De-Risking Emerging Markets Investments

Macro Context and Investment Gap

• Emerging market growth rates top 7% for the top five economies, compared to G7 growth of roughly 4% or lower.
• The UN estimates a $2.5 trillion annual funding gap to achieve Sustainable Development Goals (SDGs).
• Post-2008 financial regulations caused the top 600 financial institutions to deleverage, removing over $4 trillion in assets that previously supported emerging market growth.
• The development paradigm shifted in 2015 from donor-led ODA to the SDGs, recognizing a $12 trillion market of commercial opportunities aligned with development goals.
• Foreign Direct Investment (FDI) surpassed Official Development Assistance (ODA) in 1994 and was six times larger than ODA last year.

Perception vs. Reality of Risk

• Infrastructure defaults in Africa are actually lower than those in North America, contradicting the high perceived risk often cited by investors.
• The primary barrier to private capital is the "perception of risk" rather than actual default data, particularly in regions requiring local expertise and "boots on the ground."
• Standard Chartered notes a scarcity of "bankable projects" rather than a scarcity of capital, urging multilaterals to assist in project design and regulatory structuring.
• Citi highlights that $250 trillion is available in global capital markets, but private capital requires projects to meet established credit criteria rather than waiting for public funds to arrive first.

Regulatory Barriers and Basel Accords

• Basel III regulations require 250% capital reserves for equity investing, creating a disincentive for global financial institutions to engage in emerging market equity.
• Regulatory rules often treat local currency transactions by local branches as foreign currency exposures for headquarters, creating friction for local currency financing.
• Current guarantee structures often fail to meet "prompt payment" definitions (e.g., 180+ day periods vs. the required 60-90 days), preventing banks from receiving zero risk-weight treatment under the standardized Basel approach.
• New Basel revisions (Basel III/IV) introduce output floors, limiting benefits from internal models and increasing pressure for guarantees to qualify under standardized approaches.

The Role of Multilaterals and MIGA

• MIGA currently supports approximately $20 billion in private investment in developing countries through political risk insurance and credit enhancement.
• MIGA's "Non-Honoring of Sovereign Obligations" (NHSO) product provides banks with full capital relief, whereas partial guarantees often offer zero capital relief under current regulations.
• MIGA reports a 30-year loss record on 830 projects across 111 countries, enabling them to leverage private reinsurance markets (increasing reinsurance by $10 billion in four years).
• The World Bank Group's "Maximizing Financing for Development" initiative prioritizes private sector participation before utilizing public funds.
• New multilateral development banks (AIIB, New Development Bank) are positioned to adopt guarantee models more nimbly than legacy institutions.

Structural Challenges in Guarantee Instruments

• Research by the Milken Institute found 80% of development guarantees are inefficient due to non-compliance with regulatory standards and lack of clarity.
• Key friction points for rating agencies include uncertainty in "prompt payment" clauses, which can create liquidity gaps of two to four years, lowering credit ratings.
• Conditionality covenants that allow guarantees to terminate midstream can destroy bond ratings for both banks and non-bank institutional investors.
• Many guarantee agreements restrict assignability or require prior approval for secondary sales, preventing banks from offloading risk and freeing up balance sheet capacity.
• Rating agencies operate on a "first dollar of loss" methodology, meaning partial guarantees (e.g., 95% cover) may still result in significant rating downgrades if the remaining 5% exposure is not well-structured.

Innovations and Future Directions

• Citi is working on converting the Green Climate Fund's $10 billion lending facility into a reserve fund for a guarantee agency to leverage private capital at a 1% cost.
• A "Shin Initiative" within the World Bank Group prioritizes private financing over MDB loans when private capital can operate or finance a project.
• New investment models are emerging in Africa where companies bring their own capital for small-scale projects (e.g., 5-50 MW power plants) in exchange for long-term Power Purchase Agreements (PPAs) without sovereign guarantees.
• Experts propose a new institutional mechanism capable of processing 5,000+ simultaneous credit enhancement applications for SDG-aligned projects within a single day, rather than the current multi-year timelines.
• Currency risk mitigation tools, such as guaranteed cross-currency swaps, are identified as high-value but underutilized products to reduce capital charges for long-term investments.
• ODA counting rules currently exclude government guarantees; reforming this to treat credit cover as ODA one-to-one could unlock significant catalytic funding.

Investor Behavior and Deal Structuring

• Non-bank institutional investors (pension funds, insurance companies, and firms like Goldman Sachs) are driving project finance demand due to low yields on risk-free assets, provided risk is clear and identifiable.
• Successful deal structures often involve "tranching" risk, where multilaterals take the first-dollar loss or construction risk, allowing long-term bond investors to enter once the asset is operational.
• Developers cite a critical lack of funding for pre-development work (feasibility, land agreements, PPAs), noting that private investors are unwilling to fund early-stage costs without high certainty of success.
• Local banks in emerging markets often prefer investing in sovereign bonds rather than the real economy due to favorable risk-weighted capital requirements on government debt.
• Citi emphasizes leveraging existing corporate clients (utilities, energy companies) to execute projects using their own balance sheets rather than pure project finance to reduce legal and transactional friction.