Coping with Aid Volatility

• Author: Benn Eifert and Alan Gelb
• Position: Worked previously as a Junior Professional Associate/Director for Development Policy in the World Bank's Development Economics Department

Aid may become even more unpredictable, but there are ways to tackle the problem

Low-income countries face many sources of instability. Their economies are usually dependent on a single primary commodity, making them particularly vulnerable to climate-or trade-related shocks, and their political systems are prone to destabilizing regime changes. And even though low-income countries have few ties with international capital markets-which can be a source of instability in middle-income countries-they are still vulnerable to the consequences of volatile financial flows in the form of aid. Like private capital flows, fluctuations in aid can occur because of outside changes (for instance, shifts in donor sentiment) or in response to perceived domestic changes (for instance, in governance and economic management).

In the years ahead, the volatility of aid flows is likely to increase. Donors are planning to markedly increase aid and step up coordination and selectivity of aid recipients to help poor countries reach the UN Millennium Development Goals by 2015. In addition, donors are shifting away from project aid to program aid (given in the form of direct budget or sector support)-and countries will be seeking to underpin long-term recurrent spending (such as recruiting teachers and increasing the pay of nurses and doctors) with program aid. This shift will help reduce transaction costs and drains on limited capacity caused by the need to implement a large number of projects. But program aid flows tend to be more volatile than project aid, which is usually committed up front and disbursed on a multiyear basis.

Thus, the development community runs the risk of slipping into a low-level equilibrium-that is, countries that budget prudently over the medium term would discount pledges of assistance; donors would then see fewer funding gaps, in turn causing aid commitments to fall behind intended increases or even in absolute terms. Signs of this happening are already evident, with many low-income countries discounting aid commitments in their plans. To improve aid predictability, donors must lengthen funding horizons, and the annual review and programming cycle must be strengthened at the country level. However, even if progress is made on these fronts, four major challenges remain:

· How can countries deal with residual short-run volatility in disbursements?

· Can donors lengthen their commitment horizons without excessive risk of misallocating aid?

· How should levels and trends in performance influence the amounts allocated to project aid and budget support?

· What is the role for results-based aid allocations-as distinct from policy-based allocations-and how can results-based systems be improved?

We studied each of these questions to find ways to improve the predictability of aid, especially aid delivered in the form of budget support. We built on the existing literature on this topic, which tells us that aid is quite volatile (Ales Bulir and Javier Hamann, and others estimate that variability is 30-60 percent of the mean). Volatility is higher for countries that depend heavily on aid, and program aid tends to be more volatile than project aid. Commitments are often statistically unhelpful in predicting disbursements-astonishing given the importance placed on commitments in medium-term fiscal programs-and despite efforts to improve predictability, there has not been much progress. A large body of evidence suggests that the costs of large macroeconomic shocks, including aid shocks, is high. And anecdotal evidence suggests that efficiency costs associated with unstable budgetary revenues are large, and that unpredictable cash limits on spending undermine agreed programs and so weaken ministries' accountability for results.

Cushioning aid shocks

Given that aid volatility is here to stay, what can countries do to smooth the impact of short-run fluctuations in disbursements? Reserves represent the first line of defense for aid-receiving countries, and countries can adapt reserves and fiscal rules to cushion aid disbursement shocks. But could countries also develop a parallel mechanism, such as a stabilization...