1. Macroeconomic Policies for Combating HIV and AIDS Conference organized by UNDP Poverty Centre Brasilia, November 20-21 November 2006 David Bevan Department of Economics University of Oxford

2. 2 Introduction Aid flows have tended –to become more concentrated –hence sometimes large relative to the recipient economy Present efforts, if successful, will tend to reinforce this Current concerns about aid absorption –aid has often been poorly managed and ineffective in the past –but also reflect the worry that aid may become problematic when it is large relative to the economy, even if it is well-managed Narrow and broad interpretations of macroeconomic hazard. –macroeconomic hazards given the institutional and political framework –possible adverse impacts on this framework, which may make macroeconomic problems worse

3. 3 The institutional and political framework Concerns about possible adverse impacts Aid dependency –‘no representation without taxation’ Corruption and rent-seeking Weakened process of institutional improvement Implications Evidence that weak institutions leads to poor macroeconomic policies and performance Focus on institutional reform as part of the aid ‘package’

4. 4 The potential problem of real exchange rate (RER) appreciation 1 The usual diagnosis Export growth and diversification seen as important for economic growth Part of aid will be spent on nontradable goods, driving up their price – so that the real exchange rate appreciates This makes exporting less profitable, so export volumes suffer Hence the aid comes at a potential price in reduced growth

5. 5 The potential problem of RER appreciation 2 Some qualifications to this diagnosis In practice, countries appear to be able to absorb very high aid inflows without suffering growth reductions While some aid goes to enhance current consumption (so just adds to demand) much of it goes into investment (so has an effect on supply also) –If the productivity increase is specialized in nontradables, their supply may expand as fast or faster than demand, leading to a depreciation –If it is specialized in exportables, exports may still increase rapidly despite the depreciation (profitability Relief of bottlenecks Depends on the relative impact on supply and demand

6. 6 The potential problem of RER appreciation 3 Implications Whether there will be a problem is not a given, but contingent on country specifics and on policy design Very difficult to judge what is the case, so may often be best to ignore the issue However, there are two special situations where this is not so –Gradual changes may be more easily absorbed than rapid ones –There will be differences in the speed of the supply pay-off – for example, between spending on physical infrastructure/income generation versus that in the social sector

7. 7 Medium-run supply responses D E E-biased supply response D-biased supply response Neutral supply response

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12. 12 Inconstancy of aid flows 1 Long-run movements in the aid-GDP ratio Large increases/decreases problematic even if –Completely predictable –Recipient government allowed unrestricted freedom to smooth Would still pose a severe management/political problem In practice, neither condition likely to hold An extended aid ‘pulse’ will typically have to be spent more or less simultaneously Very difficult to know when a change is likely to be transient and when it may persist

13. 13 Inconstancy of aid flows 2 Medium-term fluctuations and falling commitments Government spending needs to be planned over the medium or longer term Most donor commitments are firm only over relatively short horizons It is costly to embark on programmes that have to be cut back because of funding problems But the converse is also true Is it always prudent to be conservative?

14. 14 Inconstancy of aid flows 3 Short-term volatility and cyclicality Even when aid flows are reasonably stable in the medium term, they may be volatile in the short run Move to budget support, may make matters worse Domestic revenues in low-income countries have also tended to be volatile These two sources of instability have tended to reinforce rather than offset each other Volatility a particular problem if financial depth is lacking May imply higher foreign exchange reserves needed

15. 15 Inconstancy of aid flows 4 Implications for policy Macroeconomic policy management is substantially more difficult than in industrialized countries –Greater volatility to cope with, in real economy as well as budget –Shocks of uncertain duration rather than fairly regular cycles –Fewer and less potent instruments What is best response to a shock? –Smooth a temporary shock –Accommodate to a permanent one –Recognition problem

16. 16 Inconstancy of aid flows 5 Consider an addition to recurrent public health expenditure (g), initially grant financed for several years, but falling back into the domestically financed budget subsequently (say after year T) It produces a flow benefit valued at b The domestic tax system inflicts marginal and average deadweight losses on the private sector θ m > θ a > 0 For example, a marginal dollar of revenue costs the private sector $(1 + θ m ) The government discount rate is r Suppose first that all of b is “psychic” as opposed to money income The tax rate is

17. 17 Inconstancy of aid flows 6 Then we should require a benefit cost ratio: If b takes the form of money income, this would be:

18. 18 Conclusion Risk of Dutch disease problems is real but has probably been exaggerated –Not inevitable –Can be managed –But management may be unpalatable Risk of inconstancy probably more severe and certainly less tractable –Always costly to handle –In case of HIV/AIDS even more so –Crucial to find ways of handling this