Protecting the Poor:
Global Financial Institutions and the
Vulnerability of Low-Income Countries
Edited by Jan Joost Teunissen and Age Akkerman
Low-income countries are highly vulnerable to exogenous shocks such as sudden
drops in the prices of their exports, hurricanes, droughts, shortfalls in aid flows,
and volatile private capital flows.
Rich countries and global financial institutions recognise the need to avoid or
mitigate the effects of these shocks to poor countries, but they only see a limited
role for themselves. Poor countries and their advocates, on the other hand,
stress that the international community should do more since shocks cause
severe harm to developing country economies and, especially, the poor.
Protecting the Poor: Global Financial Institutions and the Vulnerability of
Low-Income Countries brings together in-depth analyses and valuable policy
proposals of both officials and critical observers. It spells out what poor
countries, rich countries and the international financial institutions can do to
address the vulnerabilities of low-income countries.
It also addresses why the governance of the international financial system should
be improved. Contributing authors advocate that improvements should go
beyond the short-term agenda of policymakers – such as the latest financial crisis
or the newest debt relief proposal. “Fundamental” reforms are needed, they say.
Contributors also review the role of the IMF in low-income countries. Some of
them see the design of proper “exit strategies” as one of the main future challenges
of the IMF, whereas others stress the need for the Fund to recast itself in the role
of partner in development rather than macroeconomic master.
FONDAD
The Hague, The Netherlands
www.fondad.org
Hannah Bargawi, Caoimhe de Barra, Ariel Buira, Stijn Claessens,
Kees van Dijkhuizen, Ernst van Koesveld, Matthew Martin, José Antonio Ocampo,
Geoffrey Underhill, John Williamson and others
Protecting
the Poor
Global Financial Institutions
and the Vulnerability
of Low-Income Countries
Edited by
Jan Joost Teunissen and
Age Akkerman
FONDAD
9 789074 208260
ISBN 90-74208-26-0
ISBN 90-74208-26-6
pg_0002
Forum on Debt and Development (FONDAD)
FONDAD
is an independent policy research centre and forum for inter-
national discussion established in the Netherlands. Supported by a
worldwide network of experts, it provides policy-oriented research on a
range of North-South problems, with particular emphasis on inter-
national financial issues. Through research, seminars and publications,
FONDAD
aims to provide factual background information and practical
strategies for policymakers and other interested groups in industrial,
developing and transition countries.
Director: Jan Joost Teunissen
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0003
Protecting the Poor
Global Financial Institutions
and the Vulnerability
of Low-Income Countries
Edited by
Jan Joost Teunissen and
Age Akkerman
FONDAD
The Hague
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0004
ISBN-10: 90-74208-26-6
ISBN-13: 97890-74208-26-0
Copyright: Forum on Debt and Development (
FONDAD
), 2005.
Cover photograph: Jan Joost Teunissen
Permission must be obtained from
FONDAD
prior to any further reprints, republi-
cation, photocopying, or other use of this work.
This publication was made possible thanks to the support of the Department for
Development Cooperation of the Dutch Ministry of Foreign Affairs.
Additional copies may be ordered from
FONDAD
:
Noordeinde 107A, 2514 GE The Hague, the Netherlands
Tel.: 31-70-3653820, Fax: 31-70-3463939, E-mail: a.bulnes@fondad.org
www.fondad.org
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pg_0005
Contents
Acknowledgements
vii
Notes on the Contributors
viii
Abbreviations
xii
1
The Dialogue on the Vulnerability of Low-Income Countries:
By Way of Introduction
1
Jan Joost Teunissen
From a Lack of Dialogue to the Fashion of Dialogue
2
Better Dealing With Shocks
4
Changing the Rules of Global Financial Governance
8
The Future Role of the IMF in Low-Income Countries
10
Conclusion
12
2
Policies to Reduce the Vulnerability of Low-Income Countries 14
John Williamson
1 The Nature of Balance of Payments Shocks
15
2 Possibilities of International Action
18
3 Domestic Policies for Curbing the Impact of Shocks
26
4 Concluding Remarks
33
3
Insurance as a Tool to Reduce Vulnerabilities
35
Kees van Dijkhuizen
Insurance Through the Market.
36
Insurance By the IMF.
37
Insurance Through Further Debt Relief.
39
Possibilities for Self-Insurance.
39
Insurance Through Currency Matching.
40
4
Protecting Africa Against “Shocks”
42
Matthew Martin and Hannah Bargawi
1 Defining Shocks
44
2 Identifying Africa’s Shocks
47
3 Solutions
58
4 Conclusion
68
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5
Curbing the Impact of Shocks
72
Ariel Buira
Domestic Policies
74
International Policies
77
6
The Need for Institutional Changes in the Global Financial
System
79
Stijn Claessens and Geoffrey Underhill
1 Forces for Change in the International Financial System
81
2 Public versus Private Views and Interests
86
3 Design of the International Financial System
96
4 Legitimacy of the International Financial System
105
5 Conclusions
108
7
The Democratic Deficit of International Arrangements
115
José Antonio Ocampo
Groups versus Institutions
116
Competition Between International Institutions
118
Ownership
119
Diversity of Views and the Streamlining of Conditionality
119
Rating of Countries by Quality of Institutions
120
Millennium Development Goals
122
8
Future Challenges for the IMF in Low-Income Countries
123
Jan Derk Brilman, Irene Jansen and Ernst van Koesveld
1 Exit Strategies from Fund Financing
124
2 The Fund’s Signaling Role in Low-Income Countries
129
3 The IMF and Debt Sustainability
137
4 Concluding Remarks
143
9
Reviewing the Role of the IMF in Low-Income Countries
145
Caoimhe de Barra
1 The Role of the Fund in Poverty Reduction
146
2 The Fund’s Role in Mobilising Finance for Development 147
3 What Are the Changes in Policy and Practice Needed to IMF
Conditionality.
149
4 Signaling: Is the Debate Over.
151
5 Conclusion
153
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vii
Acknowledgements
his book is yet another result from the Global Financial Govern-
ance Initiative (GFGI), which brings together Northern and
Southern perspectives on key international financial issues. In this
initiative, FONDAD is responsible for the working group Crisis
Prevention and Response, jointly chaired by José Antonio Ocampo,
under-secretary-general for Economic and Social Affairs of the United
Nations, and Jan Joost Teunissen, director of FONDAD.
FONDAD very much appreciates the continuing support of the
Dutch Ministry of Foreign Affairs and the stimulating ongoing
cooperation with the Economic Commission for Latin America and
the Caribbean (ECLAC) in Santiago de Chile, the North-South
Institute in Ottawa, the African Economic Research Consortium
(AERC) in Nairobi, Debt Research International (DRI) in London,
the Korea Institute for International Economic Policy (KIEP) in Seoul
and the many other organisations with which it works together.
This is the second volume emerging from a conference held in The
Hague on 11-12 November 2004. The previous volume is entitled
Helping the Poor: The IMF and Low-Income Countries. A special thanks
goes to Ernst van Koesveld at the Dutch Ministry of Finance, who
assisted in the organising of the conference in The Hague, and to
Adriana Bulnes and Julie Raadschelders, who assisted in the publishing
of this book.
Jan Joost Teunissen
Age Akkerman
September, 2005
T
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viii
Notes on the Contributors
Hannah Bargawi (1980) was until September 2005 a researcher at Debt
Relief International, helping to administer the research and advocacy arm
of this capacity-building organisation. She has co-authored various studies
on issues relating to debt, new finance and the Bretton Woods institu-
tions. Prior to this she worked as a teaching and research assistant at the
School of Oriental and African Studies where she completed a masters in
development economics. She returned to university to prepare a PhD.
Caoimhe de Barra (1970) is policy and advocacy coordinator with Trócaire,
the Irish Catholic Agency for World Development, where she has worked
since 1997. Her areas of responsibility include development finance,
participation and poverty reduction. She has recently co-authored the
Trócaire report: “The Other Side of the Coin – An Alternative Perspective
on the Role of the IMF in Low-Income Countries” (September 2004).
She also wrote “PRSP as Theatre – Backstage Policy Making and the
Future of the PRSP Approach” (September 2004) and “PRSP: Are the
World Bank and IMF Delivering on Promises” (April 2004). Both were
written for CIDSE/Caritas Internationalis.
Jan Derk Brilman (1978) is policy advisor at the International Economics
and Financial Institutions Division at the Dutch Ministry of Finance. He
concerns himself primarily with debt sustainability in low-income coun-
tries and with the financial management of the international financial
institutions. He has published articles on aid effectiveness and debt
sustainability issues.
Ariel Buira (1940) is director of the G-24 Secretariat in Washington D.C.
Previously, he was senior member of St. Anthony’s College, Oxford
University and Ambassador of Mexico in Greece. He served at the Central
Bank of Mexico as advisor to the director-general, director of International
Economic Research, as international director, as deputy governor and as a
member of the Board of Governors. At the IMF he has been staff member
and executive director. He has lectured on economic analysis at the Institute
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Notes on the Contributors ix
of Technology of Monterrey and was professor of economic theory at the
Centre for Economic and Demographic Studies of El Colegio de México.
He has a wide range of publications. His latest papers refer to the condi-
tionality and governance of the Bretton Woods institutions. For the G-24,
he edited Reforming the Governance of the IMF and the World Bank
(Anthem Press, 2005) and The World Bank at Sixty (Anthem Press, 2005).
Stijn Claessens (1959) is senior adviser in the Financial Sector Vice-
Presidency of the World Bank. He started his career as a research fellow at
the Economic Research Unit and Project LINK of the Wharton School,
University of Pennsylvania, and has been a visiting assistant professor at
the School of Business Administration, New York University, before joining
the World Bank in 1987. From 2001 to 2004, he was professor of Interna-
tional Finance at the University of Amsterdam. His current policy and
research interests are firm finance and access to financial services; corporate
governance; internationalisation of financial services; and risk manage-
ment. He has provided advice to numerous emerging markets in Latin
America, East Asia and transition economies. His research has been
published in the Journal of Financial Economics, Journal of Finance and
Quarterly Journal of Economics. He is on the Editorial Board of the World
Bank Economic Review and an associate editor of the Journal of Financial
Services Research, and a fellow of CEPR.
Kees van Dijkhuizen (1955) is treasurer-general at the Dutch Ministry of
Finance. In this capacity, he is alternate governor of the IMF, member of
the G-10 deputies, member of the WP-3 of the OECD, and member of
the Economic and Financial Committee of the EU. He started his career
at the Budget Affairs Directorate at the Ministry of Finance. In 1985, he
moved on to the General Economic Policy Department of the Ministry of
Economic Affairs (as Director in the period 1992-97). He then returned to
the Ministry of Finance, to become (deputy) director of the Budget and
subsequently treasurer-general (as per mid-2000). He has published several
articles on budget policy from both a national and EU perspective.
Irene Jansen (1978) is senior policy advisor at the International Econom-
ics and Financial Institutions Division at the Dutch Ministry of Finance.
She concerns herself primarily with the role of the IMF and the World
Bank in low-income countries. She started working as policy advisor at the
International Monetary Affairs Division of the Ministry of Finance in
2001, focusing on the (at the time) candidate EU-countries and EMU
related issues. She published several articles on economic and exchange
rate policies in the (new) EU member states.
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x Global Financial Institutions and the Vulnerability of Low-Income Countries
Ernst van Koesveld (1971) is deputy head of the International Economics
and Financial Institutions Division at the Dutch Ministry of Finance. He is
closely involved in discussions on shaping the policies of IMF, World Bank
(also as Dutch Finance participant in the IDA14 negotiations) and the
regional development banks. He started his career at the Ministry of
Economic Affairs in 1994. In 1998, he moved to Lithuania to work as a
policy advisor and programme coordinator for the UN Development
Programme. In 2000, he continued this work in Vietnam, dealing with the
coordination of donor flows, private sector development and human
development issues. He has published several articles and reports on
economic policy, poverty reduction, the international financial architecture
and the role of the IFIs, particularly the IMF.
Matthew Martin (1962) is director of Debt Relief International and
Development Finance International, both non-profit organisations which
build developing countries' capacities to design and implement strategies
for managing external and domestic debt, and external official and private
development financing. Previously he worked at the Overseas Develop-
ment Institute in London, the International Development Centre in
Oxford, and the World Bank, and as a consultant to many donors, African
governments, international organisations and NGOs. He has co-authored
books and articles on debt and development financing.
José Antonio Ocampo (1952) is under-secretary-general for Economic
and Social Affairs of the United Nations. He was from 1998 to 2003
executive secretary of the United Nations Economic Commission for Latin
America and the Caribbean (ECLAC). Previously, he was minister of
Finance and Public Credit of Colombia, director of the National Planning
Department and minister of agriculture. He was a senior researcher and
member of the board of directors of FEDESAROLLO in Bogotá,
Colombia. He has been an advisor to the Colombian government and
director of the Center for Development Studies at the Universidad de los
Andes. His academic activities have included being professor of economics
at the Universidad de los Andes and Professor of Economic History of the
Universidad Nacional de Colombia. He has been a visiting fellow at
Oxford and Yale University. He has served as a consultant to the IDB, the
World Bank and the United Nations. He has published widely in
academic journals and books.
Jan Joost Teunissen (1948) is director of FONDAD. He started his career
in 1973 as a social scientist and freelance journalist in Chile. Seeing his plan
to work in Chile’s agrarian reform and rural development aborted by the
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Notes on the Contributors xi
coup d’état of 11 September 1973, he engaged himself in activities aimed
at the return of democracy in Chile. He focused on economic boycott as a
political instrument to bring about regime change in Chile and other
dictatorships. In his work on international economic and political issues, he
forged links with academics, politicians, journalists and high-level policy-
makers in various parts of the world. In the Netherlands he stimulated
discussions on the origins and solutions to the international debt crisis.
Supported by economists such as Robert Triffin, Jan Tinbergen, Johannes
Witteveen and Jan Pronk he established FONDAD in 1987. He has co-
authored books and articles on finance and development issues.
Geoffrey Underhill (1959) is director of the Amsterdam Institute for Social
Sciences at the University of Amsterdam since May 2003. He has taught at
the University of Stirling (Scotland), at McMaster University in Canada,
and the University of Warwick (UK). From the beginning of the 1990s
his research began to focus on the political economy of monetary relations
and financial services in a context of transnational financial markets, global
capital mobility, and state macroeconomic management. His most recent
books are Political Economy and the Changing Global Order, edited with
Richard Stubbs (Oxford University Press, 2005), and International Finan-
cial Governance under Stress: Global Structures versus National Imperatives,
edited with Xiaoke Zhang (Cambridge University Press, 2003).
John Williamson (1937) is senior fellow at the Institute for International
Economics in Washington D.C. since its founding in 1981. He has taught
at the Universities of York (1963-68) and Warwick (1970-77) in England,
the Pontificia Universidade Católica do Rio de Janeiro (1978-81) in Brazil,
as a Visiting Professor at MIT (1967 and 1980), LSE (1992), and Princeton
(1996), and is an Honorary Professor at the University of Warwick (since
1985). He was an economic consultant to the UK Treasury (1968-70),
advisor to the International Monetary Fund (1972-74). From 1996-99 he
was on leave from the Institute of International Economics to serve as Chief
Economist for the South Asia Region of the World Bank. He was project
director for the UN High-Level Panel on Financing for Development (the
Zedillo Report) in 2001. He is author, co-author, editor, or co-editor of
numerous studies on international monetary and development issues. His
most recent publication is Curbing the Boom-Bust Cycle: Stabilizing Capital
Flows to Emerging Markets (Institute for International Economics, 2005).
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xii
Abbreviations
ACP
Africa, Caribbean and the Pacific
AfDB
African Development Bank
AFRODAD African Forum and Network on Debt and Develop-
ment
AFTA
ASEAN Free Trade Area
ATM
automated teller machine (to withdraw money)
BIS
Bank for International Settlements
BWIs
Bretton Woods institutions
CAR
Central African Republic
CEPR
Centre for Economic Policy Research
CFA
Communauté Financière Africaine
CFF
Compensatory Financing Facility (of the IMF)
CPIA
Country Policy and Institutional Assessment (of the
World Bank)
DFID
Department for International Development (UK)
DRI
Debt Relief International
DSA
Debt Sustainability Analysis
DSF
Debt Sustainability Framework
DSR
Debt Service Reduction Option
ECLAC Economic Commission for Latin America and the
Caribbean (of the UN); (in Spanish CEPAL)
ECM
External Contingency Mechanism (of the IMF)
EFTA
European Free Trade Area
EMU
Economic and Monetary Union (of the EU)
ESAF
Enhanced Structural Adjustment Facility
EU
European Union
EURODAD European Network on Debt and Development
FDI
foreign direct investment
FLEX
Fluctuation of Export (EU instrument to compensate
ACP countries for fluctuations in export earnings)
FSF
Financial Stability Forum
GDP
gross domestic product
GNP
gross national product
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Abbreviations xiii
HIPC
heavily indebted poor country
IDA
International Development Association
IDB
Inter-American Development Bank
IEO
Independent Evaluation Office (of the IMF)
IFIs
international financial institutions
IFS
International Financial Statistics (of the IMF)
IMF
International Monetary Fund
KIEP
Korea Institute for International Economic Policy
LICs
low-income countries
MCA
Millennium Challenge Account
MDBs
multilateral development banks
MDGs Millennium Development Goals
MICs
middle-income countries
NAFTA North American Free Trade Agreement
NEPAD New Partnership for Africa's Development
NGO
non-governmental organisation
NPV
net present value (of HIPCs' debt)
ODA
official development assistance
OECD
Organisation for Economic Cooperation and Develop-
ment
OPEC
Organization of the Petroleum Exporting Countries
PPP
purchasing power parity
PRGF
Poverty Reduction and Growth Facility
PRSC
Poverty Reduction Support Credit
PRSP
Poverty Reduction Strategy Paper
PSI
Policy Support Instrument
PSIA
Poverty and Social Impact Analysis
PV
present value (of HIPCs' debt)
SDR
Special Drawing Right
SDRM
Sovereign Debt Restructuring Mechanism
STABEX Stabilisation of Export Earnings (EU instrument to
stabilise ACP countries’ agricultural export revenues)
UK
United Kingdom
UN
United Nations
UNDP
United Nations Development Programme
US
United States
VAT
value added tax
WFP
World Food Programme
WTO
World Trade Organization
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1
1
The Dialogue on the Vulnerability of
Low-Income Countries: By Way of
Introduction
Jan Joost Teunissen
sk a policymaker of a rich country or a high official of the IMF
what their institution is doing to help developing countries
overcome the serious problems of a sudden drought or a drop in export
prices, and the typical answer will be: “We know that these countries
can be hit very hard by exogenous shocks and you can be sure that we
do whatever we can to help them. But don’t expect miracles from us.
We have to carefully analyse what we can do, and what they can do to
better address shocks. We should not act too swiftly or too generously
because we run the risk of these countries not doing what they need to
do in the first place: follow policies that prevent these shocks from
having such a big impact on their economies. The only real, long-term
solution will be to help these countries become less vulnerable.”
If you then ask the same official what is being done to help the so-
called low-income countries (a group of 59 developing countries with a
per capita annual income of less than $765), who are particularly
vulnerable to exogenous shocks, the typical answer will be that these
countries indeed need special attention. “But again,” the official will
hasten to add, “let’s not fool ourselves and come up with all kinds of
supportive schemes. In this case too, we need to carefully analyse and
discuss what policies low-income countries themselves should follow to
better resist shocks.”
Obviously, many officials see it as part of their job to make reassuring
statements, and obviously, many observers and critics see it as part of
their job to do the opposite: demonstrate what is missing or wrong in
A
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2 The Vulnerability of Low-Income Countries: By Way of Introduction
the official policies and suggest ways to address these gaps and errors.
That’s how the game works in politics, and that’s how it works in
economics too – in economic policymaking, I mean. This simple law
also applies to the topics of this book: the financial vulnerabilities of
low-income countries, what these countries and the rich countries and
international financial institutions can do to address them, why the
governance of the global financial system should be improved, and
what the main future challenges of the IMF in low-income countries
will be. This book brings together the views of officials as well as
critical observers. But before highlighting a few of their insights, I would
like to give you my view of the quality of the debate that has taken place
between officials and observers over the last twenty years – just to put
things in perspective.
