Chapter

2. Managing the Real Exchange Rate

Author(s):
Yongzheng Yang, Robert Powell, and Sanjeev Gupta
Published Date:
March 2006
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2.1. Absorbing and Spending Aid Flows

A key issue in assessing the macroeconomic implications of scaling up official resource transfers to Africa is the potential impact on the real exchange rate, exports, and competitiveness. Standard analysis suggests that foreign aid flows augment domestic resources and therefore leave the economy, as a whole, better off. In practice, however, the macroeconomic impact of aid depends both on how a country spends the resources and on its policy response. The interaction of fiscal policy with monetary and exchange rate management is key. To highlight this interaction, IMF (2005d) discusses two related but distinct concepts: absorbing aid and spending aid.

2.1.1. Aid Absorption

Aid absorption is defined as the extent to which a country’s nonaid current account deficit widens in response to an increase in aid inflows.4 This captures the quantity of net imports financed by the increased aid and represents the additional transfer of real resources enabled by the aid. Absorption captures both the direct and the indirect increases in imports financed through aid, that is, the government’s direct purchases of imports as well as second-round increases in net imports resulting from aid-driven increases in government or private expenditures. For a given fiscal policy, absorption is controlled by the central bank through two mechanisms: 1) how much of the foreign exchange associated with aid it chooses to sell, and 2) its interest rate policy, which influences the demand for private imports through aggregate demand. The aid is not absorbed, however, if central bank sales of foreign exchange are matched by private accumulation of foreign assets. Box 1 discusses the absorption of aid for HIV/AID programs.

Aid absorption is the extent to which a country’s nonaid current account deficit widens in response to increased aid inflows. It reflects the increase in net imports resulting from increased aid.

Box 1.Absorption of Financing for HIV/AIDS Programs1

External grants have been the dominant source of funding for HIV/AIDS–related expenditures in low- and middle-income countries. In several countries, financing needs for HIV/AIDS programs exceed total public health expenditure, and they could rise to up to 10 percent of GDP for some low-income countries. Thus, HIV/AIDS programs can present challenges similar to those associated with the type of significant scaling up of aid discussed in this handbook. Absorption of grants for HIV/AIDS depends on the composition of spending. Much of the HIV/AIDS–related spending finances antiretroviral drugs, which are imported in almost all low- and middle-income countries. In the countries with high HIV/AIDS prevalence rates (and thus disproportionally high treatment costs), much of the external financing is likely to be spent on imports, thus mitigating the macroeconomic implications of high aid inflows. However, other components of HIV/AIDS programs, such as prevention and orphan support, largely take the form of domestic spending on nontraded goods and services.

HIV/AIDS programs also have implications for economic growth and the government’s fiscal balance. Programs reduce both the human losses from the disease and the number of new infections. To the extent that productive capacity is preserved, this has a positive effect on government revenues. At the same time, a successful prevention program means that the demand for HIV/AIDS–related services will eventually decline. Masha (2004), for example, estimates that these indirect savings will amount to at least 15 percent of the annual costs of Botswana’s National Strategic Program on HIV/AIDS.

1 By Markus Haacker and draws on Haacker (2004a, 2005).

2.1.2. Aid Spending

Aid spending is defined as the widening in the government fiscal deficit (net of aid) that accompanies an increase in aid.5 Spending captures the extent to which the government uses aid to finance an increase in expenditures or a reduction in taxation. Even if the aid comes tied to particular expenditures, governments can choose whether or not to increase the overall fiscal deficit as aid increases. Aid-related expenditure increases can be for imports or for domestically produced goods and services.

Aid spending is defined as the widening in the government fiscal deficit that accompanies an increase in aid. It indicates the extent to which the government uses aid to finance either an increase in expenditures or a reduction in taxation.

2.1.3. Absorption and Spending Policy Options

Absorption and spending are policy choices. If the government spends aid resources directly on imports or if the aid is in kind (for example, grain or drugs), spending and absorption are equivalent, and there is no direct impact on such macroeconomic variables as the exchange rate, the price level, or the interest rate. But if a country receives foreign exchange resources and the government immediately sells them to the central bank, then the government must decide how much of the local currency counterpart to spend domestically, while the central bank must decide how much of the aid-related foreign exchange to sell on the market. In general, therefore, spending is likely to differ from absorption.

If the government spends aid resources directly on imports or if the aid is in kind, then spending and absorption are equivalent. When a country receives foreign exchange resources, then spending is determined by the government and absorption is determined by the central bank.

Four basic combinations of absorption and spending are possible in response to a scaling up of aid (Table 2). Each one has different macroeconomic implications.

