The Future of Development Financing: Challenges, Scenarios and Strategic Choices Keith Bezanson

1. The Future of Development Financing: Challenges, Scenarios and Strategic ChoicesKeith Bezanson Development Centre - OECD 04 February, 2005, Paris

2. Background and structure of the presentation • Background • Report on the future of development financing written with F. Sagasti and F. Prada • Sponsored by EGDI at the Swedish Ministry for Foreign Affairs • Final study in a set under the Development Financing 2000 initiative • Structure of presentation • Brief account of development financing ‘system’ • Scenarios of the development financing system: components; four scenarios for 2015; policy implications • Concluding remarks

3. The role of financing in development • Initial focus: • Capital investment and financial resources (big push, priority of capital investment) • Gradual evolution towards: • More complex appreciation of of development process and of the role of finance in relation to other factors (human capital, institutions, governance, knowledge, geography) • Current conception: • Finance is essential but not sufficient for development

4. The evolution of international development financing over time • Shift from official (ODA, MDBs) to private sources (FDI, remittances) • Downward trend and higher volatility in net official flows (especially in relation to GDP of donor countries) • Shift in the type of private financial flows: from commercial bank debt to FDI, bonds and equity • Structure now skewed in favour of highly concentrated and mobile private flows and less towards long-term development needs

5. Initiatives to reform international development financing • United Nations (since 1997: incremental but sustained improvements, financial constraints) • International Financial Institutions (changes in IMF, World Bank, larger role of regional and subregional development banks) • Bilateral agencies (coordination, aid effectiveness, selectivity, focus on poor, tied aid) • European Union (criticisms of aid and trade, EU and national funds, enlargement, fiscal constraints) • Emerging initiatives (reward performance, enhance private flows, issue-based partnerships, direct budget support, global public goods, International Financing Facility, global taxes?)

6. The international development financing ‘system’ at the beginning of the 21s century • Growth in number of institutions has led to a complex and messy array of development assistance organisations • Rapid and uncoordinated expansion of private agents and flows • Incoherent picture of overlap, duplication and missing entities that can hardly qualify as an international development financing ‘system’ • Major shocks have driven change in the past • Cumulative unease creates opportunity for fundamental rethinking of development finance

7. Key attributes of an effective international development financing system • Adequacy (match between development financing and needs of developing countries) • Predictability (amount, anti-cyclical funds) • Responsiveness (balance needs vs. performance) • Diversity and choice (variety of instruments, institutions and programs) • Capacity to absorb shocks (rapid response) • Links to domestic resource mobilization (complementarity) • Voice, representation and accountability (in the formulation of key policies) • Flexibility, adaptation and learning (with the possibility of ‘sunset clauses’ and mergers)

8. Scenarios for development financing: components • Institutional arrangements (‘scaffolding’ to place financial instruments) • Financing instruments (variety of means to channel resources) • Developing country capacity to mobilize finance (external and domestic sources) • Political viability (factors affecting reform process) • Combinations of these components lead to four scenarios (time horizon: 2015)

9. Scenarios: institutional arrangements • Business as usual (BASU). By 2015: • Little or no change in organisational structures: conflicts, rivalry and overlap persist (“dysfunctional family”). • Large gap between expectations and results: sense of failure. MDGs remain distant • Leadership failures, missing institutions Broad range of intermediate outcomes • Comprehensive reforms (CORE). By 2015 • Significant changes (incremental but sustained): improved management and accountability, collaboration, better division of labour, synergies • Expectations and results more aligned. Advances in reaching MDGs • Combination of forward-looking leadership, innovative and risk-taking approach

10. Scenarios: financing instruments • Eight categories of financial instruments (existing and proposed): • Bilateral aid • International organizations and agencies • International financial institutions • Private sector • International capital markets • International taxes and fees • Creation of international markets • Global and regional partnerships

11. Capacity to mobilize financial resources • Developing countries have very different capacities to mobilize external and domestic finance • Current classification schemes focus primarily on categories according to: • Income per capita • Debt service burden • Special conditions (e.g. post-conflict) • Great variation within these categories in country capacity to mobilize internal and external resources. Indicators: • Domestic savings, fiscal deficit, gross fixed capital formation, bank credit • Exports, international reserves, direct foreign investment, ODA flows

12. Capacity to mobilize financial resources Heterogeneity of developing countries: income levels and indicators of capacity to mobilize financial resources

13. Capacity to mobilize financial resources • Need for alternative schemes to classify countries (various options explored) • Adopted a sequential approach to classify countries according to indicators of: • capacity to mobilize external resources (FDI, exports) • capacity to mobilize internal resources (domestic savings, tax revenues) • Result: nine categories of countries: • Matrix with high, medium and low external and internal resource mobilization (plus four outlier countries) • Shifts in country placements over time

14. Capacity to mobilize financial resources Category A Category B Category C Category 0 Country categorization Category 1 Category 2 Category 3

15. Capacity to mobilize financial resources Category A Category B Category C Country changes of category and ranking between 1990-1996 (blue dot) and 1997-2002 (green dot) Category 0 Category 1 Category 2 Category 3

