Otaviano Canuto & Matheus Cavallari, World Bank: Bloated Central Bank Balance Sheets

[caption id="attachment_11618" align="alignright" width="300"] European Central Bank. Photo: Mannelore Foerster/Getty Images[/caption]

Central banks of large advanced and many emerging market economies have recently gone through a period of extraordinary expansion of their balance sheets and are all now possibly facing a transition to less abnormal times. However, the fact that one group is comprised by global reserve issuers and the other by bystanders receiving impacts of the former’s policies, carries substantively different implications. Furthermore, using Brazil and the US as examples, we also illustrate how the relationships between central bank and public sector balance sheets have acquired higher levels of complexity, risk, and opacity. Those challenges will remain as the unwinding of central bank portfolios is not likely to lead them back to where they were.

(I): Unconventional Monetary Policies

Since the global financial crisis hit the international economy in 2008, central banks in major advanced economies have widened their range of monetary policy instruments, increasingly resorting to unconventional tools. Initially to avoid a deepening of the financial destabilisation and bankruptcy of solvent-but-illiquid private sector balance sheets, and subsequently to fight economic stagnation and deflation risks as private agents deleveraged, the US Federal Reserve Bank (Fed), European Central Bank (ECB), Bank of England (BoE), and Bank of Japan (BoJ) have all – in different moments and intensities – implemented programmes of massive purchases of government securities and/or private assets from markets with a simultaneous creation of bank reserves on their liabilities side (quantitative easing – QE).

“The increasing global financial integration in the last decades has imposed increasing challenges to make liquidity management effective as cross-border volumes of capital flows expanded significantly.”

Central bank policies seemed to shift towards including financial stability as a goal, while uncertainty regarding counterparty risks remained elevated. To that aim, crisis-hit economies saw broad liquidity provision to domestic banking systems through QE, with the latter evolving later on to becoming a tool to boost the efficacy of interest-rate cuts.

Together with forward guidance, debt swap programmes, lines of long-term loans to banks and, more recently in the Eurozone, negative interest rate policies, such use of unconventional monetary policies led to an extraordinary expansion of their balance sheets (chart 1 – left side). First, central banks’ balance sheets expanded by supplying reserves to assure smooth settlement of financial transactions. Because of the elevated uncertainty on counterparties’ solvency, banks were hoarding those reserves instead of lending in interbank markets – also as a way to self-insure. This balance sheet expansion could be seen as liability-driven – i.e. originated from policies aiming at central banks’ liabilities. The second wave of expansion came from QE per se: policymakers bought assets to reduce long-term interest rates and shift portfolio compositions. Those asset purchases were financed by creating reserves, making this second expansion of central bank balance sheets an asset-driven one.

[caption id="attachment_11621" align="aligncenter" width="589"] Chart 1: Advanced Economies - Central Bank Balance Sheets. Source: Credit Suisse, The future of monetary policy, January 2017.[/caption]

The asset composition moved from government bills only to various types of bonds and equities (chart 1 – right side) – with differences among central banks mirroring underlying structural differences in shapes of local financial markets (weights of bank intermediation versus capital markets, shares of government bonds in private portfolios). In the case of the Eurozone, institutional weaknesses, the fragmentation of the banking system and risks of country exits imposed additional challenges to ECB policies.

The size and responsibilities acquired by central bank balance-sheet operations also reflected an over-reliance on monetary policy to support macroeconomic recovery. Either because of an option for fiscal austerity in the Eurozone as a whole or for early pursuits of fiscal consolidation (US, UK), opportunities to resort to fiscal policy as an additional engine were left behind.

There are intrinsic challenges to isolate and assess the impact of QE on macroeconomic outcomes. However, most analysts agree that, besides precluding deep downward spirals of debt deflation and bankruptcy, its transmission through lower debt service, positive wealth effects, and weaker currencies (euro, yen) contributed to an economic recovery, including by helping banking, household, and corporate deleverage in countries that adopted those unconventional policies. The size acquired by central bank balance sheets was to some extent a flipside of the over-size of domestic and international private portfolios built in the run-up to the global financial crisis, the unwinding of which would have been even more disorderly otherwise. The incompleteness of such unwinding – including debt restructuring and consolidation of portfolios – helps explain the relative feebleness of recovery and the extended time horizon of unconventional monetary policies in the Eurozone.

After almost a decade since unconventional monetary policies came to unfold, a casual observer might be asking when the policy agenda will shift to exit strategies and unwinding of central bank portfolios. Indeed, the main provider of global liquidity, the Fed, is already gradually hiking interest rates, as the US economy came close to full employment. In fact, two presidents of regional Federal Reserve Banks have already expressed their willingness to shrink the Fed’s balance sheet.

Other major central banks may start exiting only later down the road, as further private sector deleveraging – or public debt restructuring – is still needed. However, spill-overs from the first mover have already induced capital flows rebalancing. Lack of synchronisation in paces of economic recovery will place additional challenges for orderly balance sheet adjustments.

There are strong reasons to believe that there will be no return to the pre-QE configuration of balance sheets. Together with the pro-recovery motivation for central bank policies, structural and regulatory factors have contributed to their balance sheet dynamics, and made central banks not just market regulators, but also quasi-market makers.

First, the increasing global financial integration in the last decades has imposed increasing challenges to make liquidity management effective as cross-border volumes of capital flows expanded significantly.

Second, changes in financial regulation have induced private agents to alter their behaviour and strategies. Basel III requires banks to carry a minimum amount of high quality liquid assets, which could be met by simply holding reserves at central banks. These rules have discouraged banks from receiving short-term cash balances from institutional investors and made central banks the only remaining player able to provide liquidity services.

Finally, central banks may need to accept an increasing role as funding providers, as banks are not incentivised to use short-term balances for arbitrage trades. Thus, a new task came under the purview of central banks: monitoring relations between various benchmark curves – i.e. operating as quasi-market makers. One may expect that the new normal configuration of central bank balance sheets will not necessarily be as bloated as the one during recent abnormal times, but will not return to the pre-crisis size and profile.

(II): Spill-overs from Abroad

As financial markets started normalising globally in the wake of acute crisis moments, unconventional monetary policies generated a collateral effect by shifting abundant liquidity to other countries – small advanced economies and emerging market economies (EMEs) mostly casual bystanders at that point. Until the 2013, taper tantrum started to affect EMEs following the Fed’s first announcement of a forthcoming end of QE, liquidity excesses eventually turned into massive capital flows to those countries.

Capital inflows had already led to a piling up of foreign currency reserves in recipients – particularly when accompanied by high current account surpluses – prior to the global financial crisis. After a slowdown in the immediate aftermath of the crisis, those flows and the corresponding reserve accumulation returned with strength for some time, until slowing down again more recently (chart 2).

[caption id="attachment_11622" align="aligncenter" width="876"] Chart 2: Selected Economies - Gross International Reserves 2005 Q1 - 2016 Q1 (US$ billions). Source: IMF, External Sector Report 2016.[/caption]

The intensive wave of capital flows to EMEs in between the crisis eruption and the taper tantrum reflected unconventional monetary policies in large advanced economies, combined with enthusiasm about what then seemed to be a steady growth decoupling of the former. It is worth noticing the higher weight of short-term flows and bond purchases in the QE-influenced wave comparative to previous periods.

While capital inflows and reserve accumulation had already been leading to challenges faced by monetary policymakers in EMEs, these were exacerbated by the features of the QE-originated wave. Even an EME not manipulating exchange rates – i.e. pursuing strategies of curbing domestic demand and deliberate exchange rate undervaluation – would not be expected to take a hands-off approach to exchange rate pressures and allow the liquidity wave from abroad to be fully absorbed via local currency appreciation.

Therefore, accumulation of reserves with corresponding central bank balance sheet accommodation became the norm. Holding up against local currency appreciation while sterilizing monetary impacts of reserve accumulation meant expanding balance sheets of recipient EMEs – an asset-driven increase of the central bank balance sheet. That was a major factor behind several EMEs’ central bank assets reaching proportions of GDP comparable to those of economies adopting unconventional monetary policies (chart 3).

Differences in Monetary Policy Frameworks

From the standpoint of the component of reserve balances in central bank balance sheets, unconventional policies in advanced economies shifted their banking systems from a structural deficit of reserve balances to a structural surplus. EMEs in turn, by then already with a long history of surplus reserve balances – usually caused by exchange rate interventions, government financing and, sometimes, provision of assistance to unhealthy banks – had asset-driven surpluses intensified by QE.

There are three basic means to sterilize monetary impacts of asset purchases – foreign assets and government or private securities – when the central banks intends to outweigh their initial effect as additions to commercial bank reserves on the liabilities side: (i) retaining them as additional required or voluntary free reserves, fine-tuning the corresponding remuneration in the latter case; (ii) issuing central bank own securities; and (iii) using government securities held in their portfolio to make reverse repo operations with the private sector.

[caption id="attachment_11623" align="aligncenter" width="564"] Chart 3: Central Bank Total Assets to GDP Ratio. Source: International Financial Statistics, IMF.[/caption]

Central banks vary widely in the use of those tools. Ferreira (2016) compares the cases of Brazil (BCB), Fed, ECB, Mexico (Banxico), and Korea (BoK) and remarks that:

The sterilisation of central bank purchases of private assets, government bonds, and foreign assets was mainly done with retention of remunerated voluntary reserves (mainly Fed and ECB) and issuance of central bank own bonds (notably BoK). Fed and BCB are not legally authorized to issue own bonds (chart 4a).

