Development finance institutions (DFIs) have a rich history with assisting emerging market participants in funding much needed infrastructure projects. However, the nature of these DFIs is that of a policy driven multinational juggernaut, which could at times skew bargaining positions of emerging market borrowers.
For emerging market borrowers, the idea of policy driven requirements could sometimes be seen as a convenient safeguard to fall back on when negotiations became tense. DFIs would also provide standard form documents as a base on which to begin negotiations and would leverage their position on similar financings where these documents were used. From the DFIs perspective, some of these transactions could be considered high risk, whether in the form of regime changes, volatile industries, or concerns on repayment. There is also a reputational aspect to consider, especially with the additional magnification of ESG requirements.
The debt offered from DFIs is not cheap, on the contrary, commercial terms are usually onerous on borrowers. Most DFIs do not take hard collateral either as the back office burden of managing an asset is wrought with complications (that once again link to policy). Usually cash collateral is preferred, however the fundamental issue with that approach is that cash collateral could be used elsewhere.
Towards the late 2000s, a trend started to develop where sovereign money from developed economies started being pushed into emerging markets. By 2009, China became the largest trade partner in Africa and was (and still is) the largest bilateral lender for public sector loans across the continent. The debt offered presented a stark contrast the policy laden DFI debt that African borrowers were accustomed to, and allowed borrowers to accelerate growth plans for much needed infrastructure.
This new debt was to usher in a new age of economic prosperity for Africa. However, details of these financing arrangements were not made public in most instances, save for terms like below market interest rates and extended grace periods on debt. By looking at market indicators it became apparent that the true costs of this debt were ring fenced elsewhere into the structure.
Resource backed lending is not novel by any means and forms the foundation for pre-export financing transactions. However, the concept is not without controversy, as borrowing countries must commit future revenues to be earned from its natural resource exports to service the over-arching loan. On its own the model is commercially acceptable when there is a stable market for the underlying commodities, however where is a dip in the price of these commodities the results can be catastrophic. Unable to service loans, African states would either turn to the IMF for a bail-out or be forced to honour the terms of hard collateral terms.
Africa started to turn away from these debt arrangements, knowing that the IMF would no longer assist and that aggressive collateral terms and low-priced debt are a fatal concoction. Evidence of this change in dynamic includes the slowing down of the belt and road initiative, as well as a 30% drop in committed Chinese loans into Africa between 2018 and 2019. We are past the peak. There is a gap left, one which would represent a middle ground between policy laden expensive debt, and cheap collateral heavy debt.
The gap has attracted institutional investors, who are regarded as safe money financiers. As opposed to outright loans, these investors prefer a portfolio of capital market instruments which indirectly offer emerging market participants capital holidays while servicing coupons only. Investing in these markets has also been made easier through de-risking instruments offered by DFIs. Apart from de-risking, these safe money investors are attracted to emerging markets due to portfolio diversification, extended geographical footprint and ESG impact.
Portfolio diversification has become more prevalent in light of the unstable macro environment of the global landscape. Whether it be wars, inflation or political uncertainties, the need to have a portfolio of assets that can counterbalance each other is crucial for risk averse underlying investors.
Exposure to perceived high risk industries could also be more profitable going forward, as produce from industries like agriculture will retain value as the cost of living increases. These industries also offer institutional investors the ability to scale at levels of what they are comfortable with, with different tenors of debt which allows for a diverse cashing out policy that can promote liquidity at different intervals. This principle goes hand in hand with geographical diversification, as with uncertainty looming in the West (and the East), countries or regions which remain out of the political limelight may be safer options to have exposure to. This would also offer institutional investors a degree of neutrality given the current global climate.
Probably the most obvious synergy between institutional investors and emerging market projects is the steady supply of sustainably linked investments. We saw this with the influx of investments by US State pension investors in Kerala, with the trend extending to agriculture projects in Africa. De-risking takes some of the sting out of what could be perceived as putting capital at risk in order to bolster ESG credentials, but sheer variety and volume of pipeline transactions serves as a risk mitigator in itself.
There is a funding gap, but not for long. Institutional investors can take the middle ground between aggressive debt and cautious debt. What has accelerated this trend is the ESG agenda that has come to the forefront both in collective consciousness and in finance. The next decade will determine how successful this trend can be, but there is ample opportunity for both emerging market participants and safe money to create a mutually beneficial, and most importantly, scalable relationship. It would seem that each party would have a paramount role is shaping the policy of the other.
Marc Naidoo is a finance partner in international law firm, McGuireWoods’ London office. His practice focuses on emerging markets, with a particular emphasis on Africa and sustainable finance.
