World Bank Document

Box 5.3
Estimating the grant element
The grant element in a loan is defined as the difference In theory, the discount rate should be carefully chosen
between the original face value of the loan and the dis- to reflect the cost of capital. In practice, a 10 percent rate
counted present value of debt service, as a percentage of is usually assumed for all currencies and time periodsthe
original face value. As Box table 5.3A shows, the the convention used in the grant element tables pubgrant
element is greater the lower the interest rate on the lished by the OECD. However, using any single inflexiloan
and the longer its maturity or grace period. ble rate has obvious drawbacks, as it does not take
account of changes in market interest rates or of big differences
in rates for different currencies.
Box table 5.3A Grant element of selected loan terms A better alternative is to set the discount rate equal to
the rate of interest at which commercial finance with the
Loain termns
same maturity could be borrowed in international mar-
Interest rate Maturity Grace period Grant element, kets at the time and in the particular currency of the loan
10 percent discount rate in question. In many instances, of course, commercial
0 30 5 77 percent funds would not be available for such long maturities, so
6 20 0 23 percent a premium should be added to the discount rate to make
6 10 0 15 percent allowance for this. The effect of a discount rate that var-
6 10 5 21 percent ies according to currency and over time is to lower the
15 percent discount rate grant element for official loans from countries in which
6 10 5 40 percent interest rates are low and to raise it for loans from couna.
Assumes immediate disbursement of loan and equal annual repay- tries in which rates are high and during periods of high
ments.
international rates in general.
Box 5.4
Three innovative financial instruments and their use by developing countries
Three financial instruments that are increasingly used in * Graduated payment loans. Debt service payments are
domestic financial markets (notably the mortgage mar- initially low and gradually build up. In the early years of
ket) have not yet been used by developing countries, but a loan, amortization may even be negative. This instrumay
have certain merits for them. ment could be particularly suitable for project finance,
* Flexible maturity loans. Instead of variable interest where earnings and debt-servicing capacity rise as the
rates, loans carry a variable maturity. Debt service pay- project matures. By matching the stream of debt service
ments are held constant in absolute terms (or, perhaps, obligations with the expected foreign exchange earnings
in relation to a borrower's income). When interest rates of a project, debt managers would avoid tying up foreign
rise, the amortization part of debt service declines and reserves for debt servicing.
the loan's maturity increases accordingly. With a large * Shared equity loans. Lenders would accept belowrise
in interest rates, negative amortization will occur; market interest rates in return for a share in the equity of
lenders will effectively be providing new money to bor- projects. For the borrower, the risk involved in a project
rowers. Flexible maturity loans offer advantages to both is shared with the lender. However, since a project's
borrowers and lenders. Borrowers are certain of their earnings depend on what price is charged for its output,
debt-servicing obligations. Lenders are able to manage a loan agreement would have to contain some pricing
their assets with less worry about debt rescheduling and formula. This would give lenders some influence over
possible write-offs. For developing countries, this would the management of the project (though it would also
be doubly attractive if debt service payments could be raise their administrative costs). Lenders might also
tied to export receipts, as it would reduce the uncertainty want to stipulate some compensation procedure or
over volatile commodity prices.
insurance against political risks.
nerability of borrowing countries to rising interest Debt managers may sometimes be able to raise the
rates. For those developing countries that have proportion of debt at fixed terms. For example, offirecently
rescheduled their debts, the proportion of cial export credits can often substitute for commercial
debt at floating rates (34 percent at the end of 1983) borrowing (see Chapter 7). New financial instruwas
nearly twice that of nonrescheduling coun- ments, such as flexible maturity and shared equity
tries. Similarly, the interest to exports ratio of loans, are becoming available to developing counreschedulers
was more than twice that of nonre- tries (see Box 5.4). And some middle-income counschedulers
and rose much faster between 1980 and tries are already using interest rate swaps to ex-
1982. change floating rate for fixed rate loans (see Box 5.5).
78