Lecture 3: Vulnerabilities Related to the Scaling Up of Aid and Other
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Transcript Lecture 3: Vulnerabilities Related to the Scaling Up of Aid and Other
Thorvaldur Gylfason
Aid and other capital flows
History, theory, evidence
Foreign aid and economic growth
Effectiveness: Does aid work?
Macroeconomic challenges
Dutch disease
Aid volatility
Policy
options in managing aid flows and
lessons from recent experience
Preparing for scaling up aid
Vulnerabilities
Monetary and fiscal policy options
Debt sustainability
Governance issues
Conclusions
and guidelines
Unrequited
transfers from donor
to country designed to promote
the economic and social
development of the recipient
Excluding
commercial deals and
military aid
Concessional
loans and grants
included, by tradition
Grant
element ≥ 25%
Development
aid can be
Public
(ODA) or private
Bilateral (from one country to another)
or multilateral (from international
organizations)
Program, project, technical assistance
Linked to purchase of goods and
services from donor country, or in kind
Conditional in nature
IMF conditionality, good governance
Moral duty
Neocolonialism
Humanitarian intervention
Public good
National (e.g., education and health care)
International
Social justice to promote world unity
UN aid commitment of 0.7% of GDP
World-wide redistribution
Increased inequality word-wide
Marshall Plan after World War II
1.5% of US GDP for four years vs. 0.2% today
But Think tank in Nairobi disagrees, see
www.irenkenya.com
Objectives
Individuals
in donor countries vs.
governments in recipient countries
Who
should receive the aid?
Today’s
Aid
poor vs. tomorrow’s poor
for consumption vs. investment
Conflicts
Beneficiaries’ needs
Donors’ interests
Aid
is a recent phenomenon
Four major periods since 1950
1950s:
Fast growth (US, France, UK)
1960s: Stabilization and new donors
Japan, Germany, Canada, Australia
1970s:
Rapid growth in aid again due
to oil shocks, recession, cold war
1980s: Stagnation, aid fatigue, new
methods, new thinking
Rapid
growth of development aid
US provided 50% of total ODA
To countries ranging from Greece to South
Korea along the frontier of the “SinoSoviet bloc”
France
To former colonies, mainly in West Africa
UK
provided 30%
provided 10%
To Commonwealth countries
Stabilization
of aid from traditional
donors and emergence of new donors
US contribution decreased considerably
after the Kennedy presidency (1961-63)
The
French contribution decreased
starting from the early 1960s
New
donors included Japan,
Germany, Canada, and Australia
Rapid
growth in aid from industrial
countries in response to the needs of
developing countries due to
Oil
shocks
Severe drought in the Sahel
The
donor governments promised to
deliver 0.7% of GNI in ODA at the UN
General Assembly in 1970
The
deadline for reaching that target was
the mid-1970s
Stagnation
of development
assistance
Donor
fatigue?
Private investor fatigue?
12
United
States: largest donor in
volume, but low in relation to GDP
US
aid amounts to 0.2% of GDP
Japan:
second-largest donor in volume
Nordic countries, Netherlands
Major
donors to multilateral programs
Sole countries whose assistance accounts
for 0.7% of GDP
EU:
leading multilateral donor
Even
though targets and agendas
have been set, year after year,
almost all rich nations have
constantly failed to reach their
agreed obligations of the 0.7% target
Instead of 0.7% of GNI, the amount
of aid has been around 0.4% (on
average), some $100 billion short
40
35
1985
1990
2000
30
25
20
15
10
5
0
sub-Saharan
Africa
Asia
Oceania
MEDA
Latin America
Europe
Sub-Saharan
Africa and Asia have
received the most aid, the former a
rising amount over time
Aid to Sub-Saharan Africa is high in
relation to GDP
For
the 44 countries in the IMF’s Africa
Department, net official transfers are as
follows:
< 5% of GDP:
14 countries
6%-16% of GDP: 24 countries
> 20% of GDP:
6 countries
The
Blair Report and the Sachs Report
called on world community to increase
development aid (particularly for
Africa) to enable developing countries
to attain the MDGs by 2015
2005
G-8 Gleneagles communiqué called
for raising annual aid flows to Africa by
$25 billion per year by 2010
2005 UN Millennium Project called for $33
billion per year in additional resources
For comparison, US gave $20 billion in 2004,
not $70 billion as suggested by UN goal
The
recent increase in aid flows
toward developing countries
(particularly Africa) poses crucial
questions for both recipient
countries and donors
What
is the role of aid?
