Simon Scott: Write Your Own ODA Receipt, June 2023

stevecutts

Jun 11, 2023

3 min read

Updated: Oct 23

About this paper

In this June 2023 paper, Simon Scott uses a worked example of a $100 million, 20-year loan to show how the choice of discount rate changes its reported ODA grant equivalent. The paper also discusses equity investments and reproduces a graph and cartoon from the original document.

Editorial note: The original text follows in its historical context. References to rules, proposals, figures and future events reflect the source document, rather than an update to the present day.

Write your own ODA receipt

by Simon Scott

In its only substantive defence of the DAC’s changes to Official Development Assistance (ODA), its Secretariat asks itself

Do the discount rates agreed by the DAC unduly inflate ODA?

and answers, among other things, that

The impact of the choice of discount rates on the valuation of loans is relatively low.

But is this true? To investigate, I took the simple example of a $100 million loan for 20 years at a 3% p.a. interest rate, repayable in full at maturity, and worked out what its “ODA grant equivalent” would be using different discount rates.

I got the result below. Applying a 3% discount rate exactly cancels the loan’s interest earnings, and therefore scores its grant equivalent as zero. Given that, over the last decade, major DAC lenders have often been raising funds themselves at under 3%, this probably overestimates their “financial effort” in making this loan, even allowing for their administrative and other costs. The graph shows that if a donor’s total cost in making the loan had been 2.5%, charging 3% would have yielded it a profit, or negative real “grant equivalent”, of -$8m.

Original graph showing how the reported ODA grant equivalent rises as the discount rate increases.

But the DAC has chosen discount rates much higher than 3%, which vary by borrowing country. For upper-middle income country borrowers, such as China, the DAC selected a discount rate of 6%. This makes a donor score $34m. in ODA for extending this loan. For lower-middle income borrowers, the DAC opted for a 7% discount rate, which values the loan at $42m. For low-income or “least developed” countries (LICs/LDCs), the DAC uses a 9% discount rate, yielding $55m. of ODA.

It is plain that, far from being “relatively low”, the impact of the choice of discount rate on the valuation of a loan is decisive. In fact, it fully determines a loan’s “grant equivalent”. Admittedly, the DAC will only score this if it meets a specified minimum percentage of the loan (“grant element threshold”), but the loan above easily qualifies for any recipient. So even though it very likely makes a profit, the DAC’s high discount rates will generate a large, bogus “grant equivalent” for it, reportable as ODA. And if by chance the borrower defaults, the donor will score even more ODA for eventual debt relief.

The DAC is now planning to extend the use of grant equivalents to equity investments. In March it proposed to score ODA for these using discount rates peaking at 12% for LICs/LDCs. The graph applies equally to equities, and it shows that, if a “donor” invested $100m. for 20 years in one of these countries, received 3% each year in dividends, and then sold its stake at par, it would score $67m. in ODA. Apparently someone has judged this not quite generous enough, so a revised proposal now tweaks the 12% rate to 13%, making the equity yield $70m. in ODA.

The higher the discount rate, the higher the ODA. The reason is that it’s the transaction’s returns that the rate is discounting. The higher you set the rate, the smaller you make the returns and the more generous the loan or investment appears to be. The mechanism really is as simple as that.

And the DAC certainly understood how it worked in the old days. In 1967, a blue-ribbon panel convened by the United Nations Secretary-General, and led by the future Chair of the DAC’s statistical working party, observed that:

A point to be stressed is that the grant element in a loan made on specified terms will vary

with the discount rate used…The higher the discount rate, the higher the grant element.

[“Measurement of the Flow of Resources to Developing Countries”, UN, New York, 1967, p. 125]

That is just as true today as it was over half a century ago. You can score any amount of “ODA grant equivalent” you like, from a negative amount up to 100% of a transaction’s value, simply by sliding the discount rate up or down. As Dilbert put it…