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National development banks are in fashion and here to stay. A number of countries benefited from the global economic boom during the 2000s as exports and commodity revenues surged. These countries鈥� governments stored some of the current and fiscal account surpluses and used the capital to expand state financial institutions. Two prominent types of institutions have grown rapidly, namely (SWFs) and (NDBs), which often have financial return and development stimulation as their core mandates, respectively. Much attention has been afforded to how these organisations鈥� activities have turned into a . For example, the Norwegian SWF鈥檚 investment spans across , including shares in more than 9,000 companies, and China鈥檚 NDBs have emerged as the developing world鈥檚 project backer.

More recently, NDBs have been identified as important agents in funding domestic development projects in a wide range of . The perceived role of NDBs is from a reactive counter-cyclical role towards a proactive patient capitalist role. Popularity in NDBs may appear to be obvious due to the rising interest in pursuing state-designed and over the past decade. While many observations have focused on the growing inclination towards state activism as catalyst to NDBs鈥� expansion around the world, this piece examines three structural challenges incentivising developing countries to mobilise NDBs.听

The first, and the most obvious, rationale is to fix the capital market failure.听

The developing world鈥檚 financial markets and institutions have been expanding, though their aggregate size remains moderate. Figure 1 illustrates the depth of financial development or the significance of diverse financial instruments in relation to economic sizes. This figure illustrates that, despite a notable increase, the index of emerging economies in 2017 was lower than that of advanced economies in 1980. The growth of the index has been slow in low-income countries.

Figure 1. Financial development index: Depth (1980鈥�2017)

Source: IMF Financial Development Index Database

More importantly, patient capital providers have a weak presence in developing countries. Institutional investors, which include insurance companies and mutual and pension funds, have been identified as potential investors in development projects. However, these investors鈥� size in major developing economies is just over 40% of the GDP on average, which is small compared to that of advanced countries (Figure 2).听

Figure 2. Institutional investment assets (2017 or latest)

Note: EMD 20 = 20 largest emerging market and developing countries with available data
Source: World Bank Global Financial Development Database

The expectation that advanced countries鈥� institutional investors would do the heavy lifting seems to be exaggerated. While these investors may have with limited liquidity constraints, development projects often require different types of patience that cannot be understood in strictly financial terms. Moreover, international development finance institutions鈥� efforts to crowd-in private capital have, so far, been .听

Infrastructure financing is a key example. On top of the fact that the private sector as a whole accounts for a small fraction of total investment in the developing world ( in 2017), the contribution of institutional investors has been limited, averaging of total private participation in 2011鈥揌1 2017.听

Many developing countries are now trying to fill this gap, or fix the capital market failure, by mobilising NDBs.听

Secondly, the role of external development funds is shrinking in middle-income countries, causing the so-called .

As developing countries move up from the low-income to middle-income status, the relative size of aid inflows shrinks, and the terms and conditions become . Tax revenue often struggles to rise quickly enough during this period to fill in the gap.听

There has been a notable decline in the ratio of overseas development assistance (ODA) to GDP in middle-income countries (Figure 3). The recent ratio is only approximately a fifth of what it was 25 years ago. The ratio is now small for upper middle-income countries, averaging just 0.07% during the 2010s. This figure is higher in lower middle-income countries but has seen a dramatic decline from 3.2% in 1991 to 0.7% in 2017.听

Figure 3. Net ODA (1970鈥�2017)

Source: World Bank World Development Indicators

In addition, the tax revenue in middle-income countries has failed to keep up with economic expansion. The tax revenue-to-GDP ratio stagnated during the second half of the 2000s and declined by nearly one percentage point between 2011 and 2016 (Figure 4).听

Figure 4. Tax revenue (2005鈥�2016)

Source: World Bank World Development Indicators

The shrinking role of ODA and tax revenue means that the government must search for non-budgetary financial resources, such as those from NDBs, to conduct development projects.

Thirdly, NDBs can act as policy tools that enable governments to overcome legal and political constraints in fiscal management.听

The financial technocrats鈥� attachment to fiscal stabilisation has been highlighted as a hurdle in expanding development investment. As well as this factor, there are legal issues that make it difficult for governments to expand development financing. The developing world has been adopting fiscal rules with zeal from the early 2000s (Figure 5). In 2015, 60 developing countries had fiscal rules in place. While fiscal rules contain diverse characteristics in terms of coverage, strength, and flexibility, they tend to constrain governments鈥� investment capacity.听聽聽聽聽

Figure 5. Number of countries with fiscal rules (1985鈥�2015)

Source: IMF Fiscal Rules Dataset

Furthermore, fiscal reallocation is often challenging because existing budget structures are a reflection of past political and social struggles over priorities. More specifically, governments may arouse public discontent when attempting to redirect significant amounts of fiscal resources from consumption spending towards capital investment. This possibility can make governments lethargic, especially in democratic countries where elected officials start counting down for the next election from their first day in office.听

NDBs have been used by executives to bypass legal and political difficulties in mobilising fiscal resources in countries such as and . A number of newer democratic developing countries are also considering this option to navigate through constraints.听

Due to these issues, namely the limited role of private capital and donor funds, domestic institutional difficulties in expanding fiscal investment, combined with the moderation of the theoretical and ideological battle over state economic activism, the developing world鈥檚 interest in NDBs is expected to continue, as demonstrated with the case of Indonesia.听

Of course, NDBs are not a silver bullet: they are inevitably under the influence of the and and vulnerable to partisan politics and rent-seeking. NDBs鈥� effective operation requires of technical knowledge, market information, and coordination capacity. However, considering the structural factors highlighted in this piece and the colossal development goals, developing countries鈥� and 鈥�鈥� using NDBs should be encouraged with the potential challenges in mind.听

Kyunghoon Kim is a PhD student in the Department of International Development at King’s College, London.

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