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Vulnerabilities Related to the Scaling up of Aid and other capital Flows. Course on External Vulnerabilities and Policies Tunis, March 2 – 1 3, 2009. Thorvaldur Gylfason. Outline. Aid and other capital flows History, theory, evidence Foreign aid and economic growth

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Vulnerabilities related to the scaling up of aid and other capital flows

Vulnerabilities Related to the Scaling up of Aid and other capital Flows

Course on External Vulnerabilities and PoliciesTunis, March 2–13, 2009

Thorvaldur Gylfason


Outline

Outline

  • Aid and other capital flows

    • History, theory, evidence

  • Foreign aid and economic growth

    • Effectiveness: Does aid work?

    • Macroeconomic challenges

      • Dutch disease

      • Aid volatility

    • Policy options in managing aid flows and lessons from recent experience

      • Preparing for scaling up aid

      • Vulnerabilities

      • Monetary and fiscal policy options

      • Debt sustainability

      • Governance issues

  • Conclusions and guidelines


Development aid definition

development aid: definition

  • Unrequited transfers from donor to country designed to promote the economic and social development of the recipient

    • Excluding commercial deals and military aid

  • Concessional loans and grants included, by tradition

    • Grant element ≥ 25%


Development aid definition1

development aid: definition

  • Development aid can be

    • Public (ODA) or private

    • Bilateral (from one country to another) or multilateral (from international organizations)

    • Program, project, technical assistance

    • Linked to purchase of goods and services from donor country, or in kind

    • Conditional in nature

      • IMF conditionality, good governance


Motivation why aid

Motivation: Why aid?

  • Moral duty

  • Neocolonialism

  • Humanitarian intervention

  • Public good

    • National (e.g., education and health care)

    • International

      • Social justice to promote world unity

      • UN aid commitment of 0.7% of GDP

  • World-wide redistribution

    • Increased inequality word-wide

    • Marshall Plan after World War II

      • 1.5% of US GDP for four years vs. 0.2% today

      • But Think tank in Nairobi disagrees, see www.irenkenya.com


Motivation why aid1

Motivation: Why aid?

  • Objectives

    • Individuals in donor countries vs. governments in recipient countries

      • Who should receive the aid?

    • Today’s poor vs. tomorrow’s poor

      • Aid for consumption vs. investment

  • Conflicts

    • Beneficiaries’ needs

    • Donors’ interests


Past trends

Past Trends

  • Aid is a recent phenomenon

  • Four major periods since 1950

    • 1950s: Fast growth (US, France, UK)

    • 1960s: Stabilization and new donors

      • Japan, Germany, Canada, Australia

    • 1970s: Rapid growth in aid again due to oil shocks, recession, cold war

    • 1980s: Stagnation, aid fatigue, new methods, new thinking


Past trends 1950s

Past Trends: 1950s

  • Rapid growth of development aid

  • US provided 50% of total ODA

    • To countries ranging from Greece to South Korea along the frontier of the “Sino-Soviet bloc”

  • France provided 30%

    • To former colonies, mainly in West Africa

  • UK provided 10%

    • To Commonwealth countries


Past trends 1960s

Past Trends: 1960s

  • Stabilization of aid from traditional donors and emergence of new donors

    • US contribution decreased considerably after the Kennedy presidency (1961-63)

  • The French contribution decreased starting from the early 1960s

  • New donors included Japan, Germany, Canada, and Australia


Past trends 1970s

Past Trends: 1970s

  • Rapid growth in aid from industrial countries in response to the needs of developing countries due to

    • Oil shocks

    • Severe drought in the Sahel

  • The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970

    • The deadline for reaching that target was the mid-1970s


Past trends 1980s and 1990s

Past Trends: 1980s and 1990s

  • Stagnation of development assistance

    • Donor fatigue?

    • Private investor fatigue?


Donor fatigue

Donor fatigue?


Private investor fatigue

Private investor fatigue?


Who are the donors

Who are the donors?

  • United States: largest donor in volume, but low in relation to GDP

    • US aid amounts to 0.2% of GDP

  • Japan: second-largest donor in volume

  • Nordic countries, Netherlands

    • Major donors to multilateral programs

    • Sole countries whose assistance accounts for 0.7% of GDP

  • EU: leading multilateral donor


Who are the donors1

Who are the donors?

