Aid and Fiscal Space: Managing Fiscal Policy in the Context of Scaled-Up Aid

1. Aid and Fiscal Space: Managing Fiscal Policy in the Context of Scaled-Up Aid Peter S. Heller Agip Professor of International Economics Bologna Center, SAIS The Johns Hopkins University

2. Outline of presentation • Multiple potential sources of fiscal space • Clarifying the potential medium-term fiscal framework (MTFF) • Four key challenges in managing fiscal policy with scaled-up aid • Factors adding to the complexity of the task of managing fiscal policy with scaled-up aid • Conclusions

3. Multiple potential sources of fiscal space • Some create only modest challenges for fiscal policy management • Enhanced revenue • Expenditure rationalization: cutting subsidies; reducing losses of state-owned enterprises; eliminating quasi-fiscal outlays • Others approaches create greater challenges • Seignorage creation • Debt relief (MDRI etc) • Domestic and external nonconcessional borrowing • Encouraging public-private-partnerships • Exploiting a scaling-up of external aid: grants and concessional loans

4. Simplifying the issues • In what follows, we only address the challenges posed by the significant scaling up aid flows that would be implied if industrial nations deliver on their Gleneagles commitments of a doubling of aid flows by 2012 • Assume that all the aid is in budget support; that the MOF has significant discretion over the allocation of the additional fiscal space implied among expenditure (or revenue reducing) alternatives

5. First challenge: clarifying the potential medium-term fiscal framework (MTFF) To start, critical for budget & fiscal policy managers to make judgments on the following questions: • What are the potential medium-term aid scaling up scenarios? • Note divergent views: Sachs--a MDGs needs-based approach; IMF: focus on what aid is clearly promised; Heller: explore and consider using more optimistic scenarios that would be consistent with donors’ stated Gleneagles commitments • What scenarios for potential new external nonconcessional borrowing post-MDRI are being considered?

6. Clarifying the potential medium-term fiscal framework (continued) • Within each scenario, analyze the likely allocation of spending--balance in spending that would be allocated as between traded and nontraded goods • Assess the “bindingness” of expenditure commitments once a scaling up of expenditure programs has occurred • Assess associated risk factors--what potential for volatility? • Explore implications of borrowing strategies for debt sustainability

7. Why is it important to clarify the medium-term fiscal framework?-1 • To strengthen likelihood that government policy objectives with regard to the use of scaled up aid are realized! • Presume that the objective of seeking scaled-up aid is to realize the implied real resource transfer--this means not only to increase spending from the aid but also to obtain increased real resource absorption • Higher absorption should be reflected in a higher current account deficit in the balance of payments

8. Why is it important to clarify the MTFF?-2 • To ensure the sustainability of scaled-up government expenditure programs and realize intentions with respect to scaled-up investment projects • There are important economic costs to having to retrench midstream in programs delivering vital social services, human capital development programs, and investment projects! • In some cases (anti-retroviral programs), these might be a matter of life death!

9. Why is it important to clarify the MTFF?-3 • To clarify ex ante what fiscal instruments can be used to moderate the potential effects of aid volatility • For example, if aid proves less (more) than anticipated in a year, does the government explicitly allow for a higher (lower) deficit --drawing down (accumulating) fiscal reserves or incurring additional (reducing) domestic debt? • To work with sectoral agencies to reduce the vulnerability of their programs to the potential for aid volatility • Last but not least, to facilitate exploration, with the Central Bank (CB), as to how to coordinate fiscal and monetary policy management to realize government’s macroeconomic policy objectives • Specifically, what role reserve management strategies can play in enhancing sustainability and offsetting volatility?

