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Development finance must be more powerful

Development finance must be more powerful

For cash-strapped governments, development finance institutions (DFIs) offer an understandably attractive vision: that of development carried out by the private sector at a low cost to the state. Such institutions try to build businesses and create jobs by borrowing money and buying stakes in companies, and look for healthy returns. Their goal is “to do good without losing money,” as an early president of the UK put it. In recent times, they have been tasked with improving the climate, promoting sustainable development goals and guiding investors into difficult markets.

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This grand vision explains a recent influx of money into bilateral DFIs. In 2019, America founded the American International Development Finance Corporation (dfc), with an investment limit of USD 60 billion, twice as much as its predecessor. The year before, Canada launched its first dfi. In Europe, the combined portfolio of the 15 largest institutions will double in a decade to reach €48 billion ($53 billion) by the end of 2021. Some organizations operate as full investment arms of their governments; others are more like public banks, in which commercial investors have a minority stake. However, there is a common problem: DFIs have yet to demonstrate that their model can deliver on the ambitions in the world’s poorest places.

The money ends up in all kinds of businesses, from risk insurance for marine conservation in Belize to investments in Ethiopian telecom operators. European institutions allocate a third of their money to financial institutions, which then lend it to local companies. Another quarter goes to energy projects, such as solar panels and hydroelectric power plants. dfis have largely avoided losing money and made modest gains in the process, though covid-19 temporarily pushed many into the red. By their own reckoning, they have created millions of jobs.

Still, this avoidance of loss may indicate over-caution. In theory, DFIs go where private investors are afraid to enter, demonstrating the potential of new markets. In practice, they often look to low-cost co-financing from donor agencies that provide grants or concessional loans to “take risk off the table” by making the companies involved less likely to fail, says Conor Savoy of the Center for Strategic and International Studies, a think tank. Philippe Valahu of the Private Infrastructure Development Group says his donor-backed fund, which focuses on Africa and Asia, has taken on projects that DFIs rejected “because they were considered too risky”.

One problem is where to spend. In 2021, some European DFIs invested only half of their investments in sub-Saharan Africa or South Asia, the two places where almost all the world’s poor live. In difficult countries it can be difficult to find projects that are ready to receive funding. A failed investment can be bad for both development and the balance sheet, argues Colin Buckley of the Association of European Development Finance Institutions. “You have a negative demonstration effect,” he says. “What you tell all investors is, ‘Don’t come here, you’re just going to lose money.'”

Another problem is the type of investments DFIs make. Companies in developing countries need capital that lingers and bears risk, just like equity capital. But only a few DFIs, such as those in the UK and Norway, have large equity portfolios. In America, the DFC’s use of equity is limited by federal budget rules, which treat it as a gift rather than a returnable investment. In Europe, some large dfis have been set up and regulated like banks, with loans like bread and butter. Banking rules designed for Europe are difficult to apply in countries where some clients do not have documents such as certificates of incorporation, says Michael Jongeneel, CEO of fmo, the Dutch dfi.

Many institutions are trying to be more adventurous. The DFC of America made about 70% of new investment last year in middle-income countries below the $4,256 threshold that makes a country upper-middle-income, according to the World Bank. British International Investment (bii) puts most of its money in Africa and holds about 9% of its portfolio in a “Catalyst” fund, which seeks out the riskiest investments. In 2021, a group of dfis launched a new platform to pool expertise and map markets in so-called “fragile” states, including research visits to Liberia and Sierra Leone.

But DFIs are caught between conflicting expectations, explains Samantha Attridge, co-author of a recent study for think tank odi. Governments want them to generate a financial return, to go where private investors don’t want to and to involve a lot more private investors in their projects. “If you want to create maximum impact by going to the hardest places, you’re not going to be able to get purely commercial investors on your side,” said Nick O’Donohoe, CEO of bii.

Governments, as primary shareholders, must decide what exactly the purpose of dfis is. That means being realistic about what markets can achieve in the midst of obstacles to investment, such as political uncertainty or a lack of contract enforcement—the kind of gnarly problems DFIs aren’t designed to solve. “Robust private sector development and access to capital is critical to growth,” said Scott Nathan, CEO of dfc. But they can’t always come first.

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