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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pg_0082
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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Collier, P. and J. Dehn (2001), “Aid, Shocks and Growth”, Policy
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Commonwealth Disaster Management Agency (2000), Commonwealth
& Small States Disaster Management Scheme, London, January.
Crowards, T. (1999), “An Economic Vulnerability Index for Developing
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the Development of the Cotton Sector in Africa”, Press Release,
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the Event of Fluctuations in Export Earnings”, EC/TFN/GCF4/53-
EN, Brussels, September 1999.
European Union Department (2000), “Hitch-Hiker’s Guide to
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Ferreira, Francisco, Giovanna Prennushi and Martin Ravallion (2000),
“Protecting the Poor from Macroeconomic Shocks: an Agenda for
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Fondad, The Hague, November 2005. www.fondad.org
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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 question is, in view of these
shocks, should not be the IFIs more helpful.
In keeping with their mandate, we have seen what the Fund could
do. But what about the multilateral development banks. First of all,
they could lend at the full capacity, most of them are lending well
below it. The World Bank is lending at a little above half of its lending
capacity. As a minimum, they should avoid running long periods of net
negative transfers of resources to the developing world. In the case of
the World Bank, this was in the order of 12 to 14 billion in the last
couple of years. They could also try to be counter-cyclical in their
lending, although I realise that it is not always easy if you are investing
and dealing with investment projects and so forth. Amar Bhattacharya
had some very good suggestions for expanding lending operations by
increasing investment in infrastructure; I hope they are put into effect.
Moreover, through resort to portfolio diversification, they can lend to
countries in their own currencies. This is technically possible without
incurring any losses and, in fact, obtaining higher returns than lending
in dollars, according to simulations over a 20-years period, done by
Randall Dodd and Shari Spiegel (2004) for the G-24. This is a very
recent paper and some people in the IDB and Wall Street are now
looking at this possibility.
References
Laura dos Reis (2004), “A Fiscal Insurance Proposal for the Eastern
Caribbean Currency Union”, paper presented at the XVIII G-24
Technical Group Meeting, 8-9 March.
G. Calvo, A. Izquierdo and L.F. Mejia (2004), “On the Empirics of
Sudden Stops: The Relevance of Balance Sheet Effects”, NBER
Working Paper 10520, Cambridge MA.
Claudio M. Loser (2004), “External Debt Sustainability: Guidelines
for Low- and Middle-Income Countries”, G-24 Research Paper,
Washington D.C.
Randall Dodd and Shari Spiegel (2004), “Up From Sin: A Portfolio
Approach to Salvation”, paper presented at the XVIII G-24 Technical
Group Meeting, 8-9 March.
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79
6
The Need for Institutional Changes in
the Global Financial System
Stijn Claessens and Geoffrey Underhill
1
ince the 1980s, persistent episodes of financial crisis in developed
and developing countries have put the international financial system
under stress. Efforts to reform the architecture of global finance since the
1990s have failed to prevent severe crises from occurring in middle-
income countries, and financial integration remains a contentious aspect
of globalisation. Despite many attempts at the international level,
many developing countries still suffer from high external debt and a
poor match between their development financing needs and the avail-
ability and forms of both private and public capital. More generally,
there is much disappointment and scepticism among policymakers and
citizens worldwide concerning the contribution of the international
financial system to global development.
Global financial market integration, debt problems and limited and
poorly matched resource transfers are realities, and the issues cannot be
avoided. Indeed, discussions on reforms to the international financial
——————————————————
1
This is a revised version of a paper presented at the FONDAD conference on
Developing Countries, Global Finance, and the Role of the IMF: Towards a New
Relationship., The Hague, 11-12 November, 2004. We would like to thank the
discussant, José Antonio Ocampo, and the participants for very useful comments.
Stijn Claessens also likes to thank the participants in the 2nd EU Development
Network Conference, November 25-26, 2004, Paris for comments. The full
paper, from which this article is drawn, was originally prepared for the HIPC
Unit of the World Bank and we would like to thank Vikram Nehru for
commissioning it. The opinions expressed do not necessarily represent those of
the World Bank, its Executive Directors, or any of its member countries.
S
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80 The Need for Institutional Changes in the Global Financial System
architecture are proceeding, private debt workout mechanisms are being
adjusted, (official) debt relief schemes have been put in place, and
development assistance is continuously being re-evaluated. Disagree-
ments in policymaking, public and academic circles over the scope,
depth, and shape of the reform process remain, however, profound.
The recurrent nature of the debates suggests that deeper reforms to
the institutional framework are imperative. The failure of fundamental
reform to materialise also suggests that some important blockages in
the policy process need to be circumvented if change is successfully to
be implemented. Changes for the better will require going beyond the
shifting topics of immediate interests among policymakers – i.e. the latest
financial crisis, the difficult private-public relationship in debt workouts,
or the debt problems of low-income countries – and addressing funda-
mental questions of the nature of the governance of the international
financial system. Furthermore, political strategies to circumvent the
current pattern of vested interests in global financial markets and
governance will need to be constructed. This chapter’s purpose is to lay
out the elements that need to be addressed when rethinking the
governance mechanisms of the international financial system.
First, we develop a framework for analysing the tensions between the
achievement of global and national development objectives and a world
of fragmented governance, multiple institutions, accelerated financial
integration and increased private sector roles. We approach the topic by
covering four sets of interrelated issues, each of which derives from the
other: (i) Forces for change: How do globalisation, increased financial
integration and the emerging norms and standards of global governance
affect and define the nature and objectives of the international financial
system. In other words, how is the contemporary international financial
system different today from when it was put in place, and what issues in
terms of governance do these changes raise. (ii) Public versus private
interests and power: How do these changes in both markets and govern-
ance affect the balance of power between public authorities and private
interests in international monetary and financial policies. What does
this mean for the (shifting) discourses of the “public good/public
interest” in financial governance. (iii) The design of the international
financial system: 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. What sorts of obstacles limit the scope for change.
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Stijn Claessens and Geoffrey Underhill 81
And (iv) The legitimacy of the international financial system: How might
policy processes and institutions at the global level become more ac-
countable and outcomes more legitimate in relation to the policy pref-
erences of citizens of all economies, in particular of the developing world.
In addressing these four issues, we highlight the many concerns beyond
the immediate or approximate causes and consequences of financial
crises, sustained debt overhang, or poor forms of resource transfers.
1 Forces for Change in the International Financial System
In this section, we examine the economic and financial changes that are
affecting the global financial system. Globalisation has involved increased
financial integration, increased cross-border entry, mergers and acquisi-
tions of financial institutions, and lower formal and de facto barriers
between specialised market segments. These changes were triggered by
regulatory changes at the domestic level, particularly in the US and the
UK, and capital account liberalisation (Helleiner, 1994). Cross-border
capital flows have been the most important form of increased financial
integration for the last two decades. Furthermore, capital market integra-
tion has lowered the cost of raising capital in developed and developing
country markets alike. Spurred by governments that have removed entry
barriers, the costs of establishing a physical presence have likewise declined
in the last decade, resulting in a dramatic increase of cross-border entry
of financial institutions and bank consolidation and financial institu-
tions’ mergers and acquisitions across borders and market segments.
Finally, in recent years especially, remote delivery of financial services has
become much easier; through enhanced communications capability,
banking services can now be accessed from anywhere and trading services
are no longer restricted to any physical location or exchange.
These structural changes in the markets are a few of the many dimen-
sions of global financial integration over the past two decades. They
originated in developed countries as their financial systems and economies
matured and they cast off the restrictions of their developmental
experience and the heritage of war and depression, and have spread
globally. We focus on those dimensions most related to changes in actor
preferences in relation to the institutions of governance. One dimension
concerns how the changes affect the preferences – financial, political and
otherwise – of the public sector, international organisations, private eco-
nomic actors and citizens. A second dimension concerns the pressures for
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82 The Need for Institutional Changes in the Global Financial System
general economic and policy convergence, that is, those systemic devel-
opments that are driving national and local financial systems to search
for global or apparently similar solutions. We discuss each in turn.
1.1
Changes in Preferences
Financial integration and globalisation more generally affect the
capacities and preferences of different socio-economic actors, interest
groups, and constituencies in relation to the nature and objectives of
the international financial system. These constituencies and groups
include private financial and corporate sector interest groups, state
officials, international organisations, non-government organisations,
and citizens. The changes are many, and include changes in relation to
objectives, tools, and voices.
The end of the cold war removed competition with a rival system and
thereby an important anchor to public interventions in national
governance and the international system. The demise of a “socialist”
alternative and of an active Soviet foreign policy reduced the need to
accept social compromises in economic policy as an antidote to unrest
and social upheaval in the developing world. As developed economies
matured and post-war interventionism lost much of its rationale, models
of market-based (or market-friendly) development became central to the
policy agenda in western capitals. There was also less tolerance for autho-
ritarian exceptions to more consensual forms of government in emerging
markets. The failure of a range of state-interventionist development
models to deliver higher income levels in many countries, particularly in
Latin America, brought such strategies increasingly under criticism.
Despite the successful experience of developmental states in East and
South-East Asia,
2
interventionism often appeared to be at the root of
problems such as increased inequality, poor environmental performance
and other externalities. Chronic inflation and debt burdens induced by
state-managed development strategies lent further credence to more
market-oriented approaches. At the same time, globalisation introduced
more intense competition among countries and firms. All of these trends
stimulated changing actor preferences and forms of policy reform.
Correspondingly, the tools of national instances and international
agencies changed as policy became aimed at a greater role for local and
——————————————————
2
Concerning the debate on the “developmental state”, see Underhill and
Zhang (2005).
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Stijn Claessens and Geoffrey Underhill 83
foreign private sectors. It gave the international agencies a smaller voice
in the world of global opinion and debates. It left national authorities
with fewer means to steer local economies, both in normal times and in
times of financial crises. Facilitating private sector market processes
became commensurately more important to policymakers. While these
developments were the intended outcomes, they also had some un-
intended consequences: new institutions did not necessarily emerge
promptly to compensate for the vacuum or the altered sets of preferences.
An important element of these changes had to do with the increased
role of the private sector in economic activities, which we take up in
detail in the next section. We discuss here the consequences for intel-
lectual leadership and international financial markets.
The liberalisation of media in many countries has given all actors
more voice. The intellectual leadership of international agencies has
become increasingly challenged by more vocal NGOs, whose analysis
and research capacity sometimes rivals the agencies themselves. Techno-
logical developments such as the internet have allowed smaller groups to
voice their opinions more easily. Policymakers have been searching for
new solutions as they interacted with other actors in policymaking
processes, but they have found this difficult and bewildering at times.
More importantly, the increase in capital flows has reduced the discre-
tionary room for manoeuvre left to public policymakers in the national
and international domains. The capacities of official and international
agencies to respond to financial crises were in particular limited, both in
terms of resources and effective policy implementation. The dual shift
towards greater levels of private sector provision of capital and integra-
tion across borders has stimulated internationally mobile capital to opt
out of historical relationships with public officials and other players in
national level policy processes. The greater emphasis on shareholder
value and mobility has given capital more voice relative to labour and the
liberalisation of financial markets and capital account has given (inter-
nationally mobile) capital more voice. The break-up of national policy
networks induces further changes in actor preferences.
Another related aspect of change is the larger scope of markets, greater
number of players, and the more decentralised nature of transactions.
This diminishes the power of individual entities, whether they are
corporations, shareholders, government agencies, etc. Moral suasion by
central banks, for example, to stave off a financial crisis by “directing”
commercial banks is simply much less effective in (international)
financial markets today since there are too many players and investors
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84 The Need for Institutional Changes in the Global Financial System
involved. The jurisdiction of public agencies corresponds less and less to
the real domain of the market for which they are responsible. These
changes have also stimulated a search for influence on the rules of the
game, rather than on the market outcomes directly. As such, these
trends increase the motivation of actors to search for (global) norms to
allow some standardisation, which we take up in the next subsection.
1.2
Institutional Environment Convergence
There has recently been an important degree of convergence in national
financial, corporate governance, accounting and many other standards,
including non-financial standards (e.g. labour and environmental regula-
tion). The need for standards has increased as the boundaries of the
markets increasingly cut across national boundaries. In financial services,
increased cross-border presence in financial systems, greater international
issuance of securities and other forms of globalisation has led to the
spread of similar market practices and “soft” forms of regulations and
laws, such as more harmonised issuing standards for equity and debt.
There is little evidence that this has led to a decline in banking or capital
market standards. If anything, the break-up of national financial policy-
making “clubs” and the institution of market-based regulation have led
to more and in particular more statutory-based enforcement of standards
(Vogel, 1996). As part of the new international financial architecture,
there are now many, somewhat higher standards to which firms and
countries can adhere to or at least to which they may be held accountable.
Examples include the various standards being assessed under the ROSCs
(Reports on the Observance of Standards and Codes). More generally,
globalisation has done away with some institutional differences and led
to more common standards and practices. Cross-border standards imply
some degree of harmonisation of the framework under which govern-
ments and firms (ought to) behave. Over time and to a certain degree,
this convergence will take some of these issues off the global public
policy agenda, although less so for developing countries.
Public agencies seek such standards in order to enhance the efficiency
of their policies through international cooperation. Yet private interests
within developed countries have mostly driven these trends. Private
actors seek standards to lower transaction costs through private sector
cooperation, and public actors respond to their political pressure. The
increased harmonisation of international accounting standards, for
example, has been driven by the two largest markets, the US and EU,
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Stijn Claessens and Geoffrey Underhill 85
and has been conducted by semi-private agencies, the International
Accounting Standards and the Financial Accounting Standards Board
(Dewing and Russell, 2004). Similarly, when firms raise capital abroad
or list and trade their stocks on international stock exchanges – as firms
seek lower cost of financing and investors value the institutional aspects
of international environments more than that of local markets, they
overcome some of the institutional differences between countries, but
again, this is largely due to market forces. Other standards, such as the
Core 25 Principles for Banking Supervision, have had a public sector
origin but with much private sector input.
While originating in developed countries, the new global standards
have the greatest impact on public and private actors in developing
countries. The largest impact from the accounting or the Core 25
Principles for Banking Supervision standards, for example, will be in
developing countries. There are several reasons for this. Globalisation
in financial services industries has been affecting developing countries
the most. Crises have been and are likely to remain largely an emerging
market phenomenon. The trend in listing abroad and subsequent
effects on what type of corporate governance system firms aim for has
been more important for developing countries (sometimes more than
half of local market capitalisation is listed or traded abroad; Claessens,
Klingebiel and Schmukler, 2002).
At the same time, many of these countries are furthest from the
frontier of change and their financial and other systems of governance
are less adapted to global integration processes. Many practices under
the heading of “financial repression” have been integral to the
(successful) development strategies of some of these countries, but sit ill
with standards developed in countries that now have a more liberal
environment. Consequently, the legal and regulatory institutions of
developing countries are often poorly adapted to international coopera-
tion and require extensive changes for the implementation of the new
standards. And developing countries have been less involved in the
formulation of the standards. Despite the informal input of the G-20
since its formation in 1999, few of the standards developed in recent
years have had major inputs from developing countries due to the
overwhelming representation of developed countries in the various
committees designing the new rules. As a result, the speed and extent
of changes are greatest for developing countries.
Despite the increased pressure for standards and the very real achieve-
ments in terms of convergence, the process remains incomplete. Global
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86 The Need for Institutional Changes in the Global Financial System
economic space is a long way from the single market of national level
economies. The integration process still links often disparate entities at
different levels of development or with different sorts of legal and institu-
tional practices. These differences lend volatility to, in particular, the
global financial system and they have a differential impact on the various
actors and economies involved. Effective convergence and standard
setting should put the emphasis more on obstacles to successful imple-
mentation and application as opposed to standard setting itself: for
example, the focus should be on getting firms to disclose rather than
enhancing disclosure rules. Even then, new issues will emerge, global
integration will remain imperfect, and standard setting will remain
incomplete. Other issues, especially those such as debt workout that are
in the main relevant to developing countries, will remain. The deeper
issue is whether the political and other constituencies for addressing
these questions are in the right place in a globalised world, which is a
question on the governance of the international financial system.
In short, both market structures and the preferences of the public
and private actors involved have been in considerable flux. As govern-
ments sought to promote competition and to loosen the grip of old
financial services coalitions on the governance of the sector, cross-
border integration was, in part, the result. The most market-
competitive financial institutions had long encouraged this process,
seeing considerable advantages to a more integrated system and better
access to other national markets and other market segments. The
structural changes that followed had a dramatic impact on the options
for financial institutions, which had to learn to cope with the new
environment, as did governments. The impact was not the least for
developing countries and their financial sectors. Governments and
international institutions alike were confronted with new policy
dilemmas that resulted from integration and capital mobility. Crisis
and instability led in turn to calls for a reassessment of global financial
architecture.
2 Public versus Private Views and Interests
In this section we take increased financial integration as a given and
examine the changing balance of power between public authorities and
private interests in international monetary and financial policies. This
has led, among other things, to shifting discourses of the “public
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Stijn Claessens and Geoffrey Underhill 87
good/public interest” in financial governance, especially as they relate
to the development process. Furthermore, it has led to the institution-
alisation of private sector interests in the policy process. The private
interests of developed country financial institutions are increasingly
evident in public policy outcomes concerning financial governance at
the national and global level.
The financial services industry has a long history of self-regulation. In
the post-depression, post-war world, however, there was a strong
determination by governments to ensure that the market dynamics of
the financial sector did not operate contrary to the public interest,
especially where stability and crisis were concerned. The emphasis was
on constraining market forces and integrating the financial sector into
national macroeconomic and economic development strategies: private
(sometimes state-owned) finance for profit, but subordinate to the wider
public good in a democratic or developmental state context (where many
European states were clearly “developmental” as well). Liberalisation,
cross-border integration, and associated institutional changes over the
past three decades have resulted in a greater role for the private sector,
less constrained by public policy priorities, at both national and global
levels. Within national financial systems, this increased role has come
about through the privatisation of state-owned banks, the deregulation
of interest control and credit allocations, the removal of barriers between
market segments and products and the general liberalisation of product
innovation. The dismantling of regulatory barriers has led to consolida-
tion in the financial sector, making for larger, more transnational players
confronting government.
