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Exogenous shocks: When governments are powerless
04/2005
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[ Exogenous shocks ]
When governments are powerless
Natural disasters often hit developing countries particularly hard. Similarly, exchange rate fluctuations or changing commodity prices can have devastating consequences for poor countries. As their governments are unable to tackle exogenous shocks without assistance, they depend on aid from the international donor community. Donor instruments, however, are not up to the task.
[ By Kathrin Berensmann ]
Exogenous shocks are events which are beyond the control of a particular government. Two examples are changes in commodity prices on the world market and natural disasters. Even exchange rate fluctuations or the erratic provision of official development aid can be regarded as exogenous shocks. Poor countries are particularly susceptible to exogenous shocks. They have little fiscal leeway, their social security systems are normally overextended anyway and their financial and capital markets are in no position to provide cover through insurance or modern hedging instruments.
One of the reasons developing countries are particularly vulnerable is that their economies have structural weaknesses. These include dependency on primary products, concentration on a small number of export products and the fact that there is little variation in their industries. This becomes particularly apparent if we look at the highly indebted developing countries. In 1999, almost two out of three of these countries made more than 50% of their export earnings with only three (or even fewer) products. Primary products make up almost two thirds of the total exports of the least developed countries. These products are usually agricultural, so production depends on the climate, a fact that, in turn, exacerbates the effects of bad weather.
To make matters worse, negative shocks cause a considerable reduction in economic growth, whereas positive shocks (for instance, the increase in an export price) do not encourage economic expansion to the same extent. One reason is that many hardships (as death or bankruptcy) are irreversible. On the other hand, in a poorly differentiated economy, it is hard to invest additional earnings sensibly, because there are simply no opportunities.
In general, it can be said that anything which assists economic modernisation also reduces susceptibility to shocks. Diversification (particularly of exports) is the only strategy which has an impact on the causes of high susceptibility to crisis. A government’s fiscal deficit must remain moderate if it is to have fiscal leeway in an emergency. Solid fiscal policy also helps to create national stabilisation funds. Experience with such funds has been varied to date, but it does show that the key elements are transparency, good governance and competent institutions.
Social insurance systems are also particularly important for absorbing the effects of shocks. A well functioning banking system and an efficient capital market are also helpful. Adequate currency reserves allow central banks to level out exchange rate fluctuations. The result of all of this is that comprehensive development is necessary to absorb exogenous shocks. Consequently, poor countries are systematically over-extended and depend on aid from donor countries in emergencies (IMF, 2003).
Rich nations have some ad hoc instruments at their command, but they rarely implement them in good time. This is partly because exogenous shocks are often not recognised immediately. For example, commodity prices tend to change slowly, but the impact is nevertheless devastating. Even a drought may not be recognised immediately, quite apart from the extent of the consequential loss or damage it causes. If funding instruments are to mitigate the negative consequences of exogenous shocks, then three features are necessary:
– Ready availability – donors should make funds available quickly and simply.
– High rates of subsidisation – funds should be given on highly concessional terms, because developing countries are not able to pay interest on loans at market rates.
– Medium-term planning – loans should be made for a term of several years, because developing countries need time to rebuild their economies (Berensmann, 2005).
Reform agenda
for multilateral donors
Multilateral donors, such as the Bretton Woods Institutions, the UN and the European Union, have a range of instruments available to help overcome natural disasters. The IMF makes emergency assistance available, which is paid out quickly. The World Bank essentially has two instruments to mitigate the effects of natural disasters (Emergency Recovery Loans and the Disaster Management Facility), but its assistance is somewhat ad hoc and discretionary if there are changes in commodity prices or exchange rate variations. Likewise, the instruments offered by other multilateral donors to cushion commodity price and currency shocks are inadequate. This is particularly so in the cases of the IMF and the EU.
Since 2000, the EU has provided budgetary aid to African, Caribbean and Pacific (ACP) countries to compensate high losses in export earnings through the FLEX scheme (Fluctuation of Export Schemes). The payouts are supposed to be made quickly and there are two conditions: a 10% loss of export earnings (two percent in the case of least developed countries) and a 10% deterioration in the programmed public deficit. Experience from 2000 to 2002 showed that these rules were two harsh. Only six applicants fulfilled the criteria and FLEX granted barely ¤ 36 million. As a result, the European Commission relaxed the criteria last summer (European Commission, 2004).
The IMF’s Compensatory Financing Facility is intended to provide medium-term assistance to countries experiencing either a temporary shortfall in export earnings or a rapid increase in the cost of cereal imports due to factors outside the authorities’ control. However, this facility has not been used since 2000. It is available only for the medium-term and there are many conditions attached. Nor does the facility grant any concessionary loans (IMF, 2004)
When crises are the result of exogenous factors, the IMF uses the Poverty Reduction and Growth Facility (PRGF) making funds available which were originally intended for other purposes. Loans from this facility, which the IMF grants at subsidised interest rates, should actually serve as long-term support in the case of balance-of-payment difficulties. The IMF provides medium-term financial assistance to address short-term balance-of-payment difficulties by way of the Stand-By Arrangements (IMF, 2003). However, loans of this nature are not granted on concessionary terms, interest rates are even one to two percent above the basic interest rate.
The IMF does not have an appropriate instrument to make funds readily available to cushion commodity price and currency shocks. However, it would be sensible, for example, if there were a procedure guaranteeing that, in the event of a crisis, terms of payment such as interest rates or term were altered automatically. For example, loans could be converted into grants, interest rates lowered or repayment periods extended. However, for this to make sense, there would have to be a prior agreement on clear and transparent rules defining which countries can access this kind of financing facility according to which criteria and the extent of the changes meant to occur in crises (Berensmann, 2005). Such conditions would ensure rapid relief. On the other hand, there is the risk that they might cement structures. If it transpires that a fall in commodity prices is permanent, then more must be done than bridging a financial gap in the short-term.
In both theory and practice, it can prove difficult to correctly diagnose variations and shocks and to counteract them with appropriate instruments. However, since it is clear that poor countries cannot adequately deal with exogenous shocks on their own, the donor community must continue to work on this area. Of course, the donor bodies should also continue their endeavour to coordinate their assistance better.
Dr. Kathrin Berensmann
is an economist and works at the German Development Institute in Bonn in the areas of debt, monetary and exchange rate policy and international financial markets.
kathrin.berensmann@die-gdi.de
References:
Berensmann, Kathrin, 2005:
Die Zukunft der HIPC-Länder: Ist Schuldentragfähigkeit langfristig erreichbar?, in: Messner, Dirk und Imme Scholz, Ed.: Zukunftsfragen der Entwicklungspolitik, Baden Baden: Nomos
European Commission, 2004:
European Commission Adopts Action Plan to Help Developing Countries Fight Agricultural Commodity Dependency and Support the Development of the Cotton Sector in Africa, News Release Nr. 16, 2004
IMF, 2003:
Fund Assistance for Countries Facing Exogenous Shocks, Prepared by the Policy Development and Review Department, August 8, Washington, D.C.
IMF, 2004:
Review of the Compensatory Financing Facility, February 18, Washington, D.C.
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