Over the past few years, multilateral development banks (MDBs) have followed a ‘billions to trillions’ agenda. The idea is that billions of dollars in public funds can catalyse trillions in private investment for climate finance and the green transition.
In Latin America and the Caribbean, the estimated gap between current levels of development financing and the amounts needed to meet the UN Sustainable Development Goals has been estimated at more than $650bn annually.
While the development requirements stretch far beyond the capacity of these institutions, there is a strong push for MDBs to act as major enablers of these efforts.
As most of these institutions were founded decades ago, how should their role change to support increasingly high ambitions?
“There is much more cross-border finance going on by the private sector than had been the case when these institutions were founded in the second half of the 20th century,” says Daniel Zelikow, vice-chair, public sector and chairman of the advisory board at JPMorgan Development Finance Institution.
Within MDBs, private sector lending and mobilisation have been placed at the centre of their strategies. By 2018/19, lending to the private sector represented 35% of major MDB lending to the region, compared to 20% in 2004/05. The private sector arms of some MDBs are active in Latin America and the Caribbean as well, such as IDB Invest and the International Finance Corporation (IFC), the investment arm of the World Bank Group.
Rising interest rates
In the current high interest rate environment, MDB lending could potentially be much more attractive in terms of costs and availability. Thanks to their triple-A rating, MDBs have the ability to borrow at low interest rates on global markets and in turn lend at a lower cost.
This will be especially true for Latin America and other emerging market borrowers, which usually experience capital outflows when developed countries’ interest rates rise.
Nevertheless, these institutions have to be much more careful with the financial structure of the deals they support. “In an environment of higher and more volatile interest rates, we may have to structure deals differently, for example in terms of the grace period or the tenor of the transaction, or the combination of loan-versus-equity-versus-guarantee components,” explains Orlando Ferreira, chief finance and administration officer at IDB Invest.
Higher interest rates means that those arranging financing will need to pay higher costs, suggesting the need for longer-term borrowing at a fixed rate.
“MDBs should be actively helping their sovereign borrowers hedge their exposures to financial risks inherent in cross-border finance, such as interest rates, exchange rates and commodity price exposures, and most have the products appropriate for the task,” says Mr Zelikow.
Rising interest rates makes it even more complicated, especially when it comes to climate and energy investments, which are characterised by high up-front costs and low recurrent expenses.
“Take the case of a solar power plant. It costs quite a lot to build, but the good news is you don’t have to buy gas anymore,” explains Charles Kenny, a senior fellow at the Center for Global Development. “High interest rates make this model less attractive because borrowing money upfront is more expensive.”
It is likely that 90% of MDB loans are denominated in hard currency
As important as interest rates are, the currency mismatch between MDBs’ dollar-denominated loans and local currency revenues of their borrowers is a much bigger problem, according to Chris Clubb, managing director for Europe at Convergence, a global network for blended finance. “It is likely that 90% of MDB loans are denominated in hard currency, posing huge foreign exchange risk to the borrowers and the countries.”
While most of what IDB Invest does is denominated in US dollars, the institution has been increasing its participation in local currencies. “Now we offer our clients 23 different local currency and interest rate solutions. The current interest rate environment might push the bank to increase deals in local currency,” says Mr Ferreira.
Expanding their scope
While there is a strong consensus that MDBs can play a role in supporting the green transition, there are multiple ways this could be achieved.
It could be done with these banks’ shareholders approving capital increases or trying to do more with the current capital structure. Others suggest leveraging the institutions’ operational capabilities.
In July 2022, finance ministers from the G20, a group of 20 of the world’s biggest economies, published a review of MDBs’ capital adequacy frameworks. The review encourages MDBs to rethink their approach to capital adequacy, as they may be able to lend more with the same amount of capital.
“If you look at the total balance sheet capacity of all the MDBs, relative to what they’re actually doing, they are only arranging around 50% of the transactions that they could be doing. Not all of them are systemically underutilising their capital, but on average they are as a group,” says Mr Clubb.
