This paper reviews the current state of affairs in developing countries and their thinking on external risk management. It identifies the reasons behind the limited risk management by sovereigns. Perverse incentives arising from a too generous international safety net, developing countries' limited access to international financial markets arising from low creditworthiness, a limited supply of financial risk management tools of developing countries, and a poor supply of skills are the reasons that have inhibited risk management. Another constraint has been the limited attention given to the strategic objectives for risk management. Going forward, the paper identifies actions by international financial markets, governments and international financial institutions that can help to improve risk management.
This
paper analyzes the issues involved in sovereign risk management,
focusing on developing countries. It justifies the need
of risk management at the country level by briefly reviewing
the various shocks that developing countries are exposed
to. It then reviews the actual use of risk management tools
by developing countries and identifies the reasons why risk
management has been so limited in practice. It describes
some important reasons behind the lack of risk management,
e.g., the degree of incompleteness of international financial
markets, weak incentives in international markets, poor
incentives at the country level and a limited role till
date of international financial institutions and international
agencies. The paper sketches a way forward by analyzing
possible actions at various levels to improve risk management.
Developing
countries often face more international risks than the typical
developed countries. Generally, commodity prices and terms
of trade are the most obvious sources of risk where on an
average developing countries are more exposed to risk than
the most developed countries (although there are some exceptions,
such as Norway, oil). As recent consequences have shown
again dramatically, climatic shocks and natural disasters,
such as drought, earthquakes, hurricanes and others tend
to afflict many developing countries as well, more than
most developed countries. Most of the developing countries
and especially small countries, have limited potential to
act against these natural risks internally. Some of these
shocks are partly under the influence of governments as
they can take preventive actions, such as building dikes
for irrigation, using drought-resistant crops, and other
actions including encouraging diversification. But in many
cases, these solutions are too costly or inefficient or
the shocks are outside the country's influence. Other sources
of risks, arising from conflicts and wars, are also prevalent
in developing countries, but these are perhaps more endogenous
to economic performance. |
