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Thorvaldur Gylfason
Pretoria, South Africa
9-20 July 2007
 Definitions, motivations, trends
 Aid effectiveness
 Theory and evidence
 Macroeconomic dangers of aid
 Dutch disease
 Aid volatility
 Policy options in managing aid flows
 Preparing for scaling up aid
 Monetary policy options
 Fiscal challenges and debt sustainability
 Strengthening governance
 Conclusions and guidelines
Development
aid
 Unrequited
transfers from donor to
country designed to promote the
economic and social development
of the recipient (excluding
commercial deals and military aid)
Concessional
loans and grants
included, by tradition
 Grant
element ≥ 25%
Development
 Public
aid can be
or private
 Bilateral (from one country to another)
or multilateral (from international
organizations)
 Program, project, technical assistance
 Linked to purchase of goods and
services from donor country, or in kind
 Conditional in nature
 IMF conditionality, good governance
 Moral duty
 Neocolonialism
 Humanitarian intervention
 Public good
 National


Like education and health care
International
Social justice to promote world unity
 UN aid commitment of 0.7% of GDP

 World-wide redistribution
 Increased inequality word-wide
 Marshall Plan after World War II
1.5% of US GDP for four years vs. 0.2% today
 People at www.irenkenya.com in Nairobi
disagree

Objectives
 Individuals
in donor countries vs.
governments in recipient countries

Who should receive the aid?
 Today’s

poor vs. tomorrow’s poor
Aid for consumption vs. investment
Conflicts
 Beneficiaries’
needs
 Donors’ interests
Aid
is a recent phenomenon
Four major periods since 1950
 1950s:
Fast growth (US, France, UK)
 1960s: Stabilization and new donors

Japan, Germany, Canada, Australia
 1970s:
Rapid growth in aid again due
to oil shocks, recession, cold war
 1980s: Stagnation, aid fatigue, new
methods
United
States: largest donor in
volume, but low in relation to GDP
 2%
of GDP
Japan:
second-largest donor in
volume
Nordic countries, Netherlands
 Major
donors to multilateral programs
 Only countries whose assistance
accounts for 0.7% of GDP
EU:
leading multilateral donor
40
35
1985
1990
2000
30
25
20
15
10
5
0
sub-Saharan
Africa
Asia
Oceania
MEDA
Latin America
Europe
12
 The
Blair Report and the Sachs Report
called on world community to increase
development aid (particularly for
Africa) to enable developing countries
to attain the MDGs by 2015
 2005
G-8 Gleneagles communiqué called
for raising annual aid flows to Africa by
$25 billion per year by 2010
 2005 UN Millennium Project called for $33
billion per year in additional resources

For comparison, US gave $20 billion in 2004,
not $70 billion as suggested by UN goal
Aid
fills gap between investment
needs and saving and increases
growth
 Poor
countries often have low savings and
low export receipts and limited
investment capacity and slow growth
Aid
is intended to free developing
nations from poverty traps
 Example:
Capital stock declines if saving
does not keep up with depreciation
To understand the link between aid
and investment, consider resource
constraint identity by rearranging the
National Income Identity:
Y=C+I+G+X–Z
I = (Y – T – C) + (T – G) + (Z – X)
In words, investment is financed by
the sum of private saving, public
saving, and foreign saving
Rearrange again:
Y+Z=E+X
where E is expenditure
E=C+I+G
Thus, total supply Y + Z equals total
demand E + X
Aid increases recipient’s ability to
import: Z rises with increased X
o Is it feasible to lift all above a dollar a day?
o How much would it cost to eradicate extreme
poverty? Let’s do the arithmetic a la Sachs
o Number of people with less than a dollar a
day is 1.1 billion
o Their average income is 77 cents a day, they
need 1.08 dollars
o Difference is 31 cents a day, or 113 dollars per
year
o Total cost is 124 billion dollars per year, or
0.6% of GNP in industrial countries
o Less than they promised! – and didn’t deliver
Regression
analysis to measure
the impact of aid on
 Saving
 Investment
 Public
finance
 Economic growth
 Saving

Negative effect on saving
Substitution effect?
 Boone, 1996; Reichel, 1995


Positive effect for good performers

E.g., South-East Asia, Botswana
 Investment


No impact on private investment
Positive impact for good performers
 Public


finance
Uncertain effect on public investment
Positive effect on public consumption
Growth:
Mixed results
 Most
early studies showed no
statistically significant impact
 Some more recent studies show
negative impact
 Bias and endogeneity issues
Need
to distinguish between
different types of aid
 Leakages,
cash vs. aid in kind
aid has
sometimes been
compared to natural
resource discoveries
 Aid and growth are
inversely related
across countries
 Cause and effect
 156 countries,
1960-2000
Per capita growth adjusted for initial income (%)
 Foreign
r = rank correlation
r = -0.36
6
4
2
0
-2
-4
-6
-8
-20
0
20
40
60
Foreign aid (% of GDP)
80
 Examples
 Rajan

and Subramanian (2005)
No robust relationship between aid and
growth
 Burnside

of recent studies
and Dollar (2001)
Aid works in “countries with good policies”
 Clemens,
Radelet, and Bhavnani (2005)
Aid works if measured correctly
 Distinction between fast impact aid
(infrastructure projects) and slow impact aid
(education)
 Financial vs. social returns

