ECGA 5450 Crises, Adjustment and Poverty Spring 2018 The Macroeconomics of Foreign Aid

Surges of foreign aid often follow the end of conflict or natural disasters (Haiti in 2009 and Sri Lanka after the 2004 Tsunami). Public health emergencies and natural disasters can lead to large aid inflows. Though well intended, foreign currency inflows sometimes reaching 20-30% GDP can lead to the same sort of macroeconomic adjustment problems created by private capital flows or terms of trade windfalls (the reverse of “sudden stops” or current account reversals). Though most Least Developed Countries do not have large manufacturing sectors, Dutch Disease style harm to the tradables sector caused by an appreciation of the real exchange rate or non-tradables inflation or displacement of domestic production by imports (a risk with food aid for example). Since the tradables sector in many countries includes agriculture, aid surges may hurt some of the same groups aid targets (small farmers for example). In extreme cases, aid can lead to a “boom famine” as documented by Sen (1973) in India during World War II (spending on war preparations drove up real wages and the price of food grains, leaving those not directly involved in the wage boom unable to purchase enough food). While in-kind food aid often drives down local food prices (raising real wages). Post-conflict aid inflows, for example, can reach a third of GDP or more (see Figures 4.15 and 4.16 from UNDP BCPR 2008 Chapter 4 reprinted below). At the 2005 Gleneagles G-8 Summit participants promised to double aid to Sub- Saharan African countries, from in some cases already high levels (for more on the politics of the Gleneagles aid surge, see the Why Poverty Documentary Give us the Money: , Bono and ( and where Birhan Woldu appeared in 2005). Many in the development community had strong reservations about the Gleneagles Aid surge, largely unfounded in retrospect (IMF-UNDP).

In an effort to catalog potential macroeconomic problems with aid inflows and to identify the options open or receiving economies the IMF (2005) and others have agreed on some terms for describing how aid can be “absorbed” or “spent” (or not). Here aid is “absorbed” when it results in a change the in current account balance (CAB). This “absorb aid” idea should not be confused with absorption A = C + I + G or Alexander’s Absorption approach countries capacity to make good use of aid (aid effectiveness). To absorb aid is simply to use it dollar for dollar to finance a current account deficit of the same magnitude. Why might the IMF think this is a good idea? (as opposed to the WB or UNDP?). If and when aid is disbursed by donors it may be used to finance a current account deficit (imports of goods and services) or it can augment reserves or be held abroad (hopefully in government accounts). If aid flows are unpredictable, one cannot blame the government for not spending or absorbing it promptly (it takes time to spend others money).

Most of the issues the IMF worries about arise in an economy operating at or near its productive capacity. Figure 1 reviews these possible uses of aid in the familiar Metzler diagram. Suppose aid finances a surge in public investment (to rebuild or build new roads and ports for example). Following the discussion outlined in IMF (2005) aid inflows can have both a current account (CA) and a capital account component (F). Aid affects the CA = X – M – r*D since countries can use aid to increase imports or service past debt (without increasing exports X). Aid also affects the capital account (KA) as debt may be forgiven. By definition the change in reserves equals the current plus the capital account balance, -

∆R = CA +KA. Subtracting aid inflows from the current and capital account yields the no aid CA and KA, –

AID = ∆R (NACA +NAKA) (1) - What balance of paymentsincrease identity the non-aid (1) iscurrent telling account us is that deficit. aid can Put be another used forway, to aid increase: can be used to financepurposes: reserve i) reserves; accumulation, ii) to capi increasetal outflows non aid or capitalmore imports outflows through NAKA a (sometimeswider CA deficit. referred Generally to as donorscapital expectflight); aid or to be used to increase imports CA deficit, though in some circumstances an increase in reserves may be warranted: the extent to which this happens is referred to as the “absorption” of aid: so that the share of aid absorbed is the

∆NACA/∆AID. If the change in aid inflows (say 10% of GNI) equals Generallythe change the in extent the CA to balance, which aid aid is is absorbed said to beis determinedfully absorbed. by the central bank (while the various government agencies determine the extent to which aid is “spent” as discussed below). Except for the special case in which the government spends the entire aid increment on imports (or the aid is in- kind in the form of medicine or food for example) absorbing aid by increasing the NACA means the local currency must appreciate, the that is q = PT/PNT must decrease to move the economy up and to the left on its TNT PPF. This happens naturally when the Central Bank sells the aid dollars to the private sector causing either a fall in the local currency price of dollars, e, or an increase in the price of non- tradables, PNT (recall that PT =ep*, where e is the nominal exchange rate). This means aid inflows can create the adjustment problems associated with any currency inflow, including inflation (via PNT) and a reduction in tradables output. If reserves are low or the exchange rate already strong or if aid inflows are expected to decrease the Central Bank may choose not to sell the dollars and reserves will rise. Using aid to accumulate reserves may also make sense if it helps create confidence in the currency, thereby reducing unofficial capital outflows or the NAKA from equation 1 above.

The IMF worries that if the economy is operating near full capacity and Aid inflows are not “absorbed” via an increase in imports, private investment will be “crowded out.” This scenario is illustrated in Figure 1 below, in the first panel aid is fully absorbed so public investment (the purpose of the aid in this case) can increase the full 10% of GDP without any reduction in private investment (the interest rate does not increase). In panel B the aid is not absorbed so that the increase in public investment spending raises interest rates, perhaps crowding out private investment. One might argue that even if the aid is absorbed tradables output is reduced as the economy shifts toward imports, so either way foreign aid, generally considered a good thing, creates some adjustment problems, potentially. Countries sometimes do not fully absorb aid: recent IMF estimates suggest that about 70% of ODA (official development assistance to low income countries) is absorbed eventually (see Aiyar and Ruthbah, 2008, page 14). The part that is absorbed then must lead to a currency appreciation unless productivity in the tradables sector increases. However, a number of studies have found even large aid inflows seem to have very little affect on the RER (q): in fact in many cases post-conflict recipients of aid, for example, actual depreciated their real exchange rate in the fact of large aid inflows (see figures 4.1, 4.15 and 4.16 from the UNDP BCPR report on Post-conflict Recovery, Chapter 4, Macroeconomic Policy Considerations). 1 Similarly, World Bank researchers, (see Elbadawi et al., 2008, see Figure 3) and Berg et al. (2005) find countries such as Uganda, Mozambique and Ethiopia (but not Ghana) have managed to absorb large aid inflows without any evidence of the Dutch Disease. But as Killick and Foster (2007) emphasize past immunity to the Dutch Disease does not imply it is not a threat, especially

