Since the 2008 Global Financial Crisis (GFC), the financing needs of developing countries have significantly expanded. This was reflected in increased debt accumulation throughout the 2010-2020 period. High debt levels make countries particularly vulnerable to changes in international lending conditions and the risk perceptions of investors, increasing capital flow volatility and making countries more liable to sudden reversals. This pre-COVID-19 trend placed a major constraint on government responses to confront the urgency of the pandemic and, in the medium-term, restricts their capacity to recover in the face of emerging shocks such as climate disasters and those associated with the conflict in Ukraine.
Bearing this context in mind, on May 19th and 20th 2022, the United Nations Conference on Trade and Development (UNCTAD) and the Economic Commission for Latin America and the Caribbean (ECLAC) invited experts and policymakers to a workshop to discuss the role of innovative financing instruments to build forward better. The workshop drew on work undertaken as part of a Development Account Project, Response and Recovery: Mobilizing financial resources in the time of COVID, coordinated by UNCTAD. The workshop focused on Latin America and the Caribbean, a region particularly susceptible to external vulnerabilities with the highest debt service ratio in the developing world; between 2010 and 2020, the financing needs of the region increased from $279 to 643 billion dollars and according to UNCTAD estimates, in 2021 Latin America and the Caribbean total debt corresponded to 160% of exports–only slightly lower than Sub-Saharan Africa with 172% and almost twice that of East Asia and the Pacific with 82%. However, experiences, lessons and recommendations discussed in the workshop were not limited to the Latin America and the Caribbean region.
Together, experts identified five critical policy agendas that can support economic recovery across developing regions in 2022:
1. Urgently re-channel unused SDRs and initiate a new allocation
In August 2021, the International Monetary Fund (IMF) issued $650 billion in new SDRs, the highest allocation in its history. Although welcome, as a consequence of quota-based allocations, these new resources were mostly–about 65%- channeled to developed countries, which do not use or need SDRs. In contrast, 98 developing countries have deployed SDRs for different purposes–obtaining hard currency, restructuring debt obligations, funding fiscal expenditure– but the available resources have been insufficient to meet their needs (see the presentations of Andres Arauz, Esteban Pérez Caldentey/Francisco Villarrea, and Maia Colodenco). The inequality of SDR allocation makes it imperative to efficiently rechannel idle SDRs to developing countries.
There are some options on the table. The first– and fastest–option is a reallocation of unused SDRs within the IMF through their new Resilience and Sustainability Trust (RST). However, as it stands, countries may find the terms and policy conditionality associated with this facility discouraging, given the small size of the credit line – up to SDR 1 billion– and the need to be enrolled in another IMF program. Moreover, the RST is limited in size, as only US$ 40 billion of idle SDRs have so far been pledged, with no prospect for replenishment. In order to properly serve the needs of developing countries, the RST–or other rechanneling mechanisms through the IMF– needs to be improved and scaled up.
However, options also exist outside of the IMF. SDRs can be rechanneled using Multilateral Development Banks (MDB), which are already prescribed holders, and Regional Financial Arrangements (RFA). By using SDRs as a source of funding, these institutions could leverage their operation and support investments and balance of payments liquidity to developing countries (see Mark Plant’s presentation).
Politically, SDR rechanneling is not a simple task. Some central banks from developed countries have a strong, sometimes legally-mandated, aversion to this. Even those countries in favor of rechanneling their SDRs may face institutional impediments, limiting the potential resources reallocated and delaying the process. For this reason, additional, potentially regular, allocations of SDRs would be the ideal manner for developing countries to have access to supplementary SDRs in the short-run (see Andres Arauz’s presentation)
2. Make state-contingent debt instruments more acceptable to improve liquidity and debt sustainability in times of shocks
The risks attached to a growing stock of debt are often disproportionally borne by borrowing sovereigns. In times of economic, social, or climate distress, governments may have no option but to service debt at the expense of supporting the needs of their own populations. International initiatives have been insufficient to alleviate debt burdens in times of distress, as Covid-19 demonstrates. The IMF Catastrophe Containment and Relief Trust (CCRT), the Debt Service Suspension Initiative (DSSI), and the Common Framework for debt treatment beyond the DSSI have been insufficient to prevent developing countries from falling deeper into debt distress (see Leonardo Vera’s presentation).
Apart from improving external debt relief initiatives, designing state-contingent debt instruments (SCDIs) can help developing countries improve liquidity and debt sustainability in times of crisis and better share risks between borrowers and lenders. SCDIs include ex-ante threshold conditions or events that can automatically trigger debt restructuring or repayments suspension if reached. Some examples of SCDIs are GDP (or GNI) linked bonds, disaster-linked bonds, and hurricane-linked debt clauses (see the presentation from Fausto Hernández Trillo and Leonardo Vera). Possibly, SCDIs could be linked to key economic variables with a direct bearing on debt servicing such as the ability to generate foreign currency earnings from exports (which was part of the contractual arrangement for post-war Germany in the 1953 London Agreement) (see intervention from Hamid Rashid).
Grenada and Barbados have successfully deployed SCDIs and other nations could benefit from this tool, especially those more susceptible to natural disasters and the impact of climate change (Dave Seerattan’s presentation). However, SCDIs are not silver bullets and there are major challenges for countries to issue SCDIs. For instance, the higher premium over conventional bonds that governments must pay to investors to compensate for the exposure to risks is a key issue.