MDBs are often accused of being too conservative and focused on protecting their balance sheet. For example, instead of lending directly to small and medium-sized enterprises (SMEs), they might offer lending to commercial banks on the condition that they, in turn, support SMEs. This practice makes sense as MDBs are not in a position to support local firms directly. Additionally, lending to traditional lenders is safer and protects their triple-A rating.
“I personally don’t see why the IFC needs to be triple-A rated,” says Chris Humphrey, senior research associate at the global affairs think tank ODI. “Why can’t it be single-A or double-A rated — charge slightly higher loan prices, but take much more risk and be much more catalytic and developmental? It’s very different when you’re talking about the public sector-focused MDBs, which should be triple-A rated institutions.”
Other proposals to increase the banks’ role focus on securitisation, which see MDBs package the loans they have granted and sell them to private investors, rather than letting them sit on their balance sheets. “They should find ways to shift the risk off their balance sheet to an external investor for a fee, to clear space on their balance sheet to do more,” says Mr Humphrey. “IFC and IDB Invest, in my view, should be doing a lot more of that.”
From billions to trillions
Most of the proposals to mobilise private investors require effectively a very high rate of leverage of private capital for each dollar put in as a guarantee or subsidy by the public sector. The idea is that a little bit of public finance could mobilise a multitude of transformative private sector development projects.
Leverage ratios are often used as a proxy indicator of the success of blended-finance investment. According to an ODI report published in 2019, $1 of MDB investment currently mobilises an average $0.75 of private finance.
“When you look at public–private partnership (PPP) deals, they are not seeing a very high leverage. When MDBs invest with private companies in a PPP, they are reaching leverage ratios of 1:1. Just across public–private infrastructure projects in developing countries, a third of the money comes up front from governments,” explains Mr Kenny.
“IDB Invest was started in 2016. At the beginning, we were able to bring about $0.50 from the private sector for each dollar we invested,” explains Mr Ferreira. “Right now, we mobilise about $1.10 — a significant jump in terms of crowding in private investors. And we continue to think about better ways to mobilise more private capital.”
The idea that public funds can encourage private investments explains why the International Development Association, the part of the World Bank Group that arranges low-interest loans and grants to the poorest countries, started providing cash to help finance IFC deals in eligible countries through the ‘Private Sector Window’ mechanism.
“It was designed to pay out $5bn between July 2017 and June 2023, but has committed less than half of that, just $2.2bn, to date,” says Mr Kenny. “As of December 31, 2021, only $694m had actually been disbursed. They are finding real difficulty in finding suitable deals to back in poorer countries. The idea that we can scale this up from $5bn to $1tn seems a bit difficult.”
In a world with abundant opportunities to attract finance from private sources, the role of MDBs, according to Mr Zelikow, should evolve to focus increasingly on advice, project preparation and risk management, not just long-term US-dollar loans.
MDBs are increasingly focused on advisory, as well as channelling their financial resources to poorer and smaller countries that have less access to private capital and less ability to pay market interest rates.
There are also large amounts of capital that are available to be invested from local sources. The challenge is to develop local markets so that there are financial instruments for local institutions to make these investments.
“The involvement of MDBs in evaluating and managing policy and regulatory risks, and their willingness to engage governments on these matters in ways the private sector cannot, is hugely valuable,” says Mr Zelikow.
This suggests that MDBs do not necessarily need to be at the top of the capital stack, but could only be taking riskier pieces of the stack that are very hard for the private sector to calibrate in terms of evaluation.
Real impact
Aside from the pure development impact, another objective of development finance is making sure public funds do not end up subsidising private investment that would have gone ahead even without public funds — the so-called ‘financial and development additionality’.
The assessment of both is very challenging because of the lack of definitional and methodological harmonisation.
With regards to development additionality, some argue MDBs tend to evaluate the single project’s outcome rather than the outcomes at the sector and country level, which will be more useful.
Does IFC’s investment in a power plant in Tanzania lead to a bigger power sector in that country?
“Does IFC’s investment in a power plant in Tanzania lead to a bigger power sector in that country? According to our studies, we cannot see any impact on the number of people who have access to electricity or electricity consumption. You can’t see any impact on the development outcomes,” says Mr Kenny.
