The Disruption of Development Finance

Editor’s Note: The Trump administration is skeptical of spending on foreign aid and development, a sentiment shared by many Americans. Not surprisingly, many new actors are filling the void. Most are undemocratic and favor development policies that do not accord with U.S. interests. Karen E. Young of the American Enterprise Institute describes this change in the development landscape and calls for a renewed U.S. commitment to development spending.

Daniel Byman

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A central logic of development assistance and access to finance after World War II is based on a consensus that open markets are best able to deliver growth, and that leverage from international financial institutions to encourage liberalization and rule of law can nudge (or force) governments to make better choices. As the World Bank reports, that advice has been largely successful and contributed to remarkable and unprecedented progress in reducing extreme poverty over the past quarter century.

In 2015, more than a billion fewer people were living in extreme poverty than in 1990. The opening of China and the ignition of economies in South Asia—driven by a global consensus on the power of economic liberalization, expansion of property rights and access to capital—has changed the world. However, it did not happen in a vacuum. American ideas about markets inspired China’s liberalization and then facilitated it by providing access to capital through international financial institutions that the United States helped create. Today, U.S. leadership is absent from the development finance conversation, and other actors with narrower interests are filling the vacuum.

Gulf Arab states are engaging in unprecedented economic interventions across several key African states. Sudan and Ethiopia have received generous central bank deposits, aid, foreign direct investment and commitments of future support totaling nearly $20 billion since 2011. Gulf financial support (in loans, in-kind oil and gas, investment, and central bank deposits) to Egypt has reached nearly $90 billion by some estimates in the same period. Pakistan is another major recipient of Saudi and Emirati aid and investment support, with commitments of more than $30 billion in the past year alone.

On Feb. 2, the United Arab Emirates committed $2 billion in investment, development projects and loans in Mauritania. (Inflows of foreign direct investment to Mauritania amounted to just $71 million in 2018, for a sense of the enormity of the commitment.) Within the UAE foreign policy leadership, there is a general consensus that aid and foreign investment can be linked, and at the Ministry of Foreign Affairs and International Cooperation, the two mandates of diplomacy and economic cooperation go hand in hand. The ministry’s aim is to have 10 percent of UAE foreign aid to be “in kind,” as a means to link the export of energy products or construction projects to foreign policy engagement. The economic resources of the country are fungible as tools of diplomacy, aid and foreign policy. And when the government can leverage its sovereign wealth funds and special situation investments from funds like Mubadala to direct financial support for policy goals, the development goals of the recipient state are secondary or tertiary to the priority of return on investment and state security.

The implications of this shift toward the financing of development projects that prioritize the return to the donor state has many implications, few of which are well understood. In a field dominated since the end of World War II by Bretton Woods institutions such as the World Bank and the International Monetary Fund, these new development finance actors challenge multilateral development assistance, the liberal order and its founding states. China (and its infrastructure loans distributed as part of its Belt and Road Initiative) and the Gulf Arab states and their sovereign wealth funds can be potential partners in a shared vision of global growth and institutional norms, or they can advance their own national interests. They are doing the latter. The interests of these disparate actors do not always overlap, nor do they share an ideology or methodology on the best ways to create economic growth in poor states with weak or nonexistent democratic institutions. And in the absence of a clear plan of action and stable partners on the ground, these projects can sometimes go awry. As rival factions of the Somali government competed with one another in Somalia in 2018, one group seized bags filled with $10 million of UAE aid that had been intended to finance a military training project.

Moreover, an emerging preference for bilateral financial intervention over multilateral engagement undermines both national development planning and global development goals. Many of these new foreign economic interventions feature state-to-state project finance (exemplified by China’s “predatory lending”), direct capital injections and promises of foreign direct investment untethered to local development objectives. The problem with this emerging trend is that the legal and institutional basis of economic growth—through promotion of rule of law, accountable governance, and more inclusive or democratic decision-making—is entirely absent from the agenda. The lenders don’t bring it up, and the borrowers and recipient governments are incentivized to make deals with as little input as possible from their fellow citizens and political rivals. The outcome is a short-term development agenda tied to the politics and leadership of the moment.

