Four Challenges for Blended Finance and Development Finance Institutions

Overseas development assistance amounts to about $135 billion dollars annually, but the cost of paying for the Sustainable Development Goals will be in the trillions. As a result, blended finance is something of a buzz phrase these days. It refers to financing structures and solutions that mix private capital with public support to get investments — think access to reliable electricity, more and faster-growing SMEs, or better primary health care — off the ground. Australia and Canada are enthusiastic about building new Development Finance Institutions to help do this, and other countries are ramping up the scale of theirs (the UK government just gave the CDC group, its national development finance institution (DFI) a $1 billion capital increase).

I left a workshop on blended finance last week in Paris (organised by the World Economic Forum and the OECD) excited about the potential of these new structures and instruments to deliver social returns. But I was also struck by the challenges DFIs and their advocates must overcome in order to fully realize that potential. Here are four.

1. Risk transfer isn’t the same as risk mitigation

Let’s say that the International Finance Corporation (IFC) lends $25 million to a company building a hydroelectric dam in Vietnam (it might, as many DFIs do, sweeten the deal by agreeing to get repaid later than other lenders or offer a cheaper interest rate). This coverage has a potential cost. If the government reneges on an agreement to pay a certain price per kWh for the dam’s electricity, the project could default. The IFC moves that risk on to its own balance sheet by participating in the deal.

The argument cited in favour of this transfer is that the IFC provides a “political umbrella” or, more evocatively, a “protection racket.” Partners are more likely to play nicely, the reasoning goes, because the institution has access to the right corridors of power and, by being part of the World Bank Group, can threaten wider action than what’s written into contracts or debt covenants.

For example, another member of the World Bank Group, the Multilateral Investment Guarantee Agency, insures companies against risks like expropriation. It’s paid out on just six claims in its history — six — worth $16 million, compared to a gross exposure of $9.3 billion. Seeing this and thinking that one should get into political risk insurance is like seeing Muhammad Ali’s career win-loss record and thinking that pro boxing’s a pretty safe bet.

The problem is that any lowering of risk that comes from a DFI’s clout doesn’t generalise. Public investors might pick deals under the false impression they can mitigate risk, when really all they do is move it to their own balance sheets. When this works, it gives a leg up to investees based on opaque, backroom suasion; when it doesn’t, the deals go sour.

2. Don’t confuse addition for additionality

If that hypothetical $25 million loan from the IFC were supplemented by $75 million in debt and $50 million in equity from private sources, it could seem like IFC had “crowded in” $125 million in “additional” capital — a seemingly impressive 5:1 leverage ratio.

But that calculation implies that the investment wouldn’t have gone ahead if the DFI hadn’t been involved. We should be skeptical. Could this deal have happened without a DFI? Could it have gone ahead at a lower price than the DFI is paying for it, either implicitly through providing a political umbrella or explicitly through offering concessional terms?

Even though DFIs report additionality measures and leverage ratios, these are a kind of convenient fiction. They don’t account for what would have happened in the absence of the DFIs’ involvement; they measure addition, not additionality.  (There are ways to measure additionality, but this “counterfactual thinking” doesn’t seem to have been mainstreamed into evaluation or reporting tools as yet).

3. Measurement matters

Many development investors articulate the social outcomes they want firms to deliver. The CDC group’s 2012–2016 strategy, for example, calls for creating more jobs in its target markets.

The trouble arises when these actors measure the outcomes they’ve committed to.  There’s been an entire revolution in applied economics around impact evaluation, much of which has made its way into monitoring and evaluation best practice. But DFIs are still measuring quantities like net job creation using well-intentioned but flawed tools such as simple baseline-endline surveys, backing employment out of input-output tables, or other back-of-the-envelope approaches.

Some participants at the workshop pointed out that DFIs don’t have the budgets to pay for rigorous evaluation. That’s a real constraint. But just as we increasingly insist on reliable numbers in evaluating development work that’s publicly funded by grants, we must get in the habit of demanding the same from development that’s publicly financed by equity and debt — and be willing to pay for it.

4. Don’t forget about capture or distortion 

It’s natural that development finance practitioners focus on the risks on firms, like macroeconomic risk from volatile exchange rates or regulatory risk from unexpected new laws. But development finance also creates risks that fall on other stakeholders: the public sectors of the countries DFIs represent (and so their taxpayers), and the markets in which their investees work.

The risk of capture arises because DFIs are tempting targets for companies looking for government support. Adverse selection plays a role — the kinds of companies seeking support might not be the most dynamic or the most deserving. And this is exacerbated when it’s institutionalised, like when Germany’s DEG includes supporting the internationalisation of German firms as a strategic objective, or when the Overseas Private Investment Corporation (OPIC), an American DFI, limits its support to projects that are at least a fourth American-owned.

International development has endured a long, bruising fight over tied aid. It’s still ongoing in a few important sectors, like US food aid. We should work hard to avoid tied finance.

Just as capture is a risk that doesn’t fall on the firm but does fall on the public sector, distortion is a risk that falls on the market that firms operate in. Public support for firms can make markets worse off overall because it depends on a small group of experts allocating cheap capital and other help to hand-picked recipients. “Picking winners” can mean that we can end up subsidising inefficient incumbents that stifle competition and discourage more investment in their sectors — precisely the opposite of the long-run results we’re working for.

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Tackling these pitfalls early on will help our DFIs evolve into a vital part of our development toolkit for delivering better services, creating new jobs, and increasing productivity at the world’s economic periphery. Failure would be bad, not only because of the market distortions that would result, but also because it would leave taxpayers footing the bill for failure, making a potentially valuable poverty-fighting tool politically untenable.