Managing the Fiscal Impact of Aid

• Author: Ales Bulir and Timothy Lane
• Position: Senior Economist, in the Policy Review Division of the IMF's Policy Development and Review Department/Division Chief

Poor countries must find better ways to manage spending in the face of volatile and unpredictable aid flows.

Although foreign aid has been shrinking as a share of the budgets of donor countries, it remains very important for recipient countries. They can use it to finance activities that they may not have enough resources to finance on their own-for example, building schools and hospitals; paying the salaries of teachers and nurses; and upgrading water quality, roads, and sanitation. Aid used for such purposes benefits the poor directly. These prospective benefits of aid are the basis of the Monterrey Consensus, forged at the UN Conference for the Financing of Development held in Monterrey, Mexico, in March 2002. Under this consensus, industrial countries plan to increase the aid they provide to poor countries.

But countries receiving large amounts of aid can come up against other economic hurdles that, if not handled well, may undermine the benefits. Most obviously, this can happen if corrupt groups siphon away the aid or if well-intentioned governments use it for "white elephant" projects. Moreover, if influential groups within a recipient country strive to control the aid for their own purposes, the resources burned up by such rent-seeking behavior must be weighed against the benefits.

The solution to these problems is clear in principle, although very difficult to apply in practice: aid should be allocated to countries whose political and administrative systems are comparatively clean and that pursue prudent macroeconomic policies. For those countries with significant deficiencies in these areas, donor countries should make it a priority to assist them in setting up systems of accountability to help ensure that they benefit from the aid.

But even if aid is used judiciously, other serious but less obvious problems may arise. First, aid recipients may contract what is known as "Dutch disease"-a syndrome often seen in countries that have a windfall after discovering oil. The windfall is typically spent on nontraded goods, pushing up demand and relative prices for these goods and causing the currency to appreciate, thereby making the country's exports uncompetitive and reducing revenues from non-oil sectors. Second, donor countries' actual disbursements of aid tend to fall short of their commitments. Third, aid shortfalls are not wholly predictable: aid flows are volatile and less reliable than other sources of revenue. These problems add up to major fiscal headaches for aid-dependent countries.

Dutch disease

How important is the Dutch disease effect likely to be in practice? In a number of countries, persistently high aid has been accompanied by real currency appreciation and declining output of traded goods. For example, during the 1990s, Bhutan and Tanzania each received...