From a Lack of Dialogue to the Fashion of Dialogue
Let’s imagine the above conversation between an observer and a typical
high-level official of the IMF taking place twenty years ago – after
television and newspapers had shown dramatic images of desperate
people in, say, the streets of Kampala or Caracas protesting against
“IMF intervention”. In such a case and at that time, the official would
have said that these protesters might have good intentions, but they did
not really know what they were talking about. Today, however, the
typical official would not say that. He or she would listen carefully and
engage in what is en vogue today, i.e. a dialogue with “civil society”.
Don’t get me wrong, I am not ridiculing today’s fashion of dialogue
between global financial institutions and their critics. I very much
welcome this dialogue and hope it will contribute to a better knowledge
of developing country problems and a better understanding of differing
points of view. But it is always good to remind ourselves of the
eventual pitfalls of such a dialogue. Are the officials really listening to
the arguments of their critics and considering them seriously. And, vice
versa, are the critical observers really listening to the arguments of the
officials.
To answer the last question first: Yes, I think the critics are listening
to and carefully reading the officials’ arguments and documents – that
is what they are doing all the time. The answer to the previous ques-
tion, however, is less clear-cut. I would say, the answer is yes and no.
Yes, because if the officials had not listened to their critics, it would be
hard to imagine why they placed debt relief, poverty reduction and
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Jan Joost Teunissen 3
shock prevention high on their agendas. And yes also, because from the
moment that FONDAD started organising discussions between academics
and policymakers and experts from developing and developed countries
fifteen years ago, I have been witness to the seriousness, frankness and
open-mindedness of these discussions – our books demonstrate this.
But maybe I should add a footnote here: the typical FONDAD
dialogue has not been one between those who see themselves as the
masters of wisdom (the officials) versus the nasty outsiders who blame
them for all kinds of negative things (the critics). Rather, it has been a
dialogue between those who are longing for new insights (the officials)
and those who are keen on discussing their analyses and insights with
the policymakers (the critical observers). Both groups have always
enjoyed the opportunity of learning from each other, and the officials
did certainly not see the critical observers as having less wisdom. On
the contrary. Often they listened with great interest to the profound
analyses and new ideas of the latter. Possibly this has also to do with
the fact that quite a few of the critical observers have been officials
themselves in previous jobs – as, for instance, the job histories of two
contributors to this book, Ariel Buira and John Williamson exemplify
– or still are, as the job histories of Stijn Claessens and José Antonio
Ocampo illustrate.
Why then, is the answer also “no”. Mainly because I see that the
policymakers of rich countries and the officials of global financial
institutions have the natural tendency of looking for safety. So when
they make public statements or give policy advice, after having listened
carefully to critical analyses at FONDAD conferences or other
meetings, they easily return to the habit of using the studies that
support their policies, rather than those that are critical and suggest
alternative policies. One reason for this is that they know it is difficult
to get support for alternative policies from management and peer
groups. Another is that they don’t want to be seen as supporters of
outside views that are not shared by management.
So my experience has also been that officials, after an inspiring
exchange of ideas, easily return to the daily routine of limiting their
attention to the studies that confirm the views of their peers and
superiors – staff reports and “conforming” academic studies. As one of
my friends, after a couple of years of working at the World Bank, once
jokingly (but with a certain bitterness) asked: “Do you know what
IBRD stands for.” “Of course,” I answered, “International Bank for
Reconstruction and Development.” “No,” he said, “International Bank
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4 The Vulnerability of Low-Income Countries: By Way of Introduction
for Rewriting Drafts”. He had had to endlessly rewrite draft reports,
until they finally fit into the management’s thinking.
I am not saying that official staff reports merely pay lip service to
their masters. Nor am I saying that they do not provide useful insights.
I am saying that staff reports are often less critical and contain less
innovative ideas than they would if their authors had been stimu-
lated to express themselves freely, without fear of being corrected by
their superiors or, anticipating such correction, by exercising self-
censorship.
Finally, another reason I think officials may tend not to consider
seriously enough the arguments and proposals of critical observers, is
that they know it is often not the quality of the ideas that count, but
whether they serve certain interests. No matter how good the ideas of
critics (and officials) may be, if they do not concur with the dominant
views, they will simply be neglected or rejected.
With this sense of reality in mind, let us now look at some of the
ideas presented in the chapters that follow.
Better Dealing With Shocks
In his chapter on “Policies to Reduce the Vulnerability of Low-Income
Countries” (Chapter 2), John Williamson examines the nature of the
balance of payments shocks that hit poor countries, discusses the
possibilities of international action in order to reduce the impact of
shocks on small developing countries, and suggests what developing
countries can do for themselves to reduce their vulnerability to
shocks.
Williamson starts by saying that the vulnerability to exogenous shocks
has been “the perennial concern of low-income countries”. The best-
known of these are terms of trade shocks, which stem primarily from
variations in the prices of commodities that still form the staple exports
of most low-income countries, but it may also come from variations in
import prices (especially of oil). Output shocks, either caused by climatic
abnormalities or by political developments (like revolutions or civil
wars), have also been important in many countries. Hurricanes and
other natural disasters can also cause significant macroeconomic
damage in small countries, much of which takes the form of losses to
the capital stock.
Before writing the chapter, Williamson’s impression was that interest
rate shocks and shocks to the flow of capital would be less important,
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Jan Joost Teunissen 5
“but so far as the flow of capital is concerned this turns out to be a mis-
leading characterisation of the 1990s, and may be even less true in
future”.
Williamson’s emphasises what the international community can do.
He discusses three mechanisms that can be used to attenuate the impact
of terms of trade shocks: (1) commodity stabilisation agreements, (2) a
revived IMF’s Commodity Financing Facility, and (3) a HIPC contin-
gency facility. He sees these as “three progressively less ambitious ways
in which the international system could help its poorest members deal
with shocks”.
Williamson also recommends what developing countries can do them-
selves to become more shock-resistant. He observes: “The most common
problem is that countries run their economies without leaving the slack
that is necessary if they are to react to shocks in a stabilising way. … In
the best of worlds there is also going to be a role for better economic
management.” In his view, countries could improve economic manage-
ment in various ways. They should, for instance, apply fiscal policies
that lower debt/GDP ratios during booms, so that they have the scope to
finance borrowing in times of recession. They should also limit their
borrowing to such levels that they can service even under unfavourable
conditions. And they should borrow in domestic rather than foreign
currency (following the “original sin” Eichengreen-Hausmann proposals)
to prevent the problem of a so-called currency mismatch.
In Chapter 3, Dutch treasury general Kees van Dijkhuizen enthusi-
astically embraces Williamson’s notion that a developing country’s
vulnerability also depends on its own economic policies. He stresses
that these policies “should include structural measures, notably export
diversification, but also monetary and fiscal policies as a kind of self-
insurance”. He is, however, a bit sceptical about the desirability of the
three international mechanisms proposed by Williamson and suggests
as an alternative strategy a focus on the microeconomic level. “Govern-
ments can promote the development of a financial sector that offers all
kinds of insurance or other market-based mechanisms to manage
risks.” He also sees many problems with the Eichengreen-Hausmann
proposals of lending in domestic currencies. Van Dijkhuizen concludes
that through its traditional mechanisms of monitoring, policy advice
and temporary finance, the IMF “can assist countries in better
anticipating and responding to shocks”.
Matthew Martin and Hannah Bargawi (Chapter 4), who work closely
with HIPC countries, turn their attention to how poor African countries
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6 The Vulnerability of Low-Income Countries: By Way of Introduction
can be better protected against exogenous shocks. They stress that such
shocks can reduce GDP by as much as 5 percent, thus causing
“dramatic cuts in budget spending on the Millennium Development
Goals”. They point to strong evidence that the income of the poor is
hit even harder by shocks, “provoking a major setback to progress
towards the MDGs”. They observe that even though recent IMF and
World Bank Board papers have confirmed the need to avoid or
mitigate the effects of shocks, both institutions have tightly limited
their own proposed roles in this process. In the view of Martin and
Bargawi, current international measures to deal with shocks “fall way
short of the scale and frequency of shocks to which African economies
are subjected”. They therefore examine in detail how Africa could be
better protected against shocks.
The authors first provide an in-depth discussion of the many types
of shocks that can be distinguished (predictable or non-predictable,
input or output, temporary or permanent, etc.) and conclude that none
of these distinctions should be used as an argument to withhold assis-
tance. “If a country is making genuine efforts to promote economic
development and reach the MDGs,” they say, “shocks should be
foreseen and avoided – and if this is not possible, genuine unforeseeable
‘shocks’, especially those which impact on MDG progress, should be
compensated regardless of their source, nature or duration.” Then they
identify the key shocks to which African countries are subject, and
which countries (especially HIPCs) are most sensitive to the different
shocks identified. And finally, they propose a number of measures the
international financial community can take, both in preventative and
curative terms. The measures they suggest, are: (1) improving analysis to
prevent shocks from occurring; (2) taking measures against individual
types of shocks; and (3) taking comprehensive measures against Africa’s
overall vulnerability to shocks.
With regard to the first measure, they spell out in considerable detail
how the IMF and World Bank can improve their baseline forecasts and
design comprehensive anti-shock plans. In their view, a “top priority”
would be establishing fiscal contingency reserves in all low-income
countries linked to the potential scale of shocks, just like such
contingency reserves “are normal practice in developed economies,
which are much less vulnerable to shocks”.
With regard to measures against individual types of shocks, they
report that they can be dealt with in three ways: (1) risk management;
(2) insuring low-income countries against shocks; and (3) automatic
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Jan Joost Teunissen 7
adjustment to debt service. Given that these three ways only treat one of
the symptoms of an external shock (a high debt burden), rather than its
causes or its comprehensive impact, they argue strongly in favour of
overall measures against shocks. “Given the frequency of multiple
shocks hitting most African countries … the onus is on the official
system to implement three main measures to offset and compensate for
shocks.”
The first overall measure they propose is adjusting Poverty Reduction
and Growth Facility (PRGF) programmes to shocks. The second is
providing supplementary financing in the form of highly concessional
loans, or preferably grants, as compensatory and contingency financing
against shocks. And the third is building overall contingency mecha-
nisms into adjustment programmes. They stress that such anti-shock
financing would need to be set aside up front, “as genuine financing
against contingencies, rather than after the shock when its negative
effects on the economy have already been felt”.
Martin and Bargawi conclude that, “as African HIPC governments
have themselves suggested,” there is no better use or higher priority for
additional aid funds than immediate, low-cost contingency financing.
“Together with measures to prevent shocks by better analysis and
improved policymaking, and to offset or compensate specific types of
shocks, this could guarantee Africa’s protection against shocks, ensuring
that this key factor would no longer disrupt its progress towards the
MDGs.”
In Chapter 5, G-24 Secretariat director Ariel Buira broadly agrees
with the proposals by Williamson and Martin-Bargawi. He stresses,
however, that Williamson’s domestic policy recommendations are easier
formulated than applied. For example, Williamson’s recommendation
that countries should aim for a redistribution of expenditures over time
is difficult, says Buira. First, because capital inflows are pro-cyclical
(borrowing increases in good times and falls in bad times), second,
because fiscal policy is also pro-cyclical (government expenditure
expands in good times and falls in bad times), third, because emerging
market monetary policies tend to be pro-cyclical (expansionary in good
times and restrictive in bad times), and, fourth, because capital inflows
are associated with expansionary macroeconomic policies in good times,
as are capital outflows with contractionary policies. “In these circum-
stances,” stresses Buira, “it is very difficult for countries to pursue
counter-cyclical policies. Perhaps the Fund should help them do so,
and perhaps they should try harder.”
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8 The Vulnerability of Low-Income Countries: By Way of Introduction
Changing the Rules of Global Financial Governance
Chapters 6 and 7 of the book deal with the governance of the global
financial system.
In their chapter on “The Need for Institutional Changes in the
Global Financial System” (Chapter 6), Stijn Claessens and Geoffrey
Underhill observe that despite many attempts at the international level
to improve the functioning of the system, many developing countries
still suffer from high external debt and insufficient development
finance, creating “disappointment and scepticism among policymakers
and citizens worldwide concerning the contribution of the international
financial system to global development”. They advocate a change in the
management of the global financial system that goes beyond the topics
of immediate interest to policymakers – i.e. the latest financial crisis,
the difficult private-public relationship in debt workouts, or the debt
problems of low-income countries. Instead, they argue, “fundamental
questions” of the nature of the governance of the international finan-
cial system need to be addressed.
Rethinking the governance of the international financial system,
Claessens and Underhill discuss four sets of interrelated issues. First,
how is today’s international financial system different from when it was
put in place, and what issues in terms of governance do these changes
raise. Second, how do these changes in both markets and governance
affect the balance of power between public authorities and private
interests in international monetary and financial policies. Third, are
the current rules and institutions of the international financial system
the right ones to address the global public policy issues and what sorts
of changes in governance can be made to improve the international
institutional framework, especially with regard to the global development
process. And fourth, how might policy processes and institutions at the
global level become more accountable and outcomes more legitimate in
relation to the policy preferences of citizens of all economies, in
particular of the developing world.
After an in-depth discussion of each of these four issues, Claessens and
Underhill draw a number of tough conclusions. First, they stress that
there is little doubt that the interests of developed countries predominate
in current global financial governance processes, and that “private
interests of developed country financial institutions are increasingly
evident”. Private banks have played a major role in pushing for cross-
border liberalisation in both developed and developing countries. In
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Jan Joost Teunissen 9
this way, developing countries now face the power of both public and
private agencies of developed countries, “often in coalition with each
other”. “In many developing countries, foreign financial institutions
from developed economies have had a large role in domestic financial
markets and have been able to ‘threaten’ national agencies, thus gaining
a stronger voice than the local constituents of the ‘public interest’
behind the national policy agenda.”
Second, they conclude that the failure to deliver on many of the
goals set out by the international development community, the debt
problems of low-income countries, the setbacks to the development
process represented by persistent financial crises, and the continuing
difficulties with debt workout and the crisis management framework,
“all raise questions about the effectiveness and legitimacy of international
financial governance”.
Third, they conclude that the serious deficiencies in the governance of
the international financial system clearly point to the need for reform.
“Fundamental issues of political economy are at stake: the role of public-
ly accountable institutions versus the private sector at both national and
global levels; the balance of power between core and periphery
countries in the global economy; the tensions between national (in
particular developmental) and global system-level imperatives; the
relative influence of citizens in national and world affairs; and the
legitimacy of both national and global institutions. … Solutions will
not be easy and may have to be found in building regional coalitions
among developing countries and moving away from the assessment of
policies by markets and international financial institutions.”
Maybe I should add here that it is remarkable that one of the
authors, Stijn Claessens, reaches such strong conclusions since he
worked with the World Bank for many years before he became a
professor in international finance at the University of Amsterdam.
When he started writing this paper with Geoffrey Underhill he was still
a university professor, but when he presented it at the FONDAD
conference, he had returned to the Bank. This corroborates my earlier
point: if World Bank or IMF officials feel they can express themselves
freely or are stimulated to do so, they have very interesting things to say.
But it also corroborates another point I made earlier: generally speaking,
officials do not seem to be encouraged to engage in such endeavour, or
lack the interest, self-assuredness or courage to do so.
José Antonio Ocampo (Chapter 7) very much likes the Claessens-
Underhill analysis and conclusions, and underlines that the developing
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10 The Vulnerability of Low-Income Countries: By Way of Introduction
countries will only be able to change global financial governance if they
organise themselves into an interest group. Ocampo observes: “Rather
than accepting the current rules of the game, developing countries will
have to play the game by identifying their collective interests and take
these to the international organisations and, hopefully, also to the
markets and say: These are the interests that we want to defend. The
current international system will only be workable if it is based on
stronger regionalism. A stronger regionalism is the only way to balance
the huge asymmetries in power that we have in the system.”
Touching on other issues than those presented in the Claessens-
Underhill chapter, Ocampo also discusses the so-called ownership issue,
the streamlining of IMF conditionality, and the new fashion of rating
developing countries by the quality of their institutions. Ocampo
stresses that in all three cases it should be the countries themselves that
determine what development strategies (ownership of programmes)
and economic policies (conditionality) they want to follow, and how
they want to improve their institutions. “Trying to build institutions
through ranking countries and using that ranking for aid allocation
purposes will lead to a loss of legitimacy rather than an improvement in
the way of working,” says Ocampo.
The Future Role of the IMF in Low-Income Countries
In the last two chapters of the book the future role of the IMF in low-
income countries is discussed. Even though this topic has already been
treated extensively by a number of excellent experts (including Amar
Bhattacharya, Graham Bird, Stijn Claessens, Louis Kasekende, Ron
Keller, Matthew Martin and Mark Plant) in the previous Fondad book
Helping the Poor: The IMF and Low-Income Countries, we thought it
would be interesting to include two more chapters on this topic –
which continues to be intensely debated – in this volume. One is
written by Dutch officials and another by a critical Irish observer. The
inclusion of these chapters not only provides the opportunity to report
on the latest developments, but it also makes it possible to compare
what these authors see as the main future challenges for the IMF and
what the contributors to the previous volume saw as the main
challenges. I will not make that comparison, but you may find it
interesting to do so.
In Chapter 8, Dutch Finance Ministry official Ernst van Koesveld
and colleagues examine what they see as the main challenges for the IMF.
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Jan Joost Teunissen 11
The first challenge, in their view, is the Fund’s longer-term financial
involvement in low-income countries and how a gradual exit to a
surveillance-only relationship can be promoted. The second challenge
is the role of the Fund in cases where financial assistance is not critical
to alleviating balance of payments needs, but where involvement for
signaling purposes is important. And the third is the Fund’s approach
to debt relief and how debt sustainability can be promoted.
Discussing each of these challenges, Van Koesveld and colleagues
observe that the longer-term relationship between the Fund and low-
income countries should not be confused with a need for IMF
financing being provided over longer periods. “An analysis of whether
the economic problems in a country merit financial involvement of the
Fund should be made at the end of each Fund programme and include
a view on the (protracted) balance of payments need,” the authors
stress. They therefore see the issues of “saying-no” and the design of
proper “exit strategies” as one of the main future challenges of the IMF.
Preventing the build-up of high debt levels in low-income countries is
another pressing issue, they say. And third, they hope that the Fund
will be able to shift from a direct role in financing balance of payments
gaps to a more indirect role in catalysing other sources of funding by
providing signals on the macroeconomic and financial developments in
countries.
The authors conclude that the three challenges are closely interlinked.
“If the Fund is better equipped to design and implement a gradual exit
strategy, a country may be better able to shift from IMF financing to
other, more concessional funding, which, in turn, reduces the build-up
of new, possibly unsustainable debt. This process will be facilitated if
the IMF can use the new Policy Support Instrument, providing a
strong signal, also on debt sustainability, but without financing.”
Caoimhe de Barra (Chapter 9), the policy and advocacy coordinator
of the Irish development NGO Trócaire, observes that in an era where
“partnership” is the leitmotif of development discourse, “the IMF stands
apart”. The IMF largely continues to talk to a limited group of officials
in ministries of finance and central banks, she says. “Tortuous debate”
on the role of the IMF in low-income countries has taken place at Board
and staff level, and has been “at its most fundamental” when it was
about whether the Fund’s role is to have a strictly bilateral relationship
with member countries, focused only on macroeconomics, or whether
it should position itself as part of a multilateral framework, “with a
specialisation in macroeconomic stabilisation but a clearer focus on
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12 The Vulnerability of Low-Income Countries: By Way of Introduction
poverty reduction”. De Barra examines the role of the Fund in poverty
reduction in low-income countries and discusses some of the key issues
in the Fund’s review of its role in low-income countries. The issues she
reviews include: How should the Fund address poverty. What is its
role in mobilising finance for development. What are the changes in
policy and practice needed to IMF conditionality. What deeper
changes are required in the Fund’s signaling role.
After a discussion of each of these issues, De Barra concludes that
the IMF should engage in a partnership model for low-income
countries, where the Fund plays an equal role with other donors and
supporters of the development efforts of sovereign governments. “This
is not an outlandish proposition,” she says, “but it might require an
extraordinary effort from the Fund and its political principals to
relinquish power, adopt a genuinely multilateral attitude and recast
itself in the role of partner rather than macroeconomic master.”
