This Selected Issues paper on Zambia reports that the authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community.

Abstract

This Selected Issues paper on Zambia reports that the authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community.

I. The Macroeconomic Impact of Scaling Up Donor Assistance: A Simulation Analysis1

1. In preparing the forthcoming National Development Plan 2006–10 (NDP), the Zambian authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community. This paper aims to shed some light on the macroeconomic impact of such a scaling up of donor assistance. It uses a financial programming model that focuses on a few key relationships with assumed values for the parameters.

2. The paper is organized as follows. Section A describes the scaling up exercise, which is broadly in line the pro-poor growth alternative policy scenario featured in the draft NDP. It also details the reasoning behind the choice of values selected for the parameters. Section B discusses the results from the application of this framework for the macroeconomic impact of the scaling up. Section C then presents a sensitivity analysis, which gives insight on the effects of varying some of the model’s key parameters. The paper ends with some concluding remarks.

A. The Scaling Up Exercise

3. The exercise focuses on the impact of a 50 percent scaling up of donor assistance by 2010, where half of the aid is directed to rural infrastructure and the rest split equally between health and education services. That is, over the 5-year period 2006–10, annual flows of donor assistance are assumed to increase steadily by US$70 million a year (1 percent of GDP in 2005) above the aid levels projected in the baseline medium-term scenario. This additional amount of annual assistance (US$350 million in 2010) would then be maintained over the foreseeable future. All the assistance is assumed to be in the form of grants. In addition, the simulation includes projected savings from the Multilateral Debt Relief Initiative (MDRI), whereby credits disbursed by the Fund, the World Bank, and the African Development Bank (AfDB) by end-2004 are fully written off.2

4. The degree to which a scaling up of aid affects real GDP growth, inflation, the fiscal deficit, the exchange rate, imports and exports, and other macroeconomic variables depends upon a number of factors.3 The immediate impact of the increase in public sector spending is largely determined by the availability (existing underemployment) of factors of production to meet this increased demand and whether the foreign exchange receipts from the aid are used to mop up the liquidity generated. A portion of the increased government demand would be met through imported goods and services, such as medicines, construction equipment, and foreign contractors. On the supply side, additional infrastructure and health and education services would have a positive impact on productivity; however, not without long time lags in some cases, particularly for spending on education and child health. To the extent that the expansion of the public sector creates an excess demand, relative prices would need to adjust to attract needed resources. The degree of adjustment would be determined by the demand and supply elasticities in the relevant markets (Table I.1).

Table I.1.

Assumed Values of Main Parameters

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Source: Fund staff estimates.

Receipts net of government spending on imports.

5. The amount of imports initially demanded by the expansion in public sector demand depends on the nature of the spending. For spending on infrastructure investment (mainly road building), we assume that foreign contractors and importation of heavy equipment absorb 60 percent of the government’s outlay. The remaining 40 percent represents domestic and foreign contractors’ local expenses and domestic earnings on capital. For both health and education services, the main expense is typically salaries. It is assumed that a 30 percent portion of expenditures on health are used for imports, mainly drugs, while the figure for education is considerably lower (5 percent) for items such as text books. A larger import component for meeting government demand implies that the stimulus effect of public spending on the domestic economy is smaller. In this case, government’s direct imports account for just under 40 percent of the total spending, mainly reflecting the large share of spending on infrastructure.

6. While government spending on domestic goods and services provides an initial stimulus, the ability of the supply-side of the economy to respond can be constrained. Most notably, there is short supply of trained doctors, nurses, and other core health workers in Zambia.4 For the health sector, it is assumed that 75 percent of government domestic spending involves higher wages and the crowding out of factors of production (mainly labor) from other sectors. Given the relatively ample supply of new teachers graduating from public and private teaching training institutions, education spending is assumed to involve less crowding out (50 percent), although the hiring of teachers still means that scarce skilled workers are drawn from other sectors of the economy. Because low-skilled labor, which is in excess supply in Zambia, comprises a large part of the labor used in construction, it is assumed that spending on infrastructure involves a relatively small amount of crowding out (10 percent).

7. Assuming that government spending is used effectively, the positive impact on productivity and real GDP growth over the longer term from spending today can be substantial.5 To capture this effect, it is assumed that there are lags between when government expenditures take place and the projects come on stream and productivity gains are realized. For infrastructure investment, it is assumed that projects can come on stream in two years. The lags for health and education services are longer, because they are largely directed at children who would not enter the labor for many years to come. Lags between expenditures and productivity gains are assumed to be 5 years and 10 years, respectively, for health and education. The shorter lag time for health reflects programs directed toward adults (for example, anti-retroviral treatment for HIV/AIDS) and that parents can be more productive if time spent caring for sick children is reduced. With regard to the effectiveness of government spending, a real rate of return of 15 percent a year is assumed for all pro-poor programs. For simplicity, it is assumed that the additional contribution to GDP is provided in perpetuity following the end of the assumed time lag.6

