The development finance issues to watch, and reforming the World Bank

This year is big for development finance. It’s not just about continued World Bank reform and broader efforts to overhaul a dated international financial system, but it’s a year when a key new climate finance framework must be agreed upon and where economic headwinds and geopolitical tension will pile more pressure on indebted countries and make it harder to attract investment in lower-income countries. “This is truly a historic year,” Kevin Gallagher, director of the Global Development Policy Center at Boston University, said at a recent Devex event. It is the 80th anniversary of the Bretton Woods Conference that created the World Bank Group, and it's 50 years since the adoption of the United Nations Declaration on the Establishment of a New International Economic Order, where developing countries called for a more equitable, interdependent system. “We need a major transformation of the development finance institutions to make them bigger, to make the policies better, and to make them more equal so that there’s more voice and representation for developing countries,” Gallagher said. “The key metric for me is can we bend down the cost of capital.” Some questions to be tackled this year seem almost perennial — how to reduce heavy debt burdens, how to attract private capital into risky markets, and how to get the system of development finance institutions to work more efficiently and collaboratively. But there are also developments to watch as World Bank reforms seek to modernize the institution, boost its lending, and adjust its focus, fresh climate finance targets are hammered out, and new instruments like debt-for-nature swaps and guarantees are on the rise. Here’s what you need to know: Global geopolitical and economic uncertainty Interest rates are still high in much of the world, making borrowing expensive. Geopolitical conflicts are straining supply chains. Food insecurity is also on the rise, and more than 50 countries, home to more than half of the global population, head to the polls this year. It is not exactly an uncomplicated or easy environment to raise funds for development, despite mounting needs. “There’s no shortage of big external kinds of exogenous factors that may be influencing investor behavior,” Amit Bouri, CEO of the Global Impact Investing Network, told Devex. But despite the macroeconomic trends and geopolitical uncertainty, investors surveyed by GIIN last year still said they planned to increase investments in sub-Saharan Africa and Latin America, he said. But when there is unease, investors turn to places and products they are comfortable with. That means foreign investments in low-income countries are unlikely to meet demands. The math isn’t in their favor when investors can park assets in safe U.S. Treasury bonds and earn nearly as much as they might from a riskier investment in a low- or middle-income country. Already, debt distress has left some 60 countries without access to capital markets to borrow money. Even among those that do, many lower-income countries can only borrow at rates that exceed their growth rate, which could result in more debt distress down the road, Gallagher said. “We need a major transformation of the development finance institutions … so that there’s more voice and representation for developing countries.” --— Kevin Gallagher, director of the Global Development Policy Center, Boston University “We have a tension that’s even more pronounced in this moment because of what’s happening geopolitically,” Bouri said. So investors in emerging markets and developing economies, whether it be development finance institutions or others, must partner more effectively and play a lead role in attracting private capital. Debt Debt distress will continue to be a massive factor in the development finance landscape this year, and experts tell Devex it doesn’t appear much progress will be made to address the challenge. While the Group of 20 major economies put in place the common framework for debt treatment to ensure swift and smooth debt workouts for low-income countries, fewer than a handful of countries have used it. It has proven to be slow and ineffective, experts said. While it “was aspirationally potentially the right direction, it has pretty much failed,” said Stephanie von Friedeburg, managing director of banking and capital markets advisory at Citi. Zambia defaulted on its debt in 2020, and while it struck a preliminary agreement through the common framework process, that seems to be falling apart over an argument that creditors are not all held to the same terms. That deal, which had been held up as an example of how it could work, continues to languish, and might not even be replicable. The common framework “is in gridlock on a number of levels,” said Gallagher. Not all creditors participate on the same terms, the private sector has not sufficiently engaged, and the system is not doing enough to reduce the debt so countries can finance their climate and development priorities, Gallagher said. “I don’t see huge movement on that,” he said about improving or replacing the common framework. “The good news there is that there’s a global consensus that it doesn’t work.” Tensions between the United States and China, and upcoming elections in the U.S. make it unlikely that the bold leadership from those nations and other G20 members needed to actually address the issue will emerge, he added. Several development finance experts said they are bullish on the growth of the debt swap — be it a debt for nature or debt for development deal. While not a solution to the broader debt crisis, they could help reduce debt in a limited way in some situations and direct more capital to address critical issues. Multilateral development bank reform World Bank chief Ajay Banga, who took the post in May, is working to leverage existing capital and better attract private capital. While progress was made last year on reform, experts said more is needed, and the changes need to go beyond just the World Bank Group to other multilateral development banks and development finance institutions. The World Bank often sets an example for other MDBs, so how reforms there unfold should influence other institutions. Banga convened the so-called private sector lab last year to garner investor perspectives on how to improve the World Bank and better draw in private capital. The lab’s recommendations are much anticipated and some could come by the Spring Meetings in April. Banga is also pushing for the World Bank’s Multilateral Investment Guarantee Agency, which provides guarantees to protect investments from non-financial risks, to triple in size. Guarantees will be critical to de-risking investments and attracting more private capital and are one focus of the private sector lab, development experts told Devex. One big question is whether shareholders will give the World Bank a capital increase this year to meet the growing demands for development finance and reform objectives. The consensus among experts is that all the capital adequacy reforms the World Bank is rolling out to stretch its funds are insufficient to meet the needs. Several other international financial institutions, including the Inter-American Development Bank’s private sector arm IDB Invest, are expected to receive new funds from their donor governments. But capital increases are not enough to meet the ballooning global needs, von Friedeburg said. “Getting more money into those institutions and deploying it in the same old way is not going to give us the multiplier that we need to make a difference,” she said. In addition to the capital adequacy reforms, the World Bank also needs to explore other changes to more efficiently and effectively spend its money, development experts said. The World Bank and other MDBs focus too much on project finance and should form a more coordinated policy based on country