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Country allocation, levels of concessionality and graduation issues

The Financing for Development outcomes recognize the importance of providing concessional finance to those countries with the least capacity to mobilize other sources of financing and those in “special” development situations, such as the LDCs, LLDCs, SIDS and countries in conflict and post-conflict situations. Specifically, the Addis Agenda notes that the allocation of concessional public finance should take into account: i) a recipient country’s level of development, including income level; ii) institutional capacity and vulnerability; and iii) the type of project to be funded, including its commercial viability. It also notes the special needs of different country groups, in particular LDCs. In addition, the Addis Agenda recognizes the importance of addressing the financing gap that many countries experience when they graduate to middle income country (MICs) status.

Official flows to countries with the greatest needs

Disbursements of ODA to countries most in need of concessional resources and most vulnerable to external shocks have stagnated in recent years. Despite an increase in ODA to LDCs in 2016 of less than 1 per cent in real terms to $43.1 billion, the medium-term trend is one of stagnation. Moreover, ODA flows to LDCs are very unevenly allocated, with almost half directed to seven countries in 2014 and 2015.  In the Addis Agenda, donors had committed to reversing the decline in ODA to LDCs. While this was achieved on aggregate, nine DAC members saw their aid to LDCs decrease between 2015 and 2016.

Aid to small island developing States (SIDS) did increase significantly, from $5.1 billion in 2015 to $7.1 billion in 2016. This increase was driven by Spain’s restructuring of Cuba’s debt, which accounted for $2 billion in aid. Short of this exceptional measure and the 2010 spike in ODA inflows to Haiti due to the earthquake, ODA to SIDS has not kept pace with the overall increase in aid flows since 2000, and remains very concentrated in a few SIDS, despite the increasing frequency, volatility, and intensity of weather-related hazards many of them are exposed to. ODA trends to landlocked developing countries (LLDCs) and African countries (see below) broadly mirror the patterns for LDCs and SIDS. 

 

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This is of concern because vulnerable countries are most reliant on ODA to complement scarce domestic public resources and have only limited access to other forms of external financing. While gross ODA disbursements amount to only 1.3 per cent of government revenue in all developing countries on average, this figure is much higher in LDCs, where ODA represents about 15 per cent of government revenue on average. In 16 LDCs, gross ODA disbursements amount to a fifth of total domestic revenue or more, and in four of them it exceeds 50 per cent.  ODA also represents the largest external financial flow for 22 SIDS, accounting for over 40 per cent of all external financing. 

A survey of donor spending plans through 2019 suggests country programmable aid (CPA) to the LDCs should rise in this period. The survey also projects that global CPA should remain stable up to 2019, with a continued upward trajectory for LDCs. (CPA is a proxy for aid that goes to recipient countries and that is programmable at the country or regional level). ODA to SIDS – which had dropped steadily between 2010 and 2014 before rising in 2015 – is projected to remain stagnant through 2019, calling for special attention and monitoring given their structural vulnerabilities.  

 

Graduation issues

As many developing countries have recently graduated or will graduate from concessional financing windows thanks to strong per capita income growth, concerns have been raised over their access to sufficient and affordable long-term financing for SDG investments. As per capita income increases above low-income thresholds, access to external (concessional and non-concessional) public finance often decreases faster than can be compensated by increasing tax revenues in per capita terms—the so-called “missing-middle” challenge.  Extreme weather events and other external shocks have exacerbated these concerns: countries vulnerable to external shocks often exceed per capita income thresholds but have limited capacity to mobilize public resources domestically due to their small size, remoteness, and/or vulnerability.

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Graduation is relevant in several contexts, including (i) graduation from access to the concessional windows at MDBs; (ii) graduation from LDC status; and (iii) graduation from ODA eligibility. In all cases, per capita income is an important criterion. For LDC graduation, it is one of three components, complemented by the Human Asset Index and an Economic Vulnerability Index composed of indicators of structural vulnerability to economic and environmental shocks. For graduation from soft windows of MDBs, per capita income is complemented by an assessment of creditworthiness. ODA eligibility relies on income alone.

A country’s categorization as a low-, middle- or high-income country is not directly related to graduation; it is instead an analytical classification by the World Bank, updated annually. However, the classification is an input to decisions on lending eligibility from MDBs. At about $1.200 per capita income, the point at which countries are re-classified as middle-income countries, consideration for a graduation process from soft windows of MDBs is triggered. Incidentally, the income threshold for LDC graduation is set at a similar level. The move from middle-income to high-income on the other hand, at per capita incomes of about $12.200, triggers graduation from ODA eligibility

LDC Graduation

Because development partners generally do not use LDC status per se to allocate resources, LDC graduation usually has only limited impact on concessional financing flows. Information provided by major donors shows that in most cases, graduation has limited impact on bilateral development cooperation programmes. In some cases, graduation may trigger a shift towards concessional loans rather than grants, or towards loans with less favorable terms.  Graduation affects a country’s eligibility for specific multilateral instruments, including for climate finance (the Least Developed Countries Fund), trade capacity-building (the Enhanced Integrated Framework in Aid for Trade), and financial inclusion (the United Nations Capital Development Fund). However, to date these have corresponded to relatively small shares of total funding available.

