By Creon Butler, Research Director, Trade, Investment and New Governance Models, and Director, Global Economy and Finance Programme, Chatham House and Harald Hirschhofer, Senior Advisor, TCX
Developing countries need external finance on a very large scale to meet the Sustainable Development Goals; the COVID-19 pandemic has not only increased the amount they need but also made it harder to access private funding. This makes public Development Banks more important than ever, especially to catalyse investments by pension funds and other institutions in socially productive assets.
But to achieve this they urgently need to address a long-standing blind spot by giving much greater weight to helping developing countries access the risk management tools necessary to protect their finances against global shocks. Climate change and the increased incidence of pandemics make shocks affecting critical economic sectors, such as commodities and tourism, or the availability of international finance, more likely.
As one of the most important multilateral development lenders, the International Development Association (IDA) of the World Bank Group should lead the way. It provides very long-term financing on highly concessional terms to the world’s 74 poorest countries, currently lending about USD 25 billion per year. The upcoming replenishment of IDA’s financial resources (due to be completed in December 2021) is a golden opportunity to focus attention on financial risk in development finance.
Progress has been made in widening the supply of insurance against specific risks linked to weather, earthquakes and other natural disasters that cause significant economic and fiscal damage in poor countries. But these products are still limited in scale and scope.
Borrowers need to issue debt with a suitable mix of currencies, maturities and fixed and floating interest rates to offset, as far as possible, the macro risks to their revenues and expenditures. However, most poor countries have very limited – if any – access to hedging markets and lack the capacity to handle hedging instruments.
There are five practical ways in which IDA, working with the International Monetary Fund (IMF), other Multilateral Development Banks and Development Finance Institutions, can help low-income countries enhance their overall macro-financial resilience.
First, by ensuring borrowers are able to make a comprehensive assessment of the specific financial exposures they face arising from climate, health, and other global shocks, and can formulate effective risk management strategies to mitigate them.
Second, by boosting debt management capabilities in borrowing countries, and specifically those aspects that are needed to access the more sophisticated instruments necessary to mitigate currency and interest rate market risk. Recent discussions with Treasuries and Debt Management Offices in some of the poorest countries underlined that local capacity to manage currency risks borne by the government debt is very limited, reflecting either a lack of financial resources or inability to recruit staff with the necessary expertise.
Responses could include expanding the risk management focus of the IMF/World Bank’s Debt Management Performance Assessment, supporting borrowers in strengthening their legislative and regulatory frameworks, and encouraging informed oversight of the debt management process, as well as transparent accounting and reporting procedures. Otherwise, the risk mitigation strategies developed locally may never actually be implemented.
Third, by offering a range of currency, interest rate and maturity choices to best suit borrowers’ needs. Dollar-denominated loans may be convenient for the lender but they all too often impose substantial risks on the borrower that may not be fully understood at the time. In the short term, IDA should help catalyse risk hedging markets and expand financing choices for poor countries. For instance, it could offer local currency indexed loans, which provide hard currency resources to finance development but increase borrower protection against global shocks that cause exchange rate volatility. Over the medium term, public development banksshould prioritise more radical options to help poor countries hedge emerging risks including GDP- and climate-linked loans and contractual debt standstills.
Fourth, by ensuring concessional terms incentivise prudent risk management. Today, IDA offers highly concessional and undifferentiated interest rates on hard-currency loans, together with long maturities and grace periods. This can result in borrowers taking on much higher currency risk than is desirable. IDA would in part address this by also offering local currency instruments with concessional terms. But it could also link the availability of concessionality, in general, to borrowers pursuing stronger debt management strategies and management.
Fifth, by supporting more ambitious institutional reforms to broaden and deepen debt and currency markets that are critical to low-income countries. Current proposals, which link this goal to the re-distribution of surplus Special Drawing Rights (SDRs) following the recent IMF allocation, include the proposal by the UN Economic Commission for Africa (UNECA) for a Liquidity and Sustainability Facility1 and the proposal for an International Currency Fund. Both deserve consideration.
Improving the ability of low-income countries to manage macro-financial risk through better public debt management will also reduce the risk they represent on the balance sheets of lending institutions and their shareholders. This will become increasingly important to IDA and its donors as it seeks to fund balance sheet expansion by raising funds on private bond markets.
National policies to achieve sustainable long-term growth with political and macroeconomic stability will remain critical to attract public and private finance. But the five steps described above can be implemented relatively quickly and will significantly widen opportunities and skills to manage financial risk in low-income borrowers. The forthcoming IDA replenishment is an excellent opportunity to start making a difference.