The Future of Education Financing - Mobilizing Domestic Savings?

By Dan Bond, international economist and development finance consultant.

The recent OECD announcement that official aid from rich to poor countries declined four percent last year after having fallen three percent in 2011 gives additional impetus to efforts to find innovative sources of financing for education and other development needs.  Additional impetus comes from February’s Education for All Global Monitoring Report Note that gives a new and higher estimate for the annual financing gap for basic education in low income countries of $26 billion per year for basic education – and $38 billion if secondary education is added. The report notes that in order to fill the gap donors need to increase and reallocate funds for education, developing countries need to increase their tax base and prioritize education, and innovative new sources of funding – including funding from the private sector, the BRICs and new international taxes such as the International Financial Transaction Tax – will be necessary.

Making better use of domestic financing in developing countries

In addition developing countries could fill part of the gap if they did a better job mobilizing their own domestic institutionalized savings into investments for development.  Today more than $6 trillion in assets are controlled by institutional investors (pension funds, insurance companies, mutual funds, etc.) in developing countries (not including China).  And these assets are increasing by over 15% per year. However, few developing countries have solved the problem of how to prudently deploy these accumulated savings into healthy development spending.

Much of these domestic institutionalized savings must be held for long periods of time and their future disbursement is quite predictable.  Thus these assets could be an important source of long term financing for the country’s social and economic infrastructure. Unfortunately, only a modest portion of these assets are currently being used in this way.  In part this is due to the fact that the development of savings pools in developing nations has outstripped the development of local capital markets where such funds might be deployed.

Recent work commissioned by UNESCO (and funded by the Open Society Foundation) for the Advisory Panel of Experts on Debt Swaps & Innovative Approaches to Education Funding suggests one step that donors could take to assist governments in developing countries in their efforts to mobilize these funds.  Through the use of Debt Conversion Development Bonds (DCDBs) long-term financing for infrastructure projects in education and other social sectors could be obtained from domestic institutional investors, while at the same time providing the investors with much needed safe long-term assets.

In brief, DCDBs are domestic bonds issued by a developing country government, the future debt service payments of which are matched by the fiscal space created by creditors forgoing future debt service payments.  DCDBs are a variation on traditional debt conversions (often referred to as debt swaps) that may be of use when donors wish to spread the costs of financial assistance over time utilizing the capacity of the beneficiary government to bring forward the benefits of this assistance via the issuance of domestic bonds.

The basic building blocks of a Debt Conversion Development Bond program are the following:

• One or more creditors agree to write off specific debts (or debt service payments for a number of future years) in exchange for a commitment from the beneficiary country’s government to use the fiscal space generated by this action to support the issuance of government bonds and to use the revenue obtained from the bonds to fund specific social and economic development projects.
• Creditors who provide debt for conversions have the opportunity to negotiate with the beneficiary governments about the allocation of the funds raised by issuing DCDBs.  They can negotiate means for monitoring results if they so desire.  And they can provide technical assistance and other forms of financing to help ensure concrete development results from the projects that are funded.
• The beneficiary government would then issue one or more domestic bonds.  The time profile of the future stream of debt service payments on these bonds should be aligned with the time profile of the fiscal space created by the debt conversions.
• The effort and cost of issuing DCDBs should be modest.  Although DCDBs may be marketed as a special form of financing and designated to fund specific development projects, in actuality will be just another “plain vanilla” government bond.  There will be no special financial structuring required or any additional credit rating needed.  Governments that are already regularly issuing longer term government securities will already have in place all the necessary infrastructure for issuing DCDBs.
• The proceeds from the bonds would then be used by the beneficiary government to fund the social and economic development projects agreed upon with the donors.
• The government would repay the bonds from the savings realized over time by not having to make payments on the converted debt.

Debt conversions and debt forgiveness have been used successfully over the past three decades to provide significant fiscal space for developing countries and thus allow them to spend more on development. They are a regular feature in the official development assistance (ODA) of several donor countries.  DCDBs take traditional debt conversions one step further by linking them to the issuance of domestic bonds by recipient governments.

A key attraction of DCDBs for donor governments is that they allow the donor to mobilize substantial development funding today while spreading the cost over a number of years.  Thus DCDBs may also be a particularly attractive form of aid during periods of fiscal austerity in the donor country.

A key attraction of DCDBs for the beneficiary country is that they allow the government to obtain substantial funding today by issuing bonds that will be repaid with no added fiscal burden in the future.  DCDBs can also help develop the domestic bond market in the beneficiary country.  In the longer term this can be their most significant and sustainable impact.  Well-developed domestic bond markets can be instrumental in channeling the rapidly growing institutionalized savings of the developing countries into social and economic development projects.

>>Readers interested in learning more about this proposed new form of financing will find a short paper describing the concept here.

Dan Bond is an international economist and development finance consultant who is currently working with a number of organizations including AMF Guarantee, Mountain Pacific Group, Results for Development and the Open Society Foundation. Email:  daniel.l.bond@gmail.com