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The Macroeconomics of managing increased aid inflows:
Experiences of low-income countries and policy implications

Andrew Berg, Mumtaz Hussain, Shekhar Aiyar, Shaun Roache, Tokhir Mirzoev and Amber Mahone

International Monetary Fund (IMF)

June 2006

SARPN acknowledges the World Institute for Development Economic Research as the source of this document.
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Executive Summary

This paper investigates the macroeconomic challenges for low-income countries created by a surge in aid inflows. It develops an analytical framework for examining possible policy responses to increased aid, and then applies this framework to the experience of five relatively well-governed countries that experienced a recent surge in aid inflows: Ethiopia, Ghana, Mozambique, Tanzania, and Uganda. Each country’s policies were supported by a PRGF arrangement during most of the period under review.

Central to managing a surge in aid inflows is the coordination of fiscal policy with exchange rate and monetary policy. To highlight this interaction, the analytical framework focuses on two distinct but related concepts: absorption and spending.

  • Absorption is defined as the widening of the current account deficit (excluding aid) due to incremental aid. It measures the extent to which aid engenders a real resource transfer through higher imports or through a reduction in the domestic resources devoted to producing exports.

  • Spending is defined as the widening of the fiscal deficit (excluding aid) accompanying an increment in aid.
Spending depends on fiscal policy. For a given fiscal policy, absorption depends on exchange rate policy and monetary policy. If the government receives aid-in-kind, or uses aid directly to finance imports, spending and absorption are equivalent. More typically, the government sells aid dollars to the central bank, and uses the local counterpart currency to finance spending on domestic goods. Absorption depends on the response of the central bank, with foreign exchange sales influencing the exchange rate and interest rate policy shaping aggregate demand, including for imports. The combination of absorption and spending chosen by an economy defines the macroeconomic response to aid.

To absorb and spend is the textbook response to aid; the government increases investment, and aid finances the resulting rise in net imports. Even if the government spending is on domestic goods, the aid allows the resulting higher aggregate demand and spending to spill over into net imports without creating a balance of payments problem. Some real exchange rate appreciation may be necessary to enable this reallocation of resources.

  • In the sample countries, however, a full absorb-and-spend response was found to be surprisingly rare. Typically, there was a reluctance to embrace absorption—and the consequent real appreciation—due, at least in part, to concerns about competitiveness.
Other responses to incremental aid may be justified under some circumstances and for a limited period of time.

To save incremental aid, that is to neither absorb nor spend, may be a good way of building up international reserves from a precariously low level or of smoothing volatile aid flows.

  • In two of the sample countries—Ethiopia and Ghana—absorption and spending were both very low. In Ethiopia, reserves were accumulated to bolster the exchange rate peg against the dollar. In Ghana, a buffer against extremely volatile aid inflows was built.
To absorb but not spend substitutes aid for domestic financing of the government deficit. Where the initial level of domestically financed deficit spending is too high, this can help stabilize the economy. Alternatively, this approach to aid can also be used to reduce the level of public debt outstanding, crowding in the private sector. When debt reaches low levels, however, there are typically limits to the extent to which the financial system can effectively channel additional resources to the private sector. Further attempts to absorb without spending may amount to “pushing on a string,” increasing excess liquidity or even causing capital outflows rather than increased domestic activity.

To spend and not absorb is a common but problematic response, often reflecting inadequate coordination of monetary and fiscal policies. This response is similar to a fiscal stimulus in the absence of aid. The aid goes to reserves, so the increase in government spending must be financed by printing money or government borrowing from the domestic private sector. There is no real resource transfer given the absence of an increase in net imports.

  • In Mozambique, Tanzania, and Uganda spending exceeded absorption, creating a surge in domestic liquidity. In Mozambique, this led to high inflation. In Uganda and (initially) Tanzania, treasury bill sales were used to contain inflationary pressure, leading to a rise in interest rates and the domestic debt burden.
Spending and not absorbing can lead, over time, to a spend-and-absorb outcome, if monetary and exchange rate policies are supportive. The fiscal stimulus potentially increases import demand and hence admits the possibility of greater absorption in a later period. This delayed absorption could then be financed by the accumulated aid. In order for this mechanism to operate, however, some real appreciation may be necessary, including through inflation if the exchange rate is pegged. Curtailing liquidity through treasury bill sterilization could lead to the least desirable result: no absorption of aid, coupled with a crowding out of private sector.

The experience in these cases sheds little direct light on the medium-term implications of absorbing and spending aid, mostly because this strategy was not consistently pursued in the sample. There is no evidence of aid-related Dutch disease in the sample countries, with the real effective exchange rate remaining stable or depreciating. This is due in large part to the policy decision to accumulate reserves rather than fully absorbing aid—a policy typically inspired by concerns about competitiveness and the level of the nominal exchange rate.

In general, targets in PRGF-supported programs appear to be compatible with an absorb-and-spend response, but the consistency of monetary and exchange rate policy with fiscal policy needs greater attention in cases where the authorities deviate from this approach. Fiscal targets accommodate surges in aid, and reserve targets are consistent with an (aid-financed) increase in the current account deficit. However, where countries are unwilling to follow this strategy—perhaps in order to guard competitiveness—more care needs to be taken that an appropriate second-best outcome is achieved. In particular, when recommending treasury bill sterilization to reduce aid-related money growth, concerns about inflation must be balanced against the dangers of failing to absorb the aid and of crowding out the private sector.

The key long-run strategic choice is whether to use the aid—by absorbing and spending—or not, in which case the aid should be neither absorbed nor spent. The latter choice, in the long run, is equivalent to forgoing aid, unlike the short run, where it can be used to smooth aid volatility. Thus, it is only appropriate when competitiveness concerns dominate the returns from productive aid-financed investment. In this case, attention should be focused on how, and how fast, to scale up aid so as to minimize competitiveness problems, for example by focusing on ways to use aid to increase productivity.

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