A quarterly magazine of the IMF

December 2002, Volume 39, Number 4

Poor countries must find better ways to manage spending in the face of volatile and unpredictable aid flows.

Although foreign aid has been shrinking as a share of the budgets of donor countries, it remains very important for recipient countries. They can use it to finance activities that they may not have enough resources to finance on their own—for example, building schools and hospitals; paying the salaries of teachers and nurses; and upgrading water quality, roads, and sanitation. Aid used for such purposes benefits the poor directly. These prospective benefits of aid are the basis of the Monterrey Consensus, forged at the UN Conference for the Financing of Development held in Monterrey, Mexico, in March 2002. Under this consensus, industrial countries plan to increase the aid they provide to poor countries.

But countries receiving large amounts of aid can come up against other economic hurdles that, if not handled well, may undermine the benefits. Most obviously, this can happen if corrupt groups siphon away the aid or if well-intentioned governments use it for "white elephant" projects. Moreover, if influential groups within a recipient country strive to control the aid for their own purposes, the resources burned up by such rent-seeking behavior must be weighed against the benefits.

The solution to these problems is clear in principle, although very difficult to apply in practice: aid should be allocated to countries whose political and administrative systems are comparatively clean and that pursue prudent macroeconomic policies. For those countries with significant deficiencies in these areas, donor countries should make it a priority to assist them in setting up systems of accountability to help ensure that they benefit from the aid.

But even if aid is used judiciously, other serious but less obvious problems may arise. First, aid recipients may contract what is known as "Dutch disease"—a syndrome often seen in countries that have a windfall after discovering oil. The windfall is typically spent on nontraded goods, pushing up demand and relative prices for these goods and causing the currency to appreciate, thereby making the country's exports uncompetitive and reducing revenues from non-oil sectors. Second, donor countries' actual disbursements of aid tend to fall short of their commitments. Third, aid shortfalls are not wholly predictable: aid flows are volatile and less reliable than other sources of revenue. These problems add up to major fiscal headaches for aid-dependent countries.

How important is the Dutch disease effect likely to be in practice? In a number of countries, persistently high aid has been accompanied by real currency appreciation and declining output of traded goods. For example, during the 1990s, Bhutan and Tanzania each received aid averaging around 20 percent of GDP a year, and, in each country, the sectors producing tradable goods shrank by about 15 percentage points of GDP. Of course, such examples do not prove anything in themselves. For one thing, it is difficult to disentangle the effects of aid from those of other factors affecting the real exchange rate and the output of traded goods. Second, reverse causation is possible—for instance, if donors provide additional aid to compensate a poor country for a collapse in its export earnings. But several systematic studies controlling for these effects indicate that Dutch disease can be significant, particularly in countries where aid accounts for a very large share of national income. At the same time, the literature on overall aid effectiveness suggests that such effects do not generally override the positive effects of aid on growth, provided that the overall policy environment is sound.

What should be done if aid generates Dutch disease? Dutch disease is not a reason for refusing grant aid—any more than it is a reason for oil-producing countries to leave their oil in the ground. For countries in which aid receipts are permanent, Dutch disease may represent the economy's adaptation to this source of income. But if aid inflows are temporary, the need to keep the real exchange rate at a sustainable level could be a reason for countries to budget conservatively, increasing their planned long-term spending by less than the full amount of aid they receive in a given year. They may also consider other steps to reduce the extent of Dutch disease—for instance, by spending aid mainly on traded goods—or to mitigate the adverse impact on the traded goods sector.

Another dimension to aid flows is that they tend to fall short of donors' commitments, and by an amount that is hard to predict. These shortfalls largely reflect the vagaries of donors' budgets and the attachment of conditions to aid and therefore make it difficult for recipient countries to plan their spending.

Promises, promises. Aid recipients must base their spending plans to some extent on donors' commitments of aid, which tend to be overoptimistic. As a result, the budgets of the recipient countries often contain an element of illusion: some of the planned spending is to be financed using aid that does not materialize. What happens to this spending? In countries with IMF-supported programs, the IMF typically tries to project conservatively, so that its aid projections are systematically lower than donor commitments. Donors and recipients both view this approach as harsh because it limits spending. But, in fact, the IMF, too, overestimates aid commitments, and the projections in the programs it supports still err systematically on the high side (see table).

Typically, IMF-supported programs compensate for aid shortfalls by incorporating "adjusters" that, up to a point, allow a country to keep its spending on track if aid receipts are less than programmed. With these adjusters, the country's target for net international reserves is scaled down by the amount of the shortfall (usually with a U.S. dollar limit on the adjustment), and its domestic credit ceiling is boosted accordingly. In effect, the country can continue to spend at the level originally planned, running down foreign reserves and expanding domestic credit to make up for the aid that does not arrive. This approach reduces the risk that a country has to curtail its planned spending instantly or maintain this spending only by relying more heavily on domestic financing. But persistent aid shortfalls can introduce a lack of transparency into macroeconomic programs, by making fiscal policies and targets for international reserves appear more conservative than they are.