Conclusion
This book is yet another contribution to a dialogue on international
finance and development issues in which, as Caoimhe de Barra remarks,
there are many partners. It is fashionable to stress that governments
and citizens in developing countries should “own” the IMF and World
Bank programmes they are engaged in. The following chapters show
that while such ownership is indeed crucial, it is rarely put into practice
or it is not put into practice in a way preferred by the governments and
citizens of developing countries. As José Antonio Ocampo observes
when he discusses the evaluations of poverty reduction programmes by
the IMF and World Bank: “Ownership will start by evaluations being
really done by countries – not by the IMF or the donors, or the World
Bank, or the NGOs, but by country teams. That should be the
framework for any evaluation”.
Protecting the poor and vulnerable in low-income countries means
listening to the voice of the poor. In the chapters that follow, their
voice is echoed by the agreement between both officials and observers
that the volatility and suffering caused by exogenous shocks are among
the pressing problems that the international community needs to
address. There is less agreement on what exactly the rich countries and
the international financial institutions should do to address these
shocks, and if and how the governance of the global financial system
should be improved. Nor is there full agreement on what the main
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Jan Joost Teunissen 13
future challenges of the IMF in low-income countries will be. The
debate continues on all of these issues.
In my view, there is only one way that the dialogue between officials
and critical observers can deliver optimal results: serious consideration
of ideas that aim to resolve pressing economic problems and improve
the democratic decisionmaking in both national economies and the
global economic system. A prerequisite for such democratic decision-
making is that all stakeholders become involved and are well-informed.
The following pages not only contribute to enhancing the level of
information, but they also highlight the weak as well as the hot spots in
the current debate.
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14
2
Policies to Reduce the Vulnerability of
Low-Income Countries
John Williamson
1
perennial concern of low-income countries has been their vulner-
ability to exogenous shocks. The best-known of these are terms of
trade shocks, which stem primarily from variations in the prices of
commodities that still form the staple exports of most low-income
countries, but may also come from variations in import prices
(especially of oil). Output shocks, either caused by climatic abnormalities
or by political developments (like revolutions or civil wars), have also
been important in many countries. Hurricanes can also cause macro-
economically-significant damage in small countries, much of which
takes the form of losses to the capital stock. My impression was that
interest rate shocks and shocks to the flow of capital tend to be less
important than in middle-income countries, but so far as the flow of
capital is concerned this turns out to be a misleading characterisation of
the 1990s, and may be even less true in future.
But the reason that countries are vulnerable to shocks is not just
because shocks happen: it is also a function of policy reactions. Perhaps
the most common problem is that countries run their economies
without leaving the slack that is necessary if they are to react to shocks
in a stabilising way. Doubtless it would be preferable from the stand-
point of developing countries to reduce their vulnerability by creating
——————————————————
1
Revision of a paper presented to a conference organised by FONDAD in The
Hague on 11-12 November 2004. The author is indebted to Jacob Kirkegaard for
research assistance and to participants in the FONDAD conference for comments.
Copyright Institute for International Economics: All rights reserved.
A
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John Williamson 15
international mechanisms (like buffer stocks or a revival of the IMF’s
Contingency Financing Facility or the Birdsall-Williamson contingency
protection mechanism for HIPC countries) that would attenuate the
impact of shocks on poor countries, but in the best of worlds there is
also going to be a role for better economic management.
The chapter starts by examining the nature of the balance of payments
shocks that hit poor countries. It proceeds to look at the possibilities of
international action in order to reduce the impact of shocks on small
developing countries. The final section focuses on what countries could
do for themselves to reduce their vulnerability to shocks.
1 The Nature of Balance of Payments Shocks
Table 1 shows a measure of the relative size of four different shocks to
the balance of payments outcomes of developing countries, disaggregated
into low-income countries, small low-income countries (the former
group excluding countries with a population above 100 million people),
and middle-income countries. The boundary line between low- and
middle-income countries is the standard World Bank dividing line of a
per capita income below or above $735 per annum in 2002, with
income converted at market exchange rates rather than PPP.
The measure of the shock is in principle the standard deviation of
the dollar value of foreign exchange receipts or payments on the
particular item in question, as a proportion of the standard deviation of
the average of total current account imbalances. For interest payments
and remittances this is straightforward. For capital flows one might ask
what sense it makes to express the shocks relative to the size of shocks
to the current account; the answer is that this is purely a normalisation,
to be able to see how important these shocks are relative to other
shocks. The terms of trade shock is more complex. What we did is take
the World Bank’s World Development Indicators (WDI) figure for the
terms of trade, which is the volume of imports that can be bought with
a given volume of exports, expressed in constant local currency terms.
This would be the same as the single factoral terms of trade if
productivity in the export-producing industry were constant. That
figure was converted into dollars by the IFS figure for the average
annual dollar exchange rate during the year, and then its standard
deviation was calculated. Unfortunately, this procedure produces
nonsensical results for a few countries that suffered from hyperinflation
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16 Policies to Reduce the Vulnerability of Low-Income Countries
at some time in the 1990s, presumably because the conversion to dollar
terms can produce an answer that is enormously different to the correct
one. The second half of Table 1 therefore shows the results excluding
those cases in which the calculated standard deviation of the terms of
trade exceeded 1,000 percent.
Each entry in the table therefore shows how important the item in
question is in producing balance of payments shocks relative to shocks in
the current account balance. For example, the table shows that for low-
income countries shocks to interest payments average only 16 percent
of the size of shocks to the current account balance, while shocks to
remittances average 27 percent of the size of shocks to the current
account. The dominant source of shocks to the current account turns
out to be shocks to the terms of trade, as expected. However, shocks to
capital flows are considerably more important, and turn out to be even
larger than shocks to the current account. This fact surprised me in
regard to the low-income countries (as it did some other participants in
Table 1 Balance of Payment Shocks to Developing Countries
1990-2002 (Relative to Current Account Shocks)
Country Group
Standard
Deviation of
Total Interest
Payments
Standard
Deviation of
Remittances
Standard
Deviation of
Terms of Trade
Shocks
Standard
Deviation of
Total Capital
Flows
LICs
1
16%
27%
120%
132%
Small LICs
16%
25%
128%
140%
MICs
1
21%
39%
3102%
116%
Excluding Outliers
2
:
LICs
14%
27%
67%
134%
Small LICs
15%
24%
69%
142%
MICs
20%
40%
44%
116%
Sources:
Terms of trade data from World Bank (2004a); current account data (
BN
.
CAB
.
XOKA
.
CD
),
interest payment data (
DT
.
INT
.
DECT
.
CD
), remittances data (
BX
.
TRF
.
PWKR
.
CD
) and total
capital flows data (
DT
.
NFA
.
DLXF
.
CD
) from World Bank (2004b); exchange rate data from
IMF (2004).
Notes:
1
LICs: low-income countries; MICs: middle-income countries.
2
Outlier identified as having a terms of trade standard deviation denominated in dollar of
more than 1,000% of the country's current account balance. Following outliers excluded;
Nicaragua (LIC), Zambia (LIC), Armenia (MIC), Brazil (MIC), Bulgaria (MIC) and
Romania (MIC).
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John Williamson 17
the conference) but not in regard to the middle-income countries. But
it did not surprise Matthew Martin, whose work for the Commission
for Africa (see Chapter 4) had also revealed much volatility in capital
inflows – and especially in aid receipts – in low-income countries. Stijn
Claessens suggested a possible reconciliation: that perhaps higher mo-
ments in the probability distribution than the second are indeed greater
in middle-income countries, and perhaps it is these higher moments
that are really important in inducing crises.
One might suspect that terms of trade shocks are larger in the small
low-income countries than in the large ones, which export a wider variety
of goods and therefore have more chance to diversify such variability
away. The second row in Table 1 therefore shows the results excluding
the large countries, defined as those with a population exceeding 100
million persons. The terms of trade effect is indeed marginally larger,
although the results are in any event dominated by the large number of
small countries. The result for the middle-income countries is domi-
nated by the hyperinflation cases. After excluding these (the bottom sec-
tion of the table), it can be seen that terms of trade shocks are much
smaller for middle-income than for low-income countries. Indeed,
terms of trade shocks are little bigger than shocks to remittances! While
the low-income countries suffer rather more instability from capital
flows than do middle-income countries (on the measure used), in the
middle-income countries – unlike low-income countries – capital-flow
instability is the dominant source of balance of payments shocks.
Shocks to the balance of payments are important because they feed
through into shocks to the real economy. A loss in export revenue has a
multiplier effect on domestic spending. It also causes a loss of tax
revenue, often directly but in any event as a result of the slowdown in
consumption. Any negative shock to the balance of payments gives a
country less to spend abroad, which may result in the government
being forced to further restrict demand. It may be able to avoid such a
cutback in imports, by either running down the reserves or borrowing
more. So a country faced by a negative shock to the balance of pay-
ments has a choice between accepting lower activity and more poverty
and unemployment, or else seeing both domestic and foreign debt
increase. I shall argue subsequently that a country can mitigate the
impact of a negative payments shock, but that is by keeping enough
reserves that it can afford to lose some and a low enough debt that it
can afford to borrow more. In that case shocks will impact even more
on debt levels.
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18 Policies to Reduce the Vulnerability of Low-Income Countries
2 Possibilities of International Action
Traditionally attention has been focused primarily on stabilising the
prices of primary commodities. Variations in these prices are indeed
the principal source of terms of trade variability, and as shown above
therefore a major source of the exogenous shocks in small countries, so
it is a natural reaction.
During the 1970s negotiations to establish a “new international
economic order” included an attempt to establish a “common pool” to
finance buffer stocks of the principal commodities entering world trade.
Insofar as the price fluctuations of those commodities are less than
perfectly correlated, a given level of assurance that the buffer stock will
not run out of money can be provided with a lower cash outlay by
financing the buffer stocks through a common pool rather than
individually. Those negotiations ended in failure, and indeed those few
buffer stocks that had survived up to the 1970s (like tin) subsequently
collapsed. The idea of commodity price stabilisation has nowadays
practically disappeared from the international agenda.
Perhaps we have gone too far in abandoning such ideas. Perhaps we
have allowed ourselves to be too impressed by the fact that mistakes
were surely made in running buffer stock schemes. It was surely a
mistake, for example, to try to construct buffer stock mechanisms that
would improve the sellers’ average sales price; or that would stabilise
prices within a narrow range; or that would stabilise the price around
an unchanging mean. Price stabilisation is something different to (and
perhaps less difficult than) improving the sellers’ terms of trade, and a
mechanism that is intended to stabilise prices should be strictly limited
to that task. And it should be obvious that any attempt to stabilise
price within a range narrower than that within which it is possible to
make a reasonable estimate of the equilibrium price is doomed to failure.
Moreover, new techniques and demands are liable to change the
equilibrium price over time (just as new information may change our
estimate of that equilibrium price), so that a failure to embody a
feedback mechanism that changes the estimate of the equilibrium price
in response to new facts and new information must doom a commodity
stabilisation scheme to failure.
But suppose that the world learnt those lessons, and was suitably
unambitious about what it asked of a new scheme. Specifically,
consider the feasibility of stabilising the price of oil within a broad
band, as has been urged by Fred Bergsten (2004). The argument is that
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John Williamson 19
the price of oil is currently so high because there has been so little
investment in the recent past, and that investment has been deterred by
the fear of the price of oil collapsing again as it did in the late 1990s. A
credible promise of the consumers to cooperate with the producers in
preventing a new price collapse could, it is argued, induce a new wave
of exploration and investment that would bring the price back down.
Bergsten suggests a price zone of $15 to $25 a barrel; I suppose that my
instincts would suggest a rather higher range, more like $20 to $30 a
barrel initially. (Of course, the range might subsequently be changed, if
evidence suggested that the equilibrium price lay outside the band.)
The key questions are: What instruments would be potentially available
to defend such a range. And: Would producers find the promise to
deploy such instruments sufficiently credible to persuade them to change
their investment policy accordingly. Obviously any such agreement
that started under conditions such as those currently prevailing would
not initially attempt to enforce the upper margin as a maximum; that
would become feasible only as excess capacity was rebuilt.
Could one defend even the bottom of such a range, and how. To
make a minimum price credible, which would be essential to it inducing
more investment, one would want membership by all the main
producing countries, including the non-OPEC ones, and the main
consuming countries, especially those that have a policy of building up
strategic stockpiles. The producing countries would have to commit
themselves to constraining production in the event of the price
threatening to fall through the price floor, to complement the restraint
that OPEC tries to exert on its members. One would certainly want
participation in such an arrangement by Canada, Mexico, Norway, and
Russia, as well as OPEC, all of which would need to agree to cut back
production to less than the nationally-optimal level in the eventuality of
low prices. The cooperation of the importing countries would be
necessary in the first place to give their blessing to such action by the
exporting countries, since in the past some of them – most especially
the United States – have been sharply critical of any action to restrain
production in the interest of keeping prices up. Furthermore, however,
those importing countries that manage a strategic stockpile would need
to agree to vary the rate of addition to the stockpile with the deliberate
objective of price stabilisation. At the very least, they should agree to
suspend purchases at a time when the price of oil is being pushed up
above the top of whatever price range were established. Conversely,
they should be willing to accelerate stockpiling at a time such as 1999
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20 Policies to Reduce the Vulnerability of Low-Income Countries
when an oil glut was pushing prices down below the bottom of the
price range. The benefit of a successful oil price stabilisation scheme
would be the avoidance of “oil shocks” to the world economy.
In one way it would be exceptionally difficult to stabilise the price of
oil, because it would be unlikely that an international authority could be
created in order to run a typical commodity stabilisation fund able to sell
its holding to depress prices when the price threatened to rise to the top
of its permitted range. Because of the strategic importance of oil, one
would have to expect that the consuming countries would want to
maintain control over the disposition of oil in reserves held on their na-
tion’s territory, which would raise questions as to whether the interna-
tional agency responsible would be free to sell at its discretion. On the
other hand, the strategic importance of oil means that several of the
major countries already have strategic reserves, whose rate of acquisition
could in principle be varied in the interest of price stabilisation.
It would be simpler to build up internationally controlled stockpiles
of most of the other main commodities, even though there would not
be available the policy tool of varying the offtake into nationally-
managed reserves. The main issues would, once again, be obtaining the
finance to buy for the stockpile, and setting the price limits that would
govern purchases and sales. In the first instance the stockpile would
only be able to post a purchase price, since by hypothesis it would have
nothing to sell. That purchase price might be set at, say, 20 percent
below the central rate, which should be determined by a formula to
ensure that it would respond to changes in the equilibrium price and
that no attempt would be made to use it as an instrument for securing
a secular improvement in the terms of trade of commodity exporters.
The formula should be expressed in SDRs (so that changes in the value
of the dollar did not distort real prices significantly) and might be, say,
the average price of the commodity over the preceding ten years.
A buffer stock costs money. The question has to be asked whether it
is a good use of resources to invest them in building up buffer stocks
rather than investing elsewhere. The IMF seems to have decided that
the interest and carrying costs of buffer stock schemes outweigh the
benefits of price stabilisation. Kees van Dijkhuizen (see Chapter 3)
points out that this scepticism had received powerful support from an
IMF paper by Cashin, Liang, and Dermott (1999). Their analysis
showed that in nearly two-thirds of major commodities (27 out of 44)
the price shocks experienced over the 40-year period 1957-98 had
lasted on average at least 5 years. Since one can only stabilise price
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John Williamson 21
shocks that are temporary, this suggests that it would be uneconomic,
or even impossible, to stabilise the prices of the majority of primary
commodities. Thus this sort of scheme is at best one that might work
only for a minority of primary commodities.
It was such scepticism which caused the international community,
when such schemes were proposed in the 1960s, to create instead (in
1963) a mechanism that allowed a commodity exporting country hit
by a terms of trade shock to borrow under a low-conditionality IMF
facility, the Compensatory Financing Facility (CFF). This had the
advantage of also covering shocks due to output declines, e.g. as a result
of climatic factors or natural disasters, which are probably more often
temporary than price declines. That Facility was progressively
liberalised through the next 18 years, with a Buffer Stock Financing
Facility being added in 1969, several liberalisations of access, and the
addition of a right to draw in response to an excess in the cost of
importing cereals in 1981. However, in 1983 the tide turned and
access to the Facility started to be tightened. In 1988 a comprehensive
restructuring of the Facility occurred. One element of this was addition
of an External Contingency Mechanism (ECM), which added to what
a country could draw under the Fund’s regular facilities if certain
critical external variables (like export prices and interest rates) turned
out to be less favourable to the borrowing country than had been
assumed when its programme was drawn up. As a result, the facility
was renamed the Compensatory and Contingency Financing Facility
(CCFF). But other elements involved cutting back what a country was
entitled to draw, and tightening the conditions, under the old
compensatory programme. As Figure 1 shows, the net effect of the
Figure 1 Compensatory and Contingency Financing Facility 1963-99
(in millions of SDR
)
0
500
1.000
1.500
2.000
2.500
3.000
Source: IMF data.
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22 Policies to Reduce the Vulnerability of Low-Income Countries
reforms was to accentuate the reduction in the use of the Facility that
had occurred after 1983, interrupted only by a brief surge in use in
1991 as a result of the dislocations caused by the first Gulf War and a
large drawing by Russia in 1998. Since 1988 the facility has remained
largely unchanged, apart from elimination of the Buffer Stock
Financing option and the ECM as a part of the Fund’s post-Asia crisis
rationalisation.
The CFF is intended to allow a member country to borrow when it
has a balance of payments need and suffers a temporary overall shortfall
in the value of exports (or surge in the cost of cereal imports) as a result
of factors beyond its control. The member country is required to
cooperate with the Fund in resolving its payments problems, but since
this phrase is not further defined it amounted in practice to low condi-
tionality. A staff paper issued prior to the 2000 Board discussion of the
Facility
2
argued that there is no longer a strong rationale for the Facility.
In almost all cases of a need for balance of payments financing, there is
also a need for adjustment, which in the Fund view implies a need for
high conditionality so as to give reasonable assurance that the required
adjustment will actually occur. Second, most middle-income members
have access to alternative (private) sources of finance. And third, most
low-income countries cannot afford the relatively high interest rates of
the CFF, and should instead borrow an increased sum from the highly
concessional Poverty Reduction and Growth Facility intended for these
countries.
I do not find all these arguments completely convincing. Most
countries that have some balance of payments need also need some
measure of adjustment: if they don’t, then surely they will find it easy
to borrow from the private markets. A key question is whether one
agrees that any country that ought to be adjusting also ought to borrow
under high-conditionality facilities that give the Fund the right to
supervise its adjustment programme. Most countries prefer to manage
their own programme, without being “nannied” by the IMF. If they
show themselves incapable of managing their own programme, then
there is not much option but to bring in the IMF to supervise the
adjustment programme, but one can wish for them to be given the
benefit of the doubt initially. And even if a middle-income country
——————————————————
2
Review of the Compensatory and Contingency Financing Facility and the
Buffer Stock Financing Facility – Preliminary Considerations, Dec. 9, 1999, at
http://www.imf.org/external/np/ccffbsff/review/index.htm.
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John Williamson 23
would be able to borrow from the private market, doesn’t international
solidarity with a country hit by adverse circumstances beyond its
control suggest that the international community can reasonably
extend it credit on the mildly concessional terms inherent in a regular
Fund programme. These arguments would suggest that the CFF
should be restored to something like its former state so far as middle-
income countries are concerned.
The Fund’s argument is more persuasive where the low-income
countries are concerned. It does indeed seem desirable to give them
credit on the highly-concessional terms of the PRGF. Admittedly some
of us think it would be logical to make the interest charge a country
pays dependent on the identity of the borrower rather than the identity
of the Facility from which it borrows, but if that is unacceptable to the
Fund’s accountant then the solution may be to augment a PRGF loan
when an exogenous shock hits. It was suggested by several participants
in the FONDAD conference that one advantage of this is that it would
permit bilateral donors with grant funds available to buy out such loans,
thus combining relatively prompt action by the IMF with grant aid
(which most donors can provide only with a lag) in response to a
negative exogenous shock. Perhaps the most contentious issue will be
whether any such “shocks window” within the PRGF will be subject to
high or low conditionality. As with middle-income countries, I favour
starting off with low conditionality and tightening this only if the
country is failing to adjust.
