Building Inclusive States

Fragility arises when states are ineffective and when they are also illegitimate and unaccountable. These features are interconnected. People don’t want to cooperate with, or cede resources to, a state they cannot influence. We present a simple framework where the key to exiting fragility is a balance between the state and society. The state needs to develop more capacity, but to do this society needs to develop the ability to discipline and control it. We emphasize the existence of this type of “virtuous circle”—a phenomenon we call the “Red Queen effect.” We argue that the way of thinking about state-building is in terms of both widening the corridor in which the Red Queen effect operates and devising strategies to get into the corridor. We show how the framework helps account for the diminishing fragility of the state in post-apartheid South Africa, Somaliland, Sierra Leone, and Colombia.

Monetary and Exchange Rate Policy in Fragile States

This chapter charts monetary and exchange rate policy aspects of countries’ descent into, and exit from, economic fragility and draws out some key normative policy lessons for fragile countries and their external partners. Choices around exchange rate regime and the conduct of monetary policy in fragile states will rarely be fundamental drivers of deep structural fragility, even though they may present as proximate causes. Nor are they likely to be decisive in driving the recovery from extreme fragility. However, monetary and exchange rate policy choices can and do play an important role in affecting movements into fragility as well as shaping potential exit paths. Moreover, choices in these domains affect the likely distribution of rents, including those generated by policy distortions themselves. In doing so, they alter the balance of power and can decisively shift the points of influence for policy, including by outside agents.

Building Governance Capacity in Areas of Limited Statehood

Areas of limited statehood where central government authorities lack the capacity of implementing and enforcing decisions and/or lack the monopoly over the means of violence, are ubiquitous. However, these areas are neither ungovernable nor ungoverned. Enormous variation exists, that includes badly governed places but also “good governance” in areas of limited statehood, sometimes separated only by a few blocks. Effective governance (public service provision, rule-making) depends on three factors: legitimacy; social trust relations within communities; and adequate design of institutions, including financial resources. International Financial Institutions (IFIs) should thus focus on building governance capacity rather than further engaging in state-building, which has failed despite substantial investments. If the central state is autocratic and/or predatory, building state capacity will only make a bad situation worse. Yet, if the central government is constrained by the rule of law and by democratic institutions, but lacks the capacity to implement and enforce decisions, then capacity-building might help improve governance.

Assessing the Role of the IMF in Fragile States

This chapter presents an assessment of the IMF’s role in countries in fragile and conflict-affected situations, drawing primarily on the findings of a recent evaluation report by the Independent Evaluation Office. The IMF is widely acknowledged to have made significant contributions to helping build core economic policy institutions, achieve macroeconomic stability, and promote macro-critical reforms in these countries. Quantitative analyses based on a “dynamic” list of fragile states suggest that the IMF’s program engagement has been positively associated with increased tax revenue, higher GDP growth, and greater official aid inflows. Even so, the IMF’s business model, focused on short-term macroeconomic stabilization, has a tendency to treat fragile states like any other country and does not always fit well with their long-term sustained development needs. The chapter argues that the IMF’s support for fragile states has yet to achieve its full potential and identifies areas where effectiveness can be strengthened.

Aid Effectiveness in Fragile States

Fragile states are highly dependent on foreign aid and are characterized by several features that impair their economic and social performance. This chapter reviews the literature on aid effectiveness and presents several stylized facts on aid flows to fragile states and exploits project-level data to provide evidence on aid effectiveness in fragile states. Comparing project success rates across fragile and other developing countries confirms that aid given to fragile states is less likely to be effective than elsewhere. Our results indicate that a project implemented in a fragile state is about 8 percentage points less likely to be successful than a similar project financed in another developing country. Our analysis does not imply that aid to fragile states should be reduced across the board, but points to several factors that could hamper the growth dividend of aid.

Do Financial Flows Make a Difference in Fragile States?

A rising number of people is living in fragile countries whose weak institutions fail to deliver on decent work and poverty reduction. The chapter discusses to what extent external financial flows, such as remittances, foreign direct investment or official development aid, can substitute for weak institutions. Fragility matters: fragile countries receive different amounts of financial flows than their non-fragile peers, and these flows affect them differently. Fragility lowers the effect of financial flows on growth, living standards and inequality. Foreign direct investment (FDI) has a moderate impact on poverty alleviation, albeit concentrated on employment gains in mining and natural resources. Remittances provide some weak relief for the poor, with less pernicious effects on growth and labour supply than in non-fragile countries. ODA does not improve social outcomes but rather exacerbates fragility. Policymakers should focus on improving upon the positive contribution of FDI and remittances on jobs and growth, avoiding the remittances trap.

The State of Finance in Fragile States

This chapter describes the state of financial development in fragile states. Our analysis primarily relies on indicators from the World Bank Global Financial Development Database, which have been used extensively in the literature to capture the degree to which financial services and activities are present in an economy (depth) and the extent to which they are disseminated and made available to the population (inclusion). We find that financial depth in fragile states is underdeveloped and financial inclusion is low, but with significant heterogeneity among fragile states. We conduct empirical exercises which suggest that fragility is negatively related to financial development, both in terms of depth and especially in terms of inclusion, and exercises that also point to certain aspects of fragility most associated with financial underperformance. Finally, we use a benchmarking exercise to estimate how much financial underdevelopment in fragile states is costing them, in terms of economic growth.

Fiscal Policy in Fragile Situations

While in principle fiscal policy in all countries is a central component of the “long route of accountability” binding citizens and the state, in fragile states the political dynamics shaping the extent to which this “route” does in fact deliver incrementally better key services (such as security and health) to citizens—and for which citizens, in turn, give the state due credit—are highly fraught. Using five governance measures across two time periods (2005–10, 2010–15), we document the wide array of pathways by which the fiscal policy space can and does change and can lead to variants in outcomes. The absence of a clear singular empirical story connecting fiscal policy to effective outcomes suggests the limits of what can be asked of aggregate governance measures in providing context-specific policy guidance in fragile situations; such measures need to be closely accompanied by solid theory, experience and context-specific knowledge.

Exports, Exchange Regimes, and Fragility

Economic growth is significantly slower in fragile environments and twice as volatile as in other emerging economies. Backwardness also shows in exports, which have remained stagnant and non-diversified since the 1980s. We revisit the role of exchange regimes in fostering exports and economic growth and, thereby, in reducing political fragility. We use a DSGE model tailored to replicate key features of fragile economies: presence of frictions in market adjustment and learning, influence of external shocks, and the crucial role of governments in providing public investment and delivering social transfers to the population. Our DSGE model allows us to track the response of variables associated with fragility to shocks that are likely to be important in fragile economies. The simulations we perform below illustrate the types of general-equilibrium interactions that may complicate the analysis of the effects of shocks that typically affect fragile economies on endogenous variables that may influence fragility.

Fiscal Capacity and State Fragility

This chapter discusses issues that arise in building an effective fiscal state and relates this to debates about causes and consequences of state fragility. It argues that the lack of capacity to raise revenue is symptomatic of a wider range of issues that lie at the heart of state fragility, including a weak private sector, a lack of legitimacy and poorly functioning administrative structures. Building the capacity to mobilize revenues requires building a social contract based on a culture of voluntary compliance in addition to strengthening more tangible aspects of the state. This has far-reaching consequences policies that aim to strengthen fiscal capacity in the context of fragility.