These trends have in general resulted in improved financial sector
functioning, more stability and greater access of firms and households to
financial services (see, for example, Levine, 2005). More generally, the
private sector is accepted as crucial for successful financial sector func-
tioning. More contentious, however, is the debate about to what extent,
under what conditions, and for which policy goals public authorities
should cede prerogatives to private interests in markets when it comes to
financial sector regulation and supervision.
3
This is for at least two
reasons: the limits to private sector self-regulation; and the dynamics of
institutional change.
——————————————————
3
There are other arguments, not discussed here, as to what can be best done by
the private or public sector related to the general nature and type of public goods.
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88 The Need for Institutional Changes in the Global Financial System
2.1
Limits to Private Sector Regulation
In all market systems, collective action problems and the possibility of
market failure are prevalent. The resolution of these problems requires
some form of (private or public) collective provision of regulatory and
supervisory authority and policies. Nowhere is this more important
than in crisis-prone financial markets. Historically, the public and
private sectors have shared the development of regulatory and super-
visory functions and institutions. Thus as mentioned above, private
sector self-regulation is common in financial services industries. Even
where public sector authorities and policies played a dominant role in
the post-war period, self-regulation was usually part of the framework,
at the very least in terms of implementation.
This is in part because financial services provision is characterised by
the use of many and often interlocking networks. The market infrastruc-
ture for financial services involves network systems for trading, payment
and clearing, distribution (e.g. ATMs), and information. A need for
technical expertise and a high level of complexity in the sector plays a
role. These networks are often commonly shared and run on a not-for-
profit basis by participants themselves, as is often the case for credit
registries, or as for-profit organisations, as is the case for many stock
exchanges these days. The oversight structures for these commonly-
owned network infrastructures often involve self-regulatory arrange-
ments. Sometimes, these are purely private forms of regulation, as in case
of many clearinghouses, but often the private forms are mixed with
government oversight or delegated mandates. For stock exchanges, for
example, typically there will be a division of oversight responsibilities as
well as oversight by the public sector of the private sector’s own oversight
role. Self-regulation is also common in licensing expertise, as for broker-
age houses or for obtaining certified financial analyst licenses.
Self-regulation and self-regulatory organisations and associations are
likely to work well when the subsidiary body has more specific informa-
tion, better resources, a broader range of sanctions and more enforce-
ment powers.
4
Nevertheless, self-regulation has its limits (as does public
——————————————————
4
Self-regulation and self-regulatory organisations may be better able to judge the
quality of the application for a brokerage license, may have greater insights in what
constitutes market manipulation and have more information systems to detect such
behaviour. They may also be able to de-license, issue a reprimand (name and shame),
and impose financial sanctions, which may be more difficult for a government agency.
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Stijn Claessens and Geoffrey Underhill 89
sector regulation and supervision)
5
and needs to be coordinated with
other aspects of macro and microeconomic governance. Thus self-regu-
lation is typically embedded in the legal and regulatory fabric of national
policy communities and networks across a range of sectors.
There have always been limits to self-regulation, just as there are
limits to what public sectors can meaningfully do in a private market
setting. The main point is, who makes the rules and for whose benefit.
This question is highly relevant in a sector where the (short-term) private
gains from regulatory laxity or indeed semi-official cartel arrangements
can be considerable, and the longer-terms costs for the whole economy
likewise. Particularly following recent scandals in developed countries’
capital and financial markets, the limits to private market-based forms
of regulation and supervision have become more apparent.
6
These limits have been in part the result of structural changes in
markets, which are in turn linked to liberalisation and cross-border inte-
gration. Stock exchanges are losing their monopoly in trading, making it
harder to control activities through voluntary and club-type mechanisms.
The trend of privatisation and vertical separation of the various parts of
the financial market infrastructure, e.g. the demutualisation of stock
exchanges, and the separation and privatisation of central counterpart,
clearing and settlement functions, have made it more urgent to place
certain oversight functions with government agencies.
7
Indeed, the
public sector has stepped in to retain more or even to assume some powers
previously delegated to the private sector. This happened, for example,
with the accounting and audit boards in the US, and earlier with
securities markets regulation and supervision in markets like the UK.
——————————————————
5
There is much evidence that public sector regulation and supervision of banks
serve private interests or the interests of the regulators, rather than public policy
objectives (Barth, Caprio and Levine, 2005).
6
Why these problems have arisen now in what are otherwise very sophisticated
financial markets is less clear, but their emergence appears to correlate to the very
market-based liberalisation which is discussed in this section. As public authorities
have become more reliant on disclosure practices of firms, and the incentive
systems for corporate managers depend increasingly on market performance in a
situation of intensified competition (in line with the arguments concerning
“shareholder capitalism”), personal reward and the social functions of firms in the
economy have become increasingly intermingled.
7
Although it is hard to generalise in this area as many countries, especially
emerging markets, coming from more centralised models, are still in the opposite
process of giving greater responsibility to the private sector.
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90 The Need for Institutional Changes in the Global Financial System
The trends are also due to the breakdown in boundaries of once-distinct
market segments, particularly the trend known as “securitisation”.
Cross-border market integration and the more decentralised nature
of markets have their own dynamics, making the picture more
problematic. The coherence and shared norms of national financial
services policy communities is taxed by global integration, and the juris-
dictions of national agencies are tested. Credit and operational risks, for
example, have become more complex to assess across both functional
market segments and international boundaries. One can expect less from
self-regulation in stock markets when the concept of a stock exchange
has become unclear with the advent of new electronic trading systems
and participants have become increasingly diverse and international.
8
Markets have responded in some dimensions to the increased global
nature of financial activities. Clearing and settlement systems that deal
with credit risks have emerged (such as the continuous-time linked
system for banks), which have also forced coordination in forms of
transaction across borders. The increased use of technology has intro-
duced new risks, but private sector groups (such as BITS) assess these
risks and propose new approaches. The collective action clauses for
bond contracts that countries (both developed and developing
countries) under US or UK jurisdictions are increasingly adopting are
market mechanisms that have helped as well.
Many international markets and products, however, are too complex
to expect purely private forms of coordination to be fully effective.
How a handful of commercial banks and the government of major
developed countries contained the debt crisis of the 1980s, for example,
is no longer feasible. The multiple forms of financing combined with
large numbers of creditors and debtor countries make coordination
difficult in a crisis, as the events of the fall of 1998 showed, and risk
management by individual (national) agencies is insufficient. Financial
institutions are also more heterogeneous and are often involved in more
activities in multiple market segments. These trends make coordination
more difficult and they increase the risk of conflicts of interest (for
example, multiple interests, use of privileged information, etc.).
The problems of coordination and the potential for conflicts of
——————————————————
8
What type of (private or public) arrangements could one expect to cover a
trade between, say, a German and Brazilian investor of a French stock listed on a
US stock exchange, but traded on electronic trading system owned by a
consortium of international investors, but legally incorporated in the UK.
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Stijn Claessens and Geoffrey Underhill 91
interest have indeed become system-wide. Given the diversity of interests
among financial institutions and of national financial systems, it is
harder to assemble a coherent coalition of public and private actors for
designing new rules. Building institutions of governance at the global
level is costly and takes time. In the absence of public forms of
governance in which private self-regulation can be designed and then
embedded at the global level, one must be modest as to what can be
expected from alternative forms of rule-making, such as a Code of Good
Conduct, that has been under development for sovereign debt restruc-
turing in recent years.
Despite both private and public inputs, these processes have largely
represented creditor countries’ views with considerable deference to the
interests of private actors, and developing country issuers have so far
been rightly so more sceptical of their benefits.
9
The greater coherence
among large-scale, private financial conglomerates, which are simultane-
ously active in the markets and policy processes of a wide range of states,
enhances the risk that the rules may be designed so as to (largely)
benefit the private sector, in particular the more globally-active and
integrated institutions. Apart from the nature of the rules, to what
extent will the private sector have the incentive to enforce or to disclose
information concerning (non-binding) arrangements. We must at least
expect that developing countries will have more urgent and different
needs from either the private sector or creditor countries, and global
governance must reflect these needs if the development process is to be a
success. In the end, only cooperation among national public sectors or
properly global institutions can deal with free riders and enforcement.
2.2
Dynamic Effects
The dynamics of institutional change are complex in any policy
domain, particularly where the liberalisation of financial markets is
concerned. There are obvious links between the institutional environ-
ment and the successful functioning of the financial sector, as the law
and finance literature and recent financial crises have shown where
weak or missing institutions hamper growth or cause crises. The lessons
that the institutional environment needs to be consistent with speed
——————————————————
9
Developed countries’ market participants are also concerned about the new
codes, but more likely because they may lead to legal liabilities and thus costs
should they take the form of statutory or regulatory standards.
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92 The Need for Institutional Changes in the Global Financial System
and forms of financial liberalisation and deregulation are now more
accepted, although there are still many questions about what consti-
tutes an institutional environment appropriate to a particular type of
country at a specific level of development.
Liberalisation by definition cedes prerogatives to the private market
forms of interaction at the expense of public agencies seeking to direct
the course of economic development. While in many cases liberalisation
may accomplish public policy goals better than state intervention, it
will not always do so. This is particularly the case where endemic forms
of market failure, such as financial crisis, are present. An even more
complex issue is the dynamic by which economic reforms (financial
liberalisation, capital account liberalisation, and privatisation) affect the
balance between private and public interests in shaping the institu-
tional environment. History tells us that a variety of models can work,
but that some combinations clearly lead to trouble. These endogenous
forms of institutional change are still poorly understood.
These dynamics must be understood in terms of the nature of
policymaking in the financial sector, wherein the stability and
successful functioning of the financial system is closely linked to state
and wider public interests. Economic development and growth requires
successful financial intermediation, and states themselves are heavily
involved in debt and other financial markets: states thus need and
overlap with financial institutions. This situation is accentuated in the
case of developing countries. Given their (perceived) systemic impor-
tance, commercial banks have traditionally benefited from a large safety
net provided through various means (deposit insurance, lender of last
resort, etc.). Most financial services markets have some form of more or
less intrusive public sector regulation and supervision. Regulation and
supervision are unlikely to be successful without at least minimal
consent of the sector itself, and where this is largely private, the consent
of these private interests. This means that private financial interests
become privileged negotiating partners in these crucial policy processes.
Their preferences are the most likely to be enshrined as public policy,
particularly where states are anxious to attract capital for their own or
general development needs.
Furthermore, financial services are characterised by low transparency
and central banks have traditionally had close and relatively exclusive
relationships with banks and other financial institutions that fostered
this. Central banks are, after all, banks, and they certainly think more
like banks than they think like ministries of economic development.
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Stijn Claessens and Geoffrey Underhill 93
Given this closeness of public and private actors and their shared
interests in the policy process, the definition of public interest as
distinct from the interests of private sector itself is consistently difficult
in financial services industries, leaving greater scope for private interests
to affect rules and outcomes. Thus although many improvements in
the institutional environment have been a response to or codification
of market forces, regulatory capture is a persistent threat.
The forms in which the private sector may gain too large a stake will
vary by economy. In developed countries, they make take the form of
lobbying and regulatory capture, which may not breach formal laws but
can undermine public policy objectives. The role of the private sector
in lobbying for financial sector regulatory change in the US (say the
repeal of the Glass-Steagall act separating investment and commercial
banking) and some other developed countries has been well documented.
Heinemann and Schüler (2002) conduct a cross-country analysis on
supervisory systems and financial structure in Europe and find
empirical support for the private interest (Stigler) view on regulation
aimed at a “preference for laxity,” and less so for a “barriers to entry”
view. At its worst, lobbying for a regulatory framework of “shareholder
capitalism” deteriorates into Enron, WorldCom and securities market
scandals involving outright crookery.
In developing countries, the dynamics unleashed may, in addition or
instead, take the form of more overt corruption, e.g. banking licenses
up “for sale”, or a call for more securities markets regulation and super-
vision being ignored for (too) long as insiders have captured legislators.
Alternatively, there may be rampant clientelistic lending in which, for
example, industrial concerns are permitted to own financial institutions
and thus effectively lend to themselves at will, all of which goes un-
checked or is poorly supervised. Importantly, the dynamics can influence
the development processes in diverse national economies differently.
While in more developed countries, these problems may introduce
minor distortions and adverse growth consequences, in emerging
markets they can lead to financial crises with large output losses or severe
growth costs, and major wealth redistributions (Zhang, 2000).
While corruption and weak governance is not new, these dynamics
were not entirely anticipated. The breakdown of financial repression
and other institutions of developmental states was bound to be dramatic
and to result in a reshuffling of the political as well as the economic cards
(Zhang, 2002). Many reform and adjustment programmes still have
faltered for reasons of misjudging the dynamics, e.g. few foresaw the
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94 The Need for Institutional Changes in the Global Financial System
adverse dynamics of mass privatisation in terms of creating no or little
constituency for improving the institutional environment in transition
economies. While one cannot perfectly assess these possibilities ex ante,
an assumption of diversity among cases and greater attention to the
political dynamics of policymaking and legal institutions in various na-
tional settings would be a start. Global financial governance must take
such problems as starting points, not afterthoughts.
As an analytical exercise, the respective responses and capacities for
adaptation of different (public and private) actors relative to the speed,
type, and sequence of deregulation, privatisation, etc. in a dynamic
institutional environment need to be assessed. Here aspects such as the
expected drain of human capital from regulatory and supervisory
agencies or the anticipated rents to be earned from bribing officials
once a financial system is liberalised need to be brought into the
picture. In addition, in liberalising institutional investors, one should
anticipate shifts in regulatory preferences, e.g. preferences for different
(better or worse) regulation, supervision, and corporate governance.
10
In essence, though difficult to predict, the changes in market structure
and institutional and normative framework of governance needs to be
plotted against potential changes in actor preferences.
At the international level, evidence is less abundant, but the dynamics
are no less troublesome. Private banks have clearly played a major role
in pushing for cross-border liberalisation in both developed and
developing countries. As liberalisation began, the coherence of private-
public sector interactions at the national level was diluted, but the
jurisdictions of state agencies remained constrained to the national level.
Despite some eventual successes such as the Basel process, cross-border
cooperation was, as always, difficult and slow to emerge. Furthermore,
it tended to be crisis-led since crises forced national authorities into
more supervisory or other cooperation. Private interests (free of
cumbersome questions of sovereign or legal jurisdiction) were much
quicker to regroup in coherent coalitions at the international level, for
example the Institute for International Finance (IIF), and private
preferences of globally active institutions tended to converge quickly, as
noted above. Once again, the influence of private interests in evolving
mechanisms of global governance may have been too strong. It has been
——————————————————
10
In addition, the effects of changes in regulation on financial institutions’ and
financial markets participants’ profitability and franchise value would be analysed,
and how that in turn may affect the ability and incentives to manage risk over time.
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Stijn Claessens and Geoffrey Underhill 95
argued, for example, that the Basel II capital accord reflects private
interests to a much greater degree than did Basel I (Soederberg, 2002;
Wood, 2004). Supervisory agencies were involved in close relationships
with international banks as their essential consultative partners in the
negotiations. Banks were particularly effective in making their case in
what ended up being very technical discussions (see further Claessens,
Underhill and Zhang, 2003 for this argument).
Dynamics at the international level also have implications for develop-
ing countries. Again, as for domestic liberalisation, there can be benefits.
A process of international liberalisation and greater financial integra-
tion can constrain discretionary macroeconomic policies, which can be
(more) valuable for inflation and debt-prone emerging markets. As in a
domestic context, these beneficial pressures of the private sector can
take many forms depending on the individual case (e.g. better stan-
dards for credit cards as international lenders enter). On a system-wide
basis, there have been many beneficial forms of global self-regulation,
such as the various standards mentioned before. But there can be
perverse consequences, maybe even more so than for domestic trans-
actions and institutions.
For one, a global system is far from transparent and considerably
dilutes the influence of developing countries on financial markets.
They face the power of both public and private agencies of developed
countries, often in coalition with each other. Lines of authority are far
from clear and developing country preferences are difficult to enforce in
the light of urgent development needs. Geopolitical and other factors
add extra spin to the problem. There are thus more degrees of freedom
for the private sector to operate in ways favourable to their own interests
rather than in line with broader international or national development
goals. In many markets, especially developing countries, foreign players
have a large role in domestic financial markets and can “threaten” na-
tional agencies, thus gaining a stronger voice than the public interest calls
for. This can be done directly, say in case of emerging markets and devel-
oping countries in times of financial distress, as the arguments used for
(many) bailouts by governments of foreign investors. Or it can be by
having international agencies pursue policy conditionality on inter-
national aspects more favourable to private interests.
Although it is less likely than it would be in a domestic context to take
the form of corruption, the consequences can be equally severe. The
financial bailout of crises, for example, seems to have benefited inter-
national lenders disproportionately at the cost of domestic investors and
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96 The Need for Institutional Changes in the Global Financial System
taxpayers, especially the poor. When these outcomes confront the
legitimate and democratically expressed policy preferences of developing
countries, the dissonance is considerable, and they find themselves with
little influence on the norms and outcomes set by global governance
processes.
As noted, global arrangements such as the Basel Committee are
characterised not only by low transparency but may have furthered
private sector interests to the detriment of developing countries, are even
less accountable to their national interests, and may have aggravated
matters (see Coleman, 1996). The (long-ongoing) debate on sovereign
debt restructuring mechanisms is another example. The private sector, in
particular financial intermediaries, has argued against debt restructuring
mechanisms since according to them, those would lead to higher costs
of debt. More likely, however, their opposition is motivated by the fact
that, as investors, they will be worse off since such rules will in part
reduce the scope for moral hazard and (unnecessary) bailouts. Private
interests resent potential constraints on their freedoms even when it
can be clearly demonstrated that debt workout arrangements, which
work perfectly well at the domestic level, would be better for all,
including the banks, in global crisis situations (Miller and Zhang,
2000).
