A Countercyclical Framework for a Development-Friendly IFA

Abstract

The last three decades have seen developing countries, and particularly those more integrated into world financial markets, swing to the rhythm of highly procyclical external financing. Financial volatility has a direct effect on the balance of payments and domestic financial markets, and through them, on domestic economic activity and other macroeconomic variables. In the face of strong swings of private capital markets, developing countries lost ‘policy space’ to adopt autonomous countercyclical macroeconomic policies, and faced difficult challenges in creating deep financial markets. A vicious circle involving procyclical financing, incomplete financial markets and institutions, and constraints on macroeconomic policy emerged. Imperfect financial markets have been a source of volatility, but deep financial markets, improved financial governance structures and countercyclical macroeconomic policies have been difficult to develop in a highly volatile financial environment (Fanelli, 2006). The unfortunate outcome of this dynamic is that ‘twin’ external and domestic financial crises have become far more frequent since the breakdown of Bretton Woods exchange rate arrangements (IMF, 1998; Bordo et al., 2001).