A country may be recommended for graduation from LDC status by the Committee for Development Policy (CDP), an independent advisory body of the United Nations Economic and Social Council (ECOSOC), if it meets the graduation threshold in two of the three criteria in two consecutive triennial reviews.  If endorsed, graduation becomes effective three years after the General Assembly takes note of the ECOSOC endorsement of the recommendation of the CDP. Hence, the graduation process takes at least six years. There are also safeguards in place to ensure smooth transition, including by extending and gradually phasing out LDC-specific support measures related to ODA volumes and modalities, market access and World Trade Organization agreements. 

Graduation from Concessional Windows of MDBs

Graduation from the soft windows of the MDBs—the World Bank Group’s IDA, the Asian Development Bank’s Asian Development Fund, and the African Development Bank’s (AfDB) African Development Fund—has a more direct impact on financing volumes and terms. Consideration for graduation is triggered when per capita income exceeds the operational cut-off, for example $1.215 for IDA in 2016. If accompanied by a positive creditworthiness assessment (based on political risk, debt burdens, growth prospects and other factors), a country receives time-bound transitional terms from IDA, and International Bank for Reconstruction and Development financing is phased in while IDA financing is gradually phased out. The full process typically takes multiple years, and is accompanied by a graduation task force that aims to ensure a smooth path of transition.  Exceptions exist for small States, which remain eligible to access IDA funding even if they exceed income thresholds. More recently, funds from the concessional financing facility are available to middle-income countries that host large numbers of refugees.

Graduating countries are faced with “harder” terms of regular assistance by MDBs, even though maturities and interest rates are still more favourable than market terms. Relatedly, the shift in financing sources tends to impact the sectoral allocation of international public finance, with less focus on social sectors such as health, which are often financed in grant form. Other sources of concessional finance, such as bilateral ODA, also remain available; and under IDA, transition support is granted to countries that have recently graduated—most recently for Bolivia (Plurinational State of), India, Sri Lanka and Viet Nam.

Graduation from ODA eligibility

The OECD/DAC reviews the list of countries eligible for ODA every three years. If a country exceeds the high-income threshold for three consecutive years, it is removed from the list and development finance contributions can no longer be counted as ODA. The last triennial review of eligible countries took place in November 2017. Three countries that had exceeded the high-income threshold from 2014 to 2016 were removed from the list (Chile, Seychelles and Uruguay as from 1 January 2018).

In its high-level meeting in October 2017, DAC members recognized “the need to ensure that development co-operation approaches and tools can effectively respond to the new complexity of sustainable development by providing appropriate support to countries as they transition through different phases of development”.  In response, a proposal for a methodology for reinstating a country or territory that has graduated from the DAC List and later suffers a drop in its per capita income has been drafted for consideration by the DAC. A plan is also being developed on how to take forward the decision to “establish a process to examine short-term financing mechanisms available to respond to catastrophic humanitarian crises in recently graduated HICs, including, without prejudice, a possible role for ODA spending based on objective criteria while ensuring no diversion of resources from existing ODA recipients”.

Improving the overall landscape

The missing-middle challenge underlines the importance of a smooth transition process, and the need to strengthen the support provided to countries as they undergo graduation. United Nations agencies already provide support to LDCs as they graduate, including through an LDC graduation task force. The United Nations Resident Coordinator and the United Nations Country Team also provide support for smooth transition. This type of engagement could be a model for more systematic engagement of United Nations country teams in helping countries plan transitions in financing mixes. Changes in the terms and volumes of the available external financing mix also call for a more strategic approach to manage the overall resource envelope available for sustainable development investments, in an integrated manner. The Task Force will explore the role of integrated national financing frameworks in more depth in next year’s report.

A more ambitious step would be to move towards a system of gradation. Allocation of concessional finance would still decline as countries become wealthier, but middle-income countries would be eligible for financing for specific projects/sectors, such as regional or global public goods,  possibly with differentiated financing options that reflect country contexts and project characteristics. There are also attempts to create additional flexibility in accessing regular windows for specific projects. The IDA18 Scale-Up Facility makes non-concessional financing additional to their regular allocation available to IDA countries for projects with potential for strong returns on investment, development impact and growth dividends. The AfDB is considering moderately concessional loans, which have higher interest rates but long maturities suitable for infrastructure investments.

Existing exceptions and multidimensional assessments already address limitations of an income-only assessment of development and ‘graduation readiness’. They include IDA’s small-state exception, which allows states with a population of 1.5 million or less to access the most concessional IDA financing terms even if their per capita income exceeds the IDA operational cut-off. Similarly, use of the creditworthiness criteria by MDBs allows them to take into account the broader macroeconomic situation, debt risks and other factors, so that graduation is a process, rather than a sudden event.

There is room for different agencies to learn from each other’s attempts to address diverse circumstances of countries. The replenishment cycles of the concessional windows of the MDBs are one entry point for achieving greater harmonization. A wider-reaching proposal is to use broader assessments of progress more systematically. For example, the LDC category could be used in a wider range of processes. New measures have also been put forward in this context, such as the structural gap approach used by the Economic Commission for Latin America and the Caribbean (see Structural Gap Analysis) or the United Nations Development Programme’s SIDS-specific criteria.

