By: James Dorman, Trade Treasury Payments (TTP)

Trade is perhaps the most powerful engine for reducing poverty ever devised. Over the last three decades, it has been the driver of lifting hundreds of millions of people into the middle class. But there is currently a fundamental paradox at the heart of international trade – the demand for trade credit far outweighs the supply banks are willing to provide. The global trade finance gap is estimated at $2.5 trillion, and it is hitting small and medium-sized enterprises (SMEs) in emerging markets the hardest.

The problem is compounded by risk. Traditional commercial banks, bound by the Basel III capital requirements, have an extremely low appetite for risk. Investing in trade in less-stable frontier jurisdictions is particularly unappetising for commercial banks, as the cost of due diligence likely exceeds any potential returns. SMEs in these areas looking to participate in the green transition or any other infrastructure-heavy developments particularly struggle, as private investors tend to avoid any large-scale infrastructure building in developing nations due to the risk posed by political or financial instability. This means SMEs in these regions hoping to get involved with high-impact development sectors are effectively precluded from commercial financing.

So, we have this terrible irony that those most in need of the benefits of trade are the least likely to enjoy them. Blended finance looks to correct this failing by essentially acting as a strategic bridge connecting private capital with high-impact trade opportunities previously thought to be unbankable. The key to creating this bridge is non-commercial capital.

The blend in blended finance

In its most basic terms, blended finance is a strategic approach to development finance that uses relatively small amounts of public capital or capital from philanthropic sources to mobilise larger amounts of commercial investment.

Blended finance shouldn’t be thought of as a distinct asset class, but rather as a structuring approach that uses public and philanthropic funding to make development commercially viable.

The “blend” involves three distinct components:

•       Concessional Capital: Capital provided by Development Finance Institutions (DFIs) or philanthropic sources provides the foundation, taking a first-loss position or accepting the potential for lower returns to “de-risk” the project for commercial funders.
  
•       Technical Assistance: Grant-funded project preparation, feasibility studies, capacity building, etc., further improve commercial viability.
  
•       Risk Mitigation Instruments: Guarantees, insurance, and other risk mitigation tools offer private investors protection against pitfalls like currency fluctuations or political instability.

By utilising these complementary layers, once commercially unbankable projects are transformed into genuine opportunities that fit the rigorous risk-return profile of private investors. This theory is already being put into practice; blended finance is the primary vehicle for Energy Transition Mechanisms (ETMs), and we can see a clear example of its benefits in action if we consider the case study of the early retirement of a coal-fired power plant.

Here, ETMs can use low-cost concessional loans to buy out coal plants years ahead of their scheduled closure. Closing a functional coal plant early would be a costly, “unbankable” proposition ordinarily, but concessional capital covers the buyout costs and de-risks the venture from an investment standpoint.

Alongside the plant being decommissioned, capital can also be put towards the construction of renewable energy alternatives. At the same time, grants can help pay for the retraining of coal workers. Finally, guarantees ensure private investors feel safe funding the replacement renewable energy venture.

So, the transition from a functional coal plant with remaining useful life to a renewable alternative — a project that was once a financial non-starter – is made an attractive, de-risked private investment prospect through the application of blended finance.

A strategic solution to contemporary problems

This is the “how” of blended funding, but why is it becoming more prominent now? We are starting to redefine how we view trade and aid, and how the two can intersect. Traditionally, aid has been seen as the domain of governments and NGOs and trade the realm of corporations. Now we’re seeing that removing them from silos is the key to true sustainable development.

This paradigm shift has been somewhat pushed by the scale of the Sustainable Development Goals (SDGs). Through the prism of modern economic realities, public money alone is a drop in the ocean of what’s needed. While there are billions being spent, meeting targets like the 2030 SDGs or the global commitment to Net Zero by 2050 requires trillions.

Government pockets aren’t going to suddenly get infinitely deeper, so DFIs look to adapt and pivot. Rather than simply lending money, their role now is to act as a magnet for private sector participation. Through the strategic implementation of concessional capital to reduce risk, the impact of public funds can be massively multiplied by the catalytic effect of leveraging private capital to create truly sustainable trade.

This is already being seen in action in an ambitious undertaking by the South African Just Energy Transition Partnership (JETP). The partnership aims to use an initial commitment of $8.5 billion in public and concessional funding from international partners as a catalytic spark to mobilise capital from private institutional investors to cover the cost of a $98 billion plan to accelerate the retirement of South Africa’s coal-heavy power utility.

The challenges of blended finance

Blended finance can prove the viability of new markets, meaning they can grow and flourish without the continued need for concessional capital. In a tighter global credit environment marked by rising interest rates, the de-risking capability of blended finance is a prerequisite for private capital to remain engaged in emerging markets.

The potential of blended finance is enormous, with the Organisation for Economic Co-operation and Development (OECD) recognising its strength in allowing DFIs and private investors to work together and leverage each other’s resources and knowledge. But it is not without its problems.

Critics point to several bottlenecks that prevent it from reaching its full theoretical potential. For one, structuring a blended deal is a complex, labour-intensive undertaking, and each deal is a bespoke package. Think of the stakeholders involved: development experts, lawyers, commercial bankers – groups that seem like they rarely speak the same language and incur a lot of advisory fees and transaction costs. There is a market pull toward standardisation to allow for more streamlined and cost-effective interaction between development experts and commercial financers, and to remove this scalability barrier.

There is also the issue that public or philanthropic money is being used to mobilise private capital, but, as with any private financing deal, there isn’t necessarily the transparency to know exactly how much private capital was mobilised, or indeed if it could have been mobilised without the need for public and philanthropic capital. Interestingly, this is a problem that somewhat solves itself in one of the more prominent emerging markets benefiting from blended finance – fintech.

Blended finance is helping develop many SMEs involved in the digital infrastructure side of fintech; as they support the implementation of digital ledgers and blockchain-based tracking in emerging markets, blended finance from development agencies essentially creates a digital track record for the companies it supports. When a company has this verifiable digital history, it makes the transition to pure commercial financing smoother once it is proven financially viable.

Finally, there is the speed consideration. Trade lives and dies on the speed at which it moves, and development bureaucracies move at a glacial pace by comparison. For blended finance to truly work as intended and meet its potential, approval processes and other administrative functions need to be streamlined.

The new normal for mobilising private finance?

Blended finance is at a critical juncture, moving from a period of experimentation to one of strategic, scalable implementation. Market integrators, like the Toronto-based blended finance network Convergence, are building the data benchmarks that allow investors to see that trade in frontier markets is not as risky as they may perceive it to be. This perception shift is crucial as we look to the future of trade.

By embracing blended finance as the norm rather than something sitting at the fringes of impact investing, there seems to be a real opportunity to close the $2.5 trillion trade finance gap and move towards a system where a business’s ability to trade is determined by the quality and sustainability of its output, without the geography of its operation being an impassable barrier.