What would doubling aid do for macroeconomic management in Africa?

Report
from Overseas Development Institute
Published on 23 Apr 2006
Summary of conclusions
The purpose of this paper is to explore the consequences for macroeconomic management of the envisaged scaling-up of aid to African countries, to report on the results of recent research and to consider the policy implications. Building on recent work from the International Monetary Fund, ODI commissioned country studies of Mauritania, Mozambique, Sierra Leone and Tanzania to examine their recent experience of aid surges. The IMF study additionally included analysis of Ethiopia, Ghana and Uganda, and was based on a distinction between the absorption and spending of aid. ODI followed this approach, but extended it to consider longer-term and more qualitative matters. ODI also commissioned a paper on the macroeconomic effects of commodity price surges, to examine what inferences might be drawn from these experiences.

The strength of the following conclusions is undermined by three factors: serious deficiencies in data on aid flows; difficulty in identifying unambiguous and relevant episodes of aid surge comparable with the scaling-up that is projected for the next few years; and a bias in country coverage towards those which donors regard as having good policy reform records. In retrospect, we also regret that we did not pay more attention to the influence on aid surges on the quality of state spending decisions, a factor which emerges as rather crucial in our analysis. These limitations should be kept in mind when reading the following chief conclusions:

- The countries in question were already highly reliant on aid prior to their aid surges. This added to the potential extent of macroeconomic repercussions from the aid increases.

- The record for these countries reveals great year-on-year and medium-term aid volatility, with large swings in aid receipts and past surges followed by aid declines. This has coloured the policy responses of recipient governments. The current donor promise to increase aid for the MDGs and sustain it thereafter would, if implemented, represent a sharp break from past experiences.

- Evidence from the literature on commodity booms emphasises a strong link between terms of trade movements and fluctuations in economic activity. It further shows that gains to output or income from booms have often been at best meagre and short-lived, while the costs resulting from subsequent price declines have been both significant and of longer duration. Additional revenues have often been badly spent, with deterioration in the quality of public expenditures.

- In considering the macro consequences of an aid surge, it is the extent to which the resulting increased availability of foreign exchange is absorbed - in the form of a widened balance of payments current account deficit - which is critical. It is only when additional foreign resources enter the economy that aid has an impact on the levels of production, consumption and investment that the economy can attain.

- The most appropriate policy response to an aid surge cannot be identified without reference to a rather wide range of considerations. The need for a case-by-case approach is indicated. The closest to a general golden rule is for government to avoid large excesses of spending over absorption, as such excesses threaten to generate inflationary pressures with adverse consequences for growth, poverty reduction and the private sector.

- In the cases studied, governments proved more willing or able to spend aid than to absorb it (see Table 11). In none of the seven cases was the aid increase both fully absorbed and fully spent. This result is clearly contrary to what is preferred by many donors.

- The country cases produced little evidence of aid increases resulting i symptoms of Dutch Disease. However, this was partly because governments consciously sought to avoid this (hence the limited absorption). For this and other reasons, we regard the issue of whether a large scaling-up of aid would induce Dutch Disease problems as unresolved. There is logic and evidence pointing in both directions and we caution against assuming that a doubling of aid to African countries would not induce this type of macroeconomic difficulty. Much would depend on how the aid was deployed and on its productivity.

- Looking at macroeconomics overall, while the envisaged doubling of aid would bring real benefits, there is a risk that it could be accompanied either by exchange-rate appreciations or counter-productive excesses of spending over absorption. Serious declines in the quality o fpublic spending may also occur, which would reduce the benefits derived. The potential for major gains is clear but there are reasons for doubting whether this potential will be substantially realised.

- We see the following as the main determinants of the eventual outcome: the degree of co-ordination of fiscal and monetary policy within recipient countries; the perceived predictability of the aid increases. Based on past experiences, it would be reasonable and responsible for recipient governments to plan on the basis that the aid surge will not be sustained; the quality of public financial management and the degree of donor influence on that; and the quality of aid data flows to permit evidence-based macro policy decision-making.

- Finally, there are important lessons for the policies of donor governments and IFIs: It is crucial to increase the reliability and predictability of aid, and to construct credible mechanisms for convincing recipients that the unreliability of past promises will not be repeated. Mechanisms such as the proposed International Financing Facility can underpin global aid flows, but they need to be supported by credible action to limit the volatility of aid to individual countries.

Given that scaling-up of aid should generally be accompanied by increased absorption if it is to avoid undesirable consequences, there needs to be more explicit agreement as to how the foreign exchange will be absorbed, as well as how budget resources will be spent. This has implications for the content of IMF policy advice and programmes. In particular, there is an urgent need for governments and their development partners to return to the fundamentals of relieving growth constraints and, in particular, the supply-side and other constraints on export success.

Rapid increases in aid stand a good chance of being wasted unless they are provided in he context of more carefully prioritised plans than exist at present. Failing this, there is a risk that donor disillusion will develop, leading to broken promises which leave recipient governments with the familiar problem of transient benefits succeeded by high costs as they try to run expanded services and infrastructures with lower than expected resources. Donors should accept the politically unpalatable fact that there is a range of circumstances in which it makes sense for recipient governments to use all or part of n aid surge to add to reserves, external and domestic. Where there are good reasons for thinking that the tax system is holding back private sector growth, using aid as an opportunity for tax reform can also be legitimate.

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