Soft loans as ‘gateway drug’?

Sri Lanka may be sliding into a trap due to over-reliance on public financing for infrastructure development and concomitant overuse of ‘soft loans’ in the process. 
To achieve its ambitious growth targets, Sri Lanka needs to increase infrastructure investment from its current 1.6 percent of GDP to at least 4 percent to reach modest levels, in comparison with developed countries at almost 7 percent. 
The previous government oversaw substantial infrastructure investments especially in roads, followed by power, ports, airports, and irrigation--yielding an impressive construction boom. Rapid Sri Lankan growth observable today owes heavily to transport and construction.
Critics chide the previous government for financing infrastructure development too heavily through bilateral loans with unfortunate ‘strings attached.’ ‘Concessionary finance’ secured through these loans often requires using contractors from the lending country and contracts typically get awarded without competitive tenders. 
For both reasons, costs wind up unnecessarily high. True, such ‘soft’ loans come with lower interest rates than those on commercial loans. However, ‘Strings attached’ costs, render them more expensive than they look.

Not first to utilize soft loans
The previous government was not Sri Lanka’s first to utilize soft loans. Earlier upgrades at the Colombo port and Bandaranaike International Airport, for example, relied on concessionary funding from Japan. In the post-conflict period, Sri Lanka has drawn heavily on China. Soft financing from China, more than US$ 4 billion for the road sector alone, far exceeds that from any other bilateral source. India is ramping up, however, with US$ 318 million in funding for upgraded railways approved this year, on top of some US$ 996 million in past support for that sector. 
Sri Lanka’s accelerating reliance on soft loans comes in a context of increasing difficulty in securing commercial credits for infrastructure projects, especially in developing countries. The post-2008 worldwide slowdown appears to have exacerbated this credit crunch, origins of which may lie back with the emerging-market currency crises of the nineties.
Soft loans represent one key portion of the larger phenomenon of ‘tied aid,’ wherein bilateral development assistance comes with requirements that the recipient country utilizes goods and services from the donor country on aid-assisted projects. 
Like loans, assistance in the form of grants may be tied to use of donor country goods and services. A substantial literature grapples with the question whether tied aid is suboptimal for development objectives. In one study, the Organization for Economic Co-operation and Development (OECD) finds that: “Tying aid to specific commodities and services, or to procurement in a specific country or region, can increase development project costs by as much as 20 to 30 percent.”
Tied aid may retard development not only by imposing unneeded costs but also by retarding recipient-country capacity building in business expertise and labor force skills. The OECD highlights additional problems, including shipping expenses, delivery delays and incentives toward poor project selection due to concessionary funding. 
Much of the literature foregrounds the fact that tied aid’s original core purpose was economic development for the donor country by promoting export of its goods and services. Ongoing tension persists between the non-identical objectives of donor country export promotion and recipient country development. Tied aid programmes often take shape in complex negotiations between foreign aid and economic development agencies in the donor government, not to mention its foreign policy wing.
Though donor countries such as the United Kingdom, Denmark, the Netherlands and Norway have stepped sharply away from tied aid, China has been slow to do so. One observer contends that China encourages both agencies and state firms to “mix and combine foreign aid, direct investment, service contracts, labor cooperation, foreign trade and export.” This bears particular relevance for Sri Lanka, given its recent China-dependency. 

Corrosive effect on competitive tender norms
As worrisome as the hidden direct costs of soft bilateral loan funding is its possible corrosive effect on competitive tender norms in infrastructure procurement generally, including commercial lending and private providers. Resort to soft bilateral financing may foster a habit of by-passing competitive tender procedures. Through several decades and governments, Sri Lanka adhered for the most part to ‘Government guidelines on tender procedures’ in procuring infrastructure and services. Beginning with bi-lateral infrastructure borrowing highlighted above, however, it has lately drifted away from competitive tender procedures under the guidelines. The trend away from competitive bidding now extends even to domestically-executed roadway rehabilitation. 
Contractors may secure jobs without competitive bidding if they link the government with commercial lending to finance a project. State borrowing for the road sector without competitive tenders now amounts to some US$ 1.5 billon. A number of newspaper articles have taken critical note.

Competitive bidding
Departure from competitive bidding was codified legally in 2011 with promulgation of ‘Supplement 23’ to the procurement guidelines. This badly-drafted regulation purports to authorize non-competitive procurement only in circumscribed settings but in fact creates loopholes wide enough for proverbial trucks to drive through. 
Several problems are easy to grasp. The Supplement applies to “unsolicited or stand alone development proposals.” The concept of ‘unsolicited’ proposals is generally understood and widely used, but that of ‘stand alone’ proposals is not. It is unclear whether ‘stand alone’ denotes a category distinct from ‘unsolicited’ or is merely a confusing alternative term.  The idea of a ‘stand alone’ proposal fits poorly with the idea that development initiatives should comport with an overall government plan. It seems to invite renegade interventions and governmental favoritism. The category of ‘unsolicited’ proposals is problematic as well because validity is not tightly defined as in, for example, U.S. State Department rules. 
Again in contrast with those rules, Supplement 23 authorizes non-competed contracts where the sole justification is that the proposing party “commands reputation and know-how, otherwise scarcely available.” Because such a criterion invites both subjectivity and favoritism, it should apply only in combination with other exceptional circumstances. Finally, in setting out criteria for allowing non-competed contracts, the Supplement punctuates a list of specific items with a final item authorizing them whenever departure from competitive bidding is “justifiable.” Such a catch-all exception completely swallows the competitive bidding rule. It lights up a pathway to degraded financial discipline and needlessly high costs, encroaching seriously on scarce funds for social sectors and other priorities.
In a context of infrastructure credit crunch, Sri Lanka’s best way forward remains obscure. Development aid critics cite Eritrea’s decision that building a railway system entirely with domestic resources and expertise was better than accepting tied foreign assistance.  Whether this applies to Sri Lanka’s current infrastructure challenges is far from clear. What is clear is that soft financing poses threats to both cost control and capacity building. As Supplement 23 suggests, it may also portend a general threat to Sri Lanka’s competitive bidding norms. While that threat has so far manifested itself mainly in the road sector, there is no reason it could not metastasize elsewhere. It behooves Sri Lanka’s government to maintain vigilance over departures from earlier norms of transparency, neutrality and frugality.
(This column is part of the ‘PPP Knowledge Week’)