Blog: Public aid is driving financial innovation to support international development

International development is increasingly being financed in innovative new ways. Public aid money is critical and its role should be celebrated more

This article was originally published by SPERI

I was delighted to read that Professor Mariana Mazzucato has recently launched a new Institute for Innovation and Public Purpose (IIPP) at University College London. The Institute describes its mission as to ‘rethink how public value is created, nurtured and evaluated’ and in particular how the public sector and public finance can drive innovation and actively co-create and shape the markets of the future (and not simply fix market failures or de-risk business ventures). As Professor Mazzucato argued in her inspiring work ‘The Entrepreneurial State’, the role of public finance and the state in fostering some of the innovations we now take for granted (such as the Internet and GPS) is frequently (and some would argue deliberately) overlooked.

In 2015, world leaders adopted the Sustainable Development Goals (SDGs) at the United Nations, a radical new action plan to eliminate poverty, tackle climate change, and build peaceful, equitable and prosperous societies everywhere by 2030. Governments convened in Addis Ababa, Ethiopia the same year to work out how to pay for it all.

Much of the discussion in Addis Ababa focused on ways to mobilise more private sector resources for development, and minimised expectations that taxpayer-funded development aid and other international public finance flows would play a prominent role in financing international development efforts. Official Development Assistance (ODA) (which comes in at around US$ 140 billion annually) is compared to foreign direct investment and equity flows to developing countries (which come in at about US$ 800 billion combined annually) to justify this argument.

This storyline however downplays aid’s role in driving financial innovation, leveraging finance from capital markets and using public money in creative ways to pilot new approaches, reduce risk, and build and shape new markets that in turn provide private investors with opportunities to invest in much-needed sustainable development interventions.

Government funded aid is, for example, increasingly being used to ‘crowd-in’ private investment in infrastructure, health and other sectors through mechanisms such as advance purchase agreements, guarantees, interest rate subsidies, insurance, incentives for successful performance and matching funds.  ODA can also be used to provide technical assistance and other advisory services, absorb transaction and project preparation costs. While the amount of public financing supplied for a particular project may be smaller in volume terms than that provided by private sector partners, many projects, especially those that are higher-risk or where finance is needed over the long-term, could not be realised without some form of public sector support. Many of these innovative financing (or ‘blended’ finance) approaches have provided opportunities for new collaborations between public and private actors in development. While the devil is always in the detail of any arrangement between public and private entities, such approaches when done well can make viable investments in developing countries that would not otherwise have been possible.

Another example is the green bond market. Green bonds are debt securities which tie the proceeds of a bond issue to environmentally-friendly investments. Issuers can be private companies, supranational institutions (such as multilateral banks) and public entities (municipal, state or federal). Ten years ago, this innovation barely existed; in 2016, over US$ 118 billion in green bonds were issued with this number projected to reach US$ 200 billion this year. Sovereigns, multilateral and national development banks have been the ones to kick-start and shape this market over the last decade. Public issuance has been essential to establish models, provide initial market liquidity and educate investors about the asset class. They have also been more easily able to absorb the additional transaction costs associated with this financing modality, since issuers must track, monitor and report on use of proceeds during the lifetime of the bond.

Other financial innovations championed by the public sector include the International Finance Facility for Immunisation (which sees donors issue bonds on international capital markets for immunisation programmes in poor countries, repayable by future streams of development aid), or countercyclical loans, implemented by the French Development Agency (AFD) (which allow for automatic reductions in debt service for up to five years when a major shock strikes). This can help avoid debt crises. Building on AFD’s experience, the private insurance industry is now developing a loan model whereby insurers service the debt on the sovereign issuer’s behalf for an agreed time, allowing the sovereign to allocate resources to responding to a catastrophe.

Donor funds are also playing a role in the rapidly-expanding market for sovereign catastrophe insurance. The much-lauded Caribbean Catastrophe Risk Insurance Facility (CCRIF) recently made a payout of US$19 million to Dominica following Hurricane Maria which tragically laid waste to the island in September this year. CCRIF is a public private partnership which was originally capitalised via contributions provided by a variety of official donors such as Canada, the EU, USA and Germany. In the case of Haiti, insurance premiums are paid in part or in full by official donors and sovereign catastrophe insurance which would be impossible without this support. Donors are showing increasing interest in supporting countries to access the sovereign insurance market.

Impact investment (investments made by private investors that have a positive social or environmental impact alongside a financial return) meanwhile has attracted much hype over the last few years as a promising strategy to finance development and the SDGs. Yet as Oxfam America has pointed out, some of the companies that have achieved impact and scale had previously benefited from millions of dollars in public aid support over many years, prior to securing (or sometimes alongside) private investment capital.

Finally, in 2014, UNDP established its Innovation Facility, which uses public aid resources to support pilot projects in developing countries that ‘test-drive’ alternative or emerging sources of finance to meet sustainable development challenges. These include social and development impact bonds, equity-based investments, crowdfunding and blockchain for example. The aim is to help countries to deepen and diversify their sources of financing for development, and to scale successful innovations.

Finance from official donors, often perceived as bureaucratic and stagnant, is on the contrary vibrant and undergoing a continuous process of change and innovation. It is supporting innovations in financing sustainable development, and many crucial development interventions would not be possible without it. The narrative needs to move away from an obsession over the ‘volumes’ of financing that the private versus the public sector can offer towards one that recognises that all sources of financing have a complementary role. Aid and international public finance flows help create and shape markets, fund innovation and leverage finance from other sources.

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