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FEDS Notes

October 9, 2014

The Social Discount Rate in Developing Countries

Missaka Warusawitharana

The "social discount rate" is the interest rate used in cost-benefit analyses of infrastructure and other public projects. As seen from the discussion of the Stern report on climate change (see Stern, 2007, and Nordhaus, 2007), differences in the social discount rate can have substantial implications for evaluating the costs and benefits of public projects. This note proposes a heuristic approach to deriving a social discount rate for developing countries based on the sovereign borrowing rate.

The main methods currently used to calculate the social discount rate are: (1) the social rate of time preference and (2) the social opportunity cost of capital. The first approach is based on the argument that public investment reduces private consumption and thus equates the social discount rate to a rate of time preference, usually estimated with the Ramsey formula.1 The second approach is based on the argument that public investment crowds out private investment one-for-one and, as such, the discount rate is estimated based on the pre-tax real rate of return for private investment, typically estimated using returns to private capital. Based partly on this approach, leading development banks, such as the World Bank and the Asian Development Bank, typically apply a real discount rate in the range of 10 percent to 12 percent when evaluating projects in developing countries (see Zhuang et al., 2007, and Harrison, 2010). Many government agencies in these countries follow such guidelines and apply a similar discount rate when evaluating public projects. Applying such relatively high discount rates implies, for example, that projects requiring a significant upfront cost to realize a flow of benefits over long periods of time may be discouraged.

This note proposes using the real interest rate at which developing countries can borrow as the social discount rate. For instance, one could use a recent average of a sovereign government's cost to borrow in U.S. dollars, adjusted for U.S. inflation rates, to measure the social discount rate for a developing country. A rationale for this measure is that it would significantly correspond to the borrowing cost of the government that would, in most cases, be responsible for funding the project. Thus, using the sovereign borrowing rate as the social discount rate would enable one to match the projected cash inflows from the project to the cash outflows for the government responsible for financing it.2 This approach, in fact, reflects the current practice of most European governments, who link the social discount rate to their borrowing costs. In addition, U.S. government agencies either use a rate based on government borrowing rates or a higher rate obtained from a social opportunity cost of capital calculation (see Office of Management and Budget, 1992).

The proposed method would not have been feasible until recently, as most developing countries were not able to access dollar-denominated sovereign debt markets. Reflecting the increased globalization of financial markets, however, there has been a marked increase in access to sovereign debt markets for developing countries, as detailed in The Economist (2014). Table 1 lists data on recent issuance of dollar-denominated sovereign debt with maturity greater than five years by selected developing countries.3 Many of these countries issued their first such bond during the past few years.

Table 1: Recent US$ Sovereign Debt Issuance by Developing Countries
Country Issue Date Yield-to-maturity Amount (US$ millions)
Kenya 6/17/2014 6.88% 1500
Zambia 4/7/2014 8.63% 1000
Ivory Coast 7/16/2014 5.63% 750
Sri Lanka 4/8/2014 5.13% 500
Pakistan 4/9/2014 8.25% 1000
Ecuador 6/16/2014 7.95% 2000
Senegal 7/23/2014 6.25% 500
Honduras 12/11/2013 8.75% 500
Gabon 12/5/2013 6.38% 1500
Bolivia 8/15/2013 6.25% 500
Nigeria 7/2/2013 6.63% 500

The figures in Table 1 indicate that using sovereign borrowing costs would result in lower social discount rates than are currently applied in developing countries' cost-benefit analyses for public projects. The (nominal) interest rates in Table 1 (labeled "yield-to-maturity") average about 7 percent; after adjusting for U.S. inflation, the implied social discount rate would be on the order of 5 percent. This lower discount rate is similar to that recommended by Lopez (2008) for selected Latin American countries. It should be noted that the low social discount rate implied by the proposed method would rise if sovereign debt yields were to increase notably, possibly due to a change in the global macroeconomic environment or country-specific developments.

Discount rates ought to incorporate a risk premium, since the projected future benefits of a project may not materialize. The use of sovereign borrowing rates implicitly assumes that the risk premium on public infrastructure projects is the same as the premium for the default risk of a country. In contrast, the social opportunity cost of capital approach assumes that the risk premium on public infrastructure projects is the same as that on private investment. But the private risk premium on private project is likely too high for public sector projects, due to the fact that it involves compensation for factors (for instance, weak institutions) that may not apply for the consideration of public projects.

Another consideration that points toward using a moderate social discount rate in developing countries is that current practices might tend to underestimate some of the potential benefits of many infrastructure projects. For instance, public infrastructure projects frequently are expected to generate positive externalities (see Fernald, 1993), which would potentially amplify the returns from the infrastructure investment compared with current estimation practices. These externalities are hard to estimate, and are typically overlooked in a traditional cost benefit analysis.

To summarize: this note argues for using real sovereign borrowing rates as the social discount rate for evaluating public projects in developing countries. Compared with standard approaches, such an approach would currently result in a lower discount rate than currently applied, potentially leading to greater public infrastructure investments in developing countries. If carried out wisely, such investments may help boost living standards for many people in these countries.

Fernald, John, 1999, Roads to prosperity? Assessing the link between public capital and productivity, American Economic Review, volume 89(3), pages 619-638.

Harrison, Mark, 2010, Valuing the future: The social discount rate in the cost-benefit analysis, Visiting Researcher Paper, Australian Government Productivity Commission.

Nordhaus, William, 2007, The Stern Review on the economics of climate change, Journal of Economic Literature, volume 45, pages 686-702.

Office of Management and Budget, 1992, Circular no. A-94, Guidelines and discount rates for Benefit-Cost Analysis of Federal Programs. Washington, D.C.

Stern, Nicholas, 2007, The Economics of Climate Change: The Stern Review, Cambridge University Press Cambridge, UK.

The Economist, 2014, Frontier markets: Wedge beyond the edge, The Economist, April 5.

Zhuang Juzhong, Zhihong Liang, Tun Lin, and Franklin De Guzman, 2007, Theory and practice in the choice of social discount rate for cost-benefit analysis: A survey, Asian Development Bank ERD Working Paper #94.

1. The Ramsey formula implies that the social rate of time preference equals the intertemporal discount rate plus the consumption growth rate times the elasticity of the marginal utility of consumption. Return to text

2. This ignores the potential foreign currency risk faced by the borrowing government. This risk could, in principle, be hedged using financial instruments, though such hedging would need to be included in the total cost of the project. Return to text

3. I thank Wenxin Du and Rick Ogden for helping provide the data. Return to text

Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers.

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Last update: October 9, 2014