Public Information Notice: IMF Executive Board Discusses PRGF Program Design
September 16, 2005
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On September 2, 2005, the Executive Board of the International Monetary Fund (IMF) discussed the design of policy programs supported under the Poverty Reduction and Growth Facility (PRGF). The staff papers for this review comprise an overview paper, Review of PRGF Program Design-Overview, and three background papers: Monetary and Fiscal Policy Issues in Low-Income Countries; The Macroeconomics of Managing Increased Aid Inflows-Experiences of Low-Income Countries and Policy implications; and Can PRGF Policy Levers Improve Institutions and Lead to Sustained Growth?
In September 1999, the IMF established the Poverty Reduction and Growth Facility to make the objectives of poverty reduction and growth more central to lending operations in its poorest member countries. PRGF-supported programs are underpinned by comprehensive country-owned poverty reduction strategies, prepared by the country with broad participation of key stakeholders.
Earlier reviews of the PRGF by IMF staff in 2002 and by the Independent Evaluation Office of the IMF in 2004 confirmed that the design of the programs supported by PRGF lending has become more accommodating to higher public expenditure, in particular pro-poor spending.
With the marked reduction of macroeconomic imbalances and resumption of growth in an increasing number of low-income countries in recent years, the policy challenges that these countries face have evolved. Increasingly, countries are facing a range of viable policy options: should they use any fiscal space to cut excessive tax burdens or raise public spending to improve the provision of public services? Some of these issues are especially pertinent in light of the prospect of a significant scaling-up in foreign aid flows to the low-income countries in the years ahead.
Against this backdrop, the present review focuses on selected policy issues facing low-income countries that have achieved broad macroeconomic stability-with particular emphasis on the role of institutions in economic growth, the macroeconomics of aid absorption, and the budgetary and monetary policies that will encourage growth and poverty reduction. The studies used a variety of methods, including econometric analyses and case studies.
Executive Board Assessment
Executive Directors welcomed this review of the appropriateness of the Fund's policy advice and program design for low-income member countries. They felt that the various findings and policy lessons will be valuable in informing the work of the Fund with these members.
Many Directors supported the staff report's focus on specific policy issues for countries that have achieved broad macroeconomic stability, noting that it complements the more generalized methodology of last year's review of the design of Fund-supported programs and makes the review particularly relevant for program design in countries that may want to utilize a possible Policy Support Instrument. They considered that many of the policy lessons were pertinent to other low-income countries. Nevertheless, a number of Directors stressed that PRGF-eligible countries are not a homogeneous group and may require different approaches to program design. Many Directors also stressed the importance of full ownership for successful program implementation.
Directors concurred that macroeconomic outcomes in low-income countries have improved markedly in recent years, with an increasing number of countries registering higher growth, lower inflation rates, smaller fiscal deficits, and increased foreign exchange adequacy. They considered that these positive outcomes are partly due to better economic management and the reforms pursued over the last decade, but other factors have also contributed, including debt relief, higher aid inflows, and a generally benign international environment. Nonetheless, Directors noted that per capita income levels in most of these countries remain very low. Directors expressed concern about the absence of a more robust pick-up in export growth even among the sample of stronger performing low-income countries, and saw an urgent need to improve on this record.
Some Directors would have liked to see a more extensive analysis of the link between PRGF program design and poverty reduction, including the alignment of the PRGF to poverty reduction strategies.
Growth and Institutions
Directors noted the importance of broad economic institutions for the ability of developing countries to sustain economic growth and avoid crises. They therefore welcomed the analysis in the background study of the extent to which countries with weak initial economic institutions can generate episodes of sustained economic growth, looking at the experience of actual episodes over the past four decades. Directors noted the existence of some cases where sustained growth was ignited without particularly strong broad institutions and which, in the course of their growth episode, were successful in improving the quality of institutions, creating a virtuous circle of development.
Directors welcomed the analysis that points to a role for policy levers in initiating sustained growth episodes when broad institutions are initially weak. They noted the consistency between key findings—on the need to avoid exchange rate overvaluation and to maintain macroeconomic stability more broadly—and the broad policy advice given to developing countries by the Fund. A number of Directors noted that the sustained growth cases have to a great extent relied on exports of manufactures, supported by a relatively liberal trade regime, suggesting that this experience might also be relevant to other countries. Other Directors emphasized the importance of education and low income inequality in contributing to the sustainability of growth episodes. Directors saw merit in the argument that the sustainability of growth depended on creating, and nurturing, constituencies for economic reform and better domestic institutions.
Beyond the need to develop constituencies for reform, Directors concurred that the traditional focus in Fund-supported programs, including PRGFs, on maintaining broad macroeconomic stability, avoiding overvalued currencies, and pursuing trade openness, is vital to help countries sustain growth. A number of Directors believed that removing structural impediments to faster growth in manufactured exports could pay particular dividends in producing sustained growth episodes. Strengthening structural reforms could be of particular importance in countries where investment and export growth are found to be sluggish. Measures that could play such a role include lowering costs to business entry, and strengthening property rights and mechanisms for enforcing contracts. However, Directors reiterated that Fund conditionality should focus on areas that are macro-critical, and that the Fund will need to collaborate closely with the World Bank and other institutions. Directors argued that Fund-supported programs could also make a useful contribution to institutional reform, by enhancing fiscal transparency and governance.