Empirical
evidence
Types of aid
Diminishing returns and limits to
domestic absorptive capacity
Interaction with governance and
good policies
Post-conflict situations
Aid
leads to corruption
Aid tends to be misused
 Svenson
(2000)
 Murshed and Sen (1995)
Aid
is badly distributed, sometimes
for strategic reasons
 Alesina
and Dollar (2000)
 Collier and Dollar (2002)
Aid
increases public consumption,
not investment
Aid is procyclical
 When
Aid
it rains, it pours
leads to “Dutch disease”
 Labor
intensive and export industries
contract relative to other industries in
countries receiving high aid inflows
Growth
is perhaps not the best
yardstick for the usefulness of aid
 Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
 In 1960s, Netherlands discovered natural
resources (gas deposits)


Currency appreciated
Exports of manufactures and services suffered,
but not for long
 Not
unlike natural resource discoveries,
aid inflows could trigger the Dutch Disease
in receiving countries
Review
theory of Dutch disease
in two rounds
Demand and supply model
Two-sector model
 Demand
effects
 Supply effects
 Exchange rate volatility
Real exchange rate
Payments for
imports of goods,
services, and capital
Imports
Earnings from
exports of goods,
services, and capital
Exports
Foreign exchange
eP
Q
P*
Devaluation or
depreciation of e
makes Q also
depreciate unless P
rises so as to leave Q
unchanged
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
eP
Q
P*
1. Suppose e falls
Then more lira per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Summarize all three by supposing
that Q falls
Then X rises, Z falls
Real exchange rate
Aid leads to appreciation
and thus reduces exports
C
B
A
Imports
Exports
plus aid
Exports
Foreign exchange
Real exchange rate
Oil discovery leads to appreciation
and reduces nonoil exports
C
B
A
Imports
Exports
plus oil
Exports
Foreign exchange
Real exchange rate
Composition of exports
matters
C
B
A
Imports
Exports
plus oil
Exports
Foreign exchange
 Dutch
disease is a real phenomenon, not
monetary
 Real exchange rate always floats
 Recall: Q = eP/P*
 Flexible exchange rate regime

Nominal appreciation
 Fixed

exchange rate regime
Inflation
 Look
at this more closely in two-sector
model of traded vs. nontraded goods
Traded goods (T)
Production frontier (supply)
Nontraded goods (N)
Traded goods (T)
Indifference curve (demand)
Equilibrium
Production frontier (supply)
Nontraded goods (N)
T
Indifference curve (demand)
Price line, slope = -PN/PT = -Q
Equilibrium
Production frontier (supply)
N
Increased demand for N
PN/PT rises (appreciation)
Supply of N increases, supply of T falls
T
T = ON = AE
Slope = -PN/PT N = OA
Cannot add T and N
Convert T into units of N
E
AE/AB = PN/PT
AB = AE(PT/PN) = PTT/PN
Y = N + PTT/PN = OA + AB
Y = N + T/Q
N
O
A
B
N
T
Production frontier: T = a – 0.5bN2
a
E
(2a/b)0.5
Increase in a
Increase in b
Tangency at E:
dT/dN = -bN = -Q
N = Q/b (supply)
N
a and b are
indicators of
efficiency,
inefficiency
Increase in Tmax and Nmax
Decrease in Nmax
T
Indifference curve: U = T + ln(N)
a
E
(2a/b)0.5
Tangency at E:
0 = dT + (1/N)dN
dT/dN = -1/N = -Q
N = 1/Q (demand)
N
T
a
E
Equilibrium at E:
Supply = demand
Q/b = 1/Q
Q = b0.5
(2a/b)0.5
T = a – 0.5b(b-0.5)2 = a – 0.5
N
Supply:
N = Q/b =
b0.5/b = b-0.5
Demand:
N = 1/Q =
1/b0.5 = b-0.5
T
Suppose aid increases
demand for N by q%:
N* = (1+q)/Q = Q/b
Q2 = b(1+q)
Q = [b(1+q)]0.5
N* = (1+q)/[b(1+q)]0.5
= [(1+q)/b)]0.5
dN*/dq > 0
N
T = a – 0.5b[(1+q)/b]-0.5)2 = a – 0.5(1+q)
dT/dq < 0
T
So, in this case,
aid reduces GDP
Without aid:
Y = N + T/Q
= b-0.5 + (a–0.5)b-0.5
= (a+0.5)b-0.5
With aid:
Y = N* + T/Q
= [(1+q)/b)]0.5
+ [a – 0.5(1+q)]/[b(1+q)]0.5
= …N
= [a+0.5(1+q)]/[b(1+q)]0.5
Can we sign dY/dq? Yes!
dY/dq = -0.5bQ-3T < 0
 Aid
 It
is likely to lead to Dutch disease if
leads to high demand for nontradables
Trade restrictions
 Recipient country uses aid to buy nontradables
(including social services) rather than imports

