## Executive Summary and Selected Chapters (_061407) ## Source details **Canonical URL:** [Executive Summary and Selected Chapters (_061407)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/2007/eng/_061407.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/2007/eng/_061407.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/2007/eng/_061407.pdf.json) --- ### Overview and purpose - The Fund aims to help low-income countries design macroeconomic frameworks that support sustained growth and poverty reduction while maintaining macroeconomic stability and debt sustainability. - The paper responds to a Medium-Term Strategy (MTS) mandate to advise LICs on macroeconomic policies in the face of increased and volatile aid inflows. - Focus: operational implications of high and volatile aid for the design of Fund-supported programs; provides a conceptual framework for country teams to give case-by-case advice without specific quantitative performance thresholds for spending and absorption of additional aid. - Timeframe of assessment: experience since the establishment of the PRGF in September 1999 and through the first programs monitored under the PSI. ### Central analytic framework - Core concept: "spend-and-absorb" framework: - Absorption: widening of the current account deficit (net of aid) due to incremental aid; measures real transfer of resources via higher imports or reduced domestic resources devoted to exports. - Spending: widening of the fiscal deficit (net of aid) accompanying an increment in aid. - Four short-run policy combinations (definitions preserved): - Absorbed & Spent — central bank sells aid dollars; fiscal deficit rises; aid used for public investment and consumption; no change in money supply; risk of Dutch disease. - Absorbed & Not Spent — central bank sells foreign exchange; fiscal deficit unchanged; helps stabilization; provides resources for private investment. - Not Absorbed & Spent — central bank accumulates reserves; fiscal deficit rises; no real resource transfer; unsterilized leads to money supply rise and inflation risk; sterilized leads to domestic crowding out and domestic debt accumulation. - Not Absorbed & Not Spent — central bank accumulates reserves; fiscal deficit unchanged; no real resource transfer; equivalent to rejecting aid in the long run. ### Seven framing questions the paper addresses - How cautious or optimistic should baseline aid projections be in a Fund-supported program? - To what extent, at what pace, and in what combination should increased aid be used—to raise public spending, to finance higher net imports, and/or to help build higher foreign exchange reserves? - How can fiscal, monetary, and exchange rate policies be coordinated to avoid excessive inflation, crowding out of private investment, or exchange rate volatility related to scaling up? - How should countries manage macro policies in the face of high volatility of aid? - How can competitiveness be safeguarded amid higher aid-based spending? - How can debt sustainability be maintained in determining how much debt-financed spending can be undertaken? - How might programs manage limits to micro-absorptive capacity and issues surrounding expenditure allocation and monitoring resource use—drawing on input from development partners, in particular the World Bank? ### Methodology - Two elements: - (i) broad examination of quantitative program conditionality and adjusters across 60 programs (26 “first generation” and 34 “second generation” PRGF-/PSI-supported programs); - (ii) multi-year case studies of LICs with large or strongly increasing aid inflows (scaling up defined as an increase in aid by 5 percent of GDP or more). H3: Key findings on program design and operational experience ### Changes in program stance and outcomes - Programs have become more accommodating of the use of aid and more supportive of pro-poor spending since 1999. - Program design evolved to accommodate spending of (more) aid in baselines and partially to accommodate unanticipated aid and offset shortfalls. - Aid volatility has often complicated fiscal policy design and forecasting. - Actual aid absorption was substantially smaller than projected and permitted under most Fund-supported programs; absorption typically lagged spending. - Monetary authorities’ reluctance to allow currency appreciation often led to larger-than-programmed international reserves, creating inflationary pressures. - Real appreciation has frequently been a concern but has rarely manifested as a problem. ### Quantitative and cross-country evidence (selected figures preserved) - Inflows rose from an average of 15 percent of GDP in 2000 to 20 percent in 2004 (including debt relief). - Overall aid inflows have doubled in U.S. dollar terms since 2000. - Less than 20 percent of PRGF-eligible countries saw a scaling up of aid relative to GDP over 2000–05; about half received less aid-to-GDP in 2005 than in 2000. - Grants accounted for about 70 percent of DAC member and multilateral assistance to PRGF-eligible countries in 2005 (excluding debt forgiveness), up from less than 60 percent in 2000. - Estimates by the World Bank and the UN suggest extra ODA on the order of $40–60 billion a year could be needed to meet the MDGs. The OECD estimated ODA from OECD-DAC countries