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Financing for Development and Small Island Developing States: A Snapshot and Ways Forward

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UNDP & UN-OHRLLS Discussion Paper

Written by Gail Hurley, Policy Specialist on Development Finance

Executive Summary

This paper provides a snapshot of development financing in small island developing States (SIDS). It aims to inform and reinvigorate international policy debates around how SIDS can finance – and meet – the world’s new sustainable development agenda, the SDGs (Sustainable Development Goals). This discussion is particularly timely in view of the Third International Conference on Financing for Development in Addis Ababa, Ethiopia in July 2015. The conference will define the financing framework for the new SDGs. A robust and inclusive outcome to this conference must necessarily recognize the special development challenges faced by SIDS, and include measures designed to support them to meet the SDGs.

This paper reviews recent key data on domestic and international financial flows, such as development and climate aid, foreign direct investment, remittances, tax revenues and savings. It also explores in detail some SIDS’ continued struggles to maintain debt sustainability. All SIDS regions, namely the Caribbean, Pacific, and Atlantic, Indian Ocean, Mediterranean and South China Sea (AIMS) countries are included in our evaluation.

SIDS are extremely mixed when it comes to human development. Some enjoy very high levels of human development such as Barbados and Singapore; others, such as Comoros, Guinea-Bissau and Haiti score poorly. When it comes to domestic and international financial flows, the picture is similarly mixed; some countries rely heavily on domestic and international capital markets (i.e. private finance) to meet fiscal deficits and fund development while others are heavily aid dependent. Some attract foreign direct investment while others do not.

Despite these differences, most share a number of key challenges when it comes to financing for development. These include limited capacities to mobilize domestic resources, high per capita costs when it comes to essential service provision and vulnerability to environmental and economic shocks.
Climate adaptation costs are also among the highest in the world for SIDS when measured as a proportion of national output.

The paper finds that, overall, high levels of public debt remain a key challenge for many small island states, especially in the Caribbean. Current approaches, which have relied on SIDS to negotiate solutions with their creditors on an ad-hoc basis, combined with fiscal retrenchment have not, in many cases, been sufficient to adequately address the problem. Moreover, if debt instruments – public and private – expand in the future to help finance the SDGs, there is a risk this may further aggravate already fragile debt positions.

When it comes to development aid, the data shows that SIDS receive very little Official Development Assistance (ODA) as a share of total ODA, at just 5.7%. However when aid receipts are measured as a proportion of national income and on a per capita basis, they are larger recipients. Most aid flows are concentrated in the Pacific and some countries in the region are heavily aid dependent.

On the whole, SIDS have not been able to leverage as much climate and environmental aid as may have been expected, despite their vulnerability to climate change and other environmental shocks. This is due to factors such as limited capacities to apply for and manage climate finance (typically administered via complex funds), as well as unfulfilled donor commitments and a donor bias towards mitigation rather than adaptation finance. As countries disproportionately exposed to shocks such as extreme weather events, the paper also reviews SIDS’ record on accessing sources of international finance that aim to support countries to deal with the impact of shocks and emergencies.

SIDS have also, in many ways, been a success story; most are classified as middle-income. Paradoxically, this makes many ineligible for concessional finance (and a low aid priority for donors). This paper finds however, that many SIDS continue to experience severe structural constraints in their efforts to mobilize more domestic resources for development. Savings rates are also low when compared to other developing countries. Combined with high climate adaptation costs and infrastructure investment needs, these factors mean that international finance will be indispensable to SIDS. We find that while foreign direct investment (FDI) could be strengthened, it also has its limitations as a source of development finance due to its heavy concentration in particular countries and sectors, and its volatility and procyclicality.

The paper makes a series of recommendations which aim to tackle some of SIDS’ major financing for development challenges. For instance, further work is needed to assess whether a Heavily Indebted SIDS Initiative and/or expanded use of debt-for-climate/debt-for-nature swaps could be useful in helping to restore debt sustainability in severely indebted countries. We also advocate for the piloting of innovative financial instruments designed to reduce risk and support effective debt management, such as GDP-indexed official sector loans and countercyclical loans. In the case of the former, debt repayments are tied to economic performance; in the latter, debt service is allowed to fall or become zero when a major economic shock occurs. Both instruments attempt, in different ways, to link debt service to ability to pay and could be useful to SIDS.

Finally, we make the case for revisiting eligibility criteria for concessional finance from multilateral and bilateral lenders. Specifically, we propose a basket of indicators be used to determine the most appropriate financial instruments and levels of concessionality for different countries. This basket includes: income per capita, vulnerability to shocks, capacity to mobilize domestic and international finance, level of debt, social indicators and type of programme being funded. More work is needed to operationalize this proposal but the approach could be extremely important to SIDS. All these measures need to be combined with efforts at the national level to strengthen revenue collection and debt management capacities as well as improve the quality of public expenditures.

Looking forward, the evolving development financing landscape presents considerable opportunities for small island developing States in the future. Opportunities include an expansion in environmental and climate focused international public finance, the emergence of new and innovative financial instruments and an expanded donor and lender pool. However SIDS’ capacities to leverage these resources and use them effectively must be strengthened. Support will also be needed to help SIDS develop ‘bankable’ projects. Meanwhile SIDS’ vulnerability to shocks is unlikely to diminish and progress (or not) in tackling climate change will profoundly impact their development trajectories. It is hoped that the Addis Ababa Financing for Development process can act as another ‘call to action’ in support of small island developing States.