The text discusses the disparities in borrowing costs between small manufacturers in developing and developed countries, highlighting that this difference may not entirely be justified by actual risk but rather by investor sentiment. The authors are affiliated with the Institute for Economics and Peace and the UN Development Programme and propose solutions to recalibrate how risk is priced in developing economies.
Key Points:
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Borrowing Costs Discrepancy:
- A Kenyan firm may face borrowing costs of 18%-20% annually, while a German firm might pay only a third as much.
- Much of the higher cost in developing countries arises from the way investors assess risk rather than actual performance.
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Impact on Investment:
- Overstated risk leads to capital being priced out of areas that require investment the most.
- The opportunity for impact investors to achieve alpha (returns exceeding the market) is lost.
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Recommendations:
- Strip Out Sentiment: Disentangle genuine default risk from fear-based premiums in country risk assessments.
- Use Evidence for Pricing: Shift from arbitrary metrics to actual performance data from established databases, showing that businesses in developing nations often default less than assumed.
- Reward Resilience: Implement criteria that account for the positive contributions of businesses to local economies and resilience, reflecting it in the pricing of loans.
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Impacts of Applying Suggestions:
- By applying these methods, the estimated borrowing cost for a typical Kenyan business could drop significantly, showcasing that proper risk measurement can make businesses in developing countries more viable for investment.
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Calls to Action:
- The authors encourage development finance institutions and investors to adopt these approaches, emphasizing accuracy over charity in pricing strategies to better align financial returns with social impact.
Conclusion:
Addressing the mispricing of risk in developing economies not only supports impactful investment but also ensures that capital flows to where it can do the most good. The proposed framework offers a more nuanced and accurate method for assessing risk, potentially unlocking new opportunities for both investors and small businesses in these regions.