 

 

Structural Gap Analysis

As in the case of other middle-income regions, Latin America and the Caribbean has seen its share of ODA diminish. The proportion of ODA received by the region has declined compared with other developing regions, as well as relative to its average gross national income (GNI). ODA flows dropped from an average of 0.4 per cent of regional GNI in the 1990s to 0.17 per cent in the 2000s, and the region’s share of ODA dropped from 15 per cent in the to around 8 per cent.

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The importance of ODA for middle-income countries varies significantly. In the majority of countries ODA represents less than 1 per cent of GNI, while for others it represents more than 30 per cent. In Latin America and the Caribbean, ODA represents over 10 per cent of GNI in 2 countries (Guyana and Nicaragua), between 1 and 6 per cent in 10 countries, and below 1 per cent in another 18 countries.
 
Countries with similar income levels are characterized by different economic and social development (such as social protection, education and health-care quality), and financial participation and inclusion, as well as different levels of resilience to economic and social shocks. Poverty rates in middle-income countries in Latin America range from 0.3 per cent to 67.4 per cent. Inequality is also variable, with the Gini coefficient ranging from 0.28 to 0.66. 
 
Recognizing the heterogeneity of middle-income countries, the Economic Commission for Latin America and the Caribbean (ECLAC) has proposed structural gap analysis as an alternative to using income levels to classify countries. Middle-income countries are characterized by disparate social conditions, significant and persistent levels of poverty and inequality, and differing environmental vulnerabilities. They also remain economically and socially vulnerable, due to undiversified production and export structures, shallow financial markets, dependence on external financial flows, and other factors. Their capacity to mobilize domestic and external resources also varies greatly, and depends on factors beyond per capita income, including external conditions beyond their control. This makes per capita income an incomplete criterion for allocating international resources.
 
The structural gaps approach identifies key structural obstacles that are holding back sustained, equitable and inclusive growth in middle-income countries, such as regressive tax systems and low tax collection, limited redistributive effects of social spending, high inequality, low labour productivity, and lagging infrastructure spending. The ECLAC approach uses a comprehensive set of indicators that reflects country-specific obstacles and allows them to prioritize development needs in a particular country and a given time. 
 
This approach would also allow countries and regions to identify and order development priorities, needs and challenges, and to decide which areas and gaps to prioritize and confront. It could thus contribute to broadening the policy dialogue, including on sources of financing and allocation criteria at the global level.
 

 

Concessional resources - IDA replenishment
The World Bank Group Group’s International Development Association (IDA provides concessional long term loans and grants to countries with GNI per capita below USD 1,215 (threshold for fiscal year 2016) and several small island economies above this cutoff. 
 
In the context of its 18th replenishment, IDA is adopting a new financing framework to better target concessional resources. This responds to the Addis Agenda’s encouragement of MDB shareholders to develop graduation policies that are sequenced, phased and gradual.
 
Figure 1: Continuum of IDA Financing Terms expands in IDA18 
Source: World Bank Group
 
IDA financing terms are linked to countries’ risk of debt distress, with: grants provided to those at high risk; a mixture of grants and credits to those at moderate risk; and concessional credits to those at low risk. ‘Blend countries’ that have been above the income threshold for more than two years no longer have access to grants, but can obtain financing on ‘blend terms’, which are above concessional levels but still below market rates. ‘Gap countries’  – countries with incomes above the operational cutoff, but not creditworthy for IBRD lending – also have access to blend credits. 
 
Changes in IDA 18  include:
 
A greater engagement of IDA in small states (including making the most concessional lending terms now available to all small states), and making official finance on non-concessional terms available for ‘transformational projects’ in blend countries. Such resources will be channeled through the IDA18 Scale-up Facility (SUF).
 
Doubling resources allocated to countries classified by the World Bank as “fragile or in conflict situations,” with the aim of providing USD 2 billion to help refugees and their host communities, and will significantly increase financing for its regional programme. 
 
Changes to IDA’s financing, including a scaled up Crisis Response Window and a new Private Sector Window. 
Levels of concessionality at the project level

 

The Addis Agenda also commits providers of development finance to take the nature of a project funded into account when determining the level of concessionality. The Intergovernmental Committee of Experts on Sustainable Development Financing (ICESDF) had made a recommendation to this effect (see figure), proposing that ‘international public finance should take into account […] the type of investment. Concessionality should be highest for basic social needs, including grant financing appropriate for least developed countries. Concessional financing is also critical for financing many global public goods for sustainable development. For some investments in national development, loan financing instruments might be more appropriate, particularly when the investment can potentially generate an economic return.’

 

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An example of such adjustments of concessionality is the IDA Scale-up Facility, which provides financing on IBRD (and thus less concessional) terms for specific ‘potentially transformational’ projects or programmes to IDA-eligible countries. It is being expanded in the context of the IDA 18th replenishment, and aimed at projects that can help ‘remove critical constraints to development’, or in other words productive investments with strong returns on investments that enhance GDP growth and government revenues.

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