1

These charts compare strong and weak recovery countries as listed in Table 4.1 and 4.2, below, my contribution to this report. if aid doubles from already high levels as proposed at by the G-8 Gleneagles meeting in 2005. The key is a strong supply side response, if both productivity grows and aid mobilizes idle local resources, the crowding out and Dutch Disease problems anticipated by the capital inflows literature may not materialize.

Fiscal Policy response to aid inflows: to spend or not

Absorption is a widening of the fiscal deficit in response to aid inflows, the same aid inflow is said to be “spent” if the government widens the fiscal deficit by the amount of the aid inflow, or following the IMF (2005) definition, measured in local currency or as a % of GDP:

Spending = -

∆(G T)/ ∆Aid

Spending G could be spent on imports or domestically produced resources. If aid is in kind (ART drugs or food aid for example) spending and absorption automatically equal aid inflows and there is no impact on macroeconomic variables (inflation, interest rates and the exchange rate). However, the case in which aid is a “gift” to the government which then takes the foreign exchange and sells it to the Central Bank (in exchange for local currency, which it needs to pay for good and Theservices four locallyextremes) is are where discussed macroeconomic in Gupta et al.complexities and IMF (2005) and complicationsand in Aiyar and enter Ruthbah the picture. (2008):

1) Absorb and spend the aid, in which macroeconomic consequences may be minimal, but again it depends on how this equality of the CA and public budget deficit is achieved, again unless aid is instantly spending on imported government purchases, in which case the dollars enter and exit before they can have macroeconomic consequences.

2) neither absorbed or spent (Aid funds goes right into reserves—which may help if reserves are at very low levels or capital flight is a problem)

3) Aid is spent but not absorbed, as in Figure 1 below, the potential crowding out/inflation scenario and

4) the aid is absorbed but not spent, which is deflationary by perhaps has the greatest potential for Dutch Disease side effects (all the increase in imports and the decrease in traded goods output is shifted to the private sector.

Each of these cases can lead to many scenarios and none are likely to be observed in pure form. Empirical evidence presented by Aiyar and Ruthbah (2008) is summarized below in Table 3 (see page 13 and 14 of their paper). In the short run (long run), about 30% (83%) of aid is absorbed and 56% (160%) is spent, while about 14% of aid shows up as investment in the short run rising to 26% in the long run. Hence absorption is a macroeconomic issue in the short run, while spending becomes an issue in the long run as aid has a multiplier effect on government spending. Again, it should be noted that just because African countries seem to have avoided the worst inflationary and RER appreciation side effects of the Dutch Disease does not mean these problems will not reappear in the future, as Killick and Foster (2007) point out contemplating the proposed doubling of aid to Sub-Saharan Africa proposed at the 2005 Gleneagles G-8 summit. And though causes by remittances rather than aid a strong RER has inhibited post-war growth in El Salvador (see Hausmann and Rodrik, 2005).

The Marshal Plan Case Study: external assistance and post conflict recovery2

Recovery from war requires strong political leadership, good economic policy, a little luck. The role of foreign aid in assisting economic recovery, however, is a subject of some debate. Clearly aid has a vital and non-controversial role to play as humanitarian assistance and to demobilize soldiers, reintegrate displaced persons, as discussed in chapter 3. Aid can also support capacity building and help rebuild government institutions vital for economic recovery. But important questions remain: Does a prolonged surge in aid undermine the local initiative and agency needed to revive private investment and put people back to work? Does aid facilitate or delay institutional change? These are important questions because for many countries a return to the pre-war economy is not acceptable. An almost universal precursor of conflict is poor economic performance and reconciliation after civil war almost always hinges on equitable distribution of political power and economic rewards (witness the conflict over oil revenue in Iraq). Post war economic policy must not just rebuild what was destroyed by war, but reshape institutional arrangements to make them more inclusive and conducive to rapid growth and human development. Most successful economic recoveries do not end rivalries among regions and ethnic groups; rather they redirect persistent and age old social conflicts into more constructive competition for markets, political influence and public goods (see boxes 4.1. and 4.3).

A classic example of a post-conflict assistance package that successfully broke with the past is the European Recovery Program after World War II. Rapid post-war growth in Europe enhanced human development and security to the point that the bitter nationalist and ethnic rivalries that drove two centuries of devastating wars eventually melted into open borders and a common currency. European political and ethnic rivalries did not vanish, but were redirected into the growth of trade and commerce.3 The Marshall Plan jump started Europe’s recovery by combining generous aid with conditions on economic policy in a particularly creative way, in part because it viewed and approached the major European countries in a regional and later global context (see Box 4.1).4 The ERP did set out to restore the pre-war economy of the U.S. or Europe: this was a nightmare known as the Great Depression. Rather the Marshall Plan was part of a new national and international policy regime designed to prevent a recurrence of the great depression. Repairing structures damaged by war is clearly necessary for recovery, but repairing and recasting institutions is crucial for long term economic development. By helping governments stabilize their finances and build new political coalitions, the Marshall plan helped redraw the basic social contract among key economic players in Europe (see Box 4.1 and 4.3). What is

2 The material in this section was prepared for Chapter 4 of UNDP, Bureau of Crisis Prevention and Recovery (2008) Post-conflict economic recovery, enabling local ingenuity, and some of it is there, however the more technical discussion was omitted in the final report. 3 This cold war delayed this process in the Balkans, but every new entrant to the European Union is advised to undertake a mini-ERP: generous development project assistance is combined with fiscal conditionality and a mandate to upgrade key economic institutions. Not everyone can join the EU, but today every region has similar economic integration pacts or regional trade agreements. Vietnam, Cambodia, El Salvador and Mozambique all display this mix of better fiscal policy and efforts to boost regional integration.

