Guarantees, Subsidies, or Paying for Success? Choosing the Right Instrument to Catalyze Private Investment in Developing Countries - Working Paper 402

Governments, donors, and public sector agencies are seeking productive ways to ‘crowd in’ private sector involvement and capital to tackle international development challenges. The financial instruments that are used to create incentives for private sector involvement are typically those that lower an investment’s risk (such as credit guarantees) or those that lower the costs of various inputs (such as concessional loans, which subsidise borrowing). We argue that the public sector is unlikely to have better information about risk and reward than the private sector, so using either instrument shifts downside risk from private firms to taxpayers. We propose a better contract to support private sector investment by enhancing the returns to the private sector, linking payments to specific, measurable, and agreed milestones or outputs. We argue that these contracts are less distortionary and produce better results for a lower expected cost than other incentive programmes. We motivate the argument with an economic and financial model and discuss political economy considerations that reinforce the current status quo in favour of generally suboptimal instruments such as guarantees and loan subsidies.