Reintroducing Concessional Loans into the Development Toolbox
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Introduction
Global indebtedness has soared to unsustainable levels and requires a long-term solution, not an endless series of bailouts. The process for helping indebted countries is inefficient and does not serve U.S. interests. To be part of the solution for countries facing a debt crisis, the United States must refresh its lending practices and learn from the mistakes and successes that China has made in its lending to the Global South. It is time to seriously reconsider how the United States may be a part of the solution. Is there a role for concessional loans in the U.S. development portfolio? Is the current U.S. strategy of funding foreign assistance exclusively through grants always the right one? Tethering development finance to U.S. foreign policy objectives while producing fiscally sustainable outcomes is a component of great power competition with China that has yet to be satisfactorily assessed.
Between 2010 and 2022, government borrowing increased by almost 4 times in Asia and the Pacific, 3 times in Africa, 2.5 times in Europe and Central Asia, and 1.6 times in Latin America and the Caribbean. The Covid-19 pandemic, Russia’s invasion of Ukraine, and rapid rate hikes by the Federal Reserve and other major central banks have worsened the fiscal outlook for many deeply indebted low- and middle-income economies, particularly commodity-exporting countries vulnerable to market volatility. According to the International Monetary Fund (IMF), global public debt hit a record $97 trillion in 2023, with developing countries shouldering a disproportionate amount relative to their share of the global economy.
As emerging markets default on their loans in record numbers, the institutions of the current multilateral debt architecture—including the IMF, Group of 20 (G20), and Paris Club—have struggled to provide comprehensive or timely debt service relief, concessional financing, and debt restructuring. At least 53 economies—including Argentina, Egypt, Ghana, Nigeria, Pakistan, and Sri Lanka—either have defaulted on some of their debts or have debt levels that the IMF considers unsustainable. Despite representing only 5 percent of the global economy, these countries are home to approximately 20 percent of the world’s population and face the highest borrowing costs. This underlying “debt tsunami” poses a major threat to global financial stability and undermines efforts to finance lagging UN Sustainable Development Goals (SDGs).
Debt service payments now account for critical percentages of national budgets in the developing world, preventing government spending on essential public services and other investments needed to attract business. According to a June 2024 UN Trade and Development report, approximately 48 countries encompassing a population of 3.3 billion people spend more on interest payments than on education or health. In 2022, low-income nations disbursed $49 billion more to their external creditors than they received in foreign aid.
The Evolution of Development Financing: From Loans to Grants
Debt has long been recognized as a powerful tool for economic growth and innovation when used judiciously. The U.S. foray into development loans can be traced back to President Franklin D. Roosevelt’s Good Neighbor policy in the late 1930s, at which time the United States began extending development loans to Latin American countries through the U.S. Export-Import Bank (EXIM). Over the decades, institutions such as the U.S. Trade and Development Agency (USTDA), EXIM Bank, the U.S. International Development Finance Corporation (DFC), the Inter-American Development Bank (IADB), and the World Bank Group have played significant roles in providing extensive lending programs aimed at fostering global development. For instance, in 2023 alone, the World Bank Group disbursed nearly $73 billion for various projects in sectors such as infrastructure, health, and education. Similarly, the recently constituted DFC has been instrumental in supporting economic development in emerging markets, committing $7.4 billion in financing in 2022 across diverse sectors, including renewable energy, healthcare, and technology.
Despite the potential benefits of debt, its use in development circles has often been contentious, with many policymakers favoring grants over loans due to concerns about overindebtedness and financial stability. This shift in perspective was significantly influenced by the 2000 Meltzer Commission’s recommendations, which advocated replacing up to 50 percent of World Bank and other development agency loans with grants. The commission argued that grant funding, particularly for critical needs such as sanitation and potable water, would prevent poor countries from falling into unsustainable debt. According to then U.S. secretary of the treasury Paul O’Neill, the philosophy of “more grants, less loans” was justified by the belief that the World Bank, by lending instead of donating funds to fight poverty, had driven poor countries “into a ditch.”
The Meltzer testimony recommended that international finance institutions use grants to improve the quality of life in low-income countries through humanitarian assistance efforts. The commission proposed that the grants be paid directly to service providers on evidence of completion from independent auditors. Grants would bypass corrupt governments, and auditing results would improve performance. The administration under President George W. Bush went on to start one of the largest aid programs in half a century, the President’s Emergency Plan for AIDS Relief (PEPFAR) program, which remains grant funded.
