External environment

The world around us is constantly changing and is becoming increasingly complex. In 2021, FMO continued to adapt to the realities of a global pandemic and the uncertainties that came with it. Global challenges such as climate change and rising inequalities have become even more pressing, affecting the most vulnerable communities and countries in disproportionate ways. In this chapter, we discuss the relevant trends and developments - at the time of drafting this report - that affect FMO and its markets.

Economic recovery

The pandemic continued to affect the global economy. In the first half of 2021, developed economies began to recover due to high vaccination rates and strong support from central banks and governments. Financial markets saw an increase in liquidity and equity markets rose strongly over the first three quarters of the year. With supply chains slow to respond to an increase in economic activity and demand, supply shortages caused inflation to rise. However, hopes for a quick recovery were diminished in Q4 with the emergence of the Omicron strain. In the emerging markets (EMs) in which we invest we see countries recovering at widely differing rates.

In some EMs, governments rolled out large support packages for the private sector and households, while central banks lowered policy rates and conducted quantitative easing. This boosted liquidity and asset prices as well as private investors’ confidence. EM capital outflows recorded in early 2020 have been reversed. In this environment of ample liquidity and compressed risk premiums, companies were able to (re)finance themselves locally at attractive rates.

In other emerging markets and low-income countries (LICs) in particular, recovery has been much slower because of lower vaccination rates and less government support. In these markets, private sector indebtedness increased, with SMEs facing solvency and liquidity problems. Government debt-to-GDP ratios also rose. Almost 60% of LICs are already in, or near, high-debt distress. With 60% of EM government debt issued in response to the crisis ending up on domestic banks’ balance sheets, the sovereign-bank nexus has deteriorated in these markets.^[1] The pandemic has left EMs and LICs financially vulnerable to a resurgence of the virus, a spike in inflation or an unbalanced tapering of monetary policy.

Geopolitical tensions

Geopolitical tensions are rising, which may affect FMO’s activities. Risks emanate from a diverse set of drivers including rising global competition between countries; state failure and conflict; and the way global challenges like climate change and the global pandemic are tackled. These risks may lead to increasing volatility and uncertainty in commodities and financial markets. Financial institutions could also be caught in the crossfire of sanctions and economic retaliation if violent conflict were to erupt in Eastern Europe or Southeast Asia.

In Africa, violent extremism has displaced two million people in the Sahel, while fighting between rebels and the government continues in Ethiopia’s Tigray region. Tensions in Europe are mounting as Russia invaded Ukraine. Internationally, there are concerns for the national and regional security and the potential impact on displacement, involuntary migration and natural gas supply from Russia to Europe. Meanwhile, China is investing in lithium projects outside its borders to secure its access to the metal key to the energy transition. Development financing is increasingly employed as an instrument in the struggle to reassert spheres of influence, most notably by China through its Belt and Road initiative.

Development progress

The pandemic has slowed, and in some instances reversed, progress towards the SDGs. While EMs are estimated to reach 6.5% GDP growth in 2021, this is mostly a temporary recovery effect after the COVID-19-induced drop in 2020. LICs are estimated to achieve only 3.1% growth in 2021 and employment prospects for low-skilled workers and youth remained bleak. Inequality increased, as did the likelihood of income falling below extreme poverty thresholds.

Global warming is still progressing faster than the 1.5-2 degrees Celsius as required by the Paris Agreement.^[2] Despite COP26, most governments are showing little progress towards achieving this goal. Still only about 20 percent of global emissions are subject to emissions trading schemes or pricing measures. Tax revenues related to environmental policy have declined over the past 15 years, while public expenditures on environmental policy have stayed flat.

Development finance institutions (DFIs) such as FMO continue to have an important role in financing the SDGs. In a 2021 report, the Overseas Development Institute concluded that investments in the poorest countries have fallen behind, and that the SDG funding gap has increased. There are more opportunities for DFIs to invest in fragile and conflict-affected states and support the just (energy) transition. This requires high-risk capital and blended finance and early-stage investments.^[3] However, these projects often present greater risks and require more time, due diligence and resources from an organization. Such investment decisions should, therefore, be carefully balanced with other (potential) investments.

Sector developments

We have observed shifts in all three of our focus sectors.