Another possible mechanism for giving poor countries some protection
against exogenous shocks was proposed by Nancy Birdsall and John
Williamson (2002) in our study of debt relief. While rejecting the idea
of 100 percent debt cancellation for the group of countries that were
already in the HIPC Initiative, we suggested three ways in which that
initiative could be expanded. One of these was to legislate a ceiling of
2 percent of GDP on the sum that any HIPC should pay in debt
service: if it looked to be in danger of breaching that ceiling, additional
debt should be forgiven so as to eliminate the possibility. It is not clear,
however, that any HIPCs still remain in danger of breaching that ceiling.
A second extension was to expand the country eligibility to all poor
countries,
3
which meant in practice to allow large countries like
Indonesia, Nigeria, and Pakistan to become eligible. It seems that
——————————————————
3
I.e. those with average income below the IDA threshold then at $735 per
annum at market exchange rates.
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24 Policies to Reduce the Vulnerability of Low-Income Countries
Indonesia and Pakistan are coping fine without debt forgiveness, but
Nigeria is another matter and clearly ought to be allowed to become
eligible for HIPC relief. The third proposed extension is the one that is
of relevance in this context, since it proposed a contingency mechanism
to help countries hit by adverse shocks.
The aim of the HIPC Initiative was to ensure that any qualifying
country should have its debt reduced to less than 150 percent of
exports, on the argument that history showed that most countries were
capable of carrying that much debt, but not too much more, without
undermining their ability to manage their economy. To try and ensure
that a qualifying country would be in that situation for some years after
reaching Decision Point, joint teams from the IMF and World Bank
projected key variables like debt, GDP, and exports for 15 years from
the base date. These projections, especially for the growth of exports,
were widely held to be on the optimistic side. If that is correct – and
the number of countries that were forced to take advantage of the
possibility of taking an extra bite at the cherry of debt relief between
Decision Point and Completion Point suggests that it was – this would
imply that many countries are liable to find themselves over-indebted
again before many years.
The usual conclusion that has been drawn from this analysis is that
indebted countries need more debt relief than they were provided under
the HIPC Initiative. We suggested, however, that it would be a more
efficient use of resources to provide more debt relief in those specific
instances where events showed there to be a need for more relief, rather
than universally. In order to avoid distorting incentives, it is important
that this relief should be given only where a country suffered an increase
in its debt/export ratio as a result of circumstances beyond its control.
Similarly, to leave an incentive for export diversification one wants to
make this extension of the existing “topping-up” provision of finite
duration; we suggested ten years. The programme might be administered
by requiring the IFIs agreeing on a HIPC programme to state their
assumptions about the price trend of important commodity exports; if
a programme country subsequently suffered an export shortfall that
could be attributed to a below-projected trend price to an extent that
threatened to push debt/exports above 150 percent, it should be entitled
to compensation to pay down its debt.
Who would administer such a programme and where would its
money come from. We envisaged the IMF as the administrator, for
two reasons. First, the IMF has had the experience of administering the
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John Williamson 25
CFF over the years, which has given it expertise – or at least agreement
on a set of conventions – needed to estimate whether export shortfalls
can be attributed to circumstances beyond a country’s control. Second,
the IMF has a potential source of the finance that would be needed to
run such a facility. Specifically, we suggested using some of the IMF’s
stock of redundant gold, which is presently carried on the IMF’s books
at a fraction of the current free market price of gold, for this purpose.
It has to be admitted that the authors were not in full agreement on
how the IMF’s gold should be mobilised for this purpose: one of us
believed in the straightforward technique of selling the stuff, while the
other was happy to contemplate a repeat of the financial shenanigans
that were used to mobilise part of the IMF’s gold stock in 1999. This
involved increasing the price at which a part of the gold was carried on
the IMF’s books, and using the increase in the Fund’s net worth to
forgive some part of its debts from the HIPCs. (The problem with this
technique is that it eats into the Fund’s free currency resources, since
some of these are used to pay off the HIPC’s creditors, raising the
possibility that to keep the Fund liquid the industrial countries will in
due course have to supply it with more resources.)
While economic shocks will never disappear, terms of trade shocks
are a sufficiently regular part of economic life that one would have
thought that it ought to be possible to attenuate their impact on the
poorest countries. That the international community could do a good
deal more than it currently does is strongly suggested by one example
that Ariel Buira drew to our attention at the conference: the experience
of Greece. Here is a country with weak fundamentals that has
nevertheless not suffered crises at the hands of the financial markets,
presumably because it was assumed that the EU would come to its
rescue if necessary. Commodity stabilisation funds, a reinvigorated CFF,
and a contingency fund for the HIPCs are three progressively less
ambitious ways in which the international system could help its poorest
members deal with shocks, if it so chose.
Several participants in the conference also argued that low-income
countries could do a fair amount to protect themselves against such
shocks, by taking advantage of the risk-sharing techniques already
present in financial markets. Producers of primary commodities can,
for example, sell their crops forward at planting time (well, the
producers of annual crops can, even if those of tree crops cannot).
Most producers can buy insurance against climatic disasters. The
World Bank is beginning to help low-income countries to access such
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26 Policies to Reduce the Vulnerability of Low-Income Countries
facilities. A new study of mine (Williamson, 2005) advocates a number
of these techniques, including the sale of growth-linked bonds by
sovereign debtors. There is surely scope for a number of these
techniques to help, though it is doubtful whether they should displace
the mechanisms previously discussed.
3 Domestic Policies for Curbing the Impact of Shocks
While many shocks are external in origin, they have usually had such
devastating effects on developing countries because of the policies that
these countries have chosen to pursue. Four main lines of policy are at
fault. First, countries have often been unable to adopt counter-cyclical
fiscal policies designed to prop up demand in the face of a shock
because they have more or less exhausted their borrowing possibilities
during the good times. It is easy for a country to find itself in this situa-
tion because a country’s credit ceiling may well be lowered when it
encounters difficulties. So unless it has used the good times to run
surpluses and work down the debt/GDP ratio it may easily find it
impractical to borrow more under bad conditions. Second, many
countries have chosen to use the exchange rate as a nominal anchor in
order to reduce inflation when the international capital market was
willing to lend freely, and have then found themselves defending an
overvalued exchange rate when a sudden stop sets in. Third, countries
have borrowed internationally up to the hilt when the opportunity
arose, thus building up excessive debt, often of short maturity, in the
good times. Fourth, many of those debts have been expressed in
foreign rather than domestic currency, thus resulting in a large increase
in indebtedness when it was necessary to devalue the national currency.
Reducing the vulnerability of developing countries to adverse shocks
means changing these four patterns of behaviour. I propose to discuss
them sequentially.
3.1
Fiscal Policy
Standard Keynesian analysis argues that countries should run budget
deficits so as to keep activity up when the economy is tending toward
recession, and surpluses in the good times. In practice, most developing
countries have the fiscal space to run deficits in bad times only if they
have previously gone out of their way to run surpluses so as to reduce
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John Williamson 27
the debt/GDP ratio to a level that will not frighten creditors from
buying more assets when the economy is in recession. Counter-cyclical
policy in developing countries has to start in the boom. (While any
country with a non-independent central bank could order the central
bank to buy more government debt, this is likely to feed rapidly
through into inflation in the absence of a willingness of the public to
buy additional interest-bearing debt.) Some might question whether
this does not make a counter-cyclical fiscal policy excessively costly, for
it implies that a country will have to forego investment and consump-
tion during the boom if it is to be in a position to expand spending
during a recession. But what is necessary to run a counter-cyclical
policy is a redistribution of spending through time rather than a reduc-
tion in the average level of spending. On the contrary, if the policy is
successful it will keep production up during the recession and thus
increase rather than reduce the average level of spending.
It has been claimed that pro-cyclical fiscal policies may be optimal
(Talvi and Vegh, 2000). The logic is that budget surpluses create
politically irresistible pressures for increased public spending, combined
with the belief that it is economically preferable to cut taxes and thus
allow the private sector to spend extra money rather than channel it
into inferior public expenditures. However, this is not really a ground
for saying that optimal fiscal policy is pro-cyclical so much as to say
that the second-best tax policy, given the political unsustainability of
budget surpluses, is to cut taxes during booms and thus pre-empt an
increase of public expenditure that would otherwise occur.
Keynes got it right: optimal fiscal policy involves a counter-cyclical
fiscal policy, running budget surpluses in good times and deficits in
bad times. Lags in the operation of fiscal policy may make this difficult
even if the government is well-motivated and not subject to populist
political pressures of the Talvi-Vegh type. But this does not mean that
all thought of a counter-cyclical policy should be abandoned, it simply
means that reliance should be placed on the automatic fiscal stabilisers
rather than discretionary policy, which is indeed the main mechanism
for anti-cyclical fiscal policy in developed countries. Of course, even
that may not be possible until a period of fiscal surpluses has strength-
ened debt positions so that governments can afford to run deficits in
bad times without provoking an excessive rise in interest rates. But a
fiscal policy that gave unfettered play to the automatic stabilisers would
be a vast improvement over the current tendency to cut spending
during the recession and cut taxes during the boom. And the automatic
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28 Policies to Reduce the Vulnerability of Low-Income Countries
stabilisers would be enhanced if governments aimed to build up social
safety nets over time, as one expects to happen as countries modernise.
What can be done to shift policy in that direction, recognising that
the problem is essentially one of political economy. The first step is to
recognise, publicly and explicitly, what is desirable. This means not just
enunciating the desirability of a counter-cyclical policy, but also a
target for the average fiscal balance over the cycle. A natural candidate
for this role is the so-called Golden Rule of public finance: at least
balance the revenue budget over the cycle, so that debt increases only
to the extent that the public sector is building up assets on the other
side of the balance sheet. (Naturally these should be assets with a yield
at least as high as the interest rate that the government incurs on the li-
abilities it issues to finance this investment.) If the government starts
off with debts that are too large to permit it to run a counter-cyclical
policy, then the target for the structural budget surplus should initially
be larger than the Golden Rule so as to bring the debt/GDP ratio down
over time. (This is the policy that several emerging markets, like Brazil,
Jamaica, and Turkey, already seem to have adopted. An obstacle to
low-income countries following their lead is the predilection of donors
for seeing their money spent on hard projects. Donors need to learn to
give programme aid and to like seeing it used to build up contingency
reserves and run down debt.) Once such rules had been adopted, those
who wished to splurge during a boom would clearly face the onus of
making their case. Could one go further in a democracy.
In a recent publication (Kuczynski and Williamson, 2003, especially
chapter 4), we argued that it might be possible to create political
reinforcement for a prudent counter-cyclical fiscal policy by designing
a mechanism for regional peer monitoring of fiscal obligations.
4
The
rules might be those spelt out above. The problem would be to find a
suitable organisation to undertake the monitoring and apply the peer
pressure. It would need to be an organisation that was felt to be under
the control of the debtors rather than their creditors: one of the
regional development banks rather than the World Bank, for example.
It would need to command the technical expertise to give it credibility.
None of the existing international organisations seem completely
appropriate for the task, but the regional development banks might be
——————————————————
4
The idea was inspired by the European Growth and Stability Pact, though
that is not to endorse the rather primitive (and in some circumstances pro-
cyclical) specific rules embodied in that pact.
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John Williamson 29
the most promising place to build the technical expertise that would be
needed.
3.2
Exchange Rate Policy
Numerous crises have in the past been sparked by the attempt to hold a
fixed exchange rate, especially in recent years when a country had
decided to treat a fixed (or predetermined) exchange rate as its nominal
anchor. However, those days appear to be over. Nowadays most of the
larger countries have adopted a floating exchange rate, and even though
they have not abjured all thought of intervention as the purists might
hope, the danger of their being forced into offering a one-way bet to
the market has vanished. Some of the smaller countries have taken the
ultimate step of dollarisation: whatever one may think about the
wisdom of this, it at least precludes an exchange rate crisis. Thus this
issue no longer has the salience it used to.
3.3
International Borrowing
For some years the flow of financial capital to emerging markets has
been highly volatile (see Table 1 above), and these variations have been
the principal cause of strong cyclical fluctuations in the middle-income
countries. Financial markets generate powerful forces, arising from the
incentive that remuneration practices create for managers not to stray
far from the market benchmark, plus the fact that a creditworthy
borrower is one to whom others are willing to lend, which tend to
explain why these variations have been so strong. Moreover, since there
is no reason to believe that these forces are being undermined, strong
fluctuations in the desire to lend seem likely to persist in future. This
suggests that, if the flow of finance is to be stabilised, it will have to
occur as a result of changes in the behaviour of borrowers. Since it is
impractical to borrow more than the lenders are willing to lend, change
will have to result from greater restraint by borrowers when the
markets are pushing money at emerging markets.
The public sector can directly control its own borrowing (which in
the past was often a major part of the problem). A country that follows
the rules for fiscal discipline that were discussed above would find its
own borrowing needs were limited. There is also the question of where
such borrowing should occur, at home or abroad. In the past many
countries have borrowed on the world market and therefore in foreign
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30 Policies to Reduce the Vulnerability of Low-Income Countries
currency, partly because this was almost always cheaper (in the sense of
requiring a lower interest rate) and usually easier, and partly because
they needed the foreign exchange that borrowing on the world market
would bring in. However, it will be argued below that there is a good
case for terminating borrowing in foreign currency, and that borrowing
should be done on the domestic market in domestic currency. Most
emerging markets now have domestic bond markets where this would
be possible, and of course some foreign funds would be likely to flow
in over the exchanges in order to buy debt so this does not amount to
refusing to tap the international capital market.
Borrowing by the private sector is not subject to direct policy control
in the same way. If a government wishes to limit private borrowing
during a boom, then it will have to use capital controls or some
substitute, such as a tax, an encaje, or increased reserve requirements on
the banking system. The most desirable of the options is a tax or an
encaje: they are relatively non-distortive, market-friendly, comparatively
difficult to evade, and avoid penalising domestic financial intermediation
as an incidental by-product of discouraging capital inflows.
The international community needs to make a collective decision as
to what attitude to take to the use of encajes or substitute mechanisms.
It looks as though there is a danger of their being ruled out of court as
a result of a unilateral decision of a single country to pressure other
countries one at a time into excluding their future use.
5
If other
countries wish to avoid this, then they need to raise that issue as a
policy matter in an appropriate international forum. The IMF is the
obvious candidate.
3.4
Currency Denomination
When most emerging markets raise a loan abroad, it is almost always
denominated in foreign currency, typically dollars. Implying a belief
that these countries have no other way of borrowing abroad, Ricardo
Hausmann has dubbed this phenomenon “original sin” (see, for
example, Eichengreen and Hausmann, 2003). Most developed
countries, like a few emerging markets (such as South Africa and India),
borrow primarily in domestic currency, but they do this by floating
——————————————————
5
I refer to the US decision to force the countries with which it has signed
bilateral free trade agreements, Chile and Singapore, to virtually renounce use of
capital controls even in self-defense during a foreign exchange crisis.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0045
John Williamson 31
bonds in their domestic markets and allowing foreigners to buy some
of them. An increasing number of emerging markets have been
adopting a similar path in recent years.
However, when a developing country borrows in dollars (or allows a
significant volume of domestic loans to be denominated in dollars) it is
liable to create a “currency mismatch” (Goldstein and Turner, 2004).
That is, either the financial intermediary that takes a dollar loan and
lends in local currency, or the corporation that borrows in dollars and
has local currency receipts, acquires a balance sheet that is unbalanced
in its currency assets and liabilities. If the corporation is selling abroad
then it has some element of a natural hedge, although even then this
need not be a very good hedge unless sales are overwhelmingly in the
dollar bloc rather than to a diversified world market.
The consequence of this practice is to add an important element of
instability to the economies that engage in currency mismatching. In
particular, currency devaluation results in an increase in the burden of
debt relative to debt servicing capacity. Since currency devaluation is
part of the normal and efficient reaction to a wide range of adverse
shocks, this results in an increased burden of debt servicing at the worst
possible time.
The reason that the practice arose is that foreign lenders were
reluctant to lend in a currency that would enable the borrower to
inflate away its debts, especially since many of the countries appeared
all too willing to resort to inflation in times of difficulty. An obvious
solution is to index debt instruments to the country’s own price level,
which prevents the issuing country inflating away its debt, unless it is
also able and willing to fiddle its statistics, which is normally possible
only within rather narrow limits. Unfortunately, financial markets are
characteristically conservative, and therefore suspicious of innovative
solutions, such as those that would help an economy to function
reasonably efficiently despite the absence of assured price stability.
Indexation preserves the basic advantage of domestic currency debt: the
burden of debt service is eroded, rather than increased, by (real)
depreciation. In this crucial way indexation is very different to
denomination in dollars. It is only to the extent that the depreciation
feeds through into inflation that the lender is protected, but this is
sufficient to protect lenders from what really matters, the ability of the
debtor to arbitrarily expropriate the wealth of creditors.
One of the major sources of currency mismatch has traditionally
been the lending of the multilateral development banks (MDBs), since
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0046
32 Policies to Reduce the Vulnerability of Low-Income Countries
these have mostly made loans denominated in dollars. Eichengreen and
Hausmann (2003) have argued that it does not have to be this way,
and have proposed an ingenious scheme to permit official debt to the
MDBs to be transformed into indexed domestic currency debt.
6
The
specifics of their proposal were oriented to the World Bank, which they
proposed should issue bonds denominated in a basket of indexed
emerging market currencies, for sale to international investors (who are
known as “Belgian dentists” in the trade). The World Bank would
avoid exposure to currency risk by making indexed loans to the
countries whose currencies compose the basket, in the same proportions
as constitute the basket. Kees van Dijkhuizen raises the issue of how
the MDBs would maintain matching assets and liabilities, given that
one would want to fix the composition of the currency basket so as to
enhance the liquidity of assets denominated in it (see Chapter 3). His
own suggestion is that the MDBs might use such bonds for only a part
of their portfolios, and keep some debt denominated in foreign
currency. An alternative possibility might be for the MDB to cover a
part of its liabilities on the forward market, so as to maintain a
balanced book.
Another perennial worry about this proposal is whether a basket of
emerging market currencies would be sufficiently stable to attract
“Belgian dentists”, given that a crisis in one emerging market often
spills over into others so that a number of their currencies depreciate
simultaneously. This is in fact a question that Eichengreen and
Hausmann asked themselves, and they performed what seems to me to
be the appropriate test: they ran a simulation of how such baskets
would have behaved based on past experience. They concluded that
such a basket would have been no more unstable in terms of the dollar
than major international currencies like the euro or Swiss franc in
which it is perfectly possible to denominate loans.
Emerging markets also sell many bonds to international investors,
borrow from international banks, and so on. Governments could start
to transform that debt also: partly into assets like the growth-linked
bonds referred to earlier, and partly into indexed local currency debt.
Investors would doubtless demand a higher real interest rate ex ante for
holding such debt, but it would be worthwhile for governments to pay
——————————————————
6
Let me make it clear that I am not endorsing the Eichengreen-Hausmann
thesis that foreign currency borrowing is unavoidable, but simply their proposal
for eliminating the use of foreign currencies in denominating MDB loans.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0047
John Williamson 33
a higher real interest rate because of the better risk-sharing characteristics
of such debts. And initially investors might refuse to hold long-dated
debt, so that any gain in avoiding currency mismatching would be offset
by a loss in increased maturity mismatching. One would hope that this
would prove an infant-market problem: insofar as investors are better
placed to carry these risks than are the governments of the borrowing
countries, there would eventually be a real social gain in shifting from
foreign currency denominated debt to indexed domestic debt.
It is conceivable that the emergence of a market in government
bonds denominated in domestic currency would stimulate an
equivalent market for private debt. However, it might also be that such
a market – especially for non-indexed debt, as would be needed for the
short-term paper that is much more important in private borrowing –
would require some additional incentive. If so, a natural instrument
would be differential tax rates, in which a tax surcharge would be
applied to the interest payments, and/or the interest receipts, on loans
denominated in foreign currency. Such a surcharge might be increased
gradually to create pressure for a progressive but non-traumatic shift of
debt obligations from foreign to domestic currency.
4 Concluding Remarks
Developing countries, and particularly low-income countries, are subject
to important shocks emanating from exogenous variations in their
balance of payments. Various mechanisms might be used by the inter-
national community to attenuate the impact of terms of trade shocks,
and three, of progressively diminishing scope, have been examined in
this chapter: commodity stabilisation agreements, the revival of the
IMF’s Commodity Financing Facility, and a HIPC contingency facility.