  • Even though targets and agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target

  • Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short


Official development assistance by donor 2005 usd billion

Official development assistance by donor 2005 (USD billion)


Geographical distribution of aid

Geographical distribution of aid (%)


Geographical distribution of aid1

Geographical distribution of aid (%)

  • Sub-Saharan Africa and Asia have received the most aid, the former a rising amount over time

  • Aid to Sub-Saharan Africa is high in relation to GDP

    • For the 44 countries in the IMF’s Africa Department, net official transfers are as follows:

      < 5% of GDP: 14 countries

      6%-16% of GDP: 24 countries

      > 20% of GDP: 6 countries


A recovery in sight

A recovery in sight?

  • The Blair Report and the Sachs Reportcalled on world community to increase development aid (particularly for Africa) to enable developing countries to attain the MDGs by 2015

    • 2005 G-8 Gleneagles communiqué called for raising annual aid flows to Africa by $25 billion per year by 2010

    • 2005 UN Millennium Project called for $33 billion per year in additional resources

      • For comparison, US gave $20 billion in 2004, not $70 billion as suggested by UN goal


Macroeconomics of aid

Macroeconomics of Aid

  • The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donors

    • What is the role of aid?

    • What is the macroeconomic impact of aid?

    • Is the impact of aid necessarily positive, or could aid have adverse consequences?


Macroeconomics of aid1

Macroeconomics of Aid

  • Aid fills gap between investment needs and saving and, if well managed, can increase growth

    • Poor countries often have low savings and low export receipts and limited investment capacity and slow growth

  • Aid is intended to free developing nations from poverty traps

    • E.g., capital stock declines if saving does not keep up with depreciation


Aid and investment

Aid and Investment

To understand the link between aid and investment, consider Resource Constraint Identity by rearranging the National Income Identity:

Y = C + I + G + X – Z

I = (Y – T – C) + (T – G) + (Z – X)

In words, investment is financed by the sum of private saving, public saving, and foreign saving

  • This is where aid enters the picture

    Aid is treated as part of government saving which increases domestic resources to finance investment.

Sg

Sp

Sf


Aid and investment1

Aid and Investment

Rearrange again:

Y + Z = E + X

where E is expenditure

E = C + I + G

Total supply from domestic and foreign sources Y+Z equals total demand E+X

Aid increases recipient’s ability to import: Z rises with increased X, incl. TR

Aid is treated as part of government saving which increases domestic resources to finance investment.


Aid and growth

aid and growth

  • Poor countries are trapped by poverty

    • Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty

    • Countries become stuck in poverty traps

  • Aid enables poor countries to free themselves of poverty by enabling them to cross the necessary thresholds to launch growth

    • Saving

    • Technology

    • Human capital


Aid and poverty

Aid and Poverty

  • Is it feasible to lift all above a dollar a day?

    • How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs)

  • Number of people with less than a dollar a day is 1.1 billion

  • Their average income is 77 cents a day, they need 1.08 dollars

    • Difference amounts to 31 cents a day, or 113 dollars per year

  • Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries

    • Less than they promised! – and didn’t deliver


Empirical studies of aid

Empirical Studies of Aid

  • Several empirical studies have assessed the impact of aid on growth, saving, and investment

  • The results are somewhat inconclusive

    • Most studies have shown that aid has no significant statistical impact on growth, saving, or investment

  • However, aid has positive impact on growth when countries pursue “sound policies”

    • Burnside and Dollar (2000)


Empirical studies of aid1

Empirical Studies of Aid

  • Regression analysis to measure the impact of aid on

    • Saving

    • Investment

    • Public finance

    • Economic growth


Does aid work domestic responses

Does aid work? Domestic responses

  • Saving

    • Negative effect on saving

      • Substitution effect? I.e., crowding out?

