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Finance in Conflict and Reconstruction

Author: Tony Addison, Philippe Le Billon and S. Mansoob Murshed
Date: 2001
Size: 17 pages (90 kB)

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Summary

What role does finance play in war and post-conflict reconstruction? Domestic and foreign finance can determine who wins the war, the duration of the conflict and can contribute to increased post-conflict poverty and inequality. Action to reduce war finance (and to increase its cost) may encourage peace, provided such action is implemented across the international community. Financial liberalisation during reconstruction may foster economic instability and endanger peace. Strong financial regulation and supervision is important.

Links between the financial sector and conflict are closer than one might expect. Narrow development (as opposed to development that spreads benefits widely across society) is an important cause of conflict and is financed in ways that raise a society's propensity to violent conflict and increase poverty and inequality. Post-conflict, rebuilding the financial system is important to achieving broad-based reconstruction, since otherwise private investment is limited. Further, additional public spending on reconstruction can be funded if domestic capital markets recover. In the area of currency reform, institutional weaknesses exacerbate difficult choices.

Weak financial regulation increases the risk of conflict by facilitating fraud, thus destroying savings and living standards. Further, financial sectors, are often controlled by elites through family/business cross-holdings. Use of the state banking system to finance private accumulation is an additional conflict risk factor. In terms of war finance:

• Diasporas and commercial borrowing provide external capital inflows. (Rebels may raise large foreign loans on the basis of resource wealth.)
• Moving this money through the international financial system sometimes involves technical assistance from international organised crime.
• Large profits from drugs and other illegal activities can change the nature of a conflict, reducing the importance of political goals, with a profitable low-intensity conflict preferred to larger-scale warfare
• Use of financial centres in former conflict countries (which apply only liberal rules to attract business) can thwart sanctions
• Seigniorage revenue from issuing a national currency is important
• Members of the international community provide official financial flows (or ignore private flows) to oppressive governments.

Key reconstruction policy questions include how far the financial system should be liberalised and the respective roles of state-owned versus privately-owned financial institutions. Financial liberalisation and bank privatisation often go together in programmes supported by Bretton Woods Institutions. In the absence of democratic institutions to oversee regulation, banks are often free to act as they please and regulation is captured.

Economic policy favouring one socioeconomic group over another frequently contributes to conflict: policy change, reconstruction, and the creation of peace should be the same agenda. Action to reduce war finance should be carefully considered as it is likely to have asymmetric, unpredictable effects on belligerents. Donors should also note that:

• Action against organised crime partly constitutes action against the finance of conflict.
• It is important to develop a market for public debt, so that public spending on reconstruction can be financed without resorting to monetisation of the fiscal deficit.
• Financial reform is critical to resurrecting (or creating from scratch) domestic capital markets.
• Financial liberalisation must be complemented by large institutional investments, particularly in prudential regulation and supervision by the monetary authorities.
• Currency arrangements are often highly politicised in conflict/post-conflict societies and political objectives must be considered.
• When national currencies are very weak and uncertainty is high, a currency board may be the appropriate solution.
• In extremis, it may be better to use a major convertible currency (already in parallel circulation). Yet this has its costs: the credibility of economic policy is improved, but the post-conflict economy cannot adjust to external shocks via devaluation, and seigniorage revenue is forfeited.

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Source: Addison, T., Le Billon, P., and Murshed, S. M., 2001, 'Finance in Conflict and Reconstruction', Discussion Paper No. 2001/44, World Institute for Development Economics Research of the United Nations University (UNU-WIDER), Helsinki
Organisation: World Institute for Development Economics Research of the United Nations University, http://www.wider.unu.edu/