Ad Hoc Commentary – financing the sustainable development goals

The sustainable development goals (SDGs) agreed by world leaders in Sep 2015 are ambitious. It comes with a hefty price tag, and experts caution that the funding shortfall could be as large as 3 trillion dollars a year. Daunting as it may sound, I wish to echo Bertrand Badre’s, World Bank Group CFO, optimism:

“…I think it’s ambitious, but it’s possible…” https://d396qusza40orc.cloudfront.net/fin4devmooc/pdf/week01_transcript/Week%201_video3.pdf

 

The focus of this short digital artifact is on the innovative financing that is required to make this happen. With a background in computer engineering and molecular biology, yours truly is not a finance expert. However, what gives me the audacity to comment is my broad background: from commercial bank to investment bank and then to development bank; across many functions: financial control, business planning and analysis, derivatives structuring, structured products trading, bank sales and strategist, valuation control, and risk management. The experience of seeing things from many different perspectives probably skews the probability in favor of coming up with ideas that might work.

 

In my humble opinion, the recipe to success is:

  1. Innovative financing
  2. Overcoming entrenched self-interests
  3. Technological solutions

We will be focusing on innovative financing here. But let us briefly touch on the other two points.

 

Overcoming entrenched Self-Interests

When thinking about complex problems like development, where there exists entrenched self-interests, it is useful to follow in the footsteps of [1] by transporting ourselves mentally beyond the self-interests of the various stakeholders. This has the advantage of separating financial matters from political ones. Of course, developmental concerns are inherently political and so divorcing the two completely makes no sense. However, we save ourselves much vexation if we focus on the simpler financial issues first. To paraphrase Laughlin: “To build a power plant, we need both enough votes and enough money, but if there isn’t any money, we’re simply not going to build the plant. Moreover there’s more benefit than usual in seeking clarity in this case because the very large stakes involved encourage people to misunderstand each other and, dare we say it, make a statement or two now and then that they know to be untrue.”

 

Technological Solutions

It is also worth reminding ourselves that development is sometimes confused with infrastructure today. This is understandable because traditional solutions to development had traditionally been bricks-and-mortar solutions that typically involves physical presence of a building. It will become clear if you read the transcript of Jay Collins’, Vice Chairman of Citi Corporate and Investment Bank, recent video lecture: “…[Citi is] part of the sustainable development investment fund which is somewhat a misnomer because it doesn’t have infrastructure in its name, but its highly geared toward infrastructure…” https://d396qusza40orc.cloudfront.net/fin4devmooc/pdf/week03_transcript/Week%203_video2.pdf

In the same transcript, he also made the jump from talking about development to talking about infrastructure as if it was a natural thing to do. To achieve the SDGs, we probably need to move away from a physical-infrastructure-view to a holistic-solution-view that involves smart technological solutions. Mobile banking is probably the simplest example. We need to optimize the composition of traditional bricks-and-mortar versus e-banking to maximize the trade-off between the benefit of financial inclusion and the cost of providing banking services. These optimization are best left to the respective development specialists and those of us in finance is better off focusing on what we do best, channeling money to where it is most required, thus the focus of this digital artifact.

 

Innovative Financing

When thinking of innovation, it is useful to recognize that society is defined by a bell curve. This is phenomenon is described in the book Diffusion of Innovations [2]. Far out ideas or bonds will always have a buyer because, the first 2.5%, the innovators, are addicted to innovations. They will queue up overnight to buy innovation, be it the latest iPhone, or any hypothetical future SDGs bond: no poverty bonds, zero hunger bonds, good health and well being bonds, quality education bonds, gender equality bonds, clean water and sanitation bonds, affordable and clean energy bonds, decent work and economic growth bonds, industry innovation and infrastructure bonds, reduced inequalities bonds, sustainable cities and communities bonds, responsible consumption and production bonds, climate action bonds, life below water bonds, life on land bonds, peace justice and strong institution bonds, and partnership for the goals bonds. You get the idea.

 

Enthusiasm for innovation also defines the next 13.5%, the early adopters who rely heavily on their gut and are quite willing to put up with new products or bonds. However, true success can only be achieved after you have penetrated both the innovators and the early adopters, that is 15% to 18% of the market.

 

Unfortunately, many ideas get stuck at second gear and infrastructure finance is one of those. To cross the chasm of early adopters into the realm of the early majority that usually defines success, we need innovative infrastructure finance that work with current financial market realities. We should think of ourselves as financial geologists, working with the current landscape to extract the most money into infrastructure. Too often we hear pundits complaining that regulatory overreaction is not friendly to infrastructure investment. However, the beauty of banking is that we boast a strong tradition of innovation. Let’s innovate around today’s realities.

 

There are three features of financial markets that are relevant to infrastructure today:

  1. Long term finance is probably dead due to regulations like Basel III and Solvency II
  2. Credit insurance is probably dead too after the demise of mono-line insurers
  3. Despite what the private sector claims, the public sector is still the elephant in the room, providing us with more than 80% of infrastructure finance.

 

It is quite simple to solve feature 1, someone would just need to convert the risk from long-term bond into a perpetual-rollover short-term bond. Banks had traditionally played this role of borrow short-term (from depositors) and lend long-term (to mortgagers and businesses) on their own balance sheets. If banks are unable to play this traditional role due to new regulations, then we probably need to set-up a marketplace (a supranational central counterparty) where we bring together financial actors that will supply and demand capital. This supranational central counterparty can borrow many ideas from derivatives central counterparties where they also managed to transform credit risk into funding liquidity risk, which is another way to say convert long-term lending risk (which is mostly credit risk) into short-term borrowing risk (which is mostly funding liquidity risk).

 

Feature 2 is basically telling us that we should move away from the old school credit support structure. Traditionally, an AAA counterparty comes in to put a guarantee into an infrastructure project that enables it to achieve financial feasibility. That is old school and not scalable. We will probably get more bang for our buck if the grant money is used to solidify the financial capacity of the supranational central counterparty that we talked about in the previous paragraph.

 

Lastly, feature 3 is trickier. Ideally, we need local capital markets with sufficient depth and sophistication to support domestic resource mobilization. However, this is not the case today and we are faced with the compounding problem that sovereign balance sheets are stretched globally. Perhaps a solution is to have the sovereign play both sides in the supranational central counterparty structure we described above. We probably can have local governments seeking capital in the supranational central counterparty structure, while central governments provide capital in the same marketplace. This would probably kick start the infrastructure asset class which hopefully can provide the depth and sophistication of a local capital market. The supranational led development of capital markets can probably be catalyzed by mandating standardization of documentation, rule of law, and all the good things that comes with standard processes. We can also introduce collateralization by physical assets, and move capital away from the uncollateralized borrowings that tend to lead to unfettered booms and busts.

 

Private sources of finance is a very compelling story, and brings with it all the supposed benefits of efficiency and productivity gains. However, in the next 15 years, if we are to reach the SDGs by 2030, then perhaps we should first create a central marketplace and use the new transparency to crowd-in the private sector into making the world a better place.

 

[1] Page 1, Powering the Future, Robert Laughlin, Nobel Laureate in Physics, 2011 http://samples.sainsburysebooks.co.uk/9780465027941_sample_269803.pdf

[2] Diffusion of Innovations, Everett Rogers, 5th Edition, 2003