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Are private investors the best people to decide development priorities in poor countries?

Olivia Bryanne Zank, 22 May 2014

In a blog post in March I reported that, more than six months after the launch of development impact bonds (DIBs), there are still no pilot projects to test the controversial model in practice.

I argued that this might be related to a number of problematic issues with DIBs, and I explored the issue of performance by results in particular.

In this post I explore a second concern with the DIBs, namely their reliance on private investors to decide on funding allocations.

In effect, DIBs take funding discretion away from the current donor and developing country governments and NGOs, who, despite all their flaws, at least are development professionals and can be assumed to have some expertise on the matter.

Instead, financial investors will make the decision on what to fund and what not to fund. But how are financial agents and investors assumed to know what constitutes a good, feasible, impactful project with long-term benefits?

Proponents argue that the financial return offered on the DIB will send a signal to the market about the quality of the project. But actors in financial markets are not civil servants, teachers, engineers or doctors and it is highly unlikely that they will have the kind of expertise it takes to know what kind of project is likely to work at a specific time and place. (You could argue that people working in development don’t know either, but that’s a different issue).

Of course those currently making funding decisions will still have some say in that they create the DIBs offered, but investor demand will no doubt be influential on what projects are able to secure funding. The ultimate funding decision will therefore be made by actors who cannot be assumed to have any expertise about development.

Hopefully, some will be guided by legitimate ideas and rudimentary research about what works (after all a large amount of development impact research is publicly available from networks such as 3ie, J-PAL and their partners). Other investors, however, will not bother to research at all and will be guided only by the return offered on the bonds (indeed, that is the point, to use price signals).

Furthermore, the payments-by-results structure of the DIBs will incentivise investors to take more interest in project management. Being the funders of a project, they will have significant influence on management decisions, but without having any development expertise to speak of, this may not be a good thing. Hopefully, investors will be humble enough to realise this. Some, however, will not.

Related to this second point, therefore, is the concern that if DIBs acquire the liquidity their proponents hope for, by laws of supply and demand, returns will be higher according to investor perceptions and expectations of project quality. As such the cost of finance for development projects will wax and wane according to investor confidence and opportunity costs, just like it does for the rest of the economy.

Keynes famously compared investment decisions to a beauty contest, wherein contestants (investors) are asked to choose the picture (project) they think the average contestant will choose. Their own opinion on beauty (project quality) therefore does not matter as much as the average opinion (or more correctly, the average prediction of the average opinion). Of course, DIBs are far from having the liquidity that would create such mechanisms, but it is worth keeping in mind.

DIBs (and the Social Investment Bonds, SIBs, which precede them) do indeed offer ways of shifting risk burdens to private investors who arguably are better positioned to bear it and as such may significantly increase the amount of investment in the social good.

However, there is a concern that their introduction will exacerbate a worrisome trend present in the development sector today, namely a bias towards quantifiable, short-term projects. In addition they could introduce volatile changes in the costs of finance according to investor moods and expectations

It is therefore necessary to be very critical about which projects are suitable for funding in this manner and which are best kept within state or civil society realms.

  • Olivia Bryanne Zank is a researcher with Public World and is completing a Masters in the political economy of development and finance at the School of Oriental and African Studies in the University of London.
     
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