[stop-imf] IMF on the macroeconomics of managing increased aid inflows

[Robert Weissman]

IMF Civil Society Newsletter
February 2006

FEATURE ARTICLE:

An interview with Andy Berg on the macroeconomics of managing increased
aid inflows

In 2005, there was particular focus by the international community on
increasing the amount of aid and debt relief for low-income countries
(LICs) in order to significantly strengthen the poverty reduction
effort. The pressure to translate commitments into reality must
continue. But there is also a growing sense in the international
community that we must find ways to make aid more effective. As part of
the review of the design of IMF-supported policy programs in LICs, IMF
staff prepared a paper that focused on the macroeconomic effects of aid.
Andy Berg, chief of the Development Issues Division in the IMF=92s Policy
Development and Review Department, is the lead author of =93The
Macroeconomics of Managing Increased Aid Inflows: Experiences of
Low-Income Countries and Policy Implications.=94 We asked him to describe
the main findings of the paper and the lessons for IMF policies in
low-income countries.
Q: What were the main reasons for writing this paper?
A: There is a lot of talk about the difficulties with managing aid
inflows. We wanted in this study to be constructive and concrete. We
thought that it was important to look at issues that worry donors,
international organizations, and especially aid recipients. Are aid
surges inflationary? Do they crowd out the export sector by causing
=93Dutch disease=94 (The term is used for currency appreciation or inflatio=
n
arising from an inflow of external resources, which can adversely affect
net exports and incomes of producers in the trading sectors)? And what
can be done about it? We thought that the most practical thing to do
would be to look at recent country experiences where there had been
large aid increases. We wanted to see what happened in these countries,
what did the IMF advise, how things turned out, and what lessons could
be drawn. We looked at Ethiopia, Ghana, Mozambique, Tanzania, and
Uganda, five countries that had big jumps in aid inflows in recent years
(equal to around 5 percent of GDP) .

Q: And what did you find?

A: The first thing we found was that we had to revisit our expectations
about how the aid would be used. We expected that governments would
spend the money on goods, both imported and local, and that the country
as a whole would use the dollars to buy more imports. This would, in
principle, be the most effective way to use the aid. For aid to be used
as intended, it must give rise to spending by the recipient government
and absorption of more imports. But what we found is a lot more varied
and, ultimately, confusing. We were surprised to find that a full
absorb-and-spend response was rare. In most cases, aid was spent, but
not absorbed, meaning that while the Finance Minister increased spending
on the basis of more aid, the aid dollars remained in the central bank.
Foreign exchange reserves were being built up, so the aid dollars were
not being used to finance the higher spending. Instead, the recipients
had to finance domestically, by either printing more money or borrowing
from the public. To put it another way, much of the aid is spent in
local currency domestically, to hire teachers for example. The Central
Bank can finance this spending by using the aid dollars to buy back the
local currency that was used to pay the teachers. This way, the dollars
are available in the economy to pay for higher imports. But if the aid
dollars stay in the Central Bank, it=92s just as if the domestic spending
was financed through domestic money creation.
Why aren=92t the dollars always used to finance the aid-related spending?
Sometimes there is a need to build up an adequate level of reserves. But
often the authorities are worried that to do so would cause the exchange
rate to appreciate and thus =93Dutch disease.=94 It seems that sometimes
they=92d rather spend domestically, risking higher inflation or higher
interest rates, than use the aid dollars and risk Dutch disease. In two
of the cases (Ethiopia and Ghana), most of the increase in aid during
the high-aid period we studied went into faster reserve accumulation. In
addition, the deficit (spending less domestic revenue) did not increase
over the aid-surge period. In other words, the aid surge was mostly
neither spent nor absorbed. The other three cases (Uganda, Tanzania, and
Mozambique) mostly or fully spent the aid increase but also mostly did
not absorb the aid. The result was a complex mix of higher inflation and
interest rates and, occasionally, pressures for exchange rate appreciation.

Q: Many would say this is the IMF=92s fault=97that we prevent countries fro=
m
getting more aid because of fear of Dutch disease.

A: We actually found that the Fund-supported programs were consistent
with spending and absorbing; in other words, in these five cases,
reserves were being accumulated well beyond the minimum levels specified
in the Fund-supported program. Typically, we advised authorities to sell
more foreign exchange. Sometimes our reports somewhat obliquely talked
about the merits of more exchange rate flexibility, which in this
context really means letting the exchange rate appreciate. So on the
whole, it is not a Fund concern that is driving these countries. It is
the financial authorities who are concerned about stability=97particularly
of their exchange rate.

