By Martin Chrisney, Senior Director, IDAS Institute, KPMG International
In 2015, global leaders endorsed the United Nations’ 17 Sustainable Development Goals (SDGs), thus providing a framework to identify and fund socially beneficial investment. This Agenda 2030 offers guideposts for public and private investments with time-bound targets for poverty reduction, health outcomes, educational achievement, gender equality and the environment—among others.
While the Agenda 2030 applies to all countries, the severity of the challenge is greatest for developing economies, where the United Nations estimates an additional $2.5 trillion a year of investment is needed. To reach the goals in these markets, the community of donor agencies and multilateral banks seeks to partner with private capital to leverage and expand investment.
So we should ask: Is the private sector up to the task? The evidence suggests that private capital can scale to the level needed in combination with other sources of funding. However, it is critical to take into account the role of different financial instruments and the varying risk appetites of investors. Finally, a larger role for private capital requires innovations by international finance institutions that go beyond those already adopted.
Cross-border flows today: From trillions to more trillions
Already private-sector finance is the dominant source of external funding for developing economies. The Organization for Economic Cooperation and Development (OECD, 2018a) estimates that nearly $1.0 trillion of private finance reaches developing economies each year—some three times the level of official creditor flows (see Table 1). These funds include foreign direct investment, debt financing for governments and the private sector, and portfolio investment. Although impressively large, private finance does not necessarily target the goals of the Agenda 2030 and will not be its main source of funding.
For the most part, national governments will provide the majority of the money needed for public works and services. These public goods can be funded from domestic sources including increased tax collection, reduced subsidies, increased savings and more efficient expenditures—including the use of public-private partnerships. By some estimates, governments are likely to account for 65 percent of the SDG-funding gap, which would leave the private sector’s contribution at around $500 billion annually, based on historical patterns (see Table 1). This can be considered as the floor, if all other sources of funds increase in line—including remittances.
Table 1
Closing the Agenda 2030 Financing Gap
The ceiling for private finance depends on the ability to develop new instruments and attract new long-term investors. Currently, assets under management that adhere to the United Nations’ Principles for Responsible Investment total $89 trillion, some of which is managed by pension funds that have $28 trillion in assets in OECD countries. There are also $820 billion in pension-fund assets in a sample of 29 emerging economies that can offer much-needed local-currency finance (OECD 2018). According to UNCTAD 2014, the maximum private participation could reach $1.8 billion. This is possible only if these sources of funding are tapped, and the number of bankable deals increases.
Follow the money
It is important to note that the role of private capital varies by type of instrument and the risk profile of the investee market. For example, the share of foreign direct investment (FDI) is roughly the same for the lowest-income economies (3.8 percent of the gross domestic product average for 2015-17) as it is for upper-middle-income economies (3.9 percent) (see Graph 1). This lack of difference among countries by income level reflects, in part, the fact that FDI investors have controlling-ownership interest in their investments. Investors can more readily reduce both operational and management risks and, therefore, are more willing to invest in developing countries regardless of income group.
Graph 1
Source: World Bank (WB) data based on International Monetary Fund (IMF) balance-of-payments reporting.
Note: The data for private credit and official credit is based on balance-of-payments reporting.
On the other hand, net private capital flows of debt and equity increase as countries’ incomes rise. Commercial lending and capital-market finance often have less recourse to underlying assets, and they concentrate instead on more creditworthy markets—while portfolio investment is riskier and has a more limited ownership stake. Data from the World Bank’s Doing Business Index (plotted in Graph 1 on the Avg. Doing Business Score-RHS) shows that business risks are greatest in low-income countries (the index is lower), implying both higher operational costs and greater uncertainty. While higher-income countries generally have better Doing Business scores and similarly better credit ratings.
