How to note. MACROECONOMICS NOTE No. 2. Macroeconomic Issues for Scaling-Up Aid Flows

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1 How to note Part of a series of four notes on macroeconomics for DFID staff OCTOBER 2004 MACROECONOMICS NOTE No. 2 Macroeconomic Issues for Scaling-Up Aid Flows This note is concerned with the macroeconomic management of large aid flows. It builds on the DFID Policy Paper The Macroeconomics of Aid (2002) but concentrates on the macroeconomic challenges of a sustained scaling up of the volume of aid, especially when aid levels are already high. It consists of three sections: Section 1 outlines the challenges, Section 2 provides a checklist of issues to be considered in evaluating a country s capacity for scaling up, and Section 3 describes possible policy responses that may help countries address constraints on absorption. 1. MACROECONOMIC PERSPECTIVES ON SCALING-UP AID Opportunities currently exist for a significant scaling up of concessional financing to some lowincome countries to support progress towards the Millennium Development Goals. Hand in hand with these opportunities go the challenges of effectively managing such large resource flows. 1 These include not only the technical challenge of designing and implementing effective public expenditure programmes and associated aid management systems (neither of which are discussed in this note) but also the macroeconomic and political challenge of ensuring that scaling up especially if it is rapid does not jeopardise overall macroeconomic stability. From a macroeconomic perspective, the scope for scaling up aid flows will be shaped by two factors: The absorptive capacity of high-aid economies, and how higher levels of aid affect macroeconomic performance in the medium term The nature of adjustment costs, which will determine how the rate at which aid flows are increased affects the economy in the short run 1 Financing needs the basis for scaling up are hard to estimate and at least some of the current estimates might owe as much to advocacy as they do to true economic costing. Nonetheless, even on the basis of the least ambitious figures, the implied resource flows are sufficiently large relative to the current income of potential recipients, and are likely to be sufficiently persistent, to have a significant impact on the volume of public expenditure and the overall structure of recipients economies. 1

2 Absorptive Capacity Concerns about the potentially adverse effects of higher levels of aid stem from a range of core anxieties about the functioning of a high-aid economy: 2 Growth effects High levels of aid may induce Dutch disease effects, undercutting export performance and thereby reducing growth (see DFID, Policy Note and Technical Appendix, December 2002). Fiscal and debt sustainability effects Reliance on high levels of aid may reduce incentives for domestic revenue mobilisation. Except in circumstances where all aid is in the form of grants, higher aid flows raise concerns about external debt sustainability. Pressures to meet the recurrent- and replacement-cost implications of higher aid-funded expenditure from domestic resources puts pressure on the fiscal balance after grants and raises concerns about medium-term fiscal sustainability and domestic debt sustainability. Macroeconomic stability effects Aid flows are often volatile, fickle and politically influenced. As a result, they have the potential to increase macroeconomic instability (i.e. inflation and interest rate and exchange rate volatility). o Concerns about volatility are arguably most acute when aid is in the form of budget support rather than project support. In such circumstances, the effects of volatile aid flows are felt not just in terms of the expenditure programme but may also have powerful macroeconomic effects as a result of overall fiscal volatility. Institutional effects High aid dependence can distort institutional development in a number of ways: o through higher transactions costs, by requiring substantial resources to be allocated to the coordination and management of aid flows o by encouraging corruption and rent seeking behaviour o by shifting political attention at the margin towards the creation of an enabling environment for aid which may not be the same thing as an enabling environment for sustainable private sector led growth 2 These concerns are reflected, for example, in the IMF s Staff Note on Higher Aid Flows (April 2003). 2

