ACCURATELY DETERMINING ECONOMIC RATES OF RETURN FOR THE FINANCING OF LARGE-SCALE EMERGING MARKET DEVELOPMENT PROJECTS Introduction Many

private party large-scale development projects in emerging-market nations have been funded by or received loan guarantees from multilateral organizations such as The United Nations Development Project (UNDP), The African Development Bank (AfDB), The European Bank for Reconstruction and Development (EBRD), and The World Bank (WB) through its private sector arm, the International Finance Corporation (IFC). The WBs ultimate goal is to provide economic development for these nations with the hope that this development will lead to the reduction and eventual eradication of poverty.

When assessing the impact of a project on the development of a nation, the IFC uses a metric referred to as the countrys Economic Rate of Return (ERR). ERR calculations take into account all stakeholders of a project the project financiers (whose return is captured in the private return, or financial rate of return (FRR)), the financiers employees, the projects suppliers & customers, producers of complementary goods, competitors of the project (and new entrants into that market), neighboring residents affected by the implementation of the project, and the rest of society. ERR determination focuses more on the efficiency of resource allocation and therefore treats each group equally. By choosing to evaluate ERR this way, one has to question whether the objectives of the multilateral agencies is met. If the objective of the organizations is the eradication of poverty, should more weight not be placed on the value of the project to the neighboring community (and

to local suppliers) and less emphasis given to the project financiers (who are already compensated via the FRR)?

ERR Framework Currently The Economic Rate of Return (ERR) can loosely be defined as The net benefits to all members of society, as a percentage of cost, taking into account externalities and other market imperfections. In a Harvard Business School Professor Benjamin Esty defined a two-step process for calculating an Economic Rate of Return. This method is described briefly thus: ERR = Actual Revenues Opportunity Costs = Actual Revenues Opportunity Costs + (Actual Costs Actual Costs) = (Actual Revenues Actual Costs) + (Actual Costs Opportunity Costs) ERR = Private Returns + Cost Gains.. (1) where Private Returns = Actual Revenues Actual Costs Cost Gains = Actual Costs Opportunity Costs This simple calculation assumes the exclusion of taxes and other social anomalies.

The analysis presented above highlights the fact that there is a difference between Private and Social Returns. Though the difference between opportunity costs and actual costs is the only difference noted above, other reasons for this difference could include: Taxes, Tariffs and other forms of Government intervention which could reduce private returns; Transaction Costs; and Non-market effects such as the impact of the project on the environment.

In addition to highlighting the differences between the ERR and the FRR (or social returns and private returns), the analysis also shows, through the gains in costs, that investments in large-scale projects should result in economic development. Why is this not always the case? Rather than giving equal weight to FRR and Opportunity Costs in the determination of Social Returns, less emphasis should be placed on private returns, and more significance should be placed on other stakeholders who are likely to receive more economic benefit from the project.

Social Returns: Who Are the Other Stakeholders? Exhibit 1 is a diagram that shows the interaction of the stakeholders of a large-scale investment project. Aside from the project financiers, the other stakeholders and their interests are: EMPLOYEES: This group experiences 2 major benefits 1) wages over and above the opportunity cost of labor and 2) training that could be valuable to other employers CUSTOMERS: The project provides 3 major benefits to customers, including: 1) the provision of a novel good or service, 2) a better quality of an existing type of product or service, and 3) an increase in the supply of a particular good or service, which could lead to price reduction. PRODUCERS OF COMPLEMENTS: The producers of complements are likely to benefit from the fact that an increase in the products production of a particular good will likely result in the increased sale of complementary goods.

SUPPLIERS: By choosing to supply their wares to the project firm, local suppliers will benefit positively from the project.

COMPETITORS: Though competition will intensify if the good provided by the project is similar to an existing market, society benefits, as a whole, as the price paid for the good or service will be lower. By contrast, if a project requires a certain type of input from a supplier that can be used by other entities, the increased demand for this input (due to competition) could result in a price increase, which would result in a benefit to the supplier and thus society as a whole.

NEIGHBORS: Perhaps the most important of all stakeholders, the neighboring community stands to benefit positively and negatively from the project existence. Positive benefits include improved infrastructure and basic services such as schools, medical facilities and community centers. However, the environment is likely to be affected. Although there could be some positive environmental impacts, the likelihood is that this will not be the case (problems such as oil spills and air pollution can result depending on the nature of the project).

