Blended Finance: Dream or reality?

In addition to public funds, private funding sources – domestic and foreign – are deemed indispensable. This is even viewed in some circles as the ideal way of meeting the funding shortfalls. More specifically, these private funds encompass private investments as well as philanthropy and remittances.[1] In its International Cooperation Strategy 2021-2024, the Swiss Government advocates for diversifying and scaling up cooperation with the private sector; it envisages deploying Official Development Assistance (ODA) funds as a means of raising "additional private funds" for sustainable development.

The Blended Finance approach in particular is one of the financial vehicles intended to attract private resources for sustainable development financing. While it has generated very high expectations, the outcomes to date have been rather modest.

Let us try to achieve some clarity on the basis of five questions:

1. Blended Finance: What is it about?

There is no universally accepted definition of Blended Finance. The underlying idea, however, is for funds and other resources (personnel, expertise, political contacts, etc.) from bilateral and multilateral official development aid to be deployed as a "levers" to mobilise private sector investments for development cooperation.

2. What are the currently existing models?

In practice, Blended Finance works as follows: private investors generally aim for a financial return commensurate with the investment risk, in other words, a risk-adjusted return. The higher the risk – real or perceived – the higher must be the hoped-for return to offset that risk.

In public financing (bilateral or multilateral), there are essentially two approaches to attracting private investors to projects that (a priori) do not meet risk-based return expectations. Under one approach, the investment risk to the private investor can be reduced (de-risking); under the other, the potentially yield accruing to the private investor can be increased.

In general, risk reduction through instruments such as guarantees or first loss capital is applied to projects that seem profitable enough but carry a considerable risk of default or loss of value. The yield may be increased by granting preferential loans to the investor to offset certain project costs, or through an equity stake. These are ways of offering an investment incentive to private investors. Another possibility is technical assistance to reduce certain transaction costs (in the form of feasibility studies, for example).

Both approaches – reducing risk and increasing return – are tantamount to subsidising private investors from official development assistance funds.

3. How does this benefit the poorest?

This is the key question. The Federal Act on International Development Cooperation states that such cooperation is meant to support "primarily the poorer developing countries, regions and population groups" (Article 5.2). To this day, however, there is little evidence of any benefit from such blended finance in the poorest countries.

Blended Finance has indeed grown exponentially, but has so far bypassed the least developed countries (LDCs). The bulk of Blended Finance transactions have gone to middle income countries (MICs), where the main beneficiaries are the sectors with the highest return on investment – i.e. energy, financial services, industry, mining and construction. Sectors like education or health are hardly involved.

4. What are the risks?

Blended Finance carries the following risks:

• First, it must be borne in mind that if the volume of international cooperation funding remains constant, increased support for this form of financing means a decline in "classic" official development assistance (ODA) funds.
• Second, development funding intended for LDCs could come under pressure if blended finance projects take place principally in MICs.
• Third, there is a danger that the internationally recognised principles of the effectiveness of development cooperation may not be respected; these principles specifically require that development priorities are set inclusively, in other words, in agreement with the beneficiaries.
• Fourth, the use of such funding instruments could cause market distortions in developing countries and crowd out local enterprises and investors.
• Lastly, blended finance entails a debt risk for developing countries.

The Alliance Sud Position paper "Blended Finance – Mischfinanzierungen und Entwicklungszusammenarbeit" (in German and French) offers an in-depth analysis of the potential, limits and risks of blended finance and makes some recommendations.

5. What are the alternatives?

The question generally arises as to whether and under what circumstances the use of Blended Finance and partnerships between players from official development cooperation and private enterprises could fulfil the (high) expectations placed on them.

It should be recalled in this connection that the Addis Ababa Action Agenda (AAAA) provides for the mobilisation of domestic public resources as a priority area of intervention for development financing and that combating illicit financial flows is indispensable in this context. Moreover, in developing the private sector, priority should go to local enterprises, especially micro, small and medium-size enterprises (MSMEs) – especially businesses run by women – and to domestic financial markets.

Blended Finance can thus be just one among several financial instruments with which to implement the 2030 Agenda.

[1] Over recent years, remittances – money sent back to their home countries by workers living and working abroad – have skyrocketed. For numerous developing countries, they currently represent the most substantial source of foreign financing, outstripping even Official Development Assistance (ODA) and Foreign Direct Investment (FDI).