Research Office
10 December 2018

Can Blended Finance and New Industrial Policies Help Achieve the SDGs?

The Graduate Institute’s Centre for Finance and Development, in collaboration with the Center for Global Development, Washington, USA, and the CDC Group – the UK’s development finance institution – jointly hosted the International Conference on Blended Development Finance and the New Industrial Policy on 8–9 November 2018. In order to achieve the Sustainable Development Goals (SDGs), the world needs to close the financing gap and channel resources more effectively towards development. This will require going “from billions” of official development assistance (ODA) “to trillions” in investment. This, in turn, will require the joint efforts of domestic governments, private investors and multilateral development banks (MDBs). Some of the participants share some of the broad ideas and their specific work discussed during the conference.

Question to Nancy Birdsall, President Emeritus and Senior Fellow, Center for Global Development:

How do you see the relevance of this conference regarding the advancement of the SDGs?

This conference is relevant right now for three reasons. First, the blended finance concept is really being worked over now, particularly at the big multilateral development banks. This is about the “billions to trillions” idea – how to go from billions of public money to leverage or mobilise trillions of private money. So, that is critical to meeting the SDGs. My take is that the prospects are pretty grim for low-income countries with weak government and high poverty levels. On the other hand, with the substitution of available capital, i.e. public capital, in middle-income countries, more capital is going to the poorest countries.

Second, the industrial policy side of the conference is also very pertinent because since the global financial crisis there has been renewed questioning of the conventional neoliberal Washington Consensus model. I would say there still remains much of the Washington Consensus – on macrofundamentals in particular. However, it is also obvious that many developing countries are looking around to see what kinds of alternative models might be the key to their development.

Finally, this conference is very much about sharing ideas, including between the blended finance group and the industrial policy group. There is certainly a link. For example, if a government – people often refer to Ethiopia or Rwanda – has the capacity and the interest to look for a new industrial model, then they are more likely to benefit from the leverage of public capital from the private sector. In a way, that is a vision for the future, and the conference explored how that could happen and why it should happen.

Question to Giulia Lotti, Economics Specialist, Office of Strategic Planning and Development Effectiveness, Inter-American Development Bank:

You discussed your co-authored paper on “Mobilization Effects of Multilateral Development Banks”. What are the mechanisms through which the entry of MDBs mobilises funds from other sources? Your work suggests there hasn’t been a crowding out effect.

One of the mechanisms could be signalling. When MDBs enter specific country sectors, it could signal the fact that there is some knowledge of things that are going well in that sector. It could also signal the intention of the country to adopt reforms and hence that its current institutions foster a good investment climate. Our paper doesn’t exploit the heterogeneity across sectors but focusses only on infrastructure, particularly to see if the effects hold. That is indeed the case.

Another mechanism that could explain the results is that there is lower risk in entering along with the MDBs because they have better knowledge of the project. What our paper shows are the indirect effects but we also find direct effects when partners enter together with the MDBs. So, the risk is lower when you have preferred creditor status because of the informational advantage. There are some countries where this effect isn’t as strong but this is based on historical data and as for the future, we haven’t explored it yet.

Question to Andrew Powell, Principal Advisor, Research Department (RES), Inter-American Development Bank:

You spoke about the huge gap in infrastructure financing. What is the role of different actors in providing financing for infrastructure projects and bearing the associated risk burdens?

There are many different types of risks in development projects, particularly infrastructure. The best way is to analyse those risks and devise a typology of risks. We have a particular typology in mind that includes endogenous versus exogenous risk and systemic versus idiosyncratic risk. Depending on what kind it is, the risk should be managed in different ways by the various actors. For example, investors can diversify away individual exogenous risk, so there is no point in a MDB coming in and providing guarantees. Individual idiosyncratic risk is a difficult one because it needs very close monitoring of the project by someone who has skin in the game and who is good at monitoring – typically, the operational company that is going to run the project or a commercial bank with skills in project finance. It is unlikely to be an outside investor such as an institutional investor.

There is also systemic exogenous risk such as currency risk, interest rate risk and oil prices. Markets should be able to create instruments to deal with them. However, if those markets don’t exist, then international financial institutions (IFIs) or MDBs have a role in creating them.

The most difficult risk is the systemic endogenous risk – that is perhaps where MDBs have a comparative advantage because we have relationships with the governments involved. In this regard, I am thinking for example of government counterparty risk. So MDBs can provide a guarantee and because of the closer relationship with the government, we have some advantage in providing that instrument.

Question to Ernest Liu, Postdoctoral Research Associate, Julis-Rabinowitz Center for Public Policy and Finance at the Woodrow Wilson School, and at the Simpson Center at the Economics Department, Princeton University:

Your paper shows how governments can use industrial policies to favour upstream sectors based on their size distortions. What is the upper bound of your policy recommendation? What does this say about the policies followed by planned economies prior to the 1990s?

My theory suggests that this is the sufficient statistic based on which sectors should be prioritised. To address your question, you need to know the proper counterfactual of how production technologies in the economy will change and how the structural linkages will change when an intervention actually affects the whole structure of the economy. My theory answers what the impact to the aggregate is if the government spends 1 dollar, that is, starting from an economy with no intervention at all. The math captures the effect of this dollar in spending, so we can use that to compute the first-order approximation of the gains, but we cannot compute large-scale effects. To address that, it is not an issue of the boundary of the theory but an issue of the boundary of what is knowable. One would need to know what the effect on the economy would have been if you targeted a sector by x % – empirically, this is not something that can be estimated.

Question to Alan Rousso, Managing Director, External Relations and Partnership, EBRD:

One of the conference sessions was called “Development Finance Institutions at the Crossroads”. Why now, and how is the momentum running up to the SDGs different from the context prior to the Millennium Development Goals (MDGs)?

In some respects, the MDBs are at a crossroads. This is partly because of the current discussion on how one builds the architecture of international financial institutions and strengthens it to have a greater contribution to development goals – particularly to the SDGs. The question remains whether this should be an architecture similar to the one we already have – of different regional development banks working within their own regions – or an architecture where we deploy the skills and the capital strength available to MDBs in a more efficient and collaborative way to mobilise more private sector finance to close the SDG funding gap. Many discussions were concerned with that issue: Are MDBs sufficiently equipped to be able to leverage their balance sheets? Are they focused enough on the SDGs to mobilise private sector funding? Do they have the right approach to delivering impact that relates to the SDG targets?

Not all the MDBs were as focused on the MDGs – one issue was that the MDGs had a more social focus. We are running into issues of capital constraints today at MDBs, so we need to think about leveraging balance sheets better than what might have been the case before. We have discussed, during the conference, synthetic securitisations in order to free up headroom to be able to lend more, as the African Development Bank has just done, and also different types of securitisations in order to bring in more private sector capital, such as the Managed Co-Lending Portfolio Program of the International Finance Corporation. We do need to devise different types of instruments if we want to get closer to the very ambitious goals set in Addis Ababa on going from billions to trillions. They may turn out to be unachievable but we need to keep trying. I think the MDBs – because of their mandates and their business models of having people on the ground and knowing the clients, countries and what investors require to invest – are very well positioned to be conduits for finance in the less developed markets.

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Papers cited:

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Interview by Nayantara Sarma, PhD candidate in International Economics.