What is the macroeconomic impact of aid?
Is the impact of aid necessarily positive,
or could aid have adverse consequences?
Aid
fills gap between investment
needs and saving and, if well
managed, can increase growth
Poor
countries often have low savings and
low export receipts and limited
investment capacity and slow growth
Aid
is intended to free developing
nations from poverty traps
E.g.,
capital stock declines if saving
does not keep up with depreciation
To understand the link between aid and
investment, consider Resource
Constraint Identity by rearranging the
National Income Identity:
Y=C+I+G+X–Z
I = (Y – T – C) + (T – G) + (Z – X)
Sp
Sg
Sf
In words, investment is financed by the
sum of private saving, public saving,
and foreign saving
This
is where aid enters the picture
Rearrange again:
Y+Z=E+X
where E is expenditure
E=C+I+G
Total supply from domestic and foreign
sources Y + Z equals total demand E + X
Aid increases recipient’s ability to
import: Z rises with increased X, incl. TR
Poor
countries are trapped by poverty
Driving
forces of growth (saving,
technological innovation, accumulation of
human capital) are weakened by poverty
Countries become stuck in poverty traps
Aid
enables poor countries to free
themselves of poverty by enabling
them to cross the necessary
thresholds to launch growth
Saving
Technology
Human capital
Is it feasible to lift all above a dollar a day?
How much would it cost to eradicate extreme
poverty? Let’s do the arithmetic (Sachs)
Number of people with less than a dollar a
day is 1.1 billion
Their average income is 77 cents a day, they
need 1.08 dollars
Difference amounts to 31 cents a day, or 113
dollars per year
Total cost is 124 billion dollars per year, or
0.6% of GNP in industrial countries
Less than they promised! – and didn’t deliver
Several
empirical studies have
assessed the impact of aid on growth,
saving, and investment
The results are somewhat inconclusive
Most
studies have shown that aid has no
significant statistical impact on growth,
saving, or investment
However,
aid has positive impact on
growth when countries pursue “sound
policies”
Burnside
and Dollar (2000)
Regression
analysis to measure
the impact of aid on
Saving
Investment
Public
finance
Economic growth
Saving
Negative effect on saving
Substitution effect? I.e., crowding out?
Boone 1996; Reiche 1995
Positive effect for good performers
E.g., South-East Asia, Botswana
Investment
No impact on private investment
Positive impact for good performers
Public
finance
Uncertain effect on public investment
Positive effect on public consumption
Growth:
Mixed results
Most
early studies showed no
statistically significant impact
Some more recent studies show
negative impact
Selection bias and endogeneity issues
Need
to distinguish between
different types of aid
Leakages,
cash vs. aid in kind
aid has
sometimes been
compared to natural
resource discoveries
Aid and growth are
inversely related
across countries
Cause and effect
156 countries,
1960-2000
Per capita growth adjusted for initial income (%)
Foreign
r = rank correlation
r = -0.36
6
4
2
0
-2
-4
-6
-8
-20
0
20
40
60
Foreign aid (% of GDP)
80
No
robust relationship between aid and
growth
Aid works in “countries with good
policies”
Aid works if measured correctly
Distinction between fast impact aid
(infrastructure projects) and slow
impact aid (education)
Infrastructure:
High financial returns
Education and health: High social returns
So,
empirical evidence is mixed
Need to distinguish between
different types of aid
Need to acknowledge diminishing
returns to aid as well as limits to
domestic absorptive capacity
Need to clarify interaction with
governance and good policies
Special case: Post-conflict situations
Aid
may lead to corruption
Aid may be misused, by donors as well
as recipients
Donors:
Excessive administrative costs
Recipients: Mismanagement, expropriation
Aid
may be badly distributed,
sometimes for strategic reasons
Supporting
opposition
government against political
Aid
increases public consumption,
not public investment
Aid is procyclical
When
Aid
it rains, it pours
leads to “Dutch disease”
Labor-intensive
and export industries
contract relative to other industries in
countries receiving high aid inflows
Dutch disease may undermine external
