The Macroeconomics of Managing

Increased Aid: Country Experiences

“Global Conference on Gearing Macroeconomic Policies to Reverse the HIV/AIDS Epidemic”

November 2006

Jan Kees MartijnInternational Monetary Fund

Outline

A framework for assessing macro implications of increasing aid: absorption and spending

Findings from case studies Prescription under IMF-supported

programs Related evidence on monetary

programs Concluding thoughts

Defining Spending and Absorption

Spending of aid: widening of the fiscal deficit, net of aid, as a result of new aid.– Spending = (Govt. expenditures-Domestic

revenues)/Aid

Absorption: widening of the current account deficit, net of aid, in response to an increase in aid.– Absorption = (non-aid current account

deficit)/Aid– Central bank’s willingness to sell foreign

exchange is crucial.

Policy Responses – Four Options

1. Absorbed and Spent Textbook case where central bank

sells aid foreign exchange and fiscal deficit rises as aid is spent.

No change in money supply. Risks Dutch disease.

2. Absorbed but not Spent – Central bank sells foreign exchange

but fiscal deficit remains unchanged.

– Helps achieve stabilization, lower debt, provides resources for private investment.

3. Not Absorbed but Spent – Central bank accumulates foreign

exchange as reserves; fiscal deficit rises as aid is spent. No real resource transfer.

– Unsterilized: Money supply rises. Risks inflation.

– Sterilized: Crowding out of private sector. Costly domestic debt.

4. Not Absorbed, not Spent

– Central bank accumulates foreign exchange as reserves; fiscal deficit net of aid unchanged. No real resource transfer.

– Equivalent to rejecting aid (in long run).

Main Findings (1)

No evidence of Dutch disease—real exchange rates did not appreciate.

Real Effective Exchange Rate

60

80

100

120

140

t=-1 t=0 t=1 t=2 t=3

Aid surge period Ethiopia

Ghana MozambiqueTanzania Uganda

reference line=100

Main Findings (2)

Aid was not fully used—in no case was it both spent and absorbed.

Was Aid Absorbed?

-12

-8

-4

0

4

8

12

Ghana

Ethiop

ia

Moz

ambiq

ue

Tanza

nia

Uganda

in p

erce

nt G

DP

Increase in Aid

Increase in Current Account Deficit Netof Aid

Was Aid Spent?

-2

0

2

4

6

8

in p

erce

nt G

DP

Increase in Budgetary Aid

Increase in Fiscal Deficit Net of Aid

Main Findings (3)

Some countries neither spent nor absorbed: aid went into reserves and spending did not increase.– Ghana, Ethiopia– Why? Desire to build up reserves or smooth

volatile aid flows

Some countries spent the aid but resisted absorption. This amounts to domestic financing of spending.– Most common, though unattractive, response:

Tanzania, Uganda, Mozambique.– Why this choice? One factor: fear of

appreciation.

What Did the IMF Program Prescribe?

PRGF programs generally encouraged an absorb-and-spend policy.– Fiscal deficit net of aid incorporated planned

increases; reserve targets were modest.– In a few cases, absorption without spending

was envisaged when macro stability not established or domestic debt too high initially (e.g. Ghana)

However, PRGF programs often dealt with aid surprises more cautiously. Asymmetric adjusters with respect to aid surprises common.

Lesson: the Need for Coordinated fiscal and Monetary Policies

Coordinated choice. Either #1 or #4, depending on benefits of higher govt. spending vs. adverse impact of appreciation.

Uncoordinated outcome. Suppose also that the Minister controls spending and the CB controls absorption. This could lead to suboptimal outcome (#3).

1. Spend and Absorb

2. Absorb but not Spend

3. Spend but not Absorb

4. Neither spend nor absorb

Competing objectives. Suppose the Minister of Finance (and donors) care mostly about increasing spending and the central bank mainly dislikes appreciation.

Performance under Monetary Programs

Corresponding performance under monetary programs: reserves higher and domestic credit lower than programmed under IMF programs.

(based on 1999-2004 performance of 15 Post-stabilization LICs)

Background: The Monetary Impact of Aid

When the government receives aid, it sells foreign exchange to the central bank and gets local currency deposits.

ΔNFA=-(ΔNDA), no effect on reserve money.

Aid spent → govt. draws down deposits, NDA and money increase.

Now CB faces a choice: sell foreign exchange, sterilize, or allow inflation.

NFA +100 RM 0NDA -100

NFA +100 RM +100NDA 0

Central Bank Balance Sheet

Central Bank Balance SheetAid inflows and money supply

Outcomet-2 t-1 t(1) t(2)

Projected

Inflation (end year CPI) 4.1 4.9 6.0 5.9 6.3 Inflation (GDP deflator) 4.3 5.2 6.3 6.1 6.8 Real GDP growth 6.0 5.9 4.9 4.9 5.1 Broad money growth 12.0 12.3 12.2 13.3 17.5 Reserve money growth 10.5 9.7 10.3 15.7 NDA contribution -0.6 -6.8 -7.8 -11.5 NFA contribution 10.3 16.4 18.2 27.1 Velocity (% change) -0.6 -0.4 -1.6 -4.3 Money multiplier (% change) 1.6 2.7 3.1 2.4

# observations 29 43 54 54 54

Deviations from projections 3/ 4/

Inflation (end year CPI) -0.7 -0.5 -0.3 -0.4 Inflation (GDP deflator) -1.0 -1.0 -0.5 -0.7 Real GDP growth 0.2 0.6 -0.2 -0.2 Broad money growth -4.5 ** -5.9 *** -5.4 *** -4.3 *** Reserve money growth -4.6 * -6.0 *** -5.4 *** NDA contributio 6.9 5.1 3.7 NFA contributio -13.1 -11.3 ** -8.9 * Velocity (% change) 4.5 *** 3.8 *** 2.7 *** Money multiplier (% change) -1.4 0.2 0.7

Projection as of 1/

Monetary Projections and Projection Deviations (averages, in percent)

Main Findings on Monetary Performance

While inflation objectives are generally met,

Money growth is higher than projected With significantly higher reserves – in

part due to the lack of absorption of aid inflows

Which is partly offset by lower domestic credit – in part due to sterilization using domestic instruments

The Post-Stabilization LICs

Country list: Albania, Azerbaijan, Bangladesh, Benin, Ethiopia, Guyana, Honduras, Kyrgyz Republic, Madagascar, Mongolia, Mozambique, Rwanda, Senegal, Tanzania, and Uganda.

Concluding Thoughts

“Spend and absorb” is the only sensible response to aid in the long run.– Some real appreciation may be necessary to

enable reallocation.– When maintaining a peg, some inflation may

be necessary as a relative price adjustment (and reallocation of resources).

– In the short run, other options may be considered (e.g., building reserves)—as in Ghana, Ethiopia

“Spend and not absorb” is problematic option because it leads to deficit financing. If aid is to increase reserves, it can’t also finance spending. Yet this is a common response.

Ensure coordination between fiscal and monetary policies.