      • Boone 1996; Reiche 1995

    • Positive effect for good performers

      • E.g., South-East Asia, Botswana

  • Investment

    • No impact on private investment

    • Positive impact for good performers

  • Public finance

    • Uncertain effect on public investment

    • Positive effect on public consumption


Does aid work domestic responses1

Does aid work? Domestic responses

  • Growth: Mixed results

    • Most early studies showed no statistically significant impact

    • Some more recent studies show negative impact

      • Selection bias and endogeneity issues

  • Need to distinguish between different types of aid

    • Leakages, cash vs. aid in kind


Aid and growth1

aid and growth

r = rank correlation

  • Foreign aid has sometimes been compared to natural resource discoveries

  • Aid and growth are inversely related across countries

  • Cause and effect

  • 156 countries,1960-2000

r = -0.36

Other people’s money


Does aid work the current debate

Does aid work?The current debate

  • No robust relationship between aid and growth

  • Aid works in “countries with good policies”

  • Aid works if measured correctly

  • Distinction between fast impact aid (infrastructure projects) and slow impact aid (education)

    • Infrastructure: High financial returns

    • Education and health: High social returns


Impact of aid on growth and investment

Impact of Aid on Growth and Investment

  • So, empirical evidence is mixed

  • Need to distinguish between different types of aid

  • Need to acknowledge diminishing returns to aid as well as limits to domestic absorptive capacity

  • Need to clarify interaction with governance and good policies

  • Special case: Post-conflict situations


Reasons for the possible ineffectiveness of aid i

Reasons for the Possible Ineffectiveness of Aid i

  • Aid may lead to corruption

  • Aid may be misused, by donors as well as recipients

    • Donors: Excessive administrative costs

    • Recipients: Mismanagement, expropriation

  • Aid may be badly distributed, sometimes for strategic reasons

    • Supporting government against political opposition


Reasons for the possible ineffectiveness of aid ii

Reasons for the Possible Ineffectiveness of Aid ii

  • Aid increases public consumption, not public investment

  • Aid is procyclical

    • When it rains, it pours

  • Aid leads to “Dutch disease”

    • Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows

    • Dutch disease may undermine external sustainability


Reasons for the possible ineffectiveness of aid iii

Reasons for the Possible Ineffectiveness of Aid iii

  • Aid volatility and unpredictability may undermine economic stability in recipient countries

    • Economic vs. social impact

  • Growth is perhaps not the best yardstick for the usefulness of aid

    • Long run vs. short run

      • E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run


Dutch disease

See my “Dutch Disease” in the New Palgrave Dictionary of Economics Online

Dutch disease

  • Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness

  • In 1960s, Netherlands discovered natural resources (gas deposits)

    • Currency appreciated

    • Exports of manufactures and services suffered, but not for long

  • Not unlike natural resource discoveries, aid inflows could trigger the Dutch Disease in receiving countries


Dutch disease1

Dutch disease

  • Foreign exchange is converted into local currency and used to buy domestic goods

  • Fixed exchange rate regime

    • Expansion of money supply leads to inflation and an appreciation of real exchange rate

  • Flexible exchange rate regime

    • Increase in the supply of foreign exchange leads to an appreciation of the nominal exchange rate, so the real exchange rate also appreciates


Impact of aid on the real exchange rate

Impact of aid on the Real Exchange Rate

  • Review theory of Dutch disease in two rounds

    • Demand and supply model

    • Two-sector model

      • Demand effects

      • Supply effects

      • Exchange rate volatility


Vulnerabilities related to the scaling up of aid and other capital flows

Balance of payments equilibrium

Payments for imports of goods, services, and capital

Imports

Real exchange rate

Earnings from exports of goods, services, and capital

Equilibrium

Exports

Foreign exchange


Vulnerabilities related to the scaling up of aid and other capital flows

Real exchange rate

e refers to foreign currency content of domestic currency

Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

Q = real exchange rate

e = nominal exchange rate

P = price level at home

P* = price level abroad


Vulnerabilities related to the scaling up of aid and other capital flows

Three thought experiments

1.Suppose e falls

Then more dinars per dollar,

so X rises, Z falls

2.Suppose P falls

Then X rises, Z falls

3.Suppose P* rises

Then X rises, Z falls

Summarize all three by supposing thatQ falls

Then X rises, Z falls


Vulnerabilities related to the scaling up of aid and other capital flows

Aid reduces exports

Aid leads to appreciation, and thus reduces exports

C

B

Imports

Real exchange rate

Exports plus aid

A

Exports

Foreign exchange


Vulnerabilities related to the scaling up of aid and other capital flows

Oil: same story

Oil discovery leads to appreciation, and reduces nonoil exports

C

B

Imports

Real exchange rate

Exports plus oil

A

Exports

Foreign exchange


Vulnerabilities related to the scaling up of aid and other capital flows

Oil: same story

Composition of exports matters

C

B

Imports

Real exchange rate

Exports plus oil

A

Exports

Foreign exchange


Dutch disease and the exchange rate regime

Dutch Disease and the Exchange Rate Regime

  • Dutch disease is a realphenomenon, not monetary

  • Real exchange rate always floats

  • Recall: Q = eP/P*

    • Flexible exchange rate regime

      • Nominal appreciation

    • Fixed exchange rate regime

      • Inflation

  • Look at this more closely in two-sector model of traded vs. nontraded goods: Skip


