The Case for Liquidity Support for Frontier Markets

More development finance is needed, particularly more official development assistance (ODA) from developed countries to developing countries. But official financing has never been the only way to finance development. As countries move from lower-income status to middle-income status and demonstrate sound macroeconomic management, they begin to borrow from international financial markets.

Taking on such debt prudently can contribute to advancing a country’s economic wellbeing. Governments around the world use debt to finance themselves: public investment opportunities that have concrete realizable returns can be responsibly financed by the private sector; and market finance can help smooth government expenditure when domestic revenues are cyclical, ensuing countries do not get knocked off their development path by temporary changes in economic fortune. Frontier market countries—those beginning to access global capital market—can take on debt responsibly as part of their development strategy.

The puzzle for development finance experts has been that the capital flows from developed financial markets to developing countries are nowhere large enough to meet financing needs for the Sustainable Development Goals (SDGs), even if official assistance were to be ramped up significantly. Cyclically low investment returns in the developed world should make investment in developing countries quite attractive, yet investments in frontier markets, particularly in Africa, do not begin to meet the development needs of these countries.

The puzzle is how to accelerate responsible private external financing in developing countries—that is, how to intermediate between the existing large pots of capital in developed financial markets and investments in emerging middle-income countries, as there appear to be market imperfections that keep money from flowing.

Sovereign debt markets for many frontier market countries are themselves underdeveloped. Misperceptions of the risk entailed in investing in such countries result in interest rates that are higher than those charged on the debt of more established middle-income countries, even though economic fundamentals are broadly the same. Multilateral development banks (MDBs) and development finance institutions (DFIs) can help overcome some of these misperceptions by jumpstarting investments and taking on some of the perceived risk to allay investors’ hesitancy.

The lack of a secondary market for emerging middle-income country debt, in particular a repo market, also impedes financial flows. Secondary markets give investors an assurance that they can use the sovereign debt they hold to get liquidity if needed—temporary or permanent. And without a repo market, interest rates will be higher, as investors will require a premium for the illiquidity of these investments. Such flexibility is particularly important in these times of heightened uncertainty as the world emerges slowly and unevenly from the economic turmoil induced by the COVID-19 virus. No escape hatch results in investor hesitancy. Repo markets for frontier African country debt are unlikely to develop on their own as sovereign debt in these markets are still seen as a “boutique” investment and the market is thin.

The Liquidity and Sustainability Facility (LSF) is an proposal to jumpstart a repo market for frontier countries in Africa, and perhaps beyond. It should lead to a virtuous circle of attracting more investors and lowering borrowing rates for these economies. Central bank reserves of developed countries would provide lending capital for the fund. The design minimizes risk to these reserves, with the repo risk being held by the original investor.

Experts estimates that the LSF will need up to $30 billion of backing to get to full capacity and establish an active repo market. While at first glance, this seems like a large amount of money, global reserves are about $12.5 trillion, so we are talking about lending (not donating) about 0.25 percent of global reserves to back this fund.

This could be done either through direct lending of the reserves to the LSF or perhaps via lending the LSF a small part of the new allocation of $650 billion of Special Drawing Rights (SDRs) that is about to take place in August 2021. SDRs are central bank reserves issued by the IMF that allow for the free exchange of hard currency reserves among central banks on demand. Many of the new SDRs will go unused in developed countries’ central banks, so why not put them to use for the LSF? While the use of SDRs outside the IMF poses some technical problems, the fact that the LSF design mimics that of the IMF’s Poverty Reduction and Growth Trust (PRGT) makes it more attractive that other non-IMF-based proposals.

Some have questioned whether public monies should be used in this way at all, calling this a subsidy to the private sector and suggesting that the LSF will only comfort private investment bankers who currently hold debt of these countries. But the investors continue to bear the risk of the bonds they purchased—public monies are only used to provide the liquidity if needed. Central bank loans may entail taking a bit more risk on developed countries central bank balance sheets, but these balance sheets are solid and, in a time of enhanced global need, a bit more risk is a small price to pay for ensuring that financing flows to frontier markets in Africa continue. And, when repo institutions were first created in the United States and Europe, their initial funding was by central banks—there is every reason to do something similar for Africa now. Constructive critics have noted there are important lessons to learn from past experiences and getting the operational details of the LSF right will be important to its success.

The ultimate beneficiaries of the LSF will be the African countries that will see lower interest payments on debt. The UN Economic Commission for Africa estimates the savings could be as much as $11 billion over five years. The LSF will also make these countries more attractive investments and bring badly needed capital to them. The solution to any market hegemony by a small set of investment banks is to bring more participants to the market—exactly the aim of the LSF.

There is little doubt that the structure of global development financing needs a deep rethink: more official development assistance is needed; the MDBs and DFIs need more capital and need to take on more risk; and developing countries themselves need better plans for emerging from the crisis and building a green and equitable future, including mobilizing domestic resources.

Inevitably part of that rethink must involve mobilizing a larger share of the vast amounts of private capital in developing countries for development. The LSF is a modest proposal to dent the structural barriers to those capital flows—an investment well worth undertaking with a small part of the world’s reserves.