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Conflict and Financial Reconstruction

by Tony Addison

​The last ten years or so have seen 56 major armed conflicts in 44 different locations, most of them civil wars. Different types of conflict have different types of effect on the domestic financial system.

These include: guerrilla insurrections that disrupt the rural financial system (e.g. Colombia today, and Guatemala during its long civil war); cronyism in bank lending linked to autocratic rule (e.g. the Yugoslav Federation in the 1990s and Zimbabwe today); and temporary shutdowns in the financial system caused by military revolt (e.g. Côte d’Ivoire in 1999-2000 and Guinea-Bissau in 1998) as well as successful or attempted secessions (most recently East Timor and Kosovo).

Other types of conflict and their financial effects include: the looting of banks to finance genocide and profit from it (e.g. Rwanda in 1994); civil wars that leave central banks intact but otherwise damage financial infrastructure (Angola from the 1970s onwards and Mozambique during its 16-year civil war); and civil wars that comprehensively destroy the formal financial-system (e.g. Cambodia in the 1970s and Somalia 1992-94). Finally, there are inter-state conflicts in which formal financial institutions are stressed but nevertheless continue to operate (e.g. the 1998-2000 war between Eritrea and Ethiopia).

National priorities for financial reconstruction therefore vary significantly depending on the scale and character of the destruction as well as the country’s institutional resources and human capital. And the political dynamics of each conflict (as well as the war-to-peace transition) also play a role.

There is no hard and fast dividing line between ‘war’ and ‘peace’, and ‘post-conflict’ is often a misnomer. Notwithstanding the political challenges, countries should aim for a broad-based reconstruction that benefits the majority of people (and not just a narrow elite). Rebuilding the domestic financial system, so that normal economic activity and investment resume, is critical to success.

Institution-Building is Imperative

A country’s central bank may remain operational during civil war (e.g. Angola and Mozambique), it may shut down temporarily but reopen relatively quickly (e.g. Congo-Brazzaville and Rwanda), or shut down completely (Somalia’s central bank remains closed after its looting in 1991).

Creating a central bank is high on the list of priorities for institution building in countries that have seceded (for example Eritrea in 1993). But institutional capacity may initially be too meagre to create a fully operational central bank (for example East Timor). Capitalisation (or recapitalisation) of the central bank must also compete with other expenditure priorities (including humanitarian and social spending), and it can be undermined by an inadequate fiscal framework (the taxation and public-expenditure management systems often need to be rebuilt or created from scratch).

Reviving the Financial System is Critical to Recovery

Resuming normal economic activity will be severely impeded without a revival of commercial banks and insurance companies. The provision of bank finance for working capital, fixed investment, and residential reconstruction must also restart.

Banks may take considerable time to restore their capital base, restructure their bad debts, and re-equip Conflict and Financial Reconstruction by Tony Addison and re-staff themselves. On the demand-side, loss of collateral (compounded by delays in property restitution), the destruction of business records, and difficulties in obtaining insurance combine to intensify the credit-market problems that typically disadvantage any but the largest borrowers. This hits small and medium sized enterprises which otherwise constitute a potentially powerful source of post-war employment growth.

Damaged judicial systems also make it difficult to enforce contracts, thereby deterring lenders. Some of Rwanda’s borrowers defaulted safe in the knowledge that creditors were unlikely to pursue them through the courts, which were overburdened in dealing with the genocide’s perpetrators.

Easy Bank Licensing leads to Unsound Banks

As a result of the pillage of state and commercial banks by insiders (often connected to powerful elites), financial systems are often insolvent (or close to it) prior to the start of major violence (e.g. CongoBrazzaville, Indonesia, and Somalia).

Fiscal transfers traditionally covered the losses of state banks. But expenditures for post-war reconstruction and poverty reduction make large demands on public funds (which typically remain low until the economy’s tax-base starts to recover). Therefore little public money is available to recapitalise state banks, and infusing private capital (both domestic and foreign) by means of complete or partial bank privatization is favoured. Mozambique’s two largest banks were created out of the former state banking system in this way.

Although privatization and the licensing of private banks helps to recapitalise the system, the process10 can be highly non-transparent, especially when it begins during war. Private banks in conflict-affected countries are often licensed on highly favourable terms.

Strengthening Regulation is Politically Challenging

Conflict-affected countries have seen the relaxation of controls on deposit and lending rates (and practices). Financial liberalization has merit for economies that have otherwise failed in the strategy of directing credit to selected priority-borrowers (state-controlled financial systems and directed credit worked well in the reconstruction of Japan and some Western European economies after World War II, and in the post-war reconstruction of South Korea in the 1950s).

But financial-liberalization only works when financial regulation and supervision improves as well (as financial crises over the last two decades demonstrate). Legal reform must also create clear property rights (for collateral-based lending) and punish fraud.

The weaknesses prevalent in the financial systems of developing countries are seen in acute form in conflict-affected countries. Considerable technical assistance is required. Professional staff must also be paid a salary commensurate with their responsibilities (otherwise they will leave for the private financial sector).

Political interference in supervision is acute in conflict-affected countries, especially when the oversight provided by such democratic institutions as parliamentary committees and an independent media is weak or absent. Warlords may own private banks and other financial institutions, originally capitalised with war booty (e.g. Liberia and the former Yugoslavia). Furthermore, the legal framework in which to pursue bank fraud is often grossly inadequate and corruption is often rife.

Not surprisingly, bank crises are frequent. In 2000 two of Mozambique’s largest banks reported losses totalling US$ 177 million. Bank crises result in credit contractions which undermine growth. And their fiscal cost is often substantial (thereby taking resources from development spending, including pro-poor services and infrastructure). As a part shareholder in the country’s two largest banks, the Government of Mozambique’s share of the losses is estimated to be US$ 130 million (3 per cent of GDP).

Reconstruction for Broad-Based Recovery

The key challenge is therefore to rebuild economies so that the benefits of recovery are spread as widely as possible across society, and especially down to the poor. Such broad-based recovery requires considerable institution building, together with the reform of institutions that are not working well (and whose deficiencies may have contributed to the general economic decline that often precedes the outbreak of civil war).

However, narrow reconstruction — which benefits a political and economic elite, sometimes including those who profited from war — will occur unless national authorities prioritise the poor. Democratic oversight of state-institutions to ensure that they act in the public interest is also critical. And the international community must provide adequate technical assistance, as well as external finance, to support national priorities.

When there are so many humanitarian needs and so much human misery connected to war, it might seem overly narrow to discuss the seemingly esoteric issues of financial-sector policy. But there is little prospect for a fast recovery in output and employment without a well-functioning financial system. And without economic recovery, demobilised fighters will have few livelihoods other than war and crime, and economic hardship will enable demagogues to exploit ethnic rivalries and tensions, thereby undermining peace itself.

Tony Addison is deputy director, WIDER. A longer version of this article appears as a briefing paper of the DFID Finance and Development Programme (www.devinit.org/ findev and www.man.ac.uk/idpm). Papers arising out of this research can be found at the WIDER Web site www.wider.unu.edu. See also: T. Addison, P. Le Billon, and S. M. Murshed (2001), ‘Finance in Conflict and Reconstruction’, Journal of International Development, Vol.13 No.7.