37034 NOTES AGRICULTURAL & RURAL DEVELOPMENT WHEN MARKETS DO NOT WORK, SHOULD GRANTS BE USED? BY: GRAEME DONOVAN ISSUE 9 APRIL 2006 In rural development today, there is much more THEORY reliance on the market than in past decades. In many Grants, in the present context, are government subsi- countries, governments have new roles, and no longer dies. They can be used to increase the supply of goods sell outputs and inputs, or deliver credit. Instead, they and services, or to increase demand for these. They are supposed to help the private sector develop. can be used for investment or for consumption. They can be used to buy assets for the poor, or to supple- There are still frequent complaints that markets are ment their incomes. They are most often used for not developing, or that they are not delivering enough training, or to promote the development, dissemina- volume or value of goods and services. Questions of tion, and uptake of new technologies. This note looks what to do to reduce poverty, increase employment at grants mainly as one-time subsidies aimed at help- and widen consumer choice are still to be answered. ing investment rather than consumption. To deal with problems of inadequate markets and the persistence of deep poverty, development agency per- The theory of grants starts by defining three types of sonnel designing projects have increasingly turned to goods--"private," "pure public," and "impure pub- grants to provide solutions. lic." These are defined as follows: This note examines the theory of grants, draws lessons Private Goods: these goods are excludable (those who from a review of their use in twelve projects that start- own them can restrict their use by others, especially by ed mostly in the years 1998-2000, discusses findings, those who do not pay for them) and rival (their use by and recommends ways to deal with problems faced in one consumer reduces their availability to other con- grant projects. sumers--they cannot be used over and over again); examples are marmalade and cars. Private sector mar- kets most often provide these goods. Pure Public Goods: these goods are not excludable, nor rival; examples are market regulations and national defense security. The public sector most often provides these goods. Impure Public Goods: these goods are less than fully excludable or rival. One example of an impure public good is a road that many users can use at once (thus, not rival), but for which a toll can be charged (thus, excludable). Such goods are sometimes called toll goods. Another example is the fish stock in the ocean. As one user increases its catch, there are fewer fish available for others. Therefore, the ocean fish stock has the characteristic of rivalry. But, it is very hard to restrict users, so there is only a weak characteristic of exclud- ability. Such goods are sometimes called common prop- erty resources. The greatest temptation to use grants occurs in the pro- duction of impure public goods, on grounds of market failure or policy failure. Impure public goods are often produced by the private sector, but there is always a risk 2. Is a grant the best remedy? Possible reasons for private that not enough of them may be produced because the sector production to be restricted, or inhibited, indicat- private sector may not be able to capture a sufficient ing whether a grant is likely to help are as follows: share of the economic benefit to society. Impure public · Lack of public goods such as infrastructure, legisla- goods are also sometimes produced by the public sector, tion, or information (e.g., trying to mill grain with- but there is always a risk that either too much or too little out electricity): the best solution is to invest in of them may be produced because the public sector does these public goods--it will not help to give grants not receive or react to market signals as does the private to reduce the high costs of production caused by sector, and thus can be an inefficient producer. their absence. · Lack of economies of scale (no single enterprise big If there is a market failure, the public sector can step in to enough to make the lumpy investments needed): produce the good itself, or it can take other actions to try grants do not automatically help, although it may to overcome the market failure. Such actions may include: help for governments to support collective action · Defining, protecting, and enforcing property rights in making lumpy investments. · Providing infrastructure · High risk (from long gestation periods of invest- · Supporting provision of information ments, political instability, lack of transparency in government policy, natural disasters, etc.): private All three of these actions reduce transaction costs for sector insurance schemes can handle some risks, private sector participants in the market. The public sec- and governments should first deal with any insuf- tor should give priority to those actions that reduce ficiencies in their own policies and performance, transaction costs substantially. It should not try to deal and only then consider grants. with every market failure because governments cannot · High costs of protecting property rights: in general solve all of them efficiently. governments should establish and protect proper- ty rights and provide subsidies (grants) only where The nature of goods (how they