Meeting of Multilateral Development Banks Tunis, Tunisia, December 8-9,2004. Chairman s Summary

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1 Introduction Meeting of Multilateral Development Banks Tunis, Tunisia, December 8-9,2004 Chairman s Summary At the July 2002 meeting of niultilateral creditors, participants agreed to hold the general meetings once a year and convene ad hoc meetings on specific topics as needed. This was the third such ad hoc meeting, on External Shocks and Debt Sustainability in Low Income Countries and was hosted by the African Development Bank at the Abou Nawas Palace Hotel in Tunis, Tunisia on December 8-9,2004 and chaired by The World Bank. Representatives from 15 multilateral institutions and one observer institution participated in the meeting2 Participants expressed their appreciation to the African Development Bank for hosting the meeting and for their generous hospitality. Recent work by the Bank and Fund on an operational framework for debt sustainability in low-income countries identified extemal shocks as one of three factors strongly affecting the risk of debt distress (the other two being the debt burden and the quality of policies and institutions). While the primary responsibility for dealing with the effects of shocks re! ts with the low income countries themselves, the international community can also play a constructive and supportive role, provided such support is fully consistent with the country s own development priorities as expressed in its PRSP. It was with this in mind that the World Bank Board, and later the Development Committee in its recent annual meetings communiquk, called on World Bank staff to present additional analysis on the risks associated with extemal shocks in low-income countries as well as an evaluation of possible measures (including new financial instruments that creditors could offer) to mitigate the impact of such shocks on growth and debt sustainability. Mr. Chanel Boucher, Vice President for Planning, Policy and Research of the African Development Bank opened the meeting. Mr. Boucher noted that the exchange of views during the meeting would play a key role in moving the development agenda forward and in stepping up and strengthening the cooperation and partnership among the multilateral development institutions towards achieving a consensus on a prudent and feasible operational mechanism for debt sustainability. He urged the participants to flirther reinforce the existing partnership while making optimal use of the comparative advantages and complementarities in the assisting countries for the proposed debt sustainability analysis. The World Bank representative provided I See HIPC Debt Initiative: Multilateral Development Banks Meeting, October 9-10, 2002, Chaimian s Summary dated October 30,2002 (IDA/SecM ). The following organizations were represented at the meeting: African Development Bank (AtDB); Arab Bank for Economic Development in Africa (BADEA); Caribbean Development Bank (CDB), Central African States Development Bank (BDEAC); European Commission (EC); European Investment Bank (EIB); Intemational Fund for Agricultural Development (IFAD); International Monetary Fund (IMF); Islamic Development Bank (IsDB); Nordic Investment Bank (NIB); OPEC Fund for Intemational Development (OPEC Fund); West African Development Bank (BOAD) and The World Bank. Also in attendance were representatives from Cote d Ivoire and Mali. The bilateral observer was Saudi Fund for Development (SFD). One resource person from the University o f California at Santa Cmz also participated in the meeting.