Brazil is the only case where reverse repos based on government bonds was the predominant tool. Relatedly, government bonds held on the asset side by the central bank had to augment considerably in order to make feasible the ramp up of foreign asset accumulation and its sterilisation. That explains the tall sizes of both foreign assets and government bonds in BCB’s assets as a feature unique to Brazil in this group (chart 4b). It also is part of the explanation of why the bloating of BCB’s balance sheet took it to a size equivalent to almost 50% of Brazil’s GDP, substantially taller than all other central banks in the group (see also chart 3).

It’s Complicated!

There are multiple channels through which monetary policy and central bank balance sheets interact with government fiscal accounts and balance sheet. Bloated central bank balance sheets have magnified the weight and the complexity of that web of relations, one in which country-specific institutional features matter. Let’s offer some examples.

Take for instance the unique Brazilian over-reliance on reverse repos for monetary sterilisation approached in the previous item. As observed, BCB relies mainly on reverse repos to drain liquidity surpluses, being current reserve requirements considered already high. So, the monetary authority sells – with repurchase agreement – government bonds from its balance sheet, and the treasury supplies those bonds if needed to avoid losing control of the policy rate.

That tool has an accounting implication beyond the monetary policy realm. It implies that Brazil’s general government gross debt as measured by the International Monetary Fund (IMF) and most other analysts is higher than what would be the case if there was no single reliance on reverse repos and therefore less need to hold so huge volumes of government securities in BCB’s balance sheet.

[caption id="attachment_11624" align="aligncenter" width="584"] Chart 4a: Selected Countries - Central Bank Liabilities 2015 (% of GDP).
Source: Ferreira, C. L. K. (2016), “A dinâmica da dívida bruta e a relação Tesouro-Banco Central”, in Bacha, E. (ed.), O Fisco e a Moeda: Ensaios sobre o Tesouro Nacional e o Banco Central – Em Homenagem a Fabio Barbosa, Civilizaçao Brasileira.[/caption]

The standard method to account for gross public debt is to consider all public debt in the central bank balance sheet, including even the extra buffer held to minimise the risk of losing the capacity to set the monetary policy rate. It is fair to say that this part of the gross public debt corresponding to assets held by BCB and not by markets should not be treated as a result or a component of Brazil’s fiscal and public debt dynamics. Cross-country comparisons of public debt should take that into account.

Ilan Goldfajn, BCB’s president, has recently declared that remunerated voluntary deposits will be added to the monetary policy toolkit in the near future, offering a remuneration equivalent to reverse repos. The stock of the latter has reached levels above 16% of GDP of last year and over time shall be partially replaced with remunerated voluntary reserves, with relevant fiscal accounting implications. By following the Fed’s practice of paying interest on banking reserves, the central bank’s portfolio of government bonds could be reduced. Consequently, the gross public debt, as compiled, for example, by the IMF, would be lower.

[caption id="attachment_11625" align="aligncenter" width="575"] Chart 4b: Selected Countries - Central Bank Assets 2015 (% of GDP).
Source: Ferreira, C. L. K. (2016), “A dinâmica da dívida bruta e a relação Tesouro-Banco Central”, in Bacha, E. (ed.), O Fisco e a Moeda: Ensaios sobre o Tesouro Nacional e o Banco Central – Em Homenagem a Fabio Barbosa, Civilizaçao Brasileira.[/caption]

Another connecting channel between fiscal and monetary policy realms is made by occasional profits and losses incurred by central banks in their operations. That is a channel that has now, obviously, become much more significant than in the past.

An example comes from Fed’s Operation Twist in 2011 and 2012, a debt swap programme in which the Fed bought long-term Treasury bonds in the market and sold short-term Treasury bonds to flat long-term interest rates. The transaction amounted to hundreds of billion dollars. The Fed holds these long-term bonds in its assets, where an increase of 100 basis points in interest rates of the 30-year Treasury bond would impose up to a 20% loss on their value. In January 2017, the Fed’s balance sheet had up to 55% of government securities and close to 40% of asset backed securities (ABS).

Despite implicit potential losses in the Fed’s balance sheet, Operation Twist is directly accounted as part of US gross public debt. Moreover, the Fed has profited from the difference between negative short-term real interest rates and the positive yield-to-maturity on the long-term bonds. By buying ABS and drying up the surplus of reserves, the Fed also pays interest on these reserves. This carry trade has been profitable for the Fed. Profits amounted to up to $97.7 billion in 2015, being transferred to the US Treasury in 2016 (chart 5 – left side). However, this picture can revert dramatically as short-term interest rates rise and the yield curve steepens.

The Fed’s capacity to pay interest on reserves and resort to the latter as a sterilisation tool – seen in the previous item – is not an old practice. It was introduced to avoid losing control of monetary policy from the QE collateral effects. Hypothetically, a situation could arise that might make the Fed run out of Treasury bonds to sell in the market. However, paying interest on reserves affects central bank’s profit – there is a budgetary impact – and does not require government bonds as a collateral. Therefore, the gross public debt would be higher than in the case the monetary authority had kept using reverse repos to drain liquidity excesses, such as in Brazil, creating distortions in cross-country comparisons.

[caption id="attachment_11626" align="aligncenter" width="570"] Chart 5: U.S. and Brazilian Central Bank Remittances to the Treasury.
Source: Federal Reserve (2015 remittances include $19.3 billion transferred as capital surplus) and Central Bank of Brazil.[/caption]

Another example of this complexity – and risks and opacity – acquired by fiscal-monetary links in the era of bloated central bank balance sheets associated to central bank operational income comes from Brazil (chart 5 – right side). Given the magnitude of foreign assets held by BCB, like some other EMEs, exchange rate oscillations often lead to significant central bank non-realized gains and losses in local currency.

In Brazil, central bank’s income is legally mandated to be transferred every six months to the Treasury Single Account on the liabilities side of the BCB’s balance sheet. Chart 4a exhibits how high the balance in that account has grown. According to Mendes (2016) and Ferreira (2016), to a large extent this stems from the treatment of gains and losses from non-realised results from exchange rate variations – which are accounted apart from other balance sheet items. While gains have been deposited in the Treasury Single Account, losses have been compensated with government transfers of new public bonds to the BCB’s balance sheet. Over time, this has raised balances on both the Treasury Single Account (liabilities) and Treasuries (assets).

By the same token, there are challenges associated with the accounting of results from foreign currency swaps, which were intensively adopted by BCB during and after the 2013 taper tantrum in order to smooth local currency depreciation pressures. By design, swap results are in opposite direction to the ones from actual foreign reserves: e.g., actual exchange rate depreciations imply local currency gains with the BCB stock of foreign assets, while there is a simultaneous payment of premium on (smaller) notional values of swaps. Nonetheless, while the latter are non-realised, the former is accounted in the fiscal balance.

Final Remarks

Nobel Prize laureate Sir John R Hicks argued that monetary systems and institutions are particular to each epoch in history. In that context, he wrote in his Monetary Theory and History (1967):

“Monetary theory is less abstract than most economic theory; it cannot avoid a relation to reality, which in other economic theory is sometimes missing. It belongs to monetary history, in a way that economic theory does not always belong to economic history.”

Such variability and evolutionary nature of monetary systems and institutions over time also has a flipside when it comes to space. Analyses and policy choices on monetary and financial systems cannot rely simply on abstract and universal principles, and is obliged to take into account historic-specific contexts.

That historical specificity of money and finance was shown here in our approach to the two recent distinctive-but-combined types of experiences of bloating balance sheets lived by central banks. Furthermore, we saw how variegated and country-specific the array of monetary policy tools and institutions is. On the other hand, as this recent evolution does not seem likely to be unwound and reverted, all share in common the challenge of facing new risks and complexity coming with the new normal of central bank balance sheets.

[caption id="attachment_11628" align="aligncenter" width="288"] Authors: Otaviano Canuto and Matheus Cavallari[/caption]

About the Authors

Otaviano Canuto is an executive director at the World Bank and Matheus Cavallari is a senior adviser to the executive director.

All opinions expressed here are their own and do not represent those of the World Bank or of those governments Mr Canuto represents on its board. References in this article available upon request.


President Trump: Math Is Hard

[caption id="attachment_11632" align="alignright" width="300"] President Donald Trump[/caption]

Since 1990, when his landmark Taj Mahal casino and hotel defaulted on interest payments to its bondholders, businesses owned by Donald Trump have filed no less than six times for bankruptcy. In fact, asking the courts for protection against duped creditors whilst shaving off shareholder equity seems a Trump hallmark.

With the release of the 2018 federal budget – the first compiled by the new administration – it has become clear why the president’s business undertakings fail to meet investors’ expectations – double counting.

Worryingly named A New Foundation for American Greatness, the 2018 budget contains a number of contradictions and plain accounting errors, the most glaring of which results in $2 trillion being spent twice. The amount corresponds to the extra tax revenue expected to flow into federal coffers over the coming decade due to robust economic growth. In the budget, the windfall is clearly earmarked to cut the deficit.

