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Moving support to developing countries from billions to trillions cannot be done through official grants and lending alone. The bulk of the additional money must come from the private sector. While relatively high yields on projects in developing countries should attract international capital flows, the trends are not positive, and amounts are not at the magnitude needed. MDBs and DFIs are the key intermediaries in accelerating the flow of these funds as they offer to the private sector substantial expertise in finding, framing, financing and evaluating projects in developing countries.
CGD is working with both the private sector financiers and MDB/DFI officials to gather information, formal and informal, to 1) uncover the blockages to increased international capital flows for development; 2) propose concrete changes to MDB/DFI policies and procedures that could facilitate these flows; and 3) open new pathways for the public and private sectors to interact so that private investment in developing countries accelerates.
A key element of the scaling up is how DFIs will use blended finance—traditional market-term financing combined with concessional finance—to speed up investment in riskier projects with more development impact. In this area, the primary questions are:
The shareholders of the private finance operations or windows (PSWs) of the multilateral development banks (MDBs) expect them to pursue three objectives simultaneously: (1) market returns, (2) high mobilization rates (dollars of private finance raised per PSW dollar committed), and (3) high development impact. It is no surprise that in the real world there are often tradeoffs among these objectives. Yet shareholders send mixed messages about where their priorities lie. The actual PSW track records suggest more success on objective (1) than on (2) and (3).
This confused status quo becomes untenable in the context of the enormous challenges of financing the Sustainable Development Goals (SDGs), the disappointing data and trends for actual private finance flows for development, limited aid dollars, and tight fiscal constraints on developing country government capacity to fund infrastructure and other development spending. A 2018 report estimates that a total of $60 billion of private finance was mobilized by PSWs in 2016, hardly a sufficient contribution to addressing annual SDG financing gaps in the trillions.
Some inside and outside these institutions are urging them to evolve from lenders to mobilizers—a change that does not mesh well with PSW financial models that favor profitable lending for their own account. Guarantees, for example, account for only about 5 percent of PSW commitments but generate about 45 percent of private finance mobilized.
All this suggests an urgent need to change PSW business models to maintain their financial sustainability while doing much better on mobilization and development impact. Two factors are critical for meeting this challenge: enhanced risk management capability and greater flexibility regarding risk-adjusted returns. Crowding the private sector into projects with high development impact can be advanced by disciplined use of blended finance to reduce or share risk, boost returns, or form a partnership in which one party accepts delayed or below-market risk-adjusted returns.
Adapting the PSW model
PSWs need a better way to be effective and efficient partners in blended finance arrangements. To this end, I have proposed that special purpose vehicles (SPVs) with separate balance sheets be added to the PSW toolkit. They would be purpose-built for taking on more risk, while the core PSW balance sheets would retain their AAA rating and their profitability. The SPVs would target pervasive gaps in capital markets such as limited early-stage finance for firms, local capital markets, and pre-operational infrastructure projects; and scarce finance for the riskiest project tranches like junior equity or debt. The SPV financial goal would be simply to preserve shareholder equity at the entity level.
The basic idea is for the two parts of the PSW—the SPV and core operations—to offer a seamless continuum of products and services to clients. In some cases, this would make deals bankable that otherwise would not pass credit committees. In others, it would make scale and larger deals possible. And in still others, it would mean a smooth handoff from the SPV to the core PSW operations when clients or markets are ready for commercial finance and growth.
Capitalizing such SPVs would offer attractive features to MDB PSW shareholders:
The new capital requirement would be relatively small compared to PSW core balance sheet needs.
The resources funding the SPV would take the form of shareholder capital rather than one-time contributions to individual donor trust funds or reliance on IDA replenishment resources. SPV capital adequacy and the need for possible capital increases could then be periodically assessed.
The SPV shareholder and governance structure could be established de novo, that is, without dilution worries for shareholders that do not wish to participate.
Shareholders would be deploying their new capital in a way that directly advances the institutional change they seek—more openness to innovation, more mobilization, and a greater focus on areas and projects with high development impact.
A better approach than creating an SPV for each MDB would be to establish just one SPV that all MDBs could access. It could be structured in a way that facilitates both collaboration across MDBs to gain more access to SPV resources as well as healthy competition to ensure that the best projects are selected.
