How to Fund an Elephant Hiding in Your Room

More, please.

More, please.

Dan Altman, who has blogged on these pages before, has a great piece in the HuffPo on an innovative new way of funding private sector enterprises in developing countries.

Since I started working in aid effectiveness, one thing that has always struck me was quite how little aid goes towards the development of a viable private sector. In Malawi, the 2008/09 Annual Debt and Aid Report showed that only 1 per cent of all the aid provided to Malawi in that year went towards activities that were classified under Trade, Industry and Private Sector Development. That translated into $8.3 million. It’s a tiny amount of money for what must ultimately become the central driving force of any economy. What’s more, when donors or domestic Governments do get involved, they don’t fund actual private enterprises. Instead they cast themselves as facilitators for a better business environment, as the World Bank do in its series of Business Environment Strengthening Projects, and as USAID does through many much smaller activities.

Yet a functioning private sector and flourishing domestic economy would be the single best way of addressing poverty: it creates jobs, has an internal growth dynamic, and through tax raises the revenues for sustainable Government action in health, education, sanitation and infrastructure development. These are massive positive externalities that arise from a large scale private sector development process – and when large positive externalities exist, conventional markets will not allocate enough resources to maximize social benefits.

This is exacerbated by the high risk of investment in private sector enterprises in developing countries. Though these enterprises often have a very high potential return they find it particularly difficult to attract investment because there are so many risk factors that may jeapordise their returns, with political instability and shocks to the economy at the forefront.

The upshot of this is that funding for private enterprises, particularly large-scale commercial ones with the largest capacity to create jobs, is very thin on the ground: donors do not support them, and private investors are unable to take on the risk involved. This is where Dan’s idea comes in: he suggests that Governments, who have much longer time horizons and greater ability to absorb risk, can establish swaps markets. On such markets, investors would be able to make high-return, high-risk investments in private enterprises in developing countries, then go to the swaps market and exchange this risky investment for a more stable asset. Governments can make this exchange because they are better able to hold risk, and this extra risk can essentially function as a type of aid to the developing country in which the private enterprise is held. The appeal is clear: private entrepreneurs select investments in the private sector without holding all the risks associated with them, the enterprise gets the resources it needs and the economy benefits from higher investment. The Government(s) that contribute to this swap market provide a sort of diffuse aid to the private sector development of poor countries, an area they have traditionally neglected badly due to their dislike of engaging directly with commercial enterprises.

At first sight, the idea really grabs me. There is much to think about still, about how exactly it would work, about how any potential moral hazards must be dealt with if it is to subsidise risk to some extent, and about how much it would be used. But innovative ideas on how to stimulate large scale commercial enterprise and production are extremely thin on the ground, and when we have any we need to give them all the thought and consideration they deserve.

My one major concern is that it does not address what I consider to be one fundamental constraint to private development in Africa: that most countries are not yet capitalist in their relations of production. It’s partly or largely because of the failure to accumulate assets among capitalists and create a true wage-labour force that private economic development hasn’t been strong. The swap market proposed would open investment opportunities to people who already have assets, probably mainly international capitalists, but will not stimulate the creation of a domestic capitalist class. What do readers think of this idea, though?

4 thoughts on “How to Fund an Elephant Hiding in Your Room

  1. D. Watson

    April 1, 2010 at 4:52pm

    I’m glad someone is paying attention to the fact that donors aren’t paying enough attention to the private sector. They aren’t. But honestly, did we learn nothing from the current banking crisis? Oh wait, yes, we did. We learned that rich governments are willing to buy bad loans to subsidize hedge funds, banks, insurers, and venture capitalists. The idea could have some merit, but it’s going to take more explanation why this isn’t a disaster waiting to happen when systemic risk bites.

    And under his banner that “innovation is a public good” can we please differentiate between true public goods and merit goods where most of the benefits are captured privately, there are just some nice secondary effects, which incidentally are also privately captured?

  2. Daniel Altman

    April 1, 2010 at 11:57pm

    Thanks for your comment. Here is my reply.

    The market I proposed can be used to free up money for investments with and without a social component – and I think it *should* be used for both, because in every case it will open up new gains from trade. I’m not sure how it would either create more or unduly suffer from systemic risk, so you might want to explain that further.

    Any government that participates in the swaps market will have to do its due diligence on the investments involved, just as the private sector would. But as I outline in my proposal, the government should, overall, make money from swap transactions. There is no subsidy here, unless the government decides to offer even higher rates of return than those necessary to make the swaps. Rather, the government would be using its unique position to unlock a market that otherwise would not exist.

  3. Ranil Dissanayake

    April 6, 2010 at 9:46am

    Lee – I thought so too, at first. There would be a moral hazard if you basically got stable bonds in exchange for any crazy investment you made with potentially huge returns, and if the risk was subsidised. Two things mitigate the moral hazard:

    1) There is a fee associated with getting the more stable bonds – this payment essentially brings the npvs close(r) to parity but leavens risk.

    2) The due diligence done by the donor/Government backing the market should reduce or eliminate the crazy investments.

    3) Dan explains elsewhere that you may not swap the assets: you can just swap the returns. thus you’ll still hold the asset (though earn a more stable return) and if things go totally belly up, you’re not completely immune.

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