A few pages along, the Trump Administration touts its tax reform which, it assures, will be “deficit neutral”. In other words, any future tax cuts will not negatively impact the revenue received by the US government. Such a “deficit neutral” set of tax cuts can be enacted in two ways: broadening the tax base – increasing the number of people who pay taxes and/or closing fiscal loopholes – or counting on economic growth – spurred by tax cuts – to compensate for the loss in revenue by enlarging the tax base.

Here’s the problem: even assuming that accelerated economic growth will produce an extra $2 trillion in federal revenue, that money cannot be spent twice: it either compensates the loss of income resulting from the tax cuts, or is used towards reducing the deficit. President Trump, however, says that he can do both at the same time. It explains why the man is without equal.

That is not the only trick up Mr Trump’s sleeve. On page 13 of the budget, he proposes to eliminate the death tax paid by heirs on estates greater than $5.5 million. Yet, six pages later, table S-3 breaks down the federal government’s tax receipts by category – one of these being estate tax. The table shows that over the next ten years Uncle Sam expects to rake in up to $328 billion creaming off estates. In fact, the takings are set to double over that period from $21bn in 2018 to $43bn in 2027. Notwithstanding written assurances to the contrary, President Trump has no intention of doing away with the death tax.

Former Treasury Secretary Larry Summers called the Trump Administration’s blatant double counting the “most egregious error in a presidential budget in living memory”. However, Budget Director Mick Mulvaney, a Tea Party luminary and founder of the House Freedom Caucus that aims to dismantle Obamacare, says his fake math is part of a cunning plan to boost GDP growth while shrinking the deficit: “We can assume three scenarios after the tax reform is implemented: it could reduce the deficit, it could add to the deficit, or turn out to be deficit neutral. Given the fact that we’re this early in the process about dealing with tax reform, we thought that assuming that middle road was the best way to do it.”

In other words: the Trump Administration is clueless when it comes to budgeting. Luckily, even Republican senators declared the budget, first unveiled on Wednesday, dead on arrival while House Republicans were barely able to contain their shock – feigned or otherwise – at the draconian proposals which include a 50% spending cut for Medicaid, and a 30% reduction of the Environmental Protection Agency’s budget. The State Department is set to lose 29% of its budget whilst the National Endowment for the Arts would cease to exist altogether. The budget does, however, earmark $1.6bn for President Trump’s border wall and seeks to up defence spending by $52bn.


CFI.co Meets BSC Management Team: Expertise at the Helm

The sustainable development and constant growth of BIDV Securities JSC (BSC) for the last seventeen years are result of the continuous effort and dedication of its entire staff.

[gallery columns="5" link="none" ids="12596,12597,12598,12594,12595"]

Current Chairman of the Board Doan Anh Sang boasts well over thirty years’ of experience in the financial services world. Mr Sang is also deputy general director of Bank for Investment and Development of Vietnam (BIDV).

BSC’s Chief Executive Officer, Do Huy Hoai is responsible for day-to-day operations. Mr Hoai has worked for 28 years in the banking sector with an emphasis on stock market operations and transactions. BSC’s success and achievements is in part credited to his management expertise. As such, BSC has been a noticeable presence in Vietnam’s securities industry since the establishment of the country’s twin stock exchanges.

Director of Investment Banking Pham Xuan Anh brings fifteen years of experience to the company and is responsible for this strategic division of BSC. His clients include industry-leading companies in both the private and public sectors such as Eurowindow Holdings, Vietnam Airlines, Bank for Investment and Development of Vietnam (BIDV), Corporation of Vietnam Airports, and petrochemical Binh Son Refinery.

Tran Thang Long, Director of Research at BSC, has specialised in deep market research for over a decade. His team provides strong back-up to BSC clients, investors, and other departments. He is a reliable source of information and regularly publishes updated market-coverage reports. By providing potential investors with thoughtful corporate insights, the Research Department directly contributes to the success of IPOs of major companies.

Last but not least, Tran Ngoc Diep, chief accountant of BSC, is in charge of cohesive planning, administrative organisation, and risk management. With executive management experience spanning ten 10 years, Mrs Diep has contributed tremendously to the smooth and seamless running of BSC’s internal management system. She enjoys the full trust from the board of directors and departmental heads.

Determined to become a full-fledged investment bank in Vietnam, BSC management promotes skills development and innovation amongst the firm’s employees. In order to achieve the objective in near the future, BSC has set up several programmes and initiatives that serve three core principles:

The development of the customer network. In essence, it is crucial to concentrate on both the governmental business sector and industry-leading private businesses. This undoubtedly creates a vast network of customers which enables the cross-selling of products and services and promote synergies.

Additionally, BSC aims to develop its HRM team in order to further increase efficiencies within the organisation. Every employee is given opportunities to gain experience and develop skill sets. The focus is not merely on investing in human resources, but also on the ability to perform in a professional working environment. BSC has managed to attract and retain highly qualified professionals who are committed to look after the long-term interests of the company.

BSC has successfully managed to nurture and cultivate its corporate image and identity. In recognition of its achievements the company has received a number of prestigious awards from both stock exchanges (HNX and HSX), the Ministry of Finance, and international entities for its contribution to the development of the Vietnamese securities market.

Finally, BSC actively fulfils its corporate social responsibility via a number of programmes that aim to alleviate poverty and promote education. BSC is also actively engaged with efforts to reduce and eliminate illiteracy. CSR initiatives are undertaken in all parts of the country.


Evan Harvey, Nasdaq: ESG Reporting - Six Reasons Why

[caption id="attachment_11682" align="alignright" width="300"] NASDAQ[/caption]

The corporate reporting of sustainability data – call it ESG, or environmental, social, and governance data – has come a long way. Only 20% of Fortune 500 companies reported ESG data in 2011. By 2016, according to the Governance and Accountability Institute, only 20% failed to report. More than 10,500 organizations have created almost 40,000 separate sustainability reports, according to the Global Reporting Initiative. The Bloomberg terminal now includes more than 700 different ESG disclosures from nearly 12,000 companies.

This information flood has produced interesting market insights, but it is also becoming clear that the value of ESG reporting does not reside entirely in the output of data. The very process of gathering this data and integrating it into management practices can create operational and economic benefits beyond those determined by investor valuation. ESG-related efficiency and performance improvements can impact intangible brand value, enterprise risk management, and product and service innovation.

Stock Exchanges Step Up

The significant increase in ESG data reporting has been driven by a number of cultural dynamics, including the climate crisis, economic instability, institutional scrutiny, and the rise of “big data” analytics. But discrete initiatives have also been influential. The UN Sustainable Stock Exchanges initiative, launched in 2009, has successfully encouraged 33 exchanges to publish ESG reporting guidance to their listed companies. The Sustainability Working Group at the World Federation of Exchanges spent two years (2013-2015) researching the intersection between market forces and ESG performance, ultimately advocating for 33 separate and distinct data disclosures.

“The UN Sustainable Stock Exchanges initiative, launched in 2009, has successfully encouraged 33 exchanges to publish ESG reporting guidance to their listed companies.”

Other projects – the FSB Task Force on Climate-Related Financial Disclosures, the SEC Regulation S-K Concept Release (US), and the Non-Financial Reporting Directive (EU), amongst others – have also fostered awareness. But in each of these cases, the data products themselves are not the only tangible sign of progress. Indeed, each initiative has taken great pains to elucidate the business case behind ESG reporting, the internal value drivers that companies may realise just by undertaking this work.

While ESG factors are often seen as non-financial performance indicators, the ways in which a company tracks, measures, and manages them undoubtedly has financial consequences. The very term “non-financial” is a misleading one, because ESG information is relevant and measurable. If investors are attracted to a company, and own the stock longer, due to ESG performance signals, that has a real financial impact. But the subtle values that sustainability can provide, as we detail below, may also be just as measurable.

Looking Beyond the Balance Sheet

Academics and investors have been able to find correlation between companies with good ESG practices and other positives, such as lower cost of capital, lower stock price volatility, and better valuation over the long term. Deutsche Asset & Wealth Management, for example, recently published a study (ESG & Corporate Financial Performance: Mapping the Global Landscape) that reinforced this supposition. We would also draw your attention to a recent paper published by UNEPFI titled Fiduciary Duty in the 21st Century. As those and other sources assert, the broad impact of ESG creates real impacts upon a host of business drivers, including:

Access to capital

Cost savings and productivity

Risk management

Revenue growth and market access

Brand value and reputation

License to operate

Human capital management

Employee retention and recruitment

Mergers and acquisitions

New product and service innovation

But this list does not address other impacts, tactical concerns that exchanges believe are of increasing importance to our issuers. Exchanges often serve as ESG touchpoints, training partners, and investment facilitators for public companies. As part of that engagement, and faced with the variant opinions of thousands of well-run companies, exchanges are compelled to create a business case of their own: Why are exchanges doing this work? How can we work together to create value? These six distinct value drivers, all tied to best practices in ESG, have proven most persuasive.

[caption id="attachment_11638" align="aligncenter" width="886"] Source: Bloomberg[/caption]

1. Overcoming Framework & Questionnaire Fatigue
There are dozens of reputable reporting agencies and ratings firms covering “sustainability” in the broadest sense; companies are besieged with requests for ESG information, especially in the supply chain and RFP process. ESG reporting advice from the exchange often helps companies separate the meaningful from the esoteric and efficiently prioritise information requests.

2. Gaining Competitive Advantage
Companies with the expertise and resources to gather and report ESG data, as well as handle a diverse multitude of stakeholder interests, are disproportionately winning contracts, customers, and media praise. Exchanges can make this case successfully – and often do.

