A quarterly magazine of the IMF

September 2005, Volume 42, Number 3

Scaling up aid flows is just the start of a complex set of decisions and tough choices

Aid is back on the global agenda. An unlikely alliance of rock stars, politicians, and grassroots activists has put the issue of combating poverty at the forefront of global policymaking. Rich countries seem increasingly energized to confront persistent poverty in much of the developing world with plans to boost aid, cancel debts of poor countries, and increase trade access for goods from developing nations. This has sparked fresh hope that the enormous and inexcusable gaps in living standards between rich and poor countries can be narrowed, brightening the prospects for millions in the process.

Should this promised scaling up materialize, donor and recipient countries will still need to ensure that the aid actually achieves results, given the spotty record so far. It is critical, therefore, that any large increase in aid be accompanied by considered efforts to ensure that lessons of the past are learned and that new challenges are anticipated. Development partners must focus on six principal challenges:

• ensuring that larger aid flows promote growth and reduce poverty;
  
  
• increasing substantially the delivery of government services and investments in infrastructure, and managing spending decisions when a large proportion of financing (aid) is outside the government’s control and uncertain in duration;
  
  
• dealing with the possibility that higher aid flows might cause an appreciation of an aid recipient’s currency, or domestic inflation, with adverse effects on the country’s international competitiveness;
  
  
• handling the increased complexity of managing monetary, fiscal, and exchange rate policies when higher aid is subject to uncertainty in terms of its magnitude, timing, and likely economic effects;
  
  
• recognizing that substantial aid in the form of even concessional loans could result in debt problems in the future; and
  
  
• managing the potentially adverse effects of growing aid dependency.

This article explores why increased aid flows will require economic policymakers to confront these issues and outlines the roles to be played by development partners—donors, recipient countries, and the international financial institutions (IFIs)—if these challenges are to be successfully met. The central message is that the mobilization of additional aid resources is only one (albeit essential) step in the journey to achieve the Millennium Development Goals (MDGs).

Achieving results

Ensuring that increased aid promotes growth and reduces poverty is certainly the most important task. After all, empirical studies offer only mild (and not uncontested) support for aid boosting growth. Encouragingly, a recent Center for Global Development (CGD) study (Clemens, 2004) suggests such a positive relationship. It says that once one excludes those aid flows aimed at political and humanitarian goals, a positive net effect is observed for the remaining aid focused on economic objectives (see "Aid and Growth" on page 16 of this issue). But recent IMF work by Raghuram Rajan and Arvind Subramanian (2005) finds no robust evidence of such an effect—positive or negative—of aid on growth, with their conclusion holding across time horizons, time periods, types of aid, types of donors, and characteristics of recipient countries. They suggest that this may be due to aid flows giving rise to real appreciation of the aid recipient’s currency—a "Dutch disease" effect—thereby undercutting its competitiveness in the traded goods sector and weakening growth.

The CGD study, as with most studies of aid and growth, finds diminishing returns to aid. The maximum growth rate occurs where the subset of aid aimed directly at growth reaches 8 percent of GDP. Since this subset is about half of aid, this is roughly equivalent to where total aid reaches about 17 percent of GDP (see World Bank and IMF, 2005). Similarly, recent World Bank analyses of the economic effect of higher aid flows in Ethiopia are highly sensitive to the pace at which aid is assumed to be scaled up. These results may reflect absorptive capacity constraints that may impede a rapid scaling up of government service delivery in response to higher aid flows. Considering that aid to a number of African countries is already above 10 percent of GDP, these results underscore the need for development partners to intensify their efforts at appraising the productivity of alternative uses of aid.

But it is also important not to overemphasize the mistakes of past aid efforts, given the complicated issues that have to be considered in the aid-growth relationship. Even Rajan and Subramanian emphasize that their results principally suggest the need for future aid to be designed better, with attention paid to experimentation with alternative approaches in connection with any scaling up. Some economists, notably Jeffrey Sachs, have argued that only a comprehensive but well-focused aid push will enable poor countries to overcome the multiple bottlenecks ensnaring them in a vicious cycle of poverty. And some aid—such as spending on those affected by HIV/AIDS, tuberculosis, and malaria; investments in education and health care for children; the provision of targeted social safety net transfers to the poor; or investments in infrastructure—would not be expected to benefit growth in the short term. Only over time will such outlays enhance a country’s capacity for sustained higher productivity and growth.

