This blog is adapted from ‘Crowding-In Private Finance: What Multilateral Banks Can Do Differently,’ the author’s chapter in a new Brookings Press book, "From Summits to Solutions: Innovations in Implementing the Sustainable Development Goals." The eight-day U.N. High Level Political Forum on Sustainable Development ended on July 18, with a draft ministerial declaration adopted. The declaration reaffirmed the support of countries that are working towards making the SDGs a reality.
The global economy has transformed significantly since the establishment of the Multilateral Development Banks (MDBs), mainly due to globalization and the evolution of country-driven development strategies. These transformations have led to the general acceptance of private sector and private international finance as key to economic development. Thus, MDBs will need to form partnerships with the private sector to catalyze private finance for development well into the 21st century.
An evolving development landscape
While initially focused on providing funding, the MDBs have evolved into institutions that provide cutting edge knowledge products about development at the global, regional, country, and local levels, and help build capacities to manage interrelated development processes. Traditionally, the MDBs, have focused on the implications of global policies in developing countries in areas such as trade, debt relief, poverty alleviation, economic growth, and environmental protection by working directly with governments and government agencies. The MDBs play a seminal role in promoting economic and financial stability, and advocate for global public goods in several international fora including the Group of 20 (G-20) and Group of 7 (G-7). Consequently, the MDBs play a vital and well-suited role to help countries achieve the Sustainable Development Goals (SDGs) and address the challenges posed by the 2030 Agenda.
The attainment of the SDGs requires a mountain of resources that cannot be gathered through traditional sources of funding, be it Official Development Assistance or MDBs’ resources. Trillions of dollars are required annually to reach the SDGs by 2030. This is well beyond the ability of international financial institutions, including MDBs. To implement the 2030 Agenda, the role of MDBs must shift from transferring resources to mobilizing them. Hence, private sector financing and investments are vital for the implementation of the 2030 Agenda and achievement of the SDGs.
Crowding in the private sector
The role of the private sector has gained momentum, and a core challenge for the MDBs is to open up opportunities for them. The MDBs are adept at serving as intermediaries between countries that need to invest in development projects and private finance. They have a sterling track record in aiding countries enhance their national capabilities for project and public investments, and they also provide assurance that disputes are settled in an impartial manner.
The MDBs could bring the private financial sector on board through an ex-ante and ex-post engagement as financier or co-financier of projects. Both the ex-ante and ex-post approaches entail innovative and new types of partnerships between the MDBs, governments, and the private sector. To succeed in this endeavor, the MDBs will have to modify their operational approaches and the internal staff incentive structures.
Two channels that MDBs can utilize to augment the role of the private sector are to assist governments in creating conditions for appropriate market-oriented growth, and collaborate with the private sector and increase private capital flows by becoming participant investors. Conversely, to successfully partner with the private sector, the MDBs must improve their expertise in various aspects of international banking, adapt to the flexibility and confidentiality required of private sector operations, and develop a new risk culture and the knowledge base for commercial risk analysis.
The comparative advantage of the MDBs in this partnership is that they possess a capital structure that permits them to operate in high-risk environments, and their relationship with developing-country governments enables them to reduce political risks in a manner that the private international financial sector appears unable to do. Governments tend to have more faith in a project when there is a partnership between the private sector and an MDB, which is duty bound to protect its members’ interests. The success of MDB collaboration with the private sector involves judicious design and implementation, as well as the allocation of the intertwined risks (political, regulatory, and commercial).
Cascade and Maximizing Finance for Development
The World Bank Group has pioneered an approach of pursuing private sector solutions for attaining development goals while reserving public finance for critical areas where private sector involvement is not optimal or available. With a view to enhancing its commitment to Maximizing Finance for Development (MFD), the World Bank introduced (in March 2017) the “cascade approach,” a concept that leverages private sector financing and solutions. If public debt and contingent liabilities are limited, then private solutions are promoted, and if not, then the option of public finance is pursued while upholding environmental, social and fiscal standards, and good governance criteria.
The cascade approach serves as a complement to domestic resource mobilization and enhances the effectiveness of public finance. MFD dovetails with the WBG private sector arm International Finance Corporation’s (IFC) strategy to “create markets” as well as the World Bank risk guarantee arm Multilateral Investment Guarantee Agency’s 2020 strategy. MFD reinforces regulatory or policy frameworks, champions competition, and develops local capital markets. Operationalization of the cascade approach requires effective cross-WBG coordination and systematic efforts to equip staff with guidance, resources, training, and monitoring to scale up and integrate MFD into World Bank operations and its engagement with clients. The MFD approach has been piloted in nine countries: Cameroon, Cote d’Ivoire, Egypt, Indonesia, Iraq, Jordan, Kenya, Nepal, and Vietnam. The cascade approach, if implemented across all MDBs, will facilitate a paradigm shift in the way the MDBs operate.
Portfolio approach and managing risks
Often institutional investors’ margins are so thin that the cost of acquiring the knowledge and relevant expertise to analyze and evaluate development projects might render financing development less attractive, if not impossible. Hence, to ensure that institutional investors participate in financing development, the cascade approach needs to be complemented by a mechanism that permits the private financial sector to buy into the portfolio of the MDBs, ex-ante, or prior to the preparation and implementation of the project, and/or ex-post, or after the project has been fully disbursed. This “portfolio approach” is a method through which the MDBs can mobilize and catalyze financial resources from institutional investors.
Bankable projects do not emerge out of thin air. MDBs need to scale up the use of the in-house expertise to prepare and implement projects while also transferring this expertise through technical assistance to country governments. Technical assistance can also be provided to the private sector in developing countries (through, for example, advisory services by IFC) to prepare projects that are of interest to foreign investors, be it financial or physical investments.
Investments need de-risking for the private sector but also for the public sector. Part of the de-risking will be quality preparation and implementation of projects, but also through proper management of exposure, including contingent liabilities, that are created through the various forms of public-private partnerships. In the cascade approach, these will emerge directly between governments and the private sector. In the portfolio approach, the risks will emerge on the balance sheets of the MDBs. The recent capital increase for IBRD and IFC will greatly assist in this matter.
Indeed, developing countries should not underestimate the risks associated with the cascade and portfolio approaches. Thus, the MDBs should actively assist developing countries with project management, including preparation, implementation, and supervision of projects. They should also provide assistance in public investment management and risk management, including guarantees and implications of public private partnerships for debt management. In addition, the MDBs need to take the lead in preparing the classes of assets that can be offered under the portfolio approach to the financial markets.
The MDBs must collectively own the 2030 Agenda to mobilize private finance for development, otherwise achieving the SDGs will not be possible. The partnership between the MDBs, governments, and the private sector holds great promise, and if the each of the stakeholders does their part, we move closer to reaching the ambitious SDGs.