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In search of better outcomes for low-income countries

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
November 2003
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Since the establishment of the Poverty Reduction and Growth Facility (PRGF)—the IMF’s concessional loan facility—in September 1999, the organization has made a concerted effort to strengthen analytical work on macroeconomic issues affecting low-income countries. One product of this drive was an October 23-24, 2003, workshop hosted by the Macroeconomic Studies Division of the IMF’s Research Department. The forum pointed to a number of ways that the IMF could make its macroeconomic policy recommendations more effective and improve the success rate of achieving program targets. These include improving data, gaining greater insight into the role of institutions, rethinking IMF program design, and reassessing how aid is disbursed.

Agustin Carstens, IMF Deputy Managing Director, opened the workshop, insisting that a better understanding of institutions in developing countries is crucial for the IMF’s work. While IMF documents provide a good sense of the macroeconomic state of a country, he said, they usually offer little insight into the institutional underpinnings of macroeconomic policy. It is also critical to improve national accounts data because poor data undermine effective policymaking. In a similar vein, Carstens also emphasized the positive role diversification can play in insulating economies from large shocks that can worsen poverty.

Consistency of IMF programs

Can ways of improving IMF program design be found by exploring how macroeconomic outcomes are related to program targets? The IMF’s Reza Baqir, Rodney Ramcharan, and Ratna Sahay focused on how outcomes fared relative to the targets set under a program. Using data on program targets and actual outcomes for a broad range of macroeconomic variables covering 29 countries for around 12 years, they asked whether there are trade-offs between program objectives and whether intermediate targets help achieve overall objectives.

The authors did not find strong evidence of tradeoffs between objectives, but, focusing on program targets for economic growth, inflation, and the current account balance, they found that all targets are met only 8 percent of the time. Second, while growth objectives are more likely to be achieved if the fiscal targets are met, there appears to be a conflict between meeting the net foreign assets and growth objectives.

Why are IMF program objectives not met more frequently? Ramcharan explained that a change in policy can change expectations and thereby affect the behavior of economic agents, who, in turn, affect the growth rate. Mohsin Khan, Director of the IMF Institute and Associate Director of the IMF’s Middle East and Central Asia Department, suggested that part of the answer may lie in a tendency to set overly optimistic program targets.

Political foundations of “resource curse”

It is well known that natural resource endowments can have a negative effect on growth and may indeed become more of a curse than a blessing. Some resource-rich countries—such as Botswana, Chile, Malaysia, and, to some extent, Oman and Thailand—have largely avoided this curse, but others have not fared nearly as well.

Why do resource windfalls lead to worse economic performance? They seem to generate dysfunctional state behavior, such as overspending and implementation of counterproductive public policies, said Thierry Verdier (Delta-Ecole Normale Superieure), presenting a joint paper with James Robinson (UC Berkeley) and Ragnar Torvik (Norwegian University of Science and Technology). Furthermore, resource booms may create underdevelopment, not so much because of any inefficiency in resource extraction but because they provide politicians with greater scope to influence the outcome of elections and the allocation of resources. The overall effect on economic outcomes depends on the strength of domestic institutions: countries with good institutions tend to benefit from resource booms because the institutions mitigate the perverse political incentives that booms create. Countries with bad institutions, in contrast, tend to suffer the resource curse.

Sovereign borrowing and market access

At what stage of development can low-income countries expect to tap international capital markets? What differentiates countries that can borrow regularly from those that can do so only occasionally or never? And, to what extent do government policies matter? Gaston Gelos (IMF), presenting the results of a study coauthored by Ratna Sahay and Guido Sandleris (Columbia University), noted that out of a sample of 143 developing countries, 51 never accessed international credit markets over the past two decades; 78 had access to the markets for fewer than 14 of the 18 years under study; and only 12 countries had consistent access (14 or more years out of18).

What accounts for these differences? Smaller economies, as measured by GDP, have a more difficult time tapping the markets than larger economies, suggesting that fixed borrowing costs may be an important deterrent. Not surprisingly, political stability and institutional investor ratings matter: higher political risk and lower ratings translate into less access. Vulnerability, as measured by the share of agriculture in GDP, also tends to be associated with market access. And the existence of an IMF-supported PRGF program is negatively associated with market access, which is not surprising because these programs impose strict limits on borrowing from private markets, as well as because low-income countries tend to have low debt-servicing capacity. Finally, the authors found that defaults do not appear to affect market access and that the period between default and resumption of market access was considerably shorter in the 1990s than the average of four years in the 1980s.

