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Thorvaldur GylfasonPretoria, South Africa
9-20 July 2007
Definitions, motivations, trends Aid effectiveness
Theory and evidence Macroeconomic dangers of aid
Dutch diseaseAid volatility
Policy options in managing aid flowsPreparing for scaling up aidMonetary policy optionsFiscal challenges and debt
sustainabilityStrengthening governance
Conclusions and guidelines
Development aid 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 bePublic or privateBilateral (from one country to another) or multilateral (from international organizations)
Program, project, technical assistanceLinked 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 Like education and health care
International Social justice to promote world unity UN aid commitment of 0.7% of GDP
World-wide redistributionIncreased inequality word-wideMarshall Plan after World War II
1.5% of US GDP for four years vs. 0.2% today
People at www.irenkenya.com in Nairobi disagree
ObjectivesIndividuals in donor countries vs. governments in recipient countriesWho should receive the aid?
Today’s poor vs. tomorrow’s poorAid for consumption vs. investment
ConflictsBeneficiaries’ needsDonors’ 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, Australia1970s: Rapid growth in aid again due to oil shocks, recession, cold war
1980s: Stagnation, aid fatigue, new methods
United States: largest donor in volume, but low in relation to GDP2% of GDP
Japan: second-largest donor in volume
Nordic countries, Netherlands Major donors to multilateral programsOnly countries whose assistance
accounts for 0.7% of GDP EU: leading multilateral donor
0
5
10
15
20
25
30
35
40
sub-Saharan Africa
Asia Oceania MEDA Latin America Europe
1985 1990 2000
12
The Blair Report Blair Report and the Sachs Sachs ReportReport 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
Aid fills gap between investment needs and saving and increases growthPoor 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 trapsExample: 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 – ZY = C + I + G + X – ZI = (Y – T – C) + (T – G) + (Z – X)I = (Y – T – C) + (T – G) + (Z – X)
In words, investment is financed by the sum of private private savingsaving, public savingpublic saving, and foreign savingforeign saving
Aid is treated as part of government saving which increases domestic resources to finance investment.
Rearrange again:
Y + Z = E + XY + Z = E + X
where EE is expenditure
E = C + I + GE = C + I + G
Thus, total supply YY ++ ZZ equals total demand EE ++ XX
Aid increases recipient’s ability to import: ZZ rises with increased XX
Aid is treated as part of government saving which increases domestic resources to finance investment.
o Is it feasible to lift allall above a dollar a day? o How much would it cost to eradicate
extreme poverty? Let’s do the arithmetic a la Sachs
o Number of people with less than a dollar a day is 1.1 billion
o Their average income is 77 cents a day, they need 1.08 dollarso Difference is 31 cents a day, or 113 dollars
per yearo Total cost is 124 billion dollars per year,
or 0.6% of GNP in industrial countrieso Less than they promised! – and didn’t
deliver
Regression analysis to measure the impact of aid onSavingInvestmentPublic finance Economic growth
Saving Negative effect on saving
Substitution effect? Boone, 1996; Reichel, 1995
Positive effect for good performers E.g., South-East Asia, Botswana
InvestmentNo impact on private investmentPositive impact for good performers
Public financeUncertain effect on public investmentPositive effect on public consumption
Growth: Mixed results Most early studies showed no statistically significant impact
Some more recent studies show negative impact
Bias and endogeneity issues Need to distinguish between
different types of aidLeakages, cash vs. aid in kind
Foreign aid has Foreign aid has sometimes been sometimes been compared to compared to natural resource natural resource discoveriesdiscoveries
Aid and growth are inversely related across countries