  • Aid is absorbed and spent. This is the situation assumed in most scaling-up scenarios. The government spends the aid increment, and the central bank sells the foreign exchange, which is absorbed by the economy through a widening of the current account deficit. The fiscal deficit is larger but is financed through higher aid.
  • Aid is neither absorbed nor spent. The authorities could choose to respond to aid inflows by simply building international reserves. This might be an appropriate short-run strategy if aid inflows are volatile or if the country’s international reserves are too low. In this scenario, government expenditures are not increased, and taxes are not lowered. Hence, there is no expansionary impact on aggregate demand and no pressure on either the exchange rate or the price level.
  • Aid is absorbed but not spent. Increased aid inflows can be used to reduce inflation. This might be appropriate if inflation levels are excessively high. The authorities choose to sell the foreign exchange associated with increased aid inflows to sterilize the monetary impact of domestically financed fiscal deficits. The result would typically be slower monetary growth, an appreciated nominal exchange rate, and lower inflation. It may also allow for lower domestic debt and interest rates.
  • Aid is spent but not absorbed. A final possibility is that the fiscal deficit, net of aid, increases with the jump in aid, but the authorities do not sell the foreign exchange required to finance additional net imports. The macroeconomic effects of this fiscal expansion are similar to increasing government expenditures in the absence of aid, except that international reserves are higher. The increased deficits inject money into the economy, and inflation increases.
Table 2.Possible Combinations of Absorption and Spending in Response to a Scaling Up of Aid
  • Aid is absorbed and spent.
  • The government spends the aid.
  • The central bank sells the foreign exchange.
  • The current account deficit widens.
  • Aid is neither absorbed nor spent.
  • Government expenditures are not increased.
  • Taxes are not lowered.
  • International reserves are built up.
  • Aid is absorbed but not spent.
  • Government expenditures are not increased.
  • The central bank sells the foreign exchange.
  • Monetary growth is slowed; nominal exchange rates appreciate; inflation is lowered.
  • Aid is spent but not absorbed.
  • The fiscal deficit widens (expenditures are increased).
  • The central bank does not sell foreign exchange.
  • International reserves are built up.
  • Inflation increases.

The composition and quality of spending also affect the impact on growth. In assessing the overall macroeconomic impact of aid flows, therefore, it is important to distinguish between different types of aid (project or program), the types of expenditures (capital or current) the aid finances, and the efficiency with which the aid is used. On the other hand, a complete absorption of aid through an equivalent increase in imports is unlikely to boost growth directly in the short term, although it may do so through spillover effects over time. These issues are addressed in Sections 4 and 5.

2.2. Adjusting the Real Exchange Rate

In a donor-financed scaling-up scenario, the assumption is typically that most (though not necessarily all) aid is both absorbed and spent. In this case, some real exchange rate adjustment may be necessary and, indeed, appropriate in response to a sustained higher level of aid because of the effects on the relative demand for imports and for domestically produced tradables and nontradables.

2.2.1. Dutch Disease

Increased aid boosts demand for both imports and domestically produced nontradable goods, including public services such as health care and education. Bevan (2005) notes that the public sector is typically assumed to have a higher propensity to consume domestically produced goods and services than the private sector. Thus, the domestic component of demand will likely be higher if the aid finances higher public expenditures than if it finances tax cuts, transfers to the private sector, or lower domestic borrowing. A country can import goods directly from the world market, but only domestic producers can supply nontradables.

“Dutch disease” describes a scenario in which currency appreciation makes tradable goods less competitive and leads to an increase in imports. The result is a shift of resources away from the production of tradable goods and toward nontradables.

Unless there is considerable excess supply in the economy, the prices of nontradables must become higher than the prices of tradables (that is, the real exchange rate must rise) in order to encourage resources, including labor, to switch from the production of exportables to the production of nontraded goods. As the real exchange rate appreciates, the tradable goods sector contracts compared with the nontradable sector—that is the so-called Dutch disease.

Dutch disease effects are likely to be stronger when trade is more restricted, when production is at full capacity, and when the ability of consumers to switch between domestic and imported goods in response to relative price changes is more limited as a result. Increased trade liberalization can facilitate aid absorption without leading to Dutch disease effects and is therefore one policy option available. Although Nkusu (2004) stresses that a failure to take sufficient account of idle capacity may lead to excessive concern about Dutch disease effects, unemployed capital and labor are relevant only if they can be brought into productive use in response to higher domestic demand. Hence, if critical inputs are in short supply (for example, specialized labor) and cannot be replaced by resources that are in abundant supply, full capacity can coexist with a generalized unemployment of factors. The mechanism for real exchange rate appreciation varies depending on the exchange rate regime. In a pure float, the central bank sells the foreign exchange associated with the aid, causing a nominal (and real) exchange rate appreciation. In a fixed exchange rate, a period of inflation raises the real exchange rate, with the central bank accommodating higher government expenditures. The increase in aggregate demand and the real appreciation cause an increase in net import demand, forcing the central bank to sell foreign exchange to defend the fixed nominal exchange rate.

