This blog was originally published by Devex in association with ID4D, an international blog for exchanges and constructive debates on development hosted and facilitated by the Agence Française de Développement (AFD)
In September 2015 at the United Nations in New York, 193 countries adopted the Sustainable Development Goals. The SDGs are an ambitious new action plan for the next 15 years that aims to eradicate extreme poverty, protect the planet and ensure peaceful prosperous societies everywhere. Meeting the SDGs will require unprecedented investments in areas such as health and nutrition, education, infrastructure development, agriculture, peace and security and environmental protection.
For the 48 least developed countries, achieving the SDGs will be a particularly difficult task; levels of deprivation are acute, infrastructure is inadequate and capital is in short supply. In 2012, 43 percent of people still lived in extreme poverty in the LDCs (based on the $1.90 a day or less poverty line).
LDCs are intrinsically vulnerable to economic and environmental shocks and are less able to mobilize and attract the significant amount of finance needed to implement the 2030 Agenda, as compared to other developing countries. Tax revenues are weak — on average just 18 percent of gross domestic product — and private investment is limited.
Where private investment does exist, it remains heavily concentrated in a few resource-rich African LDCs. This combination of challenges means that many LDCs remain heavily reliant on official development assistance.
In 2014, LDCs received about $41 billion in ODA from OECD donor countries, a share of total aid that has unfortunately declined over recent years. It is clear, however, that ODA and domestic revenues alone will not be sufficient to fund the large-scale investments needed to achieve the SDGs in the LDCs.
In this context, how can LDCs make use of a broader suite of financing instruments now available to support their development? And how can donors help them in this effort?
Over the past 15 years, new financing instruments have emerged both within and in addition to ODA. These include: blended finance; guarantees; green bonds; local currency loans; diaspora financing vehicles; impact investing; performance-based loan contracts, and; insurance, among others. But beyond a handful of cases, these approaches have not been widely used in the LDCs.
What is blended finance?
Blended finance represents one strategy to mobilize additional resources for investments in sustainable infrastructure. These mechanisms work by using aid resources to leverage additional sources of finance, both domestic and international. Grants are blended with other public or private sources of finance such as loans, risk capital and/or equity, typically for infrastructure, energy or private sector development projects. Blended finance projects can help stretch scarce development aid resources further. Guarantees also have the potential to make investments in LDCs more attractive to private investors by altering the risk-return profile of the project.
One example is the French Development Agency’s SUNREF program, or the Sustainable Use of Natural Resources and Environmental Finance. SUNREF takes an integrated approach to environmental finance, supporting local financial institutions to fund an ecological transformation in the energy, water and agriculture sectors. Financial support and technical know-how provided through the project help local banks identify promising green investments and structure an attractive offer (maturity, interest rate, and investment premium) to local investors. The technical assistance component has been key to the success of the program, and it has also disseminated best practices.
These types of instruments call for new forms of partnership between government, international development agencies and private investors. They require transparency. Such arrangements are not always easy to implement and require extensive external support, especially at the beginning. They do, however, have the potential to scale up the resources available for infrastructure financing.
How can LDCs manage volatility and shocks?
In addition to financing for long-term sustainable development investments, LDCs also need support to manage volatility and shocks more effectively and to make their economies more resilient. LDCs are among the most vulnerable countries in the world to shocks and stresses, and they typically have less capacity to cope. The Ebola health crisis in West Africa is one recent case in point.
Many multilateral and bilateral lenders now offer a variety of risk-management products that enable countries to hedge their exposure to different kinds of risk, including interest rate risk, currency and commodity price risks and weather-related risk. These products allow borrowers to plan efficient responses to shocks and stresses and to optimize their debt management strategies. Examples include GDP-linked sovereign bonds, countercyclical loans, the inclusion of “hurricane” or “catastrophe” clauses in loan contracts, weather-related insurance schemes and lending in local currencies.
Recent research by UNDP simulated the possible benefits of adopting GDP-linked loan contracts for LDCs’ external debt with official multilateral and bilateral creditors, which are their main creditors. Under these types of contracts, debt service is allowed to rise in times of high economic growth when tax revenues are higher, but they fall during periods of economic slowdown. The results show that debt service would have fallen by almost 8 percent over the 2003-2014 simulation period, potentially allowing states to maintain essential expenditures in more difficult times.
Further options to help countries manage risk and volatility are countercyclical loan instruments implemented by AFD — where it is agreed ex-ante that debt service will automatically be allowed to fall, or become zero, in periods of external shocks. These have been implemented in Mali, Tanzania, Mozambique, Senegal and Burkina Faso. Looking forward, other bilateral and multilateral lenders could explore use of such approaches. Initiatives such as the Africa Risk Capacity Insurance Company Ltd — a sovereign-level mutual insurance company established by the African Union — represent promising instruments to cover risks related to extreme weather events and natural disasters, particularly in the field of food security.
While these types of financial instruments have the potential to bring new solutions to the financing of Agenda 2030 in the LDCs, they will not be effective unless they are adapted to the specific needs and circumstances of each country and fully support national development strategies. Expanding financing to the LDCs — in ways that make sense to each country — will be critical if we are to remain true to the SDG promise to “leave no one behind.”