Aid and Growth Nexus. Dollar and Burnside (2000) argue that aid positively influences long term growth in countries with good policy environment. This is intuitively correct because we all accept that humanitarian assistance by averting crises and human suffering is generally considered. In addition, no one can deny that building schools, hospitals, roads and power plants and paying teachers, doctors, nurses and engineers under aid projects complements private investment and contributes to overall human development, growth and development. But, there are complementarities involved in aid-growth nexus – building schools has to be accompanied by teachers who are present regularly to reach, hospitals need pharmaceuticals and doctors as well as nurses simultaneously for health care to improve. Further, country absorptive capacity, aid management, including project implementation and recurrent budget availability, have differential aid impact on growth. While some countries utilize aid inflows effectively, most countries do not and the aid effectiveness and growth relationship is very complex, possibly nonlinear in relationship, and its quality cannot be captured by indices such as Bank’s CPIA (country policy and institutional assessment).
Aid could hurt growth through two channels. First, aid inflows push the price of goods and services, such as aid managers, engineers that work on roads, power, and school building, doctors and nurses, and building contractors because of demand for such services. These goods and services are needed by both traded and non-traded sectors. For example, aid projects that utilize such services will drive up the wages of such service workers. If wages are pushed up for these qualified personnel, non-tradable sector is likely to increase prices of its output to compensate for the higher costs so as to maintain its profitability. On the other hand, the tradable sector because it faces external competition and the price for its output is fixed will run into a loss-making situation and is likely to lose its competitive edge because of the higher wages for the same qualified personnel.
Second, in a flexible exchange rate regime, aid inflows will push up the nominal exchange rate, thereby reducing the tradable sector’s competitiveness if wages do not adjust downwards. Third, large aid inflows are likely to create a ‘Dutch Disease’ phenomenon. Aid inflows by pushing up wages of certain goods and services, put upward pressure on all other sectors to increase wages. There is likely to be a generalized rise in wages through out the country. These effects of aid inflows on growth are not mutually exclusive but the loss of competitiveness, especially in the tradable sector. Fourth, aid inflows do not provide any incentive for a country to improve its tax collection and administration and perpetuate a culture of aid dependency. Aid inflows by relaxing the resource constraint of the government could weaken institutions of tax and expenditures, and allow for lack of transparency and corruption in the use of such resources.
To counter this, aid inflows have to be spent for the benefit of tradable sector (imported capital and machinery, intermediate goods etc) rather than non-tradable sector accompanied by fiscal adjustment. Only then will wages not rise and appreciate the exchange rate.
Resources are not everything. While construction of classrooms and hospitals will spur growth in the short term, in the longer term, the critical ingredients for contribution of human capital and physical capital to economic growth may be the right incentives to avoid absentee teachers and doctors, for availability of teaching materials and pharmaceuticals, and for ensuring adequate supply of power and water.
Aid inflows have some adverse effects on growth of tradable sector, overall wages, and employment, especially in labor intensive, low skilled, exporting sectors. Remittances, which are private-to-private transfers, do not generate adverse effects on competitiveness. Aid inflows go through recipient government to the final beneficiaries (i.e. citizens) and this could have a distortionary effect in the economy as described above. In contrast to aid inflows, inflows of worker remittances directly reach the beneficiaries and do not appear to have a distortionary effect.
While a scaling-up of aid promotes the transfer of real resources from rich to poor countries, beyond a certain threshold (of about 5 percent of GDP per year), a surge in aid poses macroeconomic problems and could have a negative impact on growth in the long term, particularly if aid is channeled more towards consumption and less towards investment. There is also evidence that revenue collections are lower in highly-aided countries.
Debt, Debt Relief and Growth. Studies investigating the link between external debt and growth place a strong emphasis on the role of investment. Large debt stocks are typically expected to lower growth through the channel of reduced investment which is usually described by the debt overhang hypothesis. Outstanding debt ultimately becomes so large that investment will be inefficiently low without sizable debt or debt service reduction. The burden of large debt sooner or later can lead to extreme scarcity in liquidity, negatively impacting upon capital formation, growth, and consumption. The incentive effect of this hypothesis refers to the low public and private investment because a larger and larger share of resources is transferred abroad for debt servicing. In other words, some of the returns from investing in the domestic economy are effectively taxed away.
Another strand of the debt overhang theory emphasizes the point that large debt stocks increase expectations that debt service tends to be financed by distortionary measures (inflation tax or cuts in public investment). Under such uncertainty, private investors will prefer to exercise their option of waiting and may choose to invest less, or divert their resources towards quick, financial returns with high risk, or resort to transfer their money abroad (capital flight).
The original Laffer-Debt curve graphed the expected repayment against the face value of debt service. It shows that as outstanding debt increases beyond a threshold level, the expected repayment begins to fall due to the adverse effects mentioned above. Patillo et al. (2002) discuss the possible nonlinear relationship between debt and growth.
There is enough evidence that external debt slows growth beyond a certain level (of about 50 percent of GDP or 20-25 percent of GDP in net present value terms). This is the so-called ‘Debt Laffer Curve.’ Therefore, substantial reduction in external debt as under the HIPC Initiative is estimated to add about 1 percent in per capita GDP growth (e.g. annual GDP growth of HIPC countries averaged about 1.2 percent per year during 2000-02 compared with 0.2 percent during 1990-99.
External debt also affect GDP growth indirectly through its effect on public investment. One reason is that the cost of servicing debt decreases fiscal revenues and tends to depress public investment. The crowding-out of investment intensifies with rising debt service to GDP ratio, thereby suggesting a non-linear relationship between debt, debt-service and growth. Policymakers are urged to use the resources released by HIPC debt relief for raising public investment, without increasing budget deficits, in an effort to increase growth.
Reducing the stock of debt alone, rather than immediately reducing debt service, is unlikely to induce governments to increase their allocation to public investment. Front-loading of debt relief and topping-up relief makes eminent sense if poorer countries are to be assisted through debt relief, but every one percent in debt relief by itself raises public investment, on an average, by only 0.2 percent.
In sum, on an average poorer countries, have to learn to manage with aid flows of about 5 per cent of GDP per year, while ensuring that the debt stock is maintained below the 50 percent of GDP threshold, and that the borrowing is on concessional terms to ensure low debt service obligations each year. Beyond these thresholds, aid and debt will negatively impact upon GDP growth. The above discussion points to prudent external borrowing strategy and maximizing aid effectiveness for ensring long term growth.