On 10 October 2016, a diverse group of high-level government officials, civil society representatives, and private sector businessmen convened at the United Nations headquarters in New York City. At hand was a discussion over how to best implement the recently adopted 2030 Agenda for Sustainable Development and its attendant Sustainable Development Goals (SDGs), a comprehensive 17-point agenda that, if achieved, aimed to improve the living conditions of hundreds of millions of people through transformational investments in infrastructure, industry, entrepreneurship, and environmental protection. The SDGs were lauded for their ambitions. At the meeting, then UN Secretary-General Ban Ki-moon hailed the goals as “the people’s agenda, a plan of action for ending poverty in all its dimensions, irreversibly, everywhere, and leaving no one behind” (UN 2015b).
However, it was ubiquitously acknowledged that implementing the SDGs would be extraordinarily expensive. One study estimated that developing countries would collectively need more than USD 4.5 trillion in investment annually, a sum that eclipsed the combined financial power of the world’s development agencies by more than 30 times (WEF and OECD 2015a, 4). With development assistance (as a percentage of donor country GDP) waning, donor government funds alone would be insufficient; development institutions would need to mobilize funding from the private sector. With global private capital markets worth more than USD 200 trillion, private enterprises, commercial banks, and institutional investors would be critical to marshalling these resources. As H. E. Peter Thomson, President of the UN General Assembly, remarked, “the private sector serves as the custodian of the largest pools of the world’s resources, and the main engine driving entrepreneurship and innovation around the world. It is therefore vital that the private sector is brought in as a key partner in our discussions on how to mobilize the investments that are needed to achieve the SDGs” (UN 2017b). Development institutions had fully embraced private capital as a key to achieving outcomes; development policy had become focused on its mobilization.
To be certain, the desire to use private capital to finance economic development had been a long-standing conviction. In the 1950s, development institutions like the World Bank prioritized funding for privately-led projects and avoided supporting state-owned enterprises as a matter of policy. In 1956, the International Finance Corporation (IFC) was established with the express objective to promote private entrepreneurship. This strategy reflected a deep-seated belief that developing country public institutions lacked the dexterity and capabilities to ignite economic growth. Three decades later, the landmark 1989 World Development Report emphasized that a vibrant domestic financial sector was critical to a developing country’s growth potential and reemphasized private initiative as the central driving force. However, throughout this period, development institutions struggled to mobilize private investment. Foremost among the reasons was that development projects were often not financially viable for private capital. They were the projects that required large capital investment, had long—and uncertain—repayment horizons, and were located in countries with higher political and economic risk. These were—and still are—all factors that private investors eschew.
In order to attract private investment, development institutions began to align economic development policy with the logic of financial markets. This required two components. First, development projects hewed closer to commercial investment principles. Development institutions prioritized financing over grants in order to create projects with a revenue stream to pay back investors. To match projects to investors and avoid creating moral hazards, interest rates on those financing programs reflected, at least partially, the riskiness of the project. Second, in order to attract more private investors to these new and riskier investment opportunities, development institutions redeployed donor government funds to absorb risk within the newly-created financial instruments. Crucially, this risk assumption altered the risk-reward calculation for private investors and turned previously unbankable development projects into investment opportunities. As a result, these financial instruments grew in number and complexity over time, and attracted substantial private investment. Throughout this process, development institutions drove innovation for new instruments and their application to new sectors. These financial instruments, which relied on a mix of commercial logic and public risk assumption, constitute what I term marketized development financial instruments.
Marketized development financial instruments are now so pervasive that their advantages are axiomatic. Development institutions and private investors alike have embraced them as way to bring private investment to, and catalyze growth within, development countries. Over the past decade, the World Bank has redoubled its efforts to create new financial instruments backed with donor government funds, ranging from future-flow securitizations to diaspora bonds (cf. Ketkar and Ratha 2009). The World Bank’s president, Jim Yong Kim, has also publicly embraced private investors in development projects via World Bank risk-sharing schemes (Thomas 2018). KfW, the German development bank, has created more than a dozen investment funds, and participated in at least 30 additional investment vehicles with more than EUR 1.4 billion in funding since 2008. From the SDGs to smaller, targeted funds, marketized development financial instruments are now central to international development policy.
