Making the Most of Bad Situations

By Hugh Bredenkamp

Governments in low-income countries are having to deal with a lot of bad news these days. Slow growth in the advanced economies is dampening demand for their exports and affecting inflows of investment, aid, and remittances. Changes in credit conditions elsewhere influence the availability of trade finance. Volatility in commodity prices creates problems for both importers and exporters. Meanwhile, climactic and other natural disasters continue to occur at the local and regional level.

For low-income countries, the impact of these problems can be especially damaging. A surge in food prices can undo years of poverty reduction. A collapse in the price of a key export commodity can throw many people out of work and cause tax revenues to slip, just when expenditures on public services are needed most. For the poorest countries, events elsewhere can quickly affect employment, inflation, the budget, debt, and the balance of payments.

Tailored financing

To soften the painful adjustment associated with these events, low-income countries have tended to rely on external financing from the IMF, World Bank, and other international institutions. This role of the international institutions will remain critical, and we have undertaken reforms and innovations to make IMF financing more responsive to the needs of the LICs. (The World Bank has also undertaken important reforms.)

While the nature of our mission means that IMF financing role will remain largely “ex post” (arranged after the event), the January 2010 reforms allow us to provide financing that is better tailored to a country’s specific needs and is delivered more promptly.

Those LICs that have built up macroeconomic buffers can use them as a sort of “self-insurance” to soften a blow. Many did this effectively in 2008 and 2009, responding to the global recession with looser monetary and fiscal policies. These counter-cyclical policies were possible because in the preceding several years many low-income countries had brought down inflation, improved their fiscal and debt situations, and built comfortable levels of foreign exchange reserves—thanks to careful macroeconomic management and external debt relief.

Self-insurance and official financing will remain critical for LICs, but complementary strategies can also help. In a recent paper (joint with World Bank staff) we explore the potential role of contingent financial instruments (CFIs) in helping governments in low-income countries deal with some types of bad events. CFIs are pre-arranged instruments that are triggered when a particular (carefully-defined) event occurs. They can take the form of insurance instruments, market hedging contracts, credit lines, and debt instruments with repayment terms adjusted depending on certain events.

Because CFIs are automatic, they can disburse quickly if an event occurs—making public finances more predictable. This helps a government to avoid abrupt spending cuts or other difficult policy measures that might otherwise have to be taken.

Use of CFIs by low-income countries overall has been limited (although the use of commodity hedging by public entities has recently been increasing). However, the international financial institutions can play a useful role in facilitating their increased development and use.

Managing risks

The core priority is to help LICs to build strong frameworks for measuring and managing the risks they face, along with operational and practical advice on how to best manage assets and liabilities (such as public debt management) in light of these risks. The IMF and World Bank already provide specialized assistance in these areas.

International partners are in several cases already helping to design and facilitate the use of CFIs in low-income countries. In Ethiopia, a drought index known as Livelihoods, Early Assessment, and Protection (LEAP) is linked to donor contingency funding to provide timely delivery of cash to distressed households in the event of severe drought.

With support from the World Bank and the UK’s DFID, Malawi has purchased weather derivative contracts to help protect itself from severe drought. Malawi also uses hedging contracts for maize; by carefully specify the terms for physical settlement, these customized contracts protect not only against import price volatility but also such factors as transportation constraints and the performance of local traders—enhancing the country’s food security.

Ways to ramp up help

International financial institutions could ramp up their assistance in a number of ways. These could include supporting the design and implementation of risk pooling arrangements, serving as intermediaries for market hedging transactions, and helping to design and coordinate issuance of contingent debt instruments. (France already offers a development loan with a floating grace period, providing flexibility in repayment terms under certain circumstances.)

To reiterate, these efforts ought to be seen as complementary to self-insurance by LICs, and to the more conventional financing provided by international financial institutions.  But facilitating use of contingent financing instruments—especially as part of a broader effort to help low-income countries manage the many risks they face—would pay off over time with enhanced economic stability.

8 Responses

  1. We need to start looking for a United Europe as one country, and each member country becomes a state within United Europe. And all financial problem should be shared among the states so that United Europe become a lot stronger instead of what we have today. Europe need to get stronger or we will lose all power as one.

  2. The issue of funding LICs goes much deeper than what is perceived by the reformists. LICs have the majority of their population in rural areas where the need for assistances is highest. These areas are hardly touched by funding, aid, and “economic sustainability.”

    Food, aid, and tailored lending to a LIC only benefit (if at all) the few who are able to participate in the formal mainstream market of that particular country, whilst the poor and poverty stricken are still left behind. Food and aid is all nice and well but one needs to create a sustainable environment which will allow the poor to work their way out of poverty and not live on hand-outs.

    One should start investigating the idea of Social Businesses which will not only provide the necessary services but also create an industry where the locals can participate.

    • Great is yet to come; all this while, the IMF has responded to problems in the developed countries, but meanwhile, for the undeveloped countries it has been hard times; for those developed countries, it has been a great opportunity to create wealth in undeveloped countries. Now is the time that IMF SHOULD SHIFT THE STRUCTURE in order to balance the whole economic system, without favoring any countries. It should just depend on the outlook and potential of each country.

      Blessed be the days to come ahead……in peace with love.

  3. I am not an economist; however, with the little knowledge I garnered in university I have been trying to assess what is the general objective of the world’s financing institutions like the IMF and World Bank for the the global economy. With the global economy in distress due to the ever growing demands of the world’s population and scarcity of resources, I reckon it is time to devise a plan to deal with the world’s crisis. I mean endemically the world is faced with the challenge to survive with ever decreasing resources.

    Also in terms of the financing mechanism available to support LICs, the idea is great but I don’t see LICs being able to repay their foreign debts if they are not even sustainable on their own. The repayment terms therefore can be made as feasible as possible but given that the larger economies are being faced with challenges of their own, it is evident that the repercussions of these challenges are mirrored significantly in the smaller yet dependent economies .

    The world economy focus needs to shift direction from a capitalist economy to a more mixed economy and cater to meet the needs of the people. More global integration between MDCs and LICs is needed to ensure a global recovery from this crisis.

    Thank you…

  4. Hugh, this is a great summary on how interrelated our world has become and insight on the funding out there. Given the big scope of development and emergency needs in LICs, and the fact that the various types of funding available from many different sources is dwindling, it is important to centralize these financial resources for better utilization, efficiency, and effectiveness.

    It is easy to get mired in local politics and short-term or immediate problems at the expense of a global view and more long-term and sustainable planning. Education on what is available out there, better planning for the future, and resource management are also great tools for decision makers to use in meeting the needs of their people.

    • Given the big scope of development and emergency needs in LICs, and the fact that the various types of funding available from many different sources is dwindling, it is important to centralize these financial resources for better utilization, efficiency, and effectiveness. We agree, however, that the challenges of the current rising demands over population, food, and not proper financial institutions makes it more difficult for a developing country to sustain growth; it looks like economy wars are almost ready to burst out there with current rising demand and population…..we choose the IMF as a better institution for the world economy and sustainability of each country

  5. The wealthier countries can contribute in such ways as giving food or drastically lowering the food prices to “help out” in a matter of speaking.

    I think the 2010 January reform for the IMF to “tailor lending to a country’s specific needs” was the correct reform as the priority system works best because only that country knows what it actually needs.

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