This foreign assistance tool allows USAID to mobilize local wealth for national development
By John Wasielewski | July 26, 2017 on CSIS.org
Even in poor countries, there are significant pools of private capital that can be tapped through business solutions for social problems. The challenge, from the perspective of international donors, is identifying catalytic interventions that can mobilize these local sources of finance to meet development objectives. The U.S. Agency for International Development (USAID) Development Credit Authority (DCA) is one way to accomplish this goal. Simply put, DCA is a tool that allows USAID to use risk-sharing guarantees to mobilize local wealth for national development.
The way it works is relatively simple. In most developing countries, it is very hard for small and medium-size enterprises to access capital. Local banks typically lend to large corporations and the government because they are “safe” borrowers; banks are quite hesitant to lend to smaller businesses because they lack experience in assessing their creditworthiness. This is where DCA comes in.
USAID, in partnership with local banking and nonbanking institutions, has networks and relationships in emerging economies around the world and is well positioned to identify entrepreneurs and businesses that just need a little capital to succeed. Through DCA, USAID can guarantee up to 50 percent of a loan by a local bank or local nonbank financial institution to encourage them to lend to local entrepreneurs who would otherwise be perceived as too risky to receive credit. Over time, this serves as a demonstration that helps these local institutions build the skills and confidence to lend into new sectors, regions, and businesses even without a DCA guarantee.
Since its first guarantee in the Philippines in 1999, DCA has issued 542 guarantees in 74 countries, resulting in more than 250,000 loans with a 2.4 percent default rate. At full utilization, these guarantees could mobilize $4.8 billion in local private financing for micro, small, and medium-sized enterprises, agricultural enterprises, infrastructure, and other projects that contribute to economic growth and development in emerging economies. All of this is achieved at more than a 20:1 ratio in terms of cost to the U.S. government.
DCA’s creation and subsequent success fits into a broader movement toward leveraging the private sector as the central driver of development. Increasingly, traditional development assistance is a minority stakeholder in the development process — trade, foreign direct investment, and domestic resources are far larger forces for transforming economies and societies. Building on its effective use of DCA, USAID’s institutional response to this new reality was to establish the Private Capital Group within the agency, which uses DCA and other instruments and resources available to USAID to work with private investors globally to further identify opportunities for private investment in developmentally beneficial projects. These efforts, along with DCA, gives the U.S. government a catalytic tool for leveraging, directing, and magnifying these larger pools of capability and resources to drive economic growth and achieve our foreign policy objectives.
DCA’s creation and growth has also tracked the acceptance of other nontraditional development tools, including Development Finance Institutions (DFIs), a topic CSIS has covered in depth. While the Overseas Private Investment Corporation (OPIC) also offers guarantees, the terms and goals of the guarantees differ. DCA uses up to 50 percent risk-sharing guarantees to non-U.S. and U.S. institutions to target local capital markets to mobilize credit for micro, small, and medium-size enterprises, energy, and infrastructure projects in emerging economies. OPIC works with U.S. companies, using 100 percent guarantees on debt, to encourage investment in complex and emerging markets.
Unfortunately, DCA is not particularly well understood outside of USAID. The loan guarantees issued by DCA are not a free-standing foreign assistance program, but rather an instrument like a grant or technical assistance program that can be deployed when it is appropriate and useful to meet USAID’s ongoing development goals. While it is important that DCA be accompanied by well-designed and targeted technical assistance programs — which increase the borrower’s ability to repay the loan and can bring a more accurate perception of the risks to local institutions — the guarantees encourage the local wealth of a country to invest in its own development. By encouraging and partnering with local institutions and governments with the financial means to address their own problems, we are working ourselves out of a job.
Rebecca Black, a retired USAID mission director, noted in an e-mail to the author that, “the reason I advocated for use of the Development Credit Guarantee in Mission program is simple: levering new and expanded resources to meet our objectives; bringing in new partners to enhance our engagement and presence as a development catalyst; inspiring staff to look beyond grants and technical assistance for the most effective development tools — and building their core competence skills on the way; and, to be honest, to innovate, explore new opportunities, and build coalitions that further our mission and global goals.”
USAID created DCA as part of its ongoing pursuit for appropriate tools and efficient use of taxpayer dollars in the foreign assistance program. For much of its existence until the 1980s, USAID used direct loans and very generous loan guarantees to assist countries on their path toward development. Tens of billions of dollars were lent directly to countries over the years. Performance on these loans was uneven at best, and in the late 1980s and early 1990s this practice became the target of criticism from administration officials and Congress.
DCA can trace its roots to a government-wide discussion about reforming the use of credit and guarantees that resulted in the Credit Reform Act of 1990. Before the Credit Reform Act, the full cost of loans and guarantees had to be budgeted on an annual basis. The act essentially recognized that the true cost of the loans and guarantees was the amount that was not paid back and the amount of claims necessary to cover the liabilities inherent in the guarantees. A formula for calculating this was established, and agencies then had to provision for the loan and or guarantee only to the amount they expected to lose.
