Aid to the private sector: What works

Norway supports private sector development mainly through the state-owned investment fund Norfund. In 2015, Norway earmarked 1.7 billion NOK of the national aid budget to private sector development. 1.5 billion went to Norfund. Despite clear strategic goals, Norwegian aid to private sector development is problematic according to Magnus Hatlebakk, senior researcher at CMI.

Magnus Hatlebakk has done a literature review on the effects of aid. Here is a short Q&A summarizing his findings on the effects of aid on private sector development.

-Why isn’t aid channeled through Norfund effective?

-The main challenge is that Norfund primarily invests in sectors where there is already available capital. Norfund has for example invested in hydroelectric power projects in Brazil, where private capital is readily available. Brazil has a 100 years long tradition of hydro power development, and chances are the Brazilians know hydroelectric power better than we do.  

Aid to the private sector may in general  lead to a crowding-out of domestic investments. An influx of aid money from the outside will compete with domestic and regional capital.

-Does the risk of crowding-out mean that donors should be extra cautious investing in the private sector?

-There is always the risk of crowding-out when investing in the private sector. This does not mean that such investments should be avoided, but it means that investments need to be smart. Investments in the private sector should be based on a mapping of where there is a real lack of capital. This will normally be in poor areas of poor countries, where access to credit is limited. And rather than investing directly in the private sector, the private sector may benefit even more from investments in roads and other public infrastructure that will not easily be established by the private sector alone.

-Microfinance has increased tremendously over the past years. Norfund has also supported microfinance projects in a wide range of countries. Is microfinance a magic bullet that can lift people out of poverty or have expectations been too high?

-Microfinance, and also well designed support to small businesses, is likely to be more beneficial than large-scale investments that will compete with local capital. Still, we should be aware that research indicates that microfinance is not sufficient to transform the lives of poor people. Loan customers often use the money to pay for big or unexpected expenses, like weddings, medical treatments or repairs. If they expand their business, it is usually only for a short period of time, as they repay the loans. These loans are still beneficial, but do not in isolation lead to poverty reduction.

Lifting people out of poverty calls for more complex methods and programmes. An example is BRACs Graduation programme that has an all-encompassing approach and has yielded positive results. Instead of simply offering a loan, they offer cash transfers early on, health insurance, follow up through home visits and capital of a more lasting character, like livestock. In a sense, the BRAC-programme resembles the rural development programmes that Norway used to support some decades ago. It may be time to go back to this kind of programmes , keeping in mind that changes that look small may be substantial for the people in question, and that change takes time. A balanced development process requires development not only in urban areas, but also investments in infrastructure and human capital in remote areas, where we still find the majority of the world's poor.