United Nations: LDCs need to use external aid to transform their economies

The Least Developed Countries (LDCs) need to use external finance to structurally transform their economies, in order to manage their aid dependency and eventually escape from it, according to the UN Conference on Trade and Development (UNCTAD).

In its latest Least Developed Countries Report 2019, UNCTAD said that the LDCs account for 15 of the 20 most aid-dependent countries in the world due to persistent shortfalls in their domestic savings, among other factors.

It said that the LDCs should take ownership of their development agenda and manage the allocation of external development finance in alignment with their national development priorities.

The international community also needs to step up its support towards their common goal, it added.

In this context, UNCTAD called for the revitalization of the traditional aid effectiveness agenda through an "Aid Effectiveness Agenda 2.0."

It said that the implementation of an "Aid Effectiveness Agenda 2.0" should contribute to the deepening and acceleration of structural transformation, which would thus allow LDCs to eventually escape their current dependence on official development assistance (ODA).

"For LDCs to attain the Sustainable Development Goals and escape aid dependency, they need external finance that is targeted at the structural transformation of their economies," said Dr Mukhisa Kituyi, Secretary-General of UNCTAD.

According to the UNCTAD report, dependence on external resources to finance fixed investment and, more generally, sustainable development is a crucial feature of the economies of the least developed countries (LDCs).

Consequently, such dependence has a determining impact on the ability of these countries to reach their development goals, especially the Sustainable Development Goals and the objectives of the Programme of Action for the Least Developed Countries for the Decade 2011-2020 (Istanbul Programme of Action).

For LDCs, said UNCTAD, undergoing structural economic transformation is ultimately a condition to both escape aid dependence and realize the right to development.

To achieve the structural transformation of their economies, LDCs need to mobilize and allocate the financing required for long-term investment in new productive sectors and activities, as well as investment in the technological and organizational upgrading of existing sectors and productive units.

They also need to mobilize and allocate financing to current expenditure related to structural transformation.

These financing requirements exist at the micro, meso and macro levels. State capacity is crucial to ensure, directly or indirectly, the availability at reasonable conditions of financing at these three levels.

Ensuring availability at the micro level is the task of financial policies and, possibly, monetary policies.

In contrast, at the macro level, it requires the capacity to put in place development-friendly macroeconomic policies, to formulate national development finance plans and strategies and to consider the options available to finance different areas, types of projects and Sustainable Development Goals-related activities.

LDCs face stark difficulties

According to the UNCTAD report, with the world fast approaching the end of the period for implementing the Istanbul Programme of Action and one third of the time elapsed to pursue achievement of the 2030 Agenda for Sustainable Development, LDCs continue to face stark difficulties in reaching their development goals.

In this context, taking stock of their dependence on external development finance, a key facet of the development challenges of LDCs, is useful.

This issue has long been discussed as both a symptom and a cause of sluggish structural transformation. Such dependence is one reason for international support mechanisms for LDCs, said UNCTAD.

Midway into the implementation of the Istanbul Programme of Action, in 2015, the international community adopted the 2030 Agenda for Sustainable Development and the Addis Ababa Action Agenda of the Third International Conference on Financing for Development.

The Addis Ababa Action Agenda points to vastly expanded financial resources to finance the investment and expenditures required to reach the Sustainable Development Goals.

"The outcome to date, however, has been disappointing," said UNCTAD.

The required additional financing to be made available to developing countries has not materialized, and total external finance declined by 12 per cent in real terms between 2013 and 2016.

Inflows of foreign direct investment (FDI) to developing countries in 2018 were 3 per cent lower than in 2015, while LDCs suffered a much sharper contraction of FDI inflows, at 37 per cent, over the same period.

At the same time, the foreign debt levels of many countries have risen to critical levels. By mid-2019, one third of LDCs were in debt distress or at high risk of debt distress.

The challenging financing landscape is compounded by deceleration in world economic growth and world trade, as well as lingering global trade tensions.

According to UNCTAD, together with rapid population growth, environmental degradation and persistent fragility and conflicts, difficulties in financing the development of LDCs could jeopardize the realization of the Sustainable Development Goals.

This negative external landscape is a major obstacle to sustainable development, given the ongoing strong dependence of LDCs on external resources.

Such dependence on external resources to finance development, deriving from the continuous failure of domestic savings to finance these countries' fixed investment needs, is common to most developing countries, both LDCs and other developing countries (developing countries that are not LDCs).

The crucial role of ODA in development financing is, however, the major specificity of LDCs that renders many of them dependent on this particular external resource.