Any such agreements should be complemented and supplemented by a
conduct of macroeconomic policy on the part of developing countries
that would enable them to limit the impact of shocks on their
economies. Fiscal policy should aim to lower debt/GDP ratios during
booms so that countries have the scope to finance borrowing in time of
recession. Exchange rates should be maintained at a competitive level
rather than used as a nominal anchor. Countries should limit their
borrowing to levels that they can service even under unfavourable
conditions. And they should borrow in domestic rather than foreign
currency and in growth-linked bonds.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0048
34 Policies to Reduce the Vulnerability of Low-Income Countries
References
Bergsten, C. Fred (2004), “Risks Ahead for the World Economy”, In:
The Economist, 11 September.
Birdsall, Nancy and John Williamson (2002), Delivering on Debt Relief:
From IMF Gold to a New Aid Architecture, Center for Global
Development/Institute for International Economics, Washington
D.C.
Cashin, Paul, Hong Liang and C. John McDermott (2000), “How
Persistent Are Shocks to World Commodity Prices.”, IMF Staff
Papers, Vol. 47, No. 2, IMF, Washington D.C.
Eichengreen, Barry and Ricardo Hausmann (2003), “The Road to
Redemption”, In: B. Eichengreen and R. Hausmann (eds.), Other
People’s Money: Debt Denomination and Financial Instability in
Emerging Market Economies, University of Chicago Press, Chicago.
Goldstein, Morris and Philip Turner (2004), Controlling Currency
Mismatches in Emerging Markets, Institute for International
Economics, Washington D.C.
IMF (2004), International Financial Statistics, IMF, Washington D.C.,
October.
Kuczynski, Pedro-Pablo and John Williamson (2003), After the
Washington Consensus: Restarting Growth and Reform in Latin America,
Institute for International Economics, Washington D.C.
Talvi, Ernesto and Carlos A. Vegh (2000), “Tax Base Variability and
Procyclical Fiscal Policy”, NBER Working Paper 7499, Cambridge
MA.
Williamson, John (2005), Curbing the Boom-Bust Cycle: Stabilizing
Capital Flows to Emerging Markets, Institute for International
Economics, Washington D.C.
World Bank (2004a), World Development Indicators, World Bank,
Washington D.C.
World Bank (2004b), Global Development Finance, World Bank,
Washington D.C.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0049
35
3
Insurance as a Tool to Reduce
Vulnerabilities
Kees van Dijkhuizen
1
ohn Williamson’s excellent chapter addresses one of the core tasks of
the Fund. There are various views on the role of the IMF in low-
income countries, but there should be little doubt that the Fund has an
important role to play when it comes to shocks that result in severe
balance of payments problems. Taking the Fund’s Articles of Agree-
ment, this role is at least two-fold. First of all, it includes monitoring
economic developments and providing policy advice on how to better
prepare for shocks and how to respond once a shock hits. Second, the
Fund is to provide countries with resources to correct balance of pay-
ments problems without taking measures destructive of national or
international prosperity. This rightly puts a shock for one country in a
global perspective.
Unfortunately, many shocks are exogenous, that is, beyond the
control of a country’s authorities. Although shocks may be exogenous,
they are no surprise. We know for a fact that the average low-income
country has a major natural disaster every 2½ years and experiences a
commodity price shock every 3½ years. As such, it is not beyond, but
within the control of a country to anticipate to a shock in order to
mitigate its impact. I therefore fully agree with Williamson’s notion
that a country’s vulnerability is a function of both the occurrence of
shocks and the quality of its policy reactions. I also generally agree with
what seems to be a core element in his proposals, that is: matching, for
example matching good times with bad times.
——————————————————
1
Special thanks go to Ernst van Koesveld. The usual institutional disclaimer applies.
J
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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36 Insurance as a Tool to Reduce Vulnerabilities
Insurance Through the Market.
Let me now comment on a number of Williamson’s thought-
provoking ideas. His first proposal is to have a fresh look at international
commodity stabilisation agreements, especially for non-oil commodities.
2
I have three observations.
First, I agree that many stabilisation schemes in the past had too
many objectives. This is contrary to the well-known rule of the first
Nobel Prize winner for economics, Jan Tinbergen, implying that one
instrument should be employed to reach one goal. Arrangements did
not only aim at stable prices, but also at reasonable prices, guaranteeing
incomes, protecting vested interests, and so on.
Second, stabilisation schemes not only require excellent early detec-
tion systems and timely public interventions, but they also presuppose
strong political commitment to save the surpluses in good times to use
them in bad times. But from the Nobel Prize winners Kydland and
Prescott we have learned that this idea of intertemporal matching
bumps into time-consistency problems. Are politicians able to
withstand popular pressure and to stick to the rules.
Third, the success of stabilisation schemes hinges on the assumption
that the price shock is temporary and will revert itself in the short run. In
other words, counter-cyclical interventions require the existence of a
cycle in order to smooth prices over time. However, (IMF) research indi-
cates that taking a forty-year period (1957-98), shocks took more than
5 years or were even permanent for two-thirds of all major commodities,
i.e. 27 out of 44 (Paul Cashin et al., 1999). The actual lack of matching
opportunities over time seems to be the main reason why the various
international agreements, for example for sugar, tin and coffee, turned
out to be financially unsustainable and broke down. Of course, it is hard
to predict the duration of an adverse price shock, but wouldn’t it be wise
to err on the side of caution and to focus on adjustment towards export
diversification rather than to set up new large-scale stabilisation schemes.
An alternative strategy would be to focus on the micro-level: govern-
ments can promote the development of a financial sector that offers all
kinds of insurance or other market-based mechanisms to manage risks
(microfinance, catastrophe bonds, forward contracts, etc.). Rather than
technical constraints, the thin financial markets constitute the main
——————————————————
2
Indeed, an agreement for oil seems to be most logical at the moment, but I
agree that given the strategic importance of oil, this might be a non-starter.
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Kees van Dijkhuizen 37
problem in low-income countries in this respect. During 1985-2000,
for example, less than 1 percent of low-income countries’ total losses
from natural disasters were covered by insurance. It is estimated that
less than 2 percent of the volume of futures and options instruments
can be attributed to developing countries (IMF, 2003).
Therefore, advice from international organisations, especially the
Fund and the Bank, bilateral donors, and commercial banks will be
crucial. In this respect, it is worth mentioning the recently created the
Netherlands Financial Sector Development Cooperation, being a
concrete example of a public-private cooperation aimed at promoting
financial sector development in emerging market economies, transition
countries and low-income countries. It is supported by three ministries
(Finance, Development Cooperation, Economic Affairs) and four
major commercial banks and the FMO (Finance for Development
Organisation).
3
More specifically, the World Food Programme (WFP) has started an
interesting pilot in this area. The objective of the pilot is to contribute
to an ex ante risk-management system to protect the livelihoods of
Ethiopians vulnerable to severe and catastrophic weather risks. The
pilot uses a weather derivative to demonstrate the feasibility of
establishing contingency funding for an effective response in the event
of low precipitation. The WFP will buy an insurance policy that pays
out when the rainfall in Ethiopia is below a certain level. In years of
good or mediocre rainfall, the WFP will pay interest, out of its income
from donors, but when drought comes, bondholders will lose their
principals. Should disaster strike, the WFP will have ready cash to
support farmers. This scheme should be up and running by 2007.
Similar activities are part of the Commodity Risk Management (CRM)
initiative of the World Bank with financial support of a number of
donors (Panos Varangis et al., 2004).
Insurance By the IMF.
This brings me to the second of Williamson’s proposals, which relates to
the Fund’s role of providing financial assistance. He proposes to restore
the Compensatory Financing Facility (CFF), the Fund’s anti-shock
facility, in its earlier form in order to facilitate its use. The economic
literature seems to make a reasonably strong case for the principle of
——————————————————
3
See www.nfx.nl for an overview of FMO’s activities.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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38 Insurance as a Tool to Reduce Vulnerabilities
providing external finance to help support domestic absorption of a
temporary shock and to support policy reforms to smooth adjustment to
more permanent shocks. Apart from the technical complication how to
distinguish between the temporary and permanent shocks, as noted
earlier, practice is understandably more nuanced. Even in the case of a
clearly permanent shock, temporary financing may be warranted to
smooth the adjustment path to the new equilibrium, as noted in the
Fund’s Articles. I expect that in most cases addressing the shock requires
both financing and adjustment. The obvious route would then be to
augment existing PRGF arrangements, preferably with only marginally
increasing conditionality. Since the start of the ESAF and PRGF, one
out of four arrangements has been augmented, with an average aug-
mentation of nearly 1 percent of GDP. In 2004, the IMF also decided
that either a new PRGF or an augmentation of an existing PRGF could
be justified when a country is hit by a shock resulting from a multilateral
trade agreement. In my view, this move is welcome and consistent with
another purpose in the Fund’s Articles, namely to facilitate the expansion
of international trade – in fact, a third reason why the Fund has an
important role to play in relation to shocks. More recently, the Fund
introduced a new shock facility for low-income countries that do not yet
or no longer have a Fund arrangement. It will be important that the
actual use of this facility should meet the same criteria as normal PRGF
programmes. This will avoid inefficient facility-shopping by members
and promote equal treatment.
The practice of the next years will show whether there is still a ra-
tionale for a CFF for low-income countries. Let me nevertheless make
three other comments on the CFF. First, it might be worthwhile to
consider reintroducing an oil-import element, which was added
temporarily from November 1990 to December 1991 when oil prices
rose sharply as a result of the first Gulf War. Second, a good thing of
the CFF is that its eligibility criteria explicitly include that the shortfall
should be temporary by calculating the deviation from the trend over a
five-year period. Third, the criteria require that the shortfall should be
beyond a country’s control. This mitigates what is called the Samari-
tan’s dilemma: governments may have less incentive to undertake
structural reforms when they expect the Fund, with the multilateral
and bilateral donors in its wake, to come to their rescue. In addition to
addressing the humanitarian needs, it is important that these extra funds
are effectively put into use to reduce vulnerability for the medium turn.
As with all kinds of insurance, moral hazard needs to be minimised.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Kees van Dijkhuizen 39
Insurance Through Further Debt Relief.
Avoiding the Samaritan’s dilemma is also an important element in the
Birdsall-Williamson proposal to compensate HIPC countries for
exogenous shocks that push their debt burden again above the HIPC
norm. In my view, the proposal comes close to what is now happening
under the name of topping up, the costs of which are part of the overall
HIPC Initiative. Moreover, this exercise is largely, if not fully, overtaken
by the recent initiative for multilateral debt relief, as discussed by
Brilman, Jansen and Van Koesveld in this volume. Additional debt relief
will enlarge a country’s fiscal space to reach the MDGs and comes down
to a form of budget support. Finally, for the post-HIPC situation as well
as other low-income countries, we should in principle apply the new and
forward-looking debt sustainability framework that is being developed
by the Fund and the Bank. This framework is meant to prevent debt
crises, notably by providing grants, rather than to solve them ex post.
Possibilities for Self-Insurance.
The Samaritan’s dilemma also brings us back to the notion that a coun-
try’s vulnerability is a function of both the occurrence of shocks and its
own policies. These policies should include structural measures, notably
export diversification, but also monetary and fiscal policies as a kind of
self-insurance. Regarding fiscal policies, Williamson got inspired by the
European Stability and Growth Pact, especially by its peer monitoring
mechanism. As part of strengthening and clarifying the Pact, it has been
decided to pay more attention to the extent to which countries can and
should match good and bad times over the economic cycle. Second, the
logic of the Golden Rule is intuitively appealing, as it should safeguard
investments during economic downturns. This touches on the new
discussion in the Fund and the Bank on what is called creating fiscal
space for public investment. A focus on the current balance, however,
guarantees neither macroeconomic stability nor debt sustainability, not
to mention the quality of investment. At least, the Golden Rule should
be accompanied by a debt rule, like in the UK. Additional debt may be
compensated by an increase in assets, but we should note that debts are
certain, while the value of assets will only be known in the future. In this
sense, the Golden Rule may in fact run the risk of creating another kind
of balance sheet mismatch. I prefer that investment expenditures are an
integral part of the budget and overall priority-setting.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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40 Insurance as a Tool to Reduce Vulnerabilities
Insurance Through Currency Matching.
The last and potentially most promising idea is Williamson’s support of
the Eichengreen-Hausmann proposal. It intends to solve the so-called
original sin, implying that developing countries are hardly able to borrow
in their own currencies, which results in a currency mismatch problem. I
have a number of general observations. First, an important issue is the
question of whether the new bonds issued by the multilateral banks will
gain the interest of private investors. The answer probably depends on
the risk and return characteristics of the newly created bond. It seems
likely that the required return on new bonds probably has to exceed the
return on US dollar bonds in order for investors to buy them. As a
consequence, the interest rate that multilateral banks will require for
local currency loans to developing countries will also be higher than on
dollar loans. This implies a trade-off for governments: either they borrow
in their own currency and pay a somewhat higher interest rate or they
maintain their exposure to exchange rate depreciations with large poten-
tial consequences for financial stability in the long run. The viability of
the Eichengreen-Hausmann proposal therefore depends on the question
of whether risk-return features can be such that both the lenders and the
borrowers of funds will be willing to participate in this new market.
Does a basket of developing countries’ currencies provide sufficient
opportunities for risk sharing. Recent history has shown that in times of
financial distress, developing countries’ exchange rates not seldomly tend
to move in the same direction. The transmission of exchange rate shocks
throughout the Asian crisis countries and the devaluation of the Brazilian
real following the Russian crisis are merely examples of the many
episodes in which exchange rate shocks in one or more countries have
jumped over to other countries. This limits the degree to which a basket
of currencies provides risk-sharing opportunities.
A second and more practical question is how the multilateral banks
will maintain the matching of assets and liabilities. To assure a liquid
market, it seems preferable to fix the composition of the basket of
currencies. But then the portfolio of outstanding loans to developing
countries on the asset side should also have a fixed composition in order to
assure the matching of assets and liabilities. This implies strict constraints
on the provision of loans by the multilateral banks, which seems very
undesirable. Indeed, lending policies should be based on countries’
performance and opportunities rather than the banks’ portfolio considera-
tions. This argument does not deny the possibility that the multilateral
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Kees van Dijkhuizen 41
banks start with adopting the proposal for only part of their portfolios.
For developing countries themselves, keeping some debt denominated in
foreign currency would have the advantage of keeping the discipline not
to engage in competitive devaluations. Third, Hausmann and Eichen-
green propose to use inflation-indexed loans to remove any perverse
incentives for governments for creating excessive inflation. The question
is which inflation index should be used. To fully eliminate the moral
hazard problem, the inflation index should be composed or at least
checked by an institution that is independent of all the stakeholders
involved. A good starting point could be to include only those develop-
ing countries that comply with the Special Data Dissemination Standard
(SDDS), which is part of the Fund’s surveillance tool kit.
It seems that this proposal, too, brings us back to the role of the IMF
with regard to shocks in developing countries. Through monitoring,
policy advice and temporary finance the Fund can assist countries in better
anticipating and responding to shocks. John Williamson has put on the
table a number of very stimulating proposals to reduce the vulnerability of
developing countries. The bottom-line seems to be that when we cannot
escape bad luck, we should at least ensure that it is matched by good
policies and good instruments! Most of his proposals rightly comprise an
element of softening fluctuations over time by a kind of matching or
insurance. Since this is the core business of both public and especially
private banks and insurance companies, it seems natural that they are
closely involved. In my view, this avenue is very much worth exploring
further. I am pleased to note that the Fund and especially the Bank have
taken up this important challenge as part of their work programmes.
References
Cashin, Paul, Hong Liang and C. John McDermott (2000), “How
Persistent Are Shocks to World Commodity Prices.”, IMF Staff
Papers, Vol. 47, No. 2, IMF, Washington D.C.
IMF (2003), “Fund Assistance for Countries Facing Exogenous Shocks”,
prepared by the Policy Development and Review Department, IMF,
Washington D.C., August.
Varangis, Panos, Sona Varma, Angélique dePlaa and Vikram Nehru
(2004), “Exogenous Shocks in Low-Income Countries: Economic
Policy Issues and the Role of the International Community”, mimeo,
World Bank, Washington D.C.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0056
42
4
Protecting Africa Against “Shocks”
Matthew Martin and Hannah Bargawi
1
or Africa’s future and the reaching of the Millennium Development
Goals (MDGs), it is vital to analyse the issue of how to protect the
continent against exogenous “shocks”, that is, events beyond the control
of African governments.
2
African countries, especially low-income
countries, are highly vulnerable to shocks. These may impact directly
on the balance of payments – notably exports (commodity price
changes, drought and floods) – or the budget – notably budget revenue
(import duty shortfalls, devaluation); or less directly by increasing
balance of payments or budget financing needs (import price increases,
notably for food and petroleum; and erratic donor aid flows).
3
Such
shocks can reduce GDP by as much as 5 percent, and cause dramatic
cuts in budget spending on the Millennium Development Goals.
There is also strong evidence that the income of the poor is hit even
harder by shocks, provoking a major setback to progress towards the
MDGs. In recent years, the HIPC Debt Relief Initiative has also
emphasised the vulnerability of Africa’s debt sustainability to external
shocks.
Effective protection against the impact of shocks would therefore be
a highly worthwhile investment for international financing and policy,
——————————————————
1
Revision of a paper prepared for the Commission for Africa
2
For more detailed information on the implementation and architecture of an
anti-shocks facility and case study evidence of the impact of exogenous shocks in
low-income countries, see DRI’s forthcoming report prepared for DFID entitled
“Investigation into the International Architectu re for Economic Shocks Financing”.
3
Of course, many African countries are frequently subject to shocks arising from
conflict and other political factors, which will also make their debt less sustainable,
but these are not considered in detail in this chapter.
F
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pg_0057
Matthew Martin and Hannah Bargawi 43
supporting and encouraging good economic management. Yet it has
long been established that the international community is bad at protect-
ing against shocks.
4
African countries and the international financial
system have devoted insufficient attention to avoiding the occurrence
of shocks through better forecasting and policies, and to counteracting
them rapidly with funding that is predictable, sufficient, cheap and free
from excessive conditionality.
Recent IMF and World Bank Board papers have highlighted the
need to avoid or mitigate the effects of shocks, but have tightly limited
their own proposed roles in this process. The IMF (IMF, 2003a and
2004) indicates that it should be responsible only for adjusting macro-
economic policy to prevent and offset shocks, for signaling the
existence of a shock, and through providing very limited extra finance
by augmenting Poverty Reduction and Growth Facility (PRGF) loans.
The World Bank (World Bank, 2004) sees its role as helping with anti-
shock structural policies, signaling financing needs to offset a shock,
catalysing donor support, and providing limited extra finance by aug-
menting Poverty Reduction Support Credit (PRSC) loans. The EU is
the other main multilateral institution tasked with offsetting shocks
but its FLEX (Fluctuation of Export) scheme, though a vast improve-
ment on the earlier STABEX, has provided very little finance during
2000-03.
5
All of these measures fall way short of the scale and frequency of
shocks to which African economies are subjected. In the context of a
potential major increase in global grant flows linked to the Monterrey
commitments and the International Financing Facility, it is urgent to
examine how Africa could be better protected against shocks. In this
chapter we will: (i) define what is meant by shocks; (ii) identify the key
shocks to which African countries are subject, and which countries
(especially HIPCs) are most sensitive to the different shocks identified;
(iii) propose possible solutions open to the international financial
community, in both preventative and curative terms. The remaining
sections of this chapter deal with each issue in turn.
——————————————————
4
See, e.g. Dell (1985), Helleiner (1985), Martin (1991), Williamson (1983).
5
In 2000, the FLEX scheme, the EU instrument to compensate African,
Caribbean and Pacific (ACP) countries for short-term fluctuations in export
earnings replaced STABEX (Stabilisation of Export Earnings), established in 1975
under the first Lomé Agreement to stabilise ACP countries’ agricultural export
revenues.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0058
44 Protecting Africa Against “Shocks”
1 Defining Shocks
What exactly is a “shock”. It is best defined as an event which impacts
unexpectedly on an African economy, and which is “exogenous” – beyond
the control of the government to prevent – though, as this chapter will
show, neither the unexpected nature nor the lack of government
control are inevitable.
