Making the Most of Bad Situations

IMF Blog, December 13, 2011

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Author: Hugh Bredenkamp
Date: December 13, 2011
Low-income countries (LICs) face multiple external shocks: slow growth in advanced economies, reduced demand for exports, affected inflows of investment, aid, and remittances, changes in credit conditions that influence trade finance availability, volatility in commodity prices, and climactic and other natural disasters occurring at local and regional levels.
For LICs, these shocks can quickly affect employment, inflation, the budget, debt, and the balance of payments; examples include a surge in food prices undoing years of poverty reduction and a collapse in the price of a key export commodity causing job losses and tax revenue slippages.

LICs have relied on external financing from the IMF, World Bank, and other international institutions to soften painful adjustments.
The IMF’s financing role will remain largely “ex post” (arranged after the event).
January 2010 reforms allow the IMF to provide financing that is better tailored to a country’s specific needs and is delivered more promptly.
The World Bank has also undertaken important reforms (as noted in the text).

Some LICs built up macroeconomic buffers that function as “self-insurance” to soften shocks.
Many LICs responded to the 2008 and 2009 global recession with looser monetary and fiscal policies, enabled by prior improvements:
- brought down inflation,
- improved fiscal and debt situations,
- built comfortable levels of foreign exchange reserves,
- benefited from careful macroeconomic management and external debt relief.
Self-insurance and official financing will remain critical complements to other strategies.

CFIs are pre-arranged instruments triggered by a carefully-defined event.
Forms of CFIs include insurance instruments, market hedging contracts, credit lines, and debt instruments with repayment terms adjusted depending on certain events.
Advantages of CFIs:
- Automatic disbursement allows quick response when an event occurs.
- Makes public finances more predictable.
- Helps avoid abrupt spending cuts or other difficult policy measures.
Use of CFIs by LICs overall has been limited, although commodity hedging by public entities has recently been increasing.
International financial institutions can facilitate increased development and use of CFIs.

Core priority: help LICs build strong frameworks for measuring and managing risks.
Provide operational and practical advice on managing assets and liabilities, such as public debt management.
The IMF and World Bank already provide specialized assistance in these areas.
Examples of CFIs and donor-linked mechanisms:
- Ethiopia: a drought index known as Livelihoods, Early Assessment, and Protection (LEAP) linked to donor contingency funding to deliver timely cash to distressed households in the event of severe drought.
- Malawi: with support from the World Bank and the UK's DFID, purchased weather derivative contracts to protect against severe drought; also uses hedging contracts for maize with carefully specified terms for physical settlement to protect against import price volatility, transportation constraints, and local traders’ performance, enhancing food security.

International financial institutions could increase assistance by:
- supporting the design and implementation of risk pooling arrangements,
- serving as intermediaries for market hedging transactions,
- helping to design and coordinate issuance of contingent debt instruments.
An example of contingent debt innovation: France offers a development loan with a floating grace period, providing flexibility in repayment terms under certain circumstances.
These efforts should be complementary to self-insurance by LICs and conventional IMF/World Bank financing.
Facilitating use of contingent financing instruments, as part of broader risk-management assistance, would pay off over time with enhanced economic stability.

Source: Making the Most of Bad Situations, Hugh Bredenkamp, December 13, 2011.