The Meltzer Commission report came just a few years after the IMF and World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative in 1996. The initiative aimed to ensure that no poor country faces an unmanageable debt burden and offered significant debt relief to qualifying countries. Debt forgiveness was seen as one of the reasons many African countries began to move along a positive economic trajectory. During this time, influential actors such as the Catholic Church and U2 lead singer Bono advocated for debt relief. They supported and contributed to the Jubilee 2000 campaign, which urged the elimination of debt for many low-income nations. This activism swayed the opinions of several politicians and resulted in the approval of funds for international debt forgiveness by the Republican-led 106th Congress.
In 2005, the HIPC Initiative was supplemented by the Multilateral Debt Relief Initiative (MDRI), providing 100 percent relief on eligible debts from institutions such as the IMF, World Bank, IADB, and African Development Fund. There was hope that this forgiveness would resolve the issue entirely. However, many debtor countries continued irresponsibly borrowing after the HIPC Initiative. Despite the significant debt relief provided by the HIPC and MDRI Initiatives, countries such as Bolivia, Haiti, Honduras, and Nicaragua continued to face fiscal challenges. Honduras and Nicaragua saw their debt levels rise again due to continued borrowing and economic mismanagement, while Bolivia and Haiti struggled with persistent poverty and political instability, which undermined the benefits of debt relief. The initiatives brought about a moral hazard as the massive wave of forgiveness offered only temporary relief without addressing the underlying issues of fiscal discipline and economic sustainability within debtor nations.
The roots of the transition to a grants-based development strategy were planted before the HIPC and MDRI Initiatives or the Meltzer Commission. The “New Directions” strategy, embodied in the Foreign Assistance Act of 1973, marked a shift in thinking from large capital projects such as infrastructure and policy reform to technical assistance and meeting basic human needs. As a result, infrastructure investments as a percentage of total investment by multilateral development banks (MDBs) such as the World Bank and Asian Development Bank declined for decades before seeing a resurgence in the early 2000s. Projects in higher-income developing countries such as Brazil, Uruguay, and Venezuela were phased out as the new bottom-up approach was implemented and projects were allocated solely to nations with the lowest incomes. Loans represented about a third of total military and economic assistance until a decline in this figure began in the 1980s. By 2001, loans represented a mere 1 percent of aid. The decline was, in part, due to a response to the debt issues occurring at the time.
Today, the U.S. development portfolio is almost entirely grant based, with foreign aid in fiscal year (FY) 2022 totaling an estimated $70.4 billion, or about 1 percent of total spending. Of this aid, 25 percent was for humanitarian activities, 21 percent was for health programs, 18 percent was for peace and security assistance, 18 percent was for economic development assistance, and the remaining 18 percent was for program support, human rights, and multisector assistance, among other purposes. Most of this aid is implemented by nongovernmental organizations rather than foreign governments, emphasizing a model that prioritizes grants over loans to minimize the risk of debt crises in developing countries. The United States remains the largest foreign aid donor globally, accounting for around 29 percent of total official development assistance from donor governments in 2023.
China’s Emergence as a Major Lender and Its Use of Predatory Loans
Loan-based financing of the Global South did not stop when the United States transitioned away from lending. Instead, countries sought loans from alternative sources, including China and commercial creditors. With immense borrowing needs and limited access to development finance, emerging markets have increasingly resorted to more expensive private sector and Chinese lenders operating outside of the official Paris Club regime, creating a more diffuse credit landscape with a far riskier profile.
The Paris Club, an informal group of official creditors from major economies, aims to find sustainable solutions to payment difficulties that debtor countries experience. It provides a platform for restructuring sovereign debt and operates based on consensus and shared principles of fairness, ensuring that all participating creditors agree to similar terms and that the debtor nation is treated equitably. This coordinated approach helps prevent disorderly defaults and maintains stability in the global financial system.
China’s disregard for the Paris Club’s principles and practices poses significant challenges. China’s lending is often opaque, more expensive, and stringent, with undisclosed terms and conditions. This lack of transparency and coordination can lead to debt traps, in which borrowing countries find themselves unable to service their debts, potentially leading to a loss of sovereignty over key assets. This approach undermines the cooperative framework the Paris Club established and creates a riskier credit environment for emerging markets.
