at both the national level and the international level, in the interests of
borrowers and creditors.
• The preservation of relative autonomy of capital account issues in
developing countries for the appropriate regulation of short-term capital fows or avoidance of sudden capital reversals.
198 Joshua Yindenaba Abor et al.
• Providing time-bound and time-focused debt rescheduling, where
and when necessary, rather than protracted and chaotic debt renegotiations that aggravate the costs of a debt crisis to borrower countries.
The International Financial Institution Advisory (‘Meltzer’) Commission,
appointed by the US Congress in 1998, which submitted its report in 1999,
also made certain recommendations. The Meltzer Commission Report
(1999) noted that the operations of the World Bank were associated with
high cost and low effectiveness. The IMF also paid little attention to the
fnancial structure of developing countries, as its short-term crisis management was considered costly. Its responses were considered too slow, its
advice inappropriate, and its efforts at infuencing policy and practice intrusive (Rao, 2003). The Meltzer Report focused on eliminating moral hazard
associated with the IMF, which was considered as the main cause of reckless
borrowing. The commission proposed several reforms, specifcally to the
functioning of the IMF, to address these problems, though the report also
considered the role of the World Bank, the RDBs, the WTO, and the BIS. The
role of the IMF in particular was seen as relevant to avoiding fnancial crises
and resolving crises that may occur.
Other reports included the Geneva Report (1999) and the Overseas
Development Council Report (2000). Williamson (2000) reviewed the fndings of these various reports and made the following recommendations:
• The IMF should narrow its activities and focus more on its core competencies in the areas of surveillance and ensuring macroeconomic
stability among member countries.
• The IMF’s surveillance should take the form of surveilling the world
economy its member countries.
• The IMF should focus on the role of being a lender of last resort to
member countries affected by crisis, and countries should have to
‘prequalify’ for assistance, instead of the conditionality, which is
linked to IMF lending.
• The World Bank and the RDBs need to concentrate on providing
technical assistance and public goods and facilitating private sector
fows to middle-income countries. They should replace loans going to
developing countries with grants, with the condition that the recipient
countries have a good record of delivery.
7.6.2 Proposals on reform after the global fnancial crisis
The global fnancial and economic crisis of 2007–2010 exposed the faws in
the precrisis global fnancial architecture in terms of its implementation and
structure. Looking back, the warning signs were quite clear, given the policy lapses and wrong judgements. Schinasi and Truman (2010) argue that
the global fnancial architecture, in terms of structure and implementation,
was not effective in advancing corrective measures at the national, regional,
continental, or global level until the global fnancial system was affected
by a full-scale global crisis. Elson (2017) suggests that the global fnancial
crisis has raised questions regarding the effectiveness of the global fnancial
Chapter 7 • Global fnancial architecture 199
architecture’s crisis-prevention capabilities, and clear defects can be identifed in its international guidelines for fnancial regulation, international policy coordination, the oversight of global fnancial stability, and the global
fnancial safety net. Even though some improvements have been made in
reforming the global fnancial architecture as well as the Financial Stability
Board (FSB), a signifcant number of reforms are still needed to enhance the
ability to safeguard global fnancial stability and address global crises. The
FSB, as an international body, exists to promote global fnancial stability by
ensuring that the development of regulation and the formulation fnancial
sector policies are well coordinated. Box 7.5 provides a profle of the FSB.
BOX 7.5 Financial Stability Board
The Financial Stability Board (FSB) was founded in April 2009 and
is responsible for monitoring and providing advice concerning the
global fnancial system. It was created to succeed the Financial Stability Forum (FSF), which was established in 1999 by the G7 ministers of
fnance and governors of central banks in line with the recommendations that Dr Hans Tietmeyer, president of the Deutsche Bundesbank,
gave. Dr Tietmeyer was commissioned by the G7 to propose new
structures to enhance cooperation among the various international
and national supervisory bodies and IFIs in order to ensure the promotion of global fnancial system stability.
He recommended the setting up of a FSF that was endorsed in
February 1999 at a meeting by G7 ministers and governors in Bonn.
The frst FSF was convened in Washington, DC, in April 1999. In
November 2008, the G20 countries’ leaders asked for an expansion of
the FSF to enhance its effectiveness. The membership of the FSF was
expanded and re-established as the FSB. This was announced at the
G20 Leaders’ Summit in April 2009.
The FSB was established to specifcally carry out the following
functions:
• Assessing vulnerabilities affecting the global fnancial system
and identifying and reviewing, on a timely and ongoing basis in
a macro prudential perspective, the regulatory, supervisory, and
related actions needed to address these vulnerabilities and their
outcomes, promoting coordination and information exchange
among authorities responsible for fnancial stability.
• Monitoring and providing advice on market developments and
their implications for regulatory policy
• Monitoring and providing advice with regard to best practice in
meeting regulatory standards
• Undertaking joint strategic reviews of the international standard setting bodies and coordinating their respective policy
200 Joshua Yindenaba Abor et al.
•
•
•
•
development work to ensure this work is timely, coordinated,
focused on priorities and addresses gaps.
Setting guidelines for establishing and supporting supervisory
colleges.
Supporting contingency planning for cross-border crisis management, particularly with regard to systemically important frms.
Collaborating with the IMF to conduct early warning exercises.
Promoting member jurisdictions’ implementation of agreed commitments, standards, and policy recommendations, by monitoring the implementation and through peer review and disclosure.
It is composed of a Steering Committee and three Standing Committees,
(i.e. Standing Committee on Supervisory and Regulatory Cooperation
[SRC)], Standing Committee on Assessment of Vulnerabilities [SCAV],
and Standing Committee on Standards Implementation [SCSI]).
The FSB certainly has a signifcant role to play to promote stability in the global fnancial system. Strict adherence to and implementation of the international standards by members of the FSB is critical to
achieving the overarching objective of international fnancial stability.
Source: www.fsb.org/about/
Schinasi and Truman (2010) identifed six principal areas to consider
in reforming the global fnancial architecture:
• Regulatory requirements for capital, liquidity, and leverage and the
potential benefts/costs of systemic-risk taxes.
• Perimeters or boundaries of fnancial regulation, supervision, and
infrastructures.
• The regulation and surveillance of global money and fnancial markets.
• Systemically important fnancial institutions or the ‘too big to fail’
(TBTF) problem
• Crisis management, rescue, and resolution.
• Effective management of volatile capital fows.
7.7 OTHER NOTEWORTHY ORGANISATIONS/GROUPS
7.7.1 The Group of Seven (G7), Group of Ten (G10)
and Group of 20 (G20)
The G7, G10, and G20 all play crucial roles in the global fnancial architecture due to the infuence they wield and the impact their decisions have on
other countries.
The G7 serves as a forum for the major
industrial nations to discuss economic and fnancial issues among themselves.
7.7.1.1 THE GROUP OF SEVEN (G7)
Chapter 7 • Global fnancial architecture 201
It was formed in 1975 after the collapse of the exchange rate system in 1971,
the 1970s energy crisis and the recession that followed, and during the time
of the Nixon shock. The main aim was to expedite shared macroeconomic
plans and activities. The member countries are Canada (joined in 1976),
France, Germany, Italy, Japan, the United Kingdom, and the United States.
The presidents of the European Council, the European Commission, and the
managing director of the IMF also participate in G7 meetings. Russia was
a member from 1997 until it was suspended in 2014 after its annexation of
Crimea; Russia withdrew in 2017. When Russia was a member, it was known
as the G8. In addition to the yearly meeting of heads of states, since 1987, the
fnance ministers and Central Bank governors of the G7 nations have met at
least every half-year to review and assess economic happenings and policies.
The presidency of the group operates on a rotating basis annually, a new term
commencing on 1 January of the year. The order is as follows: France, the
United States, the United Kingdom, Germany, Japan, Italy, and Canada.
The G7 is important in the global fnancial architecture because of
the wealth and importance of its member countries. However, critics have
argued that the G7 no longer represents the world’s most powerful economies since China is not a member.
The following are some of the initiatives that the G7 has launched:
1 The G7 launched an initiative for 42 heavily indebted poor countries
(HIPC) in 1996.
2 In 1999, the G7 got more directly involved in the management of the
international monetary system through the Financial Stability Forum,
which was formed earlier in 1999, and the G20, which was set up
after the summit to improve discourse between major industrial and
emerging market countries. The G7 also announced their plan to
cancel 90% of bilateral and multilateral debt for the HIPC, totalling
USD100 billion.
3 In 2005, the G7 decided to reduce debts by up to a 100% on a situation
by situation basis.
4 In 2008, the G7 met twice in Washington, DC, and in Rome in February 2019 to deliberate on the global fnancial crisis.
The G10 refers to a group of 11 countries that
agreed to play a part in a supplementary borrowing arrangement for the IMF.
This is known as the General Arrangements to Borrow (GAB), and it allows
the countries to offer support when the IMF’s resources are found to be less
than what a member country, and in some exceptional cases a nonmember
country, needs. This GAB was formed in 1962 by the governments of eight
IMF members and the central banks of two others: Germany and Sweden.
Although Switzerland joined in 1962, the name G10 was maintained.
After it was formed, it broadened its engagement with the IMF, which
led to the creation of the Special Drawing Right (SDR) in 1969. The G10
was also the medium for the discussions that led to the Smithsonian Agreement after the collapse of the Bretton Woods system. Due to the importance
of its activities, the Bank for International Settlements (BIS), the European
7.7.1.2 THE GROUP OF 10 (G10)
202 Joshua Yindenaba Abor et al.
Commission, the IMF, and the OECD are offcial observers of the activities
of the G10. The members of the G10 are Belgium, Canada, France, Germany,
Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom,
and the United States. The Basel Committee on Banking Supervision (BCBS)
was set up by central bank governors of the G10 countries in 1974.
The G20 is a group made up of counties
with both advanced and emerging economies. The members are Argentina,
France, Japan, South Africa, Australia, Germany, the Republic of Korea, Turkey, Brazil, India, Mexico, the United Kingdom, Canada, Indonesia, Russia,
the United States, China, Italy, Saudi Arabia, and the European Union. The
G20 was created in 1999 to improve policy coordination between its members, stimulate fnancial stability, and reform the international fnancial
architecture following the 1990s fnancial crisis.
Membership in the G20 includes the heads of state and government,
fnance ministers, and central bank governors of the G7, 12 other key countries, the European Union, and the European Central Bank. The managing
director of the IMF and the president of the World Bank, plus the chairs of
the IMFC and the Development Committee, also participate in G20 meetings on an ex offcio basis. The IMF works closely with the G20, particularly
on issues related to global economic growth and international monetary
and fnancial stability. The IMF’s work often provides a platform for G20
deliberations; vice versa, agreements reached at the G20 level are taken
into consideration in the IMF’s decision-making process, even though such
agreements have no legal status or binding effects at the IMF. The G20
works closely with the OECD, which is profled next.
7.7.1.3 THE GROUP OF 20 (G20)
7.7.2 The Organisation for Economic Cooperation
and Development (OECD)
The OECD is an intergovernmental economic organisation with 36 members. It was formed in 1961 to kindle international trade and economic
growth. The OECD’s member countries and partners collaborate on global
issues at local, national, and regional levels. Its headquarters are in Paris,
France. The OECD works with government policymakers and citizens to
set international norms and fnd solutions to social, economic, and environmental issues. Some of the issues they work on include improving economic
performance, creating jobs, improving education, and battling international
tax evasion. All of this is done through data and analysis, the exchange of
experiences, best practice sharing, and advice on public policies and global
standard setting.
The OECD works through a secretariat. The Secretariat’s work is
oriented by OECD members whose representatives participate in OECD
committees and working parties. There are some committees with each
directorate or department supporting one or more committees. There are
also some committee working parties and subgroups. The OECD has a
well-being index based on 11 topics: housing, income, jobs, community,
Chapter 7 • Global fnancial architecture 203
education, environment, civic engagement, health, life satisfaction, safety,
and work–life balance.
The OECD has acted as a strategic advisor and is an active partner to
the G20. The OECD participates in G20 working group meetings and provides data, analytical reports, and proposals on specifc topics, sometimes in
collaboration with other international organisations. The OECD contributes
to all stages of preparation of G20 summits. The G20 does not have a secretariat but relies on the support of established international organisations.
As a result, the OECD secretariat has evolved into a quasi-secretariat of the
G20. For example, the OECD and G20 countries worked together for two
years to develop new international tax standards and measures, addressing
issues like preventing treaty shopping, country-by-country reporting, and
fghting harmful tax practices.
7.8 THE UN SUSTAINABLE DEVELOPMENT
GOALS (UN SDGS)
The SDGs consist of 17 goals and 169 targets adopted by the United Nations
in 2015 to replace the Millennium Development Goals (MDGs).
The goals relate to development and empowerment and include issues
such as poverty, hunger, women’s empowerment, affordable and clean
energy, taking care of the environment, decent work, clean water and sanitation, and quality education. Given the worldwide scale of the SDGs, meeting the SDGs is expected to lead to more development overall.
The United Nations Conference on Trade and Development (UNCTAD) in 2015 estimated that about USD5–7 trillion would be required
annually until 2030 in order to achieve the SDGs. This funding gap is
enormous and may require the support of fnancial institutions. The SDG
fnancing gap arguably represents a tremendous opportunity for fnancial
institutions.
Weber (2018) argues that fnancial institutions have a critical role to
play in fnancing the SDGs through various fnancing options. He outlines
different types of banking as well as fnancial products and services that
might address the SDGs, including conventional banking. These include
socially responsible investing (SRI), impact investing, social banking, green
and social impact bonds, development banking, project fnance, and green
lending.
Schmidt-Traub and Sachs (2015) point out that multilateral development banks (MDBs) have the requisite structures and mechanisms to
fnance the SDGs because of their mandate to support development-related
programmes, expertise of their staff, and track record in managing complex
projects, among other strengths. However, they posit that the conservative
loan approach of MDBs is a constraining factor on their increasing their
lending activities.
Wiek and Weber (2014) posit that the fnancial sector can both be the
source of sustainability problems and the solution to those problems through
their fnancing choices. Some MDBs fnance climate-change-mitigation
204 Joshua Yindenaba Abor et al.
TABLE 7.2 Financial products and services addressing the SDGs
Goal
Goal detail
Suggested fnancial product for fnancing
1
No poverty
2
3
4
5
No hunger
Good health and well-being
Quality education
Gender equality
6
Clean water and sanitation
7
8
Affordable and clean energy
Decent work and economic growth
9
Industry innovation and
infrastructure
Private international development
fnance through impact investing
Microfnance for smallholder farmers
Healthcare investments
Philanthropic donations to schools
Microfnance and lending to women
and female entrepreneurs
Socially responsible mutual funds
investing in water
Renewable energy investment
General investments into the real
economy
Project fnance and commercial lending
integrating social and environmental
criteria for lending decisions
Fair payment of fnancial sector
employees
Mortgage lending
Socially responsible investing
10
Reduced inequalities
11
12
Sustainable cities and communities
Responsible consumption and
production
Climate action
Life below water
Life on land
Peace, justice, and strong
institutions
13
14
15
16
Climate fnance
Financing ecological services
Financing ecological services
Lending to public institutions
Source: Weber (2018)
and climate-change-adaptation projects while fnancing coal power plants
(Ghio, 2015; Yang & Cui, 2012).
7.9 CONCLUSION
This chapter has provided an extensive review of the wide range of institutions that make up the global fnancial architecture. There has been signifcant expansion and development of the global fnancial architecture since the
end of the Second World War and especially in more-recent decades with the
unprecedented growth in global capital fows and the globalisation of trade.
We have paid particular attention to the events that have led up to and that
have emerged since the eruption of the global fnancial crisis in 2008.
Since the 1970s, there has clearly been a marked shift in the focus of
global and national fnancial regulation away from product and price controls and towards stronger prudential regulation and supervision. Global
competition has never been more intense, but more-recent events have
exposed the extent to which fnancial institutions are vulnerable to greater
risks in the context of a rapidly evolving global fnancial framework.
Chapter 7 • Global fnancial architecture 205
Discussion questions
1 Describe the global fnancial architecture and the key features of the
international fnancial system?
2 Consider any country of your
choice and examine the structural
adjustment programme implemented in that country. Evaluate
the success or otherwiseof the
programme.
3 Discuss the role of regional development banks in fnancing development projects.
4 What is fnancial globalisation?
Examine the relevance and benefts of fnancial globalisation and
the risks associated with it.
5 Discuss the dynamics of fnancial
globalisation. In what ways did
fnancial globalisation contribute
to the global crisis?
6 Evaluate some of the proposals on
reform after the global fnancial
crisis.
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CHAPTER
8
Sovereign wealth
management
Mbako Mbo and Charles Komla Delali Adjasi
8.1 INTRODUCTION
Sovereign wealth management centres on prudent public fnance management, wherein the need to plan for economic shocks and taking care
of excess liquidity (arising mainly from monetised natural resources), have
historically motivated a conscious approach to managing sovereign wealth.
In essence, current wealth accruing to the state is partly saved up for the
future. Countries endowed with natural resources periodically experience
excess liquidity, particularly corresponding to periods of global economic
boom, but quite commonly too, recessions do occur. Thus, the effects of economic recessions are substantially diluted by calling up on fnancial wealth
accumulated during periods of excess liquidity.
Countries beneft from their natural resources in a number of ways;
Chile, which opted to nationalise its copper mines, benefts directly from
fnancial returns from these mines, just as the state-owned oil companies
among the Persian Gulf countries have been at the forefront of sovereign
wealth creation in that region. Botswana, a country frequently cited as an
African example of how natural resources can transform a nation, has not
nationalised its diamond and other mines (although it holds a stake), but
rather benefts through distributions, royalties, and taxes.
Although natural resources dominate the original sources of allocations made towards sovereign wealth accumulation by governments, with
oil and gas in the lead at 56% of the cases,1 the Wharton Leadership Centre
lists other common sources as balance of payment surpluses, offcial foreign
currency operations, the proceeds of privatizations, fscal surpluses, and
receipts resulting from commodity exports.2
Although countries have held reserves in one form or another for centuries, the concept of managing sovereign wealth in a fund setup is a recent
one, commonly associated with funds that evolved alongside the Persian
Gulf States oil strikes in the 1950s. Successive waves of similar types of
funds continued to emerge almost throughout the decades that followed,
corresponding mainly to booms in oil and other natural resources in countries like South Korea, UAE, Saudi Arabia, and Iran.
With the proliferation and success of sovereign wealth funds (SWFs)3
since the 1950s, the objectives of sovereign wealth management have
been interestingly expanding, particularly so in emerging economies. The
208 Mbako Mbo and Charles Komla Delali Adjasi
increasing pressures on traditional sources for domestic infrastructure development funds in particular have forced governments to seriously look into
the diversifcation and externalisation of revenue streams. In 2007 the International Monetary Fund (IMF)4 offered a broad categorisation of funds involved
in sovereign wealth management, on the basis of their stated objectives:
1
2
3
4
5
Stabilization funds.
Savings funds.
Reserve investment funds.
Development funds.
Contingent pension reserve funds.
The expanding objectives and focus of sovereign wealth management
have reshaped the approach to it and its position in the global economy,
fnancial markets in particular. In this chapter, we look at the evolution and
overview of sovereign wealth management, the changing role of sovereign
wealth managers, asset-liability management in emerging economies, asset
allocation and risk management for sovereign wealth funds, and the challenges and opportunities of sovereign wealth funds.
8.2 THE CONTEXT OF SOVEREIGN WEALTH
MANAGEMENT
The existence of failed economies around the world epitomises the reality
that sovereign states, just like corporations, can fall into positions where
they have no resources with which to fulfl their sociopolitical and national
defence objectives. Unfortunately, failed economies are not always a result
of a lack of economic resources, and causes extend to poor governance and
sheer lack of economic foresight; in all probability, this situation is avoidable. For example, in ‘Conceptualising the Causes and Consequences of
Failed States’, John (1998) cites countries like Venezuela, Tanzania, Ghana,
and Zambia as some of the countries that faced the imminent failure of the
economy at some point. This is despite a wide range of economic resources
that these countries have been endowed with – for example, the diamonds
and natural gas in Venezuela, copper in Zambia, and forestry and wildlife
resources in Tanzania. Ghana has since emerged as one of the fastest growing economies across the African continent, posting an impressive gross
domestic product (GDP) growth Awanzam and Okudzeto (2018).
However, good governance and sociopolitical unrest on their own are
not enough; countries heavily dependent on natural resources in particular
are prone to both resource depletion and moderate to severe economic shocks.
A case in point is what transpired in the oil-rich Middle East as an aftermath
on the 2007/2008 global fnancial crises. Aggregate GDP growth rates for Golf
Cooperation Council (GCC) economies dropped from 7.2% to a mere 0.8%,
and housing prices plummeted by as much as 62% in Kuwait (Salah, 2010).
Although the role of the government in the global economy has gradually neutralised over time, albeit at different scales across geographies, private wealth is yet to demonstrate its ability to avert, its willingness to avert,
or even an active relevance in averting state economic failures. On the contrary, we have seen state bailouts and private capital fight during times
of economic hardship; the 2007/2008 fnancial crises saw the US federal
Chapter 8 • Sovereign wealth management 209
government approve a USD700 billion rescue plan for corporations that
were facing total collapse as a result of an economic downturn. Otherwise,
capital outfow patterns displayed some negative response to the fnancial
crises (Cheung, Steinkamp, & Westermann, 2013).
Clearly, good economic governance should embody foresight, and an average economy must be able to withstand severe but plausible economic shocks, at
least over a period of time. With such in place, a sovereign will maintain socioeconomic stability, which is also critical for retaining private capital. Private capital is simply not widely available for the rescue of sovereigns facing economic
troubles; it is for the creation of private wealth. Consequently, SWF management
needs to become a prominent feature of good economic management.
8.3 THE ANALYTICAL FRAMEWORK
To put the discussions of this chapter into context, we use the analytical
framework in Figure 8.1.
FIGURE 8.1 A conceptual framework for SWF
BODY OF THEORY
Trade Surpluses
Evolution of Sovereign
Wealth Management
˜
Lessons Learnt (Economic
˜
downturns)
˜
Strategic Control
Theories of
Economics
International Trade
Theory
Financial
Management
Theories
Sovereign Wealth Funds (SWFs)
˜
Set-up
Funding
˜
˜
Management
˜
Commercialized
Public Entity
Outsourced
Management
Level of Political
control
Board Structures
Corporate Governance
The
more
“Traditional Funds by role/type
o Stabilization
o Savings
o Reserves & Pensions
o Development
A policy Tool
Roles”
The Role of Sovereign
Wealth Funds
The emerging Roles
An international Economic
Cooperation Tool
Opportunities
Capital availability
Public Private Partnerships
Patient Capital
Challenges
risk/return Information Asymmetry
Threats to financial stability
adjustment, role of Government
Capital
flow
patterns,
Asset Price distortions
210 Mbako Mbo and Charles Komla Delali Adjasi
8.4 EVOLUTION AND OVERVIEW OF SOVEREIGN
WEALTH MANAGEMENT
SWF management gained momentum from the 1950s with the setting up
of funds focused on sovereign wealth investment, which progressively got
dotted the globe, as depicted in Figure 8.2.
Even though the term ‘sovereign wealth fund’ is believed to have been
coined as recently as 2005, funds involved in the management of sovereign
wealth have been emerging over several decades, particularly since the 1950s.
In Figure 8.3, we show the trends in the building up of these funds over the
years, which for now we shall not necessarily refer to as sovereign wealth funds.
FIGURE 8.2 Evolution of SWF over time
FIGURE 8.3 Cumulative growth in the number of funds, 1953–2017
90
80
70
60
50
40
30
20
0
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
10
Chapter 8 • Sovereign wealth management 211
For the purposes of our discussion, the proliferation of funds involved
in the management of sovereign wealth (see Dixon, 2016) shall be considered in three distinct phases; before the 1970s, before the fnancial crisis of
2007/2008, and the period following the 2007/2008 global fnancial crisis.
8.4.1 Before the 1970s
According to the Sovereign Wealth Fund Institute, only three sovereign
wealth–focused funds were in existence as of the fall of 1970, domiciled in
the US and the Persian Gulf regions. It is widely believed that the Kuwait
Investment Board, founded in 1953 (now the Kuwait Investment Authority) was the world’s frst investment vehicle to be given a sovereign wealth
management mandate, followed three years later by the Revenue Equalisation Reserve Fund in the pacifc island of Kiribati. The genesis of Kuwait’s
massive wealth potential came with the oil discovery in 1938, although no
large-scale exploration activities were carried out until after World War II.
By 1951 Kuwait had begun signifcant oil trading activities, realising massive exports leading to an impressive sovereign wealth accumulation trend.
This growth in wealth then triggered the setting up of a sovereign wealth–
focused fund in 1953.
Around the same time, the geographically isolated pacifc island of
Kiribati (then Gilbert), which had traditionally relied on tax and royalty
revenues linked to phosphate mining, was forecasting a decline in national
income. The Revenue Equalisation Reserve fund was thus set up in 1956
to diversify sources of government revenues from phosphate-mining
activities.
Alongside Kuwait, Saudi Arabia discovered massive oil deposits,
although its exploration work and actual trading began much earlier. The
kingdom experienced a large infux of foreign currency from its oil-related
exports as from the late 1930s prompting the king, under the advice from
some US offcials, to set up a central bank of some sort. Thus, the SAMA Foreign Holdings was formed in 1952, but initially not with a specifc sovereign
wealth management mandate like that of the Kuwait Investment Board.
SAMA, or the Saudi Arabian Monetary Authority, has since evolved to be
the kingdom’s fully fedged central bank, with just under USD500 billion in
assets under management (AUM) by February 2018.
The concept of managing sovereign wealth gained recognition during
the early 1950s, driven by two primary variables: excess wealth accumulating from monetised oil resources (Kuwait and Saudi Arabia) and the need
to diversify the economy from overrelying on a single commodity (Kiribati).
According to the Sovereign Wealth Fund Institute, no further funds came
into being until the mid 1970s, when another wave was experienced, lasting
into the 2000s. This phase is considered in the next section.
8.4.2 Before the fnancial crisis of 2007/2008
The Sovereign Wealth Fund Institute lists 37 funds with mandates related
to sovereign wealth management that emerged between 1974 and 2006, a
212 Mbako Mbo and Charles Komla Delali Adjasi
year before the global fnancial crisis of 2007/2008. Oil and other natural
resources continued to dominate the origins of the funds, but other sources
began to emerge, including surpluses on balance of trade accounts and general budget surpluses. The regional dominance by oil-rich territories began
to dilute as well, and Asia took the lead in funds emerging as of 1969 and
until 2006, funded from sources other than oil.
The historically central role played by oil production in the evolution of sovereign wealth management cannot be underplayed. The
average OPEC oil price (crude) per barrel experienced signifcant downwards pressure as from the mid 1980s, remaining relatively subdued at
below USD20 per barrel until two decades later, when the price recovered to an average USD27.6 per barrel in 2000. Corresponding to this is
a signifcant drop in the emergence of sovereign funds, particularly outside Asia were only three funds were registered in Norway (Government
Pension Fund–Global in 1990), Botswana (Pula Fund in 1994), and Abu
Dhabi (Mubadala Investment Company in 2002 and Abu Dhabi Investment Council in 2007).
Similarly, unlike the Persian Gulf countries, the advent of sovereign
wealth management in Eastern and South Eastern Asian countries was
not predominantly driven by oil production. Most sovereign wealth–
focused funds in these countries emerged after 1970, alongside a wave of
industrialisation among the Asian Tigers (Singapore, Hong Kong, Taiwan,
and South Korea). A signifcant rise in economic performance was also
being registered in Southeast Asia as from the late 1960s into the next few
decades, driven mainly by the ability to export agricultural produce and
processed food.
Oil regained its position as a signifcant driver of sovereign wealth,
with an upsurge of oil surplus originated funds between 2000 and 2007
in oil-rich states in Asia once again, but particularly in the Middle East.
This is a period characterised by a steadily rising price of crude oil, which
improved from an average of USD28 per barrel in 2000 to USD69 per barrel
in 2007 and up to USD94 in 2008, before a dramatic drop to USD61 per barrel a year later.
FIGURE 8.4 SWF by source of seed capital
Original Sources of funds emerging between
1970 and 2006
Non oil sources
South
Amercia
Africa &
Europe
Middle East
Other
sources
Asia
Oil
Chapter 8 • Sovereign wealth management 213
FIGURE 8.5 Evolution of SWFs in Asia (pre-2007/2008 fnancial crisis)
Asia
1970–1979 1980–1989 1990–1999 2000–2007
Temasek Holdings (Singapore)
Hong Kong Monetary Authority
Investment Portfolio Khazanah
Nasional (Malaysia)
Brunei Investment Agency
Singapore Investment Corporation
Hong Kong Monetary Authority
Investment Portfolio
SAFE Investment company (China)
Kazakhstan National Fund (Kazakhstan)
State oil fund (Azerbaijan)
Korea Investment Corporation
Timor Leste Petrolium Funds (East Timor)
State Capital Investment Corporation
(Vietnam)
The Middle East region has been the pioneer of sovereign wealth management, driven mainly by accumulating oil-linked fscal surpluses. The oil
surpluses were supported by steady to rising oil production on the back
of a strong recovery of global crude oil prices. Figure 8.6 depicts crude oil
production and price trends between 1998 and 2008.
During this period, seven sovereign funds came into being, four of
which in the United Arab Emirates (UAE), where the average daily oil
production grew by 16% from 1999 levels to exceed three million barrels per day in 2007. Production in Bahrain and Oman remained fairly
stagnant between 1999 and 2007, with marginal oscillations, while Qatar
registered an impressive 75% jump in daily oil production in the same
period.
The evolution of sovereign wealth management in Africa continued,
but at a more noticeable pace only from the early 2000s. Oil-rich nations
like Libya, Gabon, and Algeria had lagged behind for geopolitical and economic reasons. Libya, for one, emerged from heavy sanctions imposed on it
frst by the US in 1978 initially targeting military supplies but later extending to oil trade in 1982. The United Nations (UN) and the European Union
(EU) also came up with their own sets of sanctions against Libya in 1992,
thereby compounding the trade complications. Not until 2004 did the US lift
its sanctions, followed shortly by the EU and UN. This opened new trade
possibilities between Libya and rest of the world, coming at a time when the
oil price was on a speedy recovery, exceeding USD50 per barrel for the frst
time in history in 2005. Surpluses began to soar, and the Libyan Investment
Authority was born in 2006.
Algeria joined the bandwagon in 2000, after successfully arresting
its own economic woes, which included crippling amounts of public debt,
widening fscal defcits and arguably, limited trading partners (until then,
214 Mbako Mbo and Charles Komla Delali Adjasi
FIGURE 8.6 Trends in the Middle East: oil prices and production
12,000
100
1,000 barrels per day
10,000
80
70
8,000
60
50
6,000
40
4,000
30
20
2,000
-
USD/barrel of crude oil
90
10
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Iran
Iraq
Kuwait
Qatar
Saudi Arabia
United Arab Emirates
Other Middle East
Oil Prices
-
FIGURE 8.7 Evolution of SWFs in the Middle East (pre-2007/2008 fnancial crisis)
Middle East
1970–1979 1980–1989 1990–1999 2000–2007
Abu Dhabi Investment Authority Saudi
Arabia Public Investment Fund State
General Reserve Fund (Orman)
Abu Dhabi investment Council
Mubadala Investment Company
(Abu Dhabi) Investment Corporation
if Dubai Orman Investment Fund
Mumtalaka Holding (Bahrain)
Qatar Investment Authority RAK
Investment Authority – UAE
Algeria had remained too reliant on France, and the ties between the two
countries remain strong to date).
Other nations like Gabon, where a sovereign wealth fund came into
being in 1998, and Equatorial Guinea, where the Future Generations Fund
was incepted in 2002, had previously limited their international trading avenues through their own laws and regulations. Gabon, after joining the WTO
in 1995, introduced a new and relatively progressive investment code in
1998, which was seen as conforming, in all material respects, to the Central
African Economic and Monetary Community (CEMAC) investment regulations. This facilitated domestic trade but more importantly, from sovereign
wealth perspective, Gabon’s ability to partake foreign investment.
Equatorial Guinea made its large oil discovery in 1996, but its recorded
sovereign wealth management activity began in 2002, when reserves accumulated to signifcant growth, driven by increasing production supported
by improving prices of crude.
Chapter 8 • Sovereign wealth management 215
FIGURE 8.8 Evolution of SWFs in Africa (pre-2007/2008 fnancial crisis)
Africa
1970–1979 1980–1989 1990–1999 2000–2007
Revenue Regulation Fund (Algeria)
Gabon Sovereign Wealth Fund
National Fund for Hydrocarbon
Reserves (Mauritania) Fund for
Future Generations (Equatorial
Guinea)
Pula Fund (Botswana)
Libyan Investment Authority
FIGURE 8.9 Evolution of SWFs in other parts of the world (pre-2007/2008
fnancial crisis)
Other
1970–1979 1980–1989 1990–1999 2000–2007
Alaska Permanent Fund (US)
Social and Economic Stabilisation
fund (Chile)
New Zealand Superannuation Fund
Future Fund (Australia)
Government Pension Fund–Global
(Norway)
Like in the period leading to 1970, the evolution of sovereign wealth
management into the 21st century was driven predominantly by fscal
surpluses, although the dominance of oil as the major contributor to such
surpluses somewhat declined between 1980 and 1999, mainly as a result
of depressed oil prices. Industrialisation and commodity-led international
trade boosted the accumulation of surpluses among the Asian Tigers (Singapore, Hong Kong, Taiwan, and South Korea) and the high-performance
economies in Southeast Asia.
The signifcant and sustained recovery of global crude oil prices
in the early years of the 21st century propelled fscal prosperity in oilrich states, particularly in Middle East but also, interestingly, in Africa,
where economic reforms were being undertaken alongside improving
geopolitical dynamics in countries such as Libya, Gabon, Algeria, and
Guinea-Bissau.
8.4.3 Period succeeding 2007/2008 global fnancial crisis
The majority of countries around the world experienced a major economic downturn due to the 2007/2008 fnancial crises, which affected both
advanced and emerging economies. The genesis of these crises has been
traced to the US subprime lending, which is estimated to have swelled up to
216 Mbako Mbo and Charles Komla Delali Adjasi
a trillion dollars by 2007, representing a signifcant 7% of overall outstanding mortgages in the US. Perhaps two main features made the subprime
mortgage prominently problematic:
1 Low credit quality (i.e. the borrowers in this instance were generally
those with ultra-low credit scores).
2 The loan-to-value ratios were high.
As fate would have it, the housing market collapsed, and borrowers
defaulted and could not release the bonded assets primarily, because market conditions were not supportive. Credit losses among individual banks
swelled up to drastically affect the collective banking market (see Shabbir, 2009), the ability to extend new credit lines shrunk, and the fow of
money that was needed to propel economic growth dried up. The activity levels of creating, buying, and selling new assets hit historic lows, and
international trade slumped, leading to reducing trade surpluses, forcing
countries to turn to reserves. All this happened when the level of the integration of the world economy had advanced, with trade dependency on
the historically isolated China estimated to be over 65%. This precipitated
the rate at which the fnancial crises spread from the US to rest of the world.
The reduced world economic activity, on the other hand, was affecting the
global demand for oil, leading to a 33% slump in price of crude to average
at USD61 per barrel during 2009.
For sovereign wealth management, the surpluses that had, at this
point, driven the evolution of sovereign funds were dwindling and in fact
became a thing of the past in some jurisdictions. The two main drivers
of these fscal surpluses had taken a hit: favourable trade balances and
‘healthy’ oil prices. Surprisingly, a total of seven sovereign funds came
into being at the pick of the fnancial crises, four of which were funded
from oil-related fscal surpluses (Saudi Arabia Public Investment Fund,
Russia National Welfare Fund, Samruk-Kazyna JSC, and Turkmensistan
Stabilisation Fund).
Seemingly, important lessons were learnt from the effects of the fnancial crisis, as a historic 18 sovereign funds came into being within the frst
FIGURE 8.10
Evolution of SWFs: the aftermath of the 2007/2008 global
fnancial crisis
2008–2009 2010–2016
Saudi Arabia Public Investment Fund
Russia National Welfare Fund
Samruk-Kazyna JSC: Kazakhstan
Sovereign Fund of Brazil
Turkmenistan Stabilisation Fund
Sharjah Asset Management- UAE
Russian Reserve Fund
Chapter 8 • Sovereign wealth management 217
six years after the pick of the crisis in 2008/2009. The naming conversion
of some of the funds that came into being post fnancial crisis are refective of lessons learnt from the dangers of depleting reserves: North Dakota
Legacy Fund, Colombia Savings and Stabilisation Fund, Western Australia
Future Fund, Mongolia Future Stability Fund, West Virginia Future Fund,
and Luxembourg Intergenerational Fund. Thus, instead of being seen primarily as a surplus driven vehicle, nations, perhaps from the lessons of the
crises, began to comprehend the idea of actively seeking to create reserves
for the future.
Angola is also a case in point; in 2012, the government set up a USD5
billion SWF known as the Fundo Soberano de Angola (FSDEA) with a specifc mandate to safeguard existing wealth for future generations. Its investment philosophy was to target low-risk non-oil industries that would then
diversify future wealth prospects away from oil.
Despite a signifcant recovery of oil prices as from 2010 continuing
until 2013, oil once again lost its dominance as an originator of sovereign
wealth funds, and only seven of the 18 funds originated from oil-linked fscal surpluses.
Natural resources, initially oil but later other resources like minerals, have supported the growth of global trade and attendant surpluses.
SWM gained popularity: no fewer than 80 sovereign wealth funds dotted the globe5 by early 2018. The SWFI estimates its member SWF to
have held a combined USD7.7 trillion in AUM at the end of February
2018.
FIGURE 8.11 Evolution of SWFs post-2007/2008 global fnancial crisis
2008–2009 2010–2016
National Development Fund of Iran
Russia Direct Investment Fund
North Dakota Legacy Fund–US
Colombia Savings and Stabilisation Fund
Kazakhstan National Investment Corporation
Bayelsa Development and Investment Corporation-Nigeria
Nigerian Sovereign Investment Authority
Fondo de Ahorro de Panama
FINPRO- Bolivia
Senegal FONSIS
Ghana Petroleum Funds
Western Australia Future Fund
Mongolia Future Stability Fund
Papua New Guinea Sovereign Wealth Fund
West Virginia Future Fund
Fondo Mexicano del Petroleo
Luxembourg Intergenerational Fund
Turkey Sovereign Wealth Fund
218 Mbako Mbo and Charles Komla Delali Adjasi
8.5 SWF FUNDING, MANAGEMENT, AND GOVERNANCE
8.5.1 Funding
As we highlighted in earlier sections, SWFs are born out of an intention to
prepare for the future, be it to shield national revenues from volatility or
saving for future generations. Invariably, governments allocate substantial
amounts as seed capital for SWF formation; an example includes Angola’s
FSDEA USD5 billion in 2012 (World bank, 2013). After its formation, funding modalities for SWFs differed, including a purely self-funding arrangement and some formula-based allocation from state revenues. SWFs like
Mubadala of Abu Dabhi, Botswana’s Pula Fund, and Temasek of Singapore
are examples of state-backed SWFs with no regular government funding. At
the other end of the spectrum, the Funds for Future Generations in Equatorial Guinea has a commitment from the government for a stipulated 0.5%
annual allocation from oil revenues. In between the continuum exist some
SWF whose continuing state support is contingent on certain conditions or
the occurrence of certain events. A perfect example in this case is the Economic and Social Stabilisation Fund of Chile, which from its inception had
an entitlement to an allocation from a state budget devised when copper
revenues were optimal.
How an SWF is supported by a sponsoring government from time to
time can be seen as linked to its broad objective or simply its type. Saving
funds and stabilisation funds typically get a one-off but substantial capital
and thereafter self-fund from a little portion of their returns: the portion that
does not get reinvested. By contrast, development and future generations’
funds typically get additional allocations for incremental investments.
8.5.2 Governance and management structures
The governance and management structures of SWFs are predominantly
infuenced by investment strategy, investment approaches, and risk appetite. The setup normally ranges from institutional arrangements supported
wholly by management and governance structures of a sponsoring institution (a ministry of fnance or a central bank), to a fully fedged institution with its own staff, management, and board. The former is typical with
stabilisation and saving funds, which normally carry a low risk appetite,
investing only in premium securities. Such an approach to investment does
not call for fully fedged investment teams, because there is little monitoring
beyond analysis and reporting; neither do they pursue any implementation of investment projects. Botswana’s Pula Fund is an example: it was set
up by the central bank (Bank of Botswana), which manages and controls it
under its regular management structures. The fund is essentially a longterm investment portfolio aiming to preserve part of diamond income for
future generations through global investments in low-risk instruments.
On the other end of the spectrum, we fnd Temasek, the Singaporean
SWF. Temasek is a fully fedged corporation employing over six hundred
personnel across its ten offces in different parts of the world. The SWF is
Chapter 8 • Sovereign wealth management 219
governed by a fully fedged 14-member board, with a team of 25 senior
executives leading the operations. Again, the relevance of such a structure
stems from Temasek’s approach to investment and from the risk appetite;
it is an active investor that buys and holds stakes in subsidiaries and associate companies and spends time assessing other risky investments of higher
long-term returns.
