Helping Countries Overcome Shocks

External shocks such as droughts and floods, commodity price fluctuations, war or civil unrest, and international economic volatility, can undermine low-income countries' ability to meet their debt obligations, says Vikram Nehru, Director of the Bank's Debt Department, which oversees the Heavily Indebted Poor Countries Initiative.

This is because low-income countries can find themselves in a situation where they have to borrow more to cope with the effects of a shock at the same time as government income is falling.

"Exogenous shocks are an extreme form of volatility, and their negative impact on low-income countries appears to have increased in magnitude and frequency over time," Nehru says.

This makes helping low-income countries weather exogenous shocks, over which they have no control, a crucial factor in achieving long-term debt sustainability, he says.

Shocks More Difficult In Low-Income Countries
Dealing with shocks can also be more difficult in low-income countries because often the resources, instruments, or policy options needed to manage or mitigate them are unavailable or difficult to implement because public institutions are weak.

A paper prepared for the World Bank's Board says shocks can have a disproportionate effect on the poorest countries and often lead to increases in poverty.

"The macro-consequences of shocks to low-income developing countries - on Gross Domestic Product, growth and poverty and on internal and external balances -tend to last a long time, often requiring painful adjustment measures,' the paper says.

Why Shocks Hit Low-Income Countries Harder
The fact that commodity prices have become more volatile since 1973 has hit low-income countries the hardest. This is because they tend to rely on commodity price exports for a larger proportion of their export earnings. Research shows that downturns in commodity prices tend to vary in length but can last several years.

Low-income countries also have a natural disaster, on average, once every two and a half years (compared to four and a half for the average developing country). Earthquakes, floods, droughts and cyclones account for 90 percent of all the fatalities and damage from natural disasters in developing countries.

What Low-Income Countries Can Do
The paper recommends low-income countries adopt a three-pronged strategy to effectively address exogenous shocks:

• They should take preventive measures to cushions against exogenous shocks - such as building up foreign exchange reserves and developing efficient domestic financial and risk markets
• Countries in partnership with donors and creditors should build social safety nets to make sure the poorest people are protected in the aftermath of a shock
• Countries should create stronger co-ordinating mechanisms across multilateral and bilateral creditor and donor agencies - where part of donor assistance to low income countries is allocated to deal with unforeseen contingencies.

What The Bank Can Do
The paper recommends that the Bank examine its own instruments to determine whether changes need to be made to help low-income countries take the necessary steps to deal with external shocks.

"The Bank should also examine ways in which it can facilitate low-income countries' access to market-based instruments, such as insurance products."

It also recommends that the work on helping low-income countries overcome shocks take into account the ongoing discussions over the replenishment of the International Development Association which are currently underway and the Bank's on-going work on debt sustainability.

The Poorest Are Hit Hardest
The paper finds that the poorest people in low-income countries are the most vulnerable to the effects of shocks because they have more difficulty moving across occupations and geographic areas and have reduced access to funds. Their dependence on public services (especially health and education) also exposes them to cuts in government spending.

The adverse effects of negative shocks "tend to be irreversible". Negative shocks can cause capital outflows that are difficult to reverse and permanently harm education and health outcomes. Financial crises can spark a credit crunch that can lead to irreversible damage to the industrial and social fabric. Household assets may be drawn down prematurely in the wake of a shock. This can reduce the ability of the poor to smooth income. Unemployment of unskilled workers can become permanent when employers hoard skilled labor in downturns, reducing the likelihood that unskilled workers will be rehired if and when the upturn eventually arrives.

While the global community has helped low-income countries prevent and mitigate the effects of shocks in the past, their assistance has been largely ad-hoc.

There is no clear mechanism by which donors and creditors can supplement country efforts to deal with the effects of shocks in a timely, objective manner and on appropriately concessional terms.

"Often low-income countries, many of which are already significantly indebted, resort to borrowing to tide them over exogenous shocks," Nehru says. "This usually increases their indebtedness further and raises the risk of future debt distress."

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