New data, new doubts

An extraordinarily influential paper produced by Craig Burnside and David Dollar (World Bank) in 2000 found that “aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies but has little effect in the presence of poor policies.” At the workshop, William Easterly (New York University (NYU)) presented the results of a study he coauthored with Ross Levine (University of Minnesota) and David Roodman (NYU) that questions the thesis that aid promotes growth even in countries with sound policies. Participants found this a very disturbing message, not only because a number of decisions (such as the establishment of the U.S. Millennium Challenge Account) had been influenced by the Burnside and Dollar paper but also because the study suggested that aid is ineffective, irrespective of policies.

Why might aid not work so well, even with good policies? Part of the answer, Easterly suggested, may be that aid agencies are fundamentally unaccountable. Because of the lack of a feedback mechanism between aid recipients and donors, aid agencies have little incentive to learn, unlike firms in the private market that must pass a market test to survive or governments that face the voter test.

Participants suggested that an analysis that distinguishes between different types of aid—such as budget support and direct project aid—may produce different results. Furthermore, if measured by a different yardstick, such as its ability to raise the consumption levels of the poor, aid may prove to be effective.

Growth-equality trade-off?

Humberto Lopez (World Bank) entered the poverty debate by assessing the effect that pro-growth policies have on inequality. Improving education and infrastructure and lowering inflation lead to increased growth and reduced income inequality, he said. While financial development, increasing trade openness, and decreases in the size of government also lead to faster growth, they are associated with higher inequality. Is their overall impact pro-poor? Lopez argued that, while these policies are likely to be pro-poor in the long run, they are likely to lead to higher poverty in the short run. These findings, he noted, call for the adoption of a pro-poor policy package at the center of any poverty reduction strategy, as well as measures that diminish potential short-run increases in poverty.

When is debt sustainable?

When do developing countries fall into debt distress—that is, find themselves in arrears, resorting to Paris Club debt relief, or pursuing nonconcessional IMF support? Art Kraay and Vikram Nehru of the World Bank took a closer look at what triggers unsustainable debt. They found that the risk of debt distress depends on a small set of factors: initial debt burdens, the quality of policies and institutions, and shocks. While at some level these results are not too surprising, Kraay noted, they do have profound implications for how resource transfers to low-income countries could be financed. The probability of debt distress is already high in many low-income countries and is likely to increase sharply, even if the large-scale development finance required to meet the UN Millennium Development Goals is provided in the form of highly concessional lending.

Debt relief: Who benefits?

What should donors do when poverty reduction is the objective and funds are used instead to fund military procurement, public sector payrolls, urban services, or lower taxes for affluent households? Once the recipient government is in possession of the funds, it has an incentive to meet the needs of its constituency, and those with a voice are often those with means. Aid funds are therefore not only fungible but hostage to the domestic political status quo.

What does this imply for the usefulness of debt relief as an instrument to increase the consumption of the poor in low-income countries? To answer this question, Tito Cordella (IMF), presenting a paper coauthored with Giovanni Dell’Ariccia (IMF) and Ken Kletzer (UC Santa Cruz), argued that if the preferences of the poor and of donors are similar but differ from those of the recipient governments, and if a high debt stock prevents market access, then donors should forgive interest payments but keep the stock of debt as leverage; this will force recipient governments to redistribute these funds to the poor.

A case for sterilizing aid inflows?

Do aid inflows, which constitute a very large share of many recipient countries’ GDP, cause real exchange rate appreciations, and should the base money effect of aid inflows be sterilized to prevent this? Presenting a paper coauthored with colleagues Alessandro Prati and Ratna Sahay, Thierry Tressel (IMF) said that large aid flows in the past had led to small real exchange rate appreciations but that these effects could become large if aid is substantial stepped up. To address this possibility, they developed a theoretical model to identify conditions under which preventing a real appreciation through sterilization improved welfare. But many participants remained skeptical that aid levels would ever rise so high and noted that evidence of real exchange rate appreciation being caused by aid inflows was weak.

For the full text of the papers, please check online at http://http://www.imf.org/external/np/res/seminars/2003/lic/index.htm.

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