Aid effectiveness

Spurred by two recent reports—the UN Millennium Project Report (the “Sachs Report”) and the Commission for Africa Report (the “Blair Report”)—the development community is talking about substantially increasing aid flows to low-income countries. But apart from the question of whether larger aid flows will materialize, there is also the question of whether recipient countries will be in a position to make good use of them. As part of an ongoing IMF effort to raise awareness of absorption issues and to discuss the macroeconomic issues that can arise from increased aid inflows, the IMF Institute and the African Department organized a high-level seminar in Maputo, Mozambique, on March 14-15.

Both the Blair and Sachs reports advocate a large and rapid scaling-up of aid to finance expenditures that would help low-income countries reach the UN Millennium Development Goals. In the past, however, development assistance has had mixed results, and evidence on the effects of aid on growth remains elusive and contradictory. Moreover, even if some benefits of aid are undisputed, managing these flows effectively is fraught with challenges.

The Maputo seminar, cofinanced by Germany’s Internationale Weiterbildung und Entwicklung and the U.K.’s Department for International Development, sought to explore the macroeconomic implications and policy challenges of a substantial increase in foreign aid. Participants included ministers with finance and development portfolios and central bank governors from Cameroon, The Gambia, Ghana, Malawi, Mali, Mozambique, Nigeria, Rwanda, Senegal, and Sierra Leone as well as other senior officials from Benin, Burkina Faso, Democratic Republic of Congo, Cote d’Ivoire, Kenya, Niger, South Africa, Uganda, and Zambia. The seminar’s sessions examined the varied complications posed by constrained absorptive capacity, the effects of aid flows on real exchange rates, the macroeco-nomic strains arising from the volatility and unpredictability of aid, the complex interaction of aid flows with debt and fiscal policy, and the implications of increased aid for the recipient country’s governance and political economy.

Elusive impact on growth. The role that aid has played or could play in stimulating growth has long been a topic of debate in development circles. In Maputo, the argument continued unabated and without resolution. Steve Radelet (Center for Global Development) presented new econometric evidence suggesting that infrastructure spending and short-term-impact aid have made significant contributions to promoting economic growth, albeit with diminishing returns. Other participants—notably Aart Kraay (World Bank) and Arvind Subramanian (IMF)—took issue with this assessment, arguing that aid explains a very small component of the variation in growth and poverty reduction.

Good institutions are vital. Something that nearly all participants agreed on was that the critical determinants of success lie elsewhere—in institutions, governance, policies, and exogenous events—and success will depend upon countries’ ability to sustain effective and efficient governments and good policies. A paper by Simon Johnson (IMF) and Arvind Subramanian addressed the many challenges involved in promoting institutional change and acknowledged the well-known limits associated with trying to import institutions. The authors joined Kraay in focusing on how external interventions, including aid, could help build strong institutions that in turn will set up the right conditions for growth.

The unsettled matter of competitiveness. Economic theory posits that large-scale increases in aid, like other exogenous inflows of foreign exchange, can reduce an economy’s competitiveness and adversely affect the tradable goods sector if the aid flows, spent on nontradable goods, fuel an appreciation of the real exchange rate. Reduced net exports can, in turn, limit opportunities for efficiency gains through international interaction and thus exert a detrimental effect on long-run growth.

While the validity of the theory is widely recognized, there is much disagreement among economists on the empirical extent of the problem. David Bevan and Christopher Adam (both from Oxford University) suggested that while government spending underwritten by aid flows may induce some initial real appreciation, it can—even if targeted to nontradable goods and services (for example, infrastructure)—enhance productivity and competitiveness in the tradable-goods sector over the longer run. In Subramanian’s view, though, the original theory had it right. He presented new econometric evidence, based on a recent and extended sample, that suggested that aid has tended to adversely affect the competitiveness of tradable-goods industries and thus dampened prospects for export-led growth.

Managing volatile aid flows. As Aleš Bulíŕ and Javier Hamann (both IMF) documented in their paper, aid flows have been persistently volatile, and discrepancies continue between donor commitments and disbursements. Their research also showed that aid has been largely procyclical. Less clear-cut is the extent to which this volatility and unpredictability stem from recipient country noncompliance with program conditions as distinct from the failure of donors to make stable commitments and abide by them. Whatever the cause, many seminar participants said, volatile and unpredictable aid flows pose major difficulties for recipient countries.

Efforts are afoot, however, to address these fluctuations. Paul Isenman (OECD) reported that the OECD Working Party on Aid Effectiveness and Donor Practices has recently endorsed a set of measures designed to address the problems that donor behavior poses for aid recipients. At the same time, Alan Gelb (World Bank) and others argued that policymakers in recipient countries should focus more on using aid to build reserves and develop fiscal cushions. These resources would then allow them to avoid disruptions in important expenditures. Participants expressed widespread support for allowing— indeed encouraging—aid recipients to exercise a greater latitude in the timing of aid-financed expenditures.

Looking ahead

Given possible substantial increases in aid flows to low-income countries and the likelihood of bottlenecks and real exchange rate appreciation, what are policymakers to do to better prepare their countries? There was broad agreement at the seminar that policymakers should watch very carefully for signs of absorptive capacity constraints at the micro level—that is, price jumps, wage increases, or profit shifts in traded-goods sectors. Such developments should prompt a reevaluation of government spending, whether aid-financed or not, and perhaps also a reevaluation of monetary policy.

By the same token, policymakers would do well to adopt spending plans that are sensible in light of their perceptions of constraints on absorptive capacity. They should not allow donors to dictate an excessive allocation of resources to donors’ “flavor-of-the-day” sector if this will lead to bottlenecks. As both Nancy Birdsall (Center for Global Development) and Goodall Gondwe (Malawi’s Minister of Finance) pointed out, having donor activity crowded into one or two sectors—even crucial sectors such as education and health care—can have serious consequences for the effective usage and absorption of this aid, and, potentially, for resource allocation in the broader economy.

Analyzing the supply-side response is also critical in determining the best macroeconomic management of future aid flows. Gelb pointed out that there is considerable scope for enhancing Africa’s export competitiveness by improving its infrastructure. There are broad and substantive benefits to be reaped from a more reliable supply of electricity, for example, and from the more efficient delivery of other services for businesses. Well-designed policies that provide incentives for entre-preneurship will, over time, strengthen the supply responses of low-income economies and should allow them to grow more rapidly and reduce poverty by capitalizing on global markets.

The seminar led to a general understanding that in formulating policies, it will be important, too, for the authorities to keep in mind the trade-off between the expected benefits of aid-financed expenditures in reducing poverty and the potentially negative effects that aid flows can have on a country’s competitiveness. The IMF can play a role in helping recipient countries recognize the potentially adverse macroeconomic effects of large aid flows and in identifying likely issues and trade-offs.