4 In order to increase the overall supply of goods in the receiving country, aid must be “absorbed” meaning finance an excess of imports over exports (a larger trade deficit). In the case of ERP funds this seemed assured as the aid took the form of imported goods. However, countries may choose not to absorb aid, but to use foreign currency inflows to accumulate reserves or pay down foreign debt. In this sense aid can be “saved.” Similarly, aid given to governments can be used to finance spending in excess of domestic revenues: aid that is used to finance government budget deficits is “spent” in modern parlance. But again governments may choose to “save” aid funds by paying down domestic debt (the idea of “saving” aid is not popular with donors who often earmark aid for particular projects or program most significant about the ERP is not that it helped Europe recover from war, though this was important, but that it helped move the major European economies on a new faster growth track, complete with stronger and wider social safety nets.

Box 4.1: Marshal plan aid for recovery: why it worked so well

The European Recovery Program (ERP) is widely credited with Europe’s rapid post war recovery. When George Marshall proposed his plan in mid 1947, Europe’s devastated economies were recovering, but still plagued by high inflation, rationing, social unrest, and even a short but violent civil war in Italy. The power was on and the trains were running, but there were frequent strikes and deep disagreement over what to nationalize, what debt to service, what prices and wages to set, and what to do about wartime currencies. Just two years later in 1949 inflation fell back into single digits, budget and trade deficits narrowed and investment and productivity growth began a thirty-year run that made pre-war Europe look like it was standing still (see Figure 4.5). What made the ERP so effective? Does it provide important lessons for modern aid programs? UNCTAD’s Richard Kozul-Wright (2006) identifies four keys to the Marshall’s Plan’s success: • The program was generous, comprehensive and regional in focus: about $120 billion at today’s prices over four years and to attack an entire region’s problems, not just those of a single country. • European governments were given latitude to plan their own recovery programs and though aid was conditional, commitments were multi-year and substantial. • Conditionality was limited, and gradual liberalization tolerated: performance targets and aid commitments were multi-year, reducing perceived and actual aid volatility. • Strong leadership and vision brought coherence to aid allocations and conditionality, as both donor and recipients saw economic and political benefits in the plan’s success. The nuts and bolts of how the Marshall Plan helped Europe recover are the subject of some debate. The conventional view is that aid financed imports fueled an investment boom. This explanation, however, is not supported by the facts. France grew 16% in 1946, before the ERP began. Aid funds, though generous, barely covered 20% of investment in these large economies. France’s investment recovery was slow, and exports grew more rapidly than imports in Italy after 1948. It appears rapid growth was not fueled by imported investment goods, or even foreign investment: something else happened. How did ERP aid help Europe recover? At a 1991 Hamburg conference experts from Europe and the U.S. concluded that the ERP’s key role was to help finance fiscal deficits, ease shortages, pay down debt and build a durable political consensus on the role of private and public enterprise.5 Eichengreen and Casella (1993) argue aid funds helped break France and Italy out of a high inflation trap by reducing the share of the budget deficit financed locally and by easing the distributional conflicts driving up wages and prices. Both governments were in “delayed stabilization” mode: divided political factions blocked fiscal and price reforms fearing their constituents would be hurt. By reducing the need for sharp adjustment and by compensating potential losers, ERP funds broke the deadlock. The promise of continued aid financed government spending convinced political dissidents on the left and right to form a centrist coalition to secure multi-year Marshall Plan funding from the United States. These transfers eased the pain of adjustment and helped build a crucial political consensus around a new growth strategy. Aid also eased shortages of basic necessities, facilitating relaxation of price controls and currency and goods rationing. This made governments more popular and boosted confidence that the recovery was on track. Inflation fell, financial stability improved and key export industries flourished (Italian textiles for example) the political coalition assembled to secure Marshall Plan funding proved durable. Eichengreen and Delong (1991) argue that this new wage, price and benefit setting “social contract” along with better public finance sparked Europe’s long post-war boom. The Marshall Plan financed the first round of deals, but the same players stayed at the table for the next thirty years, forging an exceptionally successful mix of fast growth with stronger and broader safety nets.

5 Dornbusch, Rudiger , W Nölling and R.G. Layard eds. (1993) Postwar Economic Reconstruction and Lessons for the East Today MIT Press, Boston, see the chapters by Eichengreen and Delong, Gilles Saint-Paul (on France) and on Italy Eichengreen and A. Casella and Marcello De Cecco and Francesco Giavazzi, “Inflation and Stabilization in Italy: 1946-51” (chapter 3). Box 4.2 Did France and Italy “absorb” and spend Marshal Plan funds?

