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Guarantees to finance cities in developing countries: a promising tool for donors?

Issue Briefs N°04/2017. Iddri, 2017. 4 p.

The need to correct market failures that limit developing cities’ access to financial funds is a key argument in favour of a new role of donor. The use of guarantees thus raises fundamental questions on the risk taken: who shall bear the risk? Is the role of ODA to actually assume these risks? As such, financial engineering innovation cannot tackle this political issue.

KEY MESSAGES:

  • In theory, guarantees can offset market failings inasmuch as they help to mitigate risks and leverage private sector funds, which makes a strong case for their potential to respond to the needs of developing cities.
     
  • Yet, guarantees are only a downstream financial tool and cannot replace the need for financially viable projects, local government autonomy, sound local financial management, and sustainable urban development policies.
     
  • The extension and financial sustainability of the tool supposes strengthening the capacity of local governments to contain their level of debt, and also that donors learn and adapt in view of limiting transaction costs, which are currently considerably higher than those incurred by traditional loan and grant instruments.
     
  • Today, the terms of the guarantee debate are defined by the donors and thus framed from the supply-side perspective of providing financial products. Yet, more benefit would be gained were they more focussed on an understanding of the needs and actual demands of cities and private-sector financiers.
     
  • Guarantees do not eliminate the risks linked to financing developing cities: they transfer the risk to a third party (i.e. the donors). Their capacity to reduce this risk depends on political will, on the mobilisation of operational arrangements able to assume this risk, and on the donors’ role in taking on the financial risk to attract private investors.