China’s emergence as the largest official lender to developing countries has proved the main stumbling block in the escalating sovereign debt crisis, with estimates of Chinese debt exposure ranging up to $1.5 trillion. Beijing’s unusual lack of transparency and reluctance to forgive debt have paralyzed the IMF’s ability to provide technical assistance and implement financial stabilization programs that hinge on financial assurances from existing creditors. Emergency programs such as the G20’s Common Framework—developed in late 2020 as a channel for low-income countries in need of rapid debt relief—have been plagued by delays, coordination issues, and enforcement challenges. These issues are in large part due to China’s reluctance to provide significant debt relief concessions, as well as concerns that some creditors, especially China, are pursuing more favorable side deals than others. Additionally, there are concerns that IMF bailouts or hard currency inflows from aid or remittances would flow directly into Chinese pockets. As multilateral debt talks stall, borrowers in distress have waited years for a restructuring deal without receiving a cent from the IMF.
China’s emergence as a major lender has been transformative for global development finance. As of 2017, China had become the world’s largest official lender, surpassing the World Bank, IMF, and Paris Club combined. The China Overseas Development Finance Database details 1,099 Chinese development finance commitments abroad, amounting to $498 billion between 2008 and 2021. This volume of lending equaled 83 percent of the World Bank’s sovereign lending during that time frame, making China’s direct foreign investments some of the most active worldwide. In China’s $80 billion annual development portfolio, the vast majority of loans are targeted toward low-income countries, with significant concentrations in Southeast Asia, Africa, and South America. Today, more than 5 percent of global gross domestic product (GDP) consists of China’s outstanding claims. However, many of China’s loans are not categorized as development loans or are classified as concessional loans. From 2013 to 2018, 49 percent of Chinese foreign assistance, which totaled an average of $7 billion annually, took the form of concessional loans.
Chinese loans, almost all of which come from official government or state-controlled channels, have drawn significant criticism for being opaque and predatory. Even though China’s lending is under state control, it is decentralized and managed by various institutions that are hesitant to accept losses on their loans. Since 2000, there have been 150 documented cases of default, debt restructuring, or other credit events involving Chinese loans to developing nations. The proportion of countries defaulting on these loans has more than doubled, exceeding 10 percent of all nations since 2016. For some nations, up to 50 percent of their foreign loans originate from China, with the majority spending over a third of their government revenue on servicing this foreign debt. Notably, Sri Lanka and Zambia have already defaulted, unable to meet even the interest payments on loans used for constructing ports, mines, and power plants. This rapid increase in defaults demonstrates the risks developing countries take due to China’s lending practices.
China’s lending strategy often involves high interest rates and stringent terms. Many of these loans are not reported in the most widely used official debt statistics, creating a hidden debt problem. This means debtor countries and international institutions alike have an incomplete picture of how much countries around the world owe China and under what conditions. For instance, an analysis discovered that Zambia owed $6.6 billion to Chinese state-owned banks, roughly double the amount previously thought. This systematic underreporting complicates global efforts to manage and restructure debt effectively.
Chinese lending is also widely considered transactional, driven by a desire to secure access to critical resources such as oil, minerals, and other commodities. Some experts believe Beijing’s willingness to finance infrastructure projects, even in high-risk environments, reflects this strategy. The approach has led to increased debt burdens for borrowing countries and has been criticized as a form of “debt trap diplomacy.” Countries such as Ghana, Pakistan, Sri Lanka, and Zambia have faced severe economic consequences, including defaults and significant reductions in essential services, due to their inability to manage high debt repayments.
China’s ascent as a major creditor leveraging state-owned enterprises for its lending activities has introduced a significant challenge into the global economic order and the existing debt crisis. Its lending terms often include nondisclosure agreements and confidentiality clauses, making it difficult for other creditors to gauge the full extent of a country’s indebtedness to China. This development has major consequences for global debt restructuring initiatives. China’s parallel system of development finance challenges the traditional Western approach to providing assistance and negotiating debt relief, which has dominated since the end of World War II. As China’s influence continues to grow, its lending practices and the resultant debt burdens on developing countries remain critical issues for the international community, especially the United States and its allies.
Debt Damages Foreign Assistance
Due to the severity of the debt crisis, there are now a dozen key strategic developing countries—including Kenya, Laos, Mongolia, Pakistan, and Zambia—devoting more resources to paying interest on their debt to China than to public goods and services key for development, such as education and healthcare. Development assistance does not exist in a vacuum.
