Journal Issue

Research: Helping Countries Cope with Aid Volatility

International Monetary Fund. External Relations Dept.
Published Date:
November 2006
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In July 2005, world leaders meeting in Scotland announced a $50 billion increase in official development assistance to poor countries to help them achieve the Millennium Development Goals (MDGs) by 2015. This prospective surge in aid is focusing policymakers’ and researchers’ attention on the macroeconomic challenges associated with absorbing large aid inflows. How can aid (both official and private flows) be used as efficiently as possible so that it boosts countries’ growth and helps them achieve the MDGs?

It is generally agreed that the best way to lift the poor out of poverty is to accelerate economic growth, but there is little agreement on how foreign aid affects growth. One reason may be that, in the past, aid was used in ways that did not systematically lead to an acceleration (or a deceleration) of growth, with both microeconomic and macroeconomic factors contributing to the disconnect between aid and growth. A recent IMF Working Paper examines these macroeconomic factors and explores whether there are any macroeconomic policies that could dampen the potential Dutch disease (when real exchange rate overvaluation hurts export industries and overall productivity) effects associated with large and volatile aid flows.

Aid-growth disconnect

Although the study focuses on macroeconomic factors, microeconomic factors also impinge on aid effectiveness. But even when microeconomic distortions are minimized, countries trying to absorb large amounts of aid are likely to face substantial macroeconomic challenges. It has been argued that the systematic, adverse effects of foreign aid on the competitiveness of recipient countries’ exports may explain why aid does not appear to boost growth. This argument, made by Raghuram Rajan and Arvind Subramanian in “What Undermines Aid’s Impact on Growth?” (IMF Working Paper 05/126), is supported by evidence that the share of labor-intensive and tradable industries in the manufacturing sector declines as foreign aid increases. Indeed, productivity gains in tradable sectors, combined with strong performance of manufactured exports, have typically characterized virtually all cases of sustained growth since World War II. Although manufacturing exports remain feeble in many sub-Saharan African countries, the same was true of the East Asian “dragons” during the early 1960s, just before their impressive economic takeoff.

How have exports reacted to aid flows and macroeconomic policies in poor countries? The study measures typical responses, develops a theory that delivers predictions consistent with such responses, and examines the welfare implications of alternative macroeconomic policies (see box).

Signs of Dutch disease?

The findings show that poor countries have indeed been affected by Dutch disease: foreign aid tends to cause both the trade balance and exports to deteriorate. But a lower trade balance is also consistent with a financing role of foreign aid—that is, as foreign aid rises, recipient countries can finance larger trade deficits.

The negative response of exports to foreign aid is a typical symptom of Dutch disease. This negative response occurs in “normal” years—defined as years that do not immediately follow a conflict and that are not affected by large negative shocks, such as sharp reductions in commodity export prices or natural disasters (drought, hurricanes, or earthquakes). In years marked by negative shocks—which account for 44 percent of the observations in the sample—foreign aid does not reduce exports and might even boost them. In sum, the evidence bears out the Dutch disease theory, but only for normal years, which suggests that aid may also buffer exports from negative shocks.

Macroeconomic policies can help

To gauge the effects of macroeconomic policies, the study measured changes in the central bank’s net domestic assets, a variable that reflects both monetary and fiscal policies. In low-income countries, tighter macroeconomic policies improve the trade balance and are associated with stronger exports. Conversely, expansionary policies tend to harm exports (provided there are enough international reserves to finance a larger trade gap). Macroeconomic policies that are countercyclical to aid flows also appear to mitigate the volatility of the trade balance. Specifically, the trade balance in countries in which the central bank’s net domestic assets fall in response to a surge in aid flows and rise when foreign aid declines is less volatile—after controlling for openness to trade, terms of trade shocks, and the fact that aid flows might respond to changes in the trade balance.

