The Macroeconomics of Managing Increased Aid: Country Experiences “Global Conference on Gearing Macroeconomic Policies to Reverse the HIV/AIDS Epidemic” November 2006 Jan Kees Martijn International 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.

Main Findings (2) Aid was not fully used—in no case was it both spent and absorbed.

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 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. Δ NFA=-( Δ NDA), 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.

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.