6
Shocks can be divided in the following
categories:
•
shocks to international commodity prices (to commodity exports or
imports), market conditions, or access to trade partner markets,
which can cut exports (and export-related budget revenue) or
increase import cost, and cut export-related external financing;
•
natural disasters such as earthquakes, cyclones, drought, floods or
locust plagues (and diseases hitting crop production), which can hit
GDP, exports, budget revenue and food production (increasing
import needs), and force increases in budget expenditure;
•
conflict-related shocks, notably the negative effects of conflict in a
neighbouring country, the impact of terrorist attacks, which can
causes extra budget costs for security and refugees, or undermine
tourism revenues and related budget taxes;
•
global financial market shocks leading to outflows of foreign private
capital, either directly for countries which receive large amounts of
such capital, or through contagion from neighbouring countries or
large regional economic powers, which can provoke domestic
financial crises;
•
shocks to international interest or exchange rates which can increase
debt burdens and destabilise foreign private capital flows, or cut
investment returns on reserves;
•
shortfalls in external aid flows which can lead to foreign exchange
and budget shortfalls;
•
shocks of sudden human diseases (e.g. SARS) which can hit tourist
revenues;
•
changes in host country policies for migrant labour, which can cut
remittances.
It is crucial to distinguish between true exogenous shocks and “non-
shocks” which are no less important but require different solutions.
——————————————————
6
This chapter does not discuss positive shocks, because analysis indicates that
they have little effect on long-term growth or poverty reduction (see World Bank,
2004).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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pg_0059
Matthew Martin and Hannah Bargawi 45
“Non-shocks” include:
(a) Predictable trends or repeated events at a national, regional or inter-
national level. Among the obvious national examples are: repeated
droughts, creeping desertification and depletion of water tables to
which all Sahelian countries have been subject for more than 20 years;
gradual depletion of resources or increases in extraction costs that
reduce mineral or timber exports; routine aid shortfalls of disburse-
ments due to disbursement problems; and health epidemics, notably
HIV/AIDS, tuberculosis, etc.
International examples include: price falls when many countries
increase exports of a commodity simultaneously in the absence of any
world demand increase;
7
the secular downward trend in global com-
modity prices which is now universally acknowledged to have occurred
during the last 30 years; commodity – and market-specific factors (for
example in bauxite for Guinea and Guyana, phosphates for Togo, and
uranium for Niger) which make prospects for traditional exports more
bleak than based on global market analysis; changes in regional or global
trade policy that lead to reductions in tariff revenues, or in exports due
to ending of trade preferences; changes in global climate (e.g. global
warming and the impact of El Niño).
(b) Miscalculations of the effects of policy changes. Good examples of
these have been: dramatic underestimations of the negative effects on
budget revenues of tariff reductions due to regional or international
agreements; overprojections of the revenue collections resulting from tax
reforms; and overprojections of the positive effects of efforts to liberalise
or diversify exports. To these should be added the “shocks” caused by
misdesign or misimplementation of policies which produce what seem
like perverse “shock” effects (when with more adaptation of policies to
the recipient economy, such effects could have been foreseen).
8
A large number of “shocks” would therefore not be shocks if more
reliable and less optimistic analysis were undertaken before projections
——————————————————
7
According to commodity market analysts, commodities subject to fallacy of
composition and the African low-income countries they affect include: cocoa (Côte
d’Ivoire, Ghana, Sierra Leone, São Tomé); coffee (Bu rundi, Cameroon, Côte
d’Ivoire, Ethiopia, Kenya, Madagascar, Rwanda, São Tomé, Sierra Leone, Tanzania,
Togo, Uganda); cotton (Benin, Burkina, CAR, Cameroon, Chad, Mozambique,
Mali, Senegal, Sudan, Togo and Uganda); gold (Ghana, Mali and Tanzania); and
tea (Burundi, Kenya, Malawi, Rwanda, Tanzania and Uganda).
8
These issues have been extensively treated elsewhere: see Killick (1984),
Martin (1991), Martin and Mistry (1992).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
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46 Protecting Africa Against “Shocks”
were made. Many previous authors – including the Bretton Woods
institutions (BWIs) – have indicated systematic tendencies to over-
optimism in the projections underlying BWI programmes, whether due
to optimism over effects of policies in the country, or to over-optimism
about global economic trends.
9
With more realistic projections, based on
probability and frequency analysis of volatility in key variables, and
properly calibrated vulnerability indices, most shocks would disappear
from future programmes.
10
However, more “realistic” projections might
also carry the risk of reducing projected growth rates up front, and
therefore abandoning the MDGs entirely. The aim of “realism” should
be to integrate potential shocks into projections, and make sure that
growth rates in non-shock years are raised even higher to ensure the
attainment of the MDGs even including shocks.
Some would like to define very narrowly the types of shocks against
which the international community should take action. They argue
that some types of shocks (e.g. commodity price falls, oil price rises) are
more valid (because less within the control of government) than others
(such as aid shortfalls or domestic financial crises), since the latter can
be influenced by recipient government policies. They also argue that
shocks are only “real” shocks if they persist over longer periods (e.g.
3-year averages); otherwise, they would not be valid for compensation
or for changing adjustment programme targets.
However, more recent analysis shows that it is relatively easy to
separate the impact of the exogenous shock – for example, the propor-
tion of aid shortfalls that are due to donor policy and procedural
problems, and the scale of domestic financial crisis provoked by other
exogenous shocks. It also shows that even short shocks can have
persistent long-term effects on growth and poverty.
Others have highlighted a need to distinguish between input shocks
(e.g. lack of rain, producing drought) and output shocks (e.g. effect on
GDP or exports), and that the two do not always correlate. However,
in low-income countries, which are much less resilient in the face of
shocks, input shocks almost entirely transform themselves into output
shocks, so the distinction is unnecessary.
The largest long-running debate is over whether temporary or
permanent shocks should be compensated. Some feel temporary shocks
——————————————————
9
For comprehensive analyses, see Batchelor (2000), Martin and Mistry (1992).
10
For excellent vulnerability indices see Atkins et al. (2000); Crowards (1999);
OECD (2000); and UN (2000).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0061
Matthew Martin and Hannah Bargawi 47
make the strongest case for compensation, because with rapid financing
a country can move back to the correct long-term path immediately;
others prefer to compensate permanent shocks, arguing that a country
can more easily adjust to temporary shocks and needs more compensation
for long-term shocks. However, more recently (IMF, 2004a; World
Bank, 2004) the BWIs have acknowledged that even apparently
“temporary” shocks will have permanent negative effects; and that there
are massive returns from financing against permanent shocks to replace
lost capital stock, smooth national adjustment to the new economic
situation, or maintain the incomes of the poor. As a result, there appears
to be equal support for funding temporary and permanent shocks.
Finally, it is suggested that some shocks are extremely difficult to sepa-
rate from policy errors, and that providing financing to offset their
effects runs a risk of moral hazard. Governments would make less short-
term effort to overcome shocks, or less long-term policy measures (e.g.
export diversification) that reduce the impact of shocks. This has been
true of some past financing mechanisms (e.g. EU STABEX) in which
finance was focused on increasing production of the commodity which
had received the shock. However, it is now acknowledged that it is very
easy to design financial support to avoid such moral hazards and that
governments focus more on short-term rather than long-term anti-shock
measures because they lack the financing to do both.
This chapter treats all limitations of and distinctions among shocks
as spurious. If a country is making genuine efforts to promote economic
development and reach the MDGs, shocks should be foreseen and
avoided – and if this is not possible, genuine unforeseeable “shocks”,
especially those which impact on MDG progress, should be compen-
sated regardless of their source, nature or duration.
11
2 Identifying Africa’s Shocks
To prioritise solutions, we need to know which shocks are most important
for Africa overall, and which African countries have been most subject to
certain types of shocks, so that we can identify the need for solutions to
specific or overall vulnerability. In this section we identify: (i) the key
shocks that hit Africa, (ii) their impact, and (iii) their probability.
——————————————————
11
This argument could also be applied to domestically-sourced shocks, which
are not covered in this chapter.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0062
48 Protecting Africa Against “Shocks”
Table 1 Indicators of Vulnerability by Type of Shock
Aid
1
Climate
2
Exports
3
Imports
4
Reserves
5
Conflict
6
Algeria
¤
L
.
x T d
.
Angola
v !!! x v d v c v
.
Benin
.
v
¤
x v d v
Botswana
¤
!!! x R d
Burkina Faso
.
v
¤
L x R
N
Burundi
.
v
¤
!!! x v v
.
N
Cameroon
v
@
c v
Cape Verde
. ¤
R d c
Central African Rep.
.
v !!!
v c v
.
Chad
. ¤
L x d c v N
Comoros
T
.
Congo, Dem. Rep. v
¤
!!! v d v c v
.
Congo, Rep.
v !!! x d c v
.
N
Cote d'Ivoire
v !!! T d c v
.
N
Djibouti
. ¤
R d c
Egypt
¤
.
T
Equatorial Guinea !!! x n.a. c
.
Eritrea
.
¤
L
d
.
Ethiopia
.
v
¤
x v v c v
.
N
Gabon
x v d c
Gambia, The
.
v
¤
L
d
Ghana
. ¤
x v R d v c v
Guinea
.
v
c v N
Guinea-Bissau
.
v x v d v
.
Kenya
.
v
¤
!!! T d v c v N
Lesotho
¤
R d
.
Liberia
n.a. x n.a. c v
.
Libya
¤
x d
Madagascar
.
v L
@
v T c v
.
Malawi
.
v
¤
!!! x d v c v
Mali
.
v
¤
L
d v N
Mauritania
.
v L x d v
.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0063
Matthew Martin and Hannah Bargawi 49
Table 1 (continued)
Aid
1
Climate
2
Exports
3
Imports
4
Reserves
5
Conflict
6
Mauritius
@
x d c
Morocco
¤
.
x d
Mozambique
.
v
¤
!!! @ v R d v
.
Namibia
¤
!!!
d c
Niger
.
v
¤
L
v c v
.
Nigeria
¤
!!! L x v d
.
Rwanda
.
v
¤
v T v v
.
N
São Tomé & Principe
.
v x d v
.
Senegal
.
v
¤
L
d c v N
Sierra Leone
.
v v
c v
.
N
Somalia
n.a.
¤
n.a. n.a. c v
.
South Africa
¤
!!!
d c N
Sudan
v
¤
n.a. c v
.
Swaziland
!!! x R d c
Tanzania
.
v
¤
!!! v T d v N
Togo
.
v
¤
d v c v
.
Uganda
.
v
¤
!!! x v T v v
.
Zambia
.
v
¤
!!! x d c v N
Zimbabwe
¤
!!! T
c
.
Notes:
1
Aid:
.
represents dependency of 10% or more of GDP; volatility v is where the
GNP ratio has a standard deviation of 20% or over.
2
Climate:
¤
refers to drought, !!! refers to heavy rains or floods,
@
represents a
cyclone,
L
represents locusts and
.
represents earthquakes.
3
Exports:
x
refers to export concentration (where commodity provides over 50%
of export revenues);
v
is for countries with a standard deviation of export levels of
over 20%; T refers to sudden declines in tourist revenues;
R refers to shocks due
to shortfalls in migrant worker remittances.
4
Imports:
d
refers to import dependence (imports to GDP ratio of 30% or over);
v is for countries with a standard deviation of import levels of over 20%.
5
Reserves: c refers to import coverage (international reserves under 4 months of
imports of goods & services); v is where standard deviation of import coverage is
20% or over.
6
Conflict:
N
represents a country affected by a neighbouring conflict;
.
represent a
country with its own internal conflict/severe political instability or war.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0064
50 Protecting Africa Against “Shocks”
2.1
Which Shocks Hit Africa.
Table 1 presents in summary form indicators of potential vulnerability
of African countries to shocks, as well as the shocks to which they have
been subject in the last ten years. It shows:
•
Very high prevalence of natural disasters: at least 44 countries have
suffered natural disasters in the last ten years, including 34 suffering
from various types of drought, 22 from other climate shocks (floods,
cyclones or hurricanes), 11 from locusts and 3 from earthquakes.
12
•
High aid dependency and volatility: 28 African countries (including 25
HIPCs) are potentially vulnerable to aid shocks, as measured by aid
dependency (aid/GNP ratio over 10 percent). In addition, aid flows
have been highly volatile, with a mean standard deviation for African
HIPCs of 38 percent, and 29 countries suffering a standard deviation
over 20 percent in the last ten years. All but 5 of the 34 African
HIPCs for which data are available have a standard deviation of aid
flows which exceeds 20 percent, and for 12 it exceeds 40 percent.
Other analysis (Arellano, 2002; Bulir and Hamann, 2001) as well as
almost all ESAF/PRGF Board papers refer to considerable aid short-
falls each year compared to programmed amounts, as one of the most
persistent shocks blowing programmes off course. Johnson et al.
(2004) indicates that aid can frequently fall short of projections by as
much as 25-30 percent, with budget support being more volatile but
project support falling more consistently short, due to over-optimism
about donor pledges being turned into actual disbursements, under-
estimating delays caused by donor or recipient policies or procedures.
•
High export concentration and volatility: 24 countries are very vulner-
able to export shocks, depending on one commodity for more than
50 percent of export revenues, and within this depending on between
1 and 3 products for more than 70 percent of export revenues.
13
In
addition, African HIPCs have a very high export volatility: standard
deviation as a percentage of the mean level averages 23 percent, and
exceeds 20 percent for 20 of 34 African HIPCs. Moreover, 10 coun-
tries have suffered important shocks to tourist revenues; and 8 to
worker remittances. PRGF programme documents also indicate
——————————————————
12
High prevalence of natural disasters is in line with the findings of IMF
(2004) and UNDP (2004).
13
Export concentration also makes countries more vulnerable to imposition of
trade barriers by partners.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Matthew Martin and Hannah Bargawi 51
persistent shortfalls of exports compared to projections, particularly
for non-traditional exports.
•
High import dependence and volatility: African HIPCs are also highly
dependent on imports, with a mean import/GDP ratio of 35 percent
and 33 (including 19 HIPCs) having import/GDP ratios exceeding
30 percent, indicating high potential vulnerability to shocks. However,
African HIPCs’ imports have been considerably less volatile than
exports and aid flows, with mean standard deviation of only
18 percent, and only 12 countries with a standard deviation over
20 percent. Most countries are particularly dependent on food and
fuel imports, which are generally the least elastic and flexible types of
imports and therefore most subject to international price shocks.
Food accounts for more than 20 percent of imports in 15 African
HIPCs, and fuel for more than 20 percent in seven African HIPCs.
According to PRGF Board papers, the vast majority of HIPCs have
also been subject to import excesses over projections. This has been
particularly true for oil imports since 1999, given international price
rises, but also for wider imports due to over-optimism about their
impact on reducing import demand through devaluation or domestic
production of alternatives.
•
High prevalence of war and conflict: no fewer than 26 countries have
had their own internal conflicts or been involved in regional conflicts,
and 15 have had to cope with severe negative impacts from conflicts
in neighbouring countries.
14
•
Foreign private capital crises: another area of persistent shortfalls for
almost all countries has been foreign private capital (FDI, portfolio
investment, and private sector debt). Data on these flows are very
poor in African countries, but at least 13 countries – as well as the
whole CFA franc zone before the devaluation in 1994 – have
suffered major crises related to surges and slumps of foreign private
capital in the last ten years, with particularly severe examples in
Ghana, Zambia and Zimbabwe (see also Bhinda et al., 1999; Martin
and Rose-Innes, 2004).
Overall, it seems that the most serious shocks for Africa are natural disas-
ters, aid flows, exports, imports and conflict, but most African countries
suffer multiple shocks – more than 46 have suffered at least three types –
and all have suffered at least one type during the last 10 years.
——————————————————
14
For a good example of analysis of the impact of neighbouring conflict, see
Dore et al. (2003).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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52 Protecting Africa Against “Shocks”
2.2
The Impact of Shocks
In principle, shocks can impact on the whole economy (GDP), or just
one sector or region. Natural disasters and conflict tend to impact
economy-wide. However, the other shocks discussed above have their
immediate impact on the balance of payments.
15
For example, the main
shocks that impact on exports of goods and services are: price shocks
which reduce export earnings; climatic, disease or other shocks to
export production; shocks such as terrorism, war or disease that disrupt
tourism earnings; and changes in host country policies that reduce
worker remittances.
In addition, most of the above balance of payments shocks will have
two wider impacts. First, they commonly provoke devaluation (if the
exchange rate is flexible) unless immediately offset by inflows of external
finance. In turn, this devaluation causes problems elsewhere, including
inflation, and higher external debt service in domestic currency or
budget revenue terms. Second, they will reduce foreign exchange reserves.
Reserves have been highly volatile for African HIPCs, with mean
standard deviation exceeding 47 percent of average levels, and exceeding
20 percent for all but two countries. PRGF documents also indicate that
most countries have been failing to meet programmed reserves targets,
usually due to foreign exchange shortfalls reflecting other external shocks.
The level of reserves measured in months of imports is also commonly
used as an indicator of vulnerability to shocks, with a usual objective of
having 4-6 months of import coverage. Most African low-income
countries have very low reserves: 30 countries have less than 4 months of
imports of goods and services, and only six countries reach 6 months.
16
However, shocks can also have a major indirect impact on other
sectors, of which the most important one is the fiscal sector. Typical
impacts are lower budget revenues due to cuts in export (including
tourism) or import taxes and related VAT; higher expenditures to
combat the impact of shocks (especially natural disasters); lower
(especially capital) expenditures if the shocks are not offset by additional
financing, or if aid shortfalls lead to cuts in spending. However, the
usual impact is pro-cyclical – i.e. cuts in expenditures and revenues
——————————————————
15
For more details, see Martin and Alami (2001).
16
This presentation probably understates vulnerability because IMF programmes
now normally measure reserves in months of the following year’s imports of goods
and services.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
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Matthew Martin and Hannah Bargawi 53
during negative shocks. In addition, countries tend to try to finance
additional expenditures (or offset other shortfalls) by borrowing
externally or domestically. This is usually because countries have no fiscal
contingency reserve or “fiscal space” to absorb the impact of shocks.
Shocks can also make debt unsustainable. This reflects their impact on
the denominators of debt sustainability ratios – exports of goods and
services and budget revenue. Shocks can impact on almost every line
item of the balance of payments and the budget, thereby increasing
financing gaps. Insofar as these gaps are filled by additional borrowing
rather than grants, this will also raise debt ratios above sustainable levels.
Shocks also cause major uncertainty in both private and public sectors.
This tends to reduce long-term savings and investment plans among all
major domestic and foreign actors. Shocks also tend to have major long-
term and cumulative effects on the economy. Commodity price shocks
tend to be especially “persistent” – they reach their maximum negative
effect after 4 years and low-income economies take 5 years to overcome
around 50 percent of their effects (see World Bank, 2004). Shocks also
have almost irreversible effects such as falls in human capital (deaths),
large capital outflows, credit crunches and permanent unemployment.
The most important impact of shocks is on poverty. All of the shocks
described above will reduce scope for poverty reduction – for example,
by decreasing smallholder export earnings, by reducing imports of goods
or aid flows destined for poverty reduction, and by reducing budget
expenditure on poverty reduction. A large amount of recent analysis has
demonstrated that many different types of shocks – including financial
crises – have a dramatic impact on increasing poverty, reversing trends
towards the MDGs.
17
The precise impact depends on the degree of prior
poverty and on the effectiveness of the national and international
counter-measures, but in low-income countries high poverty and lack of
adequate safety nets, external reserves cushions or internal stabilisation
mechanisms exacerbate the impact. The poor tend to suffer much more
during crises, because they lack assets or credit to protect themselves
from income falls and unemployment, they are less mobile than the
wealthy due to lack of education, skills and health, and they lose sources
of income such as transfers from wealthier relatives or communities, or
from government, in part because their “voice” is weak. As a result,
every 1 percent decline in growth can increase the proportion of the
——————————————————
17
See Agenor (2001); Aizenman and Pinto (2004); Cline (2002); Lustig (2000);
and World Bank (2000).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
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54 Protecting Africa Against “Shocks”
population in absolute poverty by as much as 2 percent.
In addition, Agenor and Lustig have also argued convincingly that the
poor also tend to benefit much less from post-shock recoveries, because
shocks cause irreversible damage to their investment in human (educa-
tion, health, and nutrition) and physical capital. The poor are also
constrained in their efforts to get out of poverty by their extreme worry
about the risks of future shocks. This makes “economic insecurity” rank
very high in their own participatory assessments of factors causing
poverty, and leads the poor to invest less for the long-term. As a result,
shocks can have a permanent effect of increasing poverty.
