The Millennium Development Goalsand Macroeconomic Policies

Anis ChowdhuryDonald Lee

Department of Economic and Social AffairsUnited Nations, New York1

1 The views expressed herein do not necessarily reflect the views of the United Nations or any of its agencies.

Introduction

The Millennium Development Goals (MDGs) are the expression of the international community’s commitment to universal development and poverty eradication made in the UN Millennium Declaration in September 2000. The MDGs contain a set of concrete targets to be achieved by 2015. These targets include halving world poverty and hunger, reaching universal primary education, reducing under-5 and maternal mortality by two thirds, and halving the number of people without access to safe drinking water. At the same time, the Declaration called for a new partnership between the developed and the developing countries “to create an environment – at the national and global levels alike – which is conducive to development and the elimination of poverty.” Thus, the Millennium Declaration contains clear obligations for the developed countries in terms of easing market access, lessening the debt burden, channelling financial resources and providing development assistance to the developing world. At the same time, the developing countries are expected to improve governance and conduct effective development policies, which include “sound” macroeconomic management defined as a combination of very low inflation (around 3 per cent), balanced or surplus budget, flexible exchange rate and open capital account. Thus, international support became conditional upon developing countries following policies deemed “sound” by international financial institutions and the donor community.

There are serious concerns about the progress made so far. Although a number of countries have achieved major successes in combating extreme poverty and hunger, improving school enrolment and child health, and expanding access to clean water, control of malaria, tuberculosis, and neglected tropical diseases, and access to HIV treatment,2 the progress has been very uneven. For example, globally China has accounted for most of the decline in extreme poverty. Without it, progress does not look very encouraging; the number of people living in extreme poverty actually went up between 1990 and 2005 by about 36 million. In Sub-Saharan Africa and parts of Asia, poverty and hunger remain stubbornly high. The number of people living on less than $1 a day went up by 92 million in Sub-Saharan Africa and by 8 million in West Asia during 1990-2005.2 Of the 117 countries for which data are available, 63 were now on track (in 2009) to meet the MDG underweight target compared with 46 countries in 2006. Considering their historical experience, some poor countries and whole regions have made remarkable progress in some areas. For example, Sub-Saharan Africa has made huge improvements in child health and in primary school enrolment over the last two decades. Between 1999 and 2004, Sub-Saharan Africa achieved one of the largest reductions in measles’ deaths worldwide ever. See also Bourguignon (2008).

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Many development practitioners have pointed out the apparent incongruence between the so-called “sound” macroeconomic policy mix and poverty reduction efforts. They believe that the donor-favoured macroeconomic policy framework, to which the poverty reduction strategies must conform, is too restrictive and that there has been no two-way feedback between poverty reduction strategies and macroeconomic policy framework. The criticisms of the macroeconomic policy-mix began to surface after the Asian financial crisis and became louder in the wake of the current global financial and economic crisis, which is estimated to have added about 64 million people to the ranks of extreme poverty.3

Development practitioners also pointed out the failure of most rich countries to reach their promise of delivering aid amounting to 0.7 per cent of their GNI. Collectively, aid represented only 0.3 per cent of the GNI of donors in 2008.4 Moreover, these aid flows have been volatile and unpredictable. This has had adverse impacts on the budgetary situation of many poor countries, especially in Sub-Saharan Africa, which needed donor support the most. One of the arguments against accelerating aid flows is that it would put upward pressure on these countries’ real exchange rate, adversely affecting their competitiveness. That is, too much of a good thing may ultimately harm them.

This paper aims at shedding some light on both critiques. It is argued that restrictive macroeconomic policy-mixes advocated by the international financial institutions and the donor community have largely failed in most cases to generate sufficiently high growth to have significant impacts on poverty reduction. The poverty reducing impact of growth has also been weakened by the rise in inequality 3 According to the World Bank’s Global Economic Prospects 2010, globally, the number of people living in extreme poverty is expected to increase by some 64 million in 2010 as compared with a no-crisis scenario. The World Bank also estimated that 100 million people in low-income countries were pushed deeper into poverty due to doubling of food prices during 2007-2008.4 This refers to aid from OECD countries. In 2005, the 15 countries that are members both of the European Union and of the OECD Development Assistance Committee (DAC) committed to reach a minimum ODA country target in 2010 of 0.51% of their GNI. Some are projected to surpass that goal: Sweden, with the world’s highest ODA as a percentage of its GNI at 1.03%, is followed by Luxembourg (1%), Denmark (0.83%), the Netherlands (0.8%), Belgium (0.7%), the United Kingdom (0.56%), Finland (0.55%), Ireland (0.52%) and Spain (0.51%). But others will fall short: France (0.46%), Germany (0.40%), Austria (0.37%), Portugal (0.34%), Greece (0.21%), and Italy (0.20%). See, “Donors’ mixed aid performance for 2010 sparks concern”, http://www.oecd.org/document/20/0,3343,en_2649_34447_44617556_1_1_1_37413,00.html

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associated with the policy reforms promoting market liberalisation and deregulation. As far as the adverse real exchange rate impacts are concerned, the paper argues that it is not a fate accompli. Countries receiving large aid inflows can take countervailing macroeconomic measures to avoid any adverse real exchange rate impacts.

Growth, inequality and poverty – a historical account5

Economic growth is the single most important factor for poverty reduction. However, the impact of growth on poverty will vary depending on what happens to inequality during the growth process. If inequality worsens, as hypothesised by Kuznets,6 then the growth elasticity of poverty will decline. The converse is true if inequality declines. Thus, for there to be any reasonable impact of growth on poverty reduction, inequality should at least remain unchanged during the growth process.

From this perspective, the 1960s was the golden age for developing countries. This is evident from Table 1. Evaluating the growth experience of developing countries, the first World Development Report (WDR, 1978) concluded:

The developing countries have grown impressively over the past twenty-five years: income per person has increased by almost 3 percent a year, with the annual growth rate accelerating from about 2 percent in the 1950s to 3.4 percent in the 1960s…Moreover, it compared extremely favorably with growth rates achieved by the now developed countries over the period of their industrialization: income per person grew less than 2 percent a year in most of the industrialised nations of the West over the 100 years of industrialization (p. 3).

The progress made by developing countries is more impressive considering that their populations have been growing at historically unprecedented rates. During 1950-75, their total population increased at 2.4 percent a year. This is substantially faster than the population growth rates – typically about 1 percent a year – that the now developed countries had to

5 This and the following sections draw significantly on background papers for the United Nations publication, Report of the World Social Situation 2010: Rethinking Poverty.6 According to Kuznets’ hypothesis, inequality worsens initially with the rise in the income level and then falls producing an inverted u-shaped relationship between income level and inequality.

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contend with during the period of their industrialization (pp. 4-5).

Table 1: Decadal GDP Growth Performance of Developing Regions

Region 1960-70 1970-80 1980-90 1990-2000East Asia minus China 6.4 7.6 7.2 5.7South Asia 4.2 3.0 5.8 5.3Latin America 5.5 6.0 1.1 3.3Africa 5.2 3.6 1.7 2.3

Source: Bosworth and Collins (2003), Table 1

The 1970s was a difficult period for most developing countries, especially in South Asia and Africa, with the breakdown of the Bretton Woods system of fixed exchange rates and the commodity and oil price shocks.7 This was reflected in the declines in their GDP growth rates (Table 1). The Latin American countries managed to maintain their growth rates, mainly by borrowing recycled petro-dollars8 from the commercial banks in the US. They faced a debt crisis in the 1980s when interest rates rose sharply due to anti-inflationary policy in the US and the UK. Only a small band of economies in East Asia – Singapore, Republic of Korea (South), Taiwan and Hong Kong –withstood the difficult international economic environment and grew rapidly. This group of economies was followed by Malaysia, Thailand and Indonesia in Southeast Asia.

The contrasting experiences of debt-ridden Latin America in the 1980s and the historically unprecedented growth of East Asia over the same period provided the empirical context against which the current restrictive macroeconomic framework evolved. It was claimed that the failure of key Latin American economies was due to high inflation – caused by unsustainable fiscal deficits and money creation – and the inefficient, protectionist policy of import substituting industrialisation. The contrasting picture in East Asia was of low inflation, fiscal prudence, outward-oriented industrialisation leading to robust growth, and hence sustained declines in poverty.

Thus, the developments in the 1970s and 1980s acted as a catalyst for an ideological shift in the conduct of macroeconomic policy and the role of the state. Debtor countries had no other recourse but to seek

7 Industrialised countries, too, faced for the first time stagflation caused mainly by oil price shocks.8 Deposits in the western banks of oil exporting countries, which enjoyed windfalls from oil price hikes.

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support from the World Bank and the International Monetary Fund (IMF). By the beginning of 1986, 12 of the 15 debtors designated by the then US Secretary of the Treasury, James Baker, as top-priority debtors - including Brazil, Mexico, Argentina, and the Philippines - had agreed to structural adjustment programmes (SAPs). From 3 per cent of total World Bank lending in 1981, structural adjustment credits rose to 19 per cent by 1986. Five years later, the figure reached 25 per cent. By the end of 1992, about 267 structural adjustment loans (SALs) had been approved. The orthodox policy framework of the SAP was vigorously pursued in the 1990s, despite the fact that most Latin American and African countries under SAPs failed to recover, and their average growth rate did not reach 1960-70 or 1970-80 levels.

Table 2 presents the performance of 20 countries which can be categorised as highly or intensively adjusting. Obviously, the 1980s was a lost decade for many of these countries. Despite following structural adjustment reforms in the 1980s and 1990s, the rate of per capita income growth in the 1990s in most countries did not recover to levels achieved during the 1960-80s. Poverty and inequality also rose in most of the adjusting countries.

Table 2: Performance of Highly Adjusting Countries

Country Annual per capita GDP growth (%)

Poverty (million below

$1 a day)

Inequality (Gini)

1960-

1980

1980-

1990

1990-

2000

2000-

2006

1981 2005 1981 2005

ArgentinaBoliviaChileCote d’IvoireGhanaJamaicaKenyaMalawiMauritaniaMexicoMoroccoPakistanPhilippinesSenegal

2.22.11.62.5

-1.00.62.72.91.62.62.52.82.8

-0.33.04.83.6

-1.7-2.61.5

-3.3-0.40.30.4

-0.5-1.0-1.01.43.2

-1.50.1

-1.91.32.7

3.01.75.30.51.7

-0.7-0.31.21.41.50.41.21.01.0

-0.23.12.2

2.51.22.9

-2.42.91.11.10.12.10.93.63.12.81.80.63.24.0

0*1.1090.7110.5835.7350.1216.4975.4490.5996.8012.056

62.03815.488

4.1231.0140.6372.049

1.744*1.8010.1163.7896.7590.006

7.029.7720.3961.7730.892

35.18819.130

3.9402.4140.1011.960

44.5*42.056.441.235.443.257.550.343.946.339.233.441.054.134.443.443.6

50.0*58.254.948.442.845.547.739.039.047.140.831.244.039.234.440.843.2

6

TogoTunisiaTurkeyUgandaVenezuelaZambia

-0.72.60.2

0.3-1.7-2.9

4.1-0.5-2.1

2.41.42.7

8.6440.9703.289

14.9182.477

7.38

44.455.860.5

42.647.650.7

* Argentina-urban Sources: World Development Indicators for growth; for poverty and inequality: http://iresearch.worldbank.org/PovcalNet/povDuplic.htmlThe growth acceleration since 2000 in some of the countries in this group has been mainly due to the commodity price boom (as in Argentina and Ghana) or strong performance of domestic agriculture and the increased inflow of remittances (as in Pakistan and Jamaica). Chile’s relatively impressive performance can be attributed to some unorthodox policy measures that came to be known as heterodox policies. For example, even while it was consolidating its fiscal situation, its social expenditure rose. Public expenditure on health increased from 1.1 per cent of GDP in 1985 to 2.6 per cent in 1992. Like-wise, public expenditure on housing increased from 0.7 per cent of GDP in 1985 to 1.3 per cent in 1992, while social security and education expenditure remained constant at around 6.5 per cent and 3.5 per cent of GDP, respectively (Riveros, 1994). It also promoted exports through a set of fiscal incentives and a competitive real exchange rate. This was made possible because of the tax Chile imposed on short-term capital flows - in defiance of the orthodox policy prescription

One of the early evaluations of the SAPs in Latin America, noted, “the adjustment process has been quite costly, generating drastic declines in real income and important increases in unemployment. In fact, … in a number of Latin American countries in 1986 real per capita GDP was below its 1970 level!” (Edwards, 1988, p. 2). By comparing the adjusting and non-adjusting countries during 1980-1989, an International Labour Organisation (ILO) study concluded: “the claim that, on average, official adjustment programmes under the auspices of the World Bank and the IMF have performed well, not only by the conventional standards of promoting adjustment and preserving growth but also in terms of protecting the poor, is very hard to substantiate convincingly” (Khan, 1993, p. 67).

Just before stepping down as President of the World Bank, James Wolfensohn made a sombre assessment of two decades of experiment with conservative macroeconomic policies and SAP: “if we take a closer look, we see something else – something alarming. In developing countries, excluding China, at least 100 million more people are living in poverty today than a decade ago. And the gap between rich and poor yawns wider” (Wolfensohn, 2000).

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Interestingly, China, which according to Wolfensohn, contributed most to the reduction of global poverty in recent decades, did not participate in this experiment. During 1985-1997, the average rate of inflation in China was around 11 per cent and domestic credit grew at an average rate close to 25 per cent (average money supply growth was over 28 per cent). The average real lending rate was less than 1 per cent. It also followed a policy of an under-valued real exchange rate to support exports and to discourage imports. This mix of pro-growth monetary and exchange rate policies produced very rapid GDP growth of about 10 per cent for almost three decades which has helped reduce poverty, despite growing inequality. Furthermore, China’s restricted capital account shielded it from the 1997-1998 East Asian financial crisis.9

Two other East Asian countries which achieved spectacular growth and reduction in absolute poverty are South Korea and Indonesia. Both economies had inflation rates far above the 3-4 per cent target prescribed in the orthodox policy advice of the IMF. For example, the average inflation rate in Korea during 1970-80 was 19.8 per cent; yet its per capita GNP grew at 8.5 per cent per annum during that period. Korea saw the rate of absolute poverty fall from over 40 per cent in the 1960s to around 4 per cent in the 1990s. Likewise, Indonesia managed to grow at close to 8 per cent per annum during 1970-80, despite an average annual inflation rate of 20.5 per cent. Indonesia’s average annual inflation rate in the 1990s was around 9 per cent - before it was hit by the contagion of the worst financial and economic crisis in Asia - and its average annual growth rate was 7.5 per cent. Indonesia’s consistently high growth was also accompanied by reasonably equitable distribution of income with a Gini coefficient of 0.35 – the lowest among Southeast Asian countries. The result has been a dramatic decline in absolute poverty from around 70 per cent in the late 1960s to around 12 per cent in 1997.

What role did the macroeconomic policy-mix play in the disappointing growth performance? We propose to examine this issue next.

The role of the macroeconomic policy-mix

9 China followed a combination of expansionary and restrictive fiscal policy during this period; the overall budget deficit was only -1.7 per cent of GDP. Since the Asian crisis in 1997-98, China has switched to a combination of restrictive monetary policy and expansionary fiscal policy; the overall budget deficit during 1998-2006 was slightly over 3 per cent of GDP, while growth of money supply (M2) and domestic credit slowed to around 16 per cent. The average inflation rate during the later period was 1 per cent and the average real lending rate was around 5 per cent.

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The centrepiece of the IMF’s macroeconomic policy advice has been inflation targeting and stabilisation of public and external debt. Thus, the common features of the policy-mix have been an inflation target of around 3 per cent and a primary budget surplus, or at least a balanced primary budget. This is despite its own internal research showing a threshold inflation rate of 11-12 per cent beyond which inflation might have negative consequences for economic growth (Khan and Senhadji, 2000). Like-wise the IMF’s advice on fiscal consolidation or budget surplus has been contrary to the findings of its internal survey paper which reported research findings involving 101 developing countries using the World Bank data for the period 1960-95 (Hemming, Kell and Mahfouz, 2002). The research found evidence that “large fiscal consolidations result in lower saving” (Hemming, Kell and Mahfouz, 2002, p. 35). The study also concluded that the fiscal multipliers were positive, especially when there was an accompanying monetary expansion with limited inflationary consequences. The most revealing finding of the IMF survey was that “increased government spending does not substitute for private spending, it enhances the productivity of labor and capital”.

It is telling that the World Bank’s Learning from a Decade of Reform (World Bank, 2005, p. 95) notes that “macroeconomic policies improved in a majority of developing countries in the 1990s, but the expected growth benefits failed to materialise, at least to the extent that many observers had forecast. In addition, a series of financial crises severely depressed growth and worsened poverty... [B]oth slow growth and multiple crises were symptoms of deficiencies in the design and execution of the pro-growth reform strategies that were adopted in the 1990s with macroeconomic stability as their centerpiece.”

A number of growth-retarding factors can be identified that resulted from the Washington consensus macroeconomic policy-mix. Most important among these are: (a) declines in public investment, and (b) volatility of output growth.

Trends in public investment

As can be seen from Figure 1, there have been precipitous declines in public investment since the early 1980s in both Latin America and Sub Saharan Africa, the two regions which experienced growth slowdowns. The declines in public investment were a direct result of excessive focus on attaining budget sustainability with little regard for

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the composition of government expenditure. In most cases, the budget was brought to a balance or surplus by cutting public investment instead of by raising taxes, as cutting non-discretionary expenditure, such as public sector salary or subsidies, was politically more difficult. Developing countries generally face significant problems with regard to tax administration. Other than advising to improve the efficiency of tax administration, the IMF/World Bank programmes showed an aversion to the use of direct taxes due to the fundamental ideological inclination towards smaller government. The removal of trade-related taxes andvarious tax incentives to attract foreign investors seriously eroded the fiscal space for many developing countries, as the declines in revenues were not matched by expected increases in indirect consumption based taxes, such as value added tax (VAT). Thus, the developing countries were faced with a difficult task of improving their fiscal balance while their revenues were falling. The situation was made worse as the declines in public investment were not matched by anticipated increases in private investment.

Reviewing the situation, an IMF report, prepared in consultation with the World Bank and the Inter-American Development Bank, notes:

“The share of public investment in GDP, and especially the share of infrastructure investment, has declined during the last three decades in a number of countries, particularly in Latin America. Since the private sector has not increased infrastructure investment as hoped for, significant infrastructure gaps have emerged in several countries. These gaps may adversely affect the growth potential of the affected countries and limit targeted improvements in social indicators.” IMF (2004, p. 3).

The report also acknowledges that fiscal analysis and policy, which focuses on the overall fiscal balance and gross public debt, may have unduly constrained the ability of countries to take advantage of increased opportunities to finance high-quality infrastructure projects. Research at the Inter-American Development Bank finds that public investment in infrastructure in the period 1987-2001 was negatively affected by IMF adjustment loans. Interestingly, it also finds that debt increases were associated with higher public infrastructure investment, an effect that was robust to the inclusion of many other fiscal and macroeconomic variables (Lora, 2007).

The agricultural sector suffered most from the declines in public investment, as public spending in agriculture has plummeted across developing countries in recent years. In Africa, public spending in

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agriculture fell from 6.4 per cent of total public spending in 1980 to 5 per cent in 2004. In Asia it fell, from 14.8 to 7.4 per cent and Latin America saw a decline of 66 per cent from 8 to 2.7 per cent of total public spending in agriculture. (See, Akroyd and Smith, 2007, and International Labour Organization, 2008, p.22).

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Figure 1: Public investment in Latin America and Africa

(a) Latin America

(b) Sub Saharan Africa

12

0

2

4

6

8

10

12

14

1970 1976 1982 1988 1994 2000

% o

f GD

P

Argentina Mexico Chile LA Average

02468

101214161820

% o

f GD

P

Malawi Kenya TunisiaMauritius Cote d'Ivoire SAA Average

Source: IMF (2004), “Public Investment and Fiscal Policy”, Fiscal Affairs Department

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Growth volatility

Figure 2 presents coefficient of variation of annual growth rates by decades for regional economies. As can be seen, both Latin American and African economies experienced increased volatile growth in the 1980s and 1990s. This is markedly different from the experience of the Southeast Asian economies, which grew rapidly in the 1980s and 1990s (until hit by the financial crisis in 1997-98).

There is a growing body of empirical research that finds a robust, negative cross-country relationship between growth and volatility. They also find a significant negative correlation between growth and medium-term business cycle fluctuations. (See for example, Ramey and Ramey, 1995; Kroft and Lloyd-Ellis, 2002 and Aysan, 2006). One of the causes of increased output growth volatility has been pro-cyclical macroeconomic policy aimed at price level stability and fiscal sustainability. It is well known that when macroeconomic policies target price stability, it causes excessive fluctuations in output as the burden of adjustment falls on only one variable -- output. Most developing countries are prone to supply shocks due to their high dependence on agriculture and imported energy. Output fluctuations will be greater when macroeconomic policies remain focused on price stability in the face of such shocks (Walsh, 2000).

Figure 2: Coefficient of variation of average annualgrowth rates of regional economies

0

5

10

15

20

25

Southeast Asia Africa 12 Latin America 20

1950s 1960s 1980s 1990s

Source: World Development IndicatorsNotes: Southeast Asia: Indonesia, Malaysia, Philippines, Thailand and Singapore;

14

Africa 12: Morocco, South Africa, Mauritius, Nigeria, Egypt, Uganda, Etiopía, Kenya, Malawi, Zimbabwe, Zambia, Ghana; Latin America 20: Panama, Colombia, Honduras, Costa Rica, Guatemala, El Salvador, Brazil, Argentina, Venezuela, Bolivia, Mexico, Trinidad &Tobago, Nicaragua, Peru, Uruguay, Chile, Dominican Republic, Ecuador, Jamaica, Paraguay

The focus on price stability rests on the belief that it would create favourable conditions for private investment, capital inflows and exports, which should eventually spur growth. Thus, the decline in output and hence employment is expected to be short-lived. It is this belief that framed the IMF’s advice to Indonesia to raise interest rates and restrain government expenditure at the height of the crisis in 1997-98. Indonesia remained faithful to this advice even when it left the IMF programme, and stuck to a contractionary monetary policy to contain inflation caused by the recent hikes in food and energy prices in the international markets. The same was observed in many other developing countries.

Many of the developing countries also do not have the “policy space” to conduct counter-cyclical macroeconomic policies in response to shocks. This stems from two sources. First, the requirement to keep the budget in balance, or fiscal sustainability forces them to cut expenditure during downturns as revenue falls. Secondly, countries with an open capital account cannot pursue an autonomous monetary policy, control the exchange rate and maintain an open capital account. While all three are potentially feasible, only two are possible at any point in time.

Additionally, most developing countries do not have resources or “fiscal space” to undertake large scale counter-cyclical measures. As noted earlier, there has been a significant reduction in trade-related revenues following trade liberalisation in many developing countries. Various fiscal incentives and tax cuts aimed at luring private investment have also cut into their fiscal space.

In sum, declines in public investment and excessive growth volatility, which had adverse impacts on overall growth performance of many developing countries, especially in Latin America, Africa and transition economies of East Europe, were results of the Washington consensus inspired macroeconomic policy mixes and policy reforms. They have not only compressed both policy and fiscal space for conducting counter cyclical policy measures to smoothen output volatility, but in fact, contributed to excessive volatility, and hence retarded growth. The stability of nominal macroeconomic variables, such as inflation and fiscal balance, failed to generate much hoped for private sector investment.

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Impact on poverty and inequality

The disappointing growth performance that emerged obviously slowed poverty reduction. The conservative macroeconomic policies of the Washington consensus also have contributed to the rise in inequality, and hence further impaired poverty reduction efforts.

It is claimed that conservative monetary policies that aim at lower inflation is good for the poor. Since wage adjustments typically lag behind price rises, inflation tends to reduce the real wage. Since most of the poor are wage earners, the share of the poor in the national income declines vis-à-vis that of profit earners. If the poor have any savings, this is mostly held in cash. Inflation reduces the real value of these money holdings. If inflation is unanticipated, the poor will be harmed disproportionately when compared to other groups in the economy because they have weaker bargaining power and are generally unable to hedge against inflation.

However, one can present a number of counter arguments. First, if the real wage declines due to inflation, then employment should rise. Therefore, the employment effect of inflation can outweigh the real wage effect on poverty. This is likely to be the case, as the inflation elasticity (real wage) of poverty is found to be significantly less than the output (employment) elasticity of poverty. For example, one IMF study by Ghura, Leite and Tsanarides (2002), using pooled data from a cross section of 85 countries, found the inflation elasticity of the income of the poor to be 0.03 as opposed to the output (employment) elasticity of 0.94.

Furthermore, as explained above, the conservative macroeconomic policy framework increased the volatility of output and employment. Output variability has a negative impact on both poverty and inequality (see Romer and Romer, 1999 for cross-country evidence). Empirical studies find that the bottom two income quintiles suffer disproportionately from volatile swings in income (Laursen and Mahajan 2005; Breen and Garcia-Penalosa, 2005). This happens as poor unskilled workers are the first to lose their jobs and it takes much longer for the job market to recover than output. Poor workers do not have diversified sources of income, and are less mobile between sectors and areas. Reductions in public expenditure on health, education and other social programmes in order to maintain fiscal balance, especially during economic downturns, also disproportionately affect the poor. The inability of the poor to cope with negative shocks can result in a loss of human capital. Poor families are found to remove their children from school when family

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income suddenly falls. Income instability also impacts negatively on their nutritional status if they are forced to make cutbacks on their food expenditures.

The role of foreign aid

As is well known from the two-gap model,10 the theoretical rationale for foreign aid is to fill the savings-investment and/or foreign exchange gaps; developing countries have a deficient level of domestic savings to finance the level of investment necessary to achieve their desired rates of economic growth, and/or a lack of foreign exchange reserves to acquire imported capital goods. Bacha (1990) extended the two-gap model into a three-gap model, wherein the fiscal gap constrains private sector investment at a level below what available national savings would permit. According to the three-gap model, foreign aid can relax the financing constraint by supporting the budget. From the development or planning (ex ante) perspective, the government of a developing country can estimate the fiscal gap, and identify its foreign exchange needs to the donors, who can then fill the gap. In other words, foreign aid shifts the government budget constraint outwards and allows government to spend more to meet development needs without having to resort to inflationary financing.

However, donors and development practitioners have raised concerns about the fungibility of aid, in particular the use of aid to expand unproductive activities of the public sector. Development practitioners have also pointed out the possibility of lax revenue efforts by a government as a result of large foreign aid inflows. That is, essentially, foreign aid does not add to the budget; it merely substitutes for domestic revenue. Because of additional problems related to poor governance and the possibility of corruption, donors are now increasingly using aid conditionality to obligate governments to undertake tax reform and other public-sector reforms in order to overcome these problems. The effectiveness and welfare implications of such aid conditionality remain debatable.11

Trends in aid flows

The global economic slowdown of the early 1990s produced large fiscal deficits in donor countries leading to deep cuts in official development assistance (ODA), which fell from 0.30 per cent of their 10 See Chenery and Bruno (1962), Chenery and Strout (1966) and Thirlwall (1999).11 See McGillivray (2000) for a survey of issues surrounding aid fungibility and fiscal behaviour, and Easterly (2003) for a critical appraisal of the effectiveness of aid conditionality and aid selectivity.

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GNI in 1992 to 0.22 per cent in 1997. Prior to the current global financial and economic crisis, ODA flows to developing countries were falling measurably during 2006-2007. In 2008, aid flows from the Development Assistance Committee (DAC) of the OECD increased, reaching almost $120 billion, recovering to a share of 0.3 per cent of the combined GNI of donor countries. However, the continuation of the crisis (a double-dip recession) or a slow recovery will put downward pressure on aid flows. Many donors target annual aid flows as a share of GNI, leading the value of aid to fall with falls in national income, even if the share of ODA remains constant. Even though donor countries have repeatedly reiterated their ODA commitments, timely delivery of these commitments may still be disrupted if the present crisis is protracted.

An additional immediate concern is that official aid flows could become even more volatile. Already before the crisis, low-income countries, especially the least developed countries, have seen large fluctuations in annual aid flows of up to 2-3 per cent of GDP (Figure 3). For many low-income countries there are few alternatives to development assistance when faced with crisis-related declines in export and fiscal revenues; thus, uncertainty about the level of aid inflows complicates macroeconomic policies in response to the crisis.

Figure 3: Volatile aid flows (percentage of GDP)

Source:

OECD/DAC and UN/DESA data bases.As a consequence of the global economic slowdown, most developing countries will experience severe balance-of-payment problems. Based on the worst case scenario, the World Bank expects that 98 of 104 developing countries would fall short of covering their external

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0%

1%

2%

3%

4%

5%

6%

7%

8%

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Other

Sub-Saharan Africa

LDCs

financing needs, with an estimated external financing gap rising to an estimated $268 billion in 2009 alone, but which could well be as high as $700 billion against a scenario of further declines in private capital flows and increased capital flight. For low-income countries alone, the IMF estimates that the balance-of-payments shock could amount to $140 billion in 2009. Some 30 low-income countries are estimated to already face inadequate levels of reserves to cover a critical minimum of three months of imports. Based on the latest current account deficit projections of World Bank for 2010, along with schedules of private foreign debt coming due, the total external financing needs of developing countries are expected to be in the order of $1.1 trillion in 2010, compared with an estimated $1.2 trillion in 2009.12 After taking into consideration estimates of the expected amount of private sector financing, developing countries could still face a total financing gap of as much as $315 billion in 2010.

This huge gap has to be filled through foreign aid from multilateral and bilateral sources. If this is not forthcoming, the growth prospects for many poor countries will suffer with huge implications for poverty reduction and the achievement of the MDGs. Thus, there are calls for an acceleration of development assistance, especially in light of the fact that existing commitments have still not been met. However, the question is, if such an acceleration happens, would a large inflow of foreign aid jeopardise macroeconomic balance and cause real exchange rate appreciation to the ultimate detriment of the poor?

Aid flows and macroeconomic imbalance13

Theory

The first formal treatment of real exchange rate misalignment due to large foreign inflows that cause stagnating exports and deteriorating external balance (a Dutch disease like syndrome) is by van Wijnbergen (1986) who disaggregated the economy into tradable (T) and non-tradable (NT) sectors and examined the impact of foreign aid on the relative prices of the two (PT/PN).14

In the two-sector, traded-non-traded model, it is assumed that PN is determined by domestic demand and PT is determined in the world market (hence it is exogenous for a small open economy). When 12 World Bank (2010)13 This section draws on, Chowdhury, Anis (with Terry McKinley) (2006).14 The relative price (PT/PN) between the traded and non-traded sectors can also be regarded as the real exchange rate (if the nominal exchange rate is fixed). PT is a proxy for the world price (in local currency) while PN represents the domestic price level.

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foreign aid is spent domestically, according to van Wijnbergen, a large portion occurs in the NT sector since government services and infrastructures are largely non-tradable. This causes a rise in PN and hence a real exchange rate appreciation (PT/PN falls). As a result, resources shift from tradables to non-tradables, and the tradable-sector shrinks. To the extent that part of the spending induced by foreign aid is directed at the tradable-sector, the availability of exportables declines. Furthermore, the increased expenditure due to the multiplier effect of the initial government expenditure causes imports to rise. The net effect of a decline in exportables and a rise in imports is a deterioration of the external balance. This adverse effect is exacerbated if the export sector is characterised by “learning-by-doing” (LBD) externalities, and hence has higher productivity than the NT sector. It is assumed that the shrinking of the export sector leads to falling productivity in the whole economy.

In the words of van Wijnbergen (1986, p. 130), “This point may be worth stressing: substantial amounts of aid will put upward pressure on the real exchange rate and will in that way counteract the export promotion schemes often recommended by the aid donors.” (Emphasis original). In such a circumstance, according to van Wijnbergen, the export sector (especially if it is characterised by LBD infant industries) should be supported with increased production subsidies.

Yano and Nugent (1999) introduce an interesting twist to the Dutch disease debate. In their model of 2-factors and 3-goods (exports, imports and non-tradables) including an import tax (tariff), foreign aid inflows can paradoxically reduce the overall welfare of the recipient country. However, in contrast to the Dutch disease model, the immiserising effect of foreign aid occurs in the Yano-Nugent model because of a decline in the price of NT. While in the Dutch disease model, excess demand for NT goods causes PN to rise (implying sluggish or inelastic supply of NT), in the Yano-Nugent model, aid-funded projects cause an expansion of NT goods (infrastructure, education, health), and hence a supply-induced reduction in PN. This result, however, depends on the presence of import tariffs since they allow the expansion of the import-competing sector and the corresponding contraction of the export sector. Import barriers or tariffs make the import-competing sector essentially non-tradable. Thus, the Yano-Nugent model shows that if foreign aid finances excessive expansion of import-substituting activities (protected by tariffs), the real income of a small country might decline. Note that this result depends on an excessive expansion of the NT sector. No transfer paradox arises when the NT sector expands to keep the demand-supply balance at the existing price level.

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Choi (2004), in a theoretical model also involving two factors and three goods, shows that the possibility of a reduction in PN is remote. According to Choi (p. 250), “As long as the entire amount of foreign aid is not used for capital formation in the import-competing sector, or some development aid is used in the export sector, the transfer paradox cannot occur”. (Emphasis original). In their own empirical work, Yano and Nugent (1999) themselves do not find much evidence to support their theoretical arguments. Only in four countries out of 44 in their sample did they find some evidence of a transfer paradox.

In support of his argument against the Yano-Nugent transfer paradox, Choi cites the example of the Marshall Plan after World War II – one of the most historically successful aid programs. Between 1948 and 1952, 15 European countries received more than US$ 13 billion from the US under this plan (equivalent to US$ 100 billion in 2005). The majority of these countries were small, and the aid money went to rebuild both non-tradable and tradable sectors. Within the non-tradable sector, aid money went to both export and import competing activities. Interestingly, none of these countries is known to have suffered from a transfer paradox.

Limitations

The logic of the Dutch disease model is not compelling. First, the original Dutch disease model does not consider the possibility of using sterilising monetary policy in response to an excessive over-valuation of domestic currency. As noted earlier, the central bank can sterilise the monetary impact of foreign aid in a number of ways, such as selling its holdings of government bonds, raising the reserve requirements for commercial banks or transferring government deposits from commercial banks to the central bank. One could object by pointing to the supposedly limited scope for sterilisation because of the underdeveloped nature of capital markets in low-income countries. However, according to a recent study at the IMF (Prati et al, 2005), the practice of sterilisation is widespread among aid-receiving countries. Over the period 1960-1998, the study found 704 episodes – out of 1,935 episodes of foreign aid inflows that were greater than two per cent of GDP – during which net domestic monetary assets of the central bank fell. The study also reports on the more recent experiences of Ghana, Ethiopia, Mozambique, Tanzania and Uganda, which also have reduced net domestic monetary assets in response to surges in aid flows.

The central bank can also neutralise the impact of increased inflows of foreign aid by reducing the size of the money multiplier through 1)

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influencing reserves and/or 2) influencing private sector behaviour with regard to currency holdings and deposits. For example, by lowering the interest rate, the central bank could encourage commercial banks to keep excess reserves and individuals to hold more cash and fewer deposits. This outcome will simultaneously increase the reserve-deposit ratio and the currency-deposit ratio, which, in turn, will reduce the size of the money multiplier. The government can also influence the money multiplier by shifting its deposits from the central bank to commercial banks or vice-versa to influence.

Thus, the central bank and the government can minimise the harmful effects of increased aid flows on money supply, and hence on inflation and the real exchange rate. However, as will be explained later, a full sterilisation that leaves the real exchange rate unchanged is not desirable. The central banks of the aid recipient countries have to accept some real appreciation in order to carry out a transfer of real resources. Sterilisation policy should be pursued only when there are signs of excessive over-valuation of the domestic currency.

The government can choose to keep foreign aid in an overseas account—instead of depositing it in the central bank—in order to use it directly to finance imports. Under this arrangement, private importers buy foreign currencies from the government, which then settles the transactions on behalf of importers from its overseas account. If the private importers borrow from their banks to pay the government, the banks simply credit that to the government accounts that they hold. This leaves the banks’ balance sheets unchanged. Hence, there will be no impact on the domestic money supply.

Thus, this arrangement is similar to the direct transfer of resources via commodity aid, which can be absorbed without real appreciation. However, the government has to ensure that the aid money is used to import non-competitive imports. That is, aid financed imports must not substitute for goods and services that would otherwise have been imported or produced locally. This will ensure that real resources are transferred without real appreciation.

An added advantage of this arrangement is that the government can effectively follow a managed float exchange rate system in order to avoid excessive real appreciation of the domestic currency. That is, it can choose at what nominal exchange rate it wants to sell foreign currencies to private importers, keeping an eye on the movement of the real exchange rate.

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One of the glaring omissions of the Dutch disease model is a lack of recognition of the supply-side effect of increased foreign aid. It implicitly assumes that the supply in the NT sector is sluggish so that the price of NT is driven up in response to increased demand. The model also assumes, in effect, that the economy is characterised by full employment, which would require resources to be transferred from the tradable sector to the non-tradable sector. It is not possible in this model for both sectors to grow together. The model also ignores the productivity enhancing role of infrastructure, education and health (which are part of the NT sector). It also assumes that “learning-by-doing” (LBD) occurs only in the tradable sector.

These assumptions are at odds with the experience of most developing countries, where a vast army of underemployed and unemployed do not find jobs even when they are ready to work at a lower real wage (See Nkusu, 2004). A large number of empirical studies find a positive impact of public infrastructure, education and health on productivity growth.15 Furthermore, there is no reason why LBD or other kinds of externalities cannot occur in the non-tradable sector.

In addition to the impact of foreign aid on the supply of money, one needs to consider the impact on money demand. The inflationary impact of increased foreign aid flows depends on a growth rate of money supply that exceeds the growth rate of real GDP. As the economy grows, so does the demand for money needed to facilitate the increased transactions. As noted by Little et al (1993), the typical developing country has a rapidly growing demand for money, as the economy becomes more monetised and as households and firms increasingly hold assets in financial forms such as currency, demand deposits or time accounts. This means that the income elasticity of the demand for money is likely to be greater than unity in low-income countries. Therefore, if one allows for the growth enhancing effects of aid-financed public investment, then the economy can accommodate an increase in money supply without generating significant inflationary pressure.

Thus, the alleged impact on inflation and real appreciation of increased foreign aid, which would supposedly cause a Dutch disease, is not inevitable. It depends on how the monetary authority manages its assets and liabilities and uses interest rate policy, and on how the supply side responds to fiscal expansion. In an IMF working paper, Gupta et al (2005, p. 13), concluded:

15 See Adam and Bevan (2004); Calderon and Serven (2003); Gupta, et al (2004); Barro and Sala-I-Martin (1995); and Krueger and Lindahl (2004).

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“The macroeconomic impact of aid is likely to depend on how the aid is used. If aid is used to boost supply capacity, its macroeconomic consequences are likely to be mitigated… Once appropriate consideration is taken of the supply-side impact of aid flows, there is no clear presumption as to whether, over the medium term, there will be a real exchange rate appreciation or depreciation or whether the tradable sector will contract or expand. This is essentially an empirical issue, on which individual country circumstances are likely to differ”. (Emphasis original).

Evidence

Unfortunately, “… there are remarkably few empirical studies of Dutch disease in aid-receiving countries” (Prati et al, 2005, p. 32). Figures 4A and 4B present scatter plots of average net aid/GDP ratios vis-à-vis inflation and real exchange rates of 42 aid dependent countries for the period 1970-2003. The range of net aid dependence varies from 4 per cent to 49 per cent of GDP.16 To calculate the real exchange rate, we have used the nominal US$ exchange rate of domestic currency and taken the US Consumer Price Index as a proxy for

Figure 4A: Aid/GDP Ratios, Inflation and Real Exchange Rates(Average 1970-2003)

16 One can use alternative measures of aid dependence, such as aid/government revenue or aid/government expenditure. Net aid is a capital flow concept and is net of principal payments. However, a better indicator is net aid transfers (NAT), which is net of both principal and interest, and excludes debt cancellations. Recently the Center for Global Development has produced a data set of NAT. See http://www.cgdev.org/doc/data%20sets/roodman05/NAT.xls.

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0

20

40

60

80

0 10 20 30 40 50 60

Average aid/GDP ratios between 1970-2003

Infla

tion Inflation

Linear (Inflation)

-2000

-1000

0

10002000

3000

4000

5000

0 10 20 30 40 50 60

Average aid/GDP ratios between 1970-2003

Rea

l exc

hang

e ra

te

Real exchange rate

Linear (Real exchange rate)

Figure 4B: Aid/GDP Ratios, Inflation and Real Exchange Rates (Average 1970-2003)

without Outliers (inflation > 30%, Real exchange rate > 700)

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0

5

10

15

20

25

0 5 10 15 20 25

Average aid/GDP ratios between 1970-2003

Infla

tion Inflation

Linear (Inflation)

0

200

400

600

800

0 5 10 15 20 25

Average aid/GDP ratios between 1970-2003

Rea

l exc

hang

e ra

te

Real exchange rate

Linear (Real exchange rate)

Source: IFS/IMF and IDS/OECD online database

foreign prices. Thus, the real exchange rate is defined as RER= eUS CPI/Domestic CPI, where e is the local currency value of one US dollar, so that a rise in the real exchange rate indicates a real depreciation of the domestic currency.

Contrary to the Dutch disease hypothesis, the relationship between inflation and net aid is clearly negative, even without outliers (i.e., inflation rates >30% and net aid/GDP > 30%). Although the relationship between net aid and real exchange rates is negative, implying that a rise in net aid inflows leads to real appreciation, when outliers (real exchange rates > 700 and net aid/GDP > 30%) are omitted, it becomes mildly positive. That is, in the absence of exceptionally high inflows of net aid, the real exchange rate is likely to depreciate. In sum, the cross-country evidence on the Dutch disease is mixed, at best, with any evidence in its favour heavily influenced by outliers.

Table 3 presents correlation coefficients of net aid/GDP ratios with inflation rates and real exchange rates for 13 African countries, including nine countries that recently experienced a surge in HIV/AIDS related aid inflows. In eight countries, the association between net aid inflows and real exchange rates is positive, implying a

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real depreciation. In the remaining five countries there is weak evidence of real appreciation. The correlation between net aid inflows and inflation rates is in most cases found to be positive (in contrast to the results for the larger sample just mentioned). Hence, because of the mixed evidence, it is not possible to say a priori whether a rise in net aid inflows would lead to real appreciation or higher inflation. As will be shown later, the macroeconomic impact of aid inflows depends on the way the government and the central bank respond with public investment, credit allocation and reserve management policies.

Table 3: Correlation Coefficients of Net Aid/GDP ratio with Inflationand Real Exchange Rates in Highly Aid Dependent African Countries

Countries Real Exchange Rate

Inflation

Ghana (1970-1997) 0.79 -0.32Chad (1983-2002) -0.48 -0.07Burundi (1970-2003)

0.76 0.13

Rwanda (1970-2003)

0.13 -0.01

Uganda (1980-2003) 0.69 -0.51Ethiopia (1970-2002)

0.36 -0.13

Kenya (1970-2003) 0.45 0.68Lesotho (1973-2003)

-0.30 0.28

Malawi (1980-2003) 0.42 0.39Mozambique (1986-2003)

-0.09 0.66

Swaziland (1970-2003)

-0.48 0.55

Tanzania (1970-2003)

0.72 0.45

Zambia (1970-2003) -0.08 -0.05

Sources: IDS (OECD) and IFS (IMF) online data basesNotes: The real exchange rate is estimated as (Nominal exchange rate * US CPI)/Domestic prices). The US CPI is a proxy for foreign prices in each country. The nominal exchange rate is expressed as the price of one US$ in domestic currency. So, a rise in the real exchange rate means a real depreciation.

Our evidence cited above is roughly in line with the observation of Lewis (2005, p. 9), “the available evidence on the macroeconomic effects of large aid flows is somewhat ambiguous. The evidence base

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is modest, and country circumstances appear to play a major role in determining the impacts.”

The recent IMF survey of empirical findings on Dutch disease in Africa, by Gupta et al (2005), concurs. Following are their findings:

“… this evidence is not overwhelmingly significant. Econometric estimates often show the impact of aid on the exchange rate to be small and statistically insignificant. … Time series models tend to reveal that the real exchange rate responds less to aid variations than to other exogenous factors, such as terms of trade variations. Moreover, some studies of African countries find that aid inflows appear to be associated with a real depreciation, reflecting increased productivity (supply-side response) as a result of aid” (p. 14).

“To the extent that higher aid flows alleviate supply bottlenecks, they can offset the effect of an exchange rate appreciation on export growth” (p. 15, emphasis original).

“When aid flows build up public infrastructure and thus augment the productivity of private factors, it is possible to realize significant medium-term welfare gains from aid, even in the presence of some short-term Dutch disease” (p. 16, emphasis original).

In sum, the theoretical literature on Dutch disease ignores the important condition that foreign aid is channelled mainly through the government of the recipient country, in support of its budgetary position. In many developing countries, investment needs are high, but private savings are low. Hence, governments are forced to run deficits because their revenue base is narrow and their tax administration weak. However, low private savings limit governments’ ability to borrow domestically. At the same time, developing countries cannot borrow internationally at reasonable interest rates due to their poor credit ratings.

Thus, foreign aid remains the only source of deficit financing available to maintain public investment high enough to generate the economic growth necessary for poverty reduction. For example, during Indonesia’s early phase of transformation aid inflows financed 80-90 per cent of development expenditures. In the absence of foreign aid, the governments of developing countries would have no other option but to borrow from their central banks (namely, print money) to finance their investment needs.17 In other words, foreign aid allows 17 A typical developing country finances approximately 50 per cent of budget deficits through the banking system (Little et al., 1993). Easterly and Schmidt-Hebbel (1993: 221) estimated a seigniorage effect of about two per cent of GNP for a

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the recipient government to pursue an expansionary fiscal policy without causing significant inflationary pressures through monetary expansion.

Even when developing countries are able to raise domestic savings, they can find themselves in a quandary, wherein they cannot use the savings for investment due to shortages of critical imports because of a lack of foreign exchange. As a result, they suffer from Keynesian type unemployment (or underemployment) despite the fact that real wages in most cases are very low, and often are below the poverty line. The unemployment/underemployment problems in these countries cannot be attributed to the downward inflexibility of real wages. Further cuts in real wages would simply swell the pool of working poor. In such circumstances, foreign aid facilitates imports that support the increased investment needed to create productive employment.

Concluding remarks

The achievement of the Millennium Development Goals, in particular the target to reduce by half the proportion of persons living on less than $1 a day, has become a catch phrase to focus the attention of the global community on the need to ensure sustained economic and social progress in all developing countries. In this paper, we have tried to demonstrate the importance of macroeconomic policies for both growth and stabilisation, as well as for managing large aid flows, in the pursuit of the MDGs. The underlying macroeconomic framework that has been proposed to developing countries in working towards fulfilling the MDGs by 2015 is “sound” macroeconomic management which is generally understood to mean a combination of very low inflation (around 3 per cent), balanced or surplus budget, flexible exchange rate and open capital account. We find that there is an apparent incongruence between so-called “sound” macroeconomic policy framework and poverty reduction efforts. We have tried to argue that restrictive macroeconomic policy-mixes advocated by the international financial institutions and the donor community have largely failed in most cases to generate sufficiently high growth to have significant impacts on poverty reduction.

sample of 35 developing countries, as opposed to one per cent for a sample of 15 developed countries. Thus, in developing countries, monetary policy can serve as an instrument for fiscal authorities. Taylor (1979, p. 27) puts it succinctly: “The Bank has to ‘print’ money by absorbing government obligations if the Finance Minister orders it to do so ...” For more details on the link between budget deficits and money supply in developing countries, see Hossain and Chowdhury (1996).

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Most rich countries have failed to keep their promise of delivering aid amounting to 0.7 per cent of their GNI, while the volatility and unpredictably of these flows have had adverse impacts on the budgetary situation of many poor countries. We find that the argument that accelerating aid flows would exert upward pressure on the real exchange rate of aid recipients and, thus, adversely affecting their competitiveness, not particularly convincing since these countries can take countervailing macroeconomic measures to avoid any adverse real exchange rate impacts.

In essence, we believe that international support to achieve the MDGs should not be conditional upon developing countries following policies deemed “sound” by international financial institutions and the donor community.

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