Vulnerabilities Related to the Scaling up of Aid and other capital Flows

1. Vulnerabilities Related to the Scaling up of Aid and other capital Flows Course on External Vulnerabilities and PoliciesTunis, March 2–13, 2009 Thorvaldur Gylfason

2. Outline • Aid and other capital flows • History, theory, evidence • Foreign aid and economic growth • Effectiveness: Does aid work? • Macroeconomic challenges • Dutch disease • Aid volatility • Policy options in managing aid flows and lessons from recent experience • Preparing for scaling up aid • Vulnerabilities • Monetary and fiscal policy options • Debt sustainability • Governance issues • Conclusions and guidelines

3. development aid: definition • 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%

4. development aid: definition • Development aid can be • Public (ODA) 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

5. Motivation: Why aid? • Moral duty • Neocolonialism • Humanitarian intervention • Public good • National (e.g., 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 • But Think tank in Nairobi disagrees, see www.irenkenya.com

6. Motivation: Why aid? • 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

7. Past Trends • 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, new thinking

8. Past Trends: 1950s • Rapid growth of development aid • US provided 50% of total ODA • To countries ranging from Greece to South Korea along the frontier of the “Sino-Soviet bloc” • France provided 30% • To former colonies, mainly in West Africa • UK provided 10% • To Commonwealth countries

9. Past Trends: 1960s • Stabilization of aid from traditional donors and emergence of new donors • US contribution decreased considerably after the Kennedy presidency (1961-63) • The French contribution decreased starting from the early 1960s • New donors included Japan, Germany, Canada, and Australia

10. Past Trends: 1970s • Rapid growth in aid from industrial countries in response to the needs of developing countries due to • Oil shocks • Severe drought in the Sahel • The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970 • The deadline for reaching that target was the mid-1970s

11. Past Trends: 1980s and 1990s • Stagnation of development assistance • Donor fatigue? • Private investor fatigue?

12. Donor fatigue?

13. Private investor fatigue?

14. Who are the donors? • United States: largest donor in volume, but low in relation to GDP • US aid amounts to 0.2% of GDP • Japan: second-largest donor in volume • Nordic countries, Netherlands • Major donors to multilateral programs • Sole countries whose assistance accounts for 0.7% of GDP • EU: leading multilateral donor

15. Who are the donors? • Even though targets and agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target • Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short

16. Official development assistance by donor 2005 (USD billion)

17. Geographical distribution of aid (%)

18. Geographical distribution of aid (%) • Sub-Saharan Africa and Asia have received the most aid, the former a rising amount over time • Aid to Sub-Saharan Africa is high in relation to GDP • For the 44 countries in the IMF’s Africa Department, net official transfers are as follows: < 5% of GDP: 14 countries 6%-16% of GDP: 24 countries > 20% of GDP: 6 countries

19. A recovery in sight? • The Blair Report and the Sachs Reportcalled 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

20. Macroeconomics of Aid • The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donors • What is the role of aid? • What is the macroeconomic impact of aid? • Is the impact of aid necessarily positive, or could aid have adverse consequences?

21. Macroeconomics of Aid • Aid fills gap between investment needs and saving and, if well managed, can increase 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 • E.g., capital stock declines if saving does not keep up with depreciation

22. Aid and Investment 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 • This is where aid enters the picture Aid is treated as part of government saving which increases domestic resources to finance investment. Sg Sp Sf

23. Aid and Investment Rearrange again: Y + Z = E + X where E is expenditure E = C + I + G Total supply from domestic and foreign sources Y+Z equals total demand E+X Aid increases recipient’s ability to import: Z rises with increased X, incl. TR Aid is treated as part of government saving which increases domestic resources to finance investment.

24. aid and growth • Poor countries are trapped by poverty • Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty • Countries become stuck in poverty traps • Aid enables poor countries to free themselves of poverty by enabling them to cross the necessary thresholds to launch growth • Saving • Technology • Human capital

25. Aid and Poverty • Is it feasible to lift all above a dollar a day? • How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs) • Number of people with less than a dollar a day is 1.1 billion • Their average income is 77 cents a day, they need 1.08 dollars • Difference amounts to 31 cents a day, or 113 dollars per year • Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries • Less than they promised! – and didn’t deliver

26. Empirical Studies of Aid • Several empirical studies have assessed the impact of aid on growth, saving, and investment • The results are somewhat inconclusive • Most studies have shown that aid has no significant statistical impact on growth, saving, or investment • However, aid has positive impact on growth when countries pursue “sound policies” • Burnside and Dollar (2000)

27. Empirical Studies of Aid • Regression analysis to measure the impact of aid on • Saving • Investment • Public finance • Economic growth

