The notion that public investments should be used to ‘leverage’ additional investments from private actors is increasingly used in a variety of development finance forums, including aid, development finance, agriculture and, in particular, climate finance.
What is leverage?
In development finance debates, the term is rarely used consistently by the World Bank or others, but the WBG defines the basic concept as:
“the ability of a public financial commitment to mobilise some larger multiple of private capital for investment in a specific project or undertaking.”1
This financial leverage of private capital is the focus of this paper, and is how the term ought to be generally understood. However, the Bank often uses the term in a general sense to mean any large overall impact of a smaller amount of Bank investment or advisory input.
The International Finance Corporation (IFC), the Bank’s private sector arm, also uses the term in both a loose and tight definition, and often calls it ‘mobilisation’. In fact, the IFC has a more strict definition:
Core mobilisation: “financing from entities other than IFC that becomes available to clients due to IFC’s direct involvement in raising resources.”2
It sometimes refers to other activities that may encourage or support private sector investment, such as advisory services, as ‘catalytic mobilisation’. This distinction is important – this chapter only focuses on the first part, which the IFC calls core mobilisation, but which is more commonly thought of as financial leverage. To be crystal clear, we will not use the term in the following three ways, and encourage others to also not use it in these contexts:
(a) Catalytic investments are not financial leverage – for example the World Bank-coordinated paper for the G20 on climate finance unhelpfully bundled all public investments “that encourage much more widespread climate-friendly changes in behaviour by private firms across the whole economy” as leverage. This makes the term essentially meaningless, as (a) most public investments are intended to induce changes in behaviour of private actors, and (b) it is very difficult to quantify the direct impacts on private sector actors of such public investments. For example, the Bank suggests that “carefully designed and scaled public investments in demonstration projects to pilot and debug new technologies and institutions can have a major impact in promoting learning and the diffusion of new ideas.” In each individual case this may be true – or may fail – but the aim is to change markets and behaviours on a more fundamental scale, not to directly leverage additional resources.
(b) Pooled financing is not financial leverage – the World Bank, through its trust funds, has promoted the pooling of donor, multilateral development bank (MDB) or other public financing to tackle certain issues. However, it has also caused confusion by sometimes calling this leverage. For example, the most recent Clean Technology Fund (CTF) semi-annual report claims its investments are “expected to leverage $9.874 billion in co-financing from governments, MDBs, private sector, and other sources.”3 The donor and other public funding in this example is only leverage from the CTF’s perspective – the other public bodies might just as well have claimed to have leveraged the CTF money!
(c) Inducing policy reform is not financial leverage –the use of international financial institution (IFI) or donor influence to push, cajole or advise developing countries to change their policy positions is sometimes described as leverage. It would be better thought of as political influence, and is highly problematic. It normally undermines domestic democratic space, may promote the wrong approaches, can degrade government capacity, and rarely works as intended – as previous campaigns against policy conditionality have shown.4 The use of technical assistance (TA) is a grey area – many argue that this is often attached to a particular policy agenda that is being promoted, and in general terms, TA has a very poor track record, particularly when it is donor driven.5
Methods of Leverage
The different types of financial leverage are largely already in use at the World Bank Group. They can be divided into three types: loans, equity investments, and risk management products.
There are four main types of loans at the IFC: investment loans; syndicated loans; financial intermediary loans; and concessional loans.
(a) Investment loans – the IFC lends to a company to undertake a specific project. The IFC obtains its money to make the loan by selling bonds on international bond markets. The IFC is able to do this because its shareholders, governments, have provided it with capital.
(b) Syndicated loans – the IFC coordinates (and is the largest participant of) a loan for a project made by a group of investors (which may include banks, investment funds and so on). The IFC’s portion is still borrowed from capital markets, as with investment loans.
(c) Financial intermediary (FI) loan – The IFC lends money to a financial intermediary – normally a bank – which then lends to its clients.
(d) Concessional loans – IFC grant funding has traditionally been very small, and focussed on technical assistance, called advisory services by the IFC.6
(a) Direct equity investments – the IFC buys ownership of a portion of a company, which is funded by the IFC’s net worth, not the bond market. The IFC normally buys between 5 and 20 per cent of a company’s equity20 and never more than 35 per cent of the total company value. It tries not to be the biggest shareholder.
(b) Investing in private equity (PE) funds – the IFC has been investing in private equity funds since the 1980s, and has ramped up its activities over the past ten years.7 It now claims to have backed 10 per cent of all funds that operate in emerging markets. The IFC invests as a ‘limited partner’, meaning that it contributes a limited stake to, but does not run, the PE fund.
(c) Setting up its own PE funds through the IFC Asset Management Company (AMC) – this is a relatively new venture for the Bank. The AMC is an IFC subsidiary company, domiciled in Delaware8 which pools funds from the IFC and other investors to invest in IFC clients.
(d) Quasi-equity investments – the IFC may also “invest through profit– participating loans, convertible loans, and preferred shares.” The amount of financial leverage will depend on which of these options are used, and the exact terms of each deal, but in essence they are more like equity investments than loans.9
3. Risk management products / securitised finance
There are a number of risk management products that the World Bank Group sells to companies. These are a bit like insurance: in each case the company pays the Bank a fee and the Bank only pays the company should the risk materialise.
