Estimating the costs of supporting
the private sector through DFIs
Discussion paper
Eurodad
Contents
Acknowledgements ....................................................................................................................... 3
Introduction .................................................................................................................................. 4
Part 1. Methodological and technical issues................................................................................. 4
Two key typologies: subsidies and DFIs .................................................................................... 4
Social opportunity costs versus value of subsidy ...................................................................... 7
Rate of return as a measure of the public vs private nature of DFIs ........................................ 7
Pipeline approach to measure how much subsidy is passed on ............................................... 8
Social rate of return .................................................................................................................. 8
Intangible support ..................................................................................................................... 9
Double-counting...................................................................................................................... 10
Part 2. Relevance of this research ............................................................................................... 11
DFIs to be explored ................................................................................................................. 11
The key aspect of social benefits ............................................................................................ 11
The debate about ODA and other development flows ........................................................... 11
The role of the private sector in development ....................................................................... 12
Nature of DFIs’ investments and their contribution to development .................................... 12
Accountability and transparency of DFIs ................................................................................ 12
Annex – Discussion paper ........................................................................................................... 14
2
Acknowledgements
This report was written by Javier Pereira as part of a research project commissioned by
Eurodad’s María José Romero.
Special thanks go to the experts consulted during the course of this research project, including
the active participation of some of them in an expert seminar in early June in London: Richard
Gower (Foresight Economics), Jane Lethbridge (Public Services International Research Unit,
University of Greenwich), Cécile Sangaré (Organisation for Economic Co-operation and
Development), Luiz Vieira (Bretton Woods Project), Stephen Spratt (Institute of Development
Studies), Matthew Martin (Development Finance International) and Paddy Carter (Overseas
Development Institute).
June 2014
3
Introduction
Over recent years, the level of investment managed by Development Finance Institutions
(DFIs) has increased significantly. The activities of DFIs have come under increased scrutiny,
with several civil society organisations, think-tanks and academics investigating whether they
are truly delivering social benefits. Particular emphasis has been placed on whether these
benefits are additional, in the sense that they offer an improvement against a counter-factual
of ‘no DFI lending.’ However the other side of the equation – the costs of DFIs to the public
sector – and in particular the subsidies they receive from taxpayers and pass on to their clients,
is relatively underdeveloped.
This report presents a comprehensive framework to assess the costs of DFI operations. Some
of the costs that this framework attempts to measure have not been addressed in the existing
literature. For example, the financial crisis prompted significant research on the costs of
sovereign guarantees provided to banks that were too big to fail, but no research attempts
have tried to quantify the extent of sovereign guarantees to DFIs.
This report summarises the findings of a research project commissioned by Eurodad on
estimating the costs of supporting the private sector through DFIs. The project was composed
of two phases. The first consisted of the preparation of a technical discussion paper that
presents methods that could potentially be used to quantify the subsidies DFIs receive (see
annex). The second consisted of an expert seminar (held 9 June 2015 in London), convened to
discuss a methodology that could be used to improve Eurodad’s understanding of the social
costs of DFIs’ operations.
This report is structured as follows. The first part summarises the discussion around the
methodology and technical aspects of the research. This part complements and develops some
aspects included in the discussion paper. The second part summarises the discussion about
how this particular project relates or could help to advance the research agenda on DFIs in
different areas. It provides ideas for further research, but more importantly, helps to illustrate
the significance of this project.
Part 1. Methodological and technical issues
Part 1 presents the key technical and methodological issues raised in the discussion paper and
the seminar. Particular attention is paid to technical obstacles and areas that need to be
developed further, and that are important to take into account before applying the
methodology that was developed through this project. Two different and very relevant
typologies have to be considered as part of this project: a typology of the subsidies and a
typology of DFIs.
A typology of subsidies
This research project categorises subsidies in three different ways (see table 2.1 below). First it
considers the subsidies that DFIs receive from taxpayers, and second it considers the subsidies
DFIs provide to their clients. The two measures need not necessarily be equal, since some of
the subsidies received by DFIs may, for example, be absorbed by X inefficiencies. There is also
a final, third category: subsidies direct from taxpayers to DFI clients. This third category
4
includes elements like loan/grant co-financing, which do not necessarily pass through a DFI on
their way to the private sector, but are contingent on the DFI’s involvement in the project.
Table 2.1: Typology of subsidies based on to whom they accrue
a) Subsidies from taxpayers to DFIs
i) Cash transfers (ODA)
ii) Subsidised loans
iii) Equity stakes and paid in capital (with no expectation of dividends)
iv) Implicit or explicit sovereign guarantees
v) Exemptions from indirect taxes
vi) Exemptions from income and employment taxes
vii) Exemptions from corporate taxes
viii) Intangible support (i.e. a ‘seal of approval’ from the host government, access to privileged
host government information or diplomatic support from shareholder governments)
b) Subsidies direct from taxpayers to DFI clients
i) Grant co-financing (using ODA)
ii) Intangibles (i.e. a ‘seal of approval’ from the host government, access to privileged host
government information or diplomatic support from shareholder governments)
c) Subsidies from DFIs to their clients
i) Interest rate subsidies
ii) Longer maturities on loans
iii) Grace periods on loans
iv) Absorbing exchange rate risk
v) Expectation of lower returns on equity stakes
vi) Guarantees and risk insurance
vii) Lower / Fewer fees
viii) Technical Assistance
c)
For each channel, we consider in the discussion paper the likely extent of subsidies in this area,
we also review potential methods for estimating the subsidy and finally consider data
requirements for these methods.
A typology of DFIs
The term “DFI” refers to a range of different institutions and there is not an agreed typology of
DFIs. These institutions have different mandates, capital structures and funding strategies
which are likely to affect the valuation of their costs and subsidies. In order to apply a
methodology to measure the subsidies DFIs receive, it is important to differentiate among
different types of DFIs.
There are different ways in which DFIs can be classified. The table below provides a simplified
overview of DFIs in relation to some key subsidies. This approach could be developed further.
In addition, the Organisation for Economic Co-operation and Development (OECD) has already
5
tried to explore existing differences among DFIs. It has, for example, quantified capital
contributions and reinvested earnings and dividends.i The OECD has also identified a number
of criteria to differentiate DFIs, which would be worth considering in the context of this
project:ii
 the primary purpose test;
 operating in Official Development Assistance (ODA) eligible countries;
 development goal of the institution and evidence of development impact;
 Untied ODA;
 additionality test (not being market disturbing);
 transparency and accountability.
The best way to explore the typology of DFIs would be to apply the methodology to a sample
of institutions in order to evaluate existing differences on the basis of hard facts. This exercise
would complement and expand the efforts made by the OECD. It could also contribute to shed
some light onto fundamental questions such as what exactly a DFI is. Although there are a
number of institutions that are generally considered to be DFIs, there is less clarity about
others. For example, Compañía Española de Financiación del Desarrollo (COFIDES) provides
“cost-effective medium and long term financial support for viable private direct investment
projects in foreign countries where there is a Spanish interest” and therefore does not operate
under a primarily development mandate. For this reason, the Spanish government does not
consider Cofides’ operations as development finance and, also for confidentiality reasons, does
not report data to the OECD. However, COFIDES is a founding member of the grouping known
as European Development Finance Institutions (EDFI) and several authors consider it a DFI.
This illustrates the blurred lines existing between institutions with a developmental mandate
and those that promote national interests. It is therefore important to develop a fine-tuned
typology of DFIs.
6
Social opportunity costs versus value of subsidy
It is generally considered that the best way to value the costs incurred by the public sector is
measure the social opportunity costs. This is the approach proposed to measure items
considered under the headings “subsidies from taxpayers to DFIs” and “subsidies from
taxpayers to DFI clients” in the discussion paper (see annex).
However, applying this methodology to “subsidies from DFIs to clients” is not so
straightforward as it depends on whether you consider DFIs to behave as part of the public
sector or the private sector. If you consider DFIs as a part of the public sector, then you would
use the social rate of return to estimate the opportunity costs. In practice, one would be
comparing the costs with the possibility of the government investing the money in something
else. However, if you consider that they act as private sector entities and are independent
from the government, then one cannot compare operations with other public investments and
would need to measure the opportunity costs in relation to the commercial rate of return
expected instead, i.e. the opportunity costs of other investments that could be made by a
private actor.
This question is closely linked to the typology of DFIs discussed in the section above. Some DFIs
operate more like private sector institutions (for example the Netherlands Development
Finance Company, FMO, does pay dividends) or receive fewer subsidies. There are a number of
different features one could consider, whether individually or collectively, in order to assess
whether DFIs operate under an official or commercial mandate. For example, it is possible to
look at the institution’s mandate in order to assess the balance between what one would
typically consider as public endeavours (development, addressing market failures or
constrains, etc.) and those of private sector actors.