3. Establish a multilateral credit rating agency to reorient financing towards productive investment
Credit Rating Agencies (CRAs) have long-held a powerful yet ambiguous position in international finance as both player and umpire, with profound effects on economic policy -making and investor decisions. Their track record in meeting their objective to dampen procyclicality is disappointing, with mistakes, conflicts of interest, concentrated market power, short term horizons, and lack of transparency in their assessment of the credit worthiness of sovereigns (Stockhammer presentation). This means that CRAs often contribute to macroeconomic instability by amplifying cycles and contagion, with asymmetrical impacts on vulnerable populations, as seen during the pandemic when countries availing themselves of the G20’s debt initiatives were faced with downgrades despite attempting to achieve a more sustainable fiscal position.
Frustration with CRAs has led to a variety of proposals across different regions for alternatives that can challenge the monopoly of the three major CRAs and refocus priorities on sustainability and financial stability.
One such proposal is for a Multilateral Credit Rating Agency (MCRA) that could improve and stabilize credit rating assessment of sovereigns and achieve the Sustainable Development Goals (SDGs) (Schroeder presentation). An MCRA would provide a distinctive and more effective assessment for developing countries, as it would integrate both long- and short-term horizons. Moreover, it would develop an alternative model to better align with the realities of developing countries and mainstream climate considerations including double materiality wherein considerations of both climate’s impacts on finance and finance’s impacts on climate are recognized (Spiegel presentation). An MCRA would ultimately prioritize assessing economic development trajectories, rather than credit-worthiness, while reorienting financing towards productive investment.
But establishing such an institution isn’t without challenges, whether in regulatory capture, enabling innovative ways to service government debt, and convincing enough governments to use the MCRA.
4. Increase South-South learning from development banks to share innovative recovery ideas
The global pool of regional and national public banks includes over 900 institutions overseeing $20-49 trillion of assets- depending on different estimations- with accumulated expertise and institutional knowledge. When the pandemic forced the global economy onto life support in March 2020, governments depended on public banks to deploy their policy responses. In a seminal and wide-ranging study of the reaction of public banks’ to the pandemic, a recent volume released by UNCTAD found a variety of innovative policy tools being deployed across regions, where banks stepped up to the challenge of economic crisis.
The workshop heard several examples from Mexico, Argentina and Peru. Mexican development banks issued green bonds to finance climate investments, and supported workers to access mortgages. Argentina saw a significant expansion of their guarantee system, with two innovative policies to support independent workers and SMEs with no credit history. In Peru, the government worked with the central bank to provide guarantees to firms accessing working capital and short-term loans. At the regional level, the Latin American Development Bank (CAF) provided lending in non-US currencies to reduce interest and currency rate exposure to volatility and has been working on linking amortization to oil price fluctuations and climate disasters.
The UNCTAD study found that globally, public banks were able to rapidly mobilize for pandemic response measures; that their public purpose mandates were key to their success; and that the institutional capacity, history and legacy of these public institutions were critical to their success. The pandemic experience demonstrated that development banks don’t just have a countercyclical role, but also a structural role, driving development finance towards development outcomes.
While not all banks had the same space to react, the role of Southern-led banks was significant, and indicated new centers of gravity in global public finance. However, their limitations highlight the need for scaling up in the response to mounting demands and emerging risks facing banks including interest rate rises, mandate tensions, and threatened public purpose from the derisking agenda.
5. Deploy capital flow management to support productive investment and structural transformation for recovery
Analyzing the heterogeneous impacts of the pandemic revealed significant differences between developed and developing countries, as well as among developing countries, with less diversified and poorer countries faring worse. Their larger informal sector, heavier contact-intensive industries, and lack of tradable high-skill services and high-tech manufacturing sectors led to high exposure to price volatility in primary commodities.
This link between productive structure and Covid impacts led authors Alberto Botta, Giuliano Yajima and Gabriel Porcile to explore the underlying causes of productive backwardness in their 2021 paper Structural change, productive development and capital flows: Does financial “bonanza” cause premature de-industrialization? Their analysis focused on the linkages between large capital inflows and premature deindustrialization, revealing that large capital inflows showed a negative correlation with measures of productive development for the full sample of countries examined. This negative effect was much stronger in developing countries and highlighted that large capital inflows could lead to reductions in manufacturing shares and diversification, signaling the need for capital inflow management to guard against instability and deindustrialization.
The conversation was timely in light of the IMF’s revised policy framework for managing cross-border financial flows agreed earlier this year, which expands the circumstances under which countries can restrict capital inflows, but stopped short of addressing the challenges of capital outflows facing developing countries amid ongoing pandemic and conflict spillover effects. Indeed, the recent example of Argentina’s experience with outflows under an IMF program highlighted how crucial outflow management can be (Katiuska King presentation).
The research findings underline the role of macroprudential policy for transformative post-Covid recovery, whether in tackling illicit, extractive or speculative financial flows to instead focus on driving productive and climate-friendly investments into structural transformation. Indeed, the implementation of capital controls can enable a more developmental monetary and fiscal policy to build this resilience to future shocks (Manual Albaladejo presentation).
The workshop highlighted the range and scale of challenges facing Latin America and the Caribbean, and indeed all developing regions, but also the plethora of bold and ambitious policy ideas on offer. With compounded crises on the horizon, multilateral, regional and national strategies must work together for a sustainable and transformative recovery. As detailed during the workshop, this should include an expansionary global financing strategy, sustainability-enhancing financial instruments, new institutions to reorient economic decision-making towards climate-resilient recovery, macroprudential reforms to sustain the stability necessary for development, and collaboration and learning between regions and nations.