Hard Financial Questions about Soft Development Money

Jurgen Stark

Achieving the Millennium Development Goals (MDG’s) by 2015 is a tremendous challenge facing the international community, and there is widespread agreement that additional external aid is required to meet it. So the question now is not whether to increase aid, but how best to finance it.

The search for additional and more stable funding to meet the MDG’s has led to various proposals for innovative financing mechanisms and debt relief, in particular by British Chancellor of the Exchequer Gordon Brown. But the broad range of proposed schemes to bolster resources for development assistance raises hard questions about the appropriate balance between objective needs and sound and effective financing.

Donors as well as recipients must ensure consistency between financing and absorptive capacity. They must also ensure that additional official financing and debt relief will not distort incentives or create moral hazard. New money should go to good performers, not just to those who are experiencing debt distress.

In addition to these issues, financing proposals to achieve the MDG’s should be discussed from a central banker’s perspective. The best solutions include sufficient increases in rich countries’ foreign aid allocations and more ambitious trade liberalization. But such policies seem politically untenable in the short term, even though – according to the World Bank’s estimation – an appropriate conclusion of the current trade round under the auspices of the World Trade Organization could contribute $350 billion a year to developing countries by 2015.

Similarly, when it comes to increasing foreign-aid budgets, politicians want solutions that are not “felt” by taxpayers (that is, voters) and that can remain outside of national budgets. However, opaque solutions designed to avoid critical public scrutiny do not seem particularly democratic. “Innovative” financing solutions might also undermine the clear assignment of responsibilities for raising and using public money.

Indeed, the term “innovative financing mechanism” conjures the idea that there is an easy way to meet the MDG’s. But, in the end, there are only three ways to secure additional financing for development aid or debt relief: higher taxes, increased indebtedness (that is, higher taxes for future generations), and/or monetary expansion.

One proposal calls for taxing national and international financial transactions. Others call for allocating Special Drawing Rights (SDR’s) from the IMF, or for using the IMF’s gold resources. But none of them appears desirable.

To be effective, any tax on financial transactions would have to be implemented on a global scale, which currently does not seem realistic. Moreover, taxation would increase costs (passed on to borrowers) and reduce the volume of transactions, thereby fueling market volatility amid decreasing liquidity.

Allocating new SDR’s also is inappropriate. Above all, SDR’s represent liquidity and can be allocated only if and when there is a “global need,” which would currently be difficult to prove given highly liquid and “easy” international capital-market conditions.

Even if a “global need” were recognized, SDR’s, as a component of countries’ official foreign-exchange reserves, should not be available for budgetary spending. Financing development aid with SDR’s – or even to replace budget-financed aid with such allocations – is comparable to financing budget deficits with central bank money.

In any case, new SDR allocations require the support of 85% of votes within the IMF’s board, which appears unachievable in the foreseeable future, as major shareholders are opposed. Even the special one-time issuance of SDR’s, agreed upon in 1997 to ensure that all Fund members receive an “equitable” share of cumulative SDR allocations, has still not been activated, owing to insurmountable opposition.

Finally, the proposed “better use” of the IMF’s gold holdings to finance the costs of debt relief seeks to raise up to $8 billion. At the current market price, this would require selling about a quarter of the Fund’s holdings of 103.4 million fine ounces. However, these reserves represent an important “hidden” asset that lends strength to the Fund’s balance sheet. The IMF’s creditors consider it a necessary safeguard against increased risks in the Fund’s credit portolio.

This is because the Fund has experienced exceptionally high access and prolonged use of its resources by a few large economies in the last decade. Moreover, the IMF’s share in crisis countries’ total external debt has reached unprecedented and systemically problematic levels.

As a result of both tendencies, there is a high concentration of credits on a few large borrowers. To use IMF gold for further debt relief in the face of increased risk threatens the Fund’s financial integrity and contradicts the recent decision to increase the IMF’s precautionary balances.

Development aid has to be financed in “real terms,” or in a reputable manner, not by spending central bank money or by jeopardizing the IMF’s financial integrity. Aid should preferably be financed out of donor countries’ national budgets in a transparent, democratically accountable way. “Innovative” must not become a euphemism for non-transparent, ineffective, or unsound.