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The critical role of development finance institutions in economic development

December 03, 2018
An appreciation for the role of private capital in economic development is not new: the UK’s CDC Group and the International Finance Corporation (IFC) were founded over 50 years ago to channel private sector capital from developed to developing countries. While much emphasis is placed on the role of governments to grow incomes in these countries, the private sector is often the primary growth engine in emerging markets—generating 9 out of 10 jobs.[1] Moreover, official development assistance (ODA) budgets have stagnated. Foreign direct investments (FDI) have now overtaken the volume of ODA by a factor of 5 to 1.[2] And in 2012, for the first time, developing economies absorbed more FDI than their developed counterparts.[3] As a result, during the last 15 years, the role of ODA as the major source of development financing has shifted. ODA has been redefined as a “catalyst” to mobilize additional investments, especially private capital.

Development finance institutions (DFIs) such as the IFC and Overseas Private Investment Corporation (OPIC), play a critical “middleman” role in catalyzing this private capital. DFIs provide financing and technical expertise for deals where the private sector will not invest, thereby bringing capital and skills to underserved markets. Due to their development mandate, DFIs can offer loan pricing and tenors that might be uneconomical for a private sector investor. These long tenors are often critical to infrastructure projects than can form the basis of future development in these markets. In some cases, DFIs can provide a grant—or work with a philanthropic donor —to help an organization investigate a new program or opportunity, such as an emerging market bank looking to lend to women entrepreneurs. These grants are uncommon in private-only investment. Technical assistance is another area where DFIs provide differentiated support. Over years of investment, a DFI may develop a portfolio of dozens of deals in a given sector, region, or country. In these challenging markets, such expertise may be the difference between a successful investment and a non-performing loan.

DFIs also provide leverage with governments in emerging markets to de-risk investments, where institutions and private sector protections are weak. In this way, DFIs can accelerate reform through the deals they finance. A tangible deal, with very real development impact (say, 1,000 jobs or $50M in direct loans to SMEs) coming from a DFI can provide the necessary leverage to make a policy or legislative change in an emerging market.[4] DFI funding is bolstered by bilateral or multilateral treaties laying out the terms of investment and providing certain recourse if deals go awry. This is particularly pronounced in political risk insurance, where a claim may end with sovereign-to-sovereign negotiations, rather than a private company attempting to collect from a sovereign. In spite of these advantages, DFIs are careful to avoid “crowding out” the private sector—thereby actually undermining private investment. The World Bank, with its “cascade” approach, has attempted to internalize this process. The organization is encouraged to first consider what policy interventions could be made in an investment country to de-risk the opportunity for private-only investment and therefore minimize any market distortions.[5]

As a result, development finance institutions provide assurance to the private sector that financial returns are possible. If a DFI makes money in an emerging sector or region, private enterprise and investment are more likely to follow. For example, OPIC provided an innovative political risk insurance policy to the Energoatom project, a spent fuel storage facility in the Ukraine. By de-risking the bond issuance from the Ukrainian government, Ukraine was able to access the US capital markets for the first time and finance a significant energy infrastructure project. With OPIC political risk insurance, the bond rating broke the sovereign ceiling; Moody’s rated the bond Aa2, while the sovereign was rated at Caa2.[6] Bangladeshi and Afghan telecom is another success story. Bangladesh now has 117.6M mobile phone users, and Afghanistan has 21.6M—both upwards of 70 percent of the entire population. Fifteen years ago there were essentially no cell users in either of these countries, and the private sector largely shied away from the market due to political, market, and economic risk. DFIs proved the catalyst to build these markets and provide almost 140M people with cell access.[7] By financing telecom companies’ entry into the market when the private sector would now, DFIs allowed these companies to demonstrate the viability of the sector in Bangladesh and Afghanistan.

There is an inherent conflict in development finance institutions’ dual emphasis on financial returns and economic development. As DFIs invest in the poorest countries, financial returns become more challenging. But as financial institutions, the success of DFIs is built on strong earnings, and without returns there are no demonstrative effects to catalyze private capital. Some critics believe DFIs should avoid investment in middle- or high-income countries, and accuse them of irrelevance when private banks are keen on providing financing in emerging markets. However, the benefits of development finance outweigh these challenges. From 2000 to 2016, the total annual commitments by all DFIs (bilateral and multilateral) grew from $10 billion to around $70 billion, an increase of 600 percent. ODA grew by roughly 50 percent over the same period.[8] This is a strong demand signal for the kinds of risks DFIs will take, above what the private sector will take on. Financial Times’ chief economics commentator, Martin Wolf, said in 2017: “We have no hope in achieving the Sustainable Development Goals (SDGs) without high growth in poor countries.”[9] As DFI success stories suggest, this growth will be the result of collaboration between public and private capital.

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  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

References

   [1]https://www.csis.org/analysis/rethinking-private-capital-development

   [2]https://www.csis.org/analysis/rethinking-private-capital-development

   [3]http://unctad.org/en/PublicationsLibrary/wir2013_en.pdf

   [4]https://www.forbes.com/sites/danielrunde/2014/10/17/development-finance-institutions-come-of-age-dfi/#4e7d6b735c2c

   [5]http://documents.worldbank.org/curated/en/859191517234026362/pdf/WPS8320.pdf

   [6]https://www.opic.gov/press-releases/2018/innovative-opic-political-risk-insurance-product-facilitates-ukraine%E2%80%99s-first-access-us-capital-markets

   [7]https://www.forbes.com/sites/danielrunde/2014/10/17/development-finance-institutions-come-of-age-dfi/#4e7d6b735c2c

   [8]https://www.csis.org/analysis/dfis-drive-development-agenda-center-stage

   [9]https://www.csis.org/events/development-finance-institutions-changing-global-economy

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