There is a complementarity between private and public resources. Net capital flows from bilateral donors and multilaterals naturally concentrate on low- and low-middle-income countries as part of their poverty-reducing mandates. These resources include grants, low-interest loans or market-priced loans, which benefit from sovereign guarantees and are less sensitive to risk than private finance. As a result, international financial institutions are key to leveraging more private finance. Especially in lower-income countries, public resources need to be “blended” with private capital in individual projects or investment funds.
Enabling environment
While the potential to leverage private finance is immense, the scale of investments linked to the Agenda 2030 has, so far, not supported the original optimism about channeling trillions of additional dollars from capital markets and long-term institutional investors. There is still an enormous gap in funding for sustainable businesses that could provide goods and services aligned with the Agenda 2030. To overcome this gap requires innovative approaches such as the following:
New institutions: A first step is the establishment of new development institutions. At the international level, the addition of the Asian Infrastructure Investment Bank (2015) and the New Development Bank (2016) have added $200 billion in authorized capital—both expanding the sources of multilateral finance and innovating their governance and operational models. Among donor governments, the newly created International Development Finance Corporation in the United States and FinDev Canada promise new approaches to leveraging capital. Finally, in developing countries, the growth of green banks and funds, such as India’s National Investment and Infrastructure Fund (NIIF), can be replicated. These institutions have innovative governance structures with independence from national governments that can be more responsive to private investors.
New instruments: Second, a wider array of financial instruments that target SDG-linked investments and access new funding sources is needed. The meteoric rise of green bonds has been impressive, and, while growth has slowed, the concept is being replicated with blue bonds (e.g., for marine conservation in the Republic of Seychelles) and SDG bonds. These provide a path to tapping the power of capital markets. New tools to de-risk operations have been used at the World Bank. The new $2.5-billion International Development Association (IDA) Private Sector Window, launched in 2017, gives risk-reduction and blended-finance options for its sister organization, the International Finance Corporation (IFC), when lending to low-income states. The IFC has also launched a new funding model with a co-lending program that attracts insurance funds to long-term infrastructure investments that match the maturity needs of these companies’ portfolios. Also, the European Union’s External Investment Plan (EIP) applies guarantees and blended finance prominently to expand private-sector capital in Africa.
New partnerships: Finally, a key ingredient is a new approach to partnering with the private sector. To successfully catalyze private funds requires a clear understanding of the risk appetite of each player. Currently, the market does not have a risk-taker of “first resort”—since no one institution has a balance sheet large enough to underwrite the guarantees or provide the equity capital required to reach the Agenda 2030 goals. Therefore, new partnership structures need to be explored.
Experimentation is needed in the use of new off-balance-sheet vehicles that mobilize donor and multilateral development bank (MDB) funds in combination with institutional investors. These structures can offer different layers of capital that match the varying risk-return expectations of investors. Such blended-finance institutions can be especially catalytic for long-term infrastructure investments.
To break the logjam in deal generation, additional grant money or contingent financing is needed that draws on private-sector expertise to identify and develop investment-ready projects. Additionally, the deal-generation capacity of MDBs and other donors can be used to develop and design operations that are then securitized in capital markets. Using a YieldCo model such as this can be done in partnership with pension funds and others to help define the types of investments, the portfolio characteristics and timing of exits. These models, and others, that engage the private sector as an equal partner are more likely to be successful in leveraging additional finance.
Conclusion
Any realistic scenario to reach the goals of the Agenda 2030 will require a broad range of financing sources. While private capital has and will continue to play a predominant role, the challenge is to expand that role, measure its impact and lever new sources of funding. In that effort, the donor and multilateral communities are critical partners. New partnerships and new business models are needed to expand the existing capacity to take risks and leverage private funds. The innovations in the market already show promise. However, much more innovation is needed.
References:
[1] OECD (2018a), Creditor Reporting System (database) [2] OECD (2018b), Global Pension Statistics, www.oecd.org/daf/pensions/gps [3] UNCTAD (2014), “World Investment Report, 2014: Investing in the SDGs: An Action Plan”,United Nations, New York and Geneva.