Due to the absence of reliable costings for MDG expenditures or
country-by-country analysis of the impact of shocks on poverty, it is not
possible to quantify the potential impact of shocks on poverty reduction
in Africa. However, recent analysis (IMF, 2004a) has indicated that
shocks occur at least once every 1.4 years for the average low-income
country, and have an average magnitude of 4.25 percent of GDP.
18
The UN calculated that to attain the MDGs, countries need 7 percent
GDP growth (12 African HIPCs have estimated that the growth rate
they need is closer to 6.3 percent), and the average growth rate currently
being projected in IMF PRGF programmes in Africa is 5 percent. The
impact of shocks would halve the progress to the MDGs, even if govern-
ments target 7 percent growth initially. However, given current PRGF
projections, which themselves fall short of MDG needs by one-third,
shocks could lead to a 75 percent shortfall in the growth needed to reach
the MDGs. There is also strong evidence that shocks have a more long-
term “drag” effect on economic growth (e.g. Chauvet and Guillaumont,
2001; Collier and Dehn, 2001; Guillaumont and Combes, 2002), and
the frequency and severity of shocks for low-income countries has been
growing. These factors mean that the above reduction of growth due to
shocks is a considerable underestimate.
Analysis of the potential impact of shocks on the long-term path to
the MDGs in each African country should be a top priority. Every
PRGF Board Paper should ideally contain a 20-year projection of the
path to the MDGs and the associated financing which is necessary, and
of the key shocks which could derail such progress.
——————————————————
18
This figure represents a combination of natural disasters that occur every 2.5
years with an average impact of 5% of GDP, and commodity shocks which occur
every 3.3 years with an average impact of 3.5% of GDP. It does not take into
account other types of shocks – notably aid shortfalls and conflict.
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Matthew Martin and Hannah Bargawi 55
2.3
How Likely Are Future Shocks.
To assess the likelihood of future “shocks” for each country, we have
used two methods: (i) recent growth rates in key variables compared to
projected trends in HIPC Debt Sustainability Analyses (DSAs). Of
course, it is true that past rates might not be repeated in future, where
they were due to policy slippages or domestic political/conflict-related
events. However, where they were due to commodity prices, climatic
events or aid/import shortfalls, there is every reason to believe that past
trends might well continue; and (ii) sensitivity assumptions made by
HIPC governments, the IMF and World Bank in HIPC DSAs.
19
Recent and Projected Trends
Recent export and GDP growth rates compared to projected trends in
the DSAs indicate that projected GDP growth rates are higher than
recent averages in all but five cases.
20
The most dramatic increases are
for Angola, Central African Republic (CAR), Chad, Côte d’Ivoire,
Ethiopia and Madagascar – but most of these large differences are
explained by recovery from civil conflict or expansion of petroleum
exports. However, the vast majority of countries have projected GDP
growth rates well in excess of recent levels, and the overall difference in
the recent and projected averages is 2.2 percent.
21
The other striking
feature of the projections is the similarity of the GDP growth rates for
most countries at between 4 percent and 6 percent. As already
discussed above, 5 percent is the minimum real growth needed to make
any difference to poverty levels (even though falling some way short of
growth rates needed to halve poverty by 2015 in most countries).
Therefore the question should be not, how can we make projections
more realistic (i.e. bring them down to match past levels), but how can
we change policy to increase growth dramatically.
The relationship between historical and projected growth rates for
——————————————————
19
Countries not covered due to lack of a DSA are: Burundi, Comoros, Liberia,
Somalia and Sudan.
20
Unfortunately, due to lack of medium-term projections for other variables in
DSAs, this analysis has had to be limited to GDP and exports.
21
We also tested periods such as the last five or three years, in order to take
into account the fact that many HIPCs have started adjustment programmes only
recently, but these made no substantial difference to the growth rates or the
conclusion that projected growth rates are much higher than historical rates.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0070
56 Protecting Africa Against “Shocks”
exports is only slightly more balanced, with 24 of 34 countries having
projected export growth rates above recent trends, compared to only 10
which are lower. However, the average difference between recent and
projected growth rates is much larger than for GDP, at 4.7 percent.
The widest disparity and the greatest potential vulnerability to shocks
are for 12 countries where projected growth rates are more than
5 percent higher than recent results (Burkina Faso, CAR, Chad,
Comoros, the Gambia, Ghana, Madagascar, Mauritania, Niger, Sierra
Leone, Togo and Uganda).
In sum, if we expect historical trends to continue, then many
countries are likely to be exposed to substantial “shocks” on both GDP
and exports. While it is possible to make reasonable arguments that
projected trends might be realistic if countries avoid policy slippage
and domestically-generated shocks, the scale of rises projected in many
countries makes this argument seem much less plausible, raising major
worries over whether African HIPCs will reach their GDP growth and
poverty reduction targets by 2015.
Potential Shocks Projected in DSAs
A second potential measure of shocks can be derived from sensitivity
assumptions about shocks considered likely in HIPC DSAs. Some of
these shocks are broadly similar to those forecast by African HIPCs in
their own national Debt Strategy Reports compiled with assistance
from the HIPC Debt Strategy and Analysis Capacity-Building
Programme,
22
for example identifying areas of vulnerability such as
commodity prices, drought or aid. Nevertheless, four key characteristics
emerge from comparing the types of shocks in sensitivity analysis in
DSAs, with those in African government debt service reduction options
(DSRs):
•
the negative shocks assumed in national DSRs are generally larger
than those in DSAs. This is because countries analyse in detail the past
effects of shocks on the economy. In contrast, shocks assumed in
DSAs are frequently small – limited in many cases to export growth
rates which are 2 percent lower (and well above historical trends).
Almost all African HIPCs feel that the scale of downside risk assessed
in the DSAs is not large enough;
•
the shocks calculated in the DSRs are generally fed through and
——————————————————
22
See http://www.hipc-cbp.org/en/open/pages/drien.php
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0071
Matthew Martin and Hannah Bargawi 57
analysed for all of their primary (and in some cases secondary)
impacts on the balance of payments and budget, therefore producing
additional financing gaps, which will also increase debt. In contrast,
many tripartite DSAs adjust one line item of the balance of payments
or budget and recalculate financing gaps accordingly, without looking
at the potential effects of a shock on GDP, and other elements of the
balance of payments or budget. African HIPC ministers have often
expressed the view that the effects of shocks should be analysed more
comprehensively;
•
DSAs take virtually no account of potential shocks to the budget.
Only one country’s DSA looked at a potential revenue shock, while all
DSRs examine alternative revenue shortfalls, particularly related to
regional trade liberalisation or slower GDP growth rates. Most DSAs
maintain exchange rates at current levels, while DSRs in countries
with floating exchange rates tend to adjust exchange rates downwards
on a purchasing power parity basis. HIPC ministers have also fre-
quently urged greater attention to potential revenue shocks;
•
DSRs take much more frequent account of climate shocks. DSAs
included them only for Mali and Mozambique, though Section 2.1
above showed 28 African HIPCs have had recent climate shocks;
•
DSAs tend to project one shock at a time, whereas Section 2.1 showed
that HIPCs are vulnerable to multiple different shocks.
Overall, which countries are the most vulnerable to shocks. Judging by
the scale of impact of the DSA shocks on PV/export ratios: Burkina
Faso, DR Congo, Congo Republic, Mauritania, Mozambique, São
Tomé and Zambia are the most vulnerable over the medium term (5 to
10 years). The pessimism of the tripartite DSAs might perhaps also be
judged by the number of downside risks analysed (though this may
simply reflect the amount of time devoted by missions). On this basis,
Chad, Ethiopia, Kenya, Mauritania and Senegal might be seen to be
more vulnerable.
Obviously, this analysis assumes that national PRSPs and PRGF
documents are taking into account all of the “non-shocks” discussed in
Section 1 above. Yet this is definitely not the case – apart from a few
notable exceptions such as HIV/AIDS in Zambia or bleak prospects for
uranium in Niger, occasional analysis of possible aid shortfalls, and
somewhat more systematic analysis of the impact of regional trade liber-
alisation or ending of trade preferences. In particular, most projections in
DSAs make highly optimistic assumptions about flows of FDI and
other private capital to Africa.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0072
58 Protecting Africa Against “Shocks”
3 Solutions
Based on the above analysis, African governments have been subject to
considerable shocks in recent years and are likely to be subject to large
shocks in the ten years through to 2015. If nothing is done, such shocks
could reduce forecast growth rates by 50 percent, and lead cumulative
growth over the 15 years to fall 75 percent short of the level needed to
halve Africa’s poverty.
What can be done to prevent such shocks or to offset them if they
occur. There are three types of measures: (i) improving analysis to
prevent shocks from occurring; (ii) taking measures against individual
types of shocks; and (iii) taking comprehensive measures against
Africa’s overall vulnerability to shocks.
3.1
Analysing and Preventing Shocks
One fundamental way to prevent shocks is to remove all which are not
really shocks. This can be achieved by improving the methodology
used in baseline economic projections:
•
improve the analytical base of baseline forecasts by enhancing baseline
data availability and reliability, notably on imports, aid and private
capital flows, by disaggregating projections more, and by analysing
historical trends and their causes as the basis for future projections;
•
adjust baseline forecasts downwards to include largely predictable
events at national, regional or international levels, such as repeated
climatic shocks, resource depletion, climate change, HIV/AIDS,
capital market shocks and international variables such as interest
rates and exchange rates;
•
in order to support these baseline forecasts, further refine analysis of
predictable country-specific shortfalls and what causes them – notably
export volume and budget revenue shortfalls, import excesses and aid
disbursement delays;
•
take even more account of independent market analysis of country-
specific circumstances influencing commodity export prices and
prospects, and of global commodity (export and import) markets
and world economic trends;
•
provide African countries with more “voice” in forecasts. For many
countries, long-term forecasts are still designed in Washington with
little consultation of African officials who know most about their
economic prospects. Donors need to accelerate capacity-building
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0073
Matthew Martin and Hannah Bargawi 59
assistance on macroeconomic forecasting, to avoid Africa’s exclusion
from the dialogue due to lack of technical tools. In particular, Africa
needs country-specific simple models to forecast MDG progress.
In order to forecast the “real” remaining shocks all PRSPs and BWI
programme documents need to:
•
base projected shocks on historical probability, frequency distribu-
tion and scale of all recent shocks, adjusting for (i) any secular long-
term changes in commodity prospects or climate and (ii) any African
policy changes which might reduce the negative impact of shocks.
Ideally, documents would build their baseline economic scenarios on
the most probable combination of these trends, and downside
scenarios on the most probable extreme negative combinations;
•
present considerably larger (though still historically realistic) potential
shocks to show the genuine risk of a return to unsustainability of debt;
•
analyse the full primary and secondary impacts of shocks on the
economy and especially on poverty and the MDGs;
•
place far more emphasis on the fiscal effects of shocks, especially on
revenue mobilisation and potential cuts in MDG-related expendi-
tures;
•
take more notice of aid shortfalls and natural disasters in more countries;
•
analyse systematically the scale of shocks that would make debt
“unsustainable” after HIPC debt relief, and build into programmes
contingency measures to stop this from occurring;
•
integrate analysis of shocks fully into the proposed long-term debt
sustainability framework for low-income countries, and the grant
allocation formulas for multilateral development banks, to tailor
Africa’s ability to absorb borrowing to its vulnerability to shocks.
Based on the above analysis, PRSPs and BWI programmes need to
contain comprehensive anti-shock plans, containing multiple policies to
prevent the most likely multiple shocks for each individual country, in
order to reduce their vulnerability. These would include:
•
protecting against natural disasters, by for example investing in
irrigation and drought-resistant crops, constructing cyclone shelters,
and building stocks of anti-locust insecticides;
•
improving predictability and stability of aid, by switching to budget
support, removing multiple donor procedural restrictions, and
improving recipient absorptive capacity;
23
——————————————————
23
For more details of these measures and their potential effects, see Johnson,
Martin and Bargawi (2004).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0074
60 Protecting Africa Against “Shocks”
•
diversifying sources of export earnings and growth, focusing on non-
agricultural sectors which are less shock-vulnerable, and ensuring
higher quality and value-added for commodities;
24
•
rationalising import use, by promoting competitive local production
of imported goods, especially sustainable local production of food
and energy;
•
promoting domestic savings and investment much more actively, to
reduce dependence on aid and foreign private capital, and diversifying
and strengthening domestic financial markets to reduce their vulner-
ability to external shocks;
•
increasing reserves to 6 months of imports as fast as possible (6
months of reserves would equal approximately 8 percent of GDP and
would allow countries to run down reserves as a first line of defense
to buffer against most shocks without reserves disappearing);
•
keeping debt levels as low as possible to prevent renewed unsustain-
ability;
•
maximise “fiscal space” by diversifying sources of budget revenue,
keeping debt levels down and especially by establishing fiscal contin-
gency reserves and anti-disaster funds (see also Happe et al., 2003);
•
protecting the poor by designing social safety nets to protect the
poor against all types of shocks;
25
establishing buffer food stocks; and
ensuring that the poor have more access to diversified sources of
income, assets, credit, markets, education/training and health care.
However, some measures will take a long time to work, particularly
diversifying exports, growth and budget revenue, rationalising imports,
promoting domestic savings and investment, and improving the access
of the poor. On the other hand, reserve enhancement, debt reduction,
more predictable aid, social safety nets, and measures to protect against
climate shocks can be more rapidly implemented and have a more
immediate preventive effect, and therefore should be given priority.
The top priority is to establish fiscal contingency reserves in all low-
income countries, linked to the potential scale of shocks. These are
normal practice in developed economies, which are much less vulnerable
to shocks, and should become so in more vulnerable low-income
countries. Fiscal contingency reserves are preferable to just accumulating
——————————————————
24
The February 2004 EU action plan on agricultural commodity chains,
dependence and poverty is a highly laudable comprehensive programme in this
direction (see EU, 2004 for more details).
25
For more details on safety nets, see World Bank (2004).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0075
Matthew Martin and Hannah Bargawi 61
foreign exchange reserves, because they would make prevention plans
focus above all on the fiscal (MDG spending) impact of shocks.
However, they would need to be sufficiently well financed to ensure
that MDG targets would be met in the baseline scenario without
drawing on the contingency reserve.
26
3.2
Individual Measures Against Shocks
Even with dramatic improvements in projections and preventive
measures, some shocks will still occur due to genuinely unexpected
events. They will need to be offset or compensated. Here, it is possible
to distinguish between measures which help with only individual types
of shocks, and those which are more comprehensive and give greater
protection to Africa overall. We first discuss the individual measures.
There already exist many ways of compensating for or offsetting
individual shocks. These types of mechanisms tend to fall into three
categories: (i) risk management; (ii) insuring low-income countries
against shocks; and (iii) automatic adjustment to debt service.
Most discussion of risk management has focused around export com-
modity risk management through hedging and derivatives (see ITF
1999; UN, 2001; World Bank, 2004). Low-income countries, and
particularly their small farmers and producers, are severely under-re-
presented in world derivative and over-the-counter markets, and largely
unable to hedge or insure against risk, except a few mineral-producing
transnationals. The World Bank Commodity Risk Management (CRM)
initiative has been helping commodity producer organisations and
financial institutions to access risk management institutions. Hedging
instruments could also be used at a more macro level to protect against
oil or food import price spikes. Progress in this area will be slow and the
impact will be only long-term, but faster action here is a priority.
Risk management has also focused on government asset and liability
risk management. There is greater potential for low-income governments
to analyse the risks (exchange and interest rate, and maturity) inherent
in their liability portfolios and to adjust their assets to match these risks
more closely. The World Bank has been leading in building low-
income country capacity for integrated asset and liability management.
——————————————————
26
Ghana has recently established such a reserve, albeit to cushion against the
impact of future adjustment of domestic petrol prices to match international
levels rather than to guarantee MDG spending levels.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0076
62 Protecting Africa Against “Shocks”
However, many low-income countries do not have sufficient assets to
be able to manage them proactively, given their low levels of foreign
exchange reserves and their vulnerability to shocks – so the first priority
is to enhance reserve levels and ensure they are liquid and available to
be used as a defense against shocks.
With regard to insuring low-income countries against shocks, it has
been argued that countries could take out insurance against virtually all
macro shocks. The Commonwealth launched a proposal in 2000 for
insurance against the most insurance friendly types of shocks – natural
disasters – via a Commonwealth Disaster Management Agency. Yet,
while entirely welcome, this has received a firm commitment only from
one country (Belize) because the frequency of shocks made the price of
insurance prohibitive. Insurance against commodity risks (exports or
imports) would be less viable and more expensive, given their
frequency and simultaneous impact on a wide range of countries. At a
micro level, efforts are being made to improve coverage against shock-
related risks in low-income countries, for firms and households.
However, this is a very long-term effort and its financial viability for all
but the wealthiest client depends on reducing premiums by reducing
country vulnerability to shocks.
Proposals have been made to automatically adjust debt service to offset
exogenous shocks. Various mechanisms have been suggested. First, by
linking debt service obligations to commodity prices. The World Bank
(2004b) has indicated that this will not be very useful, and that
providing more new grants would be better. Second, by lending new
external loans in inflation-indexed local currency instead of foreign
currency. This would protect countries against rising debt burdens in the
event of a devaluation. However, for countries with fixed currencies
(CFA zone) it would not be a good option, as an inflation-indexed local-
currency loan would be more expensive than a foreign currency one. The
impact of this mechanism would also be felt only through disbursements
over the long-term. Third, by deferring debt repayment in the event of a
shock. If implemented rapidly this would be helpful but it would also
mean accruing additional interest and so adding to the country’s debt.
Most important, all these proposals are treating only one of the
symptoms of an external shock (a high debt burden), rather than its
causes or its comprehensive impact. As such, and given the low debt
service obligations of low-income countries, they would offer only
marginal and piecemeal assistance. None of them is therefore considered
a high priority by African HIPC ministers (2003).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0077
Matthew Martin and Hannah Bargawi 63
3.3
Overall Measures Against Shocks
It would be preferable to have comprehensive protection against all
shocks. Given the frequency of multiple shocks hitting most African
countries, it is impossible to envisage that risk management products,
insurance schemes or debt service adjustments would provide com-
prehensive protection without prohibitive cost. In this light, the onus is
on the official system to implement three main measures to offset and
compensate for shocks:
The first measure is to adjust PRGF programmes to shocks. It has
long been practice for some performance criteria in some PRGF
country programmes to be adjustable in light of shocks, but this should
be generalised to all programmes, making such targets as fiscal and
current account deficits explicitly adjustable according to both positive
and negative shocks, or measuring them excluding elements which are
vulnerable to such shocks (such as donor grants or interest payments).
Alternatively, targets might be regarded as “indicative” and flexibly re-
negotiated in mid-programme reviews, without the need for requesting
formal waivers. However, there is also a case for more fundamental
reviews of programmes in order to redouble efforts to reduce poverty.
This would include designing measures to accelerate the recovery in
growth and pro-poor government spending after the shock through
counter-cyclical fiscal policy and specific anti-shock expenditures, to
establish permanent anti-shock safety nets, to combat the long-term
“downward drag” effects of shocks, and to enhance national mechanisms
for monitoring the nature and impact of shocks.
27
At all costs, a
reaction to shocks which involves cutting MDG-related spending
needs to be avoided.
The second measure is to provide supplementary financing in the form
of highly concessional loans, or preferably grants, as compensatory and
contingency financing against shocks. Various studies have shown the
effectiveness of targeting aid to offsetting shocks.
28
Yet low-income
African countries have virtually no access to systematic compensatory
financing.
29
There are only two institutions with dedicated anti-shocks
facilities. The first, the IMF’s Compensatory Financing Facility (CFF),
has been so expensive that low-income countries cannot use it. More
——————————————————
27
For more details on these aspects of policy, see especially Lustig (2000).
28
See for example Collier and Dehn (2001).
29
For more details on these see IMF (2003) and IMF (2004b).
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0078
64 Protecting Africa Against “Shocks”
recently, the IMF has proposed the establishment of an anti-shocks
window within the PRGF, on cheaper (loan) terms. The second, the
EU FLEX facility established in 2000, is a considerable improvement
on the previous STABEX, especially since its revision in May 2004 to
make access easier (European Commission, 2005). However, the
eligibility criteria remain too restrictive and it disburses very slowly
(with a lag of 15-24 months between the shock and the receipt of
FLEX funding).