Between these two extremes other variants may exist, typically involving a skeletal caretaker team hosted by the sponsoring government or central
bank, where such a team would be involved in outsourcing asset management services to third-party frms not owned by a government. For instance,
external managers administer the equity and corporate fxed-income portfolios of Chile’s SWF.
8.6 THE CHANGING ROLE OF SOVEREIGN
WEALTH MANAGERS
Traditionally, sovereign wealth management seems to have concerned itself
with saving up current and trade surpluses for the future. Perhaps a more
structured approach to defning the role of sovereign wealth managers can
be borrowed from the IMF’s Global Financial Stability Report produced in
October 2007, at the start of the US subprime crises. The report provides
the following taxonomy: stabilisation funds, savings funds, reserve funds,
development funds, and pension reserve funds.
8.6.1 Stabilisation funds
These are set up to cater for effects on inadequate diversifcation of national
revenue sources, typically by countries endowed with natural resources.
Surpluses from the trade of the natural resources are saved and called upon
when national revenues decline, usually due to depressed commodity
markets. A perfect example is the Economic and Social Stabilisation Fund
(ESSF) of Chile, established in 2007 to provide fscal spending stabilisation
by reducing dependency on the global economic and copper trading cycles.
The ESSF is funded from the fscal surplus, net of allocations to the Pension Reserve Fund, and any residual public debt obligations. Periodically,
budgetary constraints imposed by economic downturns are mitigated by a
partial call from the fund, thus avoiding the accumulation of national debt.
8.6.2 Savings funds
These are ‘intergenerational funds’ that are based on monetising existing
natural resources for the beneft of both present generations and future generations. As observed by the IMF, these funds effectively transfer nonrenewable assets into a diversifed portfolio of international fnancial assets
to provide for future generations or other long-term objectives. An example
in this case is the Equatorial Guinea’s Fonds de Réserves pour Générations
Futures (Funds For Future Generations) formed in 2002. While a full picture
220 Mbako Mbo and Charles Komla Delali Adjasi
on the fund’s performance remains largely obscure, the government’s pronounced intention at the fund’s inception was to commit transferring to it
0.5% of its oil revenues for the beneft of the future generations.
8.6.3 Reserve funds
Unlike the surplus-driven funds, which have tended to stabilise government budgets during times of constrained revenue infows, reserve funds
are set up to pursue savings objectives, usually with increased latitude to
actively pursue higher returns but still within the scope of a conservative
risk appetite. According to the IMF, assets held under reserve funds count
towards total fscal reserves and can be liquidated in times of need. A typical example is Botswana’s Pula Fund – established in 1994 and managed by
the central bank of Botswana. The fund manages foreign exchange reserves
that are more than what is expected to be needed in the medium term. Signifcant calls were made from the fund in 2001, when a Public Offcers’ Pension Fund was set up, and in 2008, due to a slump in national revenues that
was induced by the global fnancial crisis of that time.
8.6.4 Development funds
These are mostly development corporations, set up to pursue socioeconomic objectives. Typically, these corporations invest in projects with
demonstrable development outcomes and in industries and sectors that do
not have adequate private sector participation (mainly due to high risk but
low returns). Increasingly, development funds are becoming vehicles for
public–private partnership (PPP) transactions. Dubai Investment Capital
(DIC), a subsidiary of Dubai Holding, is a corporate SWF with an investment strategy that incorporates well the concept of looking beyond fnancial
returns for wider socioeconomic development. DIC played, and continues
to play, a pivotal role in the development of the boating and marine sector
in the UAE region through its investment in ART Marine Holdings. The
company is also at the forefront of importing aerospace technology from the
world into Dubai, through its investments.
8.6.5 Pension reserve funds
These funds cater for pension liabilities, and the objective is often to ensure
that pension liabilities always remain below funded assets without having
to resort to some politically unacceptable mechanisms, for example cutting
back on pension entitlements. The largest known SWF that can be classifed
into this category is the Norwegian Government Pension Fund–Global, set
up in 1990 to invest surpluses driven by a well-performing petroleum sector. Its stated mission is ‘to safeguard and build fnancial wealth for future
generations’, and its AUM had accumulated an estimated USD1 trillion by
early 2018.
Therefore, the original objective of sovereign wealth management
has really been to put aside, and grow over time, some fnancial assets to
Chapter 8 • Sovereign wealth management 221
cater for a future occurrence. However, the evolution of sovereign wealth
management has by itself infuenced a gradual evolution of objectives and
consequently the role of sovereign wealth managers. Rapid wealth accumulation by SWF in surplus economies, which is at times way beyond precautionary levels, has attracted attention of critics given the transparency
concerns around some of the larger SWFs.
Modern-day sovereign wealth managers’ tasks are much broader,
and they aremore proactive in nature; although traditionally SWFs have
evolved in reaction to fscal surpluses, today SWFs proactively pursue the
socioeconomic (and sometimes geopolitical) ambitions of their respective
countries. Next we explore a suite of newer objectives of sovereign wealth
managers, and this does not that claim any of the older objectives has been
subordinated or replaced.
8.6.6 A role in the capital and fnancial markets
Sovereign funds quite often have opportunities to operate a lean cost structure not riddled with debt issuance, service costs, and expected returns
from equity holders. This is because SWFs are generally funded from state
funds. In addition to this, sovereign funds are seldom operating companies;
most take the form of investment-holding companies with lean operational
structures. Compared to other fnancial institutions, the substantially lean
cost structure of SWFs brings two possibilities, among others.
First, a lower cost base allows SWFs to accept lower returns and sometimes in riskier investments that would ordinarily fnd it diffcult to attract
purely private capital. Thus, SWFs are increasingly becoming an important
source of capital for strategic or even risky investments with a huge potential on the upside.
Second, SWFs generally do not have operational cashfow pressures, as a direct result of a low-cost base. This enables them to provide
the much-needed capital in projects with a long payback profle. These
are typically much-needed infrastructure projects in developing economies, and SWFs occasionally support these under some form of bilateral
agreements.
Third, sovereign wealth funds typically hold excessive relative liquidity, with increased capacity to withstand credit losses. This, coupled with
the fact that SWFs have ‘patient capital’ (i.e. can invest in longer-term horizons for conservative returns), makes them crucial sources of liquidity in
the wake of credit crunches and widespread fnancial crisis. What we saw in
the aftermath of the 2007/2008 fnancial crisis is a case in point; when severe
credit losses, combined with a slump in property prices, threatened the
existence of large fnancial institutions, and consequently the global fnancial markets themselves, SWFs came to the rescue. Between 2007 and 2008,
in the US alone, a total of 30 rescue transactions were recorded, wherein
SWFs invested a combined USD40 billion in capital into fnancial institutions. SWFs such as Kuwait Investment Authority, Abu Dhabi Investment
Authority, and Temasek injected capital, thereby acquiring stakes in banks
like Merrill Lynch and Citigroup.
222 Mbako Mbo and Charles Komla Delali Adjasi
8.6.7 A policy tool
In a rather controversial emerging practice by some nations, SWFs are gradually playing a policy role. Some SWFs have in recent times been relied on
as vehicles through which countries adopt a carrot-and-stick approach to
achieve their broader policy objectives, a practice that has attracted some
scepticism and heightened calls for transparency. In 2008, the Chinese government, acting through its own SWF the State Administration of Foreign
Exchange (SAFE), invested USD300 million of government bonds issued by
Costa Rica. Following a constitutional court case, the Costa Rican government was compelled to release documents, initially meant to be confdential, that were widely interpreted to mean that China was investing in Costa
Rican bonds, in order to open diplomatic relations between the two nations,
in return for which Costa Rica was to cease its recognition of Taiwan. Interestingly, the purchase of the bonds was followed by Costa Rica’s swiftly
cutting its long-standing diplomatic ties with Taiwan.
Often geopolitical concerns seem to arise when SWFs act with less
transparency, particularly with respect to their intentions. For policy intentions to be achieved, it is almost preconditional that the two or more nations
involved are fully agreeable and all suspicion is erased. In 2006, Dubai Ports
World (DP World, or DPW) attempted to acquire a British-owned company, which held seaport management contracts for six major ports in the
US. Despite the US’s having been presumably comfortable with the ports
remaining under a British-owned management company, the US Congress
blocked the planned takeover, citing security concerns over the unknown
intentions of the UAE.
8.6.8 Bilateral and multilateral international
economic cooperation
Despite the scepticism and geopolitical concerns that emerge when SWFs
are projected as tools for policy objectives, documented cases show mutual
benefts between nations whose SWFs engage in strategic cross-border
investments. In fact, SWFs can perfectly enhance bilateral economic and
development cooperation instead of igniting political apprehension and
uncertainties. A well-cited case is the role of SWFs in the South–South cooperation, a phenomenon seen as a real game changer in replacing North–
South Overseas Development Assistance (ODA) and foreign aid fows to
south–south investments for mutual beneft. Under the auspices of the
South–South cooperation, the China–Africa Development Fund (CAD), a
Chinese sovereign fund, was formed in 2007 with an investment focus on
Africa. As of 2018, CAD held no fewer than USD10 billion available for additional African investments. The fund’s existing portfolio, as of March 2018,
was spread across 36 African countries in sectors that include energy, agriculture, manufacturing, and infrastructure. From this arrangement, CAD
will achieve portfolio diversifcation, value growth for Chinese enterprises,
and growth in exports. While otherwise, at least in theory, African states are
to beneft from improved infrastructure, a gradual transfer of skills, and the
importation of technologies.
Chapter 8 • Sovereign wealth management 223
8.7 ASSET-LIABILITY MANAGEMENT IN EMERGING
ECONOMIES
A fundamental objective of sovereign asset-liability management (SALM)
is to align investment strategies for identifed asset classes to characteristics
of all known and contingent liabilities of the state, with particular attention
to the characteristics of associated payment obligations. Sovereign wealth
management should be considered an integral part of SALM; sovereign
wealth management concerns itself with the excess of sovereign assets over
short-term obligations (including development budgets), wherein such
excess should be invested within a framework that supports the characteristics of medium- to long-term explicit and contingent liabilities. While it
is prudent to maximize returns through sovereign wealth management, of
course in well-defned and accepted risk parameters, it is equally key to
ensure that resources are seamlessly available to meet budgetary obligations at minimal costs.
Different sovereigns approach SALM in a number of evolving ways,
but falling mainly under either a full or a partial SALM implementation.
According to International Monetary Fund6 guidance, a partial approach
to SALM would typically entail matching currency mix and durations of
portions of their portfolios with the aim of reducing currency and interest
rate risks. A full approach to SALM is more integrated in nature, where a
sovereign balance sheet is created as the centre, and hence focus, of ALM, on
sovereign risk management practice. This is often referred to as the balance
sheet approach to ALM.
The challenges faced by emerging economies in sovereign asset and
liability management make the balance sheet approach both appropriate
and diffcult to implement at the same time, symbolising the amount of
work needed by such economies to achieve optimal ALM. Although registering some improvements in the recent past, emerging economies have
been riddled with inadequately disclosed sectorial interdependences, undiversifed and volatile revenue streams, the inadequate disclosure of liabilities, weak fnancial management controls, and a lack of reliable data on the
value of unexplored natural resources – a key driver of wealth.
Classical cases of weak fnancial controls and inadequately disclosing
liabilities were widely reported in Malawi (2013) and Mozambique (2014)
respectively. The credibility of government fnancial reports was under a
spotlight in Malawi after the discovery of the looting of cash resources by
government employees and private companies in September 2013. A British government–sponsored investigative audit revealed that for the six
months covered, an estimate USD32 million was syphoned from government accounts, including substantial amounts claimed by private entities
for works not done or goods and services not supplied.
In 2013 and 2014, public managers in Mozambique issued sovereign
guarantees worth over USD2 billion to Credit Suisse and VTB Bank to cover
loans to state-linked companies Ematum, Proindicus, and Mozambique
Asset Management. These guarantees, which made the loans possible were
later ruled to have been illegally issued and thus labelled illicit because they
violated budget law guarantee ceilings. In April 2018, there were mounting
224 Mbako Mbo and Charles Komla Delali Adjasi
fears that although the Zambian government was disclosing a fgure of
USD8.7 billion as its external debt, the correct fgure could be double that
amount, prompting an audit by the IMF, according to a Bloomberg7 release.
The inadequate disclosure of public assets, surprisingly, is a growing
concern among emerging economies. The major source of such concerns
is the subject of this topic: sovereign wealth funds. For instance, the SWFI
adopts the Linaburg–Maduell transparency index to gauge transparency
among its members, and a worrying number of them score 5 or below out
of 10, and many of them have no scores assigned to them, because they just
don’t provide information on the assets they own.
These and many others are real issues that continue to undermine the
strength of the balance sheet approach to SALM and demonstrate the need
for genuine political commitment in optimising a risk-based approach to the
management of sovereign assets and liabilities. Nonetheless, in this chapter,
we centre our SALM discussion on the balance sheet approach.
Table 8.1 is an outline of a typical balance sheet of an emerging economy sovereign.
FIGURE 8.12 A typical sovereign balance sheet
Assets
Liabilities
Financial assets
Deposits and cash balances
– Local currency
– Foreign currency
Securities (bonds, stocks and
treasury bills)
Loans issued
Long term investments
– Reserves
– Sovereign wealth funds
– Pension funds
Receivables & profits
– Interest on loans
– Taxes
– Fees & commissions
– Seigniorage
– Royalties
– Dividends
Financial Liabilities
Statutory expenditures
– Public service emoluments
– Other public Administrative expenditure
– Loan service repayments (including
interest payments)
Development expenditure Balances
– Bonds and Loans
– Monetary Base (multiple currencies)
– Pension liabilities
Nonfnancial assets
Infrastructure
Real estate
State-owned enterprises
Contingent Liabilities
Guarantees issued
Insurance, pension, and derivative liabilities
Natural disaster relief
Contingent assets
Insurance
Guarantees in favour
Unexplored natural resources
Net worth
Chapter 8 • Sovereign wealth management 225
As mentioned earlier, SALM is really an integrated approach to managing sovereign fnancial risk, and in his approach to crafting a conceptual
sovereign balance sheet based on a framework proposed by Merton (2007),
Mr Andre Proite,8 then investor relations manager at the Brazilian National
Treasury, identifes facets of a sovereign balance sheet that introduce certain
classes of risk:
• Foreign currency risk – currency deposits, currency payables, and
loan balances.
• Interest rate risk – infrastructure/developments, loans, and bonds
outstanding.
• Infation risk – seigniorage (and government administration).
• Aging population risk – pension liabilities.
Having dissected a typical sovereign balance sheet and highlighted typical risk classes, we next consider some practical implications of a conscious
approach to managing the assets and liabilities of a sovereign.
8.7.1 Managing sovereign assets – issues to consider
Managing sovereign assets requires an integrated risk-based approach that
among other things synchronises investment objectives to characteristics
and profles of liabilities. An important balance to strike is that of maximising returns on the asset portfolio in a given risk appetite but still minimising
the cost of funding budgetary needs of the state. Given the risk intricacies
inherent in portfolio structuring, including asset allocation as well as fnancing government liabilities in a long-term horizon, a lot of risk simulation
goes along with the management of sovereign assets in order to achieve an
optimised portfolio structure.
Approaches to optimising portfolio structures are evolving, alongside lessons learnt from economic downturns. However, the mean-variance
approach (Markowitz, 1952) continues to be a corner stone for variants in
building optimal portfolio structures for both sovereigns and nonsovereigns. The mean-variance approach simulates maximum possible returns
in certain risk variables and policy constraints like liquidity, balance of payment targets, and capital protection.
Complementing the mean-variance approach is the value at risk (VaR),
which extends the outcomes from the former by building in simulations of
volatility embedded in targeted portfolio returns. As we stated earlier in this
chapter, volatility is of a great concern in managing targets around portfolio
returns more so that negative returns might as well positively correlate with
economic downturns – hence the wide adoption of the VaR approach to
portfolio structuring.
Equally important, liquidity targets and respective timing approaches
should not be too stringent as to introduce unnecessary opportunity costs.
Unnecessarily high liquidity thresholds may also induce certain risks, particularly where foreign currency balances are involved. Liquid assets in a
sovereign asset portfolio should be held in consideration of liabilities of commensurate tenures, and care is always given to ensure government budgetary
226 Mbako Mbo and Charles Komla Delali Adjasi
needs are met at minimal costs. In this regard, the cost-at-risk approach is
used normally as a supplement to the mean-variance approaches adopted
in optimising debt profles, which is carried out in a SALM approach, hence
having a signifcant bearing of the profle of the asset portfolio. The cost-atrisk is a gross measure (i.e. it includes both the cost of risk itself and the costs
incurred because of a crystallised risk event).
Risk governance and the strength of public fnancial management controls are variables never to be downplayed in managing sovereign assets. There
are the broader issues of risk appetite and how it is arrived at, political commitment to full disclosure, commitment to transparency, and in some cases acts of
criminality. The reality is, a substantial part of a given pool of sovereign assets
will typically be of a long-term horizon spanning through political cycles and
administrations. Uncoordinated and inconsistent changes to risk appetite,
investment strategies, and liability priorities arising from evolutions in administration may easily have signifcant bearing on portfolio performance. Lack
of full disclosure at times of exchanging political power can also easily upset
SALM implementation, as was with the Mozambican case we cited earlier.
8.7.2 Managing sovereign liabilities – issues to consider
A signifcant portion of sovereign liabilities is often debt (i.e. government
borrowings). Debt levels are often capped at a certain level, although a
debate still rages on concerning what this level should be. Most importantly
from a SALM perspective, a good debt management strategy should entail a
trade-off between low cost of debt and level of risk (various types), and the
cost-at-risk approach discussed earlier applies here.
Debt is generally acquired primarily to take care of a budget defcit,
typically to fund development budgets. However, there are other objectives
that SALM technocrats ought to be aware of. A sovereign may opt to borrow in local currency (which is often pricier in emerging economies) just to
support the development of local capital markets. Local bonds, for instance,
are often referred to when setting pricing benchmarks for private issuances
and a sovereign may feel the need to consistently maintain issuances to
establish reliable price curves for various tenures. On the other hand, the
need to raise signifcant amounts of debt in local currency may be met by
an insuffcient debt capital market depth – a common feature in emerging
economies, particularly low-income and medium-income countries. These
intricacies extend the environment of managing sovereign debt beyond
asset considerations to include other policy objectives.
An integrated approach to SALM should ensure that in managing a
pool of sovereign assets and value accretion thereof, there is a constant projection of growth in liabilities, both explicit and contingent (see Maziad &
Skancke, 2014). The risk being managed here is a situation wherein value
of asset portfolio falls short of accrued liabilities over time, net of targeted
reserve thresholds. The biggest setback in incorporating contingent liabilities in a SALM environment, as we stated earlier in this chapter, is assigning
a reasonable value to them. Despite this, a number of countries have begun
actively accounting and fully disclosing contingent liabilities by using the
Chapter 8 • Sovereign wealth management 227
best reliable estimates, the most common being the practice of accounting
for debt guarantees issued by government as part of government borrowings, and counting these towards debt/GDP statutory thresholds (Chile,
Mozambique, Turkey, Botswana, and South Africa).
Some contingent liabilities are explicit in that the state becomes legally
bound to make good of them once a particular event happens; examples are
debt guarantees issued and obligations under insurance contracts, typically
trade and export credit. A prudent approach is to factor in maximum possible payout into the total liability pool.
However, there are also some liabilities, which are implicit in nature, normally those that governments are bound due to either policy consequences or
a moral duty to make good on. Examples are disaster relief, corporate bailouts
to avert wider economic impacts of market failures, and the assumption of
liabilities sitting with state-owned enterprises (SOEs) (typically privatisation
targets). It is not uncommon for countries to set up funds against some of the
implicit liabilities, but such funds must be managed as part of sovereign pool
of assets to permit full disclosure, although this is not always the case.
8.8 ASSET ALLOCATION AND RISK MANAGEMENT
FOR SOVEREIGN WEALTH FUNDS
The modern portfolio theory, or MPT (Markowitz, 1952), is often a good starting point in discussing the construction of an investment portfolio through a
risk conscious approach to asset allocation. MPT assumes that returns and volatility can be optimised and minimised respectively if an investment portfolio is
effciently diversifed. However, the extent to which MPT holds true, particularly beyond one period, has been under the spotlight in recent times, as data
from the real world does not necessarily correspond to MPT-based simulations.
Portfolio construction in an SWF is often not a straightforward undertaking. SWFs invest for extended time horizons, often seeking value accretion beyond aggregated short-term returns (Chee, 2011). In addition, SWF
objectives may not necessarily be all return based; earlier in this chapter, we
pointed out the following as some of the common broader objectives pursued by SWFs: stabilisation, development, equalisation, policy and political strategies, and bilateral cooperation. All these factors have a signifcant
bearing on asset allocations by SWFs, and diversifcation motivated under
the MPT is often fawed. For example, a state may decide to hold onto some
strategic investments through SOEs, which then results in a signifcantly
skewed portfolio. Similarly, the China–Africa Development Fund we mentioned will never, by design, achieve a truly geographically diversifed
investment portfolio typical of an international investor.
Further, some ‘investment’ decisions by SWFs are reactionary in
nature, often taken in the interest of wider economic and market concerns,
just as SWFs are used as vehicles for corporate bailouts and market stabilisations. In the working paper ‘Optimal Asset Allocation for Sovereign
Wealth Funds: Theory and Practice’, Bondie and Brière (2013) attempted to
show that an ‘an optimal composition of sovereign wealth should involve
a performance seeking portfolio and three hedging demand terms for the
228 Mbako Mbo and Charles Komla Delali Adjasi
variability of fscal surplus and external and domestic debt’. Such a view
underscores the broader nature of sovereign wealth investment objectives.
Simulating past trends on SWF investment portfolio performance, as
well as their structures, currently proves a nearly impossible task given the
secrecy around their investment decisions. Real risk taken by SWFs and
losses incurred are not suffciently appreciated. However, some cases tend
to demonstrate the intricacies involved in SWF asset allocation.
The Norway Pension Fund–Global (GNPFG), as an SWF, made a signifcant 26% return on its portfolio for 2009. This was after a 2007 decision to
take up more risk, signifed by an increase of equity component of GNPFG’s
benchmark portfolio from 60% to 70%. In a study on GNPFG’s asset allocation,
Papaioannou and Rentsendorj (2015) cast doubt on its effciency, on the basis of
the effcient frontier expectations, although they accepted a broad conformity to
Markowitz’s single-period model. Quite usefully, the authors point out two key
features that can be attributable to GNPFG’s portfolio performance: fexibility
in asset allocation decisions and the ability to design a countercyclical portfolio.
The issue of fexibility is almost embedded as a need rather than a
reality in the case of SWFs. We have highlighted cases where a reaction is
expected from an SWF to ‘save’ the economy or markets, as was the default
position with Western banks bailed out by Asian SWFs at the height of the
2007/2008 fnancial crisis. This is achieved with a suffcient degree of fexibility. As demonstrated by GNPFG’s case, a countercyclical portfolio plays
a key role in some of the SWF core mandates, particularly for those that aim
for the stabilisation of revenues and the diversifcation of revenue sources.
Finally, it remains diffcult for SWFs to evade some real constraints in
achieving an optimal asset allocation in an ordinary sense of return-focused
investments. To start with, an SWF-specifc effcient frontier is diffcult to
ascertain given the lack of transparency and information asymmetry concerns
around SWFs; a benchmark is almost impossible to agree on. Referring to nonsovereign investments for benchmarking is often possible but undermined by
the reality that the acceptability of assets, risk levels, and geographies in the
case of SWF investments is a decision beyond pure economics. Ultimately,
a countercyclical portfolio, with regular assessments supported by adequate
periodic assessment and rebalancing could achieve better results.
8.9 CHALLENGES AND OPPORTUNITIES OF SOVEREIGN
WEALTH FUNDS
SWFs are faced with a plethora of signifcant challenges, mostly pointing to
inadequate transparency and political undertones. The political uncertainties tend to correspond to the disruptive nature of SWFs to the ‘normal’
world economic order, mainly as SWFs continue to penetrate markets of
core economies. This could potentially give rise to geopolitical tensions. In
an address to the International Centre for Monetary and Banking Studies,
in Geneva, in December 2007, Mr Philipp Hildebrand, the then vice-chair of
the governing board of the Swiss National Bank discussed what he terms a
‘vicious cycle of fnancial protectionism’. Mr Hildebrand associated such a
cycle with a policy reaction that would generally be aimed at protecting the
Chapter 8 • Sovereign wealth management 229
world economic order as we know it, but facing the disruptive variant that
SWFs are, mainly due to three main occurrences:
1 The reversal of gains made in diluting government’s role in world
economy – the gains have been in the strength of a gradual liberalisation and deregulation of global economic structures. Large statebacked SWFs are seen as largely confusing an evolving (and perhaps
desired) pattern of capital fows based on economic forces.
2 The long-held rational view that capital fows in search of optimal riskadjusted returns is challenged – SWFs have made capital allocation
decisions involving investments that tend to challenge the notion that
the maximisation of returns (within set risk parameters) underpins the
free fow of capital. Blurred transparency only exacerbates the problem, more so that SWF investments are mostly in foreign territories,
and intentions are not necessarily declared publicly. One question that
has been asked, and that remains inadequately addressed is, why did
the Norwegian Investment Fund short sell bonds of banks in Iceland?
3 SWFs change the traditional pattern of capital fows, which has been
from core regions of the world to the peripherals; the IMF and World
Bank in particular have been conduits for the fow of capital from the
developed countries to emerging economies, including poor states.
Among other forms of fows, developmental loans and relief funds
have been channelled mainly to Africa, Latin America, and parts of
Asia to develop infrastructure, support social amenities, and make economic reforms. However, in the advent of SWFs, this is changing, with
signifcant capital fows from emerging economies into advanced ones.
SWFs in Southeast Asia and Middle East, among others, have wellknown investments in the US. Beyond the reversal of the norm of capital fows from the core to peripherals, SWFs are becoming an important
vehicle for the fow of capital between the peripherals themselves. The
South-South cooperation involves a lot of capital and technology fows
between countries formerly viewed as peripherals, wherein a Chinese
SWF, the CAD, plays a pivotal role in the fow of capital from China to
Africa. The BRICS bank could be viewed in the same light as well.
The challenges of SWFs are not limited to the economic and fnancial protectionism possibilities; as we outlined earlier, there are other problems of
signifcance surrounding them, perceived or real.
8.9.1 Information asymmetry
SWFs are still seen as largely lacking in transparency, particularly with
respect to the areas of capital fows, investment objectives, and intentions
given their state backing. This has come under the spotlight when investments were made, but with no obvious fnancial returns, as would be
expected under cross boarder capital fows norms. Elsewhere in the chapter, we cited cases involving DP World and Norwegian Investment Fund,
among the many investments that raised suspicion. The Linaburg–Maduell
transparency index is a tool adopted by the Sovereign Wealth Funds Institute
230 Mbako Mbo and Charles Komla Delali Adjasi
to issue periodic rankings of member SWFs’ transparency, measured by the
level of information disclosure. This came about amid concerns of perceived
unethical agendas.
8.9.2 A threat to fnancial stability
SWFs generally cause the fow of funds across global economies, chasing investments with longer-term horizons. This means that their cumulatively signifcant
investment at the global scale can absorb short-term market shocks and lead to
longer-term stability in market prices. However, the Financial Stability Forum9
observes a problem on the fip side of the coin: SWFs are largely opaque in their
structures, objectives, and performance. With little to no level of public accountability (Wong, 2009), the IMF argues that SWFs may change their governance
structures and investment policies, including asset allocation decisions, just to
conceal their failures. Given the volumes that SWFs deal with, serious instability
in the global fnancial market may ensue (Jory, Perry, & Hemphill, 2010).
8.9.3 Market and asset pricing distortions
Two distinct variables make SWFs a threat to market stability and rationality
in asset pricing: the sheer size of their investment fows, backed by state funds,
and their tendency to make investments at prices not determined by market
forces. As observed by Anthony Wong in the Brooklyn Journal of International
Law in 2009, under the theme ‘Ruling the World: Generating International Legal
Norms’, SWFs operate with limited liabilities and usually face inadequate calls
for accountability. It may then follow that SWFs tend to have an increased latitude to take up disproportionate risks in investments of scale, with a potentially
large impact to the markets (Wong, 2009). Unfortunately, the artifcially set asset
prices for a given risk scale would then infuence key decisions in the larger
markets, wherein return chasing investments become wrongly priced.
8.10 THE SANTIAGO PRINCIPLES
SWFs have historically attracted controversy, critics expressing a lack of
transparency, inadequate accountability, and obscured governance structures. Heightened scepticism derive from the decisions of some of the
world’s leading SWFs during the 2007/2008 fnancial crises, which involved
their buying into foreign fnancial institutions, among others. In response
to the growing concerns, the IMF convened a working group specifcally to
address the transparency, governance, and accountability of SWFs.
However, the principles are a set of what can be seen as generally
accepted code and are voluntary in nature. The implementation of them is left
entirely up to the subscribing SWFs, with no real consequences for not implementing them. The principles aim to offer a reference point for the adopting
SWF’s, guiding them towards operations and investment decisions that seek
to optimise risk-adjusted returns. This then deals with concerns surrounding
questionable investment decision typically seen as being politically motivated.
The 24 principles are grouped into three parts, as shown in Figure 8.13.
Chapter 8 • Sovereign wealth management 231
FIGURE 8.13 Components of the Santiago SWF principles
Brief description
Part A
Legal framework, objectives,
and coordination with
macroeconomic policies
Part B
Institutional framework and
governance structure
Part C
Investment and risk management
framework
Member SWF are guided to publicise their
legal structures and framework, their policy
mandate, and their funding arrangements.
Member SWFs are required to set up sound
governance structures, clearly articulating
the division of roles and accountability
among stakeholders. At the centre of
these provisions is an expectation that
government, as the owner, should limit
its interference in the operations and
investment decisions of SWFs.
SWFs are required to have in place robust
investment and risk management
frameworks and to disclose their
investment policies. They are also expected
to disclose their strategic-asset allocations
and any investment decisions that are
not based on economic and financial
considerations.
8.11 CONCLUSION
The concept of managing sovereign wealth in a fund setup dates back to
the 1950s, with its genesis commonly traced to oil-rich states in the Persian
Gulf region. Trade surpluses, mainly linked to oil exports, have traditionally remained the key source for ‘seed capital’ among governments that set
up SWFs. However, as the concept gained popularity over years, nations
started seeing sovereign wealth funds, as they became known from the early
2000s, as a real opportunity to either stabilise national revenues or diversify
them. Apart from revenue stabilisation (or equalisation), SWFs also take the
form of development, saving, or reserving funds, and oil no longer dominates as the major source of seed capital, although natural resources and
minerals still do.
Institutional arrangements among SWFs differ, including a fully
fedged institution with its own governance and management structures
and a desk-based operation hosted by a sponsoring government ministry
or a central bank. The precise structure depends on the mandate, approach
to investment, and risk appetite, whereby SWFs with a mandate to implement investment projects as part of their mandate and carry a higher risk
appetite in return for chasing higher returns would typically have fully
fedged institutional structures. However, SWFs with no implementing
232 Mbako Mbo and Charles Komla Delali Adjasi
mandates and lower risk appetites and return targets would normally be
hosted in the institutional setup of a hosting government ministry or central bank.
SWFs have their own signifcant challenges, mainly cantered on geopolitical themes, including the reversal of gains made in diluting the role
of governments in the world economy, the backwards fow of funds from
core to peripheral economies of the world, and information asymmetry
related to investments made on no apparent economic and fnancial considerations. Beyond geopolitics, SWFs are frequently criticised for distorting market asset prices and generally considered a threat to global fnancial
stability.
Perhaps the manifestation of SWF challenges lies with their perceived lack of transparency and weak accountability obligations, and in
response to these, an IMF-convened working group concluded a set of 24
Generally Accepted Principles and Practices in 2008. The principles aim
to offer a reference point for the adopting SWFs, guiding them towards
operations and investment decisions that seek to optimise risk-adjusted
returns. The principles offer comprehensive guidance on three broad
areas:
1 Legal framework, objectives, and coordination with macroeconomic
policies.
2 Institutional framework and governance structure.
3 Investment and risk management framework.
To a great extent, these principles can be seen as dealing with concerns
around the possibilities of politically motivated investment decisions.
Discussion questions
1 ‘Historically, SWFs have predominantly been a result of a reactive
approach by governments with
surpluses of one form or another,
but this has since changed’. Please
discuss, with examples.
2 The 2007/2008 global fnancial crises
brought to the fore the fundamental
challenges SWFs pose to the global
geopolitical economy. Certain transactions left many with more questions than answers. Please elaborate.
3 The Santiago Principles aim to
address fundamental concerns on
governance and transparency of
SWFs, and they are divided into
4
5
6
7
three distinct parts. Please discuss
any two principles, under each
part with examples.
Outline and fully discuss, with
practical examples, various forms
of SWFs and how governments
use them as vehicles for economic
advancement.
Why are SWFs criticized for distorting market asset prices and
global fnancial markets?
Discuss any three emerging roles
of SWFs.
What are the key considerations
for SWFs that are making assetliability management decisions?
Chapter 8 • Sovereign wealth management 233
Notes
1 Sovereign Wealth Fund Institute.
2 Wharton Leadership Centre: ‘The
Brave New World of Sovereign
Wealth Funds’.
3 The term ‘sovereign wealth
fund’ is associated with the
work of Andrew Rozanov, a
senior manager, Official Institutions Group at State Street
Global Advisors.
4 International Monetary Fund (2007,
October). Global fnancial stability report 2007. Washington, DC:
Author.
5 The Sovereign Wealth Funds
Institutes lists 78 members as of
February 2018, but there are other
(typically smaller) funds that are
not members of the SWFI.
6 IMF Sovereign Asset Liability Management Guidance for
resource-rich economies, 2014.
7 Bloomberg (April 2018). Zambia’s
‘Unknown’ Debts Face Scrutiny
After Mozambique Scandal.
8 A. Proite Asset Liability Management in Developing Countries: A
Balance Sheet Approach 2014 (A
modifed from a UNCTAD sponsored original article ‘Strengthening Capacity for Effective Asset
and Liability Management’.
9 Financial Stability Forum (19
May2007). Update of the FSF report
on highly leveraged institutions.
Basel: Bank for International Settlements. Retrieved from www.
fsforum.org/publications/.
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Generic-Documents/country_notes/
Ghana_country_note.pdf
Bondie, Z., & Brière, M. (2013). Optimal
asset allocation for sovereign wealth
funds: Theory and practice. Amundi
Working Paper. Paris: Dauphine University, Université Libre de Bruxelles.
Chee, F. P. (2011). Portfolio construction and risk management for sovereign
wealth funds. Toronto: CFA Institute,
CFA Society.
Cheung, Y. W., Steinkamp, S., & Westermann, F. (2013). China’s capital fight:
The pre- and post-crisis experiences.
Unpublished manuscript. Retrieved
from www.cb.cityu.edu.hk/ef/doc/
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the%20New%20Normal/Frank%20
Westermann(1).pdf
Dixon, A. D. (2016). The rise, politics, and
governance of African sovereign wealth
funds. The Brown Capital Management Africa Forum Paper No. 3.
Washington, DC: Wilson Centre.
John, J. D. (1998). Conceptualising the
causes and consequences of failed states: A
critical review of the literature. Working
Paper No. 25. Crisis States Research
Center. Retrieved from https://www.
fles.ethz.ch/isn/57427/wp25.2.pdf
Jory, S. R., Perry, M. J., & Hemphill, T.
A. (2010). The role of sovereign wealth
funds in global fnancial intermediation.
Hoboken, NJ: Wiley Periodicals.
Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1),
77–91.
Maziad, S., & Skancke, M. (2014). Sovereign asset-liability management- guidance
for resource -rich economies. Washington,
DC: International Monetary Fund.
Merton, R. C. (2007, November). Observations on sovereign wealth fund,
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reserve, and debt management: A country
risk management perspective. Luncheon Address at the First IMF Annual
Roundtable of Sovereign Asset and
Reserve Managers, Washington, DC.
Papaioannou, M. G., & Rentsendorj, B.
(2015). Sovereign wealth fund asset
allocations – some stylized facts on the
Norway Pension Fund–Global. Procedia Economics and Finance, 195–199.
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crisis on the middle East. The Global
Law Review, 99. Retrieved from
https://engagedscholarship.csuohio.edu/gblr/vol1/iss1/7
Shabbir, T. (2009). Role of the middle
Eastern sovereign wealth funds in
the current global fnancial crisis.
Topics in the Middle Eastern and African
Economies, 11.
Wong, A. (2009). Sovereign wealth funds
and the problem of asymmetric information: The Santiago principles and
international regulations. Brooklyn
Journal of International Law, 1081,
1098–1102.
World Bank. (2013). Economic developments and issues shaping Angola’s
future. Angola Economic Update 1.
Luanda: Author. Retrieved February 15, 2020, from www.opec.org/
opec_web/en/data_graphs/40.htm;
www.swfinstitute.org/profiles/
sovereign-wealth-fund.
CHAPTER
9
Sovereign debt
management
Amin Karimu, Vera Fiador, and Imhotep Paul Alagidede
9.1 INTRODUCTION
Generally, governments all over the world fnance their expenditures via a
menu of sources, which include tax revenues, seigneuries from the central
bank, charges and fees on publicly provided goods, and services such as
tolls, profts from state enterprises, rents from natural resources, and borrowing from both internal and external fnancial markets.
Over the 1970s and 1980s, most developing countries, including those
in Africa, increased their external debts,1 which was as a result of many factors, including the emergence of the Eurodollar market2 due to the surplus
revenue generated from high oil prices by oil-rich countries, low interest
rates, and a generally favourable world environment. Shortly, the accumulated external debt levels started increasing and rose to high levels for most
African countries that have taken too much debt without a prudent debt
management3 plan. This, coupled with the rising interest rates during this
period, implies higher cost of debt servicing,4 which further increased the
debt levels of these countries to a crisis level (Abrego & Ross, 2001; Barro,
1989; Clements, Bhattacharya, & Nguyen, 2003).
The high levels of debt accumulated by many developing countries
in the early 1990s resulted in two debt-relief programmes: the Heavily
Indebted Poor Countries Initiative and the Multilateral Debt Relief Initiative. These programmes, by the end of 2008, helped reduce the debt level,
especially for countries in sub-Saharan Africa (SSA), by about two-thirds,
which helped some of the countries, such as Ghana, to start experiencing
good and appreciable levels of growth in the short term. The gains from the
debt-relief programme is fast eroding for the subcontinent (SSA) after the
2008 fnancial crisis. For instance, available statistics from the IMF (2018)
indicate that gross government debt to gross GDP (gross domestic product)
for SSA in 2000 was 68%, which reduced to 23% by 2008, helped by the relief
programme. Since 2008, the ratio of debt to GDP has be rising, and in 2016, it
doubled the 2008 value, rising to 44%. This fast-rising debt level has almost
wiped out half of the reduction from 2000 to 2008. In percentage terms, the
2016 debt-to-GDP ratio over the 2008 value is about 91%, within a period
of just nine years, implying that the average debt level is rising by 2.3% per
year, which is far more than the average GDP per capita growth of 1.2%
236 Amin Karimu et al.
over the same period, on the basis of statistics from the World Bank Word
Development Indicators (2018).
The reasons for the high debt problems in the 1990s and in recent
years are multifaceted, driven generally by the improper management of
borrowed funds and poor domestic resource mobilization. The focus of this
chapter is on the borrowing component of government fnance, especially
the external borrowing component with regard to its effcient and effective
management in order to avoid issues such as insolvency (a state in which
the central government is unable to pay its debts on time as stipulated in the
borrowing contract) of the central government, particularly for developing
and emerging countries.
Over the years, available statistics from the IMF have shown that governments in developing countries, especially those in Africa, tend to spend
signifcantly on nonproductive sectors relative to productive sectors. For
instance, government expenditure on the component denoted ‘other’, which
includes government spending on fuel and energy, mining, manufacturing,
construction, subsidies, and general administration account for more than
50% on average, whereas in the case of agriculture, it is less than 7% over
the past two decades (Fan, Omilola, & Lambert, 2009). According to Fan et
al. (2009), a bulk of the expenditure in the ‘other’ component typically goes
to government subsidies and expenses relating to general administration.
This, among other things, suggests that the increasing share of this component may be crowding out spending on more-productive sectors, such as
agriculture, education, and infrastructure development. These sectors are
likely to promote growth and development, which make it easier to repay
the borrowed funds.
Additionally, most developing countries tend to have fewer domestic-income-generating sources for fnancing capital-intensive investment
projects that require long-term debt fnancing sources if the country does
not have the required reserves to fnance such projects. This is due to the
less developed capital markets in these countries, implying that they rely
mostly on external borrowing to fnance such projects. Such debt fnancing becomes an issue for the overall debt stock if a signifcant proportion
of the overall public debt comes from external debt. In most cases for most
of the developing countries, such debts generally attract interest rates above
the world interest rate, due to a combination of factors, such as poor macroeconomic fundamentals, poor external assets, volatile commodity prices,
and the level of accumulated debt.
The structure of the chapter is as follows. The next section presents
a brief overview of debt management in developing countries; the link
between external debt and economic growth is presented in section 9.3; and
in section 9.4, the institutional framework for government debt management is presented. Furthermore, section 9.5 provides a discussion on renegotiating debt contracts, before moving on to discuss debt-relief policies in
section 9.6, designing incentives in section 9.7, sovereign debt restructuring
in section 9.8, and a risk management framework for a government debt
portfolio in section 9.9. The chapter concludes with a section on debt sustainability analysis and medium-term debt strategy (section 9.10).