One other desirable innovation would be to allow private investors to participate in capitalizing the SPV. A public-private SPV would give risk-tolerant private impact investors and philanthropists a chance to participate in funding projects where mobilization and development impact are high. For their part, public shareholders would not have to bear the whole burden of capitalizing the SPV. Private shareholders would of course then rightly expect to have a seat at the governance table. This seems both logical and sensible if public and private shareholders are united around the same mission. As we’ve seen in other public-private partnership spheres, the private sector can introduce efficiencies and innovation that accelerate institutional change.
In what world would this “cascade” algorithm make sense? Without a good answer to that question, the cascade risks looking like ideology rather than sound development finance advice.
An economist explores the question
World Bank economist Tito Cordella has published a fascinating theoretical exploration of this question “Optimizing Finance for Development”, focused on the optimal sequencing of the three possibilities: reform, subsidies (risk mitigation), or public funding.
But as economists are wont to do, Cordella strips his model down to the bare minimum needed to analyse the question in hand. Yet his model contains some ingredients that could help us think about the cascade more broadly. Moreover, it is not always obvious how to connect his stylized model back to reality. This blog post tries to do that. Before proceeding, it should be noted that World Bank research economists do not speak for the Bank and so this is not an attempt to hoist the Bank on its own petard: what matters are the arguments being made, not who is making them.
As an economist, the first question Cordella asks is: which is more efficient, public or private? When Cordella writes that “to focus on the policy relevant trade-offs, most of the analysis features the case in which the private sector has an efficiency advantage”—that’s because for him when the public sector is more efficient the solution is trivial: the public sector should do it. That is a significant departure from, “if the private sector can do it, it should.”
But I suspect many people may feel that even basing the choice between public or private on efficiency is too reductive. Many North Americans fundamentally object to the idea of socialised medicine—for example—whilst many Europeans find the American health system equally objectionable. Societies have different ideas about fairness and equality. We could interpret “efficiency” more broadly, meaning that we want to satisfy social preferences in the most efficient manner possible. Or we could see the role of the Bank as setting out the costs of achieving various social outcomes and leaving it to the political process to decide what’s worth the price.
In Cordella’s model, public and private are assumed to have the same cost of capital but differing levels of efficiency across projects, which shows up in the form of different rates of financial return: greater efficiency means higher returns. Beneath the abstraction of a model, what do financial returns mean in the context of public provision? Some public projects charge user fees (e.g., utilities) but the government can also capture financial returns via incremental economic activity, which is taxed. Efficiency is a simple model parameter, but in reality the analysis of public versus private efficiency would (should) be complex: all else equal, perhaps public schooling is more efficient because it reaches the less well-off, and lower inequality is good for growth and tax revenues. Perhaps public roads are more efficient because they have a larger economic impact on overall economic activity than a toll road. The model also recognises that efficiency is not just about returns that can be internalised financially—projects create externalities. Cordella assumes externalities are the same under public and private provision, but that is merely because he is not interested in that aspect of the problem; the theoretical implications would be trivial: all else equal, if positive externalities are larger under public provision, the public should do it.
Cordella is focused on the set of projects where the private sector has an efficiency advantage, but the returns are not sufficient to induce investment. For these, there is an interesting problem of whether, and how, to bear the costs of overcoming that. His model introduces two helpful ideas: policy reforms that improve the commercial viability of projects can come at a social cost, and subsidies to induce private participation can be too expensive. This is a useful contribution to policy debates over “blended finance” which thus far have had little to say about when levering the private sector is not worth the trouble.
The analysis reveals that sequencing of the cascade algorithm only matters because governments are unable to perfectly fit instruments to projects. If subsidies and reforms are precise and project-specific, sequencing is irrelevant. But if the cascade approach is implemented in stages where, in effect, the “reforms department” does as much as it can with its instruments first before passing on the residual of projects to the “subsidies department,” then the sequencing is important. Cordella finds that contrary to the “cascade” it is best to apply subsidies first, and crowd-in the projects which are close to commercially viable at low cost, before turning to reforms when they come at a meaningful social cost. If reforms are cost free, the implications are trivial: do them. Cordella concludes:
The objective of maximizing private finance for development may conflict with the objective of optimizing finance for development.
A different motivation
However, the cascade is motivated by something that does not feature in Cordella’s model: the scarcity of public funds. There is no government budget constraint in the model. It could be introduced by assuming the cost of public finance is increasing in the quantity of public projects, so that “efficiency” becomes combination of costs and returns. The effect on Cordella’s model would be to expand the set of projects where the private sector has an efficiency advantage, and thus candidates for the cascade. Presumably the cost of financing subsidies would also reflect the increasing cost of public finance and the last-resort public option would become less often feasible, so the importance of reforms would rise. Behind the cascade model lies the idea that developing countries have reached the limit of fiscal space, so choosing private solutions where they are available is the only way of getting more done.