fit into the three-fold costs of enforcement are too high. classification above) may change over time. Their nature · Lack of commercialization of the economy: this changes as technologies, institutions, and legal systems especially slows down development of financial adapt to new situations. For example, developing new services and grants should not be used in these open-pollinated crops used to be done by the public sec- cases for subsidizing credit, but they may be justi- tor because the private sector could not capture the big fied for training, development of management benefits enjoyed by many people other than those who information systems, or helping to expand branch had paid for the seeds ("spillover" benefits). The private networks and install new technologies. sector could capture more of the "spillover" benefits · Lack of technology, information, or trained staff: with institutional developments including stronger prop- grants may be useful to solve these problems. erty rights, better enforcement, and technological devel- 3. Grants are generally justified for training of skills, opments such as hybrid crops with securely protected technology, innovation, information, start-ups of parent lines. The public sector does not need to be so businesses, project preparation, trade fairs, private involved in production. investment in local infrastructure, networks, lumpy capital, and collective action. DECIDING WHEN AND 4. Grants are generally not justified as subsidies for cur- HOW TO USE GRANTS rent inputs or credit, where their use may crowd out private suppliers. In deciding whether to use grants and how to design them, the following key questions and issues need to be 5. Cost-benefit analysis of grants: The key issue in ana- addressed: lyzing the worth of grants is determining whether the additional benefits of a grant outweigh its costs. The 1. Is there a market failure? Simply because the private private sector will generally take up investments that sector does not invest in something does not mean are privately profitable, regardless of whether their there is necessarily a market failure. It may mean net economic benefits to society are positive or neg- merely that profits are low in that line of business or ative. It will generally not take up investments that in using that technology. A market failure is when are not privately profitable, and some of these (those there is a significant difference between social net that have net positive economic benefits to society) benefits and private net benefits. may qualify for grants. 2 6. How big should grants be? They should be big Grants can be named for: enough to turn investments worthwhile to society into profitable investments for private businesses. · The services they support--e.g., research, technology 7. What kinds of grant instruments should be used? dissemination, export promotion, innovation, com- There are different ways in which grants can be munity development, business startup, project feasi- provided: bility assessment, training, market development, busi- ness linkage promotion, and capital. · Vouchers: These are useful to stimulate effective · The procedures used to administer them--e.g., com- demand and market development because in the petitive, demand-driven, and matching. hands of demanders they force suppliers to com- pete. Cost-effective implementation may be diffi- cult, though. · Competitive grants: Their advantage is increasing the effectiveness of grants, but the disadvantages may be increasing administrative costs and increas- ing waiting time for applicants (while they are evaluated). · Competitive bidding processes (applicants say how much they are prepared to pay themselves and what level of grant they require): Their advantage is that public budget may be saved and more proj- ects supported, but they require considerable expertise to prepare and evaluate. · Matching grants for feasibility studies and techni- cal assistance: These are seldom appropriate in less developed countries where technical or business consulting expertise is limited. 8. Who are eligible to apply for grants? It is important to decide in advance whether everyone should have access to grants or only certain specified groups - and for those who are targeted, how much do they need? REVIEW OF WORLD BANK 9. Is the capacity adequate to implement a grant PROJECTS THAT USE GRANTS scheme? To answer this question means making judgments about existing capacity and about future A wider review in 2002 for the World Bank by the TDI capacity that could be built up, if indeed a grant Group1 concluded that the use of grants tended to scheme is likely to be sustained well into the future evolve with the level of economic development, provid- at a large enough scale to justify building capacity to ing expertise mainly in low-income countries and in handle it. It is important to make sure the scheme more mature economies to support a wider range of will work without needing to bring in expensive for- policy objectives. Grants had been used for export pro- eign assistance for extended periods. motion, project preparation, research, technology adop- 10. Is the grant process transparent and accountable? tion, training, welfare-oriented community develop- This is essential for good governance, and requires ment, and income-generating schemes. Research