3 Adjustment Costs The marginal cost of aid (i.e. the macroeconomic distortions it imposes on the economy) is likely to rise with the rate at which the aid flow is increased. Hence, too rapid an increase in aid can reduce its effectiveness at the margin and lower the level of aid that can be absorbed before it starts to have an overall adverse impact on the economy. Adjustment-cost concerns emerge in two areas. First, through the direct impact of large aid inflows on the quality of aid management, coordination and public service delivery (so-called micro absorption constraints). They also reflect indirect impacts via key markets and sectors: In the labour market: where the demand for labour in critical sectors can only be met through higher labour costs and lower skill levels. These pressures may occur in the public sector, both at the implementation end (e.g. in the need for doctors) and at the coordination and management end (e.g. in the Ministry of Health), but may also be felt elsewhere in the labour market if the public sector drives up wages or cherry picks skilled workers. In the capital goods sector: where increased demand for construction goods raises their price and reduces the marginal efficiency of investment. In money and foreign exchange markets: where the volume of aid flows to government may overwhelm the capacity of the domestic monetary authorities to avoid short-run volatility in the exchange rate and interest rates; both of which are damaging to private sector investment. This risk is particularly acute in countries where financial markets are thin (see Note No. 3). Unwarranted Pessimism? These concerns command support in many quarters, and have helped underpin a powerful aid pessimism perspective on scaling up. 3 However, reliable evidence on either the likely benefits of higher aid flows, or on the costs of scaling up, is extremely scarce, especially at the country level. 4 Rushing to conclusions about the likely effects of higher aid, without good countryspecific evidence (including evidence on the benefit side), may be ill advised. Moreover, the case for scaling up, and for doing so quite rapidly, may still make sense even if adjustment costs are high. The poverty reduction imperative. Even if the costs of scaling-up aid are high, the costs of not doing so may well be much higher. 3 A general characterization (and rebuttal) of this perspective is provided in Paul Collier s paper on Aid Dependency: A Critique. 4 Some evidence is available from cross-country comparisons, but this should be interpreted with some caution: it is based on historical data and covers a period where the context for aid was very different from that envisaged today; it reflects average relationships and not the constraints facing individual countries; and it says nothing about the dynamics of scaling-up aid. 3

4 The political imperative. Donors and recipients may face a use it or lose it constraint. For example, after decades of lobbying for the 0.7% target, there is pressure to show that resources can be made use of when they do become available. Debt-sustainability pessimism may be unwarranted. Higher aid flows clearly have no debt sustainability consequences if all flows are in the form of grants. And even if aid flows are partly in the form of concessional loans these should not be of major concern in the medium term if, as seems reasonable, aid supports improved growth. 5 It may be the case that debt indicators rise in the short run before the identifiable supply-side effects of aid are felt, but short-run movements in debt indicators may be a poor measure of medium-term sustainability. Absorptive capacity and adjustment cost pessimism by be unwarranted. Current estimates of the potential scale of Dutch disease effects and the size of adjustment costs, if they exist, are based on evidence from the last two decades of the 20th century. These estimates may overstate the problems in the present context, given recent macroeconomic and public expenditure reforms, combined with improved (or at least improving) understanding about appropriate short-run macroeconomic policy responses to aid flows. Aid-induced macroeconomic instability is not inevitable. Large aid inflows can be destabilizing, especially in the presence of inflexible fiscal structures and under-developed financial markets. However, inflows that are reasonably predictable and persistent are neither intrinsically inflationary nor do they necessarily generate macroeconomic instability (see Section 3 below and DFID, December 2002). Adjustment costs are not immutable. Best practice in public expenditure management, careful attention to the sequencing of aid flows and expenditure, and access to additional policy instruments (e.g. higher foreign exchange reserves) may make it possible to ease the bottlenecks and distortions that contribute to increasing adjustment costs (see Foster, 2003; and the World Bank s World Development Report, 2004 ). The benefits of aid may also be increasing with the speed of disbursement. Even if there are adjustment costs, there remains a possible case for a rapid increase in aidfinanced public spending. Threshold effects may mean that the returns to aid are only realized if aid flows are in sufficiently large quantities to trigger sustainable growth and poverty reduction. This idea is intuitive for large public infrastructure projects, but such threshold effects may be more general. For example, there may be some minimum level of health and education, or public order and security, required to allow societies to engage in growth enhancing economic activity. 5 The debt-to-gdp ratio will decline over time if the rate of growth in the economy exceeds the relevant rate of interest on debt. The higher the debt-financed rate of growth and the higher the degree of concessionality on borrowing, the more likely it is that this condition will be met. 4

