COVID-19 v. Developing Economy: The Underdog Advantage
Much has been said and written about the impact of COVID-19 on the developing economies. Some even predict that COVID-19 may create steep inequalities in developing countries. While that might be true, much less has been written about the impact of COVID-19 in the light of inherent risks that a developing economy already presents. As a transaction advisor in the social impact space, most of my advice to clients in general focuses on managing their concerns around the unique risks that stem from investing in developing economies such as India. In recent times, these concerns have become more pronounced for obvious reasons.
Many have suggested that COVID-19 was a crisis waiting to happen. In other words, while a pandemic of this scale and severity could not have been accurately predicted, experts recognized that it was likely. That said, it has been interesting to see the responses of different countries to the pandemic. With Donald Trump trivialising the intensity of the virus, Turkmenistan choosing to ban the word ‘coronavirus’ and countries like South Korea, Hong Kong and Singapore imposing strict quarantine measures, the world has now seen varying responses to curb the spread of the virus. A common theme that has been spotted in all these responses is that they are in tune with the underlying governance framework of the respective countries. Trump has historically downplayed and even failed to recognize climate change as an issue of global concern, and so the fact that he grossly underestimated COVID-19 comes as no surprise! Similarly, it can be seen that most countries’ coping mechanism to the pandemic is nothing but a manifestation of their underlying governance pattern. Each country develops a coping mechanism which is unique to the risks (wars, natural calamities etc) it has faced over time. The way it responds to a pandemic is in part informed by this coping mechanism, and COVID-19 was not going to materially alter this very fundamental reaction.
While COVID-19 is the latest macroeconomic risk that looms over the Global South today, an interesting question that emerges is whether this pandemic poses a bigger threat to the economies of the Global South than to that of the Global North? A raft of op-eds these days present the dismal situation of economic activity across the world, painting an even gloomier picture for the emerging economies. A frequently unstated assumption here is that emerging markets were always more exposed to macroeconomic risks than their developed counterparts. Historically, developing economies have encountered significant perils; which if their developed counterparts had to deal with would have almost guaranteed an economic slump. Speaking of India, an attack on a convoy of vehicles carrying security personnel in Pulwama (Jammu & Kashmir) did not affect the Indian economy as much as if the same event had to happen in a developed country it would have been considered an ‘act of war’ forcing the economy to slow down. Geographically too, parts of India often face weather conditions that make it otherwise difficult to conduct business. For instance, the Bay of Bengal is an important gateway for the Southeast Asian countries to do business with India. In fact, a recent construction of the bridge between Thailand and Myanmar via the Bay of Bengal is expected to give the ASEAN countries access to the vast Indian markets thereby reducing dependency on China. However, the Bay often experiences low pressures/ monsoon depression that otherwise make trade possibilities challenging. Further, the ethnic conflicts prevailing in the north-east region of India (near the Bay area) do not make doing business in that area any easier. In essence, it might be fair to say that India has developed the muscle memory of dealing with a variety of macroeconomic risks which overtime have only made it’s economy more resilient.
An effective demonstration of this muscle memory occurred as the Indian government responded to curb the spread of COVID-19. With quick and early imposition of a national lockdown and strict measures taken to inflict social distancing, India had been ahead of its developed counterparts in flattening the COVID-19 curve. Be it the utilization of its digital capabilities and launching a mobile app to track the virus or significantly increasing health expenditures to strengthen the health care system of the country, India has been doing it all to contain the crisis. To treat the economic fallout of the pandemic, one of the measures introduced by the central bank of India involved immediate reliefs such as freezing creditor payments to help borrowers have liquidity and avoid the defaulter tag. Such actions indicate that while developed countries are set to experience a prolonged economic slowdown, the emerging markets of the developing countries will be able to bounce back faster since they are more resilient and have over time strengthened their governance frameworks against external shocks.