sustainability
Aid
volatility and unpredictability
may undermine economic stability in
recipient countries
Economic
vs. social impact
Growth
is perhaps not the best
yardstick for the usefulness of aid
Long
run vs. short run
E.g., increased saving reduces level of
GDP in short run, but increases growth of
GDP in long run
See my “Dutch Disease” in the New Palgrave Dictionary of Economics Online
Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
In 1960s, Netherlands discovered natural
resources (gas deposits)
Currency appreciated
Exports of manufactures and services suffered,
but not for long
Not
unlike natural resource discoveries, aid
inflows could trigger the Dutch Disease in
receiving countries
Foreign
exchange is converted into
local currency and used to buy
domestic goods
Fixed exchange rate regime
Expansion
of money supply leads to
inflation and an appreciation of real
exchange rate
Flexible
Increase
exchange rate regime
in the supply of foreign exchange
leads to an appreciation of the nominal
exchange rate, so the real exchange rate
also appreciates
Review
theory of Dutch disease
in two rounds
Demand
and supply model
Two-sector model
Demand effects
Supply effects
Exchange rate volatility
Real exchange rate
Payments for imports
of goods, services, and
capital
Imports
Earnings from exports
of goods, services, and
capital
Exports
Foreign exchange
eP
Q
P*
Devaluation or
depreciation of e
makes Q also
depreciate unless P
rises so as to leave Q
unchanged
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
1. Suppose e falls
Then more dinars per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Summarize all three by supposing
that Q falls
Then X rises, Z falls
eP
Q
P*
Real exchange rate
Aid leads to appreciation,
and thus reduces exports
C
B
A
Imports
Exports
plus aid
Exports
Foreign exchange
Real exchange rate
Oil discovery leads to appreciation,
and reduces nonoil exports
C
B
A
Imports
Exports
plus oil
Exports
Foreign exchange
Real exchange rate
Composition of exports
matters
C
B
A
Imports
Exports
plus oil
Exports
Foreign exchange
Dutch
disease is a real phenomenon, not
monetary
Real exchange rate always floats
Recall: Q = eP/P*
Flexible exchange rate regime
Nominal appreciation
Fixed
exchange rate regime
Inflation
Look
at this more closely in two-sector
model of traded vs. nontraded goods: Skip
A
large inflow of foreign aid -- like a
natural resource discovery -- can
trigger a bout of Dutch disease in
countries receiving aid
A real appreciation reduces the
competitiveness of exports and might
thus undermine economic growth
Exports
have played a pivotal role in the
economic development of many countries
An accumulation of “know-how” often
takes place in the export sector, which may
confer positive externalities on the rest of
the economy
Aid
It
is likely to lead to Dutch disease if
leads to high demand for nontradables
Trade restrictions may produce this outcome
Recipient country uses aid to buy nontradables
(including social services) rather than imports
Production
is at full capacity
Production of nontradables cannot be increased
without raising wages in that sector
Aid
is not used to build up infrastructure
and relax supply constraints
Price and wage increases in nontradables
sector lead to strong wage pressure in
tradables sector
The
risk that aid flows might have an
adverse impact on the economy as a
result of aid-induced Dutch Disease
crucially depends on how aid is used
in the recipient countries
We can identify four different cases
on the basis of how the aid is spent,
and in which the macroeconomic
implications of aid flows are different
Aid
spending can take several forms,
with different macroeconomic
implications:
Case
1: Aid received is saved by recipient
country government
Case 2: Aid is used to purchase imported
goods that would not have been
purchased otherwise (grants in kind)
Case 3: Aid is used to buy nontradables
with infinitely elastic supply
Case 4: Aid is used to buy nontradables
for which there are supply constraints
Aid
received is saved by recipient
country government
Aid
receipts leads to accumulation of
foreign exchange reserves in Central Bank
… and, unlike increased aid that is spent, are
not allowed to enter the spending stream
No
effect on money supply
No inflation
