FINANCE SECTOR DIALOGUE OP-ED
To save the world, the global financial system will have to change
This article is an extended version of a talk delivered at the Finance Sector Dialogue hosted by the Presidential Climate Commission at the JSE on 16 November 2023.
Nearly every aspect of daily urban life depends on the burning of fossil fuels — not just keeping the lights on and getting around in cars, buses, trains and aeroplanes, but also growing the food we eat, pumping our water and sewage, mining the minerals we depend on for our electronics, manufacturing the plastics we use for almost everything and making the cement and bricks we use to construct our built environment. Decarbonising all this means replacing the systems all these activities depend on.
Over the past decade, two influential communities have come to the realisation that the large bulk of the fossil fuel-driven infrastructure we now depend on for our urban-centred modes of living will need to be replaced. They took 250 years to build and must be replaced in 40.
The first is the scientific community, which now agrees that unless we reduce to zero our carbon emissions, life as we know it will not be viable within three to five decades. Real decarbonisation that aligns with the science means replacing gigantic chunks of our current material infrastructures that we currently take for granted, particularly in the most advanced industrial societies.
The second is the global finance community, which has learnt from the global financial crisis and the Covid pandemic that when the red warning lights start flashing, don’t ignore them. This time round, they talk incessantly about acting before it is too late — but it remains unclear whether they will, and how.
Unsurprisingly, calls to reform the global financial system to align with the global challenges humanity faces are starting to be heard. Over the past year, several African leaders, including our own, have reinforced the call for fundamental changes to the architecture of the global financial system.
The Africa Climate Summit that took place in Kenya in September 2023 resulted in the Nairobi Declaration that clearly reiterated this call. The United Nations secretary-general repeatedly reiterates the need for reform of the global financial system, and this will be the focus of the Summit of the Future planned for September 2024.
In a pathbreaking report by the Inter-Agency Task Force on Finance for Development entitled Financing for Sustainable Development Report 2023, it is clearly stated that the “current international financial architecture — the governance arrangements for both safeguarding the functioning of the global monetary and financial systems and ensuring that the system is aligned with sustainable development — has not kept pace with the changing global landscape.
“Some have used the term ‘non-system’ to describe the existing set of international financial frameworks and rules, institutions and markets that have evolved with different phases of economic globalisation, often in ad hoc fashion and in response to economic and financial shocks. Even in a narrow economic context, capital is not allocated to its most productive uses and the architecture fails to avert boom-and-bust cycles.”
The United Nations Department of Economic and Social Affairs coordinated the team that wrote this report, which included some heavy hitters — the World Bank Group, International Monetary Fund, World Trade Organization, United Nations Conference on Trade and Development and the United Nations Development Programme, plus all five regional UN economic commissions, and 52 specialised UN agencies and a set of related influential global research institutions.
Green swan event
The Bank for International Settlements (BIS), the global mecca of the world’s central banks, refers to climate change as a green swan event. A black swan event cannot be predicted, and the result is devastating. A green swan event can be predicted, and if nothing is done, the result could be even more devastating. Climate change is a green swan event — we all know it is happening, the BIS argues, and it could threaten the viability of the global financial system.
There are now numerous initiatives that could result in fundamental changes to the way the global financial system works. These include the Bridgetown Initiative launched by the prime minister of Barbados, Mia Mottley, which calls for a major overhaul with far-reaching implications for how developing countries gain access to more and cheaper finance.
The UN Secretary-General’s SDG Stimulus to Deliver Agenda 2030 report (2023) makes a similar argument, backed by some alarming data on global financial flows and debt. The Paris Summit for a New Global Financing Pact hosted earlier this year by President Emmanuel Macron reinforced calls to reform the global financial system and in particular, the World Bank, which has now become an explicit commitment in the World Bank Group’s Evolution Roadmap.