Managing and delivering services

While increased aid flows may facilitate a substantial expansion in vital public services and increased investment, they may create significant challenges for those sectoral ministries charged with managing the scaling up and delivery of these services. Greater reliance on aid—particularly given donor sectoral priorities—can also expose a country’s budget to significant volatility and unpredictability, a concern highlighted by African finance ministers at a recent IMF-sponsored aid conference in Maputo, Mozambique (see references). Aid comes from many sources—UN agencies and other multilateral institutions, bilateral donors, vertical funding initiatives, and many nongovernmental organizations (NGOs). Each source is subject to uncertainties relating to the size of potential aid flows; the duration of such commitments; the performance results to which funding is linked; whether aid is for projects or policy programs (and for the latter, whether it is sectoral or general budget support); whether aid is tied; whether committed aid will actually be disbursed; and the timing of disbursements. A number of issues arise in managing a government budget so heavily dependent on external assistance.

Aggregate budget sustainability. The prospect of a significant increase in aid will force recipient governments to consider how to weigh these "aid uncertainties" in deciding how much to expand service delivery. Budgets need to be considered in a medium- to long-term context, with a number of questions needing to be addressed. Should programs be scaled up on the assumption that higher aid flows will be sustained, even when few donors can commit themselves to providing aid beyond a few years? Will expenditure on aid-funded services give rise to additional demands for spending on services or goods for which donor funding is not available? If so, how would this spending be financed, given budget constraints? How should governments address the possibility of shortfalls in future donor assistance and how dependent should their budgets be on external sources? Most governments lack the capacity for any significant substitution of domestic tax resources (or cuts in nonpriority spending) in the event of such shortfalls, and there are inevitably macroeconomic limits on the potential for domestic bank borrowing.

Sectoral sustainability. Much of the additional aid will not come in the form of general budget support (that is, available to the government for spending for any purpose). In addition to specific projects, most donors still earmark program aid for sectoral (if not subsectoral) spending. While the ministry of finance has to judge the aggregate sustainability of a budget financed by uncertain higher aid flows, each ministry must consider the sustainability of aid flows dedicated to its specific sector. The impact of higher flows to certain sectors may be substantial. In health or education, increased aid may facilitate a doubling or more of a government’s spending. In fiscal year 2005, aid for HIV/AIDS spending could potentially increase public health spending by 40–50 percent in Ethiopia, Guyana, Kenya, and Zambia, and even more in Rwanda. Ministries must also decide how to expand service delivery. Should more civil servants be hired? Or should ministries rely on short-term employment contracts or greater outsourcing to minimize the budgetary risks from a potential shortfall in aid?

Public financial management. The effectiveness of aid in improving productivity, incomes, and welfare will depend on how governments manage their resources. A recent World Bank–IMF study (2005) highlighted the weaknesses of public financial management systems in formulating budgets, classification systems, commitment controls, cash management, budget reporting, audit, and regulatory capacity (for semi-autonomous agencies and extrabudgetary funds). Ironically, higher aid flows may exacerbate these weaknesses, intensifying the need to strengthen the capacity of budget managers—independent of whether services are to be directly provided by the government or contracted out to the private sector. Budget managers will need to formulate and execute budgets with a keen eye on the durability of funding commitments and be able to manage gaps between commitments and disbursements.

Organizational challenges. Organizations that function effectively on one scale may be much less successful when expanded to a substantially larger scale. There is no reason to assume that government ministries, which may already be constrained by inflexible civil service rules and cumbersome government budgetary procedures, will be more adept at making the transition to a higher level of service delivery. The sharp increase in aid flows may present comparable challenges for these agencies.

Budgetary exit strategy. It may appear excessively cautious to raise the longer-term question of what the strategy should be for weaning sectors, and the government more generally, from aid. But if donors do substantially boost aid levels, then recipients must at least weigh alternative scenarios as to how, ultimately, to phase down dependency and shift to domestic financing sources. With the pressures that aging populations will place on the public finances of donor nations, the time frame for generous aid flows may be limited.

Hanging on to competitiveness

One of the toughest issues for governments facing an increase in aid flows is a possible Dutch disease effect. Inflows of foreign currency should boost demand—both for tradables (items that are readily exported or imported, such as cars) and nontradables (items that are not readily exported or imported, such as housing), and also possibly for money itself. Greater demand for tradables could be satisfied by more imports. But higher demand for nontradables could encounter production bottlenecks and pressures for higher wages that would result in a rise in their price relative to tradables, thus pushing up the real exchange rate. And policymakers worry that a higher real exchange rate for the currency will hurt the international competitiveness of a country’s tradable goods industries, weakening the potential gains from international trade and the country’s capacity to attract investment and grow itself out of poverty and aid dependency.

If an appreciation of the currency is likely, three questions arise. Does aid induce higher productivity in the nontradable goods sector so as to more than offset the effect of a currency appreciation? Can the impact on the real exchange rate be moderated by specific policy actions, both macroeconomic and microeconomic, to lessen any adverse effects and maximize the gains of a heavier reliance on aid flows? (See box.) And even if, despite government actions, there are some adverse effects, can aid be used so that its net effect is still positive, on both growth and poverty reduction?