Chapter 9 • Sovereign debt management 237
9.2 OVERVIEW OF DEBT MANAGEMENT
To run a country effciently, the government needs money to fnance its
expenditures. The source of government funding is mainly from taxes.
However, when government expenditure outweighs the income received
from taxes, it runs into defcits. To avoid this, it has to either increase taxes
or reduce expenditures. Both of these options have serious implications for
the economy. A third option is for government to borrow from both internal
and external investors or grants from other countries. This perhaps is the
most likely option for most governments in the developing world, since
they are able to borrow to support their fnancing gap due to the low domestic-resource-mobilization5 possibilities. Borrowing from external investors
mirrors the concept of external debt.
External borrowing thus permits a country to produce and consume
far beyond the constraints of its current domestic resources. This in effect
accelerates the development of a country if well managed by investing in
projects that generate enough returns to fnance the borrowed funds. The
downside to this is that once a country borrows externally, it has to be wary
of debt management as a creeping policy concern, especially if the funds are
mismanaged.
Sovereign debt6 management, in simple terms, covers how to ensure
that the level and growth rate of public debt is sustainable. This, among
other things, implies the ability to service the debt under a varied range
of circumstances, such as increasing the cost of servicing the loans due to
worsening domestic currency against foreign debt-denoted currencies,
exposure to fnancial risk from foreign countries, and interest rate risk.7 A
key objective of debt management is sustain public debt related to fnancing
government activities in the economy, in ways that the source of raising the
needed fnance, including both domestic borrowing and foreign borrowing, does not generate excessive cost and risk that creates problems in the
domestic economy.
The adverse effects of borrowing with regard to debt management
is of prime interest. This is because most of a government’s expenditures
are used in providing social services, which do not readily offer monetary
returns. Thus, there is a high tendency for the government to default in payment of debt if the menu for servicing the debts are not planned and executed according to established guidelines. This means that a government is
obliged to engage in further excessive borrowing. The consequence implies
surges in interest rates, which of course burdens government with additional responsibilities. Obviously, these responsibilities include paying the
increased outstanding debt and the need to boost local production capacity
and increase exports in order to curtail such debts (both internal and external). The tendency of such defaults is high with small open economies that
have limited sources to raise fnance and that are highly dependent on raw
materials and nature for their economic growth8 and development. The varied nature of economic growth, coupled with the limited sources of generating revenue, suggests a high-risk premium for such countries borrowing
from the international capital market, which, among other consequences,
increases the cost of their public debt.
238 Amin Karimu et al.
Heavily indebted countries are most vulnerable to these shocks (interest rate shocks); consequently, affrmative actions in renegotiating and
restructuring debt contracts or in some other circumstances are needed, to
provide debt relief for defaulting countries. With regard to sovereign debt,
the absence of collateral – or perhaps the diffculty to take hold of such
collateral – requires that some alternative threat be mandated to incite or
create incentives to repay the debt. More importantly, it requires measures
that will reduce the risk exposure of public debt to various macroeconomic
and political shocks.
9.3 EXTERNAL DEBT AND ECONOMIC GROWTH
One of the key components of public debt is the share of external debt in
total debt. In the early 1970s, after the frst oil crisis, many countries considered external borrowing, both from bilateral sources and from multilateral sources, as a cheap and prudent way for countries with low domestic
fnancial capacity to fnance big capital projects in the quest to grow and
develop their respective countries. Most developing countries tend to have
low domestic fnancial capability and require high capital-intensive projects
to facilitate economic development.
The high levels of debt accumulated by many developing countries in
the early 1990s resulted in an increase in research on external debt and economic growth, especially after the Mexico peso crisis in 1994, which sparked
several questions:
1 At what level does external debt become a concern for economic
growth?
2 What is the nature of the relationship between economic growth and
external debt?
3 What are the channels via which external debt impacts growth?
We will present the discussion along these questions, where we try to answer
them by providing previous empirical studies to support the discussions.
9.3.1 External debt and economic growth
At what level external debt becomes a concern for economic growth
depends on three broad factors: level of external debt–to-GDP ratios, low
primary surplus,9 and varying borrowing cost, which are supported by the
debt-overhang hypothesis.
9.3.1.1 EXTERNAL DEBT–TO-GDP RATIOS In general, the ratio of government
debt to GDP above 60% is considered problematic for most countries and
even considered dangerous if it is above 100%. These numbers, however,
vary depending on how the market thinks about a country’s risk of insolvency and consequently the cost of the debt via the interest rate charge as
a refection of the risk level. For instance, in the case of countries in the EU,
public debt close to 100% of GDP is considered high risk, and markets will
react by increasing the interest rates for supplying debt to such countries.
Chapter 9 • Sovereign debt management 239
Whereas in the case of Japan, even at ratios above 200%, the market does not
consider Japan to be at high risk of insolvency and is still willing to supply
debt at lower interest rates. For most developing countries, the ratio of debt
to GDP that fnancial markets consider to be a high risk level of insolvency
is even lower, more so for external debt. This suggests that the ratio of
external debt to GDP that is considered a problem for growth depends on a
country’s macroeconomic fundamentals, such as external asset level, fscal
space, the saving culture, the willingness to buy government bonds at lower
interest rates by the country nationals, and the perception of the country’s
fnancial markets’ risk of insolvency. Japan, with huge external assets and
individual Japanese people willing to buy government bonds at low interest
rates rather than consumption, attracts a more favourable perception by the
fnancial markets on its risk of insolvency than does Greece, for instance,
irrespective of the high debt-to-GDP ratio recorded in Japan (250%) relative
to Greece (177%) provided by the IMF (IMF, 2017).
9.3.1.2 LOW PRIMARY SURPLUS The sovereign debt of a country is generally considered unsustainable if the debt-to-GDP ratio is projected to grow
without limits, given the country’s current policies and economic fundamentals, summarised by the primary surplus of the country. The primary
surplus is infuenced by three key factors: the amount of revenue the government receives, interest rate at which the government can borrow, and
the types of expenditures. The levels of these three aspects of the primary
surplus determine the level of the surplus and whether that level is consistent with the level needed to stabilise the debt-to-GDP ratio.
9.3.1.3 VARYING BORROWING COST The cost of the debt is another factor
that determines the likelihood of exposure to debt crisis. The cost of borrowing varies across countries and across time. These variations determine the
likely risk a country will face with respect to fscal crisis and consequently
debt crisis relative to other countries and over time.
There are two key determinants of the variation in borrowing cost
across countries and over time. The frst factor is the interest rate paid on
government bonds and loans, and the second is the maturity of the loans.
These two factors are also infuenced by the country’s macroeconomic fundamentals and assets. Countries with good macroeconomic fundamentals
are likely to borrow at favourable world interest rates, which implies a
lower burden on current growth with regard to debt servicing. The relatively favourable interest rates are infuenced by the lower default risk that
the good macroeconomic fundamentals reveal to the fnancial markets. For
instance, Spain can borrow at interest rates that are much lower relative to
Ghana, due to the difference in repayment risk, which is infuenced by the
country’s fundamentals, external assets position, fscal space, and perception of the fnancial markets.
The maturity period of the loans also infuences the risk of default;
for instance, short-term loans increase the vulnerability of government to
changes in investor’s sentiments, especially if the sentiments are against the
government that have a high proportion of their debt in the short term. In
240 Amin Karimu et al.
such a case, the need to refnance a signifcant share of the debt in short
periods increases, which puts more pressure on the debtor. The cost of the
borrowing therefore increases due to the need to refnance the debt in short
periods, but at the same time because the coupon on such short-term loans
are lower, the cost also reduces by that effect. The overall effect on the cost
of the loan therefore depends on the strength of these two opposing effects
of short-term loans.
9.3.2 The relationship between economic growth
and external debt
The relationship between economic growth and external debt depends on
what the debt is used for, the level of debt ratio, and the quality of institutions and policies. In the frst case, if the indebted country managed the
loans prudently by investing in growth-enhancing projects, then the debtoverhang hypothesis will not apply, because the projects fnanced with the
debt will generate enough returns to service the debt in the medium term.
Contrarily, the debt-overhang hypothesis applies when the country
is indebted but lacks good policies and institutions. In such a case, the rise
in indebtedness will eventually result in the country’s experiencing debt
overhang, where higher debt ratios are deteriorating to growth. In such a
situation, debt-relief programmes are likely the best option for creditors to
undertake to reduce future defaults by the highly indebted countries.
This hypothesis led to the introduction of the debt Laffer curve,10
which was frst introduced by Jeffrey Sachs (1988) and formalised by Paul
Krugman (1988). The key idea underlying the debt Laffer curve is that at
low indebtedness, a country’s ability to repay the debt is high due to a positive association between the debt and economic growth. However, as the
debt level increases to a crisis level, the debt becomes a drag on economic
growth and consequently has a negative effect on growth. This negative
effect of the debt on growth increases the risk level of default of the indebted
country, which may reduce the market value of the debt, due to the risk its
not repaying the debt (see Figure 9.1).
In Figure 9.1, there is a clear linear relationship between the face value
of debt and its market value up to point A, which suggests that a percent
increase in the face value of the debt of a country results in an equivalent
increase in the market value of the debt up to point A. As the face value of
the debt increases beyond the level depicted by point A, we see a divergence
between market value and face value of the debt, where the market value
tends to increase more slowly relative to the increase in the face value of
the debt. A reason for this is that at high debt levels, it becomes diffcult
for a country to fnance the debt due to the increasing burden of the debtservicing obligations.
The debt-servicing requirement tends to act like a tax on any activity that the indebted country undertakes, which requires an upfront cost in
exchange for future benefts such as investments (Pattillo, Poirson, & Ricci,
2002). Consequently, the marginal returns on debt to the right of point A in
Figure 9.1 decrease as more debt is accumulated.
Chapter 9 • Sovereign debt management 241
market vakue of debt
FIGURE 9.1 Debt Laffer curve
45°
debt overhang
B
A
face value of debt
Source: Krugman (1988)
Point B is the threshold point where the absolute increase in the face
value of the debt is more than the marginal decrease in the market value of
the debt. In such an instance, a country experiencing this is classifed as suffering from a debt overhang – hence the debt-overhang hypothesis.
Figure 9.1 is generally divided into three regions: a region up to point
A, a region between point A and point B, and a region above point B. If the
debt level is beyond point A in Figure 9.1, there are two possibilities: the
debt level is such that the country lies either to the left of point B, which is
referred to as the ‘correct’ side of the debt Laffer curve, or to right of point
B, which is the ‘wrong’ side of the debt Laffer curve (i.e. debt overhang). On
the correct side of the debt Laffer curve, debt forgiveness will not increase
the market value of the debt, whereas in a case where a country lies in the
wrong side of the curve, debt forgiveness will reduce the face value of the
debt and lead to a rise in the market value of the debt.
Another way to practicalize the debt Laffer curve is to think of it in
terms of the relationship between debt ratio and growth as demonstrated by
Clements et al. (2003). If the debt ratio is at a level where there is a positive
relationship between the two, then the country is on the correct side of the
debt Laffer curve, but it is on the wrong side if there is negative relationship
between debt ratio and growth.
One the one hand, using available data from WDI (2019) for developing countries, a scatter plot with a ftted line presented in Figure 9.2
revealed a negative relationship between debt and economic growth for
242 Amin Karimu et al.
FIGURE 9.2 Scatter plot with a ftted line
Debt to GDP ratio above the 50%
threshold
Debt to GDP ratio above the 50%
threshold
200
50
EI Salvador
Congo, Dem. Rep.
Cote d’lvoire
Georgia
Ukraine
Moldova
40
Zambia
100
Pakistan
Sri Lamka
Egypt, Arab Rep.
Debt to GDP ratio (%)
Debt to GDP ratio
150
Burundi
Micronesia, Fed. Sts.
Vanuatu
0
10
0
5
10
Bangladesh
30
20
–5
Malawi
Indonesia
50
–10
Liberia
Solomon Islands
–1
Real GDP growth
Debt to GDP ratio
Rwanda
Congo, Rep.
0
1
2
3
4
Real GDP growth
Fitted values
Debt to GDP ratio
Fitted values
Source: Authors’ computation using data from WDI (2019)
debt levels above the 50% threshold (suggested by the IMF). On the other
hand, there is a positive relation between debt and economic growth for
countries with debt levels below the 50% threshold, supporting the debt
Laffer curve.
The empirical literature provided some evidence on indebted developing countries and growth relationship – for instance, a study by Pattillo et al. (2002) for a large panel of developing countries, in which the
authors focused on the potential nonlinear relations as postulated by the
debt-overhang hypothesis. Findings from their study provided evidence
of a nonlinear relationship. Specifcally, there is negative impact associated with high debt-to-GDP ratios above the bracket (35%–40%) and, in
the case of debt-to-exports ratio, the threshold above which debt has a
negative effect range between 160% and 170%. These values show some
signifcant variation of the turning point for the debt effect on growth,
which may refect the heterogeneity in countries’ economic conditions,
policies, assets level among others, suggesting that the level of debt that
is problematic for a country is country specifc and context specifc rather
than general.
Clements et al. (2003) found the threshold for a panel of 55 low-income
countries to be above 50% for external debt-to-GDP ratio and above 100%–
105% for the net present value of external debt–to-exports ratio. Moreover,
the authors found the following the channels through which external debt
affects growth for the sampled countries: via the effciency of resources used
Chapter 9 • Sovereign debt management 243
by the indebted country and via the indirect effect on public investment
through the debt-servicing obligation. In contrast, Cordella, Ricci, and RuizArranz (2010) found that for a panel of developing countries, the threshold
to be above 15%–30% of GDP, which they classifed as intermediate debt
range. Furthermore, the debt-overhang threshold tends to be infuenced
by policies and institutions, where bad polices and institutions reduce the
threshold values.
The general take from the brief empirical literature reviewed suggests, in general, that there is a nonlinear relationship between the level of
accumulated external debt ratios and growth, but the level of the threshold
beyond which a debt overhang occurs varies with countries and with the
type of ratio used. The variations seem to be infuenced by country characteristics, the type of ratio, institutions, policies, the effcient (or not) use of
resources, and the level to which debt service crowds out public investment.
9.3.3 The channels via which external debt impacts growth
Both the empirical (Pattillo et al., 2002; Clements et al., 2003; Cordella et
al., 2010) and the theoretical (Sachs, 1988; Krugman, 1988) literature on
debt and economic growth suggests a nonlinear relationship between
these two indicators. The channels via which debt affects growth are discussed under two themes: a difference in the marginal product of capital and cost of capital and a high effective marginal tax on returns on
investment.
9.3.3.1 DIFFERENCE IN THE MARGINAL PRODUCT OF CAPITAL AND THE COST
OF CAPITAL The frst channel is where a capital-scarce country is able to
borrow at world interest rates that are relatively lower than the marginal
product of capital, as a consequence of a low level of debt, which makes the
capacity for repayment high and therefore reduces the risk premium that
the creditor charges (Eaton, 1993; Cohen, 1991).
This positive effect of low debt on economic growth also depends on
the type of capital that is fnanced with the loan, how effciently resources
are used, and the soundness policies and institutions. However, even if the
marginal product of capital is higher than the cost of capital but the borrowing country invests in a low productive sector, with bad policies and institutions, such growth effects become diffcult to be realized.
The second channel is when
the loan-servicing obligation for a highly indebted country on current production is high, which can be seen as a tax on current investment activities in the indebted country. The high debt-servicing requirement becomes
a disincentive for investment in such a country. There is therefore likely to
be capital fight from the highly indebted country to a low indebted country.
This is due to the implied tax differential imposed by the level of indebtedness, which consequently will have a negative effect on productivity and
growth, as suggested by the debt-overhang theories (Sachs, 1988; Krugman,
1988).
9.3.3.2 HIGH TAX ON RETURN ON INVESTMENT
244 Amin Karimu et al.
9.4 INSTITUTIONAL FRAMEWORK FOR GOVERNMENT
DEBT MANAGEMENT
The institutional framework within which government debt is managed is
crucial in the overall management of public debt given the risks and cost
objectives on one hand and the long-term goal of debt sustainability on the
other. Most countries manage their public debt by having a unit either in the
ministry of fnance (MoF) or separate from the ministry to be responsible
for managing public debt. These units are generally referred as debt management offces (DMOs), which were traditionally located in the ministries
of fnance before the early 1990s. In the early 1990s, some OECD countries
separated their respective DMOs from their ministries of fnance and provided them with more independence in the operation of the overall debt
management strategy, with less infuence on monetary policy.
One reason for this separation of the DMO from the MoF is to ensure
that incentive-compatibility contracts can be offered to attract highly skilled
staff to manage government debt, which was not easily possible within the
civil service pay structure of n MoF.
According to Currie, Dethier, and Togo (2003), there are generally four
major characteristics of debt exhibited by developing and emerging market economies: a less developed domestic debt market, problems of coordination between debt management and monetary policy, and problems
in managing the impact of debt servicing on the budget and in controlling
contingent liabilities. This highlights the need for an effective institutional
framework that will incorporate the four key features just presented, in a
way that that more effciently manages debt for such countries.
9.4.1 Effective governance
The government structure for the DMO should be well defned regarding
who is legally responsible for issuing new debt, invest, represent government in undertaking transactions regarding debt management, and clarifying rules regarding the principal–agent relationship. In OECD countries
such as Sweden, the minister of fnance is ultimately responsible for government borrowing and for approving a debt management strategy, but typically, the responsibility of the day-to-day operation of debt management is
delegated to a DMO.
A clear and transparent governance structure makes it easy to support
a sound and a credible fnancial system, which is supported by assurances
of a well-designed governance structure, which bring confdence to the
markets that the government debt portfolio is being managed effectively.
9.4.2 Effective organizational structure
The organizational framework for debt management must be clearly specifed, and mandates and roles clearly articulated to key players within the
debt management framework as suggested in the World Bank guideline
for public debt management (World Bank & IMF, 2001). The institutional
Chapter 9 • Sovereign debt management 245
arrangement for locating sovereign debt management functions are many as
pointed out by the World Bank guideline, which includes the MoF, central
bank of a country, and the independent debt management agency. In most
cases, however, it is mostly located in the MoF or an independent DMO,
separate from the MoF. Irrespective of the institutional arrangement that is
chosen, an important factor is to ensure that the organizational framework
surrounding debt management is characterised by clearly specifed mandates and roles, strong coordination, and sharing information among different players within the framework.
In most developing countries, the economy is generally more exposed
to fnancial shocks and therefore more vulnerable to crises in public debt
management (Currie et al., 2003). This means that public policy aspects
of risk reduction should be emphasized in debt management. As a consequence, these aspects should be incorporated into institutional arrangements: measures that will promote some elements of public policy into
debt management. Some of such elements of public policy include facilitating coordination with monetary and fscal policy, the development of the
domestic debt market, and the control of the possible impact of risky debt
structures on the budget.
9.4.3 Effective operational structure
An ineffective and inadequate operational structure within the debt management framework can impose serious operational risks,11 which could
negatively impact debt management plans and consequently the sustainability of a country’s sovereign debt. Operational risks in debt management
are generally high when there are no well-articulated responsibilities given
to debt management staff, clear monitoring and control policies that increase
the principal–agent problem, and well-structured reporting arrangements.
Effective operational structure in debt management requires that the
operational responsibility for debt management be subdivided into three
units with clearly specifed tasks and responsibilities, but with effcient communication across the units for effcient information sharing. The three units
are the front offce, the back offce, and the middle (risk management) offce.
The front offce is responsible for executing and managing transactions in
the fnancial markets. The back offce is responsible for the settlements of
transactions and maintenance of fnancial records. The middle offce is in
charge of providing risk analysis, monitoring and reporting on portfoliorelated risks, and assessing the performance of debt managers against any
strategic benchmarks.
9.4.4 Effective management of information systems
Effective and effcient management of information across the various units
in the debt management organizational framework is crucial to keeping
track of all transactions to produce timely debt data, promptly paying debt
service, improving the quality of budgetary reporting, ensuring transparency in government fnancial accounts and helping in risk analysis, and
246 Amin Karimu et al.
managing debt. Effective recordkeeping and data management are crucial
for debt management processes, especially for risk analysis and the timely
payment of debt service to avoid unnecessary costs for delays in payment of
the debt service. The data management is not free, and storing huge amounts
and sensitive data is expensive. Therefore, the costs associated with the
management of the information system should be considered in line with
the debt management operational needs as suggested by the World Bank
debt management guideline (World Bank & IMF, 2001).
9.4.5 Staff recruitment and monitoring
Debt management requires staff with strong skills in fnancial markets,
public policy, and accounting. Without such competently skilled staff, the
debt management process will be ineffective even if the governance, organizational, operational, and information management systems are effcient.
Regardless of the institutional structure of the DMO, the ability to attract
and retain skilled debt management staff is crucial for mitigating operational risk. This is a problem for developing and emerging countries, where
it is diffcult to separate the DMO from the MoF, due to the less developed
debt market, which suggests that monetary policy and debt management
are interlinked and that therefore the DMO should be kept in the MoF.
Keeping the DMO in the MoF suggests that the civil service salary scheme
would generally apply to DMO staff, which makes it diffcult to offer incentive-compatible contracts to attract such skills and retain them, since their
skills are highly demanded in the private sector too but with better salary
structures.
One possibility that is often used to attract skilled staff into the DMOs
is to offer them training packages. The problem with this approach is how
to keep them after they have acquired all the skills from the various training
programmes and have become even more competitive in the job market.
Beyond the staff recruitment and retention problem, there is also a
need to provide code-of-conduct and confict-of-interest guidelines that will
help separate staff personal fnancial affairs from sound debt management
practices.
9.5 RENEGOTIATING DEBT CONTRACT
Sovereign debts are complex to deal with in cases of default. This is especially so because collaterals cannot easily be seized to defray debts. Rather,
the terms and conditions of the debt contracts can be renegotiated. Thus,
renegotiating debt contracts can be seen as an instrument that both a borrowing country and a lending country can use to improve the terms of the
debt contract. In many cases, renegotiation is most preferred in instances
where lending countries strictly enforce their rights to seize the borrower’s
assets. Reports from Aguiar and Gopinath (2007) show that, on average,
lending countries take a loss of 40% due to post-default debt negotiations.
Yue (2010) models the interaction between default and debt renegotiation within a dynamic borrowing framework. The conclusion was that
Chapter 9 • Sovereign debt management 247
recovery rates decrease with indebtedness that affects the country’s incentive to default, ex ante. Also, in equilibrium, sovereign bonds are priced
such that they compensate crediting countries for the associated risks of
default and restructuring. They add that the model predicts interest rates
and reductions in the stated value of an asset to increase with the level of
debt. Also, results demonstrate that the changes in bargaining power have
a great impact on debt recovery rates and on the sovereign bond spreads,
thereby shedding light on the policy implications of sovereign debt restructuring procedures.
With regard to collective action and sovereign debt renegotiation,
bondholders’ incentives to renegotiate might not be aligned if lenders are
large in number. According to Weinschelbaum and Wynne (2005), if each
bondholder possesses a small fraction of the debt, each will have little incentive to forgive, because they can only marginally affect the government’s
incentives to repay. Since the probability of being paid is basically independent of an individual’s actions, they will always fnd it incentive compatible
to hold to the pre-existing debt rather than cooperate in the renegotiation
process.
Bai and Zhang (2012) highlight the effect of information frictions on
renegotiation delays vis-à-vis the role of the secondary market in reducing these delays. When renegotiating with creditors to restructure debt, the
government might prefer to have costly delays if the reservation value of
the creditors is private information. Although a low restructuring proposal
might cause costly delays in reaching agreements, it might also increase the
government payoff if the creditors turn out to have a low reservation value.
The more severe the information friction, the longer the maximum renegotiation duration. The presence of a secondary market might then reduce the
renegotiation duration by lessening the information friction through price
revelation. This implication is consistent with the empirical fnding that
sovereign debt renegotiations are on average much shorter for liquid bonds
than for illiquid bank loans. Finally, their model also reveals that to achieve
higher welfare and more-effcient allocations, the creditors have to receive a
certain level of renegotiation payoff.
Using game theory, Gromb (1994) shows how a crediting country can
rather be a prisoner to the borrower. However, the fact that the investor
always fears subsidizing an already-rich entrepreneur makes the threat of
terminating the development phase more credible. Arellano and Bai (2013)
compare a decentralized Nash bargaining protocol with one designed by
a benevolent planner. In the decentralized model, a default in one country
increases the likelihood of default for the second country because recoveries
are lower when both countries renegotiate together with the lender. In the
planning solution, in contrast, the defaults of each country are independent
of the other country. The planner simply decides on recoveries that induce
default or repayment from each country, trading off the deadweight costs
and the redistribution benefts of default.
Benjamin and Wright (2009) fnd that longer defaults are correlated
with larger reductions in the stated value of an asset and that there is a
modest tendency for countries to enter default when output is relatively low
248 Amin Karimu et al.
and to emerge from default once output has recovered to reach its trend.
They also establish that longer defaults and larger reductions in the stated
value of an asset are more likely when economic conditions in the defaulting country are weak at the time of default. With respect to sovereign debt
restructuring, on average it takes a long time for creditors and a sovereign
government to reach an agreement. Lengthy renegotiations are costly: during renegotiation, governments cannot resume international borrowing,
and creditors cannot realize their investment returns. Thus, understanding the causes of renegotiation delays better is important for both academic
and policy purposes. Alternatively, Rose (2005) shows that it is logical for
sovereign countries to fear default, since default is strongly associated with
reduced trade. This is demonstrated by using a large panel dataset covering
over two hundred trading partners and over 50 years of data to estimate a
model of trade. Results show that debt renegotiation is associated with a
decline in bilateral trade that is both economically and statistically signifcant, adding up to a year’s worth of trade, although the effect is spread over
15 years.
9.6 DEBT-RELIEF POLICIES
Debt relief is granted to borrowing countries that face a situation of debt
overhang, which is a situation where a country’s existing debt so great that
it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself. Debt relief can
be granted by creditor countries by writing off debts to the level where a
borrowing country will not face harsh economic instability.
However, opponents of debt relief argue that some borrowing
countries deliberately incur further debt with the belief that the debts
will be cancelled in the future. In fact, they argue that this situation
is not fair to developing countries that manage their debts creditably.
Thus, they encourage developing countries to spend beyond their current budgets in order to merit debt relief. Of course, others argue that
the granting of debt relief widens the dependence gap between the rich
and the poor.
When debt is seen to be unsustainable, there are a number of ways
of giving out debt relief. The Heavily Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI) are compensation
schemes that are given by the IMF and World Bank to grant debt relief to
qualifying countries. The whole purpose of the HIPC Initiative is to curtail sovereign countries’ debts to those levels believed to be sustainable by
giving them relief of debts held by creditor countries. To be eligible, borrowing countries must pursue structural reform programmes and strategies
for debt reduction. The MDRI is another debt-relief programme, which is
implemented to help defaulting countries graduating from the HIPC Initiative stage enjoy the privileges of full debt cancellation. That said, the MDRI
was set up to assist qualifying countries to get a step closer to the Millennium Development Goals (MDGs). Also, the decision to seek debt relief is
one for the defaulting country to make.
Chapter 9 • Sovereign debt management 249
9.7 DESIGNING INCENTIVES
Effective sovereign debt management irrespective of the institutional framework under which it operates requires an effective and effcient incentive
design to ensure incentive partibility between the principal’s objectives and
that of the agent in minimizing the cost of public debt, given the risk exposure of such debt.
The academic literature contains several incentive designs for organizations. A major issue in the economies of organizations around the world
is that of designing the appropriate compensation and incentive systems,
as shown in Posner’s (2010) work for CEO compensation. As Roberts (2010)
rightly points out, the problem with designing the appropriate incentive
systems should not be limited to the top level of organization but rather
include all levels of the organization. The issue of designing the right incentive system is even more relevant to DMOs, since they play a crucial operational role in the overall debt management of the public, where the strategic
objective of the principal should be in line with that of the agent for the
prudent management of public debt.
But what is the right incentive system that should be designed to
ensure incentive compatibility between the principal and the agent in public debt management? Should the design be focused on strong incentives
or weak incentives? People generally respond to incentives, but what is
usually not clear is whether the designed incentives are able to appropriately capture the right interests and all the interests of the principal for the
agent to respond as desired. In the context of debt management, whether
we should resort to designing strong incentives relative to weak incentives
or vice versa depends on fve key situations, as outlined by Roberts (2010):
1 Whether there are available good measures of the agent’s efforts or
performance.
2 Whether there are available good measures for a particular activity
and whether multitasking is important.
3 Whether cooperation among different agents is desired.
4 Whether encouraging experimentation is important.
5 Whether inducing obedience from agents who disagree with the principal about the right course of action is important.
In all fve cases, the weak incentive scheme is recommended as the optimal
incentive design relative to the strong, as demonstrated by Roberts (2010)
on the basis of earlier studies (Posner, 2010; Holmstrom & Milgrom, 1991;
Raith & Friebel, 2008; Van den Steen, 2007). In the case where there are poor
measures for agent’s performance, poor measures for at least one task in a
multitasking activity, poor measures for cooperation and experimentation,
and the principal and agent fundamentally disagree about the right way
to do things (detailed explanation is in Roberts, 2010), the weak incentive
scheme is more appropriate.
In the context of debt management, it is important to assess whether
the overall strategic objective of the principal of minimizing the cost of
public debt, given the risk, can be addressed by a single task or multiple
250 Amin Karimu et al.
tasks that are required by the agent to meet this objective, whether there is
the need for coordination of tasks across different agents, and whether the
agent needs to experiment to achieve the strategic objective of the principal.
In all this, it is important to determine whether there are excellent measures
for incentives to suggest whether a strong or weak incentive scheme should
be implemented.
The tasks of the DMO are generally many, requiring multitasking
rather than working on only a single task. For instance, front offce staff are
required to be able to handle tasks that include managing auctions, other
forms of borrowing, and all sorts of funding operations. These different
tasks are not easily measured by any performance measure to be able to use
in creating a strong incentive scheme.
The second related important thing to consider in designing the
appropriate incentive systems for the DMO is the fact that not only do staff
perform multiple of tasks, but more so, their tasks must be well coordinated,
as the front offce activities affect the back offce and the middle offce activities, and vice versa. This, among other things, suggests the need for a weak
form of incentive scheme, such that agents do not respond strongly to bad
but strong incentives.
9.8 SOVEREIGN DEBT RESTRUCTURING
Debt restructuring refers to an exchange of outstanding debt instruments
like loans and bonds, for new instruments or cash through a legal process
(Das, Papaioannou, & Trebesch, 2012; European Parliamentary Research
Service, 2017). It involves either or a combination of debt rescheduling,
which refers to an extension of repayments into the future paired with the
possibility of lower interest, and debt relief, which entails the reduction
of the nominal debt. Restructurings may be pre-emptive, coming before a
default or after a default. The restructurings done thus far have been under
four channels: the Paris club, which is a group of creditor governments; the
London club, which is a group of private creditor committees; multilateral
fnancial institutions (MFIS); and exchange offers for dispersed bondholders (Brooks & Lombardi, 2015).
Data show that since the 1950, there have been more than six hundred
individual cases of debt restructuring arising from defaults (Das et al., 2012).
Debt restructuring has gained traction in the past few years, for good reason.
The lack of a proper statutory approach anchored in law like in the case of
corporations has limited the options available for sovereign restructuring. This
has brought about the overreliance on the contractual approach mainly using
collective action clauses (CACs) to restructure. However, CACs also come
with limitations, as was witnessed recently under the Argentinian case and
the recent Greek debt restructuring. Holdout problems limit the speedy attainment of a solution while affecting the outcome of the restructuring outcomes.
This is made more complex by rulings that sometimes end up confusing international practice, rulings from litigations by parties in different jurisdictions.
The Greek case demonstrated how the requirement for a supermajority in CACs might fail to be suffcient to make binding commitments as
Chapter 9 • Sovereign debt management 251
minority creditors successfully held out notwithstanding the CACs. Greece
had tried to restructure €206 billion of debt, of which €21.6 billion was subject
to foreign law. Of these foreign law bonds, 50% failed to achieve the share
needed to activate a collective action clause (CAC) (usually at 75%), resulting in €6.5 billion of the bonds not being restructured. In this case, Greece
was forced to pay out the holdouts in full, because those who had agreed to
the CACs had their debt reduced by up to 75% in net present value terms
(Nieminen & Picarelli, 2017). On one hand, the Greek debt debacle with its
resultant contagion effects in Europe revealed the black box in policy that
debt restructuring is, and how much it can evolve into a nightmare. On the
other hand, the recent debt forgiveness process for heavily indebted poor
nations also revealed how unsustainable debt can weaken a nation’s growth
and development.
9.8.1 Stylized facts
In recent years, debt restructuring has emerged as one of the main solutions
of steering debt-ridden countries out of distress. Although there has not
been an established systematic way of handling it, some common characteristics have been identifed. According to Trebesch and Kolb (2011), four
major insights can be assigned to a majority of countries that eventually
turn out to be candidates of a restructuring;
1 Most debt crises yield more than one debt restructuring and more
than one debt renegotiation. For example, the Algeria debt crisis
(1991–1996) had two restructurings, the Brazil debt crisis (1980–1990)
had fve restructurings, and the Russian debt crisis (1998–2000) had
three restructurings.
2 There is wide variation among the durations for sovereign debt
restructuring. Between 1980 and 2007, it took an average of 30 months;
and from 2008 and 2010, the restructuring period decreased to an
average of 17.3 months. The duration of restructuring has generally
been falling over time. The highest individual country restructuring
durations include Serbia and Montenegro 2000 to 2004, which lasted
43 months; Argentina 2001 to 2005, which took 42 months; and among
the shortest was Uruguay’s restructuring, which took two months.
3 Over the past few decades, it took longer to restructure bank debt
than it took to restructure sovereign bonds. Sovereign bonds took
on average 13 months, while bank restructurings took on average 30
months.
4 Holdouts due to creditors and prerestructuring litigation are rare and
occur only in a minority of cases. Creditor legal action is restricted to
less than 30% of the total cases.
9.8.2 When are debts restructured?
Sovereign debt restructuring is associated with a period of debt overhang
where the debt has already grown big enough for the lenders to view it as
252 Amin Karimu et al.
unpayable in full. The analysis of when a country has fallen in this state has
been carried out using the debt Laffer curve, as mentioned earlier. The curve
was originally used for tax optimization to limit the growth of the budget
defcit but has since evolved into an important tool to evaluate the solvency
of a country. Countries that have reached a point of debt unserviceability
are said to be on the wrong side of the debt Laffer curve (Figure 9.1), where
restructuring is the only way out. Data from 68 countries Cruces and Trebesch (2013) demonstrate that restructuring involving higher reductions in the
stated value of an asset are associated with signifcant higher subsequent
bond yields spreads and longer periods of capital market exclusions.
9.8.3 The debt restructuring process
According to Panizza (2008) and Wright (1944), unlike debt from individuals or corporate entities, where laws can be enforced to declare bankruptcy
and legal enforcement, sovereign debt is a bit complicated. There is a special
status enjoyed by a country in the form of sovereign immunity, which leaves
little room for creditor attachment to a debtor country’s assets. Furthermore, a sovereign is assumed an unlikely candidate for bankruptcy, which
limits its default to only being illiquid. This arises from the assumption that
a country can easily repay the debt through a cocktail of fscal consolidation
measures, which may include increasing its revenue sources and decreasing
its expenditure, among other measures. Creditors faced with a default are
seldom willing to accept a repudiation of the debt. They hinge their hopes
on the assumption that countries may not be willing to risk market exclusion, embargoes, sanctions, and costs in the form of reputation, borrowing
rate increase, or asset confscation to encourage the debtors to stick to the
terms of the loan (Eaton & Gersovitz, 1981; Megliani, 2014). Furthermore,
international treaties commit the defaulting countries to making full compensation for resultant losses arising from wrong acts, as established in
international treaties.
Several studies, such as Trebesch and Kolb (2011), Megliani (2014),
and European Parliamentary Research Service, 2017, conclude that the process of debt restructuring can generally be summarized into three phases.
In the frst place, the debtor is obligated to declare the debt unsustainable
and in need of restructuring. This is the longest part of the restructuring
process, which can take months or years. Second, the country’s debt profle
is evaluated and categorized into foreign and domestic and then by creditor
type. Third, debt exchange occurs where the restructuring offer is made,
and the creditors then decide whether to accept or reject it. According to
European Parliamentary Research Service (2017), a minimum threshold
must be reached in terms of accepting creditors for the restructuring process to proceed.
According to Schwarcz (2004) and Nieminen and Picarelli (2017), the
restructuring itself takes two approaches. First, a contractual approach, also
called the private law approach, regulates the process by use of, among others, CACs. The contractual approach using CACs is employed mainly in
international bonds and allows the supermajority of creditors to modify the
Chapter 9 • Sovereign debt management 253
bond’s earlier fnancial conditions. Next the statutory approach, also called
the public law approach, involves the application of laws that govern the
process of restructuring. This would require the use laws between states
such as the sovereign debt restructuring mechanism (SDRM) of the International Monetary Fund (IMF). This process is rarely used in a sovereign
context because of a lack of a properly laid-out legal framework. Although
this process seems to be straightforward, the negotiation process is fraught
with many complications. The process may vary from creditor to creditor,
and this has seen debt market seriously agitating for a harmonization of a
process to which each participant can commit. Although the foregoing process generalizes the restructuring process, the nature of debt determines the
process, such that commercial banks, multilateral and bilateral suppliers,
trade creditors, and bondholders may have different negotiation processes,
because different interests motivate them.
9.8.4 Methods of debt restructuring
The method of debt restructuring used depends on various aspects of the
loan, especially on the parties involved, the nature and outcomes of the
negotiations, and the needs of the debtor nation. According to Megliani
(2014), the nature of the default determines the method of resolution, which
can take either one of four forms:
1
2
3
4
Submitting to arbitration.
The borrower’s making a unilateral determination.
Arriving at a consensus between the parties involved.
Taking recourse to diplomatic means.
Debtors commonly enter into negotiations. The main determinant of the
method which debt restructuring takes depends on the jurisdiction in law
(or lack thereof) that anchors the debt issue. There are two main jurisdictions
in international debt, namely English law and New York law. Other jurisdictions include German law, Luxembourg law, and so on. The law upon
which a debt instrument is based determines the jurisdiction in law, which
will decide in case the restructuring ends in court and will determine the
clauses that can be inserted into the debt instrument with regard to certain
aspects. A major aspect is the fraction of creditors required to amend aspects
of an instrument. Whereas New York law may require near-unanimous
agreement among creditors, English law requires a lower threshold – twothirds or three-quarters of the creditors – to make an amendment (Arora &
Caminal, 2003). On the basis of the law anchoring the bond agreement or
lack thereof, restructuring arrangements are either statutory (based on law)
or contractual.
9.9 RISK MANAGEMENT FRAMEWORK FOR
GOVERNMENT DEBT PORTFOLIO
To mitigate a sovereign country’s vulnerabilities from shocks, it needs a
policy framework that integrates government debt and risk management.
254 Amin Karimu et al.
Structural weaknesses in developing markets create volatility in the macroeconomy. Thus, the more unstable an economy, the more important it is to
have a comprehensive policy framework for government debt risk management. The risks inherent in the structure of the government’s debt should
be carefully monitored and evaluated. Generally, risk management policies
are approved by a country’s MoF, but there are separate agencies that are
responsible for the actual risk management operations. Common risks that
are likely to be managed are credit risk,12 liquidity risk,13 and market risks.14
According to Blommestein (2005), risk management policy framework
mirrors the vital connection between the formulation and the implementation of debt management decisions and should be based on benchmarks.
The strategic benchmark to that end is a management tool that requires a
government to specify its risk tolerance and portfolio preferences on the
trade-off between risks and expected costs. Debt managers should be able
to ascertain how a portfolio is structured with respect to cost against risk
criteria. This helps to hedge against various forms of shock. This means a
government’s choice of debt instrument issued depends on the economy’s
structure, the nature of economic shocks, and investor preferences. A strategic benchmark has two key roles:
1 It provides guidance for management of costs and risk.
2 It defnes a framework for assessing portfolio performance on cost,
risks, and return.
To guide borrowing decisions and lessen government risks, debt managers should take into consideration fscal and other risky features of a government’s cashfow. Theoretically, all governments have balance sheets that
show their cashfows. Factoring in these cashfows vis-à-vis fnancial and
other inherent risks provides in-depth insight for debt managers into managing risks associated with government debt portfolio. In addition, a fnancial analysis of a government’s balance sheet will form a basis for measuring
the costs and risks of more-viable policies and programmes aimed at managing a government’s debt portfolio. Some countries have extended this
approach to include other government assets and liabilities. For example,
in certain countries where foreign exchange reserves are funded by foreign
currency debts, debt managers have lessened government’s balance sheet
risk by ensuring that the currency composition of the debt supporting the
reserves refects the currency composition of the reserves after factoring in
derivatives and hedging transactions.
Countries where debt managers are in charge of managing liquid assets
have been adopted a multipronged method for credit risk management. In
other countries where credit ratings are available, debt managers should limit
their investments to those that have credit ratings from independent creditrating agencies that meet a predetermined minimum requirement. Of course,
credit risks can also be managed by diversifying a portfolio across a number
of fnancial counterparties and through collateral agreements. A government
should set its risk exposure limits for counterparties to factor in its actual and
contingent consolidated fnancial exposures to that counterparty that arises
from debt and operations of foreign exchange reserves management.