Other initiatives include the G20’s Capital Adequacy Framework, which is aimed at increasing lending by the multilateral development banks, the rising pressure from many quarters on the IMF to redirect special drawing rights in favour of developing countries, and India is using its leadership of the G20 to drive the Global Sovereign Debt Roundtable which is a joint initiative with the IMF and World Bank.
Egypt used its position as host of COP27 to launch the Sustainable Debt Coalition, and the so-called V20 (the 20 most vulnerable countries, which is now 58, including 24 African countries) has proposed an Emergency Coalition for Debt Sustainability and Climate Prosperity.
The most comprehensive set of proposals for reforming the global financial system from an African perspective has been articulated by Carlos Lopez, the former secretary-general of the United Nations Economic Commission for Africa. He authored a new report published in 2023 by the Africa Climate Foundation entitled Priorities for an Equitable Reform of the Global Financial System: Unlocking Climate Investment and Sustainable Development in Africa.
In it, he calls for a roadmap for Africa with 15 far-reaching recommendations. Although it places too much emphasis on reforming the World Bank, this report does address key challenges such as the extraordinarily high cost of capital, outward flows of capital from Africa, the absence of an African voice in the global governance of the financial system and the profoundly unjust rising indebtedness of African governments as they borrow more and more to deal with increasingly costly climate catastrophes.
His is a call for Africa to get its act together to take its rightful place in the institutions of global financial governance, such as the board of the IMF, the G20 and various other recommended institutional reconfigurations.
The starting point for any discussion about the reform of the global financial system should be the global estimates of what will be required to achieve the Sustainable Development Goals (SDGs) — over the years, these estimates have increased.
- Back in 2014, UNCTAD’s World Investment Report estimated that $2.5-trillion per annum was required by Global South countries.
- By 2023, the estimates were getting higher: according to the High-Level Advisory Board on Effective Multilateralism published in 2023, the estimated cost of achieving the SDGs is $3.9-$5-trillion per annum.
When we ask about the challenge of mobilising finance for sustainable transformation, these numbers mark out the territory. What they suggest is a massive expansion of the balance sheets of the world to accommodate the construction of large swathes of new climate-resilient infrastructures, but also mechanisms for handling the looming threat of stranded assets and large-scale devaluations.
According to the Climate Policy Initiative (CPI), climate finance reached $632-billion in 2019/20, half of which was contributed by the private sector.
The IMF has estimated that in 2021 ESG-related debt issuance reached $1.6-trillion, 116% higher than in 2020.
Growing evidence of greenwashing
Four thousand organisations have signed the Principles for Responsible Investment, and 450 major financial institutions from 45 countries have signed up to the GFANZ initiative (Glasgow Financial Alliance for Net Zero).
And yet, despite these impressive commitments, there is growing evidence of greenwashing. Eleven of the biggest European banks own fossil fuel assets worth 95% of their equity.
Similarly, 60 of the world’s largest banks invested $4.6-trillion in fossil fuel assets in the six years following the signing of the climate accord in Paris.
The global challenge of mobilising large-scale finance to replace large chunks of the world’s infrastructure is difficult enough. However, there is also the challenge of the unequal distribution of these global infrastructure assets and the unequal flow of financial resources in favour of the Global North. There are four matters of concern: unequal exchange, capital flight, the cost of capital and Africa’s low priority for climate finance.
Influenced by Jason Hickel’s work on global inequalities, Helga Weisz and I drafted a discussion paper in 2022 for the International Resource Panel on unequal resource flows. The results from a forthcoming report can be summarised as follows:
- 24-43% of resources extracted in the Global South are consumed in the Global North;
- 20% of all land in the Global South is embodied in goods consumed in the Global North;
- 28-38% of all labour in the Global South is deployed in the production of goods that are consumed in the Global North;
- 10% of energy generated in the Global South is embodied in goods consumed in the Global North
- Consumption is profoundly unequal: 27 tonnes of materials are consumed per capita in the Global North, versus six tonnes per capita on average in the Global South;
- Significantly, 25% of the Global North consumption is effectively procured for free due to structurally determined unfair compensation for Global South resources — or, put simply, paying the Global South less than the real value of the goods extracted in and imported from the Global South.