The mechanics of the European Recovery Plan were similar to recent post conflict aid programs: aid was tied and conditional, but countries had considerable discretion in how they used aid funds domestically. America’s Congress viewed the Marshall as a way to boost U.S. exports to Europe (albeit at the tax payer’s expense). France and Italy are among the countries who faced challenges similar to those emerging from modern civil conflict. Both economies were heavily damaged late in the war, and both emerged with constituencies sharply divided by war and outlook. Italy had a short but violent civil war, and France was divided over whether state or private enterprise should lead the recovery. Though divided these, governments had their own priorities; including stabilizing their currencies, rebuilding reserves, promoting their export industries in addition to financing fiscal deficits. As discussed further below, countries can opt to “save” aid inflows by paying down external debt, accumulating reserves or paying off domestic debt. In fact Italy caused a minor scandal when it refused to increases imports by letting its currency appreciate, using aid to build foreign exchange reserves and paying down debt instead. In fact in most years France and Italy did not use aid to import more than they exported (see Table 4-1). Using aid to lower debt and raise reserves however, seemed to help calm financial markets, stabilize the exchange rate and boosted exports.6 Several successful post-cold war recoveries used aid in similar ways. That France and Italy were able to exercise discretion over how ERP aid was used was remarkable, given that initially Marshal plan assistance was an assortment of imports, mainly food initially, given to European governments to sell on the open market. Use of the local currency generated by these sales or “counterpart” funds had to be approved by aid administrators. Sometimes ERP funds “assigned” to a particular category exceeded what was actually spent. Table 4.1 shows Italy and France assigned counterpart funds to finance 30-70% of fiscal deficits ex ante but only used 3-48%. Note that ERP aid was not fully absorbed except in 1948 when France more that absorbed its aid (see footnote 8). By 1950 Italy’s trade plus services deficit shrank to just $47 million, though 1950 aid flows were $239 million. Not absorbing aid reduces pressure on the exchange rate to appreciate, reducing exports and lowering barriers to import competing goods. Deviating from “assigned” funding, France and Italy made good use of ERP funds and pursued domestic recovery objectives as well. As discussed in the below, a number of recent post-conflict countries have tailored their own successful recoveries sometimes using aid “as assigned” and sometimes not.

Similar aspirations apply to countries suffering from modern civil conflict: restoring the pre-war regime is rarely acceptable. As discussed in Box 4.1, what is remarkable about the Marshall Plan is the extent to which Italy, France and West Germany emerged from conflict much stronger and more integrated economies than before. The regional approach of the ERP and a certain consistency in the approach to economic recovery laid the foundations for the process of economic integration that began in earnest during the 1950s (in part to compete with its benefactor).

Of course, most of the countries discussed in this report did not go through an industrial Revolution prior to war as did Japan, Italy, France and Germany. On the contrary most are relative poor rural economies dominated by agriculture and resource industries. Yet the same basic ambitions apply to countries emerging from modern civil conflict, and more so, since they are generally much poorer pre-war and more vulnerable to civil conflict than Europe or Japan. For many countries discussed here the alternative to rebuilding institutions is not just slow growth, it is returning to a destructive cycle of conflict and aborted recovery. Can most countries emerging from civil conflict replicate the performance of France and Italy? Obviously not, there are enormous differences between human and physical stock even war damaged Europe started with. The financial and transportation systems of Europe were damaged, but could be repaired fairly quickly. Stocks of physical and human capital are much lower pre-conflict in many of the countries discussed here, perhaps with the exception of Bosnia and Lebanon, who in fact did recover very quickly, much as a France and Italy might.

However, there is ample historical evidence that adequate foreign aid has made a difference in managing the consequences of contemporary wars in some contexts, even for relatively poor countries. One classic example of a ‘quasi experiment’ underscoring the role of external assistance is that of the diverging paths of post-war South and North Korea. Both South and North Korea started with similar people and resources, but set very different courses post war and ended up in very different places. Not coincidently, substantial foreign aid inflows and infrastructure investment played a role in South Korea’s success, but it was mainly the way the South Korea reorganized and integrated its economy into the world trading system that led to its sharp break with the past. Foreign aid, on the other hand, did not play much of a role in Vietnam’s remarkable economic performance since the late 1980s, after the country struggled for a decade with high inflation and shortages. Yet, foreign direct investment did after 1990 as did its commitment in 1994 to join the WTO, as will be further discussed below. The robust post-conflict growth enjoyed by Vietnam and other neighboring countries such as Cambodia seems uniquely Asian, and therefore not indicative of what is possible in other regions.

There are a number of parallels with how foreign aid helped the European recovery program countries manage their economies and its effect on key determinants of recent post-conflict recoveries, notably the trajectory of inflation and growth. Aid helps finance large budget deficits, but is rarely completely “spent” by the government and is rarely fully absorbed. This may partly explain why inflation comes down from double digits slower than one might like, but reaches single digits 4-5 years after conflict, exactly as it did in Italy and France. This pattern can also create additional stimulus to the local economy and allows the government to build up reserves or pay down debt.

In addition, for a number of economies new approaches to regional integration have played a role. During war Mozambique experienced a sharp deterioration in its relations with South Africa due to its early support for the ANC, but relations have been rebuilt with a serious of large “mega projects” owned by the South African firms in the South. Similarly, both Vietnam and Cambodia used trade agreements and negotiations to signal their commitment to expanded trade and investment, much as European nations embarked on a clear course of economic integration in the 1950s. These nations forge a new political economy that boosts growth well beyond pre-war rates (though these are often negative growth rates, another parallel with pre-war Europe and the U.S.).

Figure 4.5: Europe outperformed its prewar growth trend, figure from Eichengreen and Delong (1991) “The Marshall Plan: histories most successful structural adjustment program” NBER paper 3899, November (revise to include just Italy and France, using Madison data).

Figure 4.5 France and Italy break with the Past, post WWII

10.0

9.5 Italy France 9.0

8.5

8.0 GDP per person (log scale)

7.5

7.0 1869 1875 1881 1887 1893 1899 1905 1911 1917 1923 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 Source: Maddison (1996) The Post-cold war aid in Africa

A distinctive characteristic of post-cold war conflict has been a change in the aid cycle.7 During the cold war, foreign aid tended to increase during conflict as donors picked one side or another to support (among the countries in our sample, El Salvador shows this pattern of aid, high during but low after conflict ends). However, since 1989 there has been a tendency for aid inflows to shrink during conflict and then to increase sharply post-conflict. For this group of countries, this pattern is most pronounced for the strong recover countries (see Figure 4.7). Aid surges the first year, and then remains higher than aid inflows to slow recovery countries for about five years. Slow recovery countries on the other hand, see a larger build up before conflict ends. Measuring aid inflows as a share of imports reveals a more sustained and smoother surge in aid to strong growth countries (Appendix A).8 Armed with these two country groups, the circumstances and policy decisions that separate the two groups can be explored. A number of questions and policy decisions center on the role and effectiveness of aid.

