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Heller Rich countries aim to confront persistent poverty in much of the developing world with plans to boost aid, cancel debts of poor countries, and increase trade access for goods from developing nations. But scaling up aid flows is just the start of a complex set of decisions and tough choices. Donor and recipient countries will still need to ensure that the aid actually achieves results, given the spotty record so far. It is critical, therefore, that any large increase in aid be accompanied by considered efforts to ensure that lessons of the past are learned and that new challenges are anticipated.

Picture This Aiding Development: Tracking the Flows Bilal Siddiqi Chart-based analysis of which countries give the most aid and where the money goes. The authors argue that policy discussions should not focus exclusively on determining the limits of aid on growth, but rather on how those limits can be expanded so that aid can be made more effective in supporting development.

Building Momentum Andy Berg and Zia Qureshi A big push to deliver more aid is not the sole answer to achieving the Millennium Development Goals; rather aid must be combined with a concerted drive to improve trade access, encourage private capital flows, promote technology transfer, and enhance domestic expenditure management. But there are ways to tackle the problem, particularly if donors lengthen funding horizons. An analysis of five African countries that received big increases in aid—Ethiopia, Ghana, Mozambique, Tanzania, and Uganda—offers useful lessons for other developing countries.

Scaling Up David Andrews, Lodewyk Erasmus, and Robert Powell Ethiopia, among the poorest countries in Africa, presents one of the biggest development challenges in a region beset by frequent drought and hobbled by inadequate infrastructure.

Finance & Development, September - Contents - Volume 42 - Number 3

Would a dramatic increase in aid really help? An analysis illustrates the considerable challenges of attempting to promote faster development through more aid. More Country Ownership Sam Sharpe, Adrian Wood, and Ellen Wratten Like many other donors, the United Kingdom says experience shows that a "country-led" approach, in which the governments of developing countries themselves define and lead the poverty reduction agenda, is the key to improving aid effectiveness. Prasad The exchange rate regime is just one piece of the broader reform agenda in China.

A number of issues arise in managing a government budget so heavily dependent on external assistance. The prospect of a significant increase in aid will force recipient governments to consider how to weigh these "aid uncertainties" in deciding how much to expand service delivery. Budgets need to be considered in a medium- to long-term context, with a number of questions needing to be addressed.

Should programs be scaled up on the assumption that higher aid flows will be sustained, even when few donors can commit themselves to providing aid beyond a few years? Will expenditure on aid-funded services give rise to additional demands for spending on services or goods for which donor funding is not available? If so, how would this spending be financed, given budget constraints?

How should governments address the possibility of shortfalls in future donor assistance and how dependent should their budgets be on external sources? Most governments lack the capacity for any significant substitution of domestic tax resources or cuts in nonpriority spending in the event of such shortfalls, and there are inevitably macroeconomic limits on the potential for domestic bank borrowing.

Much of the additional aid will not come in the form of general budget support that is, available to the government for spending for any purpose. In addition to specific projects, most donors still earmark program aid for sectoral if not subsectoral spending. While the ministry of finance has to judge the aggregate sustainability of a budget financed by uncertain higher aid flows, each ministry must consider the sustainability of aid flows dedicated to its specific sector.

Finance & Development

The impact of higher flows to certain sectors may be substantial. Ministries must also decide how to expand service delivery. Should more civil servants be hired? Or should ministries rely on short-term employment contracts or greater outsourcing to minimize the budgetary risks from a potential shortfall in aid? The effectiveness of aid in improving productivity, incomes, and welfare will depend on how governments manage their resources. A recent World Bank—IMF study highlighted the weaknesses of public financial management systems in formulating budgets, classification systems, commitment controls, cash management, budget reporting, audit, and regulatory capacity for semi-autonomous agencies and extrabudgetary funds.

Ironically, higher aid flows may exacerbate these weaknesses, intensifying the need to strengthen the capacity of budget managers—independent of whether services are to be directly provided by the government or contracted out to the private sector. Budget managers will need to formulate and execute budgets with a keen eye on the durability of funding commitments and be able to manage gaps between commitments and disbursements. Organizations that function effectively on one scale may be much less successful when expanded to a substantially larger scale.

There is no reason to assume that government ministries, which may already be constrained by inflexible civil service rules and cumbersome government budgetary procedures, will be more adept at making the transition to a higher level of service delivery. The sharp increase in aid flows may present comparable challenges for these agencies. It may appear excessively cautious to raise the longer-term question of what the strategy should be for weaning sectors, and the government more generally, from aid.

But if donors do substantially boost aid levels, then recipients must at least weigh alternative scenarios as to how, ultimately, to phase down dependency and shift to domestic financing sources. With the pressures that aging populations will place on the public finances of donor nations, the time frame for generous aid flows may be limited.

One of the toughest issues for governments facing an increase in aid flows is a possible Dutch disease effect. Inflows of foreign currency should boost demand—both for tradables items that are readily exported or imported, such as cars and nontradables items that are not readily exported or imported, such as housing , and also possibly for money itself. Greater demand for tradables could be satisfied by more imports.

But higher demand for nontradables could encounter production bottlenecks and pressures for higher wages that would result in a rise in their price relative to tradables, thus pushing up the real exchange rate.