It may indeed be sensible for a low-income country to take advantage of resource transfers and accept some loss in competitiveness. If the external assistance promotes the achievement of the MDGs and confronts key infrastructural and human resource bottlenecks, it may not only raise current welfare levels but also create a future economic environment that has the potential to increase productivity and competitiveness. This strategy may imply accepting, for several years, the vulnerability that comes from being dependent on a large amount of aid. Indeed, aid may be ineffective if a country tries to hold on to competitiveness for too long.

But there still remains the downside risk that the envisaged continuity of aid flows may not be sustained. In the meantime, the competitiveness of the tradable goods sector might have been weakened, increasing a country’s vulnerability to aid shocks. Without clear guarantees, there may thus be a case for limiting the scale of aid dependency, but the optimal level will be shaped by how successfully a country can confront and resolve the policy issues. And if Dutch disease is a factor, governments need to consider what real exchange rate path is desirable over the long term (associated with both a scaling up and scaling down of aid).

The answers to these questions will inevitably be country specific and related to both the existing structure of production in an economy and how aid is likely to be used. Since most low-income countries are only now beginning to see a significant increase in aid, the potential challenge of Dutch disease is still in the future. But this means that attention is needed now, in anticipation of higher aid levels, for investments that will tackle potential bottlenecks to expanded productivity in the nontraded goods sector—in effect "keeping ahead" of the factors that can create pressures for a real appreciation of the currency.

Managing macroeconomic policies

Macroeconomic policymakers—those responsible for monetary, fiscal, and exchange rate policies—already confront substantial uncertainties as they seek to achieve key targets of growth, inflation, and the real exchange rate. Volatility in remittance flows, in the terms of trade, in capital transfers, and in foreign direct investment add to the normal uncertainties associated with the underlying demand for money and foreign exchange in the economy and those arising from some dependence on aid—with the prospect of higher aid flows creating even more uncertainties.

Because of the potential effects of aid flows on the money supply and the foreign exchange market, central banks have more work to do to maintain the appropriate monetary policy stance, including by using open-market operations, reserve requirements, and foreign exchange reserve management. For example, some low-income countries have sought to intervene in the foreign exchange market to limit or nullify the effects of aid on the nominal exchange rate and at the same time sterilize the potential monetary effect of the intervention. Typically, one observes central banks buying excess foreign currency to prevent a domestic currency appreciation, then selling central bank or government bonds to absorb the excess liquidity arising from such purchases. Usually, such bond sales have the effect of raising interest rates in the domestic financial market. Consequent effects include the crowding out of private sector borrowers, higher domestic debt service costs to the government, and quasi-fiscal losses to the central bank (as it holds low interest rate–earning foreign currency assets rather than higher-return government bonds). Hence, the pace at which aid can be received must take into account considerations of the monetary effects of the aid and their consequences for other players in the economy.

Fiscal policy also becomes more challenging. Governments may face intense pressures to cover aid shortfalls out of domestic resources, which may prove possible only by drawing on government deposits or central bank credit. Thus, when aid commitments are of a limited duration, governments need to ensure that programs are sufficiently flexible in their design so that they are not vulnerable to aid volatility or disbursement shortfalls.

More coordination of monetary and exchange rate policy with fiscal policy will also be required in the management of aid inflows. Too often, fiscal policy is driven by a desire to spend aid while monetary and exchange rate policies are driven by concern about the real exchange rate. The effect is that aid resources are used to increase reserves while an aid-related fiscal expansion ends up being financed domestically. The result is that the beneficial effects of aid are undercut by higher inflation and/or higher domestic interest rates.

Living with dependency

Increased aid will accentuate sharply the dependency of aid recipients. Consider a country that mobilizes 15 percent of its GDP in domestic revenues and receives aid of 20–25 percent of GDP. In this case, almost two-thirds of budgetary outlays are dependent on external sources. This may not be that unusual. A recent World Bank scenario for doubling aid in Ethiopia suggests that its fiscal position by 2015 would mirror exactly this level of dependency (for more on Ethiopia, see "Ethiopia: Scaling Up" on page 32 of this issue).

Becoming dependent on aid can create broader problems. A recent CGD study by Maureen Lewis on HIV/AIDS programs notes obvious dependency issues, including a reduced incentive for aid recipients to mobilize domestic resources; the potential for economic agents—whether in the government or the NGO sector—to tailor their priorities to the perceived interests of donors; a reduced pressure for governments to address inefficiencies in how public services are delivered; resistance by governments to a greater private sector role in delivering services; and the potential for increased corruption and rent seeking. Finally, countries relying heavily on aid inflows give up significant autonomy in decision making on budget priorities.