3. Broadening Investor Outreach
According to the Forum for Sustainable and Responsible Investment (US SIF), “more than one out of every five dollars under professional management in the United States – $8.72 trillion or more – was invested according to SRI (Sustainable, Responsible, Impact investing) strategies.” A significant knowledge gap still exists between investors and IR on the topic of ESG disclosure, and exchanges work diligently with companies to turn sustainability into a positive outbound narrative for corporates.

4. Redefining Internal Value Metrics
Successful integration and analysis of ESG data (and related exercises, such as materiality analyses) can lead to direct energy cost savings, elimination of organisational redundancies, innovative new products and services, and even improved staff morale – all of which have tangible economic impacts.

5. Boosting Recruitment & Retention
Good ESG policies (though often expressed, with purposeful nuance, as corporate social responsibility or corporate citizenship plans) are no longer optional. Companies with a neutral or negative perception on this topic have trouble finding and keeping talent and tend to pay more for it.

6. True Enterprise Risk Management
Companies (and especially boards) wishing to have a full understanding of their long-term risk profile cannot ignore ESG factors. The resources required to manufacture a product, for example, must be in place (and similarly priced) for many years into the future. The risks that may arise due to social inequities, or labour dynamics, must be adequately forecast. Public company board members are taking a more holistic view of the organisation than ever before, thinking (in some cases) beyond the fiduciary boundaries of shareholder return.

Based on these dynamics, feedback from investors and issuers, and the growing awareness of global regulators, it’s clear to exchanges that a smart and strategic process of monitoring, managing, and reporting of ESG data is preferential. This is the way we can help to create better companies – and better markets – for years to come.

About the Author

Evan Harvey is the Director of Corporate Responsibility for Nasdaq. He also serves on the Board of Directors for the UNGC US Network and chairs the Sustainability Working Group at the World Federation of Exchanges.


UK: Casino Politics

[caption id="attachment_11654" align="alignright" width="300"] Theresa May & Jeremy Corbin[/caption]

In a triumph of cautious optimism over alarmist gloom, UK voters delivered Prime Minister Theresa May a comeuppance of sorts, depriving her of an outright majority in parliament and refusing to buy into Tory visions of strong and stable leadership – and post-Brexit sunny uplands.

Equally surprising, Labour leader Jeremy Corbyn held his own, managing to coast his party to an additional 29 seats, and proving his critics wrong: progressive politics is alive and well in Britain. Dismissed as an out-of-touch Marxist, Mr Corbyn during the campaign did not once lose his nerve or cool and stayed doggedly on topic, rejecting the Conservative austerity model that, despite interminable expenditure cuts, failed to close the budget deficit or pay down the national debt.

Prime Minister May, who on the eve of the election proposed scrapping human rights legislation in order to better fight terrorism, a day later trumped herself by refusing to admit defeat, defiantly declaring that she had no intention of resigning and would finish “the job” even without the clear mandate she has now been denied. However, in the upper echelons of the Conservative Party the PM’s tenacity in clinging to her “strong and stable” mantra is increasingly seen as an attitude detached from reality.

Though the vote resulted in a hung parliament, PM May turned yet again and insisted that she will provide “a period of stability” given that her party received most votes. Not a week ago, the prime minister, whilst on the stump in Scotland, had warned that a loss of just six seats would see her ejected from office, imploring the British people to hand her a firm mandate to face off the European Union during the upcoming Brexit negotiations.

"A smart and experienced political operator, Mr Corbyn actually prefers the Conservatives to founder under their own power – or lack thereof."

As it happened, voters took twelve constituencies away from the Conservatives and increased the Labour seat count significantly. Meanwhile, the UK Independence Party was completely wiped off the electoral map, the Scottish National Party lost 21 seats, while the Liberal Democrats managed to gain four. The Greens succeeded to preserving their lone seat in the House of Commons. The Democratic Unionist Party of Northern Ireland returns ten members of parliament, up two, and may now provide the Conservatives with a razor thin majority in parliament – the precise coalition of chaos Mrs May had feared on the left.

Labour leader Jeremy Corbyn, all smiles, on Friday signalled that he will not try to form a coalition in order to wrestle power from the Tories. However, he would be willing to form a minority government. A smart and experienced political operator, Mr Corbyn actually prefers the Conservatives to founder under their own power – or lack thereof. Should she indeed manage to stay at No 10, one never quite knows what Theresa May is really up to, the UK may be in for a prolonged period of uncertainty with a nearly lame duck prime minister whose dismal performance at the polls has severely undermined her authority both inside and outside the country.

In Brussels, the UK prime minister’s electoral debacle causes concern. The European Commission and its chief negotiator Michel Barnier made no secret of their desire for a strong UK government enjoying wide support, fearing that a weak and wobbly one would prove unable to make commitments, take decisions, and keep its critics at bay. With talks scheduled to start on or about June 20, almost a full year after the Brexit vote, EU leaders expressed hope they would be spared any further delays.

“As far as we are concerned, negotiations can start tomorrow morning at half past nine,” said commission president Jean-Claude Juncker. However, Mr Barnier stated that talks can only begin when the UK is ready whilst EU Commissioner Günther Oettinger (Budget and Human Resources) doubted that the UK can get its “act together” in time: “We need a UK government that can act. With a weak negotiating partner, there’s the danger that the negotiations will turn out badly for both sides. I expect more uncertainty now.” Former Belgian prime minister Guy Verhofstadt, the European Parliament’s Brexit negotiator, described the election outcome as “yet another own goal” for the UK.

Calls for Mrs May immediate resignation went unheeded as the prime minister visited Buckingham Palace to ask the queen for permission to form a government. Cast in the role of kingmakers, the  Democratic Unionist Party leadership conferred through the night with the Conservatives to hammer out the details of a coalition, either tacit or formal, seeking to extract assurances on a post-Brexit soft border between Northern Ireland and the republic. The DUP also demands a maintenance of the status quo with the six counties refusing to be downgraded to a netherworld halfway inside both the UK and the EU – but not a full member of either one. This position, though far from unreasonable, adds yet another layer of complexity to the upcoming negotiations in Brussels. Finally and on a more personal note, the DUP asked for its former first minister Peter Robinson to be admitted to the House of Lords in return for making the parliamentary arithmetic work in the House of Commons.

Thus, the severely weakened prime minister will hobble along. After meeting with the queen, she offered astonishing assurances that her government will provide “certainty” and bring the country together “securing a Brexit deal that works for everyone.”

Senior Tory leaders, already sharpening their knives, exercised supreme restraint – and hid from cameras and microphones whilst at it – and only responded in muted anger, considering that forcing the prime minister’s resignation now will leave Downing Street open to a much emboldened Jeremy Corbyn.

Perhaps safe for now, the embattled prime minister is by no means out of the woods: former chancellor George Osborne, sacked last year in a cabinet reshuffle and now editor of the Evening Standard and itching for payback, came out swinging, raising doubts on the survivability of the Theresa May as leader of the Conservative Party.

Hurriedly meeting and working the phones, Tory MPs apparently agree that Theresa May is now damaged goods and needs to go. The only questions remaining concern the timetable for her exit and whether a full-blown leadership contest must be called for, potentially exposing deep fractures within the party.

The anger is focused on the string of political miscalculations that led to the Tory’s poor performance at the polls. Commenting on the surprise turn of events, pundits likened the Conservative Party to a casino with first David Cameron losing his Brexit bet and now Theresa May bungling her attempt at consolidating power – gambling away a slim but nonetheless workable parliamentary majority.

Fooled by her own sense of destiny into believing that she was up against a looney Marxist, almost universally vilified by the press, Theresa May expected to secure a towering majority in parliament – far in excess of a hundred seats – and seemed eager to don the mantle left by Margaret Thatcher, just as – by the way – her sidekick Boris Johnson, the court jester, imagines himself the second coming of Winston Churchill.

The red line through it all is the disconcerting tendency of some Tories to succumb to delusion whilst serving their own agendas, placing party politics far ahead of the nation’s best interests – a most unedifying attitude.


IFC: Energy Storage Can Open Doors to Clean Energy Solutions in Emerging Markets

For more than a hundred years, electrical grids have been built with the assumption that electricity has to be generated, transmitted, distributed, and used in real time because energy storage was not economically feasible . This is now beginning to change. Battery storage at grid scale is on the verge of commercial viability. This is good news, not only because of the over one billion people worldwide who continue to live without access to electricity, but also because of the enormous contribution energy storage can make to greater supply and use of clean energy.

As clean energy generation becomes more mainstream around the world, its variability and supply fluctuation begin to impact the electricity systems for which energy storage is a key factor. Storage can help even out spikes and dips in solar and wind resource availability and enable energy distribution to be shifted from the time of generation to the time of peak demand. There is no well-defined threshold level of renewable energy supply needed to ensure nonstop supply but in most cases grid systems operators begin to invest in storage when 10% of their overall supply comes through renewable sources of wind and solar.

Over more than a decade, energy storage system vendors and battery manufacturers have been perfecting large-scale battery technology by extending its life cycle, toughening it to harsh environments, evolving management systems and, most importantly, continually driving down the cost. The industry has now reached a pivotal moment, with large storage systems becoming more competitive with other grid assets from a business perspective.