The issue is not so much that private parties will argue for their own
interests, but rather that the institutional framework and the position of
all actors do not allow for a proper balancing of private and public views
and of various countries’ views. Global level governance is not anchored
in the sorts of chains of (democratic) accountability that serve to amplify
the voices of weaker actors at the domestic level. Private bondholders or
taxpayers, perhaps more interested in clear rules, may be less organised
than commercial banks that benefit from less clarity. Countries may
face conflicts of interest or time-consistency problems in terms of
pushing for solutions. The outcome may not only be unfair, but also
inefficient. In many cases, there have been delays and the lack of public
regulation has not been filled by global self-regulation, or vice versa.
3 Design of the International Financial System
In this section, we investigate how to analyse the design of inter-
national policymaking structures and institutions given the identifiable
problems facing the international financial system and preference-setting
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Stijn Claessens and Geoffrey Underhill 97
in national contexts. Here, the basic question is whether the rules under
which the international institutions currently operate are the “right” ones
from a first principles point of view. The question can be addressed
using several types of approaches, some of which we will discuss.
3.1
A General Public Economics Approach
A general public economics approach can be used to analyse the design
of international policymaking structures and institutions, given the
identifiable problems facing the international financial system and
preferences developed in national contexts. A useful starting point is
the definition of global public goods related to the international
financial system, fulfilling the criteria of non-excludability and
indivisibility (consumption by one or many does not reduce availability
for others).
11
These public goods could include: international financial
stability and efficiency; adequate reliability of contracts and property
rights backed up with the presence of efficient, ex post enforcement
mechanisms; a lack of abuse of the international financial system for
purposes deemed economically undesirable (e.g. financing of polluting
activities or those adding to global warming) and other global merit
public goods. Complementary, the potential tools for ensuring the
provision of such public goods would need to be identified (e.g. taxes,
quantity restrictions, policy harmonisation, disclosure, specific rules or
institutions), a far from obvious exercise, but not the focus of our
analysis here. (Of course, many of these global public goods do not
relate to the international financial system alone, and as such may
require other analyses, tools and interventions as well.)
Once the global public goods and potential and necessary policy
interventions to achieve such goods have been identified, questions to
be addressed include: what global public policy issues should and can be
productively delegated to international levels (or sophisticated forms of
transnational coordination). Correspondingly, what forms of represen-
tation should exist at the international level, given a set of national
——————————————————
11
One can further distinguish “merit” goods and other, “welfare” goods. As an
example of the latter, citizens of developed countries may well care about the welfare
of citizens of developing countries, not just because of their own interests, and
therefore a certain design of the international financial system may be perceived as
more desirable. Here we focus largely on the question whether the design of the
international financial system is best in terms of delivering merit goods.
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98 The Need for Institutional Changes in the Global Financial System
preferences and a need for national forms of representation. More
specifically, many problems in international financial markets have to
do with coordination issues, as in times of financial distress or financial
crises. What arrangements might lead to the best resolution of the
collective action problems inherent in many aspects of international
financial governance. As a very specific question, what governance
structure is preferable for an international lender of last resort or func-
tional (cooperatively-based) equivalent.
12
Or more broadly, what
constitutes a consistent set of national and international forms of
representation that effectively provides for necessary public goods at
the global level, yet at the same time respects the process of preference
formation at a national or regional level.
Obviously, the design and functioning of international organisations
is a broad area, on which much research has been undertaken (by
political economists, political scientists, and international legal scholars).
Questions on the issue of enforcement especially need to be addressed.
Countries are notionally sovereign, despite power differentials and the
constraints of interdependence, and can always ex post deviate, as has
been observed for both developed and developing countries (e.g. the ex
post deviations from the EMU Growth and Stability Pact and the many
defaults on international contracts). At the international level, the basis
for successful governance is clearly an underlying consensus on the
tools and objectives of cooperatively-designed policies. Nonetheless, to
be effective, agreements and institutions also need to be self-enforcing
(including dispute-settlement mechanisms) or to derive their commit-
ment from either clear positive incentive structures for all parties or
from political enforcement mechanisms. Given power differentials, this
has many implications, among others for representation, and the form
and impact of competition among international agencies. Even the
powerful must be subject to the rules.
In a domestic context, a majority system may deliver the first best
outcome on how to assure the provision of national public goods
(although even this is not clear in the context of say information
asymmetries or prevalence of interest groups). Even so, provision for
minority opinion and rights is an important part of domestic democratic
governance. In an analysis of the preferred voting system for interna-
tional agencies, however, it has been found that under self-enforcement,
——————————————————
12
The lender of last resort is different from that played by the IMF so far (see
Fischer, 2003).
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Stijn Claessens and Geoffrey Underhill 99
unanimity is most often the optimal system (Maggi and Morelli, 2003).
This unanimity principle is not dissimilar to how cooperatives,
including financial cooperatives such as rotating savings associations,
work in low or weak contracting environments. Whether this result
applies to international finance and international financial organisations
more generally is, as yet, unclear. Certainly, the general difficulties of
unanimity systems in yielding effective decisionmaking and in coping
with power differentials are not unknown. The need for speed and
efficiency in decisionmaking, important in financial markets, militates
against the unanimity principle. Formally, we observe mixtures of
unanimity and majority-voting systems in international financial
organisations, although in practice unanimity decisionmaking is most
commonly, even in majority systems. Thus, decisionmaking in interna-
tional cooperative environments regularly hinges on broader perceived
national interests, not just interests related to the narrower mandate of
the specific organisation, e.g. financial stability. Yet, this can clearly
sometimes lead to unfair outcomes. In the context of the HIPC debt
reduction initiative, for example, relatively poor developing countries
like Costa Rica that were creditors to HIPCs were obliged to accept
official debt reduction even though they had no say in the design of the
HIPC initiative.
Another issue is that the lack of enforcement mechanisms can lead to
unwarranted competition among international organisations. Agencies
must continuously demonstrate their value to members: that the costs
of deviating from the particular arrangement are higher than the
benefits of staying in. This creates competition, which may explain the
continued flux of private, public and mixed agencies involved in inter-
national financial affairs (for example, the G-20 and the Financial
Stability Forum are newly established). Since investments are costly
and highly specific, especially in financial markets, there are neverthe-
less limits to competition and switching, thus sustaining international
institutions to some degree. Furthermore, legal conventions provide
some international agencies with authority in specific areas (e.g. the
IMF and World Bank through the Bretton Woods conventions).
The recent changes in international financial markets nevertheless
affect the ability of some agencies to sustain themselves, with some
declining in importance (for example, the Group of Thirty was more
important some years ago) and others increasing. International agencies
also adapt, of course, as the BIS/Basel process has done (moving from
the interwar role of a bank for settling national debts to a forum for
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100 The Need for Institutional Changes in the Global Financial System
international monetary policy coordination among central bankers and
somewhat of a global financial regulatory body (see Felsenfeld and
Bilali, 2004). And the Institute of International Finance has altered its
focus from being a depository for and clearing-house on country risk
data and analysis concerning the 1980s debt crisis to an advocacy
group for international commercial banks. There is some considerable
path dependency, of course, and as such it is hard to generalise about
how the international financial system will evolve, but one can be
sceptical whether, with such dynamics, it will lead to the most efficient
outcome. Since little research has been done in this area, however,
answers remain elusive for now.
3.2
Agency Approaches
Another approach would be based more on principal-agent, agency
perspectives and game-theoretical approaches. Taking thus a more
political economy but still rational choice approach, one can try to adopt
an agency perspective to the international financial system. Principals in
various groups try to pursue their own interests with agents in various
forums voting on their behalf. Here one can think of lobbying models
where lobbying has rewards for interest groups because it affects
decisionmaking. The “technology” for affecting decisions can be
through direct payoffs, through bargaining, or by using informational
advantages. Lobbying may have first mover advantages (full competi-
tion in lobbying may otherwise lead to degenerate results), treats points
may arise from other areas (e.g. international politics), and informa-
tional advantages may arise from superior knowledge or resources. This
approach has already been applied in case of domestic financial reforms
(see for example Pagano and Volpin, 2005; Perotti and von Thadden,
2004). In less democratic countries, lobbying on legislation and
enforcement can have a major impact on financial development and
thus entry. In highly unequal countries, poorer elected politicians and
poorly paid public officials may be more vulnerable to offers of bribery.
Then lobbying allows smaller groups to exert a disproportionate
political influence on legislation or its enforcement, as first noted by
Olson (1965). Olson also observed that collective purposes and action
are more easily undertaken by small, single purpose organisations than
by broad, multi-purpose coalitions. In short, this literature models legal
and financial institutions as the outcome of political choices.
The international context is even more complex. One approach is to
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Stijn Claessens and Geoffrey Underhill 101
model it as a two-step agency problem, with private principals
(“citizens”) interacting with governments as agents at the national level,
and then, at the international level, governments as principals inter-
acting with international institutional “agents” like the FSF or the IMF,
as well as private agents, like IFIs. The risk is that specific private
interests, rather than the general public interest, become the main
principals and governments/public agencies their agents. Furthermore,
power differentials mean that only the more powerful countries can
realistically expect international institutions to behave as agents.
One can also analyse the international decisionmaking processes
using a game theory approach, again possibly in two steps. Private
groups bargain with public agencies and in turn, governments bargain
with international agencies, and sometimes international agencies
bargain directly with private interests, each having certain strengths
and threat points. While these and other types of models have been
used and empirics have been conducted on the political economy of
domestic financial reform, so far, few of these approaches have been
applied internationally. Likely, it will remain difficult to make any
statements on what these approaches will teach us about the design of
the international financial system since there are so many parameters to
consider. Furthermore, antagonistic bargaining models do little to
account for the close links between (national or international) public
institutions and private sector organisations, including the potential
prevalence of capture. Just because we consistently distinguish
analytically between public and private sectors does not mean that their
interests in governance necessarily diverge.
Related to these approaches would be efforts to identify the principal-
agent combinations or coalitions interested in international financial
reform. In a domestic context, one can expect, for example, shareholders
to be interested in voting on corporate governance reform, or depo-
sitors to be possibly interested in better banking system regulation and
supervision. Although relationships are very indirect, cross-country
analysis has indeed found relationships between financial and
ownership structures and the interest in such reform on the one hand,
and actual reform on the other (see Pagano and Volpin, 2001 for a
review). Some empirical analyses exist of international financial
decisionmaking, such as the role of political factors in IMF and World
Bank adjustment lending programmes or the allocation of official
development assistance (Alesina and Dollar, 2000). But further
empirical analysis at the international level is needed.
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102 The Need for Institutional Changes in the Global Financial System
These rational choice perspectives can provide valuable insights into
the likely ways in which different sorts of interests in a given setting are
likely to interact. However, the models will at best remain suggestive of
correlations between actor preferences, e.g. principal-agent relationships,
and actual decisionmaking outcomes. Models have difficulty demon-
strating definitively who or what, with which preferences, led to which
outcomes in the sense of causation, particularly where public and private
interests interact closely and consistently in a specified institutional
environment, yielding a process of socialisation to accepted norms, ideas,
and practices which may exclude even demonstrably necessary policy
alternatives. In the end, there is likely to be no substitute for detailed
empirical research into the preferences and relative resources of actors,
the institutional settings in which they interact, and the resulting coali-
tional politics cutting across national and institutional boundaries that
lead to outcomes.
3.3
Lessons from Current and Historic Arrangements
Analysis, theoretical and empirical, is likely to show that many of the
current institutional arrangements lack essential economic and political
justification. This is surely true of long-existing institutions like the
IMF and World Bank where the current percentage representation of
shareholders no longer reflects the relative economic or financial
importance of countries. Voting processes do not necessarily satisfy any
optimal voting model in terms of either representation or decision-
making efficiency. There is already a debate underway that can help
clarify the preferred structures as well as shed light on the underlying
political economy factors.
Similarly, sub-optimal and unrepresentative processes have developed
recent reforms to the international financial architecture, with commen-
surate defects. Which precise policy gap was the Financial Stability
Forum intended to fill and why did it emerge with its specific composi-
tion of countries (G-7 plus some international organisations). The
various G-groups (G-7, G-8, G-20, etc.) are outside the formal institu-
tional framework, yet they are very important in building coalitions
driving specific policy and institutional changes. How might they be
conceptualised. What was the anticipated role of the G-20 and why does
it include these specific countries. How do these organisations and
groups function in practice and how does this relate to their stated
objectives, if any. Was the G-20 only an attempt to co-opt the non-G-7
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Stijn Claessens and Geoffrey Underhill 103
countries into the rules and standards of the G-7, has it been dominated
by the United States, or has it led to genuine broader representation.
Much can be learned from analysing the political economy of the
origins and the effectiveness of these recent and older international
institutional arrangements.
13
Lessons can also be learned from the EU/EMU and other regional
(financial) integration efforts (NAFTA, EFTA, AFTA, Asian Monetary
Fund). The evolution of the EU has been a long political process, and by
now it has developed considerable depth to its institutional processes to
replicate domestic policy choices and domestic politics, often by
integrating EU processes and policies into national politics. While the
EU will not be easily replicated and represent the only significantly
supranational model so far, it can provide useful lessons in governance
and institutional change in international finance. The EMU, for
example, has meant member central banks and treasuries had to give up
all autonomy in monetary policy. One might set out to determine under
which conditions increased monetary and financial integration has been
associated with productive institutional changes leading to better regula-
tion and supervision and enhanced stability. Also in other financial
services areas, the EU has been debating how best to balance changes and
harmonisation in rules with institutional changes, like home supervision.
More generally, what has been the impact of the shifts in balance
between national and supranational or international agencies and the
increased financial integration on national authorities’ decisionmaking in
the EU or other regional arrangements. Have substitute arrangements
——————————————————
13
See Soederberg (2002) for an analysis of the FSF and the G-20. Other possible
arrangements to analyse include: How did the Basel II process come about. What
was the role of the private sector in the design of Basel II. What was the role of
various groups of countries, developed/developing countries. (See Claessens,
Underhill and Zhang, 2003, for some analysis.) Idem for the SDRM: what was the
role of the private sector in affecting the outcome, why was there no eventual agree-
ment. Or what motivated the change in the recent decade at the IMF in terms of
more openness and more scru tiny, including having its own independent evaluation
department. Has it meant different decisionmaking processes. Or what has trig-
gered the private sector to come up with rules, are these good rules, when does it
work and when not. A new Code of Conduct, for example, is being designed on
dealing with financial crises. Or regarding global efforts currently underway on
having firms from developed countries provide more transparency aimed at
reducing corruption, but being resisted by selected interests, e.g. oil companies.
What are the political economy circumstances that allow this to h appen. Do these
efforts reflect private market interests only or do they have a public policy value.
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104 The Need for Institutional Changes in the Global Financial System
emerged. One of the areas where little progress has been made is in the
lender of last resort, which was once the responsibility and in practical
terms lay within the capacity of national authorities. The unification of
monetary policy and the intensified integration of EU financial markets
imply these arrangements no longer apply. Why is it that this area has
been so more difficult and what does this suggests for efforts on
establishing a lender of last resort at the global level.
There are also historical lessons on some of these issues, including
from federalisation in countries such as the US and Mexico. In the US,
some have argued that the competition for capital has led individual
states of the union to offer relatively strong property rights. The key to
the successful race to the top was a common federal structure in which
freedom of movement of capital and labour was assured. Lessons from
Mexico suggest that a federal structure does not always deliver this,
because there also needs to be institutionalised political competition
among states (Haber, 2004).
There are similarities here with the debate on race to the top or to the
bottom in the context of financial competition among states and
countries. It has been argued, for example, that the ability of US
corporations to incorporate in the state of their choice (often Delaware)
led in some regards to lower standards corporate governance because as it
has allowed for more entrenched management by facilitating various
takeover protections (Bebchuk and Cohen, 2003). Others have argued
that this form of competition has led to improved corporate governance
and better firm functioning (Romano, 2005). Yet, others again have
argued that only the intervention by the federal state has restrained
individual states from offering worse environments and triggering a race
to the bottom (Roe, 2003). When does federalism deliver which results.
Of course, if the analogy is to work at the international level, we
need to consider competition among sovereign countries rather than
units of a federation and how competition for capital among these
units compares to the current internationalisation of financial services.
Again, the EU might provide some lessons here. In some areas like
banking, the EU has chosen a model of minimum harmonisation and
subsidiarity, with free competition, whereas in the area of securities
markets more uniform standards are being sought. What explains the
difference in approaches. Is banking a more local activity than capital
markets and thus less in need of uniform rules (unlikely). Was this
indeed the optimal arrangement balancing issues of efficiency and
effectiveness. Or is banking less transparent and more subject to
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Stijn Claessens and Geoffrey Underhill 105
preferential treatment by government of local champions and is full
harmonisation therefore less desirable from a political, rather than
economic perspective. To what extent do EU members actually compete
over policy, or was there a broader, transnational consensus among the
associated actors in the process. Is it the case, because competition
among individual countries largely takes place in financial markets (e.g.
through “beauty contests”), that it leads to the maximisation of private
interests. Are there forums where (collections of) countries compete
mainly in terms of public interests.
3.4
Towards a More Political Economy Approach.
As pointed out at the outset of this chapter, the tensions between the
achievement of global and national development objectives in a world
of fragmented governance, multiple institutions, accelerated financial
integration and increased private sector roles need to be better
understood, and we are just at the beginning of this analysis. To
understand these relationships and what to do about them, it is clear
though that one needs to more fully consider both the political and
economic dynamics at the national and international levels.
One needs to begin by clearly identifying the incentive structures of
both markets and policymaking institutions, and how they simultaneously
contribute to the integration of financial markets and many of the policy
dilemmas we have identified. By beginning with the preferences of actors,
one can begin to understand the pressures for change. One then needs to
understand how these preferences emerge from particular institutional
and market and institutional settings. By setting the preferences of actors
in their context of the markets and the institutionalised policy processes
of the state and international regimes, one can hope to better understand
how actors compete simultaneously for both political and economic
resources in order to shape their environment in their own image or
interest. This helps to clarify the inherent endogeneity of most variables
contributing to the eventual dynamic outcome. While parts of this chain
have been analysed, the full process is yet unclear.
