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Symposium 2009

Proposal - Financial crisis and fragile states

The Challenge

In a number of territories primarily situated in the poorer parts of the world, the state no longer performs its basic security and development functions. Beyond causing hardship for their own citiz ...

In a number of territories primarily situated in the poorer parts of the world, the state no longer performs its basic security and development functions. Beyond causing hardship for their own citizens, failed states provide breeding grounds of organized crime and terrorism.

The Impact of the Financial Crisis on “Fragile States”
James Putzel
Professor of Development Studies
Director of the Crisis States Research Centre
London School of Economics

The Global Economic Symposium needs to be much more concerned with the set of countries which have become known as “fragile states” than with the problem of “failed states” per se. The outright “failure” of states – that is when they cease to function as states at all – as occurred in Somalia or earlier in the Democratic Republic of Congo during what has come to be known as “Africa’s First World War” (1996-2001), are relatively rare events. Of much more serious proportions is the persistence of a rather large set of states, both those recovering from collapse or prolonged episodes of warfare and violence and those in danger of succumbing to the same, which have come to be labelled “fragile states”.

There is no commonly shared definition of what exactly makes a state fragile, though the OECD and the World Bank have each elaborated definitions of fragility against which they have framed policy in recent years. States are fragile when they are vulnerable to the outbreak of violence and where public authorities have only a precarious jurisdiction over social and economic life. In the absence of a clear cut definition of state fragility, the Global Symposium may want to focus on the group of states deemed fragile by the World Bank and the OECD.

Since 9/11 there has been a growing awareness that states existing on the margins of the international system, where public authority is challenged and the organisational reach of the state is short, constitute threats to regional and global security. This has been evident with the emergence of international terrorist networks, which clearly have benefitted from weak and porous states to establish safe havens for their activities. This security threat has prompted a belated reconsideration of how the international community should deal with the poorest and most unstable of developing countries – those that have come to be known as fragile states.

The international financial crisis has taken its toll on this group of states that exists on the margins of survival. Almost all of these states have poorly developed economic systems and many rely primarily on primary commodity exports, often just one or two commodities, to earn their foreign exchange. The impact of the contraction of international finance in 2008 was almost immediate in the resource extractive economies in countries like the Democratic Republic of Congo or even the more stable Zambia. Why was this so? In both these countries there is heavy reliance on copper mining. While the international price of copper fell at the start of the crisis, it did not fall to all time lows. This is because copper has been one of the commodities in which forward speculation on prices has continued during the crisis. But international corporations, facing a decline in the physical demand for copper, first cut back their expansion plans in the risky environments found in fragile states. Layoffs in Zambia’s copper belt and the mines of Lubumbashi in the Democratic Republic of Congo have been massive. Plans for recovery in the DRC have largely been based on the expansion of mineral extraction and trade.

In these fragile states, government finance, beyond that which is provided by foreign aid, is largely dependent on revenues from the mineral sector. The knock on effects of the crisis have had a severe impact on government revenues. The financial crisis has served to underline the precariousness of banking on single commodities as a basis to create the economic conditions for state-building.

Fragile states have also remained heavily dependent on the remittance earnings from citizens working abroad. The international crisis has had a severe impact on remittances, which often constitute the primary source of foreign exchange in a poor economy and form the core of what little investment funds there are for the establishment of new service or agricultural activities.

The crisis has also had a serious impact on international tourism, again one of the few areas where those fragile states that have secured a modicum of stability and private investment have pinned their hopes for economic development. Right across the board, the contraction of international finance has brought a halt to new investment in fragile states.

Finally, the longer term impact of the financial crisis, particularly via the large deficits incurred in the wealthiest countries to shore up their banking sectors, threatens a reduction in the resources these economics will invest in development assistance in the future. Many fragile states are heavily aid dependent, where any serious contraction of aid threatens not only their development budgets but even their recurrent budgets. The crisis on all these fronts underlines the vulnerability of these poor states to drastic events on the international stage and should provoke a reconsideration of strategies of intervention by the international development community.

Solutions

1. A much greater percentage of development assistance and policy advice to fragile states should be devoted to the promotion of economic production, especially in agriculture. The sharp decline in foreign assistance to agriculture and economic infrastructure and the almost total absence of assistance to manufacturing activities over the past 25 years needs to be reversed. In many heavily aid-dependent countries, donor agencies have great influence over how state officials define their priorities and where they direct their attention. Discussion on donor assistance to fragile states and support for state-building has hardly focused on the economic foundations of states and instead has been concerned mainly with issues of governance and poverty reduction. Donors need to pay attention to how aid can promote possibilities for wealth creation, which are central to achieving elite “buy in” to the state, as well as the creation of jobs and livelihood incomes, which are pivotal to the survival of people and the maintenance of their loyalty to the state. The financial crisis highlights the problem of allowing finance capital to become disconnected from the real economy and, for poor countries, the need for states, even fragile ones, to begin creating state capacity to foster the expansion of the productive base within their territories.