[caption id="attachment_11658" align="aligncenter" width="800"] AES Laurel Mountain[/caption]

The technology has been proven in the markets of North America and Europe with several vendors offering competing technologies and solutions. What’s more, the capacity for installation and operation already exists. Back-of-the-envelope calculations show more and more cases of clean energy becoming viable in an ever increasing number of markets. We can see that stationary storage has clearly begun its evolution from a niche solution to a mainstream grid asset. Nonetheless, as with solar, there is a time lag between achieving viability and mainstreaming storage with commercial partners.

According to a recent study commissioned by IFC, the World Bank’s ESMAP and the US Department of Energy, energy storage deployment in emerging markets is expected to grow 40% a year over the next decade, up from 2GW currently installed in emerging markets, resulting in about 80GW of new storage capacity. This will open up new markets and offer tremendous opportunities.

IFC expects the energy storage sector will grow significantly in coming years, leading to economies of scale. It has been tracking the storage market over several years and continues to support energy storage deployment in emerging markets.

To date, we have engaged by means of early-stage venture capital investments, helping to prepare the market for mainstream investments. Some of our noteworthy investments included Microvast, a China-based manufacturer of especially fast-charging lithium-ion batteries; Fluidic Energy, a manufacturer of zinc-air batteries used to power telecom towers; and AST, from India, which deploys photovoltaic (PV) solar plus batteries to power telecom towers.

While we have observed a remarkable transformation of the market in the last couple of years, with energy storage growing to become part of the mainstream power sector in emerging markets, challenges remain for taking this to scale. Financing appears to be the most pressing of these challenges. Although energy storage costs are expected to continue decreasing in the years to come, their current levels remain relatively high, enough to restrict access to affordable financing across emerging markets. Innovative investment mechanisms, in coordination with improved industry standards and stronger government support, will be needed to unlock the transformative potential of energy storage.

The IFC has ambitious goals for creating and opening up markets for clean energy. Supporting energy storage technology is a strategic focus as a means of extending the reach and uses of renewable energy beyond intermittent power. Energy storage will be a key third component in IFC’s clean energy asset mix, in addition to generation and efficiency. The World Bank Group’s Scaling Solar Programme, which has made it easier and faster to procure solar PV in emerging markets, may be extended to energy storage once costs fall further. Storage technology is well-suited for a similar standardised procurement approach.

Our commitment to stepping up as an advisor, investor, and partner in this important sector has never been stronger.

Initially published in the World Bank’s Development in a Changing Climate Blog.

About the Authors

[caption id="attachment_11659" align="alignleft" width="150"] Author: Alzbeta Klein[/caption]

Alzbeta Klein is the Director and Global Head of IFC’s Climate Business, Alzbeta’s role is to provide thought leadership, fundraising and facilitating all work related to renewables, climate-smart agri, green bonds and other climate business areas. Prior to her current appointment, she was a director and global co-head of Agribusiness, Manufacturing and Services Investments group where she managed over $13 billion of assets in emerging markets, leading a group of 400 bankers in 60 IFC offices worldwide. During the past 20 years, Alzbeta worked in many areas of IFC and rose through the ranks, including serving for two years as the Chief of Staff to IFC’s former CEO Mr. Lars Thunell.

Among the highlights of her career in IFC, Alzbeta headed IFC’s business growth in Eastern Europe in the early 2000s, led work in several industry sectors across IFC and originated the so called Food Fund which created the base of blended finance and impact investment for IFC.

Alzbeta joined IFC from the Export Development Corporation (EDC Canada) and the Canadian Imperial Bank of Commerce (CIBC). She received Master’s degree in Economics from the University of Ottawa, Canada, where she also studied for her doctorate; engineering degree from Prague University, Czech Republic; and executive education from Harvard Business School and INSEAD. She holds a Chartered Financial Analyst (CFA) designation. She has served on several corporate and non-profit boards, including Hans Merensky (South Africa), ShoreCap Investment Fund (US) and as the founding board member of the Chartered Financial Analyst (CFA) Society in Russia.

Alzbeta currently resides in Washington, DC with her family. She speaks five languages and is an accomplished four times marathoner.

[caption id="attachment_11660" align="alignleft" width="150"] Author: Bernie Sheahan[/caption]

Bernard Sheahan is Director of Global Infrastructure and Natural Resources at IFC, the largest global development institution focused exclusively on the private sector. He is responsible for IFC’s investments in power, transport, utilities, and extractive industries.  He joined IFC in 1986, and has previously served as Director of IFC’s Infrastructure Advisory Department and IFC’s Director of Strategy.

He holds a Bachelor’s Degree from Dartmouth College and an MBA from Harvard University.


Angela Merkel: Leader of the Free World

[caption id="attachment_11680" align="alignright" width="300"] Angela Merkel[/caption]

Playing nice gets results. Just ask Angela Merkel who became the undisputed leader of the free world after the US elevated a rather rude businessman to the presidency. Mrs Merkel’s phone manners are also much more effective. Instead of hanging up in anger, she just refuses to take calls as the Russians discovered to their dismay after they annexed the Crimea. The German chancellor, until then the Kremlin’s main conduit to the western world, gave them the cold shoulder, simply refusing to engage.

Who would have known that some 71 years after the conclusion of the largest conflagration in the history of mankind, the Germans – of all people – would get to lead the free world. Whilst Mrs Merkel seems at ease in her new role, her political future at home is less certain. Belatedly, a growing number of Germans are having second thoughts on her “wir schaffen das” can-do approach to the refugee issue. In fact, voters are becoming quite fed up with having to pay, time and again, to solve other nation’s troubles.

Before she allowed up to 800,000 refugees to resettle in Germany, the Merkel Administration had to help bailout Greece and other financially-troubled Eurozone member states. Though the rescue was largely a bookkeeping exercise which has, so far, not taxed the German exchequer, the impression remains that the country is being asked to take on the world’s problems without so much as a thank-you from the nations benefited. Greek protesters likening the German chancellor to a heartless Führer dispensing inhuman diktats did not go down well – and left a lasting impression.

Opposing Mrs Merkel in the upcoming election is Martin Schulz, the former president of the European Parliament, who now leads the social-democratic SPD and stands to do rather well at the ballot. Merkel’s Christian-democratic CDU and its Bavarian counterpart CSU together control 310 seat in the 630-member Bundestag. The so-called union parties, together since the late 1940s, received 41.5% of the vote in the 2013 election, against 25.7% for its natural nemesis, the SPD. Support for the government has, however, eroded significantly with the combined CDU/CSU currently polling at around 32% of the popular vote.

With its highly-complex mixed-member proportional representation system, which includes esoteric phenomena such as ‘overhang’ balancing seats, Chancellor Merkel may find it hard, if not impossible, to form a coalition that allows her to rule without taking on board a third partner such as the Greens or – perish the thought – the Left Party.

Though, for now, safe from extremist politics and rabid euro-scepticism, a post-Merkel Germany may not easily keep its pre-eminent position in Europe or globally. A capable politician who survived, and prospered, in the snake pit otherwise known as the European Parliament, Mr Schulz lacks the perspicacity and soft power skills that allowed Mrs Merkel to steer Germany to the top – without anybody other than, perhaps, the impoverished Greeks taking offense.

However, Mr Schulz lacks the statesman-like appearance and attitude the current German chancellor has finessed into a veritable art form. Not (yet) accustomed to see their country in the global driving seat, German voters are notorious for ignoring questions and issues that bear no direct relation to their domestic concerns. In a sense, to many the world stops at the borders. At home, Mrs Merkel battles more hot potatoes than immigration alone: opinions are divided when it comes to the need to re-equip and re-arm Germany’s defence. The economy, whilst humming along nicely, poses another worry as inflation picks up and the European Central Bank continues to insist on injecting money into the Eurozone’s economy. The call for Germany to do something about its excessive current account surplus is getting louder, yet Mrs Merkel is reluctant to encourage or incentivise consumers to embark on a spending spree. Fiscal probity remains the state’s official religion.

The good news is that whichever way German voters decide to go, populism is not about to take over in Europe’s largest and most dominant country. Thus, Germany is expected to remain the anchor of Europe and, indeed, a safe haven where alternative facts have not yet taken hold.


G20: Challenges in Shaping an Interconnected World

[caption id="attachment_11686" align="alignright" width="300"] G20 Leaders[/caption]

Expertly ducking a potentially traumatic Trump (hand)shake by shooting past the US president to his wife Melania, Polish first lady Agata Kornhauser-Duda perhaps unwittingly set the tone for the annual G20 summit – showing Mr Trump his place in the new world order he helped, also perhaps unwittingly, usher in.

Not expecting a particularly warm welcome in Hamburg, the US president first visited friendly Poland to deliver a rousing speech, in front of a rent-a-crowd audience bussed in for the occasion, in which he managed to sing the praises of Western values without once mentioning democracy or the rule of law. All the same, the president did voice support for NATO Article 5 which commits member states to mutual defence. It was a welcome first and meant to undo the harm caused when during an earlier visit to Europe the US president explicitly failed to endorse the key article.

After assuring that the West will never be “broken”, Mr Trump on Friday met Russian president Vladimir Putin in an attempt to iron out differences over Syria, Ukraine, and North Korea. Not very helpful given the circumstances, the US president invited Russia to join “the community of responsible nations”, implying that the country is at present not quite living up to global expectations.