4 Legitimacy of the International Financial System
Finally, there are issues of how policy processes and institutions at the
global level might become more accountable and outcomes more legiti-
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106 The Need for Institutional Changes in the Global Financial System
mate in relation to the policy preferences of citizens of all economies, in
particular the developing world. This concerns both the compatibility of
any global financial architecture with national economic development
aspirations and political processes as well as the bonding value derived
from the international system. Here the question of power differentials
competes with issues of representation. What is legitimate for the
powerful, based on the shareholder principle, is not always representa-
tive, and therefore legitimate, for those most likely to be affected by the
decisions taken. Furthermore, as was pointed out in Section 3 above,
forms of representation should respect preference formation at national
and regional levels. If such forms of representation not only stimulate
legitimacy, but also serve as catalysts for broader and more successful
international development processes, the economic benefits for all are
not difficult to demonstrate. Let us remember that the “democrati-
sation” of western European economic development processes in the
post-war period was also accompanied by the most astounding
improvement in economic performance. Representation and efficiency
need not work against each other.
In the eyes of some, the international financial system has been
undergoing an identity crisis. The failure to deliver on many of the
goals set out by international development agencies, the debt problems
of low-income countries, the difficulties in crisis management, among
others, all raise questions in the eyes of the general public on the
validity of the international organisations involved. The agencies and
the system more broadly are seen as failing to prevent or otherwise
successfully confront the major challenges they were supposed to
address, especially the setbacks to the development process represented
by persistent financial crisis. Of course, this is not the only point of
view. Where developed countries are concerned, the international
financial system has performed relatively well in the last three decades.
For example, the system has done well in terms of dealing with large
structural changes and has not faced the type of 1971-73 crisis
associated with the breakdown of Bretton Woods. Nonetheless if we
are to assess outcomes in terms of representation and in relation to
fairly simple notions of political legitimacy, clearly the decisions of a
minority of the powerful, the shareholder principle, has prevailed and
has imposed important costs upon those poorly represented in global
financial governance.
The different perceptions can in part be attributed to changes in the
world. One can make a case that developments have been forcing
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Stijn Claessens and Geoffrey Underhill 107
changes on international organisations for which they were not well
equipped because their original mandates were different. Institutions like
the IMF and World Bank responded to the changes in part by
broadening their agendas and taking on issues such as (global) environ-
mental performance, socio-demographic issues, and more generally
pursuing a more complex vision of the development process, relying in
part more on private sector activities. As part of this, they became more
open and participatory in their decisionmaking, making their rela-
tionships with client countries, donors and other agents (like NGOs)
more complex and risking (greater) client capture. It has also made it
more difficult for them to explain their usefulness to their shareholders
and other stakeholders, all the more so since they lost their traditional
tools in part. A vicious circle of ever more responsibilities and subsequent
failure to meet expectations for many of them resulted in even deeper
legitimacy crises for some agencies. Furthermore, one might argue, we
could not expect IFIs to change faster than their (more powerful)
members. But this account fails to bring in the role of private interests
in the policy process as discussed above, and how private preferences
have considerably reinforced the instincts of the creditor countries in
international institutions.
Many of the other international financial agencies and organisations
– such as the BIS, the Basel Committees, the FSF, etc. – do not operate
in the public eye as the Fund and the Bank do, and as such they do not
face similar goal and legitimacy crises in the eyes of their members. It is
national authorities in the first instance that address their functioning,
including the legitimacy of their policies in relation to domestic
political processes. Yet, they are not immune to problems of legitimacy
in a broader sense. The lines of accountability to national authorities of
an institution such as the Basel Committee, let alone to parliamentary
scrutiny, are less clear than their association with their private interest
interlocutors. They may appear to redress the balance between self-
regulation and sufficient public oversight of the global financial system,
but the rules they promulgate are remarkably in line with private sector
preferences.
They fail a legitimacy test in another respect. Even if one were to
accept that they are fully accountable to national policy processes, the
decisions that they take affect a far wider public than their G-7/G-10
“shareholders”. Legitimacy of the international financial system thus
needs to be conceptualised more broadly, relative to the often-
contrasting interests of the many developed and developing economies
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108 The Need for Institutional Changes in the Global Financial System
in the world today. To whom should the system be accountable, and in
whose eyes and for what purposes should the system be legitimate. It
may be helpful to think in terms of the standard categories of input and
output legitimacy (Scharpf, 1999) where input aspects of legitimacy have
to do with the legitimacy of the process, and the output side concerns
the legitimacy of the outcome. In the developed countries, private
interests and public agencies dominate the input side regarding the inter-
national financial system. Consequently, it is not surprising that the
outcome is relatively satisfactory to developed country governments and
(despite some protests) largely to their public. However, the process
(input) is singularly unrepresentative of developing country interests, and
it is not surprising that such a process leads to an outcome that is often
incongruous with the broader objectives of economic development. Why
should developing country preferences not be equally well represented,
so that international norms are compatible with national political and
economic dynamics, and not the other way around.
Solutions may have to be found in building regional coalitions among
developing countries and moving away from individual assessment by
markets and international financial institutions to representation and
assessment of collective interests. One such example was the role of a
number of developing countries in the Doha Round of trade negotia-
tions, where they steered towards outcomes much more favourable to
developing countries. Another example is NEPAD (New Partnership
for Africa's Development), which relies, among other things, on
countries designing their own reform programmes and on extensive
peer monitoring. Such mechanisms may discourage downward “policy
competition” among countries, increase regional representation and
rebalance power away from the “centre”. Another mechanism is the
financial support provided by the UK and Dutch development
ministries to the executive directors in the IMF and World Bank that
will help increase their “voice.”
5 Conclusions
There is little doubt that the interests of developed countries predomi-
nate in current global financial governance processes, via the “share-
holder principle.” Financial globalisation has also involved a change in
the balance of power between public authorities and private interests in
international monetary and financial policies. This begins at the national
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Stijn Claessens and Geoffrey Underhill 109
level in developed countries where financial services policymaking is
characterised by low transparency and national central banks have
traditionally had close and relatively exclusive relationships with banks
and other financial institutions at the national level. As national autho-
rities have taken on market liberalising policies closer to private sector
preferences, this situation has become increasingly extended to
financial governance at the global level, where the private interests of
developed country financial institutions are increasingly evident. Given
this closeness of public and private actors and their shared interests in
the policy process, it is not surprising that private interests are
predominant in determining rules and outcomes in domestic financial
systems.
How the private sector gains this stake varies by economy. In devel-
oped countries, closed-circuit lobbying or even regulatory capture may
occur, not breaching formal laws but undermining broader public policy
objectives. In developing countries, more overt forms of corruption may
be more common, e.g. banking licenses up “for sale.” It is not just the
static effects that matter. Many reform and adjustment programmes have
faltered because of misjudgements about the dynamics of liberalisation
and privatisation, which are related to political economy factors. For
example, few foresaw that the dynamics of mass privatisation in transi-
tion economies would leave little or no constituency for improving the
institutional environment. Few foresaw how private financial interests
would commandeer state-initiated liberalisation processes, undermining
the necessary adaptation of financial supervision to the new market
forces, which was a crucial ingredient of the Asian Crisis. In many
countries, a call for more securities markets regulation and supervision
was ignored since insiders captured legislators and regulators.
Global financial governance also has faced such issues. At the inter-
national level, private banks have clearly played a major role in pushing
for cross-border liberalisation in both developed and developing
countries. Their influence operated through both national and IFI
policies to this effect. As cross-border liberalisation began some two
decades ago, the effectiveness of regulation at the national level was
diluted, but the jurisdictions of state agencies remained constrained to
the national level. Cross-border cooperation and supervision has been,
as always, difficult and slow to emerge and tended to be crisis-led.
Private interests were much quicker to regroup in coherent coalitions at
the international level, pushing their preference for “governance light.”
At the level of global financial governance, developing countries face
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110 The Need for Institutional Changes in the Global Financial System
the power of both public and private agencies of developed countries,
often in coalition with each other. Geopolitical and other factors add
extra complications to the problem. The resulting lack of financial and
other regulation at the international level in line with broader national
development goals has left more space for the private sector to promote
its own interests.
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. This has been pursued either directly at the
local level, or by using the home developed-country state in bilateral
negotiations, or indirectly through the conditionality and debt workout
terms pursued by IFIs and determined by (home) developed country
shareholder power favourable to private interests. Global arrangements
such as the Basel Committee and other standard-setting bodies
dominated by developed countries have aggravated matters by
furthering overseas private sector interests to the potential detriment of
local needs in developing countries.
In the eyes of some, and as a reflection of these governance weaknesses,
the international financial system has been undergoing an identity
crisis. This assessment of course varies according to perspective. The
early experiences of developed countries with liberalisation were
fraught with difficulty. Most underwent serious national banking crises
(e.g. Scandinavia, the US), and the growth of cross-border markets
produced international crises such as the Franklin National/Bankhaus
Herstatt (1974), Banco Ambrosiano (1982), the post-1982 Latin
American debt crisis, BCCI (1992), or the Barings incidents where
contagion risked the downfall of the system. Since the early 1990s, the
international financial system has performed relatively well for these
countries. For the rest of the world, the view is different.
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 eventual legitimacy of international financial govern-
ance and of the organisations involved. While some observers may assess
the international financial system in a positive light, we nonetheless need
to assess outcomes in relation to representation in decisionmaking
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Stijn Claessens and Geoffrey Underhill 111
processes and to the legitimacy of the outcomes. Clearly, the shareholder
principle has prevailed and has imposed important costs upon those
poorly represented in global financial governance. This principle
correctly gives voice to the wealthy, but it allows substantially reduced
input to those most affected by the decisions themselves.
These serious deficiencies in the governance of the international
financial system point to the need for reform. Fundamental issues of
political economy are at stake: the role of publicly accountable institu-
tions 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. Many of these questions have been around for a long time
(going back to Smith, Marx, or Prebisch), and have been the root of
intense past and current debate (e.g. how to avoid a democratic deficit in
the EU). They are far from easy to resolve. Nonetheless, if development
policies prove consistently ineffective, the legitimacy of national
instances will remain impaired, exacerbating the problem and making
new initiatives even more difficult. Furthermore, if global level decisions
based on the shareholder principle clash systematically with development
objectives set in a context of emerging national democratic processes, the
legitimacy of global governance will be in question from the ground up.
If the weak are only heard when their opposition can no longer be
ignored, it is probably too late to come to a workable compromise solu-
tion. Surely, anticipation is not beyond human capacity.
We argue therefore that greater attention to issues of legitimacy and
accountability is likely to generate financial governance more in line with
broad international development imperatives. Furthermore, a better
understanding of the role of private interests in the current process of
cooperation in global financial governance will lead to a better under-
standing of not only the problems of the system, but also of how to
resolve them. In each section, we have identified insufficiently addressed
research issues, which can be tackled through advances in economic and
political economy research tools, and with the benefit of more data.
Our main conclusion though is that one must take problems of
governance and legitimacy as starting points, not afterthoughts. The
legitimacy of the international financial system needs to be conceptual-
ised more broadly, relative to the often-contrasting interests of the
many developed and developing economies in the world today. To
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112 The Need for Institutional Changes in the Global Financial System
whom should the system be accountable, and in whose eyes and for
what purposes should the system be legitimate.
Long-run developmental successes such as those in East Asia are,
after all, against the interests of no one. 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, toward representation and
assessment of collective interests. One such example was the push by a
number of developing countries in the Doha Round of trade negotia-
tions towards outcomes much more favourable to themselves. Another
example is NEPAD (New Partnership for Africa's Development),
which relies on countries designing their own reform programmes and
on extensive peer monitoring among other things. Such mechanisms
may discourage downward “policy competition” among countries,
increase regional representation and rebalance power away from the
“centre”. We hope that more progress like these can be made for which
further research can help.
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115
7
The Democratic Deficit of
International Arrangements
José Antonio Ocampo
he chapter by Stijn Claessens and Geoffrey Underhill lends a lot of
support to the thinking of one of my predecessors in ECLAC,
Raúl Prebisch, that the current global economic system has become
increasingly a centre-periphery system. Second, it lends a lot of support
to the ideas of Karl Marx, that private interests can be powerful in
determining what sort of regulation they are under. And, third, it lends
support to the European discussion on the democratic deficit of inter-
national arrangements. Because of these three things I like the chapter
very much.
The three basic ideas of the chapter are, first, that changes in the
system are too
much driven by the developed countries, or actually by
the dynamics in the private sector in the developed countries. Second,
that the lack of transparency that the rule-making under those inter-
national arrangements generates, facilitates the capture of the regula-
tory authorities. And third, that there are significant “legitimacy” issues
in the international system – to put it more gently and more in the
terms of the authors.
It is interesting how the dynamics work in the discussion on Basel II,
or in the discussion of debt restructuring mechanisms. The chapter by
Stijn and Geoffrey points this out very clearly. However, in the case of
the Sovereign Debt Restructuring Mechanism (SDRM), it does not
mention the important issue that some large or well-organised
developing countries can have a powerful role in the debate. Because
after all, the only developing countries that have been able to influence
the debate are the largest, or the best organised developing countries.
T
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116 The Democratic Deficit of International Arrangements
In the case of the SDRM, some powerful developing countries were
part of the coalition that killed the initiative.
Groups versus Institutions
An important issue that Stijn and Geoffrey stress is the legitimacy of
institutional versus ad hoc arrangements such as the G-7, G-20, and
G-77. Roy Culpeper has written a paper on this issue
1
and one of the
problems of institutional arrangements that he identifies is the fact
that we have competition among different institutional arrangements
without any clear way of establishing who coordinates the various
agencies at the global level. But the main problem is of course that the
decisionmaking in institutional arrangements is much tougher than in
a restricted group and that this has led to the emergence of the various
Gs. The Gs have the basic problem that they are not legitimate and
that they will never become legitimate. They are able to rule outside
the institutional arrangements and use their coalitions to enter proposals
in the institutional arrangements. That is, I think, the best use one can
make of Gs.
The Gs exist, they are natural, but they should work within the
context of institutional arrangements. However, they also give much
power to powerful forces, and especially to one powerful force which is
the United States. And they also allow initiatives to be launched of
which the costs are not borne by those who have launched them. For
example, the US announces debt cancellation for Iraq but then does
not incur most of the costs of the cancellation. And when the HIPC
Initiative was launched, many of the middle-income countries had to
pay for it even though they were not consulted at all. As a proportion
of GDP, the highest costs of the HIPC Initiative were incurred by
Costa Rica. Costa Rica was never consulted while it had two HIPC
countries next to it which were highly indebted to Costa Rica. Also,
some of the HIPC countries were indebted to the Central American
Bank for Economic Integration (CABEI) without the CABEI ever
being involved in the discussions. This shows some of the peculiarities
of the current fragmented system of decisionmaking where some of the
actors receive merit for something they don’t pay for.
——————————————————
1
Roy Culpeper, “Reforming the Global Financial Architecture: The Potential
of Regional Institutions”, Paper presented at the Seminar on Regional Financial
Arrangements, UN-ECLAC and UN-DESA, New York, 14-15 July 2004.
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José Antonio Ocampo 117
It should be made clear that we have an international system, not a
supranational system. The European Union is the only case where you
are really moving from an international system to some elements of a
supranational system. But the world as a whole has an international
system and that is why I would not use the word “supranational” to
characterise the system. And that is why I think Stijn and Geoffrey’s
points about how competition among governments plays in the system
is so interesting. Whether it leads to a race to the top or a race to the
bottom in terms of policy is a very interesting part of the chapter that
could be developed further.
In this regard, I would like to mention one of the characteristics of the
current system, which you can elegantly call the policy competition, or
the beauty contest, between finance ministers of developing countries
going to financial markets. I played that game in one of my former
duties and I can tell you that it is a very peculiar game. The rules are set
by markets, so the only way you can play that game is by presenting
yourself as the best player in the game – which creates policy competi-
tion between the different actors. Generally speaking, as Stijn and
Geoffrey point out, it may be true that sometimes it is a race to the top,
as happened with protecting property rights. But one should also
recognise that this game maximises the private influence too. Whatever
you do under those rules, the outcomes will always maximise the
private interest because the system is built, as Stijn and Geoffrey say,
around that essential idea.
At the end of their chapter Stijn and Geoffrey discuss the important
issue of the organisation of less powerful actors. The less powerful
actors, that is, the developing countries, will only have influence if they
organise themselves as a group of interest. Therefore, regionalism is
essential. There are very interesting developments going on, particu-
larly within the WTO where we have seen organised coalitions of
developing countries, including that of ACP developing countries, in
the negotiations. Another example is the New Partnership for Africa's
Development (NEPAD). The coming together of African countries
that led to NEPAD has made them a stronger coalition. So in the end,
the solution to some of the problems that Stijn and Geoffrey pose has
to come from the developing countries. Rather than accepting the
current rules of the game, developing countries will have to play the
game by identifying their collective interests and then go with them to
the international organisations and, hopefully, also to the markets and
say: These are the interests that we want to defend. The current inter-
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118 The Democratic Deficit of International Arrangements
national 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 – that is the centre-
periphery part of Stijn and Geoffrey’s chapter.
Competition Between International Institutions
Turning to the role of the IMF in low-income countries, I clearly see
the crucial role that the IMF has to play in macroeconomic issues. I am
not sure that loosening the dividing line between the IMF and the
development banks or between the IMF and development cooperation
is a good idea, for the IMF or for development cooperation. I would
prefer to keep a clear dividing line, thinking about the national level,
where the development functions of central banks were taken away
from them and given to specialised development banks.
With regard to the signaling or gatekeeper function of the IMF, my
personal judgement is that a world of competitive evaluations is better.
We should not rely on one single individual judgement of one single
institution, because, among other reasons, we all have made mistakes in
the past. Competition in ideas and judgements is a good way to avoid
making too many mistakes. We have not talked much about this, but I
really think that a world order based on various institutions is better.
The competition in the provision of services is actually good, not bad.
It is good to have competition between regional and sub-regional
development banks and among the bilateral donor community.
Similarly, it is good to have various regional monetary funds. Europe
has done a good job in taking the monetary problems of Europe out of
the IMF. If we have an Asian Monetary Fund and a Latin American
Monetary Fund and an African Monetary Fund, the system would be
more balanced.
Maybe the future IMF should be more like the European Central
Bank or the US Federal Reserve System, and not remain the centralised
institution it currently is. That is probably the direction to think about.
