From Raj Nallari  and Breda Griffith's lecture notes.
Aid and Macroeconomic Challenges
Aiyar, Berg and Hussain (2005) (ABH) examine the macroeconomic challenges for five African countries—Ethiopia, Ghana, Mozambique, Tanzania and Uganda—that experienced a large increase in aid inflows. All five countries are considered good performers with strong institutions and have benefited from the general rise in aid discussed in earlier sections and in particular from the Heavily Indebted Poor Countries Initiative (HIPC).
To examine the macroeconomic management of aid inflows, ABH examine how fiscal and monetary policy interacted in handling large aid flows. In a typical case, fiscal policy concentrates on directing aid to high priority projects, while concerns about competitiveness and inflation drive monetary and exchange rate policies. The trouble is that, by being undertaken in isolation from each other, uncoordinated fiscal and monetary policies may blunt the positive impact of aid.
ABH concentrate on the classic case in which aid dollars go to the government, which immediately sells them to the central bank and then uses local currency to increase spending on domestic goods. Their framework is underpinned by “two distinct but related concepts: absorption and spending.
- Absorption is defined as the widening of the current account deficit (excluding aid) due to incremental aid. It measures the extent to which aid engenders a real transfer of resources through higher imports, or through a reduction in the domestic resources devoted to producing exports. Absorption depends on both exchange rate policy and on policies that influence the demand for imports. The central bank controls the exchange rate through its sales of foreign exchange, while monetary policy can be used to control aggregate demand—and the demand for imports.
- Spending is defined as the widening of the fiscal deficit (excluding aid) due to incremental aid.
The combination of absorption and spending defines the macroeconomic response to a scaling up of aid.”
How the Five Countries Performed
Source: Finance and Development, September 2005
Broadly speaking, there are four possible responses to an aid surge in the short- to medium-term: (i) absorb and spend, (ii) neither absorb nor spend, (iii) absorb but do not spend, and (iv) spend but do not absorb. In their analysis, ABH look at how the five countries in their sample performed according to these categories.
- Absorb and spend. Under the first “textbook” response, the government spends the aid on domestic goods and the fiscal deficit increases. The central bank then sells foreign exchange to sterilize the local currency spent by the government. In this way, the foreign exchange pays for a widening of the current account deficit, as the aid is absorbed by the economy. A key point here is that some real exchange rate appreciation may be appropriate because if aid is used to increase net imports, higher aggregate demand and/or real exchange rate appreciation is needed. This is, in general, the first-best response to aid. Absorption ensures that there is a real transfer of resources to the recipient country, while government spending draws resources away from the traded goods sector. Other responses may be justified under particular circumstances for a short time, but in the long run the only sensible alternative to absorbing and spending is to forgo aid altogether. ABH found, however, in their sample of countries, that the absorb-and-spend strategy was surprisingly rare in the sample countries. No country fully absorbed and spent the incremental aid it received during its aid-surge episode (see table). In four of the five countries, less than one-third of the aid increment was absorbed.
Neither absorb nor spend. In this case the government does not spend the aid and keeps the new foreign exchange in the central bank. Governments may choose this option because they want to build up international reserves from a low level or smooth volatile aid flows. In two of the sample countries—Ethiopia and Ghana—absorption and spending were both very low. Both countries entered the aid-surge period with a low level of reserves—at 2.2 months of imports in Ethiopia and 1.3 months of imports in Ghana—and used the increments in aid to increase import coverage. The reserve buildup meant that aid was effectively not available to finance increased domestic spending. However, in neither country was the aid surge accompanied by a significant widening of the fiscal deficit or an increase in inflation.
Absorb but do not spend. This response substitutes aid for domestic financing of the government deficit. The government keeps expenditures steady, and the money supply shrinks as the central bank sterilizes liquidity through foreign exchange sales. Such an approach can help stabilize the economy where domestically financed deficit spending is too high. No country in the sample chose this approach for the entire aid-surge period, but it was used for particular episodes, including, for example, in Ethiopia in 2001, where the strategy helped hold liquidity in check and avoided an inflation surge. This approach can also be used to reduce domestic public debt and crowd in the private sector if the central bank uses the proceeds from its foreign exchange sales to buy back government debt.
Spend but do not absorb. This is a suboptimal response, often reflecting inadequate coordination of monetary and fiscal policy. Unfortunately, ABH find that it is all too common. Under this approach, the government increases expenditures, but keeps aid dollars in the central bank as reserves. This response is similar to a fiscal stimulus in the absence of aid because the increase in government spending must be financed domestically since there is no real resource transfer, as net imports do not increase. This can lead to money supply increases and inflation, unless sterilization is undertaken by sales of government paper (instead of foreign exchange).
ABH find that Uganda, Mozambique, and Tanzania adopted this suboptimal approach. In all three countries, concerns about the negative impact of a real appreciation on competitiveness dictated the pattern of aid absorption and the monetary response (foreign exchange sales being held in check to rein in upward pressure on the domestic currency with sterilization instead being undertaken by sales of government paper).
In all three countries, unlike in Ethiopia and Ghana, the level of import coverage afforded by gross reserves was quite high, with reserves accumulating steadily. A more suitable response to increased aid inflows might therefore have combined a widening fiscal deficit with sterilization through foreign exchange sales. In Uganda and Tanzania, such a strategy would have relaxed the need for open market operations and the sharp rise in interest rates. In Mozambique, it would have reduced inflation by reining in base money and limiting the sharp nominal depreciation.
- Fridays Academy