Chapter 9 • Sovereign debt management 255
Foreign exchange reserves play a role in granting government the
fexibility to manoeuvre in times of shocks. The level of foreign exchange
reserves should be aligned with government access to capital markets, the
cost of carrying the reserves, and the exchange rate regime, among others.
Governments that are unable to secure access to the international markets
should consider holding reserves that align with their countries’ short-term
external debt. In addition, debt managers should consider indicators that
are of interest to debt management, such as ratios of debt to GDP and to tax
revenue, average interest rates, debt service ratios, maturity indicators, and
indicators of debt composition.
Contingent liabilities are potential fnancial claims against government which have yet to materialize but can trigger a frm fscal obligation
under certain circumstances. Contingent liabilities may include government insurance against natural disasters. Debt managers in managing risks
should factor in the impact of contingent liabilities on a government’s fnancial position. Contingent liabilities come with some level of risks unlike government fnancial obligations. This is because they can be used only when
certain events take place. Also, the size of the payout depends largely on the
structure of the undertaking. Governments can reduce the contingent liabilities risks by strengthening provident supervision and regulation, introducing appropriate deposit insurance schemes, undertaking sound governance
reforms of public sector enterprises, and improving the quality of their macroeconomic and regulatory policies.
It is important also that a government monitor the risk exposures they
enter into through contingent liabilities and make sure that they are fully
aware of the risks involved in such liabilities. It is necessary also that the
government be well informed about the conditions that are likely to trigger
continent liabilities, such as policy distortion. Notably, some governments
have found it useful to centralize this monitoring function. Nonetheless, the
debt managers should be aware of the contingent liabilities undertaken by
a government. It is also important that debt managers make budget allowances in anticipation of expected losses from contingent liabilities.
It is expedient for debt managers to critically assess and manage
risks that emanate from foreign currency and short-term or foating-rate
debt. When a government overly relies on a debt management strategy that
features foreign currency or short-term debts, this situation may be risky.
This holds true in times when capital markets become volatile and exchange
rates depreciate. Also, short-term debts that may seem less costive can create substantial rollover risk for the government. In other instances, it may
limit the central bank from raising interest rates to confront issues of infation or perhaps support the exchange rate. A number of governments from
emerging market countries have considerable amounts of short-term and
foating-rate debt. Yet relying too much on longer-term fxed rate fnancing also has its associated risks as it entices the government to devalue the
debt in real terms by initiating surprise infation. Such concerns would be
refected in both current and future borrowing costs. Also, unexpected
devaluation would increase debt-servicing burdens. This could create
strains in countries and lead to the payment of higher risk premium given
256 Amin Karimu et al.
the already-heavy debt burden. Governments seeking to build benchmark
issues often hold liquid fnancial assets, spread the maturity profle of the
debt portfolio, and use domestic debt buybacks or swaps of older issues
with new issues to manage the associated rollover risks.
Another way to manage risk is to have a cost-effective management
policy in place to cater for cases of unplanned expenditure. In situations
where government fnds it diffcult to secure access to capital markets, liquid fnancial assets can provide fexibility and ease in debt and cash management operations in times of temporal fscal market distortions. They make
it easy for the government to absorb shocks where it is nearly impossible
to borrow in capital markets or perhaps expensive to. Sound cost-effective
cash management needs to be supported by an effcient infrastructure for
payments and settlements. Identifying and managing market risk involves
examining the fnancial features of the revenues and other cashfows available to the government to service its borrowings and choosing a portfolio
of liabilities that matches these as much as possible. Where cash and debt
management functions are separately managed, such as by the central bank
and ministry of fnance respectively, short-run discrepancies between debt
and monetary operations are avoided. Clearly demarcating institutional
responsibilities between the central bank and debt management offcials
promotes sound cash management practices. The IMF (2017) provided ten
guiding principles for managing sovereign risk, which due to space, will not
be discussed here.
9.10 DEBT SUSTAINABILITY ANALYSIS AND
MEDIUM-TERM DEBT STRATEGY
The issue of debt sustainability in developing countries is an issue that often
comes up in debates and discussions among policymakers and international organizations, especially in recent years after the 2008 fnancial crisis.
Equally important is the concept of medium-term debt management strategy (MTDS), which is closely linked to debt sustainability.
9.10.1 Debt sustainability analysis
According to the IMF, in developing countries, debt is considered to be
unsustainable if the following two conditions hold:
• External debt is unsustainable.
• Debt-servicing problems occur.
External debt is unsustainable when it cannot be serviced without needing
exceptional fnancing, such as debt relief. This means that when a country is
unable to honour his external debt service obligation without a debt-relief
support, the external debt of such a country is said to be unsustainable.
There are various indicators that are generally used to assess whether a
country’s external debt is likely to be unsustainable or not, which will be
discussed later in this section.
Chapter 9 • Sovereign debt management 257
Developing countries are considered to be facing debt-servicing problems or challenges when there is lack of suffcient loans or grants from external creditors (e.g. international organizations or governments) to fnance
a country’s primary defcit, and when the cost of servicing domestic debt
is high. This means that a country with a lower cost of domestic debt may
reduce its possibility of a debt-servicing problem relative to one with a high
cost of domestic debt.
In the context of facing the two conditions just presented regarding
debt sustainability, it becomes necessary to conduct DSA annually as recommended by the IMF to form a clear picture of what future commitment
can be made in regard to debt management and public investment. DSA
can be broadly defned as an assessment of how a country’s current level
of debt, and new borrowing affects its ability to honour debt service obligations in the future. This, among other things, suggests that a country with a
huge accumulated debt stock, but with fewer resources to support the debt,
and yet it continues to accumulate new debt, which runs the risk of its not
being able to honour the service obligations of the debt in the future. This
risk is higher for countries with poor policies and institutions, which could
serve as a check to wasteful use of the borrowed money.
9.10.2 How DSA are conducted
The DSA is made up of two parts: a preparing part and an assessing part
(World Bank, 2005). In the preparation part, three key steps are taken:
1 The country involved in consultation with the IMF determines the
schedule for preparation, which is generally a year but could be less
or more frequent than a year, depending on the level of debt stability of the country. When debt levels are more stable, less-frequent
updates are required. However, in a case of countries with less-stable
debt levels, frequent updates are required.
2 The country works with the IMF and the World Bank develop a macroeconomic framework.
3 The country consults key creditors for information on their lending
plans.
The second part, which is the assessment section of the DSA, involves the
following steps (World Bank, 2005):
• Link the low-income countries’ (LICs) templates for DSA to macroeconomic projections and debt data.
• Calculate current and future debt-burden indicators under the baseline. The baseline scenario is based on a set of macroeconomic projections, which refects the government’s intended policies.
• Design alternative scenarios and stress tests to identify the countryspecifc factors to be included in the DSA.
• Produce relevant tables and charts as provided by the LIC templates.
• Form a view regarding how debt-burden indicators evolve over time,
and assess their vulnerability to exogenous shocks.
258 Amin Karimu et al.
• Compare external debt-burden indicators to appropriate indicative
debt-burden thresholds.
• Assess whether and how other factors, such as the evolution of domestic debt or contingent liabilities, affect a country’s capacity of servicing
future debt service payments.
• Classify a country according to its probability of debt distress in collaboration with the IMF.
• Determine a country’s appropriate borrowing strategy, and identify
adequate policy responses.
The results from the DSA can then be used in conjunction with countries’
macroeconomic fundamentals, quality of instructions, policies, and history
of debt management to determine the warning signs and how-to response
appropriately, to correct them before their occurrence.
9.10.3 Medium-term debt strategy
The primary objective of sovereign debt management is to raise the
required funding required at the least cost over a medium term to a long
term, one that is consistent with a reasonable level of risk. This suggests
that effective debt management and how it is designed and implemented
depend to a large extent on the macroeconomic and institutional contexts.
There is a two-way interlinkage between prudent debt management and
macroeconomic policy. Generally, sound debt management is critical to
macro and fnancial stability and vice versa. An effcient debt management requires an effective debt management strategy (DMS), which can
be broadly defned as a plan in managing public debt portfolio over time,
in line with the strategic management objective conditional on the constraints imposed by government preferences with regard to cost–risk
trade-offs.
There are clear guidelines provided by the World Bank and IMF on how
to develop a good and effective medium-term debt management strategy
(MTDS). The guideline, which contains eight steps, is as follows (February
2009):
1 Identify the objectives for public debt management and scope of the
MTDS.
2 Identify the current debt management strategy, and analyse the cost
and risk of the existing debt.
3 Identify and analyse potential funding sources, including their cost
and risk characteristics.
4 Identify baseline projections and risks in key policy areas – fscal,
monetary, external, and market.
5 Review key longer-term structural factors.
6 Assess and rank alternative strategies on the basis of the cost–risk
trade-off.
7 Review the implications for candidate debt management strategies
with fscal and monetary policy authorities and for market conditions.
8 Submit and secure an agreement on the MTDS.
Chapter 9 • Sovereign debt management 259
In practice, the debt management team does not necessarily have to follow
the steps in a systematic order as presented. However, all steps should be followed, because they serve various purposes in the debt management process.
CONCLUSION
Debt levels for most developing countries are fast rising even after the two
debt-relief programmes: the Heavily Indebted Poor Countries Initiative and
Multilateral Debt Relief Initiative. These programmes, by the end of 2008,
helped reduced the debt level for many developing countries. For instance,
in SSA, the debt-relief programmes helped reduced the debt level by about
two-thirds. The gains from the debt-relief programmes seem to have been
short-lived, since the debt levels for most developing countries are getting
close to a crisis threshold. Since 2008, the ratio of debt to GDP has been rising, and in 2016, it doubled the 2008 value, to 44%. This fast-rising debt level
has almost wiped out half of the reduction from 2000 to 2008.
In 2016, out of 46 SSA African countries with available statistics, more
than half (24 countries) of them have a debt-to-GDP ratio at or above the
50% threshold considered a concern. Countries such as Capo Verde, Gambia, and the Republic of Congo have debt-to-GDP ratios above 100%, and
about 15 SSA have debt-to-GDP ratios in the 60%–98% bracket. The question
that keeps coming up in recent discussions is whether the debt-overhang
threshold in many of the developing countries has been crossed or has come
close to being crossed once again. Why are the causes of the fast-rising debt
levels in developing countries? Are the current debt levels in the developing
world sustainable? This chapter provided insights into the debt situations
in developing countries, the growth implications, institutional framework
for debt management, incentive structure for staff in debt management
offces, and debt restructuring, among others, to help us better understand
the effective management of debt in developing countries.
The fscal space for most developing countries are clearly too narrow
to support their respective growth and development pathways, and as a
consequence, they tend to rely signifcantly on external debt to close the
public fnancing gap. More importantly, the borrowed money is in most
cases not prudently spent on projects that can generate funds to repay the
debt and its servicing requirement. These call for countries to better manage
public debts by introducing an effcient institutional framework for debt
management, resource debt management offces, and excellent debt sustainability analysis procedures.
Discussion questions
1 Explain, with examples, why
at a certain threshold of debt, it
is prudent to implement debt
forgiveness.
2 Give three scenarios that can
result in debt crisis and provide
solutions to address each of the
scenarios.
260 Amin Karimu et al.
3 Explain to a policymaker why
debt forgiveness can lead to an
increase in the market value of
debt for the creditor.
4 What is debt management? Outline the various guidelines to
promote debt sustainability in a
developing country.
5 Briefy outline the processes
involve in conducting debt sustainability analysis (DSA) for a
prudent debt management.
6 In the context of debt management, whether we should resort
to designing strong incentives
relative to weak incentives, or vice
versa, depends on fve key situations, as outlined by John Roberts
(2010). Present and discuss these
fve situations in designing the
appropriate incentive scheme for
a developing country.
Notes
1 External debt is the portion of
a country’s debt owed to nonresidents, and it is the standing
amount of those actual current,
and not contingent, liabilities that
require payment(s) of principal
and/or interest by the debtor at
some point in the future.
2 ‘Eurodollar market’ is a term that
refers to US-dollar-denominated
deposits at foreign banks or at the
overseas branches of American
banks.
3 Debt management refers to the
processes to minimize the fnancial cost of the public debt while
maintaining the market and operational risks at an acceptable level,
given the general objectives of the
fscal and monetary policies.
4 Debt servicing is the requirement
of paying the principal and interest on outstanding loans.
5 Domestic resource mobilization
refers to the generation of government revenue from domestic
resources, such as revenue generated from taxes or nontax sources
(royalties, licences, levies, or other
income).
6 Sovereign debt refers to the central
government’s debt. It is debt issued
by the national government in a
7
8
9
10
11
12
foreign currency in order to fnance
the issuing country’s growth and
development.
Interest rate risk is the probability
of a decline in the value of an asset
resulting from unexpected fuctuations in interest rates.
Economic growth is the sustained
increase in the production of
goods and services over a period
of time.
Primary surplus refers to current
government spending, which is
less than current income from
taxes excluding interest payments
on government debt.
A debt Laffer curve is a curve that
shows the relationship between
the face value and market value
of debt, where market value is
determined by the market price
of debt. The curve shows when
debt reduction can be benefcial to
a country if the country is on the
wrong side of the curve.
Operational risk refers to the
probability of loss occurring from
the internal inadequacies of an
organisation.
Credit risk is the potential that a
bank borrower or counterparty
will fail to meet its obligations in
accordance with agreed terms.
Chapter 9 • Sovereign debt management 261
13 Liquidity risk is the potential
that a frm is unable to meet its
short-term debt obligations,
thereby incurring exceptionally
large losses.
14 Market risk refers to the risk that
an investment may face due to
fuctuations in the market, such
that it cannot be eliminated
through diversifcation.
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CHAPTER
10
Financial inclusion and
economic growth1
Joshua Yindenaba Abor, Haruna Issahaku,
Mohammed Amidu, and Victor Murinde
10.1 INTRODUCTION
There are at least three motivations for examining the effects of fnancial
inclusion on growth: the low level of fnancial inclusion in countries that
need economic growth most (low-income countries), the lacklustre growth
in sub-Saharan Africa (SSA) in recent times, and a realisation of the role of
fnancial inclusion in accomplishing the United Nations Sustainable Development Goals (SDGs). Each motivation is substantiated in chronological
order.
First, while fnancial inclusion (particularly, account ownership) has
almost reached a saturation point in high-income countries, low-income
countries have yet to make any signifcant progress in ensuring fnancial
inclusion. Meanwhile, these low-income economies need fnancial inclusion
the most in order to jumpstart inclusive development. On the basis of the
Findex data provided by Demirgüç-Kunt, Klapper, Singer, and Oudheusden (2015), about 90.6% of adults in high-income countries and 94% in highincome OECD countries own a bank account, while only 27.4% of adults
in low-income countries own a bank account. Similarly, while 75.1% and
79.7% respectively of adults in high-income and high-income OECD countries have a debit card, only 6.6%% of adults have a debit card in low-income
countries. This means that immerse opportunities exist in poor countries for
extending fnancial inclusion for economic development.
Second, on the basis of International Monetary Fund (IMF) data (IMF,
2018), in 2016, SSA, the poorest region in the world, experienced its lowest
growth in over 20 years. From 3.4% in 2015, growth in the region fell considerably to 1.4% in 2016. Notwithstanding the fact that growth picked up in
2017 (2.7%), it was still jaded. This appalling growth is attributable to falling
commodity prices, unsupportive global economic environment, and structural bottlenecks in some countries in the region. In particular, resource reliant economies such as Angola, Nigeria, and South Africa have bowed to
the repercussions of low crude oil prices as revenues have been severely
affected. Inopportunely, these are the three largest economies in the subregion, and for that matter, their weaknesses spill over into other countries in
the subregion. These three economies respectively grew by 0.0%, -1.5%, and
264 Joshua Yindenaba Abor et al.
0.3% in 2016. Some non-oil-dependent economies are, however, performing
impressively by experiencing growth in excess of 6%. These include Côte
d’Ivoire, Ethiopia, Kenya, and Senegal. Clearly, fnancial inclusion has a
role to play in accelerating growth in the SSA region.
Third, fnancial inclusion is indispensable to the attainment of the
SDGs. Consequently, fnancial inclusion has been integrated into the SDGs,
where it features prominently as a target in eight of the 17 SDGs:
SDG 1 – eradicating poverty.
SDG 2 – ending hunger, achieving food security, and promoting sustainable agriculture.
SDG 3 – improving health and well-being.
SDG 5 – achieving gender equality and economic empowerment of
women.
SDG 8 – promoting economic growth and jobs.
SDG 9 – supporting industry, innovation, and infrastructure.
SDG 10 – reducing inequality.
SDG 17 – strengthening the means of implementation.
As an example, one of the targets of SDG 8 is to ‘strengthen the capacity of
domestic fnancial institutions to encourage and expand access to banking,
insurance and fnancial services for all’. This means that the future of the
world depends so much on our ability to extend a wide range of fnancial
services to the poor and marginalised. In this way, a more succinct understanding and vigorous pursuit of fnancial inclusion will be a vital contribution towards attaining these lofty global goals (SDGs).
The rest of the chapter is structured as follows. Section 10.2 defnes
fnancial inclusion and provides a guide to its measurement. Section 10.3
describes the trends in fnancial inclusion. Section 10.4 discusses the determinants of and barriers to fnancial inclusion. Section 10.5 assesses the link
between inclusive fnance and fnancial development. Section 10.6 examines
the effect of inclusive fnance on economic growth. Section 10.7 discusses
the roles of institutional architecture in the fnancial inclusion–economic
development nexus. Section 10.8 concludes the chapter.
10.2 CONCEPTUALISING FINANCIAL INCLUSION
‘Financial inclusion’, an antidote to fnancial exclusion, has become a buzzword in policy, academic, and practitioner circles. However, conceptualising fnancial inclusion remains an unsettled matter. While there is almost
a consensus on the defnition of ‘fnancial inclusion’, the issue of measurement remains unsettled. Allen, Demirgüç-Kunt, Klapper, and Peria (2016)
defne ‘fnancial inclusion’ simply as the ‘usage of formal fnancial services’ (p. 2). The World Bank defnes ‘fnancial inclusion’ as the case where
‘individuals and businesses have access to useful and affordable fnancial
products and services that meet their needs – transactions, payments, savings, credit and insurance – delivered in a responsible and sustainable way’
(www.worldbank.org/en/topic/fnancialinclusion). For the African Development Bank (AfDB, 2012), ‘fnancial inclusion’ means ‘all initiatives that
Chapter 10 • Financial inclusion and economic growth 265
make formal fnancial services Available, Accessible and Affordable to all
segments of the population’ (p. 26). According to the Centre for Financial
Inclusion, fnancial inclusion is a ‘state in which everyone who can use them
has access to a full suite of quality fnancial services, provided at affordable
prices, in a convenient manner, with respect and dignity’ (www.centerforfnancialinclusion.org/). Diniz, Birochi, and Pozzebon (2012) view fnancial
inclusion as making formal fnancial services accessible and affordable to all
individuals, especially those with low incomes.
On the basis of the foregoing defnitions, we present a broad (‘consensus’) defnition for fnancial inclusion as follows. ‘Financial inclusion’
can be defned as eliminating obstacles to fnancial products and services
(such as credit, investment, savings, insurance, fnancial technology, and
payments) for everybody in the economy (rich or poor, all adults, rural
or urban dweller, educated or uneducated) and establishing a platform,
or framework, or a system which produces low-cost, fair, convenient,
safe, quality, and sustainable fnancial services and products and facilitates access to and the usage of these products and services by all, at all
times.
The conceptualisations suggest that fnancial inclusion can be viewed
as a state concept or as a process concept. Financial inclusion as a state pertains if all the ideals of fnancial inclusion (ingredients) are present in fxed
measures. Should there be a change in any of the ideals, then the state of
fnancial inclusion changes. In this light, an individual can be described as
being fnancially included or excluded. In addition, there are degrees of
exclusion and inclusion that describe various states of fnancial inclusion or
exclusion. However, fnancial inclusion as a process entails the mechanism
or path followed to change fnancial inclusion from one state of equilibrium
to another. Thus, the process leads to the state.
In terms of measurement, most empirical studies measure fnancial
inclusion by using one or more single-variable measures, such as the
ownership of bank account, number of accounts per 1000 adults, number of bank branches per 100,000 adults, savings capacity, and insurance
penetration, among others. However, these single-variable measures
have been criticised for being too narrow to convey the multidimensional nature of fnancial inclusion. Now, the trend in the literature is
to construct a fnancial inclusion index on the basis of some identifed
dimensions. Sarma (2012) constructs a fnancial inclusion index with
three main dimensions, namely the penetration of fnancial services, the
availability of fnancial services, and the usage of fnancial services. In a
similar vein, the Financial Inclusion Data Working Group of the Alliance
for Financial Inclusion (2011) has proposed three dimensions of fnancial
inclusion:
1 Access refers to availability of formal fnancial services in terms of
physical proximity and affordability.
2 Quality entails designing and customising fnancial services to the
satisfaction of consumers.
3 Usage refers to the regularity, frequency, and duration of using fnancial services.
266 Joshua Yindenaba Abor et al.
A more succinct (and universal) view of fnancial inclusion in three-dimensional form was provided by Hall (2014). The components of Hall’s threedimensional view of fnancial inclusion (FI3D) are fnancial participation,
fnancial capability, and fnancial well-being. Each dimension embodies
several subdimensions:
1 Financial participation refers to the affordability of, having access to,
and the usage of formal fnancial services and products (accounts,
credit, deposits, investment, insurance, fnancial technology, and
payments).
2 Financial capability measures the deployment of fnancial inclusion
to enhance the capability of the individual to effectively participate
in the formal fnancial system. It entails the ability of the individual
to make prudent fnancial decisions, effectively undertake fnancial
planning and budgeting, and be fnancially literate and keep up to
date with fnancial innovations and trends.
3 Financial well-being measures the degree to which fnancial inclusion
has improved the quality of life and well-being of the individual. It
measures fnancial inclusion–induced improvements in fnancial quality of life, amelioration of hardship, curtailment of over-indebtedness,
fnancial self-suffciency, and livelihood sustainability.
Thus, Hall’s conceptualisation collapses the three elements of fnancial inclusion proposed by Alliance for Financial Inclusion Financial Inclusion Data Working Group (2011) (access, quality, and usage) into one broad
dimension: fnancial participation.
10.3 TRENDS IN FINANCIAL INCLUSION
Compared to the rest of the world, fnancial inclusion is low in SSA (Table 10.1).
However, the trend shows improvement. The percentage of adults who had
any form of bank account in 2017 was 68.5% globally, compared to 42.6%
in SSA. Again, while 62% of adults aged 15 and above had some form of
account in 2014 globally, only 34.2% had an account in SSA in the same
period. Globally, the percentage of adults with an account increased from
50.6% in 2011 to 68.5% in 2017. Similarly, in SSA, the percentage of adults
with an account increased from 23.2% in 2011 to 42.6% in 2017. Unfortunately, vulnerable groups such as women, the unemployed, and the poor
have the lowest incidence of fnancial inclusion (in terms of owning a bank
account), both in the world and in SSA.
The incidence of fnancial inclusion is lower with respect to accounts
with formal fnancial institutions. While the percentage of adults with an
account in a formal fnancial institution increased from 50.6% in 2011 to
67.1% in 2017 worldwide, in the case of SSA, the same increased from 23.9%
in 2011 to 32.8% in 2017. This highlights that the growth in global trend in
formal account ownership is faster than that of SSA. Thus, efforts have to
be doubled to extend basic fnancial accounts to the unbanked in the region.
In the academic, policy, and practitioner circles, more value is placed
on using an account than on the mere owning of account, as somebody may
Chapter 10 • Financial inclusion and economic growth 267
TABLE 10.1 Trends in fnancial inclusion: SSA and world
Financial inclusion measure
SSA
World
42.6
34.2
23.2
68.5
62
50.6
32.8
28.8
23.2
67.1
61.2
50.6
Mobile money account (% age 15+)
All adults, 2017
All adults, 2014
20.9
11.6
4.4
2.1
Account, by individual characteristics (% age 15+), 2017
Women
Adults belonging to the poorest 40%
Adults out of the labour force
Adults living in rural areas
36.9
31.9
31.4
39.5
64.8
60.5
59.3
66
Digital payments in the past year (% age 15+)
Made or received digital payments, 2017
Made or received digital payments, 2014
Used an account to pay utility bills, 2017
Used an account to receive private sector wages, 2017
Used an account to receive government payments, 2017
Used the internet to pay bills or to buy something online, 2017
Used a mobile phone or the internet to access an account, 2017
Used a debit or credit card to make a purchase, 2017
34.4
26.9
7.7
5.7
7.3
7.6
20.8
7.5
52.3
41.5
22.3
15.9
16.3
29
24.9
32.6
5.5
7.1
13.4
13.7
Domestic remittances in the past year (% age 15+), 2017
Sent or received domestic remittances through an account
Sent or received domestic remittances through an OTC service
Sent or received domestic remittances through cash only
22.7
11
9.4
..
..
..
Saving in the past year (% age 15+)
Saved at a fnancial institution, 2017
Saved at a fnancial institution, 2014
Saved at a fnancial institution, 2011
Saved using a savings club or person outside the family, 2017
Saved any money, 2017
Saved for old age, 2017
14.9
15.8
14.3
25.3
54.4
10.3
26.7
27.3
22.6
..
48.4
20.6
Credit in the past year (% age 15+)
Borrowed from a fnancial institution or used a credit card, 2017
Borrowed from a fnancial institution or used a credit card, 2014
Borrowed from family or friends, 2017
Borrowed any money, 2017
Credit in the past year (%, age 15+), 2017
8.4
7.5
31
45.7
4.7
22.5
22.3
25.8
47.5
11.2
Account (%, age 15+)
All adults, 2017
All adults, 2014
All adults, 2011
Financial institution account (% age 15+)
All adults, 2017
All adults, 2014
All adults, 2011
Inactive account in the past year (% age 15+), 2017
No deposit and no withdrawal from an account
No deposit and no withdrawal from a fnancial institution
account
Source: Demirgüç-Kunt et al. (2015, 2018)
Note: Except when otherwise indicated, all statistics relate to 2017
268 Joshua Yindenaba Abor et al.
have an account but the account has been dormant for months or years.
SSA has a lower proportion of adults with a dormant account than that of
the global average. The percentage of adults who neither deposited into
nor withdrew from a fnancial institution account in 2017 was 13.7% for the
world and 7.1% for SSA. There is an upsurge in the use of digital fnancial
services. Globally, the proportion of adults who received or made digital
payments increased from 41.5% (26.9%) in 2014 to 52.3% (34.4%) in 2017,
an increase of about 10.8% (7.5%) over the four-year period. Generally, SSA
lags behind the global average with respect to account usage indicators
such as the receipt of wages and government transfers through a formal
account, the use of an account to pay bills, and making online transactions.
This is largely due to the relatively large informal sector in the region, which
encourages payments through informal channels. The share of Africa’s
informal sector in GDP is 38% compared to 24% of the GDP for Europe. This
means that formalisation can be a key driver of fnancial inclusion.
One of the important indicators of fnancial inclusion is savings. The
Harod–Domar model highlights how the accumulation of savings can help
a nation realise its growth potentials. Savings is important because it is the
building block of investment. Moreover, without investment, no signifcant economic progress can occur. Globally, the proportion of adults who
save in a fnancial institution is low, and the trend is showing stagnation.
Worldwide, the percentage of adults who saved with a fnancial institution increased from 22.6% in 2011 to 27.4% in 2014 but dropped to 26.7% in
2017. Meanwhile, in SSA the percentage of adults who saved with a fnancial institution increased marginally from 14.3% in 2011 to 15.9% in 2014
and declined slightly to 14.9% in 2017. Thus, though the formal savings rate
in SSA lags behind the global fgures, the savings rate is stagnating both
worldwide and in SSA. Some barriers to formal savings include distance
to a fnancial institution and low interest rates on savings. Formal savings
are emphasised, as opposed to informal savings, because of the many risk
involved in informal savings mechanisms and the ability for formal savings
to generate several other deposits through the deposit multiplier.
Although credit is indispensable to the growth of enterprises, access to
credit remains an intractable problem worldwide. Globally, the percentage of
adults who borrowed from a formal fnancial institution or used a credit card
was 22.5% in 2017, up from 22.3% in 2014. Similarly, in SSA, the percentage
of adults who borrowed from a formal fnancial institution was 8.4% in 2017,
up from 7.5% in 2014. Informal sector frms suffer the most when it comes to
accessing fnance due to a wide range of issues, including, but not limited to,
a lack of usable collateral, a lack of valid business registration documents, the
distance to fnancial institutions, and a low level of fnancial literacy.
10.4 DETERMINANTS OF AND BARRIERS
TO FINANCIAL INCLUSION
Determinants of and barriers to fnancial inclusion can be usefully categorised into demand-side factors and supply-side factors. On the one hand,
demand-side factors entail forces, circumstances, and characteristics from
Chapter 10 • Financial inclusion and economic growth 269
the side of the consumer which affect or impede the uptake of fnancial
inclusion. On the other hand, supply-side factors involve constraints that
arise from market failures, which affect or constrain the provision of fnancial services.
10.4.1 Supply factors
Infrastructure such as transportation, energy, communications, and fnance
are needed to provide quality fnancial services to a large number of people.
Meanwhile, these types of infrastructure are either lacking, inadequate, or
in poor condition in most developing countries and in rural areas in particular. Financial institutions are unwilling and unable to set up outlets in areas
where such key infrastructure facilities are lacking. That is why it is unsurprising that fnancial inclusion rates are lowest in rural and economically
disadvantaged settlements. Globally, the amount needed to meet infrastructure needs by 2040 is estimated at USD94 trillion (Global Infrasturture Hub,
2017). Although Asia has the largest investment need (needing about 50%
of overall global infrastructure), Africa and the Americas are forecasted to
have the largest infrastructure gap. The infrastructure investment gap in
these regions are estimated at 28% and 32% respectively. Africa’s infrastructure investment gap widens to 43% when infrastructure needed to meet the
SDGs are incorporated. Putting in place supportive infrastructure will help
extend fnancial inclusion to millions.
The costs of obtaining information and enforcing contracts are prohibitive in a number of poor countries. Financial institutions often fnd it
expensive to provide fnancial services to poor individuals who are located
in deprived areas, where transaction costs are high. The poor state of infrastructure or the lack of it exacerbates transaction costs. Banks and other
fnancial institutions are therefore more comfortable dealing with rich individuals, large frms, and the government than with the poor, who are often
classifed as ‘unbankable’. Digital fnance provides an avenue for reducing
the cost of extending fnance to the poor. Mobile payments can lower the
cost of providing fnancial services by 80% to 90%, enabling providers to
serve lower-income customers proftably (McKinsey & Company, 2016).
Among transaction costs factors, fxed costs are of signifcant consequence when it comes to extending fnancial inclusion to the poor. Beck
and de la Torre (2007) have discussed these fxed costs to include clientlevel and transaction-level fxed costs, such as the costs of maintaining an
account for an individual client and the costs of processing a transaction,
which are partly independent of the value, number, and size of transactions
respectively. At the fnancial institution level, fxed costs include physical
infrastructure such as headquarters and a branch network; ICT infrastructure; and legal, accounting, and security services (these being independent
of the value and volume of transactions processed or the number of clients
served). At the fnancial system level, fxed costs include regulatory costs
and costs of settlement and payments facilities, which are partly independent of the number of fnancial institutions regulated or involved in the
payment space. The scale diseconomies arising from these fxed costs make
270 Joshua Yindenaba Abor et al.
it unviable to extend fnancial services and payment systems unless these
diseconomies can be captured in some form or the other.
Settlements in rural and less-populated areas are often dispersed, and
this increases the cost of providing fnancial services to these areas relative
to return on the capital employed. Fixed costs in particular become more
binding in rural and less-populated communities where the market size is
unproftably small. Weighing the size of the market against the fxed costs,
a fnancial institution is usually reluctant to set up a branch or network in
an area with a small and dispersed population, especially when the demand
for fnancial services in urban areas is surging. Banks have often had to close
branches in areas that they initially thought would be promising for business but where the reality proved different. SSA has the lowest population
density in the world, with an average population per square kilometre of
40 overall and 14 in rural areas (World Bank, 2014). This could increase the
cost of extending fnancial services in the region. Thus, if governments are
not willing to capture these costs, fnancial inclusion will remain a dream to
many in the region.
Regulation can affect fnancial inclusion in several ways. First, regulations can serve as a disincentive to fnancial inclusion. The quest to quell
money laundering and terrorism fnancing has forced central banks to put
up stringent measures to enable the detection and interception of illicit
fnancial fows. Such stringent regulatory measures can serve as signifcant
stumbling blocks for the poor. For instance, ‘know your customer’ requirements, which demand overly elaborate disclosure and documentation, may
discourage the poor from opening bank accounts and from using formal
fnancial services. This is because, the poor usually do not have the proper
identifcation documents, land titles, and evidence of bills payments, among
other documents, required to access formal fnancial services. Second, weak
regulatory oversight can lead to the collapse of fnancial institutions and roll
back the clock of time on fnancial inclusion. Third, suboptimal regulation
can lead to the underproduction of fnancial services in the economy by
leading to and reinforcing ineffciencies in the fnancial system. Lastly, overregulation can hinder fnancial innovation by either stifing, being unreceptive to, or penalising fnancial frms that seek to introduce new fnancial
services and technologies into the regulatory environment.
10.4.2 Demand-side factors
Although there have been improvements in literacy on the whole, about 774
million adults cannot read and write, representing one-ffth of the global
population (Carr-Hill & Pessoa, 2008). This represents a waste of potential
human capital and economic productivity capacity. Most of these nonliterate adults are concentrated in South and West Asia, SSA, East Asia and the
Pacifc. In terms of gender, they are mostly women. In terms of geography,
they are mostly located in rural areas. Such high levels of illiteracy dovetail
into poor decision-making and lack of capacity to take advantage of opportunities, including fnancial inclusion–related opportunities. Even though
fnancial literacy is more of a problem to the nonliterate, it is a problem for
Chapter 10 • Financial inclusion and economic growth 271
the literate as well. A low level of fnancial literacy leads to poor fnancial
choices, poor fnancial planning, unnecessary risk taking, and using fnancial services and products less, among others.
Accessing and using fnancial services often do not come free or cheap.
For instance, some minimum amount is often required to open an account
even though now some banks have instituted no-frill accounts. In terms of
digital fnance, at least one must be able to afford a phone or other electronic
device to enjoy digital fnancial services. This means that in areas where
poverty is prevalent, fnancial inclusion is likely to suffer. Unsurprisingly,
fnancial inclusion penetration rates are lowest in low-income countries
rather than in high-income countries. Thus, reducing poverty can remove
an important roadblock to fnancial inclusion. The Findex Database 2018
shows that, in all cases and in all regions of the word, adults belonging to
the poorest 40% of the population are on average less likely to own a bank
account. For instance, while 70.6%, 65.3%, 54.4%, 43.5%, 69.6%, 42.6% of all
adults, respectively in East Asia and Pacifc, Europe and Central Asia, Latin
America and the Caribbean (LAC), the Middle East and North Africa, South
Asia, and SSA has any form of account, 59.3%, 56.3%, 41.9%, 35.3%, 65.6%,
31.9% of the poorest 40% respectively has an account in these regions.
Behavioural economics points to some cognitive predispositions which
can lead to suboptimal decisions and outcomes. These cognitive tendencies
can affect the degree of fnancial inclusion at various levels and fronts. For
instance, cognitive biases that tend to favour the present ahead of the future
(present bias) can lead to undersaving and investment (Karlan, Ratan, &
Zinman, 2014). These behavioural biases may be in the form of preferences
(costly self-control, loss aversion), expectations (overconfdence), price preferences (underestimating compound interest), and diffculty in making complex and contingent decisions (planning fallacies, limited attention, inability
or unwillingness to save, problem with numbers, and mental accounting).
For a comprehensive review of the impact of behavioural biases on savings,
see Karlan et al. (2014). Cognitive biases affect fnancial inclusion in several
ways. Loss aversion is often invoked to limit borrowing; present bias leads
to undersaving and a greater focus on current consumption; overconfdence
in future cashfows can lead to undersaving in the current period; underestimating compound interest can lead to high loan default rates; and biases in
problem-solving can lead to suboptimal decisions, which can affect various
fnancial inclusion indicators.
Apart from the determinants just discussed, there are some individual
level characteristics and societal level factors that impede fnancial inclusion. At the individual level, these include age and gender (women are
less likely to be fnancially included). At the societal level, factors include
religion, culture, and law and order. Other barriers to fnancial inclusion
include documentation requirements and trust issues. Dasgupta (2009)
summarises the causes of fnancial exclusion as follows:
1 Geographical – that is, nonexistence of branches in an area.
2 Access exclusion – that is, restricted access because of bank’s risk
assessment process.
272 Joshua Yindenaba Abor et al.
3 Condition exclusion – that is, conditions related to products failing to
meet needs.
4 Price exclusion – that is, charges associated with products or services
are high.
5 Marketing exclusion – that is, strategic exclusion of certain products.
6 Self-exclusion – that is, some sections of the population refuse to
approach banks, believing that any request will be turned down
(p. 41).
10.5 INCLUSIVE FINANCE AND FINANCIAL DEVELOPMENT
In recent times, the emphasis of economic policy has been on fnancial
inclusion. Not only is fnancial inclusion good for welfare, but it also has
the capacity to promote fnancial development, particularly fnancial stability. Financial inclusion enables the poor and low-income earners, who
have more stable savings and borrowing appetite, to participate in the formal fnancial system. In times of crises, deposits from retail clients serve as
a more stable funding source for banks in contrast to wholesale funding
sources, which cease during crises periods (Neaime & Gaysset, 2018).
Furthermore, fnancial inclusion enables banks and other fnancial
institutions to discover new business areas by reaching out to a vast majority of the unbanked and underbanked in developing countries. In this
regard, fnancial inclusion enables banks to diversify across locations, fnancial products and services, and income groups. This enhances the resilience
of fnancial markets and institutions. Again, fnancial inclusion increases the
effciency of monetary policy by increasing the number of participants in the
formal fnancial system, thereby increasing the scope for monetary policy.
A more fnancially included economic environment ensures that monetary
policy signals are effectively transmitted to the real sector. This is contrasted
with fnancial development, where few people are in the formal fnancial
system impeding the fow of monetary signals to the real sector. Also, by
bringing a lot of previously unbanked and underbanked customers closer
to the formal fnancial system, fnancial inclusion ameliorates information
asymmetry, allowing banks to roll out cost-effective fnancial models (Ahamed & Mallick, 2017). This reduction in information asymmetry mitigates
fnancial vulnerability by improving loan recovery while reducing a bank’s
bad loan portfolios.
The empirical literature supports the fnancial sector’s stabilising
role of fnancial inclusion. Ahamed and Mallick (2017) studied the impact
of fnancial inclusion in 2,600 banks across 86 economies over the period
2004–2012. They found that fnancial inclusion promotes fnancial stability,
especially in banks that have signifcant customer deposit profles and those
with smaller marginal costs of delivering fnancial services and in banks
operating in countries with better institutional quality. In a sample of the
Middle East and North Africa (MENA) region over the period 2002–2015,
Neaime and Gaysset (2018) found fnancial inclusion to boost banking sector resilience by stabilising the deposit-funding base in the region. Using a
panel of 97 countries over the period 2004–2012, Rasheed, Law, Chin, and
Chapter 10 • Financial inclusion and economic growth 273
Habibullah (2016) similarly found fnancial inclusion to positively infuence
two indicators of fnancial development: credit to private sector and stock
market turnover ratio. Thus, the empirical evidence largely dispels one of the
notions that banks have, which prevents them from extending fnance to the
poor: fnancial inclusion will disrupt the soundness of the fnancial system.
Notwithstanding the evidence in support of the ability of fnancial inclusion
to foster fnancial development, there is still a section of the literature that
argues that fnancial inclusion can increase the vulnerability of the fnancial system by bringing into the banking system those individuals and businesses that are high-risk borrowers (see Box 10.1 for more on this argument).
BOX 10.1 The dark side of fnancial inclusion
‘So far, we have focused on the ‘bright side’ of fnancial inclusion. Unfortunately, there can be a ‘dark side’ too. Partly in response to the global
fnancial crisis – and also inspired by Raghu Rajan’s, 2005 Jackson Hole
paper – a growing body of research questions whether fnance is always
good for growth, suggesting that ‘too much’ or ‘too fast’ fnance can
plant the seeds of future fnancial crises (Arcand, Berkes, & Panizza,
2015; Gourinchas & Obstfeld, 2012; Mian & Suf, 2014; Schularick &
Taylor, 2012). This vulnerability is not an exclusive feature of fnancial
markets in advanced economies. During the microcredit crisis in India
in 2010, the state government of Andhra Pradesh, worried about widespread overborrowing and alleged abuses by microfnance collection
agents, issued an emergency ordinance, bringing microfnance activities in the state to a complete halt. This large contraction in microcredit
supply translated into large negative effects on the labour market and
on consumption (Breza & Kinnan, 2018). More recently, the assessment
of the JDY programme in India presented by Agarwal et al. (2018) also
shows evidence of an increase in loan defaults in areas more exposed to
the programme, pointing to a trade-off between inclusion and stability’.