A counter argument is that if an economy can afford to pay for a new airport, for example, via users fees high enough for a private provider to make profits, then it should also be able to afford to pay those fees to a government-run airport or to pay via taxation. If the government has a profitable investment opportunity, it should be able to raise finance without seeing its cost of capital increase. Of course, if the government would be less efficient—perhaps it faces capacity constraints that aren’t about money but are about human resources—then that would settle it. But the cascade’s “private if possible” rule makes sense if the scarcity of public funds dominates efficiency considerations, otherwise relative efficiency should be the deciding factor. And if the public sector is equally efficient, in the sense of being equally able to capture financial returns, then it should also be able to find the money. The public budget should not be regarded as fixed, irrespective of what positive return investment opportunities that the government faces.
Maybe there are too many “shoulds” in the previous paragraph. Governments may not be able to finance all their positive-return projects. The cascade could be justified as a second-best solution for a second-best world. It may also be better seen as a signal that the Bank is now more receptive to collaborating with the private sector, rather than as a rule to be followed to the letter. But even on a more sympathetic reading, a stated policy of unconditional preference for private provision may be hard to sustain.
Unconditional support for private finance is untenable
Opinion in some of the Bank’s shareholder countries is turning againstprivate finance. More importantly, citizens of partner countries are reading stories like this: the American contractor Bechtel is lobbying the Kenyan government to choose conventional public procurement for a new Nairobi-Mombasa expressway, because it claims the financing cost under a PPP will be five times higher ($15bn versus $3bn). There is no mention of World Bank involvement in this project, but it’s a useful example. Kenya is a country with public debt approaching unsustainable levels so perhaps choosing private financing for this expressway would preserve fiscal space for something else, such as an investment in public rural roads.
What’s more, straight comparisons of financing costs can be misleading, because they obscure who carries the can for cost overruns under the two models (we should not assume a construction firm has the client’s best interests at heart, especially if advocating a cost-plus over a fixed-cost contract). The right choice is not obvious, so advice from the World Bank could be useful here. A flow chart that points straight to the private sector is not.
Cordella’s model sets aside theoretical possibilities if the implications are trivial. It may seem trivial to conclude that the choice between public and private finance should juggle both public financing constraints and comparative efficiency, but the cascade doesn’t work that way. And it should.
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How should developing countries cope with new and emerging global challenges? How do we ensure they don't get left further behind?
These were some of the questions discussed at a recent CGD event, a conversation between World Bank Group president Jim Yong Kim and CGD president Masood Ahmed.
On this week’s podcast, we hear from Jim Kim on robots, blockchain, multilateralism, and development finance—including the critical role of private actors.
“There should be a new ethics of global development that includes the private sector, because it's the only way to get to the kind of volume we need to end poverty,” Kim said. To get there, he continued, multilateral development banks need to work together.
Hear more in the clip below.
This is also a special episode of the podcast—it's my last as host, as I am leaving CGD for a new role. Thank you for listening these past three years, and please stay tuned for more episodes of the CGD Podcast.
Since the 2015 financing for development agreement, donor governments and their development finance institutions (DFIs) have all been singing from the same hymn sheet: we must do more to mobilize private investment. One way of measuring mobilization is simply to count how many private dollars are co-invested alongside public dollars, in each deal. The new Blended Finance Taskforce’s report—Better Finance, Better World—has compiled some “leverage ratio” estimates, which show the average development bank private sector window brings in 1.5 private dollars for every public dollar. The report calls for banks and DFIs to set themselves targets to multiply their leverage ratios.
Is that a good idea? It’s easy to think of objections. Speaking at a recent conference, Jeremy Oppenheim, Taskforce program director, made a forceful case: “Things just don’t change unless you target them. We know that from all walks of life.” But, he acknowledged, designing the right targets won’t be easy, will require nuance, and it must be done right.
Here I will argue that setting leverage targets in isolation might not get us what we want: more investment in developing countries. Overall investment volumes in chosen markets may make a better target, but any incentives must be soft to minimize the temptation to put public money where it is not needed.
