Working Paper 186 - Balancing Development Returns and Credit Risks: Evidence from the AfDB’s Experience
Description The objective of this paper is to shed light on the workings of project quality-at-entry frameworks used by development finance institutions during their project appraisal to measure the expected developmental returns of investments. In doing so, it looks specifically at that case of the African Development Bank’s “Additionality and Development Outcomes Assessment” (ADOA) framework. Acknowledging that the AfDB has a broad set of tools to help develop the private sector, this paper focuses on one specific instrument, i.e. its portfolio of operations not covered by sovereign guarantees, and on the specific framework put in place to measure its value-added and development outcomes/returns for each operation, i.e. the ADOA framework. The paper’s main contribution is to provide empirical regarding the extent to which key components of the ADOA framework interrelate and how they balance against credit concerns. In doing so, this paper uses a unique data set, comprising of a total of 121 private sector operations which were assessed by the framework over a period spanning from October 2008 to August 2013. The analysis aims to contribute to the process of mainstreaming development results as a key criterion for the selection of new operations, and to inform future portfolio strategic decisions along the lines of inclusive growth and strong development returns. It also aims to explain how the adopted institutional framework has helped align new operations with the organisational mandate of the AfDB and with the concerns of civil society and donors over the developmental returns of private sector operations. Analysis is undertaken through a series of statistical checks to test different relationship hypothesis between criteria used in the ADOA framework. These criteria include measures of additionality and expected development returns done through the ADOA framework and of credit risk conducted through the independent credit risk department of the AfDB. Development outcomes ratings are an aggregate of eight subcategories and is rated on a 6-point scale from “1- highly unsatisfactory” to “6- excellent”, with rating from 4 to 6 representing assessment that exceed the satisfactory threshold. Additionality is based on a combination three sub-categories and is rated on a 4-point scale from “1- none” to “4 strongly positive”, with ratings 3 and 4 indicating a more than satisfactory level of additionality, and ratings 1 and 2 indicating that additionality is less than satisfactory. Credit risk is assessed on a scale from 1 to 10, with 1 representing the lowest level of risk exposure, and high risk ratings equal to or exceeding 5. These variables are quantitative representation of qualitative variables. The first part of the analysis looks at the correlation between development outcomes, additionality and credit risk. The second part of the analysis performs a multivariate analysis of the correlation between project approval and the three ratings, as well as of the relative importance of the subcategories which make up the development outcome and Additionality ratings. All regressions employ linear models as the literature suggests that OLS estimators significance tests statistics perform better than probit when the sample size is around 100 observations. Overall, the paper finds that the introduction of an independent “Additionality and Development Outcome Assessment” to support the approval of all new private sector operations has increased the development focus of portfolio decisions along the lines drawn by institutional mandates. With this in mind, the analysis showed evidence of the importance of additionality in the project selection process. With regards to development outcomes, results highlight the importance of benefits accruing directly to households as a driver of positive externalities, but also as a feature under which projects tend to be more additional. As regards to associations between the framework’s variables, there is only evidence of a relationship between development outcomes and additionality. This suggests that the AfDB’s contribution to higher development outcomes comes to some extent through making otherwise unviable projects feasible. Conversely, the lack of significant relationship between development outcomes and credit risk suggests that it is not given that investing in riskier sectors will induce higher development outcomes. However, these results should be read with caution to as they are based on the relatively small and unbalanced sample. Against this background, more scrutiny must be put on these relationships as we get information on other projects. The paper also finds that both additionality and development outcomes raise the probability of project approval by the board. With regards to the former, financial additionality considerations are the underpinning drivers to the rating. This is partly due to the fact that the political risk mitigations tools at the AfDB’s disposal are not very developed. With regards to the latter, while all categories contribute to the development outcomes overall rating, household benefits, government, gender and social effects and private sector development come out stronger. These also happen to be cross-cutting considerations which are relevant no matter the project type.