28. Does aid work? Domestic responses • Saving • Negative effect on saving • Substitution effect? I.e., crowding out? • Boone 1996; Reiche 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

29. Does aid work? Domestic responses • Growth: Mixed results • Most early studies showed no statistically significant impact • Some more recent studies show negative impact • Selection bias and endogeneity issues • Need to distinguish between different types of aid • Leakages, cash vs. aid in kind

30. aid and growth r = rank correlation • Foreign aid has sometimes been compared to natural resource discoveries • Aid and growth are inversely related across countries • Cause and effect • 156 countries,1960-2000 r = -0.36 Other people’s money

31. Does aid work?The current debate • No robust relationship between aid and growth • Aid works in “countries with good policies” • Aid works if measured correctly • Distinction between fast impact aid (infrastructure projects) and slow impact aid (education) • Infrastructure: High financial returns • Education and health: High social returns

32. Impact of Aid on Growth and Investment • So, empirical evidence is mixed • Need to distinguish between different types of aid • Need to acknowledge diminishing returns to aid as well as limits to domestic absorptive capacity • Need to clarify interaction with governance and good policies • Special case: Post-conflict situations

33. Reasons for the Possible Ineffectiveness of Aid i • Aid may lead to corruption • Aid may be misused, by donors as well as recipients • Donors: Excessive administrative costs • Recipients: Mismanagement, expropriation • Aid may be badly distributed, sometimes for strategic reasons • Supporting government against political opposition

34. Reasons for the Possible Ineffectiveness of Aid ii • Aid increases public consumption, not public investment • Aid is procyclical • When it rains, it pours • Aid leads to “Dutch disease” • Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows • Dutch disease may undermine external sustainability

35. Reasons for the Possible Ineffectiveness of Aid iii • Aid volatility and unpredictability may undermine economic stability in recipient countries • Economic vs. social impact • Growth is perhaps not the best yardstick for the usefulness of aid • Long run vs. short run • E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run

36. See my “Dutch Disease” in the New Palgrave Dictionary of Economics Online Dutch disease • 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

37. Dutch disease • Foreign exchange is converted into local currency and used to buy domestic goods • Fixed exchange rate regime • Expansion of money supply leads to inflation and an appreciation of real exchange rate • Flexible exchange rate regime • Increase in the supply of foreign exchange leads to an appreciation of the nominal exchange rate, so the real exchange rate also appreciates

38. Impact of aid on the Real Exchange Rate • Review theory of Dutch disease in two rounds • Demand and supply model • Two-sector model • Demand effects • Supply effects • Exchange rate volatility

39. Balance of payments equilibrium Payments for imports of goods, services, and capital Imports Real exchange rate Earnings from exports of goods, services, and capital Equilibrium Exports Foreign exchange

40. Real exchange rate e refers to foreign currency content of domestic currency 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

41. Three thought experiments 1.Suppose e falls Then more dinars 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 thatQ falls Then X rises, Z falls

42. Aid reduces exports Aid leads to appreciation, and thus reduces exports C B Imports Real exchange rate Exports plus aid A Exports Foreign exchange

43. Oil: same story Oil discovery leads to appreciation, and reduces nonoil exports C B Imports Real exchange rate Exports plus oil A Exports Foreign exchange

44. Oil: same story Composition of exports matters C B Imports Real exchange rate Exports plus oil A Exports Foreign exchange

45. Dutch Disease and the Exchange Rate Regime • Dutch disease is a realphenomenon, 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: Skip

46. The risk of Dutch disease • A large inflow of foreign aid -- like a natural resource discovery -- can trigger a bout of Dutch disease in countries receiving aid • A real appreciation reduces the competitiveness of exports and might thus undermine economic growth • Exports have played a pivotal role in the economic development of many countries • An accumulation of “know-how” often takes place in the export sector, which may confer positive externalities on the rest of the economy

47. The risk of Dutch disease • Aid is likely to lead to Dutch disease if • It leads to high demand for nontradables • Trade restrictions may produce this outcome • 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

48. The risk of Dutch disease • The risk that aid flows might have an adverse impact on the economy as a result of aid-induced Dutch Disease crucially depends on how aid is used in the recipient countries • We can identify four different cases on the basis of how the aid is spent, and in which the macroeconomic implications of aid flows are different

49. The risk of Dutch disease • 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

50. How aid is used and the risk of Dutch Disease: Case 1 • Aid received is saved by recipient country government • Aid receipts leads to accumulation of foreign exchange reserves in Central Bank • … and, unlike increased aid that is spent, are not allowed to enter the spending stream • No effect on money supply • No inflation • No appreciation of nominal exchange rate • No risk of Dutch disease