Cause and effect 156 countries,
1960-2000
-8
-6
-4
-2
0
2
4
6
-20 0 20 40 60 80
Foreign aid (% of GDP)
Per
cap
ita g
row
th a
djus
ted
for
initi
al in
com
e (%
) r = -0.36
r = rank correlation
Examples of recent studiesRajan and Subramanian (2005)
No robust relationship between aid and growth
Burnside and Dollar (2001) Aid works in “countries with good policies”
Clemens, Radelet, and Bhavnani (2005) Aid works if measured correctly Distinction between fast impact aid
(infrastructure projects) and slow impact aid (education)Financial vs. social returns
Empirical evidence Types of aid Diminishing returns and limits to
domestic absorptive capacity Interaction with governance and
good policies Post-conflict situations
Aid leads to corruption Aid tends to be misused
Svenson (2000)Murshed and Sen (1995)
Aid is badly distributed, sometimes for strategic reasonsAlesina and Dollar (2000)Collier and Dollar (2002)
Aid increases public consumption, not investment
Aid is procyclicalWhen it rains, it pours
Aid leads to “Dutch disease”Labor intensive and export industries
contract relative to other industries in countries receiving high aid inflows
Growth is perhaps not the best yardstick for the usefulness of aid
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
Review theory of Dutch disease in two rounds
Demand and supply model Two-sector model
Demand effectsSupply effectsExchange rate volatility
Foreign exchange
Real exch
an
ge r
ate
Imports
Exports
Earnings from exports of goods, services, and capital
Payments for imports of goods, services, and capital
Equilibrium
*P
ePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged
*P
ePQ
1.1. Suppose e fallse fallsThen more lira per dollar, so X risesX rises, Z fallsZ falls
2.2. Suppose P fallsP fallsThen X risesX rises, Z fallsZ falls
3.3. Suppose P* risesP* risesThen X risesX rises, Z fallsZ falls
Summarize all three by supposing that Q fallsQ falls
Then X risesX rises, Z fallsZ falls
Foreign exchange
Real exch
an
ge r
ate
Imports
Exports
Exports plus aidaid
Aid leads to appreciation and thus reduces exports
A
C B
Foreign exchange
Real exch
an
ge r
ate
Imports
Exports
Exports plus oiloil
Oil discovery leads to appreciation and reduces nonoil exports
A
C B
Foreign exchange
Real exch
an
ge r
ate
Imports
Exports
Exports plus oiloil
Composition of exports matters
A
C B
Dutch disease is a real phenomenon, not monetary
Real exchange rate always floats Recall: Q = eP/P*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
Nontraded goods (N)
Production frontier (supply)
Nontraded goods (N)
Production frontier (supply)
Indifference curve (demand)
Equilibrium
N
Production frontier (supply)
Indifference curve (demand)
Equilibrium
T
Price line, slope = -PN/PT = -Q
Increased demand for N PN/PT rises (appreciation) Supply of N increases, supply of T falls
N
T
Slope = -PN/PT
BAO
N E
T = ON = AEN = OACannot add T and NConvert T into units of NAE/AB = PN/PT
AB = AE(PT/PN) = PTT/PN
Y = N + PTT/PN = OA + ABY = N + T/Q
N
Production frontier: T = a – 0.5bN2T
Increase in a Increase in Tmax and Nmax
Increase in b Decrease in Nmax
Increase in a Increase in Tmax and Nmax
Increase in b Decrease in Nmax
a
(2a/b)0.5
Tangency at ETangency at E: dT/dN = -bN = -Q N = Q/b (supply)
E
a and b are indicators of efficiency, inefficiency
a and b are indicators of efficiency, inefficiency
N
Indifference curve: U = T + ln(N)T
a
(2a/b)0.5
Tangency at ETangency at E: 0 = dT + (1/N)dN dT/dN = -1/N = -Q N = 1/Q (demand)
E
N
T
a
(2a/b)0.5
Equilibrium at EEquilibrium at E: Supply = demand Q/b = 1/Q Q = b0.5
E
Supply:N = Q/b = b0.5/b = b-0.5
Supply:N = Q/b = b0.5/b = b-0.5
Demand:N = 1/Q = 1/b0.5 = b-0.5
Demand:N = 1/Q = 1/b0.5 = b-0.5
T = a – 0.5b(b-0.5)2 = a – 0.5 T = a – 0.5b(b-0.5)2 = a – 0.5
N
T
T = a – 0.5b[(1+q)/b]-0.5)2 = a – 0.5(1+q)dT/dq < 0dT/dq < 0
T = a – 0.5b[(1+q)/b]-0.5)2 = a – 0.5(1+q)dT/dq < 0dT/dq < 0
Suppose aid Suppose aid increases demand increases demand for N by q%for N by q%: N* = (1+q)/Q = Q/b Q2 = b(1+q) Q = [b(1+q)]0.5
N* = (1+q)/[b(1+q)]0.5
