Kabul Intercontinental

Just in case we needed any reminder that risk is the principal obstacle to investment in Afghanistan, we spent yesterday evening having dinner to the sound of gunfire and explosions from the Intercontinental attack...

The human tragedy of the situation is just appalling; people are needlessly dead or injured today. The wider impact of such attacks is to destabilise an already fragile transition process.

What these attacks do for investor confidence remains to be seen, but for sure, it won't have reduced the Afghan risk premium.

Design phase complete

Some personal reflections on the last day of the ABIF design phase...

It has been an intense and extremely interesting experience bringing ABIF from a few pages of draft terms of reference to a fully designed project ready to go in just 10 weeks. Since starting work at the end of March, we have come a long way in terms of developing and piecing together the DFID Business Case, the project strategy, the sector selection and market analysis, the investment strategy, the project operations, the marketing strategy, the monitoring and evaluation framework, a workplan and a budget. And on top of that, I think that we have come up with a new way to manage a challenge fund that could significantly enhance ABIF's success. No doubt we will learn and refine as we go along, but I think that we can be reasonably satisfied with what we have achieved so far.

The good news is that because of the clarity of the original objectives DFID set for this fund, we have been able to put together a project design where each element is logically aligned in order to achieve those objectives. When all is said and done, the core purpose of ABIF is very simple; we are here to incentivise investment that will make money for the project sponsors, change the way that people do business with one another and increase the incomes of poor people. A correspondingly straightforward project design around our core objective of contributing to accelerated and inclusive growth means that we have the solid foundations necessary for the implementation phase. The result (I hope) is elegant simplicity!

What has particularly surprised me during the design phase is the evident level of demand for ABIF. I guess that it is easy to get carried away, of course there is demand for grant funds. But even when we strip away investment projects that are just about making rich people richer, there is still a promising pipeline of ideas for projects that can deliver the kind of  market changes and benefits to the poor of Afghanistan that we have designed ABIF to achieve. With a bit of guidance and encouragement, these projects can get off the drawing board with the help of DFID funds used to offset the risk that stands in the way of investment.

It is always dangerous to make predictions, but I wouldn't be at all surprised if we are able to disburse the funds much faster and achieve much greater impact than anyone envisaged at the time that the initial project outline was developed.

I have lived and worked in Afghanistan for almost 5 years out of the last 10 years. Over that period I have seen many good things happen, but early optimisim often turned into disappointment as extravagant promises of progress were unfulfilled, claims of achievements did not chime with ordinary people, or money was invested in Dubai real estate rather than the future of the country.

With 2014 on the horizon, we are entering a particularly tricky period of significant change and uncertainty. Afghanistan remains largely unprepared for the future that is set out on paper; there are systemic weaknesses in almost every direction you look (economic, political and security). There has been tangible progress but it is fragile and could easily be reversed. Afghan colleagues are hopeful, but nervous about what the future holds. But what strikes me most is that despite the potential of the country and 10 years of reconstruction efforts, poverty remains widespread, particularly in rural areas. The reality is that millions of Afghans still live in the most desperate of circumstances for no good reason at all. This situation has to change.

Afghanistan is a complex environment and there is no single or easy solution, but I am absolutely convinced that ABIF can help to make some difference to the lives of poor people in Afghanistan. The implementation phase is going to be challenging and hopefully rewarding, I look forward to it very much.



If it is my place to do so, I would like to thank everyone who has been involved in the ABIF design phase; particularly the core team of Robert Smith (who worked on the challenge fund operations), Sarah Gray (who worked on sector selection and market analysis), Tamim Ahmadyar (who provided administrative support throughout) and Edriss Raha (who has introduced us to many of the project sponsors with whom we could be working in the future). Simon Foxwell and Frankie Whitwell from Landell Mills have been extremely supportive, providing constructive strategic advice and quality assurance. Additional significant contributions came from our consortium partners ITAD (M&E) and ARG (marketing). Finally, a big acknowledgement is due to the DFID Afghanistan team. Our primary contacts there were Elyas Hashemi and Doreen Broska; their feedback has been invaluable and it has been a personal and professional pleasure to work with them.