In the area of development banking, the world has moved in that direc-
tion and it should probably go further in that direction, including
establishing, in particular, development banks totally owned by
developing countries. There are a few cases around that have been
successful, why not have more of those. The same may be true for the
traditional functions of the IMF; this would make them more balanced.
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José Antonio Ocampo 119
Ownership
Another important issue is ownership. We continue to discuss the
meaning of the concept of “ownership”, which is somewhat unclear.
We have to find an operational definition of ownership, we have to
have a better idea of what that means. The evaluations of the Poverty
Reduction Strategy Papers (PRSP) by both the World Bank and the
IMF have tried to assess to what extent PRSPs have contributed to
ownership. I have found those two evaluations particularly useful to
understanding the problems that are going on. Going back to my
previous point, 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.
This is very closely tied to the issue that capacity building is the best
measure of ownership. When you have strong capacity at the national
level, and programmes are really done by countries because of strong
capacity, you have real ownership of the programmes. Then the inter-
national community can give its points of view but such discussions
would then take place around a programme that is designed by the
countries. Until now, it has too often been the case that programmes
do not present the view of the government, and this is part of the
distortion generated by the international system.
Diversity of Views and the Streamlining of Conditionality
I feel very strongly about the need to respect the diversity of views.
Particularly about growth, poverty reduction and the needed fiscal space
there continues to be huge diversions of opinions, even increasingly
among professionals. Last year at the Latin American Economists
Association meeting, I was struck when in the final panel where I
participated, a group of well-known economists reached the consensus
that, after all, we did not know what determines growth. That is a huge
recognition of the deficiency of professionals. I find it a good recognition.
I certainly prefer it to the arrogance of those who pretend they have all
the answers. We know much less than we think we do. The economic
profession is not a very hard science. It is full of ideological prejudices,
on all sides of the debate, all sides. Diversity of views is essential.
I am always struck by the intellectual environments that you see in
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120 The Democratic Deficit of International Arrangements
different parts of the world. When you go to developing countries, you
see a real diversity of views on many things. In New York, in the UN,
it is more or less the same: there is a wide variety of views. Washington,
however, seems a bit less diverse.
It would be good to leave some things to the judgement of no one
else than the countries themselves, particularly on very contentious
issues. This is why I think the streamlining of conditionality should
really be implemented. The principle of streamlining of conditionality
was approved by the Fund, some three years ago. It is a good principle,
except that it is left to the Fund’s judgement what are the structural
conditions that are relevant for the macro economy. My point of view
is that still too many structural conditions are included in IMF
programmes and, moreover, I think that the word “structural” is used
in a confusing way for that purpose. We have to recognise that we have
had stable macroeconomic regimes under very different structural
conditions: high interventionist states with very good macro balances
and very neo-liberal states with a lot of macro imbalances.
The basic problem is that there is a huge confusion in the use of the
term “structural” in most of the literature. For instance, I would
probably agree with the Fund that having some structural fiscal balance,
or a structurally stable financial system, is a good thing. But does this
imply that you have to have privatisation. Maybe yes, maybe no. In
some countries, privatisations may help establish fiscal balances, but
that does not mean that privatised regimes are always better. It may be
the case, it may not be the case. After all, it should be left to the
democracies, not to institutions at the international level. If a country
wants to have a more privatised regime, that is the country’s choice. If
it wants to have more public sector, that is the country’s choice. I do
not think we should be judging internationally how large states should
be. That is not for international institutions to decide, that should be
left to the judgement of nation-states.
Rating of Countries by Quality of Institutions
This brings me to the very contentious issue of judging the quality of
institutions of a country on the basis of the so-called Millennium
Challenge Account (MCA) and the Country Policy and Institutional
Assessment (CPIA). Even though I share the basic concern about
institution-building, because transparency and combating corruption
are important, and even though I support the basic political principles
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José Antonio Ocampo 121
behind it, this way of doing it is unlikely to produce good results.
These two approaches are likely to be seen as impositions of views
that are based on highly imperfect information. 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. So I think that these MCA and
CPIA practices should be discontinued.
I again use the word “ownership”. Ownership here is the critical
issue. I do not think that external rating and tying support to the rating
of institutions is going to improve the institutions in a country. First of
all, two major mistakes, two major things will happen. The first one is
that the judgement will be resisted at some point. There will be
countries that say: this is not due functioning. But the second thing is
that even a country that has received a positive rating, at some point is
likely to break the rule and then you have to reclassify this country or
make an exception. I really think – and I use a peculiar case – the best
idea is to leave the judgement of institutions to developing countries
themselves, or to a grouping of developing countries that encourage the
implementation of principles they have agreed upon. For example,
NEPAD may be a much better place than IMF conditionality to build
ownership of better institutions. And the UN convention against
corruption is probably a better mechanism, as are many other interna-
tional processes that are going on. They are better ways to manage
some of these institutional issues.
Let me give you another example: the case of democracy in Latin
America, which I know very well. The Rio Group, which basically is
a grouping of Latin American countries without Cuba, took this issue
of helping weak democracies maintain a democratic regime as a
conscious effort over the last 10 to 15 years. They took the initiative
themselves. So every time you see a problem in a country – a
possibility of breaking a democratic rule – what happens is that all the
countries try to help the weak country to maintain its democracy.
That is much better. I tell you that this was never done through the
Organisation of American States (OAS), where the US is powerful.
Canada is seen in Latin America and the Caribbean as a more reliable
partner than the US. The US has always been seen as too powerful in
the game. And of course, the US is seen as having supported some
non-democratic regimes in the past. So it is much better to leave it to
the countries themselves and try to support this through other, more
indirect, means.
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122 The Democratic Deficit of International Arrangements
Millennium Development Goals
Finally, the issue of the MDG framework. This framework has been a
very good one for the political discussions. It has contributed to
policymaking in the Bretton Woods institutions. However, there is
still a tendency in the Bretton Woods institutions to think of the
Fund and the Bank as the centre of the earth. In practice, it would be
better for them to build stronger networks, not only with the UN
organisations, but also with the regional development banks and the
bilateral donors. Such networking should go beyond the practice
established at the national level, where the dialogue has improved but
nonetheless continues to be distant in many cases. At both the national
and the global levels, we have done a lot to improve the dialogue. The
Monterrey process was a major advance in terms of dialogue, but we
have to strengthen it much more in the future.
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123
8
Future Challenges for the IMF in
Low-Income Countries
Jan Derk Brilman, Irene Jansen and Ernst van Koesveld
1
hen the IMF was established in 1945, a role for the Fund in
low-income countries was not foreseen. Its founding fathers
envisioned an organisation to guard and help preserve the newly
created international monetary stability in a world of fixed exchange
rates and the gold-exchange standard. With the collapse of the Bretton
Woods system in 1971, the oil price shocks in the 1970s and the debt
crises in the 1980s, however, the Fund’s operations geared increasingly
towards emerging economies and low-income countries. Moreover,
acknowledging that macroeconomic stability as a prerequisite for
sustained economic growth and poverty reduction can only be created
over a longer term, the Fund’s involvement in low-income countries
became much more long-term than the traditional short-term balance
of payments support.
In 2003, the IMF started a comprehensive discussion on its role in
low-income countries. A first paper was published in July and discussed
in the IMF Board in September. A year later, a second paper and dis-
cussion followed (IMF, 2004a). Out of these discussions, the consensus
emerged that the IMF has an important role to play in low-income
countries, and that lending, policy advice and technical assistance
should remain the Fund’s main instruments to help low-income
countries to achieve the Millennium Development Goals (MDGs).
More specifically, we believe that the Fund’s relationship with low-
——————————————————
1
Foreign Financial Relations Directorate, Ministry of Finance, the Nether-
lands. Contact: e.koesveld@minfin.nl. The usual institutional disclaimer applies.
W
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124 Future Challenges for the IMF in Low-Income Countries
income countries should be aimed at establishing macroeconomic and
financial stability, and supporting that, the microeconomic functioning
of public finance and the financial sector. A crucial precondition for
the Fund to remain effective in low-income countries is its continuing
capacity to tailor the mix of policies and instruments to a country’s
political and economic realities.
Diverging views emerged however on various more specific issues,
including: (i) the Fund’s longer-term financial involvement in low-
income countries and how to promote a gradual exit to a surveillance-
only relationship; (ii) the role of the Fund in cases where financial
assistance is not critical to alleviate balance of payments needs, but
where involvement for signaling purposes is important; (iii) the Fund’s
approach to debt relief and how to promote debt sustainability.
These three interlinked issues are the key future challenges for the
IMF in low-income countries that we will address in the remainder of
this chapter. In Section 1, we discuss the issues of “saying-no” and the
design of proper “exit strategies”. In Section 2, we argue that when
countries have stabilised their economies, the Fund’s direct role in
providing balance of payments support needs to change into an indirect,
signaling role, i.e. to catalyse other sources of financing. Section 3
discusses how the build-up of too high debt levels can be prevented.
Section 4 concludes.
1 Exit Strategies from Fund Financing
One of the consequences of the deep-rooted and complex economic
problems in many low-income countries is the high level of longer-term
financial engagement of the Fund. The IMF has defined a longer-term
programme engagement in the case of low-income countries as having
at least two ESAF/PRGF arrangements. On this basis, 45 out of the 78
PRGF eligible countries can be classified as such as of December 2004.
Of the remaining 33 countries, 24 are recovering from severe economic
and/or political instability and are either not yet engaged in a financial
relationship with the Fund, implementing a first PRGF or involved in
a programme that went off-track. These countries could therefore enter
into a longer-term engagement in the future.
It is important to note that following the IEO “Evaluation of Pro-
longed Use of IMF Resources 2002” and the conclusions of a Task Force,
the IMF Board concluded that, “under proper circumstances, long-term
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 125
Fund financial engagement can be an appropriate response to help
member countries address deep-seated problems that, by their nature,
require many years to resolve. These problems have been particularly
prevalent in low-income countries and countries in transition.” Thus, a
longer-term financial relationship with the Fund is not necessarily worri-
some. The Board added however that “at times, prolonged use can also
be associated with insufficient progress in dealing with key economic
problems and can hinder the development of domestic institutions”
(IMF, 2003a).
The question then is whether the longer-term Fund engagement in
low-income countries has overall been justified. Elements that are of
importance in this respect include: (i) whether the economic problems
as well as the level of commitment to reform and institutional capacity
justify long-term financial involvement; (ii) whether overall and con-
tinuous progress has been made through solid implementation and
sound programme design; (iii) whether the Fund has acted if this was
not the case, for example by adjusting a programme, delaying a review
or declaring a programme off-track, (iv) whether successive arrangements
show a declining trend in access; and (v) whether explicit attention is
given to an exit strategy as part of an ex post assessment.
In June 2004, 19 ex post assessments on longer-term engagement in
PRGF countries were considered by the Board and became publicly
available. Before drawing some conclusions on the basis of these assess-
ments, a few caveats are in order. First, it is always easier to draw
conclusions with the benefit of hindsight. Thus, a conclusion that the
IMF would have better disengaged in a particular country looking back,
since ownership and/or commitment were lacking, does not mean that
the decision to agree to a new PRGF was not made with due care and
consideration at the time. Secondly, since experience with ex post assess-
ments is relatively recent, the documents still evolve in their structure
and quality. This makes a comparison between the documents somewhat
difficult at times. With this in mind, an analysis of the existing ex post
assessments according to the above mentioned criteria shows that three
different categories can be distinguished: (i) countries where the
longer-term programme engagement has overall been successful, (ii)
countries where the longer-term engagement can be called into ques-
tion and which currently still have a Fund programme, (iii) countries
where the longer-term programme engagement can be called into ques-
tion and which currently do not have a Fund programme.
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126 Future Challenges for the IMF in Low-Income Countries
Countries With a Successful Longer-Term Programme Engagement
From the 19 countries analysed, seven can be classified as having a
successful longer-term engagement with the Fund. In Albania, Armenia,
Benin, Ethiopia, Mali, Mozambique and Cambodia the longer-term
engagement of the Fund has been justified considering the existing deep
economic problems as well as the level of ownership and the institutional
capacity. In Mali and Mozambique, ownership and commitment of the
authorities have been consistently strong, leading to continuous progress
and solid implementation of reforms. In Albania, Armenia, Benin,
Ethiopia and Cambodia episodes of political uncertainty or conflict and
low commitment have existed, with temporary deteriorations in pro-
gramme implementation as a consequence. In all five countries however,
the Fund responded appropriately and only renewed its programme
relationship when ownership and stability were solidly restored and
sound progress could again be expected (and indeed materialised).
Only in Ethiopia has programme design been clearly unsatisfactory
according to the ex post assessments, while in most countries some
improvements could have been made in this area.
Despite the overall successful engagement of the Fund, none of the
seven countries has of yet fully graduated from Fund resources. With the
exception of Cambodia, future graduation is however being properly
addressed and low access PRGFs are in place or are being recommended
by IMF staff for the immediate future. The signaling role of a Fund
programme vis-à-vis donors is mentioned regularly as the reason of why
a PRGF is preferable to a surveillance-only relationship. In Cambodia,
the IMF staff recommends to raise the question of graduation “at the
time of approval of each (future) yearly programme.”
Countries Where the Longer-Term Programme Engagement Can Be
Called Into Question
Unfortunately, in the majority of the low-income countries assessed so
far questions can be raised with hindsight about the validity of the long-
term presence of the Fund. In Bolivia, Chad, Georgia, Guinea, Guinea-
Bissau, Kyrgyz Republic, Lesotho, Macedonia, Malawi, Moldova, Niger
and Zambia, economic problems were profound enough to merit a
longer-term involvement, but lack of ownership, governance problems
or capacity constraints and/or political conflict resulted in a political-
institutional climate that was not receptive to reforms. As a result, progress
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 127
was mixed at best, but more often than not disappointing. The question
then emerges why the Fund agreed to continuous new arrangements,
knowing that implementation problems would most likely persist. In
some of the ex post assessments, the Fund explicitly admits that with
hindsight more selectivity should have been used in deciding to new
programmes, which could have resulted in prolonged disengagement of
the Fund. In other cases, the Fund points at pressure from donors to
continue the arrangement for signaling purposes or to a change of
governments that gave new hope for improved implementation. Often
however, new programmes saw similar implementation problems. An
interesting case in this respect is Bolivia, where ownership of the national
authorities has hardly been an issue, but the high political resistance to
reforms from interest groups and the underprivileged majority led to
constant implementation failures, irrespective of which government
ruled (IMF, 2005). As regards programme design, the ex post assessments
usually state that more attention should have been given to capacity
constraints and the institutional environment, but design flaws have
never been a large culprit of the overall disappointing results. Moreover,
a few exceptions set aside, the response of the Fund to insufficient
progress within arrangements has generally been sound with increases in
prior actions, reviews being delayed or not completed and programmes
being announced off-track.
Seven out of the 12 countries in this category currently still have a
Fund programme. Access has declined in only one of these (Georgia)
and ex post assessments indicate that a possible exit strategy of Fund
resources has not (yet) been properly addressed in four of them. The
remaining five countries are no longer involved in a Fund arrangement,
even though the Fund foresees a future engagement in most of them,
provided that the level of commitment and/or institutional capacity
improves. Exit strategies are properly addressed in all of these five
countries, while only Guinea has had a declining access of financial
engagement of the Fund within this group.
Lessons for Future Fund Engagement and Exit Strategies
The ex post assessments give a comprehensive and overall candid
overview of past Fund involvement in low-income countries. They are
highly useful and should therefore be continued and strengthened
further. Several lessons can be drawn on the basis of them.
First and foremost, sufficient levels of ownership, commitment,
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128 Future Challenges for the IMF in Low-Income Countries
political stability, good governance and institutional capacity are essential
for the success of a Fund programme. Without these, a muddling-
through scenario emerges in which limited progress is achieved and the
Fund is sooner or later forced to (temporarily) unplug.
Second, it is important that the Fund is able and willing to say “no” at
an early stage if warranted. Although it is not and should not become
the responsibility of the Fund to improve the overall political and
institutional situation in a country, Fund programme design should
pay (more) attention to specific capacity constraints. Hence, even if the
lack of implementation is beyond the government’s control due to e.g.
strong resistance from vested interests, the Fund should consider
disengaging when constraints are such that the success of a new
programme is highly questionable. When improvements in this area
have been made – possibly with the assistance of the World Bank,
regional development banks and bilateral donors – the Fund should
naturally stand ready to re-engage. The important signaling role of
IMF programmes however, makes saying no difficult at times.
A third lesson, therefore, is that more nuanced and textured signals
– explaining why a programme goes off-track or why a new programme
engagement is unwise – are needed. This issue will be raised into more
detail in the next section on the signaling role of the Fund. Fourth, the
Fund should adhere more closely to the existing principles on declining
Fund exposure.
2
Lastly, the Fund should further strengthen its attention
to exit strategies, e.g. in ex post assessments. 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. Questions concern-
ing ownership and capacity constraints should be properly addressed as
well (as is often already the case) and lead to firm suggestions with regard
to possible new arrangements (e.g. prior actions). Thought could be
given to increasing Board involvement in the case of a longer-term Fund
engagement in order to strengthen the focus on exit strategies. Also, pre-
cautionary (low access) PRGFs, in which the IMF and a member
country agree on a PRGF programme, but the country unilaterally
——————————————————
2
In this respect, it is a welcome step that the Board decided to reaffirm the essence
of declining access and decided to new access norms under PRGF arrangements. The
norms are set as follows: 90% of quota for first-time PRGF use, 65% for second-time
use, 55% for third-time use etc. Besides these norms, the PRGF also sets a maximum
borrowing limit at 140% of quota (185% of quota in exceptional circumstances).
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 129
decides not to make use of Fund resources, could serve as a possible exit
and are worth considering. The recently approved Policy Support Instru-
ment (see next section) forms a valuable addition to this.
2 The Fund’s Signaling Role in Low-Income Countries
Although episodic IMF financing is often vital for low-income countries,
the Fund’s longer-term goal should be to phase out its financial involve-
ment. After countries have sufficiently stabilised their economies, they
should rely on, usually more concessional, donor funds to finance their
development needs to achieve the MDGs, and ultimately, they should be
able to tap international capital markets. In this process, Fund involve-
ment is expected to evolve, with its indirect role, i.e. its role in providing
a seal of approval for donors and markets, growing more important.