should rise by $50 billion in real terms between 2004 and 2010 to meet the Gleneagles commitment. - Aid volatility is significant with standard deviations of several percentage points of GDP in many cases. H3: Country case-study lessons (selected) ### Patterns from country experiences - Countries where programs accommodated spending and absorption: Mozambique, Tanzania, Uganda, Zambia (programs adjusted fiscal deficits and NIR/NDA frameworks to support spend-and-absorb). - Countries that initially constrained spending/absorption due to reserve or debt concerns or aid volatility: Ghana, Nicaragua, Rwanda (shifted later toward spend-and-absorb as conditions improved). - Ethiopia consistently “overperformed” on fiscal and reserves targets and did not make full use of PRGF flexibility. - In many case studies, aid was largely spent but not absorbed (authorities sterilized liquidity or accumulated reserves), leading to higher reserves and sometimes inflation. H3: Projecting aid and scenario guidance ### Principles for aid projections - Aid projections should represent staff’s best estimate of the amount of aid that will materialize, based on all available information (formal and informal donor indications, historical patterns, information from authorities). Aid projections should not be restricted to firm donor commitments. - Deliberate over- or underprojection requires explicit justification: - Downward bias systematically reduces current-year outlays and can prevent full spending of aid. - Upward bias can produce mismatches between revenues and financing, force future expenditure cuts, and disrupt expenditure continuity. - Prudence may call for commitment-based projections in highly uncertain cases (e.g., post-conflict). - Two-stage approach to reflect debt sustainability: - Stage 1: best-estimate assessment of aid availability. - Stage 2: where debt distress risks argue for restricting concessional loans, staff should rely on joint Bank-Fund DSA results and, if needed, set projected foreign borrowing and related targets below potential available amounts. - Fund staff should assist authorities in preparing alternative macroeconomic scenarios based on higher aid (PRS and Article IV reports), with most useful scenarios focusing on ambitious but controlled acceleration in aid inflows rather than MDG- or needs-based scaling up that may entail financing gaps. H3: Program design and monetary frameworks ### Spend versus absorb in program design - Spend approach: higher overall deficits before grants. - Absorb approach: increase in projected net imports matching higher aid and a programmed change of international reserves reflecting absorption. - Since the PRGF launch, programs increasingly accommodated spending of aid; fiscal targets were adjusted in Mozambique, Tanzania, Uganda, and Zambia when aid rose. - Monetary programs commonly target price stability and reserve adequacy; high NIR floors can block absorption, while moderate floors cannot ensure absorption. - NIR/NDA frameworks have been prevalent: three-quarters of first-generation programs adopted an NIR/NDA framework; two-thirds of second-generation programs continued to do so; some programs targeted reserve money. ### Actual absorption outcomes and monetary responses - Almost all country cases show NIR floors were exceeded and actual aid absorption was substantially smaller than projected and permitted. - Only Zambia among case studies generally saw absorption move in line with spending. - Monetary authorities’ reluctance to allow nominal/real appreciation often led to higher-than-programmed international reserves. - Programs have sometimes lowered international reserve targets or switched to reserve money targets to promote absorption (examples: Nicaragua, Ghana, Tanzania, Uganda). ### Regime-specific implications - Floating regimes: real appreciation pressures channeled through nominal appreciation; selling foreign exchange received as aid and avoiding reserve buildup can support price stability. - Fixed pegs/currency unions: absorption tends to lead to temporarily higher inflation as spending raises nontradables prices and reserves respond endogenously. - Managed floats: scaling up is relatively hard to manage—lack of transparency, refraining from selling aid-based foreign exchange, reserve money growth, and sterilization costs can undermine inflation control and crowd out investment. ### Recommended conditionality design - NIR/NDA conditionality is conducive to scaling up: floor on NIR ensures reserve adequacy; ceiling on NDA or reserve money promotes price stability. - Choice between NDA and reserve money ceilings: - Reserve money ceiling provides a monetary anchor that can encourage foreign exchange sales (hence absorption) but aid volatility complicates adherence. - Optimal design may involve NDA and NIR performance criteria complemented by an indicative ceiling for reserve money. - Program documents should explain the strategy for spending and absorbing aid and justify deviations from full spending and absorption. H3: Managing aid volatility and program adjusters ### Characteristics and implications of aid volatility - Aid inflows tend to be more volatile than domestic tax revenues; commitments are a poor predictor of disbursements; both volatility