No appreciation of nominal exchange rate
No risk of Dutch disease
Aid
is used to purchase imported
goods that would not have been
purchased otherwise (grants in kind)
Import
purchases lead to transfer of real
resources from abroad, but not to
increased spending at home
No effect on money supply
No inflation
No appreciation of nominal exchange rate
No risk of Dutch disease
Aid
is used to buy domestic
nontradables with infinitely elastic
supply due to underutilized resources
(labor and capital) in economy
Increased demand for nontradables
Because some resources are unemployed,
greater demand leads to increased supply
This has a positive impact on production
without increasing the price of
nontradables
No risk of Dutch disease
Aid
is used to buy nontradables for
which there are supply constraints,
since all available resources are
already in use (e.g., social services)
Increased
demand for nontradables
Increased prices for nontradables
Shift of resources away from the tradables
(exports) and into nontradables
Real appreciation of the currency
Dutch disease!
Monetary
policy response determines if real
appreciation of currency will be caused by
inflation or by nominal appreciation
If foreign currency is used to increase the
reserves of the Central Bank, aid spending on
nontradables leads to an increase in money
supply and to inflation
If Central Bank sterilizes the impact of aid
spending in nontradables on money supply by
selling foreign exchange, currency appreciates
in nominal terms
To
recapitulate, the risk of Dutch
disease varies, and depends on
How
aid is used (saved or spent) – CASE 1
The presence of an aid absorption
constraint – CASE 2
The impact of aid on productivity in the
nontradable goods sector – CASE 3
The existence of externalities in the
nontradable goods sector affecting the
rest of the economy – CASE 4
Aid
can give rise to Dutch disease
when the recipient country’s
government uses the aid to purchase
nontradables rather than imported
goods and when there are constraints
on increasing production in the
nontradables sectors
The risk of Dutch disease is greater
when aid is used in social sectors that
face constraints on increasing their
production due to resource scarcity
(aid absorption constraint)
How
can recipient countries avoid
translating aid into Dutch disease?
Save
aid received and increase central
bank reserves (gross, not net) by not
allowing the increased aid to enter the
spending stream
Use aid to purchase imported goods
Boost aid absorption capacity in the
nontradables sector
Policymakers
in recipient countries
need to pay attention to potential
early warning signals of aid-induced
Dutch disease such as
A tendency for wages and prices in the
nontradables sector to increase
A decline in the profitability and sales
of the export and import-competing
industries
Once
more, the macroeconomic
impact of aid depends critically on
the policy response to aid
Interaction
between fiscal policy and
monetary policy is crucial
To
highlight this interaction, apply
two related but distinct concepts
Absorption:
Monetary policy
Spending: Fiscal policy
Absorption
Extent
to which the non-aid current
account deficit widens with increased aid
Captures the amount of net imports financed
by an increase in aid
Given
fiscal policy, absorption is
controlled by Central Bank’s decision
about how much of the aid-induced
foreign exchange to sell in the markets
If Central Bank uses the full increment of aidinduced foreign exchange to bolster reserves,
aid will not be absorbed
Spending
Extent
to which the non-aid fiscal deficit
widens with increased aid
Captures the extent to which the government
uses aid to finance an increase in expenditures
Given
monetary policy, spending is
controlled by the government’s decision
about how much of the aid to spend, on
either imports or non-traded goods
If the government decides to save the full
increment in aid, aid will not enter the
spending stream
Different
combinations of absorption and
spending define the policy response to a
surge in aid inflows
Absorption and spending are equivalent if aid
is in kind or if it is spent on imports
Absorption and spending differ when the
government provides the aid-related foreign
exchange to Central Bank and chooses how
