Article

Forum: Dealing With Scaled-Up Aid

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
May 2006
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With the expected doubling of aid to Africa by 2010, the continent’s policymakers will face a host of macroeconomic challenges. How recipients and their development partners can address these challenges was the focus of a workshop hosted by the IMF and the U.K. Department for International Development (DfID) in Washington April 19-20. African finance ministers, central bank governors and other officials, donors, academics, and representatives from multilateral development institutions took up seven issues that recipients of sharply increased aid are likely to deal with.

Appreciating exchange rates. Aid recipients can experience a large real exchange rate appreciation that reduces export competitiveness (Dutch disease). To offset such a loss of competitiveness, they can use aid to improve productivity. There is little evidence to date that large aid inflows have significantly reduced the competitiveness of African exports, but participants cautioned that policymakers should be alert to this phenomenon. In certain circumstances, they observed, countries should use some aid to build up reserves.

Coordinating fiscal and monetary policies. Managing scaled-up aid will require effective coordination between different parts of government, especially central banks and finance ministries. It is often a challenge for policymakers to determine the appropriate trade-off between exchange rate appreciation and interest rate increases.

Increasing the supply response. There was a consensus on the importance of increasing the supply response to aid inflows. A strong response—in the form of improved productivity and higher employment—can mitigate Dutch disease. Countries will need to create a favorable business environment to attract both foreign and domestic investment and address supply bottlenecks, such as underdeveloped infrastructure and agriculture. Thus, they must strike a balance between spending aid resources on social and productive sectors. An open trade regime can both enhance domestic competition and alleviate the exchange rate pressures stemming from increased aid.

Strengthening institutions and governance. Participants emphasized the importance of strengthening institutions and governance to manage scaled-up aid and improve the investment climate for the private sector. Sound fiscal institutions, especially strong public financial management, would facilitate aid absorption. To use aid effectively, countries need to strengthen government’s capacity to manage aid flows and the private sector’s capacity to operate in an open, competitive environment.

Formulating an exit strategy. Aid recipients should plan to depend less on aid over time. They will thus need to increase their revenue before aid tapers off—for example, by broadening the tax base and eliminating exemptions rather than by raising tax rates.

Reducing aid volatility. Aid volatility exacerbates budgetary management—a recurring theme at the workshop. The need to address these problems will become even more urgent as African countries receive more aid. Long-term aid commitments by donors would increase predictability.

Identifying key issues and policies. Finally, participants stressed that scaling-up scenarios would help countries and donors identify key issues and help countries adopt policies to absorb higher aid flows. The macroeconomic challenges of managing scaled-up aid are substantial, but participants were confident that these challenges could be met.

Sanjeev Gupta, Catherine Pattillo, and Yongzheng Yang

IMF African Department

Laura Wallace

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