= [(1+q)/b)]0.5
dN*/dq > 0dN*/dq > 0
N
TWithout aidWithout aid: Y = N + T/Q = b-0.5 + (a–0.5)b-0.5
= (a+0.5)b-0.5
With aidWith aid: Y = N* + T/Q = [(1+q)/b)]0.5
+ [a – 0.5(1+q)]/[b(1+q)]0.5
= … = [a+0.5(1+q)]/[b(1+q)]0.5
Can we sign dY/dq? Yes! dY/dq = -0.5bQdY/dq = -0.5bQ-3-3T < 0T < 0
So, in this case, aid reduces GDP
So, in this case, aid reduces GDP
Aid is likely to lead to Dutch disease if It leads to high demand for nontradables
Trade restrictions 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 sectorAid 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
Aid is likely to lead to Dutch disease if It leads to high demand for nontradables
Trade restrictions 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 sectorAid 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
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
Studies assessing empirical relevance of Dutch disease as caused by aid flows have produced mixed resultsAid was associated with real appreciation in Malawi and Sri Lanka
Aid was associated with with real depreciation in Ghana, Nigeria, and Tanzania
Aid is volatile and unpredictableAid flows are 6-40 times more volatile than
fiscal revenueVolatility is largest for aid dependent
countries (Bulir and Hamann, 2005)Volatility increased in the 1990sAid delivery falls short of pledges by over
40% Reasons
Donors: Changes in priorities; administrative and budgetary delays
Recipients: Failure to satisfy conditions
Impact of large sudden inflowsSupply constraints in absorbing aidReal exchange rate overshooting and volatilityNegative impact on export industriesRatcheting up spending commitments without
adequate consideration of exit strategy Infrastructure investment without adequate
planning for recurrent expenditure
Impact of aid promised, but not disbursedSpending commitments cannot be financedVolatility in money supply, inflation, and
exchange rates
Domestic sterilizationSale of domestic bond instrumentsReserve requirementsCentral government deposits
Sale of foreign exchange Objectives and economic impact
of policiesNominal exchange rate vs. inflationDomestic interest rates
Options to reduce risk of Dutch diseaseSave resourcesUse aid to purchase imported goodsSpend on non-traded sectors with few supply constraints
Other spending options Spend on nontradables with supply
constraintsInfrastructure spending for future growth Social spending for poverty reduction
Balancing growth and poverty reductionGrowth effects from infrastructure
investmentTargeting spending to the poorDutch disease
Improving coordinationNGO activitiesSubnational government activitiesPrivate sector capacity
Advantages of grantsLower debt burdenUseful for social projects with uncertain
or delayed returns (health care, education)
Advantage of concessional loansIncrease total flow of resourcesProject allocationIncrease debt management capacityUseful for projects yielding quick returns
(infrastructure)
Loans vs. grants Assessing external debt dynamics Assessing fiscal debt sustainability DSA framework for ensuring debt
sustainabilityDebt and debt-service thresholdsPublic enterprises; net vs. gross debt;
risk of distress Strengthening debt management
Negative impact on budgeting, planning, and stabilization
Debt relief vs. aid Donor commitment and
transparency Respecting conditionality Flexibility to spend or save
Preventing aid dependency Protecting revenues
CompositionCorruptionTax treatment of aid
The scaling down of aid Private economic activity Real spending and recurrent
spending
Corruption and economic performanceImpact on growthLikelihood of disbursement
Anticorruption strategiesReduce state roleImprove regulatory environmentPunish offendersLiberalize 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 GuidelinesMinimize risks of Dutch diseaseEnhance growthPromote good governance and reduce
corruptionPrepare an exit strategyAssess the policy mix
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.
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