To Speed Recovery from Conflict, Focus on Local Businesses
January 3, 2014
As foreign aid budgets shrink, international aid agencies are being forced to become more efficient with less money. Increasingly, these donors recognize that fostering healthy private-sector growth is one of the most promising ways to help aid recipients become self-sustaining and ultimately self-financing. Aid to the private sector is especially important in countries affected by conflict and violence, where limited access to capital can inhibit much-needed growth, even more so than in more stable (if still poor) developing countries.
Strategies for engaging the private sector vary: some donors choose to work with large firms to increase foreign direct investment (FDI) in recipient countries, while others focus more on small and medium enterprises (SMEs) and fostering local private sector growth. The number of programs targeting the local private sector have increased in recent years, but fostering FDI remains the more common donor strategy.
Focusing on FDI to the exclusion of SMEs, however, risks missing important opportunities to promote stability and peace. Local SMEs provide almost half of the formal sector employment in developing economies but often lack access to crucial capital in post-conflict states. FDI is important to the development of fragile states as well, but foreign corporations may be reluctant to invest in states that are too unstable—something that is not an issue with the SMEs that are already there. There is a case to be made for FDI, but in conflict and fragile situations, there is an even stronger case to be made for an approach that puts SMEs at the center.
The Case for Aid to Promote FDI
Proponents of FDI see it as advantageous for both recipient countries and donors. Potential benefits for recipient countries that are able to attract FDI include immediate economic growth by increasing employment and injecting foreign capital into the recipient country’s economy. Foreign investors may also be able to afford technology and skills training for employees that local firms could not. Advocates of FDI also see it as a way to create sustained development. Foreign investors purchase assets and build infrastructure in host countries, which provide an incentive for firms to remain long-term. Foreign investors may also include the local private sector in supply chains, which generates more economic growth. FDI can be critical to peace building in places where broad-based economic growth is needed to prevent the resumption of conflict.
In addition to the advantages for the recipient country, aid programs that foster FDI can also be beneficial to donors for several reasons. First, foreign investors are generally established and unlikely to fail, making the success of the project more predictable for donors. Aiding smaller and more volatile firms is a riskier strategy for donors. Second, many donor countries see FDI as an opportunity to benefit their own enterprises, since many investor companies originate from the donor country. For example, the United States could create more aid programs that promote U.S. private sector investment in developing countries and thereby advance U.S. political and economic interests.
Despite the potential advantages of fostering FDI for both recipient countries and donors, certain types of FDI can be harmful to recipient countries. There is no automatic link between FDI and development, and benefits are contingent on the type of FDI. FDI can fail to result in development if recipient countries are forced into a “race to the bottom” in an attempt to attract investment by lowering regulations. These policies can result in poor working conditions, low wages, and environmental damage. Fragile states with weak governance may not be able to hold large corporations accountable. Providing incentives to foreign investors can also give them a competitive advantage and enable them to crowd out local firms that might be a valuable source of employment. In addition, relaxing regulations on capital flows can allow foreign investors to repatriate profits rather than invest them in the host country. An estimated 60 to 65 percent of illicit capital flight from developing countries is a result of transactions within multi-nationals. Recipient countries may also become financially dependent on FDI, leaving them vulnerable to fluctuations in the market or investor withdrawal with flights to safety of capital in uncertain times.
The Case for Aid to Local Private Sectors
Some donors choose to focus on local private sector development in fragile states that are not able to attract FDI or where FDI is perceived as harmful. Local private sector growth can result in many of the same benefits attributed to certain types of FDI, including increased economic growth and employment opportunities, while avoiding some of the potential problems of FDI. SMEs supply about 45 percent of the employment in developing states. Local SMEs do not force the recipient country into a “race to the bottom,” since the local enterprises are based in the recipient country, and local SMEs are less likely to facilitate capital flight.
SMEs in conflict-ridden countries face severe obstacles in accessing capital. Banks in fragile states favor loaning to micro-enterprises or large firms, leaving SMEs in emerging markets with an estimated $750 to $850 billion in unmet demand for finance. Aid programs can help fill this need. In certain circumstances, growing the local private sector is the only viable option for donors, since some countries are too unstable to attract FDI. Fragile states often lack the necessary institutions to handle large capital flows, either because the institutions were destroyed by conflict or never existed. In these circumstances, aiding local SMEs is the best option for short-term development.
Despite potential advantages for recipient countries, funding local private sector growth has certain disadvantages for donors. SMEs are much more likely to fail than large enterprises, and high turnover rates have several negative implications for donors. First, high default rates can make it difficult for the donor to recoup investments. A World Bank program to aid SMEs in Ghana in the 1990s was deemed unsuccessful as a result of high default rates: only 30 percent of loans were paid back. Second, high turnover rates can prevent a significant increase in employment. A case study of SMEs in Ethiopia reveals that if the exit rate of SMEs is taken into account, they actually create fewer net jobs than large firms.
Implications for Aid Policy
Ideally, U.S. aid programs would promote both FDI and local private sector growth. However, in some fragile states, fostering FDI is not feasible, since foreign investors may not be attracted to unstable states because of risk. In cases such as these, OPIC (Overseas Private Investment Corporation) could create a “first-loss equity fund” for U.S. companies, especially in fragile states that are strategically important to the United States.
In most cases, however, aid programs in fragile and conflict situations should focus more on increasing access to capital for local SMEs. For example, funds could be allocated for something akin to a first-loss equity fund, as with FDI, but with buy-in and matching grants from the host government or local private sector cooperatives and associations. Aid agencies and other authorities have other tools at their disposal that could be adapted to supporting local SMEs.
Focusing on SMEs is a more financially risky strategy for donors, since SMEs have higher failure rates than large corporations. But it is an approach that has greater potential to create needed jobs quickly, build local economies more sustainably, and thereby contribute to aid objectives more efficiently than current practice. The way aid programs engage the private sector will necessarily vary between countries, depending on their level of development and fragility, but U.S. aid projects to the private sector have great potential to advance U.S. strategic interests by promoting stability and contributing to the development of long-term economic partners.
Sadika Hameed is a fellow with the Program on Crisis, Conflict, and Cooperation (C3) at the Center for Strategic and International Studies (CSIS) in Washington D.C. Julie Halterman is an intern with the C3 program.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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