Challenges in Aid Absorption and Macroeconomic Hazard Management

1. Macroeconomic Policies for Combating HIV and AIDSConference organized by UNDP Poverty CentreBrasilia, November 20-21 November 2006 David Bevan Department of Economics University of Oxford

2. Introduction • Aid flows have tended • to become more concentrated • hence sometimes large relative to the recipient economy • Present efforts, if successful, will tend to reinforce this • Current concerns about aid absorption • aid has often been poorly managed and ineffective in the past • but also reflect the worry that aid may become problematic when it is large relative to the economy, even if it is well-managed • Narrow and broad interpretations of macroeconomic hazard. • macroeconomic hazards given the institutional and political framework • possible adverse impacts on this framework, which may make macroeconomic problems worse

3. The institutional and political framework Concerns about possible adverse impacts • Aid dependency • ‘no representation without taxation’ • Corruption and rent-seeking • Weakened process of institutional improvement Implications • Evidence that weak institutions leads to poor macroeconomic policies and performance • Focus on institutional reform as part of the aid ‘package’

4. The potential problem of real exchange rate (RER) appreciation 1 The usual diagnosis • Export growth and diversification seen as important for economic growth • Part of aid will be spent on nontradable goods, driving up their price – so that the real exchange rate appreciates • This makes exporting less profitable, so export volumes suffer • Hence the aid comes at a potential price in reduced growth

5. The potential problem of RER appreciation 2 Some qualifications to this diagnosis • In practice, countries appear to be able to absorb very high aid inflows without suffering growth reductions • While some aid goes to enhance current consumption (so just adds to demand) much of it goes into investment (so has an effect on supply also) • If the productivity increase is specialized in nontradables, their supply may expand as fast or faster than demand, leading to a depreciation • If it is specialized in exportables, exports may still increase rapidly despite the depreciation (profitability • Relief of bottlenecks • Depends on the relative impact on supply and demand

6. The potential problem of RER appreciation 3 Implications • Whether there will be a problem is not a given, but contingent on country specifics and on policy design • Very difficult to judge what is the case, so may often be best to ignore the issue • However, there are two special situations where this is not so • Gradual changes may be more easily absorbed than rapid ones • There will be differences in the speed of the supply pay-off – for example, between spending on physical infrastructure/income generation versus that in the social sector

7. Medium-run supply responses E-biased supply response E Neutral supply response D-biased supply response D

12. Inconstancy of aid flows 1 Long-run movements in the aid-GDP ratio • Large increases/decreases problematic even if • Completely predictable • Recipient government allowed unrestricted freedom to smooth • Would still pose a severe management/political problem • In practice, neither condition likely to hold • An extended aid ‘pulse’ will typically have to be spent more or less simultaneously • Very difficult to know when a change is likely to be transient and when it may persist

13. Inconstancy of aid flows 2 Medium-term fluctuations and falling commitments • Government spending needs to be planned over the medium or longer term • Most donor commitments are firm only over relatively short horizons • It is costly to embark on programmes that have to be cut back because of funding problems • But the converse is also true • Is it always prudent to be conservative?

14. Inconstancy of aid flows 3 Short-term volatility and cyclicality • Even when aid flows are reasonably stable in the medium term, they may be volatile in the short run • Move to budget support, may make matters worse • Domestic revenues in low-income countries have also tended to be volatile • These two sources of instability have tended to reinforce rather than offset each other • Volatility a particular problem if financial depth is lacking • May imply higher foreign exchange reserves needed

15. Inconstancy of aid flows 4 Implications for policy • Macroeconomic policy management is substantially more difficult than in industrialized countries • Greater volatility to cope with, in real economy as well as budget • Shocks of uncertain duration rather than fairly regular cycles • Fewer and less potent instruments • What is best response to a shock? • Smooth a temporary shock • Accommodate to a permanent one • Recognition problem

16. Inconstancy of aid flows 5 • Consider an addition to recurrent public health expenditure (g), initially grant financed for several years, but falling back into the domestically financed budget subsequently (say after year T) • It produces a flow benefit valued at b • The domestic tax system inflicts marginal and average deadweight losses on the private sector θm > θa > 0 • For example, a marginal dollar of revenue costs the private sector $(1 + θm) • The government discount rate is r • Suppose first that all of b is “psychic” as opposed to money income • The tax rate is

17. Inconstancy of aid flows 6 • Then we should require a benefit cost ratio: • If b takes the form of money income, this would be:

18. Conclusion • Risk of Dutch disease problems is real but has probably been exaggerated • Not inevitable • Can be managed • But management may be unpalatable • Risk of inconstancy probably more severe and certainly less tractable • Always costly to handle • In case of HIV/AIDS even more so • Crucial to find ways of handling this