The use of foreign aid grants during periods of crisis and capital outflows is highly detrimental to aid effectiveness. Grants, which are non-debt-creating flows, are counted as reserves at central banks once they are converted to local currency and spent on staff or supplies inside the recipient country. Foreign assistance flows are deposited in developing country commercial banks so that they may be spent on aid projects. These deposits are created by the developing country’s central bank, a state-owned enterprise that accepts foreign grant dollars as central bank reserves and creates domestic currency deposits for the local commercial bank. Hence, the counterpart to this grant-funded local currency spending is central bank reserves used to stabilize the currency when domestic bondholders, Eurobond holders, foreign direct investment (FDI) investors, China, and commercial lenders seek to liquidate their investments in a crisis-stricken country. IMF programs attempt to stabilize the currency with whatever dollars are available in order to buy time to make fiscal adjustments. This practice invariably leads to currency devaluation, usually some form of capital controls, and budget cuts. Hence, the current institutional framework necessarily involves using U.S. government grants and remittances to meet central bank reserve requirements instead of using the international purchasing power of the aid grants to fund development.
Policy tools such as budget cuts, devaluation, inflation, and multiple exchange rate mechanisms enable governments to convert foreign aid into reserves, thereby reducing the aid’s international purchasing power and impact. This weakens the impact of U.S. Agency for International Development (USAID) grants, which are meant to be spent on goods and services to stimulate development but are instead leveraged for outflows funding debt repayments as countries undertake structural adjustment programs. IMF research suggests an increase in overall aid (comprising both loans and grants) tends to reduce domestic revenues, though loans and grants have differing effects. While the borrowing country’s capacity to repay external creditors and rebuild reserves is closely monitored, insufficient effort is made to mitigate the risk that fiscal adjustments will simply allow redirection of central bank reserves to repaying Chinese lenders, commercial creditors, and local bondholders before devaluations and reserve depletion.
Since U.S. taxpayers fund reserves from aid flows, ignoring the use of foreign assistance to repay China could jeopardize critical foreign assistance budgets. As a result, the purchasing power and impact of aid grants diminish. More needs to be done to build the financial and institutional capacity of recipient countries to strengthen their ability to manage aid funds transparently. Providing technical assistance to improve their fiscal policies and debt management practices can reduce reliance on foreign aid for debt repayment. Negotiating debt-for-development swaps, for instance, can ensure that aid funds are used for their intended purposes.
The money and resources granted to a low-income country can alter how it chooses to spend government revenue. Regardless of whether the assistance is from government to government, any time dollars are deposited in the central bank of a country in debt distress, those dollars are at a higher risk of being allocated to service the debt. Grants introduce budget volatility and dependency; they may be canceled from one year to the next. When a government receives increased aid, it has several options: it can lower revenues, raise expenditures, cut domestic borrowing, or adopt a mix of these strategies. This dynamic holds true whether the aid supports the budget directly or funds specific projects. When aid finances programs that otherwise would be funded domestically, the government must adjust its budget accordingly. Over a given period, increased aid can result in lower, higher, or unchanged revenues. Foreign assistance should not be used to pay debt.
Upgrading the Development Toolbox
The United States’ choice to shift away from loans was intended to mitigate the risk of overindebtedness and maintain financial stability in developing countries. This change aimed to provide more sustainable and predictable aid without burdening recipient nations with debt; however, the developing world today is not the same as it was 30, 20, or even 10 years ago. There is now a pressing need for a refined approach to development. Grants may not be as attractive as they once were. The pervasiveness of China’s Belt and Road Initiative (BRI) demonstrates the Global South’s willingness to take on debt in exchange for infrastructure. These nations aim to graduate from relying on foreign aid to becoming self-sufficient, with robust economic growth driven by private enterprise. Additionally, many developing countries now have more financial resources from taxes and access to capital markets, allowing them to finance much of their own development. Various U.S.-led infrastructure initiatives are underway, but much work must be done to “enable a better offer.”
In the world of development finance, concessional loans emerge as an instrument for facilitating sustainable growth and institutional reform in developing countries and markets. Concessional loans can provide a structured approach to development finance, ensuring that recipient countries have both the incentive and the means to enhance their economic and governance frameworks.