It is also possible to examine the rates of return of DFIs to evaluate whether they are closer to
those of the financial sector or significantly lower and therefore suggest some form of risk
absorption or a broader mandate (e.g. including providing public goods, etc.). Another option
is to look at governance and financial aspects such as the shareholder structure, government
guarantees and the decision-making chain to assess who is in control.
On the basis of Eurodad’s previous research and the findings of this project, we decided to
consider DFIs as public institutions, although additional research needs to be conducted and a
clear set of criteria need to be developed.
Rate of return as a measure of the public vs private nature of DFIs
Looking at the rate of return was considered the most straightforward way to measure the
public/private nature of DFIs and provide an answer to the questions above. However, this
would imply making a number of assumptions with significant technical and political
implications. Using this approach would mean that all differences in rates of return can be
attributed to their role or mandate, while the operational costs, internal inefficiencies, and the
choice of financial instruments can all have a significant impact on the rates of return.
Adjusting for these effects is possible in some cases, but quite difficult in others. Several DFIs
report their operational costs, which could help fine tune this methodology. The Belgian DFI,
BIO, for example, could be a good example to identify operational costs. Adjusting for other
7
effects would require a detailed portfolio assessment (composition and weight of different
instruments and expected rates of return).
There are also implications at the policy level. For example, what does it mean when
organisations have high operational costs? If the methodology simply takes operational costs
as a measure of efficiency, then the higher the efficiency (the lower the costs), the better.
However, higher operating costs could mean they spend more time and research on the
project. If the methodology just focuses on efficiency or gives it an edge, then we might be
giving a poor mark to DFIs implementing stricter policies or due diligence procedures and/or
incentivising DFIs to reduce costs and go for easier projects.
It is important to take into account the costs of DFIs doing their job right. For example, a
mandate to invest in local and small companies in developing countries would usually involve
higher operational costs than the promotion of national companies because of the transaction
costs involved.
In practice, this means that one would need to combine the operational costs with a measure
of the additionality of the financial institution (not only financial, but also in terms of delivering
results according to their mandate). Since there are likely to be different types of DFIs (see
discussion above), this exercise would need to be broken down for DFIs classified within the
same category in order to account for the differences.
The bottom line is that more work is needed to understand how much is absorbed in
inefficiency and how much is passed on. Moreover, this work would need to be linked with the
issue of additionality and the actual impact of DFI projects in order to come up with a
constructive analysis and precise recommendations.
Pipeline approach to measure how much subsidy is passed on
Theoretically, the result of applying the methodology would be a measure of how much enters
in the form of subsidies from the taxpayer into DFIs and how much is passed on as a subsidy to
beneficiaries. The differences in both measures could be attributed to internal costs (including
inefficiencies and other operational costs; see discussion above for the implications of this).
The possibility of applying this approach depends on having all costs measured from the
taxpayer perspective (on the basis of social opportunity costs). If this would not be the case
(see discussion “social opportunity costs versus value of subsidy” and on intangible support
below), the result would be two measures taken from different reference points. This implies
that the pipeline approach could not be used to get a full picture of how subsidies are
transferred and used internally.
Social rate of return
The discussion paper proposes a number of different options to use as a proxy for the social
rate of return. It argues that the costs of borrowing by the government could be a conservative
and solid approach to this when compared to a rule of thumb or an inflation-based measure.
The OECD explained how the grant element is measured for aid related projects and described
the recent revision of the discount rate.iii The OECD’s revised discount rates consist of a base
factor of 5%, corresponding to the donor funding cost (in line with the methodologies of the
8
World Bank and International Monetary Fund), and a risk-adjusted premium which is
dependent on the recipient country. The OECD methodology recognises that in measuring the
provider effort it is necessary to take into account both the donor funding cost and the risk
associated with the project.
Based on the discussion paper and alternatives discussed during the seminar, it would seem
reasonable to adopt the same approach for the following reasons:


it provides a more realistic measure of the social rate of return expected than interest
rates, while it remains sensitive to the national context, and
it is an internationally agreed figure and there is reliable data available for every
country.
However it remains to be discussed whether this methodology should be applied to the
country where the DFI is from, instead of the countries where the projects in the portfolio are
taking place. This approach would assume we want to measure the social rate of return in
relation to any alternative investment unrelated to development made by the government
supporting the DFI (i.e. what is the rate of return of using the money for a different
investment, instead of giving it to the DFI). The other approach is to assume that the
alternative use of the fund would also be related to development, instead of any government
activity. In this case, it would be necessary to estimate rates of return for individual countries
in the portfolio. The latter approach would yield a higher figure as rates of return of
development projects tend to be higher.
Intangible support
It is extremely difficult to measure intangible support. The first challenge is selecting an
approach. If a “social opportunity cost” approach is used, then the costs of the intangible
support as described in the discussion paper, are the costs of the time dedicated by public
officials to the project (the cost to the taxpayer is the alternative use of their time by
diplomats, government experts, etc.). This would most likely show that the cost of intangible
support is very small.
The alternative approach is to measure it from the perspective of the beneficiary, for whom
the value of intangible support can be huge (sometimes the difference between a project
happening or not happening). Measuring the value from the perspective of the beneficiary
could get us closer to a true measure of the real value of “intangible support”, but could make
it difficult to integrate and compare it with items measured on the basis of “social opportunity
costs”. Additional work is needed to understand the implications of this approach and how it
can be made consistent with the methodology.
From a technical perspective, the value of intangible support for the beneficiary can be
measured in terms of success rates. Considering any project could be funded by private or
public sectors it is possible to make a pool of DFIs and private actors, and compare success
rates (based on write downs in annual accounts). If DFIs have higher success rates in similar
projects than the private sector, we could attribute that to intangible support.
9
There are significant technical difficulties in using this approach which make it very difficult to
implement in practice. Access to project level data is required in order to construct two sets of
data, but this information is not usually accessible. Perhaps one way to overcome this
problem would be to use historical data (old data from 15-20 year ago). Alternatively,
aggregated data could be used, but in order to provide a more accurate measure this would
require isolating write downs related to “development projects” in DFIs’ accounts because
many of them also work outside developing countries. Moreover, controlling for developing
countries might not be enough as there could also be differences across sectors, which include
additional granularity and building a very large dataset. There are also important problems
that arise when trying to group projects with a similar level of risk (making groups of projects
and countries with a similar level of risk). This requires very detailed data and/or making a
number of assumptions.
Another alternative to measure the value of intangible support from the beneficiary
perspective would be to compare individual bilateral DFIs with a set of multilateral DFIs. One
could argue that multilateral institutions such as the World Bank’s International Finance
Corporation (IFC) receive significantly less intangible support since they have a large number of
shareholders and a much broader mandate compared to national ones. National governments
participating in multilateral institutions are therefore less likely to use their influence (e.g.
diplomatic, economic, etc.) to make projects happen in developing countries, especially if we
compare them with projects supported by national DFIs and implemented by national
companies. In practice, the level of intangible report in projects supported by DFIs is not zero
(e.g. they might still have access to expertise, etc.), but it is possible to use multilateral DFIs as
a reference framework to estimate the intangible support of national DFIs. Since multilateral
DFIs would represent the starting point (level zero), this methodology would result in a
conservative estimate.
If we assume that multilateral DFIs receive no support, then, controlling for dissimilarities in
portfolio or typology, differences in success rates with bilateral DFIs could be attributed to
intangible support and estimated. This alternative is worth exploring in greater depth.
Double-counting
There are two potential instances of double-counting when applying the methodology. One is
the direct effect of tax emptions enjoyed by DFIs on the annual accounts. When estimating the
costs of corporate income tax, for example, it is important to take into account the effect of
such subsidies on profits (i.e. higher taxes would translate into lower benefits and have an
impact on other items in the accounts that are used to measure other aspects of the
methodology). If tax exemptions are evaluated, then a measure of “true profits” would need
to be constructed. In practice, it should be possible to deal with this by making adjustments to
the annual accounts.
The other problem has to do with the potential dynamic effects (substitution effects) of some
of the advantages enjoyed by DFIs that would be removed. For example, if the methodology
evaluates the costs of the guarantee by just comparing two scenarios (with and without
guarantee), it would fail to account for any ways in which the institution could partially
compensate for this. Accounting for dynamic effects can be extremely complicated in practice.
10
Part 2. Relevance of this research
Part 2 presents the main points discussed over the course of this project in relation to how this
particular research project relates or could help to advance Eurodad’s work on DFIs in different
areas. In some areas, it complements the discussion started in Part 1. It also introduces a
number of additional issues which are not related to the technical aspects of the methodology,
but which are key to analysing the relevance of this project.