needs, Gallagher said. They need to change the way they do business and the goals and incentives they are governed by, others said. The World Bank should develop products and use its balance sheets differently, including helping put together investments and then selling them, rather than always holding on to them, some development experts said. Today, the World Bank and many DFIs hold the vast majority of investments they make on their balance sheets. If they offload some of those to the private sector, it would free up space to make more investments. Another area that should be considered this year as part of ongoing reform efforts is changing key performance indicators and staff incentives so that they align with new objectives. The World Bank’s current target that sets 45% of all financing going to climate projects by 2025 could drive employees and the bank itself to do as many big climate projects as possible on its own balance sheets, even if there is an opportunity to bring in an investor on a commercial basis. Creating more specific goals and incentivizing staff for projects in low-income countries, including smaller projects, could have stronger development impacts and increase cooperation with the private sector. “We need to rethink what the shareholders are asking the staff and the management to deliver because that will be a big driver of some of the changes that can take place,” von Friedeburg said. Getting there requires a more frank discussion about how each MDB and commercial investors can take risks and improve how they work together rather than competing, she said. While the focus was squarely on the World Bank last year, expect an emphasis on the broader international financial architecture in 2024. That means looking at other MDBs, regional banks, and other aspects of the financial system. There are hundreds of national and regional development banks that collectively manage trillions of dollars and many are mission-oriented institutions that focus on issues ranging from local entrepreneurship and financial inclusion to infrastructure and trade. Working with that system to improve and align key metrics and objectives can help build local markets, address currency fluctuation risks, and help develop investment pipelines, development finance experts told Devex. These reform efforts should also apply to DFIs, said Haje Schutte, deputy director of the Organization for Economic Cooperation and Development’s Development Co-operation Directorate. “They are already on an impressive growth path,” but they need to evolve and work together in a more coordinated manner, he said. DFIs need to think about their distinctive contribution as publicly-backed institutions and how they can “extend the reach of capital markets towards businesses in countries that don’t typically get financed,” the GIIN’s Bouri said. “I think there should always be a question of how do you push further in terms of their operational mandate.” Mobilization The one universal theme of the year is mobilization, which, in less jargony terms, means attracting private capital to tackle development and climate challenges. It’s a priority for the World Bank and it’s top of mind for private and public sector leaders, who want to tap commercial or institutional capital to address development and climate needs. But it won’t be easy. With interest rates remaining high and new regulations related to climate and sustainable investments coming online, it could be particularly challenging. Many of the policies — including European Union rules requiring companies to disclose their climate impacts and new sustainable finance and climate standards — have been designed with the needs of high-income countries and large, well-resourced companies in mind. The worry is that companies in low-income countries can’t meet the reporting requirements and will be penalized. “We need to be careful because the regulatory squeeze could impact flows to emerging markets and developing countries,” said Samantha Attridge, a senior research fellow at ODI. As companies are required to report on emissions, including through their supply chains, they may be discouraged from working in countries without robust data systems that allow them to fully assess their carbon footprint. It could also create a “paradoxical situation” where MDBs and DFIs try to incentivize and structure deals to mobilize private capital, but the regulatory environment pulls them in another direction, she said. Another challenge is foreign exchange risk — or the chance that a transaction will lose money due to changes in the value of currencies, often the difference between a local currency and the dollar. The dollar is currently strong, political uncertainty is up, and that heightens these risks, making it more difficult and more expensive to borrow for low-income countries and the companies that operate in them. Last year the value of the Ghanaian cedi dropped significantly against the dollar — which means a business borrowing in dollars and making money in cedis will have to pay more back than they borrowed. There are proposals on the table for how MDBs might address the issue, but the system needs to figure out if the borrower or the institution takes the risk. The long-term solution is developing local markets but Attridge said that in the short and medium terms, MDBs and donors have to think about what role they can play in tackling the challenge. While exchange rate swings can make projects unviable, bad domestic policy creates many of the fluctuations, von Friedeburg said, raising concerns that donors may inadvertently distort markets as they try to address the issue. They should instead use existing mechanisms and build them up rather than create something highly subsidized, she said, adding that commercial banks and development institutions could work better together. In this environment, blended finance, where donor or philanthropic capital is used to attract private money into a transaction, will be critically important to attract more commercial investors. That might come in the form of sovereign bonds with a blended finance component to help offset risk. To date, bonds are a small, but growing, proportion of blended finance transactions, according to Joan Larrea, the CEO of Convergence. Climate finance Building off last year’s momentum, climate finance will likely continue as a key focus this year, not least because at the 29th U.N. Climate Change Conference in Azerbaijan, a major obligation is delivering a system that replaces the $100 billion a year climate finance commitment from wealthy nations to low-income countries with a funding new goal. The G20, led by Brazil, is also setting up a climate-finance working group to review the Global Environment Facility, the Green Climate Fund, the Adaptation Fund, and the Climate Investment Funds — which provide climate funding to lower-income nations — to look at how the major funds can better work together, create common rules and regulations, and make it easier for countries to directly access the money, Marcos Neto, assistant administrator at the United Nations Development Programme, told Devex. Too often the different buckets of climate finance are viewed in isolation, and there is increased tension between adaptation, mitigation, and loss and damage as various demands compete for funding is likely, he said. Adaptation finance continues to lag, but donors, MDBs, and DFIs need to invest differently to ramp up these transactions and boost blended finance in this area, Attridge said. “There is a mitigation gold rush” with MDBs and DFIs going to highly carbon-intensive emerging markets and competing with one another over a limited number of projects, she said. Instead, they need to be more strategic, change their risk profile, and support different business models, she added. Update, Feb. 8, 2024: This article has been updated to clarify that Zambia defaulted on its debt in 2020.