In contrast, other developing countries rely much more on external finance sources other than ODA.

At the same time, the landscape of official external finance for development has undergone radical changes in recent years, currently comprising not only ODA, but also financing from sources other than traditional donors.

According to UNCTAD, structural transformation is a sine qua non for developing countries - and especially LDCs - to reach the Sustainable Development Goals.

Therefore, structural transformation is the critical link between dependence on external resources and the pursuit of sustainable development.

Structural transformation will eventually allow LDCs to escape from their dependence on ODA, while allowing them to reach their development goals sustainably. The ultimate goal of mobilizing and allocating development finance is not only to attain sustainable development, but - much more crucially - also to be a means of realizing fundamental human rights.

According to the UNCTAD report, barely four years have gone by since the international community adopted the 2030 Agenda for Sustainable Development. Yet, with little more than 10 years to the 2030 deadline, the mood has shifted markedly.

Despite the rhetoric of "leaving no one behind", rising disengagement has hit LDCs hard, jeopardizing the prospects of achieving the objectives of the Istanbul Programme of Action and the more recent Sustainable Development Goals.

LDC stakes in the global economy continue to be marginal, with over 13 per cent of the world's population and barely 1 per cent of global GDP.

Moreover, progress towards meeting the various Sustainable Development Goals targets specific to LDCs has been sluggish at best.

One major reason for the slow pace of progress towards achieving the 2030 Agenda and the subsequent sluggish implementation of the Sustainable Development Goals in LDCs is the international community's lack of decisive action to make the international environment - including issues of financing for development - in which these countries' economies evolve more amenable to sustainable development, and the persistence of barriers to the structural transformation of their economies.

The pursuit of the Sustainable Development Goals in developing countries requires heavy investments in economic, social and environmental infrastructure (capital expenditure), as well as raising levels of current expenditure (i.e. operating expenditure). Current expenditure is especially crucial in the areas of health, education and social services.

UNCTAD has estimated that, for LDCs, investment needs (i.e. capital expenditure) amount to $120 billion, annually, between 2015 and 2030, a quantity three times higher than current investment in the Sustainable Development Goals, calculated at $40 billion annually.

These capital investment figures include domestic and foreign, as well as public and private, investment.

Need for significant amounts of external finance

LDCs need significant amounts of external finance to accelerate the process of structural transformation, given the lower levels of development and productivity of these countries, said UNCTAD.

The issue of financing the expenditures required to achieve the Sustainable Development Goals is directly related to two structural features of these economies: first, their dependence on external sources of financing and, second, the early stage of structural transformation at which these economies find themselves.

In general, financing investments made mainly through domestic - rather than foreign - savings remain the preferable option, often entailing more stable growth dynamics and somewhat greater policy space.

This underscores the importance of effective domestic resource mobilization, said UNCTAD.

Yet the option of financing investments through domestic savings is often not feasible at low levels of income, as is the case for LDCs.

This is due to the limited scale of domestic resources and ineffective resource mobilization (caused by failings in domestic fiscal and financial systems), as compared to the much larger investment needs of these countries.

Additionally, many LDCs suffer from large volumes of illicit financial outflows, which undermine efforts in domestic resource mobilization.

Worldwide, the volume of external financial flows to developing countries expanded significantly since the turn of the millennium, but experienced a decline in recent years.

Simultaneously, the array of instruments used - from foreign direct investment (FDI), debt and traditional ODA, to blended finance, remittances and portfolio investment - have continued to increase the potential availability, and complexity, of the development finance landscape.

In the context of balance of payments, FDI, traditional ODA, official financing stemming from South-South cooperation, remittances, external debt and portfolio investments all represent potential sources of external finance, as do emerging instruments such as the distinct forms of blended finance and public-private partnerships, said UNCTAD.

The availability of external finance to LDCs has increased significantly since the beginning of the century, from $24 billion in 2000, to $163 billion in 2017, largely because of the rising weight of remittances, FDI and external debt.

Nonetheless, LDC specificities emerge quite starkly in the composition of external finance. Unlike for other developing countries, ODA remains the most important source of external finance for LDCs, underscoring the challenges in attracting market-based external financial resources.

ODA accounted for one third of total external development financing of LDCs in 2014-2017, as compared with just 4.5 per cent for other developing countries.

In contrast, the importance of FDI as a source of external finance was the reverse for these two groups of countries.

While in LDCs it accounted for one fifth of the total, in other developing countries, it contributed almost half of total external finance.

