A quarterly magazine of the IMF

December 2006, Volume 43, Number 4

Out of the Trap
Ambroise Fayolle

How to improve financing for fragile states

Since 2001, the donor community has identified fragile states as a specific group requiring its own development approach, especially in terms of financing, reforms, and capacity building. The term fragile states encompasses many situations and includes countries recovering from conflict (postconflict countries) and those classified by the World Bank as low-income countries under stress (LICUS), meaning that they have weak institutions and policies.

While the situation in postconflict countries is often very volatile, with big medical and humanitarian needs, LICUS countries are more likely to face bottlenecks and problems of poor performance caused by weak institutions. Although both types of countries are highly heterogeneous, most of them are aid orphans and none is able to attract private financing on a sustainable basis. They face a common set of challenges, including high security risks and threats to development, which require, beyond the current ad hoc treatments, a quick, tailored, and harmonized response by donors.

Although much has been done to improve the speed and effectiveness of donors' response to these countries, a lot more can be achieved. Multilateral institutions are hamstrung by overly restrictive rules, and bilateral donors often put too much emphasis on fiduciary risks and the ring fencing of donor monies. It often appears as though the international community has lost sight of its ultimate goal: preventing the resumption of crisis (and its additional costs) and fully supporting countries that are turning themselves around.

This article looks at specific constraints faced by fragile states and how donors are addressing these issues and suggests possible ways forward.

Failing to address needs

Fragile states face volatile situations that can deteriorate very fast. They urgently need to promote "quick wins" to consolidate their citizens' confidence. The international community needs to grab every chance it gets to create momentum in favor of reformers and, in each country, agree on the appropriate timing and sequencing of donor assistance. Yet, for various reasons, aid programs are not properly designed to assist fragile states. In particular, international financial institutions (IFIs) have set up their own roadblocks that constrain swift action.

The first concerns countries' arrears. During a crisis, most fragile states will have accumulated arrears to institutions like the World Bank and the IMF. Under their rules, IFIs have to stop lending to states that are in arrears on repayments. This rule ties the hands of multilateral lenders when it comes time to help in the wake of the crisis.

A second roadblock is the conditions countries must meet to restore sound relations with the IMF. Restoration of normal relations with the IMF, and the creation of a positive repayment track record, is crucial because it permits other donors to resume fulfilling their commitments. But fragile states often find it difficult to meet the IMF's conditions, which may be hard to achieve in the short term in many cases, even if the Fund is able to show flexibility in program implementation by taking into account weak institutional capacity and the time needed to implement structural reforms.

A third roadblock is eligibility, where different criteria are used for debt relief and IMF lending. The successive extensions of debt relief to low-income countries have created a confusing situation: how do we explain to these countries that they are eligible for the cancellation of all their multilateral debts but that their arrears in repaying these very debts prevent them from the opportunity to get on track through an IMF-supported program and qualify for the Heavily Indebted Poor Countries Initiative?

Our African partners are also sensitive to the principle of fair treatment and are sometimes puzzled—as we are—by the IMF's lending policies, which do not appear to be sufficiently harmonized (in terms of, for example, eligibility for and access to financing, and disbursement triggers). In that respect, a comprehensive review of the Fund's support to postconflict countries and other fragile states, for example based on a survey by the IMF's Independent Evaluation Office, would be very useful.

Finally, research clearly shows that foreign financial flows to fragile states are usually smaller and more volatile than to other low-income countries. The tools donors use to measure performance, such as the Country Policy and Institutional Assessment (CPIA) framework used for all borrowers from the World Bank and the concessional International Development Association (IDA), tend, by construction, to penalize fragile states. The usual response of donors to persistently poor performance by their country portfolios is to curb lending, generating a vicious circle: weak governance and low disbursement rates result in reduced financial support and worsening performance. To compound the problem, donors tend to restrict their budget support to fragile states (as happened with Haiti) at a time when financial needs to address current expenses are critical.

