Chapter

Appendix 1. The Relationship between Aid Flows and Exchange Rates in Sub-Saharan Africa

Author(s):
Yongzheng Yang, Robert Powell, and Sanjeev Gupta
Published Date:
March 2006
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Aid Flows and the Real Exchange Rate

Attempts to measure the relationship between aid flows and the real exchange rate in SSA date back to the early 1980s (Appendix Table A.2.2).

  • A number of studies have found a tendency for aid inflows to be associated with an appreciation of the real exchange rate, but this evidence is not overwhelmingly significant. See Younger (1992) for Ghana, and Kasekende and Atingi-Ego (1999) for Uganda, as well as cross-country analysis by Adenauer and Vagassky (1998).
  • Econometric estimates often show the impact of aid on the exchange rate to be small and statistically insignificant. Bulir and Lane (2002) call these “traces” of aid-induced real exchange rate appreciation. Prati, Sahay, and Tressel (2003), using a panel data model, suggest that for countries whose ODA is in excess of 2 percent of GDP a year, a doubling of aid would appreciate the level of real exchange rate by, at most, 4 percent in the short run, rising to about 18 percent over a five-year period and 30 percent over a decade.
  • Time-series models tend to reveal that the real exchange rate responds less to aid variations than to other exogenous factors, such as terms of trade variations.
  • Some studies of African countries find that aid inflows appear to be associated with a real depreciation, reflecting increased productivity (supply-side response) as a result of aid. See, for example, Nyoni (1998), Sackey (2002), and IMF (2005d). The latter observes that aid that is not absorbed is not associated with any real exchange rate appreciation, noting that in a number of cases, aid surges went largely into reserves.

Exchange Rates and Exports

Region-specific studies find real exchange rate changes to be a significant determinant of the share of exports in GDP in SSA. Balassa (1990) estimates that a 1 percent change in the level of the real exchange rate is associated with a change of 0.8 percent to 1 percent in the share of exports in GDP. Similarly, Ghura and Grennes (1993) find that an actual exchange rate that is 1 percent above a model-based equilibrium exchange rate lowers the share of exports by 0.096 percent. Rajan and Subramanian (2005a) argue that in countries that receive more aid, export-oriented, labor-intensive industries grow more slowly than other industries, suggesting that aid does lead to Dutch disease.

However, the impact of exchange rate instability on exports can also be an important consideration. With a smaller sample of countries, Sekkat and Varoudakis (2000) estimate a higher elasticity between exchange rate misalignment and the share of exports in some sectors, but this result is not always significant. These studies, however, do not estimate the real exchange rate effects in the context of other factors that might hinder export growth.

To the extent that higher aid flows alleviate supply bottlenecks, they can offset the effect of an exchange rate appreciation on export growth. In a study covering 60 developing countries, Elbadawi (2002) finds that real exchange rate depreciation did play a significant role in export growth (with the elasticity varying between 0.54 and 0.64 for the entire group). But the coefficients of regional dummies in the study suggest that all other things equal, nontraditional exports from East Asia and Latin America would be higher than those from SSA, implying that supply constraints, not included in the model, might significantly account for the poor performance of nontraditional exports in this region.

Exchange Rates and Economic Growth

Recent studies find that growth accelerations are associated with real depreciation, suggesting that a large real appreciation associated with scaling up could have long-term growth costs. Several studies have built on Hausmann, Pritchett, and Rodrik’s (2004) analysis of jumps in countries’ medium-term growth trends, which they label “growth accelerations.” Their study found that the onset of accelerations had a strong correlation with real exchange rate depreciation. This finding has been confirmed for SSA (IMF, 2005f). Almost all the sustained growth cases in SSA avoided overvaluation during the growth period. The study also notes the close link between avoidance of exchange rate misalignment and macroeconomic stability, reinforcing the case for aid inflows to be accompanied by prudent macroeconomic management.

Overvaluation of the exchange rate dampens growth. With a dataset that includes 73 developing countries, spanning the period from 1975 to 1992, Razin and Collins (1997) find that overvaluation does have a significant negative impact on growth, while there is no statistically significant relationship between undervaluation and growth. According to their estimates, a 1 percent overvaluation is associated with a 0.06 percent decline in the real per capita growth rate. Dollar (1992) estimates that a 1 percent distortion of the exchange rate dampened the per capita growth rate by about 0.02 percent for 95 developing countries between 1976 and 1985.34Similarly, Cottani, Cavallo, and Khan (1990) estimate that for a group of 24 developing countries over the period 1960–83, the growth-dampening effect of exchange rate misalignment was about 0.1 percent. Ghura and Grennes (1993) find that a 1 percent overvaluation dampens real per capita GDP growth by about 0.02 percent. Bleaney and Greenway (2001) also estimate a negative effect of lagged exchange rate misalignment on growth. They estimate, with data covering 14 SSA countries over the period 1980–95, that a 1 percent lagged misalignment dampens GDP growth by 0.04 percent.

Exchange Rates and Investment

One of the channels through which a temporarily stronger exchange rate may influence the growth rate is the impact on investment. Razin and Collins (1997) posit that, in addition to its effect on the competitiveness of the tradables sector, a stronger exchange rate may also affect domestic and foreign investment, thereby influencing the capital accumulation process. Bleaney and Greenway (2001) suggest that an overvaluation might hurt investment even though it lowers the price of imported capital goods, because it reduces the returns to investment in the tradables sector and because the resulting current account deficit creates the need for tighter macroeconomic policies.

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