Beck, Peria, Obstfeld, and Presbitero (2018)
10.5 INCLUSIVE FINANCE AND ECONOMIC GROWTH
We frst look at the fnancial inclusion–economic growth transmission channels and then discuss the empirical literature on the fnancial inclusion and
inclusive growth and development nexus.
10.6.1 The fnancial inclusion–economic growth
transmission channels
Theoretically, fnancial inclusion can promote economic growth and development through the following channels: capital accumulation, innovation
and entrepreneurship, income and employment, opportunities for diversifcation, productivity, and fnancial security.
274 Joshua Yindenaba Abor et al.
Financial inclusion promotes the accumulation of savings in the banking system and in other fnancial intermediaries. These savings serve as
capital for investment in productive ventures. Again, these savings deposits are transformed into loans and other fnancial products to support the
investment plans of defcit spending units. The savings triggered by fnancial inclusion are broad based and ensure the mobilisation of resources from
economic units (rural and poor households) that were otherwise considered
unable to save.
The quality of human capital is an indisputable precursor to economic
growth. Meanwhile, the quality of human capital determines the degree of
innovation and entrepreneurship in an economy. Financial resources are
critical to the training and capacity development of human capital. Households and small and medium-size enterprises (SMEs) that are fnancially
included are more able to fnd the fnancial resources to fund their education and training needs than their counterparts who are excluded from
the formal fnancial system. Even in situations where individuals cannot
pay education fees out of pocket, an inclusive fnancial system will enhance
access to affordable credit and other avenues of support, be they private
or governmental. Financial inclusion provides new, affordable, and convenient means of paying school fees. A well-trained workforce is able to generate inventions and bring innovative solutions to societal problems. Such
new inventions and innovations bring about drastic increases in output and
economic growth. Financial inclusion spurs entrepreneurship by providing
access to capital, stimulating fnancial literacy, and imparting business management skills to individuals who otherwise would have been deprived of
opportunities to live their dreams, because of fnancial exclusion.
Financial inclusion provides business and employment opportunities for individuals, households, fnancial institutions, and governments.
Financial inclusion provides both direct and indirect employment. The
indirect jobs provided by fnancial inclusion are more diffcult to estimate
but are likely to be greater in number than the direct jobs. Financial inclusion affords banks and other fnancial intermediaries opportunities to
reach out to the untapped unbanked population through the development
of innovative fnancial services and delivery mechanisms for the poor. In
doing so, these fnancial institutions create new job openings, enhance their
proftability, and strengthen their position in the fnancial system. Entrepreneurship is facilitated in these new locations, leading to improvements
in the performance of SMEs. In a nutshell, fnancial inclusion engenders job
creation both directly and indirectly and yields income to benefciaries
therefrom.
By making funds available to a wide range of investors, fnancial
inclusion increases the range of economic choices available to individuals,
households, and businesses, leading to economic diversifcation. By helping poor people and SMEs to save and borrow, build assets, insure against
the unforeseen, and make and receive payments with ease, fnancial inclusion enables the production of diverse goods and services, access to various markets (locally and internationally), and the diversifcation of income
sources. This increases the economic resilience of benefciary individuals,
Chapter 10 • Financial inclusion and economic growth 275
households, and businesses and subsequently cascades into a more resilient and stable macroeconomy. Through diversifcation, fnancial inclusion
serves as a risk management mechanism, reducing borrowers’ reliance on
vulnerable sources of output, markets, and income.
Many economic agents are not as productive as they should be,
because of fnancial exclusion, which makes them unable to provide the
needed inputs at the required quantities at the right time to support production or take advantage of promising opportunities. With access to fnance,
rational economic agents can employ the right quantities of labour, capital,
technology, and other factors in order to boost productivity. By spurring
innovation and entrepreneurship, fnancial inclusion extends the frontier of
production, helping economic agents attain new productivity heights.
Financial inclusion opens up the range of fnancial choices available
to the poor, enables the poor to accumulate capital over the long run, facilitates long-range investment and consumption planning, and enhances the
capacity of households to absorb economic and fnancial shocks. From a
theoretical perspective, fnancial inclusion promotes economic growth
and inclusive development by enabling capital accumulation, stimulating
entrepreneurship and innovation, generating direct and indirect job opportunities, promoting economic diversifcation, boosting productivity, and
ensuring fnancial security.
10.6.2 Empirical evidence on fnancial inclusion
and inclusive growth and development
At least since Schumpeter (1912), fnancial development has been closely
linked to economic growth. However, empirical evidence on the real effects
of broad-based access to fnance on growth is relatively nascent. The empirical evidence generally supports a positive impact of fnancial inclusion on
growth and development, though the impact varies from no impact, to
moderate, to large.
Evidence from India supports the claim that broad-based fnancial
access fosters growth. In a study conducted between 2004 and 2013 and
using vector auto regression (VAR) and the Granger causality test, Sharma
(2016) concluded that various dimensions of fnancial inclusion promoted
economic growth in that country. The Granger causality test revealed bidirectional causality between the geographic outreach of banks and economic growth; unidirectional causality between the number of deposits/
loan accounts and the amount of growth; and no causality between using
bank services and economic growth. Another study in India by Lenka and
Sharma (2017) using data from 1980 to 2014 showed that fnancial inclusion
has a positive effect on economic growth in both the short run and long run.
This study, unlike the previous ones, found a unidirectional causality running from fnancial inclusion to economic growth.
Swamy (2014) examined the economic impact of fnancial inclusion
in India from a gender perspective. Using panel data from 2007 to 2012,
Swamy found a positive gender premium effect in fnancial inclusion on
income in favour of women. Specifcally, fnancial inclusion programmes
276 Joshua Yindenaba Abor et al.
were found to increase incomes (after adjusting for infation) of women by
8.40%, compared to 3.97% for men. Swamy explained that women had better awareness of fnancial inclusion instruments, used fnancial inclusion to
improve household savings, and employed fnancial inclusion in ways that
improved welfare.
Recent evidence from 55 Organisation of Islamic Cooperation (OIC)
countries by Kim, Yu, and Hassan (2018) confrmed a positive impact of
fnancial inclusion on growth using supply-side fnancial inclusion measures such as number of ATMs per hundred thousand, bank branches per
hundred thousand, number of borrowers from commercial banks per one
thousand, and life insurance premium volume to GDP. The study covered the period 1990–2013. In line with Sharma (2016) but unlike Lenka
and Sharma (2017), Kim et al. (2018) found bidirectional causality between
fnance and economic growth.
Demand-side data from Ghana support a positive effect of fnancial
inclusion on inclusive growth. First, on the basis of the Ghana Living Standard Survey data (GLSS 6), Abor, Amidu, and Issahaku (2018) documented
positive effects of mobile telephony (ownership and usage) and fnancial
inclusion (access to a bank account, savings, credit, and insurance) on inclusive growth measures such as poverty and real per capita consumption.
However, unlike Swamy (2014), Abor et al. (2018) did not fnd the effect
of fnancial inclusion on inclusiveness of growth to be more pronounced
in women-headed households than in men-headed households. Again,
they did not fnd the impact to be greater in rural households than in urban
households. Using the same dataset, Abu and Issahaku (2017) highlighted a
positive impact of fnancial inclusion on agricultural commercialisation (see
Box 10.2 for more exposition of the fnancial inclusion success story in SSA).
Evidence from randomised control trials offers less-optimistic results
of the impact of fnancial inclusion on development.2 For instance, as an
introduction to the 2015 American Economic Journal issue on microcredit
experiments, Banerjee, Karlan, and Zinman (2015) arrived at the conclusion
that the most consistent fnding from most studies is that the real effects of
microcredit on poverty are modest but not transformative, even in the case of
women’s empowerment. Borrower heterogeneity is offered as the reason
for this less enthusiastic result. In line with this, Banerjee, Breza, Dufo, and
Kinnan (2018) have recently shown that while microcredit had a persistent
effect on business activity and consumption for individuals who already
had business before the intervention, the impact on beginner entrepreneurs
was negligible. Another recent study in the MENA region found that while
fnancial inclusion reduced inequality, it had no signifcant impact on poverty reduction in that region (Neaime & Gaysset, 2018).
Further, a review by Clark, Harris, Biscaye, Gugerty, and Anderson
(2015) of seven RCTs on impacts of credit interventions in various African
countries produced mixed results. The RCT by Ashraf, Giné, and Karlan
(2009) in Kenya produced positive signifcant impact of credit on production, but no signifcant impact on income/wealth; the RCT by Beaman, Karlan, Thuysbaert, and Udryet (2014) in Mali showed a positive signifcant
impact on production; another RCT in Kenya by Burke (2014) showed no
Chapter 10 • Financial inclusion and economic growth 277
signifcant impact of credit on income/wealth and consumption/food security; the RCT by Fink, Jack, and Masiye (2014) in Zambia revealed positive
impacts on income/wealth and resilience and mixed impacts on consumption/food security; the RCT in Morocco by Crépon, Devoto, Dufo, and
Pariente (2014) produced mixed impacts on income/wealth and nonsignifcant impacts on consumption/food security; the RCT by Kim et al. (2009) in
South Africa found mixed impacts on consumption/food security; and the
RCT by Tarozzi et al. (2015) in Ethiopia showed no signifcant impacts on
income/wealth and a negative impact on consumption/food security.
Evidence from quasi-natural experimental studies offers moreencouraging results. On the basis of Mexican data, Bruhn and Love (2014)
found fnancial inclusion in the form of branch expansion by banks to have
a considerable impact on labour market activity and income of deprived
individuals and people who lived in locations that hitherto had low bank
outreach. Similarly, Burgess and Pande (2005) found that branch expansion
by rural banks could explain between 14 and 17 percentage point decreases
in headcount poverty in rural India.
BOX 10.2 Financial inclusion is a sub-Saharan success story
‘In 2014, the US-based think tank Brookings Institution launched its
fnancial and digital inclusion project to examine access to and usage
of secure, affordable, formal fnancial services among the underserved
populations of the world. The project has since reported twice annually on the nature and extent of fnancial inclusion. In its 2016 report,
it scores best practice in terms of country commitment, mobile capacity, regulatory environment, and level of actual adoption. It fnds once
more that sub-Saharan Africa is well represented in the top ten: Kenya
(84%), Uganda (78%), South Africa (78%), Rwanda (76%), and Nigeria
(72%) account for half of the top ten. Indeed, Kenya takes the number one slot for the second year running, thanks to its mobile money
revolution.
The Brookings Institution report does not cover countries such
as the US that are affuent generally. However, it points out that about
8% of households in the US do not have a bank account and that these
households suffer extra costs and burdens as a result, just as nonaccount holders do in the developing world. Sub-Saharan Africa’s people
have achieved better fnancial inclusion mainly because of the widespread availability of cheap mobile phone networks and the adoption
of mobile money platforms. The mobile operator body GSMA estimates
that another 168 million Africans will be connected by mobile phone
and money networks over the next fve years, with the total reaching
725 million by 2020.
Innovations such as the M-Pesa mobile phone–based money
transfer system in Kenya, which has revolutionised the lives of both
the rural and urban poor, offer people alternatives that did not exist
278 Joshua Yindenaba Abor et al.
only a short while ago. Today, a phone can not only let people get hold
of money in a remote rural setting, at any time of the day or night,
but also let them borrow and lend, settle utility bills and loans, receive
their salary, make deposits, buy goods, and view detailed statements
of transactions – all in much the same way as happens with traditional
banks. The latest innovation is that Kenyans can directly pay for government services such as the renewal of licences and permits by using
their mobile phones.
Mobile phones have also empowered women and reduced poverty by allowing social networks to be leveraged so people at the poorest level of society can borrow, help, and support each other. Current
trends in the mobile money industry should improve fnancial inclusion in this region further:
• Interoperable platforms allow individuals to use their mobile
money across different operator platforms.
• New technologies such as near feld payment modules allow
more people to use their phones in new ways to make and receive
money.
With 725 million Africans expected to be able to connect and carry
out transactions with each other by 2020, there will be substantial new
internal opportunities for business as well as personal enrichment for
many individuals. Rural farmers, for example, can now receive income
from farming as well as the information they need for a better harvest
next time, directly via their phones. The fnancial inclusion of the poor
thus offers new opportunities for everyone’.
Source: www.accaglobal.com/us/en/member/member/accounting-business/2016/1112/insights/success-story1.html
RCTs on savings have actually shown a somewhat more robust impact
on well-being and even entrepreneurial growth. For instance, Brune, Giné,
Goldberg, and Yang (2015) performed an RCT on savings clubs in Malawi.
In this trial, farmers were randomly assigned to one of three groups: a control group where there was no facilitation to save, a treatment group where
savings facilitation was offered in the form of an ordinary savings account,
and treatment group where savings assistance is offered for the provision of
access to an ordinary savings account and an additional savings account with
commitment devices. The results showed that the treatment group that had
savings accounts with commitment devices experienced signifcant expansion in land under cultivation, input use, and crop yield and profts over the
control group. The treatment group provided with only ordinary savings
accounts saw only gains in land under cultivation over the control group,
but not in the other indicators. In a natural experiment on savings, based on
Indian data spanning from 1977 to 1990, Burgess and Pande (2005) found
that a 1% increase in the share of savings held by rural banks leads to a 2.22%
Chapter 10 • Financial inclusion and economic growth 279
reduction in rural poverty. Other feld experiments by Ashraf, Karlan, and
Yin (2010), Dupas and Robinson (2013), and Prina (2013) collectively point to
signifcant positive impacts of savings on various welfare indicators.
While the literature is clear on how fnancial inclusion affects growth,
it does not clearly explain how economic growth stimulates fnancial inclusion. Although no adequate explanation has been given as to how growth
stimulates fnancial development, it is not hard to fathom how this happens. Four explanations are offered here. First, economic growth increases
the capacity of the government to provide the infrastructure required for
broad-based access to fnancial services. Second, a growing economy provides the business case for banks and other fnancial institutions to reach
out to the unbanked. Third, economic growth increases the fnancial capacity of banks to set up new branches and outlets and to develop and roll out
new fnancial services to a large segment of the population. Fourth, broadbased economic growth enhances the capacity of the citizenry, including
the poor, to demand various fnancial services to enable them meet their
fnancial needs and plans and to take advantage of economic opportunities.
10.7 FINANCIAL INCLUSION AND ECONOMIC
DEVELOPMENT: ROLE OF INSTITUTIONS
This subsection discusses how institutions moderate the impact of inclusive
fnance on economic development. Do institutions play any role in making fnancial inclusion more effective for broad-based development? Since
North’s (1990) infuential book Institutions, Institutional Change and Economic Performance, development economists have come to better appreciate the role of institutions in economic development. According to North
(1990), ‘institutions are the rules of the game in a society or, more formally,
are the humanly devised constraints that shape human interaction’ (p. 3).
Institutions are vital because they provide incentives for human actions
and because of the nature of these interactions and the benefts that ensue
therefrom. Therefore, institutions can determine the nature and extent of
the impact of fnancial inclusion on economic growth. Some of the institutional imperatives which can enhance the growth impact of inclusive
fnance include strong mechanisms for control of corruption, transparent
and accountable governance, protection of property rights, entrenchment
of a strong merit system, effective enforcement of law and order, effcient
bureaucracies, political stability, and protection of freedoms and human
rights, alongside a wide array of progressive habits, norms, and civic values.
There are at least four channels through which institutions can enhance
the effect of fnancial inclusion on economic development: reducing transaction costs and increasing the effciency of exchange, determining the rate of
return on investment, providing the environment for innovation and creativity, and establishing the environment for the effective collaboration and
mobilisation of social capital.
Reducing transaction costs and increasing the effciency of exchange:
institutions ameliorate transaction costs associated with information, transportation, decision-making, and bargaining. Strong institutions ensure
280 Joshua Yindenaba Abor et al.
transparency and accountability, which reduce information asymmetries
associated with transactions. Institutions establish uniform standards and
procedures to reduce red tape and facilitate economic decision-making.
Furthermore, institutions facilitate the settling of disputes arising from economic and social transactions, which enable peaceful coexistence and the
containment of fraud in transactions. Strong institutions ensure that funds
meant for road construction (to reduce transportation cost) and such other
fnancial infrastructure are not diverted for private gain. On the contrary,
‘societies with weak institutions can be trapped in a low growth equilibrium
fuelled by information asymmetry, coordination failures and other market
imperfections’ (Issahaku, Abor, & Amidu, 2018, p. 30).
Determining the rate of return on investment: institutions infuence
the rate of investment as well as return on investment by reducing the risk
and uncertainty involved in economic transactions (by providing stable
norms, standards, and procedures), ensuring property rights, and providing protection for investors. For instance, research has shown that when
farmers have legal title to land, investment in the land and output increase
(see Pande & Udry, 2005). In a number of cases, land and other productive
resources have been left idle due to prolonged and wobbly dispute resolution systems perpetuated by weak institutions. Some investors have relocated from certain economies due to the inability of the system to provide
protection for them and their properties, thus lowering investment. In some
cases, investors do not relocate, but they reduce the amount of investment
as a way of mitigating losses. The point being made here is that a household
or an investor may have access to funds but may be unwilling to invest, due
to institutional constraints, or may invest but the return on the investment
is reduced through institutional lapses. Moreover, weak institutions reduce
the rate of return on investment by increasing systematic risks and for that
matter reducing opportunities for diversifcation and the spreading of risks.
Providing the environment for innovation and creativity: creativity
and innovation are critical fuels for human prosperity and welfare. Institutions promote creativity and innovation by providing the necessary environment for innovation and creativity to thrive. Institutions unlock creative
and innovative potential by establishing the freedom to innovate and be
creative, providing protection for intellectual property, promoting investment in human capital, and ensuring the evolution of an educational system
that focuses on creativity and innovation. With the suitable atmosphere provided by institutions for creativity and innovation, fnancial inclusion can
then ensure the mobilisation of resources for investment in the generation of
new ideas, new products, and new services, thereby fostering entrepreneurship, growth, productivity, and development.
Establishing the environment for effective collaboration and mobilisation of social capital: institutions are either extractive or inclusive in
nature, depending on whether they hinder or foster growth (Acemoglu &
Robinson, 2012). Inclusive institutions promote growth, while extractive
institutions thwart growth. Inclusive institutions encourage collaborations,
networking, and information sharing, which enable the pooling of resources,
ideas, and people for the general good of society. Strong institutions
Chapter 10 • Financial inclusion and economic growth 281
facilitate the formation of clubs, joint ventures and partnerships, and other
such mobilisations of social capital for the promotion of social good. These
strong social networks and partnerships established by quality institutions
can help unlock the potentials of individuals, and groups and cause them to
optimise the benefts from fnancial inclusion products and services.3
We now turn to the empirical support for the foregoing arguments.
Recounting the role of institutions in fnance, Qian and Strahan (2007)
showed how institutions determine the shape and form of fnancial contracts. According to the study, in economies with strong protections for
creditor rights, loan durations are longer and interest rates are lower. Foreign bank ownership shares are shown to decline as creditor protection
decreases. Demetriades and Law (2006) assessed how institutions intermediate the fnance–growth nexus and produced some interesting fndings. First, a strong institutional framework magnifes the growth effect of
fnance. Second, not many growth dividends end up in poor countries with
more fnance but weak institutions. Third, the growth magnifying effect
of institutions is highest in middle-income countries endowed with quality institutions. Fourth, though the effect of fnance on growth is lower in
high-income countries, this impact improves even in these countries when
the fnancial system is rooted in sound institutions. In sum, the study found
that fnance promotes long-term growth in countries endowed with quality
institutions. On the contrary, in countries where the fnancial system is subsumed by weak institutions, improvements in fnancial systems produce
negligible benefts.
In a similar vein, Gazdar and Cherif (2015) demonstrate that while
fnance variables on their own may sometimes affect growth adversely,
institutions turn any negative effect of fnance on growth into a positive
one. Specifcally, banking sector advancement promotes growth in countries with strong law and order, low bureaucracy, and a good investment
pedigree. Compton and Giedeman (2011) disagree; they fnd banking sector development and institutions to be substitutes in growth, while stock
markets are neither substitutes nor complements to institutions in growth.
Despite the contradictory fndings, on the balance of empirical evidence and
theoretical plausibility, we conclude that institutions play complementary
roles to fnance in growth.
10.8 CONCLUSION
The main aim of this chapter was to examine the role of fnancial inclusion
in promoting economic growth. The areas covered include the conceptualisation of fnancial inclusion, trends in fnancial inclusion, the determinants
of and barriers to fnancial inclusion, links between inclusive fnance and
fnancial development, the effect of inclusive fnance on economic growth,
and the role of institutional architecture in the fnancial inclusion–economic
development nexus. It discussed capital accumulation, innovation and
entrepreneurship, income and employment, opportunities for diversifcation, productivity, and fnancial security as the main channels through
which fnancial inclusion positively affects growth. The chapter identifed
282 Joshua Yindenaba Abor et al.
an inadequate and a lack of supportive infrastructure, high transaction
costs, regulatory barriers, behavioural biases, a low level of general literacy
and fnancial literacy, high poverty rates, and a dispersed population as the
factors that limit access to and the usage of fnancial services. Institutions
are discussed as being crucial for economic development and improving
the growth impact of fnancial inclusion. This is because institutions reduce
transaction costs while increasing effciency in exchanges, determine the
rate of return on investment, provide the environment for innovation and
creativity, and establish the environment for the effective collaboration and
mobilisation of social capital.
Going forward, developing countries must prioritise fnancial inclusion in policy decisions and implementation to fully reap its benefts. Financial inclusion should be mainstreamed into social protection programmes
so that the poor, the marginalised, and the hard-to-reach segments of the
population will be roped into the formal fnancial stream. A large informal
sector and unbanked population reduces the effcacy of monetary policy,
because a greater proportion of the economy will be outside the infuence of
the policy authorities.
A strong infrastructure backbone is key to the advancement of fnancial
inclusion. Due to the cost involved in setting up infrastructure, governmental leadership and support are key factors. Governmental infrastructure plans
should incorporate fnancial inclusion. Apart from that, governments should
mobilise monetary and nonmonetary resources from banks, other fnancial
institutions, telecommunication companies, development partners, and other
stakeholders in support of the fnancial inclusion drive. Key infrastructure
which must be provided, especially in the hinterlands, to advance fnancial
inclusion include electricity, roads and transport, telecommunications network, water and sanitation, and fnancial infrastructure such as credit reference
bureaus, banks, other fnancial institutions, and regulatory bodies.
Furthermore, digital fnancial services can be leveraged to reduce the
cost of providing fnancial inclusion to the poor. Digital fnancial services
such as mobile money services, mobile banking, internet banking, biometric
payment systems, automated teller banking, and fnancial technology (fntech), among others, must be promoted to ensure the convenient, effcient,
safe, and cost-effective delivery of fnancial services. For digital fnancial
services to thrive well, a comprehensive and robust regulatory framework
that strikes a fne balance between promotion of fnancial innovation and
amelioration of fnancial risk and fraud is imperative. Related to this is the
issue of consumer protection, which entails safeguarding users of fnancial
services from Ponzi schemes, fraud, and exploitation. Regulatory frameworks that cover transparent disclosure, fair treatment, dispute resolution,
and fnancial education and costs will help foster consumer protection.
The high level of fnancial illiteracy in the world and in developing
countries in particular calls for concern. Mainstreaming fnancial literacy
in educational curricula will be a good step towards creating an awareness
of fnancial inclusion and enlightening the population on fnancial matters.
Broad-based fnancial literacy will promote fnancial planning and prudent
fnancial decision-making at the individual, household, and frm levels.
Chapter 10 • Financial inclusion and economic growth 283
Discussion questions
1 Provide at least three motivations
for studying the impact of fnancial inclusion on economic growth.
2 Discuss the role of fnancial inclusion
in attaining the UN Sustainable
Development Goals.
3 How does sub-Saharan Africa compare with the rest of the world in
terms of fnancial inclusion?
4 Is fnancial inclusion compatible
with fnancial stability?
5 Thoroughly evaluate the channels through which financial
inclusion promotes growth.
6 Trace the channels through which
institutions
affect
economic
development.
7 How can institutions make fnancial inclusion effective for economic growth?
8 Discuss the ‘dark side’ of fnancial
inclusion.
Notes
1 This chapter is part of the
research
project
‘Delivering
Inclusive Financial Development
& Growth’ and received funding
from DFID and ESRC under the
DFID-ESRC Growth Research
Programme Call 3.
2 Read more at https://voxeu.org/
article/fnancial-inclusion-driversand-real-effects.
3 Read more about the importance of institutions at www.e-ir.
info/2012/09/19/the-importanceof-institutions-to-economicdevelopment/.
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NY.GDS.TOTL.ZS
CHAPTER
11
Financing agriculture for
inclusive development
Haruna Issahaku, Edward Asiedu,
Paul Kwame Nkegbe, and Robert Osei
11.1 INTRODUCTION
At the heart of the current global development policy is how to sustainably ensure that there is enough food with the necessary nutrients available,
accessible, and affordable to the world’s seven billion people. This agenda
is emphasized in United Nations (UN) Sustainable Development Goal 2
(SDG 2), which seeks to end hunger, achieve food security and improved
nutrition, and promote sustainable agriculture by 2030. However, this goal
cannot be realized without suffcient funding, particularly for smallholder
agriculture. The UN recognizes that this goal can be achieved by, among
other things, doubling agricultural productivity and smallholder incomes,
making agricultural markets functional, and scaling up investments in agriculture to improve rural infrastructure, agriculture technology, and agricultural research and extension services. Thus, agriculture fnancing is crucial
to the attainment of sustainable development.
However, conventional funding models bewildered with credit market imperfections cannot provide the funding required to take agriculture
development to the next level. Traditional bank fnance is known not to
reach the people who need it most (the poorest of the poor). The fnancial
system in most developing countries remains inaccessible, ineffcient, and
lacking in depth. Taking sub-Saharan Africa (SSA) as an example, the average private credit provided by deposit money banks as a percentage of gross
domestic product (GDP) over the period 2011–2014 was 16.3% compared to
a global average of 40% over the same period. Bank accounts per a thousand
people in the region was 150.3 compared to a global average of 511.7, while
bank net interest margin was an average of 5.7% in the region compared
to a world average of 3.7%, over the period 2011 to 2014. Thus, both the
SSA averages and global averages point to the inadequacy of conventional
fnance for private sector development in general.
Globally, and recently, the discussion has turned towards innovative
fnancing models. The fnancing gap among smallholder farmers alone is
projected at USD430 billion to USD440 billion worldwide (USAID, 2016).
Innovative fnancing models are needed to bridge this fnancing gap and
reach the poorest segments of the population with a wide range of affordable
288 Haruna Issahaku et al.
fnancial services and products at improved terms and conditionalities. In
line with this thinking, this chapter discusses innovative ways of fnancing global agriculture to enhance its ability to deliver not just growth but
inclusive or pro-poor development. It is important that inclusive development be distinguished from inclusive growth. While inclusive development
focuses on ‘social wellbeing and protecting the ecosystem services of nature
through redefning political priorities’ (Pouw & Gupta, 2017, p. 1), the inclusive growth perspective is ‘confned to market participation (by creating
jobs for the poor) and effciency (of economic processes, policies, institutions), and builds further upon an economic paradigm that does not assign
value to social or environmental sustainability in its growth models’ (Pouw
& Gupta, 2017, p. 2). Thus, whereas inclusive development relates to social,
economic, ecological, and political inclusiveness, inclusive growth relates
mainly to social, economic, and political inclusiveness with less emphasis
on ecological indicators.
The aim of this chapter is to discuss ways that agriculture can be
fnanced to ensure inclusive development. The chapter is structured as follows. First, we discuss some stylized facts on global agriculture. Second,
we overview the challenges to accessing agricultural fnance and then the
fnancing opportunities in agriculture. Next, we discuss key innovative
fnancing models for agriculture, and roles that could be played by banks,
fnancial institutions, development agencies, and government. The penultimate section discusses how agriculture leads to inclusive development. We
end the chapter with some concluding remarks.
11.2 STYLIZED FACTS ON AGRICULTURE DEVELOPMENT
Globally, agriculture has gone through many shifts in terms of its contribution to economic growth, employment, productivity growth, and exports.
This subsection explores some stylized regularities about agriculture development across the globe. Although these stylised facts do not necessarily
establish causality, they are essential in shaping a research agenda and policy discourses (Christiaensen, 2017).
11.2.1 Stylized fact 1
Agriculture is more important to the economies of developing and poor
countries than it is to the economies of developed and wealthy nations,
but generally, its contribution to the economy is declining across the globe.
Even though this is a well-known fact (see Johnston & Mellor, 1961), the
data behind this fact are often not presented alongside the claim. In Europe
and Central Asia (ECA), agriculture plays a less prominent role in economic
development, agriculture’s share in GDP falling from 3.3% in 2000 to 2.4% in
2006 (Table 11.1) before stagnating at 2.2% in each year from 2012 onwards.
This region is constituted by some European economic giants such as the
United Kingdom, Germany, France, and Spain, whose economies are driven
largely by services. For example, in the European Union in 2014, services
constituted 73.9% of the GDP, industry 24.4%, and agriculture 1.7%.1
50.4
32.7
60.9
10.1
10.4
19.3
19.9
40.1
50.6
80.8
40.5 34.5
N/A NA.
20.0
N/A
29.9
23.4
N/A
12.6
1.9
24.1
19.6
5.2
60.0
20.4
13.4 70.9
N/A 30.3
90.9
10.4
19.3
19.8
40.0
31.8
60.7
50.5
50.8
20.3
50.4
50.7
20.1
2009
50.4
50.7
20.2
90.9
10.4
18.9
20.3
40.0
90.9
10.3
18.9
21.3
30.9
90.6
10.4
19.3
17.8
30.9
90.6
10.5
19.1
17.2
40.0
32.1
50.5
50.4
50.7
20.3
2010 2011
32.7 33.0 32.6
N/A N/A 50.9
50.6
50.8
20.2
2000 2006 2007 2008
Source: World Development Indicators (2017)
East Asia & Pacifc
Europe & Central
Asia
Latin America &
Caribbean
Low income
Middle East &
North Africa
Middle income
High income
South Asia
Sub-Saharan Africa
World
1990
TABLE 11.1 Contribution of agriculture to GDP (%)
90.4
10.5
18.7
18.1
30.9
33.0
50.7
50.2
50.6
20.2
90.4
10.6
18.9
17.8
40.0
31.8
60.2
50.3
50.5
20.2
90.3
10.5
18.5
17.3
30.9
30.8
60.2
50.4
50.4
20.2
90.2
10.4
18.0
17.4
30.8
30.2
60.9
50.2
50.2
20.2
90.6
10.4
18.9
18.7
30.9
32.1
60.3
50.4
50.6
20.2
90.9
10.4
19.2
19.8
40.0
32.6
60.5
50.4
50.8
20.3
90.4
10.5
18.6
17.6
30.9
31.6
60.1
50.3
50.5
20.2
2012 2013 2014 2015 10-year
5-year
5-year
average
average
average
(2006–2015) (2006–2010) (2011–2015)
Chapter 11 • Financing agriculture 289
290 Haruna Issahaku et al.
In contrast to ECA are South Asia (SA) and sub-Saharan Africa
(SSA), where agriculture still plays a pivotal role in economic development. The share of agriculture in GDP fell from 29.9% to 24.1% over the
decade 1990s in SA before falling to 18.0% by 2015. Similarly, in SSA the
contribution of agriculture to GDP fell from 23.4% in 1990 to 19.6% in
2000 and then fell further to 17.4% by 2015. Notwithstanding the declining shares, agriculture’s contribution to GDP is still signifcant in these
two regions of the world. Interestingly, these two regions play host to
the bulk of the world’s poor population, who often eke out a living from
subsistence agriculture.
Over the past decade (2006 to 2015), SA had the largest share of
agriculture in GDP (18.9%), followed closely by SSA (18.7%). For the
rest of the regions, the share of agriculture in GDP is far less significant:
6.3% in Middle East and North Africa (MENA), 5.6% in East Asia and
Pacific (EAP), 5.4% in Latin America and the Caribbean (LAC), and 2.2%
in ECA.
The correlation between agriculture’s share in economic growth
and a poverty profle is seen clearly when the analysis is done on the
basis of income categorization. The average contribution of agriculture
to the GDP of low-income countries (LICs) over the last decade was
32.1%, compared to 9.2% in middle-income countries (MICs) and just
1.4% in high-income countries (HICs). Again, even on the basis of income
groups, the share of agriculture in growth has declined over the decades.
Thus, the poor are dependent on agriculture, but their dependence is
declining gradually as they seek alternative livelihoods in nonfarming
enterprises.
11.2.2 Stylized fact 2
Although there are diversities in agricultural productivity and agricultural
productivity growth across the regions of the world, agricultural value
added per worker (productivity) is generally ascending. Not only is agricultural productivity higher in ECA, LAC, and MENA, but it also increases
faster in these regions (see Figure 11.1, Table 11.1) relative to EAP, SSA, and
SA. ECA is the most productive region in the world, followed by LAC, and
SA is the least productive region, followed closely by SSA. Agricultural
productivity has been twice as fast in ECA than it has in SA over the last
15 years (2000–2015). In ECA, agriculture value added per worker increased
from USD8,801.8 in 2000 to USD14,309.1 in 2015, an increase of about 63%
over the period. In SA, agriculture value added per worker increased from
USD871.7 in 2000 to USD1,131.7 in 2015, an increase of about 30% over the
15-year period. Thus, not only is agricultural value added per worker higher
in relatively wealthy regions of the world, but it also grows faster in these
regions, showing a correlation between productivity and welfare status.
The link between agricultural productivity and poverty is seen
clearly in Figure 11.2, where the trend line for agriculture value added
per worker for HICs is not only far above those of MICs and LICs but is
Chapter 11 • Financing agriculture 291
FIGURE 11.1 Agriculture value added per worker, constant 2010 USD
16,000.00
14,000.00
East Asia & Pacific
12,000.00
Europe & Central Asia
Latin America & Caribbean
10,000.00
8,000.00
Middle East & North Africa
6,000.00
South Asia
4,000.00
Sub-Saharan Africa
World
2,000.00
Linear (Sub-Saharan Africa)
0.00
2000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: World Development Indicators (2017)
FIGURE 11.2 Agriculture value added per worker, constant 2000 USD
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
2000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Low income
Middle income
High income
Source: World Development Indicators (2017)
also the only line trending upwards. Thus, a substylized fact is that poor
economies have both low agricultural productivity and low agricultural
productivity growth relative to rich economies. The implication of this
stylized regularity is that substantial welfare gains can be made in poor
countries by simultaneously increasing both agriculture productivity and
productivity growth.
292 Haruna Issahaku et al.
11.2.3 Stylized fact 3
Although agriculture remains an important employer of the labour force,
especially in economies outside ECA, for most regions of the world, the
services sector is by far the largest employer of the workforce (SA and SSA
being the exceptions). According to Figure 11.3, in 2014 the services sector had the largest share in total employment (69.5%) in LAC, followed by
industry (22.8%) and agriculture (13.9%). Next to LAC is ECA in terms of the
size of the contribution of the service sector to employment. In ECA, the services sector (66.5%) was the largest contributor to employment, followed by
industry (24.8%) and agriculture (8.3%) in 2014. In EAP, the agriculture sector’s share in employment has been larger than that of the industry sector’s
contribution but lower than that of the services sector. Figure 11.3 further
reveals that as structural shifts occur in the economy, the share of agriculture in employment declines over time, while the employment shares of
industry and services rise.
SA and SSA break the dominance of the services sector in total employment. Agriculture has remained the largest employer over the years in SA
even though the sector’s employment share is declining with time, whereas
the service sector is picking up. On the basis of a series of reports from the
United Nations Survey of Asia and the Far East, agriculture’s share in the
SA region declined from 70% in 1970 to 51% in 2010, while the services share
increased from 20% to 35% over the same period. Thus, agriculture’s share
is a little over half of total employment in SA.
Among all the regions of the world, SSA has the most dominant agricultural sector in terms of contributions to employment. This dominance
FIGURE 11.3 Employment shares by sector (% in total employment)
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Agricu Industr Service Agricu Industr Service Agricu Industr Service
lture
y
s
lture
y
s
lture
y
s
(EAP) (EAP) (EAP) (ECA) (ECA) (ECA) (LAC) (LAC) (LAC)
2012 31.5
27.6
41.0
9.0
25.1
41.0
15.0
22.8
41.0
2013 29.9
27.3
42.9
8.8
24.8
66.0
14.8
22.4
69.1
2014 28.2
27.3
44.5
8.3
24.8
66.5
13.9
22.8
69.5
2012
2013
Source: World Development Indicators (2017)
2014
Chapter 11 • Financing agriculture 293
is prevalent in both LICs and HICs in the region. According to Fox,
Thomas, and Cleary (2017), agriculture contributed 68.5% and 57.5% to
employment in LICs and HICs respectively in SSA in 2010. Household
enterprises are the next most signifcant contributor to employment in
SSA (18.2% for LICs and 29.1% for HICs in SSA). These household enterprises are often capital-constrained micro and small enterprises. Wage
employment in services and industry form a small proportion (13%) of
total employment in the region, an indication of the region’s large informal sector.
11.2.4 Stylized fact 4
Agricultural raw materials exports’ share in merchandise exports is small
and generally quite stagnant. In all the regions of the world, the share of
agricultural raw material exports in total merchandise exports was below
3% in 2015 (Table 11.2). This might not be a bad statistic so long as there
is a corresponding increase in the exports of processed goods. Understandably, SSA (3.7%), the poorest region of the world, has been more
reliant on agricultural raw material exports over the last decade than
any other region has. This is followed by LAC (2.1%), South Asia (1.6%),
EAP (1.3%), and ECA (1.3%). The reliance of SSA and poor countries in
general on raw material revenues has been of concern to policymakers
in this region, but not much progress has been realized in terms of policies aimed at adding value to exports. Relying on raw material exports
is a source of economic vulnerability because raw material outputs and
prices are highly volatile. Agriculture raw material exports as a percentage of merchandise exports grew from 3.4% over the fve-year period of
2006–2010 to 4.0% in the subsequent fve-year period, 2011–2015. This
was the largest growth over the period. Marginal growth in agricultural
raw material exports’ share in merchandise export was recorded over the
same period in EAP, ECA, and LAC, while no growth was recorded in
MENA and SA. The MENA region is the least reliant on agriculture raw
material exports, ostensibly due to huge foreign exchange revenues from
crude oil exports.
11.2.5 Stylized fact 5
GLOBALLY, FOREIGN DIRECT INVESTMENT (FDI) TO AGRICULTURE IS
SMALL According to the data available for 43 countries around the globe,
the average FDI to agriculture was only 2.7% of total FDI in 2011. This
supports the widely held belief that the agricultural sector is generally
underfunded and is less attractive to investors than are industry and services (IFC, 2012; Ruete, 2015). The outliers include Malawi (18.86%), Uruguay (15.27%), Ghana (15.75%), Cambodia (13.7%), and Lao PDR (12.3%),
where agriculture’s share for each in total FDI exceeds 10% (see Figure
11.4). At least the outlier countries are all developing countries that have
a real need for FDI to unlock the potentials of the agriculture sector. Thus,
10.4
10.7
20.9
00.4
10.4
50.3
10.8
30.3
20.2
30.5
N/A
40.8
N/A
30.1
10.7
30.5
10.6
00.3
10.3
10.4
20.0
2006
Source: World Development Indicators (2017)
East Asia & Pacifc
Europe & Central Asia
Latin America &
Caribbean
Middle East & North
Africa
South Asia
Sub-Saharan Africa
World
2000
1990
20.0
30.4
10.5
00.2
10.3
10.4
20.2
2007
10.7
40.0
10.4
00.1
10.3
10.2
20.0
2008
10.3
30.0
10.4
00.2
10.2
10.3
20.0
2009
20.1
30.0
10.6
00.3
10.5
10.4
20.0
2010
10.9
50.2
10.8
00.2
10.8
10.4
10.9
2011
TABLE 11.2 Agricultural raw materials exports (% of merchandise exports)
20.0
50.5
10.6
00.2
10.5
10.4
20.0
2012
20.1
30.3
10.6
00.2
10.5
10.4
20.0
2013
10.6
20.2
10.5
00.2
10.3
10.4
20.3
2014
10.6
N/A
10.5
N/A
10.3
10.3
20.7
2015
10.8
30.7
10.6
00.2
10.4
10.4
20.1
10-year
average
2006–2015
10.8
30.4
10.5
00.2
10.3
10.3
20.1
5-year
average
2006–2010
10.8
40.0
10.6
00.2
10.5
10.4
20.2
5-year
average
2011 2015
294 Haruna Issahaku et al.
Chapter 11 • Financing agriculture 295
FIGURE 11.4 Share of FDI to agriculture in total FDI (%), 2011
18
16.86
15.75
16
15.27
13.7
14
12.34
12
10
6
4
2
0
-1
8.83
8.21
8
7.18
6
4.21
1.42
0.52 1.07
0.31
0.49
-0.03
3.93
1.64
0.33
0
0.06 0.27
-0.12
-0.24
2.01
1.79
0.05
-0.06
0.48 0.22
0.11
1.62
0.66 0.26
0.22 0.24
1.55
0.88 0.2
0.14
1.88
-0.39
-2
Source: FAO (2017)
overall, poor countries have a higher share of agriculture FDI in total FDI
than do rich countries. According to Figure 11.4, the share of advanced
countries’ (e.g. France, Greece, Hungary, and Spain) agriculture FDI in
total FDI is minuscule.
