TWN Info Service on Finance and Development (Mar09/04)
25 March 2009
Third World Network

Financial crisis will put a damper on ODA flows
Published in NS #6660 dated 16 March 2009

Geneva, 13 Mar (Kanaga Raja) -- The current financial crisis will deal a hard blow to official development assistance (ODA) flows, dampening prospects for achieving the Millennium Development Goals by 2015, the UN Conference on Trade and Development (UNCTAD) has said.

In its latest policy brief (No. 7, March 2009), UNCTAD said that this dire situation cannot be addressed through worn-out remedies.

"New thinking will be needed - and indeed, several innovative proposals are already on the drawing board or in the trial stages, including a currency transaction tax, global lotteries, vulnerability funds, subsidized investment funds for developing countries, and markets targeting ethical investors."

According to UNCTAD, another solution that merits serious thinking, even if it initially appears utopian, would be to create safe, ODA-specific endowments funded by the interest on the assets. The endowment model has worked repeatedly well for educational institutions, and could similarly fulfil the critical need for predictable ODA flows.

The policy brief said that the current recession, and some of the stimulus measures being introduced to combat it, is compounding budget deficits and budget re-allocations in many donor countries. ODA is a soft target in such situations; during past banking crises, it has dipped anywhere from 20 to 40 percent.

The brief cited a recent study that found that the crises affecting Finland, Japan, Norway and Sweden in the 1980s-1990s were all followed by a substantial decline in foreign aid, ranging from 10% in Norway to 62% in Finland.

Furthermore, ODA levels tend to recover very slowly - in Sweden's and Norway's case, six-to-nine years after the trough, according to the same study. Finnish and Japanese aid flows, meanwhile, are yet to return to their pre-crisis peaks.

"Given the depth of today's crisis, the recovery period is likely to be similarly long," warned UNCTAD.

Recent econometric calculations by UNCTAD of all donor countries that have undergone a banking crisis in the past 30 years confirm the positive correlation between banking crises and shrinking ODA . In the year of the crisis, average ODA drops by about one percentage point. In the following year, the cumulative drop is about four percentage points, and in the fifth year, 30 percentage points.

"What will this mean for developing countries, especially those whose development, domestic spending and daily survival depend heavily on foreign aid?"

Firstly, said UNCTAD, if ODA recovers from the present crisis as slowly as it did previously - say, three to four years hence, just when world markets are beginning to pick themselves up again - developing countries will be caught short, lacking the productive capacity they need to take advantage of reviving opportunities. Second, since some donors set their aid targets as a percentage of GDP, a drop in GDP could lead to a drop in aid.

Moreover, aid budgets are usually fixed in domestic currency; and if that currency depreciates against the recipient's currency, the value of the aid budget in the recipient currency will decrease as well. The UK's aid budget, for example, is expressed in pounds, whose exchange rate has fallen steeply in recent months. Its recent depreciation will thus translate into a "real" decline of British ODA for most of the countries receiving that aid.

The policy brief said that predictability has generally not been assured thus far, because aid budgets, like other government budget lines, are subject to annual or pluriannual decision-making processes. If aid agencies were instead provided with an endowment, and their activities funded through the interest earned on principal, this would give them a degree of independence and help stabilize the global economy in the process.

In order to eliminate debt roll-over problems, this endowment could be created by issuing government consols ("consolidated annuities"; i. e., government bonds with no maturity date). The aid agency could then use the interest revenues from the consols to fund its activities - but would be prohibited from using the capital, said the policy brief.

The brief stressed that while several concerns could be raised about this proposal, all of them can be addressed.

The first concern might emanate from financial markets and voters in reaction to a large and sudden rise in the country's debt-to-GDP ratio. However, the funding mechanism proposed by UNCTAD would involve an increase in "gross" but not "net" government debt, since the newly issued government bonds would be held by one of the government's own agencies, with no change to the aggregate balance.

A second concern could be that the government would fail to honour the consols - the reason being that because they represent debt the government owes to itself, defaulting on them would be of little consequence.

While this possibility is fairly remote, the concern could be dismissed if the aid agency were allowed to sell some of the consols and use the proceeds to buy other types of long-term government bonds - as long as it were not also allowed to hold risky assets.

If there were any defaults on the consols, and the consols were held by any party other than the government, that party would view the default as a sovereign default, with all the damaging impact such an event can engender. The government would thus have a strong incentive to honour its obligations.

A third possible concern , said the policy brief, is that the proposed funding mechanism would not protect the quantity of aid from fluctuations in the exchange rate of the donor currency. This could be addressed by endowing the aid agency with government bonds denominated in a mix of currencies - or by having aid agencies from different countries exchange part of their endowment, which would also allay the second concern.

In fact, donor governments might even consider endowing the aid agencies with debt instruments issued in emerging market currencies and thus develop a useful new market for debt denominated in such currencies.

Clearly, however, the costs and benefits of altering the currency composition of the endowment need to be evaluated carefully, because linking the aid budget to the value of the currency of emerging market countries could lead to pro-cyclical aid flows.

The policy brief noted that the endowment proposal may appear ambitious and politically unviable - especially in today's global economic environment, where donor governments are likely to give higher priority to domestic concerns than external obligations. But the magnitude, complexity and global dimensions of the current crisis are such that all possible responses must be considered.

"It is now widely accepted that the crisis can be tackled only through coordinated global responses that involve not just developed but also emerging, transition and developing economies. For the latter, foreign aid provides the main, and in some cases the only, source of the financing needed to prevent their sliding into deep recession and losing their hard-earned productive and exporting capacities ."

For these countries, the kind of stimulus package that more advanced nations are able to offer themselves is simply out of reach. But their economic survival depends on keeping demand healthy.

And given the extent of global interdependence today, maintaining aid commitments and stabilizing aid flows will do much more than help recipient countries: it will also help stabilize global demand, which is in everyone's interest, the brief concluded. +