Earning a Seat at the Table
In light of the merits of issuing loans through a geopolitical lens, how can the United States best counter China’s BRI? Insofar as the United States uses grants, it has no voice at the debt restructuring negotiation table (or creditor committees). Providing countries with aid through loans not only finances development projects but also offers crucial flexibility and crisis mitigation options through mechanisms such as debt restructuring and forgiveness. In the event of economic or financial turmoil, a country facing difficulties repaying its debts can negotiate with its creditors for restructuring or even partial forgiveness of its obligations. This ability to negotiate can help stabilize the economy by freeing up resources for essential public spending and investment, thereby preserving the nation’s development trajectory. One key element facilitating this process is creditor committees, which bring together representatives from different lenders, including multilateral institutions, governments, and private creditors, to negotiate unified responses. By acting collectively, these committees can enforce debt restructuring decisions across all creditors, ensuring that the burdens of economic crises are shared equitably. The United States should seek to have a seat at the table given the size of its investments in developing countries.
This unified response is enabled by instruments such as collective action clauses (CACs). CACs are provisions included in sovereign debt contracts that allow a supermajority of bondholders to agree to a restructuring plan that binds all bondholders, even those who did not vote for the plan. These provisions are crucial for preventing holdout creditors from derailing a restructuring deal or seeking preferential treatment, which could exacerbate a country’s financial distress. Including CACs and creditor committees also helps integrate a diverse range of creditors, such as China, commercial lenders, and Eurobond holders, into coordinated relief efforts. Their participation is significant, as these creditors may not adhere to established norms such as those of the Paris Club, which has a long-standing history of helping developing countries manage their debts in times of crisis. By acting as a majority creditor, institutions such as the World Bank and IMF can wield significant influence within creditor committees, steering decisions toward sustainable outcomes. This practice ensures that all parties contribute to an equitable resolution, allowing developing nations to recover from crises more swiftly, avoid default, and maintain their path toward sustainable growth and development.
Enhancing multilateral coordination is vital to support sustainable development. Multilateral institutions should strengthen frameworks to include collective action clauses and improve transparency, especially regarding Chinese debt. U.S. institutions and international financial institutions (IFIs) should leverage their influence as lenders within creditor committees to steer debt restructuring efforts toward sustainable outcomes. This approach ensures that restructuring is not only effective but also fair and transparent, helping to stabilize the global financial system.
Improving Institutions
Loans tend to improve the institutions of recipient countries. There is evidence that an increase in the degree of concessionality of assistance is good for growth in countries with poor policy and institutional environments and low GDP per capita. By contrast, countries that have better policy environments or are richer seem to absorb less concessional (but larger) aid flows more effectively. However, it is inconclusive whether concessionality helps growth in highly indebted countries. A high degree of loan concessionality improves aid effectiveness in poor countries and in countries with a poor policy environment. These results hold true in different specifications of the econometric model and are robust to different estimation techniques. However, the results of empirical analysis provide only weak evidence that more concessionality leads to higher growth in countries with high levels of debt. These results hold for concessional loans as well as grants, with the level of concessionality varying across loans (the highest level of concessional lending is a grant).
Providing foreign aid to developing countries in the form of loans rather than grants can offer substantial benefits extending beyond immediate financial assistance. One key advantage is that loans can drive long-term institutional improvements, as in the argument for the nontraditional gains from trade related to free trade agreements (FTAs). This theory posits that FTAs compel signatory nations to enhance their economic and regulatory institutions, fostering better governance and stronger economic foundations. Similarly, development loans can instigate institutional reforms, particularly in areas such as corruption control, fiscal discipline, and governance transparency. For instance, loans from institutions such as the World Bank and IMF often come with conditions that require recipient nations to implement specific reforms. These conditions may include measures to improve fiscal management and governance.
By imposing these reforms, development loans can catalyze broader institutional change, fostering a more stable and accountable governance structure. For example, the World Bank’s support for Rwanda through loans includes conditionality and support for reforms aimed at enhancing governance, transparency, and anticorruption measures. Beyond direct conditionality, loan-based financial support can drive governments to reform financial systems, deepen domestic markets, improve institutional oversight, and address systemic issues such as corruption, fiscal mismanagement, and governance inefficiencies. Grants provide financial relief but may not foster the same level of sustainable development as loans tied to institutional improvements.
Addressing Counterarguments
There are a number of counterarguments to concessional loans that need to be addressed:
- Issuing loans would exacerbate the current debt crisis.
There is a serious concern that the United States, by becoming a lender, would add to the problem. The worst policy prescription the United States could pursue would be to replicate what China has done elsewhere in the world or issue loans to nations already overindebted to China.