8. In addition to the direct effect from government imports, the impact on the external sector is largely determined through movements in the real exchange rate. Donors’ foreign exchange must be converted to kwacha for domestic expenditures. In the case of budget support, these foreign exchange resources materialize as government deposits in the Bank of Zambia (BoZ). In the first instance, government spending then results in a liquidity injection that must be mopped up to prevent increased inflation, either through sales of foreign exchange by the BoZ or through issuances of government securities. Partly reflecting Zambia’s need to accumulate international reserves, from the low level of 1½ months of imports in 2005, it is assumed that 30 percent of the foreign exchange receipts from donor assistance, net of government’s imports, are retained by the BoZ.7 As a result, about 40 percent of the gross foreign exchange receipts from donor assistance would be used for mopping up liquidity.8

9. The absorption of these sales on the foreign exchange market requires an adjustment in the real exchange rate. The degree of appreciation of the kwacha needed to clear the market by increasing imports while dampening exports depends on the elasticities of demand and supply. The elasticity of demand for foreign exchange, derived from the demand for imported goods and services not directly financed by foreign investors, is assumed to be -1. The supply of foreign exchange—mainly from nonmetal exports of goods and services, the component of metals export receipts and foreign direct investment used for domestic inputs, and donor assistance—is assumed to be more inelastic, with an elasticity of 0.5.

10. In addition to the effect from a kwacha appreciation, the external current account deficit would be affected by the government’s imports and, looking ahead, an expansion of exports associated with the increased productivity arising from government programs. For this latter effect, it is assumed that 75 percent of the increased production from infrastructure investment would be geared to the export market, while 25 percent of the increased production from health and education services would go to exports, with the corresponding lag time discussed above.

B. Macroeconomic Impact of Scaling Up

11. The simulation exercise suggests that a scaling up of donor assistance of the magnitude considered would have moderately positive effects on the economy (Table I.2). The stimulus to the economy from the expansion in public sector demand would lift average real GDP growth from 6 percent in the baseline scenario to 6.4 percent a year over the next five years (2006–10).9 The leveling off of aid, and decline in MDRI assistance thereafter, would then have a slightly negative effect, but this would be more than offset by the positive effects of increased productivity. Still, even with a fairly generous assumption about the rate of return on government spending, the net increase in long-term GDP growth relative to the baseline is modest at 0.3 percentage points a year.

Table I.2.

Alternative Macroeconomic Framework—50 Percent Scaling Up of Donor Assistance

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

Reflects net domestic financing in the baseline scenario; includes additional issues for liquidity management in the scaling up scenario.

Including MDRI assistance.

12. The scaling up of aid flows results in a modest (1.3 percent a year) appreciation of the kwacha in real terms during 2006–10 compared to the baseline scenario. As a result, growth in imports increases during this period, while export growth is dampened slightly. Imports also expand from higher direct government imports as aid inflows increase and the external current account deficit, excluding grants, widens by just over 2 percentage points of GDP compared with the baseline. This pattern is slightly reversed during 2011–15, particularly as savings from the MDRI diminish, resulting in a narrower current account deficit. Importantly, export growth picks up after 2010, mainly reflecting the productivity effects of earlier government spending. The effect is strong enough to reduce the current account deficit after 2015 below the level projected in the baseline after.

13. The overall fiscal deficit, excluding grants, widens substantially as increased donor assistance funds additional expenditures. Including grants, however, the widening of the deficit relative to the baseline is fairly modest, reflecting only the additional interest costs of government securities issued for mopping up liquidity (rising to 0.3 percentage points of GDP over time).

C. Sensitivity Analysis

14. The sensitivity analysis presented in Tables I.3aI.3e considers the impact of varying some key parameters on selected macroeconomic variables. In particular, we look at the results for a range of values for the real rate of return (ROR), domestic supply constraints in meeting government demand, elasticities of demand and supply in the foreign exchange market, the degree of sterilization through foreign exchange sales, and the import content of government spending. In each case, the value of only one parameter is varied; all other parameters are set at their values for the scaling up scenario presented in the previous section.

Table I.3a.

Sensitivity Analysis—Rate of Return (ROR) on Additional Government Spending

(Annual percentage change, unless otherwise specified)

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

Table I.3b.

Sensitivity Analysis—Easticity of Demand and Supply of Foreign Exchange

(Annual percentage change, unless otherwise specified)

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

Table I.3c.

Sensitivity Analysis—Crowding Out by Additional Government Spending

(Annual percentage change, unless otherwise specified)

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

Table I.3d.

Sensitivity Analysis—Accumulation of International Reserves

(Annual percentage change, unless otherwise specified)

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

Table I.3e.

Sensitivity Analysis—Import Content of Additional Government Spending

(Annual percentage change, unless otherwise specified)

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Source: Fund staff projections.

Percentage change of exports and imports of goods and services as measured in U.S. dollars.

