Ó International Monetary Fund

“Pity the Finance Minister:” Managing a Substantial Scaling-Up of Aid Flows Presentation by Peter S Heller To seminar at the Overseas Development Institute June 16, 2005 Ó International Monetary Fund

The International Monetary Fund Why “Pity the Finance Minister?” What are the key issues, challenges he or she will face if there is a significant scaling up of aid flows? What must the finance minister (and his colleagues), the donor community, and the IFIs do to make good use of the additional aid resources that are being mobilized? Many questions. A few answers

Five Key Policy Challengesbeyond the mobilization of additional resources • Dealing with macroeconomic effects of moving to substantially higher aid levels • Addressing uncertainties posed for monetary and fiscal policy management • Managing the delivery of Govt services when a significant share of outlays is financed externally: aggregate and sectoral budget issues • Confronting various fiscal dependency issues • Can you use scaled up aid effectively and efficiently?

Focus in this talk principally on • Dutch Disease issue • Macroeconomic management issues • Budget management issues • But two other critical issues • Aid and growth • Dealing with multiple behavioral, institutional, and governance issues

I. Dutch Disease: • Key issue here is the macroeconomic impact (rather than the operational management issues • Is it significant? • Rajan and Subramanian: had negative impact on effect of aid and growth. • IMF study: countries experiencing aid surges treat as a concern—build up reserves; engage in sterilization efforts to minimize impact on real exchange rate • Certainly a factor to consider. Why? Impact on competitiveness of tradable goods sector

IF it is a concern of country, three questions for a MOF: • What is appropriate real exchange rate? What real exchange rate path should be pursued in context of a scaling-up of aid flows? • Can a country minimize scale of any adverse RER effect • By influencing composition and uses to which aid resources directed? • Greater share of imports: noncompetitive • Seek to enhance impact on removing bottlenecks/increasing productivity of nontradeable goods sector • By macroeconomic policy tools • Buying up foreign exchange; accumulating reserves; sterilize monetary expansion effects in market; But defeats purpose of resource transfer • What if there are limits to above approaches?

Issues for Aid-Recipient • How much RER appreciation to accept? Via either inflation or nominal exchange rate movement (what exchange rate regime in place? • What are the tradeoffs to consider if there is adverse RER effect? • Costs of RER: re competitiveness; engagement in international markets • But note potential benefits of aid. Welfare enhancing increases in consumption; infrastructure potential impact on productivity/human capital development; break out of vicious circles: • Need to consider what “exit” strategy over long-term: what can be expected in terms of ODA flows over the long-term?

Issues for Donor community and IFIs • Can they help to minimize RER effect by structuring composition of aid? • Will they accept some intertemporal smoothing if required? Aid trust fund? • Can they provide greater clarity on time frame and magnitudes of anticipated aid flows to provide? At least facilitate consideration of these issues in PRS deliberation process, (even if not providing solution to basic problem) • Can they match with greater predictability of aid flows over a significant time frame?

II. Managing Macroeconomic Policy in Context of Higher Aid Flows • In contrast to above “strategic” issue • Operational issue of managing fiscal and monetary policy to achieve targets for growth, inflation, and RER path • In context of: • multiple donors, each with own bureaucracy • multiple conditionalities/criteria • Uncertainties associated with above • Aid flows channeled both to public and private sectors • Gauging likely impact of aid flows on foreign exchange market/imports • Other sources of uncertainty on external accounts: Terms of Trade; capital flows; remittances

Macroeconomic management issues • Start by setting objectives for macro policy framework: g, tolerable inflation rate, real exchange rate • How to pursue monetary policy where there may be uncertainties noted above? Changing DD for Money function in scaled up aid environment? • How much foreign exchange reserves to build up? • What targets to constrain Govt access to bank credit? Balancing of credit creation for Govt vs. private sector (especially, if much some aid channeled to latter) • Who bears burden of sterilization if you try and limit expansion in money supply with increased Net International Reserves?

Issues posed for fiscal policy • Can governments simply scale up/down its spending pari passu with aid fluctuations? • Budget sustainability vs. fiscal sustainability • Latter relates to long-term solvency issues • Former asks whether budgetary spending programs/plans can be sustainably financed: recognizes contingent quality of spending dependent on aid flows • If aid flows don’t materialize, or with lags, need to engage in smoothing from reserves. How much reserve buildup necessary?