5 2. ASSESSING COUNTRY-SPECIFIC CAPACITIES FOR SCALING UP: A CHECKLIST The debate on the macroeconomics of scaling up will revolve around four core questions: How much additional aid-funded expenditure can be absorbed? How quickly should it be injected? How do current conditions constrain the capacity to scale-up aid flows and the rate at which this can occur? What policy instruments or actions are required to mitigate any adverse effects of higher aid flows? This checklist sets out a set of questions which serve to shape an assessment of the capacity to scale-up aid in a specific country, and the speed with which this should occur. ASSESSING CURRENT CONDITIONS AND FUTURE PLANS Any assessment of proposed scaling up requires an assessment of current macroeconomic conditions, the structure of aid and public expenditure, and the country s recent track record in managing aid flows. Scale, composition and duration of aid flows How large are current aid volumes? How have they evolved over recent years? What are the anticipated patterns? o Relative to GDP, domestic revenue and public expenditure. What is the composition of current aid flows? o Grants versus concessional loans o Projects versus budget support What is the likely scale and duration of new flows? What do new flows imply for debt sustainability indicators in the short run (i.e. before growth effects of aid-financed expenditure materialize) and the medium term (when growth effects begin to be felt)? 5

6 Composition and likely growth effects of planned aid-financed expenditure How import intensive is expenditure (public and private) likely to be? Is expenditure likely to be labour or capital intensive? Is there a sufficient supply of appropriately skilled labour? What are the anticipated supply-side effects (and over what time horizon)? For instance: o from boosting private-sector productivity growth o from building up human capital (via education, training and health improvements) o via reductions in the cost (or increase in the quality) of public service provision Fiscal and monetary consequences of higher aid flows Are higher aid flows expected to change the prospects for revenue mobilization? For instance: o through anticipated real exchange rate movements 6 o as a result of the stimulus to private-sector activity o by reducing the urgency of reforms to the domestic tax collection system Are macroeconomic policies capable of handling higher aid flows? o Is overall fiscal control well established with a track record of low inflation? o Is there capacity for fiscal adjustment, if needs be, in the face of unanticipated changes in the level or timing of aid flows? o How susceptible is the economy to external shocks, how well is macroeconomic policy able to cope with these, and how might increased aid flows affect this capacity? o Is there a coherent monetary and exchange rate strategy in place to ensure the efficient management of official and private capital flows and to avoid excessive interest rate and exchange rate volatility? (See Note No. 3) o Are foreign exchange reserves large enough to cope with potential external volatility, particularly volatility of aid flows? 6 For example, in circumstances where domestic revenue is skewed towards trade taxes, revenue mobilization (as a share of GDP) could decline simply as a result of the appreciation of the real exchange rate which will lower the domestic value of trade tax revenues relative to GDP. 6

7 o Does the thinness of domestic financial markets and the state of development of other key institutions restrict the capacity for effective monetary and exchange rate policy? How might increased aid flows interact with domestic institutions (for example systems of public expenditure management) and how might they impact on the political economy of the recipient country? SCALING UP IN PRACTICE: IDENTIFYING BOTTLENECKS AND DUTCH DISEASE EFFECTS Standard Dutch disease arguments focus on the demand-side effects of aid. Aid inflows tend to appreciate the real exchange rate through increased demand for non-tradables. This reduces incentives to export which, given the central role of export production in the growth process, undercuts aggregate growth. Given that they are overwhelmingly non-tradable, the same real exchange rate appreciation also bids up the relative price of public services. These demand-side effects of aid are intensified if the additional expenditure is skewed towards non-tradable goods, and if production in the non-tradable sectors is close to full capacity. 7 The key to assessing the impact of aid, however, is the response of the supply side to the increased inflows. If aid-financed expenditure (i) augments the physical capital stock, (ii) helps improve the quality of human capital, or (iii) supports productivity growth in the private sector, then the simple link between the real exchange rate and competitiveness of the export sector is broken. Aid inflows may be associated with an appreciation, depreciation or indeed no change in the real exchange rate. The principal Dutch disease risks tend to arise when: short-run overshooting of the real exchange rate has permanent adverse effects on the real economy monetary and exchange rate policies are unable to smoothly manage the domestic monetary consequences of aid inflows These outcomes will be more likely the faster the rate of scaling up, and could occur if, for instance: o the (temporary) loss of market share or decline in export production in the short run means that domestic export production techniques lag behind international best practice 7 How much genuine spare capacity really exists is often unclear. Unemployed capital and labour are only relevant as excess capacity if they can be brought into productive use in response to increased demand. Frequently, however, demand is highest for resources already in short supply such as skilled labour. 7