LDCs' reliance on external finance, and the persistence of their relative position in terms of aid dependence, points to a continuous need for support, which is widely acknowledged in the Addis Ababa Action Agenda and within the framework of the 2030 Agenda for Sustainable Development (target 17.2).

This need has become more acute in recent years, due to the stark changes the international aid architecture has been undergoing.

The state of LDC aid dependence depicted so far is worrisome in itself. The situation has become even more challenging for LDCs as the aid landscape has changed considerably in recent years.

It has become more complex and less transparent since the early 2000s, which further challenges the already constrained capacities of LDC policymakers to manage the financing of sustainable development in their countries, said UNCTAD.

Over the last 15 years, the aid architecture has been transformed, due especially to the following developments: changes in the aid policies of traditional donors that affect their aims, priorities, modes of delivery and partnerships; shifts in the relative importance of actors, including particularly the changing role of non-governmental organizations and new forms of private sector engagement; (re)emergence of new actors and sources of development finance, especially in relation to the strengthening and broadening of South-South cooperation; entry of philanthropists, who have come to play a major role in some fields (e.g. health); and development of new modalities and instruments of raising and delivering aid in the wake of innovations in global financial markets, e.g. blended finance and public-private partnerships.

These crucial developments are transforming the global scene of official development financing, which is becoming far more fragmented, complex and opaque.

Such changes present challenges to the limited institutional capacities of LDC policymakers and other domestic economic agents, said UNCTAD.

As they strive to mobilize the much higher financing necessary to launch the structural economic transformation required to achieve the Sustainable Development Goals, these changes add to the challenges that LDCs have traditionally faced.

At the same time, these changes provide opportunities, given the possibility of accessing a wider array of sources and modalities of financing, said UNCTAD.

This has been dubbed the "age of choice" for development finance. However, the extent to which the selection of options has widened depends on countries' creditworthiness. If it is low or lacking, access to private funds on commercial terms in international capital markets (e.g. by emitting bonds) is excluded, or at least more difficult and costly, as an option.

Aid Effectiveness Agenda 2.0

According to the UNCTAD report, the present relationship between traditional donors and beneficiary countries is largely a result of two factors, namely, lingering issues on the original aid effectiveness agenda on which progress has been limited or incomplete; and rapid changes in the aid architecture, which present new challenges to recipient countries.

To take into account both lingering and emerging issues, traditional donors and beneficiary countries are advised to launch a new agenda, namely, Aid Effectiveness Agenda 2.0.

This agenda should have two components, namely, addressing the unfinished business of the original agenda and dealing with the challenges that have emerged from ongoing changes in the aid architecture.

The implementation of Aid Effectiveness Agenda 2.0 should therefore effect changes to the existing aid architecture and correct for many of the challenges faced by LDCs under the traditional system, said UNCTAD.

It noted that over 10 years after the signing of the Paris Declaration and the Accra Agenda, their principles remain relevant, as does the principle of putting recipient countries and their priorities at the centre of the aid system.

This is consistent with the role attributed to States by the 2030 Agenda and the Addis Ababa Action Agenda.

Developing country policymakers still place a higher priority on ownership, alignment with national priorities and effective delivery, for example, the speed of project delivery, in raising project finance.

Yet, to a great extent, these principles have not been implemented and have decreased priority in mainstream aid policymaking.

Therefore, a core element of Aid Effectiveness Agenda 2.0 is to reaffirm these principles and address the unfinished business of the original aid effectiveness agenda. There is a need to fully implement international commitments made following previous negotiations and affirmed in major international declarations.

Private sector engagement implies an increased reliance on FDI and public-private partnerships. Negative experiences with such partnerships are common in both the global North and South, said UNCTAD.

It noted that many of the donor countries championing such partnerships abroad through the strategies of their development finance institutions are changing their approaches to domestic public-private partnerships, but similar developments are lagging in recipient countries.

Giving primary consideration to the singular issue of accountability can help LDCs affect private sector engagement in ways that enhance its contribution to structural transformation and sustainable development.

Regardless of the outcomes of the modernization of the ODA architecture, the redefinition of what counts as ODA warrants a careful assessment of development impacts, to determine whether the evolving notion of ODA is appropriate in the era of the 2030 Agenda.

For Aid Effectiveness Agenda 2.0 to be meaningful, it is important that the OECD's Development Assistance Committee (DAC) members strengthen ODA-linked private sector engagement accountability in beneficiary countries including, in particular, LDCs, which are the most dependent on ODA among all beneficiary countries.

UNCTAD also noted that the relevance of South-South and triangular cooperation has increased in recent years and could have a critical role with regard to sustainable development prospects in both LDCs and other developing countries.

