The Vulnerability-Flex Mechanism: A success story?

26 February 2010

Last December, the European Commission (EC) approved the first financing decisions in favour of thirteen African, Caribbean and Pacific (ACP) countries, which are to benefit from a total of €215 million under the €500 million ad hoc Vulnerability-FLEX mechanism (V-FLEX). Initially proposed by the EC in April 2009, approved by EU Member States in July, and now operational, V-FLEX has the makings of a ‘success-story'. At a time when ACP countries are applying for the second tranche of disbursement, it is appropriate to examine this mechanism in an effort to stimulate discussion.

Although it is too early to draw conclusions regarding the performance of V-FLEX, this article considers some of its potential based on its nature and design.  It is argued that if this well-conceived and, in many ways, innovative mechanism appears promising regarding its capacity to close fiscal financing gaps in beneficiary countries, it is somewhat disappointing to see it undermined by the narrowness of its envelope and its short-term setting.

The emergence of a ‘donor of last resort'

As one of the 28 measures recommended by the EC in its communication "Supporting developing countries in coping with the crisis", V-FLEX has been conceived as a "global safety net" aimed at helping the most vulnerable ACP countries safeguard social spending in a context of deteriorated fiscal balances[1].

There was indeed a sense of urgency to respond to the needs of ACP countries in this respect[ii]. In sub-Saharan Africa, which in 2009 recorded its first negative real growth rate in GDP per capita, the overall fiscal balance has deteriorated from a surplus of 0.3% of GDP in 2008 to a deficit of 6.4% in 2009[iii]. In response, the EU effectively designed and implemented, in a very short time, a well packaged proposal that secured EU member states' support by addressing their concerns.

Used to top up the B-envelope of the National Indicative Programmes[iv] (in conformity with Article 3(5) of Annex IV of the Revised Cotonou Agreement[v]), allocations under V-FLEX are to be drawn from the reserves of the 10th European Development Fund (EDF), for which EU member states already agreed to over €22.7 billion (2008-2013). The financial repercussions on EU member states' contributions have thereby been minimized.

Given the limited amount of funds available (€500 million for two years), the EC decided to confine its action to one of a "donor of last resort" and help only the most vulnerable countries  meeting the following criteria[vi]:

(1)    High degree of "vulnerability" assessed by quantified benchmarks concerning government revenue, foreign reserves and the fiscal deficit[vii];

(2)     A "residual fiscal financing gap, not covered by other donors or by foreign and/or domestic borrowing";

(3)    Capacity of the EC to close or "significantly" reduce this gap[viii].

Support under V-FLEX is to be provided as an additional single payment to the already existing budget support programmes, or, if necessary, through existing projects or programmes, including social safety nets (a second-best proposition). To be eligible, applicant countries also need to "demonstrate a sufficient absorptive capacity through an ongoing budget support programme or an existing established social safety net or equivalent mechanism"[ix].

Well-designed but insufficient

While the EU has a strategic inclination for such a performance-based instrument (ownership, aid effectiveness, etc), topping up budget support programmes to address the consequences of an external shock is not without controversy.[x] Nonetheless, V-FLEX certainly has the merit of ensuring a quick disbursement and smooth coordination between donors on the ground. With the identification of a residual financing gap as an eligibility criterion, donor coordination was a given on paper, and seems to hold in practice, the IMF being involved in all the stages of the implementation process.[xi]

Moreover, because it is based on present and/or forecasted benchmark criteria regarding fiscal deficits, V-FLEX decisively palliates the shortcomings of the not-fully countercyclical FLEX mechanism. Indeed, not only does FLEX (Facility for FLuctuations in Export Earnings) ignore many transmission channels through which the current crisis is negatively affecting ACP countries (reduction of private capital inflows, decline of remittances and tourism, etc); it also uses past exports data to assess ‘vulnerability', which is clearly a partial indicator[xii].

Grants under V-FLEX come from non-earmarked reserves somewhat kept for such circumstances. Therefore, the common argument according to which frontloading aid might create funding gaps in the long run[xiii] holds little weight against V-FLEX.  It is more difficult, however, to counter the charge that, strictly speaking, V-FLEX does not provide "new money[xiv]".

In a context of modest possible disbursements, the EC, by favouring a discriminatory approach over an equal distribution of aid to all ACP countries, certainly ensured efficiency. The question however is: Why take the limitation of resources for granted in the first place?

Indeed, without denying the importance of this mechanism for the beneficiary countries, V-FLEX remains, in terms of budget, a small facility that leaves out many ACP countries. For the 2009 allocation, only 17 countries were considered eligible and disbursements were only processed for 13 of them. This limited geographical scope is all the more problematic since, in theory, among those countries which cannot be considered eligible are those whose "residual fiscal financing gap" is too large to be "substantially" reduced.

