Thierry Tressel

In recent years, world leaders have pledged a large increase in official development assistance to help poor countries achieve the Millennium Development Goals by 2015. To maximize the benefits of forthcoming aid flows, policymakers must be aware of the macro-economic challenges that need to be addressed to maximize the benefits of large and volatile aid flows. This article reviews recent IMF research on the macroeconomic consequences of aid flows in low-income countries.

The best way to alleviate poverty in low-income countries is by an acceleration of economic growth. Unfortunately, the empirical literature on the growth effects of aid has found no robust positive conditional or unconditional effect of aid on economic growth in cross-country regressions. In a recent paper, Rajan and Subramanian (2005a) showed that, after correcting for the possibility that aid goes to the countries that are doing badly by using instrumental variables techniques, one does not obtain any significant positive or negative effect of aid on growth on average. This does not mean that aid cannot, under any circumstances, boost growth. Instead, the interpretation is that, in the past, aid was used in ways that have not systematically led to an acceleration (nor to a deceleration) of growth.

Is the lack of consistent results disappointing? Undoubtedly yes. However, this may not be a surprise, considering the findings of existing research on the growth effects of capital flows. Indeed, cross-country regressions have also failed to uncover strong macroeconomic gains associated with financial globalization in general (Kose and others, 2006). Thus, as in the case of other types of capital flows, the costs and benefits of aid must be analyzed through the lenses of their “indirect effects” on institutions and macroeconomic management.

A concern sometimes raised is that, by expanding a government’s external resource envelope, foreign aid might weaken institutions by reducing a government’s sense of accountability to its citizens. For example, sustained periods of large aid inflows could potentially weaken efforts to mobilize domestic revenues, resulting in significant public financing gaps when aid is phased out (Gupta and others, 2005). Rajan and Subramanian (2007) provide evidence consistent with such institutional mechanisms by showing that industries that are most sensitive to bad governance grow at a slower pace in countries that receive more aid. Greater selectivity of aid may reduce such adverse governance effects. Claessens, Cassimon, and van Campenhout (2007) show that, fortunately, the allocation of aid has become more selective in recent years, and has become more responsive to economic fundamentals and the quality of a country’s policy and institutional environment.

Aid flows to poor countries are often very volatile and unpredictable, which reduces their effectiveness (Bulir and Hamann, 2006; Celasun and Walliser, forthcoming). Indeed, volatile and unpredictable aid flows can significantly complicate public expenditure management. It would be highly damaging if spending on recurrent expenditures (such as in the health and education sectors) had to be adjusted upward and downward at a high frequency to match the vagaries of aid flows. Moreover, weak monitoring and management of public expenditure may limit the capacity to quickly absorb large amounts of aid effectively.

When facing volatile and unpredictable aid flows, poor countries should aim to spend them in the medium term to fight poverty. However, in the short term, saving aid in the form of international reserves can be justified from a public finance point of view. Indeed, Celasun and Walliser (2006) find that, in the past, countries have sometimes recoursed to higher domestic financing of expenditures when experiencing sharp drops in aid receipts. In contrast, saving part of temporary aid surges would help avoid excessive reliance on domestic financing and prevent an unsustainable build-up of expenditures. As a general principle, effective medium-term budgeting requires that aid-recipient countries smooth recurrent expenditures while providing funds for key lumpy expenditures (Heller and others, 2006; Heller, 2005).

Another key macroeconomic concern arises when large aid flows are spent on goods and services produced in the domestic economy, which can push up the price of nontraded goods relative to the price of traded goods (the real exchange rate), resulting in a loss of competitiveness in export-oriented, high-value-added sectors. This phenomenon is often called Dutch disease. Rajan and Subramanian (2005b) confirm that Dutch disease is a real concern by showing that, in countries that received more aid in the 1980s and 1990s, export-oriented, labor-intensive manufacturing industries grew more slowly than other industries. Similarly, Prati and Tressel (2006) find that foreign aid inflows depress overall exports of poor countries, as Dutch disease would imply. They do not find, however, any negative effect of aid disbursed when countries experience large exogenous shocks (droughts, large negative commodity price shocks, hurricanes, or earthquakes) or during post-war reconstruction. This suggests that aid may help production recover from adverse events, which in their sample accounts for about 40 percent of observations. Kang, Prati, and Rebucci (2007) do not find signs of Dutch disease in response to “global” aid shocks in about half of aid-recipient countries. Country case studies by Berg and others (2007) find that aid-recipient countries were often reluctant to let the real exchange rate appreciate as aid flowed in, by either not spending the aid in the year it was received, or by sterilizing the monetary expansion associated with the increase in public spending.

Arellano and others (2005) construct a two-sector general equilibrium model to estimate the impact of aid volatility on consumption, investment, and the structure of production. They show that shocks to aid flows lead to substantial welfare losses in the model. They also find that countries that experience greater aid volatility have a lower share of manufacturing exports in total exports. In a two-sector general equilibrium model, Prati and Tressel (2006) show that macroeconomic policies, including sterilization, can help reduce the adverse effects of volatile aid flows by saving part of aid surges, and find consistent evidence in cross-country regressions. As these studies suggest, saving part of temporary increases in aid flows in anticipation of future aid shortfalls can be justified for a variety of reasons, including the need to build reserve buffers against future negative shocks, adjust spending paths to a country’s absorptive capacity, and limit risks of Dutch disease (see also Isard and others, 2006).

Instead of evaluating the overall macroeconomic consequences of aid, other studies have focused on assessing the direct effects of specific types of aid. Mishra and Newhouse (2007) examine the relationship between health aid and infant mortality, and obtain a statistically significant effect. They find that doubling per capita health aid leads to a 2 percent reduction in the infant mortality rate. For the average country, this implies that increasing per capita health aid by $1.60 per year is associated with 1.5 fewer infant deaths per 1,000 births. The effect can be seen as a lower bound of the actual effect, as not all health aid is spent on reducing infant mortality. Using a dataset of both bilateral aid and nongovernmental organization (NGO) aid flows, Masud and Yontcheva (2005) find that NGO aid reduces infant mortality and does so more effectively than official bilateral aid. The impact on illiteracy is less significant.