For African countries this is an issue of intense debate. As it happens, exactly half the countries in each group are in Africa (5 of 10 slow recovery and 9 of 19 rapid recovery countries). Figure 4.7 shows that on average aid rose most sharply in strong recovery countries, is a fashion consistent with post cold war patterns of aid to conflict countries. Aid to weak recovery countries rises more slowly. In weak recovery countries both growth and aid drop a few years after conflict ends. Clearly, the pattern revealed by figure 4.7 does not imply that aid causes rapid economic recovery, as causality could in fact run the other way: successful and peaceful recoveries (following severe wars) attract donor attention. Aid may also by design follow more successful peace accords or UN intervention.

Figure 4.7 suggests a big spike in aid post-conflict does not prevent strong economic recovery, and in fact may contribute to it. Many countries that have both recovered strongly post conflict and out- performed their pre-conflict growth rates have done so despite or because of abundant aid. Generally aid spikes just as conflict end and then average about 10% of GDP. For some countries however aid inflows continue averaging 15-20% of GNI for some time. This high aid group includes Ethiopia, Mozambique, Namibia, the DRC, Nicaragua, Rwanda and Uganda). Not all countries that received substantial aid grew rapidly, and not all countries that recovered strongly post conflict received substantial foreign aid (El Salvador and Vietnam are example of both cases). To sustain growth after aid declines cuntries have to find other ways to finance imports and government outlays.

Of course averages can cover a wide variation in country experiences. Figure 4.8 suggests the sharp surge in growth for this sub group of strong recovery countries is dominated by Rwanda, Mozambique and Ethiopia. Uganda’s growth recovered more slowly, but the aid inflows lagged as well. Looking behind the averages Figures 4.8 and 4.9 show aid surges and growth rates for Ethiopia, Mozambique, Rwanda, and Uganda. Mozambique and Rwanda received the largest foreign aid spikes near the end of conflict: the upswing in aid started earlier in Mozambique averaging over 40% of GNI

7 See Staines (2004) and McLeod and Davalos (2006). 8 Using imports to scale aid reduces the influence of exchange rate and income fluctuations, while retaining some measure of the relative purchasing power of aid over imports. A similar pattern appears for aid per capita, except that the aid to slow recovery countries starts higher and then declines slowly, whereas aid to strong recovery countries starts low and then increases sharply post-conflict. Measuring aid a share of income or imports captures the reality that a $100 per capita aid inflow to Ethiopia will have a much larger relative impact that the same $100 in aid per person sent to Bosnia or Lebanon (or El Salvador), since the latter have much higher average incomes. It also suggests the aid patterns reflected in Figures 4.7 and 4.8 apply more to low income countries emerging from conflict. by 1990, two years before the war ended. Aid to Mozambique surged again during the 2002 floods. For Ethiopia and Uganda aid inflows rose after conflict ended. The pattern of growth recovery broadly mimics the flow of aid, with growth recovering first in the countries that received the biggest doses of aid (Mozambique and Rwanda) though growth came more slowly in Mozambique. Growth in Ethiopia and Rwanda started later and was uneven but a late second surge of aid helped boost Ethiopia’s growth rates after 2000. At the country level and for the group as a whole, aid inflows are broadly correlated with faster growth. Figure 4.8 Aid Surges Ethiopia, Mozambique, Rwanda, Uganda

81% Mozambique Rwanda Uganda Ethiopia 61%

51% 56% 46% 53% 43%

30% 28% 27% 26% 22% 21% 20% 19% 16% 8% 9% 9% 18% 12% 14% 8% 10% 9%

P-6 -5 -4 -3 -2 -1 End +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 +11 +12 +13

Aid as % of GNI, Conflict end dates: Ethiopia: 1991, Mozambique: 1992 Rw anda:1994, Uganda: 1989

Figure 4.9 Post-conflict Growth Ethiopia, Mozambique, Rwanda, Uganda ( centered 3 year moving average) 15%

10% 8% 8%

5%

0%

-5%

Mozambique Rwanda Uganda Ethiopia -10%

-15% -4 -3 -2 -1 end +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 +11 +12 +13

3 year average GDP per capita grow h: Conflict end dates: Ethiopia: 1991, Mozambique: 1992 Rw anda:1994, Uganda: 1989

The Dutch Disease debate: Does aid undermine trade? Aid surges following war or natural disasters are generally welcome, both for humanitarian reasons and to finance rapid disarmament, demobilization and reintegration. One fear is however, that massive aid flows will disrupt and distort fragile markets and prices just when the remerging private sector needs clear signals on what and where they should be producing. The two often related concerns are inflation and currency appreciation. We have discussed inflation in the previous section, and focus on the so-called Dutch Disease.9

The name derives from the 1960s when the Netherlands discovered larger reserves of natural gas off shore. This was largely fortuitous, but the Guilder appreciated sharply undermining exports of tulips and dairy products, eliminating many jobs in those sectors.10 However, in a poor rural economy where coffee exports are important (in Ethiopia, Rwanda and Uganda) for example, a fall in the domestic value of coffee exports can have serious consequences for rural poverty and employment. Finally the surge of aid ends at some point and aid inflows return to a sustainable levels (though levels of aid may be high for some time, as they have been in Mozambique and Rwanda). So a short term signal to firms that

9 Aid or any large inflow of foreign currency tends to make the local currency stronger, and raise the price of nontraded goods. If the exchange rate is fixed, this can be inflationary (unless monetary policy is tight to the point that wages fall in nominal terms). Currency appreciation reduces the potential profits of exporters and import competing industries, including agriculture and foodstuffs (where imports are available). There are number of scenarios under which aid inflows need not lead to currency appreciation, if it increases the productivity of non-traded goods sectors, including people, electricity, rents etc. A fall in the price of nontraded goods caused by aid could be one longer term reason currencies do not appreciate, but a different explanation is pursued here. 10 This is not really a disease, luck and markets are simply telling us the Dutch should produce more nontraded goods and services and import now cheaper manufactures for example. traded goods are less profitable may mislead private firms at a critical time for encouraging investment in export and import competing industries..