The risk of dutch disease

The risk of Dutch disease

  • A large inflow of foreign aid -- like a natural resource discovery -- can trigger a bout of Dutch disease in countries receiving aid

  • A real appreciation reduces the competitiveness of exports and might thus undermine economic growth

    • Exports have played a pivotal role in the economic development of many countries

    • An accumulation of “know-how” often takes place in the export sector, which may confer positive externalities on the rest of the economy


The risk of dutch disease1

The risk of Dutch disease

  • Aid is likely to lead to Dutch disease if

    • It leads to high demand for nontradables

      • Trade restrictions may produce this outcome

      • Recipient country uses aid to buy nontradables (including social services) rather than imports

    • Production is at full capacity

      • Production of nontradables cannot be increased without raising wages in that sector

    • Aid is not used to build up infrastructure and relax supply constraints

    • Price and wage increases in nontradables sector lead to strong wage pressure in tradables sector


The risk of dutch disease2

The risk of Dutch disease

  • The risk that aid flows might have an adverse impact on the economy as a result of aid-induced Dutch Disease crucially depends on how aid is used in the recipient countries

  • We can identify four different cases on the basis of how the aid is spent, and in which the macroeconomic implications of aid flows are different


The risk of dutch disease3

The risk of Dutch disease

  • Aid spending can take several forms, with different macroeconomic implications:

    • Case 1: Aid received is saved by recipient country government

    • Case 2: Aid is used to purchase imported goods that would not have been purchased otherwise (grants in kind)

    • Case 3: Aid is used to buy nontradables with infinitely elastic supply

    • Case 4: Aid is used to buy nontradables for which there are supply constraints


How aid is used and the risk of dutch disease case 1

How aid is used and the risk of Dutch Disease: Case 1

  • Aid received is saved by recipient country government

    • Aid receipts leads to accumulation of foreign exchange reserves in Central Bank

      • … and, unlike increased aid that is spent, are not allowed to enter the spending stream

    • No effect on money supply

    • No inflation

    • No appreciation of nominal exchange rate

    • No risk of Dutch disease


How aid is used and the risk of dutch disease case 2

How aid is used and the risk of Dutch Disease: Case 2

  • Aid is used to purchase imported goods that would not have been purchased otherwise (grants in kind)

    • Import purchases lead to transfer of real resources from abroad, but not to increased spending at home

    • No effect on money supply

    • No inflation

    • No appreciation of nominal exchange rate

    • No risk of Dutch disease


How aid is used and the risk of dutch disease case 3

How aid is used and the risk of Dutch Disease: Case 3

  • Aid is used to buy domestic nontradables with infinitely elastic supply due to underutilized resources (labor and capital) in economy

    • Increased demand for nontradables

    • Because some resources are unemployed, greater demand leads to increased supply

    • This has a positive impact on production without increasing the price of nontradables

    • No risk of Dutch disease


How aid is used and the risk of dutch disease case 4

How aid is used and the risk of Dutch Disease: Case 4

  • Aid is used to buy nontradables for which there are supply constraints, since all available resources are already in use (e.g., social services)

    • Increased demand for nontradables

    • Increased prices for nontradables

    • Shift of resources away from the tradables (exports) and into nontradables

    • Real appreciation of the currency

    • Dutch disease!