According to Mr Ferreira: “We know that financing private sector projects requires analysing different variables. So, we monitor the impact of the project from inception to maturity. The project then gets reviewed by an independent office that reports directly to our board of executive directors. And there’s substantial alignment between our final rating of the project and the rating of the independent office. At the moment, based on operations that were evaluated in 2022, we are achieving a success rate of about 62% from the point of view of the overall project outcomes achieved.”
Mr Clubb agrees that this could be improved; however, he “would not suggest that there is a systemic under delivery of development impact and climate impact in MDB activity at this point in time”.
With regards to financial additionality, there is the risk MDBs might support private projects that would have gone ahead without their involvement.
The $5.25bn expansion of the Panama Canal in 2008 was an example of “crowding out” of private investors, according to a source with direct knowledge who does not wish to be identified. The project was supported by a $2.3bn financing package, which included loans from five MDBs, but could have seen a bigger role for private banks, which were interested in supporting the project.
MDBs state that their private sector lending is market priced so that market participants are not crowded out with the effect of a decrease in private investment.
The institutions typically price their loans by benchmarking against market-driven loans. The challenge is that commercial lenders sometimes lend at levels that cover their cost of capital only if other products they offer are bundled with their loans. So, in effect, lending is a loss-leader.
“This analysis does not reflect our experience,” says Mr Ferreira. “For IDB Invest, it is very important to be able to mobilise additional resources and expand our pool of funds. We not only put our own money to work, but we bring other lenders to the table and structure investments that work also for them. This makes more financing available for our clients and enables us to make a bigger impact on development.”
Mr Zelikow adds: “Sometimes the availability of funding from official lenders, whether multilateral or bilateral, drives down the spread available to private sector investors. This may be good for borrowers, but it can also discourage private investors’ involvement rather than ‘crowd in’ private money.”
Sometimes the availability of funding from official lenders, whether multilateral or bilateral, drives down the spread available to private sector investors
According to Mr Kenny, there is an increasing spread between what the private sector demands in order to deliver an infrastructure project and the cost of money that governments can get from MDBs to build it themselves.
In 2018, the International Bank for Reconstruction and Development (IBRD), African Development Bank, Asian Development Bank, European Bank for Reconstruction and Development and the Inter-American Development Bank (IDB) had combined paid-in capital from shareholders of $43bn to support an outstanding loan portfolio of $374bn. The institutions managed to achieve a 1:9 ratio, mobilising private sector investors through issuing bonds.
When it comes to infrastructure, two-thirds worldwide is owned by governments. “And there’s a reason for that,” notes Mr Kenny. “Pretending that we can go from [this] to one where the majority [of infrastructure] is private-owned is fighting against 100 years of history.”
Regional banks getting more active
In Latin America, lending by regional MDBs has significantly outpaced that of the World Bank to the region. After the global financial crisis, the World Bank reduced its lending to the region, while IDB and the Development Bank of Latin America (CAF) continued expanding, according to a report by the UN Economic Commission for Latam and the Caribbean.
Last year, CAF underwent a large capital increase of $7bn, which will effectively double its portfolio by 2030. The figure was close to the $7.5bn the IBRD received in 2018 by its 189 member countries.
“CAF got the same amount from around 20 countries. The only external countries involved in CAF are Portugal and Spain. The US is not involved,” says Mr Humphrey.
“That says a lot about how the recipient countries in Latin America perceive the bank. They are putting their money where their mouth is.”
CAF tends to prioritise the national legal and regulatory frameworks of the recipient countries when it comes to issues such as environmental evaluations or policies on resettlement for an infrastructure facility, Mr Humphrey notes. Other MDBs have established a special set of rules, so-called ‘safeguards’ that a country must abide by when using their resources.
“Some recipient countries find those policies to be an imposition of external priorities on their countries. Of course, the trade-off is that CAF financing tends to be more expensive, given its double-A minus rating. But CAF also tends to be less bureaucratic and approve loans more quickly,” adds Mr Humphrey.
The retrenchment of MDBs in the region is also the result of development aid increasingly being directed towards poorer countries. However, the more there is a shift from development issues to climate, the more financing will flow to Latin America.