For these reasons a great deal of research focused on the potential impacts of aid surges on competitiveness. The argument linking an aid surge to reduced employment via the Dutch Disease has two parts: first, the aid inflow must cause the inflation adjusted exchange rate to appreciate, making imports cheaper at home and exports more expensive abroad both of which dampen demand for traded goods, thereby slowing job growth. That’s the second part of the argument: currency appreciation harms growth.

The second part of the Dutch disease argument has generally not happened because surprisingly, aid inflows have not been associated with a stronger inflation adjusted exchange rate making them less competitive.11 It is not that the Dutch Disease is not harmful, it is that most strong recovery countries never get the virus. As shown in Figure 4.10, despite receiving large inflows of aid, strong recovery countries actually improve their competitive position post-conflict. The competitive index shown in Figure 4.10 is a trade weighted “real” or inflation adjusted exchange rate showing the price of a bundle of consumer goods relative to the price of traded goods. Since consumers prices have a significant wage component a falling index means wage costs are falling for exports (and the price of imports are rising for wage earners). Both effects tend to benefit local producers of traded goods,

The Dutch disease remains an important concern for policy makers. There is some evidence supporting the second half of the argument: real exchange rate appreciation does seem to reduce growth.12 Rodrik (2003) for example argues that a sharp depreciation of Uganda’s exchange rate contributed to its rapid recovery after 1989 (see also Figure 4.11 below). Since inflation was fairly high during this period, maintaining trade competitiveness required sharp declines in the nominal exchange rate (which in turn can be inflationary). How did Uganda manage to avoid a loss of competitiveness due to aid inflows? To some extent the same way Italy did in 1949: by not absorbing aid inflows (Box 4.1). Running a big trade deficit requires a strong exchange rate (to get people to import more and export less). Because Uganda did not use all or even most of the inflows aid to import more than it exported, there was no need for the price of imports (and exports) to fall. It is not surprising Uganda tries to keep its exchange rate from appreciating: 75% of its population live in rural areas and depend mainly on agriculture for their livelihoods.

Figure 4.10 presents a standard index of trade competiveness, with the year conflict ends set to 100 for both strong (red) and weak recovery countries. Though the aid surge is larger into strong

11Elbadawi et. al. (2007) study 36 country post conflict aid surges, in 30 cases they find aid inflows were not associated with real exchange rate appreciation, and sometimes the RER depreciated instead They examine seven cases in more detail, finding that large surges in aid into Ethiopia, Uganda and Rwanda had almost no effect on the competitiveness: in fact the inflation adjusting exchange rate depreciated somewhat. Their conclusions are clear, “The assessment of macroeconomic outcomes of aid in the seven country experiences suggests that post-conflict countries see aid as an important source for both financing post-conflict spending needs and strengthening public-sector financial positions by saving part of aid inflows. The latter takes the form of reducing public debt and/or hoarding international reserves, which are ways to prevent larger RER appreciation. Therefore it does not come as surprise that the evidence on the simple association between aid and RER appreciation is very mixed in this sub-sample. Most post-conflict aid-recipient countries appear to have exercised the option of not fully absorbing or spending aid. All this suggests the absence of large-scale Dutch disease during the post conflict cycle.” 12 See Rodrik (2003) on Uganda, and Hausmann and Rodrik (2004) on El Salvador. recovery countries, the inflation adjusted exchange rate does not appreciate; instead it becomes weaker, making exports more competitive and imports more expensive. Consistent with an increase in competitiveness, exports increase more rapidly in the strong recovery countries (although rapid export growth could also reflect other factors, as discussed below).

This finding is consistent with other detailed studies of Mozambique, Uganda, and Ethiopia (compare in particular Figure 4.12 with Berg, et al. , 2006, Figure 2.3). Figure 4.12 suggests Mozambique experienced a slight appreciation about three years, but by this is when aid declined (the surge was over). When aid shot up again in 2001-2002, remarkably the inflation adjusted currency or competitiveness index depreciates again. Burundi, for example, experienced a loss in competitiveness, as the real exchange rate began to appreciate in years seven and eight post-conflict. Again, this appreciation occurred long after conflict ended and the aid inflows began to ebb. The post-conflict countries where the real exchange rate did appreciate after conflict ended were El Salvador and Nicaragua. However, El Salvador did not experience a substantial post-conflict aid surge (though remittances did increase sharply, and large increase in remittance inflows was associated with a decline in domestic savings and investment).13 Nicaragua did experience a spike in about a year after conflict up to over 50% of GDP, but aid inflows declined sharply back to 20% of GDP but the exchange rate continued to appreciate.

In El Salvador and Nicaragua and to a lesser extent in Burundi, the exchange rate did appreciate post-conflict and in all three cases post conflict growth was disappointing. However, as shown in Figure 2, Mozambique, Rwanda and with a bit of a delay Ethiopia and Uganda all experienced large aid inflows. Yet despite these aid inflows, the inflation adjusted exchange rate did not appreciate so that competitiveness and export growth did not suffer. Except for Rwanda, Berg et. al (2006) studied these three countries as well, but look at later aid surges after 1999. The second surge into Mozambique for example was prompted by the 2002 floods, while Ethiopia engineered a major economic reform. Again, this second aid surge did not lead to stronger exchange rate.