much to spend on domestic goods while the
Central Bank decides how much of the aidrelated foreign exchange to sell in markets
Studies
assessing empirical relevance
of Dutch disease as caused by aid
flows have produced mixed results
Aid
was associated with real
appreciation in Malawi and Sri Lanka
Aid was associated with with real
depreciation in Ghana, Nigeria, and
Tanzania
Ethiopia,
Ghana, Tanzania, Mozambique,
and Uganda experienced a surge in aid
1998-2003 (Berg et al. 2007)
The net aid increment ranged from 2% of GDP
in Tanzania to 8% of GDP in Ethiopia
High everywhere, from 7% to 20 % of GDP
In
Ghana, sharp increase in 2001 followed
by a slump in 2002 and another surge in
2003
In all other countries, the surge in aid was
persistent, i.e., after the initial jump, aid
inflows remained higher than before
In
the five countries, no evidence of
aid-induced Dutch-Disease
Real
exchange rates did not appreciate
during the aid surges
Only Ghana had a small real appreciation
while the others experienced a real
depreciation
From 1.5% in Mozambique (2000) to 6.5% in
Uganda (2001)
Why?
The macroeconomic
policy response
was meant to avoid a real appreciation
Countries
were reluctant to absorb the
surge in aid
Only Mozambique absorbed two-thirds
Aid surge led to reserve accumulation
So, currency did not appreciate in real terms
Mozambique,
Tanzania, and Uganda spent
most of new aid
They had attained stability, so reducing domestic
financing of the budget deficit was not a major goal
Ghana
and Ethiopia spent little of the aid
They had a weak record of stability and low
reserves, so reducing the domestic financing of the
budget deficit was a consideration not to spend aid
Two types of policy response
1. In Ethiopia and Ghana, aid impact was
limited because only a small part of it
was either absorbed or spent
New aid was saved and reserves built up
2. In Mozambique, Tanzania, and Uganda,
spending exceeded absorption, creating
a pressure on prices
Money supply expansion was sterilized
through treasury bill sales
Foreign exchange sales were kept
consistent with a depreciation of
currency to maintain competitiveness
Was
aid-induced Dutch disease a
problem?
No evidence of significant real
appreciation following surge in aid
Macroeconomic
policy response (fiscal
and monetary policy mix) avoided real
appreciation
“Not absorb and not spend” vs. “spend
more than absorb”
The
choice in some countries to “not
absorb and not spend” new aid
preserved competitiveness while
allowing the replenishing of
international reserves
The choice in some other countries to
“spend more than absorb” went
along with sterilization of public
spending that contained inflationary
pressures
Aid
can play a key role in the development
of recipient countries, but it can also
generate macroeconomic vulnerabilities
Recipients need to implement appropriate
policies to manage aid flows to avoid
macroeconomic hazards
The appropriate policy response needs to take
into account
Potential impact of aid on competitiveness
Existence of constraints to aid absorption
Risks linked to aid volatility and to external debt
sustainability
Aid
is increasingly volatile and unpredictable
Aid flows are 6-40 times more volatile than
fiscal revenue
Volatility is largest for aid dependent
countries (Bulir and Hamann 2003, 2007)
Volatility increased in the 1990s
Aid delivery falls short of pledges by over 40%
Reasons for aid volatility
Donors: Changes in priorities; administrative
and budgetary delays
Recipients: Failure to satisfy conditions
IMF conditionality often guides donors, helping them
decide if the country’s policies are on track
Impact of large sudden inflows
Supply constraints in absorbing aid
Real exchange rate overshooting and
volatility
Negative impact on budget management
Negative impact on export industries
Ratcheting up spending commitments
without adequate consideration of exit
strategy
Infrastructure investment without adequate
planning for recurrent expenditure
Maintenance
Impact of aid promised, but not disbursed
Mismatch between revenues and scheduled
expenditures
Spending commitments cannot be financed
Necessitates difficult expenditure choices
Aid volatility translates into public expenditure
volatility
Can be costly if it compels government to cut
down on, delay, or abandon productive
