Mobilising capital

Reassuring investors by insuring them

Private-sector investors from rich nations tend to shy away from investing in developing countries because of high risks. Policymakers could boost meaningful investment flows by providing investment insurance. In this essay, the founder and managing director of DeRisk Advisory Services elaborates on the approach.

By Andrew Gaines

Since the collapse of the investment bank Lehman Brothers in 2008, investors have become ever more sensitive to risks. Currently, the sovereign debt crises of rich nations are causing anxiety. Many emerging markets have been surprisingly stable in the past three years, but the Arab Spring shows that geopolitical shifts can seemingly come out of nowhere. Natural disasters, moreover, seem to hit our increasingly densely populated planet with ever-greater frequency. The world certainly looks more risky than it did after the fall of the Berlin Wall.

Untapped potential

Many investors and businesses are interested in the long-term development and economic growth of markets in the world’s poorest countries. Nonetheless, they often shy away from investing in poor countries because of the risks, some of them real, others ima­gined. There is only a limited pool of capital, and not much of it is allocated to “development investments” (investments that drive a poor country’s development). Policymakers must therefore consider and implement mechanisms to reduce investors’ risks. Such action would serve to mobilise private capital that is currently “sitting on the sidelines”, due to investor worries about what is happening in the global arena.

In 2006, I was involved in an assessment of perceived investment risks in developing countries. Other partners included Vantage Point Global, a private-sector consultancy, and the Global Exchange for Social Investment (GEXSI), a British-based charity that was started at the World Economic Forum in 2001 with the goal of promoting entrepreneurial approaches to fighting poverty. The key idea was to use various types of insurance to make public development funds leverage private financial flows to low-­income countries. On the basis of this work, we started DeRisk in 2006 (see box).

The crucial starting point is that, for development investment to fulfil its true potential, new investors are needed. These are people or institutions that have never invested in Africa and other emerging markets. Our initial assessment showed that there is a host of obstacles that deter investors. Some of these issues are slowly being tackled and becoming less relevant. These obstacles include:
– the lack of promising formal-sector businesses in poor countries which means that investors often struggle to find partners they would trust,
– the scarcity of investment funds with a track record in the field of development investment and
– low investor awareness of opportunities in the ­developing world.
Since 2006, “impact investing” has emerged as a new investment strategy. The idea is to invest in businesses that not only generate profits, but have a positive social or environmental impact too. Mainstream investors are increasingly allocating a small percentage of large pools of capital to such businesses as well as to funds that invest in such businesses. None­theless, risks continue to thwart investments.

DeRisk’s focus has therefore been on mitigating the risks potential investors cited as deterrents. These risks belong into three categories: political risks, market risks and business risks. DeRisk has been working with dozens of development investors and businesses to reduce these risks and facilitate investments. Moreover, we strive to identify gaps in the “market” for risk mitigation. These gaps are where policymakers can make a difference.

Political risks

Political risk is basically about a state’s stability. Civil unrest scares investors. In reality, very few businesses and investments are affected, but the media keep reporting news from trouble spots. Potential foreign investors tend to interpret coverage of the election related violence that rocked Nigeria and Cote d’Ivoire earlier this year as a warning about Africa in general.

To mitigate such risks, insurers in the private sector, Lloyd’s for instance, offer products that give investors comfort that political instability will not wipe out their capital. Similar products are also offered by public sector insurers like MIGA, the Multilateral Investment Guarantee Agency that belongs to the World Bank Group.

There are two snags, however. Political risk insurance policies are complicated and expensive. To tackle the former challenge, DeRisk cooperated with MIGA and started a marketing agency programme. It allows intermediaries like DeRisk to facilitate the insurance application and underwriting process, thus reducing the administrative burden on investors. Such facilitation matters to small and medium-sized enterprises (SMEs) in particular. SMEs tend to be more resource-constrained than large multinational corporations, but their investments can be particularly relevant for making development happen.

The high costs of political risk insurance, however, often remain an insurmountable obstacle. Typically, the annual cost is one to two percent of the capital invested. This means that only investors who expect at least a 10 % return on their investment can afford this kind of insurance. Many meaningful development investments will not deliver that kind of return.

One way to close this gap in the insurance market is for governments of rich nations to subsidise political risk insurance. The leverage effect of this type of aid is important. On average, one euro of subsidy will facilitate € 100 of investment. The great advantage
of this approach is its simplicity. It does not require any new guarantee products or mechanisms. Policy­makers must only develop a framework for the type of investments they want to support, and ring-fence a budget for that purpose.

The downside, of course, is that this kind of subsidy would only tackle political risks. In itself, that is not enough to stimulate all of the development investments required. Nonetheless, subsidising political risk insurance would be worthwhile, according to DeRisk assessments.

Market risks

Development investors are exposed to the volatility of exchange rates and interest rates. Since 2006, the ability to hedge such risks has improved. Some international banks like Standard Chartered, Standard Bank or Barclays are paying close attention to emer­ging markets. They have been expanding their hedging products’ geographical reach and length of coverage.

The Dutch development bank FMO, moreover, started TCX, a currency exchange fund with the mission to provide long-term hedging products for investors with exposure to currencies of developing countries. TCX has begun to offer alternatives to investors who are interested in less liquid markets, for instance in sub-Saharan Africa.

In DeRisk’s experience, however, currency and interest rate risk has not been a serious deterrent to investment for the majority of equity investors. Price and availability are still constraints to lenders in these markets but these issues will most likely resolve themselves as financial markets develop. In this area, we do not see a gap that policymakers should close fast.

Business risks

The least progress has been made in regard to mitiga­ting business risks. The main reason is that business is inherently more risky in developing countries than in advanced nations because of
– the dearth of market data,
– the lack of skilled staff,
– poor infrastructure and
– generally underdeveloped commercial environments.
At the same time, standard tools used in developed countries to mitigate insurable risks – be it crop insurance or protection against bankruptcy of suppliers – are often not available or too expensive for development investments.

Again, these problems are likely to decrease as financial markets develop, but at current trends it will take a long time. Since the risks deter investors today, it would make sense for policymakers to step in. It would be too cumbersome to try to deal with a host of different risks separately. Therefore, DeRisk recommends a “blanket” approach for development investments.

As we have seen in the on-going euro and sovereign debt crisis, blanket guarantees by credit-worthy counterparties can have a powerful effect on the willingness of investors to extend credit to borrowers. For policymakers keen on catalysing investment in businesses that have a high development impact, a guarantee facility covering all categories of risks for development investments would therefore make sense.

There is a precedent for such a facility: GuarantCo. This guarantee facility is meant to facilitate private-sector investment in infrastructure by mitigating currency and other risks. GuarantCo is owned by members of the Private Infrastructure Development Group, a multi-donor organisation backed by Britain, Switzerland, the Netherlands, Sweden, Austria and the World Bank.

More facilities of a similar nature would be most useful. Through them, policymakers could support insurance products that cover the loss of the capital invested or not paid back for any reason. If such a facility were funded and backed unconditionally by development finance institutions like Germany’s KfW Banking Group or IFC, it would benefit from these institutions’ credit ratings and allow development investments to access a much wider range of capital.

Indeed, such investments would in effect be “risk-free” from the perspective of institutional investors worldwide. Such risk elimination is the main advantage of this option. Its main disadvantage is its complexity: it effectively requires the setting up and managing of a small insurance company or guarantee institution.

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