As previously discussed, funds intended for development may be appropriated for debt relief. Development agencies have already become a player in the debt crisis, but they do not have a voice at the table. Such agencies need a seat at the table if they are going to be a part of the solution. China is not interested in nursing indebted countries back to health but, rather, in maximizing its payoff. If development agencies do not want countries to depend on China, but rather to graduate to self-sufficiency and have access to U.S. creditors, then they must help these countries by offering an alternative source for loans.
- A forgiven loan is the same as a grant.
Taking out a loan provides a sense of ownership and accountability for the country incurring sovereign debt. Borrowing responsibly, unlike receiving grants, builds a credit history that eventually leads to greater market access. One of the issues that hinders emerging economies is the absence of robust financial institutions. Domestic lending channels can eventually develop sophisticated finance institutions in those nations. The examples of Singapore and South Korea demonstrate how loans from the United States can help develop a finance sector capable of surpassing this point of friction and achieving greater capacity. It is difficult to imagine a country that is a long-term development success story that did not develop robust financial sector capabilities.
Loans can accelerate needed institutional change and develop financial institutions that can then serve other purposes in alignment with development goals. Unlike grants, loans can incorporate conditions for debt forgiveness, aligning with strategic goals even if circumstances change. Denominating foreign assistance as a loan provides options to resolve thorny issues. If desired, debt forgiveness may be tethered to milestones regarding democracy, human rights, transparency, good governance, and other pertinent metrics. The IMF, for example, tethers its lending to strict conditionality that aligns with its mission and its institutional risk management goals.
More research and case studies are needed regarding the efficacy of loans versus grants and concessional versus nonconcessional financing. Although it would be useful to know which mode of foreign assistance is least wasteful and most effective at institutional development and what conditions affect efficacy, the geopolitical angle makes a clear distinction between the two instruments. China issues debt to expand its influence in the Global South, but the United States lacks a formidable alternative. Although allocating more resources to infrastructure projects, regardless of financial instrument, might be an important component of responding to the BRI, there is also a clear demand for loans. - The United States and its allies already issue loans through MDBs.
The U.S. contribution to MDBs is not a sufficient substitute for the United States offering its own lending instruments. The United States is not as influential in such multilateral institutions as it once was. These institutions are, in fact, multilateral by design; executing U.S. policy is not their mandate. Hence, the United States has found itself constrained in its ability to use multilateral institutions to advance policy preferences in a competitive environment, which reflects the multilateral nature of these institutions. Reassessing how to manage influence in such institutions is undoubtedly an important piece of a larger conversation on U.S. diplomacy, but lending agencies where the United States must compete for influence, such as the IMF, are not reliable tools for U.S.-specific goals. - Viewing the debt crisis through a U.S.-China prism is inappropriate.
The foremost priority of the Global South is its own prosperity, not the U.S.-China rivalry, which explains the Global South’s willingness to accept Chinese-owned debt. While U.S. strategy should not be overly reactionary to China, U.S. motives are, in part, driven by the great power competition with China. Beyond the immediate debt crisis undermining U.S. foreign aid and indirectly funding Chinese interests, there are few alternatives to Chinese loans. This arena is yet another soft power void China has filled because the United States has failed to lead. China’s approach has shown imperial tendencies, as evidenced by its seizing of ports for military purposes.
Beyond the geostrategic implications of inaction, there are opportunity costs. By reentering the loan business, the United States can establish a foundation in emerging markets, fostering future diplomatic relations and economic growth by playing a more prominent role in resolving the debt crisis. The United States is spending tens of billions annually, and more countries and higher-income developing partners can be reached through loans. Hence, adding this tool to the U.S. foreign assistance toolbox expands the envelope of aid and the geographic reach of U.S. assistance.
A Nuanced Approach to Loans
Given the insufficiency of MDBs, the Global South’s demand for infrastructure investments, geopolitical competition, and the ineffectiveness of foreign aid amid persistent debt crises, it is time to strategize how, when, and where to reintroduce loans, alongside grants, as a tool for international development. Whereas grants are indispensable for humanitarian aid and for sectors where revenue generation is not feasible, such as health and education, loans may well have a role in the U.S. development policy arsenal to help accomplish particular foreign policy objectives. The critical question is how to introduce loans effectively, ensuring benefits for developing countries, U.S. taxpayers, and diplomatic partnerships while countering China’s influence in the global arena. To achieve these goals, several considerations should be weighed to ensure the appropriate use of loans in development assistance.