Moreover, V-FLEX was created for a two-year period only. Similar to some of the EU's other proposed responses to the crisis in developing countries, like frontloaded assistance or the acceleration of the Mid-Term Review of Country Strategy Papers, it indirectly assumes a rapid economic recovery[xv]. Yet it will probably take a few more years before many developing countries regain their pre-crisis growth level. Extending both the duration and budget for V-FLEX might therefore be desirable[xvi].

Beyond the crisis, no room for complacency

The economic and financial crisis, EPAs and the MDGs

Given V-FLEX's limited potential both beyond 2010 and for about sixty ACP countries which do not currently benefit from the additional assistance, the European Parliament recommended "that economic partnership agreements (EPAs) be used as a means of meeting development needs [...]". The potential benefits of EPAs, however, will mostly be felt in the long term and these agreements can hardly represent a quick solution to the crisis[xvii]. Of course, in the short term, it will be necessary to ensure that EPAs do not add further strain on ACP government finances.  This calls for a comprehensive approach to the current crisis whose real effects on ACP countries can only be appreciated (and stymied) in light of all the challenges these countries face. In the medium term, therefore, the importance of monitoring the impact of the EU response to the crisis should not be neglected.

Thinking ahead: What EU Compensatory Mechanisms for Shocks?

In this respect, the efforts initiated by the EC to help ACP countries monitor the performance of the international response to the crisis[xviii] (V-FLEX included) should be further encouraged. Regarding V-FLEX, there are reasons to think there are (or will be) some positive lessons to be drawn from it. Indeed, if V-FLEX per se is not a panacea, it can still be held up as a positive example compared to FLEX, which has been conceptually criticized and sometimes at odds with IMF requirements[xix]. Although there are some signs of recovery in the global economy, it is nonetheless urgent to improve existing compensatory mechanisms for shocks or complement them with new ones. At a time when ACP and EU parties are negotiating the second revision of the ACP-EU Partnership (Cotonou) Agreement, it is now up to them to demonstrate their will to keep working towards the realization of a smooth and flexible partnership that can address these challenges in the future.

[1]European Commission Communication (2009a), "Supporting developing countries in coping with the crisis", COM(2009) 160/4, 8 April ; Europa PressRelease, IP/09/1920, 15 December 2009 http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1920&format=HTML&aged=0&language=EN&guiLanguage=en ; J.M.D Barroso at the Opening Session of the European Development Days, (22/10/09- SPEECH/09/493)

[ii] For more information on the impact of the global financial and economic crisis on ACP economies, see Trade Negotiation Insights, Vol(8), N4 (Special issue); http://www.ictsd.org/sites/default/files/news/tni/tni_en_8-4.pdf

[iii] International Monetary Fund (2009), "Regional Economic Outlook: Sub-Saharan Africa. Weathering the Storm", October; http://imf.org/external/pubs/ft/reo/2009/AFR/eng/sreo1009.pdf

[iv] The EDF B-envelope covers unforeseen needs and emergency assistance

[v] Europa Press Release IP/09/1920

[vi] EC (2009b) in its Replies to Oral Questions,  in front of EU-ACP JPA, 01 December 2009, http://www.europarl.europa.eu/meetdocs/2009_2014/documents/acp/dv/772/772000/772000reven.pdf

[vii] Among the 13 AC countries which benefited from V-FLEX in 2009, three  benefited from a waiver on these conditions given their "state of fragility" (Central African Republic, Sierra Leone and Comoros).

[viii] "Significantly reduce" has been defined by the Commission as meaning a reduction of at least 50% of the residual financing gap.

[ix] EC(2009b)

[x] See for instance http://capacity4dev.ec.europa.eu/containing-fall-out-global-financial-crisis-developing-countries

[xi]For more information: EC(2009b)

[xii] See for instance Griffith-Jones. S and Ocampo. J.A. (2008), "Compensatory Financing for Shocks: What Changes are Needed?", Initiative for Policy Dialogue

[xiii] EP  resolution of 8 October 2009

[xiv] Although V-FLEX funds are additional to those already granted under the B-envelope or under general budgetary support programmes, these do not constitute additional commitments from EU member states.

[xv] This argument is developed by Woods, N (2009), "The International Response to the Global Crisis and the Reform of the International Financial and Aid Architecture",  European Parliament Briefing Paper, http://www.europarl.europa.eu/document/activities/cont/200909/20090922ATT60987/20090922ATT60987EN.pdf

[xvi] See Bilal and Dalleau (forthcoming). "Africa-EU Economic Relations in Light of the Global Financial and Economic Crisis". Paper prepared for the Bremen Africa Conference 2010.

[xvii] See Bilal, Draper, and te Velde. (2009)"Global Financial and Economic Crisis". ECDPM Discussion Paper 92. http://www.ecdpm.org/dp92

[xviii] EC(2009b)

[xix] Griffith-Jones. S and Ocampo. J.A. (2008)

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