DFIs to be explored
This section is closely related to the discussion about DFIs’ typology (see Part 1). It has already
been mentioned that the methodology can help shed some light on what a DFI is. In addition
to this and with views to future research efforts, participants in the seminar argued that in
addition to large DFIs operating at international level, it would be interesting to include small
institutions that operate at national, regional or local scales, such as locally owned
development banks. These institutions have a different relationship with their clients and local
communities and it could be interested to include some examples in a future research sample
in order to explore differences in performance.
In addition to providing some necessary information to compare the effectiveness of
international and national DFIs, the research could contribute to a better understanding of the
challenges and difficulties faced by DFIs when they start operating at an international level.
Some experts consider that there is a compromise between the ability to support smaller or
targeted projects and the need to keep actual transaction costs under control.
The key aspect of social benefits
The proposed methodology looks at one side of the equation (social costs) and does not take
into account the positive impact and the additionality of the projects implemented by DFIs.
The rationale behind this is that compared to the social impact, this is a relatively unexplored
area of research where Eurodad can have a greater added value. In addition, addressing both
sides of the equation would require an amount of time that is beyond the capacity of this
project.
In any case, it is important to acknowledge that this limitation does constrain the analysis of
the results. For example, this project alone would not be able to solve questions such as the
link between subsidies and actual social impacts (which could make larger subsidies more
desirable) or explore the relationship between certain types of DFIs and their actual impact on
the ground. Nonetheless, this project has to be seen as a necessary stepping stone towards
more comprehensive research on the future role of DFIs.
The debate about ODA and other development flows
The OECD is currently in the process of modernising the measurement of ODA and working on
different ways to quantify development finance above and beyond ODA (new measure of total
official support for sustainable development (TOSSD)).
Although this research does not focus on ODA and tries to measure a large number of
additional items, it can potentially help to understand different ways in which ODA can be
11
used by DFIs and provide some evidence that can guide future research on how ODA can be
used most effectively and efficiently.
The contribution of this project to the discussion on other development flows can be more
substantial in the sense that it would provide information about the real costs of DFIs to
taxpayers. As mentioned above, this is an area where very little research has been conducted.
If these costs are significant, it could provide fuel to positions arguing for more costs to be
counted as “development flows”. However, any such claims would be premature. Without a
more comprehensive view of the other side of the equation mentioned above (the social
impact and the additionality of projects) it would be impossible to establish a link between the
costs of DFIs and their contribution to development.
The role of the private sector in development
The focus of this report could make a significant contribution to the current debate about the
role of the private sector in development. Many DFIs do provide significant support to private
sector actors. Improving our understanding of how institutions use and deliver subsidies and
combining it with research on their choice of clients (who DFIs support) would provide new
evidence to inform this debate. Moreover, this work can be further enriched by including
different types of DFIs (including national and local development banks, for example) in the
research.
Nature of DFIs’ investments and their contribution to development
A better understanding of DFIs’ costs and passed on subsidies would, complemented with
research on the impact side, encourage the debate about the nature of DFIs’ investments and
their contribution to development.
For example, the methodology could help to understand whether DFIs’ investment in certain
regions have really been made in the form of transformational investments. The methodology
would provide an estimate of the aggregate subsidy in certain regions. This measure could be
subsequently compared with data on the industrialisation of the very same regions in order to
assess to what extent DFIs have contributed to this. By drawing comparisons among regions,
institutions or sectors, and accounting for other factors, researchers could draw important
conclusions about which investment strategies are best to deliver transformational change and
industrialise countries.
Accountability and transparency of DFIs
The project will yield information about the extent of public (taxpayer) support to DFIs. This
could answer existing questions about the level of accountability required of DFIs. It has been
mentioned that there are different types of DFIs and that the limits between what a DFI
actually is or is not are blurred. Some DFIs operate under a double mandate – i.e. to promote
both development and national interest – (see example from COFIDES in Part 1), and face
some confidentiality constraints for reporting at the activity-level to the OECD DAC. The same
also applies to other DFIs that tend to operate more as independent private sector actors (they
also provide very little information about their projects).
Having an actual figure on the level of public support to different DFIs would provide real
evidence to evaluate existing calls for transparency and accountability. If the figures show that
12
DFIs receive significant public support despite governments not considering them as DFIs,
taxpayers would have strong arguments to request greater accountability and transparency
from these institutions.
13
Annex – Discussion paper
Development Finance Institutions and their Subsidies:
Towards a methodological framework for assessing their subsidy from
taxpayers, and the extent to which this is passed on to their clients
PROVISIONAL DRAFT
This report has been produced by Foresight Economics for the European Network on Debt and
Development (EURODAD), in preparation for a workshop on Tuesday 9th June.
Authors: Richard Goweriv and Ben Gowerv
14
1. Introduction
Over recent years, the level of investment managed by Development Finance Institutions
(DFIs) has increased significantly. Partly as a result of this, their activities have come under
increased scrutiny, with several civil society organisations, think-tanks and academics
investigating whether they are truly delivering social benefitsvi.
However the other side of the equation – their social costs – and in particular the subsidies
they receive from taxpayers and pass on to their clients, are poorly understood. The purpose
of this paper is to advance the debate in this area by identifying methods that could potentially
be used to quantify these subsidies. The literature in this area is relatively undeveloped, but
where possible we draw on tried and tested approaches used by other researchers, seeking to
combine them into one coherent framework. We focus in particular on subsidies from
taxpayers to DFIs.
The remainder of the paper is structured as follows: section 2 sets out a brief typology for
subsidies from taxpayers to DFIs and their clients, section 3 outlines three key methodological
considerations (individual versus group approaches, estimation of social opportunity cost, and
discounting), section 4 examines subsidies from taxpayers to DFIs, section 5 examines
subsidies direct from taxpayers to DFI clients and section 6 makes some observations
regarding subsidies from DFIs to their clients; section 7 concludes.
2. Typology of Subsidies
There are several ways of categorising the different subsidies received and passed on by DFIs.
For example, Willem te Velde and Warner (2007, henceforth W&V) make a distinction
between ‘general’ subsidies (such as differences in the cost of capital for DFIs) and ‘project
level’ subsidies that are directly visible to the DFI’s client.
From a conceptual perspective, we believe the most helpful way to categorise subsidies is to
first consider the subsidy that DFIs receive from taxpayers, and then secondly to consider the
subsidy DFIs provide to their clients. The two measures need not necessarily be equal, since
some of the subsidies received by DFIs may, for example, be absorbed by X inefficiencies (since
DFIs have minimal incentives to minimise costs) (Francisco et al, 2008).
There is also a final, third category: subsidies direct from taxpayers to DFI clients. This third
category includes elements like loan/grant co-financing, which do not necessarily pass through
a DFI on their way to the private sector, but are contingent on the DFI’s involvement in the
project.
Our typology is similar to the general versus project level approach of W&V, in that subsidies
from taxpayers to DFIs are all general, with the exception of ‘intangible support’, which occurs
at the project level; whilst subsidies to DFI clients are all project level. Intangible support
appears twice, since this subsidy accrues to both DFIs and their clients (more on this later).
15
Table 2.1: Typology of subsidies based on to whom they accrue
a) Subsidies from taxpayers to DFIs
i) Cash transfers (ODA)
ii) Subsidised loans
iii) Equity stakes and paid in capital (with no expectation of dividends)
iv) Implicit or explicit sovereign guarantees
v) Exemptions from indirect taxes
vi) Exemptions from income and employment taxes
vii) Exemptions from corporate taxes
viii) Intangible support (i.e. a ‘seal of approval’ from the host government, access to privileged
host government information or diplomatic support from shareholder governments)
b) Subsidies direct from taxpayers to DFI clients
i) Grant co-financing (using ODA)
ii) Intangibles (i.e. a ‘seal of approval’ from the host government, access to privileged host
government information or diplomatic support from shareholder governments)
c) Subsidies from DFIs to their clients
i) Interest rate subsidies
ii) Longer maturities on loans
iii) Grace periods on loans
iv) Absorbing exchange rate risk
v) Expectation of lower returns on equity stakes
vi) Guarantees and risk insurance
vii) Lower / Fewer fees
viii) Technical Assistance
c)
In summary, there are eight potential channels for public subsidy of DFIs, and ten channels
through which DFI clients can benefit from public subsidy (eight of which pass through DFIs).
Intangible support, the last item under headings (a) and (b), differs from the others in two
important ways. Conceptually, we can see this support as increasing the probability that DFIfunded project are a success, relative to the case where the private sector finances the project.