The FRR certainly cannot be excluded from the determination of social returns. The private investor assumes a number of risk factors (Exhibit 2) when investing in a developing nation, and those risks need to be accounted for. In addition, according to Dr. John Ohiorhenuan, the Deputy Director of the UNDPs Crisis and Prevention Bureau, If it were not for the private party seeing an avenue to make a profit, there would be no project to invest in in the first place. The private investor

creates the vehicle for social development. So you cannot discount his value.

This statement is true the private investor does create the vehicle for economic development when investing in large-scale projects. However, he seeks a financial profit for himself and social benefit is usually not a primary concern to him. The stated objective of the UNDP and other multilateral organizations is the reduction of poverty and promotion of sustainable development in developing nations. As such, in determining social returns, more emphasis should be given to the parties who stand to benefit most from increased income and social development: the neighboring community, some local suppliers, and indigenous people hired by the project.

Accounting for Income Inequality: Lorenz Curves and The Gini Coefficient Developed by Max Lorenz in 1905, the Lorenz curve is an efficient means of representing income inequality within a country (Exhibit 3). The curve shows the relationship between the cumulative percentage of actual income received and the percentage of the population that received the particular income. Building on this, the Italian mathematician Corrado Gini, in his paper Variabilit e mutabilit published in 1912, defined a relation (the Gini coefficient) which is defined as the area between the Lorenz curve of a probability distribution function and the curve of a uniform distribution probability distribution function to the total area under the uniform distribution curve. Gini coefficients range between 0 (meaning that no inequality exists in the income of a nation) to 1 (implying perfect income inequality). Exhibit 4 shows the Gini coefficient for select nations.

Mathematically, the Gini coefficient can be represented as:

Gy = 2 cov Y , F ( y ) y

(2)

where = mean income F(y) = normalized rank of a household in the distribution of income

In his paper entitled Benefit Incidence Analysis on Public Sector Expenditures in Ethiopia: the case of Education and Health, Michael Seifu combined the Gini coefficient with the mean national income to define a social welfare function:

W = Y (1 G y ) . (3)
Social Returns can be calculated by applying equation (1) above. However, by slightly modifying equation (1) to be of the form ERR = Private Returns + {1+ [1-(ln (W)/10]}*Cost Gains . (4) multilateral organizations can require a higher ERR for projects, with the additional gains being realized by the lower-income stakeholders (i.e., not the private investors). A higher Economic Rate of Return does not necessarily mean that the lower income stakeholders will receive additional economic benefit. However, the higher ERR could force private investors into realize the necessity of investing not only for his own financial return, but also for the benefit of the local economy of the project region. In addition, this simple framework does not address such issues as government expropriation and mismanagement of funds (such as was observed after the IFCs investment in the Chad-

Cameroon Pipeline Project), but this can be rectified by modifying the function to emphasize improving returns to the necessary stockholders.

Exhibit 1. Stakeholder Diagram

Customers Producers of Complimentary Products Financiers (FRR) Neighbors Employees

Rest of Society

Competitors & New Entrants

Suppliers

Source: Benjamin Esty, Frank Lysy, & Carrie Ferman, An Economic Framework for Assessing Development Impact, Harvard Business School Case 9-202-052.

Exhibit 2. List of Potential Risk Factors faced by Project Financiers 1) Sovereign Risk: a. Direct Currency Risk b. Indirect Currency Risk c. Expropriation i. Direct ii. Diversion iii. Creeping d. Multilateral Agency Involvement e. Sensitivity of Project to wars, strikes, etc f. Sensitivity of Project to natural disasters 2) Operating Risk: a. Resource Risk b. Technology Risk 3) Financial Risk: a. Probability of default b. Political Risk Insurance

Source: Campbell Harvey, Country Risk Worksheet

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Exhibit 3. The Lorenz Curve and the Gini Coefficient

Cumulative % of Income

Uniform PDF Curve

o iC e

t i en c ffi

n Gi

Lorenz Curve

% of Population receiving Income

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Exhibit 4. Human Development Statistics for Select (Low Development) Nations