13 Similarly, Hausmann and Rodrik (2004) claim El Salvador’s slow growth has been caused by and exchange rate appreciation. Elbadawi et. al. (2007) also present some empirical evidence that an overvalued exchange rate slows growth in a sample of 78 post-conflict and other developing economies. Figure 4.10 Trade competitiveness index (year conflict ends = 100) 120 Weak Recovery cty average Strong Recovery Cty average 110 100 90 80 70 60 50 Increase in 40 competitivenes 30 20

E-7 E-6 E-5 E-4 E-3 E-2 E-1 End E+1 E+2 E+3 E+4 E+5 E+6 E+7 E+8 E+9 Note: This is the trade weight real exchange rate computed as domestic consumer prices divided by a trade weighted index of leprices of trading partners (a fall is a depreciation of the real exchange rate). For documentation and comparisons with IMF REER series, where available see Appendix A. Source: IMF DOTS 2005, and IFS and WDI prices indices. Author's calculations, UNDP- BCPR Real Exchange Rate series, October 2007.

Figure 4.11: Average post-conflict export growth is higher for strong recovery countries

30%

25% Strong recovery country exports grow an average 20% of 14% annually the first 8 post-conflict years 16% 15%

10% 5% 5%

0%

-5%

-10% Weak Recovery country exports grow about 6% Including Guinea-Bissua adds annually on average the first 8 years after tremendous volatility but does not -15% conflict ends (solid line excludes Guinea Bissau) change post-conflict average much... -20% -6 -5 -4 -3 -2 -1 End +1 +2 +3 +4 +5 +6 +7 +8

Note: Real average export growth by country groups (see Table 4.10 and 4.11). The blue dotted line is the average export growth for Nicaragua, Guatemala, Namibia and Guinea-Bissau only. The red dotted line is average export growth for Chad, El Salavador, Ethiopia,

Figure 4.12 Trade competitiveness index (year conflict ends = 100) 140

Ethiopia 120 Uganda Mozambique 100 Rwanda

80

60

40 Increase in competitivenes 20

0 E-5 E-4 E-3 E-2 E-1 End E+1 E+2 E+3 E+4 E+5 Note: This is the trade weight real exchange rate computed as domestic consumer prices divided by a trade weighted index of wholeprices of trading partners ( a fall is a depreciation of the real exchange rate).

Finally, note that maintaining competitiveness may have come at some cost. Both Uganda and Mozambique aggressively depreciated the nominal value of their currency, at first just to line of up the street exchange rate with the official exchange rate. Both countries have experienced higher inflation than countries who pegged their exchange rates to the dollar or Euro (Bosnia and El Salvador for example). Davies (2007) argues that higher inflation in turn leads to capital flight, which undermines seigniorage revenues, among other things. Similarly, Berg et al. (2006) and Addison (1996) suggest that by not absorbing more the aid inflows, the excessive domestic spending implied by large aid inflows contributed to inflation directly. Importing more goods would in principle ease pressures on domestic supplies, potentially limited immediately after conflict, but in fact as shown in the Figure 4.13 strong recovery countries imported more as well (on average). They also ran larger current account deficits than slow recovery countries (see Figure 4.19) so the policy mix that kept exchange rates competitive needs to be studied at the country level.14 However, since the countries which kept their currencies more competitive, also recovered more quickly, despite moderate to high inflation (particularly in Mozambique) these concerns are mitigated to some extent.

14 See for example Berg et al. (2005) do for six African countries, including Ethiopia, Mozambique and Uganda. References

Aiyar, Shekhar and Ummul Ruthbah (2008) Where did all the Aid go? An Empirical analysis, IMF Working paper #08/34, IMF, Washington D.C. www.imf.org/external/pubs/ft/wp/2008/wp0834.pdf

Berg, (2006) The Macroeconomics of Scaling up Aid: Lessons of recent Experience, IMF Occasional paper 253.

Dornbusch, Rudiger , W Nölling and R.G. Layard eds. (1993) Postwar Economic Reconstruction and Lessons for the East Today MIT Press, Boston, see the chapters by Eichengreen and Delong, Gilles Saint-Paul (on France) and on Italy

Eichengreen and A. Casella and Marcello De Cecco and Francesco Giavazzi, “Inflation and Stabilization in Italy: 1946-51” chapter in Dornsusch et al. (1993) cited above.

Elbadawi, Ibrahim, Linda Kaltani, and Klaus Schmidt-Hebbel (2007), “Post-Conflict Aid, Real Exchange Rate Adjustment, and Catch-up Growth”, World Bank Policy Research Working Paper 4187, April, Washington, DC

IMF (2005) Monetary and Fiscal Policy Design Issues in Low-Income Countries

IMF (2005b) The Macroeconomics of Managing Increased Aid Inflows: Experiences of Low-Income Countries and Policy Implications,

- Killick, Tony and Foster (2007) “The macroeconomics of doubling aid to Africa…” Development Policy Goldsbrough,Studies Review, David v. 25 et n.2,al. “ 167Inflation12. Targets in IMF-Supported Programs”, Center for Global Development’s Working Group on IMF Programs, Washington DC.,

Hausmann, Ricardo and Dani Rodrik (2005) “Discovering El Salvador’s Production Potential,” mimeo, Harvard University, Kennedy School, mimeo.

Heintz, J. (2006) “Globalization, economic policy and employment: Poverty and gender implications” ILO Employment Policy Unit, ILO, Geneva and

McKinley, T. and D. Hailu “The Macroeconomics Debate on Scaling up HIV/AIDS Financing” Policy Research Brief No., IPC, UNDP, Brazil and Nicholas Staines (2004) “Economic Performance over the Conflict Cycle” in J. Clement ed. Post-conflict Economies in Sub-Saharan Africa: lessons from the DRC, IMF, Washington DC.

Rodrik (2003) "Growth Strategies”, NBER Working Paper #10050, Cambridge, MA.

