Challenges in Expanding Aid Flows

• Author: Peter S. Heller and Sanjeev Gupta
• Position: Deputy Director/Assistant Director, in the IMF's Fiscal Affairs Department

To enable the developing countries to achieve the Millennium Development Goals by 2015, the target date, the international community is calling for an increase in foreign aid to 0.7 percent of industrial country GNP from 0.24 percent of GNP at present. But a large increase in aid flows could pose a number of challenges for the poorest countries.

The long-standing goal of raising official development assistance (ODA) to 0.7 percent of industrial country GNP is an important element of the strategy for reducing global poverty and meeting the Millennium Development Goals by 2015 (see box). A dramatic growth in ODA can also lead to an expanded supply of needed global public goods. But the industrial countries must move quickly to mobilize these additional financial resources while they can, because they will face new budgetary constraints within 10-15 years, when the current baby boom generation begins to retire and collect state pensions and other benefits.

If the industrial world were to be successful in meeting its ODA targets, financial aid would increase to about $175 billion, slightly more than three times current levels. This could pose challenges-both macroeconomic and microeconomic-for developing countries, particularly if the funds were distributed primarily to the world's poorest countries. Transfers of money to a developing country in amounts that are large relative to the size of its economy can be problematic. Recent studies have provided evidence of "Dutch disease" (a term that broadly refers to the harmful consequences of large inflows of foreign currency into a country) in such aid recipients as Burkina Faso, Côte d'Ivoire, Ghana, Malawi, Senegal, Sri Lanka, Togo, and Uganda. To ensure that enhanced ODA is used efficiently in the fight against global poverty, it is crucial that the international community examine closely the different possible approaches it could take in deciding how to allocate aid, both among countries and among complementary global poverty reduction programs.

Millennium Development Goals

At the Millennium Summit in September 2000, the world's leaders set seven goals for the international community to meet by the year 2015 that add up to an ambitious agenda for reducing poverty and its causes and manifestations. An eighth goal was added the following year.

Progress toward the goals has been mixed thus far for a number of reasons, including insufficient and inefficient public spending and crippling debt burdens in the developing countries, inadequate access for developing country exporters to industrial country markets, and declining official development assistance.

Goal 1 Eradicate extreme poverty and hunger

Goal 2 Achieve universal primary education

Goal 3 Promote gender equality and empower women

Goal 4 Reduce child mortality

Goal 5 Improve maternal health

Goal 6 Combat HIV/AIDS, malaria, and other diseases

Goal 7 Ensure environmental sustainability

Goal 8 Develop a global partnership for development

A UNDP-sponsored conference bringing together government officials from around the world and representatives from the international financial institutions to discuss the challenges of increasing financing for development was held in Monterrey, Mexico, in March 2002.

Potential challenges

Why are large aid flows to small economies problematic? What bottlenecks would have to be addressed if ODA increased for many countries? Economic theory suggests that whether or not economies have problems absorbing such aid flows depends on both the size of external resource transfers relative to the size of the recipient economies and the extent to which such transfers are spent on domestic goods and services rather than on imports. If ODA were spent entirely on imports, the country's balance of payments would be unchanged; any increase in imports would be completely financed by foreign inflows, and the inflows would have no direct impact on the country's money supply or on aggregate demand.

But, if a significant share...