The benefits therefore accrue to both the DFI (increased likelihood of returns) and the client,
all else constant. The second important difference is that intangible support is the main form
of subsidy that arises from both host and shareholder governments, rather than solely the
shareholder government (the other being certain forms of tax exemptions).
It is also worth noting that some of the subsidy passed on to the private sector by DFIs is
intentional, but some may be unintentional, if these private sector beneficiaries are able to
exploit information asymmetries, such that DFIs believe projects to be - for example - lower
risk than they actually are.
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3. Methodological Considerations
Before considering the subsidies themselves, it is worth making three general points about the
methodologies we consider.
3.1 DFI by DFI versus group estimates
Wherever possible, we seek to identify methodologies that would allow the estimation of
subsidy for a specific DFI. However, for some subsidy channels, this is not possible. In these
instances, we suggest approaches that would allow an average subsidy across DFIs as a group
to be estimated.
3.2 Opportunity Cost
Conceptually, there are two ways of valuing subsidies. The first is to estimate the value of the
subsidy to the recipient (i.e. the DFI or private sector client). The second is to estimate the
cost of the subsidy to the taxpayer. The two methods will give different figures and the
appropriate choice is determined by what you intend to use the numbers for.
If the numbers are going to be set against the social benefits that a DFI delivers, in order to
determine whether the social benefits a DFI delivers exceed their social costs, then economic
theory is clear that subsidies should be evaluated against the social opportunity costvii of
government resources (HMT, 2011). That is, the next best alternative use of that money by
the government. If, alternatively, the aim is simply to put a figure on the benefit to the DFI (or
private sector), then it may be more appropriate to consider how much money the subsidy
saves them (compared with alternative sources of finance).
This is a crucial conceptual point. Guided by the terms of reference, we have taken the former
approach for sections 4 and 5, advocating methods that assess the opportunity cost of the
subsidy to taxpayers. A DFI’s subsidy is thus, “the social opportunity cost minus the price the
DFI actually pays [for government finance]” (Schreiner and Yaron, 2001: 22).
However, it is not always possible to value subsidies in this way, and the paucity of appropriate
methods sometimes forces us into valuing subsidies based on their value to a DFI rather than
to taxpayers. We clearly indicate where this is the case.
Furthermore, as our analysis progresses it will become clear that the need to prevent doublecounting of subsidies to DFIs means that it is often necessary to estimate both the benefit of
the subsidy to the DFI and the social opportunity cost to the taxpayer, which further
complicates the analysis.
Finally, it is important to point out that the measure of social opportunity cost chosen forms a
crucial assumption in any calculation of subsidy value. And unfortunately, identifying the true
social opportunity cost is fraught with difficulty. In practice, authors in this field (such as
Schreiner and Yaron, 2001; Nawaz, 2010; and others) have sort to identify an estimate of the
social opportunity cost using the following principles: first, accuracy to true opportunity cost.
17
Second, consistency with public analysis measures to facilitate comparison. Third, selecting
credible and transparent rates. Fourth, preferring higher rates to lower rates, all else constant.
These authors argue for choosing higher rates, all other things equal, because they are
interested in determining whether DFIs (and microfinance institutions, MFIs) could be
financially sustainable without subsidy, and choosing high rates therefore adds a degree of
conservatism to their conclusions. For this project however, conservatism would imply
preferring lower rates to high, as this will produce a more conservative estimate of the subsidy
from taxpayers to DFIs. We therefore suggest reversing the fourth principle and preferring
lower rates to high.
In the literature, there are five ways in which social opportunity cost has been calculated in
relation to DFIs and MFIs (Nawaz, 2010):
1. Using inflation (Rosenberg, Christen and Helms, 1997).
2. Interest rates for treasury bills, sometimes plus a mark up for administrative costs and
reserve requirements (commonly between 2 and 3 percentage points (Yaron, 1992;
Warusawitharana, 2014).
3. Using a rule of thumb of 10 or 12 percentage points (Belli et al, 1998; Katz and Welch,
1993).
4. Using the cost of private debt (local prime rate i.e. lending rate) (Nawaz, 2010).
5. Adding a premium for risk to the local prime rate (Benjamin, 1994; Schreiner, 2003).
The first suggests a real opportunity cost of zero once inflation has been accounted for. This is
clearly a substantial underestimate (Schreiner, 1997).
The second measure has been the most popular when evaluating DFIs and MFIs (Nawaz, 2010),
and is used by several European governments when evaluating their own projects
(Warusawitharana, 2014). The assumption here is that the next best thing to do with public
funds (other than subsidise DFIs) is not to spend them. Thus the opportunity cost is money
saved by not having to issue a government bond. Measures of subsidy that use the deposit
rate as a measure of social opportunity cost are lower bounds (Schreiner and Yaron, 2001),
since in practice, most practitioners accept that there is almost always a portfolio of potential
projects offering higher social (if not always financial) returns than the cost of government
borrowing.
The third is used by the World Bank and several governments (Gollier, 2011), it has served to
provide assumptive consistency in an area where the true social opportunity cost of public
funds, particularly when earmarked for anti-poverty measures, are not agreed upon (Nawaz,
2010). However it is arbitrary, representing “the highest credible lower bound” (Schreiner and
Yaron, 2001: 20).
The fourth and fifth rely on the premise that private debt will replace public debt (Nawaz,
2010). This does not measure the opportunity cost to the public purse, and furthermore it
does not necessarily measure what it would cost a DFI (rather than an MFI) to raise its capital
on private markets. The fifth has more commonly been applied to MFIs than DFIs, with risk
18
premiums based on an MFIs age and profit levels (Schreiner, 1997). As there is no evidence of
the same relationship between risk and age for DFIs as MFIs, this measure would lack
credibility and transparency.
In line with the principles described above, and placing extra emphasis on the need for this
project to offer both conservative and transparent estimates of subsidy, we suggest using
option 2 (interest rates on government debt) but without an arbitrary mark up for
administrative costs. This provides a transparent and credible lower-bound of social
opportunity cost. In the current economic climate, where rates for borrowing are low, the
social opportunity cost will be significantly below the 10 or 12 percentage points arbitrarily
assigned in the third method, limiting the likelihood that subsidies to DFIs are being overstated
and increasing the likelihood that they are understated. The availability of relevant interest
rates from the IMF’s International Financial Statistics (IFS) ensures the transparency of this
measure.
3.3 Net Present Value versus Annual Costs
We focus primarily on annual measures of subsidy. However, if a multiyear assessment of
subsidy is required it will be important to discount these annual flows, providing a net present
value (NPV) of subsidy, rather than simply summing all of the annual flows across time. In
general, similar methods to those used to identify annual subsidies could be used, but with the
additional step of accounting for a discount rate when these annual flows are amalgamated
(Schreiner and Yaron, 2001).
4. Subsidies to DFIs from Taxpayers: Estimation Methods by Subsidy
Channel
In this section, we work through the typology in section 3, examining each of the subsidy
channels from taxpayers to DFIs. For each channel, we consider the likely extent of subsidies
in this area, before reviewing potential methods for estimating the subsidy and finally
considering data requirements for these methods.
i) ODA Cash Transfers
Extent of Cash Transfers
In general it is clear that whilst DFIs might be involved in the management of ODA funds, or be
involved in projects that are co-financed with ODA, “it is unusual for DFIs to have direct control
over [ODA]” (W&V). It thus seems likely that very few DFIs are absorbing ODA grants as
general income. Instead, where DFIs have access to ODA funds, they are kept as a separate,
project-based item that is rarely under the DFIs direct control.
Consequently the issue of ODA subsidies is more relevant to section 5, which considers
subsidies from taxpayers direct to DFI clients, contingent on the involvement of a DFI in the
project. ODA cash grants are not a common means of subsidising DFIs themselvesviii (Te Velde,
2011). However, below we briefly describe how an ODA cash grant to a DFI from taxpayers
would be valued, for cases where this does arise. It may become increasingly important if ODA
eligibility criteria relating to private sector instruments are expandedix.
19
Potential Methods & Data Requirements
Cash transfers represent a subsidy to a DFI. Ths is equivalent to the face value plus the social
opportunity cost rate of return, as below. This represents the (social) return that the
government could otherwise earn on the ODA.
Sc = T x (1 + m)
Where:
Sc = Subsidy to DFI from cash transfers
T = Total cash transfers to DFI
m = Social rate of return
(ii) Subsidised Loans
Extent of Subsidy
It appears unlikely that DFIs typically receive subsidised loans from governments. Several
bilateral DFIs do not borrow money at all, and are instead financed entirely by the equity stake
of their shareholder government and retained earnings (see Table 3, W&V). And whilst others
do borrow money, this is typically by issuing bonds on capital markets, which are bought by
private investors (for example two thirds of the IFC’s funding comes through bond issues, IFC,
2014a: 11).