The agribusiness, food & water (AFW) sector held out relatively well during the pandemic, despite disruptions to supply chains and high costs of container shipping. Agri commodity prices increased by 28% in 2021 (40% above pre-pandemic levels), in part because of labor scarcity and the rising cost of natural gas, a key ingredient of fertilizers and other key inputs. Governments stocking up on food staples are expected to drive prices up further. With commercial banks withdrawing from these markets, there is greater additionality for FMO. Moreover, the sector can play a role in responding to the climate crisis in terms of mitigation, adaptation and sequestration through forestry and regenerative agriculture and farming practices.

The energy sector presented both challenges and opportunities. On the one hand, renewables have become more competitive. Investments in renewable power capacity grew at a record pace, with solar alone accounting for more than half of all new renewable power in 2021. Elevated fossil fuel prices have made renewables even more competitive. Subsequently, there are fewer opportunities for FMO in this sector. Volatility in commodity, transportation and energy prices pose further challenges. On the other hand, there are opportunities for FMO to focus more on other sub-sectors such as transmission, distribution and storage that are crucial for the acceleration of the phase-down of unabated coal power, as called for by the COP26.

Financing needs have shifted. The pandemic has made financial institutions (FIs) more cautious about lending to certain sectors, resulting in lower demand from FIs for traditional financing and greater demand for risk-sharing. Central banks stepped in and prevented banks from paying out dividends to preserve capital. In 2021, credit losses were lower than feared in 2020 and many FIs have since recovered.

Technological innovation in FinTech, AgriTech and EnTech continued to impact FMO's market. New technologies allow financial services to reach previously un(der)served customers. FinTech solutions provide access to loans and payment of salaries to workers in rural areas. In the agricultural sector, for instance, technology increases supply chain traceability and accountability. Technology can enable the measurement, traceability and reduction of a company's carbon footprint across its supply chains or is used to monitor crops (e.g. with drones) to produce more and better quality food. Technology in energy storage and distribution will continue to drive developments in the energy market.

An increasingly complex operating and regulatory environment

Pressure is increasing on companies to mitigate the impact of their operations and supply chains on the environment and local communities. In boardrooms across the globe, shareholders are demanding that companies take more ambitious steps to address climate change. Regulators are picking up pace in setting new standards for climate-related disclosure and risk management. NGOs are winning court cases against companies and governments, which in their view are not sufficiently setting and following up on climate ambitions. FMO also has conversations with its stakeholders about its climate commitments. Some NGOs and the media have, for instance, been critical of some of our past investment decisions. We do not shy away from dialogue and aim to learn from our experiences.

The regulatory environment for financial institutions and DFIs is changing rapidly and becoming more complex. The following list is a selection of the regulations that (are likely to) impact FMO’s operations and the markets in which we operate:

Financial Economic Crime and tax integrity

Financial institutions are expected to act as gatekeepers to help prevent financial economic crime (FEC) and preserve the integrity of the financial system. The way FMO safeguards its customer integrity is regulated by the European Commission (EC) and supervised by De Nederlandsche Bank (DNB, the Dutch central bank). We closely monitor high-risk countries, as defined by the EC and the Financial Action Task Force, to ensure customers in these countries undergo adequate due diligence. In 2021, following an extensive Know Your Customer (KYC) file remediation effort, external validation confirmed that FMO demonstrated compliance with the Dutch Anti-Money Laundering and Anti-Terrorist Financing Act (Wwft) and Sanctions Law. The validation identified several recommendations that FMO will follow up on in 2022.

Basel IV

The translation of the Basel IV agreement into European law (CRR-3) will increase the capital requirements for FMO as of 2025. The draft text published in October 2021 proposed a higher risk weight for equity investments, although the increase was less than expected, decreasing the effectiveness of the regulation. In addition to a higher risk weight for equity investments, FMO will be required to apply a higher capital charge for some types of credit risk exposures, and for market risk and operational risk.

Climate related risks

In 2020, the European Central Bank (ECB) published guidance on the prudent management of climate-related and environmental risks and the supervisory expectations for banks. FMO has a project in place to align with these expectations in and, in 2021, continued to align our internal procedures, disclosures, business strategy, risk management and governance frameworks. Please refer to the TCFD section in our Climate feature and separate TCFD report for further information.

EU Taxonomy

In 2020, the EC introduced a taxonomy for sustainable activities. This is a classification system for determining whether an economic activity is environmentally sustainable. This is the first year FMO is disclosing in line with the EU Taxonomy. Please refer to the EU taxonomy section for further information.

1 IMF, Global Financial Stability Report, April 2021.
2 https://ec.europa.eu/commission/presscorner/detail/en/IP_21_6021
3 ODI (April 2021). Development finance institutions: the need for bold action to invest better.