Directors saw a need for increased spending in many low-income countries, in particular for public investments, health care and education, if these countries are to meet the Millennium Development Goals (MDGs). However, they emphasized that progress towards the MDGs is not contingent on higher public expenditures alone, noting the potential tensions between higher government spending and both debt sustainability and private sector activity, which could be crowded out. Directors considered that while increased aid inflows, in particular grant support, could relax the constraints relating to taxation, private sector credit, and debt sustainability, real currency appreciation could still give rise to loss of export competitiveness that dampens growth. They noted, however, that, ex post, real exchange rate appreciation had not been a problem in the sample of countries studied, in part because the authorities restricted absorption precisely to avoid a loss of competitiveness, and that these countries had managed to raise their revenue effort following an aid surge. Directors observed that considerations about fiscal space and the policy mix are country-specific.
Directors stressed the substantial role that a better allocation of existing resources can play to help increase fiscal space. Underlying reforms could involve better public expenditure management and improved project selection.
Directors emphasized the need for low-income countries to bolster domestic revenues in order to provide more room for public expenditures. In this context, they noted the importance of expanding the tax base through reductions in exemptions and improving compliance, while taking account of the impact on poor households and avoiding tax regressiveness.
Directors considered that for countries with little debt, external borrowing can be an efficient route to finance development expenditures. However, they observed that even concessional borrowing can lead to an excessive build-up of debt, and most low-income countries already have a rather high public debt burden. Directors stressed that the pace at which countries accumulate new debt will need to be monitored carefully in order to avoid the emergence of debt problems. Directors reaffirmed that the recently-operationalized framework for debt sustainability analysis in low-income countries should be the main vehicle for assessing the appropriate fiscal path. In countries with a moderate debt burden, including as the result of further debt relief that is currently being considered, the pace at which new debt is being accumulated needs to be monitored carefully through the debt sustainability framework. To the extent that such countries become increasingly reliant on non-concessional rather than concessional borrowing, this will create new challenges for the design of Fund programs and surveillance, and care will need to be taken to ensure consistent treatment across countries. Directors considered that for those countries with debt burdens close to or above the agreed policy-dependent debt thresholds, grants rather than loans should help finance MDG-related spending.
Absorbing Higher Aid Inflows
Directors considered higher aid inflows to be an important complement to domestically-generated funds for financing poverty-reducing expenditures. They noted the stronger prospects for increases in aid inflows to low-income countries in the coming years. Directors considered that these inflows could help underpin macroeconomic stability, by financing fiscal deficits and crowding in private sector investment through lower interest rates. Nevertheless, some Directors stressed that in the long run countries should aim to reduce their dependence on external assistance. They also emphasized the importance of aid coordination among donors and of donor alignment of their aid programs with national budgets and priorities.
Directors considered effective management of these resources to be critical for the achievement of the MDGs. They underscored, in particular, the importance of monetary and fiscal policy coordination in managing a surge in aid inflows. In this context, Directors noted the useful distinction between aid-related "spending"—i.e., the accompanying increase in government expenditures—and "absorption"—i.e., the resulting widening of the current account deficit (excluding aid).
Directors were of the view that, given a large increase in aid inflows, if absorption capacity is adequate and adverse effects on the tradables sector are contained, a spend and absorb strategy would be appropriate. In that case, the government increases spending, and aid finances the resulting rise in net imports. Directors considered that, within this scenario, programs should have adjusters to allow higher-than-anticipated aid inflows to be spent, when countries have finance-constrained plans for productive spending. Several Directors noted that a key challenge will be identifying the point beyond which real appreciation associated with this strategy is likely to become problematic.
Directors considered, however, that a more restrained spending policy could be in order if the effectiveness of higher spending is constrained by absorptive capacity, if there is a tension between aid volatility and spending rigidities, or if there is an unacceptable erosion of competitiveness. In this context, Directors cautioned against a policy of aid-financed public spending that is offset by a more restrictive monetary stance. Sterilization—while limiting the inflation and real appreciation pressures—would raise interest rates and heighten the crowding-out of private investment, while raising public domestic debt. Directors also encouraged countries in which higher aid-based spending would pose a serious threat to competitiveness to consider using the aid for enhancing productivity and/or removing domestic supply constraints.
To help limit concerns about aid volatility, Directors urged donors to increase the predictability of aid. Moreover, they encouraged countries whose budgets are more dependent on aid to consider maintaining a relatively large reserve buffer. Directors also considered that program design could provide greater leeway to draw down reserves when shortfalls in aid materialize, through adjusters on domestic financing, unless reserve levels are inadequate.
Monetary and Exchange Rate Policies
Most Directors supported the case for continuing to target single-digit inflation, as higher inflation levels tend to depress economic growth, and hurt the poor disproportionately. As low-income countries are prone to exogenous shocks, they suggested targeting an inflation range, and most Directors supported a focus on core inflation where this concept is feasible and acceptable. At the same time, a few Directors believed that the appropriateness of single digit inflation will need to be examined on a case-by-case basis, taking into account possible exchange rate appreciation effects and the stance of fiscal policy.
Directors observed that the monetary growth targets of PRGF programs of the mature stabilizers have regularly been exceeded without a significant overshooting of inflation targets—owing to higher-than-expected money demand with the attainment of price stability. They considered that, in light of this finding, monetary projections should more often allow for a trend decline in velocity once inflation has been brought under control. Directors also indicated that for mature stabilizers that do not have a fixed exchange rate regime, the standard Net Domestic Asset (NDA)/Net Foreign Asset (NFA) framework provides a useful safety valve that allows money supply to respond to unforeseen changes in money demand. However, indicative targets for reserve money growth should continue to be employed as they provide a useful monitoring tool.