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Development finance institutions must seize the opportunity at the Finance in Common Summit

Expert comment

Written by Andrew Herscowitz, Samantha Attridge

Image credit:The Colombian city of Cartagena, which hosts the 2023 Finance in Common Summit (Image credit: Fausto Daniel Moya / Unsplash)

As more than 500 public development banks (PDBs) managing over $23 trillion in global assets gather in Cartagena, Colombia this week for the fourth Finance in Common Summit, development finance institutions (DFIs) should not miss the opportunity to engage with local PDBs. Local PDBs offer a great chance for DFIs to accelerate development and climate impact.

The value of the Finance in Common movement

The Finance in Common movement has built up powerful momentum over the last four years. It is both exciting and refreshing. At its core is the ambition to develop a much more inclusive, cohesive and effective development finance architecture. The network and summits have served as critical platforms to bring together development financiers from diverse regions, with different mandates and scale, to achieve common global objectives in climate and development. In an era of growing geopolitical bifurcation, the movement offers a meaningful platform not only for engagement and collaboration between institutions of the Global North and South, but also for supporting regional and national PDBs in accessing new resources in capital and knowledge, as well as building new partnerships through the FIC coalition.

Why ‘localize’? And what does this mean?

The United States Agency for International Development (USAID) defines localization as ‘the set of internal reforms, actions, and behavior changes that we are undertaking to ensure our work puts local actors in the lead, strengthens local systems, and is responsive to local communities’. It aims to move 25% of its programming through local partners by fiscal year (FY) 2025. USAID spent $41 billion in funding in 2022 which, if it was able to achieve its ambitions, would lead to approximately $10 billion a year in expenditure through local actors by the end of FY 2025.

As development institutions like USAID continue to set goals to ‘localize’ their development assistance, DFIs and multilateral development banks (MDBs) should be doing the same – not just because this is the right thing to do from a development standpoint, but also because the economic impact of ‘localising’ development finance can be significantly greater than efforts involving the transfer of official development assistance (ODA).

When an aid agency programs its resources through local entities, it builds capacity, injects new money into the economy for particular projects and puts local actors with on-the-ground knowledge in control of resources. It can also stretch its development capital further given that supporting local personnel is far cheaper than bringing in expatriates. Nevertheless, it is difficult to predict what will happen to a local organisation when external aid finance dries up or is shifted.

By contrast, when a DFI provides financing to a local business, it injects capital into the economy, creates local jobs and supports the growth of an entity that will survive for as long as the company’s business model is successful. There are almost no limits to how much growth a business can experience. And the money that a DFI lends or invests is generally repaid and can then use this capital to lend again, creating substantial leverage.

Like ODA development agencies, DFIs and MDBs should be working to put themselves out of business. Doing this, however, requires localization of development finance.

DFC and ‘localization’

In 2019, the US Congress established the US International Development Finance Corporation (DFC), replacing its predecessor the Overseas Private Investment Corporation (OPIC). OPIC required that a US business be involved in all its investments, resulting in the vast majority of these being made in just a few American clients. From a development standpoint, a crucial aspect of the BUILD Act that created the DFC was the removal of this US linkage requirement.

While not calling it ‘localization’, the DFC in its inaugural Roadmap for Impact development strategy established the goal of expanding its client base by at least 75 new clients by 2025. It has already far exceeded this target by gaining more than 200 new clients since its inception, many of which are local companies in the countries where the DFC operates. At the end of FY 2022, the DFC had an investment portfolio of approximately $36 billion with a total financing ceiling of $60 billion.

Upping their game

Working through and supporting national PDBs offers DFIs an opportunity to boost their localization efforts and increase the mobilisation of local private investment. By providing financing to national PDBs in the right way, DFIs can derive several benefits:

1. Building local capacity in the countries that DFIs are mandated to support.

While some might question a national PDB’s underwriting standards when compared to the large DFIs, the purpose of development capital is to help build that capacity. DFIs can provide this technical assistance.

2. Reaching populations and businesses that DFIs cannot.

DFIs have limited on-the-ground presence in the countries where they operate. If they are serious about lending in low-income countries or fragile regions, working with local PDBs that understand the risks of lending in these areas can be a more effective tool for providing financing to underserved populations, such as indigenous populations in the Amazon or young people in Northern Benin.

3. Financing borrowers whose debt and equity needs tend to be too small to justify the high transaction cost of a direct relationship with a DFI.

Most DFIs struggle to provide financing for transactions lower than $5 million, in large part due to the high transaction costs of doing business with a DFI (e.g. legal fees; environmental, social and governance [ESG] requirements, etc.). There also are great inefficiencies in having DFIs lend directly to micro-businesses.

4. Supporting the development of local capital markets.

Local PDBs can help mobilize the vast pools of local private capital, supporting the development of domestic capital and sustainable finance markets more broadly. Working through local PDBs is key to bringing down the local cost of capital and reducing foreign exchange risk.

5. Accessing and de-risking bankable pipelines.

DFIs struggle to find bankable investment projects, especially in infrastructure. Many local PDBs play a key role in identifying and developing bankable projects and working with local government to shape policy and regulatory frameworks which are conducive to private investment, thus de-risking projects.

DFIs must be allowed and encouraged to engage with national PDBs

A major challenge in advancing these kinds of partnerships is the fact that most national PDBs are sovereign-owned; consequently, many DFIs are not authorized or choose not to lend to such entities. DFI shareholders must reverse this practice. For their part, DFIs must subsequently invest in technical assistance to help PDBs build their underwriting capacity, where appropriate, and to incentivize strong PDB development impact measurement and reporting. It is also imperative that the cost of the DFI capital invested in or lent to national PDBs be kept down so as not to significantly increase the cost of borrowing for local businesses.

The FICS Summit presents an opportunity to hold these frank conversations on how DFIs can truly move the needle in catalyzing investment in the Global South. Although getting it right will cost some money (in the form of ODA resources), using this finance more aggressively to facilitate blended and concessional financing can eventually help put development banks and agencies out of business.