Getting incentives right
The problem of incentives within DFIs is not new. World Bank president Jim Yong Kim, who is trying to transform the institution from a lender and investor into a facilitator of private investment, acknowledged in a speech last year that DFIs have all too often “competed with each other to finance projects—especially, the low-hanging fruit that the private sector, with a little help, could finance on commercial terms.” He recognizes that his staff face incentives to get large loans agreed, so when they involve private investors in projects they are often “working against their own interests.” The development banks have between them agreed a way to define and attribute mobilization. Kim said the bank is “working to change the incentives . . . so we can reward every effort to crowd in private financing,” but so far leverage ratio targets have not been announced.
The most obvious concern with targeting leverage ratios is that it will bias DFIs towards middle-income countries where it is easier to attract private co-investors. Or maybe I should say, further bias. Oppenheim and his colleagues see this danger clearly and argue the bias can be offset by other incentives within DFIs to reward doing deals in difficult places.
Targeting mobilization may also further tempt DFIs to participate in projects that would have gone ahead without them. A high leverage ratio can be reported by contributing a small sum to a large private project that has no need of it. A new OECD report, Making Blended Finance Work for the SDGs, found that of all the instruments they track, guarantees appear to have mobilized the greatest quantity of private investment, but that just raises the question of whether the private participation can really be attributed to those guarantees. No private lender would turn away generously discounted credit risk insurance, but that does not mean they only invested because of it.
Not all dollars are equal
There is also a more fundamental problem with how leverage is measured. The way it is currently done uses the face value of public and private contributions, which makes little sense. We want to know how much private investment we are getting per dollar of public money, but the cost to the public sector of contributing a $10m grant is not the same as of contributing a $10m loan. Similarly, whilst blended finance instruments are intended to raise risk-adjusted returns over the threshold where private financiers are willing to invest, the value of such instruments to private investors is not measured by their face value (it would be measured by how much private investors would be willing to pay for it).
Yes, leverage targets could be differentiated by instrument, guarantees, subordinated debt, and so forth. But to the extent that DFIs are able to vary the terms of any given instrument, a leverage target could tilt them towards greater concessionality where the reported leverage ratio would be higher, but not necessarily the biggest bang for public buck. In principle leverage ratios should be calculated after first re-basing the public contribution as a grant equivalent; in practice that may be too hard to do.
A better measure of the cost to the public sector would also help with value-for-money questions. Sometimes the price we may have to pay to induce the private sector to participate in commercially unappealing projects may be too high. A price might be worth paying if, for example, the private investors learn something that leads to subsequent investments without public assistance. But in some cases, all they may learn is not to touch certain types of project without generous public support. It is hard to see why aid should be diverted simply to induce private participation in investments, if that’s all that would be achieved. Thus far the debate on blended finance has had very little to say about when mobilizing the private sector is too expensive.
Perhaps the greatest problem with leverage targets was identified in a classic management studies paper, written in 1975, called “On the folly of rewarding A, while hoping for B.” We hope to increase the total quantity of investment in the service of development, but what we are measuring is the ratio of public and private capital within a set of transactions that have public involvement. These are not the same thing. If we succeed in changing the ratio of public and private money in each DFI deal, what have we achieved? Nothing if the total quantity of investment has not changed. In principle making greater use of private money in each project could free up public money to take on more projects elsewhere, but the audience at tworecent blended finance conferences in Paris were repeatedly told that money is not the problem, investment opportunities are. Especially in Africa.
It is tempting to conclude that because what we are really trying to achieve is more investment, then that is what DFIs should target. If we knew, for example, that the global set of DFIs is only capable of investing $50bn annually off their own balance sheets, then if we set them a target of $200bn total deal volume (including private contributions) that would implicitly target a 1:3 leverage ratio. Targets could be set for each DFI and differentiated by market or sector. This approach is instrument agnostic, leaving DFIs to figure out which instruments offer the greatest value for money.
Sadly, it too suffers from the rewarding A hoping for B problem. We hope for additionality, we’d reward any investment that combines public and private investors. Pressure to “get money out the door” is bad enough already. If additionality is observable at all, it is tacit knowledge inside DFIs. Nobel prizes in economics have been awarded for research into the performance of contracts when the desired outcome is partially unobservable. In such circumstances contract theory says high-powered incentives can be inefficient. That suggests it may be better to try to reward staff when they are informally “known” to have created additional investments with private participation, rather than explicitly reward metrics that can be gamed.
So where does this leave us? The Blended Finance Taskforce is certainly right that the incentives within DFIs must change, to turn competition with private investors into collaboration. And that change should manifest itself as higher leverage ratios. Explicit leverage ratio targets are problematic, but so is the status quo; the priority is to improve on it, not to attain perfection. Soft incentives that reward increased overall investments with greater private participation, where we want it, are needed, but the incentives must not be strong enough to bulldozer those within DFIs whose job it is to hold the line on additionality.
