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.
Key Takeaways
- A "soft financing" or "soft loan" is a loan given with next-to-no or no interest with extended grace periods, offering more leniency than traditional loans.
- Many developing nations that need funds but cannot afford to borrow at market rates can benefit from soft loans.
- In the case of government lenders, soft loans may be used to forge ties between the lending and borrowing countries.
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 over $19 billion in loans (also called Foreign Direct Investment) from the Chinese government from 2010 to 2021, according to the China-Africa Research Initiative at the Johns Hopkins University School of Advanced International Studies. 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 also by Chinese companies. Many of the firms that move into the complexes are also Chinese, 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, Japanoffered a soft loan to India to cover 80% of the cost for a $15 billion 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, Ethiopia's debt to China as a percent of gross national income was approximately 10%, and it was in danger of defaulting on them. In Sept. 2018, China had to agree to restructure some of the debt, lowering the repayments and extending the loan term periods by 20 years. In the aftermath of the COVID-19 pandemic, soft lending from China to Africa has slowed, down to only $1 billion in 2022.
Who Typically Offers Soft Loans?
Soft loans are typically offered from developed countries, such as China and the U.S., to developing countries. The latter countries often don't have the resources to qualify for higher cost loans.
What Makes a Loan "Soft?"
Soft loans generally have much more favorable terms than "hard" loans. That may include low to no interest and extended repayment periods.
What Country Is Known for Extending Soft Loans?
China has funded many projects through soft loans. In exchange for low or no interest, China often expects countries to use Chinese companies or goods to complete their funded projects.
The Bottom Line
Soft loans are an essential tool for many countries that are struggling to fund necessary infrastructure upgrades. While soft loans do help, they often come with strings attached, such as using certain products or companies.
