The Private Sector in Fragile Countries: what role for the DFIs?

Sir Paul Collier is a British economics professor and the director of the Centre for the Study of African Economies at Oxford University. He is also a guest lecturer at the Centre for Study and Research on International Development (CERDI).
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Paul Collier
Fragile states are the future of aid. Partly, this is because those poor countries that are politically stable are increasingly gaining access to capital markets, making aid less important. Partly, it is because poverty is becoming increasingly concentrated in fragile states. According to the OCDE, in 2015, 43% of people who live off 1,25 USD a day live in the 50 countries on the unstable states list. By 2030, these countries are forecast to be home to a substantial majority of the world’s poorest people. Partly, it is because the weakness of public services in these societies exposes them to health shocks that can spread across borders, so generating international public ‘bads’, as the Ebola Crisis demonstrated.

Evidently, some of the aid to fragile states will be to respond to humanitarian emergencies. Successful response to crisis depends upon speed, and so substantial finance needs to be available as soon as disaster strikes. An implication is that finance for such emergencies needs to be redesigned from its past reliance upon ad hoc international appeals, to an approach based on insurance against specified risks. Potentially, donor agencies could use the vast global commercial insurance market to buy cover for these risks, making the cost of responding to emergencies a predictable and modest charge on budgets.

While such changes will be helpful in improving the emergency responses that inevitably follow from fragility, the major task of aid in fragile states is clearly to help their economies to grow: with rising prosperity societies gradually become less fragile. The main engines of economic growth are firms: they have the organizational knowledge to transform the productivity of the workforce through scale and specialization. But the condition of fragility discourages firms from operating in the country. Due to widespread poverty, markets are small. Typically, the state is not in secure control of its territory so firms face an existential uncertainty. Often the capacity of the state to invest in economic infrastructure and to provide critical economic services such as the rule of law and education, fall far short both of modern standards, so firms face unusually high costs. Often societies are highly exposed to economic and political shocks yet lack the cushions commonly found in other societies: hence, firms are exposed to a range of non-commercial risks. This gives rise to a syndrome from which it is difficult to escape: lacking firms, the economy remains very poor; but being very poor the society remains fragile. Since fragile societies will struggle to lift themselves out of this syndrome, there is a clear need for international assistance to break it.

However, to break this syndrome aid has to be deployed in fragile countries very differently from in more conventional settings. The priority for development assistance should be to induce firms to enter the market. As reputable firms operate in the country, the resulting economic growth will reduce fragility, generating major public benefits both for the society itself and for the international community. This public benefit should be paid for by public money: otherwise, too few firms will come to the country.

Because there are so few proper firms in fragile states, those firms that come will often be the first firm in the sector: they become pioneers. In advanced economies the pioneering firms are typically exploring new technology. The public benefit of pioneering is widely recognized in public policy: through various mechanisms public money is used to assist them. In fragile states the pioneers are exploring new markets rather new technology. Paradoxically, because the economies of fragile states are so underdeveloped, they need pioneering firms even more than the developed countries. Yet mechanisms for public support have been missing: this is a legitimate and important use of aid. By pioneering a market, a firm makes it easier for other firms to follow. For example, the first firm in a sector will need to train workers in unfamiliar skills; subsequent firms can poach these ready-trained workers and so face lower costs. This is a benefit to the country, but a disadvantage for the pioneering firm, and so again it needs to be compensated using public money. For decades, large aid budgets have been devoted to training of civil servants, but there has been no equivalent aid for the training done by pioneering firms.      

The right public vehicles for aid to pioneering firms in fragile states are the DFIs rather than the aid agencies. The DFIs routinely work with firms, and their investments are subject to the discipline of the market. In consequence, they can deploy aid to pay for identified public benefits, such as those discussed above, while leaving commercial risk with firms where it properly belongs. The aid agencies lack these skills and so firms would be tempted to abuse access to public money. As with all commercial investments, DFIs are in the risk business and so some of their investments will fail. To offset this, when an investment succeeds they need to be able to capture the upside, and this implies that they should acquire an equity interest in companies rather than rely only on debt. Since the DFIs have relatively little capital, they need to work it hard. Hence, once a firm is established in its market the DFI should sell on its holding to conventional asset managers such as pension funds. These funds are generally unwilling to establish the specialist teams able to evaluate new projects. But as DFIs build reputation for skill in such decisions, participation by a DFI may itself become sufficient to reassure other asset managers that a project is viable.      

There are many DFIs, but since all are public agencies whose mandates are to promote the economies of poor countries they are not in competition with each other. Rather, collectively they are pioneering an asset class of investments in low-income countries. For this they need to cooperate: for example, their instruments for bearing the non-commercial risks that pioneer investors face could usefully be standardized, making it easier both for firms and asset managers to understand them.

DFIs have an important role in fragile states: in effect, they should be creating new markets. They are not needed to finance investments in markets that are already well established: these could be financed by the private financial sector and competition from DFIs could slow the development of such finance and so be market-destroying.

Finally, DFIs are not there to make profits that can be transferred to aid agencies. They should be deploying aid money, not providing it. The unique role is to enable firms to go to countries where they are most needed.