(a) Risk sharing products10 – the borrower sells part of the risk of a new investment to the IFC.
(b) Partial credit guarantees11 – sometimes called ‘first loss’, the IFC promises to pay a creditor up to a certain amount should the borrower default.12 These include cross-border guarantees to allow companies to access international finance that they otherwise would not be able to access.13
(c) Political risk insurance –MIGA provides this for foreign companies, who are worried about losses due to five risks: currency inconvertibility and transfer restriction (a hedge against capital controls); expropriation of assets by the government; war, terrorism or civil disturbance; breach of contract; and non-honouring of sovereign financial contributions.
(d) Catastrophe insurance – the World Bank has, in recent years, piloted weather-related insurance to farmers.14
(e) Hedging products – like other banks, the IFC offers clients a variety of products to hedge against exchange rate volatility
Ten problems with leverage
1 Assessing financial additionality is difficult and headline figures are not reliable
Additionality – and hence leverage – cannot be assumed just because public institutions are co-investors with private funds. The following issues often arise:
(a) Replicating existing investment – while the IFC says it aims to invest in ‘frontier’ areas, where private investment is not currently flowing, there are serious concerns about whether this is the case:
i. Leverage implies that private investors will put forward a majority of the capital, implying they have a very strong interest in investing.
ii. Very little IFC investment flows to low-income countries, and the vast majority goes to middle- income countries that already have much better developed financial sectors.
iii. The sectors favoured have tended to be ones where investors – particularly foreign investors – are already investing in developing countries. For example, over half of the IFC’s current portfolio is invested in the financial sector, infrastructure and extractives
(b) Failure to achieve additionality – their own internal evaluations suggest that, even adopting a broad definition, the IFC fails to achieve any financial additionality in 15 per cent of investments. Any headline claims that $x of public money leveraged $y of private investment should be treated with scepticism.
2. The higher the leverage ratio, the stronger the private sector influence and the lower the likely financial additionality
In all forms of leverage where private investors put forward most of the capital, they will have the predominant influence in the design and implementation of the investment. Their goal is to make money, not to promote development, and there will be trade- offs between their objectives and those of the public institution. The greater the leverage ratio, the smaller the overall contribution of the public body, and hence the lower its power and influence in the design and implementation of the investment .
Also, as noted above, higher leverage ratios imply that the project is more likely to have been funded without any public sector involvement.
3. National strategies and policies should be paramount – but may be ignored or overridden in the quest to achieve leverage
The overwhelming experience of successful developing countries is that private sector investment needs to be directed and influenced by a national strategy – to ensure sufficient investment in areas which will increase productivity, employment and sustainable poverty- reducing growth.
Therefore attempts to leverage private sector finance should be directed by national strategies and institutions and take place at the national level. However, most existing models and institutions operate through global funds or international financial institutions that are not always well linked to national plans.15
4. Many existing World Bank methods promote foreign investment as if it were an end in itself: it is not and entails risks as well as rewards
Foreign direct investment (FDI) can help developing economies by providing jobs, creating demand for domestic products and upgrading skills and technologies. However, there are a number of problems that can be caused by foreign private investment that need to be carefully considered and managed by developing countries, including:
(a) Sectors invested in – many developing countries, particularly low-income countries, have only been successful at attracting foreign investment into resource extraction. This can have huge social, environmental and human rights impacts, and is associated with significant governance problems such as corruption and resource capture by elites
(b) Macroeconomic impacts – money flowing into countries, particularly if the amounts are large, can have important impacts, particularly on exchange rates. To invest in a country, foreign companies use hard currencies to buy local currency, thus pushing up the value of the local currency. This affects exporters in particular. Conversely, foreign investors have often pulled their money out during economic crises, which can cause currency collapses.
(c) Diversion of domestic investment – many foreign companies actually borrow the money that they invest from local capital markets, which may mean diverting it from investment in other local businesses that may be higher priorities for development plans.
(d) Investment flows out, as well as in – research by the South Centre, an intergovernmental think-tank, shows that in recent years inward FDI flows have often been matched by outward profit repatriation, and inward portfolio investment by outward withdrawal of equity capital.16
(e) Capital flight and tax evasion – Global Financial Integrity, and NGO, estimates that developing countries lost between $725 billion and $810 billion per year, on average, between 2000 and 2008, through illicit outflows.17 Most of these were due to trade mispricing and other tactics used by multinationals to help them avoid tax.
(f) Political influence – multinationals have been adept at using the threat of moving elsewhere to not only negotiate favourable terms for their investments, such as tax concessions not available to domestic companies, but also to push for lighter regulation of their activities.
5. Leverage means increasing debt and often involves linking poor countries more closely to volatile global financial markets
Leveraged finance is not aid; it is lending to companies, usually at market rates, which must be repaid. Often developing countries or particular sectors do suffer from lack of access to credit, but this cannot be assumed.18 Though the links to global financial markets through traditional lending models described above are weak, they are becoming far stronger in the new models promoted by the AMC and others. This may make greater credit available, but also means borrowers are more directly connected to global financial markets, which can be highly volatile.