Unequal exchange is the deeper underlying logic that determines the persistence of our increasingly unequal world which, according to Oxfam, allows 1% of the world’s population to make twice as much money as 99% of the world’s population.
It has been estimated that $2-trillion illegally flowed out of Africa into mainly international tax havens over the period 1970-2014, $600-billion of which flowed out after 2000. Including interest, this is $2.4-trillion. This is three times higher than the total accumulated African debt by 2018. Total official development assistance for the period 1990-2015 was $2.6-trillion.
Cost of capital
According to the UN Secretary-General’s SDG Stimulus to Deliver Agenda 2030 report, a key global challenge is the high cost of capital that developing countries have to carry. The average cost of capital, according to this report, in least developed countries was 5-8% before interest rates started to rise, compared to 1-2% in developed countries. Some African countries pay up to 15% interest on the debt they can access despite the fact that the African region has the lowest default rate for infrastructure projects compared to other regions (5.5%).
According to Professor Ghosh, 113 countries pay more on debt than they spend on health and education combined. Thirty-seven of 69 of the poorest countries are in debt distress — most of them in Africa. Most of these countries would not be in debt distress if they could borrow at 1%.
If African countries are required to borrow at 5-15% to fund climate actions aimed at achieving climate goals that benefit all of humanity, then what that means is that they are being asked to become more indebted, with detrimental socioeconomic implications for their own populations to mitigate climate changes they did not create.
According to the Report of the Independent High-Level Expert Group on Climate Finance, 63% of the climate finance raised is debt. Only 16% of this debt was low-cost or concessional debt. Equity comprised 32% and only 5% was grants.
Africa as low priority
According to the African Development Bank, only 2% of the $2.8-trillion invested in renewable energy over the period 2000-2020 was invested in Africa. And yet, it is a scientific certainty that if Africa energises using fossil fuels, none of the Paris targets will be achieved. Africa’s generation capacity for a population of more than one billion in terrawatt-hours is equal to France and Germany combined, which have a population of 140 million. One could have assumed that given this scientific certainty, far more would have been invested in Africa, but this is not the case.
African countries are falling ever deeper into debt, with debt levels now the highest in a decade. Debt comprises a quarter of Africa’s GDP. By 2021, the combined debt of all African countries was more than $1-trillion. Servicing this debt is worsened by the fact that the tax-to-GDP ratio is very low, at 16% — the result of decades of neoliberal advice to lower taxes as a growth catalyst.
The bottom line is that the global architecture of the financial system enables the systematic flow of capital out of the African economies. This is exacerbated by climate change that catalyses a vicious circle of rising climate costs and debt distress. African countries spend 3-5% of their GDP on climate change responses. Climate change could lower African GDP by 2-4% by 2040 in a business-as-usual scenario.
The African challenge
There are various estimates of the African financing challenge.
According to the African Development Bank, $127-billion is required per annum to achieve the NDCs (National Determined Contributions as per UNFCCC requirements). However, current investment levels are not much higher than $30-billion per annum, which means the funding gap is $99-billion.
The Climate Policy Initiative has estimated that the annual requirement is much higher, at $277-billion. Given its estimate that current investment levels are $37-billion per annum, this means the funding gap is R240-billion per annum.
The Columbia Center on Sustainable Development at Columbia University in New York has estimated that $136-billion is required to fund a low-carbon energisation programme, compared to an estimated investment in the same of only $4-billion per annum. This leaves a funding gap of $132-billion per annum.
In short, according to these estimates, the funding gap is between $99-billion and $240-billion per annum.
Because Africa’s population is growing faster than anticipated by demographers and its GDP growth rates are relatively high, the world is starting to realise it has an interest in ensuring Africa does not energise using fossil fuels if the Paris targets are to be met. This could translate into increasing attention being paid to the need to increase the flows of climate finance into African countries.
