The finance gap and sources of finance
The recently agreed Sustainable Development Goals (SDGs) require in the order of $2-3 trillion per year additional funding for emerging markets and developing economies (EMDEs). The biggest sums are required for infrastructure, climate change, and agriculture. The sources of this finance are:
- Public Domestic, Private Domestic;
- Public International Concessional – Official Development Aid (ODA);
- Other Financial Flows (OFF) provided by Multilateral Development Banks (MDBs) and Development Finance Institutions (DFIs); and
- Private International such as Foreign Direct Investment (FDI).
EU Data in 2010 indicated that domestic public resources exceeded international public finance by a factor of 20. The latter was only 2% of the total finance available in EMDEs. Private finance was on a par with public finance.
Private finance is needed to fill the gap
While the Millennium Development Goals focused primarily on public investment needs for ending extreme poverty, the SDGs pursue a broader agenda that includes investments in sustainable agriculture, infrastructure, urban development, climate change mitigation, and other areas that can be financed through private means. Overall, the bulk of financing for sustainable development can and therefore should originate from private sources. The world has ample savings – estimated at $22 trillion per year with a stock of financial assets of some $218 trillion (UN 2014) – and liquidity to finance the private investments in the SDGs. Yet private financing remains vastly insufficient. A central question is therefore how global savings can be translated into the long-term private investments that the world needs in the pursuit of sustainable development. In essence this will require that sufficient sustainable investment opportunities become available with a risk-return profile that is more attractive than the return for other ‘unsustainable’ investments. Private financing may come from institutional investors, corporations, banks, bond issuance, sovereign wealth funds, and other sources.
MDBs and DFIs should mobilize private finance more
The G20 in 2013 stated that “Long-term financing is critical for investment and necessary to fuel longer-term global growth. Its availability and composition has been affected by a combination of factors, some related to the global financial crisis and cyclical weaknesses in parts of the global economy, others related to structural factors and/or longer-term trends. All major categories of long-term financing debt flows, bank lending, bonds, portfolio equity and FDI have been affected, but to different degrees and in different ways”. With limited direct lending capacity going forward, and the fiscal constraints of many of their major shareholders, there is a need to ensure that the catalytic role and potential of MDBs and DFIs in mobilizing long-term investment financing is fully utilized. Maximizing the impact of public resources on growth, and financial and private sector development, requires demonstrating meaningful “additionality”.
MDBs and DFIs are constrained and face multiple masters
MDBs and DFIs have two sets of ‘principals’: the overt political and financial owners of these development institutions – government shareholders with sometimes conflicting objectives and unequal voting rights – and the suppliers of finance provided by bond investors. The former tout their activities to promote development while the latter other pay close attention to their balance sheets and profitability. Also, this financing model has afforded development institutions more operational autonomy from shareholders. The MDBs and DFIs have no formal regulator but are effectively constrained by private sector Credit Rating Agencies (CRAs). The external pressure and attention in the aftermath of the financial crisis in 2008 has led the agencies to revamp their methodologies for evaluating different classes of investments, including development institutions, and have become an increasing constraint on MDB and DFIs’ operational capacity. The revised CRA methodologies implemented after 2012 have restricted the development institutions even further, making it more difficult for them to meet the call of the G20 and others to ramp up development operations without a major increase in shareholder capital, despite their very high financial security. Callable capital was created to give MDBs and DFIs greater financial security, but in practice it has led many development institutions to be even more conservative than they might be otherwise, pushed by shareholders to ensure that callable capital never will be called.
Financial innovation and desintermediation are possible solutions
Faced with shareholders who are unwilling to provide material additional paid-in capital, the demand for AAA rating by bond holders and constraint by CRAs is pushing MDBs and DFIs to explore other ways to contribute to increased SDG finance demand:
- Restricting lending to sovereign borrowers viewed by CRAs as highly risky, as a way to limit the impact on risk-weighted assets and single-exposure concentration penalties.
