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Why Free Money is Bad: Co-creative blended finance and the future of development

In his landmark work The Mystery of Capital, the renowned Peruvian economist Hernando de Soto identified one of the important differences between the WEIRD (Western, Educated, Industrialized, Rich, and Democratic) countries and the rest of the world: the ability to establish clear title to assets and the ability to easily use those assets as collateral to obtain a loan. In the United States, the vast majority of entrepreneurs finance new businesses with a second mortgage on their home. In most of the world, people don’t own their homes and even if they do, it’s very difficult for them to establish clear title so banks are unwilling to let them use the home as collateral.

Why does this matter for international development? It partially explains both the need for philanthropy and foreign assistance and why traditional “free money” philanthropy and foreign assistance contributes to a cycle of dependence. The inability for people in developing countries to access loans and other forms of capital means they need access to other kinds of finance. Generous philanthropists and official development agencies like USAID and its peers, have stepped in to provide grants and other forms of “concessional finance” (free or nearly free money with little or no strings attached). While generous and helpful on one level, this “free” money undermines the development of debt and capital markets in these countries. A bank or other lender can’t compete with free.

How to break the cycle? Blended finance. Bringing together some concessional finance and technical assistance and combining it with commercially-available finance lowers the barrier to entry. As an example, a philanthropy or development agency may offer to buy loan default insurance or provide a first loss guarantee to a local bank on the condition that it provides a loan to an applicant who has a solid business plan but who lacks collateral. This contributes to the entrepreneurial ecosystem and to the debt market, growing the pool of qualified candidates and available funding to make loans.

For this to work, however, the terms and conditions need to work for both parties and hence the need for a co-creative approach to blended finance. In a research report CollaborateUp recently produced on Blended Finance for Education in Latin America, we found a deep market of innovative education entrepreneurs (people and businesses looking to provide goods and services for students, teachers, schools, etc) but limited understanding among financial institutions of how these businesses operate and their cash flow needs and constraints. As an example, most loans require regular monthly payments — the same amount every month. Most schools, however, only operate and collect fees nine months out of the year. Modifying the loan repayment terms to match the school’s cash flow would make it much easier for the school to repay.

Coming to agreement and structuring a loan of this type requires the consent of multiple parties and the need for co-creation. Banks don’t like one-off loans. Instead, they prefer a standard loan product. Using the convening power of an official donor like USAID to bring multiple education business and private schools together with financial institutions to structure a standard loan product backed by concessional finance (e.g., default insurance or first loss guarantee) with technical assistance (both paid for by the official donor), will both accelerate the process of co-creating a standard loan product and increase the depth of both qualified applicants and lenders.

Done well, a co-creative approach to blended finance that brings together potential recipients, financial institutions, investors, private philanthropists, and official donors will lay the foundations for solving the “mystery of capital” Dr. de Soto identified. It will also help fulfill USAID’s localization goals and the goals of many private philanthropists to break the cycle of dependence and create sustainable debt and capital markets that support long term economic growth. But it must start with a sincere commitment to listening to the needs of all parties and letting them guide the co-creation of these financial instruments.