Why long term financing must not be short-changed

Friday, July 8, 2016

Co-authored by Asli Demirgüç-Kunt, World Bank Director of Research, joined the WBG in 1989 and has a distinguished record undertaking research and advising on financial sector and private sector development issues. She created the World Bank’s Global Financial Development Report, has authored over 100 publications, and has published widely in academic journals. Her research has focused on the links between financial development and firm performance and economic development.
Unlocking resources and connecting development assistance to infrastructure, industry and other essential investments to attain the Sustainable Development Goals (SDGs) by 2030 cannot happen in the absence of long term financing, which is why the topic of this post is relevant for Financing for Development readers gearing up for next week’s big UN conference in Addis.
The use of long-term financing by small and medium enterprises in developing countries fell by almost half since the 2008 financial crisis, leading to concerns among international policymakers.
Large firms in developing countries were also affected when such funding fell off in the wake of the crisis. This is because bigger firms tend to rely on international markets and were vulnerable to the large drop in syndicated bank lending ever since. While corporate bonds and domestic syndicated loans have expanded in developing countries since the crisis, these increases were concentrated in only a handful of countries and, thus, did not typically compensate for the overall slump in international syndicated loans.
Long-term finance is vital for infrastructure investments, which are critical for development. Many of these are public-private partnerships to fund schools, roads, power plants, electricity grids, railways and broadband access projects.
Long-term finance is also needed if the private sector is to fund construction of power plants and if companies are to invest in machinery and equipment. When such funding is unavailable, firms become vulnerable to the risks that existing debt financing may not be rolled-over. In turn, they become leery of making new fixed investments (for example in machinery and equipment) that are important for economic growth.
The important role of long-term finance in development is the topic of this year’s forthcoming Global Financial Development Report by the World Bank Group.
The use of long-term finance is typically more limited in developing countries, particularly for smaller firms. For example, the median long-term debt to asset ratio for a small firm in a developing country is only 1.4 percent, whereas its high income country counterparts uses more than five times as much long-term finance at 7.3 percent. Firms in high-income countries report financing almost 40 percent of their fixed assets externally, whereas this figure is barely 20 percent in low-income countries. Similar differences exist for individuals’ use of term finance.
It is not easy to extend the maturity structure of finance. Research shows that weak institutions, poor contract enforcement, and macroeconomic instability naturally lead to shorter maturities on financial instruments. Indeed, these shorter maturities are an optimal response to poorly functioning institutions and policy weaknesses. The forthcoming Global Financial Development Report – GFDR for short — will also include policy recommendations to promote long-term finance and emphasize that the focus should be on fixing the fundamentals, not on interventions such as directed credit or subsidies which deal with the symptoms rather than the cause and suffer from political capture and poor governance practices. Hence, there is no substitute to doing the hard work of improving institutions. These include pursuing policies that promote macroeconomic stability, promoting a healthy, contestable banking system, adequately protecting the rights of creditors and borrowers, promoting better information availability, and facilitating long-term development of capital markets and institutional investors.
Well-designed public-private partnerships for large infrastructure projects can help governments mitigate political and regulatory risks and mobilize private investment.
Multinational Development Banks can help promote long-term finance by structuring risk-sharing products that allow private lenders and institutional investors to participate in this financing while reducing project and credit risk as well as by offering knowledge and policy advice to help shape the institutional reform agendas.