Development finance trends to watch in 2021

Shifting financial markets, evolving public policy priorities, and the pandemic are all impacting the mix of products and strategies garnering more attention in development finance this year.

Some areas seem to be slow-moving trends, including blended finance. But others, such as social bonds, seem to be experiencing a rapid acceleration. As private finance and capital markets exert their influence on development finance, there continues to be a push for better standardization and harmonization of metrics, in large part to avoid dilution of impact.

As some of these instruments gain popularity, they’re raising questions about whether they will direct private capital to countries and issues that need it most, and importantly, what they may divert increasingly limited official development funds from.

Here are some trends to watch:

Bonds on the rise

Interest in Sustainable Development Goal-related bonds is on the rise, presenting an opportunity for greater growth and the potential to leverage the products for more financing — even if questions remain on how to define them.

“We need, effectively, green bonds to turn into a bit of a rainbow,” said Daniel Hanna, global head of sustainable finance at ‎Standard Chartered Bank, at an Organisation for Economic Cooperation and Development event last week. “We need to be creating these products that link to the various different SDGs that really drive capital to where it matters the most.”

While green bond issuance and popularity have been on the rise for more than a decade, social bonds and sustainability bonds are newer instruments and made substantial gains last year.

In 2020 there were about $142 billion in global social bond issuances, up from $17.4 billion in 2019, according to the International Finance Corporation. While that is evidence of rapid growth, it is a small part of the total global bond market.

“Social bonds have gained traction as a means of channeling funds toward SDG-related sectors and objectives … and we continue to see a notable rise in social bond issuance in response to the pandemic,” Tom Ceusters, director of treasury market operations at IFC, wrote in the report.

But barriers to scaling bonds persist, with the chief concern being clarity and transparency around what counts as a green, social, or sustainability bond, experts said at the OECD event. With green bonds, the EU has created a standard to help define the instrument. But the same guidance doesn’t yet exist for social bonds, and there is a risk of having different standards in different geographies, the experts said.

For bond markets to grow, there also needs to be a greater supply of projects to invest in and more private sector collaboration, they added.

And governments need to do a better job of taking ownership over where they want to direct capital and explaining how their investment budgets are linked to the SDGs, Hanna said.

Growing interest in guarantees

There is growing interest — and debate — around the use of guarantees to finance development. It’s driven in part by the European Commission’s push to use budget guarantees to support high-risk investments in lower-income countries, and also by the private sector, which likes the instrument.

With official development assistance dropping and development finance institution balance sheets squeezed as they contend with the economic consequences of COVID-19, guarantees are becoming a more interesting tool, said Paul Horrocks, head of the private finance for sustainable development unit at the OECD Development Co-operation Directorate. Civil society organizations, however, are not convinced, and are concerned that guarantees would take away limited ODA from other areas.

DFIs, particularly in Europe, are looking to the commission to drive the way they operate, and guarantees can “look like an attractive option in the COVID era,” Horrocks said, adding that they are more cost-efficient than debt or equity and can help de-risk projects.

Some DFIs already provide guarantees, including the U.S. International Development Finance Corporation and Sida, the Swedish development agency, which will likely serve as models to others.

Europeans aren’t the only ones considering guarantees: in the past 18 months, Canada was given the authority to do guarantees and is determining how to do so effectively, said Elissa Golberg, ‎assistant deputy minister of strategic policy at ‎Global Affairs Canada. She added that seeing more case studies from those at the forefront, such as the Swedish, would be helpful.

A key concern and point of confusion is that guarantees do not currently meet the OECD definition of ODA. The OECD Development Assistance Committee continues to work with members to come to an agreement about how to count private sector instruments, including guarantees, as ODA and how they might be scored.

Reaching for scale and standards in blended finance

This is not the first year where blended finance has been a key trend to watch in the development finance space, and it likely won’t be the last. While it hasn’t taken off as quickly as some might have hoped, efforts to standardize the tool and get more deals done continue.

“The COVID crisis has just amplified this gap of funding to the frontier markets ... we're not driving capital deep enough to where it needs to go to fulfill the SDGs,” said Jay Collins, the vice chairman of banking, capital markets, and advisory at Citigroup. “There are a number of reasons why blended finance is a critical tool in the toolkit to get there. But we're falling short.”

The reasons why? Failure to do blended finance at scale and with speed, a need to bring in the ODA community to provide a layer of grant capital to catalyze the deals and change the risk profile, and building competency and trust among the major players involved, he said.

One tool that could help is the creation of a blended finance fund, which would start with the intention of scale and use similar structures to those that might be used on a smaller project, Collins said. That fund is a key recommendation in the report released by the Global Investors for Sustainable Development Alliance.

Whether it’s the blended finance fund or another mechanism, broader programs that aggregate multiple projects under a single framework can help get to scale, particularly in small markets, said Andre Wepener, the head of power and infrastructure finance at Investec Bank.

Several experts have pointed to IFC’s Scaling Solar program as a good example of how to create a framework across geographies that includes some capacity-building support and makes it easier for the private sector to get engaged.

As these mechanisms are structured, it's important to determine how to build local capacity to structure bankable deals and build an understanding of additionality and sustainability on banking teams “and mesh that with the financial capacity of the grant community such that we could use their risk layer in an appropriate way,” Hanna said.

Sharing information in a “digestible format” is also critical to more effectively doing blended finance deals, Hanna said. Such information can help eliminate the gap between real and perceived risk, serving as a shorthand in much the same way that credit ratings do, he said.

As part of an effort to help blended finance actors make informed decisions, last week OECD released a new blended finance framework, a guide for implementing its blended finance principles. It is aimed at helping policymakers and investors evaluate what makes a good blended finance deal.

Despite the interest, there are still concerns about the small amount of blended finance going to least-developed countries and concerns that de-risking the deals isn’t the right use of limited ODA dollars.

While blended finance can and should be an effective tool, “there are certain pitfalls” that donors should look to avoid, including ensuring that any concessional funds aren’t distorting markets, said Tellef Thorleifsson, CEO of Norfund, the Norwegian Investment Fund for low- and middle-income countries.

It is particularly useful in project development, where projects may not have otherwise gotten off the ground and commercial funding is hard to obtain, and in fragile states and least-developed countries as well, he said. The negative effects are largely in middle-income countries, and often in certain industries, particularly the energy sector.

“It needs to be catalytic in addition to concessional,” Thorleifsson said, adding that monitoring and transparency are important.