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GLOBAL CRISIS IMPACT RISK

Low-income Countries Remain Vulnerable in Global Downturns

IMF Survey online

January 10, 2012

  • Low-income countries at risk from crises generated elsewhere
  • IMF study highlights vulnerability of poorer countries
  • Need to build up buffers for use in times of trouble

Most low-income countries recovered swiftly from the 2008–09 financial crisis and have posted steady growth since early 2010.

But progress in rebuilding economic buffers has been slow, and these countries are now less prepared to respond to new external shocks, according to an IMF study.

Speaking at a panel discussion at the Center for Global Development (CGD) in Washington, D.C., IMF Deputy Managing Director Min Zhu said that with the world’s attention focused on Europe, it is important not to lose sight of the fact that low-income countries in recent years have been affected by crises caused by other countries.

If another global downturn develops, low-income countries will have more limited budgetary space to respond. A recently conducted vulnerability exercise by the IMF estimates that an additional 23 million people could fall into extreme poverty; poorer countries could need $27 billion in external financing under that scenario.

Protecting against trouble

Poorer countries need access to external assistance from the international community to better protect their economies against external shocks and help them to manage volatility.

“We at the Fund are very much determined to carry out our mission, one important part of which is to maintain economic and financial stability for the low-income countries, to promote sustainable and inclusive growth in those countries,” Zhu said. “We have increased our capacity for concessional loans to $17 billion through 2014 and have made our financial instruments much more flexible to be able to reach out to countries who need our help.”

The December 14 discussion, moderated by CGD vice president Lawrence MacDonald, was based on the key findings of two new IMF reports: a study on how current risks and vulnerabilities, including a sharp downturn in global growth and further commodity price shocks, would affect low-income countries, and a second report in which the IMF and the World Bank explore the role that contingent financial instruments such as commodity hedging, contingent debt, and self-insurance could play to help low-income countries manage global volatility.

Response to global shocks

Hugh Bredenkamp, Deputy Director of the IMF’s Strategy, Policy, and Review Department, explained in a presentation that with less-diversified economies, low-income countries do not have the necessary cushion to adjust easily to negative shocks. Most poorer countries recovered swiftly from the global crisis and have grown strongly since early 2010, but progress in rebuilding macroeconomic buffers has been slow, and these countries are now less well prepared to deal with external shocks than they were before the crisis.

The IMF study finds that low-income countries are highly vulnerable to the risk of a sharp global downturn, at a time when there are severe downside risks to the global outlook and donor financing is likely to be more constrained. In the event of a global growth downturn, poorer countries with the fiscal capacity should try to maintain spending to soften the economic and social impact.

Also, in countries with contained inflation, monetary and exchange rate policy could be used more actively to mitigate the impact of the shock. In case of a protracted downturn or lack of fiscal space, low-income countries should limit revenue declines and prioritize spending, the study recommends.

Surge in commodity prices

Low-income countries also remain vulnerable to surges in commodity prices given in particular the severe impact of food prices on poverty. A pragmatic macroeconomic policy response, Bredenkamp suggested, includes targeted measures to protect the poor, fiscal space permitting, combined with a monetary policy that may largely accommodate the first-round impact on inflation, although those countries with limited reserves may need to tighten policies to support external and price stability.

Anticipating future shocks and aiming to strike a balance between rebuilding of buffers and spending is costly, carries an opportunity cost, and thus requires tradeoffs, Bredenkamp emphasized. Also, while there are potential benefits from commodity price market hedging, technical assistance on risk management is a crucial first step.

Improving the tradeoffs requires managing public spending effectively, and strengthening fiscal revenue and social safety nets. “No one size fits all,” Bredenkamp said.

Hedging contracts

“Contingent financial instruments”—such as commodity hedging contracts or loans carrying flexible repayment terms—can soften the impact of the shocks. Complementing conventional external financing and the use of a country’s own buffers, these instruments can help governments to avoid abrupt spending cuts or other difficult policy measures.

Despite increased popularity of commodity hedging, low-income countries’ use of other types of contingent financial instruments has been limited. Bredenkamp suggested that the international financial institutions could facilitate their increased development and use, while also helping poorer countries themselves to develop the strong risk management frameworks that are needed to use these instruments effectively.

Liliana Rojas-Suarez, a CGD senior fellow, agreed with the recommendations in the IMF studies and pointed to the relative costs between two approaches for risk management—self insurance and market hedging. She also floated the idea of a pilot program organized by international financial institutions to explore GDP-indexed bonds or trade-indexed debt for small countries from different regions.

Rocky road ahead

Steve Radelet, chief economist at the U.S. Agency for International Development, said the good news for low-income countries was how well they had responded to shocks in 2009, including progress in institution and capacity building. The bad news, he said, is that the huge demands from around the world have shrunk donors’ aid budgets. “The prospects for USAID are not very good,” he added.

In the end, all agreed that while risks have increased, poorer countries are less prepared to deal with shocks than before the crisis. The key messages from the study are that in the event of a downturn and faced with tradeoffs, low-income countries should, if possible, maintain spending to soften economic and social impact in the face of opportunity costs and tradeoffs. To build resilience, they should build up economic buffers, deepen the financial sector, strengthen social safety nets, and diversify the economy.

Finally, international financial institutions have an important role to play in responding to higher financial needs in the event of a downturn, and in helping to design contingent debt instruments and other contingent financial instruments that meet the needs of low-income countries.