- Deploy loans on a case-by-case basis.
A systematic overhaul would take far too long, unnecessarily forfeit the practical and procedural expertise acquired in the current grant-based system, and severely weaken foreign aid in the short to medium term. Critically, loans should not be a one-size-fits-all solution; instead, they should be deployed on a highly customized case-by-case basis to ensure that the specific economic conditions and developmental needs of each country are adequately addressed. An effective loan-based strategy in an emerging market may not be appropriate for a low-income country.
Additionally, in a scenario where donating to a middle-to-high-income country may come at the expense of programs needed in lower-income countries, perhaps a loan to the middle- or high-income country would help resources go further. Foreign assistance to higher-income countries should not detract from resources available to poorer nations. A more balanced approach might look like the immediate humanitarian needs that grants address, with long-term growth potential facilitated by loans. - Prioritize significant sectors.
Loans should be considered for projects that are economically viable and have potential to generate revenue, thereby enabling the recipient country to service the debt without compromising its financial stability. A win would be a project delivering on the developmental goals of the recipient country and the strategic interests of the United States, as well as creating a return on investment. Such projects could include the infrastructure, renewable energy, and technology sectors, which support workforce development, job creation, FDI, and other contributors to economic growth and stability. - Evaluate country characteristics.
Assessing the recipient country’s institutional capacity to manage and use loans effectively is crucial. This assessment includes evaluating governance structures, financial management systems, and transparency measures. Grants and loans perform better in countries with strong institutions. The United States does not want to make the same mistake China did with some of its BRI loans by overissuing loans to high-risk nations. A nation that has quality institutions or demonstrates a strong positive trajectory may be a good target recipient for loans. - Consider political feasibility.
Loans may be reserved for instances where grants might have political costs. Loans could be a useful tool in moments where the size and timeline of an endeavor may seem too large of an undertaking with grants. For example, aid to Ukraine is detracting from aid allocated elsewhere while donor fatigue compounds. A lend-lease model, similar to the Lend-Lease Act for the United Kingdom during World War II, could be employed. This model provides substantial long-term support to a trusted ally through loans rather than grants, emphasizing strategic partnership and future repayment. Framing aid to Ukraine in this way, with the Ukraine Democracy Defense Lend-Lease Act, has helped sustain its defense while aligning long-term repayment with broader geopolitical stability. In instances where a large-scale aid effort is required, loans can be used to sustain support without overwhelming immediate budgets or political capital. - Do not abandon grants.
An approach to development that includes loans should not spiral into something unintended. Issuing loans must not be mistaken for a prelude to a new iteration of the HIPC Initiative. The U.S. development apparatus has spent decades acquiring valuable technical expertise regarding grants. It would be unwise for development agencies to abandon or heavily reduce grant-based projects, but there are adjustments that, if pursued, would foster some of the benefits of loans.
Again, a major concern with grant-based development projects is that the central banks of indebted nations will convert the funds to local currency and use this to pay off loans owed to China. To help counteract this, the United States should disburse money as projects are completed, not up front, monitoring disbursements pursuant to project completion.
Conclusion
The U.S. government should consider issuing loans in order to complement existing grant mechanisms, help nations navigate the Beijing-bolstered debt crisis, and act in the most strategic sense. Loans should be designed with concessional terms, including extended durations, low interest rates, and grace periods, to ensure that they remain manageable for recipient countries. Loans and grants can supplement each other: grants can address immediate humanitarian needs and critical infrastructure, while loans can fund revenue-generating projects that build long-term economic growth. This combined approach ensures that urgent issues are addressed without exacerbating debt burdens while also promoting sustainable development and financial independence in recipient countries.
China is exploiting nations by swapping debt for equity. This new era of mercantilism must be stopped. Reintroducing loans as a development tool, when done thoughtfully and strategically, can enhance the effectiveness of U.S. foreign assistance, foster sustainable development, create strong diplomatic ties, and effectively counter China’s growing influence in the developing world.
Daniel F. Runde is a senior vice president, director of the Project on Prosperity and Development, and holds the William A. Schreyer Chair in Global Analysis at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Rafael Romeu is a senior associate (non-resident) with the Project on Prosperity and Development at CSIS. Austin Hardman is a research assistant with the Project on Prosperity and Development at CSIS.
This paper was made possible by support provided by DevTech Systems, Inc., and was informed by two roundtables of experts held on June 6, 2024, and July 10, 2024.