Fiscal policy issues posed for aid recipient • How to ensure compatibility of aid flows with macro targets • How much prudential margin desirable in managing monetary and fiscal policy • Resolution of potential tensions between MOF and autonomous central bank: If a MOF/PRSP opts for some RER appreciation in context of aid flows, requires either movement on nominal exchange rate or prices Consistency required

Issues raised for donors • Predictability once again—critical for fiscal and monetary policy management • Implies need to minimize homogeneity of conditionality • Again, clarity on flows: to public and private sectors

III. Managing a Budget and Delivery of Public Services with high dependency on aid flows • Issues again arise from multiple donors/conditionalities/uncertainties; • Rising share of total expenditure financed externally • Rising share of a sector’s budget—both public and private—financed externally (recognizing the interdependency, in some sectors, of public and private activities; (recognizing potential contingent obligations of government in the absence of private sector activities)

Six issues in budgetary management • Aggregate Budget sustainability • How much to scale up considering sectoral budget preemptions; O&M; degree of budget support provided • (how much of budget acquires a nondiscretionary character?) • Linkage of these issues to macro policy • Sectoral budget sustainability • How to build up program in light of relative uncertainties? • Short term contracts? contracting out to private sector? Increase in civil service? employees? Mix of training required? • What game plan, over time, for exit strategy from aid dependence? • How to address inconsistencies that remain in priorities between donors and Govt?

Public financial management subject to greater challenges in a scaled up aid environment: need better systems • For recording and analyzing character and duration of prospective aid flows • Assessing potential O&M implications • Formulating budgets robust to alternative aid funding scenarios • Risk management techniques in managing budgets • Extend fiscal sustainability analyses to take account of uncertain grant flows

Organizational challenges • How easy to scale up substantially the size of a bureaucracy delivering services? • A phenomenon recently observed by NGOs • Similarly for government bureaucracies

Addressing implications of higher fiscal dependency • Potentially adverse implications for domestic resource mobilization efforts • Rent-seeking/corruption • Further distortions to civil service compensation system (honoraria for meetings; travel incentives; ad hoc benefits etc) • Reduced incentive to address prevailing inefficiencies in government delivery of services and management • Incentives to tailor programs to donor interests • Governance of reserves • Loss of political legitimacy: Bevan: no representation without taxation • How to strengthen accountability as part of donor assistance? USAID ideas post Hurricane Mitch

Developing a budgetary exit strategy • With clarity, developing a game plan by sectors; and for aggregate budget; for scaling up and for scaling down • Re scale of different sector’s activities • Re financing over time of such sectors • Relative balance of public and private sector activities in a sector • Sequencing issues become critical: training vs. delivery of services • Substitution funds

IV Aid and Growth • A final key challenge for MOF: How to facilitate effective use of aid to stimulate self-sustaining rapid growth • Rajan and Subramanian • Clemens et al • Burnside and Dollar What is important is to underscore that the literature does not offer considerable encouragement that aid has very significant positive effects on growth rate? Does this matter? Re critical need for aid in some areas (e.g., health sector) Can one learn from past and do better in this window of opportunity?

Responding to these challenges • Donors • Aid recipients • IFIs

Aid recipients In context of PRSP • Clarify development strategy, and implications for real exchange rate • Clarify implications for uses of aid • Develop game plan for scaling up and scaling down: aggregate and sectoral • Consider policies for structuring delivery of enhanced services and investment, reflecting “aid uncertainty regime” • Consider appropriate prudential reserve • Strengthen PFM and examine potential preemptions of fiscal space by current expansion of fiscal services • SEQUENCING critical

Donors • Enhance long-term predictability (in addition to reducing discordance between commitments and disbursements within budget year) • Achieve objectives re alignment & harmonization • Reconcile above with need for performance based funding • Clarify for aid recipients allowable reserve policy; make this transparent to international community • Policies to enhance accountability: earmarking? • Other approaches beyond direct aid? • Expand provision of global public goods • Policies that facilitate lower costs to low income countries for the purchase of critical goods and services • Take advantage of regional public goods • Reduce trade barriers and export subsidies • Policies with respect to immigration/training to encourage fluid movements between MDCs and LDCs

IFIs, including regional development banks • Strengthened advisory role: re • Development strategy • Fiscal and macroeconomic policy management • Macroeconomic policy advice with longer term focus • Alternative aid scenarios • Exchange rate sustainability and aid absorption assessments • Assess exceptionality arguments • Advise on macroeconomic policy management • Clarify appropriate targets: continue asymmetric targets for fiscal adjustment? • Greater clarity on monetary policy targeting when significant aid to the private sector

Strengthening fiscal and budgetary management • Intensify TA for PFM, revenue administration, and accountability mechanisms • Strengthen characterization of fiscal situation—short, medium, and long term • Characterize potential volatility and uncertainties in aid flows • Presentation of Medium-term BUDGET frameworks • Provide estimate of underlying level of ODA inflows likely over medium to long-term given nature of commitment regimes • Distinguish “priority” expenditure responsibilities • Enrich fiscal sustainability analyses • Use scenario analyses • Develop analytics on determining appropriate levels of financial reserves and debt • Address absorptive capacity concerns • Advise on policy issues related to scaling up of service delivery and fiscal policy management

Concluding thoughts • Role of IFIs will become more important • Current IFI approaches to considering impact of scaling up on aid flows are not sufficient • Recipient countries: PRSPs need to be strengthened to address larger issues posed by aid scaling up • May be tension between achieving MDGs and achieving self sustaining growth • Can resources for aid be used in other ways to benefit low income countries? • It will take more than more money.

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