The G20 has delivered a clear message that multilateral development banks (MDBs) need to be “better, bigger, and more effective.” That’s the headline of the G20 reform plan adopted in November that not only sets the direction of travel— but establishes a detailed roadmap with 13 recommendations and 44 actions.
A key demand is for MDBs to mobilize more private capital for development, alongside efforts to leverage more financing from their own balance sheets. It is a goal that the World Bank Group and other MDBs are moving fast to achieve, with ambitious near-term targets in sight. This includes mobilizing $65 billion in climate finance for low and middle-income countries by 2030. The private sector is also pivotal to meeting the World Bank Group and African Development Bank’s efforts to connect at least 300 million people in Africa with electricity access by 2030.
To achieve these targets, we need to be clear-eyed about the obstacles that hold back private capital from entering emerging markets. That includes, among other factors, the question of risk.
From currency depreciation and regulatory uncertainty to difficulties in enforcing contracts, there is no doubt that investing in emerging markets entails risks. But in aggregate, how risky are such investments?
The answer to that question has come into focus thanks to the Global Emerging Markets Risk Database (GEMs) Consortium, an initiative that involves 26 MDBs and development finance institutions. GEMs pools data on default and recovery rates for around 18,000 projects, totaling over half a trillion dollars, from 1994 to 2023. It is the largest credit risk database for emerging markets, designed to drive investment to developing countries by helping investors better assess the risks.
Analysis of the GEMs data by the International Finance Corporation (IFC), the private-sector arm of the World Bank Group, challenges the perception that emerging markets are high-risk environments.
Take the average default rate. At 3.6%, loans to private sector firms in the GEMs portfolio performed similarly to many non-investment grade firms in portfolios dominated by advanced economies. For example, global corporations rated B by Standard and Poor’s and those rated B3 by Moody’s saw default rates of 3.3% and 4%, respectively.
More importantly for global investors, default rates in the GEMs portfolio display a low correlation with default rates globally for corporations with similar risk ratings. Across the six major periods of global economic stress over the past three decades, default rates for emerging market firms in the GEMs portfolio did not rise as much as default rates for similarly rated corporates in advanced economies.
During the 2008 global financial crisis, for instance, default rates in the GEMs portfolio were lower than for advanced economy comparators. In other words, advanced economy investors who included emerging markets in their portfolios reaped diversification benefits when they needed them most.
One of the most compelling findings from the GEMs data is the disconnect between a country’s sovereign risk rating and the default performance of its corporations. Sovereign ratings have long been a significant factor in how investors assess the risk of private sector lending and investment in a country. However, the GEMs statistics show that relying too heavily on sovereign credit ratings may lead investors to misjudge corporate risk in emerging markets.
For example, in lower-income countries the average default rate for private borrowers was 6% — less than half the default rate that might be expected based on their sovereign credit ratings (14%). The divergence between private sector default rates and those implied by sovereign ratings narrows significantly as country income levels increase. Likewise, the gap shrinks when considering countries with better sovereign ratings.
But what happens when defaults occur? GEMs statistics show that these assets also have higher-than-expected recovery rates. On average, investors in GEMs loans to private sector counterparts recover 72% of their investment after a default, outperforming Moody’s Global Loans at 70%, Moody’s Global Bonds at 59%, and JPMorgan’s Emerging Market Bonds at 38%. These higher recovery rates suggest that even when defaults occur, investors in emerging market firms are not at all left empty-handed.
MDBs, which invest heavily in local expertise and in-country staff, can play a pivotal role in demonstrating the viability of projects in markets that have not historically seen large FDI flows. They can provide advisory services to companies to improve their financial management and governance. And they not only structure and finance projects, but also supervise implementation through the life of the loan. These actions help mitigate project and borrower risks and contribute to both lower defaults and higher recovery rates. The good news for global investors is that IFC and other development finance institutions are looking to rapidly scale up their mobilization of private capital and are creating new vehicles to do so.
The evidence is clear. By incorporating emerging markets into global portfolios, investors not only stand to benefit from diversification but also play a role in supporting the long-term development of economies that need it most. It bodes well for the G20’s call to scale up private capital for development – and the ability of multilateral development banks to answer it.