Risk based approach to a challenge fund

We are now in the final stages of putting together the investment strategy for ABIF. Two of the biggest challenges facing us in defining the investment strategy for the fund were:

1. How to ensure that we incentivise without subsidising; and
2. How to ensure that we do not displace commercial finance providers.

I think that we have come up with a solution to both problems by applying some relatively simple tools from the world of private sector corporate finance.


Incentive or subsidy?
The operational objective of the fund is to incentivise commercially viable investment projects that will achieve our strategic objective of achieving market change that will accelerate inclusive economic growth. The incentive we offer is co-investment in the form of a grant to the private sector partner. Incentivising investment is all well and good, but in the absence of some rational mechanism to target and ration funds, a well meant grant can so easily become a market distorting and value destroying subsidy.

The original design for ABIF suggested that we should limit the ABIF grant by fixing a maximum grant level of 50% of the total investment project when co-investing with individual companies and 70% when co-investing with business associations, and then rely on competition between potential grantees to maximise leverage of donor funds. This strategy was intended to limit the risk of subsidy and has the advantages (from the donor project's point of view) of being the established way that challenge funds operate (so it is the "safe option") and administratively simple (so it is easy to understand).

However, it is a very blunt instrument, which fails to take into account the market circumstances in which the fund is operating and could exclude high risk/high impact projects from applying to the fund.

First, where do the pre-determined numbers 50% or 70% (or any other number that different challenge funds use) come from, why not 25% or 75% or anything in between? Answer, any number pre-determined in this way would be completely arbitrary. Secondly, why should funding two identical projects in different places and different times impose the same limit? Answer, none at all.

In the imperfect market of donor funding (where gaming is rife), there is just as much risk of subsidising a project by giving a 30% grant as there is a 50% grant or a 70% grant if you don't understand the investment risk associated with the investment project. The riskier the location (for ABIF, places like Helmand), the higher the grant has to be to offset that risk and incentivise investment that will impact some of our least accessible target beneficiaries. The riskier the innovation (say a business model completely untried in Afghanistan), the higher the grant has to be to offset the risk and accelerate the introduction of new products or services that will impact the incomes of our target beneficiaries. And of course, the converse is true, the less risky the location and the less risky the innovation, the lower our grant should be. Thus the risk based approach is a vital value for money tool for donors.

Adopting a risk-variable investment strategy not only provides a basis for opening up the competition to more risky investment projects and for comparing projects on a like-for-like basis, it also provides a mechanism to avoid subsidy. However imperfect the challenge fund competition may be, by having a risk benchmark for each project will allow us to identify the level of grant that would cross the line from incentive into subsidy and negotiate the ABIF contribution accordingly.


Avoiding displacement
Afghanistan has a very limited commercial investment finance market. Bank corporate lending is minimal and there are very few investment finance products available on the market. However, there is something, however inadequate, going on. The last thing that a donor funded grant fund should do is to nip the market in the bud by blundering in and distributing grants to private sector investors. The danger of displacement is very real.

To try to avoid displacement, the original ABIF design had as an eligibility criteria that the investment project should have failed to attract commercial finance. In other words, the fund would only provide a grant if the banks wouldn't touch the investment project. Sounds sensible at first glance, but two issues:

1. Another blunt instrument; why shouldn't ABIF support projects that banks would fund, but because of high interest rates (about 20% in Afghanistan) the investment is non-viable?
2. The risk of gaming is obvious; get a letter from a bank declining a loan, and go to ABIF where you can get free money!

Again, the risk based investment strategy provides an answer. By understanding the investment project risk and the cashflows associated with the project, it is relatively straightforward to arrive at a weighted average cost of capital (WACC) that turns a commercially viable project into a viable investment opportunity. In any country, the WACC would be derived from the cost of equity and debt to the investor. The justification for ABIF providing grants is that the WACC for Afghan investors is so high that investment doesn't pay, the returns are simply not high enough to cover the cost of the finance.

