Blog: Cash in times of crisis

This article was originally published by Righting Finance

In 1936, John Maynard Keynes famously said: “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill done.”

I often hear my colleagues in the development world talk about ‘volatility as the new norm’. The only certainty is greater uncertainty, they say. As uncertainty has deepened and risks have grown we can observe that this is changing the shape of official sector financing for developing countries, as well as affecting developing country governments’ choices as to where they allocate scarce public resources; increased resources are being skewed towards crisis preparedness and response.

In 2011, UNDP – the organization that I work for – adopted a new tag line: ‘empowered lives, resilient nations.’ ‘Resilience’ presumably in the face of more frequent and more intense shocks whatever their nature and origin. Shocks can have a major impact on human rights through, for instance, the loss of livelihoods and homes. In such circumstances, international human rights frameworks and conventions still require states to provide an environment in which the human rights of all citizens can be realized.

Since the 1980s, progressive financial deregulation – within countries and between countries – has led to increased instability and recurrent financial and economic crises. The full-fledged financial deregulation of financial markets and the increased sophistication of speculation techniques and financial engineering culminated most recently in the outbreak of the 2008 financial crisis. This is combined with volatility associated with more frequent and extreme weather events almost certainly associated with climate change. So how should developing countries manage this increasingly volatile external environment?

Traditional approaches to development have emphasized the importance of government’s domestic policy choices and how these support – or undermine – macroeconomic stability and development progress.  But in an increasingly globalized and interdependent world, development can be derailed by events way beyond a country’s control; domestic policy choices of governments can be relegated to backstage. The most recent financial crisis – which had its origins in the subprime mortgage market in the United States but whose impacts have been felt worldwide – is one example. Higher food and energy prices caused by speculation on commodities markets are another example.

Countries are typically advised to ‘manage risk’ more effectively and to ‘build resilience’. It’s true that governments can take a variety of measures to boost their defenses. For instance, governments can put in place flood mitigation infrastructure or invest in drought preparedness. Governments can impose capital controls, i.e. place regulations on the inward and outward flow of foreign capital in order to better manage currency appreciation, asset bubbles and volatility.  But one key element is undoubtedly about the cash: do you have the cash you need to respond to crises or can you get it from somewhere – fast and on reasonable terms and conditions?

We already know that many developing countries have built up substantial foreign exchange reserves over recent years, in part to act as a cushion against future shocks. In 2012, the IMF reports that emerging and developing countries held a total of almost USD 7 trillion in foreign exchange reserves, an increase of almost 12 percent on reserve assets in 2010. These reserves are typically invested in low-yielding assets such as US Treasury bills and bonds, with the ‘carry cost’ – the difference between the cost of acquiring the reserves and the income earned on them – estimated by some researchers (see Yilmaz Akyüz and Dani Rodrik) at billions of dollars lost annually for developing countries. This also does not include the opportunity cost of not using the reserve assets for investments in building national productive capacities; these investments could yield high development returns.

Some developing country governments have put their cash into multi-country insurance schemes such as the Caribbean Catastrophe Risk Insurance Facility (CCRIF). The Asian Development Bank has recommended that a Natural Catastrophe Risk Insurance Mechanism be established for Asia and the Pacific. CCRIF provides Caribbean governments with immediate liquidity in the event of natural catastrophes and so helps limit the financial (and social) impact of these disasters.

At the international level, the international financial institutions (IFIs) are also placing increased emphasis on shocks support. Over the last few years, all the major multilateral lenders have created new emergency and shock loan windows and/or have significantly boosted old ones.

The IMF and World Bank now have a myriad assortment of shocks facilities. From these two institutions alone, I counted no less than nine separate credit lines designed for various kinds of emergency and shocks response. The Inter-American Development Bank, Asian Development Bank, African Development Bank and European Commission also have their shocks and emergency liquidity funds, many of which were created – and all of which have been expanded – since the recent financial crisis.

For instance, at the end of 2012, the Inter-American Development Bank launched two new contingent credit facilities for Latin America and the Caribbean; one to help countries deal with shocks caused by external financial crises and another to help nations cope with the aftermath of natural disasters. The African Development Bank created a USD 1.5 billion ‘Emergency Liquidity Facility (ELF)’ in 2009 to deal with the fallout from the financial crisis.

I don’t think we should underestimate the importance of the crisis response from the IFIs. Total lending from all the major international financial institutions rose from USD 54 billion in 2008 to over USD 203 billion in 2010 and USD 202 billion in 2011. The response was swift, large and undoubtedly helped mitigate the worst economic and social impacts of the financial crisis. In expanding crisis financing, the IFIs are responding to a clear need.

The question is whether we are seeing scarce public resources for development – domestic and international resources – being diverted from long-term development purposes towards dealing with the fallout from external shocks and crises. And if we are, is it a case of dealing with the symptoms rather than the causes of crises? Which one is more consistent with the individual and collective human rights obligations of governments?

UNDP has recently partnered with the Commonwealth Secretariat on an initiative which aims to support the governments of small vulnerable economies to build expertise on shocks and emergency finance, as well as build knowledge on options for longer-term finance from non-traditional and innovative sources (such as the diaspora for instance). For small vulnerable economies which are especially exposed to external shocks and have small administrations, dealing with an increasingly complex financing landscape can be an enormous challenge.

We live in a world in which there is so much demand for development financing and for building national productive capacities through public investments. The problem is not a shortage of cash but a misallocation of resources. We can talk all we like about the importance of more finance for infrastructure and long-term development but if countries – and publicly funded lenders – constantly need to reinforce funds for emergencies and crisis response, then surely it’s time to pay more attention to the root causes of greater instability?

There have been some tentative steps forward. Basel III aims to improve the stability of the international financial system with measures to strengthen the regulation, supervision and risk management of the banking sector. For instance, banks must now meet certain capital requirements to enable them to absorb shocks. Despite this, the market fundamentalist laissez-faire approach of the last 20 years remains fundamentally intact. UNCTAD makes the case for a new start in financial market regulation under which financial efficiency is defined as the sector’s ability to stimulate long-term economic growth and provide consumption smoothing services; financial instruments which do not contribute to functional, or social, efficiency should be weeded out. ‘Nothing short of closing down the big casino will provide a lasting solution,’ says UNCTAD. In order to reduce the frequency and intensity of ‘natural’ disasters, more action on climate change is long overdue.

The UN’s on-going process to define a set of sustainable development goals to succeed the MDGs post-2015 provides a window of opportunity to address some of these concerns. Many human rights organizations have called for human rights to be at the forefront of what will replace the Millennium Development Goals. They have called for a comprehensive review of the financial and monetary system that we have and how well it serves human rights. The importance of a coherent international financial and monetary system was in fact recognized in the UN Monterrey Consensus on Financing for Development in 2002. But in the MDGs, the issue was mostly buried and forgotten. Post-financial crisis, there is now much attention on the importance of so-called ‘systemic’ issues. It’s clear that in the post-2015 context, the issue of financing for development cannot simply be limited to financing in ‘normal’ times. At the moment, it’s baby steps forward but perhaps we can capitalize on the post-2015 process to reinvigorate this debate.

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