10. Four key policy challenges highlighted in this talk • Choosing the fiscal anchor • Reconciling the implications of particular choices for the use of scaled-up aid with macroeconomic policy objectives • Strengthening the capacity for fiscal risk management • Ensuring adequate policy coordination between fiscal and monetary authorities

11. Key challenges: choosing the appropriate fiscal anchor • Fiscal anchor--what fiscal aggregate should be used as your basic policy objective in managing fiscal policy over the medium to long term. Obviously, must be compatible with • Fiscal sustainability--both solvency and liquidity • Consistent with key macroeconomic policy objectives • No easy answer as what should be the anchor. Need to assess and clarify, for a given country: • How much room and pace is there for new debt accumulation? • Is there scope for an increase in revenue share? • What increase in expenditure is consistent with development needs and actual absorptive capacity? • What would be impact of specific aid-or debt-funded expenditure program on sustainability of public spending? Growth? Real exchange rate? Inflation?

12. Choosing the appropriate fiscal anchor-2 • I have argued that one wants to use a targeted expenditure path as the anchor, consistent with an aid scaling-up scenario that is seen as potentially viable and consistent with sustainable debt path. • Argue on the basis of the importance of establishing a sustainable expenditure path, consistent with potential aid scaling-up, to work towards meeting the MDGs and realizing more rapid growth • In the past--pre-MDRI--IMF implicitly used external debt levels as the anchor • More recently--post-MDRI--the IMF (e.g., in Ghana) proposed that domestic debt levels should be the anchor

13. Operational considerations in choosing an expenditure path as the fiscal anchor • Still need sustainable debt prospects • Choice of expenditure path must maximize likelihood of sustainability for scaled-up programs--avoid the possibility of volatility, particularly for current spending programs • Must also take account of how the composition of the chosen expenditure program will affect the macro economy • Must balance MDG objectives with need to address critical bottlenecks limiting growth and absorptive capacity • Is there a maximum G/GDP for your country?

14. In choosing a given expenditure path as fiscal anchor, recognize that • MT expenditure path may fall below the outer limit implied by your projection of potential aid flows • Chosen expenditure path may imply higher financial reserves • Ex post, a given anchor may imply higher or lower level of domestic borrowing or deposit buildup than anticipated ex ante • Cannot choose appropriate fiscal policy without considering composition of expenditure • Close coordination between MOF and sector aid recipients is vital in choosing desired expenditure path • Both macroeconomic stability and program expenditure stability are important objectives

15. Key policy challenges: reconciling implications of particular choices for use of scaled-up aid with macroeconomic policy objectives-1 Scaled-up aid has the potential to appreciate the real exchange rate • To both spend and absorb the aid (i.e., ensure a real resource transfer from abroad)--when only a portion of the aid is directly used for imports-- • Will create pressures for an increase in the money supply as the government sells the additional foreign exchange for local currency • This may put pressure either on the • Nominal exchange rate • Prices subject to potential for an increase in the demand for money

16. Reconciling full use of aid with macro policy objectives-2 • Degree of pressure is in part determined by how the aid is used: • Does it eliminate bottlenecks in capacity to supply nontraded goods? • Does it enhance productivity in the economy? Particularly in the nontraded goods sector? • Is some aid used to facilitate self-insurance against aid volatility--viz., through an increase in foreign exchange reserves

17. Reconciling full use of aid with macro policy objectives-3 • Note distinction between likelihood of “Dutch Disease effect” and perception by CB that it will happen! • Central Bank may thus seek to limit potential expansionary monetary effects of higher aid flows by policy of active sterilization • Selling domestic bonds in a thin financial market • Crate upward pressure on interest rates • Likely crowding out of the private sector • The result would thus be to limit the extent of absorption of the aid flows--beyond the increase required to build up reserves for cushioning against potential volatility in aid flows

18. Key policy challenges: ensuring adequate policy coordination between fiscal and monetary authorities • Ex ante coordination • If aid is seen to be supply-enhancing and bottleneck removing, the central bank may be less prone to lean against the absorption of the aid • If government willing to accept the implied tradeoff between the benefits from use of scale up aid flows and the costs associated with some real exchange rate appreciation, this should be reflected in policies pursued by both CB and MOF. • Accept implications either for nominal exchange rate or price level • But should not lead ex post to very different fiscal policy course in terms of traded vs. nontraded goods balance! • Need to avoid inconsistency between objectives and implementation of monetary and fiscal policy

