Soft Loan

What Is a Soft Loan?

A soft loan is a loan with no interest or a below-market rate of interest. Also known as "soft financing" or "concessional funding," soft loans have lenient terms, such as extended grace periods in which only interest or service charges are due, and interest holidays. They typically offer longer amortization schedules (in some cases up to 50 years) than conventional bank loans.

Soft loans are often made by multinational development banks (such as the Asian Development Fund), affiliates of the World Bank, or federal governments (or government agencies) to developing countries that would be unable to borrow at the market rate.

How a Soft Loan Works

Soft loans are often offered not only as a way to support developing nations but also to form economic and political ties with them. This often happens if the borrowing nation has a resource or material that is of interest to the lender, which may want not only repayment of the loan but favorable access to that resource.

China, in particular, has been active in extending financing to African nations in the last decade. For example, Ethiopia has received $10.7 billion in loans from the Chinese government from 2010 to 2015, according to the China-Africa Research Initiative at the Johns Hopkins University School of Advanced International Studies. That includes an entire grant and soft loan package totaling $23 million to support Ethiopian development and infrastructure, such as power lines, cellular networks, industrial parks, roads and a railroad linking the cities of Djibouti and Addis Ababa, the Ethiopian capital. The loans are all part of China's plan to support Ethiopia and to promote the development of trade between the African country and the Asian giant.

In another example, the Chinese government extended a $2 billion soft loan to Angola in March 2004. The loan was made in exchange for its commitment to provide a continuous supply of crude oil to China.

A soft loan is financing with generous terms — a below-market interest rate, for example — that is often offered to developing countries.

Pros and Cons of Soft Loans

While at first glance soft loans can seem like a win-win situation, they do have disadvantages — as well as advantages — for lenders.

Pro: Breaks for Business

Along with serving as a platform for the lender to establish broader diplomacy and policies with the borrower, soft loans offer favorable business opportunities. The aforementioned railway and industrial parks in Ethiopia are not only being built with Chinese funds but by Chinese companies. Many of the firms that move into the complexes are Chinese, too, and they receive considerable tax breaks on income and imports from the Ethiopian government.

Con: Shaky Returns

The length of time it may take to repay a soft loan could mean the lender is tied to the borrower for an extended number of years. While this may mean the lender might not see a direct return on the financing it offered for some time, it does create an opportunity to dialogue with the borrower for other purposes.

For instance, in 2015, Japan offered a soft loan to India to cover 80% of the cost for a $15 billion fund a bullet train project at a less than 1% interest rate, with the caveat that India would purchase 30% of the equipment for the project from Japanese companies. By the time the countries signed a formal agreement, Japan’s commitment increased to 85% of the cost, in the form of soft loans, for a then-estimated $19 billion project cost.

There is also the issue of the borrower having repayment problems, despite the soft loan's generous terms. Nations may be tempted to take on more debt than they can afford. Such a situation occurred with Ethiopia.

As a result of those Chinese loans, its debt-to-GDP ratio rose to 88%, and it was in danger of defaulting on them. In September 2018, China had to agree to restructure some of the debt, lowering the repayments and extending the loan term periods by 20 years. Nevertheless, China had plans to implement eight more major initiatives with African nations by 2021.