The Bridgetown Initiative launched by the prime minister of Barbados is a platform of reforms that if implemented would result in a fundamental global restructuring and realignment of the world’s balance sheets. In essence, four clusters of reforms are envisaged.
- Make the global financial system much more shock-absorbent and flexible by including “pause clauses” in all debt agreements, providing for two-year suspensions in the event of climate shocks. While many multilateral development banks (MDBs) have accepted this idea, most debt is held by the private sector and there is not much appetite there for such an idea. Furthermore, and more significantly, to promote greater and more flexible liquidity, more special drawing rights (SDRs) need to be issued by the IMF and this must be done in a more predictable and consistent manner until the quantity of SDRs equals 20% of total reserves, and is then increased regularly thereafter to remain at 20% of global reserves.
- Unblock the flow of private capital: private capital does not flow in sufficient quantities to developing countries because of the asymmetrical structure of the financial system that defines certain currencies as stable and the rest as risky. This pushes up the cost of capital for many developing countries. One solution is a systemic global approach to guarantees aimed at unlocking private flows of capital. Guarantees are nothing more than using one set of balance sheets to underwrite the expansion of another set for the sake of raising the total levels of investment in “risky” jurisdictions.
- Triple the size of the MDBs, with expanded lending capacity focused on building resilience in vulnerable parts of the world. This can be achieved by sweating the existing balance sheets (as advocated by the G20 Capital Adequacy Report) plus new capital injections from member states equal to $100-billion over 10 years.
- Loss and damage: create a revenue stream by establishing a Loss and Damage Fund to assist countries hit by environmental catastrophes to obviate the need for them to recover using debt. One option would be to use revenues from (the anti-developmental) Carbon Border Adjustment Mechanism taxes for this purpose, or seeding the fund with special drawing rights in some way.
Role of public development banks
The Bridgetown Initiative, however, has ignored the potential of the world’s public development banks (PDBs), otherwise known as development finance institutions. Recent research shows that there are now 522 PDBs across all world regions. They currently hold $23-trillion worth of assets and invest $2.5-trillion per annum — which is equal to 10-12% of total investment. Furthermore, the assets of these PDBs have tripled since the 2007 Global Financial Crisis and have now gained an identity they never had before as a result of the four annual Finance in Common summits that have taken place since 2019.
If the principle of a three-fold increase in the investments made by MDBs (as advocated by the Bridgetown Initiative) is applied to all PDBs, that would increase the investments made by these institutions from $2.5-trillion to $7.5-trillion per annum. Even if only half of this is achieved and most of these investments were SDG-oriented, this might bring the global target of $3.9-$5-trillion per annum within reach.
The increasing number of African countries that have followed the South African example of formulating a Just Energy Transition Investment Plan (JET IP) is a healthy sign that African governments are recognising the need to be proactive. They all have nationally determined contributions (NDCs), but these have to be turned into JET IPs to become implementable.
The SA JET IP is significant not only because it was the first, but because it was formulated by a task team of South African experts appointed by the President. The JET IP estimates that R1.5-trillion will be required to fund the energy transition over the next five years. Only 10% of this will be sourced from international donors — the famous $8.5-billion pledge announced at COP26. The rest will have to be sourced from South Africa’s domestic financial resources. There is no doubt that this is possible, but only if the appropriate institutional mechanisms are put in place to unlock what is largely private sector (and in particular, pension fund) funding.
Compared to Organisation for Economic Co-operation and Development countries, the proportion of South African pension money invested in national infrastructures is minuscule. And yet, according to the SA Reserve Bank, the value of funds in our retirement industry is equal to 50% of the GDP.
Maybe we need to start thinking creatively about how it will be possible to massively upscale the funding required to achieve the SDGs and climate goals. The two dominant approaches are essentially about using the market and the Keynesian “tax, borrow and spend” approach. I will propose a third — what Steffen Murau refers to as the “monetary architecture” approach.
