Wednesday, 9 April 2014

Capital Market Access as IDA Eligibility Criterion – Worthless and Dangerous


In 1960, private capital flows to poor countries were unimportant relative to trade; they were fairly tranquil and consisted mostly of direct foreign investment. That year, IDA was established in recognition of the fact that, for many of the poorest countries, private capital and market based multilateral sources of financing were not adequate. From the start, demand for IDA resources outstripped supply. Hence the need to ration demand for concessional finance through defining eligibility criteria. Apart from the concept of relative poverty, as measured by GNI per capita below an agreed threshold, IDA eligibility and graduation criteria were constructed around the absence of creditworthiness to tap private capital markets.

 

Five decades later, creditworthiness has arguably lost any positive and normative value as an eligibility and graduation criterion for screening the access to multilateral concessional finance. It might equally be dropped. Moreover, capital market access has also been very difficult to predict since the early 1980s. It is an inappropriate determinant for graduation scenarios. These lessons are explained by the radically changed nature of private capital flows to developing and emerging countries, both LICs and MICs.

 

Notably the past three decades have witnessed an impressive range of capital flow cycles – surges (or bonanzas) being followed by ´sudden stops´ (Calvo, 1998)[1]. Private capital flows, and by implication creditworthiness or capital market access, have no predictive value for scenario analysis. Using quarterly gross flows data, Forbes and Warnock (2012)[2] construct episodes of gross capital-flow surges, stops, flight, and retrenchment. For the observation period from 1980 through 2009, they identify 162 episodes of surges, 211 of stops, 180 of flight and 203 of retrenchment in a sample of 56 mostly developing and emerging countries. They conclude that the past decade that witnessed an impressive range of capital flow cycles these waves of capital— which can amplify economic cycles, increase financial system vulnerabilities, and aggravate overall macroeconomic instability—were just a continuation of experiences in the 1980s and 1990s.

 

The drawbacks of private bank credit and portfolio equity and bond flows from a development perspective are still in place (Reisen, 1999)[3]:

  • First, they suffer from three major distortions: the problem of asymmetric information causes herd behaviour among investors and, in good times, congestion problems; the fact that some market participants are too big to fail causes excessive risk taking. It is questionable therefore whether the financial markets will discipline governments into better policies; even if they were to do so, the social and economic costs may be excessive.
  • Second, any shortfall in capital inflows will require immediate cutbacks in domestic absorption to restore external balance. The savings-investment balance is more likely to be achieved through cuts in investment than through higher savings in the short term, compromising future output levels. Current output levels fall to the extent that rigidities prevent resource reallocation, so that contractionary disabsorption effects outweigh expansionary substitution effects.
  • Third, the expansion of domestic credit connected with unsterilized capital inflows may not be sound enough to stand the rise in domestic interest rates and the fall in domestic asset prices that go with a reversal of these inflows. The resulting breakdown of domestic financial institutions provides incentives for monetary expansion and fiscal deficits incurred by the public bail-out of ailing banks.

 

Things have worsened in the last decade: The low or negative term premium in the yield curve in the advanced economies from mid-2010 has pushed international investors into poorer-country local bond markets. By lowering local long rates, this has encouraged much increased foreign currency borrowing in international bond markets by emerging market corporations, much of it by affiliates offshore (Turner, 2014)[4]. The crucial determinant of the global financial boom-bust cycle is monetary policy in the US, which affects leverage of global banks, credit flows and credit growth in the international financial system. The close link between the US monetary stance, volatility, investors´ risk appetite and debt flows has been observed for a while now. Emerging and developing countries, whatever their exchange rate regime and even their macroeconomic policies, are natural victims with their narrow asset bases relative to investor portfolios (Rey, 2013)[5].

 

Hunger for yield has recently led to a sudden surge in borrowing by countries in a region that contains some of the world’s poorest nations.  Sub-Saharan African countries, which long have had to rely on aid to supply part of their foreign currency needs, have for the first time many been able to borrow in international financial markets, selling so-called Eurobonds, which are usually denominated in dollars or euros. In several cases, African countries have been able to sell bonds at lower interest rates than troubled European economies such as Greece and Portugal could (Sy, 2013)[6]. Table 1 shows Sub-Saharan IDA-only or IDA-blend countries that have recently tapped international bond markets.

 

Table 1: Sub-Saharan IDA Countries with Recent Bond Issues

Country
Year
Size, million $US
Angola
2012
1,000
Ghana
2007
750
Nigeria
2011
500
Rwanda
2013
400
Senegal
2009
200
Zambia
2012
750

Source: http://www.worldbank.org/ida/borrowing-countries.html ; Sy (2013).

 

We should take the IDA (2012:7) warning seriously:  “History has shown that pushing countries into market based borrowing before their economies are sufficiently robust to absorb the associated higher debt servicing costs is counter-productive and likely to lead only to situations where countries have to reverse graduate into IDA”. Africa does not have to repeat the costly experiences with her newly acquired access to capital markets that have burdened emerging and developing countries over the past three decades. Poor countries rather continue to need money with a focus on institution building, on social and on environmental impact – all requirements of successful aid effectiveness.



[1] Guillermo Calvo (1998), “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden
Stops”, Journal of Applied Economics (Nov): 35-54.
[2] Kristin Forbes and Francis Warnock (2012), "Capital flow waves: Surges, stops, flight, and retrenchment," Journal of International Economics, Elsevier, vol. 88(2), pages 235-251.
[4] Philip Turner (2014), “The global long-term interest rate, financial risks and policy choices in EMEs”, BIS Working Paper No. 441
[6] Amadou Sy (2013), „First Borrow“, Finance & Development, Vol. 50.2.

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