External environment
Our markets have faced record-breaking capital outflows[1] and recessions as a result of COVID-19, which has reversed some of the progress made in the past two decades towards reducing poverty and inequality. More than ever, FMO’s role as a Development Finance Institution (DFI) is needed.
Impact of COVID-19 on our markets
The global economy and financial markets, particularly those in emerging markets (EMs), have been greatly affected by the COVID-19 pandemic. The IMF estimated that emerging markets and developing economies contracted by 2.4% in 2020 but are expected to recover and grow by 6.3% next year. Significant downside risk remains to this projection as the world continues to experience the impact of the pandemic.[2]
In March, the sudden realization of severe macroeconomic disruptions led to the collapse of equity markets and the largest capital outflow[1] ever seen in emerging markets, resulting in a large drop in EM exchange rates versus the US dollar and euro. While EM capital flows and currencies have since won back terrain, the recovery has been uneven, with some markets remaining more affected than others. Highly indebted markets have proved to be particularly vulnerable to market stress. For example, Argentina, Lebanon, Ecuador and Zambia defaulted, restructured or are in the process of restructuring their government debts. Turkey, where the private and financial sectors have high external debt ratios, has seen its lira fall by more than 30% in 2020 and remains at risk of a current account crisis.
The energy sector has been particularly disrupted by the pandemic, as prices for energy commodities dropped to historic lows and construction projects ground to a halt. In contrast, the agricultural sector has not been affected as much, as prices for these commodities remained fairly constant and production and trade were disrupted less. Financial institutions in EMs have so far held up relatively well. As the crisis lasts longer, however, they may face higher impairments and customer defaults.
The current crisis will slow progress towards achieving the SDGs and in some cases has exacerbated existing challenges. The pandemic has significantly impacted employment and economic growth (SDG 8). Demand and economic activity have further suffered from local lockdowns and ongoing social distancing. Some companies are laying off employees as they face sharp decreases in demand and interruptions to production and shipping. In EMs, millions of workers in the informal sector have been affected. Many have lost their jobs and are left without an income as they are unprotected by social security or local laws, resulting in increased levels of poverty and inequality (SDG 10). Meanwhile, the world continues to face a climate crisis (SDG 13) that is becoming more urgent as countries are not yet delivering on commitments made in the Paris Agreement. Despite the drastic reduction in economic activity due to COVID-19, the resulting 6% drop in greenhouse gas emissions projected for 2020 falls short of the 7.6% target needed to meet the 1.5°C ambition set in the Paris Agreement.[3]
Road to recovery – the role of DFIs
Constrained by high debt ratios and low real interest rates prior to the crisis, many governments and central banks in EMs have struggled to adequately shield the private sector. DFIs such as FMO play an important role in building back better, by supporting and investing in these businesses, and the jobs they provide. In the short-term, we continue to align our COVID-19 response with peers and partners to support our customers. Meanwhile, government imposed lockdowns and travel restrictions have challenged FMO’s conventional way of sourcing and following up on new business opportunities. This has required us to find new ways of working (e.g. virtual due diligence). We will continue to explore and develop new ways of working to invest in our markets.
Use of blended finance
The availability of development finance has increased significantly over the past few years, even during the pandemic. DFIs can draw from a greater pool of blended finance offered by institutions like the European Commission (EC), Global Climate Fund (GCF) and national governments. Project development to address the gap in supply and demand for concessional funding has become clearer and is starting to gain traction in the industry. IFC, for instance, received a large capital increase to aid project and market development that typically takes considerable time and funds to get off the ground.
Mobilizing commercial capital
Commercial capital is crucial to achieving the SDGs. In the years leading up to the pandemic, impact investing had picked up pace among institutional and other commercial investors. Despite experiencing one of the largest capital outflows ever, overall EMs were able to recover from the shock as foreign investments picked up pace towards the end of 2020. However, the recovery has been unequal with some markets lagging behind. FMO needs to continue to demonstrate that impact investing in these markets – even under the current circumstances – is worthwhile and profitable. FMO’s role is to bring together public and private parties to invest capital (back) into emerging and developing markets to boost their resilience post COVID-19. With our syndicated and blended product lines, FMO can develop products with different risk profiles and pave the way for the private sector to invest in EMs. We are pleased to see that several of our commercial partners, such as our FMO Investment Management (FMO IM) funds and Munich Re, have expressed their ongoing commitment to co-invest in select FMO loans.
Regulatory changes
Several new regulations have impacted or are likely to impact FMO’s operations and the markets in which we operate.
Financial Economic Crime (FEC) and tax integrity | Financial institutions are expected to act as gatekeepers to help prevent Financial Economic Crime and preserve the integrity and reputation of the financial system. FMO faces strict regulations and supervision from both the EC and the Dutch Central Bank (DNB) with respect to safeguarding its customer integrity. We closely monitor countries considered by the EC and the Financial Action Task Force as high-risk to ensure customers located in these countries undergo the adequate level of due diligence. In 2021, we will step up our efforts to ensure full compliance with the Dutch Anti-Money Laundering and Anti-Terrorist Financing Act (Wwft) and Sanctions Law by the end of 2021.
Basel IV | The translation of the Basel IV agreement into European law (CRR-3) is expected to increase the capital requirements for FMO, starting in 2023. We will be required to apply a higher risk weight to equity investments and a higher capital charge for market and operational risk. Therefore, we already started assessing solutions and alternative options to prudently manage our capital.
Climate related risks | The European Central Bank (ECB) published a guide on climate-related and environmental risks. The guide outlines the ECB’s understanding of prudent management of these risks and outlines supervisory expectations for banks. This will likely have implications for FMO’s internal procedures, climate-related and environmental disclosures and how we reflect climate and environmental risks into our business strategy, risk management and governance frameworks.
EU Taxonomy | Member states and the European Union (EU) will be required to apply the Taxonomy when adopting measures (e.g. labels or standards) in setting requirements for financial products or corporate bonds presented as ‘environmentally sustainable’. Banks will be required to report on how their investments align with the climate change mitigation and adaptation sustainability objectives of the Taxonomy beginning on January 1, 2022. FMO expects the other sustainability objectives of the Taxonomy to be ready for reporting in early 2023. FMO is carrying out an assessment of how to apply the EU Taxonomy to its current practices. FMO’s Green Label for new investments is largely aligned with the environmental objectives of the EU Taxonomy. ESG standards are an integral part of FMO’s investment process. The main challenges of aligning with the Taxonomy are in how to apply EU regulations to markets outside of the EU and in areas where accepted international environmental and social standards do not fully align with its Do No Significant Harm criterion. These issues will be addressed in 2021 by the International Platform on Sustainable Finance, a body chaired by the European Commission and which is informed, among others, by the EDFIs.
- 1 International Monetary Fund (September 2020). Emerging Market Capital Flows under COVID: What to Expect Given What We Know.
- 2 International Monetary Fund (January 2021). World Economic Outlook Update.
- 3 United Nations (2020). The Sustainable Development Goals Report 2020.