Private sector finance for development - pitfalls and opportunities

Private finance contributes to development by financing new investments, enabling entrepreneurship and innovation, and creating jobs. It is driven by markets, profit, and risk. Most private finance in developing countries is via foreign direct investment (FDI). However, FDI may not be aligned with national economic development priorities. Hence, in this paper, the term “private finance for development” refers to privately-sourced finance that is used for publicly approved development projects. The largest component of private finance for development is net transfers of privately-sourced public sector or publicly-guaranteed debt. Net transfers show how privately sourced bonds and bank credit contribute to new investments. They comprise gross disbursements of loans less interest and principal repayments.

Some features stand out from the data on net transfers reported by the World Bank’s International Debt Statistics. First, private capital flows were relatively small in most regions for the period 1990-2000. Recently, they have increased, notably to sub-Saharan African countries. Second, private capital flows have been highly volatile in every region. Third, the most recent cycle, the post-COVID-19 period, produced large negative transfers for all regions. These had turned around by 2023, except in Africa and Latin America, suggesting that private financing may be experiencing an upswing. To feature more prominently in sustainable development, private finance must be enlarged and become more stable. This can happen only if the cost of capital comes down, and if risk and the perception thereof is lowered.

Limited information on developing countries. 

Private finance flows most easily where there is reliable and accessible information on risks and returns. The conventional view is that investments in emerging markets are high risk, yet asset managers do not have access to sufficiently disaggregated data to incorporate risk metrics into their asset allocation models. The credit risk information architecture in developing countries is very underdeveloped. 

This is starting to change. 

The Global Emerging Markets Risk (GEMs) database consortium has released new reports on the credit performance of lending to private and public entities in developing countries . It suggests that lending to private companies in emerging markets is equivalent to lending to non-investment grade firms in advanced economies – with annual default risk of 3.56% and loss-given-default of 27.8%. 

However, experience with lending to projects that are carried out by the public sector or that have a public guarantee has been far better. The annual default rate here has been 1.06%, and the loss-given-default rate, 5.1%. Yet, awareness of this data is poor. A survey conducted on behalf of the International Finance Corporation (IFC) showed that almost two-thirds of respondents were unaware of GEMs.2 Confidentiality concerns continue to limit the expansion and dissemination of such databases, which is regrettable considering their potential role in private finance for development. 

Regulatory constraints. 

Good credit information is institutionalized in financial regulations, specifically Basel III (for banks) and Solvency 2 (for insurance companies). Under Basel III, capital cover for each loan depends on the assessed risk. Without detailed credit registries – unavailable in many EMDEs – the risk weighting depends on generic values, which tend to be conservative. Basel III also incorporates the liquidity requirements of a Net Stable Funding Ratio, which encourages banks to use the cost of long-term liabilities as the basis for their long-term loans, raising the cost of lending. Long-term loans for infrastructure in developing countries have a trifecta of risks under Basel III that raise the cost of capital for such projects. 

Hence, since Basel III’s adoption, banks have cut back lending to these infrastructure projects. While this has happened everywhere, it has had a disproportionate impact in developing countries. In advanced economies, bond finance has substituted for bank loans – which has not been possible in most developing countries. Similarly, Solvency 2 makes long-term financing for development from insurers and reinsurers more expensive by highlighting political and regulatory uncertainty, construction risk, and low levels of liquidity. With both Basel III and Solvency 2, data-driven risk assessments by sector and location would permit investment allocations to be based on actual risks and returns, rather than on perceptions and anecdotes. 

The pipeline development quandary. 

An oft-cited bottleneck for private finance is the lack of “bankable” projects. Already in 2015, the Addis Ababa Action Agenda highlighted potential difficulties in implementing the Sustainable Development Goals: “insufficient investment is due, in part, to … an insufficient number of well-prepared investment projects.”Without bankable projects and structures for private capital to flow, no one will incur the up-front cost of developing these projects (estimated at 5%+ of project costs)

Efforts have been made to scale up project development. A Global Infrastructure Facility was created in 2014, with the support of the G20. In its first ten years of operation, it mobilized around $71 billion in private finance across 67 countries ($7 billion per year). Yet, 40-80 such facilities would be needed to reach the scale required. While there are benefits from global and regional project development facilities, a more efficient future path would be to locate these in developing countries. The World Bank reports that 13 developing countries now have government-sponsored and -funded project development facilities to attract private finance for infrastructure. However, they do not fully recover their costs and are thus constrained from scaling up. They also face specific challenges with small-scale projects and with cross-subsidizing project preparation where projects fail to advance to financial close. Work is needed to develop bankable projects. The IFC has had some success by reorienting 30% of its analytical support to upstream activities – work designed to advance projects to private investment within five years. Similar activities throughout the private finance ecosystem are needed. 

Absence of scalable risk mitigation instruments. 

Several project risks are outside the control of private investors – for example, political, regulatory, construction/land/permit-related and foreign exchange risks. Transferring these risks to insurers and guarantee agencies can be expensive and time-consuming. An alternative is to transfer risks to governments through blended finance. The historical experience with structuring blended finance deals has been summarized in Convergence’s State of Blended Finance 2024 report. It cites annual average investment totaling $15 billion over the last decade but recognizes difficulties with discerning time trends due to discrete changes in country situations.

Blended finance requires concessional resources. Deployment of these has varied. Convergence identifies four typical structures: provision of loans and equity; guarantees and insurance; grants for project preparation and design; and technical assistance grants for policy and regulatory reform and strengthening. Noted by Convergence is the limited expansion in official development assistance (ODA) for blending since 2018, with a dropoff of 45% due to reduced activities in Ukraine. Blended finance helps mobilize private and official finance. To date, $1 of concessional finance has mobilized $1.8 dollars of private finance and $2.3 of official non-concessional finance,10 which in blended finance transactions, mostly comes from multilateral lenders. Bilateral lenders increased their exposure to developing countries by just 3% during 2015-2023. During this period, it was reduced in upper-middle-income countries and increased in lower-middle-income countries. 

Underdeveloped domestic financial markets. 

Currency risk poses a particular challenge. Private financiers must address credit risk with revenue in local currency but with liabilities in foreign currency. This is minimized where projects can access domestic finance, which is becoming increasingly available from public development banks. About 530 of these now account for 10% of global investment. Under the umbrella of Finance in Common, these (many in the Global South) provide solutions and partnerships that reflect domestic conditions. Their support includes participation and leadership platforms, dialogue with government counterparts on policy and regulatory reform, and mobilization and prioritization of concessional aid to overcome investment bottlenecks. With local financiers as trusted partners, foreign private finance becomes easier to mobilize.

Notwithstanding the headwinds limiting private finance for development, there is considerable potential. New initiatives exemplify mobilizing private finance at the project level. These include entities like the Green Guarantee Company and the Investment Mobilization Collaboration Agreement. The need is to shift from individual transactions to partnerships on priority development programs. In partnerships, investors can scale their activities and reduce their risks so that finance flows in larger volumes, making it cheaper and less volatile.