Problematically, much of the demand for infrastructure investment in emerging markets is met by predatory lending and recycled petrodollars. Using the broadest definition of infrastructure, the world spent $9.5 trillion on all types of asset classes in 2015, equivalent to 14 percent of global gross domestic product, according to research by the McKinsey Global Institute. McKinsey estimates that $3.7 trillion in infrastructure investment is needed annually through 2035 to keep pace with projected growth, and more than 60 percent of the investment needed will be in emerging markets. To meet that finance demand and tap the development potential of the Middle East, Eastern Europe, Latin America, China and beyond, there must be ideological leadership on how to grow. Right now, the United States is at the fringes of the global development conversation, but it is in America’s strategic interest to take a more assertive role and expand rule-based markets.

While the United States has been largely disengaged from this shifting landscape during the Trump administration, the new U.S. International Development Finance Corporation (DFC) opened its doors in January. The DFC will combine the operations of the former Overseas Private Investment Corporation (OPIC) with the credit guaranty arm of the U.S. Agency for International Development. The new DFC will double its exposure cap to about $60 billion, from OPIC’s $29 billion. A U.S. effort to encourage private finance to join forces to provide social and physical infrastructure funding for developing states is welcome, but it will still be outspent and underleveraged compared to its Gulf and Chinese peers. According to the American Enterprise Institute’s China Global Investment Tracker, which records transactions greater than $100 million, China has pursued more than 1,600 major investments from 2005 through 2019, together worth $1.2 trillion, and an additional 1,700 construction projects, worth more than $800 billion. The Arab Gulf states have also ramped up direct financial support since 2011, including commitments of foreign direct investment, loans, in-kind oil and gas transfers, and central bank deposits. Though this development support can be difficult to measure because it is distributed in a range of forms through complicated mechanisms, from direct government assistance to investments by state-linked entities, the intent is the same as Western governments’ use of aid and development finance: to influence recipient states through the exercise of soft power.

What the United States can and should provide is convincing evidence of the success of economic growth supported by rule-based institutions and open markets backed by private and public capital. U.S. agencies have been doing this work. The Millennium Challenge Corporation has invested capital as grants in foreign infrastructure development projects (and required recipient governments to contribute capital and meet governance standards to qualify for U.S. support), with some success in Liberia and Sierra Leone, among other places, though their allocation capacity is small compared to the lending, investment and direct financial support that China and the Arab Gulf states can provide. But that might not always be an obstacle. Some recipient governments and politician may prefer restrictions on eligibility of loans and direct investment as a means to combat waste and corruption in their own governments. If the United States can leverage its aid and development finance institutions with capital from the private sector, and potentially with new state actors, there could be some innovation to create blended finance models with accountability. The Abu Dhabi Fund for Development, a UAE government aid entity, has announced a partnership with the DFC to “support private sector investment as a stabilizing force in the Middle East. The collaboration will also bolster the efforts of ADFD—which has traditionally operated as a foreign aid agency—to develop a new private sector financing arm,” according to a press release by the DFC.

There are signs that U.S.-based private financial institutions are interested in engaging the development finance space alongside traditional multilateral development banks and government finance initiatives. On Jan. 21, JP Morgan announced the formation of a new development finance institution. The bank cited the need for investment in developing countries in its announcement, noting that “the United Nations estimates that achieving the Sustainable Development Goals—which seek to address basic infrastructure, food, security, climate change, health, and education—by 2030 will require $5 to $7 trillion per year, with an annual investment gap of about $2.5 trillion in developing countries.” JP Morgan’s strategy, as a private bank, is to use its own capital from its investment banking business to finance $100 billion of development finance projects annually. These infrastructure and development projects provide low rates of return on investment, but they provide long-term investments and are attractive to investors looking to diversify their holdings. Though there are plenty of private investors in infrastructure and debt finance projects across the developing world, JP Morgan is the first large private institution to connect a financial product to a development agenda with specific, shared goals.

We are in the midst of a significant disruption of development ideas and financial intervention. How new development players decide to structure their economic institutions and pathways to achieve economic growth will have a profound effect on U.S. influence globally and, eventually, the health of the American economy. This will also have a huge impact on how poor countries with weak systems of governance seek help, construct their institutions, and set expectations for their citizens’ economic and social mobility. Now is the time for the United States to get back in the development business.