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GG2022 – Beyond Business as Usual: Turning Challenges into Opportunities in Post-2015 Development Financing Strategies

Jiajun XU - 25th September 2013

Jiajun XU examines possible directions for development financing after 2015.

As the target date for the Millennium Development Goals (MDGs) approaches, it is high time to start re-thinking development financing after 2015. An important challenge is how to ensure that future graduates from low-income countries (LICs) to middle-income countries (MICs) can gain reliable access to effective and sufficient credit.

The challenge is not entirely clear-cut. Despite their huge demand for scaling-up investments to finance their accelerated industrialization and urbanization, these would-be MICs often fall between two stools – market-rate financing (including equities, bonds, commercial loans, etc.) and official development finance (credits below market rate or grants provided by official agencies for economic development and welfare of developing countries).

This is the result of a broader trend in development finance. On the demand side, the new geography of global poverty holds that a majority of poor people will live in MICs as a result LICs being lifted out of the low-income status and a deepening exacerbation of inequality within MICs. On the supply side, the weight of developing countries in the distribution of both global savings and investments will increase from 1/5 in 2000 to 2/3 in 2030; thus, South-South flows will mushroom. These transformative changes demand creative policy approaches.

The first question is how to engage with emerging markets and rising capital exporters to innovate financial institutions connecting surplus and deficit agents and channel capital to productive uses in future LIC-graduates. Rising capital exporters, like China, are facing a binding constraint – their underdeveloped financial systems lag behind their rising economic weight.

A practical solution would see Multilateral Development Banks (MDBs) engaging with capital exporters to experiment with new forms of financial institutions to address this binding constraint. The World Bank is ideally positioned to build on the China-World Bank partnership for innovation. China is seeking creative solutions to diversify its investment destinations of capital and to invest the funds into productive investments abroad. This issue has gained strategic importance in China since the country has become the world’s principal capital exporter and is likely to remain so in the decades to come. The World Bank can play a leveraging role through its unique position in catalyzing frontier reforms in public investment systems, financial sectors, and poverty reduction. These innovative approaches allow countries to take pragmatic and gradual steps to avoid the pitfalls of externally-imposed institutional developments while encouraging home-grown institutional innovations. This approach has great potential to enable China to utilize new tools of technology to leap-frog in the development of its financial markets (e.g., the Taobao e-commerce and payments platform in China allows consumers to be sellers, buyers and investors at the same time). This opens a new opportunity for latecomers like China to deepen their financial markets in an unconventional manner while mitigating risks of unregulated informal markets undermining financial stability and client interests.

The second question is how to respond to the changing needs of LIC-graduates by channeling market financing towards green and inclusive investments. For instance, the World Bank’s soft-loan window – International Development Association (IDA) – will face a wave of graduation of its recipient countries. More than half of its current 67 recipient countries will graduate from LICs. Unlike its parent institution, the World Bank Group’s International Bank for Reconstruction and Development (IBRD), IDA is financially reliant on donor countries. The emergence of LICs from their low-income status can lead to severe cuts in traditional donors’ contributions. While these graduates remain eligible for soft-loans and grants from IDA, they have no reliable access to global capital markets.

Even if they have access to financial markets, market failure often results in short-term profit-seeking rather than long-term investment financing. Public entrepreneurship, which uses innovation to harness public and private resources in pursuit of social objectives, is crucial to solving the problem of market failures by overcoming first mover problems and generating long-term investment. Public entrepreneurs can identify potential value-creation opportunities that are often suppressed by status-quo inertia, marshalling public resources in concert with private resources in order to fulfill the “imagined” vision. They are also well positioned to foster mutually beneficial interactions between public and private actors. For instance, MDBs can move from a lending culture to an enabling culture. In that capacity, they can create financing modalities to mobilize innovative sources of finance to act as “a bridging fund” helping future LIC-graduates to create markets for low-carbon infrastructure and renewable energy investments. Through micro-lending and micro-finance, these markets can be accessible to the poor. Public finance is crucial for orienting investments towards a green and inclusive trajectory as it can play a proactive role in building a track record of success and gain investor confidence in untested frontier markets.

Affordable public financing can easily result in crass competition among national finance providers (such as export credit agencies and national development banks) by competing on cheap terms of credits, which fuel international conflict, breed corruption in creditor countries, perpetuate financial dependence, and undermine debt sustainability in debtor countries. In fact, many existing rules on development finance, such as export credits, have prohibited intermediate interest schemes that LIC-graduates would need. Multilateral development institutions, such as the World Bank, have a comparative advantage to use public finance to incubate market development while mitigating risks of destructive bilateral competition.

A business-as-usual scenario foresees international aid organizations disengaging themselves from the bulk of the world’s poor with a sharp decline in the supply of its concessional financing. Looking forward, it is important to go beyond the aid-giving mindset. A way forward is to innovate financial intermediations in capital exporters and to spur public entrepreneurship for long-term green and inclusive investments.

 

Jiajun Xu is a GG2022 fellow, former junior research specialist at the High-Level Panel Secretariat of Eminent Persons on the Post-2015 Development Agenda and a PhD (DPhil) candidate at Oxford University. The views expressed in this column are those of the author and do not reflect those of her affiliations. This column is part of a series from the GG2022 fellows.