Bridging the great finance divide between developed and developing countries

The economic fallout from the COVID-19 pandemic in developing countries will not be transitory. While global economic output has returned to and surpassed pre-pandemic levels, in nearly one fifth of developing countries GDP per capita by the end of 2023 will still be below 2019 levels.[1] Poorest countries and countries with the least fiscal capacity have been the worst affected. While emerging markets in Asia have strongly rebounded thanks to accommodative policies in many economies,[2] growth in Sub-Saharan Africa and Latin America has remained flat since 2019. The least developed countries have seen increased poverty and inequality. Compared to 2019, an estimated 77 million more people were living in extreme poverty in 2021, setting back the fight against poverty by nearly a decade. Human capital losses are expected to be equally high. This is before considering the effects of the war in Ukraine and rising food prices.

 

The “great finance divide” has been the key driver of divergence between developed and developing economies. Developed countries borrowed record sums at historically low interest rates to support their economies through the pandemic and to invest in recovery. Most developing countries have had no such option.[3] In the coming months, increasing interest rates and the strengthening of the US dollar will likely prompt more austerity measures in developing countries.

Private capital flows to middle-income and upper middle-income countries are returning to pre-pandemic levels but lower middle-income countries are not catching up. Net capital flows to low-income countries fell sharply by 85%, from their pre-pandemic peak of $8.3 billion to $1.2 billion in the second quarter of 2021.[4] This exacerbates the structural lack of access to capital in developing countries. In these countries, banks already provide less credit to the private sector from the deposits they collect compared to banks in developed economies. Official development assistance from developed to developing countries has remained steady notwithstanding the pandemic: development expenditure cuts in some countries (e.g., UK, France) have been compensated by other countries ramping their commitments in 2021 (e.g., United States, Japan, Italy).

“Mobilizing resources towards the sustainable development goals” (SDGs) is the catchphrase of today’s development debate. The definition of the 17 UN Sustainable Development Goals in 2015 focused political attention and resources towards development. Whereas the previous Millennium Development Goals were focused on increasing donor assistance to developing countries, the private sector features prominently in the SDG discourse. Development finance institutions are increasingly investing in the private sector and are seeking ever new tools to bring private capital to developing countries.

Two years into the pandemic, it is time to take stock of SDG financing.

First, developing countries’ external debt is likely to be unsustainable and financial tools to enhance these countries’ fiscal capacity are insufficient. Under the auspices of the Italian G20, multilateral development banks are considering changes to capital requirements that would help in ramping up concessional sovereign lending.[5] Some sovereign debt relief has been provided for developing countries through the Group of 20 Debt Service Suspension Initiative, but payment suspensions are temporary. The new allocation of the International Monetary Fund’s Special Drawing Rights to the equivalent of $650 billion in 2021 is a step in the right direction to redress the imbalance of global financial institutions in favor of developed economies. Finally, the UN Development Program has repeatedly asked, with little success, for changes in the methodology that rating agencies use with developing countries to make them longer-term oriented.

Second, we need to get better at mobilizing private capital towards sustainable investing. The G20 and G7 put private finance mobilization at the top of agenda.[6] The main tool for mobilizing private capital is blending public with private resources to make it commercially attractive for private investors to participate in high impact projects. Results have been mixed so far and are difficult to assess due to a lack of comparable data.[7]

Blended finance use public (or donor’s) resources to subsidize private investors allowing them to reduce risks or increase returns. Determining what is the minimum return that makes a project feasible is not a science, but it is typically done by setting a level slightly below what investors obtain in developed economies. While this may be a necessary and powerful tool to bring large institutional capital (e.g., insurances, asset managers) to developing countries, it requires a nuanced understanding of the necessary conditions under which such subsidy should be provided. For example, private investors typically find it difficult to take infrastructure project development risks because it is difficult to predict whether the projects will see the light of day and thus some level of subsidization may be necessary. On the opposite side of the spectrum, for example, development finance is not the best tool to provide permanent tariff subsidies for energy or utility prices.

Achieving the SDGs will require moving “from billions to trillions” in resource flows. However, to mobilize private capital development, finance institutions need to have a real discussion on when a public subsidy to private investors or private companies is warranted. International organizations are consensual in nature and present the SDGs as universal objectives that need a technical solution. The reality of development finance portrays a more nuanced picture. Development finance uses public resources, and it is therefore political. It requires striking the right balance between public and private sector support, using multilateral or bilateral institutions, balancing longer-term environmental priorities and shorter-term growth demands. To bridge the financing gap and achieve the SDGs, development finance institutions need to focus more on what interventions can change the behavior of private investors and thus transform markets, and on the rationales for subsidizing private investors.

 

 


All opinions are expressed on a personal basis.

 

 


Footnotes:

[1] UN, Financing for Sustainable Development Report 2022.

[2] IMF, 2022 Financial Outlook.  Asia developing countries real GDP per capital increased by 15% from 2019 to 2021.

[3] UN, Financing for Sustainable Development Report 2022. The average fiscal response to Covid-19 in developed economies was 12% of GDP, compared to 5.7% in developing countries and 3.2% in low-income countries.

[4] UNCTAD, Financing for development: Mobilizing sustainable development finance beyond COVID-19, March 2022.

[5] Independent Review of Multilateral Development Banks’ Capital Adequacy Frameworks, 2022.

[6] Group of 20 Eminent Persons Group on Global Financial Governance, Making the global financial system work for all, 2018,

[7] ODI, Blended finance in the poorest countries. The Need for a better approach, 2019.

 

 

financeworldinequalitydevelopmentsocial issueseconomy
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