Development finance trends to watch in 2023

Development finance will come under pressure this year as growing demands and economic volatility lead to questions and calls for reform in the industry, experts say. Rising interest rates, a growing debt crisis, and high commodity prices will make it more difficult to address critical global development challenges this year, even as mounting crises create greater urgency for investment. These challenges will drive trends in development finance this year, including a greater focus on mobilization, MDB reform, debt, and blended finance. Development finance institutions are being called on to do more and there will be an “important political debate about the architecture for development finance” this year, said Haje Schütte, the head of the Financing for Sustainable Development Division and deputy director of development at the Organisation for Economic Cooperation and Development. At the center of that will be the World Bank reform efforts, spurred by its shareholders, who want to see the institution address mounting development and climate challenges more effectively. “I believe the question will be how does the system get fit for purpose to mobilize capital in support of global public goods,” Schütte said. Climate finance is a key cross-cutting theme that is driving much of the change in development funding and institutions. Organizations are asking how to fund programs and projects that address climate disasters, improve resilience to shocks caused by global warming and support a transition to renewable energy sources. Here is what you should keep an eye on in 2023: Mobilization Mobilization, or how aid dollars can be used to attract private funding to address global challenges, is the top trend of the year, according to several development finance experts. It is central to the reform conversations playing out at the World Bank and other multilateral development banks. Those institutions are increasingly under pressure from shareholders, the Group of 20 leading economies, private investors, and development advocates. They are being asked to better leverage their funds and do more with their existing resources to address various global crises, including climate-related disasters and adaptation efforts. In 2022 official development assistance was $185.9 billion — a slight increase, but nowhere near enough to meet development challenges. “We obviously know this is a scarce good,” Schütte said. “It will not grow sufficiently so that means that the mobilization of private finance will be politically even higher on the agenda than it has been previously.” Expectations around how multilateral development banks and DFIs can mobilize additional capital have not been met in the past, Schütte said. He warned that these institutions may need to make “quite fundamental changes” to become more effective. There is a vast gap between the private finance needed and the amount available. Official development assistance mobilized about $51 billion in private finance in 2020, according to an OECD report published earlier this month. The same report pegs the gap to finance the Sustainable Development goals at $3.9 trillion in 2021. And macroeconomic trends — from monetary tightening to rising interest rates — will make things even harder. “The job of mobilizing has just gotten incredibly more challenging and difficult,” said Samantha Attridge, a senior research fellow at Overseas Development Institute, a think tank. Her view is that with the global economy as it is, capital is likely to move away from lower-income countries or sit on the sidelines. Blended finance This isn’t a new trend, but in response to more difficult market conditions, it is likely there will be more emphasis on blended finance — or the use of concessional capital, such as grants, to help de-risk investments so other investors will participate. “The cost of doing business has increased and there will be a need for risk mitigation and subsidization,” Attridge said. But don’t expect a massive ramp-up of blended finance this year, said Joan Larrea, the CEO of Convergence, a global network focused on blended finance. While Convergence is pushing governments, donor agencies, and development banks to “retool” and do more blended finance deals, “none of these agencies turn on a dime,” she told Devex. One challenge is that blended finance is a “very small part” of MDB and DFI operations, and there is limited data about how these institutions use catalytic capital and what type of investments it mobilizes, Attridge said. DFIs often take senior debt positions in funds and depending on how they are structured may not have any concessional capital of their own. The key will be how to find the necessary grant or philanthropic capital in an increasingly financially constrained environment, Attridge said. Bilateral DFIs should consider issuing debt on capital markets as a way to mobilize more capital, and for those that are funded by governments it could free up additional money for blended finance to enable riskier investments, she said. Debt Underlying most conversations around development finance is the growing debt crisis. It’s clear that more countries will default this year and that to date the mechanisms in place to try and restructure debt have not been particularly effective. One question in the year ahead will be whether the G-20 will revamp its Common Framework on debt restructuring, how the countries working through the process will fare and whether investors including China and private lenders will participate. The Common Framework is unlikely to change before more defaults because the G-20 is “at its best when it reacts to crisis,” said Marcos Neto, the director of the United Nations Development Programme’s Sustainable Finance Hub. One instrument that may see more use this year is the debt-for-climate swap, where a lender agrees to forgive debt payments if the funds are put toward addressing a country’s climate change response. Portugal recently announced such a deal with Cape Verde. Swaps could also be “an opportunity to attract private creditors to the negotiating table” if new mechanisms could come up with a way for them to count their losses in the deal toward their climate pledges, Neto said. While much of the focus is likely to be on alleviating this national debt, MDBs and DFIs should look at how they can help small and medium-sized enterprises deal with debt and keep economies working, said Florian Kemmerich, a managing partner at Bamboo Capital Partners, an impact investing platform. ESG, impact investing, and mainstream markets Environmental, Social, and Governance investing and impact investing have both been growing steadily in recent years, but there are swirling concerns about the claims some of these investments make and a political backlash against ESG investing in the U.S. Republican lawmakers have taken aim at financial companies, including BlackRock, criticizing their ESG investments as politicizing finance and discriminating against fossil fuels. While those attacks don’t appear to be going away, it appears that demand is still driving companies to grow their ESG operations, though it has had an impact on some corporate commitments. “Trying to use capital as a force for good is a trend and you see a lot of main financial players, big ones, trying to enter the ESG space, not because they want to but because the demand side is there,” Kemmerich said. Much of that demand remains in high-income countries, and it still is difficult to funnel more investments toward addressing global challenges in low-income countries. The only way to appeal to more mainstream investors is by creating financial vehicles that aggregate investments, and which include blended finance and guarantees in order to bring down risk, Kemmerich said. Meanwhile, impact investment has been quicker to trickle into low-income countries than ESG, but faces some of its own challenges, and will feel some shocks from the volatile market environment. Some of the most impactful investments could struggle the most amid higher interest rates. While those investments might not make the types of commercial returns that some of the big investment firms are after, they play an important role in development finance. In the past, the 3% return they offered didn’t look so bad, but convincing investors to accept less than what they could earn on a safe bet, such as a bond purchase, may make it hard for impact firms to raise funds, said John Simon, a founding partner at Total Impact Capital. Standards Not perhaps the sexiest of trends, but in an era where many financial instruments, and institutions, are coming under fire for the veracity of their claims, this year will see some new standards and frameworks to try and create guidelines for investments and ensure their impact. “The whole area of integrity, holding people accountable to pledges, and standards, will continue growing,” Neto said. The International Sustainability Standards Board will release its first set of global guidelines on corporate sustainability disclosures later this year. The requirements ISSB will release are an effort to create a global set of metrics about how entities disclose all significant sustainability-related risks. The Taskforce for Nature-related Financial Disclosures will release its framework aimed at helping companies and other organizations disclose biodiversity-related risks. And the U.S. Securities and Exchange Commission rule requiring some companies to disclose carbon emissions and climate risk is also expected in the first half of the year. OECD has been calling for “ESG standards with more bite” because there is evidence that ESG investments “don’t live up to expectations at times and don’t really make a difference,” Schütte said. The organization is also working on some principles around green, social, sustainable, and sustainability-linked bonds to make it easier to issue them and ensure that the investments achieve their goal. A recent OECD survey found that fund managers plan to issue more bonds in the year ahead.