What this meant for affected government agencies was that there was a terrific budget advantage to using loans and guarantees to fulfill their goals. A team of attorneys led by then-Assistant General Counsel Michael Kitay sought to create an instrument based on the new act for USAID. USAID could now approach private financial institutions and partner with them in a true risk-sharing arrangement to lend their capital to credit-worthy but under-collateralized businesses and projects. The authority would be administered and supported by a skilled staff of professionals, who would not only “price” the risk but also assist USAID missions in assessing the local markets for the feasibility of commercially viable lending in each country and in the design of guarantees that would be put in place across the USAID world. In a chapter from Fifty Years in USAID: Stories From The Front Lines, Kitay explains where he found his inspiration:
My inspiration for DCA came from the compelling story of Bank of America’s origin at the turn of the twentieth century. U.S. legal systems were weak and dysfunctional, and banks did a poor job mobilizing and lending private capital, which was available only to the wealthy few able to meet 200 to 300 percent collateral requirements. Entrepreneurs and small-business owners struggled to grow their businesses without credit. Into this breach stepped a small bank (founded by Amadeo Giannini, who founded the Bank of Italy), which eventually became the Bank of America. It pioneered lending to small businesses and individuals based on sound business plans and good character, rather than on collateral alone. Other U.S. banks followed its lead, and credit that was once scarce became widely available, fueling productive economic activity throughout the United States. I based DCA on the assumption that there is insufficient capital to fuel economic growth in developing countries and that appropriating Bank of America’s strategy could fuel a similar revolution in the way private capital in these countries is mobilized and put to work.
USAID first proposed DCA early in the 1990s, but Congress and the Office of Management and Budget (OMB) both had serious doubts about USAID’s capacity to issue and manage guarantees. Only after the 1998 foreign assistance legislation did the Congress grant permission to USAID to utilize U.S. Treasury– backed guarantees to encourage and mobilize local currency lending in the countries where it had programs. An Office of Development Credit was established within the agency, a director was put in place, and a team of professionals skilled in finance and risk analysis was hired. There are five core principles that guide the use of DCA:
- Private-sector driven — private banks lending from their own balance sheets based on their own strategies and methodologies;
- Equal risk sharing — partial guarantees ensure partners make sound lending decisions. Ninety five percent of all DCA guarantees have been issued at 50 percent or less;
- Development focused — guaranteed lending explicitly linked to USAID development objectives;
- Additionality — supporting projects that will result in new development outcomes not possible without the use of the guarantee;
- Leverage — using increasingly limited donor funding to crowd in as much private-sector financing at minimum risk.
Bringing private financing into the development arena remains a goal that is not fully realized. DCA is a way to encourage the mobilization of local capital. Using DCA and technical assistance, USAID missions were early actors in what is now being called “blended finance.” Other donors, following the U.S. lead, have, often with USAID advice, instituted similar guarantee programs, including the Swedish International Development Agency; the Danish, Spanish, and African Development Bank through the establishment of the African Guarantee Fund; and the UK Department of International Development, now UKAID, through the establishment of GUARANTCO. Most recently, the government of Nigeria set up its own guarantee program to mobilize local financing in its economy.
Today, the use of loan guarantees provided under DCA has become part of almost every USAID mission’s portfolio, growing at a compounded rate of 20 percent per year. There are examples where DCA has been an instrument for driving change; one case is its use in the microenterprise world. The U.S. government used to provide nearly $300 million annually in grant funding for global microfinance institutions. By using DCA, missions challenged the notion that grant funding was necessary and used the guarantee to support bonds issued in the local capital markets. In each case the bonds were oversubscribed and the needed capital was raised locally; this is a practice that continues to this day. In Armenia, DCA was able to mobilize $5 million for microfinance lending at a cost of approximately $230,000.
There are DCA success stories from around the world, and in most cases, lending continues even after the loan guarantee program ends. In Honduras, DCA worked with the Covelo Foundation to lend to local farmers who lacked collateral typically required for credit. U.S. government resources were leveraged at a ratio of more than 20:1, and the Covelo Foundation has continued the lending program even without DCA guarantees. Similarly, DCA provided two guarantees to Root Capital in Latin America and East Africa to expand lending to local coffee farmers. Root Capital’s portfolio tripled in both regions after the guarantee programs.
Two decades after its creation, DCA is a model of financial innovation within USAID. Official development assistance comprises a small (and shrinking) share of financial flows into emerging economies around the world. In this context, it is vital that we identify opportunities where USAID’s unique network and knowledge can be used to leverage larger market forces to create economic growth and job creation. DCA achieves these goals. It was designed in recognition of the rapidly growing private financial sector now present in the emerging markets, and it provides a cost-effective instrument to help these markets continue to grow and mature.
John Wasielewski is a senior associate with the Project on Prosperity and Development at the Center for Strategic and International Studies in Washington, D.C., and the founding director of the Office of Development Credit at USAID.
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