Perspective

Future-proofing businesses through development finance

This article was first published by Oliver Wyman here

 

This article captures the insights from a recent workshop exploring the role of development finance institutions in future-proofing small and midsize enterprises, organized by Oliver Wyman in cooperation with the European University Institute’s School of Banking and Finance.

Having just come through the COVID-19 crisis, small and medium-sized enterprises (SMEs) find themselves face-to-face with a range of new challenges, including rising costs of production, a talent shortage, increased political risk, and an expected global economic slowdown in 2023.

Development finance institutions (DFIs) play an important countercyclical role in helping SMEs weather the storm and emerge stronger. In doing so, they not only tailor their support solutions but also increasingly seek to ensure their activities remain relevant to broader global macrotrends – in particular, the effort to achieve a net-zero emissions world.

 

Headwinds ahead

The current macroeconomic environment poses major challenges for SMEs. A deterioration in consumer sentiment will likely lead to a reduction in consumption and, thus, business revenues, while a mix of exogenous shocks (including rising energy prices, supply chain constraints) is increasing production costs.

The weakening financial position of businesses compounds such difficulties. SMEs accumulated significant debt during the low-interest rate environment of the past decade. Now, however, borrowing costs are rising rapidly while corporate profits are declining, and banks are tightening lending standards given a worsening macroeconomic environment. Consequently, access to finance is declining for SMEs, restricting their ability to cover expenses and make capital investments.

At the same time, governments are less able to support SMEs. Fiscal policymakers will need to manage tightening national budgets and will find it challenging to provide support measures such as the subsidy programs set up during the COVID-19 crisis. With inflation at multidecade highs, central banks are unlikely to offer relief and reverse their course of monetary tightening in the near term.

 

How DFIs provide support

DFIs have the capacity and capabilities to support SMEs where commercial lenders are hesitant and governments cannot. They continue to have significant room to maneuvre because of their strong financial position. Moreover, they have an agile toolkit at their disposal, comprised of a range of funding and financing products as well as advisory services.

Importantly, DFIs are adopting a tailored approach to supporting SMEs. To be more effective in their work, institutions calibrate their product offering based on the underlying economic challenges of the specific geographic context. For example, the European Investment Bank (EIB) has leveraged guarantee programs to address market failures in Europe and facilitate SME access to commercial loans. In Latin America, small enterprises have required measures that enable them to become part of the formal economy. There, the IDB Lab has deployed a combination of grants and advisory services to support innovative ventures that help address the informal sector, such as digital payment solutions.

 

Preparing for inclusive and sustainable growth

To remain relevant as catalysts of change, DFIs also seek to align their activities with broader macrotrends, such as inclusive and sustainable growth. Those trends are critical to building the economy of the future, allowing us to unlock previously untapped business models and reach net-zero emissions in the coming decades.

DFIs are adapting their mission to this new environment. Many institutions have begun revising their mandates to focus more on inclusion and diversity and are expanding programs to support female and minority business owners and address regional disparities. For example, the British Business Bank has launched several regional investment funds seeking to help boost productivity, innovation, and jobs in the United Kingdom.

Moreover, DFIs are overhauling their metrics of success, increasingly emphasizing the broader economic, social, and ecological impact of their work. For instance, a core element of the 2022 strategic plan of the Brazilian development bank BNDES is to shift the organization’s focus from purely financial value creation to one of positive socio-environmental impact.

DFIs are stepping up their climate finance activities. They are increasing the financing and funding of climate-positive projects and introducing bespoke, new products that aim to accelerate efforts to achieve net zero. The EIB has invested in dedicated private equity and venture-capital facilities to cover critical market gaps in long-term financing sources for climate tech. And several institutions are introducing transition finance programs, which will provide capital to companies seeking to reduce their emissions.

Additionally, DFIs are leveraging their advisory services to support firms in adopting sustainable business models. They seek to build bridges between emerging climate technologies and industries that have been slow in introducing innovative solutions to reduce emissions; the Asian Infrastructure Investment Bank, for example, provides dedicated support for construction companies to transform their operations and cut emissions. In this context, through their vast capacity and credibility, DFIs are helping set climate standards.

 

Unlocking economic potential

Going forward, DFIs will play a key role in facilitating innovation by crowding in investments for emerging sustainable technologies. In particular the green hydrogen industry will require support to overcome financing gaps, and several DFIs including the Chilean economic development agency CORFO are already in the process of establishing dedicated hydrogen funds. 

Unlocking the full potential of these breakthrough technological developments will pave the way for more sustainable and inclusive growth. DFIs are best equipped to accomplish this and propel economic transformation, even in times of hardship.