 Production

is at full capacity
Production of nontradables cannot be increased
without raising wages in that sector
 Aid
is not used to build up infrastructure
and relax supply constraints
 Price and wage increases in nontradables
sector lead to strong wage pressure in
tradables sector
 Aid
 It
is likely to lead to Dutch disease if
leads to high demand for nontradables
Trade restrictions
 Recipient country uses aid to buy nontradables
(including social services) rather than imports

 Production

is at full capacity
Production of nontradables cannot be increased
without raising wages in that sector
 Aid
is not used to build up infrastructure
and relax supply constraints
 Price and wage increases in nontradables
sector lead to strong wage pressure in
tradables sector
Aid
spending can take several forms,
with different macroeconomic
implications:
 Case
1: Aid received is saved by recipient
country government
 Case 2: Aid is used to purchase imported
goods that would not have been
purchased otherwise (grants in kind)
 Case 3: Aid is used to buy nontradables
with infinitely elastic supply
 Case 4: Aid is used to buy nontradables
for which there are supply constraints
Studies
assessing empirical relevance
of Dutch disease as caused by aid
flows have produced mixed results
 Aid
was associated with real
appreciation in Malawi and Sri Lanka
 Aid was associated with with real
depreciation in Ghana, Nigeria, and
Tanzania
 Aid
is volatile and unpredictable
 Aid flows are 6-40 times more volatile than
fiscal revenue
 Volatility is largest for aid dependent
countries (Bulir and Hamann, 2005)
 Volatility increased in the 1990s
 Aid delivery falls short of pledges by over 40%
 Reasons
 Donors: Changes in priorities; administrative
and budgetary delays
 Recipients: Failure to satisfy conditions
Impact of large sudden inflows





Supply constraints in absorbing aid
Real exchange rate overshooting and volatility
Negative impact on export industries
Ratcheting up spending commitments without
adequate consideration of exit strategy
Infrastructure investment without adequate
planning for recurrent expenditure
Impact of aid promised, but not disbursed


Spending commitments cannot be financed
Volatility in money supply, inflation, and
exchange rates
Domestic
sterilization
 Sale
of domestic bond instruments
 Reserve requirements
 Central government deposits
Sale
of foreign exchange
Objectives and economic impact of
policies
 Nominal
exchange rate vs. inflation
 Domestic interest rates
Options to reduce risk of Dutch disease
 Save
resources
 Use aid to purchase imported goods
 Spend on non-traded sectors with few
supply constraints
Other spending options
Spend on nontradables with supply
constraints
 Infrastructure
spending for future growth
 Social spending for poverty reduction
Balancing
growth and poverty
reduction
 Growth
effects from infrastructure
investment
 Targeting spending to the poor
 Dutch disease
Improving
 NGO
coordination
activities
 Subnational government activities
 Private sector capacity
Advantages
of grants
 Lower
debt burden
 Useful for social projects with uncertain or
delayed returns (health care, education)
Advantage
 Increase
of concessional loans
total flow of resources
 Project allocation
 Increase debt management capacity
 Useful for projects yielding quick returns
(infrastructure)
Loans
vs. grants
Assessing external debt dynamics
Assessing fiscal debt sustainability
DSA framework for ensuring debt
sustainability
 Debt
and debt-service thresholds
 Public enterprises; net vs. gross debt;
risk of distress
Strengthening
debt management
Negative
impact on budgeting,
planning, and stabilization
Debt relief vs. aid
Donor commitment and transparency
Respecting conditionality
Flexibility to spend or save
Preventing
aid dependency
Protecting revenues
 Composition
 Corruption
 Tax
The
treatment of aid
scaling down of aid
Private economic activity
Real spending and recurrent spending
Corruption
and economic performance
 Impact
on growth
 Likelihood of disbursement
Anticorruption
strategies
 Reduce
state role
 Improve regulatory environment
 Punish offenders
 Liberalize and reform institutions
Improving
public expenditure
management systems
From
aid fatigue to new initiatives
Aid effectiveness is ambiguous
 Positive
results likely with better policies
and governance
Five Primary Guidelines
 Minimize risks of Dutch disease
 Enhance growth
 Promote good governance and reduce
corruption
 Prepare an exit strategy
 Assess the policy mix
Isard, Lipschitz, Mourmouras, and Yontcheva, 2006,
Macroeconomic Management of Foreign Aid:
Opportunities and Pitfalls, IMF.
 Gupta, Powell, and Yang, 2006, Macroeconomic
Challenges of Scaling up Aid to Africa: A Checklist
for Practitioners, IMF.
 Rajan and Subramanian, 2005, “Aid and Growth:
What Does the Cross-Country Evidence Really
Show?”, IMF Working Paper.
 ______, 2005, “What Undermines Aid’s Impact on
Growth?”, IMF Working Paper.