MDG Share of income or consumption (%) HDI rank 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 Madagascar Swaziland Cameroon Lesotho Djibouti Yemen Mauritania Haiti Kenya Gambia Guinea Senegal Nigeria Rwanda Angola Eritrea Benin Cte d'Ivoire Tanzania, U. Rep. of Malawi Zambia Survey year 2001 1994 2001 1995 .. 1998 2000 .. 1997 1998 1994 1995 1996 1983 .. .. .. 2002 1993 1997 1998 e e e e e e e e e e e e e c e e Poorest 10% 1.9 1.0 2.3 0.5 .. 3.0 2.5 .. 2.5 1.8 2.6 2.6 1.6 4.2 .. .. .. 2.0 2.8 1.9 1.0 Poorest 20% 4.9 2.7 5.6 1.5 .. 7.4 6.2 .. 6.0 4.8 6.4 6.4 4.4 9.7 .. .. .. 5.2 6.8 4.9 3.3 Richest 20% 53.5 64.4 50.9 66.5 .. 41.2 45.7 .. 49.1 53.4 47.2 48.2 55.7 39.1 .. .. .. 50.7 45.5 56.1 56.6 Richest 10% 36.6 50.2 35.4 48.3 .. 25.9 29.5 .. 33.9 37.0 32.0 33.5 40.8 24.2 .. .. .. 34.0 30.1 42.2 41.0 Richest 10% to poorest 10% 19.2 49.7 15.7 105.0 .. 8.6 12.0 .. 13.6 20.2 12.3 12.8 24.9 5.8 .. .. .. 16.6 10.8 22.7 41.8 Inequality measures Richest 20% to poorest 20% 11.0 23.8 9.1 44.2 .. 5.6 7.4 .. 8.2 11.2 7.3 7.5 12.8 4.0 .. .. .. 9.7 6.7 11.6 17.2

Gini index 47.5 60.9 44.6 63.2 .. 33.4 39.0 .. 42.5 47.5 40.3 41.3 50.6 28.9 .. .. .. 44.6 38.2 50.3 52.6

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167 168 169 170 171 172 173 174 175 176 177

Congo, Dem. Rep. of the Mozambique Burundi Ethiopia Central African Republic Guinea-Bissau Chad Mali Burkina Faso Sierra Leone Niger

.. 1996 1998 1999 1993 1993 .. 1994 1998 1989 1995 e e e e e e e e e

.. 2.5 1.7 3.9 0.7 2.1 .. 1.8 1.8 0.5 0.8

.. 6.5 5.1 9.1 2.0 5.2 .. 4.6 4.5 1.1 2.6

.. 46.5 48.0 39.4 65.0 53.4 .. 56.2 60.7 63.4 53.3

.. 31.7 32.8 25.5 47.7 39.3 .. 40.4 46.3 43.6 35.4

.. 12.5 19.3 6.6 69.2 19.0 .. 23.1 26.2 87.2 46.0

.. 7.2 9.5 4.3 32.7 10.3 .. 12.2 13.6 57.6 20.7

.. 39.6 33.3 30.0 61.3 47.0 .. 50.5 48.2 62.9 50.5

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References 1) Benjamin Esty, Frank Lysy, & Carrie Ferman, An Economic Framework for Assessing Development Impact, Harvard Business School Case 9-202-052, February 7, 2003. 2) Philip LeBel, PhD., Economic Analysis of Development Projects, Center for Economic Research on Africa, Montclair State University, Spring 2003. 3) Michael Seifu, Benefit Incidence Analysis on Public Sector Expenditures in Ethiopia: The Case of Education & Health. 4) Benjamin Esty, Frank Lysy, & Carrie Ferman, Nghe An Tate & Lyle Sugar Company (Vietnam), Harvard Business School Case 9-202-054, May 27, 2003 5) Benjamin Esty, Frank Lysy, & Carrie Ferman, Teaching Note: Nghe An Tate & Lyle Sugar Company (Vietnam), Harvard Business School Case 9-202-067, June 12, 2003 6) Benjamin Esty & Aldo Sesia Jr., An Overview of Project Finance 2004 Update, Harvard Business School Case 9-202-065, April 29, 2005. 7) Campbell Harvey, Aditya Agarwal, & Sandeep Kaul, Project Finance Introduction. 8) New York Department of Transportation Handbook of Economic Development, Elements of Economic Analysis of Projects.

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