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: Ethiopia, Bono and Bob Geldof (Live Aid and Live 8 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.