Things are changing

To address these pressing issues, donors have begun to ease restrictions and build an as yet unfinished multilateral framework to help fragile states. Although limited funding and operational constraints, including a lack of coordination between donors, leave many issues to be tackled, several measures have been taken to develop an overall framework.

Emergency Postconflict Assistance, initiated by the IMF in 1995, is now used frequently. It can be implemented more rapidly than a traditional IMF loan. This assistance is useful, since a country must repay only its arrears to the Fund to be eligible. However, the Fund's financial terms, notably the relatively short duration and, hence, relatively low concessionality, limit to some extent the usefulness of this facility relative to total needs.

The World Bank has put in place the Postconflict Fund and the LICUS Fund to grant specific financing for analytical work and technical assistance, in particular in social fields, even for countries with outstanding arrears. Increased use has also been made of an IDA mechanism to provide additional resources, despite poor performance.

The African Development Bank, with strong support from France, set up a facility in 2004 for the clearance of arrears owed by countries recovering from conflicts. This approach has been successful for such countries as Burundi and the Republic of Congo, which are strongly supported by bilateral donors. However, difficulties remain for aid orphans.

A UN peace-building commission has been created involving IFIs and others, such as regional organizations and key donors. Its role is to assist in countries' transition from conflict to postconflict peace building, notably by mobilizing and coordinating the efforts of the international community. Further work needs to be done to put this approach into action.

The European Union (EU) has also broadened the scope of its activities to include help in the political and security spheres, as well as in ongoing development financing. The European Commission still has to rationalize and strengthen its organization to make substantive progress in supporting dialogue and aid implementation in fragile states, including the development of a regional approach.

The Development Assistance Committee of the Organization for Economic Cooperation and Development has been working to improve assistance for fragile states since 1995. It has identified guidelines and is leading an assessment of how problems of fragile states—conflict prevention, peace building, and security system reform—are addressed and integrated into broader development programming.

The CFA franc zone set up a working group to consider innovative solutions for fragile states after a meeting of African and French ministers in Paris in September 2006.

Before going much further, however, it would be useful to get donors to agree on the definition of a fragile state and to deepen their dialogue to ensure that they agree on the guidelines to be adopted. The World Bank recently proposed including four categories in the description of fragile states: prolonged crisis, postconflict and political transition, gradual reform, and deteriorating governance. Because labeling a country as fragile can be a sensitive issue, focusing on the degree of fragility seems more appropriate, both to identify the issues and to give a signal that the situation is temporary and can be addressed. As a bilateral donor, France has already adapted its doctrine to help fragile states and is now able to give earmarked budget support to postconflict countries as soon as they receive IMF disbursements. This aid can be used to help reduce multilateral arrears and enable other partners to resume their aid. In 2004, France also eased Agence Française de Développement procedures to provide grants even to countries in arrears to this agency.

Way forward

Yet much remains to be done to sustain countries' efforts and provide the proper incentives. In particular, the following steps would make a big difference:

IMF conditionality. Discussions about a facility with more flexible conditions and a larger capacity-building component to deliver support to these countries should narrow the focus of conditionality down to fewer objectives, related mostly to fiscal performance and public financial management. The question of access to the new facility (not too restricted), interest rate (not too high), and the repayment period (not too short) should also be discussed, along with a more flexible approach to benchmarks. As in EU programs, the use of a flexible incentive tranche could also be considered as a device to develop a policy dialogue with the government. The IMF is already very active in postconflict countries, and its role in coordinating donor technical assistance should be strengthened in its areas of expertise.

