Structured Funds: A Crisis Instrument in Times of the Coronavirus Pandemic?

The coronavirus pandemic has triggered the greatest economic crisis in almost a century: the global economy could contract by up to 7.6 percent in 2020 (OECD, 2020). The Global South is particularly hard-hit, as private investors shift their investments to seemingly secure markets in times of crisis. In March 2020 alone, private investors withdrew USD 83 billion from emerging markets (IIF, 2020), which further increases the financing needs of these countries.

Capital flight exacerbates the existing liquidity squeezes of the micro, small and medium-sized enterprises (MSME) in developing countries, 40 to 44 percent of which already had insufficient access to credit before the crisis (IFC, 2017). Shutting down the local economy also affects MSMEs more than larger companies, as they usually have fewer reserves and are less digitalised (OECD, 2020). As MSMEs account for 30 percent of private sector jobs in developing countries (EUIFI, undated), millions of jobs are at risk.

Structured funds are a financing approach that addresses both the financing needs of developing and emerging countries as well as the credit constraints of MSMEs. Structured funds usually combine federal budget funds of the German government with market funds of the Kreditanstalt für Wiederaufbau (KfW) and/or other financial institutions with private investments. The public donors in the fund assume a large part of the investment risk, thus reducing the risk for private investors. The funds grant loans to financial institutions such as microfinance banks in developing and emerging countries. These in turn grant loans to MSMEs or other sub-borrowers.

The German Federal Ministry for Economic Cooperation and Development (BMZ) plans to increase its contributions to the structured funds for MSMEs (named in the concept: REGMIFA and SANAD) as part of the Emergency COVID-19 Support Programme (BMZ, 2020). The German Institute for Development Evaluation recently completed an evaluation of structured funds (see Policy Brief 3/2020). Against that background, this blog post examines the potential for structured funds to bridge liquidity squeezes in MSME financing in developing and emerging countries and thus contribute to mitigating the economic impact of the coronavirus pandemic.

The structured funds' large risk buffer reduces the risk for private investors, who thus have an incentive to invest in regions and sectors that they consider to be risky. So far, however, the mobilisation of private funds has been particularly successful in countries that are considered less risky, including Southeastern Europe, while the mobilisation of private funds has been less successful in Sub-Saharan Africa. Consequently, private investors account for less than 30 percent of total resources in most funds. Nevertheless, due to the funds’ high financing volume overall (provided by public donors, development finance institutions and private investors), structured funds contribute to covering the financing needs in developing and emerging countries and thus also have the potential to cushion private investors' capital flight as a consequence of the coronavirus pandemic. An increase in public funding might at least prevent private investors from withdrawing further resources from these funds. In doing so, the funds can respond flexibly to the needs of particularly affected countries and sectors, as they usually operate regionally or even globally. New funds, on the other hand, take a relatively long time to set up and are therefore not suitable for addressing short-term provision of financing as needed in times of crisis.

Since the funds grant loans at standard market conditions, they are less suited to financing the poorest countries or financial institutions with particularly risky portfolios and marginalised groups, although these are impacted the most by crises. Structured funds should therefore be considered as complementary to other approaches such as grants, which are non-repayable and therefore lay no claims on economic viability. In addition, structured funds are currently mainly active in the MSME sector. Through the coronavirus pandemic, however, considerable financing needs in sectors, in which structured funds had only invested sporadically or not at all until now, have become more urgent. This applies above all to the health sector, but also to the education, water and sanitation sectors.

Structured funds provide long-term financing and thus contribute to the stability and financial sustainability of the respective country's financial institutions and the financial system. This is particularly true for seven of the nine funds examined that offer a share of their financing in local currency. In those cases, the funds assume the full currency risk. The coronavirus pandemic shows why this is important for financial institutions: currencies such as South African Rand and Brazilian Real depreciated by 20 percent against the US Dollar between January and April 2020 (Handelsblatt, 2020), driving up the cost of repayments in US Dollars.

The evaluation shows that the funds' financing enables the financial institutions to grant more loans, which means that more sub-borrowers - often MSMEs - have access to financing to bridge liquidity squeezes caused by revenue declines. Since the funds mainly support financially stable institutions, they are more likely to ensure access to financing even in times of crisis than small, younger institutions.

However, this also means that most financial institutions do not reach sub-borrowers who have previously not had access to financial services. This is in part because the funds generally do not track the impact on sub-borrowers enough, for example through indicators. This makes it difficult to determine whether the institutions also grant loans to those MSMEs that are facing the greatest cashflow difficulties and whether they support the sub-borrowers in other ways during the coronavirus pandemic, for instance by suspending repayment claims. This is exacerbated by the fact that customer protection principles are not always observed. For example, some financial institutions allow sub-borrowers to take out several loans, thus increasing the risk of over-indebtedness. This also increases the risk of insolvency, especially considering the scale of the financial losses caused by the coronavirus pandemic.

Structured funds have the potential to contribute to the stabilisation of developing and emerging countries during the coronavirus pandemic. In times of crisis, they demonstrate their strengths: the investments help to cushion the capital flight of private investors from developing and emerging countries, and the flexibility of the structures allows the funds to respond to changing needs at short notice. By financing - also in local currency - financially stable financial institutions, they contribute to the stability of the financial system in the partner country and support the institutions in enabling MSMEs to access financing even in times of crisis, thus bridging liquidity squeezes. Whether this is what actually happens, however, is difficult to ascertain, as the funds do not sufficiently track which sub-borrowers are being reached and how fund financing affects them. To minimise the risk of over-indebtedness and insolvency, the funds should step up efforts to monitor their impact on sub-borrowers, especially in times of crisis. In addition, it should be examined to what extent the structured funds can also help cover financing needs in sectors other than MSMEs in order to strengthen the partner countries' resilience to future pandemics - for example in the areas of health, education, water and sanitation.