However, the framework for evaluating DFI subsidies put forward by the World Bank includes
a method for valuing subsidised loans in their illustrative example (Schreiner and Yaron, 2001).
Other authors have used this framework to evaluate subsidies to MFIs (e.g. Nawaz, 2010;
Schreiner, 2004), and in keeping with their approach we show how a subsidy like this would be
valued below.
Potential Methods & Data Requirements
The subsidy from taxpayers to DFIs through discounted interest rate payments on outstanding
loans is calculated by the social opportunity cost minus the actual interest rate received from
the DFIsx, multiplied by the value of the loans:
Sl = D x (m - c)
Where:
Sl = Subsidy to DFI from loan subsidies
D = Average public debt
m = Social rate of return
c = Actual interest rate received
Annual average public debt is half the sum of the start and end debt, assuming that changes in
debt occur at a constant pace through the year and given year-end financial accounts.
20
iii) Equity Stakes
Extent of Subsidy
Bilateral DFIs are typically owned by their respective governments through a 100% equity
stake (which often also comprises a large proportion of their total funding, alongside retained
earnings). Kingombe et al (2011) evaluate the shareholder ownership of DFIs, showing that
SwedFund, Norfund, IDC, OPIC, CDC Group and DEG (through the KfW Bankengruppe) are all
fully owned by their respective governmentsxi. In addition, our analysis shows the same is true
of BIO and IFU.
Similarly, multilateral DFIs are financed to some extent through the equity stakes of member
states (although they are also much more likely to be accessing debt markets, such that equity
is relatively less important in their funding mix).
As with subsidised loans, the subsidy to DFIs from taxpayers is the difference between
expected returns and the social opportunity cost. The return expected on an equity
investment is a combination of expected dividends and any profit expected when the stake is
sold (Copeland et al 2005). However, it appears that governments typically expect no financial
return on their equity investment.
This is for two reasons; firstly, as W&V highlight, DFIs rarely pay dividends to shareholders (the
exceptions in their study being MFO and Proparcoxii). There is therefore, no expected return
from dividends. Second, DFIs’ typical shareholders (governments) appear not to expect a
return at sale either: the few examples where DFIs have actually been sold, such as the spin
out of Actis from CDC, have occurred at a level far below market value (Guardian, 2012).
Thus for a DFI that pays no dividend, the subsidy is simply the product of social opportunity
cost and average total equity stakes. This improves upon W&V in two ways. Firstly, it is a
measure of social opportunity cost rather than merely comparing the rate of return on equity
with that of a different financial institution. As Schreiner and Yaron (2001) highlight,
approaches that rely on the return on equity, rather than opportunity cost do not fully reflect
the subsidy to DFI from public funds. Secondly, it calculates the opportunity cost in a
transparent manner, without arbitrarily using one financial institution’s dividend.
In the event that dividends were being paid by a DFI, the subsidy would need to take this into
account. As with subsidised interest rates, the dividend may be at a lower rate than a nonsubsidised financial institution would provide. Thus the subsidy would be the product of the
social opportunity cost minus the dividend paid, multiplied by the average total equity stakes.
Methods and Data Availability
Where no dividends are paid, the public subsidy is simply the social opportunity cost times the
public equity stake:
Se = E x m
Where:
21
Se = Subsidy to DFI from equity stakes
E = Average total equity stakes
m = Social rate of return
As with annual average public debt, annual average equity stakes are half the sum of the start
and end stocks, assuming that stocks grow and flows occur at a constant pace through the year
and given year-end financial accounts (Schreiner and Yaron, 2001).
Where some dividends are paid:
Sse = E x (m - d)
Where:
Se = Subsidy to DFI from subsidised equity stakes
E = Average total equity stakes
m = Social rate of return
d = Dividend rate paid
Worked Example for subsidised loans and equity stakes (from Nawaz, 2010)
Nawaz considers 204 MFIs, using their financial accounts to derive the following:
Table 4.1: Example calculation for subsidised loans and equity
Variable
Average public debt
(D)
Average annual equity
(E)
Actual interest rate (c)
Opportunity cost of
capital (m)
Definition
Average annual outstanding
concessionary-borrowed funds.
Average current (I) and previous
year (t-1) equity.
Interest cost paid on concessionary
borrowed funds.
Market lending rate (in Nawaz’s
case).
Median
$3300
$3900
7.2%
12.9%
From these the subsidy from ii) subsidised loans and iii) equity stakes can be calculated:
Sl = D x (m - c)
= 3300 (12.9% - 7.2%)
= $155
Se = E x m
= 3900 x 112.9%
= $531
While Nawaz (2010) uses the market lending rate as a proxy for opportunity cost, as has been
discussed above, a more appropriate measure for this exercise is the interest rate on treasury
22
bonds. If applied to a state-owned DFI then this adaptation is simply a case of using the figures
outlined in the IFS.
iv) Implicit or Explicit Sovereign Guarantees
Extent of Subsidy
An implicit or explicit guarantee represents a subsidy because private creditors are likely to
lend to DFIs at lower rates than they otherwise would, if the DFI was not backed by a
guarantee (W&V). Thus the guarantee lowers DFI borrowing costs on the capital markets.
As such, all DFIs that access the capital markets are likely to benefit to some extent from either
an implicit of explicit guarantee from their shareholder governments. This applies in particular
to multilateral DFIs, who can sometimes raise a large proportion of their finance through debt
issuance. However, it also applies to some bilateral DFIs who access the capital markets (see
W&V Table 3) either directly or (as in the case of DEG or Proparco) through a parent
organisation.
Potential Methods
This is an area which has received scant coverage in the literature on DFIs (although it is
considered by W&V). However, the Global Financial Crisis has resulted in a significant amount
of effort being devoted to a related problem: quantifying the government’s implicit guarantee
of systemically important (or ‘too-big-to-fail’, TBTF) banksxiii. The IMF (2014) gives a good
summary of the three main approaches taken to solving this problem in the literature.
1. Comparing the financing costs of TBTF institutions (or DFIs in our case) with those of nonTBTF banks (commercial banks). This approach is equivalent to the method advocated by
W&Vxiv for estimating the value of a sovereign guarantee to a DFI. The problem with this
approach is that it implicitly assumes that all of the differences between a DFI’s borrowing
costs and those of another financial institution are driven by the existence of a sovereign
guarantee. Unfortunately, this is a weak assumption, since many DFIs also enjoy a much
stronger financial position (even without the guarantee) than private sector institutions. As
IMF (2014: 6) comment, this approach is “less reliable and can even be misleading… [because
it] does not account for possible differences in fundamental characteristics that may drive the
spread differential.”
2. Contingent Claims Analysis. This second approach described by IMF (2014) works well for
TBTF banks but is not possible for DFIs. It exploits the difference in treatment between
shareholders and debt-holders in the event of a government bailout to estimate the value that
debt-holders place on the sovereign guarantee. This calculation requires price information for
Credit Default Swaps (a certain type of derivative contract) for the institution in question, and
these do not exist for DFIs.
3. A Ratings-based approach. First suggested by Haldane (2010), this method exploits the fact
than many ratings agencies give two scores for a financial institution – their overall score, and
their ‘stand-alone’ rating, the second of which ignores the existence of an implicit or explicit
sovereign guarantee. These two ratings can be used to assess how the guarantee affects an
23
institution’s borrowing costs, by reference to bond yields across the ratings spectrum for
financial institutions (Noss and Sowerbutts, 2012, use average yields from the Bank of America
Merrill Lynch Sterling Corporates Financials Index at each rating). This difference in yield can
then be scaled up according to an institution’s ratings-sensitive liabilities (identified from
annual accounts data), to give a total figure for the value of the sovereign guarantee to the
institution.
This third approach is conceptually straightforward, but requires good judgement – choosing
appropriate bond yields to quantify the value of the guarantee, and judging which of an
institutions liabilities are sensitive to their credit ratingxv. However, there are several examples
of its application in the literature, and it is generally seen as an acceptable method of
estimating the approximate value of a sovereign guarantee (IMF, 2014).