However, even the above facilities and amounts fall way short of
country needs, largely because they focus only on export shortfalls,
which are not the most important shocks for African countries, and do
not correlate with GDP or MDG-related budget spending shortfalls
which are the key indicators of problems in MDG progress.
The only other current way to compensate for shocks is by ad hoc
augmentation of budget support by a lender or donor. Currently the
IMF and World Bank play small roles in this area by augmenting
PRGF or PRSC loans with extra disbursements, and providing extra
disbursements to combat natural disasters. More important players are
a few bilateral grant donors, who can provide additional budget
support. However, these funds also have major problems (see also IMF,
2004a and World Bank, 2004):
•
the amounts available are often inadequate and not frequent enough.
Bilateral donors also have limits on the percentage of funds they can
use for contingency purposes;
•
apart from World Bank anti-disaster funds for IDA-only countries
and FLEX, multilateral anti-shock funds are loans, significantly
increasing debt burdens. The IMF acknowledges that most anti-
shock funds for low-income countries should be in grant form;
•
funding is not disbursed fast enough. Typically it requires at least 6
months between a shock emerging and major disbursements of
assistance, due partly to slow analysis of the impact of the shock, slow
procedures for approving funds, and especially slow procedures for
loan effectiveness, procurement and project implementation;
•
funding is far too highly conditional, with PRGF programmes often
requiring additional measures by the African government to adjust to
shocks, partly because of the shortage and delay in anti-shock funding.
Anti-natural disaster funding is in general rather more sufficient to the
scale of its task – representing 7 percent of global aid – over $6 billion.
It is also better coordinated through UN disaster appeals. Dedicated
anti-disaster facilities include the EU’s Community Humanitarian Aid
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0079
Matthew Martin and Hannah Bargawi 65
Department (ECHO), and the IMF Emergency Assistance facility.
However, the main problems here are delay in disbursement and poor
coordination of disbursement through multiple agencies (generally very
little via the African government’s budget), as has recently been seen in
the late response to the locust plague in the Sahel and the subsequent
famines in Niger as well as Southern Africa. Further problems are the
overconcentration of funds on large or highly visible disasters such as
the tsunami, and high levels of disbursements through tied aid in kind
which are overvalued or distort national food markets.
It is not surprising that, in evaluating donor aid policies and prac-
tices, African governments gave them the lowest marks for anti-shock
funding (see Johnson et al., 2004). As a result, the top priority for the
international community should be to establish an anti-shocks facility
for low-income countries (Martin et al., forthcoming). This facility
would need to be:
•
comprehensive, compensating all shock-induced shortfalls in GDP
growth, budget spending, or foreign exchange (exports, imports, aid
etc.) for IDA-only countries;
•
much bigger than current facilities to provide adequate finance;
•
grant-financed in order to avoid increasing national debt burdens;
•
fast-acting (disbursing within 3 months). To ensure this, contingent
funds would be set aside for countries each year (see below);
•
not subject to any additional conditionality beyond that of having
PRSPs.
It would obviously be desirable to coordinate facilities such as EU
FLEX and IMF Trade Integration Mechanism (TIM) with such a
facility, in order to provide consistent support to countries – the
proposed mid-term review of FLEX would provide an opportunity to
increase coordination.
What would be the cost of such a facility. To compensate for com-
modity (export and import) shocks for all IDA-only countries, which
average 1 percent of their GDP a year, and adjusting for 3 percent
annual global inflation, the estimated cost of such a facility would be
$48-50 billion over the next 11 years – i.e. around $4.5 billion a year.
30
Additional funding would be needed to offset aid and foreign private
——————————————————
30
This figure is calculated for IDA-only countries on the assumption that
blend-countries can borrow from other sources, namely PRGF and IDA loans. Of
the $48-50 billion over 11 years, less than half (roughly $22.5 billion) would be
allocated to African IDA-only countries.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0080
66 Protecting Africa Against “Shocks”
capital shocks, and to implement specific measures to prevent future
disasters and protect the poor. Assuming that anti-disaster funding is
generally sufficient in amount,
31
the facility could also be used to front-
load disbursements of external finance and avoid disrupting government
budget plans, with donors reimbursing the facility later.
However, not all this funding would need to be additional or
provided as grants. A considerable proportion could be met through
the IMF anti-shock facility for less debt-distressed countries, and around
$130 million a year could come from FLEX. Donors could also fold
their existing grant contingency support into such a facility.
The third measure to be taken by the official system is to build
overall contingency mechanisms into adjustment programmes. In order
to ensure the effectiveness and speed of anti-shock financing, it would
need to be set aside up front, as genuine financing against contingen-
cies, rather than after the shock when its negative effects on the
economy have already been felt. It would be relatively easy to calculate
the contingency allowance needed for each country, based on historical
and forecast vulnerability indices of the types designed by the Caribbean
Development Bank, EU, OECD and UN.
In order to provide a basis for such up-front financing, the BWI
Boards would be presented with two sets of economic projections at
the occasion of each semi-annual PRGF review. Both of these would
aim to attain the MDGs: one would be a realistic “base case”, including
“likely” shocks such as the impact of HIV/AIDS; the other would be a
realistic assessment “low case”, allowing for shocks which would
probably hit the economy, and conducting analysis of GDP and
budget as well as balance of payments effects of the shock. The anti-
shocks facility above would then be committed up to levels to keep
MDG-related budget spending on track, and boost reserves to
6 months of imports, in the event of the low case occurring, and the
funds representing the extra financing needed for the low case scenario
would be put into a blocked fiscal contingency reserve account for the
recipient country. Following any evidence of a shock (e.g. a trigger
such as a projected shortfall of 2 percent of exports, reserves or budget
revenues, or 0.25 percent of GDP), a rapid-response analysis mission
(by the BWIs together with the EU and a bilateral donor) would assess
——————————————————
31
However, some confusion over the data on disaster funding exists, indicating
that of the $6 billions allocated per annum, $2 billion is spent on refugees, with
$1.5 billion of this being spent in donor countries on action relating to refugees.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0081
Matthew Martin and Hannah Bargawi 67
its impact and immediately recommend disbursements, which would
occur within a maximum of 3 months after the shock.
Four questions might be asked about such a fund: First, how do we
avoid a “moral hazard” that countries might rely on guaranteed
external finance and not take serious steps to prevent or adjust to
shocks. While this has been a problem with some past compensatory
finance, the use of the funding for MDG-related budget spending and
reserves enhancement, as well as to fund specific measures to prevent
future disasters and protect the poor, would automatically prevent this
moral hazard. No additional conditionality or “pre-qualification”
mechanism based on developing comprehensive anti-shock plans in
PRSPs should be accepted, as this would merely add to the already
heavy burden of conditionality and delay vital funds.
Second, why should we set aside funding up front which might not
need to be spent on shocks, rather than spending it on essential
immediate needs. It has already been stressed that many OECD
countries regard fiscal contingency reserves as essential to efficient
budgeting: a case that is all the stronger for low-income countries
which are highly vulnerable to shocks. In addition, one crucial lesson
of development financing for Africa in the last 30 years has been that
insufficient anti-shock action and finance has been a recipe for
magnifying economic instability and other distortions, ending up
costing donors far more in the long-term because they need to provide
more new financing and debt relief. Therefore, adequate contingency
finance up front is essential. A small portion of the funding would, in
any case, be set aside for guaranteed spending on measures to prevent
future shocks and establish systems to protect the poor.
Third, how do we distinguish clearly between shocks that require to
be compensated and other reasons for slippages which require more
adjustment. The EU, IMF and World Bank do not have problems
doing this in the context of FLEX and CFF, or augmentations of
PRGF or PRSCs. Nor does the UN have problems distinguishing costs
and funding needs of natural disasters It would simply be a question of
extending these methods to cover other types of shocks.
Fourth, what would be done with unspent funds. Depending on the
assessment of future risks of shocks for the country, and a new assess-
ment of its own ability to protect itself against shocks through budget
revenue and foreign exchange reserves, they could be either carried over
into the following year’s fiscal contingency reserve or reallocated to be
spent on projects to protect the poor against future shocks.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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68 Protecting Africa Against “Shocks”
4 Conclusion
Africa is already suffering from large shocks beyond its control, which
will continue, and will play a major role in making it impossible for the
continent to reach the MDGs. As African HIPC governments have
themselves suggested, there is no better use or higher priority for addi-
tional aid funds than immediate, low-cost contingency financing.
Together with measures to prevent shocks by better analysis and
improved policymaking, and to offset or compensate specific types of
shocks, this could guarantee Africa’s protection against shocks,
ensuring that this key factor would no longer disrupt its progress
towards the MDGs.
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72
5
Curbing the Impact of Shocks
Ariel Buira
1
am in broad agreement with the arguments presented by both John
Williamson and Matthew Martin. More than 50 low-income coun-
tries are very vulnerable to exogenous shocks as a result of commodity
prices changes and the concentration of their exports in one, two, or
perhaps even three commodities that account for more than half of
their exports.
Many of these shocks are the result of sharp changes in terms of trade.
As has been observed, every two or three years terms of trade shocks
can reduce their exports by 2.5 to 7 percent of GDP and, when you
take the full multiplier effects of this, by as much as 20 percent of GDP.
These are estimates of Paul Collier made at the World Bank.
Other exogenous shocks are related to natural disasters, the impact of
conflicts in neighbouring countries, sudden reductions in aid, imposition
of trade barriers in major markets, and others. The frequency and
severity of shocks are closely correlated to growth; their impact on
growth is asymmetric and their effects are often irreversible.
High volatility has been demonstrated to be harmful to output and
harmful to growth. The volatility of macroeconomic variables tends to
have not only high output costs, but tends to lead to the curtailment of
investment in infrastructure. There is evidence that half of the total
fiscal adjustment efforts in Latin America in the 1990s was achieved
through the curtailment of investments in infrastructure and these cuts
were not compensated subsequently. So, the pro-cyclical policies
resulted in a decline in GDP growth rate of about one percent a year.
——————————————————
1
The views expressed are those of the author and do not necessarily represent
those of the G-24.
I
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Ariel Buira 73
Dependency on commodities and generally close links between
developing countries’ external sectors and demand conditions in the
industrial world, make these countries very sensitive to changes in
demand and result in a high level of volatility in their export sector,
much higher than the variation in export growth in industrialised
countries. In fact, three to four times as much.
Advanced countries show much lower volatility. The standard devia-
tion for their exports in terms of trade is 0.97. For the developing
countries as a whole it is 3.2, for sub-Saharan Africa it is 3.3 and for
Latin America and the Caribbean it is 4.4, which is rather surprising.
For the Middle East it is 3.2.
The problem of commodity shocks is very severe in low-income coun-
tries because as a norm when your level of per capita income raises above
one thousand dollars, the economy tends to become much more diversi-
fied. Of course, this is not always the case, you have countries like Chile,
which has a very sophisticated economy, but copper continues to
account for some 40 percent of total exports and terms of trade shocks
may have an impact of 6 percent of GDP. The case of some oil
producers with high incomes is very similar.
The problem addressed by John Williamson is a major one for many
low-income countries and I too recall the establishment of the CFF in
the early 1960s, which was considered very innovative. Going a little
over the history of this CFF, by 1983 industrial countries had the
feeling that the CFF was often used to postpone what they felt were
necessary policy adjustments, so they tightened the access to it and the
use of the CFF since then was sharply reduced.
For me, what is surprising in the chapter by John is the importance
of capital flow shocks for low-income countries with very limited access
to financial markets. These are said to be greater than current account
shocks and low-income countries are said to suffer more instability
from capital flows than middle-income countries. Perhaps John will
provide the data source for this statement and elaborate a little bit on
this point, which I found counter-intuitive. I do not know if the
standard deviation of capital flows in low-income countries is greater
than in middle-income countries. It would seem the size of the flows is
small and the impact on the economies is not as large. Thus, I would
like to hear his explanation for this.
I agree with John’s comments on commodity agreements. I think
that one would have to keep a very clear distinction between price
stabilisation and income stabilisation. Probably the attempt to achieve
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74 Curbing the Impact of Shocks
the second hindered the achievement of price stabilisation.
I agree with John also that countries facing balance of payments
problems and the need to adjust need not resort to the Fund’s high
conditionality programmes, which are usually underfinanced. When
countries are hit by adversities through no fault of their own, they
certainly deserve support. The CFF would be a very appropriate
mechanism for this sort of situations. In fact, I would say one has to
enlarge CFF because quotas are so small today, on average less than
1 percent of GDP, and access to resources under the CFF was limited
to less than half of a member’s quota.
If the rates of charges are high, well the rates should be adjusted
downwards, although I think that today they are at close to 2 percent
and that is close to zero in real terms.
Domestic Policies
Let me turn to the domestic policies for curbing the impact of shocks.
Since Keynes, one of the main legacies of macroeconomic theory for
advanced economies has been the awareness of business cycles and the
development of tools to deal with them. The issue has been at the
centre of policy debate, as market-oriented economies frequently saw
periods of growth interrupted by periods of recession. Such boom-bust
cycles have triggered short-term policies in industrial countries that
sought to reduce the effects of downturns in income and expenditures.
Automatic stabilisers have been built into fiscal policy over the last 70
years and the impact of business cycles in industrial countries is
ameliorated through unemployment insurance and automatic tax
adjustments that soften the impact of the cycles. This is something that
has been happening since the 1970s at least, although the neo-liberal
revolution changed the emphasis of policies away from fiscal and
monetary policies as instruments of fine-tuning. Counter-cyclical
policies have also remained in place. However, in developing countries
the space for the pursuit of counter-cyclical actions is much narrower.
What determines the variability to which developing economies are
subjected. Are there any hidden reasons for this. Well, in principle one
could distinguish at least four. I have already mentioned the much
greater dependence on primary commodities and, as a result, the vari-
ability of exports, which is three to four time higher for developing
countries than for advanced economies. A second element is – of
course, there are differences between regions and countries within the
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Ariel Buira 75
different regions, some have diversified more and so forth but as a
whole – a smaller and more volatile access to financial markets. Indeed,
the average magnitude of a sudden reversal in capital flows in emerging
market countries is about 6.1 percent of GDP, while it is only 1 percent
in industrial countries (see Calvo et al., 2004). Additionally, the fragile
external and fiscal position of many of these countries has restrained
their ability to obtain external financing. Third, there is generally less
market confidence perhaps as a result of less reliable macroeconomic
policies in the past, and there is, consequently, an inability to pursue
counter-cyclical policies. Fourth, the inability to borrow in their own
currency beyond a limited extent given the small size of the domestic
financial markets and their own history of monetary instability and
exchange rate depreciations.
Lacking the capacity to finance counter-cyclical policies, most
commodity producers have followed pro-cyclical policies – policies are
tight in times of recession and are expansionary in times of the upswing.
This has weakened further the growth prospects when external condi-
tions deteriorated. John recommends that countries should aim for a
redistribution of expenditures over time. This is of course impeccable,
but it is also very difficult to do. First, because capital inflows are pro-
cyclical; your borrowing is increased in good times and falls in bad times.
I agree, by the way, with John’s remarks on the Chilean “Encaje” and
the use of capital controls. Second, because fiscal policy is also pro-
cyclical; government expenditure expands in good times and falls in
bad times. Third, emerging market monetary policies tend to be pro-
cyclical: expansionary in good times and restrictive in bad times. And,
fourth, again, capital inflows are also associated with expansionary
macroeconomic policies in good times, as are capital outflows with
contractionary policies. In these circumstances, it is very difficult, for
countries to pursue counter-cyclical policies. Perhaps the Fund should
help them do so, and perhaps they should try harder.
John proposes that since there is no real mechanism to support
countries faced with contractionary shocks giving rise to cyclical down-
turns, they should resort to policies of self-insurance. This is perhaps a
prudent solution, but I do not know whether it is the right one or
whether it is the only one. The increase of reserves, which is something
many countries, particularly in Asia, have been doing, has a very high
opportunity cost generally. I would say that self-insurance is perhaps the
most primitive and costly means of insurance. From self-insurance you
move on to group insurance, and from group insurance you ultimately
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76 Curbing the Impact of Shocks
go to global insurance and you invent the IMF. But if countries do not
want to go to the Fund because it does not meet their needs…. Well,
this may reflect on Fund policies and will be discussed later.
Nevertheless, group insurance is possible. Laura dos Reis has written
a paper for the G-24 that develops the proposal for the implementation
of a fiscal insurance mechanism for the member countries of the
Eastern Caribbean region and for the African members of the CFA
franc zone that works rather well (Laura dos Reis, 2004). Fiscal group
insurance can cushion members against transitory shocks. The volatility
of fiscal revenues would be reduced for countries that join the fiscal
insurance arrangement, which allows cross compensation under a risk-
sharing scheme. Their contributions are proportional to the size and
the frequency of external shocks and – since regional fluctuations in
output and government revenues in these regions are not significantly
correlated – the fiscal insurance scheme can take advantage of the
asymmetries and lead to welfare gains for all. You can look at the paper
in the webpage of the G-24.
You may recall that in some recent studies by the Fund and by other
authors as Kaminsky, Reinhart and Beck, they say that countries
should avoid crisis by keeping external borrowing at the safe level. This
safe level is at times as low as 15 to 20 percent of GDP. This brings to
mind the case of the dog that did not bark, that led Sherlock Holmes
to the solution of a mystery. We have a very interesting case of a
financial crisis that did not happen. I refer to an emerging country with
a debt in excess of one hundred percent of GDP, with a very low level
of exports to debt and very large fiscal deficits; this country is Greece.
Its currency has not been subjected to speculative attacks for a very
long time, since well before it adopted the euro as its currency. It was
thought by markets to have the protection of being a member of the
EU and it was presumed that the EU would come in its support if it
would come under a speculative attack. In spite of having poor funda-
mentals, considerably worse than those of many emerging markets
countries that suffered devastating speculative attacks and financial
crisis, Greece came through unscathed. Portugal with better funda-
mentals is in a similar situation.
I think there is a lesson to be drawn from this experience, one that
illustrates the role that external support can have in maintaining
confidence and in preventing financial crises. This was after all the role
assigned to the IMF’s ill-fated Contingency Credit Line; this was what
it was supposed to do and unfortunately never did.
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Ariel Buira 77
International Policies
Like John, I tend to believe that the international community should be
more helpful and display more solidarity to assist those countries that
undergo external shocks. I also feel that the CFF would deal with not
only commodity revenue shortfalls, but impacts of oil prices hikes too.
I recall that in the 1970s the IMF had established the low-conditionality
facility to deal with exactly these exogenous shocks: the oil facility. Of
course, we are in the realm of political economy, with the emphasis on
political. At that time, several industrial countries including Italy, UK
and Spain, were interested in drawing from it. Since then industrial
countries have walked away from the Fund and the chances of such a
scheme, although technically quite feasible, are very slim.
The details of how a counter-cyclical facility could be established to
support emerging market countries have been worked out in a paper by
Claudio Loser, a former head of the Western Hemisphere department
in the Fund, in a paper for the G-24, which can be found on the G-24
webpage (Loser, 2004). But if countries in control of the Fund are not
prepared to establish a new counter-cyclical facility, could a less
ambitious proposal of simply reactivating and expanding this CFF be
put forward.
Another question is why governments do not borrow in their own
currency. Surely, they realise the risk posed by currency mismatches.
Over the last decade a number of emerging market countries have seen a
rapid expansion of the domestic financial market, the better-known cases
are probably Chile and Mexico. These countries have gone a consider-
able way to develop their domestic capital market as a means to reduce
dependence on external credit. They have done this mostly through a
combination of price stability and fostering the growth of fully funded
pension funds that would feed long-term capital markets. They have
attained a measure of success, but the markets are still not large enough
to cope with borrowing needs, perhaps over time they will.
John suggests the issuance of inflation-indexed bonds. Both Chile
and Mexico have also issued domestic currency bonds indexed to infla-
tion and, of course, dollarisation is a form of indexation, as was done in
Argentina and some other countries, not always with good results.
Now, domestic investors fear that a country that is prepared to default
on its external debt is probably even more prepared to default on its
domestic debt. Countries with a history of domestic debt default are
found to be some four times more likely to be dollarised than countries
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78 Curbing the Impact of Shocks
that have not, curiously. Anyway, the quest