Temporary monetary policies can have permanent real effects

One intriguing finding of this study is that monetary tightening has a positive effect on exports. In a standard Keynesian model, with capital mobility, flexible exchange rates, and sticky prices, the effect should be the opposite. Indeed, a monetary tightening, by raising interest rates, fuels private capital inflows, causing nominal appreciation and temporary real appreciation as prices remain sticky in the short-run. In this setting, as Paul Krugman shows in “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Thatcher: Notes on Trade in the Presence of Dynamic Scale Economies” (Journal of Development Economics, 1987), temporary monetary policy tightening negatively affects export competitiveness by temporarily appreciating the real exchange rate.

We develop a model whose predictions are consistent with our empirical results by reversing the key assumptions of Krugman’s model. Specifically, we assume that the capital account is closed, the exchange rate is fixed, and prices are flexible. These assumptions are realistic: most low-income countries are small economies open to trade but with relatively closed capital accounts (both de jure and de facto). Moreover, the vast majority of them maintained exchange rate regimes that were either fixed or managed floats over the past decades. Finally, low-income countries usually have large informal nontraded sectors in which prices are quite flexible.

We consider a two-sector, small open economy receiving an exogenously given flow of foreign aid, which is either consumed or invested in productivity-enhancing public goods. Examples of public goods that can enhance overall productivity in the medium term include infrastructures (such as roads, access to electricity, and sanitation), education, and health care. Moreover, as in standard models of Dutch disease, we assume that the economy grows as a result of learning by doing in the tradable (export) sector and overall productivity gains. We add to this model monetary and fiscal sectors, assuming that government bonds are the only interest-bearing financial instrument in the economy.

We show that, under these conditions, changes in the central bank’s net domestic assets affect real variables through changes in the price of nontraded goods relative to that of traded goods. A macroeconomic tightening tends to depreciate the real exchange rate by reducing aggregate demand and thus boosts exports. Our model implies that temporary monetary policy actions have permanent real effects because they modify the productive structure of the economy. Macroeconomic policies do matter.

What macroeconomic policy response maximizes welfare for a given net present value of foreign aid? By reducing the net domestic assets of the central bank through a combination of fiscal and monetary actions, a country’s authorities can undo some of the money supply expansion associated with foreign aid inflows, thereby preventing real appreciation, preserving the competitiveness of the tradables sector, and raising international reserves and national savings.

A temporary tightening of net domestic assets is not always the optimal response to a surge in aid inflows. It amounts to postponing aid spending and, therefore, improves welfare only if the economy is better off saving part of its aid for later use. This happens when the current consumption benefits of aid are relatively low, and the net effect of current aid on productivity growth is small, or even negative, because of Dutch disease.

By contrast, when current consumption and productivity benefits of aid are large, tightening macroeconomic policies as aid grows would be unnecessary and, in fact, inappropriate. Years with negative shocks—for which there is no evidence that foreign aid depresses exports—epitomize this case. Macroeconomic policies could even be expansionary when donors back-load aid disbursements and the immediate consumption and productivity benefits of aid are large. In this case, however, the limited availability of international reserves—especially when reserves are also kept for insurance purposes—could prevent recipient countries from using expansionary policies to bring forward the benefits of foreign aid.

Overall, the results suggest that macroeconomic policies can mitigate the undesired consequences of aid volatility and the risks of Dutch disease. The study argues that when aid flows are excessively front-loaded, tighter monetary and fiscal policies can improve welfare by increasing national savings and heading off Dutch disease effects. But when aid flows are too back-loaded, fiscal and monetary policies should be expansionary, although insufficient international reserves might constrain the effects of these policies.

Finally, although these findings suggest that macroeconomic policies could help shape the impact, over time, of foreign aid, they do not provide any indication that this aid might be too generous or not generous enough.

Alessandro Prati and Thierry Tressel

IMF Research Department

Based on IMF Working Paper No. 06/145, “Aid Volatility and Dutch Disease: Is There a Role for Macroeconomic Policies?” by Alessandro Prati and Thierry Tressel. Copies are $15.00; see page 324 for ordering details.

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