While the Fund’s financial involvement may be relatively limited for
countries, the financial implications of its signals are sizeable. This section
reviews the recent discussion on this so-called signaling role of the Fund,
especially from an EU donors’ perspective, who together account for
over half of global ODA with a further rise expected.
IMF interactions with member countries, notably in the context of
surveillance and programmes, have an important signaling function to
the international financial community. Although signaling is a kind of
by-product of the Fund’s core business, it is increasingly considered as
one of the main tasks of the Fund in low-income countries. The term
“signal” refers to the conveying by the Fund of information that
influences the financing decisions of outsiders (such as donors and
private market participants). This can be through on/off mechanisms (a
typical example of which is a Fund programme, where the signal is given
by the approval and continuation of the programme) or through a multi-
dimensional picture (a typical example of which can be found in
surveillance, where the signal comes from the textured views expressed in
the course of surveillance). The Fund also provides assessments of
members’ macroeconomic conditions and policies in response to various
ad hoc requests from multilateral development banks, creditors or
donors. The most recent guidelines on these so-called assessment letters
(also known as comfort letters) state that the assessments should be both
“sufficiently nuanced” and “written clearly” to inform financial decisions
of outsiders. They should be circulated to the Board for information, but
this does not imply Board endorsement (IMF, 2003b).
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130 Future Challenges for the IMF in Low-Income Countries
The Risks of an Increased Signaling Role
The Fund’s signaling function appears to have become increasingly
important, as reflected by the number of IMF Executive Board
discussions that touched upon the issue. Recently, the discussion has
focused on the signaling role of the Fund in low-income countries,
effectively providing a seal of approval to donors. An important
signaling role for the Fund fits in the view that the Fund’s engagement
with low-income countries should not be equated with IMF financing
being provided over longer periods of time. In particular in the case of
so-called mature stabilising countries and pre-emerging market
economies, the Fund’s signaling may be more important than its
(episodic) financing role. The Fund could rely on catalysing other
funding, especially if the latter are provided on more concessional
terms to avoid unsustainable debts.
The signaling role of the Fund has also become more important
given donors’ gradual shift from project aid to budget support. This
shift is based on the belief that national ownership and effective aid
allocation are best served by providing direct budget support.
Assurances by the IMF that recipient countries’ macroeconomic
policies and public finance management are of sufficient quality often
guide disbursement of budget support. The Fund is uniquely placed to
provide such signals, including information on financing gaps,
borrowing capacity and absorptive capacity, to inform donor decisions.
Especially in the case of countries with Fund-supported programmes,
the Fund is considered to play the role of “gatekeeper”, providing on/off
signals on which much donor financing depends.
The Independent Evaluation Office, among others, has pointed out
two possible risks of this development (IEO, 2002; see also DFID/HM
Treasury, 2004). The first is that the Fund’s actions may result in stop-
and-go processes and large swings in official financing, thus further
reducing the predictability of aid.
3
The second possible risk is that
linking aid to IMF-supported programmes can compromise the quality
of these programmes – and hence, the quality of the signal. This is
——————————————————
3
Bulir and Lane (2002) find that project aid disbursements are more or less
independent of the status of an IMF-supported programme. Budget support,
being already less predictable than project aid, turned out to be very sensitive to
programme interruptions. In fact, the penalty for programme interruptions was
80%: aid disbursements were 80% below the initial commitment level.
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 131
because this linkage raises the stakes of programme negotiations to the
point of putting strong pressure on both country authorities and the
IMF to reach an agreement, even though both parties may have doubts
about the programme’s feasibility. This, in turn, may contribute to
unduly prolonged use of Fund resources and hinder an effective imple-
mentation of exit strategies from the side of the Fund. A third risk
would be that the Fund’s financial involvement will add to the often
already high debt levels of countries.
The recent historical review by Fund staff (IMF, 2004b) confirms
that there are various difficulties in designing a successful signaling
mechanism:
•
There is a tension between the intention to influence donors (the
Fund’s catalysing role) and the intention to leave them to arrive at
their own judgement (reducing the negative and unintended conse-
quences of the Fund’s perceived gatekeeper role).
•
In order for positive signals to be meaningful, negative signals must
also have been a possibility. However, the Fund has been reluctant
to send negative signals, to protect the frankness of the dialogue with
the authorities and to avoid a sharp reduction in foreign financing;
•
On-off signals are open to misinterpretation if they set a standard
other than upper credit tranche conditionality, which is the normal
standard for IMF-supported programmes (so-called Staff-Monitored
Programmes, for example, have a lower policy commitment content);
•
The credibility of signals is helped when backed by financial
resources, although recourse to Fund resources can be a signal of
need as well as strength;
•
On/off signals tend to crowd out multidimensional ones, and less
intrusive signaling instruments are likely to be less effective.
IMF staff therefore concludes that many attempts to develop new
signaling instruments have not stood the test of time or have failed to
gain Board support.
In Search of a New Signaling Instrument: EU Donors’ Perspective
The US has consistently been a strong advocate for a new instrument. In
response to the US proposal for a so-called non-borrowing arrangement,
IMF staff decided to put on the table a new signaling instrument in
September 2004. The new instrument was tentatively named the Policy
Monitoring Arrangement (PMA). The Board did not have a final
judgement, but encouraged staff to pursue consultations with potential
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132 Future Challenges for the IMF in Low-Income Countries
users, private market participants and donors to ascertain the usefulness
and potential demand for a signaling mechanism
(IMF, 2004c).
To this aim, the Fund circulated a questionnaire to recipient countries,
other multilateral agencies and donor governments. The following
draws some general conclusions on IMF signaling from the perspective
of EU donors. Fourteen EU donors (Austria, Denmark, Finland,
France, Germany, Italy, the Netherlands, Poland, Portugal, Spain,
Slovenia, Sweden, the United Kingdom and the European Commis-
sion) filled in the questionnaire. The Czech Republic, Cyprus, Estonia,
Hungary, Latvia, Lithuania and Malta indicated that their aid policies
are still under development, while Belgium is currently in the process
of revising its policies.
All EU donors use Fund signals to inform their development assis-
tance decisions. In line with the economic literature, donors believe that
the Fund signals convey three kinds of information: superior informa-
tion from the Fund about a country’s economy, policies and prospects;
assessment of a country’s commitment to sound policies; and informa-
tion on financing needs and available resources. Given its relationship
with the national authorities as well as its competence and expertise,
the Fund has an information advantage, at least with regard to macro-
economic policies, financial sector issues and public finance manage-
ment. In effect, the Fund can reduce the information asymmetry of
bilateral donors vis-à-vis the recipient countries.
A key issue is whether the approval or presence of an IMF-supported
programme is one of the requirements for aid allocation. All EU
donors indicate that this is not the case for project aid. The only excep-
tion is if the project is in the economic/financial sector and the Fund
information brings to light an issue that might affect successful imple-
mentation of the project. The picture emerging from the responses of
those countries that disburse substantial amounts of budget support
varies. Three groups can be distinguished. For the first group of
countries, a Fund arrangement being on-track is a strict requirement
for budget support. If a programme goes off-track, the donors would
directly stop providing budget support. For a second group of donors,
the Fund arrangement being on-track is effectively a policy requirement
for budget support. Countries in this group, however, clearly state that
there is never an automatic or mechanistic use of this IMF signal; there
is always room for own judgement based on a variety of other sources
of information. If a Fund-supported programme goes off-track, they
will reconsider but not necessarily stop budget support. This decision
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 133
will also depend on the reasons why the Fund cannot but delay
programme reviews. A third group of countries focuses completely on
the substantive reasons why a programme goes off-track, and attaches
no specific value to the on/off signal. None of the EU donors indicate
that a Fund arrangement is a legal requirement. Overall, the perception
that donor support is directly linked to the status of a Fund arrange-
ment is not confirmed by the EU responses to the questionnaire. In
procedural terms, the link is indirect at best.
4
Nearly all EU donors attach value to a regular, and mostly also
frequent, availability of Fund signals, which help donors improve the
predictability of aid. This is particularly relevant if a PRGF review is
delayed or if there is no IMF arrangement in place; otherwise the
normal PRGF review schedule will more or less guarantee regular Fund
signals. In the latter case, some donors suggest to issue assessment
letters reports on a more frequent basis, for example twice a year,
following a pre-announced schedule. They also indicate that assessment
letters should contain up-to-date information and be candid on policy
strengths and weaknesses with a clear underpinning of the conclusions
reached. In this way, assessments letters could effectively combine an
on/off signal with a more textured picture.
Various EU donors need an on/off signal, but others do not believe
on/off decisions are a necessary feature of a signal or even oppose
on/off signals. Most of the donors that need on/off signals consider
upper tranche conditionality and Board endorsement as necessary
components of a clear signal, for others they are not. Even more
importantly, nearly all donors would also highly appreciate more
textured and multidimensional signals as they would enhance insight
into the development process and foster well-informed decisionmaking.
A recurring issue in the responses to the questionnaire is that donors
——————————————————
4
This does not deny the fact that the correlation between IMF arrangements
and bilateral budget support is and may remain strong, which suggests that
donors do not always use the available room for manoeuvre. Besides, only a few
EU donors have responded to the question what they do with the committed
resources if they decide to discontinue budget support due to the off-signal by the
Fund. Normally, these funds will be allocated for other development purposes or
become part of a broader budget prioritisation. One donor applies the interesting
rule that for IMF/Bank constituency countries, 50% of the budget reserved for
macroeconomic support will be allocated to programmes or projects that are
instrumental in getting the Fund programme back on track. This promotes
flexibility in decisionmaking and predictability of aid flows.
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134 Future Challenges for the IMF in Low-Income Countries
want the IMF to explain especially why PRGF reviews are delayed or
why a PRGF programme is effectively off-track. At present, there is
often a lack of information, which may imply ambiguous and mixed
signals. The “noise” around the signal may then dominate the signal
itself. Is the delay or off-track situation due to macroeconomic or
macro-critical structural policy failures. Is it because of temporary
circumstances beyond the control of the authorities and for which the
Board for some reason is not expected to grant a waiver. Is it due to
typical IMF procedures, for example in terms of its safeguard policies.
A better explanation would help donors to assess whether the reasons
are relevant or critical for the effectiveness of the aid. Such a process
may, in turn, mitigate unnecessarily large swings in aid flows.
The recent experience in Vietnam may serve as a good example in
this respect. PRGF reviews were delayed, subsequently the programme
was curtailed, because the national authorities were not willing to allow
an audit of the central bank management of foreign exchange reserves.
In addition to the procedural reason for curbing IMF lending, the
Fund – especially the Board – criticised the lack of progress in reforms
of the state-owned enterprises and state-owned commercial banks.
However, at the same time, the Fund signaled in its documentation
and briefings that macroeconomic policies were sound. Based on this
set of nuanced information, donors expected that aid effectiveness
would not be undermined and continued to disburse funds. Vietnam
does not intend to renew the PRGF, but the Fund now informs the
donor community better during Consultative Group Meetings and in
other documentation and briefings. In the case of Mozambique,
financial sector reforms caused a bottleneck in the implementation of a
Fund-supported programme, but again donors decided to continue to
provide budget support, linking this to annual progress in the PRSP. In
both cases, “stop and go” processes were prevented thanks to good
communication and a sound mutual understanding.
None of the EU donors believes the volume of IMF lending to be an
important characteristic of an IMF programme. Rather, the mere
presence of an IMF programme is the decisive factor for especially
budget support. No donor will – necessarily – stop providing budget
support if an average PRGF programme is followed up by a low-access
PRGF programme, i.e. around 10 percent of a country’s quota. In case
a successor programme is not foreseen because the country no longer
has a balance of payments need, most donors expect to continue
budget support, but effectively need a clear IMF signal to do so. At the
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 135
same time, some donors believe that if the Fund puts its money on the
line, this adds to the credibility of the Fund on/off signal.
In sum, EU donors, including the Netherlands, generally believe
that there was a kind of gap in the IMF instruments available to low-
income countries, but thought that this gap could largely be addressed
by modifying existing instruments and practices rather than to
necessarily introduce a new instrument or mechanism. The following
suggestions are the most often given:
•
provide regular information on the status of a PRGF programme,
especially if reviews are delayed or effectively off-track (e.g. accord-
ing to the review schedule);
•
give regular Fund assessments when a PRGF arrangement is not yet
or no longer in place, for example by sending assessment letters to
donors twice a year;
•
provide better explanation, especially of off-signals, to donors to
enable them to assess whether there is substantive reason to suspend
or even stop financial support;
•
give more textured information in addition to on/off signals, which
would contribute to a higher quality of decisionmaking on aid
commitments and disbursements.
These suggestions are expected to somewhat loosen the linkage between
IMF on/off signals and aid decisions. This allows the Fund to continue
catalysing other sources of finance, but with a lower risk of compromis-
ing the quality of its seal of approval and a lower risk of unjustifiable
stop-and-go processes in bilateral aid flows.
Agreement on a New Signaling Instrument
Most EU donor responses were in line with the general outcome of the
questionnaire as far as all donors were concerned. The Fund will
therefore intensify and improve its policy on the issuance of assessment
letters, providing donors with fuller and more textured information.
On the issue as to whether the Fund should extend its present tool kit,
many non-EU donors responded more positively. Apart from the
donors, the low-income countries were also approached to respond to
the questionnaire. They turned out to have similar views on the
information issues as donors, but were largely in favour of both better
using the existing tool kit and introducing a new instrument to fill the
perceived gap between a programme relation and a surveillance-only
relation. Subsequently, the issue was taken up again by the IMF. Most
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136 Future Challenges for the IMF in Low-Income Countries
G-7 countries favoured the introduction of a new instrument, while
others, including the Netherlands, were ready to support the new
instrument, but argued that it should meet the following criteria in
order to enhance the Fund’s effectiveness:
•
upper tranche conditionality (tailor-made to country circumstances);
•
endorsement by the Fund’s Executive Board (adding to the strength
of the signal);
•
based on a country’s poverty reduction strategy (ensuring national
ownership);
•
provision on a voluntary basis (truly demand-driven);
•
clear focus on mature stabilisers (within the group of low-income
countries).
The bottom-line of this approach is that a new instrument should not
undermine the existing IMF instruments, particularly low-access PRGFs
that have proven to be useful to low-income countries that still face a
limited balance of payment problem and precautionary arrangements,
that are effectively being used by middle-income countries as a way to
signal their graduation towards the financial markets. It is therefore
important to confine the new instrument to a subgroup of low-income
countries that have fully surmounted stabilisation problems, but still
need an IMF programme for signaling purposes. To ensure that
existing instruments would not be undermined, the design and
procedures of the new instrument should be the same. It would also be
important that the instrument would not be “put into the market” as a
more attractive instrument than existing ones and that countries were
more or less pushed to apply for it. Even if countries belonged to the
group of mature stabilisers, they should still be free to choose for a
(low-access) PRGF-programme.
After consultations with both donors and potential users of the new in-
strument and collecting views through the questionnaire, the Fund came
with a new proposal under the name of Policy Support Instrument (PSI)
and targeted towards so-called mature stabilisers. This group currently is
limited to a handful of countries in Africa and Asia, but is expected to
grow over time. The characteristics of the PSI are consistent with the
abovementioned criteria and thus received overall support among the
Fund’s shareholders. A PSI will also provide the basis for rapid access to
concessional Fund resources in case of exogenous shocks, similar to a
possible augmentation of a PRGF-arrangements for the existing group of
members. With the adoption of the PSI in October 2005, a long dis-
cussion on the signaling role of the IMF was brought to a successful end.
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 137
We will however have to monitor its usefulness and its implication
closely. The introduction of the PSI and the better use of assessment
letters do not reduce the Fund’s role in low-income countries, but
mark a shift in countries that have reached a relatively high degree of
stabilisation from direct financing towards indirect support, i.e.
advising and catalysing. Together with a more frequent use of low-
access PRGF-arrangement for countries that have not fully stabilised
yet, this will further help to prevent a build-up of unsustainable debt
levels in low-income countries.
3 The IMF and Debt Sustainability
Debt has been a problem for many low-income countries in the past
and threatens to be so in the future. There are two sides to the debt
problem. First, how to handle unbearably high debt burdens that are
already in place, in particular how to decide on debt relief. Second,
how to prevent the build-up of unsustainable debt levels. The IMF,
together with the World Bank, is playing a leading role in both.
Debt Relief
Twenty-eight countries have already received HIPC assistance and
their average debt service has been cut in half. Even though the HIPC
process could therefore be called a success, many believe that additional
relief is necessary. One of the reasons for this belief is that there are some
countries that again reached unsustainable debt positions after receiving
HIPC debt relief. An example is Uganda, whose debt-to-export ratio
was reduced to less than 150 percent when it reached HIPC completion
point in 2000, but had again risen to 288 percent in 2002. There is
also discussion on whether a debt of 150 percent of exports is really
sustainable, or – if it is deemed so – whether it is bearable in a broader
sense since it reduces a country’s resources to reach the MDGs. Against
this background, the US launched a “Bold proposal” in 2004 to give
100 percent debt stock relief to HIPCs on International Development
Association (IDA), African Development Fund (AfDF) and IMF debt.
The proposal was quickly followed by counterproposals from the UK,
Canada, the Netherlands, France, Japan, Germany and Norway.
Discussions focused mainly on three issues.
The first was whether to give debt stock relief or debt service relief
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138 Future Challenges for the IMF in Low-Income Countries
(in the latter a country’s debt would not be written off, but its
scheduled principal and interest payments would be cancelled on a
yearly basis). Debt stock relief will provide the most definite assurance
for a country of increased fiscal space in the future, thereby increasing
predictability, which facilitates financial planning. Debt stock relief can
also be preferred since debt stock is (independently of the current debt
service) predictive of the risks of a financial crisis and has a negative
effect on economic growth through “debt overhang”, i.e. the knowledge
that a debt stock will have to lead to large debt service payments in the
future can reduce incentives to invest, thereby reducing growth. Debt
service relief has as its main advantage that it allows for ongoing condi-
tionality, which can help guarantee effective use of the resources that
are freed up by the relief. As is made clear by some HIPC countries
that have had a drop in their policy performance after receiving HIPC
assistance, it is not certain that all HIPCs will maintain the policies
that are needed to make effective use of the fiscal space that is created
through debt relief. Since providing debt relief on an IDA loan comes
down to giving budget support over a period of up to 40 years (the
maturity of an IDA loan), proponents of debt service relief are of the
opinion that donors should be able to stop this form of “unconditional
budget support” if policies deteriorate. An additional advantage of debt
service relief, also in enabling ongoing conditionality, is that it can be
used to mitigate the moral hazard effects of debt relief. Countries may
start borrowing at an unsustainable rate after receiving relief under the
assumption that the new debt will also not have to be paid back. By
making the debt service relief conditional on prudent debt manage-
ment, this moral hazard effect can be neutralised. Finally, debt service
relief will protect the financial solidity of the participating institutions.