11.2.6 Stylized fact 6
GLOBALLY, THE AGRICULTURE SECTOR RECEIVES MARGINALLY LESS PRIVATE SECTOR CREDIT THAN IT DESERVES The share of agriculture sector
credit in total credit is almost insignifcant. On the basis of data available for
103 countries across the globe (see Figure 11.5), the average private sector
credit to agriculture was only 4.5% of total credit in 2015. The corresponding agriculture orientation index2 is 97.8%, which means that credit to the
agriculture sector is marginally below the contribution of the sector to economic growth (i.e. agriculture sector receives marginally less credit than it
deserves). Although the agriculture orientation index gap is not that big,
the funding gap that this entails can be of signifcant consequence to the sector. There are signifcant cross-country variations in agriculture credit ratios
across the world. On the one hand, we have countries with high agriculture
credit ratios: agriculture shares of credit of at least 15% (e.g. Kyrgyzstan,
Zambia, Sudan, and New Zealand). On the other hand, there are countries
with infnitesimal agriculture shares of credit (e.g. UAE, Turkey, Trinidad
and Tobago, Togo, Oman, and Niger). Clearly, however, countries congregate towards low credit ratios.
296 Haruna Issahaku et al.
FIGURE 11.5 Share of agriculture credit in total credit, 2015
Zambia
0.17
0.10
Uruguay
0.15
0.01
United Republic of Tanzania
0.08
0.00
Ukraine
0.07
0.10
Turkey 0.00
0.05
Trinidad and Tobago
0.00
0.00
Timor-Leste
0.04
0.01
Tajikistan
0.11
0.03
Sudan
0.16
0.09
Singapore
0.01
0.03
Serbia
0.07
0.00 0.02
Saint Vincent and the Grenadines
0.01
Saint Kitts and Nevis 0.00
0.02
Republic of Moldova
0.08
0.01
Peru
0.05
0.02
Panama
0.04
0.10
Oman
0.00
0.03
Niger
0.00
0.16
0.05
Nepal
0.05
Mozambique
0.03
0.04
Montserrat 0.00
0.03
0.03
Mali
0.03
0.06
Malaysia
0.07
Lebanon
0.01
0.19
Kenya
0.04
0.05
Jordan
0.01
0.02
Italy
0.05
0.01
Iraq
0.03
0.10
India
0.13
0.06
Honduras
0.06
0.09
Guinea-Bissau 0.00
0.02 0.04
Ghana
0.04
Georgia
0.02
0.04
France
0.06
0.08
Estonia
0.05
0.03
Egypt
0.01
0.04
0.00
Dominica
0.01
Czechia
0.02 0.04
Costa Rica
0.04
0.02
Cambodia
0.10
0.03
Burkina Faso
0.02
0.04
Brazil
0.01
0.02
Bosnia and Herzegovina
0.02
0.10
Bhutan
0.05
0.03
Belize
0.12
0.03
Belarus
0.11
0.00
Bangladesh 0.00
0.05
Austria
0.00
0.07
Aruba 0.00
0.07
Argentina 0.00
0.09
Anguilla
0.00
0.05
Albania
0.02
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20
Source: FAO (2017)
Chapter 11 • Financing agriculture 297
11.3 CHALLENGES OF AGRICULTURAL FINANCING
There are some major constraints peculiar to agriculture perceived as the
source of the diffculty for the sector to attract fnancing. Some of these challenges as outlined by the International Finance Corporation (IFC) (2012)
include seasonality, high exposure to undiversifable risk, limited availability of usable collateral, prohibitive information and transaction costs, competing priorities of banks and other fnancial institutions, and inadequate
access to long-term funding.
Seasonality: agricultural activities in most developing countries are
seasonal in nature and are characterized by long gestation periods. This
means cashfows from the sector tend to be unpredictable and clustered
around certain times of the year. From a banking perspective, the erratic
cashfows make liquidity management diffcult and impose an additional
cost, since customized products will have to be designed in unfamiliar
territory.
High exposure to undiversifiable risk: most agricultural activities are highly exposed to undiversifiable risks, such as drought, floods,
fire, and prices. Since most agricultural production activities face the
same risks, true diversification is difficult to attain, and this increases
the risk of loan default in the sector. This is further compounded by
the fact that there is a lack of a well-developed insurance market for
agriculture.
Limited availability of usable collateral: most farmers do not have
suitable collateral such as real estate, automobiles, and titled land. Because
of legal and sociocultural barriers, most of the assets of agricultural households such as land and housing are not properly titled. Therefore, for the
banker, what could be offered as collateral by the farmer provides poor protection against default risk.
Prohibitive information and transaction costs: poor infrastructure,
dispersed population, and settlements make the information and transaction costs in agriculture high. Rural areas often lack good road network,
potable water, electricity, and telecommunications infrastructure. These factors combined make it diffcult for banks and other fnancial institutions to
establish viable branches in agricultural settlements.
Competing priorities of banks and other fnancial institutions: banks
have several competing priorities, involving reaching out to more frms in
the metropolitan areas, establishing new branches in densely populated
urban areas, and investing in new technology. Given the promise that the
aforementioned areas have, the agriculture sector is often placed at the bottom of the pecking order of bank business.
Inadequate access to long-term funding: all over the world, only
a handful of businesses have access to long-term fnance. This is even
worse in developing countries, particularly for agriculture, mainly
because long-term funds are expensive and are complicated by maturity
mismatch.
298 Haruna Issahaku et al.
11.3.1 Funding challenges of plantation
and animal agriculture
For plantation farming in particular, funding challenges which require
attention include high initial capital required to establish a plantation, high
capital cost and accumulation due to the long period between initial planting and harvesting time, prohibitive biological and economic risks, and
unattractive and inappropriately designed investment incentives by governments in the past (FAO, 2019). Similarly, animal agriculture is plagued
by some peculiar challenges/risks, including being viewed as a major
source of pollution, being associated with the deforestation and degradation of rangelands, being viewed as a preserve of the rich and not pro-poor,
and being thought of as competing with humans for grains (Steinfeld &
Mack, 2019). Other risks in the sector include a lack of funding for research,
the scarcity of land and water resources, trade barriers, health challenges
such as infectious diseases, a weak regulatory framework and weak regulatory oversight, and global environmental changes related to climate, habitat, and feedstock (National Research Council, 2015).
11.4 FINANCING OPPORTUNITIES IN AGRICULTURE
Banks and other fnancial institutions are increasingly recognizing the agricultural sector as potentially proftable. The fnancing opportunities in agriculture
are evident in the expanding demand for food, the diversifcation opportunities offered by agriculture, the need to manage sector-specifc risk with fnancial innovations such as index insurance, the low level of fnancial inclusion
in agriculture, and worsening climate change (IFC, 2012). The exact nature of
these opportunities is explained next.
The ever-expanding demand for food is driven by a growing population
and changes in dietary habits. Global food demand growth is projected to
reach 50% by 20303 and 70% by 2050. To meet this growing food demand,
farmers will need funds to purchase or invest in inputs such as certifed
seeds, fertilizers, and agrochemicals. The increasing demand for inputs
will also have a ripple effect on fnancing requirements for input suppliers.
On the other side of the value chain will be the need for warehouses, storage facilities, and agro-industries to process the agricultural outputs. All
these different players will need more fnancing to meet the increased food
demand.
The agriculture sector provides an opportunity for fnancial institutions to broaden and diversify their portfolios. As an example, in the heat of the
global fnancial crises in 2008, agricultural prices soared and almost doubled across the world. A study conducted by the International Finance Corporation in 2012 showed that countries with a large share of agriculture in
GDP had declining nonperforming loans (NPLs) during the crises, while the
reverse was the case for countries with a lower share of agriculture in GDP.
The risky nature of agriculture in terms of production, price, and market risks marks an opportunity for fnancial institutions to design risk mitigation products and services for the sector. The sector is confronted with
Chapter 11 • Financing agriculture 299
foods, droughts, fres, and livestock disease outbreaks such as swine fu,
which represent both challenges and opportunities. These risks present
opportunities for designing risk-mitigating products such as forwards and
futures contracts as well as weather insurance.
The large number of unbanked people, especially in the agriculture sector,
marks an opportunity for fnancial institutions to rope in this underserved
segment into the mainstream fnancial system.
Worsening climate change implies that sustainable means of production must be explored. In addition, this marks an opportunity for fnancial
institutions to develop and tailor fnancial products and services to sustainable production systems that are consistent with climate-change-adaptation
strategies.
11.5 INNOVATIVE FINANCING MODELS
FOR AGRICULTURE4
Due to high information asymmetries, poor track record, unpredictable
weather conditions, and the absence or low quality of the collateral, it is
important that fnancing strategies for the agriculture sector be designed
to reduce credit risk. We now turn the discussion to the various innovative
ways that agriculture can be fnanced.
11.5.1 Financing farmers and agricultural entrepreneurs
Farmers and agricultural entrepreneurs require funding for inputs, production, transportation, processing, packaging, and storage. Farmers and agricultural entrepreneurs can funded by direct fnancing (retail model) (Ruete,
2015) or indirect fnancing (wholesale model) by channelling fnancial services through cooperatives or farmer-based organizations (IFC, 2012). On
the one hand, the advantage of the direct approach is that the fnancial
institution gets up close to benefciaries to understand their circumstances
and to be able to extend a variety of fnancial services beyond credit. It
also allows the fnancial institution to collect deposits directly from farmers. A success story5 in direct lending is the case of Equity Bank in Kenya,
where the bank partnered with Alliance for a Green Revolution in Africa
(AGRA), the International Fund for Agricultural Development (IFAD), and
the Kenyan government to provide loans to the tune of USD50 million to
2.5 million farmers and 15,000 agriculture input dealers with little or no collateral requirements. The bank gave the loans to farmers at 12% instead of
the 18% interest charged other borrowers. Equity Bank reduced risk exposure by limiting the maximum amount a farmer will take and by using a
group-based lending approach. As of June 2008, Equity Bank had disbursed
USD18.75 million to 37,000 benefciaries. Equity Bank touts this as a success
story because it helped in transforming smallholder food insecure farmers
into semi-commercial farmers (IFC, 2012).
On the other hand, the indirect lending approach has the advantage of
signifcantly reducing the risk of default since the lending is done through
300 Haruna Issahaku et al.
a farmer-based organization. A success story of indirect lending is the case
of the Zambia National Commercial Bank Plc (Zanaco). Zanaco provided
lending through District Farmer Associations duly registered with the Zambian National Farmers Union (IFC, 2012). The facility was called the Munda
credit facility. Before the farming season commences, District Farmer Associations assess the input needs of farmers and submit the list to the Zambian National Farmers Union for onwards submission to the bank. The bank
requires 50% cash collateral from the District Farmer Associations. Upon
harvesting, farmers sell proceeds to designated processors who pass on the
money to the bank. The bank then deducts loan principal and interest and
crop insurance premiums and returns any outstanding amount to farmers
through the District Farmer Associations. Any District Farmer Association
that fails to meet payment schedules is dropped from the scheme. The principle is ‘all for one, one for all’. The scheme served 25 District Farmer Associations in the 2010/2011 farming season, covering 4,026 farmers, from six
hundred farmers in the previous farming season. Under the Munda scheme,
the productivity of maize farmers rose from 1.5 metric tons per hectare to
3 metric tons per hectare due to improved access to and use of fertilizer,
improved seeds, and other modern technology (IFC, 2012).
The suite of products that could be extended to farmers and agricultural SMEs via the direct and indirect approaches include savings account–
linked input fnance, inclusive fnance, leasing and factoring, trade fnance,
weather-based insurance, and credit guarantee schemes.
11.5.2 Financing movable assets
Given the diffculty in getting usable collateral from the agriculture sector, fnancing movable assets, which can themselves serve as collateral, is
a viable alternative. Financing can be provided for movable assets such as
machinery and equipment, small infrastructure, warehouse receipts, commodities, and even livestock (IFC, 2012). Some of the products under this
fnancing model are as follows:
• In equipment fnancing, banks closely collaborate with equipment
manufacturers to supply farm equipment such as tractors, irrigation
facilities, combine harvesters, and factory equipment, among others,
to farmers. Benefciaries take the equipment after minimum initial
deposits and then use the equipment to generate cashfows to defray
the loan. The equipment serves as collateral and is repossessed by the
fnancial institution upon default.
• In cattle banking, banks lend to farmers, take live cattle from the farmers, and keep them in their custody as collateral.
• By leasing agriculture machinery and automobiles, farmers get to
these inputs for a given period in exchange for determined payments.
At the end of the contract, the farmer may have the option to purchase.
Leasing has been employed successfully by some frms in Uganda (see
Box 11.1).
• In warehouse receipt fnancing, secured lending is provided to owners of commodities that are stored in warehouses assigned to the
Chapter 11 • Financing agriculture 301
lending institution. With warehouse receipts, agriculture products
can be stored to serve as collateral; to be traded for cash; or to be used
in futures and forwards contracts (Giovannucci, Varangis, & Larson,
2000). The National Microfnance Bank of Tanzania is a success story
of warehouse receipts for cashews and coffee.
• In collateral management agreement (CMA) fnancing, an agreement
is reached between a collateral manager, an owner or a depositor of
a commodity, and a bank. The commodity is kept in the custody of
the collateral manager and stored in a warehouse. The commodity is
released only once the custodian has received notice from the bank
that the commodity owner has fully repaid the loan. In the event of
default, the commodity is sold to repay the loan. CMAs are quite
expensive and may be better suited for agricultural SMEs than smallholder farmers (IFC, 2012).
BOX 11.1 Development Finance Company Uganda: leasing
Development Finance Company Uganda (DFCU) is a leading commercial bank in Uganda. DFCU is listed on the Uganda Stock Exchange
and operates 29 branches throughout the country. Of the bank’s credit
portfolio, 5% is in the agricultural sector.
The frst three rural branches (in Mbarara, Mbale, and Hoima)
were opened in 2000 as part of a project funded by the U.S. Agency
for International Development (USAID). DFCU has since started leasing operations in other towns, like Lira and Arua, using its own funds.
DFCU specializes in providing fnance leases to SMEs for agricultural
machinery – particularly tractors, milk equipment, harvesters, and
agro-processing equipment. Typically, DFCU fnances 60% of the asset
purchase, while the client fnances the additional 40%. The client share,
however, may range from 10% to 50%. DFCU retains full ownership
during the life of the lease, though the asset is transferred to the client or
sold to a third party after the lease terminates. Although DFCU’s interest rates are similar to those of banks, their leases are more attractive to
SMEs because they typically offer longer payment periods (three to fve
years compared to around two years), provide fexible lease payment
schedules that match enterprise cashfows, and recognize the leased
asset as primary collateral. Additional security is requested only in specifc circumstances. Cashfows are evaluated through documentation
on income sources, three to fve years of audited fnancial statements,
and the company’s history and business plan. It is the borrower’s obligation to select the equipment and submit an inspection report with an
invoice. The asset must be insured during the entire life of the lease; the
DFCU Insurance Premium Financing facility is available and may be
tied to lease payments. DFCU staff engineers regularly monitor assets,
and lease offcers supervise clients in delinquency.
Out of the 231 leases that DFCU facilitated in 2011 (valued at 18.3
million), 19 of these were agricultural (2.2 million). Roughly 20% of
302 Haruna Issahaku et al.
the bank’s agricultural credit occurs through their leasing operations.
DFCU reports 32% portfolio growth for leasing in the previous year,
with nonperforming assets (NPAs) limited to 1% and write-off at 0.4%.
Key success factors include technical and agricultural expertise to offer
leasing products that meet consumer needs and quick turnaround time
to permit equipment use during the current season.
Source: IFC (2012)
11.5.3 Financing agriculture value chains
One fnancing approach that mitigates costs and risks in extending support
to farmers and agriculture SMEs is agriculture value chain fnancing. It offers
a comprehensive way of fnancing agriculture instead of the segmented and
disintegrated way of supporting individuals and specifc segments of the
sector. Agriculture value chain entails successive linkages through which
raw materials and resources are turned into fnal products for consumption.
The value chain may comprise production, processing, packaging, storage,
transportation, and distribution.
To quote Miller and Jones (2010, p. 2), agriculture value chain fnance
(AVCF)
is any or all of the fnancial services, products and support services fowing to and/or through a value chain to address the
needs and constraints of those involved in that chain, be it a need
to access fnance, secure sales, procure products, reduce risk
and/or improve effciency within the chain.
The comprehensive design of the AVCF approach requires a thorough analysis and full understanding of the chain in its entirety for the approach to
succeed. Value chains can be fnanced from within (internal fnance) or from
without (external fnance) (Miller & Jones, 2010).
Internal value chain fnancing comes from the actors in the value chain
itself, actors who have built relationships among themselves, such as a fertilizer supplier providing fertilizer to a farmer on credit to be paid upon harvest. The fnancing approach may entail product fnancing, input supplier
credit, trade fnance, lead frm fnancing, and marketing company credit.
External value chain fnancing is provided by actors outside the value
chain on the basis of established relationships and frameworks. An example
is a microfnance institution’s providing a loan to a producer on the basis
of an agreement with a buyer. Financial instruments under this approach
entail trade receivables fnance, loan guarantees, factoring, and forfaiting.
11.5.4 Financing agriculture by using capital market vehicles
There are three main vehicles for fnancing agriculture through the capital market. These are debt, equity, and derivative instruments. The capital
market is particularly important because it provides long-term funds. A
Chapter 11 • Financing agriculture 303
common problem in the African banking system is the inadequacy or in
most cases unavailability of long-term loans longer than fve years. Nevertheless, for plantation crops, fve years may not even be long enough for
harvesting to begin (from planting). Thus, there is a mismatch between
farmers’ investment horizons and the tenure of funds. The capital market
can reduce this mismatch by providing avenues for agricultural ventures to
raise long-term funds by issuing stocks and bonds.
Debt fnancing through bonds: large-scale and commercial agricultural ventures can raise long-term capital by issuing bonds of various tenures to investors. Such bonds can either be listed on an organized exchange
(listed bonds), or they may be privately placed through sales to selected
institutional investors. Some of the types of bonds that could be issued
by agribusinesses include corporate bonds, project bonds, infrastructure
bonds, or green bonds.
Equity fnancing: agribusinesses may seek equity participation and
through that raise funds for investment. Agricultural sector companies can
issue shares to the investing public to raise funds for investment in long-term
projects with positive net present values. Equity fnancing can be obtained
either through a listing on an organized exchange or through private placement. Through the formal listing procedure, an agricultural company with
the help of an underwriter can go through an initial public process to sell its
shares to the general public and raise funds. In this case, the ownership of
the company is diluted, enabling greater participation in the management
and decision-making processes of the business. If the agribusiness concern
does not want to go through the formal listing procedure, it can privately
arrange to sell the shares to some target entities and individuals, usually
institutional investors such as pension funds, insurance companies, and
mutual funds. Shares bought via private placement can only be traded over
the counter and not on an organized exchange.
Organized Stock Exchanges: agricultural sector companies that are
well established can get listed on the organized stock market by following the prescribed listing procedures. The listing requirements for stock
exchanges are usually stringent, making it diffcult for SMEs and start-ups
to meet such requirements. The capital requirement alone may be out of the
reach of most agricultural sector companies in developing countries. Thus,
this route of fnancing is suitable for large-scale agribusinesses with long
track records of viability. This avenue offers businesses the opportunity to
raise large amounts of money for long-term investments.
Alternative Exchange for SMEs: the current trend is to establish
a parallel capital market for only SMEs and start-ups. Such alternative
exchanges usually have less-stringent listing requirements compared to
the main bourse. The alternative stock exchange provides access to relatively cheap long-term capital for SMEs, including those in the agricultural
sector. Few African countries have an alternative market for SMEs, and in
those countries that have such a facility uptake by SMEs in general, and
agriculture sector SMEs in particular, is low. The alternative exchanges
in Africa include Alternative Exchange (AltX) (run by the Johannesburg
Stock Exchange), the Ghana Alternative Market (GAX) (run by Ghana
304 Haruna Issahaku et al.
Stock Exchange), Alternative Securities Market (run by the Nigeria Stock
Exchange), and the Growth Enterprise Market Segment (run by the Nairobi
Securities Exchange).
Use of derivatives to fnance agriculture: much of the risk in agriculture can be managed by derivatives. A derivative is a fnancial instrument
whose value depends on the value of an underlying asset. In this particular
context, the underlying asset can be agricultural commodities such as arable
crops (e.g. maize, sorghum, wheat, rice, millet, and soybean) or commercial and plantation crops (e.g. cocoa, coffee, rubber, and cashews). Some
derivative instruments available for use in agriculture include spot contracts, forwards, futures, options, exchange-traded funds, and swaps. Agricultural commodity derivatives can trade on general commodity exchanges,
exchanges developed purposely for agricultural commodities, and overthe-counter exchanges. The development of agricultural and international
commodity markets in developing countries will provide a signifcant boost
to agriculture.
Agricultural and international commodity markets: the development of agricultural and international commodity markets will help promote agriculture in a number of ways. Agricultural commodity markets
can reduce transaction costs and risks, make prices and other information
available for prudent decision-making, provide instruments for managing
various risks in agriculture, facilitate market access, reduce market margins,
and indirectly encourage banks and other fnanciers to fnance agricultural
value chains (Jayne, Sturgess, Kopicki, & Sitko, 2014).
About 14 commodity exchanges are in Africa, at various stages of
development. These are shown in Table 11.3. Integrating these exchanges
will create a larger and more robust commodity market for the development
of Africa’s agriculture. Such integration efforts may begin at the subregional
or trade bloc level and then be scaled up to the African Union (AU) level.
Developing countries, particularly African countries without agricultural commodity markets, should not rush to establish commodity
exchanges (CEs) but should instead ensure that the right conditions are frst
put in place. These preconditions have been identifed by Jayne et al. (2014,
p. 7) as follows:
1 A pre‐existing vibrant spot market.
2 The potential to achieve suffcient volume traded across the exchange
to cover its fxed costs.
3 The presence of ancillary marketing services being offered to enable a
commodity exchange to be instituted at relatively low cost.
4 Modes of institutional governance and appropriate incentives suffcient to motivate rapid learning on the part of the CE’s management
and a commitment from a government to desist unpredictable and
discretionary forms of intervention in commodity markets.
Apart from agricultural commodity exchanges, general international commodity exchanges such as the Chicago Board of Exchange, the Chicago
Board of Trade, Intercontinental Exchange (Atlanta, USA), Central Japan
Commodity Exchange, Deutsche Börse/Eurex, and Saint-Petersburg
Chapter 11 • Financing agriculture 305
TABLE 11.3 Commodity exchanges in Africa
Name
Abbreviation
City
Commodity types
Ghana Commodity
Exchange
Africa Mercantile
Exchange
Egyptian Commodities
Exchange
Nairobi Coffee Exchange
Ethiopia Commodity
Exchange
Mercantile Exchange of
Madagascar
East Africa Exchange
Agricultural Commodity
Exchange for Africa
Auction Holding
Commodity Exchange
Bourse Africa (previously
GBOT)
South African Futures
Exchange (part of JSE
Limited)
Abuja Securities and
Commodity Exchange
Lagos Commodities and
Futures Exchange
AFEX Commodities
Exchange Limited
GCX
Accra, Ghana
Agricultural
AfMX
Nairobi, Kenya
Agricultural, energy
EGYCOMEX
Cairo, Egypt
Agricultural, energy
NCE
ECX
Nairobi, Kenya
Addis Ababa,
Ethiopia
Antananarivo,
Madagascar
Kigali, Rwanda
Lilongwe,
Malawi
Lilongwe,
Malawi
Ebene City,
Mauritius
Sandton, South
Africa
Coffee
Agricultural
ASCE
Abuja, Nigeria
Agricultural products
LCFE
Lagos, Nigeria
AFEX Nigeria
Abuja, Nigeria
Agricultural products,
Oil and gas, currency
Agricultural products
MEX
EAX
ACE
AHCX
JSE
Agricultural, metals,
energy
Agricultural
Agricultural
Agricultural
Metals, forex
Agricultural
Source: Wikipedia (2019)
International Mercantile Exchange, among others, accommodate the trading of agricultural commodities. This opens a bigger market for the trading
of agricultural commodities worldwide.
11.5.5 Risk management
Agriculture is saddled with a lot of risks, and these risks also present fnancing opportunities for fnancial institutions. Some of the risks faced by farmers arise from unpredictable weather leading to foods or droughts, pest and
disease outbreaks, price volatility, long gestation periods, impeded access to
credit, and inputs and markets. An innovative approach to fnancing agricultural risk is to incorporate insurance into a credit scheme. For example,
NMB Bank Tanzania and Basix in India make life insurance a compulsory
component of their loans (IFC, 2012). This way, one of the risk components
that could cause the farmer to default on the loan is taken care of. Examples
of innovative risk management fnancing instruments are presented in the
following subsections.
306 Haruna Issahaku et al.
Some examples are credit-weather insurance,
credit-health insurance, production insurance, and index-based insurance
products; because of the seeming reluctance of individual insurance companies to invest in agriculture, there is the need to create a platform that pools
a number of insurance companies to design innovative insurance packages
for the sector. This reluctance to insure agriculture production may be due
to a lack of expertise to understand the peculiarities of the sector, inadequate
funds, and a lack of innovation. When several insurance companies come
together, these challenges are ameliorated, enabling them to design customized insurance products for various clients in the sector. The Ghana Agricultural Insurance Pool (GAIP) is one initiative that could be replicated in
other African countries. It is made of 19 insurance companies that pool their
funds and expertise to develop various agricultural insurance products for
the Ghanaian market. The following are some of the innovative agricultural
products provided by GAIP:
INSURANCE INSTRUMENTS
• Drought index insurance – this product is designed specifcally for
small-scale farmers who are many and scattered throughout the country. This insurance package covers the three phases of plant growth –
that is, germination, vegetative growth, and fowering/maturity. Payout is based on validated weather reading from a ground weather
station or satellite. This type of insurance is suitable for crops such as
maize, millet, groundnut, sorghum, and vegetables.
• Area yield insurance – claims are paid to the insured farmers when
their yield falls below the average yield in a defned geographical
area, such as the district where the farm is located. Although the product can be applied to various categories of crops, it is most suitable for
cocoa cooperatives and cocoa commercial farmers.
• Multi-peril crop insurance – this package is designed for commercial
farmers and investors in the agricultural value chain, such as aggregators, banks, off-takers, input dealers, and processors. A key qualifying
criterion is that the product be designed for a minimum farm size of 50
acres. This package allows a client to insure against as many hazards
as deemed appropriate.
• Poultry insurance – this package is designed for a wide range of
domestic and foreign poultry, including chicken, turkey, guinea
fowl, and duck reared intensively. Some of the perils insured against
include diseases (with the exception of avian infuenza), pests, fooding, thunder damages, and theft.
MARKET-BASED INSTRUMENTS Market-based price risk management
products such as forwards, futures, options contracts, and exchange-traded
swaps can be deployed to manage different kinds of risk in agriculture.
Emerging economies like Brazil, Argentina, China, India, and South Africa
have markets that help manage price risk for players in agriculture. The
Bagsa Agricultural Commodity Exchange in Nicaragua facilitates bilateral
cash and forwards contracts in the agriculture sector as well as auction
services. Bagsa has about 180 shareholders and 36 brokers. The total value
Chapter 11 • Financing agriculture 307
traded on the exchange in 2013 alone amounted to USD720 million.6 Some
of the commodities traded on the exchange include live cattle, meat, milk
products, paddy rice, beans, and coffee.
11.5.6 Financing agriculture through savings
Agricultural frms and households stand to beneft greatly from massive
savings mobilization drives. According to Höllinger (2011), savings enable
individuals and frms to self-insure and to build capital for investment in
business activities, education, health, and asset building. In addition, savings assuage the collateral burden by increasing savers’ access to collateral
in the form of built assets (assets and properties acquired through savings)
and accumulated capital: the amount saved can serve as collateral for a loan
(Brune, Giné, Goldberg, & Yang, 2015; Schaner, 2015). Savings can be promoted at the individual level or group level.
Individual savings products entail normal savings products, no-frills
savings accounts, and subsidized savings accounts. The normal savings
accounts provided by banks and allied fnancial institutions often require a
minimum balance in accounts at all times and impose limits on withdrawals. In some cases, the interest paid on such accounts is minimal. This often
makes such savings products unattractive to farmers. This is where no-frills
accounts come in. No-frills accounts, also known as zero balance accounts,
waive minimum balance requirements on savings accounts. Also, the cost
charged per transaction on no-frills accounts is lower than the per unit
transaction cost of conventional savings accounts. The promotion of no-frill
accounts should enable a large number of the unbanked to be roped into
the formal fnancial system. In cases where no-frills accounts products are
not available, savings accounts could be subsidized such that government
or an enabling institution bears the cost of minimum balance requirements
and other bank charges for farmers. This should reduce the cost of saving
for farm households.
The available empirical evidence on the benefts of individual savings
in the agricultural sector is encouraging. In a study conducted in Kenya
on 779 couples who opened bank accounts in 2009, Schaner (2015) examined the impact of subsidized savings in the form of removing the minimum savings balance and making temporary interest payments to account
holders. The fndings revealed that the savings subsidy enhanced account
penetration while increasing the income of benefciaries. Men who received
higher subsidies reported higher incomes, asset ownership, and entrepreneurial activity two and half years after the intervention. Similar benefts
were not reported for women. Using data collected in the Tanzania National
Panel Survey (TZNPS), Bandara, Dehejia, and Lavie (2014) reveal that bank
account ownership by a household is linked with a reduction of eight to ten
child labour hours per month.
Group savings products are suitable for societies where cooperation and social bonds are valued and encouraged. This is usually so in the
rural areas of developing countries. The limited availability of formal savings products in agriculture and rural areas has popularised group savings
308 Haruna Issahaku et al.
mechanisms such as village savings and loan associations (VSLAs) or rotating credit and savings associations (ROSCAs). A typical VSLA comprises a
group of 15 to 25 self-selected individuals who bring their savings together
and issue small loans to members on the basis of the savings. The activities
of the group run in cycles of one year, after which the savings and profts
realized from the small loans are distributed back to members.7 In a typical ROSCA, members pool their savings into a common fund, usually on
a monthly basis, such that at the beginning of each cycle, a single member
withdraws a lump sum. Each member takes their turn to withdraw a lump
sum. This system of continuous contribution and rotation of funds continues for as long as the group survives.8
The empirical evidence shows positive effects of group savings
schemes. In a randomized impact evaluation of VSLA establishments in
80 villages in Burundi, Annan, Armstrong, and Bundervoet (2013) found
that while the incidence of poverty increased by 10% among households in
control villages, it reduced by 14% among treatment households. A similar
impact evaluation of ROSCAs in Mali revealed that participating households experienced a reduction in poverty and food insecurity (BARA & IPA,
2013).
11.5.7 Financing agriculture through foreign
direct investment (FDI)
The insuffciency of savings and other domestic fnancing sources to satisfy the funding needs of agriculture in developing countries mean that
they will have to look elsewhere to fll this gap. FDI is one source of capital infow that can help bridge the funding gap in agriculture. To attract
more FDI to the agriculture sector, developing countries must understand
the factors that drive FDI fows to the sector. The literature shows that factors that draw FDI to the agricultural sector include the size of the economy
(the larger the better), trade openness (the more open the better), infrastructure (the more endowed the better), forest land share (the larger the better),
size of agricultural market (the larger the better), agriculture value added
(the larger the better), and poverty (the lower the better) (Farr, 2017; Abdul
Rashid, Abu Bakar, & Abdul Razak, 2016).
Agricultural sectors in developing countries stand to beneft a lot from
FDI. Some of the benefts of FDI have been discussed extensively in the literature. FDI increases agricultural production, productivity, employment;
lowers prices (Gerlach & Liu, 2010); and has positive technological spillover
effects (Tondl & Fornero, 2010). Chaudhuri and Banerjee (2010) found that
FDI in agricultural land improves welfare and also reduces unemployment
among both skilled labour and unskilled labour.
However, the benefts of FDI must be counterbalanced against the
negatives. FDI can hurt the health of households and degrade and pollute the environment (Ben Slimane, Huchet-Bourdon, & Zitouna, 2016). Of
recent interest is FDI in agricultural lands, a phenomenon called land grabbing. So far, the literature on the impact of FDI in agricultural land on food
security is scanty and controversial. In a qualitative study in Africa, Cotula,
Chapter 11 • Financing agriculture 309
Vermeulen, Leonard, and Keeley (2009) concluded that foreign investors
in agricultural land are simply land ‘grabbers’ that hinder local development and increase food insecurity by exploiting water resources and using
certain fertilizers and other chemicals which are harmful to the environment. On the contrary, Sliman et al. (2016) found that agricultural FDI leads
to improvements in food security. The authors, however, found that FDI
in the secondary and tertiary sectors leads to food insecurity. Santangelo
(2018) has advocated an analysis of the impact of land grabbing in developing countries on the basis of the origin of FDI infows. On the one hand, the
author found that FDI in land from developed country investors in addition to positive spillovers enhances food security by increasing land used
for crop production due to home institutional pressure for the respect of
human rights and responsible farming practices. On the other hand, FDI in
land from developing country investors, in addition to negative spillovers,
leads to food insecurity by displacing farmlands owing to home-country
institutional pressure to align with ‘national interests’ and ‘government
objectives’.
11.5.8 Digital fnancial and agricultural development
Conventional fnancing mechanisms have not been able to satisfy the fnancing needs of agriculture, particularly the needs of smallholder farmers.
Indeed, access to fnance has become a common and intractable problem in
developing country agriculture. Meanwhile, 80% of the world’s population
is fed by smallholder farmers who total about 1.5 billion people (USAID,
2016). Again, smallholder farmers form the largest proportion of the world’s
poor who live on less than USD2 a day (Grossman & Tarazi, 2014). The
fnancing shortfall among smallholder farmers is estimated to be USD430
billion to USD440 billion (USAID, 2016). Thus, smallholder farmers are by
far the group that needs fnancial inclusion the most, but unfortunately,
they are also among the most diffcult to reach. The potentials of digital
fnancial services (DFS) can be harnessed to jumpstart fnancial inclusion
among all categories of farmers and those who are hard to reach in general.
DFS refers to gaining access to or using fnancial services and products through digital channels such as mobile phones, tablets, computers,
point-of-sale devices, and electronic cards (debit cards, credit cards, and key
fobs). Digital fnancial instruments can be used to access credit, subscribe to
insurance, transfer money, make purchases, access information without the
need for face-to-face contact with the parties in the transaction, unlike conventional brick and mortar banking. According to the World Development
Report 2016, digital fnance can be harnessed to promote fnancial inclusion,
increase the effciency of fnancial service delivery, and drive fnancial innovation. Digital payments (e.g. mobile payments) can break access barriers
and bring fnancial services to the doorsteps of the poor. Digital fnance lowers the cost of fnancial transactions and the delivery cost of fnancial services. This is because digital fnance allows for the unbundling of fnancial
services and products and enables the automation of fnancial service delivery at any scale: small, medium, and large. Digital fnance offers limitless
310 Haruna Issahaku et al.
possibilities for fnancial innovation. These innovations can range from process automation to the development of new and customized products and
services at a reduced cost in an effcient manner.
USAID (2016) outlines some roadblocks in smallholder agriculture
and indicates how fnancial digitization can remove them. These roadblocks include diffculty in getting the right fnancial products for smallholder farmers, the low competitiveness of smallholders in agriculture
value chains, women’s lack of a voice in decision-making in agriculture,
poor post-harvest management and inability to speculate for higher prices
for products, low savings capacity, diffculties in managing weather risks,
and high cost of inputs. Digital fnancial services can be used to remove
these roadblocks by reducing the cost of delivering fnancial services, reducing price opacity, encouraging inventory-based credit, reducing risk in the
delivery of fnancial services and increasing access of the poor, including
women, to a wide range of fnancial services, such as credit, savings, crop
insurance, weather insurance, and payments.
There are four main innovations in digital fnance (Bank of England,
2014):
1 Wrappers provide a digital interface with a bank account or credit
card. With the help of wrappers, one can receive SMS alerts when a
transaction is done with a bank account by use of either cheque or
credit card.
2 Mobile money systems store mostly local currency as a credit on the
smart card or in the books of the service provider and enable transactions online or through a mobile phone. Mobile money services,
especially those mediated by mobile phones, have become popular
among the unbanked and underbanked in Africa. Various telecommunication companies have rolled out mobile money services to help
the poor gain access to fnancial services – speedily, at reduced cost,
and at greater convenience. Farmers are able to make and receive
payments through their mobile phones. This means they can easily
sell farm products and access farm inputs. Farmers can also purchase
investment products, save money, and access funds via their mobile
phones. Increasingly, mobile money services are being linked to the
formal fnancial system, such that it is now possible to transfer money
from a bank account to a mobile money wallet and vice versa. Some
common mobile money services include M-Pesa, MTN mobile money,
TigoCash, and Airtel money.
3 Credits and local digital currencies are alternative units of account
denominated in foreign currency aimed at promoting spending in a
local economy or as a way of exchanging game proceeds.
4 Digital currency is a new type of currency that is available only in
digital form and not in physical paper currency or coin currency form.
Digital currencies can be transferred only electronically. Many countries are still sceptical about the use of digital currency.
Some recent empirical studies have provided support for the importance of
mobile technology and digital fnancial services in promoting agricultural
Chapter 11 • Financing agriculture 311
development. Information and communications technology (ICT) has been
found to boost extension services delivery (Fu & Akter, 2016), agribusiness
(Tadesse & Bahiigwa, 2015), land management (Jordan, Eudoxie, Maharaj, Belfon, & Bernard, 2016), and productivity (Issahaku, Abu, & Nkegbe,
2017). In particular, Issahaku et al. (2017) showed that mobile phone use
increased the productivity of maize farmers by at least 261.20 kg/ha per
production season. The authors found that mobile phone use affected productivity through three main channels: extension services, the adoption of
modern technology, and market participation.
Already, there are success stories about the application of digital
fnancial services to promote agricultural development along agricultural value chains. For instance, USAID’s/Ghana’s Agricultural Development and Value Chain Enhancement (ADVANCE) II project is using
a digital fnancial system (mainly mobile phone mediated) to establish
and strengthen linkages among smallholder farmers, markets, fnance,
large-scale farmers, traders, and input and equipment suppliers. Under
ADVANCE II, farmers receive payments for their harvest via mobile
money; the capacities of mobile money agents have been built to serve
farmers well; farmers are encouraged to save. The government of Nigeria
implemented a pilot programme, an e-voucher system, for the distribution of fertilizer subsidies in 2011. By 2013, the system was scaled up to
the entire country and served over 4.3 million small-scale famers. Under
this system, each farmer had a mobile phone e-wallet with a unique personal identifcation number (PIN) to access fertilizer subsidies. This has
drastically reduced corruption in the distribution of subsidized fertilizer
in Nigeria (USAID, 2016).
11.6 OVER-INDEBTEDNESS IN AGRICULTURE
Rising debt among farmers and agriculture-related companies has become
of great concern to agricultural sector players. Davydoff et al. (2008) have
conceptualized over-indebtedness as a high debt service that pushes an
individual or household below the poverty line. The causes of unsustainable debts in agriculture are many and varied. A review by Datta, Tiwari,
and Shylajan (2016) identifed the causes of high indebtedness in agriculture
as unproductive uses of the loan (for marriages, funerals, and other social
ceremonies), erratic rainfall, foods and drought, declining production and
productivity, overreliance on noninstitutional sources of credit (money
lenders), persistent losses, and rising costs of inputs. Some other causes of
over-indebtedness include a lack of coordination among debtors due to a
lack of information on the credit history of borrowers, pests and diseases,
and high levels of fnancial illiteracy.
Thus, any farm policy intended to curtail unsustainable debts in agriculture should incorporate these factors. Furthermore, debtors and policymakers need to establish debt thresholds that lead to over-indebtedness for
various farming communities and households. In a study in South Africa,
Ntsalaze and Ikhide (2017) found that exceeding a debt-to-income ratio of
42.5% leads to declines in household welfare.
312 Haruna Issahaku et al.
Over-indebtedness has both direct effects and indirect effects on poverty (Ntsalaze & Ikhide, 2017). In terms of the direct effects, the high debt
service burden reduces the availability of resources for agricultural households to meet their needs. The indirect effects arise from the fact that high
debt subdues growth due to a reduction in farm investments. Other consequences of over-indebtedness include stigmatization, legal consequences,
insolvency, and perpetual penury.
11.7 AGRICULTURE FINANCE PLUS
Complementarities are crucial in agricultural fnancing. In this regard, agricultural fnancing must come in a full package in order to be effective. Agricultural credit and other fnancing programmes must have an education
and training component that teaches farmers how to effectively apply the
credit to good effect. Apart from fnancing needs, farmers and agriculture
companies need training on which breed of animal or seed to plant, when
to start the business, how to keep records, and customer care, among others. If these other needs are not properly taken care of, it will be diffcult for
farmers and agricultural sector companies to meet their fnancial obligations when they fall due. Thus, agricultural fnancing programmes should
incorporate education, training, and fnancial literacy. This is called agriculture fnance plus. Agriculture fnance plus should help improve the use of
funds and thus reduce the risk of default in the sector.
11.8 ROLE OF GOVERNMENT IN AGRICULTURAL
FINANCING
The state has a critical role to play in providing funding and creating an
enabling environment for agriculture to thrive. The roles of government
could range from establishing the legal and regulatory framework, infrastructure fnance, research and development (R&D) fnance, and establishing loan guarantee funds.
