Helping countries cope with aid volatility

• Author: Alessandro Prati/Thierry Tressel
• Position: IMF Research Department
• Pages: 320-321

Page 320

In July 2005, world leaders meeting in Scotland announced a $50 billion increase in official development assistance to poor countries to help them achieve the Millennium Development Goals (MDGs) by 2015. This prospective surge in aid is focusing policymakers' and researchers' attention on the macroeconomic challenges associated with absorbing large aid inflows. How can aid (both official and private flows) be used as efficiently as possible so that it boosts countries' growth and helps them achieve the MDGs?

It is generally agreed that the best way to lift the poor out of poverty is to accelerate economic growth, but there is little agreement on how foreign aid affects growth. One reason may be that, in the past, aid was used in ways that did not systematically lead to an acceleration (or a deceleration) of growth, with both microeconomic and macroeconomic factors contributing to the disconnect between aid and growth. A recent IMF Working Paper examines these macroeconomic factors and explores whether there are any macroeconomic policies that could dampen the potential Dutch disease (when real exchange rate overvaluation hurts export industries and overall productivity) effects associated with large and volatile aid flows.

Aid-growth disconnect

Although the study focuses on macroeconomic factors, microeconomic factors also impinge on aid effectiveness. But even when microeconomic distortions are minimized, countries trying to absorb large amounts of aid are likely to face substantial macroeconomic challenges. It has been argued that the systematic, adverse effects of foreign aid on the competitiveness of recipient countries' exports may explain why aid does not appear to boost growth. This argument, made by Raghuram Rajan and Arvind Subramanian in "What Undermines Aid's Impact on Growth?" (IMF Working Paper 05/126), is supported by evidence that the share of labor-intensive and tradable industries in the manufacturing sector declines as foreign aid increases.

Indeed, productivity gains in tradable sectors, combined with strong performance of manufactured exports, have typically characterized virtually all cases of sustained growth since World War II. Although manufacturing exports remain feeble in many sub-Saharan African countries, the same was true of the East Asian...