2 2 background to the meeting including an update of a request from the Development Committee and a recently held workshop on the same topic held in Berlin in November, The meeting covered six broad issues related to external shocks and debt sustainability in low income countries (the agenda is attached). External Shocks and Debt Sustainability in Low Income Countries MDB representatives and country representatives examined the impact of exchange rate, climatic, natural disasters, and terms of trade shocks on the growth rates and debt burdens of low income countries. Participants reviewed existing financing instruments and examined new instruments that could assist low income countries in dealing with the imnact of extemal shocks. Three pillars of the debt sustainability framework for low income countries were discussed, including backward-looking indicative thresholds for debt indicators, fonvard-looking debt dynamics including stress tests, and donor financing strategies. External shocks were indicated as part of the stress testing framework. One participant noted that a number of HIPC countries are now in a position to benefit from such a fonvard-looking debt sustainability framework. The participants were briefed by the IMF representative and Mr. Nelm of the World Bank (via audio conference) on the status of the emerging consensus on the IMF/World Bank debt sustainability framework and its operational implications on the financing terms of concessional resource allocations to low income member countries of MDBs. Participants agreed that the new framework would provide (i) guidance to low-income borrowers and their creditors on an appropriate borrowing and lending strategy that addresses the risk of debt distress; (ii) a standardized fonvard-looking analysis of debt in the face of plausible shocks; (iii) an assessment of debt sustainability guided by country-specific debt burden indicators related to the quality of a country s policies and institutions; and (iv) an operational framework for determining the gradloan financing terms for concessional resources. Mr. Nehru also commented on options for revising the indicative debt burden thresholds under which grant and loan allocations will be determined under IDA-14 replenishment to be discussed next week. Some participants raised a concern that their institutions may not be able to mobilize sufficient grant resources for the countries in their portfolio, as provided for in the framework. AfDB repi :sentative outlined the AfDB post-conflict facility and stressed the need for augmenting financing requirements for NEPAD and Water initiatives, and urge country authorities to consider their inclusion in second generation PRSPs. Interactions between external shocks, growth and buffer mechanisms. A conceptual framework for analyzing shocks was put forward including input shocks, mitigating factors, output shocks, smoothing channels, and consumption shocks. The size of shocks and their impact on growth and debt were discussed. It was noted that growth rates and exchange rates in these countries are more volatile and financial markets are relatively less developed, making it more difficult for the countries to manage the effects of shocks on their income and consumption. It was also observed that sovereign borrowing to smooth consumption during shocks increases debt burdens and risk of debt distress. In such a volatile environment, participants agreed to the need for improving sovereign risk management supported by policy reforms, institutional development, and international financial support on appropriate terms and

3 3 using suitable financial instruments. Strategic elements for dealing with shocks include preventive actions, self-insurance, and hedging and insurance on international markets. Macroeconomic assistance provided by the MDBs and aimed at smoothing fiscal volatility and debt risk generally supports these strategic elements. The current macro assistance package includes fiscal prudence and stabilization; while micro assistance covers counter-cyclical credit to the corporate and agricultural sectors, and commodity risk management and hedging instruments for producers. Finally participants agreed that the agenda for future work should include evaluating impact of existing instruments; determining which shocks have the largest impact; and strengthening IFIs role in prevention and planning. Exchange rate shocks. A session on exchange rate shocks began with a presentation on European Investment Bank s lending in local currency. The mechanics of the interest rate determination for the synthetic local currency loans provides useful insights into the potential sovereign local currency lending instruments. Local currency risk exposure is borne by the lender and managed through project selectivity, appropriate pricing, and country and total exposure limits. Subsequently, the difference in observed volatility between foreign and local currency denominated debt was discussed. One view is that obstacles to international financial integration limit risk diversification and therefore make it harder for markets to develop. In low income countries, duration risk is often high, resulting in short-term maturity of local financial assets and holding foreign currency denominated assets provides risk diversification. Indexed local currency denomination of external debt was suggested as a means of reducing volatility of debt service. Stabilization of countries in coizflict. An AfDB representative outlined the Post Conflict Country Facility (PCCF) framework for stabilization and arrears clearance. Four guiding principles underpin the design of arrears clearance programs for affected countries: sustainability, additionality, flexibility and compatibility. Such framework has so far been applied to Burundi and the Republic of Congo and is likely to be applied :o the five additional African HIPCs that remain to reach the decision point under the HIPC Initiative with outstanding arrears to the AfDB. The Cote d Ivoire representative outlined the devastating impact of civil war in his country since He appealed to the international community for support with stabilization including eventual arrears clearance. Terms of trade slzocks. It was pointed out that commodity price shocks explain most of real exchange rates volatility in 22 low income countries highly dependent on commodity exports. Volatility and long-run growth were found to be negatively correlated, mostly due to shocks rather than nomial cyclical fluctuations. Another speaker suggested that market access and protectionism are key constraints inhibiting export growth and resilience to shocks. Some participants stressed the importance of export diversification as a structural approach to reducing volatility. There was some discussion over the relationship between fiscal volatility and commodity price volatility, and one participant noted that direct government losses from shocks may not be large while indirect losses may be substantial while difficult to capture. The representative from Mali discussed the country s exposure to terms of trade shocks through high percentage of cotton and gold exports.