2. Development assistance and policy advice to fragile states needs to put much more emphasis on the promotion of internal economic integration. Donors have focused attention on promoting liberal economic models aimed at integrating poor economies with global markets. While tapping the benefits of trade is central to the development process, this can only be done effectively through the establishment of domestic linkages within developing economies. The financial crisis highlights how precarious it is for fragile states to rely entirely on external finance to underpin domestic investment. In most fragile states the majority of the population is dependent on low productivity agricultural production heavily marked by subsistence farming. Poor or non-existent infrastructure - particularly farm to market roads, irrigation systems, energy supply - and virtually no investment in basic manufacturing to process and capture added value in the production of primary commodities or to produce fertilisers and simple farm tools mean that few forward and backward linkages exist within the economies of fragile states and the possibilities for commerce between distant towns and regions remain untapped. The absence of functioning postal systems and banking networks limit access to credit and finance for investment in productive processes or trading activities. Without renewed attention to the promotion of internal economic integration there will be few possibilities to make states more resilient let alone to set them on the course for development.

3. Development strategies promoted by the donor community in fragile states need to be concerned with developing the capacity of states to foster the creation and consolidation of private businesses and investment. The prescriptions for development offered by the donor community rely almost exclusively on a model of the state that limits its activities to improving the “climate for private investment” from both domestic and foreign actors. Instead, donors need to realise that in conditions of fragility, assistance must be extended to state organisations and officials to gradually play a more active role in assembling groups of private investors to foster investments in well-chosen infrastructure projects and new productive and trading activities. This necessarily involves the expansion of skills and rudimentary systems of accountability in state organisations, which are sorely lacking in most fragile states. However, there is little chance of promoting the expansion of private sector activities in most fragile states without active involvement of public authorities. Globalisation has allowed elites in even the weakest countries a life-line to maintain and reproduce their wealth through involvement in international markets, providing few incentives for investment in the more precarious and risky environments at home. Historical experience has demonstrated that the corruption that accompanies public involvement in private sector activities can be tamed and contained with the expansion of economic activities. This is risky, but the risks associated with total laissez-faire and economic stagnation and the contraction of market activity have proven far greater.

4. Support for the creation and consolidation of security and basic legal systems in fragile states is necessary to creating the conditions for an expansion in production and trade. Donor support to security has often been cast as a problem of security sector reform focused on subjecting security forces – military and police –to civilian scrutiny, but in many fragile states – those emerging from conflict – first order questions often involve the creation of state security forces, which are run with a unified chain of command whose members receive wages sufficient for their survival and the survival of their families. Support to legal systems has often been cast in terms of the protection of human rights and the expansion of access to justice, worthy goals, but the first order question is the establishment of basic organisations of adjudication to settle disputes and enforce contracts, whose reach and accessibility to all can be expanded over time. Without functioning security forces and basic legal systems, that can provide a modicum of leverage to the state and a modicum of protection of the population in terms of both physical protection and the protection of property rights, it is difficult to see how elites can be encouraged to play by rules as they engage in economic activities or to take risks in investment. Without credible security forces rural producers will also remain risk adverse and their trading activities will remain limited or non-existent. Without the establishment of credible security forces and very basic legal organisations it is unlikely that a state can expand its revenue collection.

5. The international community must transform aid delivery to fragile states to ensure it bolsters the establishment of government systems for public finance and budgetary management rather than undermining them or pre-empting their creation. Assistance to creating the capacity for public financial management in fragile states is often seen as a technical undertaking but in fact it is highly political. The channelling of aid to projects managed entirely by donors or NGOs may make some short term gains, may even be necessary where capacity in public agencies is next to nil, but can have deleterious affects of enormous proportions in creating sites of patronage and decision making beyond the reach of the state. Budget support, or the direct transfer of resources to national treasuries in fragile states, is extremely difficult where skills are lacking and fiduciary risks are high. However, the danger of establishing organisations “parallel to the state”, creating what is in effect a “dual public sector” can pre-empt the creation of capacity within states and undermine states, including their representative organisations. Donors should deploy aid in ways that enhance government systems of decision making on resource deployment: establishing trust funds co-managed by the state and donors and developing sector wide approaches where donors pool funds but more importantly defer to government management of sector programmes (health, education, infrastructure), ensuring projects are managed by government officials under adequate and audited systems. Donors take short cuts by channelling aid to individual ministries within states rather than building a state’s capacity to exercise oversight over aid funds and donors seldom report accurately the composition or destinations of their aid flows to government officials. All this undermines the development of state capacity, but more importantly it undermines the development of the state as the site for crucial decision making about the allocation of resources. This is the heart of state business and without consolidating these functions of the state the conditions of fragility cannot be overcome.

6. Donors need to stop pressing for financial liberalisation in fragile states and support efforts for the creation and consolidation of national banking systems. The financial crisis illustrates the precarious nature of fully integrating international finance. A large number of African countries have resisted the complete liberalisation of their banking systems and this, in retrospect, appears entirely prudent. Historically, the interaction between state authorities, finance and productive enterprise has been crucial to launching dynamic processes of capital formation required in “late developers”. This is because finance needs to be harnessed to a strategy for national development and goals of structural transformation. While possibilities in fragile states remain modest, the construction of the financial basis for national economic integration needs to be considered as a fundamental part of state-building. The international financial crisis only helps to illustrate this point.

Fragile states, even those poorly integrated in the international economy have suffered severely from the international financial crisis. They were among the first to feel the impact of the hesitance of banks to lend to big international companies, whose first casualties were their operations on the margins within the risky environments of fragile states. It is also likely that these states will be the last to experience the benefits of recovery as demand begins to pick up in the rich economies of the North. The impact of international crises, involving finance, food and environment, is likely to continue to be felt most severely in the most fragile states, where life and work are based on precarious foundations. These international events provide moments for a reassessment of development strategies that should not be squandered.

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