Despite these dynamics, investment sentiments of foreign investors in developing economies during present times are bearish. Businesses across the world today are treading cautiously given the economic turbulence that COVID-19 is unfolding. Investors are prone to adopting a fear based approach to investing when markets globally are experiencing a turmoil. Instead, they would be better off if they were to adopt a knowledge based approach and understand the inherent strengths that emerging markets present. Considering that emerging economies are better positioned to withstand macroeconomic risks, they present better growth opportunities. COVID-19 is an opportunity for economies of the world to do business differently — by channelizing investments and building partnerships that shape the markets to deliver sustainable and inclusive growth. One way is to alter the investment approach and include new structures that “blend” public funds with private capital. Public funds include philanthropic or development funds such as USAID, Gates Foundation etc. Such funds tend to assume the risks that private players are usually unwilling to bear, where the underlying motive is to attract private investment for social good. However, the private player still approaches this with a profitability first intent. In this regard, to them, this is an investment opportunity like any other. The purpose behind such blending is to invest towards achieving sustainable development goals in a developing country. Blending public capital with that of private players can help accelerate economic restoration and boost confidence of private players who would have otherwise chosen not to invest in developing economies. Some of the investment structures that could be considered to respond to the pandemic are detailed below.
1. Guarantees: Guarantees are commitments from contributors of public capital to protect private players if there is a default on payment by a borrower. Guarantees tend to protect private players from losing their capital as well as improve the creditworthiness of the borrower. Such guarantees funded from public capital can mobilise more private capital than what would have otherwise been lent/invested in the borrower. In a recently concluded transaction, I had the opportunity to advise a European foundation that partially guaranteed repayment obligations of an Indian company delivering micro-finance and micro-enterprise services. As a result of the guarantee, the Indian company was able to secure INR 1.7 billion (USD 22 million) from other private players in capital to use towards extending micro-finance services to the poor communities in India.
2. First loss capital: First loss capital is the kind of capital provided from public sources wherein the public sector investors assume the first loss on investments made by private sector investors. Such capital de-risks the investments made by the private players by preventing them against potential downsides and taking the first loss in the event of losses. Providers of first loss capital take the junior most position in an equity or debt transaction and provide favourable terms to private investors that involve market rate returns. The capital structure of the Medical Credit Fund is a befitting example that leveraged first loss capital structure to mobilize private debt for the health sector in Africa. Such innovative layered capital structure enables private players to wade into unchartered waters but still end up with a valuable business opportunity that allows them to first test the waters instead of taking a plunge.
3. Pay for success bonds: Also known as social impact bonds, pay for success bonds are bonds that reward an outcome- in this context a social benefit. Implementation of such a bond involves multiple participants such as an outcome funder, a risk investor, a performance evaluator and other intermediaries that manage the execution of the project. The risk investor is usually a source of public capital that provides upfront capital for specified targeted outcomes. The performance evaluator frames the success metrics (agreeable to all stakeholders) and evaluates the outcomes against those metrics. The outcome funder makes payments to the risk investor depending upon the extent of outcomes achieved. Launched in 2018, the Utkrisht Impact Bond purported to support private healthcare services in India and is a successful example of the pay for success model. Recently, as a response to COVID-19 in the European Union COVID-19 social bonds have been announced as a step towards economic recovery. These bonds are focused on health care and direct lending for small and medium and enterprises.
Public sources of capital in these kind of blended investments may easily be perceived as ‘dumb’ money or investment approaches that involve substantial risks. More so when such investments are proposed in emerging markets, which is often the case. However note that providers of public capital also have better understanding of the geography they invest in than mainstream investors and therefore their capital makes private players more comfortable. As a result, investment structures like the above can play a dominant role in recouping the confidence of investors in developing markets.
There is a great deal of uncertainty in today’s markets, however with uncertainty sometimes comes opportunity. Given the severity of current circumstances, we can choose to be afraid of the future, or we could rely on patterns of resilience as demonstrated by developing economies in the past to inform our investment decisions in the present. We may just need the right investment vehicle to get there.