Financing instruments. The World Bank (and other regional banks) could also, in specific circumstances, be authorized to provide grants to countries in arrears, keeping in mind the issue of moral hazard. These grants could be financed through net income allocations and earmarked to specific expenditures, such as programs supporting the disarmament, demobilization, and reintegration of militias, or pro-growth programs. A stability instrument, which should be finalized in 2007, will enable the EU to deal with political crises. The scope of this instrument should be as broad as possible, and governments should ensure that its procedures allow quick disbursements. Then, the financial community should clearly recognize that budget support, or earmarked funds, can be useful, reduce transaction costs, and facilitate the implementation of policies, especially in the early stages after a conflict has ended, when governments are most fragile and need help to cope with a variety of expenses.

Debt relief. A more flexible link between the Paris Club and IMF programs for postconflict countries could be envisaged to give the authorities an earlier opportunity for debt relief. For example, we could propose that even before an upper credit tranche agreement with the IMF has been approved, the IMF could defer a country's arrears, either totally (covering arrears and payments due) or partially (if the country's financial capacity is such that it can service payments falling due), without any concessional component. This deferral would apply only to payments due for a limited period. The debtor country would in this way resume normal relations with the Paris Club, but with reduced debt service requirements, enabling it to reestablish a payments track record. Creditors would undertake, on the basis of this track record, to deal with the issue of accumulated arrears once an agreement—not necessarily a standard type—has been signed with the IMF. This scheme was the preferred option for Iraq, whose creditors granted an initial treatment of the debt on the basis of a postconflict program, with the subsequent phases of the agreement being made conditional on Iraq's satisfactory implementation of a standard program.

Donor coordination. Closer coordination between all actors, including the IMF, should be a priority in fragile states. All donors involved, in partnership with the countries, should agree on joint assessments and strategies. A pooling of risks, which could take the form of a trust fund, should help reassure bilateral donors hesitating to take action.

The regional dimension of crisis. Donors should include in their calculations the potential for a crisis in one African country to spill over to its neighbors. They should also recognize the crucial contribution of neighboring countries, which often compensate for the lack of external financing in the early phases of a crisis. Consistent with the principles of the New Partnership for Africa's Development, and to boost regional integration, an African postconflict fund managed by the African Development Bank and subregional bodies could be envisaged. Its objective would be to channel financing and involve neighboring countries in the resolution or prevention of crises. It could also be used to address regional issues involving a number of countries, such as the impact of refugees.

Capacity building. A clear priority should be given to state building rather than excessive ring fencing of programs and projects, which tend to absorb or divert national capacities (as happened in Afghanistan). Because of the huge need to strengthen state and local institutions and restore the delivery of basic services (by strengthening both institutions and civil society capacities, as well as oversight and control bodies, to ensure demand-driven and efficient service delivery), the main response should go beyond external technical assistance. First, countries' national capacity should be systematically assessed (within the country, for both public and private sectors, at the regional level, and abroad—how diasporas can be mobilized, for example). In addition, practical experience has shown that coordination of donor technical assistance and training and country ownership are critical for developing capacity. The pooling of donor assistance should be considered in fragile states, based on a comprehensive assessment of needs in core areas, including short-, medium-, and long-term strategies. On the partner side, care must be taken to ensure that key ministries endorse the strategy and are in a position to monitor the results.

Become more realistic

All in all, given that fragile states face urgent and specific needs, the framework created by donors to support them is both too slow and not comprehensive enough. To some extent, the emphasis by IFIs and donors on arrears payments as a key element for building a track record is more and more inconsistent with the need to shorten the time for establishing such a track record. Besides, the donor community itself has an interest in bringing timely assistance to those countries. In many country cases, the sooner assistance has been provided to postconflict countries and the bigger it has been, the more efficient and the less expensive the assistance has been overall.

In short, it sometimes seems that fragile states have been excluded from the Monterrey Consensus and its consequences. The emphasis by the international community on the Millennium Development Goals, the harmonization and alignment of the development agenda, the introduction of performance-based allocation systems, and the international community's aid instruments, while suitable in many environments, don't seem well tailored to help the world's most vulnerable countries. It's time to be more realistic in helping fragile states recover from their torment.