The market approach boils down to pricing in carbon, reinforcing carbon markets and giving central banks a watching brief to ensure banks do what is necessary to ensure what the Bank for International Settlements calls climate resilience. In a speech at Nelson Mandela University in October, the South African Reserve Bank governor articulated this position.
The Keynesian approach is essentially about pumping cash into green infrastructures. For some who advocate this position, treasuries are the focal point for managing an increase in taxes, more borrowing, and spending appropriately. On the other extreme is Modern Monetary Theory which makes central banks the focal point for what is effectively “green QE” (quantitative easing).
The risks of both make them questionable: market-centred strategies will be too slow, and green Keynesianism has serious limitations in a world afflicted with high levels of sovereign debt (especially in Africa); “green QE” has potentially devastating inflationary consequences (especially if spending goes into unproductive economic activities).
The third approach
The monetary architecture approach is a systems approach that proceeds from the assumption that a credit-based dollar-dominated financial ecosystem is a web of interlocking balance sheets. Everyone’s liability is someone else’s asset, and vice versa.
Once this monetary landscape has been mapped, it becomes possible to identify what Murau calls “elasticity spaces” — combinations of balance sheets could be most effectively expanded to generate the capital required to finance the green transformation. Making a distinction between “firefighters” and “heavy lifters”, Murau argues that the central bank should be left sufficiently unencumbered to be a firefighter when the inevitable bubbles and crises hit. The same, to some extent, applies to treasuries.
The heavy lifters, therefore, could be a combination of what Murau calls Off-Balance Sheet Agencies (primarily public development banks), plus the pension funds, and possibly the shadow banks. In the African context, the heavy lifters would have to include international agencies involved in the transfer of concessional debt and grants to African countries, supported by regular allocations of SDRs.
The end result is a massive expansion of the balance sheets of heavy lifters within systems where firefighters have what it takes to intervene to rebalance the system when things go wrong (which they will). For this to work, states would have to develop the capacity for this kind of macro-financial governance.
Herewith three examples to illustrate the advantage of a balance sheet perspective.
Over the past 30 months, rooftop solar installations in SA have hit the 4.8 gigawatt mark. This equals a financial investment of at least R65-billion. Without anyone planning it, this was achieved because the balance sheets of households and businesses were leveraged, financed mainly by commercial banks.
Another example, from my own experience, would be transferring the prudential authority of the Development Bank of Southern Africa (DBSA) from the National Treasury to the South African Reserve Bank so that the former is seen by the South African capital markets to be regulated like all other banks. That would create trust, and allow the DBSA to possibly quadruple the size of its R110-billion book.
A third example is a company called Creation Capital Investments that offers pension funds (under pressure to adhere to Regulation 28) a way of investing in a listed note on condition the funds find their way into infrastructure projects (which are unlisted assets).
All three are balance sheet reconfigurations that unlock capital without increasing pressure on the fiscus. We need hundreds of these innovations by yesterday.
In summary, if we are really serious about mobilising the finance required to address the challenges, we will have to go beyond the paradigms that dominated 20th-century thinking. A Keynesian solution may have been appropriate when the value of financial assets was 30% of GDP (in the 1950s), but not today when financial assets are 620% of GDP.
The balance of power is not aligned with global needs, hence the proliferation of calls for reforms of the global financial system. Similarly, a market-centred solution rests on the assumption that economies tend towards equilibrium and therefore state intervention is irrational. The empirical and theoretical justification for equilibrium economics can no longer be sustained. Even some of the most prominent economists who once defended general equilibrium models have questioned their usefulness.
From a planetary perspective, we are in extra time. To win the race against time we will have to move beyond rhetoric. If the global financial system is not intentionally reformed, it will come apart at the seams and history shows that mass violence soon follows. There must be a better way. DM
Professor Mark Swilling is co-director of the Centre for Sustainability Transitions at Stellenbosch University.