ABIF cannot change the risk that determines the cost of capital, and it cannot change the future investment project cashflows, but it can reduce the size of the original investment to achieve those cashflows. So ABIF provides an investor with a third financing option; in addition to equity and debt, the investor can apply for a grant. We know the cost of debt (about 20%), we know the cost of grant (0%) and if we can find out the cost of equity (in Afghanistan, retained earnings), we can calculate the appropriate level of grant that would avoid displacement of other sources of finance. Knowing this number would allow us to provide a complimentary source of finance, rather than a competing source of finance. ABIF will be able to offer grants at a level that fits into the realities of the commercial finance market.

The way forward
Having designed and agreed the principles of this risk based investment strategy, the next step is to work out the details and put it into practice. So far as we are aware, this is the first time that a challenge fund has tried to bring this degree of rigour to its grant giving so there is no model to follow from the world of private sector development.

Our plan is to conduct a kind of business confidence survey. By speaking with business leaders around Afghanistan, we can understand their perceptions of risk and therefore their implied cost of equity. This survey will need careful planning and design, but we do think that the results will allow us to:

1. Arrive at an estimate of the implied cost of equity; and
2. Uunderstand varying risk perceptions around Afghanistan.

Armed with this understanding, the next step will be to interpret the survey findings and incorporate them into the detailed investment modelling tools. Given that applicants have to demonstrate the commercial viability of their proposals (one essential tool being a cashflow forecast), we should have the necessary data to complete the calculations.

It will be extremely interesting to see how this works in practice, but it is particularly pleasing that we now have an investment strategy that will ensure that the project is as rigorous about controlling its inputs as it is about measuring its results.

Privatising development successfully

Defining the ABIF log frame has made it clear to me that the M4P approach is all about privatising development, which in turn has important implications for the detailed design of ABIF. Maybe this is stating the obvious? However M4P writing tends to focus on changing markets and impacting beneficiaries, rather than on the significance and implications of the approach itself. A quick Google search didn't come up with anything linking M4P with privatising development or how this privatisation process should be managed, so here are some thoughts on this connection.

When designing the ABIF log frame one of the questions we have been debating is what belongs at the output and outcome level. The answer for an M4P programme is very different to a traditional development programme. I remember that at Katalyst we also discussed this for a long time (in fact the first 8 years of the project). Finally with external help, I think that we reached the right conclusion; outputs are all about the changes in the market (supply and demand side), and the outcome is about increasing the competitiveness of small enterprises.

This is also the right structure for our log frame because at the heart of M4P is the confluence of development objectives and commercial incentives. The roles of the project and the target client is not so much to be giver/receiver of development support (although this happens), as to be co-sponsors of a commercially viable project that will deliver development impact. From the project's point of view, we are increasing donor funds by mobilising private sector resources to achieve development objectives, and from the client's point of view, he is increasing private sector resources by attracting donor funds as additional investment capital.

Going back to the log frame, which after all is just a tool to capture the conceptual thinking behind the project design, the private sector co-investor's contribution belongs at the input level. It is as if we have teamed up with a donor funded partner (another project, an NGO or similar), but rather than pooling donor resources, we are co-investing with a private sector partner to achieve the project's objectives. Together (but motivated by different/complimentary objectives), we are working to bring sustainable change to the way that markets work, and this is the output of the project.

Once I made this conceptual leap (from thinking of the client's investment as an output of the project, rather than the project itself), it became clear that M4P is about privatising development. It seems that the development community is at an early stage of this transition, but it appears to be underway, at least for the time being.

Privatising development is an important route towards sustainable development. It is widely recognised that the private sector uses resources more efficiently than the public sector, and the private sector has this defining characteristic of being self-sustaining. The more that the private sector can be harnessed in development (in countries where every penny counts), the better. Logically, the rate of development will be faster the more that the private sector is involved in development.

However, there are two key considerations in following this path:

1. The recent global financial crisis has demonstrated yet again that there is a clear role for the state as regulator to prevent excess and abuse, so the M4P intervention must balance the respective roles of the private sector and the state in markets; and
2. The M4P programme must ensure that it is efficiently incentivising private sector investment, not wastefully subsidising private sector profits.

