External grants are important for low-income countries, particularly in their efforts to reach the Millennium Development Goals (MDGs) and combat the HIV/AIDS pandemic. Some critics contend that IMF-supported programs discourage higher grant flows intended to support poverty-reducing spending. In fact, the IMF strongly supports higher external grants, and works with its member countries to ensure that they are used to best advantage.

Why are external grants important for low-income countries?

Low-income countries will require an estimated $30-70 billion per year in additional government spending to reduce poverty and achieve the Millennium Development Goals (MDGs).¹ This increased spending must be financed through some combination of higher domestic revenues, external assistance and government borrowing.

Higher levels of external grants and their more effective use are important elements of the Monterrey Consensus to fight poverty and reach the MDGs in low-income countries. Especially for countries that are at risk of debt distress from further borrowing—even on concessional terms—increased grant financing enables higher poverty-related spending without incurring additional debt. The IMF is a strong advocate for increased external grants to these countries—including from the Global Fund to Fight AIDS, Tuberculosis and Malaria and the Education For All Initiative. The key is to ensure that this increased funding is well used.

Challenges in absorbing additional grant inflows

To make the best use of additional grants, countries need to confront a number of economic challenges. These include ensuring effective administration and absorption, maintaining macroeconomic stability, and formulating budgets under uncertainty.

First, a recipient government must develop the ability—or "capacity"—to effectively use additional grants. In many low-income countries, public administrative capacity is low. Institutions for delivering services may be inadequate, as may systems for planning and monitoring. It may also be difficult for countries to expand spending rapidly in some areas if there is a limited supply of skilled labor. For example, a lack of trained teachers could impede rapid expansion of the school system. Or, an expansion of HIV/AIDS treatment and prevention programs could draw away the limited number of qualified health professionals providing other health services. Moreover, some countries suffer from poor governance. Lack of transparency in government operations, lax spending controls, and weak legal frameworks can all contribute to an environment where resources—including external grants—are diverted or misused.

Second, government spending plans must be formulated in light of the potential volatility and unpredictability of grants. Disbursements of grants depend on a host of factors, including political developments and progress in meeting conditions set by donors. But volatile grant flows can increase fiscal uncertainty and make long-term planning difficult. For example, if the duration of grant financing is uncertain, a government faces great risks in hiring new staff on a permanent basis. Grant-financed spending may also give rise to future expenditure commitments that need to be met even after grants are no longer available. For example, grants that finance the building of new roads or improvements to port facilities may not include funds for maintenance after the projects are completed.

Third, a country must be capable of absorbing additional aid flows in a way that does not undermine macroeconomic stability, which is critical for long-run growth. Grant inflows could lead to higher inflation and real exchange rate appreciation, both of which could be detrimental to growth and efforts to reduce poverty. For example, consider external assistance that is used to finance higher spending on domestically produced goods and services (such as the construction of roads or schools), rather than higher imports. This increased domestic demand, especially in combination with labor force or other supply constraints, would likely put upward pressure on domestic prices, at least in the short-run. Higher domestic inflation, in turn, typically leads to an appreciation of the real exchange rate, thereby reducing the competitiveness of a country's exports. The poor are often hardest hit by these changes, especially if they are producers of exports (as is often the case in agricultural economies).

How the IMF supports the effective use of grants

The IMF is working on several fronts to help its low-income member countries meet these challenges and incorporate increases in government spending in a way that minimizes the risks. These efforts include collaboration with the World Bank and other partners on structural issues, advice and assistance on implementing supporting macroeconomic reforms, and increased flexibility of Fund-supported programs. In particular:

The IMF works in collaboration with the World Bank and other development partners to ensure that IMF-supported programs incorporate structural reforms that reduce bottlenecks in the economy and improve its flexibility, especially by increasing the pool of skilled workers available to provide services in health and education.

IMF policy advice—including in the context of lending programs—often recommends measures to improve both the composition and efficiency of spending. Higher public spending is not sufficient for achieving sustainable growth and poverty reduction. For example, in many countries the benefits of government spending on education and health accrue largely to richer income groups, so that increased general allocations of funds for these sectors do little to alleviate poverty. Instead, measures need to be taken to better target the education and health benefits to the more disadvantaged members of society, including those in rural areas.

The IMF also encourages countries to undertake reforms that improve the transparency of their fiscal systems, thereby making governments more accountable to their constituents for the use of grant resources. In particular, the Fund recommends that external grants be channeled through the budget. This enables a country's authorities to allocate all resources under the government's control according to the country's own priorities-as established in its Poverty Reduction Strategy Paper (PRSP)—and after assessing the tradeoffs among competing demands for funds.

The Fund often supports its policy advice with technical assistance (TA) to provide training to government officials and help them to implement needed reforms. TA is provided on a wide range of fiscal issues, including budget formulation, tax and customs administration, public expenditure management, and the design of social safety nets. TA is also provided to assist with statistical reforms and to help countries adopt international standards and codes, including in the area of fiscal transparency.

Finally, the IMF works closely with member countries to incorporate additional external resources into Fund-supported programs. The Fund has been criticized for not allowing spending to increase by the full amount of an increase in grants or concessional lending. In fact, IMF-supported programs do not have a ceiling on the amount of external assistance that can be spent, and programs have increasingly supported higher expenditures in recent years (see Box 1).²

The presumption in Fund-supported programs under the Poverty Reduction and Growth Facility (PRGF) is that they will accommodate additional aid inflows for financing poverty-reducing spending and achieving the MDGs. As discussed in Box 2, the IMF normally considers two measures of the deficit—inclusive and exclusive of external grants. Projected grant levels are built into the formulation of program targets. In cases where an unexpectedly high grant inflow can be readily absorbed, the programs generally provide for adjusters to deficits that allow for higher-than-targeted expenditures and higher-than-targeted deficits (excluding grants). In the case where absorptive capacity is weak or the magnitude of inflows poses a threat to macroeconomic stability, the IMF would counsel the country's authorities about compensatory measures that could reduce the risks. For example, a country might be advised to cut other, less productive spending, in order to partially offset a grant-supported increase in spending on HIV/AIDS. Or, it might be counseled to spread the increase in spending over a longer time period in order to facilitate a more gradual impact on the labor force. But, ultimately, these decisions must be made by the country's authorities.