How aid is used and the risk of dutch disease case 41

How aid is used and the risk of Dutch Disease: Case 4

  • Monetary policy response determines if real appreciation of currency will be caused by inflation or by nominal appreciation

    • If foreign currency is used to increase the reserves of the Central Bank, aid spending on nontradables leads to an increase in money supply and to inflation

    • If Central Bank sterilizes the impact of aid spending in nontradables on money supply by selling foreign exchange, currency appreciates in nominal terms

So, in either case, currency appreciates in real terms


How aid is used and the risk of dutch disease lessons

How aid is used and the risk of Dutch Disease: lessons

  • To recapitulate, the risk of Dutch disease varies, and depends on

    • How aid is used (saved or spent) – CASE 1

    • The presence of an aid absorption constraint – CASE 2

    • The impact of aid on productivity in the nontradable goods sector – CASE 3

    • The existence of externalities in the nontradable goods sector affecting the rest of the economy – CASE 4


How aid is used and the risk of dutch disease lessons1

How aid is used and the risk of Dutch Disease: lessons

  • Aid can give rise to Dutch disease when the recipient country’s government uses the aid to purchase nontradables rather than imported goods and when there are constraints on increasing production in the nontradables sectors

  • The risk of Dutch disease is greater when aid is used in social sectors that face constraints on increasing their production due to resource scarcity (aid absorption constraint)


How aid is used and the risk of dutch disease lessons2

How aid is used and the risk of Dutch Disease: lessons

  • How can recipient countries avoid translating aid into Dutch disease?

    • Save aid received and increase central bank reserves (gross, not net) by not allowing the increased aid to enter the spending stream

    • Use aid to purchase imported goods

    • Boost aid absorption capacity in the nontradables sector


Risk of dutch disease early warning signals

risk of Dutch Disease: early warning signals

  • Policymakers in recipient countries need to pay attention to potential early warning signals of aid-induced Dutch disease such as

    • A tendency for wages and prices in the nontradables sector to increase

    • A decline in the profitability and sales of the export and import-competing industries


Scaling up aid flows conceptual framework

Scaling up aid flows: conceptual framework

  • Once more, the macroeconomic impact of aid depends critically on the policy response to aid

    • Interaction between fiscal policy and monetary policy is crucial

  • To highlight this interaction, apply two related but distinct concepts

    • Absorption: Monetary policy

    • Spending: Fiscal policy


Aid absorption and spending

Aid absorption and spending

  • Absorption

    • Extent to which the non-aid current account deficit widens with increased aid

      • Captures the amount of net imports financed by an increase in aid

    • Given fiscal policy, absorption is controlled by Central Bank’s decision about how much of the aid-induced foreign exchange to sell in the markets

      • If Central Bank uses the full increment of aid-induced foreign exchange to bolster reserves, aid will not be absorbed


Aid absorption and spending1

Aid absorption and spending

  • Spending

    • Extent to which the non-aid fiscal deficit widens with increased aid

      • Captures the extent to which the government uses aid to finance an increase in expenditures

    • Given monetary policy, spending is controlled by the government’s decision about how much of the aid to spend, on either imports or non-traded goods

      • If the government decides to save the full increment in aid, aid will not enter the spending stream


Policy responses to aid inflows and implications

Policy responses to aid inflows and implications

  • Different combinations of absorption and spending define the policy response to a surge in aid inflows

    • Absorption and spending are equivalent if aid is in kind or if it is spent on imports

    • Absorption and spending differ when the government provides the aid-related foreign exchange to Central Bank and chooses how much to spend on domestic goods while the Central Bank decides how much of the aid-related foreign exchange to sell in markets


Dutch disease is it real

Dutch disease: is it real?

  • Studies assessing empirical relevance of Dutch disease as caused by aid flows have produced mixed results

    • Aid was associated with real appreciation in Malawi and Sri Lanka

    • Aid was associated with with real depreciation in Ghana, Nigeria, and Tanzania


Lessons from scaling up aid

Lessons from scaling up aid

  • Ethiopia, Ghana, Tanzania, Mozambique, and Uganda experienced a surge in aid 1998-2003 (Berg et al. 2007)

    • The net aid increment ranged from 2% of GDP in Tanzania to 8% of GDP in Ethiopia

    • High everywhere, from 7% to 20 % of GDP

  • In Ghana, sharp increase in 2001 followed by a slump in 2002 and another surge in 2003

    • In all other countries, the surge in aid was persistent, i.e., after the initial jump, aid inflows remained higher than before


Aid induced dutch disease the evidence

Aid-induced dutch disease: the evidence

  • In the five countries, no evidence of aid-induced Dutch-Disease

    • Real exchange rates did not appreciate during the aid surges

    • Only Ghana had a small real appreciation while the others experienced a real depreciation

      • From 1.5% in Mozambique (2000) to 6.5% in Uganda (2001)

  • Why?

