Press Release No. 06/79

Press Release: IMF-DFID Workshop Examines the Macroeconomic Challenges of Scaling Up Aid

April 21, 2006

Since the 2005 Gleneagles G-8 Meetings, which committed to doubling aid to Africa by 2010, the scaling up of aid has become a topical issue. On April 19-20, the International Monetary Fund and the U.K. Department for International Development (DfID) held a workshop on assessing the macroeconomic challenges of scaling up aid at the IMF Headquarters. The workshop was attended by African finance ministers, central bank governors, officials, and representatives of donors, multilateral development institutions, and academics.

The aim of the workshop was to advance the debate on scaling up from theory to the operational issues that confront countries and their development partners. These issues vary depending on country situation. Participants concentrated on seven broad issues.

• A large appreciation in the real exchange rate as a result of aid could reduce the export competitiveness of an aid-receiving country. Participants stressed the important distinction between short- and long-term appreciations: A loss of competitiveness could be offset if aid is used to improve productivity. There is currently little evidence that large aid inflows have significantly reduced the competitiveness of the traded goods sector ("Dutch disease") in Africa. However, some participants cautioned that it would be prudent for policymakers to remain alert to this phenomenon. Under certain circumstances, it is appropriate for countries to use some aid to build up reserves.

• There was consensus on the importance of increasing the supply response to aid inflows. A strong supply response—in the form of improved productivity and higher employment—would mitigate cases of Dutch disease. Countries need to create a favorable business environment to attract foreign and domestic investment alike, and address supply bottlenecks, such as underdeveloped infrastructure and agriculture. The composition of aid-financed spending should be balanced, with investment in more productive sectors. An open trade regime can both enhance domestic competition and alleviate the exchange rate pressures arising from increased aid.

• Participants emphasized the importance of strengthening institutions and governance to effectively manage scaled-up aid and improve the investment climate for the private sector. Sound fiscal institutions, especially strong public financial management, would facilitate aid absorption. If aid is to be used effectively, it is necessary to strengthen government capacity to manage and administer aid flows, as well as private sector capacity to operate in an open, competitive environment.

• Aid-receiving countries should make plans to reduce dependence on aid over time. Higher aid often leads to higher recurrent expenditures. Donors often pay for the building of schools but governments have to pay for additional teachers. Thus, there will be a need to increase revenue before aid tapers off. Additional revenue could be mobilized by broadening the tax base and by eliminating exemptions rather than by raising tax rates.

• Managing scaled-up aid inflows requires effective coordination between different parts of government—central banks, ministries of finance, and line ministries. It is often a challenge for policymakers to determine the appropriate trade-off between exchange rate appreciation and interest rate increases.

• Aid volatility creates serious problems for budgetary management—an issue that was a recurring theme throughout the workshop. The need to address these problems becomes even more urgent as aid increases. Long-term aid commitments would increase predictability.

• Finally, participants stressed the need to move the agenda forward by building scaling-up scenarios. Such exercises would help countries and the donor community identify key issues and policies needed for a country to absorb higher aid flows. The participants recognized that the macroeconomic challenges of managing scaled-up aid are substantial, but were confident that—together with their development partners—they can meet these challenges.