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I was invited by Matthew Bishop, the U.S. editor of The Economist and author of Philanthrocapitalism, to contribute a piece to an issue of Alliance Magazine that he's guest editing. The focus is on "discontinuous thinking for a crisis." Here is my piece on catalytic philanthropy in full.

With free markets in retreat, economic development risks losing one of its foremost drivers. People forget that economic growth in India and China alone, fostered by open markets, has lifted hundreds of millions out of absolute poverty over the past 15 years. A crisis is a terrible thing to waste, so this is a good time for capitalism's greatest beneficiaries to bring its sheen back. Philanthropy can play a pivotal role in catalysing markets and market-based solutions that promote inclusive economic growth in developing countries.

Developing countries are plagued by instances of mispriced risk, where the perception of risk is often far greater than the reality, which drives up the cost of capital. Though market clearance – in which supply is equal to demand so the market 'clears' – is a central tenet of free markets, a nudge is often required to kick-start markets. Philanthropic capital with a longer horizon can very effectively provide this stimulus, demonstrating a market opportunity into which commercial capital then flows.

Small and medium enterprises (SMEs) are traditionally an economy's largest job creator, so any developing country aiming for rapid and inclusive growth requires a robust SME sector. Contrary to popular opinion in venture capital circles, real investment opportunities may well lie in ‘bread and butter’ industries with a high or exponential correlation to GDP growth and huge social impact (waste management, for instance, or logistics and warehousing). The first true exit for a venture capital firm in India is likely to come next year in a business with a high social impact: microfinance. The bottom line in these businesses is that social and financial returns are not mutually exclusive.

There are several factors that retard the growth of SMEs, including lack of policy, limited knowledge networks and poor management skills, but availability of finance is key. Realizing this, the Soros Economic Development Fund, Omidyar Network and Google.org have set up the SONG[1] Fund at the Indian School of Business to invest in early-stage companies that will generate financial and social returns without compromising on either. There is enormous scope for long-term 'patient' capital to be deployed effectively. For instance, with 80 per cent of India's healthcare system in the private sector, our research reveals an opportunity to help build an asset management business around low-cost healthcare services.

Low-income housing is typically ignored in developing countries, and slums and shanties are a poor substitute. Market surveys in India have shown that there is a shortfall of 25 to 35 million houses in the $4,000 to $30,000 price segment. Our research shows that it is possible to generate internal rates of return of 40–60 per cent by building for the lowest end of the market. We have set up a for-profit housing company that will build houses for between $4,000 and $6,000, targeted at the working poor.

In doing so, we have identified several opportunities for catalytic philanthropic capital to play a role, besides the obvious as investors. There is a serious inability to access project finance, so anyone who can provide a first-loss guarantee can effectively catalyse the market and bring even smaller developers to the table. Similarly, end customers in the developing world can incur severe penalties for defaults and late payments arising from cyclical cashflow problems such as illness or unemployment. A payment protection insurance plan funded initially by philanthropists could offer incentives to mortgage providers and banks to offer loans.

The CARE Protected Note, developed by Derilab SA of Switzerland, offers investors the option to support a large low-income Pakistani school system that is based on a public-private partnership, and to participate in a structured product with capital protection at maturity. A yearly coupon will be paid to the CARE Foundation only if the school system grade average is greater than the regional average; if not, the coupon is returned to the investor. The CARE Protected Note offers the investor a tradable and liquid financial product, where investments in a liquid underlying asset generate positive returns. This mechanism not only provides incentives for all parties, and protection and returns to the investor, but also sources capital for charitable projects that is more sustainable than donations.

These three examples of innovations clearly show that the 'base of the pyramid' market segment needs more financial ingenuity, not less. Many more exist. Most just need a nudge from smart philanthropic capital to see the light of day.

Dr Reuben Abraham is a professor and executive director of the Centre for Emerging Markets Solutions at the Indian School of Business, Hyderabad.
1. SONG is an acronym for Soros, Omidyar Network and Google.