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When Resources Come from 'Partners' Instead of 'Donors'

Chinese workers at construction site in Khartoum, Sudan: Brazil, China, India see themselves as development partners, not donors (photo: Ashraf Shazly/AFP)

DEVELOPMENT FINANCE

When Resources Come from 'Partners' Instead of 'Donors'

By Nkunde Mwase
IMF Strategy, Policy, and Review Department
and Yongzheng Yang
IMF Asia and Pacific Department

June 19, 2012

  • Major emerging market economies scaling up development financing activities
  • Financing has helped alleviate supply constraints, boost trade and investment
  • Opportunities come with challenge of maximizing benefits, minimizing risks

Rising levels of development financing by major emerging market economies have intensified the debate on aid effectiveness and debt sustainability.

Unlike aid from advanced-economy donors, financing from the major emerging market economies excluding Russia focuses on mutual benefits without involving policy conditions on how the funding is used.

A new IMF study examines the philosophies and methods of development financing by the major emerging market economies, and examines the implications for low-income economies and for future engagement between low-income countries and emerging market countries.

Competing paradigms

The major emerging market economies, with the exception of Russia, provide financial assistance based on the principle of “mutual benefits” and in the spirit of South-South cooperation.

Brazil, China, and India see themselves as development partners, not donors. Their experience as recipients of traditional development assistance and their identification with other recipients also contribute to their sensitivity to the term ‘aid’. Indeed, the term is sometimes contentious: China does not regard itself as providing aid.

In addition, these major emerging market economies do not attach to their financing any conditions related to governance, economic policy and performance, or institutional reforms. Conditionality, they argue, would undermine the principle of respecting national sovereignty and promoting solidarity. Partly reflecting China’s own recent development history and its policy of noninterference, it believes that the long-term development of a country is ultimately the responsibility of the recipient and not of the development partners—as noted by African Development Bank economist Richard Schiere.

While traditional donors attempt to improve governance by attaching policy conditions to aid, China argues that “tied aid”—financing that is tied to purchases from the source country—helps lower the risk of financial mismanagement and misappropriation of funds.

Though conditionality has often been criticized as intrusive and weakening country ownership of reforms, tied aid has reportedly not been able to address concerns about transparency and corruption, especially given the general lack of comprehensive, meaningful, and timely statistics. The IMF’s Nkunde Mwase finds that these countries lend more to countries with weak institutions, underscoring concerns that emerging markets’ financing could undermine efforts to improve governance in low-income countries.

Approaches to sustainability

Most of the major emerging markets’ development financing is concentrated in the infrastructure sector, although there are some differences among them. Russia, similarly to traditional donors, has recently focused on social spending, seeing poverty reduction as the main objective of its official development assistance. Some emerging markets note that there has been an overemphasis on “social projects” in the provision of aid, at the expense of building productive capacity and of faster poverty reduction in the long run.

Different approaches to development financing have also led to divergences over the concept of debt sustainability between some emerging market countries and traditional donors. China and India generally focus on a project’s economic viability while traditional partners emphasize long-term debt sustainability at the economy level.

China distinguishes between productive and nonproductive investments; the latter are generally financed through grants and the former generally by loans. In contrast, traditional partners pay more attention to debt sustainability at the macroeconomic level, often based on the results of IMF–World Bank debt sustainability analysis, which also takes into account the recipient’s ability to repay based on fiscal revenue that the investment project would generate.

Overall, the differences are, however, narrowing with emerging market countries increasingly appreciating the importance of overall debt sustainability and traditional donors the need for investing in physical capital.

Seizing on the opportunities

The scaling up of public investment associated with most development financing by major emerging market countries is likely to have large positive growth effects. Indeed, emerging market financing is starting to play an important role in alleviating infrastructure bottlenecks in many low-income countries and this has helped them tap their natural resources as well as reduce costs of doing business in general.

The World Bank’s Vivien Foster and the University of Nairobi’s Joseph Onjala have noted that emerging market financing for low-income countries has resulted in a 35 percent improvement in electricity supply, a 10 percent increase in rail capacity, and reduced prices for telephone services.

To the extent that emerging market financing of infrastructure reduces domestic costs of production and increases productivity, there could be positive supply side effects that could improve export competitiveness.

Emerging market development financing can help strengthen regional trade linkages. In addition, the IMF’s Montie Mlachila has noted that the strong focus of emerging market financing on improving access to trade and natural resources has been associated with a sharp increase in trade flows and foreign direct investment between low-income countries and major emerging market economies. The IMF’s Issouf Samake and Yongzheng Yang find significant growth spillovers from emerging markets to poorer countries, both through direct channels such as bilateral trade and indirect channels such as global commodity prices.

Meeting the challenges

While emerging market development financing has generated significant economic benefits for low-income countries, it also poses challenges that call for better economic management to minimize the associated risks and expand future benefits.

Policy issues raised by emerging market financing are not new; similar issues arose in the past in relation to aid from traditional donors. Nevertheless, given the recent scaling up of emerging market financing and some of its unique characteristics, it is worth highlighting some of the key policy issues.

Ensuring high returns on projects. As with other sources of financing, it is critical that low-income countries align projects with national development priorities.

Improving transparency and governance. Efforts should be made to improve data on the size and terms of financing flows and the structure and conditions of packaged deals, as well as the rights of concessions for natural resources.

Safeguarding debt sustainability. Macroeconomic analysis of total project financing, including assessments of risk, implications for public finances (including how maintenance costs will be financed and contingent liabilities associated with some foreign direct investment projects) and growth impact, is critical to avoid potential debt sustainability problems while ensuring adequate public investment.

Deepening project linkages to the local economy. Low-income countries and major emerging market economies could work together to build incentives, as part of a total package for development financing, to encourage local employment, foster skills development, and improve technology transfer.