The Macroeconomic Challenge of More Aid

• Author: Shekhar Aiyar, Andrew Berg, and Mumtaz Hussain
• Position: Economists/Division Chief in the IMF's Policy Development and Review Department/Economists

An analysis of five African countries that received big increases in aid

The international community is currently seeking to scale up official development assistance, provide further debt relief, and explore several innovative mechanisms for development financing to help low-income countries achieve the Millennium Development Goals (MDGs). But a surge in aid inflows-possibly to the tune of several percentage points of a recipient's GDP-presents considerable macroeconomic challenges for the recipient country. How should countries adapt their monetary and fiscal policies? Will inflation result? Will the large inflows boost the exchange rate and make exports less competitive, and should this be resisted?

We examined the record of five African countries-Ethiopia, Ghana, Mozambique, Tanzania, and Uganda-that have recently experienced a surge in aid inflows, often from already high levels (see Chart 1). These countries benefited from the general rise in aid over the past decade and in particular from the Heavily Indebted Poor Countries Initiative, which reduced debt servicing costs and thus increased net aid flows. All five countries enjoy relatively strong institutions, so that policymaking is not dominated by macroeconomic disarray, misgovernance, or postconflict reconstruction. Therefore, their experiences offer useful lessons in scaling up aid to well-performing poor countries.

[ SEE THE GRAPHIC AT THE ATTACHED ]

A framework for policy analysis

To examine the macroeconomic management of aid inflows, we found it useful to highlight the interaction of fiscal policy with monetary and exchange rate policy. Too often, fiscal policy concentrates on directing aid to worthy projects, while concerns about competitiveness and inflation drive monetary and exchange rate policies that may negate the desired impact of the aid.

We concentrated on the typical case in which aid dollars go to the government, which immediately sells them to the central bank and then uses local currency to increase spending on domestic goods. Of course, aid could come in kind, or equally, the government could spend the aid directly on imports, but these cases are analytically less interesting and pose fewer policy challenges-with a limited impact on macroeconomic variables. Our framework is underpinned by two distinct but related concepts: absorption and spending.

· Absorption is defined as the widening of the current account deficit (excluding aid) due to incremental aid. It measures the extent to which aid engenders a real transfer of resources through higher imports, or through a reduction in the domestic resources devoted to producing exports. Absorption depends on both exchange rate policy and on policies that influence the demand for imports. The central bank controls the exchange rate through its sales of foreign exchange, while monetary policy can be used to control aggregate demand-and the demand for imports.

· Spending is defined as the widening of the fiscal deficit (excluding aid) due to incremental aid.

The combination of absorption and spending defines the macroeconomic response to a scaling up of aid.

How the five performed

Broadly speaking, there are four possible responses to an aid surge in the short-to medium-term, and we looked at how the five sample countries performed according to these categories.

Absorb and spend. This first choice is the textbook response to aid. The government spends the aid on domestic goods, widening the fiscal deficit. The central bank sells foreign exchange, removing from circulation the local currency spent by the government. This foreign exchange pays for a widening of the current account deficit, as the aid is absorbed by the economy. There is a reallocation of productive resources from the traded goods sector to government spending. A key...