By Hugh Bredenkamp

Governments in low-income countries are having to deal with a lot of bad news these days. Slow growth in the advanced economies is dampening demand for their exports and affecting inflows of investment, aid, and remittances. Changes in credit conditions elsewhere influence the availability of trade finance. Volatility in commodity prices creates problems for both importers and exporters. Meanwhile, climactic and other natural disasters continue to occur at the local and regional level.

For low-income countries, the impact of these problems can be especially damaging. A surge in food prices can undo years of poverty reduction. A collapse in the price of a key export commodity can throw many people out of work and cause tax revenues to slip, just when expenditures on public services are needed most. For the poorest countries, events elsewhere can quickly affect employment, inflation, the budget, debt, and the balance of payments.

Tailored financing

To soften the painful adjustment associated with these events, low-income countries have tended to rely on external financing from the IMF, World Bank, and other international institutions. This role of the international institutions will remain critical, and we have undertaken reforms and innovations to make IMF financing more responsive to the needs of the LICs. (The World Bank has also undertaken important reforms.)

While the nature of our mission means that IMF financing role will remain largely “ex post” (arranged after the event), the January 2010 reforms allow us to provide financing that is better tailored to a country’s specific needs and is delivered more promptly.

Those LICs that have built up macroeconomic buffers can use them as a sort of “self-insurance” to soften a blow. Many did this effectively in 2008 and 2009, responding to the global recession with looser monetary and fiscal policies. These counter-cyclical policies were possible because in the preceding several years many low-income countries had brought down inflation, improved their fiscal and debt situations, and built comfortable levels of foreign exchange reserves—thanks to careful macroeconomic management and external debt relief.

Self-insurance and official financing will remain critical for LICs, but complementary strategies can also help. In a recent paper (joint with World Bank staff) we explore the potential role of contingent financial instruments (CFIs) in helping governments in low-income countries deal with some types of bad events. CFIs are pre-arranged instruments that are triggered when a particular (carefully-defined) event occurs. They can take the form of insurance instruments, market hedging contracts, credit lines, and debt instruments with repayment terms adjusted depending on certain events.

Because CFIs are automatic, they can disburse quickly if an event occurs—making public finances more predictable. This helps a government to avoid abrupt spending cuts or other difficult policy measures that might otherwise have to be taken.

Use of CFIs by low-income countries overall has been limited (although the use of commodity hedging by public entities has recently been increasing). However, the international financial institutions can play a useful role in facilitating their increased development and use.

Managing risks

The core priority is to help LICs to build strong frameworks for measuring and managing the risks they face, along with operational and practical advice on how to best manage assets and liabilities (such as public debt management) in light of these risks. The IMF and World Bank already provide specialized assistance in these areas.

International partners are in several cases already helping to design and facilitate the use of CFIs in low-income countries. In Ethiopia, a drought index known as Livelihoods, Early Assessment, and Protection (LEAP) is linked to donor contingency funding to provide timely delivery of cash to distressed households in the event of severe drought.

With support from the World Bank and the UK's DFID, Malawi has purchased weather derivative contracts to help protect itself from severe drought. Malawi also uses hedging contracts for maize; by carefully specify the terms for physical settlement, these customized contracts protect not only against import price volatility but also such factors as transportation constraints and the performance of local traders—enhancing the country’s food security.

Ways to ramp up help

International financial institutions could ramp up their assistance in a number of ways. These could include supporting the design and implementation of risk pooling arrangements, serving as intermediaries for market hedging transactions, and helping to design and coordinate issuance of contingent debt instruments. (France already offers a development loan with a floating grace period, providing flexibility in repayment terms under certain circumstances.)

To reiterate, these efforts ought to be seen as complementary to self-insurance by LICs, and to the more conventional financing provided by international financial institutions.  But facilitating use of contingent financing instruments—especially as part of a broader effort to help low-income countries manage the many risks they face—would pay off over time with enhanced economic stability.