Development Finance: More Bang for each ODA Buck

Published on : 19.04.23

By: Marcus Fedder, 

At FDL, our mission is to facilitate an inclusive and diverse conversation around development finance. To achieve this, we regularly invite external experts to contribute summaries of longer reports, blogs or original op-eds, sharing their unique insights and ideas with our audience.

The struggle to end poverty and fight climate change is leading to ever-growing demands for more development aid (ODA) in the form of capital replenishments of Multilateral Development Banks (MDBs) and other Development Finance Institutions (DFIs), especially towards funds dealing with development and climate issues.

The Summit for a New Global Financing Pact hosted by President Macron last June promised nothing less than a new era for development finance, one with a new financial system that will endeavor to make billions available in order to tackle the pressing climate challenges ahead.

Marcus Fedder

Marcus Fedder is Vice Chair of TCX and was formerly Treasurer of the EBRD, Vice Chair of TD Securities and a Director of IFFIm. He also worked for the World Bank in the 1990s.  He has acted as an advisor to IFAD in the past.

Skjermbilde-2023-06-28-kl.-13.36.28

Alas, as stated in this column by Jayati Ghosh and co-authors, it has failed to meet its lofty goals so far. Mobilizing private capital is difficult and ODA is limited.

Even wealthy countries like Germany are cutting back on their development budgets. Ultimately, there is a growing realization that the billions, if not trillions, needed may not be coming fast enough. The subsequent logical question that has to be asked is whether or not more can be done with existing money within existing institutions. Are DFIs all operating at maximum efficiency?

A review of the lending capacities of MDBs was launched under the Italian G20 Presidency, leading to the publication of the Report of the Independent Review of MDB’s Capital Adequacy Frameworks:  Boosting MDBs investing capacity  in July 2022. The report sets out a package of recommendations which, taken together, were intended to help MDBs pursue increased development investment and impact as well as sound financial management. A key takeaway of the report was that MDBs should take more risks, which, in other terms, means lending more.

Unsurprisingly, the response from finance professionals at the World Bank was not particularly enthusiastic, fearing that an expansion of lending without a fresh capital injection could lead to a loss of its AAA rating.

This sacrosanct rating status guarantees capital market borrowings at the finest terms and hence lending at the lowest sustainable rates. Prodded by its main shareholder, the United States, the World Bank proposed to implement part of the panel’s recommendations, under what it called its “Evolution Roadmap”, which would add $50 billion to its balance sheet by 2030.

christy-jacob-O2wROeJxZ6A-unsplash

However, many deemed this proposal too timid. For instance, the UK based ODI promptly followed up, focusing inter-alia on the capital adequacy framework, stating that “the slight reduction in the equity-to-loans ratio, the elimination of the statutory lending limits and progress on hybrid capital instruments – as proposed in the draft Roadmap – are all positive steps and will generate an estimated $50 billion in lending space over the next 10 years.

Nonetheless, World Bank management has resisted grappling with the more fundamental aspects of the CAF (capital adequacy framework) reform proposals, particularly whether the Bank (as well as rating agencies) are overestimating financial risks to the detriment of lending capacity.” Under the Indian G20 Presidency, another taskforce produced the report “Strengthening MDBs: the Triple Agenda”, further elaborating on proposals of how to make MDBs more efficient. Whilst the focus on optimizing MDB balance sheets is important, one has to realize that according to Moody’s, the World Bank as of FY2021 already had a leverage ratio of 4.75, down from 5.19 in FY2020 and that the average leverage ratio of AAA MDBs stood at 2.8.

Yes, these ratios can be tweaked, but, as importantly, we should broaden the scope of institutions considered to include all DFIs, including bilateral funds, many of which have a leverage ratio of 0. If they were to add a 2.8 or 4.75 leverage ratio to increase business volumes and thus outreach, a lot more money would be available. The G-20 reports focused on MDBs alone as their first step, but next natural reform should  address the inefficiencies of (a) funds that have been set up, inter alia to fight climate change and (b) those bilateral development finance institutions which operate in a sub-optimal way.

Let us look first at the latter:  The UK’s BII, the DFC of the USA, BIO of Belgium or IFU of Denmark and many other of the bilateral development finance institutions remain unleveraged and thus, from a balance sheet perspective, less efficient.

One frequent argument against leveraging is that it would prevent from taking risks on the asset side, for instance reducing the equity investments that those institutions can make. This is not the case: this is not a zero-sum game. EBRD, IFC and others do both. The unleveraged bilateral Development Finance Institutions only need to look at their neighbors to see how things can be done differently: the Dutch FMO (equity EUR 3.5bn, balance sheet EUR 10bn), the French AFD (equity EUR 8.8bn, balance sheet EUR 64bn) or the German KfW (equity EUR 37bn, balance sheet EUR 555bn) all efficiently leverage their equity via borrowings in the international capital market and thus achieve much higher business volumes – more bang for each equity buck.

Another inefficient use of capital can also be found in some multilateral funds:

The Green Climate Fund is an example of an institution that operates below its capacity. With USD 12.5 billion committed (and only USD 3.5 billion disbursed after 10 years of operations), it now needs to ask member countries for replenishments in order to continue and grow its operations. Rather than asking the Fund to optimize its balance sheet and follow the recommendations of the G-20 report, governments simply pour more money into the pot, which is clearly a sub-optimal use of scarce development resources.

yoel-winkler-zCAh6tOWFt8-unsplash

Another example is IFAD, the International Fund for Agricultural Development, which was set up to lend its equity in concessional loans to the poorest countries in order to support smallholder farmers.

Loans for less poor Upper Middle-Income countries are priced with reference to a floating interest rate (Euribor or SOFR), leading the fund to decide that such loans could be funded out of borrowings.  Consequently, IFAD set up the policies and infrastructure, enabling it to obtain two AA+ ratings so that it could start borrowing in the capital markets to leverage its equity. Now other lower income countries can also obtain such floating rate funding in addition to their allocated slice of concessional funding which comes from the fund’s equity. IFAD’s leverage ratio is still extremely low, but the institution is now set up to expand its lending and have a greater outreach and impact. As negotiations over IFAD’s replenishment are starting, now is the time to make use of this leverage.

That leaves the question about IDA, as the institution’s leverage is very low.

But IDA’s loans are to the greatest extent on concessional terms, which are not linked to market rates. Only an expansion of non-concessional lending could be funded by additional borrowings as IDA’s long term fixed funding rates (via swaps) are significantly higher than its concessional lending rates. Both IFAD and IDA show that there is a limit to leverage not only from a prudent financial management and ratings perspective but also from a lending perspective, as only those loans that are linked to market interest rates can realistically and without significant losses be funded by borrowings whereas no-interest or extremely-low interest concessional loans have to be funded by the institutions’ equity.

Nonetheless, all DFIs, be they MDBs, bilaterals or funds, should analyze and define their optimal leverage ratio based on their product blend and on prudent financial considerations. It is essential if they are looking to grow their lending businesses beyond current levels and increase their impact on pressing issues in the fields of economic development, poverty reduction and climate finance, where much more needs to be done and cannot be achieved under current conditions, with limited, unleveraged resources.