The Creation of Marketized Development Financial Instruments
While the evolution to marketized development financial instruments mirrored the global growth of financial markets, their creation was far from preordained. Given the unprofitable and riskier nature of development projects, marketized development financial instruments were dependent on one crucial factor: donor government risk assumption of developing country investments. Traditional development policy, which distributed assistance primarily as grants or project loans, provided few opportunities for financial instruments, and even fewer risk guarantees. Yet by the early 1980s, and accelerating through the 2000s, donor governments had come to embrace these new financial instruments as critical to development policy. Therefore, this book asks why donor governments, which were reluctant to add financial burdens from development assistance, supported these new marketized development financial instruments abroad in which they assumed investment risk? In addition, development institutions played a central role not only as the primary creator of these financial instruments, but also their greatest proponents. Why did development institutions—rather than the private financial sector—champion marketized development financial instruments? Finally, which institutions were critical in facilitating this evolution?
I argue that development institutions played a critical role in creating, managing, and promoting these new marketized development financial instruments as a way to solve two problems. First, beginning in the late 1970s, donor countries wanted to increase the speed and scope of development assistance in ways that served broader political interests but simultaneously preserved financial sustainability. Second, development institutions themselves had long desired to provide assistance in ways that maintained economic incentives and were financially sustainable. Marketized development financial instruments enabled development institutions to respond to these pressures. Development institutions—particularly the German development bank KfW—experimented by convincing politicians to redirect funds away from grants and loans and toward more complex financial instruments. This promotion of risk-sharing mechanisms through marketized development financial instruments allowed assistance to be faster, more flexible, and more attractive to private capital. Moreover, by using donor government assistance as risk buffers within financial instruments, development institutions were able to decrease investment risk to private investors while also reducing the annual outlays on the part of donor governments. Critically, in order to ensure that these new instruments pursued development objectives and avoided creating moral hazards, development institutions not only strictly adhered to market operating principles, but also created new financial instruments and maintained managerial control over them. This ensured that both financial intermediaries and end-users had incentives to pursue the development projects envisioned by donor governments.
Development institutions were the actors best suited to catalyze these new financial instruments. Since they already existed at the nexus of private markets and public ownership, development institutions had the familiarity with financial markets as well as a political mandate to pursue economic development abroad. Their access to government resources enabled innovations of new risk-sharing financial instruments that the private sector could not develop. Moreover, development institutions also had the institutional ability to maintain equity stakes and managerial control over investment decisions. This was a crucial factor in ensuring that these financial instruments balanced between pursuing development objectives while simultaneously maintaining proper incentives for recipients. In short, development institutions did what private financial institutions could not do—they leveraged donor government development assistance as a risk buffer in new financial instruments that made development projects attractive to private investors. Interestingly, private investors remained on the sidelines for much of this process. While they were beneficiaries of a government risk-subsidized investment vehicle, private investors remained skittish. In the end, development institutions not only strongly supported marketized development financial instruments, but also spearheaded their creation.
In order to examine the evolution of marketized development financial instruments, I focus on the understudied experience of Germany’s KfW. Using archival research and over 70 interviews with development practitioners, I argue that KfW played a particularly important role beginning in the late 1980s in innovating new marketized development financial instruments. Three key institutional characteristics enabled KfW to become a pioneering development institution. First, KfW had the strong political and economic backing of the German government and was close to policymakers in developing new policies. Second, KfW’s institutional flexibility to create, manage, and hold equity stakes in new marketized development financial instruments meant that it could ensure incentives were maintained. Third, KfW had extensive experience with private financial markets through its own domestic promotional business, meaning that it was institutionally experienced in mixing public institutions with private initiatives. These three characteristics became particularly important for KfW during critical junctures of political urgency for the German government. Reunification, the fall of the USSR, and the Balkan crisis provided the necessary political impetus to allow KfW to leverage its unique institutional characteristics and ...