If debt stock relief is given and donor compensation does not materi-
alise, the institutions can potentially face a large loss. Debt service relief
allows the institutions to stop the relief if not enough donor compen-
sation is available.
The second issue on which views varied was how to determine the
level of debt relief. Several countries wanted to simply cancel out-
standing debt in full. Other countries believed that 100 percent debt
relief would unnecessarily undermine a country’s credit culture and
that therefore debt relief should only be given in order to reach
sustainable debt levels as determined by the new Debt Sustainability
Framework (DSF, see below). Basing the amount of debt relief on debt
indicators has two drawbacks, however. First, it will result in giving the
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 139
highest debt relief to those countries that in the past followed
imprudent debt policies, thereby rewarding poor performance.
Although this will also be the case if the full debt relief option is chosen
(since countries with a higher debt will receive more relief in that case
as well), this effect becomes more pronounced by only giving relief on
debt above a certain threshold. This problem is exacerbated by the fact
that the new DSF applies lower debt thresholds to poor performing
countries. Countries that are poor performers are thus more likely to
have an unsustainable debt and to receive more debt relief. The second
drawback is of a more political nature. Although some HIPCs have
again built up an unsustainable debt, many low-income countries are
below or only slightly above their debt sustainability threshold. Thus,
giving debt relief only up to this threshold would greatly lower the
overall amount of debt relief.
The third issue of discussion among the different donor countries
related to eligibility. In order to qualify as a HIPC, a country needs to
have an income below the PRGF-eligibility threshold (885 dollar a
year) and at the same time a debt above 150 percent of debt-to-export.
Thus, those countries that became eligible for HIPC debt relief were, at
the time, among the poorest and most heavily indebted. Various
countries believe that the HIPC countries should therefore again be the
countries to profit from the new debt relief. Others, including the IMF,
find that the HIPC relief has brought the debt burden of many HIPCs
under control and that there are non-HIPCs at least as poor as some of
the HIPCs. According to them, it would be unjust to let those
countries qualify for debt relief which used to have a debt above
150 percent but have since received HIPC debt relief, while at the
same time excluding countries that are just as poor but have debt ratios
that are (in some cases only just) below 150 percent. For IMF debt
relief this is especially problematic since the IMF is expected to finance
relief out of its own resources. The use of IMF resources without
applying uniformity of treatment is questionable in principle, but is
also in conflict with the IMF’s legal provisions. Under the Fund’s rules,
any decision by the Fund to differentiate between members must be
based on the application of criteria that are relevant to the objective of
the power being exercised. This seems not to be the case for the
proposed differentiation between non-HIPCs and post-completion
point HIPCs.
In September 2005, a compromise was reached on giving 100 percent
debt stock relief, without reference to debt sustainability indicators.
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140 Future Challenges for the IMF in Low-Income Countries
Countries will receive debt stock relief but will at the same time receive
a proportional cut in their AfDF and IDA allocations. The net receipts
from IDA and AfDF will therefore remain dependent on the quality of
a country’s policies and institutions (as measured by the Word Bank’s
and AfDB’s Country Policy and Institutional Assessment)
5
reducing the
reward for poor performers and upholding the incentives for good
performance
6
. It was also decided to give debt relief to HIPCs only, but
equal treatment has been guaranteed to a large extent because donor
countries will compensate IDA and AfDF for the debt relief given to
HIPCs and this additional financing will be distributed among all
IDA/AfDF-recipients. This procedure cannot be used for the IMF
since it is impossible to reduce IMF allocations in proportion to the
relief given (since the IMF does not have a fixed allocation per country,
but gives its assistance based on balance of payments need). Uniformity
of treatment will therefore be achieved by basing eligibility for relief
that will be financed by the IMF’s own resources on an income
criterion. IMF relief for HIPCs whose income is above this threshold
will be financed out of the PRGF Trust, which does not belong to the
IMF’s own resources but which is made up of donor contributions.
Although it is not yet possible to say exactly how much debt relief will
be given under the initiative, it is clear that it will lead to a comparable
amount of debt relief as will be granted under HIPC. The Fund’s share
amounts to about SDR4 billion, double the amount of debt relief it has
committed under HIPC. The initiative will thus provide all low-income
countries with a significant boost in resources to support their efforts to
attain the MDGs.
How to Prevent the Build-Up of New Unsustainable Debt.
The fact that some HIPCs find themselves in an unsustainable debt
situation only a few years after receiving significant debt relief increased
the call for prevention measures. In response, the IMF and World Bank
——————————————————
5
The CPIA consists of a set of criteria representing the different policy and
institutional dimensions of an effective poverty reduction and growth strategy.
6
Relief countries that currently receive loans from IDA will have the advantage
that they will effectively trade in these conditional loans for unconditional grants
(the relief). This will result in a NPV advantage of about 40% (IDA loans have a
grant equivalent of about 60%). On the other hand, if the debt relief lowers a
country’s debt relief under its debt sustainability threshold (see below) IDA will
change its grant financing into loan financing.
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 141
proposed a new Debt Sustainability Framework (DSF) in February
2004. The DSF determines how much debt a country can have
without having the risk of debt becoming too high: its debt threshold.
Under the HIPC Initiative, a common threshold of 150 percent of
debt-to-exports was used for all countries. This could be defended
because of equal treatment considerations (otherwise some countries’
debt would be reduced to lower levels than that of others), but it did
ignore important country differences in the ability to service debt. The
Fund and the Bank therefore tried to develop thresholds that were
more country specific. Further research showed that there are two key
determinants of debt levels that a county can sustain.
The first is the quality of a country’s policies and institutions as
measured by the World Bank’s Country Policy and Institutional
Assessment (CPIA). Thus the IMF and the World Bank set different
debt thresholds on the basis of performance. These thresholds can be
found in Table 1.
Discussions focused mainly on how high the respective thresholds
should be. This choice would have to balance the risk of debt distress
with the costs of applying tighter constraints on borrowing. IMF and
World Bank eventually chose thresholds that would give a country
with a debt ratio at these thresholds an average chance of debt distress
(a disruption in debt service payments) in the following three years of
about 20 percent. Apart from the wish to be cautious, the concurrent
discussions on the IDA grants window also played a role. Since IDA
deputies had decided to give IDA grants only to countries with an
unsustainable debt, lower debt thresholds would increase the percent-
age of grants in total IDA allocations, a wish of one important donor,
the US. The downside of this relatively low threshold is that the “type I
error” is about 60 percent. That is, about 60 percent of the countries
that the framework will identify as having an unsustainable debt and
Table 1 Debt Thresholds for Public and Publicly Guaranteed
External Debt
Country Policy and Institutional Assessment (CPIA)-category
Weak
(CPIA<3.25)
Medium
(3.25 <CPIA<3.75)
Strong
(CPIA>3.75)
NPV/GDP
30%
40%
50%
NPV/Export 100% 150%
200%
Debt service/Export 15%
20%
25%
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142 Future Challenges for the IMF in Low-Income Countries
therefore in need of reducing its debt burden, will actually not
experience any debt servicing trouble if no further actions are taken.
The second key determinant of the debt levels a country can sustain
is its susceptibility to shocks such as adverse movements in key macro-
economic variables or volatility in export earnings. Therefore, the IMF
and World Bank will construct a forward-looking debt sustainability
analysis (DSA) under the framework in which they project how a
country’s debt ratio will evolve given a country’s expected economic
performance in the medium to long term and given its exposure to other
economic factors such as exogenous shocks. If the projections show that
a country is likely to break its debt thresholds or that it will not make
enough progress in lowering its debt ratios if they are currently too high,
the IMF and World Bank will advise on a change in debt policies.
At the time of writing, only a few of such forward-looking DSAs had
been constructed. The IMF therefore still has to show that it can cope
with a number of challenges that will result out of the application of the
DSF. One such challenge is how flexible the IMF will have to be if coun-
tries threaten to break their thresholds. Since low-income countries rely
heavily on external assistance, their potential to pro-actively manage their
maturity structure and currency composition of their debt is limited and
the change in policies in order to adapt its debt structure will thus often
have to be a reduction in new borrowing. If not enough grant financing is
available, this can only be done by reducing government expenditures.
The IMF and World Bank have decided to apply relatively conservative
thresholds but if these thresholds really start to bite, countries may prefer
to increase their risk of debt distress in order to maintain government
expenditure at current levels. Tension in this regard may be increased by
the fact that the DSF will likely work pro-cyclical. Since debt ratios will
rise if exports or GDP fall, a reduction in borrowing and therefore
possibly in government expenditure will be called for exactly when
economic times are rough. Note that the IMF is itself also a provider of
credit. Would it be tempted to be less strict in order to be able to
continue its own lending. The integration of the debt sustainability
assessment into the Fund’s and Bank’s own lending decision is often
called the third pillar of the new framework, which will need to be
further explored. Another challenge will be how to solve short-term
liquidity problems. Since many development assistance loans have a
grace period, even shifting from loans to grants will not have much
impact on a country’s debt service profile in the short to medium term.
The IMF can provide extra liquidity support through an augmentation
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Jan Derk Brilman, Irene Jansen and Ernst van Koesveld 143
of its PRGF if there is an increased balance of payments need due to a
shock, but IMF financing would at the same time add to the debt stock.
How should smoothing of short-term liquidity problems be weighted
against longer-term solvability issues. We look forward to the coming
years, in which increased experience with the framework will provide
useful insights on how to deal with these issues.
4 Concluding Remarks
We have discussed some of the main challenges related to the Fund’s
future role vis-à-vis low-income countries. In many respects, these
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 sustain-
ability, but without financing.
In general, the recognition of a 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. The Fund
should phase out its financial involvement when it is no longer
effective or no longer needed. The issues of “saying-no” and the design
of proper “exit strategies” are among the main future challenges of the
IMF. Especially for countries that have stabilised their economies, the
Fund’s direct role in providing balance of payments support needs to
change into an indirect role, i.e. to catalyse other sources of financing
for the achievement of the MDGs.
In order to attain the MDGs, low-income countries need significantly
more resources and more fiscal space. One of the most pressing issues is
the build-up of high debt levels in most poor member states. The new
multilateral debt relief initiative and the application of the new debt
sustainability framework should prevent the building up of new
unsustainable debts.
In sum, we expect the Fund to remain of vital importance in low-
income countries in the decade to come, but the nature of its involve-
ment will change, as it has over the last decades. We hope this change
will manifest itself in a shift from a direct role in financing balance of
payments gaps to a more indirect role in catalysing other sources of
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144 Future Challenges for the IMF in Low-Income Countries
funding by providing signals on the macroeconomic and financial
developments in countries. This would reflect countries’ progress in
bettering their predicament.
References
Bulir, Ales and Timothy Lane, (2002), “Aid and Fiscal Management”,
Working Paper 02/112, IMF, Washington D.C., June.
DFID/HM Treasury (2004), “IMF Signalling in Low-Income
Countries”, Discussion Paper, HM Treasury and Department for
International Development (DFID), London.
IEO (2002), “Evaluation of Prolonged Use of IMF Resources: Evalua-
tion Report 2002”, Independent Evaluation Office of the IMF,
Washington D.C.
IMF (2003a), “IMF Concludes Discussion on Prolonged Use of Fund
Resources”, Public Information Notice 03/49, IMF, Washington
D.C., April.
IMF (2003b), “Operational Guidance Note for Staff on Letters and
Statements Assessing Members’ Economic Conditions and Policies”,
SM/03/216, IMF, Washington D.C., 20 June.
IMF (2004a), “IMF Concludes Discussion on the Fund’s Support of
Low-Income Member Countries: Considerations on Instruments and
Financing”, Public information Notice 04/40, IMF, Washington
D.C., April.
IMF (2004b), “Signaling by the Fund – A Historical Review”, prepared
by the Policy Development and Review Department, IMF,
Washington D.C., July.
IMF (2004c), “Policy Monitoring Arrangement”, prepared by the Policy
Development and Review Department, IMF, Washington D.C.,
September.
IMF (2005), “Bolivia: Ex Post Assessment of Longer-Term Program En-
gagement – Staff Report and Public Information Notice on the
Executive Board Discussion”, IMF Country Report No. 05/139, IMF,
Washington D.C., April.
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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145
9
Reviewing the Role of the IMF in
Low-Income Countries
Caoimhe de Barra
n an era where “partnership” is the leitmotif of development
discourse, the IMF stands apart. In a context of increased multi-
donor initiatives to develop joint assistance strategies with partner
governments, the IMF largely continues to operate in strict bilateralism,
with a limited group of interlocutors in Ministries of Finance and
Central Banks.
Tortuous debate on the role of the IMF in low-income countries has
taken place at Board and staff level. At its most fundamental, the
debate has been about whether the Fund’s role is to have a bilateral
relationship with member countries only, focused 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 poverty reduction.
This chapter argues that the Fund has a contribution to make to
poverty reduction and sustained growth, but that this is only possible if
it operates as a partner with other stakeholders at both international and
national levels. The Fund should remain focused on its core areas of
competence but change the way it operates. To be effective its contribu-
tion needs to be coherent with a broader understanding of the nature of
development and the political economy of growth and poverty reduction.
This chapter addresses some ongoing areas for debate around the role
of the Fund in low-income countries. How should the Fund address
poverty. What is the Fund’s role in mobilising finance for development.
What are the changes in policy and practice needed to IMF condi-
tionality. What deeper changes are required in the Fund’s signaling role.
I
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146 Reviewing the Role of the IMF in Low-Income Countries
1 The Role of the Fund in Poverty Reduction
The primary role of the Fund in low-income countries should be to
highlight to governments the implications of alternative macro-
economic policy paths and encourage governments to decide which
path to follow, based on that government’s consideration of the social,
economic and political trade-offs involved, after a process of domestic
consultation.
However, a narrow interpretation of this role is not tenable. While
growth in many low-income countries has stabilised after a disastrous
decline over recent decades, inequality and poverty have increased,
even in stable performers with a history of social concern, such as
Tanzania. Policies for growth and stability are not enough. Policies,
including macroeconomic policies, must be expressly designed to
achieve reduction of poverty and vulnerability. They should be subject
to rigorous testing for their ability to meet those objectives.
The Fund faces a choice therefore, both in policy development and
in application of policy at country level: it can take the option for the
poor, or it can try to take a neutral position by adopting a minimalist,
technical approach to growth and macroeconomic stability in low-
income countries. As decades of experience have illustrated, however,
there is no such thing as “neutral policy”, economically, socially or
politically. Indeed, the political economy of policy change has been a
significant blind spot for the Fund.
Taking the “option for the poor” would mean considering vulner-
ability and inequality as important determinants of potential macro-
economic policy. The operational implications are that the Fund needs
to ensure that its macroeconomic analysis is carried out in such a way
as to allow multi-disciplinary assessment of the implications of its
analysis and recommendations.
The Fund should subject its own work to independent analysis from
a poverty-reduction and social vulnerability perspective, in order to
ensure that the medium to long-term social and economic implications
of its analysis are clear to policymakers and the stakeholders in the
Poverty Reduction Strategy (PRS) processes, or its national equivalent.
Indeed, the Fund promised no less than this when it included in the
key features of the PRGF the promise to subject major reforms to
Poverty and Social Impact Analysis (PSIA). To date however, this
analysis has proven limited, dealing with a set of discrete structural
issues in a small number of programme agreements. Certainly, there is
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Caoimhe de Barra 147
no sense that PSIAs would routinely be carried out on all major or
contentious reforms, in spite of the clear “ownership” imperative of
reforms arising from such work, particularly if that is carried out
independently of the IMF.
In this chapter, I argue that the Fund should take a partnership
approach to its role. This would mean taking a country-by-country
approach to policy analysis, stimulating debate among a broad set of
stakeholders through increased transparency and being seen to be open
to national-level analysis and views. This is further elaborated below.
Institutional resources dedicated to low-income countries should
increase, including delegating increased staff and analytical and decision-
making capacity to field offices. This is a prerequisite for understanding
the country-specific complexities of development in countries for which
there are no easy parallels in development history.
2 The Fund’s Role in Mobilising Finance for Development
Low-income countries face a deep finance constraint that compromises
their ability: to deliver on basic services; to develop sustainable institu-
tions capable of managing scarce resources; to generate growth
sufficient to eradicate poverty; and to plan for and withstand foresee-
able shocks (see Trócaire, 2004; Oxfam, 2004a). This logic is broadly
accepted, and has resulted in pledges of a doubling of aid to Africa by
2010 over 2004 levels, and an overall increase to $115 billion by 2010,
from $78 billion in 2004. However, even this increase – assuming it is
delivered – will be insufficient to meet the Millennium Development
Goals, which are themselves a minimalist baseline.
The persistently binding financial constraint faced by low-income
countries dramatically narrows their range of options both in relatively
good times and when they are faced with a balance of payments problem.
Chapter 8 deals with the phenomenon of long-term users of the Fund’s
resources and argues cogently for a reduction in dependence on Fund
resources. These are valid arguments.
However, vulnerability to shocks will invariably lead low-income
countries back to the Fund, unless radical solutions can be found, such
as those outlined by Martin and Bargawi in this volume. The new IMF
shocks instrument will do little to change the fundamental problem of
the policy response to shocks, unfortunately. Demand compression
tends to be the primary policy response to crises in low-income countries,
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148 Reviewing the Role of the IMF in Low-Income Countries
given the inadequate levels of finance available and the fact that adjust-
ment based on exchange rate devaluation is frequently economically or
politically inadvisable.
