Finance

Analysis

Drowning By Numbers – Executive Summary

14 June 2000 | Briefing

Facilitating Private Sector Flows

The IMF and World Bank are advocating a new paradigm for capital flows founded on the efficiency of free-flowing private capital. This implies limiting the role of public sector institutions (including the IMF and the World Bank) to helping the market to operate effectively, intervening directly only where it fails to operate.

The IMF and the World Bank have pursued and are further pushing this paradigm shift through:

  • structural adjustment programmes (SAPs);
  • direct support for the private sector via the International Finance Corporation and Multilateral Investment Guarantee Agency and other guarantees;
  • capital account liberalisation (CAL);
  • the Heavily Indebted Poor Country Debt Initiative; and
  • strategic use of research, conferences, training and high-profile publications.

Aided by these actions, there has been a massive growth in the flows of Foreign Direct Investment (FDI), portfolio equity investment and commercial lending to developing countries in recent years. This trend has coincided with a decline in official flows of grants and loans. According to the logic of their paradigm commercial capital flows should be able to compensate for this decline, yet poverty is pervasive and crises in Mexico, East Asia and Russia show a continuing need for official flows.

The Financial, Policy and Development Costs of Commercial Flow

However, there are a number of serious doubts about over-reliance on these types of investments as mechanisms for North-South financial flows, especially in low-income countries.

They are extremely expensive in foreign exchange terms, especially for poorer countries. As a result, maintaining a positive net resource transfer requires a continual and increasing flow of new capital, which entails a very rapid build-up of foreign exchange liabilities.

They are strongly skewed away from poorer countries, whose efforts to compete for the available flows reduce the potential benefits to the host country.

They are volatile, procyclical and (in the case of equity investment) subject to serious problems of contagion, increasing vulnerability to external shocks.

They seriously limit a government’s economic policy options, and over the longer term, they may seriously weaken the political system by increasing the role of TNCs.

A universal opening to all forms of capital flows for all purposes should be avoided. This suggests a need to retain some degree of control over commercial capital flows. This is incompatible with the proposed extension of the IMF‘s mandate to include capital account liberalisation. What is needed is a selective approach, to ensure that flows are limited to those which confer net benefits from a long-term developmental perspective. Simply seeking to sustain the volume of North-South financial flows could be seriously counterproductive if the liabilities created by commercial flows prove unsustainable; or if the wider effects of the flows themselves, or of the processes of opening the economy to them and attracting them, have negative effects on economic or human development.

This suggests that:

portfolio investment should generally be avoided by low income countries, as being too expensive and too volatile;

direct investment should be limited as far as possible to the creation of new capacity for the production of exports which will not have an adverse effect on other developing countries (eg., by depressing commodity prices), and other sectors where the benefits of foreign investment to the rest of the economy outweigh the potential costs of the investment (eg., telecommunications); and

competition for FDI flows which reduces their benefits to host countries (eg., tax breaks, direct or indirect subsidies and preferentialtreatment) should be avoided.

For middle-income countries, the balance between the costs and benefits of commercial financing tends to be more favourable: the cost is lower; the build-up of the stock of investment is slower; economies are less subject to other external shocks (eg., due to the greater diversification of their export bases); and political systems are generally more robust. Nonetheless, caution is required; and the volatility of portfolio investment is likely to be a particular problem, as demonstrated by the East Asian crisis.

Apart from their limited access to commercial flows, their high cost and volatility will seriously limit the extent to which most low-income countries can rely on this source of finance. Commercial capital flows cannot simply substitute for official sources of finance. Therefore, if financial flows to low-income countries are to be increased significantly in such a way as to enhance rather than damage long-term economic and human development, this will require an increase in net official flows; more grants or loans on concessional terms; and/or a substantially greater degree of debt reduction than is currently envisaged (without an off-setting reduction in new flows).

The Volume and Terms of World Bank and IMF Resources

The scope for lowering the interest rates on IBRD, IDA and ESAF loans is limited. This suggests that a better option for improving the terms of World Bank and IMF resources would be to lengthen the repayment and grace periods.

Extending the maturity of IBRD loans would help to off-set the effects of the recent increase in interest rates and charges. This would have little or no impact on the Bank’s financial position.

