Crisis as an opportunity to balance aid with development finance alternatives
By Aniket Bhushan and Bill Morton, North-South Institute
Since August 2007, when the global economy fell deeper into crisis, the external environment for development financing has turned increasingly negative. Commodity prices have collapsed, low income country exports have been hit especially hard, private flows including direct investment have reversed sharply and remittances have contracted for the first time in decades. These combined effects have led to very significant financing gaps in developing countries, and as a result, to severe social impacts including increased unemployment and poverty. On the other hand, ODA appears to have been rising, and reached its highest ever level of $119.8 billion in 2008. However, if debt relief is excluded, bilateral aid to Sub-Saharan Africa rose by only 0.4%, and donors remain well short of commitments made at the 2005 Gleneagles G8 Summit.
In this context, the London G20 outcomes are important for developing countries. On paper, the commitments are significant: $1.1 trillion to fuel a global recovery, including several measures targeted at developing countries. We argue, however, that while the G20 commitments must be adhered to, they represent a short-term response. They should not distract from the long-term challenge facing developing countries: that of developing comprehensive strategies for aid exit. The current crisis makes this more difficult, but it also provides an opportunity to re-focus on aid exit objectives and to consider innovative ways of balancing aid with alternative sources.
The case for focusing on alternatives to aid is compelling. Firstly, domestic, rather than external resources comprise the bulk of financing mobilized to fund development and external savings are an imperfect substitute for domestic savings. Second, ODA in particular tends to be pro-cyclical, which presents significant macroeconomic challenges, is far more volatile than domestic mobilization and is accompanied by onerous conditionalities that limit policy space. There is evidence that ODA in Sub Saharan Africa (the largest recipient region) has resulted in very limited net fiscal expansion and most resources either flow right back out in the form of capital flight or are accumulated as reserves. Mobilizing ODA has political economy and governance implications â€“ countries that mobilize a large majority of their budgetary needs externally may have little incentive to focus on domestic efforts such as widening the tax base. Finally, there is considerable scepticism and frustration surrounding the developmental impact of long-term reliance on aid. Instead of ad hoc targets, donors and recipient countries need to think strategically about aid exit. There are a number of aspects of such a strategy; here we concentrate on three, described below.
Getting revenue management right and re-thinking exemptions
Examples of aid-exit are relatively rare. Countries that have made progress in this regard have utilized a combination of prudent resource management (including aid) and rethinking their exemptions regimes. Botswana is the most often cited example of the former. The presence of natural resources alone does not explain Botswanaâ€™s aid-exit: the integration of aid and resource revenue into a unified budgeting process was at the core of its success. Zambia offers similar lessons: the exemptions in place to promote FDI in the copper sector were scaled back when it was clear the government was not benefiting from the commodity upswing that preceded this crisis. The fact that scaling back exemptions did not drive out investors indicates that these are not the main incentives for investors. A 2007 study on Ghana shows that rethinking exemptions may be worthwhile regardless of the revenue impact: a growing list of discretionary waivers created numerous loopholes for tax evasion and promoted corruption, making the tax system more complex and more expensive to administer.
Integrating fragmented domestic financial markets
Many low-income countries are characterized by highly fragmented financial markets. Within these systems, it is often assumed that since incomes are very low, savings mobilization is of negligible importance. This is not the case, because in the absence of safety nets the precautionary saving motive is high. Often the need is to adapt to given conditions.
Renewed efforts could have significant payoffs in mobilizing savings and integrating fragmented markets. For instance, extending formal financial services in rural areas can have a significant poverty impact. India experimented (1977-90) with such a policy during a period of bank nationalization and consolidation, and this resulted in significant poverty reduction through an increase in non-agricultural activities. In addition, leveraging technology especially mobile telephony can play a major role. In South Africa and Botswana one third of people who do not have a bank account have access to a mobile phone; access to relatively simple money transfer services such as M-PESA (Kenya) and WIZZIT (South Africa) has significantly increased access by lowering costs. The main advantage of leveraging mobile technology however is adapting to remoteness and low population density through â€˜branchless bankingâ€™ in areas where opening a brick-mortar branch is too expensive.
Mobilizing diasporas as an investment base beyond remittances
The price of remitting funds is higher for South-South transfers and higher for smaller amounts, which penalizes the poorest. Whatever the scale of the transfer it is desirable to lower the cost of remittances. The World Bank estimates doing so could yield an additional $1 to $3bn for Sub Saharan Africa. In fact overseas diasporas have often voluntarily worked to lower remittance costs. A good example is MutualitÃ© dâ€™Ã‰pargne et de CrÃ©dit (MUTEC), an initiative of the Burundian diaspora in Europe which helped reduce the cost of money transfer to zero. Another mechanism which countries with a critical mass of diasporas are employing is Diaspora Bonds. Israel and India have substantial experience issuing Diaspora Bonds; Lebanon, Sri Lanka and most recently Ethiopia (2009) have also experimented with such bonds that are made especially attractive to diasporas. The World Bank estimates the potential Diaspora Bond market for the Sub Saharan region to be $5 to $10bn, or 15 to 25% of ODA to the region.
Each of the areas we emphasize can be part of an overall aid exit strategy; the examples demonstrate that concrete steps are possible and assumptions need to be challenged. However, each of the areas is also affected by the current crisis, which makes the G20 response critical. Thus, while the G20 CommuniquÃ©â€™s emphasis on trade and trade finance is welcome from the perspective of effective revenue management, donors should ensure that trade and investment policies do not undermine developing countriesâ€™ ability to benefit from commodity upswings.
The IMF was the biggest beneficiary of the London G20. Additional resources without reforms to the conditionality framework - which helps perpetuate the situation of fragmented markets we describe above via unrealistic inflation targets and high interest rates - will not make the IMF any more attractive to developing countries. Southern CSOs would do well to track progress on the new IMF Flexible Credit Line as well as reforms to conditionality broadly, and to mobilize around the proposal to expand Special Drawing Rights.
Finally the threat of protectionism puts remittances and foreign workers on the frontlines of the crisis. So far the G20 has failed to take into account the real cost of social and human dislocation and has yet to provide adequately for the lack of safety nets.