By Labanya P Jena and Alexander H Rutter
The G20 meeting in September is the final chance for one of the most crucial items on the agenda—Multilateral Development Bank (MDB) reform. The International Finance Corporation (IFC), a member of the World Bank Group, plays a crucial role in promoting private sector investment in developing countries. However, a critical analysis of IFC’s capital deployment strategy reveals a risk-averse approach that may hinder its ability to drive capital for sustainable development.
The IFC’s substantial cash holdings raise questions about its effectiveness as a development finance institution. It is missing opportunities to provide much-needed capital for sustainable projects. Since IFC is not a deposit-taking institution, its cash reserves far exceed what is necessary for operational and financing purposes. By the end of 2022, IFC held $32.5 billion of capital available to absorb potential losses against a total asset base of $99 billion, while capital required to maintain an AAA credit rating is $20.1 billion, as per IFC’s statement. Reducing the cash buffer will release $12.4 billion of liquidity to deploy into high-impact projects.
Although IFC operates in developing countries, 1.6 times the conservative debt-to-equity is still not justified. Indian Non-Banking financial company’s debt-to-equity ratio is approximately 6 times. By exercising a more aggressive approach to debt financing, the IFC could effectively leverage its balance sheet and maximise its impact by channelling additional funds into sustainable development projects.
Over the past five years, IFC has typically mobilised about 80 cents of external capital for every dollar it invested, as it always protects itself from downside risk. Given the multi-trillion-dollar climate and development challenges and IFC’s limited assets of ~$100 bilion, this mobilisation rate needs to increase. Embracing more innovative instruments, such as first-loss guarantees and partial credit guarantees, can crowd in additional private capital. IFC can invest in the “first” 20% of projects, crowding in private capital for the remainder. IFC should target private capital mobilisation on the order of 5:1 rather than 0.8:1.
Currently, IFC does not take on technology or commercial risks and tends to invest in companies that already have an established credit history and can access private financing. It should assume these risks that private financiers are not yet comfortable which warrants credit underwriting practices be less conservative, thereby attracting a higher proportion of private capital in projects.
In 2022, IFC’s exposure to the financial market and fund was 48%. By relying on financial markets and funds to determine project selection, the IFC exposes itself to the risk of ESG-washing, where projects with limited environmental or social impact receive funding.
As a global institution, IFC invests and borrows in diverse currencies, with USD borrowings accounting for just 42% of borrowing. IFC’s largest exposure is 10.5% of its portfolio (India), and its top three investees (India, Brazil, and China) are all relatively stable countries with minimal currency risk. Private sector investors regularly take unhedged risks in these markets, building in currency exchange rate risk as part of their expected risk vs. return profile. In contrast, IFC hedges on every transaction and passes this cost onto borrowers, making capital more expensive and, therefore, less impactful than even commercial financial institutions. The conservative currency hedging policy locks clients into higher rates with IFC than is available in the market.
The IFC’s increasing average lending and investment size suggests a bias towards large projects as well. An analysis of 450 recent projects suggested an average investment size of $88 million. Just 8.5% of projects were for an investment of less than $10 million. This bias towards larger projects may limit the IFC’s ability to support smaller-scale initiatives that can have a profound effect on inclusive growth. It means that investments tend to go to large, well-banked firms that do not necessarily need IFC’s support. Diversifying investment sizes and embracing a more inclusive approach would allow the IFC to reach a broader range of projects and play a more catalytic role in investing in startups and companies promoting innovative solutions in emerging fields like battery storage, green hydrogen, EVs, etc.
The excessive compliance requirements for IFC investments, regardless of project size, is another challenge for small companies. The excessive compliance costs deter small projects and work in favour of large companies with extensive armies of accountants and lawyers.
While IFC is vital in stimulating private sector investment in developing countries, its capital deployment strategy exhibits a risk-averse approach that hampers its potential for driving sustainable development. As a development institution, IFC should be at the forefront of being more aggressive in taking risks that the private sector will not and crowding in further private sector investment. Instead, it has shown a more conservative approach than private investors, limiting its additionality and development impact.
Writers are respectively, head, Centre for Sustainable Finance, Climate Policy Initiative, and private sector specialist, International Solar Alliance..