Extending the maturity on IDA loans could only be achieved at the expense of reducing future IDA loans. IDA credits are not generally too expensive for IDA borrowers, so it is probably only realistic to argue for more concessional terms in specific circumstances where there is a particular need, for example:

  • the poorest low-income countries;
  • other low-income countries which already have unsustainable debt burdens;
  • countries in post-conflict situations, where liquidity can be expected to be weak (or to require new borrowing) for an extended period; or
  • projects and programmes where the foreign exchange benefits are indirect or slow to materialise, particularly in the social sectors (eg., health, education, safety net programmes, etc.).

Extending the maturity of ESAF loans would need to be subsidised from bilateral aid budgets. Since this would immediately affect the availability of resources, and the policy conditions attached to IMF loans make them less attractive than bilateral loans, this would be undesirable. In principle, the IMF could contribute to the ESAF subsidy account from its own resources, including sales of its gold reserves, but this is unlikely and probably les desirable than using the available resources to finance the HIPC Initiative.

The scope for increasing the volume of resources for Bank and Fund lending is also limited. The mechanisms available for doing so represent little more than a switch of control over an essentially fixed amount of aid from bilateral to multilateral donors. Since most bilateral aid is provided on grant terms and IDA and ESAF provide loans, this is unlikely to be justifiable.

The cost of multilateral loans arises partly from their terms of repayment, partly from the transfer of policy control from borrowing governments to the Bank and Fund and partly from frequent weaknesses in the preparation, design and implementation of their programmes and projects. This suggests that there may be more scope for improving the quality than the quantity of multilateral lending. A number of measures could be taken to achieve this.

IMF and World Bank staff could ensure that governments participate fully in the process of formulating programmes and projects and that civil society is consulted.

Flexibility could be built into the programme cycle so that programmes coincide with a government’s term in office rather than an arbitrary 3-year cycle.

Improvements could be made to the Bank’s internal quality control mechanisms such as the Operations Evaluation Department and the Inspection panel; and an independent evaluation mechanism called be established for the IMF.

The Bank’s incentive structures could be changed so that staff are rewarded for the results of projects rather than the volume of money spent on them.

A mechanism could be developed whereby the Bank would assume a portion of the burden of repayment for projects which fail due to poor Bank advice or project design.

Financing Debt Reduction and the Trade-off With Official Flows

On the whole it would be undesirable to transfer more bilateral aid to the World Bank and IMF. Thus there is a trade-off between using Bank and Fund resources for maintaining current levels of lending (or improving the terms and size of IDA and ESAF loans) and providing more debt relief.

A preliminary analysis of the trade-off suggests that it would be preferable to provide debt relief rather than aid. However, the extent of this trade-off will depend critically on how the Bank and Fund contribute to the HIPC Initiative and any further debt reduction. This suggests that resources should first come those sources which will have the least impact on official financing in the future, particularly to the poorest countries, and used in sequence until the point is reached where the costs to developing/low-income countries of reduced capital flows equal the benefits of debt reduction. The sequence implied by this approach is broadly as follows:

Bank and Fund loan loss provisions;

The capital proceeds of sales of IMF gold reserves (with the largest volume of sales politically attainable);

IBRD reserves released by relaxing the capital-plus-reserves constraint on lending;

Bilateral contributions;

IDA reserves and reflows.

While the cost of using bilateral contributions to finance multilateral debt reduction is relatively high, this would not be the case if genuinely additional resources could be generated. One possibility for this would be to secure agreement from those bilateral donors which are not already doing so to meet their international commitment to provide development assistance of 0.7% of GNP for a single year, on a one-off basis, expressly for debt reduction, for example to mark the Millennium. This would generate additional resources of around $100bn – equivalent to about half of the total debt of all the HIPCS (in present value terms), even before taking account of the debt reduction likely under existing mechanisms.

If current efforts to provide adequate debt-reduction for low-income countries were to fail, other financing mechanisms might be feasible in the long term. These would include, for example, the proceeds of a “Tobin tax” – an internationally-applied tax levied at a very low rate on all international currency transactions. The sheer volume of such transactions means that such a tax would raise very considerable sums (possibly hundreds of billions of dollars per year), which would provide plentiful resources for debt reduction and other priority development needs.

To achieve just and sustainable financial flows will require political mobilisation by concerned people and governments to press the World Bank and IMF to reconsider their models and operations.