Given the development needs of the former, increased South-South development cooperation by non-traditional partners in a position to do so could bring considerable benefits. It is critical to adequately reflect LDC needs in existing frameworks for economic integration among developing countries at regional or inter-regional levels.

UNCTAD said that challenges remain, in particular with regard to regional imbalances in access to development finance by beneficiary countries, along with the need for increased clarity in the definition of concessional and non-concessional lending, given the present lack of a common definition among sources of development finance in the South.

These issues should be addressed through the revamping of development partnerships and enacting of general precepts, including mutual accountability and development impact evaluations.

According to UNCTAD, it is crucial for LDCs to place the strengthening of their fiscal systems at the centre of their development strategies, for two main reasons.

First, building fiscal systems is an integral part of State-building and there is a reciprocal relation between the quality of a fiscal system and State capacity. In order to finance the building of institutions and the formation of bureaucratic capabilities, States need to mobilize resources.

Along the development trajectory of countries, there is typically a transition from dependence on external finance towards domestic resource mobilization.

In addition, State capacity to raise and allocate fiscal revenue in a sustainable way depends on a social contract that confers legitimacy to the fiscal system, in both developed countries and as part of the ongoing development process in developing countries.

State-building and the strengthening of State capacity is in turn required for a State to be able to steer the process of structural transformation and, thereby, sustainable development.

Second, there is a relationship between taxation and aid dependence, said UNCTAD.

It is often argued that aid dependence prevents the development of fiscal capacity in recipient countries, as well as State capacity more generally, and that it tends to perpetuate a low-level equilibrium that characterizes under-development traps. Aid and taxation are often seen as imperfect substitutes, on the grounds that the availability of ODA is a disincentive to the construction and strengthening of a domestic fiscal system.

However, the extent of such negative side effects is questionable and, moreover, they may be the consequence of problems in the system of aid itself.

In addition, multilateral and regional development banks have traditionally been active in the fiscal field through the implementation of capacity-building programmes on fiscal policy and budget management, which have resulted in building islands of high-level bureaucratic competence in LDCs, typically within ministries of finance and central banks.

Yet such capacity-building activities have often largely been oriented towards fiscal prudence and decreased expenditure, rather than raising taxes and managing the longer term development impacts of fiscal policy, said UNCTAD.

Preserving multilateralism

According to the UNCTAD report, with regard to broader issues on the international agenda, LDCs have a particularly strong vested interest in preserving and strengthening multilateralism.

This is the sphere where the voice and interests of smaller countries and weaker actors in the international community are best represented and defended.

Multilateralism is, moreover, a means of pursuing the realization of human rights, including the right to development.

Yet the current economic and geopolitical conjuncture is placing an enormous strain on the multilateral system and it has recently come under criticism in the fields of trade, finance and geopolitics.

UNCTAD said that with regard to specific issues on the aid effectiveness agenda, the United Nations system has effectively promoted the Paris Declaration principles of ownership and alignment, with a commitment to promoting State capacity and decision-making on development priorities and strategies, in contrast to the shifts in the priorities of traditional donor countries away from a beneficiary country-centric approach.

It noted that this broader movement away from multilateralism seems to be reflected in the current trend in the aid architecture to target the increased use of bilateral development finance institutions.

This may ultimately elevate bilateral engagement and intensify unilateral action by a variety of actors that are not necessarily equipped to address all or any development challenges.

This change should not come at the expense of the multilateral sector, including the critical role of the United Nations in providing concrete evidence-based guidance on development cooperation for policymakers and practitioners at all levels.

The United Nations development system constitutes an essential forum to create greater solidarity across all countries and sectors and to ease tensions between competing national interests.

The LDCs have a limited voice at key discussions at which systemic issues are treated and limited chances to articulate their needs and see them adequately considered.

Based on historical experience, this lack of representation is unlikely to be addressed in the near future, yet it is important that LDC concerns be adequately taken into account, if the pledge to leave no one behind is to be taken seriously.

The need to reinvigorate multilateralism and strengthen global cooperation is increasingly being recognized, not only by the United Nations and UNCTAD, but also by the International Monetary Fund (IMF) and OECD, said UNCTAD.

With regard to aid allocation and delivery, it is crucial to reinforce the role of the United Nations in the evolving aid architecture, given that development is one of the three pillars of the United Nations and given its strong track record with regard to ownership and alignment with national priorities, it concluded.

By Kanaga Raja.

Source: SUNS - South North Development Monitor, SUNS #9025 Friday 22 November 2019.