4 4 Climate and natural disaster shocks. A speaker pointed out that natural disasters have become more frequent and more severe in the last decades. Economic cost of a natural disaster exceeds value of the physical damage and includes indirect losses such as business interruption, loss of tax base, and investment reallocations. In small developing economies most of losses are uninsured and emergency credits are given on discretionary basis. Credit ratings are affected by the LICs governments ex-ante risk management. A layering approach to natural disaster risk management can be used by LICs to retain or insure with instruments appropriate to disaster occurrence. Emergency relief has acted as de-facto reinsurance on losses in LICs while at the same time being more expensive and less efficient. The Caribbean,Development Bank (CDB) has provided disaster rehabilitation loans over the last thirty years, and in 1998 launched a disaster management strategy. This strategy includes measures to enhance institutional preparedness, protection of buildings and infrastructure, and reinstatement of economic activity after a natural disaster. CDB has an active program of risk management including ex-ante and ex-post funding for disaster mitigation. Ex-post instruments. Pertinent variables for MDBs to consider in evaluating ex-post instruments were presented. Ex-post facilities include the European Commission FLEX, IMF Contingent Financing Facility, IDB Disaster facility, AfDB Special Relic P Fund and IDA Emergency Recovery Credits and Supplemental Adjustment Credits. These are characterized by higher level of lender s discretion, and are usually constrained by the country allocation envelope. European Commission representatives presented the Commission s experience with ex-post instruments to help smooth the impact of commodity price shocks. The experience of STABEX and FLEX, and the forthcoming European Union Action plan on agricultural commodities, and the European Commission Macro-financial Assistance program for balance of payments needs were discussed. The IMF representative presented the experience of his institution in providing finance for shocks, including ENDA, Compensatory Financing Facility (CFF), SBA, and PRGF augmentation. Concerns were raised about the degree of concessionality of these instruments and their suitability for the low income countries, especially in the light of the debt sustainability framework. An important role of going through an IMF program as a signalling instrument and the relationship between such signalling and the provision of financing were discussed. More general concerns were raised about integration of the ex-post lending into the debt sustainability, debt relief, grants for development assistance and the grants for shocks. The sustainability of debt burden was mentioned as an important consideration in assessing the terms of financing for shocks. Several participants raised the question of the adequacy of the existing instruments aimed at mitigation of impact of shocks. The rules and terms of finance for the ex-post instruments were discussed. The main conclusion was that such instruments need to provide very quick disbursement and that a substantial grant element is warranted for shocks assistance in order to ensure debt sustainability. These would significantly increase the recovery of growth and performance that deteriorated due to the shock, and at the same time would not exacerbate debt sustainability in the country. Ex-ante instrunzents. Several proposals for specific ex-ante instruments to deal with shocks in LICs were considered. These included concessional loans with repayment linked to recipient s real GDP growth, local-currency inflation indexed loans, and loans with repayments adjusted to reflect moving average changes in key export and import commodity prices.

5 5 Insurance instruments discussed included weather and natural disaster insurance instruments, including some drawing upon the capacity and pooling ability in the international reinsurance market. Finally, extemal escrow accounts were pointed out to be a potential fiscal smoothing vehicle for countries with the capacity and incentives to utilize such an instrument. Contingent credit lines were suggested as a mezzanine-type instrument operating with both ex-ante and expost characteristics. A number of participants pointed out the importance of measuring the precise applicability and utility of each o f the instruments suggested in mitigatin), fiscal volatility and therefore the risk of debt distress. Conclusions and Next Steps Participants agreed that assessing and managing the impact of extemal shocks is essential to debt sustainability in low-income countries, and encouraged efforts to support preventive actions on a coordinated basis and explore new instruments to better hedge and insure against fiscal volatility induced by shocks. Participants supported the conceptual framework which brought together input, output and consumption shocks as an essential element of debt sustainability analyses. Ultimately, it is in the interest of MDBs and LICs and the international community to better incorporate extemal shocks in the thinking about debt sustainability. It was agreed that the next annual HIPC MDB meeting would be held around June 2005 in Washington D.C.