funds clear thinking about: had focused on applied and adaptive research, and evolved towards putting funds in the hands of users of · Application and decision-making procedures technology who could contract appropriate research · Sources of final authority in decision making providers (Reifschneider et al 2000). · Provisions for appeal · How to inform the eligible population The twelve World Bank-financed projects overviewed · How to ensure community decisions reflect inter- (Van der Meer and Noordam 2004) were selected as ests of all groups within communities three groups of four from grants for agricultural · Possible support for preparation of grant proposals research and development, private enterprise develop- · Reporting requirements for recipients ment, and community development. Following are the · Monitoring and evaluation main findings of this review: 3 · Too much decision making is left to implementers (as · Detailed cost-benefit analyses of all grant-financed shown by lack of information in Project Appraisal investments, to the extent that such investments are Documents). of an economic nature for which such analyses are · Economic justification for productive projects for possible. In some cases, this may be possible only at which grants are to be used is largely absent and gen- the aggregate level. erally weak. Given the scale at which the World Bank · Broader analyses of other investments such as com- operates, this is unacceptable. munity-driven development (CDD) projects and cash · Many staff involved in community driven develop- or food-for-work schemes, to ensure that the inter- ment (CDD) projects believe, incorrectly, that selection ventions proposed are the most cost-effective way to by communities will guarantee that grants will be put help the poor without distorting markets and private to uses that provide net economic benefits. sector activity. · Projects justify grants by describing various obstacles · Analysis of pilot interventions or stylized model invest- to development. It is often not clear whether or not ments should be attempted and, wherever feasible, these obstacles are market failures. In many cases, the ex post evaluation of samples of sub-projects should argument made for grants is merely that the target be carried out when economic analysis is too difficult. population is poor and lacks assets. · Project Appraisal Documents should include more · Information provided in project documents is insuffi- details of implementation, and give more guidance to cient to make the case either that grants can be effec- the implementers. tive or that they are the best intervention under the · The World Bank's Independent Evaluation Group (IEG) circumstances. should evaluate grant schemes with special attention · Little attention is given to the possible distortion of to justification, economic evaluation, and implemen- markets by using grants. tation details. · The case for cost effectiveness of grants is often insuf- ficiently made. CONCLUSION · It is hard to design and manage grant schemes. In addition, projects often provide for international con- Economic theory suggests grants can be good instru- sultants to help, a solution that is generally too expen- ments to compensate for market failure, but their improp- sive. er use is risky. It can waste public resources, distort or · Project documents are often not clear on the eligibili- destroy markets, crowd out the private sector, provide ty criteria for obtaining grants. unfair competition, and give rise to political favoritism and corruption. Careful preparation, assessment, monitoring, The review recommends the following actions in and evaluation of grant projects are essential. the World Bank for addressing these deficiencies: · Guidance notes, standard guidelines and manuals, SELECTED READING: and training for task managers, emphasizing the need Kees van der Meer and Marijn Noordam. 2004. "The to explicitly identify market failures and justify the use Use of Grants to Address Market Failures: A Review of of grants to address them, as well as providing frame- WorldBank Rural Development Projects." Agriculture and works for detailed design of grant schemes. Such Rural Development Discussion Paper 27, World Bank, guidelines should draw on the large experience with Washington, DC. grant schemes in development agencies outside the World Bank. The guidelines should be drawn up by F. Reifschneider, D. Byerlee, and F. Basilio da Souza. 2000. the Agriculture and Rural Development Department "Competitive Grants in the New Millenium." Proceedings (ARD) and promoted by training through Thematic of "A Global Workshop for Designers and Practitioners," Groups within the department. Brasilia, Brazil May 16-18. 1 TDI Group is an international consultancy, training, and project management organization. For more information about this group: http://www.tdigroup.ie/ This note is based on the larger report entitled The Use of Grants to Address Market Failures: A Review of World Bank Rural Development Projects by Kees van der Meer and Marijn Noordam. Editorial input for this note was provided by Derek Byerlee, Jock Anderson, and Kees van der Meer. You can download a full copy of the report at www.worldbank.org/rural or email ard@worldbank.org. THE WORLD BANK 1818 H Street. NW Washington, DC 20433 www.worldbank.org/rural