19. But ex post coordination of fiscal and monetary policy also required • Need adequate coordination on a real time basis: • Aid will rarely come as planned in assumed scenario--both in terms of magnitudes; likely uses; distribution between government and nongovernment actors • May be lags/leads • Other factors will influence fiscal position as well--other revenue and expenditure pressures, real economy shocks, terms of trade pressures, supply shocks

20. Monetary-fiscal policy coordination will force decisions on • Reserve management--extent of drawdown of fiscal reserves in the event of an aid shortfall • Reconsideration of what future reserve targets are appropriate, given any revision to assumptions on aid volatility • Whether more or less real appreciation of real exchange rate may be required in light of whether aid flows prove more or less than originally assumed or whether assumptions on aid use prove to be more biased in terms of greater or lesser import intensity

21. Key challenges: strengthen capacity for management of fiscal risks The uncertainties involved in significant scaling up require strengthened practices for assessing and managing fiscal risks. These include risks of • Volatility: scaling-up may increase absolute magnitude of volatile element of aid flows • Greater short-term unpredictability in terms of: magnitude or timing of aid disbursements • Long-term unpredictablity

22. Three possible approaches to managing heightened fiscal risks • Enhanced risk assessment exercises (including possible need to strengthen debt sustainability assessments); stress tests specific to country; liquidity and solvency tests • Pursue approaches to self-protection; work with donors to increase predictability; be more flexible in using aid, raise domestic revenue share; strengthen adaptability of domestic financial markets • Incorporate self-insurance and risk pooling; explicit reserve management policy with higher reserves to draw on in the event of shocks

23. Recognize that the reality and challenges are even more complex! • Aid usually does not come only via budget support to the MOF from a few donors • More aid is delivered more diversely. Much aid • Is negotiated by individual ministries and channeled to programs/projects of the individual sectors • Multiple donors involved • May be channeled and managed outside the budget • Indeed, may be received by nongovernmental actors--civil society, religious groups, private sector agents. • Makes the challenges facing fiscal policy managers far more complicated.

24. Other issues are germane to this discussion though not highlighted above Equally, the degree of actual alignment of aid with a country’s policy strategies can have macro economic implications. Raises such questions as: • How integral is the aid to a country’s sectoral strategy? • Is the aid supporting programs consistent with the national strategy for the sector? • Does it give rise to specific expenditure implications that may crowd out other elements of sectoral policy, and create pressures for additional sectoral spending as a consequence? • Does it lead to pressure for policies that may have “ripple effects” influencing other public expenditures, e.g., wage incentives?

25. Implication: MOF must have a comprehensive perspective on aid flows • Character of the aid • How predictable are the different aid components? • What conditionalities associated with different aid flows • What are terms?--grants vs loans? if loans, how concessional? • How will aid be used?--for imports? nontraded goods? What operation and maintenance implications looking forward? • Likely disbursement pattern? How sequenced over time? • Implication: importance of having institutional capacity to assess aid comparable to that associated with external debt management • How much aid is channeled to nongovernment agencies? • Potential contingency risks of volatility and shortfalls for nongovernmental aid? • Macroeconomic implications--again, how is the aid to be spent?

26. Some basic conclusions on the fiscal management implications of scaled up aid • Governments need to place greater emphasis on exploring implications for fiscal policy of alternative aid scenarios with a medium-term focus • Scaled-up aid will force consideration of how aid can contribute to national policy objectives and macroeconomic tradeoffs implied • Enhances importance of fiscal and monetary policy coordination, ex ante and ex post • Risk management issues become more important unless there is complete assurance of long-term aid predictability: reserve management issues particularly important • Need for institutional capacity in MOF to assess and take stock of aid flows