15. Varying the ROR between 10 percent and 20 percent indicates that to sustain the positive effects of a scaling up of donor assistance, government spending must be highly effective (see Table I.3a). While GDP growth benefits over the medium term from the stimulus of increased donor-financed government spending, even a fairly high ROR of 10 percent is barely sufficient to provide sustained improvements in growth, outweighing the negative effect on growth of declining assistance after 2010. In addition, capacity constraints play an important role in determining how much the economy benefits from the stimulus of rising donor assistance (see Table I.3b). In the case of no capacity constraints, the positive impact on real GDP growth during 2005–10 is a quite strong, even producing cyclical effects as aid diminishes.

16. A higher import content of government spending lowers the stimulus to the economy from increased donor-financed government spending, but it also eases the negative effect on the export sector through the “sterilizing effect” of the direct spending on imports (Table I.3c). In the case where all donor assistance is used for imports, the real exchange essentially does not deviate from the baseline projection, allowing for a stronger expansion of exports as the productivity effects are realized.

17. For a given amount of donor assistance, the impact on the real exchange rate is determined by the elasticities of supply and demand in the foreign exchange market and the share of the foreign exchange proceeds from donor assistance sold on the market (Tables I.3d and I.3e).10 The greater the sum of the demand and supply elasticities for foreign exchange (mainly determined by the underlying elasticities of demand for imports and supply of exports) the smaller the real appreciation of the kwacha needed to absorb a given injection of foreign exchange to the market. In the case of highly inelastic demand and supply, the real exchange rate becomes quite sensitive to the injection of foreign exchange from the scaling up of donor assistance, with a real appreciation of nearly 6 percent a year during 2006–10. Reducing the share of foreign exchange sales in the BoZ’s operations to mop up liquidity eases pressure on the kwacha, but the interest payments on government securities can become costly.11 At the same time, if the BoZ were to retain a larger share of foreign exchange proceeds from donor assistance, its efforts to build up reserves and reduce external vulnerabilities would be enhanced.

D. Concluding Remarks

18. As in many low-income countries, the lack of quality data in Zambia necessitates the use of assumed values for a number of parameters in macroeconomic modeling. Nevertheless, it is possible to gain a number of useful insights from this exercise. In particular, it is clear that a scaling up of donor assistance would have positive effects if the resources are used effectively. This supports the urgency of strengthening public expenditure management, as highlighted in the draft NDP.

19. The exercise also highlights that capacity constraints in the economy limit the positive effects of the stimulus provided by donor-financed government spending. This suggests that aid effectiveness could be enhanced by directing resources to ease the supply constraints rather than simply expanding demand. For example, in the case of severe shortages of health workers, an expansion of training facilities could be highly productive. Conversely, projects that do not rely on skilled labor could be quite productive from the start.

20. The injection of foreign exchange into the Zambian market would inevitably tend to create an appreciation of the kwacha. However, in the scaling up exercise envisaged in this paper, the injection would be relatively modest. In the event of highly inelastic demand and supply elasticities in the foreign exchange market, the impact on the real exchange rate could be substantial (even though the impact on export volumes would not be large). In seeking to build up international reserves, the authorities could moderate the impact on the exchange rate, but this could become costly and have only limited effects. Most importantly, to maintain an export-led growth strategy, the resources from donor assistance must be used effectively. In addition, in view of the exchange rate appreciation, the implementation of the structural reform agenda outlined in the draft NDP is critical in order to raise productivity and enhance Zambia’s international competitiveness.

21. Finally, while the simulation exercise provides a number of insights, it should be noted that the model focuses on the direct effects of the scaling up of aid and does not account for secondary effects, such as higher GDP growth on demand for imports. A general equilibrium analysis would be necessary to provide a fuller picture.

1

Prepared by David Dunn.

2

It is assumed that obligations to the Fund and the AfDB are canceled effective January 1, 2006, while obligations to the World Bank are canceled effective July 1, 2006. It is further assumed that there is no change in planned disbursements of new credits.

3

Gupta, Sanjeev, Robert Powell, and Yongzheng Yang, The Macroeconomic Challenges of Scaling Up Aid to Africa (WP/05/179), IMF, Washington, DC, 2005.

4

The Ministry of Health, with help from donor-supported consultants, is in the process of developing a 5-year strategy for increasing the supply of core health workers, which aims mainly at retaining staff through improved wages and benefits.

5

Strengthening public expenditure management systems is a major part of Zambia’s structural reform agenda.

6

For instance, in real terms, K 1 billion spent on education in 2006 would increase GDP by K 4 billion a year beginning in 2016.

7

Or about 20 percent of the gross foreign exchange receipts from donor assistance. An equivalent amount of government securities would be issued for sterilization purposes, which would create upward pressure on their yields.

8

In line with the authorities commitment to lower inflation, as emphasized in the draft NDP as a key factor for achieving high rates of sustainable growth, policies are assumed to maintain the objective from the baseline of lowering inflation to single digits by 2007.

9

For a description of the baseline medium-term outlook, see the staff report for the 2005 Article IV consultation and Third Review Under the PRGF Arrangement with Zambia.

10

Foreign exchange sales could be from central bank operations to mop up liquidity or from direct sales to the market from donor projects.

11

Moreover, sterilization with issues of government securities could become ineffective for easing real appreciation if they serve to attract additional foreign capital.