"Usually an unremarkable and rather ineffectual exercise in global politics, this year’s G20 summit deals with a world in flux – no longer merely a cliché – with fireworks on the agenda."

Usually an unremarkable and rather ineffectual exercise in global politics, this year’s G20 summit deals with a world in flux – no longer merely a cliché – with fireworks on the agenda.

Germany, playing host to the world’s most powerful, has now reluctantly assumed moral leadership with Chancellor Merkel becoming the undisputed – and unlikely – leader of the free world. The position fell to her by default as more natural candidates from the Anglophone world seem to have traded political reason for bombast.

The five permanent members of the UN Security Council – the world’s movers and shakers – all seek different outcomes from the Hamburg summit. Not one of them is likely to leave the two-day event feeling satisfied or vindicated.

President Trump’s wish list is refreshingly short: he needs help from China in keeping North Korea from going ballistic, and must establish a rapport of sorts with Mr Putin while maintaining a stand-offish attitude in order not to seem grateful for any covert assistance the Russian may have rendered during last year’s election campaign. In Hamburg, President Trump has only two dependable friends: Turkey’s Recep Erdoğan and Brazil’s Michel Temer – not exactly models of rectitude.

Chinese President Xi Jinping, who brought two panda bears along, has just a single mission in Hamburg: evade the pesky Americans and keep their tiresome nagging about North Korea to a minimum. If lucky, President Jinping may convince Vladimir Putin to jointly tackle the recalcitrant Kim Jong-Un. Shunting the US out of a diplomatic solution for the North Korea issue would be a coup of the first magnitude and offer further proof to the suspicion/fear that the Americans are retreating from the world stage.

For Vladimir Putin the Hamburg summit offers a welcome photo-op. Pulling a serious and determined face whilst conferring with the US president during their one-on-one, allows the Russian president to reaffirm his status as one of the world’s great leaders. There is unlikely to be any progress on either Ukraine or Syria.

France’s president Emmanuel Macron – fresh, dynamic, chomping at the bit, and perhaps a tad naïve – went to Hamburg armed with a history book explaining the intricacies of the Concert of Europe and, more specifically, Russia’s central role in that precarious 19th century balance of alliances. Ignoring the Crimean War of 1853, a deplorable faux pas if anything, France wants to help bring Russia back into the fold (as spelled out by President Trump in Poland) by re-establishing the Elysée Palace as the go-between that pulls Russia westwards into the European orbit. In his endeavour to regain diplomatic primacy for his country, President Macron enjoys the blessing of Chancellor Merkel who is only too glad to pass the Moscow Dossier to Paris.

Sadly last and least, British Prime Minister Theresa May’s only job in Hamburg is to convince fellow G20 leaders that she, and her government, are not (yet) a spent force. Since it became abundantly clear that the British government holds no sway over the US administration, and is wholly unable to temper its America First urges, Mrs May struggles to maintain her country’s international posture. Descending from the aeroplane that brought her to Hamburg, Mrs May promptly threw away her only ace card by declaring that she would not discuss climate change during her private meeting with President Trump – thus giving up on the notion that the UK’s “special relationship” with the United States is able to produce any tangible results.

Instead, Prime Minister May opted to call for a crackdown on terrorist financing. The choice was deemed rather unfortunate as the Home Office was found to suppress a report on the funding of Islamist extremists in the UK by friendly countries. A Home Office spokesperson admitted that the report’s contents are “very sensitive” and will not be divulged.

Then again, the G20 is not necessarily the venue of choice to change the world for the better. Likened to a diplomatic jamboree, the annual get together was set up in 2008 to encourage global cooperation in the face of financial instability. The G20’s original remit was to avoid future financial crises from happening through concerted harmonised responses and policies.

However, as is often the case with global summits, the G20 is often distracted – if not hijacked – by late breaking events. As if on cue, North Korea blasted itself to the top of the global agenda, commanding the attention of not just the United States, but China and Russia as well.

This is where German leadership is called for – and comes in. Chancellor Merkel has repeatedly stated that she will insist on speaking about climate change and development issues, such as the need to address the plight of African nations in order to stem the flow of refugees heading for Europe. As global defender of liberal values, Mrs Merkel finds herself surrounded by swaggering populists as Trump, Putin, and Erdoğan. Not easily intimidated, on the eve of the summit Chancellor Merkel took a first swipe at President Trump, declaring that his administration apparently sees free trade and globalisation as a scenario that produces winners and losers as opposed to the win-win proposition it is meant to be.

Armed with the final draft of an ambitious EU-Japan free trade deal, potentially one of the largest of its kind, Mrs Merkel aims to show that liberalism is far from dead. She is particularly well-equipped to deal with the macho strongmen in Hamburg having outmanoeuvred all to reach – and keep – her present position as the leader of the world’s strongest economy. Of the world leaders gathered in Hamburg, the German Chancellor is the only one able to fill the hole where the US used to sit. However, she made a point of sitting down, so to say, with French president Macron in order to underline that Germany adheres to multilateralism and has no ambition whatsoever to rule alone.

Admonishing all present to play nice, the German chancellor can easily take the high road, insisting that participants adhere to the meeting’s original agenda Shaping an Interconnected World, including topics such as tackling tax avoidance and evasion, evaluating the opportunities offered by climate action and the digital revolution, and sharing the responsibility for refugees and migrants by partnering with Africa for investment, growth, and jobs.

What the heavyweight participants in Hamburg must now decide is if they are to be partners or adversaries.


Philippe Le Houérou, CEO of IFC: Redefining Development Finance

[caption id="attachment_11690" align="alignright" width="251"] Philippe Le Houérou[/caption]

Complementing – and driving – World Bank President Jim Kim’s vision to transform the multilateral financier into an “honest broker” charged with mobilising and directing private capital towards developing countries, CEO Philippe Le Houérou of the International Finance Corporation (IFC, part of the World Bank Group) aims to leverage his organisation’s deep expertise and formidable reputation to significantly raise the volume of funds available to frontier markets and thus help kick-start their economies by creating markets where none existed before. The approach signals a strategic shift at the IFC which calls for a new operational framework to structure smaller deals with private sector parties that potentially carry additional risk but have a much greater development impact.

One year into his job, Mr Le Houérou explains his work thus: “I first wanted to place development impact at the heart of what the IFC does. For my second year, I want to place the IFC at the heart of development.”

Traditionally run by bankers, who usually and not unreasonably put the pursuit of profits before the need for poverty reduction, Mr Le Houérou’s new direction for the IFC has been warmly welcomed by development professionals. Abandoning the ivory tower – a penthouse office rather – that housed many of his illustrious predecessors and moving his desk a few floors down to be closer to the action, enables the chief exec to engage with individual members of staff, bridging hierarchies in order to discover, and adjust, the nuts and bolts that keep the vast organisation running smoothly.

Mr Le Houérou believes in hands-on managing. Unassuming, at times taciturn, but quick to burst into laughter, the Frenchman brings a passion to his job not normally seen in the higher echelons of development finance. Coming to the IFC from the field, rather than switching one mahogany-panelled office for another, Mr Le Houérou also brought thirty years’ worth of experience to the bank’s head office on Washington’s Pennsylvania Avenue – a street lined with power as no other. Here, he cuts a slightly different figure with his six foot tall frame usually draped in a slightly crumpled suit: this is a man who works rather than talks – a man, if you will, on a mission.

Mr Le Houérou’s undertaking seems simple enough: to transform the IFC into a market maker: “Instead of waiting for projects to fall into our lap, I want the IFC to be more proactive in creating markets by decisively moving into fragile and poor countries, places where private capital dares not tread, and create opportunities.”

“I want the IFC to be more proactive in creating markets by decisively moving into fragile and poor countries, places where private capital dares not tread, and sniff out opportunities.”

The IFC 3.0 now being erected adopts a cascading approach to development finance. For any given project, the preferred funding source should be private financing and not add to public debt; that absent the IFC will, with World Bank colleagues, try to address market failures in order to attract private capital. Should that not have the desired effect, the organisation will seek to de-risk the project by providing matching capital and guarantees to private investors. Under this scheme, public and concessional finance options are used only as a last resort when everything else has proved fruitless.

“The idea is to unburden state and public budgets. Most governments of the countries we help are already struggling with high debts burdens. Their budgets usually have no room to accommodate extra expenditures. Besides, the limited means of these countries should ideally be destined for education, public healthcare, rural roads, sanitation, and similarly important tasks where there are no private solutions. We aim to keep big-ticket infrastructure projects that generate revenues off-budget by entrusting them to the market.”

The new “cascade” approach is not just horizon to reach: it is already being piloted in nine countries with another 20 eager to sign on. The IFC and other entities belonging to the World Bank Group have dispatched country teams – each with between eight and ten professionals – to work with governments to identify and set up infrastructure projects that are “cascade-enabled”.

“The idea is perhaps not new, but it is the first time that the World Bank Group has fully embraced the principle with a consistent and dedicated approach to mobilising private capital.”

The IFC is perfectly willing – and able – to directly take on risk if that is what it takes to create markets. Essentially, the organisation now aims to put its own capital on the line – and offer it as a sort of collateral – to private investors otherwise reluctant to embark on ventures in frontier markets. The IFC can, for example, offer to assume 10% of first loss, taking the bite out of disappointing results. Mr Le Houérou describes the IFC as a leveraging machine: “We are currently able to trigger an additional $4 in private capital for every single dollar we invest. The goal is to increase this leverage and by so doing make the leap from billions to trillions.”