Box 4.1: Worked example of Ratings-based estimation of value of sovereign guarantee
Data item
Long-term credit rating for example
DFI
Stand-alone credit rating for example
DFI
Average bond yield for Aa1-rated
financials (b)
Average bond yield for A1 rated
financials (c)
Estimated impact of sovereign
guarantee on yields of DFI’s ratingssensitive liabilities (d)
DFI’s ratings-sensitive liabilities (e)
Impact of sovereign guarantee on
DFI’s annual borrowing costs (f)
Source
Ratings agency report
Example Value
Aa1
Ratings agency report
A1
Bank of America Merrill Lynch
Sterling Corporates Financials
Index
Bank of America Merrill Lynch
Sterling Corporates Financials
Index
d=c–b
4%
DFI Annual accounts
f=exd
€61bn
€610m
5%
1%
However, a strong word of caution is required regarding this approach, because it moves away
from a social opportunity-cost based valuation of subsidy. In other words, rather than putting
a figure on the ‘next best alternative use’ of support by the government, it quantifies the value
of support to the DFI. This is a key weakness.
In a social opportunity cost framework, we need to consider the ‘next best alternative use’ of
the government resources used to provide the guarantee. Eliminating the guarantee would
theoretically reduce the government’s own borrowing costs, and we could therefore plausibly
suggest that the opportunity cost is represented by the reduction in government borrowing
costs that would occur were the guarantee not to be provided. However, this is clearly very
difficult to estimate, and it does not automatically follow that the amount by which the
government’s own borrowing costs would be reduced will be equivalent to the benefit derived
by the DFI from the guarantee.
24
This area thus warrants further investigation. Theoretically we might be able to make an
argument for approximate equivalence of the benefit to the DFI and the cost to the taxpayer in
this case, but this is likely to require somewhat heroic assumptions regarding the ability of
ratings agencies, and the granularity of their ratings. It is beyond the scope of this paper.
Data Requirements
Multilateral DFIs are generally given both a general and ‘stand-alone’ rating by credit rating
agencies, such that option 3 above is feasible in their case.
Many bilateral DFIs do not borrow from the capital markets and are therefore not receiving a
subsidy through a sovereign guarantee. Partly as a result of the fact that they rarely access
capital markets, many have either not received a credit rating (e.g. CDC Group), or have simply
been given the credit rating of their host government. For example, according to Standard and
Poor’s report on Dutch DFI FMO, “we equalize our ratings on FMO with those on The
Netherlands, reflecting our opinion that there is an "almost certain" likelihood that the Dutch
government would provide timely and sufficient extraordinary support to FMO in the event of
financial distress” (S&P, 2014: 2).
For those who do access the capital markets (or can do so via a parent company), it may still be
possible to use the ratings approach if an appropriate proxy organization can be found, and
their ratings used instead – such as the parent company. For example, the German DFI, DEG
does not receive its own ratings from credit ratings agencies, but its parent company KfW does
receive both a general and ‘stand-alone’ rating. It may be that these ratings could be used as a
proxy for DEG – subject to identifying if DEG possesses any ratings-sensitive liabilitiesxvi.
In general, it would be more accurate to use the ratings approach for a selection of DFIs and
use these figures to give an approximation of the value of sovereign guarantees for other DFIs
(scaling according to their ratings-sensitive assets for example), than to use a flawed
methodology such as the general difference in bond yields for a DFI versus a commercial bank.
However, as pointed out earlier, these valuations can not automatically be treated as
estimating the social opportunity cost of providing government support.
(v) to (vii) Tax Exemptions
Extent of Exemptions for DFIs
Bilateral DFIs:
In general, the structure of bilateral DFIs, which tend to be constituted as limited companies,
means that they are unlikely to be eligible for any tax exemptions other than those specifically
mentioned in legislation. In the UK for example, CDC Group’s exemption from corporation tax
is explicitly provided for in the CDC Act of 1999. Their staff pay income tax, and they pay other
business taxes on property, indirect taxes such as VAT, and so on. Furthermore, the accounts
of DEG, IFU, Norfund and BIO show that they pay at least some corporation tax, whilst the
legislation and accounts available indicate that they are not exempt from indirect taxes or
income taxes (Bio, 2014; DEG, 2014; IFU ; Norfund, 2014).
25
W&V also provide a table showing the corporate tax exemption status for several DFIs (their
table 5). We can be reasonably confident that bilateral DFIs do not receive other beneficial
tax exemptions beyond their limited corporation tax privileges.
Multilateral DFIs:
Multilateral DFIs, however, appear to benefit from much more wide-ranging tax exemptions.
In the case of the EIB, the organisation and its employees are covered by the Protocol of
Privileges and Immunities of the European Communities (EIB, 2013: 39), which states:
“The Union, its assets, revenues and other property shall be exempt from all direct taxes. The
governments of the Member States shall, wherever possible, take the appropriate measures to
remit or refund the amount of indirect taxes or sales taxes included in the price of movable or
immovable property, where the Union makes, for its official use, substantial purchases the
price of which includes taxes of this kind. These provisions shall not be applied, however, so as
to have the effect of distorting competition within the Union. No exemption shall be granted in
respect of taxes and dues which amount merely to charges for public utility services.”
This means that the EIB is exempt from corporation tax and other business taxes (for example
on business property). It also means that where possible EU member states must compensate
the EIB for indirect or sales taxes on major purchases. However, it is unlikely that
compensation for indirect tax bills takes place in reality. Only eight EU Member Statesxvii have
systems for issuing VAT compensation or rebates for public bodies and five of these are
narrowly defined, focused on either specific sectors (e.g. health) or local government
(Jervulund et al, 2013). Furthermore, these countries do not include the location of the EIB’s
main office (Luxembourg) and there is no evidence of compensation being received in the EIB’s
accounts (EIB, 2014). This does not rule out the possibility of a subsidy related to indirect
taxation, but it does indicate that although there is provision for such a subsidy to be received,
it is probably not being taken advantage of in practice. Further clarification could potentially
be achieved through an EU Freedom of Information request.
Finally, the Protocols mean that EIB employees are not subject to income tax in their country
of residence, but instead pay income tax to the European Commission (EC) at a rate set down
in European legislation. This could represent a cost (income tax foregone) to national
governments. However, income tax paid directly to the EC from organizations such as the EIB,
reduces the funding needed for the EU budget from member states. So whether this
constitutes a subsidy or not depends on whether the tax rate payable to the EC is comparable
to national income taxes and whether this leads to a comparable reduction in the funding a
member state must provide to the EU budget. Given the complexity of calculating the latter,
and the fact that the differences between the EIB income tax system and national income tax
systems are likely to be marginal, we regard any subsidy via income tax for the EIB as of
second-order concern.
Like the EIB, the IFC is exempt from all taxes, as covered by Article VI of the IFC Articles of
Agreement (IFC, 2012), which states:
26
“The Corporation, its assets, property, income and its operations and transactions authorized
by this Agreement, shall be immune from all taxation and from all customs duties. The
Corporation shall also be immune from liability for the collection or payment of any tax or
duty.” As with the EIB, however, there is little evidence that the IFC has claimed back any
forms of indirect tax in practice.
In contrast though, for income tax the IFC seems to be a special case where some but not all
employees are exempt from employment taxes (IFC, 2012):
“No tax shall be levied on in respect of salaries or emoluments paid by the Corporation to
Directors, Alternates, officials or employees of the Corporation who are not local citizens, local
subjects, or other local nationals”
This creates an additional level of complexity that must be addressed in calculating the
foregone taxes for the IFC, which is discussed below.
In summary, tax exemptions for DFIs appear to be as follows:
Table 4.2: Tax Exemptions for DFIs
Tax Exemption:
MDFIs:
Income Taxes
Dependent on institution
Indirect Taxes
Yes in theory, but
unclaimed in reality.
Corporation Taxes Yes
BDFIs:
No
No
Yes with a few
exceptionsxviii
Methods
Calculating the opportunity cost from foregone taxes is relatively simple. For taxes that are
paid on an ongoing basis throughout the year, it is half the face value of the tax (to account for
accumulation through the year) plus the social rate of return that could be earned with these
funds. This reflects the fact that had the government not given the DFI a tax exemption; they
could have used that revenue to earn a social return in the year in question.
St = 0.5T x (1 + m)
Whereas for taxes that are paid at the end of the year, it is simply the face value of the tax.
St = T
Where:
St = Subsidy to DFI from tax exemptions
T = Total foregone tax
m = Social rate of return
27
However, assessing the amount of foregone tax is problematic. This is different for indirect,
income and corporate taxes and so these are dealt with separately below.
(v) Indirect Taxes
As has been discussed there is no indication in the literature or accounts of bilateral DFIs to
suggest that they are exempt from indirect taxes. Therefore there seems to be no foregone
indirect tax to be calculated from bilateral DFIs.
Multilateral DFIs such as the IFC and EIB are exempt from indirect taxes. However, their
exemption requires that they claim back any indirect taxes that they have paid. As this is not
mentioned in their accounts or the wider literature, it is unlikely that it is taking place.
