Front Matter

Front Matter

Author(s):
Andrew Berg, Mumtaz Hussain, Shaun Roache, Amber Mahone, Tokhir Mirzoev, and Shekhar Aiyar
Published Date:
March 2007
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    © 2007 International Monetary Fund

    Production: IMF Multimedia Services Division

    Cover design: Choon Lee

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    Cataloging-in-Publication Data

    The macroeconomics of scaling up aid : lessons from recent experience / Andrew Berg … [et al.] — Washington, DC : International Monetary Fund, 2007.

    • p. cm.—(Occasional paper (International Monetary Fund) ; 253)

    • Includes bibliographical references.

    • ISBN 978-1-58906-591-8

    1. Absorptive capacity (Economics) — Africa — Case studies.

    2. Government spending policy — Africa — Case studies.

    3. Economic assistance — Africa — Case studies. I. Berg, Andrew.

    II. International Monetary Fund. III. Series: Occasional paper (International Monetary Fund) ; 253

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    Contents

    The following conventions are used in this publication:

    • In tables, a blank cell indicates “not applicable,” ellipsis points (…) indicate “not available,” and 0 or 0.0 indicates “zero” or “negligible.” Minor discrepancies between sums of constituent figures and totals are due to rounding.

    • An en dash (–) between years or months (for example, 2005–06 or January–June) indicates the years or months covered, including the beginning and ending years or months; a slash or virgule (/) between years or months (for example, 2005/06) indicates a fiscal or financial year, as does the abbreviation FY (for example, FY2006).

    • “Billion” means a thousand million; “trillion” means a thousand billion.

    • “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point).

    As used in this publication, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

    Preface

    The international community has recently focused on scaling up aid in support of the Millennium Development Goals. Using aid effectively is thus a key priority for economic policymakers in low-income countries. This paper analyzes key macroeconomic issues in managing large increases in aid. It develops an analytical framework that emphasizes the different roles of monetary and fiscal policy and draws lessons from the recent experiences of five countries: Ethiopia, Ghana, Mozambique, Tanzania, and Uganda. An earlier draft of this paper was prepared as background for the IMF Executive Board discussion of the 2005 review of program design of the Poverty Reduction and Growth Facility.

    This paper was prepared by a staff team under the general guidance of Mark Allen, Director of the Policy Development and Review Department (PDR), and under the supervision of Mark Plant, Senior Advisor in PDR. The authors are grateful to numerous reviewers both within and outside the IMF for providing valuable input to the paper. Without implicating them in the analysis and views expressed in the paper, we would like to especially thank G. Russell Kincaid, Peter Heller, Leslie Lipschitz, Peter Isard, Arvind Subramanian, David Bevan, Christopher Adam, Catherine Pattillo, and participants at a Centre for Studies and Research in International Development seminar in Clermont-Ferrand, France, at an IMF Institute–sponsored conference in Maputo, and at the World Institute for Development Economics Research Conference in Helsinki. The authors are indebted to Emmanuel Hife for excellent research assistance, to Pille Snydstrup and Trevlyn Cubitt for providing outstanding administrative and organizational support, and to David Einhorn of the External Relations Department for editorial assistance and production of the publication.

    The opinions expressed in this paper are solely those of its authors and do not necessarily reflect the views of the International Monetary Fund, its Executive Directors, or country authorities.

    Executive Summary

    Central to managing a surge in aid inflows is the coordination of fiscal policy with exchange rate and monetary policy. To highlight this interaction, the analytical framework in this paper focuses on two distinct but related concepts: absorption and spending. Absorption is defined as the widening of the current account deficit (excluding aid) due to incremental aid. It measures the extent to which aid engenders a real resource transfer through higher imports or through a reduction in the domestic resources devoted to producing exports. Spending is defined as the widening of the fiscal deficit (excluding aid) accompanying an increment in aid.

    Spending depends on fiscal policy. For a given fiscal policy, absorption depends on exchange rate policy and monetary policy. If the government receives aid in kind, or uses aid directly to finance imports, spending and absorption are equivalent. More typically, the government sells aid dollars to the central bank, and uses the local counterpart currency to finance spending on domestic goods.

    In this case, absorption depends on the response of the central bank, with foreign exchange sales influencing the exchange rate and interest rate policy shaping aggregate demand, including for imports. The combination of absorption and spending chosen by the authorities defines the macroeconomic response to aid.