    • The macroeconomic policy response was meant to avoid a real appreciation


Was aid absorbed or spent policy responses

Was aid absorbed or spent? Policy responses

  • Countries were reluctant to absorb the surge in aid

    • Only Mozambique absorbed two-thirds

    • Aid surge led to reserve accumulation

      • So, currency did not appreciate in real terms

  • Mozambique, Tanzania, and Uganda spent most of new aid

    • They had attained stability, so reducing domestic financing of the budget deficit was not a major goal

  • Ghana and Ethiopia spent little of the aid

    • They had a weak record of stability and low reserves, so reducing the domestic financing of the budget deficit was a consideration not to spend aid


Was aid absorbed or spent policy responses1

Was aid absorbed or spent? Policy responses

Two types of policy response

  • In Ethiopia and Ghana, aid impact was limited because only a small part of it was either absorbed or spent

    • New aid was saved and reserves built up

  • In Mozambique, Tanzania, and Uganda, spending exceeded absorption, creating a pressure on prices

    • Money supply expansion was sterilized through treasury bill sales

    • Foreign exchange sales were kept consistent with a depreciation of currency to maintain competitiveness


  • Management of aid flows main lessons

    Management of aid flows: Main lessons

    • Was aid-induced Dutch disease a problem?

    • No evidence of significant real appreciation following surge in aid

      • Macroeconomic policy response (fiscal and monetary policy mix) avoided real appreciation

      • “Not absorb and not spend” vs. “spend more than absorb”


    Management of aid flows main lessons1

    Management of aid flows: Main lessons

    • The choice in some countries to “not absorb and not spend” new aid preserved competitiveness while allowing the replenishing of international reserves

    • The choice in some other countries to “spend more than absorb” went along with sterilization of public spending that contained inflationary pressures


    Management of aid flows main lessons2

    Management of aid flows: Main lessons

    • Aid can play a key role in the development of recipient countries, but it can also generate macroeconomic vulnerabilities

    • Recipients need to implement appropriate policies to manage aid flows to avoid macroeconomic hazards

      • The appropriate policy response needs to take into account

        • Potential impact of aid on competitiveness

        • Existence of constraints to aid absorption

        • Risks linked to aid volatility and to external debt sustainability


    Aid volatility and unpredictability

    Aid Volatility and Unpredictability

    • Aid is increasingly volatile and unpredictable

      • Aid flows are 6-40 times more volatile than fiscal revenue

      • Volatility is largest for aid dependent countries (Bulir and Hamann 2003, 2007)

      • Volatility increased in the 1990s

      • Aid delivery falls short of pledges by over 40%

    • Reasons for aid volatility

      • Donors: Changes in priorities; administrative and budgetary delays

      • Recipients: Failure to satisfy conditions

        • IMF conditionality often guides donors, helping them decide if the country’s policies are on track


    Consequences of aid volatility i

    Consequences of Aid Volatility i

    Impact of large sudden inflows

    • Supply constraints in absorbing aid

    • Real exchange rate overshooting and volatility

    • Negative impact on budget management

    • Negative impact on export industries

    • Ratcheting up spending commitments without adequate consideration of exit strategy

    • Infrastructure investment without adequate planning for recurrent expenditure

      • Maintenance


    Consequences of aid volatility ii

    Consequences of Aid Volatility ii

    Impact of aid promised, but not disbursed

    • Mismatch between revenues and scheduled expenditures

    • Spending commitments cannot be financed

    • Necessitates difficult expenditure choices

    • Aid volatility translates into public expenditure volatility

    • Can be costly if it compels government to cut down on, delay, or abandon productive investments

    • To avoid this, government may resort to printing money or borrowing

    • Hence, negative impact on stabilization

      • Volatility in money supply, inflation, exchange rates


    Mitigating aid volatility and unpredictability

    mitigating Aid volatility and unpredictability

    • Donors need to disburse aid according to the agreed schedule and increase transparency toward recipient country governments

    • Recipient countries need to respect the conditionality of development aid disbursements

    • Recipients need to be granted more flexibility in their choices to spend or save aid flows, specifically in light of the time span for the aid they receive

      • E.g., during2000-03, Ghana chose to save unexpected aid increases and to supplement its Central Bank reserves


    Aid flow hazards undermining external sustainability

    Aid flow hazards: undermining external sustainability

    • A substantial acceleration in aid flows could adversely affect the external debt sustainability of recipients

    • Development aid may take the form of grants or concessional loans

      • Grants are unrequited transfers

      • Concessional loans increase outstanding debt and the amount of resources needed to service that debt


    The current debate grants or loans

    The current debate:Grants or Loans?