Q: But if they did not follow our advice and did not use the aid to its
full capacity, there are important lessons for the Fund as well.
A: There are certainly lessons for the IMF, as well as for others
helping to devise policies in an environment where more aid is
available. One point the paper emphasizes is that real exchange rate
appreciation can be a natural outcome of spending and absorbing an
increase in aid. The second point is that when you resist real
appreciation by hoarding the dollars in the Central Bank, but the
government spends it anyway, then you do get macroeconomic problems.
There must be more coordination between fiscal and monetary policies,
between finance ministries and central banks, in order to make the aid
more effective. The IMF must be fully aware of these tensions, where
they exist, and work toward finding a solution.
And yes, we at the IMF must be more attuned to this issue than we have
been. We need to be extra conscious of the fact that the governments may
not be taking our advice. We have to give advice that helps them make
good decisions even when they=92re failing to follow our preferred
approach. What=92s our advice then? We need to make sure we=92re working
with them=97helping make sure that the different parts of the government
are communicating to make the right overall decisions. Specifically, we
need to pay more attention to the consistency of fiscal and monetary
policy, so if there=92s going to be a big increase in aid-related
spending, we need to make sure, if we can, that the monetary authorities
are on board with that plan and facilitate it. We need to think with
them about what the implications are for the real exchange rate and make
sure they=92re willing to accept it; or if they=92re not, to adjust things
in a sensible way. That means adjusting the way they spend aid=97maybe
spending more on imported goods, which will not cause exchange rate
appreciation, or more on productivity-raising investments=97or adjusting
the pace at which they spend it.

Q: You mention =93the pace at which they spend the aid:=94 this seems to
reflect the tension that is often cited between macroeconomic stability
and the Millennium Development Goals (MDGs). The IMF is often accused of
putting macroeconomic stability ahead of hiring more teachers or
spending more to combat HIV/AIDS. Is this a real trade-off? What is your
reply to this criticism, in light of this paper?

A: On the face of it, it does sound like a case of immense needs versus
macroeconomic technicalities=97and that we are concerned about
technicalities. And it is hard to speak about economic stability when
people are dying every day because of lack of medicines, doctors. But
there is no conflict between macroeconomic stability and pouring more
resources into combating HIV/AIDS, educating more children, or building
more roads. This is not the real trade-off. We can=97and must=97design
macroeconomic frameworks to accommodate scaling up for health,
education, defeating the AIDS pandemic=97you name it. As I said before,
the macroeconomic problem comes when the policy mix becomes
inconsistent=97if, for instance, the absorption of the aid implies a sale
of reserves that the Central Bank objects to, perhaps on the grounds of
concern about real exchange rate appreciation.

We argue in the paper that the solution should be to face squarely the
question of whether spending on reaching the MDGs is worth the
opportunity cost in terms of resources drawn from other sectors,
including possibly the export sector. If so, go ahead. If it is not
worth the opportunity cost, then don=92t use the aid at all, or change the
way it=92s spent. But we must remember, these macroeconomic issues raise
the stakes for aid. Aid dollars allow resources to be devoted to
domestic uses that might otherwise have gone into exports. But they
don=92t immediately create scarce domestic resources such as skilled
labor. If you=92re spending money and educating people, curing AIDS,
building roads and ports, that=92s fantastic and obviously must go ahead.
But if you=92re not, and if the aid is going to build schools that then
are dysfunctional after three years or in which there are no teachers,
you=92re not just wasting the aid=97you are also wasting scarce domestic
resources that might have been used elsewhere more productively. This
risk makes it that much more important that the aid be used well,
because if it isn=92t, you=92re not just missing an opportunity; you could
be doing harm.
Q: The paper says that =93a Dutch disease effect on exports via real
appreciation is absent in all five countries.=94 This might be an
important finding in the debate over whether aid causes inflation.
A: As I said, aid should not in general cause inflation. But we also
emphasize that sometimes a real appreciation may be necessary to absorb
an aid inflow. If you have a fixed exchange rate, if you really don=92t
want to let your nominal exchange rate appreciate, the only way you get
a real exchange rate appreciation is through a period of higher domestic
inflation. It=92s not that monetary policy is out of control. It=92s a
relative price adjustment=97an increase in the dollar price of domestic
goods and labor that are now in higher demand because the government is
buying more. And it could well be a necessary part of the absorption of
aid. Therefore, where countries are pursuing a fixed exchange rate and
aid increases sharply, we might expect a relative price adjustment in
the form of some inflation.