Legal and regulatory frameworks: fnancial regulation is important
for ensuring the optimal allocation of fnancial resources, reducing information and transaction costs, and the development of sustainable fnancial
markets and institutions. Financial regulation must protect farmers from
Ponzi schemes and provide some fexibility for innovative products to be
designed for the sector.
Infrastructure fnance: according to Ruete (2015), a fourishing agriculture sector requires supporting infrastructure such as road networks linking
farms to market centres, irrigation schemes to reduce farmers’ overreliance
on nature, storage infrastructure to stem post-harvest losses, telecommunications to facilitate transactions, water for household and agro-industrial
use, and electricity to power agro-industries. Infrastructure fnance can be
a collaborative effort between the government, fnancial institutions, and
private partners.
R&D fnance: innovation and knowledge are crucial to the transformation of agriculture. However, fnancing R&D in agriculture is often not
Chapter 11 • Financing agriculture 313
attractive to the private sector. This means the government must take the
lead. More funding should be channelled to the various agriculture research
institutions and universities to drive agricultural innovation.
Loan guarantee funds: governments may provide loan guarantees
schemes to reduce the default risk in the agriculture sector in order to
encourage more fnancial institutions to participate in agriculture fnancing.
11.9 CONCLUSION
The agriculture sector, although beset by a lot of risks, still has a lot of fnancing opportunities that can be explored to position it as a key tool for poverty
reduction both in the short term and in the long term. To achieve these ends,
it will take a collaborative effort between governments, fnancial institutions, development fnance institutions, and other actors in the value chain
to provide the needed fnancing for the sector. Going forward, there must
be a departure from funding agriculture in a piecemeal fashion to adopting
a more holistic approach to agricultural fnancing. This chapter, therefore,
provides an assessment of potential fnancing models of agriculture with a
view to better understanding what can work to support the growth of the
sector for inclusive development.
First, and in line with Agar (2011), we advocate an integrated approach
to fnancing agriculture. Such fnancing must encompass agriculture value
chain, nonfarm enterprise, and the household. This integrated approach is
necessitated by the fungible nature of money. It would not be enough to
make funding available to farmers only for production purposes. The consumption needs of farmers are linked to their production needs and to their
nonfarm activities. Thus, if farmers know that they can get funding only for
farming and not for their health, educational, and other needs, they will still
go for loans for farming purposes but divert them to meet their survival and
other most pressing needs. Thus, a holistic approach to funding agriculture
that addresses both agricultural and nonagricultural needs is the way to go.
Second, we note that fnancial inclusion and fnancial innovation are
critical channels by which fnancial products and services can be brought
to the doorsteps of the rural population. In the spirit of that, we argue that
digital fnancing services such as mobile banking, mobile payments, and
branchless banking services should be pursued by fnancial institutions and
fnancial sector actors in this regard.
Third, an enabling environment for business generally is also good
for agriculture fnancing and agriculture growth. In particular we argue
that improving the effciency of the judiciary and the courts, consolidating
land and property rights, and investing in infrastructure such as transport,
telecommunications, electricity, and water in agricultural areas will affect
agriculture not only directly but also indirectly, by making fnancing for
agriculture more accessible.
Finally, capacity-building programmes are needed in order to
strengthen the capacities of agricultural fnancial institutions and imbue
farmers and agriculture entrepreneurs with the requisite knowledge to
make the right fnancing decisions.
314 Haruna Issahaku et al.
Discussion questions
1 Discuss how poor countries can
reduce their reliance on raw material exports. How will this reduce
economic vulnerabilities?
2 Discuss agriculture sector-specifc
risks, teasing out the fnancing
opportunities that belie such risks.
3 How can the different risks in agriculture be mitigated by using various
fnancial instruments?
4 To what extent can movable asset
fnancing be used to ease collateral constraints in smallholder
agriculture?
5 Discuss how digital fnance can
solve some identifed constraints
in the agriculture sector.
6 Discuss the various capital fnancing mechanisms for agriculture.
Notes
1 Read more at http://marketrealist.com/2015/12/analyzing-european-unions-gdp-composition/.
2 This is computed as the agriculture share of credit, over the agriculture share of GDP.
3 Read more details at www.
un.org/waterforlifedecade/food_
security.shtml.
4 The discussion in this section is
adapted mainly from International Finance Corporation (2012)
and then Miller and Jones (2010)
and Ruete (2015).
5 The cases used to support the discussion in this presentation were
drawn mainly from the International Financial Corporation (2012).
6 Read more at www.centralamericadata.com/en/article/home/
Nicaragua_Agricultural_Exchange_
Traded_720_million_in_2013.
7 Read more about VSLAs at www.
vsla.net/aboutus/vslmodel.
8 Read more about ROSCAs at www.
investopedia.com/terms/r/rotatingcredit-and-savings-association.
asp.
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2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
06_15
06_10
11_15
Source: World Development Indicators (2017)
East Asia &
1,088.9 1,285.4 1,322.4 1,389.8 1,427.7 1,466.5 1,528.0 1,591.3 1,649.4 1,712.7 1,766.9 1,514.0 1,378.3 1,649.7
Pacifc
Europe &
8,801.8 10,448.2 10,570.4 11,336.3 11,664.6 11,444.7 12,470.7 12,336.3 13,128.5 13,774.3 14,309.1 12,148.3 11,092.8 13,203.8
Central
Asia
Latin
4,541.2 5,676.4 5,975.2 6,205.5 5,951.5 6,427.4 6,679.2 6,655.5 7,107.6 6,912.8 7,228.3 6,481.9 6,047.2 6,916.7
America &
Caribbean
Low income
401.1
422.8
455.5
462.5
472.4
482.1
479.0
494.1
490.7
500.7
504.1
476.4
459.1
493.7
Middle East
3,803.4 4,829.1 4,723.4 4,403.6 4,770.5 4,972.9 5,193.4 5,296.7 5,635.0 5,792.3 5,938.5 5,155.5 4,739.9 5,571.2
& North
Africa
Middle
1,211.2 1,478.9 1,519.9 1,566.1 1,592.5 1,661.2 1,731.9 1,773.1 1,853.5 1,886.6 1,920.0 1,698.4 1,563.7 1,833.0
income
High income 22,419.8 27,489.4 28,024.6 30,422.9 32,277.6 32,099.7 33,240.6 32,997.5 36,405.7 37,959.9 39,256.7 33,017.5 30,062.8 35,972.1
South Asia
871.7
946.3
990.7
984.2
989.8 1,048.5 1,083.4 1,093.8 1,135.8 1,130.2 1,131.7 1,053.4
991.9 1,115.0
Sub-Saharan
776.3
994.6 1,028.8 1,081.1 1,092.0 1,120.6 1,130.5 1,174.1 1,184.8 1,209.6 1,223.3 1,123.9 1,063.4 1,184.4
Africa
World
1,557.5 1,778.2 1,812.2 1,872.0 1,905.6 1,953.5 2,011.9 2,027.9 2,122.8 2,152.9 2,179.2 1,981.6 1,864.3 2,098.9
2000
TABLE A13.1 Agriculture value added per worker (constant 2010 USD)
Appendix
Chapter 11 • Financing agriculture 317
CHAPTER
12
Financing sustainable
development
New insights for the present
and the future
Gordon Abekah-Nkrumah, Patrick O. Assuming,
Patience Aseweh Abor and Jabir Ibrahim Mohammed
12.1 INTRODUCTION
Sustainable development has been a long-standing issue since the 1980s,
and several conferences have been held to discuss issues pertaining to
sustainable development. Sustainable development serves as the key idea
around which environment and development goals are structured. It also
serves as the principal goal of many more institutions in development than
in previous times.
The United Nations established an independent group of 22 people
drawn from member states in 1984, taken from both developing countries
and developed countries. The main aim of the group was to identify longterm environmental strategies for the international community. In 1987, the
World Conference on Environment and Development (WCED) published
a report titled Our Common Future. This report is often referred to as the
Brundtland Report, named after its chair, the prime minister of Norway,
Gro Harlem Brundtland (Brundtland, 1985). The report used the term ‘sustainable development’, which is widely defned as ‘development that meets
the needs of the present without compromising the ability of future generations to meet their own needs’ (p. 43). This report highlighted the argument
that economic inequities will lead to the overexploitation of resources and
that economic growth is needed especially in poorer countries in order to
satisfy their basic human needs. The report further states that this kind of
development must follow a ‘new pathway’ that does not entail environmental destruction. They report that this renewed pathway for achieving
sustainable economic growth and the equitable redistribution of wealth can
be achieved only through political participation.
The proclivity of sustainability in the words of John Robinson and
Jon Tinker hinges on three key elements: ecological, economic, and social
imperatives. They argue that most sustainable theorists and practitioners
mostly expand on the dimensions of the social imperatives to include both
Chapter 12 • Financing sustainable development 319
intergenerational and intragenerational equity. The argument is that a sustainable world must provide for the basic needs of all people living today
(intragenerational equity) without compromising the ability of future generations to meet their needs (intergenerational equity). For the current generation to be able to provide for the basic needs of all people living today
without precluding future generations from meeting their needs, rigorous
mechanisms for fnancing sustainable development that cate for the present
and the future needs of humanity will be needed. The Intergovernmental
Committee of Experts on Sustainable Development Financing (ICESDF),
for instance, suggests that suffcient funds exist internationally to achieve
sustainable development, but this requires strong political commitment
to structural reforms, coupled with new and innovative fnancing mechanisms in order to make tangible progress. The outcome of the Third Conference on Financing for Development (FfD) held in Addis Ababa in July 2015
represents a critical contribution to the post-2015 sustainable development
agenda and the drive for implementation.
We defne ‘sustainable development fnance’ as a fnancing mechanism that provides clean and innovative blended sources of fnance to
meet the needs of current and future generations. The concerted mechanism of fnance may be obtained from both domestic and international
sources, including public funds and private funds, such as environmental fnance, private sector fnance, and innovative fnance for sustainable
development.
In this chapter, we examine fnancing for sustainable development.
We frst provide an overview of sustainable development by looking at
the Millennium Development Goals (MDGs) and the Sustainable Development Goals (SDGs). We also discuss the challenges and benefts of fnancing
sustainable development, bring up the sources of fnancing for sustainable
development, and fnally make concluding remarks.
12.2 OVERVIEW OF SUSTAINABLE DEVELOPMENT
Sustainable development is concerned with development that meets the
needs of the current without sacrifcing the future generations’ ability
to meet their needs. The modern use of the term ‘sustainable development’ is derived mainly from the Brundtland Report (1987). It contains
two key concepts: frst, the concept of ‘needs’, in particular the essential
needs of the world’s poor, to which overriding priority should be given,
and, second, the idea of limitations imposed by the state of technology
and social organization on the environment’s ability to meet present and
future needs (Brundtland, 1987). The meaning of the concept of sustainable development has evolved over time. The initial focus of sustainable
development was on sustainable forest management and environmental
issues. However, as the concept evolved, the focus shifted towards economic and social development as well as protecting the environment for
future generations. We provide the evolution of the concept of sustainable
development in Box 12.1.
320 Gordon Abekah-Nkrumah et al.
BOX 12.1 The evolution of the concept of sustainable development
The United Nation Education Scientifc and Cultural Organization
(UNESCO), at a conference on the biosphere, initially launched the idea
of sustainable development in 1968. The concept of sustainable development received its frst major international recognition in 1972 at the
UN Conference on Human Environment held in Stockholm. The term
was not referred to as sustainable development, though the international community decided that development should address the needs
of the environment without causing adverse effects to the inhabitants,
so that it is maintained and passed on to future generations while being
managed in a mutually benefcial way.
Again, the United Nations Conference on Environment and
Development (also called the Earth Summit) held in Rio de Janeiro in
1992, re-echoed the need for sustainable development. The summit was
the initial international attempt to develop action plans and strategies
to achieve a more sustainable pattern of development.
In 2002, ten years after the summit in Rio de Janeiro, the World
Summit on Sustainable Development was held in Johannesburg and
attended by 191 national governments, UN agencies, multilateral fnancial institutions, and other major groups to assess progress since the
conference in Rio de Janeiro. The main areas of commitment during
the summit were sustainable consumption and production, water and
sanitation, and energy.
Source: www.sd-commission.org.uk/pages/history_sd.html
The term ‘sustainability’ is derived from the Latin root sus-tinere,
meaning to under-hold or hold up from underneath, which implies robustness and durability over time. Sustainability also depicts a paradigm that
protects the planet’s life support system to ensure the longevity of humans
and other species. While ‘sustainability’ is viewed as humanity’s target for
human–ecosystem equilibrium (homeostasis), ‘sustainable development’ is
concerned with the holistic approach and temporal processes that result in
the end point of sustainability (Shaker, 2015).
At the global level, reference is currently being made to the SDGs in
the attainment of specifc sustainable development outcomes by 2030. The
SDGs build on the MDGs, which were set in 2000. We provide some brief
discussion on the MDGs and the SDGs.
12.2.1 The Millennium Development Goals
In 2000, all 191 member states of the United Nations and at least 22 international organizations made a commitment to achieve eight international
development goals by the year 2015. These goals were referred to as the
MDGs. The MDGs were essentially antipoverty goals born out of the need
Chapter 12 • Financing sustainable development 321
to put in place a mechanism to implement the Millennium Declaration. The
Millennium Declaration considered certain fundamental values – freedom,
equality (of individuals and nations), solidarity, tolerance, respect for nature,
and shared responsibility – to be essential in international relations in the
21st century. The MDGs, along with 21 specifc targets, encapsulated the
objects of development as understood at the time, as well as key enablers for
achieving them. Thus, the goals centred on human capital, infrastructure,
and human rights, to improve living standards.
The MDGs galvanized unprecedented levels of concerted efforts of
a broad coalition of individuals and organizations working in development: academics, governments, intergovernmental organizations, nongovernmental organizations (NGOs), and other members of civil society. The
MDGs consequently became the standard for judging the success of development programmes around the world.
After 15 years of MDGs, signifcant
progress was made in several areas. One of the major achievements is the
reduction in poverty. Globally, the number of people living in extreme poverty (i.e. people living on less than USD1.25 per day) declined by more than
50%, and the global target of halving extreme poverty was achieved ahead
of time in 2010 (UN, 2015). In addition, the proportion of workers in vulnerable employment also fell, although 45% were still working in vulnerable
conditions (National Development Planning Commission [NDPC], 2015).
With regard to achieving universal primary education, signifcant
progress was made towards it in developing regions of the world. The net
enrolment rate (NER) in primary education increased from 83% in 2000 to
90% in 2012 (NDPC, 2015). Signifcant progress has also been made towards
gender equality in primary education and the participation of women in
political activities in developing regions. However, progress towards
improving gender equality in labour markets remains slow.
Substantial progress was made in improving child and maternal
healthcare even though the target was not achieved by 2015. Under-fve
mortality declined from 90 to 43 deaths per 1,000 live births between 1990
and 2015, despite population growth in developing regions. Similarly,
maternal mortality declined by about 45% worldwide, though this reduction was still below the target.
Further, the incidence of HIV at the global level reduced by 40%
between 2000 and 2013. Malaria-related mortality rates fell by 42% globally between 2000 and 2012 due to improvements in malaria interventions.
Between 2000 and 2015, over 6.2 million malaria deaths were averted, 97%
of whom were young children (UN News Centre, 2015). Also, over 2.3 billion more people gained access to improved sources of drinking water, representing 89% of the world’s population by 2012 (NDPC, 2015).
Finally, a signifcant improvement was recorded in offcial development assistance (ODA). ODA from developed economies grew by 66% in
real terms from 2000 to 2014 (UN News Centre, 2015). The debt burden of
developing countries has also fallen dramatically, and there has been a substantial increase in internet access worldwide (NDPC, 2015).
ACHIEVEMENTS AND CHALLENGES
322 Gordon Abekah-Nkrumah et al.
However, the substantial global progress masked progress across the
regions and countries of the world. First, in spite of the progress made, a large
number of people still live in poverty. An estimated 800 million people around
the world still live in extreme poverty, hunger, and deprivation. Moreover, over
160 million children under fve years of age are too short for their age, due to
insuffcient food, while 57 million children of school-going age are not in school.
Second, in spite of progress made, huge gaps in socioeconomic status and economic opportunities exist between rural households and urban
households. For instance, around the world, those in the rural population
who do not use improved drinking water sources is four times that of the
urban population (UN, 2015). Third, in most parts of the world, gender
inequalities persist, as many women are discriminated against in the areas
of economic opportunities and participation in private and public decisionmaking. Finally, in terms of climate change and the environment, environmental degradation and the negative effects of climate change persist, the
poor bearing a disproportionate share of the consequences.
12.2.2 From MDGs to SDGs
The foregoing analyses indicate that while signifcant progress has been made,
concerted and focused global efforts are needed to address extreme hardship and deprivation. Uneven progress made on the MDG targets meant that
large sections of the population in low-income countries, particularly those in
Africa, are without access to basic services. In addition, efforts on some of the
MDGs also remained off-track, especially those that relate to child and maternal
healthcare. Moreover, there has been an increasing recognizing that several key
emerging issues in development were not captured under the MDGs and that
therefore the 2030 Agenda required an expanded range of goals and outcomes.
The idea for SDGs was conceived at the United Nations Conference
on Sustainable Development in Rio de Janeiro, Brazil, 20–22 June 2012. The
aim was to come out with a set of universal goals that meet the urgent environmental, political, and economic challenges facing our world. Thus, the
SDGs came as a bold commitment to fnish what was started and address
other, more-challenging issues the world is facing. It builds on the MDGs
and aims to fll in the gaps in the objectives and achievements of the MDGs,
particularly reaching the most vulnerable. The SDGs are also known as the
2030 Agenda as the deadline for achieving the goals is 2030. The goals are
interconnected, so success in one would invariably lead to success in others.
Hence, the scope of the SDGs goes far beyond the MDGs, to include a wider
range of economic, social, and environmental objectives. More importantly,
it defnes the means of implementing SDGs.
The main focus of the MDGs was poverty reduction, and they didn’t
consider the various complications of global poverty. This lack is important to point out because the world’s social, economic, and environmental
landscape is constantly changing, which affects the poor. The SDGs thus
seek to address issues underpinning poverty and employ an approach that
interconnects all the three aspects of sustainable development: economic,
social, and environmental.
Chapter 12 • Financing sustainable development 323
TABLE 12.1 MDGs and SDGs
MDGs
SDGs
1 Eradicate extreme poverty
and hunger.
1 End poverty in all its forms everywhere
2 End hunger, achieve food security
and improved nutrition, and promote
sustainable agriculture.
3 Ensure inclusive and equitable quality
education and promote life-long learning
opportunities for all.
4 Achieve gender equality and empower all
women and girls.
5 Ensure healthy lives and promote wellbeing for all at all ages.
6 Ensure healthy lives and promote wellbeing for all at all ages.
7 Ensure healthy lives and promote wellbeing for all at all ages.
8 Ensure availability and sustainable
management of water and sanitation
for all.
9 Strengthen the means of implementation
and revitalize the global partnership for
sustainable development.
10 Ensure access to affordable, reliable,
sustainable, and modern energy for all.
11 Promote sustained, inclusive, and
sustainable economic growth, full and
productive employment, and decent
work for all.
12 Build resilient infrastructure, promote
inclusive and sustainable industrialization,
and foster innovation.
13 Reduce inequality in and among countries.
14 Make cities and human settlements
inclusive, safe, resilient, and sustainable.
15 Ensure sustainable consumption and
production patterns.
16 Take urgent action to combat climate
change and its impacts.
17 Conserve and sustainably use the oceans,
seas, and marine resources for sustainable
development.
18 Protect, restore, and promote the
sustainable use of terrestrial ecosystems,
sustainably manage forests, combat
desertifcation, and halt and reverse land
degradation and halt biodiversity loss.
19 Promote peaceful and inclusive societies
for sustainable development, provide
access to justice for all, and build effective,
accountable, and inclusive institutions at
all levels.
2 Achieve universal primary
education.
3 Promote gender equality
and empower women.
4 Reduce child mortality.
5 Improve maternal health.
6 Combat HIV/AIDS, malaria,
and other diseases.
7 Ensure environmental
sustainability.
8 Global partnership for
development.
324 Gordon Abekah-Nkrumah et al.
The MDGs came about largely through a top-down approach. The
goals were largely determined by OECD countries and international donor
agencies. However, the SDGs came about through extensive consultations.
Civil society organizations, citizens, scientists, academics, and the private
sector were all consulted in the process of formulating the SDGs. According
to Coonrod (2014), the MDGs’ targets were aimed at accomplishing at least
half the targets. However, the SDGs aim at fully accomplishing the goals,
thus setting zero-based goals (reaching the statistical zero on the targets like
poverty, hunger, and child and maternal mortality). Thus, more focus is
placed on reaching all players involved in reaching the goals.
In addition, while the MDGs addressed each of the goals in isolation,
the SDGs employ a more integrative approach. All the 17 SDGs are interconnected, so success in one would lead to success in the others (Boucher, 2015).
The SDGs brought together all three aspects of sustainable development –
that is, economic, social, and environmental – in a more integrative manner. In
terms of funding, the MDGs envisaged a substantial role for international aid.
Goal eight of the MDGs included targets for substantial amounts of offcial
development assistance (ODA) from developed to developing countries. The
onset of the 2008–2009 global fnancial crises and the economic crisis that followed led to sharp falls in ODA, and this may have played a role in the inability to achieve a number of the goals and targets. The SDGs take a slightly
different approach, by focusing on sustainable and inclusive economic development that emphasizes self-revenue-generating capacities (Coonrod, 2014).
TABLE 12.2 Differences between SDGs and MDGs
MDGs
SDGs
1 The MDGs are made up of eight 1 The SDGs include 17 goals, 169 targets, and
304 indicators to measure compliance.
goals, 21 targets, and 63 indicators.
2 The SDGs came about through extensive
2 The MDGs came about largely
worldwide grass root consultation
through a top-down approach.
3 The MDGs targets were such that 3 The SDGs aim at full accomplishment,
thus setting zero-based goals (reaching the
accomplishing at least half the
statistical zero on the targets like poverty,
targets was acceptable.
hunger, and child and maternal mortality).
4 The SDGs employ a more integrative
4 The MDGs addressed each of
approach (all the 17 SDGs are interconnected,
the goals in isolation.
thus success in one would lead to success in
others).
5 The SDGs cuts across every single country in
5 The MDGs’ main focus was on
the world, emphasizing that no one should
developed countries’ granting
be left behind. Thus, it looks at poverty
aid to developing countries
eradication in every country in the world.
through ODA.
6 In the MDGs, hunger and poverty 6 The SDGs address this shortcoming by
treating hunger and poverty as separate
were lumped together, making
issues.
it look like solving one would
automatically solve the other.
7 With the SDGs, sustainable and inclusive
7 The MDGs were anticipated
economic development was put at the forefront
to be funded by aid from
of the goals so that countries could improve
developed countries, but that
their self-revenue-generating capacities.
proved a challenge.
Chapter 12 • Financing sustainable development 325
In sum, the SDGs are universal zero goals, aimed at achieving the
unmet MDGs and more. The processes that led to the fnalization of the
SDGs were more consultative and inclusive, involving broad consultations with a cross-section of civil society and grassroots organizations. This
resulted in a more broad-based set of goals and targets. One important
aspect in which the MDGs differ from the SDGs is that in terms of funding, the former placed greater emphasis on aid from advanced countries
to developing economies, while the latter makes no such explicit expectation of donor funding but emphasizes inclusive growth through improving
revenue-generating capacities to ensure sustainability.
12.3 CHALLENGES OF FINANCING SUSTAINABLE
DEVELOPMENT
The Rio de Janerio conference highlighted a wide range of interlinked challenges that call for priority attention. These challenges include decent jobs,
energy, sustainable cities, food security and sustainable agriculture, clean
water, clean oceans, and disaster readiness. Among these challenges, the
Department of Economic and Social Affairs (DESA, 2013) under the United
Nations, conducted a survey on the challenges of sustainable developments
and highlighted four of these areas:
1
2
3
4
Sustainable cities.
Food security, nutrition, and sustainable agriculture.
Energy sustainability.
Decent jobs.
12.3.1 Sustainable cities
The world’s urban population continues to grow partly because of new
opportunities that urbanization presents to millions of people who live
in urban communities. This has contributed partly to the eradication of
extreme poverty among rural and urban people. Despite the immense contributions (e.g. access to safe drinking water, jobs, health) that urbanization brings to people, it has also contributed greatly to the world’s urban
problems, such as increased pressure on existing resources and increased
demand for essential goods such as energy, water, sanitation, public services, education, and healthcare (Polèse, 2009; Satterthwaite, 1992). More
than half of the world’s population have lived in urban areas since 2007, and
it is estimated that this proportion will reach 70% by 2050 and will account
for 80% of those living in the developing world, especially cities in Africa
and Asia. For instance, 1.3 billion people were added to small cities in the
world for the period 1950–2010, which has been estimated to be more than
double the 632 million people who were added to medium cities or the 570
million added to large cities (DESA, 2013).
The rise in population growth calls for urgent policy initiatives, especially for developing countries, to help address this challenge within the next
15–20 years. Most developing countries will need additional resources to be
able to contain the rapid urbanization that they are experiencing now. The
rapid mobility of people from the rural areas to seek better opportunities in
326 Gordon Abekah-Nkrumah et al.
urban cities, especially in developing countries, is increasingly becoming
a serious issue of concern. Most of these movements contribute to slums,
pressure on energy resources, public transport, education, healthcare, water
and heavy sanitation challenges, and more recently climate change problems, which put serious pressure on the adaptive capacity of the poor in
urban areas.
Financing cities requires taking a multifaceted approach that involves
a mixture of several fnancing mechanisms. This concerns raising money
from capital markets, such as issuing municipal bonds, bank bonds (without central government support), green bonds, and offcial development
assistance. In this regard, local, and national authorities need a close partnership in order to raise sustainable fnance for the development of their
cities. Cities in most developed countries have the capacity to raise municipal bonds directly from the capital market and loans from banks, unlike
poor countries, where these mechanisms are limited. Poor countries need
international support and resources to be able to support green technology
adaptation and capacity development. They also need both technical and
fnancial support to provide effcient public transportation, housing, water
and sanitation, electricity, healthcare, and education. Investments in infrastructure require upfront fnance, the beneft of which will only be reaped
in the medium to long term. Rich cities need to enact policies that encourage
renewable energy and reduce ineffciency and wasteful consumption. To
achieve this, regulatory strategies must be put in place to support the determination of the pricing structures, taxes, and subsides for both household
and industries for development.
12.3.2 Food security and nutrition
A strong and healthy workforce is needed to drive the socioeconomic
progress of the world, more particularly progress in poorer nations.
Nutritious food is needed to ensure that people are healthy and work
towards their development. It is against this background that governments of developing countries see it as a major priority to fnance food
security and nutrition, since developing countries are mostly affected by
food insecurity.
Since 1970, about one billion people in the world have been affected by
basic food insecurity (DESA, 2013). However, there has been an improvement among people who are undernourished. The proportion of people
who were under nourished in 1990–1992 were 20%, and this has declined
to 15% in 2008–2010. Among those most affected with food insecurity
were from sub-Saharan Africa and South Asia. This negatively affected the
region’s ability to meet the 2015 deadline for the MDGs. Additionally, there
is low diversity in the available food and low quality in food. This makes the
challenge of malnutrition even broader than the issue of hunger and undernourishment. In 2013, it was estimated that more than 2.8 million adults die
each year as a result of obesity and overweight, partly because of the high
consumption of calories by adults in both developing and developed countries (DESA, 2013).
Chapter 12 • Financing sustainable development 327
It is also estimated that food production will have to increase by 70%
globally in order to feed an additional 2.3 billion people by 2050. To meet
this target, investment in agriculture needs to increase in order to boost livestock and diary production, cereals, and fruits and vegetables, among others. This will put a lot of pressure on land, water, and biodiversity resources.
Additionally, resource constraints pose a signifcant challenge to meeting
the ever-increasing demand for food. Currently, greenhouse gas emissions
arising from agricultural practices are reducing soil fertility and leading to
water pollution. There is also the problem of climate change arising from
the volatility of weather patterns, thereby affecting crop yields and income
levels from agricultural produce.
Economically, disadvantaged people are mostly affected as a result
of an increase in land used for biofuels. This constrains the supply of food
products, which can lead to price hikes. In addition, demand for land for
housing as a result of urbanization accelerates the diversion of land meant
for agricultural purposes to urban use. To address this challenge, there is
the need to enhance social safety net policies targeted at rural development,
and strategic development plans need to reach out to disadvantaged and
marginalized households. These social safety nets will empower the most
vulnerable against short-term economic shocks and enhance long-term
resilience through the facilitation of smallholders’ access to food, help them
manage risk, and adopt new technologies to increase food production.
Finally, food waste is a serious challenge. It is estimated that, globally,
32% of food produced is wasted. We can have a sustainable food system
only if we are able to reduce food waste. This implies the need for a strong
policy framework to help address food waste if we intend to improve food
security.
12.3.3 Energy transformation
Energy transformation should be a core element of the sustainable development goals in order to improve living standards. To ensure that the environment is clean, there has been a global move to focus more attention on
renewable energy rather than on fossil fuels, which tends to pollute the
environment. Recent estimates confrm that emission trends will lead to
temperature increases with potential catastrophic consequences. Researchers have argued that even if more emission- mitigating policies were implemented, including expansion in the use of renewable energy sources and
improvement in energy effciency, a stabilization of greenhouse gas emissions at 450 parts per million (ppm) will not be achieved by 2050.
The OECD (2012c) projected that emission concentrations might reach
between 650 and 700 ppm of carbon dioxide equivalent (CO2e) by 2050 and
between 800 and 1,300 ppm of CO2e by 2100. This will lead to an increase
in the global average temperature of 2°C–3°C by 2050 and 3.7°C–5.6°C by
2100. Due to this increase, multiple pathways towards sustainable energy
have been identifed. The world can follow a large number of energy
pathways towards sustainable development, which require ambitious
policies, improved international cooperation, improved implementation,
328 Gordon Abekah-Nkrumah et al.
behavioural changes, and unprecedented levels of investment. The scenario
results indicate that, in the absence of additional targeted pro-poor energy
policies, by 2030, some 2.4 billion people will still rely on solid fuels for cooking. The implementation of highly ambitious policies in order to address the
energy–poverty nexus has the potential to ensure access to modern energy
for an additional 1.9 billion people.
There is the need for good fnancing vehicles to be put in place to cover
the upfront costs of enabling access to modern energy and purchase of appliances with a 50% fuel subsidy in relation to market prices. With this effort,
there are still over 500 million people without access to modern energy in
which most of these people are found in rural Africa and remote areas. This
means that there is the need for concerted efforts from national, bilateral,
and multilateral sources to fnance clean and affordable energy for all.
12.3.4 Decent jobs
Unemployment is a serious threat to global peace. Globally, the world’s
population consists of a signifcant share of young people, and the lack of
decent jobs for them can be challenging. Currently, there are over 1.2 billion
young people in the world and the majority of them are found in developing countries. The share of the working population in developing countries
is beginning to rise as a result of a lower fertility rate and increased longevity. As the working population is rising, developing countries, for instance,
need to put in place proactive measures to create decent and productive jobs
for the growing population. According to the International Labour Organization (ILO) statistics, there are about 74 million unemployed youth in the
world and some who are even underemployed. Most young people living
in developing countries are often underemployed or work in the informal
sector.
According to the ILO, in several low-income and middle-income
countries, nearly half of youth in developing countries are not achieving
their full economic potential, which is a further hindrance to development
in those countries. The ILO not only considered standard labour market
indicators in its analysis but went further to include issues such as irregular
employment and underutilization, job quality and satisfaction, and the transition of young people into the labour market.
These are the conditions that force the majority of the youth in developing countries out of their homes. This means developing countries need
to explore all options available to create decent jobs. This can be done
through a balanced policy agenda: upgrading skills for better employment,
an increase in productive investment, and increased access to fnance. With
respect to upgrading skills, the right training and educational investments
need to be undertaken, and this can help youth match their skills with the
requirements of the job market. Strong relationships between academia and
industry can be explored to improve skills acquisition by students. Finally,
developing countries need to deploy macroeconomic and growth-inducing policies that encourage economic diversifcations and development of
the various sectors of the economy for the purposes of job creation. Also,
Chapter 12 • Financing sustainable development 329
governments should provide a window of opportunity for youth by providing and guaranteeing loan facilities for young people who have better
business ideas to boost entrepreneurship.
12.3.5 Other fnancing challenges
In spite of the key challenges identifed and the progress made so far,
enormous challenges still remain in terms of raising the necessary funds
from identifed sources and other innovative sources to fnance sustainable
development. Some of these challenges include tax systems, weak fnancial
systems, confict between proft and sustainable development, lifestyles,
and human attitudes.
Developing countries are those most affected by unsustainable development practices. They are generally said to have weak tax systems, and even
those with relatively strong tax laws do not have the capacity to enforce
them. As a result, tax contributes a small portion of total revenues relative
to developed countries. For instance, tax revenue in developing countries
on average makes up only 17% of GDP, compared to more than 30% in
developed countries. This heavily undermines the ability of countries to
raise the necessary domestic revenue to meet the fnancing needs of sustainable development. Corruption has a negative and adverse effect on revenue
mobilization. This is due to poor fnancial management. Generally, developing countries have weak fnancial management systems, and this situation
allows for seepages. Therefore, funds that should go into fnancing sustainable development end up in private pockets. Similarly, procurement systems
are also weak, and this makes for a safe haven for the siphoning of public
resources for private gain. Unless these gaps are sealed, developing countries will continue to rely on the insuffcient external and private funding to
meet their nationally framed SDGs and other developmental projects.
To meet the fnancing needs of the sustainable development goals,
governments will have to optimize the use of funds from all sources, including public, private, and international. At the domestic level, however, the
inherent confict between public fnance and private fnance affects the ability
of governments to leverage private capital for sustainable development.
While private fnance gravitates towards proft with a focus on risk and
return, public fnance is concerned with the provision of public goods and
investments with a long-term horizon. The capacity to reconcile private
interest with public appeal is lacking in developing countries. Therefore,
the potential of private fnance for public interest in many developing countries remains untapped. And many developing countries may not be able to
maximize the synergies of different sources of fnance to meet the demands
of sustainable development.
Unsustainable consumption and production patterns are rapidly undermining the ability of countries to raise the needed fnancing to meet the
targets set by SDGs. The effort to mobilize resources must be complemented
by sustainable lifestyles, especially in the developed world. As long as the
problem keeps escalating, resources will never be adequate to address
them. It will be like ‘fetching water with a basket’: for every dollar made, a
330 Gordon Abekah-Nkrumah et al.
dollar or half a dollar in fresh damage is caused. In developed countries,
the per capita greenhouse gas emissions are 20 to 40 times greater than
what is needed to stabilize the atmospheric greenhouse gas concentration
(IFC, 2015). This unsustainable lifestyle, which evolved in the developed
world, is increasingly being emulated by high-income households in the
developing world. There is the need to have comprehensive regulation that
discourages unsustainable lifestyles that threaten to reverse any progress
made on the SDGs.
12.4 BENEFITS OF FINANCING SUSTAINABLE
DEVELOPMENT
Sustainable development fnance comes with many benefts to nations and
the world as a whole. In this section, we discuss a number of benefts of
fnancing sustainable development.
Synergy in fnancing sources helps with raising funds from multiple
sources in both developing and developed countries. Funds for sustainable
development are raised from many sources, including private, government,
and international bodies. Investments in renewable energy, biodiversity and
the ecosystem, green bonds, and education and health have increased astronomically over the years. For instance, the Frankfurt School-UNEP (2018)
report noted that investment in renewable energy has continued to increase
each year since 2004; the world has invested USD2.9 trillion in green energy
sources; and the investment was largely driven by developing countries.
Again, the funding sources used for these areas had backward and forward
linkages for other sectors of the economy.
Well-fnanced sustainable development through funds generated for
a green economy helps to reduce greenhouse gas emissions. The best way
to address climate change is to drastically reduce greenhouse gas emissions
such as methane and carbon dioxide. Money that is charged through a carbon tax and issuances of green bonds can be used to fnance the reduction
in greenhouse gas emissions.
Another beneft of synergy in fnancing sources is economic growth.
Sustainable development supports current and future generations, so mechanisms put in place to fnance it must be driven by growth. Investing in
sustainable cities helps to improve the infrastructure of those cities, which
in turn improves the economic activities of those countries and facilitates
economic growth. Additionally, renewable energy investment is a sure way
to provide clean energy sources for industrial and economic growth. When
energy is made clean and reliable and when factories are able to have a constant supply of energy, output increases.
Financing sustainable development will help to improve the employment fortunes of Africa’s youth and women. In addition, 80% of employment
in Africa is driven by the natural resource–based sectors, such as agriculture, mineral resources, forestry, and fsheries. Similarly, the tourism industry in Africa employs over 6.3 million people, and this sector also relies
primarily on the continent’s natural and cultural wealth (World Travel &
Tourism Council, 2009). All these sectors need support in enhancing the
Chapter 12 • Financing sustainable development 331
green economy, which will create sustainable jobs and improve people’s
livelihood. Therefore, sustainable development fnancing from private and
public sources can help to create much-needed jobs.
Another beneft of fnancing sustainable development is to ensure
that there is food security for all. Financing food security to reduce postharvest losses will help to reduce the over 33%–35% malnourished population in Africa. Funding issues of environmental degradation, poor soil and
water management will rapidly improve crop yield of farmers and help to
make quality food available. Also, forest conservation through fnancing
to replace falling trees and controlling illegal logging and overgrazing will
help to make food growth in those areas more secure for human consumption. This means that climate change fnancing is important for the African
continent.
12.5 SOURCES OF FINANCING SUSTAINABLE
DEVELOPMENT
In this section, we discuss the various sources available for fnancing sustainable development. Here, we focus on environmental fnance, private
sector fnance, and innovative sources of fnancing sustainable development. These fnancing mechanisms are important in addressing the challenges raised in section 12.3.
12.5.1 Environmental fnance
The environment is an important dimension when it comes to addressing
the sustainable development goals. Thus, environmental fnance is critical
for the success of the SDGs. Some of the environmental issues are climate
change, biodiversity and the ecosystem, and renewable energy. The sources
of fnance required to address these environmental issues are important.
Environmental fnance is concerned with the impact of environmental
issues on fnancing decisions. There are a number of ways that the environment can be fnanced. These include climate fnance, fnance for biodiversity and the ecosystem, renewable energy fnance, and green fnance. We
discuss them in turn.
Climate change is one of the key issues to be
considered when it comes to meeting the sustainable development goals.
This is because anthropogenic climate change presents an unprecedented
challenge to the well-being of humans and threatens economic growth in
both rich countries and poor countries. To tackle climate change problems,
long-term private and public investments are required. Therefore, climate
fnance covers a wide range of investment vehicles that are required to reduce
excessive greenhouse gas emissions. To this end, there is a clear difference
between development fnance and climate fnance. While development
fnance provides resources for global public goods and public investments
that cannot be fnanced by the poorest countries, climate fnance focuses
mainly on greenhouse gas emissions. Progress has been made regarding
12.5.1.1 CLIMATE FINANCE
332 Gordon Abekah-Nkrumah et al.
donor partners’ pledge for climate fnance. At the Copenhagen Conferences of Parties (COP) 15, the developed countries agreed to commit USD30
billion as a fast start programme for 2010–2012 and committed to provide
USD100 billion annually by 2020 to fnance climate change mitigation.
Schmidt-Traub and Sachs (2015) argued that to properly fnance climate change mitigation, investment in the following areas is required:
• Infrastructure – low-carbon energy and transmission, effcient buildings, low-carbon industrial plants, sea walls to protect against rising sea
levels, climate-resilient cities, and water management infrastructure.
• Agriculture – low-carbon agriculture and animal husbandry, droughtresistant farming practices and infrastructure, improved water management infrastructure, soil-erosion control, climate-resilient livestock
management practices, and improved food storage facilities.
• Biodiversity and ecosystem services – improved monitoring systems,
reduced deforestation, and integrated water resource management.
• Research, development, demonstration, and deployment (RDD&D) –
providing climate-resilient technologies for energy, agriculture, water
management, and healthcare; providing cutting-edged research to
identify new ideas in energy technology, water resource management,
agriculture and health, particularly for Africa.
On such investment, the success story of Woodlot management in Tanzania
can provide great lessons. See Box 12.2 for the story.
BOX 12.2 African success stories: Woodlot management for
climate change adaptation in Tanzania
In the Makete District of the United Republic of Tanzania, forest, woodland, and grassland resources are essential to the local economies. They
also play a crucial role in protecting the watersheds that are vital for the
conservation of the environment for agriculture and livestock production. Tanzanian authorities and local communities, working together
and sustained by international support, have improved smallholder
livelihoods through woodlots management practices as a strategy for
climate change adaptation while creating a new stream of income for
local communities and revenues for the city. Following an assessment
of smallholder woodlot management practices and the marketing of
timber, user groups were assisted in developing their own woodlot
operational plans and harvesting rules, in setting rates and prices for
products, and in determining how surplus income would be distributed or spent. This produced signifcant improvements in the conservation of woodlots in area and density and helped enhance soil and water
management.