Therefore again, there seems to be no foregone indirect tax to be calculated.
(vi) Income and Employment Taxes
As has been mentioned above, whilst bilateral DFIs are not exempt from income or
employment tax, multilateral DFIs can be. The amount of foregone income and employment
tax from multilateral DFIs such as the IFC can be calculated but it requires detailed information
on staff levels and salaries.
For the IFC the situation is particularly complicated as local citizens do pay income taxes but
non-citizens do not. The IFC takes this into account when setting salary levels, equating salaries
on a net-of-tax basis for citizens and non-citizens (IFC, 2014b). Consequently, the only tax
foregone is from non-citizen salaries, and the amount foregone per employee is equivalent to
the difference between salaries at each employment level for citizens and non-citizens.
Calculating the product of this and the number of non-citizens at each salary level would give
total foregone taxes.
However, a breakdown of salaries according to citizens and non-citizens or the number of noncitizens at each employment level, are not publicly available. Instead the estimate below is
based on information available for the IFC and World Bank. It has been calculated based upon
US federal income tax rates:
Table 4.3: Estimating income tax foregone from IFC
Total income tax if no exemptionsxix
Proportion of staff in head officexx
Proportion of locals in head officexxi
Proportion of tax exempt in head office
Foregone income tax from head office
Proportion of staff in regional offices
Proportion of locals in regional officesxxii
Proportion of tax exempt in regional offices
Foregone income tax from regional offices
Total foregone income tax
$81.0m
45%
25%
75%
$27.3m
55%
85%
15%
$6.7m
$34.0m
28
(vii) Corporate Taxes
At first glance, the subsidy provided through corporation tax exemptions, is simply the
calculation of foregone corporation tax based on annual accounts dataxxiii. W&V use this
calculation for the IFC, EBRD and CDC Group.
However, this calculation does not capture the impact of other subsidies on profit. For
instance, an income tax exemption would reduce a DFI’s costs, boosting profits. And we have
already valued this subsidy in the section above. If we use raw data for profits here then we
will be double-counting this subsidy.
This problem can be overcome by using a measure similar to the concept of true profit. True
profit is accounting profit minus profit gains (Nawaz, 2010). It is the profit that would be
obtained in absence of profit gained through public funds. The profits gained through public
funds are not the opportunity cost of public subsidy but the extent to which these benefits
increase accounting profit. They are the face value of these benefits.
Thus the calculation for the foregone corporate tax is as below:
Fc = Pt x t
Where:
Fc = Foregone corporation tax
Pt = True profit
t = Foregone corporate tax rate
True profit is calculated by the following:
Pt = Pa - Sp
Where:
Pt = True profit
Pa = Accounting profit
Sp = Profit gaining subsidies
Profit gaining subsidies include the face value of all foregone interest payments, indirect taxes,
income and employment taxes and sovereign guarantee gains. Foregone dividends are not
included, because dividends are not tax-deductible.
The only additional data necessary for this calculation is the accounting profit, available from
DFIs annual accounts and the foregone corporate tax rate, freely available for the country in
which a DFI is registered. The rest of the data is derived from previous calculations for other
subsidy channels.
It should also be noted that many DFIs will not be earning a profit once subsidies are taken into
account (i.e. they are not earning a ‘true profit’) and therefore would not benefit from an
29
additional subsidy via a corporation tax exemption (Yaron, 1992). However, as some DFIs do
manage to turn a true profit, this subsidy must nevertheless be taken into account (Schreiner,
1997).
Other corporate taxes.
Finally, it is worth highlighting that since MDFIs such as the IFC and EIB appear to be exempt
from all taxes, except perhaps where these payments are charges linked with the provision of
specific services (such as water, refuse collection etc) they will also benefit from exemptions to
local taxes such as business property taxation. These can be important, for example, in the UK,
business rates are levied at almost 50% of the rental value of business property (VAO, 2014).
However, the extent and type of business property taxation varies considerably from country
to country (UN Habitat, 2013). Furthermore, as these taxes are local in nature, one business
could be paying several different forms of property tax in different locations, complicating
calculations. And these taxes are also not individually itemised in Annual Accounts, making it
very difficult to assess how much a business is paying. This is an area that could be considered
further, however, property taxes are likely to be of second-order consideration compared with
sovereign guarantees and foregone dividends, for example.
(vi) Intangible Support
We have already commented briefly on the different nature of intangible support compared
with other forms of subsidy. The opportunity cost to taxpayers of intangible support from
governments to DFIs is likely to be negligible, given that it consists of little more than providing
a ‘seal of approval’ from host governments, access to privileged information or diplomatic
support from shareholder governments. The cost of these activities to taxpayers is essentially
just a function of civil servants’ timexxiv.
In contrast the benefit of intangible support to a DFI may well be substantial. One way to
evaluate this benefit would be to compare the success rate of DFI client projects, with non-DFI
client projects of a similar risk, on the assumption that the main effect of intangible support is
to increase the likelihood of a project’s success.
Specifically, consider a range of possible project xi to xj, with associated probability of success
pi to pj. Intangible support for DFIs mean that when they take on a project, the probability of
success increases by a factor y (constant across all projects). If we assume (conservatively)
that the private sector and the DFIs choose projects that are on average, of equal risk, then
any difference in the success of DFI and private sector projects is due to the factor y.
However, as already mentioned, this approach would value the subsidy according to the
perspective of the DFI, rather than the taxpayer.
5. Subsidies direct from taxpayers to DFI’s clients
In this section, we briefly consider the two types of subsidy provided directly from
governments to DFI clients.
30
(i) Grant Co-Financing
Taxpayers provide subsidies directly to DFI clients through the co-financing of grants (V&W). As
was noted in section 4, cash grants in the form of ODA are rarely directly controlled by DFIs.
However, DFI clients may benefit from ODA directly from donor governments.
The extent to which DFI clients benefit from ODA directly is difficult to quantify, for two
reasons. First, that available data does not show whether ODA is reaching a DFI client. Even
the planned improvements to ODA reporting would not provide such detail (OECD, 2014b).
Second, establishing whether a project is receiving ODA because it is a DFI client is hard to
ascertain unless explicitly stipulated in ODA policy.
(ii) Intangible Support
As with the intangible support to DFIs from taxpayers, the opportunity cost of intangible
support from taxpayers to DFI clients is likely to be negligible. However, the benefits derived
by DFI clients from this intangible support may well be substantial – see the preceding
discussion in section 4(vi).
6. Subsides from DFIs to their Clients
At the beginning of this section, it is important to return to our discussion of opportunity cost.
In sections 4 and 5, it is relatively clear that the appropriate way to value subsidies is according
to their cost to the taxpayer, thus providing the ‘left-hand side’ of a cost benefit analysis. The
figures produced can then be compared with the social benefits that DFIs provide, in order to
assess whether they represent a good investment for taxpayers. Consideration of these social
benefits is beyond the scope of this project, but this section treads close to the same territory
as will become clear below.
As before, the key issue is deciding on an appropriate proxy for opportunity cost. This decision
rests on the way in which we view DFIs, and the purpose we intend for the numbers. Broadly
speaking, we have two options:
1. Consider the DFI to be a private sector entity, maximising their profits. In this case, the
DFI’s ‘next-best alternative use’ of their funds is to earn a financial return similar to
other financial institutions.
2. Consider the DFI to be an arm of government. In this case, the next best alternative
use of a DFIs funds is to earn a social return.
The problem is that neither approach is entirely satisfactory. As the IFC themselves state, “An
adequate financial return is… essential, [but the]… IFC also considers returns to society as a
whole, including benefits and costs to other stakeholders” (IFC, 2014c: 1). In other words, most
DFIs are mandated to pursue both social and financial returns.
If we take the first approach and treat the DFI as a commercial entity, then conceptually, we
treat the choice the DFI faces as to either (i) ruthlessly pursue financial returns or (ii) to accept
a lower rate of return (potentially in order to generate more social benefits). In this case, (i)
31
becomes the opportunity cost, such that earning a return below opportunity cost (ii) means
passing on a subsidy to a clientxxv.
This approach allows us to answer questions such as whether DFIs are acting as commercial
banks, or whether they might be making an allowance for social returns by reducing their
expectation of financial returns. These are useful questions to answer. However, this
approach does not allow us to consider whether DFIs are delivering good value for taxpayer’s
money.
If we take the second approach above and treat the DFI as an arm of government, then we
treat the social rate of return as the opportunity cost, and compare this with the return earned
by the DFI in their lending to the private sector. A subsidy is passed on when they lend at a
rate below the social opportunity cost. The implication here is that non-monetary benefits
must make up any difference between the social rate of return and the financial return if the
investment is to represent good value for taxpayers.