    • Studies have shown that debt sustainability may deteriorate even if loans are concessional

      • Daseking and Joshi (2005)

    • It is crucial for donors to choose an appropriate mix of grants and loans in order for recipients to achieve the MDGs without undermining their external debt sustainability


    The current debate grants or loans1

    The current debate:Grants or Loans?

    • Advantages of grants

      • Do not increase debt burden

      • Useful for social projects with uncertain or delayed returns (health care, education)

    • Advantage of concessional loans

      • Mobilize more resources

      • Increase debt management capacity

      • Useful for projects yielding quick returns (infrastructure)


    The current debate grants or loans2

    The current debate:Grants or Loans?

    • Choice between grants and loans must balance the benefits of larger available resources against the risk of a heavier debt burden

    • Since loans force recipients to repay in future, they have an incentive to

      • Choose more profitable projects

        • This leads better allocation of aid

      • Improve external debt management


    The current debate grants or loans3

    The current debate:Grants or Loans?

    • Efforts to find an appropriate balance between loans and grants can be based on

      • Project-based approach

      • Country-based approach


    Project based approach

    Project-based approach

    • Grants

      • To finance investments with a significant social impact but whose return is uncertain or difficult to appropriate or which need a longer period to be profitable

        • E.g., education and health care

    • Loans

      • To finance projects that yield profits more quickly

        • E.g., infrastructure


    Country specific approach

    Country-specific approach

    • An appropriate balance between grants and loans is determined case by case

      • Based on the sustainability of recipient’s debt as well as its exposure to revenue/growth volatility

    • Poorest countries receive a larger proportion of aid through grants

    • Countries with higher growth rates and sound economic policies receive a larger proportion of loans


    Strengthening governance

    Strengthening Governance

    • Corruption and economic performance

      • Impact on growth

      • Likelihood of disbursement

    • Anticorruption strategies

      • Reduce state role

      • Improve regulatory environment

      • Punish offenders

      • Liberalize and reform institutions

    • Improving public expenditure management systems


    Summary and guidelines

    Summary and Guidelines

    • From aid fatigue to new initiatives

    • Aid effectiveness is ambiguous

      • Positive results likely with better policies and governance

    • Five Primary Guidelines

      • Minimize risks of Dutch disease

      • Enhance growth – Always a good idea!

      • Assess the policy mix

      • Promote good governance and reduce corruption

      • Prepare an exit strategy


    Bibliography

    Bibliography

    • Bulir and Hamann 2003, “Aid volatility: An empirical Assessment,” IMF Staff Papers.

    • ______, 2007, “Volatility of Development Aid: An Update,” IMF Staff Papers.

    • Daseking and Joshi, 2005, Debt and New Financing in Low-Income Countries, IMF.

    • Isard, Lipschitz, Mourmouras, and Yontcheva, 2006, Macroeconomic Management of Foreign Aid: Opportunities and Pitfalls, IMF.

    • Gupta, Powell, and Yang, 2006, Macroeconomic Challenges of Scaling up Aid to Africa: A Checklist for Practitioners, IMF.

    • Rajan and Subramanian, 2005, “Aid and Growth: What Does the Cross-Country Evidence Really Show?,” IMF Working Paper.

    • ______, 2005, “What Undermines Aid’s Impact on Growth?,” IMF Working Paper.


    Conclusion

    conclusion

    THE END

    • Aid can play an important role in the growth and development of recipient countries …

      • … but it can also create macroeconomic vulnerabilities

    • Recipient countries need to manage aid flows so as to avoid hazards

      • Need to consider potential impact of aid on

        • Competitiveness

        • Constraints to aid absorption

        • Risks linked to aid volatility and to external debt sustainability

    These slides will be posted on my website: www.hi.is/~gylfason


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