From Raj Nallari  and Breda Griffith's lecture notes.
Aid and the Government Budget
A scaling up of aid that may facilitate a greater expansion in public services but increased flows will also bring challenges for managing and delivering that extra aid. For example, aid flows, which are by definiton volatile can create serious budgetary challenges that feed in turn to individual ministries. The ministry’s goal to achieve aggregate budget sustainability becomes difficult in an environment in which the volume and duration of aid is not clear, when questions surround the manner and timing of disbursements, whether the increase in aid is subject to performance criteria or tied to a specific sector or policy. It is difficult to commit to undertake new service delivery in such a context, particularly if external financing is unavailable or limited and/or the government lacks the capacity to substitute domestic funds either through tax increases and/or borrowing from the domestic banks in the case of a budgetary shortfall.
Furthermore, when aid is targeted to sectors rather than individual projects, as seems most likely given the move away from project aid toward program and sector aid in recent years, then the challenge facing the particular sectoral ministry is to achieve sectoral sustainability . The impact of higher flows to certain sectors such as health and education may be substantial calling into question issues regarding staffing. It is thought that aid for HIV/AIDS could increase public health spending in Ethiopia, Guyana, Kenya and Zambia by 40 to 50 percent and even more in Rwanda (Heller, 2005).
Public financial management systems in many developing countries are inadequate and thus ill-equipped to meet the challenges a scaling up of aid would incur. A World Bank-IMF study undertaken in 2005 for semi-autonomous agencies and extra budgetary funds found weak budget formulation, weak classification systems, poor commitment controls, and inadequate cash management, budget reporting, auditing and regulatory capacity (Heller, 2005). Funds will need to be found and directed toward increasing the capacity of budget managers, equipping them with the skills required to manage gaps between commitments and disbursements of aid.
A scaling up of aid may also present organizational challenges. As noted by Heller (2005), a department that functions well on one scale may not be able to make the transition toward a larger scale. Furthermore, there is always the challenge that further aid will develop aid dependency . The incentives for governments to develop a budget exit strategy may be ignored in the face of extra flows of aid. Moreover as Heller (2005) cautions, the timeframe for generous aid flows may be limited given the demographic pressures arising in developed nations from aging populations.
Aid and Competitiveness
An increase in aid flows may generate a Dutch disease effect whereby the increased inflow of foreign currency boosts demand in the non-traded as well as traded goods sector. While increased demand in the traded goods sector can be met from increased imports, this is not the case for the non-traded sector (goods that are not readily exported or imported, e.g. housing and domestic services). Excess demand here can lead to production bottlenecks and higher wages increasing inflation and the real exchange rate. A higher real exchange rate may adversely impact the international competitiveness of the country, thus hampering its gains from international trade and its capacity for growth and investment. Heller (2005) identifies three questions a government should ask if an appreciation of the exchange rate is likely. These are:
Does aid induce higher productivity in the non traded goods sector so as to more than offset the effect of a currency appreciation?
Can the effect on the exchange rate be moderated by pursuing macroeconomic and microeconomic policies?
Even if there are adverse effects, can aid still be used so that its net effect is still positive on growth and poverty reduction?
The central bank may try to keep the pressure off the nominal exchange rate by intervening in the foreign exchange market (buying foreign exchange) and sterilizing the monetary impact by conducting open market operations. The capacity of developing country central banks to absorb liquidity may be limited, however, (lack of suitable sterilization instruments) and these policies may then result in an appreciation of the real exchange rate through the domestic inflation channel. Sterilization policies may also lead to higher interest rates and a crowding out of private investment activities. Fiscal policy may also be tightened to keep domestic inflation in check. However, using aid flows to replace, rather than supplement, existing government spending may not be the wisest policy action in the face of pressing spending needs.
The government, in its attempt to ward off a Dutch disease effect, may take advantage of resource transfers. Aid may bring about a “real transfer of resources through higher imports or through a reduction in domestic resources devoted to producing exports” (Aiyar, Berg and Hussain, 2005). Government may introduce policies that affect the demand for imports. In particular, if resource transfers facilitate the removal of bottlenecks, productivity in the non-traded sector may increase. Furthermore, increasing the supply of non-traded goods in the economy would curtail price pressures and even expand investment and growth in the economy with the increased supply of non-tradables leading to investments in physical infrastructure and human capital.
Heller (2005) argues that it may be sensible for a low income country to accept some loss in competitiveness by implementing policies that lead to a real transfer of resources from the traded to nontraded sector. Furthermore he suggests that if increased aid is successful in achieving the MDGs, the resultant economic environment will be better placed to increase productivity and competitiveness. However, he again cautions that the uncertainty with regard to the continuity of aid make accepting the loss in competitiveness a risky venture. Thus governments need to decide on a path for the real exchange rate and the repercussions for when aid is scaled up or down.
Next Friday: Aid and Macroeconomic Challenges
- Fridays Academy