Making AID Work

• Author: Peter S. Heller
• Position: Deputy Director of the IMF's Fiscal Affairs Department. This article is based on a recent paper, "Pity the Finance Minister: Issues in Managing a Substantial Scaling Up of Aid Flows"

Scaling up aid flows is just the start of a complex set of decisions and tough choices

Aid is back on the global agenda. An unlikely alliance of rock stars, politicians, and grassroots activists has put the issue of combating poverty at the forefront of global policymaking. Rich countries seem increasingly energized to confront persistent poverty in much of the developing world with plans to boost aid, cancel debts of poor countries, and increase trade access for goods from developing nations. This has sparked fresh hope that the enormous and inexcusable gaps in living standards between rich and poor countries can be narrowed, brightening the prospects for millions in the process.

Should this promised scaling up materialize, donor and recipient countries will still need to ensure that the aid actually achieves results, given the spotty record so far. It is critical, therefore, that any large increase in aid be accompanied by considered efforts to ensure that lessons of the past are learned and that new challenges are anticipated. Development partners must focus on six principal challenges:

· ensuring that larger aid flows promote growth and reduce poverty;

· increasing substantially the delivery of government services and investments in infrastructure, and managing spending decisions when a large proportion of financing (aid) is outside the government's control and uncertain in duration;

· dealing with the possibility that higher aid flows might cause an appreciation of an aid recipient's currency, or domestic inflation, with adverse effects on the country's international competitiveness;

· handling the increased complexity of managing monetary, fiscal, and exchange rate policies when higher aid is subject to uncertainty in terms of its magnitude, timing, and likely economic effects;

· recognizing that substantial aid in the form of even concessional loans could result in debt problems in the future; and

· managing the potentially adverse effects of growing aid dependency.

This article explores why increased aid flows will require economic policymakers to confront these issues and outlines the roles to be played by development partners-donors, recipient countries, and the international financial institutions (IFIs)-if these challenges are to be successfully met. The central message is that the mobilization of additional aid resources is only one (albeit essential) step in the journey to achieve the Millennium Development Goals (MDGs).

Achieving results

Ensuring that increased aid promotes growth and reduces poverty is certainly the most important task. After all, empirical studies offer only mild (and not uncontested) support for aid boosting growth. Encouragingly, a recent Center for Global Development (CGD) study (Clemens, 2004) suggests such a positive relationship. It says that once one excludes those aid flows aimed at political and humanitarian goals, a positive net effect is observed for the remaining aid focused on economic objectives (see "Aid and Growth" on page 16 of this issue). But recent IMF work by Raghuram Rajan and Arvind Subramanian (2005) finds no robust evidence of such an effect-positive or negative-of aid on growth, with their conclusion holding across time horizons, time periods, types of aid, types of donors, and characteristics of recipient countries. They suggest that this may be due to aid flows giving rise to real appreciation of the aid recipient's currency-a "Dutch disease" effect-thereby undercutting its competitiveness in the traded goods sector and weakening growth.

The CGD study, as with most studies of aid and growth, finds diminishing returns to aid. The maximum growth rate occurs where the subset of aid aimed directly at growth reaches 8 percent of GDP. Since this subset is about half of aid, this is roughly equivalent to where total aid reaches about 17 percent of GDP (see World Bank and IMF, 2005). Similarly, recent World Bank analyses of the economic effect of higher aid flows in Ethiopia are highly sensitive to the pace at which aid is assumed to be scaled up. These results may reflect absorptive capacity constraints that may impede a rapid scaling up of government service delivery in response to higher aid flows. Considering that aid to a number of African countries is already above 10 percent of GDP, these results underscore the need for development partners to intensify their efforts at appraising the productivity of alternative uses of aid.

But it is also important not to overemphasize the mistakes of past aid efforts, given the complicated issues that have to be considered in the aid-growth relationship. Even Rajan and Subramanian emphasize that their results principally suggest the need for future aid to be designed better, with attention paid to experimentation with alternative approaches in connection with any scaling up. Some economists, notably Jeffrey Sachs, have argued that only a comprehensive but well-focused aid push will enable poor countries to overcome the multiple bottlenecks ensnaring them in a vicious cycle of poverty. And some aid-such as spending on those affected by HIV/AIDS, tuberculosis, and malaria; investments in education and health care for children; the provision of targeted social safety net transfers to the poor; or investments in infrastructure-would not be expected to benefit growth in the short term. Only over time will such outlays enhance a country's capacity for sustained higher productivity and growth.

Managing and delivering services

While increased aid flows may facilitate a substantial expansion in vital public services and increased investment, they may create significant challenges for those sectoral ministries charged with managing the scaling up and delivery of these services. Greater reliance on aid-particularly given donor sectoral priorities-can also expose a country's budget to significant volatility and unpredictability, a concern highlighted by African finance ministers at a recent IMF-sponsored aid conference in Maputo...