2.2.2. Supply and Demand Effects

The macroeconomic impact of aid is likely to depend on how the aid is used. If aid is used to boost supply capacity, the macroeconomic consequences will likely be mitigated. On the other hand, if aid finances social sector spending, the macroeconomic consequences will likely be exacerbated. The interaction of demand and supply effects may cause the real exchange rate to “overshoot” its long-run value. This might mean a real appreciation in the short run, followed by a real depreciation in the medium term. The costs of such real exchange rate volatility will be high if domestic firms face high adjustment costs and if domestic financial markets are relatively under-developed. In these circumstances, exporting firms may run down their capital, lay off skilled workers, or even close down, even though the sector’s long-term prospects are favorable. Aid can directly boost supply capacity. For instance, in the Adam and Bevan (2003, 2004) model, aid is used to enhance the supply response of nontraded goods, moderating the relative price adjustment. Spending aid on infrastructure provides an instrument for improving the supply response in their model because of the range and scale of efficiencies that such spending can bring. Bevan (2005) suggests that there may be a case for giving a higher priority to scaled-up infrastructure investment than to social sector spending because it will yield a better supply response and will offset some of the adverse macroeconomic consequences of scaled-up aid. If the government does give a higher priority to improving social indicators in the near term, it may be more effective to fine-tune existing social spending than to allocate new aid flows to the social sector. This is discussed further in Section 6.

Using aid to boost capacity can mitigate the macroeconomic effects of aid inflows; using aid for social spending can exacerbate them.

2.2.3. The Impact on Exchange Rates and Growth

Once appropriate consideration is taken of the supply-side impact of aid flows, there is no clear presumption as to whether the real exchange rate will appreciate or depreciate over the medium term or whether the tradable sector will expand or contract. This is essentially an empirical issue, on which individual country circumstances are likely to differ. (See Appendix 1 for a survey on the literature about the relationships among aid, exchange rates, and economic growth, and Appendix Table A.2.2 for a summary of attempts to measure the relationship between aid and the real exchange rate in sub-Saharan Africa.)

Real exchange rate appreciation can have a significant effect on export growth in sub-Saharan Africa.

The evidence suggests that real exchange rate effects on export growth can be significant in SSA. Region-specific studies find real exchange rate changes to be a significant determinant of the share of exports in GDP. For example, 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 create Dutch disease. In cases where such negative effects are evident, it is important to ensure that the benefits of aid to the poor are greater than the costs and that the impact of exchange rate instability on exports is also considered. To the extent that higher aid flows alleviate supply bottlenecks, they can offset the effect of an exchange rate appreciation on export growth. Accelerations in economic growth rates 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 the analysis in Hausmann, Pritchett, and Rodrik (2004) of jumps in countries’ medium-term growth trends, which they label growth accelerations and which they find to be strongly correlated with real exchange rate depreciation. This finding has been confirmed for SSA in IMF (2005f), which finds that 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. In particular, overvaluation of the exchange rate dampens growth, while there is no statistically significant relationship between undervaluation and growth (Razin and Collins, 1997). One of the channels through which a temporarily stronger exchange rate may influence the growth rate is the impact on investment. For example, 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 (Bleaney and Greenway, 2001).

When aid flows build up public infrastructure and thus augment the productivity of private factors, it is possible to realize significant medium-term welfare gains from aid, even in the presence of some short-run Dutch disease (Adam, 2005). Bevan (2005) has suggested that the best practical approach is often to ignore real exchange rate effects except when there is specific information on their likely magnitudes. This neutral assumption would be more appropriate in a scenario with a gradual scaling up rather than a very rapid increase in aid inflows, and when the supply payoff (for example, from physical infrastructure) is likely to be more rapid. As an example, IMF (2005a) found no evidence that aid flows to Ethiopia after 1991 (that is, following the overthrow of the Derg regime) caused a real appreciation or harmed noncoffee exports. Instead, foreign aid was found to have a positive impact both on Ethiopia’s noncoffee exports and on their share in total exports.

Historical relationships might not be a reliable guide to the future, however, and given that the resource flows required for SSA to achieve the MDGs will be significantly higher than past aid levels, there seems a strong likelihood that such a scaling up of aid will put upward pressure on wage and price levels and cause a real exchange rate appreciation. It would thus be prudent to implement policies to counter such pressures. Building into the scaling-up scenario an assumption that the exchange rate will appreciate may also be warranted if a high proportion of aid is spent on domestic goods (as discussed in Section 5.4). These judgments and assumptions of course must be tailored to the specific country’s circumstances.

Scaling up aid to levels sufficient to achieve the MDGs is likely to raise wage and price levels and to lead to real exchange rate appreciation in sub-Saharan Africa.

4This definition of aid absorption in IMF (2005d) differs from that of domestic absorption (the sum of private consumption and investment, and government expenditure). The nonaid current account balance is the current account balance excluding official grants and interest on external public debt, whereas the nonaid capital account balance is the capital account net of aid-related capital flows, such as loan disbursements and amortization.
5The deficit net of aid is equal to total expenditures (G) less domestic revenue (T) and is financed by a combination of net aid and domestic financing: GT = Nonaid fiscal deficit = Net aid + Domestic financing. A few countries may also supplement their resources with access to nonconcessional borrowing.

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