Notice that under this approach, we have slipped into considering the benefits side of the costbenefit equation. We are implicitly assuming that the benefit to taxpayers equals the financial
return earned by DFIs plus any non-monetary benefits they generate. However, this is not
necessarily true, because as we discuss in section 4, DFIs rarely if ever pass financial returns
back to taxpayers. They normally pay no dividends to shareholder governments, and are often
exempt from corporation tax. In this case, it is not clear that the benefits side of the cost
benefit analysis should include financial returns earned by DFIs. And in any case, consideration
of benefits is beyond the scope of this project.
Finally, there is a third option for valuing the subsidies passed on from DFIs to their clients, and
this is from the client’s perspective. In this approach, we would compare the cost of DFI
funding to the client with the relevant cost of private funding for the client. This third
approach does not value the subsidy from either the government or DFI’s perspective, but it is
relevant to discussions of additionality, because it would give an insight into whether DFIs are
funding projects that are not otherwise commercially viable. This also relates to the benefits
side of the cost-benefit calculation and is therefore not within the scope of this project.
Methods and Data Availability
In each of these cases we can take either a project-by-project or ‘overall DFI’ approach. The
former requires DFI projects to be benchmarked against private sector-funded projects of
similar risk, so as to compare the funding costs (W&V). This runs up against huge data
challenges, because it is frequently very difficult to ascertain the true risk level of projects in
order to benchmark them against each other. Furthermore, the interest rates charged by
those financing these projects (DFI or private sector) are often not publicly available (W&V).
An ‘overall DFI’ approach is much simpler, and simply requires the comparison of the
(expected) rate of return for the DFI in question with either the social rate of return, or a
benchmark rate of return for commercial financial institutions (either banks, private equity or
venture capital).
32
Notwithstanding the conceptual problems with approaches 1 and 2 above, they would be
operationalised as follows.
Option 1: DFIs treated as commercial entity
The subsidy from DFIs to their clients is given by the following equation:
S = A x (m – E(r))
Where:
S = Subsidy from DFIs
A = Capital Assets (i.e. retained earnings and equity investments)
m = benchmark market Rate of Return
E(r) = DFI’s Expected Return on Assets
Annual accounts offer us an obvious proxy for expected (i.e. risk-adjusted) returns, and this is
the return on average capital. This is essentially the return achieved on all of a DFI’s
outstanding projects (using the income data presented in their accounts). Since this takes into
account the genuine success/failure rate of their projects (since write-downs are included in
the income element of the accounts), it accounts for risk, providing an estimate of expected
returns.
As a benchmark market rate of return, the expected return on equity for financial institutions
in developed countries is generally held to be around a minimum of 12% (see for example
Damodaran, 2013, or ABI, 2012). This is a relatively low proxy for those DFIs that are allowed
to issue debt on financial markets, because the sovereign guarantee they enjoy would allow
them to leverage their capital much more cheaply than a commercial bank, thus earning higher
returns. On the other hand, it is probably a high benchmark for DFIs who are not permitted to
issue debt (such as CDC Group), and therefore cannot leverage at all. It is also worth noting
that the expected return on private equity or venture capital – who invest in riskier projects –
is generally far higher, often above 20%.
Overall, Table 6.1 clearly indicates that DFIs are not earning returns on capital in this range.
Consequently on this measure, they would be seen as passing on a significant subsidy.
Table 6.1 Return on capital for selected DFIs
DFI
IFC
IFU
Norfund
CDC Group
Return on Capitalxxvi
6.4%
5.7%
4.7%
4.4%
Option 2: DFIs treated as an arm of government
33
Under this approach we simply exchange the market rate of return in our formula for the
social rate of return.
S = A x (m – E(r))
Where:
S = Subsidy from DFIs
A = Capital Assets (i.e. retained earnings and equity investments)
m = Social Rate of Return
E(r) = Expected Return on Assets
Table 6.1 shows that DFIs are typically earning financial returns in excess of the social rate of
return (since typically government borrowing costs for shareholder governments are around
2.5% currently, IMF, 2014).
As previously discussed, there are conceptual problems with both approaches.
7. Conclusion
In this paper we have sought to advance our understanding of the subsidies that DFIs and their
clients receive from taxpayers. We focus primarily on subsidies from taxpayers to DFIs, and set
out a framework for combining estimates of subsidies provided through different channels,
based on their social opportunity cost. This framework includes grants, subsidised loans and
tax exemptions.
We also outline a possible method for estimating the value of sovereign guarantees extended
to DFIs, but from the perspective of how much this is worth to a DFI, rather than how much it
costs the taxpayer to provide. Further work is required to incorporate this into the same social
opportunity cost framework as the other forms of subsidy.
Regarding intangible support from taxpayers to DFIs, we argue that the cost to taxpayers of
providing this support is likely to be low, but the benefit to DFIs may be highly significant, and
we sketch out one potential method for estimating the scale of this benefit.
Finally, we also touch on the conceptual difficulties inherent in attempting to assess how much
of the subsidy DFIs receive from taxpayers is actually passed onto their clients. The key
problem here is identifying the opportunity cost of these funds to the DFI. Again, further work
is needed in this area.
34
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i
http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=DCD/DAC%282015%2915&d
ocLanguage=En
ii
http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=DCD/DAC/STAT/RD%282015
%293/RD5&docLanguage=En
iii
http://www.oecd.org/dac/OECD%20DAC%20HLM%20Communique.pdf
iv
Richard is the Director of Foresight Economics, a consultancy specialising in economics, policy analysis
and strategy. He previously worked as an Economic Advisor in the UK’s Government Economics Service,
leading a team of economists working on international trade reform, the EU’s Common Agricultural
Policy and the G20’s food price volatility workstream.
v
Ben will shortly be joining Elixirr Consulting Services, he is currently completing an MSc in Global
Governance at University College London having previously worked for the Actuarial and Insurance
Management Solutions Department practice at PricewaterhouseCoopers.
vi
And in particular, whether these benefits are additional, in the sense that they offer an improvement
against a counter-factual of ‘no DFI lending’.
vii
Sometimes called the full economic cost, or economic opportunity cost.
viii
Some governments have recorded their equity stakes in DFIs (such as DEG) as ODA (Kingombe et al,
2011). However, the issue of equity is dealt with separately under section 4.iii.
ix
See recent discussions of the DAC (OECD, 2014a).
x
The risk of nonpayment is inconsequential since DFIs are themselves underwritten by governments,
see section 4(iv).
xi
Some governments have recorded their equity stakes in DFIs (such as DEG) as ODA (Kingombe et al,
2011).
xii
It is worth noting that unlike public shareholders, dividends foregone to private shareholders do not
constitute a subsidy to DFIs for two reasons. First, they do not constitute a public source of finance.
38
Second, because it is assumed they trade their own resources (even below market value) according to
their own benefit-cost analysis (Schreiner, 2003)
xiii
For a brief literature review, see Hoenig (2014).
xiv
W&V also suggest imputing a commitment fee for government’s callable capital as a way of
measuring the sovereign guarantee, but this approach assumes that a government’s support for a DFI is
limited to their existing capital commitments. In reality, the existence of a sovereign guarantee strongly
implies that governments would go far beyond this if the DFI was in financial distress.
xv
Noss and Sowerbutts (2012) suggest that ratings sensitive liabilities include “the sum of deposits from
other financial institutions, some financial liabilities designated at fair value (debt securities, deposits),
and certain debt securities in issue (commercial paper, covered bonds, other debt securities and
subordinated debt)”
xvi
See Moody’s ratings (Moody, 2013)
xvii
Austria, Denmark, Finland, France, Netherlands, Portugal, Sweden and the UK.
xviii
Such as FMO which is not exempt and DEG which is partially exempt.
xix
Based upon IFC’s number of staff (IFC, 2011); salary structure; employees at each grade (IFC, 2014b)
and US Federal Income Tax rates (IRS, 2014).
xx
From IFC (2011)
xxi
Based on latest available breakdown of World Bank nationalities (GAO, 1995)
xxii
Based upon World Bank figures for locally employed in country offices (World Bank, 2014).
xxiii
Since corporation taxes are typically paid at the end of the year, or in quarterly instalments from six
months after the year has started to six months after it finishes, we do not need to take the social rate
of return into account.
xxiv
Unless we assume that these activities automatically disadvantage other projects, in which case this
would need to be taken into account.
xxv
Note that the passing on of a subsidy does not in itself guarantee that the client is delivering a social
return.
xxvi
From IFC (2014b), IFU (2014), Norfund (2014), CDC (2014).
39