This second point is something which is a question I have over some of the M4P labelled interventions I have seen reported, so we are consciously addressing it through the ABIF design process in the hope of refining the approach. Why do challenge funds give matching grants, why do grant giving programmes have cost sharing agreements at a particular level? Whenever you ask these questions of specific interventions, there is never a rational or satisfactory answer, because the projects do not talk about the role of risk in business decision making.

As with other M4P programmes, ABIF will co-invest in private sector led projects that invest in pro-poor innovation. So how will we make sure that we incentivise to achieve our objectives, rather than subsidise private sector investment? There are three answers, one conceptual and the other two practical:

1. Conceptually, we focus on the risk part of the investment equation. We will only invest in projects that would be commercially viable in a less risky environment. Our investment is not designed to share project costs or to maximise leverage of private sector investment (a completely irrelevant metric from a development point of view), but to compensate for the high discount factor (the measure of risk in an investment project) applied to those future cashflows. We will therefore only invest in projects that would have a positive NPV elsewhere and we will only invest as much as it takes to turn a negative NPV in Afghanistan into a positive one. So investment project design and the potential impact (rather than financing and the potential leverage) is the key consideration.
2. Practically, we will invest based on competition between proposals. We will define the challenge and we will evaluate proposals received, the only assessment criteria being the impact that the project will achieve and the project sponsor's capacity to implement the project successfully. So we can reach a conclusion on the expected development returns of the project (the expected future impact "discounted" according to the risks arising from the capacity of the project sponsor).
3. We will give grants, not loans. By giving grants we achieve a number of goals: we avoid confusion with commercial finance providers, we are more efficient because we do not have the costs of managing repayments, we tie up less money for the same impact... but most importantly we impose development discipline on ourselves, because we have to keep going back to donors for funding, which means we have to show impact. We are not a pretend private sector investment fund with our own capital, we are a donor funded project entrusted with tax payers' money.

By adopting this approach, the hope is that we will use public money efficiently, to offset a public obstacle to investment and achieve our impact objectives. Inevitably, things will not be quite as simple as this sounds, but at least we have an approach that should minimise the risks of subsidy and allowing the private sector making super-profits from the privatisation of development.

Ease of doing business and M4P

While looking through the World Bank Doing Business survey indicators and trying to reconcile Afghanistan's ranking with the reality of the situation here and with the specific objectives of our project, two thoughts came to me:

1. There are specific ways in which the survey fails to reflect the realities of doing business in Afghanistan and can give a misleading impression of how things are here; and
2. A broader concern that the emphasis in the headline title of "ease of doing business" risks missing the importance of effective regulation of certain ways of doing business.

Of course the Doing Business survey has to work on globally comparable indicators, which means that there are inevitable compromises in the quality and relevance of those indicators for any particular country. However, it is worth thinking about these points because the Doing Business Survey is influential, it is frequently quoted as a reference in measuring Afghanistan's progress towards creating the conditions for sustainable economic growth.

If the survey is misleading in material ways and missing some important points in relation to Afghanistan, then clearly the headline ranking needs to be treated with some caution, rather than quoted without care (as it has been by both critics and supporters of Afghanistan's progress).

To illustrate the first point, I would like to focus on the "getting credit" indicator, where Afghanistan ranks 128th (2011). The indicator has four key components; strength of legal rights, depth of credit information, public registry coverage and private bureau coverage. In each area, apart from strength of legal rights, Afghanistan scores zero.

Under strength of legal rights the survey looks at several legal provisions, for example the law allowing for the use of movable assets as collateral. On this particular measure Afghanistan scores well, it does have a law on movable assets. But will lenders rely on it? They would have to be very brave. The legal provision is in effect almost unenforceable and therefore irrelevant. The problem is not with the statute, but with the way that the court system operates. As a result, bank lending is almost exclusively secured on real estate.

So by taking a mechanistic approach, rather than looking at the reality of the situation in the country, this indicator overstates the level of development. On the other hand the limitations of the survey to public and private credit agencies misses the point that in Afghanistan a thriving informal credit industry plays a hugely significant role in the economy.

