Treasury Secretary O’Neill is Half Right: Make Grants Not Loans to the Poorest Countries (But First Increase Development Assistance)

Treasury Secretary Paul O’Neill has suggested that the World Bank should begin making grants instead of loans to the poorest developing countries. He is upset that the Bank, as well other developed countries, who have seats on the Bank governing board, don’t want to go along with this proposal. (See related story.)

Secretary O’Neill is half right. He is correct in asserting that the World Bank should begin making a substantial portion of its new commitments as grants, not loans. For various reasons, the poorest countries are not able to pay back loans that the World Bank and other lenders have been making. Where he is wrong is in not recognizing the valid opposition to his position, a key reason being that that resources provided to developing countries by developed countries, including those provided by the Bank, are very scarce, and valid methods of economizing on those resources, such as making loans, not grants, are in order. What he evidently does not realize, or possibly for political reasons chooses to ignore, is that the United States has led the “race to the bottom” in not providing resources to poor countries, and that this lack of resources is a major reason why other developed countries favor grants.

The two are intertwined.

Why the World Bank should begin making grants not loans.

It will be useful if the reader has a basic understanding of a Bank loan to the poorest countries, which are made by a Bank “lending arm” called the International Development Association (IDA). An IDA loan is on very generous terms–for 40 years and for something like a 3 percent interest rate. (Would that we could finance our houses on such good terms!) The point is that there is a significant subsidy component of IDA loans–at least fifty percent and probably up to 80 percent. (To compare with U.S. mortgage loans, the interest rate on U.S. mortgage loans is certainly more than 6 percent, which would indicate that IDA loans at 3 percent, have at least a 50 percent subsidy component.) So on one important level, IDA loans are a “good deal.”

The second thing to understand is how this lending plays itself out over time–the 40 year time period of the loan. There are three things to consider: the flow of financial resources, the productivity of the loan, and the country and international circumstances surrounding the loan.

Suppose that each year for forty years a loan is made. (World Bank lending to developing countries began in earnest in the 1960s, so we are at the end of this 40 year repayment period for the first loans to many developing countries.) In the first year, the loan is made, suppose for $10 million, and suppose this amount to continue each year. The country receives all the benefits from this loan. In the second year another loan is made for 10 million. However 2.5 percent or (100 percent divided by 40 years) must be repaid. Thus the net benefit in terms of incoming resources is $9,750,000. In the 21st year the new loan is $10 million but the net benefit is only $5 million. In the 40th year the new loan is $10 million, but the loans of 39 previous years must be repaid, leaving a net gain to the country of only $250,000. In subsequent years, there is no net gain. This is how a debt crisis arrives. What looks like a good deal, and certainly is in the beginning, becomes much less so.

We can then see a very important difference between grants and loans. Over a period of time, loans, which must be repaid, will have a greater fluctuation in net benefit, with a large net benefit at the beginning and and a very small one as the number of years in which loans have been made approach the repayment period for the loans. On the other hand, a grant, identical in size each year, will deliver the same benefit each year.

A significant portion of IDA loans are for primary health and primary education. That the developed countries (through the World Bank) should support primary health and education is extremely worthwhile. Done well, it is a contribution to the poorest people in these countries, one which will enable them to lead healthier, more knowledgeable, and more productive lives. Where then are the difficulties? We would point to three areas. First, the loan may not be well used. Secondly, the political and economic circumstances in the country may reduce the benefits of the loan. To understand the third difficulty, we must remember that an IDA loan is paid to the country in dollars (which can then be used for purchasing imports for the country) , and must be repaid in dollars. This requirement essentially requires that the activity for which the economy must generate enough foreign exchange–dollars or Euros. Thus even though the loan was used for highly productive purposes, there may be difficulties in generating the foreign exchange/U.S. dollars to repay the loan.

To review this again, with examples.

First, the loan may not be well used.. The loan would typically be paid to the finance ministry of the country. All of the loan might not reach the health ministry. Alternatively, the loan could be used to finance efforts of a dysfunctional national health ministry. Though improvements were planned for and expected, they might not occur.

Secondly, the political and economic circumstances in the country may reduce the benefits of the loan. The country might be at war, or in a state of high unemployment/a low level of economic activity. Being at war would certainly increase the costs of educating children in war zones, and very possibly make it impossible. Conflict in a nation typically reduces the economy to a shambles. With high unemployment/low level economic activity, the hoped for economic benefits of educating people with the result that they would be better workers would not be as significant. People must be employed before education can be translated into higher productivity.

Finally, surprising as it may seem, the loan could be used for very productive purposes, the overall political and economic situation could be quite favorable, and yet, the loan, or the economy, might not generate sufficient foreign exchange to repay the loan. Suppose the loan is used to educate children and do it successfully. How will this generate enough foreign exchange to repay the loan? Repaying the loan requires a successful export sector. A successful export sector is not automatically created by educating children.

In conclusion, what should be done? In the ideal world, developed country assistance would be adequate in amount and provided as grants. In the real world, there is a minimal amount of development assistance, and there is pressure to economize. This is done by requiring the governments of the lowest income developing countries to repay their loans, which substantially reduces the benefits to the poorest countries and the people living there. Development assistance should be increased, and–not small steps!–every effort made to ensure that the loan will be well used and that the country political and economic circumstances will be favorable for productive use of the loan.