Development finance institutions (DFIs) have long resisted the idea that they ought to support coordinated national development strategies in the countries that they invest in, but if conversations around private roundtables at the recent World Bank/IMF meetings are anything to go by, that’s where they may be heading. And if so, it may be the private sector itself that leads them there.
The buzzword of this year’s meetings was “transformative.” The new IFC 3.0 strategy of “making markets” reflects criticism of its traditional transactional model, with each deal seen in isolation. One shareholder at the meetings asked: If we are not being transformative, what’s the point?
Hopes of achieving the Sustainable Development Goals (SDGs) rest on diverting some of the trillions of wealth held in rich countries towards investments in poor countries, but DFIs know that simply increasing their deal volumes will not be enough. DFIs have set themselves the goal of being transformative, because they know that unless they can set investment booms in motion that go way beyond their own projects, the SDGs will not be achieved.
This is true. So is the observation that if I jump out the office window, I will die unless I learn to fly. But let’s not dwell on the realism of the ambition, and look instead at where it may take DFIs.
Some transformative ideas are on the supply side. Most DFIs operate a buy-and-hold business model, and ask the private sector to participate in their investments. But the perception is that most private investors too often find co-investing with DFIs more trouble than it’s worth. One much-discussed proposal is for DFIs to move towards an originate-to-distribute model, and to see their job as creating a diversified pool of assets, packaged in a way that a larger set of private investors find easy to buy. That would increase the supply of money looking for projects, but not the supply of projects looking for money. Development finance is already experiencing something of a supply shock, with many governments allocating more money to DFIs, and complaints about the lack of bankable projects are commonplace. One thing is certain: transforming the supply side will have a greater impact if complemented by something equally dramatic on the demand side. And this is what may take DFIs in some surprising directions.
Civil society has long urged DFIs to follow the principle of country ownership and to collaborate with host governments’ national development strategies. DFIs have always shied away from that suggestion, emphasizing the (ideally) decentralized and entrepreneurial nature of the private sector, and the risks of getting investment tangled up in politics, particularly in countries prone to clientelism. But around private roundtables at the recent World Bank and IMF annual meetings, private investors were heard calling for more “programmatic” investments, by which they meant coordinated investment plans. To give a simple example, a private investor can build a hospital but they want somebody else to build the reliable power supply it needs.
The Blended Finance Breakthrough Taskforce, convened to approach the problem from the perspective of the private sector, also presented some emerging findings at the meetings, including the desirability of projects “ideally linked to sectoral development plans and policy frameworks.” A star of the meetings was the Colombian development bank FDN, which is majority owned by the government but also has the World Bank’s IFC as a shareholder. FDN is governed like a private actor but has benefited from being connected to government for matters such as land acquisition and licensing in the construction of a national highways network. This combination of public and private has attracted investments from bulge bracket Wall Street banks. The idea that national development banks may have a more important role to play was subject of much discussion at the fall meetings.
Programmatic investments also have the potential for a bigger bang for each blended finance buck. That can happen if there are complementarities in production—the hospital is more likely to succeed if the power plant exists, and vice versa. If the success of one project relies on the success of others, private actors may not undertake investments unless they know that all the required complementary inputs will be created. Kaushik Basu, former World Bank chief economist, has written about how generous state guarantees can induce private investors to undertake projects they would not otherwise, and if these are coordinated then the likelihood of the guarantees being called falls.
Optimists will say we have learnt from history and need not repeat it. Scholars such as Dani Rodrik have articulated a vision of Industrial Policy for the Twenty-First Century, with more emphasis on experimentation and less on top-down planning. We have learnt more about how to build markets starting from an unpromising institutional environment (and one might also say that China is showing the way with more programmatic investments around the developing world). None of this sits well with DFI’s traditional, demand-led business model. Of course, much of what DFIs do involves smaller businesses where these ideas are less relevant, and some of the smaller bilateral DFIs may be more effective in other niches. But to my mind, greater cooperation with host governments and national development banks is where the ambition to be transformative is likely to lead DFIs. There are hard questions to answer about the conditions under which attempts at coordinated investment in collaboration with government are likely to succeed, and what the alternatives are in other cases, but in the face of demand from the very private investors DFIs want to attract, they must rediscover the art of activist industrial policy.