8 o firms are unable to finance short-run losses forcing them to leave the export sector altogether without being able to return when conditions improve (so-called hysteresis effects) o short-run exchange rate appreciation creates incentives for excess investment in domestic assets (construction boom effects) which is not only inefficient in terms of the composition of the aggregate capital stock but also increases the pressures on the domestic financial system, especially in the presence of weak financial regulation Key Indicators I: The Demand Side What is happening to the real exchange rate and to inflation? o The real exchange rate could be measured using either an IMF measure which gives an indication of the external competitiveness of the economy, or an internal real exchange rate measure. 8 For small open economies the latter provides a better indication of the incentive for domestic firms to produce for export markets. o In either case, a decline in the ratio implies an appreciation of the real exchange rate, and an erosion of the competitiveness of the tradable-goods and export sectors. However, an appreciation of the real exchange rate is a necessary but not sufficient condition for Dutch disease effects. An appreciated real exchange rate may be fully offset by productivity-enhancing supply-side effects associated with higher aid inflows. o Are demand pressures on the non-tradable sector spilling over into generalized inflation? What is happening to export performance in general, and to non-traditional exports in particular? o Is there evidence that output in these sectors is suffering from rising input costs or loss of export market share? o What is happening to profits, employment and firm closures in these sectors? Whilst a real exchange rate appreciation squeezes returns in all export sectors there may be different reasons for being concerned about traditional and non-traditional export sectors. For example, in the traditional export sector, which typically includes cash crop or natural resource based exports, the squeeze on margins may have adverse effects on income distribution and poverty reduction, but is unlikely to affect the profitability of the sector in the long run after the real exchange rate misalignment has been corrected. 8 The IMF measure is defined as E.P*/P where E is the nominal (trade-weighted) exchange rate, P* the average price level in trading partner countries, and P the domestic price level. The Internal RER measure is the ratio (in domestic prices) of the price of tradable goods to non-tradable goods. The former is generally proxied using manufactured goods and the latter with the price of services (and/or non-traded food). 8

9 In the non-traditional export sector, however, where productivity growth is more closely linked to maintaining engagement with world markets (through strategic supply chains, innovation, technological transfer etc), the risk is that short-run contractions in output will have more long lasting effects on growth prospects. What is happening to the share of services in total production? o This is a standard indicator of Dutch disease. Some of the growth in this sector will reflect expanded public service activities and spillover effects into the demand for private services. Although this sector may be labour intensive it rarely exhibits high productivity growth. Hence, the growth of this sector may be associated with a decline in overall productivity growth in the economy. 9 Key Indicators II: The Supply Side What is happening to public-sector and private-sector investment? o Is aggregate investment increasing? o Is there evidence that public-sector investment is crowding-in private-sector investment and/or improving its productivity? o Is there evidence of construction boom effects where investment is skewed away from long-run growth sectors such as non-traditional exports, and towards the non-tradable sector, due to (temporarily) high returns resulting from appreciation of the real exchange rate? o What does evidence from investor surveys or business sentiment surveys suggest about investment patterns, productivity growth etc? What is happening to domestic labour markets? o Is there evidence of labour shortages in key sectors, or of labour movement across sectors? o What is happening to real wages: in absolute terms, relative to GDP growth, and across sectors? 9 It is important to attempt to identify changes in real activity levels in the tradable and non-tradable sectors since measured changes in their relative shares of GDP will also reflect revaluation effects resulting from movements in the real exchange rate. For example, an appreciation of the real exchange rate will automatically increase the measured share of non-tradables and reduce the measured share of tradables in GDP, even if the underlying composition of economic activity does not change. 9