Q: Some of our critics may consider this new thinking for the IMF! Does
this mean that you=92ve reconsidered the tight anti-inflation stance that
many have said limits pro-poor spending?

A: Let me speak to the broader question. There=92s been a lot of
discussion about whether the IMF is too tight on inflation, and whether
our anti-inflation stance has limited the ability of countries to
increase spending and work to meet the MDGs. The point that sometimes
inflation may be part of a needed relative price adjustment is something
we=92ve emphasized more in this paper than in the past. And it highlights
that we have to think about inflation targets in context. In the long
run, there is no trade-off between lower inflation and faster poverty
reduction. On the contrary, countries with inflation out of control
can=92t sustain growth and reduce poverty. Higher inflation does not allow
higher investment. It does not create resources for development. It does
tax people who hold cash or whose nominal incomes are fixed. And this
tax discourages private investment and tends to fall on those least able
to adapt=97in other words the poor.

But we all agree that reducing inflation from high levels can carry real
costs in the short run. The recent review of the Poverty Reduction and
Growth Facility (PRGF) program design, of which the aid inflows paper is
just one piece, underscored that we have to be careful about bringing
inflation down too fast. For example, programs should avoid excessive
zeal in resisting blips in inflation due to food shortages or oil price
increases. And in practice, IMF-supported programs are quite flexible.
Where inflation was above 10 percent the year before the start of the
program (the average was 14 percent), the first-year target averaged 9
percent.
So how low is low enough for inflation? One of the conclusions that=92s
emerged from years of studies on this issue is that inflation only
starts to cause serious damage when it gets above a certain point.
Whether you average 2 percent or 3 percent inflation doesn=92t seem to
matter for growth. In the review, we concluded that the evidence is
roughly that in poor countries the danger point is somewhere between 5
and 10 percent, so that when it gets somewhere above there, it starts to
become harmful to growth.

Why might this be? Partly because with inflation much above that level,
there is a real risk that it will take off. In low-income countries, a 6
percent inflation rate provides inflation tax receipts for the
government of roughly 1 percent of GDP. In other words, the money
printing that goes with 6 percent inflation will typically finance
spending of about 1 percent of GDP. That=92s a decent amount of resources.
But it is still tiny relative to needs. If you were willing to go up to
15 percent inflation, you=92d be able to finance maybe another 0.4 percent
of GDP in spending. Is going from 6 to 15 percent inflation worth 0.4
percent GDP in expenditure? It puts you into quite a precarious range.
It might be okay if you can manage to keep it there, but when you=92re at
15 percent, then you=92re on the edge of a slippery slope. Depending on
how much confidence there was in your overall system, people start to
really flee the currency because they see the government losing control.
It=92s a precarious balance. If you go from 15 percent to 25 or 30
percent, you might actually lose revenues. If you=92re at 15 percent in
good times and the economy faces a negative exogenous shock, then you
have a real problem on your hands, and you need a stabilization program.
No one wants a stabilization program unless it=92s absolutely necessary.

That=92s why on the whole we suggest the 5 to 10 percent range as an upper
bound. You should look for other ways to finance expenditure. Of course,
foreign grants are great but are in limited supply. If you=92re
sufficiently confident that your expenditures are not just needed but
also reasonably effective, then domestic taxation is a much more
efficient, pro-growth way to support further expenditures.

Q: How will this paper affect and inform the IMF=92s programs for poor
countries, like the PRGF and the new policy support instrument (PSI),
which is a non-borrowing facility?

A: We are discussing our results both inside and outside the Fund.
Within the Fund, the study has been built on as part of the stream of
work we are doing=97including in the African Department, the Research
Department, and the Fiscal Affairs Department=97on how to scale up aid
effectively. We hold =93Mission Chief Seminars=94 where we discuss our
results and compare them with the experience of area department mission
chiefs. Outside, we discuss and share experiences with academics and
policy-makers when we can. And of course we are continuing our work.
We=92re looking now at broadening our sample to see how general our
conclusions are, and we=92re looking more closely at questions of how to
manage aid volatility=97the focus of our study was on sustained surges in
aid. We=92re also trying to develop better analytic tools to help design
macroeconomic frameworks for scaling up aid.