investments
To avoid this, government may resort to printing
money or borrowing
Hence, negative impact on stabilization
Volatility in money supply, inflation, exchange rates
Donors
need to disburse aid according to the
agreed schedule and increase transparency
toward recipient country governments
Recipient countries need to respect the
conditionality of development aid
disbursements
Recipients need to be granted more flexibility
in their choices to spend or save aid flows,
specifically in light of the time span for the
aid they receive
E.g., during 2000-03, Ghana chose to save
unexpected aid increases and to supplement its
Central Bank reserves
A
substantial acceleration in aid flows
could adversely affect the external
debt sustainability of recipients
Development aid may take the form
of grants or concessional loans
Grants are unrequited transfers
Concessional loans increase outstanding
debt and the amount of resources needed
to service that debt
Studies
have shown that debt
sustainability may deteriorate even if
loans are concessional
Daseking
It
and Joshi (2005)
is crucial for donors to choose an
appropriate mix of grants and loans in
order for recipients to achieve the
MDGs without undermining their
external debt sustainability
Advantages
of grants
Do
not increase debt burden
Useful for social projects with uncertain or
delayed returns (health care, education)
Advantage
Mobilize
of concessional loans
more resources
Increase debt management capacity
Useful for projects yielding quick returns
(infrastructure)
Choice
between grants and loans
must balance the benefits of larger
available resources against the risk of
a heavier debt burden
Since loans force recipients to repay
in future, they have an incentive to
Choose
more profitable projects
This leads better allocation of aid
Improve
external debt management
Efforts
to find an appropriate balance
between loans and grants can be
based on
Project-based
approach
Country-based approach
Grants
To
finance investments with a
significant social impact but whose
return is uncertain or difficult to
appropriate or which need a longer
period to be profitable
E.g., education and health care
Loans
To
finance projects that yield profits
more quickly
E.g., infrastructure
An
appropriate balance between grants
and loans is determined case by case
Based on the sustainability of recipient’s debt as
well as its exposure to revenue/growth
volatility
Poorest
countries receive a larger
proportion of aid through grants
Countries with higher growth rates and
sound economic policies receive a larger
proportion of loans
Corruption
and economic performance
Impact
on growth
Likelihood of disbursement
Anticorruption
strategies
Reduce
state role
Improve regulatory environment
Punish offenders
Liberalize and reform institutions
Improving
public expenditure
management systems
From
aid fatigue to new initiatives
Aid effectiveness is ambiguous
Positive
results likely with better policies
and governance
Five Primary Guidelines
Minimize risks of Dutch disease
Enhance growth – Always a good idea!
Assess the policy mix
Promote good governance and reduce
corruption
Prepare an exit strategy
Bulir and Hamann 2003, “Aid volatility: An empirical
Assessment,” IMF Staff Papers.
______, 2007, “Volatility of Development Aid: An Update,”
IMF Staff Papers.
Daseking and Joshi, 2005, Debt and New Financing in LowIncome Countries, IMF.
Isard, Lipschitz, Mourmouras, and Yontcheva, 2006,
Macroeconomic Management of Foreign Aid: Opportunities
and Pitfalls, IMF.
Gupta, Powell, and Yang, 2006, Macroeconomic Challenges of
Scaling up Aid to Africa: A Checklist for Practitioners, IMF.
Rajan and Subramanian, 2005, “Aid and Growth: What Does
the Cross-Country Evidence Really Show?,” IMF Working Paper.
______, 2005, “What Undermines Aid’s Impact on Growth?,”
IMF Working Paper.
Aid
can play an important role in
the growth and development of
recipient countries …
…
but it can also create macroeconomic
vulnerabilities
Recipient
countries need to manage
aid flows so as to avoid hazards
Need to consider potential impact of aid on
Competitiveness
Constraints to aid absorption
Risks linked to aid volatility and to external
debt sustainability These slides will be posted on my website:
www.hi.is/~gylfason