If an appreciation of the currency is likely, three questions arise. Does aid induce higher productivity in the nontradable goods sector so as to more than offset the effect of a currency appreciation? Can the impact on the real exchange rate be moderated by specific policy actions, both macroeconomic and microeconomic, to lessen any adverse effects and maximize the gains of a heavier reliance on aid flows? And even if, despite government actions, there are some adverse effects, can aid be used so that its net effect is still positive, on both growth and poverty reduction?

It may indeed be sensible for a low-income country to take advantage of resource transfers and accept some loss in competitiveness. If the external assistance promotes the achievement of the MDGs and confronts key infrastructural and human resource bottlenecks, it may not only raise current welfare levels but also create a future economic environment that has the potential to increase productivity and competitiveness. This strategy may imply accepting, for several years, the vulnerability that comes from being dependent on a large amount of aid.

Indeed, aid may be ineffective if a country tries to hold on to competitiveness for too long. But there still remains the downside risk that the envisaged continuity of aid flows may not be sustained. Without clear guarantees, there may thus be a case for limiting the scale of aid dependency, but the optimal level will be shaped by how successfully a country can confront and resolve the policy issues.

And if Dutch disease is a factor, governments need to consider what real exchange rate path is desirable over the long term associated with both a scaling up and scaling down of aid. The answers to these questions will inevitably be country specific and related to both the existing structure of production in an economy and how aid is likely to be used. Since most low-income countries are only now beginning to see a significant increase in aid, the potential challenge of Dutch disease is still in the future.

Finance & Development, September 2005

But this means that attention is needed now, in anticipation of higher aid levels, for investments that will tackle potential bottlenecks to expanded productivity in the nontraded goods sector—in effect "keeping ahead" of the factors that can create pressures for a real appreciation of the currency. Coping with Dutch disease. If there is a Dutch disease effect on the real exchange rate, what can policymakers do?

The central bank can seek, at least in the short run, to limit an appreciation of the real exchange rate by accumulating foreign exchange reserves. This could involve a policy of intervention and sterilization buying foreign exchange in the local currency market and then using open market operations to soak up excess liquidity in the money market or restraints on fiscal policy limiting net domestic credit to the government, by limiting either loans or the drawdown of government deposits. These approaches limit pressures on the nominal exchange rate and on the domestic inflation rate, but run the risk of higher domestic interest rates—raising government debt service costs and crowding out private borrowers.

The impact of Dutch disease can be lessened if the resource transfers contribute to the removal of bottlenecks to improved productivity and productive capacity in the nontradable goods sector of the economy. An increase in the supply of nontradables would dampen pressures for an increase in their relative price. In principle, expanding the supply of so-called nontradables might require investments in roads, ports, telecommunications, energy transmission, and training for skilled workers.

Macroeconomic policymakers—those responsible for monetary, fiscal, and exchange rate policies—already confront substantial uncertainties as they seek to achieve key targets of growth, inflation, and the real exchange rate. Volatility in remittance flows, in the terms of trade, in capital transfers, and in foreign direct investment add to the normal uncertainties associated with the underlying demand for money and foreign exchange in the economy and those arising from some dependence on aid—with the prospect of higher aid flows creating even more uncertainties.

Because of the potential effects of aid flows on the money supply and the foreign exchange market, central banks have more work to do to maintain the appropriate monetary policy stance, including by using open-market operations, reserve requirements, and foreign exchange reserve management.

For example, some low-income countries have sought to intervene in the foreign exchange market to limit or nullify the effects of aid on the nominal exchange rate and at the same time sterilize the potential monetary effect of the intervention. Typically, one observes central banks buying excess foreign currency to prevent a domestic currency appreciation, then selling central bank or government bonds to absorb the excess liquidity arising from such purchases.

Usually, such bond sales have the effect of raising interest rates in the domestic financial market. Consequent effects include the crowding out of private sector borrowers, higher domestic debt service costs to the government, and quasi-fiscal losses to the central bank as it holds low interest rate—earning foreign currency assets rather than higher-return government bonds. Hence, the pace at which aid can be received must take into account considerations of the monetary effects of the aid and their consequences for other players in the economy. Fiscal policy also becomes more challenging.

Governments may face intense pressures to cover aid shortfalls out of domestic resources, which may prove possible only by drawing on government deposits or central bank credit. Thus, when aid commitments are of a limited duration, governments need to ensure that programs are sufficiently flexible in their design so that they are not vulnerable to aid volatility or disbursement shortfalls.

More coordination of monetary and exchange rate policy with fiscal policy will also be required in the management of aid inflows. Too often, fiscal policy is driven by a desire to spend aid while monetary and exchange rate policies are driven by concern about the real exchange rate. The effect is that aid resources are used to increase reserves while an aid-related fiscal expansion ends up being financed domestically.

Increased aid will accentuate sharply the dependency of aid recipients. Consider a country that mobilizes 15 percent of its GDP in domestic revenues and receives aid of 20—25 percent of GDP.

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In this case, almost two-thirds of budgetary outlays are dependent on external sources. This may not be that unusual. A recent World Bank scenario for doubling aid in Ethiopia suggests that its fiscal position by would mirror exactly this level of dependency for more on Ethiopia, see "Ethiopia: