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.