Various reports on the hawala system (including from the World Bank) have pointed to its importance as a means of making transfers and also providing short-term trade finance. This kind of finance is very important in a country where trade is the lifeblood of the economy. When making lending decisions, the Hawaladar do not (and would not) rely on public registries or private bureaux, instead they typiclly look at personal reputations and family connections. Thus in a country where such issues matter enormously, there is a viable informal mechanism that is probably just as effective as any more formal system would be at meeting immediate market needs (if not more so).

Would things be any better (in other words would economic growth be faster) in Afghanistan if additional credit related laws were enacted or credit agencies were established? The answer is that in the long-run these things will be a "good thing", but it has to be remembered that there are opportunity costs (parliamentary time, judicial training, loss of reputation linked to unenforceability etc) associated with such reforms and right now there are more pressing priorities. Not least of which would include getting the commercial court system working at the most rudimentary level and strengthening the governance and operations of the formal banking sector.

On the second point regarding the headline "ease of doing business" ranking, the issue is that ease of doing business is looked at in isolation of the responsibilities of doing business. Whereas in M4P, the two need to be looked at together.

The DB survey isn't directly concerned with issues like consumer protection or employee rights (addressed as a special topic, not in the main ranking) or environmental protection etc, so this is not a criticism of the survey itself, more a reflection on the need to balance responsibilities as an integral part of the M4P approach to economic development. It goes without saying that our project is particularly concerned with the poor, as producers, labourers or consumers. Typically, these are the people who most need protecting when making it easier for firms to do business.

If markets are to work for poor people, there need to be adequate safeguards in place (ensuring a growth in the quality as well as the quantity of income). This may not always be consistent with the notion of ease of doing business. In Afghanistan, where strong tribal and family affiliations link many politicians back to their roots, both patronage and protection play important roles. Understanding the nuances of these social and cultural systems is one of the keys to understanding how markets can play a role in Afghanistan's economic development.

We are now moving towards selecting focus sectors and using market analysis to identify key constraints to sector development. It is important that our analysis recognises teh specifics of how market systems work in Afghanistan and that the ease of doing business (in a wider sense than in the DB survey) needs to be balanced with responsibilities, thereby avoiding our work being perceived as an external intervention that somehow threatens the way that markets currently work. It is important that we recognise the role and strength of protections that exist today before we intervene to change the way that markets work. Basically, the objective will be to ensure that there are adequate mechanisms in place to support transition before destabilising current systems.

Taking this approach, achieving "systemic" change will be an incremental process, building on current systems and carefully co-ordinated with a wider development process, rather than something that happens overnight.



Note: An independent review of the Doing Business survey in 2007 made a number of important recommendations, and addressed in general terms some of the Afghan specific comments above. Nevertheless, it does no harm to think through some of these issues once more and to realise the complexity of the environment in which we seek to intervene.

What ABIF is all about

The Afghan Business Innovation Fund (ABIF) is DFID's new market development (M4P) challenge fund for Afghanistan. ABIF will manage a £4.8 million pilot fund to promote private sector innovation (new products, services and business models) in Afghanistan.

Rural and urban market systems in Afghanistan suffer from severe constraints, particularly in the areas of access to markets (particularly in remote areas), finance, information, technology and skills. These constraints have a serious impact on:

• The competitiveness of small and micro-enterprises and in turn on employment opportunities and incomes of poor people; and
• The value for money that poor people receive as customers.

To address this problem, the fund will:

• Identify the key constraints to competitiveness in sectors relevant to the poor as producers, employees or consumers;
• Encourage the development of commercially viable private sector led innovative solutions to these constraints; 
• Evaluate applications on a competitive basis; and
  
• Invest (through grants) with large and medium sized companies and specialist service providers to deliver sustainable market based solutions.

The level of ABIF's investment will be calculated to compensate for the risk of investing in innovation in Afghanistan (see post on risk based approach to challenge funds).

This project represents a significant opportunity to change the way that market systems work in Afghanistan. So much work has been done on value chain analysis and there have been countless donor interventions to address the problems that have been identified, but until now nobody has tried to use the M4P approach or the challenge fund mechanism to stimulate the creativity and harness the capacity of the private sector to deliver commercial solutions.

It will be challenging to implement this project in a country that has become so accustomed to "free" public money, but with perseverance and imagination, I sincerely hope that we can have a significant impact.