Such an order of magnitude is urgently called for. The least developed nations face a demographic bulge and other challenges that require jobs – tens of millions of them – to meet. “Whilst there is no single magic bullet that solves all problems – if there was, we’d have found it by now – we do know that sustainable development requires a thriving private sector. Only that can generate the jobs needed. Without employment there is no dignity for people, no alleviation of poverty – no hope for a better future.”

“So, we need to focus on practical solutions and that, in turn, requires us to rethink the way we operate. The current level of development aid of about $130bn annually is simply not enough. However, if we work closely together and establish cooperation between multilateral development banks and national development agencies, we can use those funds to clear the way for private investors to move their trillions to the places where it is needed most. Billions is what we have available, but trillions is what we need.”

To close the gap, Mr Le Houérou must tap into the vast pool of money currently idling on the side lines, suffering low returns in the current near-zero interest rate environment whilst unable to move due to restrictions placed on (pension) fund managers whose statutory mandates often preclude taking any position outside the rarefied sphere of the investment grade universe. Hence, the need to radically rethink development financing to accommodate this reality.

“This is precisely where the IFC can deploy its function as a catalyst and de-risk these opportunities, crowd-in investments, and scale up everything in the process. The question is how do we actually accomplish this. If we are serious about this agenda, I believe IFC should be a major driver of the redefinition of development finance.”

“Billions is what we have available, but trillions is what we need.”

Though the IFC seeks to triple its core investment portfolio to $30bn by 2030, that increase alone – whilst crucially important – will not be enough to address the shortfall in investment capital. Already now, the IFC has established close cooperation with the national development agencies of Sweden Japan, UK and France, amongst others, to further its reach.

The organisation also aims to alter the mix of its projects portfolio to mitigate overall exposure to risk and rebalance social and financial returns. “We will continue with more profitable deals in order to offset riskier propositions elsewhere whilst keeping an eye on the impact of our operations.”

In internal assessments the IFC now attaches greater weight to the economic, social, and environmental impact of its undertakings. A new ratings system is being deployed to gauge in a more systematic and objective manner the development outcome of projects under consideration. Thus, the development impact is to become a key driver of the decision-making process, alongside financial concerns. Starting in July, projects brought to the IFC’s board for approval will include estimates on development impact. This represents a big change in the way the organisation operates. Before, impact was only assessed after a project’s conclusion. “The new procedure will allow the IFC to set overall targets for development impact and benchmark outcomes against those targets. We can then easily assess how we are doing and how much headway we’ve made on development and poverty reduction.”

Mr Le Houérou emphasises that the new IFC, though perhaps not entirely novel, is about creating markets: “We always have been quite good at structuring finance for investments, either FDI or local, bringing in technical assistance, and syndicating loans. We now need to go to more difficult places, including fragile and failed states, where we will no longer wait for deals to come our way – usually few and far in between – but proactively create markets in the knowledge that once conditions are right, private investment will follow.

“We also need to move a little bit away from merely analysing situations. It is one thing to point your finger at problems, but quite another to propose workable solutions that create the conditions for markets to emerge and prosper. Rather than de-risk at project level, the IFC will work closely with the World Bank to de-risk entire countries. To create markets is, essentially, to remove roadblocks.”

And that is precisely what Mr Le Houérou has been doing at both the IFC and in the countries where his organisation is called upon to help facilitate and accelerate development. It is a new take on an existing approach, though one not just evolutionary in nature. Rather, Mr Le Houérou, aware of the urgency of his mission, is taking the proverbial bull by both horns, redirecting the entire development finance sector down a more pragmatic path: good intentions are swapped for tangible results – removing roadblocks in the process.


Otaviano Canuto, World Bank: Matchmaking Finance and Infrastructure

The world economy – and emerging market and developing economies in particular – display a gap between their infrastructure needs and the available finance. On the one hand, infrastructure investment has fallen far short from of what would be required to support potential growth. On the other, abundant financial resources in world markets have been facing very low and decreasing interest rates, whereas opportunities of higher return from potential infrastructure assets are missed. We approach here how a better match between private sector finance and infrastructure can be obtained if properly structured projects are developed, with risks and returns distributed in accordance with different incentives of stakeholders.

The world needs to invest an average $3.3 trillion, and emerging markets $1-1.5 trillion, annually just to meet currently expected rates of growth. The world currently spends about $2.5 trillion a year on infrastructure, and it is estimated that it needs to invest an average of $3.3 trillion annually just to support currently expected rates of growth (McKinsey, 2016) – with power requiring the largest amount (figure 1).

Current infrastructure investment, including IFIs, public investment, and PPPs, amounts around $1.7 trillion leaving a gap of more than $1 trillion. Institutional investors and other private sector players could increase allocations under appropriate conditions.

“The world needs to invest an average $3.3 trillion, and emerging markets $1-1.5 trillion, annually just to meet currently expected rates of growth.”

Operational commitments of major international financial institutions (IFIs) total around $80-90 billion annually – less than 10% of the infrastructure financing gap for emerging markets (World Economic Forum, 2016) – and they are declining. Annual public investment in infrastructure stands at about $1.5 trillion and is also decreasing due to fiscal deficits and increased public debt-to-GDP ratios. Public-Private Partnerships (PPPs) account for another $120 billion. Leveraging private sector investment, as well as institutional investor capital, are widely discussed as possibilities for addressing the needs going forward. Indeed, according to World Economic Forum (2016), institutional investors are currently managing assets exceeding $50 trillion in 2015, compared to $30 trillion in 2007. The same report also highlights that national savings in Asia alone were $1.36 trillion in 2011, and yet their investment in infrastructure currently represents a very small percentage of equity/debt assets.

[caption id="attachment_11712" align="aligncenter" width="591"] Figure 1: Estimated world infrastructure gap 2016-2030. Source: McKinsey Global Institute (MGI), Bridging Global Infrastructure Gaps, 2016.[/caption]

However, as World Bank President Jim Yong Kim recently said: “In our conversations with investors, nearly all of them say they would consider investing in emerging markets if it were less risky.” According to a survey of some 500 institutional investors conducted by the Global Asset Management Firm Natixis (2016), about one-third (34%) of institutions report that “they are planning to increase allocations to real assets, including real estate, infrastructure, and aircraft, in the next 12 months”, and for 63% of them the primary goal for investing in real assets is earning higher returns. After all, long-term yields in safe and liquid assets have been declining for some time (figure 3).

So far, infrastructure has been mostly financed by bank loans. Institutional investors, like all other types of debt and equity investors, have their own incentives, constraints and, objectives when it comes to defining in which countries, types of projects (greenfield vs brownfield), and at what stage of the investment project cycle (development, construction, or operation) to invest. A quick snapshot of the global infrastructure finance shows that the main sources of infrastructure financing have been bank loans (figure 4). In the case of new infrastructure in emerging and developing economies, according to estimates of the Intergovernmental Group of 24 (G24) and the Global Green Growth Institute (GGGI), “around 20% is financed by loans, mostly by development banks and a share of the private investments), 56% is financed by budget, i.e. mainly by grants, and 24% is financed by equity and quasi-equity instruments coming from private investors.”

[caption id="attachment_11713" align="aligncenter" width="589"] Figure 2: Investment needs. Economic infrastructure; %, $ trllion (at constant 2015 prices). Infrastructure investment will continue to shift to emerging markets. Source: McKinsey Global Institute (MGI), Bridging Global Infrastructure Gaps, 2016.[/caption]

Looking at infrastructure as an asset class – while comparing it to other asset classes such as government bonds, cash, equity markets, real estate, and others – can help identify and overcome mismatches between the demand for, and potential supply of, finance: an area where development financial institutions (DFIs) can step in.

Various reports indicate that, as of now, there is no systematic analysis of the type of risk instruments needed to unlock private investment in most infrastructure segments, yet inadequate coverage of risk is named as one of the reasons for projects not reaching financial close (World Economic Forum, 2016). Table 1 provides a summary of typical profiles of different stakeholders potentially participants in the value chain of financial services associated with infrastructure investments. Despite mismatches between their respective profiles and corresponding assets, pension funds, insurance companies, and private equity funds have invested in unlisted infrastructure equity. Percentages are still small, but could be increased under appropriate circumstances.

The unlisted infrastructure fund market represents a hope from this perspective as it allows to diversify risk. According to a survey of institutional investors conducted by Preqin, “three-quarters of respondents stated that the performance of their infrastructure and investments over 2015 had met or exceeded their expectations and 74% of fund managers are seeking greater appetite from investors.” At the same time, the size of this market is very small compared to alternative asset classes, and transactions in more developed markets have taken prevalence.

Another trend has been a high concentration of capital among a very few infrastructure funds: 179 unlisted infrastructure funds in market targeting $120bn in institutional capital. Yet, very few of them are reaching final close each year. Also, limited availability of attractive investment opportunities is named as one of the reasons for the remaining 26% of investors who declared then to be planning to reduce the amount of their investments.