Demand compression is a highly questionable tool in such circum-
stances however, given its negative impact on economic growth. Low-
income countries can find themselves locked into low-growth scenarios
that could be avoided through adequate, early provision of liquidity.
Bird (2005) argues in favour of increased finance rather than reducing
aggregate demand therefore. And he is right.
Rather than a new Fund facility for shocks, it would have been
preferable to establish a donor financed, grants-based shocks facility to
deal with shocks as they arise in a manner that would protect progress
made on the MDGs and stimulate a fast recovery.
Unfortunately, there is likely to be little movement on this for some
time, therefore it is important to look at the Fund’s role in helping to
prevent or mitigate shocks and in mobilising the resources promised by
donors in recent pledging sessions, including the G-8 meeting in
Gleneagles in July 2005.
Aid flows are notoriously fickle; hence, “predictability” has become a
central element in the aid effectiveness agenda. The Fund should focus
on mobilising higher levels of stable resources through its illustrations
of the economic effects of unstable aid flows, and in partnership with
other actors, the social effects of chronic resource gaps. In the latest
paper reviewing the PRSP approach, the IMF and World Bank (2005)
call for alternative scenarios to be included in PRSPs, showing what
could be achieved with a different combination of resources, policies
and other public actions. There is clearly a mandate for the Fund to
use its considerable muscle to advocate for more and better aid.
The Fund has several broad concerns on finance increases however,
which may make this difficult. One of the most important is absorp-
tion capacity and macroeconomic destabilisation. Recent analysis by
the IMF (2005A) highlights the complexity of the absorption issue and
in particular shows that aid is not being spent, because countries are
fearful of creating exchange rate imbalances and hampering exports. I
believe that the answers to this problem are not to be found in limiting
aid flows, but in marrying longer-term finance plans with programmes
to dramatically develop economic productivity and export capacity.
The implications for the IMF are important. Firstly, it shows that a
straightforward cap on the fiscal deficit which limits aid inflows is
neither necessary – as countries seem to self-censor for fear of exchange
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Caoimhe de Barra 149
rate appreciation – nor advisable. It is not advisable as it forgoes oppor-
tunities for investment, growth and poverty reduction.
In practical terms, the Fund research suggests that there should be
more flexibility in its policy recommendations, including allowing
countries to spend unexpected windfalls and to draw down on reserves
when aid shortfalls occur. However, the litmus test of this potential
change in Fund thinking will be the content of Fund agreements and
in particular the targets which are de facto conditions for an ongoing
PRGF agreement.
3 What Are the Changes in Policy and Practice Needed to IMF
Conditionality.
The legitimacy and effectiveness of conditionality in general are heavily
contested but a number of conclusions are by now axiomatic. For
example, excessive conditionality is counter-productive and undermines
ownership; conditionality should be streamlined across all donors and
particularly the IFIs; all conditionality should be based on benchmarks
drawn from governments’ national development plans; and condi-
tionality should be evidence-based and independent PSIAs should be
carried out on all major reforms.
Furthermore, it has become widely accepted that policy and process
conditionality run counter to normal democratic processes at a
domestic level and conditionality should therefore be outcome-based.
Conditionality should take the local political economy and potential
shocks into account and targets should be stress-tested for realism.
Conditionality should be disaggregated so that failure to meet a small
number of conditions does not result in aid volatility.
With respect to the Fund’s conditionality, there is particular conten-
tion around two issues: firstly, as discussed below, the Fund imple-
ments conditions independently of other donors, in spite of the move
towards harmonised approaches. Secondly, the assumptions used in the
design of fiscal and monetary targets and their links to stabilisation,
growth and poverty reduction are contentious. The flexibility granted
to countries in meeting programme targets is also highly contested.
This is particularly true for “poor” performers (Trócaire, 2004).
For example, Martin and Bargawi (2005a) found that the Fund
seems to expect countries to reach 3 percent inflation and a 1 percent
budget deficit after grants before allowing any room for flexible policies.
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150 Reviewing the Role of the IMF in Low-Income Countries
They assert that these levels may be too low to be compatible with the
growth needed to reach the MDGs. Oxfam (2004, p. 17) found that
out of 20 countries with PRGFs, inflation of less than 5 percent was
targeted without any discussion of the trade-off between this reduction
and poverty-reducing expenditure.
After many years of such critical comment, Fund research (IMF,
2005a) has recently come to the conclusion that an inflation rate of 5-
10 percent is appropriate and that countries should be encouraged to
aim to remain within this range, rather than to aim for a specific point.
This is significant as inflation is one of the “sacred cows” in the Fund.
Nonetheless, it is only a small part of a portfolio of analysis that needs
to be radically different if countries are to achieve poverty reduction
commensurate with the MDGs.
It is widely acknowledged for example, that growth targets for low-
income countries should begin with the MDGs. The use of costed
MDG outcomes as the basis for determining growth and poverty
reduction strategies has finally influenced IFI thinking, it appears. As
noted above, the latest IMF and World Bank paper reviewing the
PRSP approach calls for alternative scenarios to be included in PRSPs.
This is welcome, but it will nonetheless require a significant shift in
culture and practice for the Fund, particularly in relation to the actual
development of PRGF programmes at country level. As the IEO (2004)
found, average practice in the implementation of good principles under
the PRGF, including flexibility, is far removed from best practice. For
example, Martin and Bargawi (2005a; p. 106) found virtually no mention
of the MDGs in an examination of 72 PRGF-supported programmes.
An approach within the Fund that actively promotes flexibility in
PRGFs and alternative scenarios in PRSPs will require changes in the
way the Fund does business. Fund staff will have to engage with
experts in social and political dimensions of economic growth in order
to frame its advice in a context that is squarely focused on poverty
reduction and equitable growth. It will require that Fund staff spend
more time working in partnership with governments, donors and other
stakeholders at a country level, instead of working in isolation, in
under-staffed local offices, and interacting almost exclusively with a
small cadre of finance officials.
It will need to make its programme advice genuinely transparent and
accessible to stakeholders within and beyond government and other
donors. It will also need to engage other donors – notably key Board
members – to impress upon them the logic of financing development
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Caoimhe de Barra 151
at adequate levels now in order to reduce poverty, generate growth with
equity and build institutions for long-term development.
4 Signaling: Is the Debate Over.
Contrary to the assertion in Chapter 8, I believe the debate on signaling
for the IMF is not over. As outlined in that Chapter, the IMF holds a
critical, if unsought, role as gatekeeper for budget support, effectively.
It is in this position because the broader donor community requires
assurance that a country has its macroeconomic situation under control
if it is to receive financial assistance. At a general level, this is reasonable.
However, there are several problems with the Fund’s role as signal-giver.
First, there is a fundamental difference in the purposes of support
given by the Fund and other donors. Hence, the information required
to make funding decisions differs substantially. The Fund imposes
conditionality on countries in order to ensure that its loans, drawn
from a relatively small pool, are repaid as quickly as possible and that a
country does not fall into arrears. Its conditions are designed to ensure
that countries will not fall into future balance of payments difficulties.
Other donors, on the other hand, need to know whether aid is being
used for the purposes for which it was intended, e.g. poverty reduction
and long-term development. The interruption of a PRGF programme
because of failure to meet IMF targets is not a suitable proxy for judging
a government’s capacity to use aid effectively. Arguably, donors are dele-
gating decisionmaking power to the IMF on development issues that are
beyond the Fund’s mandate and competence.
Furthermore, while a broad indication of macroeconomic stability is
important for donors – particularly in the context of budget support –
a PRGF will contain a significant number of conditions that can in
theory send a country “off-track” if they remain unmet. These include
structural conditions, which continue to proliferate in spite of the
streamlining initiative, and micro-conditions.
1
Most budget support
donors require an on-track PRGF for disbursement. Countries such as
——————————————————
1
Structural conditionality has become tighter in recent years, in the experience
of HIPC Finance Ministers, in spite of the streamlining initiative. Martin and
Bargawi (2005a, p. 97) also highlight the excessive level of micro-conditions in
some programmes and note that there is no conceivable link to macro-stability,
for example in the condition to issue ID cards for all teachers in Sierra Leone.
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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152 Reviewing the Role of the IMF in Low-Income Countries
Honduras and Zambia have lost $400 million and $50 million
respectively in budget support and interim debt relief as a result of
going “off-track” in recent years (Oxfam, 2004).
Fund staff sometimes go to significant lengths to keep countries “on-
track”, recognising the potential impact of an off-track signal on
resource flows. However, such a response is not satisfactory for any of
the stakeholders, as highlighted in Chapter 8. Unfortunately, the new
Policy Support Instrument (PSI) is probably not the answer either.
The PSI was designed to meet needs of certain mature stabilisers
who do not require Fund resources, but for whom the signal of macro-
economic integrity is important. This is effectively an instrument of
enhanced surveillance, without a lending programme attached. It remains
to be seen how this instrument is used and what its impact is on aid
volatility in stabilised countries. It is patently clear however, that this
latest instrument retains all the hallmarks of the power imbalances
between donors, IFIs and “partner” countries that are theoretically
being dismantled under the “aid effectiveness” agenda.
The IMF’s role as gatekeeper has to be radically reformed on a deeper
level – one that places the countries’ national policymaking processes at
its centre. In the context of reasonably rapid movement towards multi-
donor assistance strategies for partner countries, this now looks more
possible than ever. Specifically, the PRGF “on/off” signal should be
replaced by a country-specific agreement between all donors and govern-
ment on the triggers that would result in aid reduction or suspension.
It should be built into a joint government / donor performance assess-
ment and harmonisation matrix.
While such joint performance assessment frameworks are increasingly
common, the IMF – and macroeconomic conditionality – remains
resolutely outside these frameworks. In a future scenario, jointly agreed
performance targets could be based on the main objectives in the PRSP,
or an equivalent national development plan, and would also include all
the core macroeconomic targets typically negotiated between the IMF
and government.
Donors, including the IMF, would commit not to impose condi-
tionalities unless they appear in the agreed matrix. The PRGF would
be based on the targets emerging from such a government-led Poverty
Reduction Strategy process – or national equivalent – on a macro-
economic framework, rather than the reverse. Above all, the PRGF
should not predetermine the macroeconomic framework for a country,
nor should donors link conditionality in budget support matrices to
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
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Caoimhe de Barra 153
existing PRGF conditions.
Civil society and parliament should input to and monitor the imple-
mentation of such a performance assessment and harmonisation matrix,
under a rights and rule-based system. Such an instrument should be an
accountability mechanism both for national governments and for
donors.
The obstacles to such a partnership-based system are limited and
surmountable. The Fund claims that it cannot legally enter multi-
donor agreements. This can be changed. It states that it can only
negotiate with governments. The above framework does not require it
to strike a deal with actors other than national governments. However,
it does require the Fund to contribute as one actor amongst many, in
offering advice and support to a government that has the freedom to
take its own decisions based on national consultation.
5 Conclusion
The debate on the Fund’s role in low-income countries has been at the
heart of policy discussions in the Fund and with external stakeholders
for many years. The Fund could try to confine itself to a strictly
bilateral relationship with member countries, focused only on macro-
economics, but this option has effectively been rendered obsolete by its
commitment to the Monterrey Consensus and the MDGs. The Fund
has to position itself as part of a multilateral framework, therefore, and
it has to leverage its core competence in macroeconomic stabilisation
and growth to help deliver the MDGs.
This chapter notes that there is no such thing as “neutral policy” and
that therefore the Fund has to take the option for the poor in its
programme design. The Fund has to take responsibility for ensuring that
its interventions, whether hard (i.e. conditionality) or soft (i.e. technical
assistance and capacity building) are consistent with poverty reduction.
It has to ensure that its surveillance and analytic work are rooted in
protection of expenditure on poverty reduction and are geared towards
mobilising higher levels of grant financing, as opposed to having a
default option towards deeper demand reduction, structural reform
and excessive fiscal and monetary tightness.
Ultimately, the role of the Fund should be to highlight to government
and other stakeholders in a Poverty Reduction Strategy-type process
the implications of alternative macroeconomic policy paths and
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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154 Reviewing the Role of the IMF in Low-Income Countries
encourage governments to decide in consultation with those stake-
holders, which path to follow. This analysis needs to take on board the
political economy of change and in particular the implications for
poverty reduction, vulnerability and inequality. This will require a
greater partnership-based approach to the Fund’s work and a change in
working culture as well as policy orientation.
Furthermore, the Fund’s staff and management need to engage other
donors – notably key Board members and Governors – to impress
upon them the logic of financing development at adequate levels now
in order to reduce poverty, generate growth with equity and build
institutions for long-term development.
I would propose a partnership model for the Fund in 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 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.
References
AFRODAD (2004), “Understanding the Poverty Reduction and
Growth Facility (PRGF) and Its Implications for Development”,
Harare, Zimbabwe.
Bird, Graham (2005), “The IMF and Poor Countries: Towards a More
Fulfilling Relationship”, In: J.J. Teunissen and A. Akkerman (eds.),
Helping the Poor: The IMF and Low-Income Countries, FONDAD,
The Hague.
EURODAD (2004), “Open Letter from 26 Civil Society Organisations
on What Role the IMF Should Play in Low-Income Countries”,
EURODAD, Brussels.
IEO (2004), “Evaluation of the IMF’s Role in Poverty Reduction
Strategy Papers and the Poverty Reduction and Growth Facility”,
Independent Evaluation Office of the IMF, Washington D.C.
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the Medium Term – Issues Paper for Discussion”, prepared by the
Policy Development and Review Department, IMF, Washington
D.C., July.
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Caoimhe de Barra 155
Countries”, prepared by the Policy Development and Review Depart-
ment, IMF, Washington D.C., August.
IMF (2005a), “The Macroeconomics of Managing Increased Aid
Inflows: Experiences of Low-Income Countries and Policy Implica-
tions”, prepared by the Policy Development and Review Department,
IMF, Washington D.C., August.
IMF (2005b), “Review of PRGF Programme Design – Overview”,
prepared by the Policy Development and Review Department, IMF,
Washington D.C., August.
IMF and World Bank (2005), “2005 Review of the Poverty Reduction
Strategy Approach – Balancing Accountabilities and Scaling Up
Results”, prepared by the Staffs of the International Monetary Fund
and World Bank, IMF/World Bank, Washington D.C., September.
Johnson, Alison, Matthew Martin and Hannah Bargawi (2004), “The
Effectiveness of Aid to Africa Since the HIPC Initiative: Issues,
Evidence and Possible Areas for Action”, Development Finance Inter-
national, London.
Martin, Matthew and Hannah Bargawi (2005a), “A Changing Role for
the IMF in Low-Income Countries”, In: J.J. Teunissen and A.
Akkerman (eds.), Helping the Poor: The IMF and Low-Income
Countries, FONDAD, The Hague.
–––– and Hannah Bargawi (2005b), “Protecting Africa Against
‘Shocks’”, in this volume.
Oxfam (2004), “From Donorship to Ownership. Moving Towards
PRSP Round Two”, OXFAM, Oxford.
Oxfam (2004a), “Paying the Price – Why Rich Countries Must Invest
Now in a War on Poverty”, OXFAM, Oxford.
Trócaire (2004), “The Other Side of the Coin – An Alternative
Perspective on the Role of the IMF in Low-Income Countries”,
Trócaire, Maynooth.
Williamson, John (2005), “Policies to Reduce the Vulnerability of Low-
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pg_0170
Helping the Poor. The IMF and Low-
Income Countries,
Edited by Jan Joost Teunissen and Age
Akkerman
FONDAD, The Hague,
June 2005
ISBN-10: 90-74208-25-8
ISBN-13: 978-90-74208-25-3
253 pages
Price: € 17.50
Contributing authors say:
“Above all, the IMF needs to adapt its condition-
ality to the needs of low-income countries and
their wishes for genuinely country-led strategies.”
Matthew Martin and Hannah Bargawi, Debt
Relief International
“The IMF should be more flexible in programme
design and react as problems reveal themselves, as
opposed to setting unrealistic monetary and infla-
tion targets.”
Louis Kasekende, Bank of Uganda
“The recurrent nature of the debt problems,
the ongoing debates, and the limited and poor
resource transfers are but signs of the need for
deeper reforms to the institutional framework
for dealing with the financing problems of low-
income countries.”
Stijn Claessens, World Bank
“The Bank’s and the IMF’s future role in-
volves… greater empowerment of the borrowing
governments and… a move from stabilisation to
more pro-poor macroeconomic frameworks.”
William Lyakurwa, African Economic Research
Consortium
“Given the lack of scientific consensus about the
causes of growth, member countries need to be
encouraged to formulate their own development
strategies that the IMF can then endorse, monitor
and support.” Graham Bird, Surrey Centre for
International Economic
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0171
Diversity in Development: Reconsidering
the Washington Consensus,
Edited by Jan Joost Teunissen and Age
Akkerman
FONDAD, The Hague,
December 2004
ISBN-10: 90-74208-24-X
ISBN-13: 978-90-74208-24-6
238 pages
Price: € 17.50
Contributing authors say:
“The Washington Consensus is the farce that
the development establishment in Washington
foisted upon the developing world as universal
science..."
Wing Thye Woo, University of
California
"...the international divergence of income levels
and high financial volatility in both the devel-
oped and the developing world are increasingly
seen as inevitable outcomes of the neo-liberal
global order."
José Antonio Ocampo, Depart-
ment of Economic and Social Affairs of the
United Nations
"There is strong evidence that trade liberalisa-
tion has helped growth and has not worsened
inequality..."
Anthony Boote, Policy Develop-
ment and Review Department, IMF
"The science of economics, the economics pro-
fession and international economic organisations
cannot continue to ignore the social, political and
cultural effects of globalisation and neo-liberal
policies."
Osvaldo Sunkel, Corporación de In-
vestigaciones del Desarrollo, Chile
“The core of the East Asian crisis was the failure
to appreciate the fatal risks of financial liber-
alisation and globalisation in the context of
weak domestic institutions.” Yunjong Wang,
Korea Institute for International Economic
Policy
From: Protecting the Poor - Global Financial Institutions and the Vulnerability of Low-Income Countries
Fondad, The Hague, November 2005. www.fondad.org
pg_0172
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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