16. International political economy and political viability • Changes in international power relations • Uneasy coexistence of: unilateralism, bilateralism, regionalism, multilateralism, public-private and private regimes, emergence of global concerns • Large economic and demographic imbalances • Fiscal constraints in donor countries • Concerns about migration • New situations and key actors • US, Japan, EU • Brazil, Russia, India, China • Multilateral institutions (IMF, WB, RDBs and SRDBs) • From G7-G8 to G20? • G77 and developing country groups • Uncertainty, but also window of opportunity

17. Interactions between scenario components • Linkages between institutional arrangements and financing instruments • Correspondence between financing instruments and country categories • Degree of utilization of financial instruments • Appreciation of: • Overlap and duplication, division of labour, consolidation • Missing institutions and instruments • Potential for expanding use of financing instruments • Limitations of classification criteria based on income per capital levels • Construction of scenarios

18. High capacity Low capacity High capacity CACs • Guarantees to catalyze external resources mobilization • Domestic currency bonds • Smooth debt service instruments Contingent credit lines MDB and bilateral regular and blend loans • MDBs and bilateral soft loans • Bilateral-private investment funds • Debt reduction instruments • Remittances MDBs and bilateral guarantees to attract private flows Low capacity MDBs and bilateral soft and blend loans Technical assistance to improve policy environment • Grants: Budget support, debt cancellation Financial instruments and country categories

19. Inertia I 1 2 BASU II Limited reforms 3 4 5 … Major reforms 6 CORE 7 IX Transformation 8 Scenarios for the international development financing system (a) Institutional arrangements (b) Financing instruments (c) Types of countries (d) Political viability Power relations

20. Scenarios for the international development financing system Inertia: • ‘Business as usual’, possible deterioration of institutional arrangements, no increase in flows or change in financing instruments, mismatch with country types. Limited Reforms: • Minor changes and disconnected improvements in institutions, modest increases and improvements in financial instruments, focused almost exclusively on poorest countries. Major Reforms: • Widespread institutional reforms, significant increases in financial flows and broader range of instruments, better balance between country types. Transformation: • ‘Comprehensive reforms’ in institutions, full range of financial instruments (some automatic) available to all types of countries.

21. Policy implications of the scenarios A framework for strategic choices: • How to move from Inertia towards Transformation? • Rich menu of possibilities regarding institutional arrangements, financing instruments, country classification schemes and political viability • Identification of main issues in each of the four components of the scenarios

22. Policy implications of the scenarios (institutional arrangements) Main issues: • Support current reform momentum and press for further reforms in international organizations • Devise and put in place institutions to deal with global and regional public goods • Establish the G20 at the heads of state level • Explore innovative institutional arrangements to deal with special problems

23. Policy implications of the scenarios(financing instruments) Main issues • Bilateral instruments: • Increase ODA in a sustainable manner and significantly reduce bilateral debt • Clarify the relation between the EU development budget, the European Development Fund and European bilateral aid • Reduce bilateralization of multilateral aid • Revamp technical assistance • International organizations and agencies • Funding patterns of international organizations: core vs. non core, voluntary vs. replenishments • Consolidation of lines of work, programs and projects (merge some programs and institutions)

24. Policy implications of the scenarios(financing instruments) • International financial institutions • A systemic perspective of the multilateral development banks and the role of the World Bank • Creation of sub-regional development banks • Multilateral debt reduction and IDA grants • Exploring greater voice and representation of developing countries in IFIs (voting power) • Private sources • Enhancing private foreign investment for infrastructure: Measures to promote FDI in poor countries • Remittances and their possible link to the provision of local public goods • Avoiding a ‘race to the bottom’ to attract external capital • Possible impact of Basle II over commercial banks

25. Policy implications of the scenarios(financing instruments) • International capital markets • Expand existing and create new guarantee mechanisms to stimulate appetite for relative more risky financial assets • Promote and expand access by developing countries (special investment funds, provision of credit ratings, financial engineering to mitigate risks) • International taxes, fees and charges • Explore possibility carbon tax when energy prices begin to diminish. Other proposals are less likely to succeed.

26. Policy implications of the scenarios(financing instruments) • Market creation • Emissions trading (Kyoto Protocol, EU) • Explore post-Kyoto Protocol options • Create public markets for key international public goods • Global and regional partnerships • Consolidate special purpose global funds • Promote regional and local partnerships to address specific problems (e.g. conservation and natural parks) • Support the International Financing Facility, but be prepared to advance variants

27. Policy implications of the scenarios(types of countries) • Main issues • Explore alternative classification schemes for developing countries • ‘Gradation’ instead of graduation • Go beyond performance vs. needs arguments for the allocation of development assistance • Dealing with changes over time in country capacity to mobilize external and domestic resources

28. Concluding remarks • Determined leadership required to move from Inertia through Limited Reforms and Major Reforms to Transformation. • Crises have driven structural reforms in the past • Fundamental shift in international development finance required • ‘Radical incrementalism’ may be best approach to advance towards Transformation: • Articulation of radical shared vision of the future. • Pragmatic, down-to-earth incremental steps to achieve it • Do not wait for major tragedies and catastrophes to steel political resolve and catalyze action