    To absorb and spend is the textbook response to aid—the government increases investment, and aid finances the resulting rise in net imports. Even if the government spending is on domestic goods, the aid allows the resulting higher aggregate demand and spending to spill over into net imports without creating a balance of payments problem. Some real exchange rate appreciation may be necessary to enable this reallocation of resources.

    In a sample of five countries studied in this paper, however, a full absorb-and-spend response was found to be surprisingly rare. Typically, there was a reluctance to absorb—and face a consequent real appreciation—due, at least in part, to concerns about competitiveness.

    To save incremental aid—that is, to neither absorb nor spend—may be a good way to build up international reserves from a precariously low level or to smooth volatile aid flows.

    In two of the sample countries—Ethiopia and Ghana—absorption and spending were both very low. In Ethiopia, reserves were accumulated to bolster the exchange rate peg against the dollar. In Ghana, a buffer against extremely volatile aid inflows was built.

    To absorb but not spend substitutes aid for domestic financing of the government deficit. Where the initial level of domestically-financed deficit spending is too high, this can help stabilize the economy. Alternatively, this approach to aid can also be used to reduce the level of public debt outstanding, crowding in the private sector. When debt reaches low levels, however, there are typically limits to the extent to which the financial system can effectively channel additional resources to the private sector. Further attempts to absorb without spending may amount to “pushing on a string,” increasing excess liquidity or even causing capital outflows rather than increased domestic activity.

    To spend and not absorb was a common but problematic response, often reflecting inadequate coordination of monetary and fiscal policies. This response is similar to a fiscal stimulus in the absence of aid. The aid goes to reserves, so the increase in government spending must be financed by printing money or by government borrowing from the domestic private sector. There is no real resource transfer, given the absence of an increase in net imports. In effect, this is ultimately a futile attempt to use the same aid dollar twice, once to build reserves and once to finance government expenditure. The cases reviewed in this paper suggest that trying to do so may reduce the effectiveness of aid.

    In Mozambique, Tanzania, and Uganda, spending exceeded absorption, creating a surge in domestic liquidity. In Mozambique, this led to high inflation. In Uganda and (initially) Tanzania, treasury bill sales were used to contain inflationary pressure, leading to a rise in interest rates and the domestic debt burden.

    Spending and not absorbing can, over time, lead to a spend-and-absorb outcome, if monetary and exchange rate policies are supportive. The fiscal stimulus potentially increases import demand and hence admits the possibility of greater absorption in a later period. This delayed absorption could then be financed by the accumulated aid. In order for this mechanism to operate, however, some real appreciation may be necessary, including through inflation if the exchange rate is pegged. Curtailing liquidity through treasury bill sterilization could lead to the least desirable result: no absorption of aid, coupled with a crowding out of the private sector.

    The experience in these cases sheds little direct light on the medium-term implications of absorbing and spending aid, mostly because this strategy was not consistently pursued in the sample. There is no evidence of aid-related Dutch disease in the sample countries, with the real effective exchange rate remaining stable or depreciating. This is due in large part to the policy decision to accumulate reserves rather than fully absorb aid—a policy typically inspired by concerns about competitiveness and the level of the nominal exchange rate.

    In general, targets in programs supported by the International Monetary Fund’s Poverty Reduction and Growth Facility appear to be compatible with an absorb-and-spend response. But the consistency of monetary and exchange rate policy with fiscal policy needs greater attention in cases where the authorities deviate from this approach. Fiscal targets accommodate surges in aid, and reserve targets are consistent with an (aid-financed) increase in the current account deficit. However, where countries are unwilling to follow this strategy—perhaps in order to guard competitiveness—more care needs to be taken to achieve an appropriate second-best outcome. In particular, when recommending treasury bill sterilization to reduce aid-related money growth, concerns about inflation must be balanced against the dangers of failing to absorb the aid and crowding out the private sector.

    The key long-run strategic choice is whether to use the aid—by absorbing and spending—or not, in which case the aid should be neither absorbed nor spent. The latter choice, in the long run, is equivalent to forgoing aid, unlike the short run, where it can be used to smooth aid volatility. Thus, it is only appropriate when competitiveness concerns dominate the returns from productive aid-financed investment. In this case, attention should be focused on how, and how fast, to scale up aid so as to minimize competitiveness problems, such as by focusing on ways to use aid to increase productivity.

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