Staines, Nicholas (2004) “Economic Performance over the Conflict Cycle” in J. Clement ed. Post-conflict Economies in Sub-Saharan Africa: lessons from the DRC, IMF, Washington DC.

UNDP, Bureau of Crisis Prevention and Recovery (2008) Post-conflict economic recovery, enabling local ingenuity, UNDP, New York, see especially Chapter 4 Macroeconomic considerations in post-conflict recovery.

Ouattara, Bazoumana, and Eric Strobl. Do Aid Inflows Cause Dutch Disease?: A Case Study of the CFA Franc Countries. University of Manchester, School of Economic Studies, 2003.

https://www.brookings.edu/wp-content/uploads/2008/09/2008b_bpea_rodrik.pdf

Ouattara, Bazoumana, and Eric Strobl. Do Aid Inflows Cause Dutch Disease?: A Case Study of the CFA Franc Countries. University of Manchester, School of Economic Studies, 2003. http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.578.2806&rep=rep1&type=pdf

The Macroeconomics of Managing Increased Aid Inflows: Experiences of Low-Income Countries and Policy Implications https://www.imf.org/external/np/pp/eng/2005/080805a.pdf

Ghana real Appreciation Check with more recent RER data https://www.imf.org/external/np/pp/eng/2005/080805a.pdf

https://www.imf.org/external/np/pp/eng/2005/080805a.pdf

Box 4.3: Democracy and recovery: redirecting indivisible into “divisible” social-conflict

Always provocative A.O. Hirschman (1994) argues that the post-war economies succeed in part by redirecting social conflict into less destructive pursuits, capitalism for example. He argues social conflict is both a by-product of market society and its progenitor, and indeed early on market forces can generate the inequalities and regional disparities that lead to conflict. “Conflict is indeed a characteristic of pluralist market society that has come to the fore with remarkable persistence. It is the natural counterpart of technical progress and of the ensuing creation of new wealth, for which market society is rightly famous. Conflicts arise from newly emerging inequalities and sectoral or regional declines- the counterpart precisely of various dynamic developments elsewhere… the vitality of pluralist market society and of its ability to renew itself lie in the conjunction and in the successive eruption of problems and crises. The society thus produces a steady diet of conflicts that need to be addressed and that the society learns to manage.”15 The absence of social conflict is not desirable if it is reflects authoritarianism and the suppression of dissent: a false consensus built on thinly disguised political repression. On the contrary, successful pluralist market societies are Hirschman argues, built on frequent and at times violent conflicts that “are or become the pillars of democratic market societies.” Hirshman’s example of the fruits of violent conflict: “the “glorious” thirty-year period of all-round vigorous growth in Western market societies that followed the conclusion of the Second World War.” In other words, recovery and high growth did not occur is spite of World War but in part because of it. Peace building then is the process of redirecting social conflict into more constructive and less lethal economic rivalries, transforming what Hirschman calls “indivisible” conflict into divisible ones that can be settled with material payoffs” Divisible conflict can be mitigated by the redistribution of material rewards, never permanently and always with the prospect of further negotiation and struggle: conflict is displaced into perpetual competition for economic rewards. Indivisible conflicts are for example ethnic or religious divisions not amenable to settlement by reallocation of wealth or power.16 The key to reconciliation then is not just peace agreements and ceremonies, but new institutional arrangements that convert indivisible conflicts into divisible ones, incorporating perhaps age old rivalries into the policy making process. Fiscal policy in particular needs to be managed in ways that allow the full range of groups and actors to perceive benefits, or at least potential benefits from a particular policy regime. Real and perceived grievances, some over access to land and resources, do aggravate ethnic divisions and exacerbate “horizontal inequalities” across regions and ethnic, tribal or religious groups. Creative and judicious use of fiscal and employment policy can ameliorate and transform indivisible ethnic conflicts into divisible ones. Both Indonesia and Malaysia have some success in using economic policies to ease ethnic and religious tensions, whereas Sri Lankan policies tend to fuel Tamil grievances.17

15 Hirschman, Albert O. “Social Conflicts as Pillars of Democratic Market Society” Political Theory, Vol. 22, No. 2. (May, 1994), 203- 218. 16 Keynes expresses similar economic competition redirects social conflict sentiments arguing “It is better that a man should tyrannize over his bank balance than over his fellow-citizens and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative.” 17 See Frances Stewart, Graham Brown, and Alex Cobham (2007) “Promoting Group Justice: Fiscal Policies in Post-Conflict Countries” CIC-PERI Public Finance in Post-Conflict Environments Policy Paper Series, University of Mass. Amherst. https://www.imf.org/external/np/pp/eng/2005/080805a.pdf http://imf.org/external/pubs/ft/fandd/2008/09/gupta.htm http://www.google.com/search?sourceid=navclient&ie=UTF- 8&rlz=1T4GGLL_en&q=macroeconomics+of+gleneagles+IMF+UNDP http://www.project-syndicate.org/commentary/rodrik37 http://www.odi.org.uk/events/macroeconomics_dec06/index.html ttp://www.imf.org/external/pubs/ft/wp/2008/wp08237.pdf http://www3.interscience.wiley.com/cgi-bin/fulltext/117999592/PDFSTART http://www3.interscience.wiley.com/cgi-bin/fulltext/117999592/PDFSTART?CRETRY=1&SRETRY=0 http://www.imf.org/external/np/sec/pr/2009/pr09319.htm http://www.imf.org/external/pubs/ft/wp/2008/wp08237.pdf http://www.imf.org/external/pubs/ft/wp/2008/wp0834.pdf http://www.undp.org/cpr/content/economic_recovery/PCER_rev.pdf http://www.imf.org/external/np/pp/2007/eng/061407.pdf http://www3.interscience.wiley.com/cgi- bin/fulltext/117999592/PDFSTART?CRETRY=1&SRETRY=0*