6. There are opportunity costs when using limited public investment to leverage private investment
Using public resources to try to leverage private sector investment means those resources cannot be used elsewhere. These opportunity costs may be particularly important in certain countries or sectors where the need for straightforward public investment – for example in climate adaptation, healthcare, education, infrastructure or environmental protection – may be very high.
7. Many of the current methods used mean both actual and potential transfer of risk to public institutions – implying moral hazard
In addition to explicit guarantees, private investors may assume that the IFC is unlikely to allow the investment to fail and may end up bailing it out – or persuading the government to do so. Sometimes, private investors may assume an IFC-backed investment will receive special privileges, for example, being less likely to fall foul of governmental interference, or benefiting from special treatment from the government. This means moral hazard is a significant issue – investors taking greater risks because they assume they will not have to bear the full costs should investments turn sour.
8 Transparency and accountability are currently very low for publicly-backed private investment in developing countries
The new IFC access to information policy, for example, is far weaker than its counterpart at the public lending arms of the World Bank Group (the International Bank for Reconstruction and Development, which is the World Bank’s middle-income country arm, and the International Development Association, the Bank’s low-income country arm).19 The use of financial intermediaries entails further loss of transparency and accountability,20 including the potential for weakened application of environmental and social standards.
9. Leverage may open the door to undue political influence in developing countries by IFIs and donors
It is important to remember that the World Bank and other international institutions are major influencers of policy in many developing countries through norm and standard setting, research, and influence over how they frame the overall discourse. This emphasis on the importance of private investors and capital markets can be seen as the culmination of a longstanding position, pushed vigorously over the past 30 years, that developing countries should orient their economies and policies to attract foreign investment
10. Positive developmental impacts may be absent
Developmental impacts are not the objective of most of the private actors involved in the above mechanisms, and it is dangerous to assume – as the IFC often does21 – that any private investment is good for growth and poverty reduction, for the reasons set out above.
1 World Bank Group et al, (2011) ‘Mobilising Climate Finance: a Paper Prepared at the Request of G20 Finance Ministers’, p.35.
2 IFC (2011) ‘IFC Annual Report 2011’, volume 2, p.9, http://www1.ifc.org/wps/ wcm/connect/CORP_EXT_Content/IFC_ External_Corporate_Site/Annual+Report.
3 World Bank CTF secretariat (2011), ‘Semi Annual Report on CTF Operations’, CTF Trust Fund committee, 2011, 4.
4 See, for example http://www.brettonwoodsproject.org/art-563637 for a summary of a report that lists many critiques of conditionality at the WBG.
5 Greenhill, R. (2006) ‘Real Aid 2: Making Technical Assistance Work’ ActionAid International www.actionaid.org.uk/ doc_lib/real_aid2.pdf
6 As these are often tied to IFC loans, it could be argued that this is one method of subsidising that lending.
8 http://www.brettonwoodsproject.org/art- 568573
9 Preferred stock are essentially like equity, but with a higher claim on assets and dividends, though without the same voting rights as normal shareholders. Convertible loans can be converted into equity at a specified time.
10 http://www.ifc.org/ifcext/treasury.nsf/ Content/RiskSharing
11 http://www.ifc.org/ifcext/treasury.nsf/ Content/PartialCreditGuarantee
12 The IFC also says it works to reduce probability of default and increase amount recovered if default happens.
13 Including the Guaranteed Offshore Liquidity Facility (GOLF): http://www.ifc.org/ifcext/ treasury.nsf/Content/GOLF
14 Bretton Woods Project (2009) ‘Helping Farmers Weather Risks? Assessing the World Bank’s Work on Index Insurance’, http:// www.brettonwoodsproject.org/art-565398
15 See for example Chang, H.J (2002) Kicking Away the Ladder: Development Strategy in Historical Perspective, Anthem
16 Akyuz, Y. (2011) ‘Capital Flows to Developing Countries in a Historical Perspective: Will the Current Boom End With a Bust?’ South Centre, http://www.southcentre.org/ index.php?option=com_content&view=artic le&id=1529%3Acapital-flows-to-developing- countries-in-a-historical-perspective-will- the-current-boom-end-with-a-bust&lang=en
17 Kar, D. and K. Curcio (2011) ‘Illicit Financial Flows fromDeveloping Countries: 2000-2009. Update with a Focus on Asia’ Global Financial Integrity, http://iff- update.gfintegrity.org
18 See for example, Rodrik, D. and A. Subramanian (2009) ‘Why Did Financial Globalisation Disappoint?’ IMF, www.iie.com/publications/papers/ subramanian0308.pdf
19 http://www.brettonwoodsproject.org/art- 568902
20 Bretton Woods Project and ’Ulu Foundation, ibid.
21 Bretton Woods Project (2010) ‘Bottom Lines, Better Lives. Rethinking Multilateral Financing to the Private Sector in Developing Countries’ BWP, http:// www.brettonwoodsproject.org/art-566197