10 Key Indicators III: Fiscal and Monetary Management Is the management of current aid flows proving problematic? o Is the rate of implementation of public expenditure programmes deteriorating? o Is there a fall in the quality of additional spending or expected returns? o Is there a decline in the rate of domestic revenue mobilization relative to projections (i.e. after allowing for changes in tax rates and real exchange rate effects)? Are aid flows excessively volatile and/or pro-cyclical relative to domestic revenue? (See also Note No. 1) The impact of volatile aid flows will depend on how closely aid and expenditure are linked. If the link is tight then volatility in aid flows will translate into volatile programme implementation. If the link is weak for example in systems of budget support then aid volatility will translate into fiscal volatility, and domestic deficit financing becomes the key adjusting item in the budget. If volatility is high in these circumstances then it places a heavy burden on the monetary authorities. The predictability of aid flows will influence the authorities ability to manage changes in the level of aid. Is the central bank confronted with difficult monetary policy problems? Is there evidence that it is unable to (i) signal a coherent medium-term policy stance, and (ii) act to smooth the short-run path of interest rates and the exchange rate? o Are domestic interest rates high and/or volatile? Or is there nominal exchange rate volatility? o Is the conduct of monetary and exchange rate policy complicated by significant private capital flows? Have the authorities developed strategies to manage these flows? o Is there fear of floating, with exchange rate intervention and issuing of bonds to sterilise domestic liquidity growth? Key Indicators IV: Private Sector Reactions If the private sector has doubts about the sustainability of scaling up, these could be manifest in a number of ways. Is there evidence of precautionary hedging of financial assets? o a decline in net private capital inflows (FDI or other flows including remittances) 10

11 o a sharp rise in the share of foreign currency deposits in the money supply o a shift towards short-maturity government debt (the yield curve rotates upwards) Is the private sector opting to wait, choosing to build up financial assets rather than committing to partially-irreversible investment in fixed capital? Are banks increasing provisions against bad and doubtful debts? 3. FEEDBACK AND ACTION: FEASIBLE RESPONSES WHEN PROBLEMS ARISE The most obvious response to stress indicators hitting dangerous levels will be to scale back the rate of increase and, possibly, the level of aid. Short of a permanent reduction in the level of aid, focus should be turned towards other actions and interventions. Sequencing Public expenditure programmes are multidimensional, so there may be some scope for altering the structure of expenditure in the short run, to mitigate absorption problems, simply by altering the sequencing or possibly the form of activities. Switching from programmes of expenditure that are intensive in non-tradables to those that have a higher import content, for instance from more labour-intensive to capital- or input-intensive expenditure. Accelerating or promoting activities likely to have rapid payoffs in terms of easing supply bottlenecks (especially in the non-tradable sector). Fiscal adjustment When the public sector faces high short-run adjustment costs, a dollar of aid at the margin may have a much higher (social) payoff if it is transferred directly to the private sector. This could occur through some combination of: lowering taxation or increasing subsidies (see below) retiring domestic debt with a view to lowering domestic interest rates and increasing credit to the private sector Relative to the case where budget expenditure is increased in line with aid flows, a revenue reduction (with no increase in expenditure) does not alter the overall fiscal stance. But when 11

12 increased aid is used to write-down domestic debt, the before-grants fiscal deficit must be set lower than when aid is used to finance increased budget expenditure, by the amount of the aid inflow. Supporting monetary and exchange rate management Reducing the volatility of aid flows and increasing their predictability will ease monetary and exchange rate management. This could involve: committing aid over longer time horizons increasing external debt relief, which generates a highly predictable increase in the net aid inflow increasing transparency on conditionality, which is particularly important in the case of budget support, when the short-run link from aid to expenditure is loose supporting greater flexibility in the management of foreign reserves by the central bank Tax policies to offset adverse short-run Dutch disease effects If rapid scaling up stimulates temporary Dutch disease effects (with demand-side effects likely to precede supply-side responses), there may be a role for temporary production subsidies or tax credits for the sectors affected. The rationale is simple: faced with temporary adverse shocks it can be socially inefficient for households and firms to move out of the export sector. However, if private markets (especially credit markets) are unwilling to finance the temporary losses incurred by staying in, private agents may have no choice but to move out. In traditional export sectors the principal concern is to provide safety nets against income losses. In non-traditional export sectors the objective is to allow firms to maintain market share and to finance the investment in innovation required to remain competitive in global markets. This guidance is part of the Policy Division Info series. Ref no: PD Info 062. Crown copyright Any part of this publication may be freely reproduced providing the source is acknowledged. 12