STUART THEOBALD: Mobilising for big financial reform

Are we at the beginning of a major reform of the global financial system, or is it a lot of hot air? The noise is certainly getting louder. At last week’s World Bank and IMF meetings in Marrakesh, Morrocco, I found myself listening to many earnest conversations about the need to “mobilise” private capital to deliver the huge volumes of investment to deal with climate change and achieve the world’s development goals.

The week before I was at the Global Steering Group (GSG) for Impact Investing in Malaga, Spain, where impact investors from across the world discussed how to get more capital to flow into investments that have a positive impact on the world.

These two events should be polar ends of the investment world — the World Bank/IMF meetings are the beating heart of global capitalism, while the GSG is the vanguard of change, attempting to make the case that investment should be doing good and not just earning returns. Yet the conversations at both were remarkably similar.

The term “mobilising” investment is misleading. Money never sits and does nothing. Idle balances in a bank account enables that bank to lend to businesses, individuals and governments. We also use money for consumption, of basic necessities as well as luxuries.

When we talk about mobilising investment we are actually talking about reallocating money, either away from other investments or away from consumption. There are therefore opportunity costs. One of the most important, and bad tempered, conversations is how to increase the financial firepower of the World Bank and IMF. To do that, the member countries will have to put more cash into the two institutions. That means governments must allocate from other priorities, including their own domestic spending, so unsurprisingly it has been very difficult to get commitment.

Higher returns

The talk of mobilising the private sector and crowding in additional investment is seen as means of getting the Bank’s existing money to work harder, and so let governments off the hook. That additional investment is from the “traditional” investment world of stocks and bonds, owned by institutions such as pension funds and managed by large asset managers. How should one get more investment from such investors?

The usual answer in financial markets is to offer them higher returns than the alternatives. Of course, this can’t always be done — you have to be able to pay the interest and the capital back. A loan is a mechanism to sacrifice future consumption to spend now. Paying more for loans means increasing the burden on the future. That can be justified if it will generate returns that exceed the cost of the loans. But in climate-related investing, projects are to prevent the global economy from being devastated rather than generate returns. Sure, returns are protected in such a scenario, but limiting climate change is a public good that no one investment can internalise. So, the option of simply paying more for funds that limit climate change doesn’t work either.

At both GSG and the World Bank meetings, part of the returns solution was the notion of “derisking” investment to mobilise private investors. Reducing risk is another way of increasing returns, all else being equal. In practice this means shifting certain risks from the commercial investor onto another balance sheet. For example, the World Bank’s Multilateral Investment Guarantee Agency issues guarantees on projects to cover risk of expropriation, breach of contract by governments and other risks. There is an economic logic to such guarantees — the World Bank is uniquely positioned to manage them given it has many engagements with host governments, so has leverage to ensure performance. But there are not many institutions with similar abilities to take on and manage risks.

Derisking can also be through blended finance arrangements. Blended finance is based on the age-old structure of corporate finance, split into equity and debt. Equity is higher risk and shareholders are the first to take pain but are also the beneficiaries of outperformance.

Limited capital

Blended finance involves a more diverse capital stack. Higher risk tranches can be allocated to development funders and, in the impact investing world, foundations and other philanthropists who are willing to sacrifice financial returns because the social impact of the investment is worth it. This idea does have genuine mobilising potential, in that it can align with the interests of all parties. Philanthropic or concessional finance that is aiming for social or environmental outcomes rather than financial returns, can maximise impact by mobilising traditional investors, and traditional investors get their commercial returns.

The problem, though, is that such philanthropic and concessional capital is very limited. Clever structuring can increase the leverage it has, but there is no scenario in which you get the scale needed. So, we are back at the need for governments to increase funding. As I listened to the conversations on how to do that, I was reminded of the uniquely SA answer: prescribed assets — the compulsion of investors to invest in certain chosen assets. No-one dared make that call explicitly, given the major distortion to financial markets and the implicit tax on savers that it would be. But given the free rider problem of investing to beat climate change, I would not be surprised if such calls come next.

Either way, change is in the air. Unimpeded financial markets are not seen as the social goods they once were. Now, they must be mobilised to direct investment flows at certain important public policy priorities. Achieving that could mean deep changes in the way global investment markets work.

  • Stuart Theobald is chair of research-led consultancy Krutham (formerly Intellidex).