[caption id="attachment_11714" align="aligncenter" width="584"] Figure 3: Ten-year sovereign bond yields. Source: Federal Reserve Bank of San Francisco.[/caption]

Defining the “attractive investment opportunities”, and matching investors to these opportunities in a more systematic way is what might make a difference. Heterogeneity in the setup of projects is often named as one of the reasons why it is so difficult to push more allocations to infrastructure. Lack of data, different contractual structures, different regulatory environments – all these aspects are part of the puzzle and are being addressed by different players; but also, the breadth of products tailored specifically for different types of institutional investors with their respective risk and return profiles is where a higher effort may payoff.

[caption id="attachment_11715" align="aligncenter" width="895"] Table 1: Stakeholders and corresponding instruments, assets, motivations, and risks. Source: authors, based on Natixis (2016), Ehlers, (2014), OECD (2015) and others.[/caption]

Categorising institutional investors according to their profiles and tailoring infrastructure investments to their needs constitutes a first step. Matching fees – charged by funds – to returns in the context of opportunities offered by other asset classes is an example of such a consideration. As widely discussed in the literature, pension funds are looking for “high returns, low risk, liquidity, fair pricing, and reliable partners”.

[caption id="attachment_11716" align="aligncenter" width="890"] Table 2: Risks, stakeholders, and project phases. Source: authors, based on Ehlers, (2014), World Economic Forum (2016) and others.[/caption]

Based on the basic profiles listed on Table 1 and Table 2, one may notice that a scenario for institutional investors to participate at the operational stage is typically favourable when refinancing is possible and the construction risk is addressed – particularly in those segments with lower risks (figure 5). Examples of these transactions include Canadian investments in Chile such as the Pension Plan Investment Board (CPPIB) paying $1.14 billion for stakes in five major toll roads; AIMCo buying a 50% interest in Autopista Central de Chile in late 2010 for $878 million; and Brookfield Asset Management buying six road projects in India, to name a few.

There are examples, however, of their participation at other stages of the cycle, including taking a construction risk. This tends to be the case when institutional investors participate in infrastructure projects in a search for higher yield – like sovereign wealth funds. This has been the case for 63% of surveyed investors by Natixis (2016).

[caption id="attachment_11717" align="aligncenter" width="893"] Box 1. Source: World Bank, IMF and OECD (2016).[/caption]

So far, institutional investors have mostly invested in upper-middle income and high income countries. Examples include Asian pension funds such as the Accident Compensation Corporation investing in New Zealand roads (primary financing) or State Super NSW investing in Australia transport sector. But there are also some cases like Care Super investing in hospitals in India. In Africa, there is a growing pool of investors coming from, mostly, the US, but also UAE, China, and UK.

Currency risk is a major factor faced by international investors in the emerging markets (table 2). Export credit agencies can help with that challenge, although often at the expense of higher cost. Other challenges frequently named are the unavailability of financial instruments or their respective cost and complexity in terms of difficulty to use. Box 1 displays some regional differences in that regard as reported by World Bank, IMF, and OECD.

Fixed-income instruments such as bonds (in the context of infrastructure project: projects bonds, municipal, sub-sovereign bonds, green bonds, and sukuk) and loans (direct/co-investment lending to infrastructure project, syndicated project loans) are likely to be a better fit for the appetite of a broad range of institutional investors in emerging market economies: significant innovation is taking place in product design that can potentially change the risks that institutional investors are willing to take and expand their investment in these two strategic sectors”.

Development Financial Institutions Have Key Role

DFIs can offer a core financial additionality by playing a key role as a catalyst, drawing private capital into long-term projects in countries and sectors where significant development results can be expected, but the market perceives high risks. Those institutions contribute their own funding (loans, equity) and/or guarantees, providing partners with an improved creditor status. IFC, for example, has invested $270 million dollars of its own capital into the Queen Alia International Airport in Amman, Jordan. As a result, the project has been able to attract enough commercial financing to cover the rest. Over the last nine years, Jordan has received more than one billion dollars in revenue – and that without having to pay back any project loans. Bringing partners into specific deals through syndications also generates additional financing. Furthermore, they can support the development of pipelines of investable projects, the scarcity of which is also highlighted as an impediment to a higher commitment by non-banking financial institutions to infrastructure.

[caption id="attachment_11718" align="aligncenter" width="583"] Figure 4: Global infrastructure finance (including corporate finance) value by source of funding, 2011-2016. Source: authors, based on data from IJ Global (2017).[/caption]

A whole set of mechanisms to assign part of risks to a third party through risk transfer and credit enhancement instruments is currently being piloted by development banks. These instruments include guarantees, insurance policies, or hedging mechanisms under which, for a fee, the provider will agree to compensate the concessionaire (or its lenders) in case of default and/or loss due to some specified circumstance.

[caption id="attachment_11711" align="aligncenter" width="587"] Figure 5: Infrastructure rists and returns. Source: J.P.Morgan Asset Management.[/caption]

The new $2.5 billion IDA Private Sector Window provides an example of such an instrument – it includes a risk mitigation facility to provide project-based guarantees without sovereign indemnity, and a local currency facility to mitigate currency risk when markets are not yet developed. Another example is a joint effort of IFC and Sida: a platform allowing institutional investors (including those with relatively conservative risk profile, e.g. insurer Allianz) to invest in developing countries by providing a first loss guarantee of 10%. According to estimates, such platforms can mobilize up to $10 of private money for every dollar of public money.

Bottom Line

The contrast between the dearth of investments in infrastructure and the savings-liquidity glut that marks the contemporaneous global economy can be reduced. Low legal, regulatory, and policy risks are of the essence. Additionally, the availability of sophisticated, developed financial markets and instruments will help, as they facilitate partnerships among different financial agents to allow each one to carry risks that are closer to their will and capacity. The greater involvement of private investors and the design of economically rational financing structures can not only boost the funding of infrastructure investments but also thereby improve the efficiency and success of infrastructure projects. Development financial institutions may play an important role in such matchmaking. i

About the Authors

Otaviano Canuto is an executive director and Aleksandra Liaplina is an economist and infrastructure finance specialist at the World Bank.

All opinions expressed here are their own and do not represent those of the World Bank or of those governments Mr Canuto represents on its board. References in this article available upon request.


Emmanuel Macron: Perfect Timing

[caption id="attachment_11735" align="alignright" width="300"] Emmanuel Macron[/caption]

The fate of the European Union may well rest on his shoulders. Front-runner in the French election campaign, Emmanuel Macron (39) is widely expected – but not guaranteed – to trash Marine Le Pen in the May 7 run-off for the presidency by a two-to-one margin. A liberal-centrist, youthful, and with plenty of flair though never before elected to pubic office, Mr Macron came out of nowhere to claim the top spot. A former minister of Economic and Industrial Affairs, the candidate promises reform without upheaval.

Mr Macron was the main beneficiary of the sudden fall from grace of conservative front-runner François Fillon who was found to have parachuted his wife into a non-existent yet well-paying job at the expense of the taxpayer. Though he refused to quit the electoral race, Mr Fillon’s popularity plummeted in the wake of the scandal dished up by the satirical weekly Le Canard Enchainé.

As the candidate to beat, Emmanuel Macron has become the main target for negative campaigning and already had to vehemently deny a gay extramarital affair. Wikipedia founder Julian Assange, still holed up in the Ecuadorian embassy in London, has promised additional revelations that may embarrass Mr Macron.

Though he has so far provided few details on his policy platform, Mr Macron did appeal for an immediate strengthening of the euro – which he called “a weak D-mark” – and a reform of the Eurozone in order to assure the common currency’s survival: “Without this, the euro will be gone in under two years.” In a speech at Humboldt University in Berlin, Mr Macron emphasised the need for action. “The truth is that we must collectively recognise that the euro is incomplete and cannot last without major reforms. It has not provided Europe with full international sovereignty against the dollar on its rules. It has not provided Europe with a natural convergence between the different member states.”

Mr Macron also stressed the need for France to reform its rigid labour market, and appealed to Germany to end its austerity fetish and start investing for its own benefit and that of Europe, adding that the “dysfunctional” euro has been a boon to German exporters. Interestingly, Mr Macron proposes the creation of a Eurozone budget to finance investments – in lieu of quantitative easing – and help struggling member states such as Greece.

On the campaign trail, Mr Macron steadfastly refuses to endorse anti-EU sentiments, preferring to remind his audience instead that the union has brought both wealth ad stability to the continent: “We need more integration, rather than less, but it must be accomplished without sacrificing sensible solutions to relatively simple problems.”

To elaborate a comprehensive policy platform, Mr Macron invited almost 400 experts to help put together a manifesto, defining ten priorities, each with a specific and detailed proposal attached. In his best-selling book – Révolution - launched last December just before the start of the election season, Mr Macron describes himself as a left-leaning no-nonsense liberal. He wants to streamline France’s overblown bureaucracy, reduce the weight of regulation, and simplify the country’s tax system, amongst others.

The En Marche! (mind the initials) movement he founded for the occasion has deftly claimed the political centre ground vacated by both Marine Le Pen and the now disgraced François Fillon. Thus, Emmanuel Macron may easily become the candidate to block Ms Le Pen’s ascendancy to the French presidency. In keeping with French political tradition, voters in the first round select their favourite candidate while in the second round the most-hated contender is summarily rejected.

A victory for anyone but Marine Le Pen will constitute a salvation – of sorts – for the grand European project, under siege by both Brexit and President Trump. Staunchly pro-European whilst also committed to reform, Emmanuel Macron may well turn out to be the right man in the right job at the right time.