- Intensive reverse engineering of CRA evaluations to better understand the impact of individual factors.
- Building capital buffers to ensure sufficient distance from downgrade triggers, thus protecting against uncertainty in CRA criteria.
- Designing exposure exchange arrangements among MDBs and DFIs, wherein they synthetically exchange individual country exposures while maintaining their overall asset risk profile, thus reducing the impact of single-exposure concentration penalties.
- Ramping up techniques for removing exposures from the balance sheet, notably through loan syndication and co-financing arrangements.
- Exploring other options for reducing balance sheet risk, such as purchasing market-based insurance on an individual exposure or portfolio basis, and portfolio guarantees with bilateral donors.
- Leveraging concessional lending windows as a way to build more equity capital.
These forms of financial innovation and desintermediations are predictable rational behaviour from financial institutions who want to survive and grow, are resource constrained, seeking more independence from their owners with sometimes conflicting agendas and facing multiple ‘masters’.
The 2015 G20 Summit – MDBs’ action plan to optimize balance sheets
Already in 2013 the G20 began calling on MDBs to work through their Boards to optimize balance sheets, in order to increase lending without substantially increasing risks or damaging credit ratings. However, it was made clear that any incremental MDB operations would have to be done in a manner consistent with existing debt sustainability frameworks, and in respect of the MDBs’ full set of governance processes. Beyond the immediate optimization of their own balance sheets, MDBs should continue to advance their engagement with the private sector and to further explore how limited public resources can be used to leverage additional private finance.
Debt financing and capital markets
MDB and DFI operations do not come close to filling the gap between SDG related funding needs and public and private sector financing. They are very ambitious in seeking an important role, and the international agenda has increasingly called for MDBs to scale up their activities, in conjunction with private sector actors. Numerous techniques are available for finance development institutions within their balance sheet constraints to engage in leveraging, including targeted investments, guarantees, loan syndication, and co-financing arrangements.
Debt financing will form the bulk of SDG investments in cooperation with the private sector, and the first option for MDBs and DFIs is to play a substitution role for debt capital markets. Since 2013, European banks in particular have been more active again in the project finance arena, including starting to work with institutional investors on ‘originate to distribute’ loan-to-bond financing deals. However, these have so far been limited to developed economy projects. The possibilities of ‘loan to bond’ structures to facilitate institutional investors’ involvement in infrastructure financing in EMDEs is a topic for further investigation, according to the literature research. Other suggestions in the literature related to capital markets are, for example, to create a more effective secondary market, which could draw in more infrastructure financing from institutional investors who typically do not take on planning, construction, and other risks for new infrastructure projects but like to invest in operational facilities. It would allow banks to recycle their capital more effectively. To ensure effective recycling of bank capital, much more needs to be done to standardize infrastructure investments and pre-plan bond refinancing as part of initial infrastructure finance plans and national public investment systems, strengthening de-risking tools from the MDBs and DFIs and currency hedging instruments like The Currency Exchange Fund – jointly owned by leading MDBs and DFIs to promote local currency financing. Moreover, investment banks and development institutions can do more to enhance the securitization of (infrastructure) investments according to the needs of institutional investors.
More research is required
We need better insight into MDBs and DFIs as financial intermediaries operating in financial markets. The aim is to understand better how these financial development institutions can leverage their role with limited capital and mobilize institutional investors to reduce the funding gap related to SDG funding needs. Capital market techniques are a possible solution to tap into the global savings primarily managed by institutional investors such as, for example, pension funds and insurance companies in developed countries.
I will conduct this research project as part of my dissertation for Master of Studies in Sustainability Leadership at the University of Cambridge, and as feasibility study for Cardano Development Foundation (incubator of innovative concepts to strengthen the financial market infrastructure in developing countries).
The results of this research will be published after completion, which is expected in July 2016.
Herman Bril is Managing Director at Cardano Risk Management Limited in London. He is also Non-Executive Chairman of TCX Fund Manager (TIM), and was Director at Cardano Development from 2010-2014.