This improved knowledge has allowed producers to increase
their incomes, and it has enabled the Makete District government to
achieve a 64% increase in council revenue for 2009/2010, following the
Chapter 12 • Financing sustainable development 333
collection of royalties from timber sales. The creation of new sources of
income triggered the setting up of community savings and credit societies that provide fnancial credits to low-income earners, using their
woodlots as sources of collateral. This has promoted inclusive growth,
enhanced the number of savings and credit operations among members, and enabled the provision of loans to fnance income-generating
activities. What is more, the concrete evidence of these benefts has
increased the national government’s interest in expanding climatechange-adaptation measures that improve rural livelihoods and the
economy as a whole.
Source: UNEP/UNDP Climate Change Adaptation and Development Initiative (CC
DARE) – ccdare.org and United Nation (2012)
Biodiversity and its
associated ecosystem provide a wide range of services to society that underpin human health, well-being, and economic growth. The OECD (2013) projected a 10% loss in biodiversity by 2050. The OECD (2013) identifed six
innovative fnancing mechanisms capable of mitigating these losses:
12.5.1.2 BIODIVERSITY AND ECOSYSTEM FINANCING
• Environmental fscal reforms involve shifting the tax burden from a
desirable economic activity onto activities that entail negative environmental externalities. They involve taxation that can broaden fscal
revenue while working towards meeting environmental goals. These
include taxes charged on natural resources, pollution, and rents that
are harmful to the environment. Some of the taxes recently charged
include taxes on pesticides, fertilizers, and other sources of emissions
(such as NOX, SO2, and CO2 emissions); natural resource extraction;
wastewater discharges; and entrance fees to natural parks.
• Payments for ecosystem services (PESs) are voluntary programmes
that provide incentives to enhance the provision of ecosystem services. PESs provide compensations for individuals and communities
whose land use or other resource management decisions infuence the
provision of ecosystem services for the additional cost of providing
these services. Globally, more than three hundred programmes have
been implemented on PESs. Out of this number, about fve PES programmes channel more than USD6 billion per annum.
• Biodiversity offsets are instruments designed to allow for the continuation of project development that is found in an overall objective of no
net loss of biodiversity. This is done in order to offset or compensate
for signifcant adverse effects arising from biodiversity impacts from
projects that have been undertaken. This is expected to be carried out
at the fnal stage of environmental impact mitigation.
• Markets for green products are fnancing sources developed for the
sustainable use of biodiversity and the ecosystem (ecotourism and
bio-trade). This means that goods have to be produced in a way that
334 Gordon Abekah-Nkrumah et al.
has a low impact on biodiversity – for instance, timber produced from
reduced-impact logging and goods, whose environmental impact is
low as a result of reduced pollution load (biodegradable). The idea
is that some consumers may decide to buy and even pay premiums
to companies that have green products, and this will push such companies and many others to adopt sustainable production methods. In
recent times, markets for such products have witnessed considerable
growth.
• Biodiversity in climate change funding emphasizes how to leverage
biodiversity benefts, with huge amounts of funding fowing to climate change mitigation and adaptation. Policymakers can harness
mechanisms for reducing emission for deforestation and degradation
as well as ecosystem-based adaptations.
• Biodiversity in international development fnance provides policymakers with the opportunity to harness synergies and better
mainstream biodiversity in broader development objectives. When
policymakers are able to brainstorm and provide quality solutions
to improve fnance for biodiversity management and conservation, it
will contribute more broadly to SDGs, which are crucial to reducing
poverty and protecting rural livelihoods.
Renewable energy is energy derived
from resources that are continually replenished, such as wind, solar energy,
and tides. Renewable energy fnance is capital intensive and thus risky for
many investors to venture into its production and supply. Because electricity is not generated and stored, its production must be matched by corresponding demand. Most countries or electricity generators use renewable
energy sources only in periods of peak demand. Globally, countries are
moving from subsidy regimes in both fossil fuels and renewable energy to
auctions where the market is allowed to interact with supply and demand
forces. Also, corporate bodies wishing to buy green electricity have various
options, including installing photovoltaic (PV) panels on their warehouses
roofs or in some countries buying renewable energy certifcates, thereby
boosting revenues for clean energy plants. According to Frankfurt SchoolUNEP Centre (2017, pp. 33–41), a number of fnancing options are available
for renewable energy:
12.5.1.3 RENEWAL ENERGY FINANCE
• Utility-scale renewable power projects are usually fnanced either on
balance sheet by a utility, energy company, or large developer or with
a mixture of equity and debt provided directly to the project itself.
• Institutional investors have become key sources of equity fnance for
projects, particularly in recent times, such as by using direct investment by institution in project equity and indirect investment through
a pooled vehicle such as a yieldco. For instance, the direct investment
institutions such as pension funds and insurance companies have
invested an estimated of USD2.8 billion in European renewable energy
projects in 2016. Africa and other developing countries provide huge
opportunities for renewable energy investment since the population is
Chapter 12 • Financing sustainable development 335
expanding and many more people are drifting towards lower-middleincome status. Investors in renewable energy should take advantage
of this development and invest in developing countries. A success
story of energy feed-in tariffs in Kenya is illustrated in Box 12.3. This
is another story of the energy investment potential in Africa.
• Debt consists of the majority of the capital required for renewable
energy projects that are funded through project fnance. In developed markets, the project debt level is about 75% to 80% of the cost
of an onshore wind installation, and the remainder is through equity
fnance. Similarly, a solar project may meet the same debt proportion,
while biomass and offshore wind projects will typically get less (i.e.
65% to 70% debt) because of the higher perceived risk.
BOX 12.3 African success stories
Renewable energy feed-in tariffs in Kenya
Kenya adopted a renewable energy feed-in tariff (REFIT) in 2008, a
policy it revised in January 2010. The REFIT aims to stimulate market
penetration for renewable energy technologies by making it mandatory
for energy companies or utilities to purchase electricity from renewable
energy sources at a predetermined price. This price is set at a level high
enough to stimulate new investment in the renewable sector. This in
turn ensures that those who produce electricity from renewable energy
sources have a guaranteed market and an attractive return on investment. Aspects of a REFIT include access to the grid, long-term power
purchase agreements, and a set price per kilowatt-hour (kWh). Kenya
REFIT covers electricity generated from wind, biomass, small hydro,
geothermal, solar, and biogas, with a total electricity generation capacity of 1,300 MW.
This policy has the following advantages:
1 It ensures environmental integrity, including the reduction of
greenhouse gas emissions.
2 It enhances energy supply security, reducing the country’s dependence on imported fuels and helping it cope with the global scarcity
of fossil fuels and its attendant price volatility.
3 It improves economic competitiveness and creates jobs.
As Kenya’s greatest renewable energy potential is in rural areas, the
effects of the feed-in tariff policy are expected to trickle down and stimulate rural employment. Additional investments could be attracted
towards renewable energy in Kenya if the feed-in tariff policy in Kenya
acquired a more solid legal status (AFREPEN/WP, 2009).
For more information, visit www.unep.org/greeneconomy/
SuccessStories/FeedintariffsinKenya/tabid/29864/Default.aspx.
336 Gordon Abekah-Nkrumah et al.
Loans for solar water heaters in Tunisia
The solar water heater market in Tunisia showed a dramatic increase
when low interest loans were made available to householders, with
repayments collected through regular utility bills. This reduced the risk
for local banks while showing borrowers the impact of solar heating
on their electricity bills. Prosol – a joint initiative of Tunisia National
Agency for Energy Conservation, UNEP, and the Italian Ministry for the
Environment, Land and Sea – has helped more than 105,000 Tunisian
families get their hot water from the sun, based on loans of over USD60
million, a substantial leverage on Prosol’s initial USD2.5 million cost.
Its success has led the Tunisian government to set an ambitious target
of 750,000 m2 of solar panels for 2010–2014, a goal that represented solar
coverage comparable to that in Spain or Italy, countries with populations several times larger than Tunisia’s. Many jobs have been created,
as 42 suppliers and more than a thousand installation companies have
sprung up to service the solar market. The tourism and industry sectors
are also involved, with 47 hotels engaged as of late 2009, and there are
plans to encourage the industry sector to make greater use of the sun’s
energy. A project is underway to make photovoltaic energy available
to a further ffteen thousand households through a similar loan and
repayment scheme.
For more information, visit www.unep.org/unite/30ways/
story.aspx?storyID=49.
Source: United Nation (2012)
12.5.1.4 GREEN BONDS Green bonds are differentiated from regular bonds
by their label, which signifes a commitment to use the fund exclusively
to fnance projects, assets, or business activities (ICMA, 2015). Therefore, a
green bond is a bond that is issued for fnancing green infrastructure and for
green investments. According to the OECD (2017) and Inderst, Kaminker,
and Stewart (2012), a green infrastructure system can be considered low carbon and climate resilient (LCR). The green bond market is rapidly growing,
with an annual issuance of green bond tripled from USD11 billion in 2013
to reach USD36.6 billion as of 2014. According to the OECD (2017), green
bonds are categorised into six distinct forms that can be issued by different
entities:
• Corporate bond – a ‘use of proceeds’ bond issued by a corporate
entity with recourse to the issuer in the case of default on interest payments or on return of principal. This category includes bonds issued
by ‘yieldco’ vehicles (an investment vehicle formed by a parent company to own operating assets). They are known as synthetic Master
limited partnerships (MLPs). Yieldco vehicles pay corporate-level
taxes, unlike MLPs, which get a tax pass to fnance asset acquisitions.
Chapter 12 • Financing sustainable development 337
•
•
•
•
•
Yieldco vehicles are often issued in the energy sector to raise more
funds to fnance renewable energy activities.
Project bond – a bond backed by single project or multiple projects for
which the investor has direct exposure to the risk of the project, with
or without recourse to the bond issuer.
Asset-backed security (ABS) – a bond collateralised by one or more
specifc projects, usually providing recourse only to the assets, except
in the case of covered bonds (included in this category). For covered
bonds, the primary recourse is to the issuing entity, with secondary
recourse to an underlying cover pool of assets, in the event that the
issuer defaults.
Supranational, subsovereign, and agency (SSA) bond – a bond
issued by international fnancial institutions (IFIs) such as the World
Bank or the European Investment Bank (i.e. ‘supranational issuers’).
SSA bonds have features similar to a corporate bond relating to ‘use
of proceeds’ and recourse to the issuer. Agency bonds are included in
this category (e.g. issuance by export-import banks), as are subsovereign national development banks (e.g. the German KfW).
Municipal bond – a bond issued by a municipal government, region,
or city. A national government entity could theoretically also issue a
‘sovereign’ bond; no green sovereign bonds have been issued to date.
Financial sector bond – a type of corporate bond issued by a fnancial institution specifcally to raise capital to fnance on-balance sheet
lending (i.e. to provide loans) for green activities (e.g. ABN AMRO or
Agricultural Bank of China).
12.5.2 Private sector fnance
Private sector fnance is the type of fnance obtained from private sector
sources of fnance. These fnancing sources are drawn and used to fnance
development projects, and they include responsible private fnance and
blended fnance.
PRIVATE FINANCE The essence of responsible
fnance is to outline standards to ensure that lending and investments
actively deliver positive development outcomes. In a responsible fnance,
there are three key primary actors that work together to ensure that responsible fnance is achieved in any economy. These include the government,
which provides consumer protection and regulation; fnancial intermediaries; and clients themselves, who need to possess a certain degree of fnancial
literacy. The Great Recession of the 1930s and the recent global fnancial
crises of 2008–2009 left lasting scars on the global fnancial system and have
had protracted impacts on the poor across the world. Financial infows to
developing countries are increasing, as are the outfows. This calls for urgent
attention that needs the work of the government, fnancial intermediaries,
and clients as a whole. For instance, fnancial infows from developing countries for responsible fnance include net FDI to developing countries, new
loans to developing countries, developing countries migrant remittances,
12.5.2.1 RESPONSIBLE
338 Gordon Abekah-Nkrumah et al.
and global ODA. Also, outfows include developing countries debt service,
proft remittances on FDI, and illicit fnancial fows (Molina, 2011).
Blended fnance is one of the complementary
tools used by the International Finance Corporation (IFC) to create markets and foster development impact. According to the IFC (2017), ‘blended
fnance refers to a fnancing package comprised of concessional funding
provided by the development partners and commercial funding provided
by IFC and co-investors’. These types of funding are provided for projects
with a high-impact factor, especially to society, the environment, and the
ecosystem. This is because such projects do not attract funding on a commercial basis, given that the returns from these projects are not commensurate with the level of risk. Since development projects need different funds
at various stages of their completion, it is prudent to use blended fnance to
avoid the risk of delay in fnancing the projects. The IFC uses a number of
fnancial instruments for blended fnance. These include risk mitigations/
guarantees, concessional debt (senior and mezzanine), equity (direct investments and private equity), and performance-based incentives. The IFC
(2017) had earmarked four priority areas for blended fnance, which follow:
12.5.2.2 BLENDED FINANCE
• The Global Agriculture and Food Security Program (GAFSP) is a
private sector window that targets countries with the highest rates of
poverty and hunger. The essence of this programme is to provide support in the form of short-term and long-term loans, credit guarantees,
and equity to support smallholder farmers and small and medium
enterprises (SME) farmers so as to enhance productivity growth, create, and deepen links in the market space and increase the capacity
and technical skills of these business owners.
• Blended climate fnance includes investment in renewable energy,
energy effciency, climate-smart agriculture, clean technology, and
adaptation that would otherwise not be funded by the private sector.
The private sector will view this kind of investment as too risky to venture into. The concessional fnancing vehicle paves the way for fnancing on complete commercial terms because the viability of these projects
will make it a proftable venture for the private sector to engage in.
• The Global SME Finance Facility supports SMEs that are women
based. They include SMEs from fragile and confict areas, those in
education and healthcare and companies that are located in the rural
markets. IFC uses blended fnancing to increase access to fnance for
marginalized businesses in the form of loan guaranteeing as well as
deepening fnancial intermediation in those markets.
• The IDA 18 IFC-MIGA Private Sector Window (IDA-PSW) is a new
fnancing tool used for crowding in private sector investment in the
lowest-income, post-confict, and fragile states that do not have a commercial solution or where no other IFC or MIGA tool can be used.
For instance, an allocation of USD2.5 billion from World Bank support
will enable private sectors working with IFC or MIGA to take risks at
a level that is commensurate with returns to promote sustainability. A
three-year pilot has been earmarked that started 1 July 2017 and goes
Chapter 12 • Financing sustainable development 339
until July 2020. The aim is to increase private sector capital investments in large-scale infrastructure and public–private partnerships
and across all sectors, such as manufacturing, education and health,
SMEs, climate fnance, and technology. The fnancial instruments
used include loans, equity, guarantees, and local currency solutions.
12.5.3 Innovative sources of fnance for sustainable
development
Apart from the various sources discussed, there are different innovative
sources of fnancing sustainable development. These include international
fnance facility, IMF special drawings rights, global lottery, and global taxes.
International fnance facility (IFF) was frst proposed by the Her Majesty’s Treasury (HM Treasury),
also referred to as the exchequer, in conjunction with the Department for
International Development of the UK. IFF was designed to frontload aid to
help MDGs. In this facility, bonds were issued to the global capital markets
against the security of government guarantees in order to maintain future
aid fows, which will be used to buy back the bonds over a long period of
time. This idea was used by France and other European countries in 2006
to fnance immunization in the International Finance Facility for Immunization (IFFm). It was initiated to rapidly accelerate the availability and
predictability of funds for immunization. The IFFIm sells bonds, offcially
called the vaccine bonds, to raise funds on the capital markets for the GAVI
Alliance, a public–private partnership, which works to save children’s lives
and protect people’s health by increasing access to vaccination in developing countries. Box 12.4 describes the detailed information regarding how
GAVI raises funds through the use of IFFIm.
12.5.3.1 INTERNATIONAL FINANCE FACILITY
BOX 12.4 GAVI Vaccine Alliance IFFIm
GAVI, the Vaccine Alliance, fnances vaccine programmes in low-income
countries. In 2006, GAVI recognized that to reach high vaccine coverage
levels as soon as possible, signifcantly more funds were needed than
were available. In response, the British Department for International
Development, the Gates Foundation, United Nations Children’s Fund,
and the fnancial services industry created the independent charity, the
International Finance Facility for Immunization (IFFIm).
Between 2000 and 2015, two-thirds of GAVI’s funding (i.e. USD11.6
billion), came from donations by governments. Every fve years, governments pledged to donate a certain amount and then make regular
payments to GAVI. IFFIm enables governments to make a legally binding long-term commitment to IFFIm – for example, an annual payment
of USD20 million for 20 years, instead of donating directly to GAVI.
Next, IFFIm creates bonds – that is, a type of long-term loan to the
value of the total amount committed by governments (in this example,
340 Gordon Abekah-Nkrumah et al.
USD400 million). International investors then buy these bonds, thus
immediately providing IFFIm with USD400 million. GAVI will have
access to these funds by applying to IFFIm. IFFIm pays back bondholders over time with the annual payments from the governments.
The proposed beneft of IFFIm was to make the money from future
donations available immediately, so that vaccine programmes could be
scaled up to reach the goal of herd immunity earlier. However, there
are two costs involved in this fnancing mechanism. First, the administration costs of IFFIm have been estimated at between 4.1% and 4.6% of
the pledged amount over the 20-year duration of the current commitments. Between 2010 and 2014, these costs averaged USD115 million
per year, the World Bank acting as treasury manager. The second cost
is the payment of interest to bondholders, which is diffcult to calculate
because it depends on currency and market conditions.
Between 2006 and 2014, IFFIm has received in total USD6.5 billion of long-term commitments from ten donor governments and has
raised USD5 billion for GAVI through selling bonds (the difference of
USD1.5 billion is held by IFFIm to reduce fnancial risk). Thus, IFFIm
has provided around a third of GAVI’s funding to date. GAVI also
receives funding (USD1.5 billion) from the advanced market commitment, which was an agreement by GAVI donors to pay for the creation
of a new pneumococcal vaccine.
In the January 2015 pledging event to secure funds for GAVI for
2016–2020, GAVI requested USD1 billion to be committed through
IFFIm. However, only USD252 million in new commitments were
made by France and the Netherlands. In contrast, GAVI received all
the USD7.5 billion that it had requested, through direct donations.
The change in funding profle compared to the last round reduction
of funds pledged through IFFIm has been described by credit ratings
agencies as a result of the diminishing policy importance of IFFIm for
the future fnancing of GAVI’s immunization programmes.
Source: Crocker-Buque and Mounier-Jack (2016)
12.5.3.2 IMF SPECIAL DRAWING RIGHTS Special drawing rights (SDRs)
are international reserve assets created by the IMF in 1969 to supplement
its member countries’ offcial reserves. In other words, it is like a global
currency maintained by the IMF. As of September 2017, 204.2 billion SDRs
(equivalent to about USD291 billion) had been created and allocated to
members (IMF, 2017). SDRs can be exchanged for freely usable currencies. The value of the SDR is based on a basket of fve major currencies:
the US dollar, the euro, the Chinese renminbi (RMB), the Japanese yen, and
the British pound sterling (IMF, 2017). The IMF borrows money at 0.05%
from member countries and lends at 1.05% to member countries that need
the funds. Since the IMF accumulates the funds through the interest payments, a special account can be created from this fund to support fnancing
Chapter 12 • Financing sustainable development 341
sustainable development goals. Countries normally leverage on SDR for
the purpose of export so that they can help their export partner countries’
currencies appreciate by buying a corresponding amount of SDR in their
currency. This helps their exporters receive a good deal for their export
commodities. The IMF can charge extra fees on this kind of arrangement to
support sustainable development fnance. Additionally, developing countries are the countries that most suffer climate change problems. SDRs will
serve as a lower cost reserve for them. The gain could be used to fnance
sustainable development, because countries would not have to borrow from
other countries or the international fnancial markets at a higher cost so as
to shore up their reserves. Furthermore, developed countries could take the
SDRs they receive and donate it to nongovernmental organization (NGO)
programmes that support sustainable development and climate change–
related activities (Herman, 2013). The development SDRs would be grants
that the awarded NGOs would convert into hard currency at their national
central bank, whose SDR holdings would thus increase at the expense of the
hard currency paid to the NGOs (Soros, 2002, pp. 181–186).
This is a corporation which designs and markets
lottery and pari-mutual systems to government, lottery operators and parimutual operators worldwide. There are three categories of draw-based games.
These are instant games, sports games (pari-mutual), and sports games (fxed
odds). Huge revenues can be mobilized from lottery to sustainable development
fnance. Also, the World Lottery Association (WLA, 2014) should vote on part
of this revenue to fnance climate change and other biodiversity and ecosystem
activities. We argue that if on an incremental basis, the lottery amount could continue to increase by approximately 4%, such a percentage should be charged for
sustainable development fnance on the total lottery amount generated.
12.5.3.3 GLOBAL LOTTERY
12.5.3.4 GLOBAL TAXES Taxes are an important source of revenue generation for countries. In recent times, a number of innovative taxes have
come on stream to help fnance government expenditure. In most developed countries, innovative taxes such as a currency transaction tax, a carbon tax, an international air transport tax, and an arms export tax serve as
key sources of raising fnance (Kapoor, 2004; Brzoska, 2017). In scaling up
fnancing mechanisms for fnancing sustainable development, developed
countries need to allocate part of these funds to the developing world to
help fnance sustainable development.
12.5.4 Financing health
We here discuss mechanisms that are specifc to fnancing health. Both domestic and international sources of funds will play a crucial role in achieving the
health-related SDGs. For a long time, the health systems of many developing
countries relied on international sources of funds for supporting the delivery
of health services. However, in many countries, domestic resources make a
major contribution to the fnancing of healthcare. For example, data available
from the World Development Indicators (WDI) suggest that domestic general
342 Gordon Abekah-Nkrumah et al.
government health expenditure as a percentage of current health expenditure in low-income countries (LICs) was 19.61% in 2015, a reduction of 8.75%
from the 2000 fgure of 28.36%. For the same period, domestic private health
expenditure as a percentage of current health expenditure reduced by 8.22%
from the 2000 fgure of 58.78% to 50.56% in 2015. This implies that domestic
resources contributed 87.14% and 70.17% to total health expenditure in 2000
and 2015 respectively. The reality in LICs is not entirely different from that of
lower-middle-income countries (LMICs). Data available from WDI equally
indicate that the contribution of domestic resources (domestic general government health expenditure as a percentage of current health expenditure
and domestic private health expenditure as a percentage of current health
expenditure) to total health expenditure was 97.12% in 2000 and 96.42% in
2015. Domestic resources come from one revenue or a combination of general revenues, social health insurance (SHI) voluntary private health insurance (VPHI), community health insurance schemes (CHIS), and out of pocket
payments (OOPP). The contributions of the various sources as a percentage
of the total current health expenditure vary depending on the nature and
income level of a particular country, as shown in Table 12.3.
TABLE 12.3 Percentage contribution of different health fnancing sources to
current health expenditure in 2015
Country
SHI%
VFM%
Benin
Burkina Faso
Cabo Verde
Central African Republic
Côte d’Ivoire
Ethiopia
Ghana
Kenya
Nigeria
Rwanda
Bolivia
Guatemala
Honduras
Egypt
Morocco
Kyrgyzstan
Moldova
Bangladesh
India
Indonesia
Myanmar
Mongolia
Philippines
Vietnam
2
–
19
–
1
–
9
4
1
3
28
16
12
5
11
6
40
–
3
14
–
19
14
22
53
47
26
77
79
55
45
61
74
42
31
66
55
70
56
54
51
82
75
68
76
43
68
50
VPHI%
5
3
1
1
9
–
–
3
–
–
3
4
5
1
1
–
–
8
5
4
–
–
13
1
OOPP%
40
36
19
40
36
52
36
54
72
26
26
56
49
62
53
48
46
72
65
65
74
39
54
43
Source: Data from the WHO National Health Account (NHA) for 2015
Note: SHI is short for social health insurance; VFM is short for voluntary fnancing mechanism
Chapter 12 • Financing sustainable development 343
• General revenues generally come from taxes (income and proft taxes,
value-added and sales taxes, taxes on imports, and taxes on profts
from the sale of natural resources) that may either be direct or indirect and paid to the national treasury and disbursed through the budget system to provide social services such as health. The mix of taxes
deployed in each country is a matter of choice and also based on the
circumstance of each country. Also, the revenue-raising capacity of
taxes is correlated with income levels and the structure of the economy. Thus, LMICs with relatively large informal sectors tend to raise
less from taxes than do high-income countries (HICs) with a large formal sector. The contribution of tax revenue to total health expenditure depends on the contribution of taxes to aggregate income. The
informal nature of the economy of developing countries implies relatively lower contribution of taxes to general government revenue and
therefore allocation to the health sector. For example, data from WDI
suggest that tax revenue as a percentage of GDP in LMICs was 12.03%
in 2015 compared to 15.31% for HICs.
• Social health insurance (SHI) is a fnancing mechanism that is based
on a defned contribution (premium) for a specifed package of benefts for a specifed period. The uniqueness of social health insurance
is the fact that enrolment and payment of premium constitute a social
contract between the enrolee and the social health insurance organization, the terms of which are coded in law and therefore cannot be
changed. As a result, SHI funds are mostly earmarked and therefore
not mixed with general government revenue. Unlike private health
insurance, SHI is often compulsory and administered by either the
government or a government agency. An advantage of SHI is that it
has a greater potential to provide effective risk coverage, in addition
to the fact that the intended transparency can improve potential contributors’ willingness to contribute to the fund. The downside of SHI
is that it may not cover the entire population, especially those outside
of the formal sector and the fact that it may increase real labour cost,
especially if employers treat the SHI premium as a labour cost. Given
that SHI tends to be treated as some form of tax and collected using
formal channels, the contribution of SHI to overall health spending
tends to be related to the structure (formal versus informal) of the
economy. Thus, the contribution of SHI to the health budget tends to
be low in LICs (see Table 12.3).
• Under a voluntary private health insurance (VPHI) scheme, individuals voluntarily buy a health insurance policy from private organizations that operate in a competitive market and at a price (premium)
that refects the risk of the buyer rather than the ability of the buyer to
pay. The advantage of VPHI is that it constitutes an additional to revenue generated either through general revenues or SHI. Major challenges associated with VPHI include the possibility of risk selection,
higher cost of operation (leading to increased premiums), and the possibility that it will cover fewer people than SHI will. The size of VPHI
in developing countries tends to be small given that VPHI premiums
344 Gordon Abekah-Nkrumah et al.
tend to be high compared to average income levels in developing
countries. The data in Table 12.3 confrm the relatively low levels of
VPHI’s contribution to total health spending.
• Community-based health insurance (CBHI) schemes are seen as alternatives that deal with the shortcomings of other fnancing mechanisms, such as VPHI and SHI, which have the tendency to focus on the
higher cost but less frequent use of health services. CBHI schemes are
normally operated and fnanced by community members who voluntarily make defned contributions for a package of health services
(primary as well as higher-level care). Providers of health services
within CBHI schemes are normally entities hired by the community
or NGOs that are in the business of providing healthcare services.
The advantage of the CBHI schemes is that the community control of
the scheme can engender transparency and accountability and hence
motivate community members to enrol in the scheme. The downside,
however, is that the voluntarily nature may mean that fewer people
enrol and may create viability and sustainability issues for such small
risk pools.
• Out of pocket payments (OOPPs) or user fees are direct payments
made by individuals or groups using health services, which are not
reimbursable. Out of pocket payment may range from offcial fees
(payment for services, medications, deductibles, and copayments)
to unoffcial payments for services that may not be available at the
healthcare facility visited by the user. OOPPs normally constitute a
large proportion of funds available for providing health services in
LICs. The poor nature of health systems and health fnancing mechanisms in developing countries makes OOPPs a major option in many
countries. According to Table 12.3, OOPPs tend to contribute a substantial proportion of the total current spending on health.
Besides domestic resources, external sources of funds normally referred to
as development assistance for health (DAH), though relatively small compared to domestic resources, still play a crucial role in the delivery of healthcare in developing countries. The levels of DAH to developing countries
have evolved over the last two decades. Estimates from the Institute for
Health Metrics and Evaluation (IHME) suggest that the period from 1990 to
2017 saw an increase in DAH from USD7,554 million in 1990 to USD37,421.62
million in 2017 in nominal terms. The estimates in Table 12.4 show trends in
DAH over the last decade.
• Bilateral agencies represent nation states and are used as channels to
disburse external resources to recipient countries. Examples of such
agencies include USAID, DFID, DANIDA, JICA, CIDA, GTZ, for the
United States, United Kingdom, Denmark, Japan, Canada, and Germany respectively. The United States tends to be the biggest bilateral
contributor to DAH. The estimates in Table 12.4 for bilateral agencies
represents contributions from some 24 countries, including contributions from the European Union as an agency. Among the 24 countries,
the United States is the largest contributor to DAH. The estimates
70.757
41.06
12.94
11.46
27.66
40.46
20.41
90.368
35.14
13.07
12.33
31.15
60.11
20.20
2009
11.666
28.93
13.73
13.05
34.45
80.26
10.57
2010
12.390
31.63
13.53
11.25
34.81
70.54
10.23
2011
12.866
30.76
11.88
14.67
36.23
50.37
10.09
2012
14.001
29.36
12.01
15.61
34.99
50.88
20.14
2013
13.322
30.61
12.96
13.21
36.73
30.71
20.77
2014
Note: *2017 fgures are preliminary estimates; PPPs is short for public–private partnerships
Source: Constructed by authors from data from Micah, Dieleman, and Chang (2017) Financing Global Health database
Total DAH (USD billions)
Bilateral agencies (%)
United Nations (%)
PPPs (%)
NGOs & foundations (%)
World Bank (%)
Regional dev. banks (%)
2008
12.782
26.35
15.46
14.95
35.71
40.59
20.94
2015
TABLE 12.4 Trends in DAH from 2008 to 2017 in billions USD and component contributions in percentages
12.416
30.06
13.57
14.25
35.10
40.42
20.60
2016
11.959
29.00
13.46
16.14
35.44
40.16
10.80
2017*
Chapter 12 • Financing sustainable development 345
346 Gordon Abekah-Nkrumah et al.
•
•
•
•
also suggest that the contribution of bilateral agencies to total DAH is
declining but remains the largest proportion of DAH.
Multilateral organizations have become channels through which
countries transfer DAH. Although these agencies constitute channels
for delivering DAH, in some instances they also play actives roles in
the implementation of programmes and interventions. Examples of
multilateral agencies include United Nations agencies such the World
Health Organization (WHO), United Nations Children’s Fund (UNICEF), United Nations Population Fund (UNFPA), and World Food
Programme (WFP). In 2012, UNICEF and UNFPA alone contributed
around USD2.8 billion to DAH through the UN system. The estimates from Table 12.4 suggest that multilateral agencies make the
third largest contribution to DAH after bilateral agencies, NGOs, and
foundations.
Public–private partnerships (PPPs) are contribution channels developed out of collaborations from private and public institutions and
are thus referred to as public–private partnerships. Major institutions in this space are the Global Alliance for Vaccines and Immunization (GAVI) and the Global Fund for HIV/AIDS, Tuberculosis,
and Malaria (GFATM). The contribution of these two organizations
to total DAH has increased steadily from 11.46% in 2008 to 16.14 %in
2017.
NGOs and foundations are international NGOs and foundations of
private individuals and corporations such as the Bill and Melinda
Gates Foundation and the Clinton Foundation. Within the past ten
years, a major contributor in this space has been the Bill and Melinda
Gates Foundation. The estimates in Table 12.4 suggest that contributions from NGOs and foundations are the second-largest contributors
to total DAH, after those from bilateral agencies.
World Bank and regional development banks also contribute to
DAH. Regional development banks include the International Bank
for Reconstruction and Development (IBRD) and the International
Development Association (IDA) as well as other regional development banks such as the African Development Bank and the Asian
Development Bank. Contributions from these banks come in the form
of loans or grants to recipient governments, either for capacity or for
infrastructure development. The World Bank and the other regional
development banks make the least contribution to total DAH, as per
estimates available for the past ten years. Unlike the other DAH channels, the contributions of the World Bank and the other development
banks have been fuctuating.
12.6 CONCLUSION
The MDGs constituted a concrete practical attempt to bring meaning to
the United Nations charter, which in principle seeks to promote development in peace, on the basis of respect for human rights and the rule of
law. The eight goals constituted an important frst step that galvanized the
Chapter 12 • Financing sustainable development 347
nations of the world towards a common purpose and the belief that a good
international formula/solution also has benefts. Clearly, a lot of progress
was made in developing countries with respect to the attainment of the
eight MDGs, especially in the areas of poverty and education in regions
such as sub-Saharan Africa and Asia. Notwithstanding the progress made
with the MDGs, it is equally the case that a lot of work needs to be done
to ensure broad-based development, especially in areas such as maternal
health, energy environment, transportation, urbanization, migration, agriculture, and industrialization. Thus, the SDGs, the successor of the MDGs,
are a more broad-based, comprehensive, and ambitious attempt to move
the wheels of development towards the vision of development in peace
with respect for human rights and the rule of law. The realization of the
SDGs will depend on the extent to which nation states, especially developing ones, are able to operationalize and refect actions aimed at achieving the goals in their respective development plans. This will require an
inclusive and broad-based participatory approach involving strong leadership from government and the participation of knowledgeable citizens,
civil society, academia, the private sector, and international partners that
understand the goals and can advocate for and insist on practical actions
to achieve them.
Even more important is the issue of how to fnance the implementation of the SDGs. Traditionally, development fnancing has emphasized
the use of ODA. However, current ODA levels (estimated to be USD135
billion per annum) are way below what is needed to fnance the SDGs.
Besides, the current levels of ODA may even reduce due to budgetary
constraints arising from contraction in the economies of those countries
most likely to give ODA. There must therefore be a shift of emphasis
from the reliance on ODA as a major source of fnancing development to
public resources and private fnancing. It is indeed a challenge to advocate for additional public resources for development in countries such
as those in SSA and South Asia, where budgets are fnanced mainly by
ODA. However, for some developing countries, especially those in the
middle-income bracket (lower-middle and upper-middle income), there
are opportunities to improve domestic resource mobilization through the
implementation of reforms that will improve the effectiveness of revenue mobilization systems and the effciency (allocative and technical) of
resource use.
At the revenue mobilization level, emphasis should be on reforms that
will help to formalize the large informal sector and therefore help to identify
such operators for the purposes of raising tax revenues from their operations. In many developing countries especially those in SSA and South Asia,
a reliable and effective national identifcation and public system is important to move closer to formalizing the informal sector. Additionally, rapid
innovations in mobile telephony could be a solution to formalizing transactions that take place in the informal economy. These measures could go a
long way to broadening the tax net and thereby increasing domestic public resources available for development. In countries where the tax depth
is low, there could be opportunities to increase the effective tax rate. This
348 Gordon Abekah-Nkrumah et al.
option may, however, not be popular among policymakers, given that it
may incur serious political costs, especially for the ruling coalition. On the
issue of effciency, reforms that seek to tighten and close loopholes in public procurement and fnancial management and administration can reduce
corrupt practices, and savings therefrom can be channelled into fnancing
development.
Besides public resources, the private sector can play a major role not
only in the capital they can make available but also in the innovative solutions they can bring to the overall strategy for the implementation of the
SDGs, as indicated in the Addis Ababa Action Agenda. The emphasis on
private capital is even more important given that there are large pools of
private capital in the developed world that hardly yield decent returns at a
time when there is the need for capital for long-term investments in developing countries. The argument that has been made in the development discourse is that the excess supply of private capital in the developed world and
the demand for this in developing countries create a unique opportunity for
the fow of private capital to developing countries to fnance projects that
will yield decent returns. The challenge, however, is that the level of risk in
most of these developing countries is so high and may therefore constrain
the fow of private capital. ODA can play a major role in this direction not
just in providing development fnance but also in unlocking private capital by leveraging the risk that owners of private capital face in developing
countries. Additionally, multilateral development banks, such as the World
Bank, IMF, and regional development banks can develop new approaches
that will help leverage risk in developing countries and thereby improve
the capacity of developing countries to mobilize the needed resources for
fnancing development. The success of both the implementation and fnancing of frameworks will depend on the level of inclusiveness and strong
coordination and collaboration among governments, think thanks, academia, the scientifc community, civil society, the private sector, the United
Nations, and MDBs.
Discussion questions
1 Provide an overview of sustainable development, detailing the
evolution of the concept of sustainable development.
2 Discuss the challenges that affect
fnancing for sustainable development? In your opinion discuss the
opportunities available to address
these challenges?
3 There are a number of fnancing
mechanisms available for sustainable development. What are some
of these fnancing mechanisms?
What are some of the weakness
with these fnancing vehicles?
4 In which ways can these fnancing
vehicles be used to address the challenges identifed?
5 What benefts do you think
developing countries can derive
from using innovative sources
of fnancing for sustainable
development?
6 Discuss the sources of fnancing
health in developing countries.
Chapter 12 • Financing sustainable development 349
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CHAPTER
13
International trade,
fnance, and development
Steven Brakman and Charles van Marrewijk
13.1 INTRODUCTION
When (developing) countries trade with other countries, they are confronted
about fnancial interactions and forces that affect the way they do business
and limit the possibilities and effectiveness of certain types of policies. The
power of these fnancial forces is enormous. According to the Bank of International Settlements (BIS, 2019), the daily turnover on fnancial markets for
all instruments on a net-net basis in April 2019 was USD6.6 trillion, which is
equivalent to about 8% of the total world income in one year.1 In this chapter, we briefy discuss the main interactions, forces, limitations, and possibilities of trade with other countries.
We start in section 13.2 by discussing the main aspects of exchange
rates, the price of one currency in terms of another. In section 13.3, we
emphasize the importance of forward-looking markets for understanding
the power of fnancial forces. These aspects are combined in section 13.4,
where we discuss covered and uncovered interest rate parity, which is crucial for understanding the possibilities and limitations of monetary policy,
as explained in section 13.5. Using this theoretical basis, in section 13.6 we
review the main policy choices made in recent history up to this day. Next,
we turn our attention in section 13.7 to the practical issues of trade fnancing
and trade fnancing gaps. Section 13.8 covers the practical issues of international (vehicle) currencies. We conclude in section 13.9 with a brief discussion of fnance, investment, and development and provide a summary in
section 13.10.
13.2 EXCHANGE RATES
In international trade fows, the exporters and importers at some point
in time are confronted with exchange rates when they have to exchange
goods or services valued in one currency in exchange for another currency.
An exchange rate is a price, namely the price of one currency in terms of
another currency. This price is determined simply by supply and demand
in the foreign exchange market. As there are many countries with convertible currencies, there are many exchange rates, such as the exchange rate
352 Steven Brakman and Charles van Marrewijk
of a Singapore dollar in terms of European euros or the exchange rate of a
Japanese yen in terms of British pounds.
Since the exchange rate is a price, a rise in the exchange rate indicates
that the item being traded has become more expensive, just like any other
price rise indicates. Therefore, if the exchange rate of a Singapore dollar
in terms of European euros rises, this indicates that the Singapore dollar
has become more expensive. Various specialized symbols have been introduced to identify specifc currencies, such as US$ to denote (US) dollars,
€ to denote European euros, £ to denote (British) pounds, and ¥ to denote
Japanese yen or Chinese yuan. Table 13.1 lists some of these international
currency symbols and the three-letter international standard (ISO) code to
identify the currencies.
As will be discussed later on, there are various types of exchange rates,
but we frst focus on the spot exchange rate, the price of buying or selling
a particular currency at this moment. Table 13.2 lists some spot exchange
rates as recorded on 3 December 2019, at 11:55:00 a.m. (UTC + 01:00).2 The
fact that we have to be so precise by listing not only the day on which the
spot exchange rates were recorded but also the exact time and the time zone
TABLE 13.1 Some international currency symbols
Country
Currency
Symbol
ISO code
Australia
Canada
China
EMU countries
India
Iran
Japan
Kuwait
Mexico
Saudi Arabia
Singapore
South Africa
Switzerland
United Kingdom
United States
dollar
dollar
yuan
euro
rupee
rial
yen
dinar
peso
riyal
dollar
rand
franc
pound
dollar
A$
C$
¥
€
Rs
RI
¥
KD
Ps
SR
S$
R
SF
£
US$
AUD
CAD
CNY
EUR
INR
IRR
JPY
KWD
MXP
SAR
SGD
ZAR
CHF
GBP
USD
Source: Van Marrewijk (2012), table 20.1
TABLE 13.2 Spot exchange rates on 3 December 2019 at 11:55:00 a.m.
(UTC + 01:00)
Price of
Bid spot rate
Ask spot rate
Currency
Country
Spread %
USD1
USD1
USD1
1.32993
0.98960
14.66009
1.33007
0.98976
14.66686
CAD
CHF
ZAR
Canada
Switzerland
South Africa
0.0105
0.0162
0.0462
Source: www.oanda.com
Chapter 13 • International trade 353
signals an important general property of exchange rates; they are extremely
variable. The website from which the information was taken updates every
fve seconds. Real-time transactions are updated even more frequently. This
makes exchange rates rather special prices, as the variability in the quoted
prices is much higher than for those for goods and services traded in the
marketplace (such as the price of diapers at the supermarket), although
generally of the same order of magnitude as many other prices in fnancial
markets.
Table 13.2 lists the exchange rate of the US dollar relative to three
countries, namely Canada, Switzerland, and South Africa. There are actually two rates quoted: the bid rate – that is, the price at which banks are willing to buy USD1 (what they are bidding for USD