Aid uncertainty. Aid receipts are uncertain not only because disbursements are subject to the vagaries of donor countries' budgetary processes, in which aid competes with domestic priorities, but also because it is allocated among different countries in ways that often reflect donors' political and strategic priorities rather than its usefulness in reducing poverty.

Another reason for aid uncertainty is conditionality. Donor countries may establish conditions that not only cover the uses to which aid may be put but also, for example, stipulate spending in certain sectors. Moreover, aid disbursements are usually subject to the IMF's "seal of approval"—donors disburse aid only when an IMF-supported program is on track. IMF conditionality is an important factor accounting for uncertainty in aid receipts, but not the only one: aid receipts tend to be significantly less than projected even in countries whose IMF-supported programs are on track. The discrepancy between projections and disbursements is even greater in countries whose programs are off track. Conditionality entails an important trade-off. Some conditions may be needed to ensure that aid is being disbursed into an environment in which good policies are in place—the kind of environment in which aid can be effective in boosting growth—but interruptions in aid flows associated with conditionality introduce greater uncertainty into the recipient country's fiscal plans.

How can the variability of aid receipts be measured? A standard gauge is tax revenues: if aid receipts were no more unpredictable than tax revenues as a source of financing for expenditure, they would pose no problem beyond those already present in any fiscal plans. According to a recent study covering 1975-97, the variance of aid receipts was, on average, nearly five times that of tax revenues (both expressed as a percentage of the recipient country's GDP)—and even higher in those countries in which aid constituted more than half of total government revenues.

The volatility of aid would be a less significant problem (and indeed, might even be beneficial) if aid receipts were countercyclical—that is, if surges in aid compensated for shortfalls in GDP. But this is not the case. The correlation between aid receipts and the recipient country's GDP, although very close to zero on average, is typically positive.

Given the uncertainty of aid receipts and the tendency for aid commitments to be excessively optimistic, what can poor countries do? There are several possible approaches, but all have some drawbacks.

Plan conservatively. Countries can leave a cushion of international reserves that they can draw down to compensate for any shortfalls in aid. Many of those with IMF-supported programs often do this, because they are able to avoid disruption to their spending plans in the event that committed aid fails to materialize on schedule. But this strategy has two major drawbacks: it requires that money be tied up in international reserves when it could be used for the country's other needs, and, to the extent that aid shortfalls are predictable, it may lead to a lack of transparency in the country's financial plans.

Base spending plans on donor promises. If governments followed this advice, they would rely fully on domestic financing in the case of aid shortfalls. The drawback is that this would make domestic financing projections both nontransparent and potentially harmful: raising more financing domestically requires either more money creation—with the risk of inflation—or a squeeze on financing of the private sector, or both.

Adjust spending. Countries could adjust spending plans in response to the aid receipts that actually materialize. This idea has some merit in that it avoids both the need for a large cushion of reserves and the risk that domestic financing compensation for aid shortfalls would disrupt macroeconomic stability. In line with this approach, the IMF has recently been advising low-income countries to base spending plans on conservative projections of donor funding and to identify a set of priority investments that can be carried out as more funding becomes available. This approach is evidently sensible in cases in which donors deliver additional aid on a sustained basis—or at least over a reasonable time frame for completion of relevant investment projects. However, there is likely to be less scope to adjust spending in response to quarter-to-quarter or year-to-year surges or shortfalls in aid in relation to committed levels. The limitations of fiscal flexibility over shorter periods were discovered in industrial countries in the 1950s, when it was considered desirable for a country to adjust expenditure temporarily as part of a Keynesian policy of stabilizing the level of economic activity; over the years, the scope for fine-tuning spending was found to be limited because most worthwhile spending programs cannot readily be switched on and off.

Thus, there is no fully satisfactory way for aid-receiving countries to cope with the variability of aid disbursements: some difficult trade-offs are inescapable. Donors can help by delivering more reliably on their aid commitments and eschewing unnecessary conditionality. Efforts are now being made to address these issues in a framework where international support for low-income countries is based on poverty reduction strategy papers (PRSPs): the PRSP serves as a planning instrument to improve use of aid, a coordinating vehicle for donor financing, and a means of assessing the consequences of aid for poverty reduction, growth, and stability. Because aid flows are typically tied to its programs, the IMF can also help by focusing its conditionality on what is critical to providing a stable macroeconomic environment in which aid can do the most good.

References:

Aleš Bul�ř and A. Javier Hamann, 2001, How Volatile and Unpredictable Are Aid Flows, and What Are the Policy Implications? IMF Working Paper 01/167 (Washington) (forthcoming in IMF Staff Papers); http://www.imf.org/external/ pubs/ft/wp/2001/wp01167.pdf

Aleš Bul�ř and Timothy D. Lane, 2002, Aid and Fiscal Management, IMF Working Paper 02/112 (Washington); http://www.imf.org/external/pubs/ft/wp/2002/wp02112.pdf