How can global partners respond?

There is no reason to believe that development partners, working together, cannot use additional aid resources effectively. But each party will have to step up to the challenge.

Aid-recipient countries. Inevitably, the principal burden of coping with increased aid flows falls on the aid-recipient countries themselves, who must "own" and take charge of their development strategy and manage well the resources arising from their own efforts and scaled-up aid receipts. The starting point is the Poverty Reduction Strategy Paper (PRSP). Most PRSPs have had a medium-term focus, with a tendency to tailor strategy to the amount of aid resources that can prudently be projected to be available. But with the prospect of more aid, it becomes important to consider longer-term strategic issues, such as how to boost service delivery and operate and maintain a larger stock of infrastructural investments in a sustainable way that can ultimately be financed from domestic resources rather than aid. Policymakers should also weigh which macroeconomic policies will ensure the ultimate capacity of a country’s producers to compete in a globalized market economy.

The sequencing of reforms becomes critical. Certain initial human capital and infrastructural bottlenecks must be tackled if adverse effects from scaling up are to be minimized. Already noted are the challenges of managing macroeconomic policy and sectoral programs. These call for greater clarity on what constitutes a sustainable overall fiscal position and sustainable budget policy in different sectors. Aid-recipient countries should also seek to minimize risk through innovations in the way in which goods and services are produced or delivered by the government. Addressing dependency concerns will require improved governance, with policies that create counterweights to predictable political economy pressures as well as the possibilities of corruption. Independent project evaluation or sectoral review boards can raise red flags about questionable policy approaches. Government audit functions can be strengthened and greater transparency can facilitate scrutiny of government outlays by civil society organizations. Some consideration may also be required as to when the use of aid may need to be deferred, either through the accumulation of prudential reserves or by seeking greater smoothing through donor-managed trust funds that can facilitate a more gradual phasing of disbursements.

Donors. For donors, gathering more resources is just the beginning. They already recognize the need for harmonization of aid processes and greater alignment of donor priorities with those of aid recipients within the PRSP framework. Here, achievement of such reforms is vital! But to help recipients use aid resources effectively, a number of other actions are required that will be challenging, given the record of aid reform efforts. These include:

• sufficient predictability in aid flows—not only between commitments and disbursements but in terms of ensuring the long-term nature of the committed aid;
  
  
• a much higher share of aid in the form of grants or highly concessional loans;
  
  
• a larger share of aid in the form of untied budget support, at least at the sectoral level;
  
  
• the minimization of aid volatility by moving away from an all-or-nothing approach to giving aid—performance-based funding criteria should be focused on correcting for weaknesses in aid use; and
  
  
• more focus on technical assistance and capacity building to strengthen policy implementation, particularly in public financial and macroeconomic policy management.

A number of donors and academics are weighing how to facilitate greater predictability in funding. The United Kingdom’s proposed International Finance Facility represents one effort to formulate a longer-term instrument that might form a basis for financing over the next decade, as do initiatives for global tax instruments. Similarly, the World Bank, the European Union, and the United States are all exploring how to increase the predictability of funding while ensuring good performance in the use of aid (see "Coping with Aid Volatility" on page 24 of this issue).

Donors should consider allocating some assistance to global public goods and introducing policies that would benefit low-income countries outside normal aid channels (for example, reducing trade barriers). Research and development can facilitate the provision of technologies that enhance the productivity of low-income country producers and reduce the cost of many essential goods and services.

International financial institutions. The recent Group of Eight debt relief initiative will undoubtedly give rise to renewed debate on the role of IFIs in channeling additional financial resources to low-income countries: the balancing of grants versus loans from the World Bank and regional development banks, and the nature of the IMF’s financial support. But what is clear is that the IFIs will be needed more than ever for providing policy advice to help aid recipients cope with intensified challenges. The World Bank and other development agencies can advise on the overall development strategy and on desirable sectoral policy frameworks. The IMF can help countries formulate and manage a long-run external policy framework, calibrate fiscal and monetary policies, and determine an appropriate foreign exchange reserve strategy. It can also help governments ensure the consistency and sustainability of their fiscal policy and budgetary spending frameworks, particularly when aid is heavily relied upon to finance recurrent expenditure programs.

A lot to do

All development partners have much to do if they are to realize the potential afforded by higher aid resources and help low-income countries achieve self-sustaining rapid growth. More aid is thus a challenge and an opportunity. By anticipating the challenges of a scaled-up aid environment, development partners can help ensure that the ultimate outcome is successful. Most important is that donors support the work of aid recipients by significantly increasing the predictability and duration of long-term aid commitments; for donors to work with recipient countries in carefully strategizing and sequencing the use of aid; and for recipient countries to strengthen macroeconomic and budgetary management.