and unpredictability have been increasing. - Shift from project to program support can raise volatility because program aid is subject to annual approval and political considerations. - Volatility complicates fiscal policy given limited flexibility to cut entitlements and wages and the damaging effects of cutting operations and maintenance. ### Program adjusters and best practice - Review of 60 programs: - 52 out of 60 programs accommodated unlimited spending of additional project support grants between reviews. - About half accommodated unlimited spending of additional project support loans (provided borrowing was concessional). - Almost half accommodated unlimited spending of additional budget support grants; some programs allowed spending up to a limited amount. - Since 1999, second-generation programs became more accommodative of spending unexpected program aid and offsetting shortfalls: 21 out of 34 second-generation programs permit domestic borrowing up to the full amount of an unexpected shortfall in budget support (compared to 7 out of 26 first-generation programs). - Guiding adjuster principles: - Programs should promote a smooth path of fiscal spending in the context of a MTBF. - Once reserve adequacy has been achieved, temporary deviations from programmed foreign financing are best absorbed through domestic borrowing, financed through reserve drawdowns, to avoid interrupting spending while preventing inflation or crowding out. - Persistent shortfalls will require gradual, well-designed expenditure adjustments. - Adjusters should often allow short-term spending increases in case of higher-than-expected program grants, with logic favoring saving positive surprises until permanency is assessed; caps and prioritization linked to PRSPs and MTBFs are recommended. H3: Allocating expenditures, absorptive capacity, competitiveness, and debt ### Micro-absorptive capacity and governance - Limits to returns on public investment and micro-absorptive capacity can argue for gradual increases in public spending. - Weak governance and poor fiscal institutions argue for gradual increases; efficiency of pro-poor spending strongly correlated with governance and fiscal institutions. - Fund staff are not expected to perform detailed absorptive capacity assessments—collaboration with the World Bank and donors is important. - Recommended institutional priorities: expenditure planning instruments, results-oriented budgeting processes, expenditure tracking systems, and accounting/control/reporting systems. ### Protecting priority spending and wage bill practices - PRSPs should define priority spending; concerns about overly-constraining definitions need resolution through PRSP processes. - PRGF-supported programs have expanded social spending; education and health spending rose on average by 0.6 percent of GDP a year in PRGF countries. - Floors for anti-poverty or social sector spending can be incorporated; some programs have used such floors. - Wage bill ceilings used selectively and revised with updated information; recent guidance emphasizes avoiding long-term wage bill ceilings and protecting priority sectors. ### Competitiveness and Dutch disease - Some cross-country econometric evidence suggests higher aid has undermined growth in labor-intensive export-oriented sectors, but no clear country case studies definitively demonstrate aid-induced Dutch disease. - Programs have generally not restricted aid use because of Dutch disease risk; instead they include targeted measures to support export competitiveness and diversification (examples: Rwanda export action plans; Zambia financial sector development plan). - Guiding principle: given scant empirical evidence, Fund-supported programs should rarely constrain aid-based spending on grounds of competitiveness risk; staff should help assess and monitor risks using criteria in Box 4 (e.g., concentration of spending on nontraded goods, lack of spare capacity, severe real appreciation, contraction in manufacturing). ### Debt sustainability - HIPC Initiative and MDRI have created room for new borrowing, but excessive nonconcessional borrowing could re-create unsustainable debt burdens. - Post-2004 guidance: use structured Debt Sustainability Analysis (DSF) and consider limits on overall fiscal deficits or NPV-based conditionality when warranted. - Indicators for close scrutiny of scaling-up scenarios: - Current/projected debt distress risks above or close to the high end of the moderate range; - Scaling-up scenarios implying sharp shifts in fiscal policy, investment rate, financing mix, productivity growth, or other key variables; - Key DSA assumptions from previous years proven significantly too optimistic; - Rapid debt growth defined as annual change in the NPV of debt of 5–7 percent of GDP or more. - Box 5 summary recommendations: - For most LICs, nonconcessional borrowing should generally be discouraged. - For countries with debt burdens well below thresholds and adequate policy environments, nonzero limits may be appropriate for viable projects lacking concessional finance. - Conditionality on total or external borrowing or on the NPV of external debt may be used where risk of debt distress is moderate or high. H3: Operational recommendations and program documentation ### Best-practice operational guidance (summary) - Aid projections: - Represent staff’s best estimate based on all available information; one baseline per program but assist authorities with alternative scaling-up scenarios. - Spending aid: - Programs should generally support full spending and absorption of aid provided macroeconomic stability and spending effectiveness are maintained. - Rarely constrain aid-based spending on competitiveness grounds; micro-absorptive capacity can argue for gradualism. - Specific conditionality (e.g., spending floors) can support expansion of poverty-alleviating programs. - Absorbing aid: - Monetary programs should aim to combine absorption with price stability and reserve adequacy. - Clear and common understanding of exchange rate regime and monetary objectives is essential. - Scaling up strengthens case for exchange rate flexibility; managed floating poses special program-design challenges. - Tie scaling-up design to NIR/NDA frameworks for monetary policy. - Aid volatility and program adjusters: - Promote a smooth path of fiscal spending under MTBF. - Allow temporary deviations from programmed foreign financing to be financed domestically and through reserve drawdowns once reserve adequacy is achieved. - Develop prior plans for expenditure prioritization and protective frameworks for essential spending (ring-fenced items). - Allocating expenditures and monitoring: - Collaborate closely with the World Bank and development partners for sectoral analysis and monitoring. - Use PRSP-based definitions of priority spending in reporting and conditionality where feasible. - Program transparency and documentation: - Program documents should clearly explain program design and deviations from standard best practices. - Deliberate biases in aid projections or departures from full spending/absorption should be explicitly justified in staff reports and MEFPs. H3: Issues for discussion (selected) - Projecting aid inflows: do Directors agree with projecting aid inflows based on a comprehensive assessment of the best available information and explaining deliberate cautious/optimistic assumptions? - Framework for spending and absorption: do Directors agree that Fund-supported programs should generally support full spending and absorption of aid in a multi-year fiscal framework provided macro stability and spending effectiveness are maintained, and that strategies for spending/absorption should be clearly explained when full spending/absorption is not recommended? - Coordination of policies: do Directors agree with recommendations to reconcile aid absorption with price stability while avoiding crowding out of private investment? - Program adjusters: do Directors agree with applying program adjusters to support a smooth path of fiscal spending, subject to reserve adequacy? - Distributive consequences and reliance on partners: do Directors agree staff should be mindful of distributive consequences and expenditure allocation effects on macro performance while relying on the Bank and partners for specific sectoral analyses? *Source: Executive Summary and selected chapters (Sections 9, 23, 39, 53, 69–78) of IMF paper on operational implications of increased and volatile aid inflows (PRGF/PSI experience since September 1999).* ### Executive Summary ...................................................................................................... ### Executive Summary ### Overview - The Fund aims to help low-income countries design macroeconomic policy frameworks that support sustained growth and poverty reduction while maintaining macroeconomic stability and debt sustainability. - The paper responds to a Medium-Term Strategy (MTS) mandate to advise low-income countries on appropriate macroeconomic policies in the face of increased and volatile aid inflows. - Focus: operational implications of high and volatile aid for the design of Fund-supported programs; provides a conceptual framework for country teams to give case-by-case advice without specific quantitative performance thresholds for spending and absorption of additional aid. - Timeframe of assessment: experience since the establishment of the Poverty Reduction and Growth Facility (PRGF) in September 1999 and through the first programs monitored under the Policy Support Instrument (PSI). ### Seven framing questions addressed - How cautious or optimistic should the baseline projections of aid inflows be in a Fund-supported program? - To what extent, at what pace, and in what combination, should increased aid be used—to raise public spending, to finance higher net imports, and/or to help build higher foreign exchange reserves? - How can fiscal, monetary, and exchange rate policies be coordinated to help avoid problems of excessive inflation, crowding out of private investment, or exchange rate volatility related to scaling up? - How should countries manage their macroeconomic policies in the face of high volatility of aid? - How can competitiveness be safeguarded in the face of higher aid-based spending? - How can debt sustainability be maintained in determining how much debt-financed spending can be undertaken? - How might programs manage limits to micro-absorptive capacity and issues surrounding expenditure allocation and monitoring resource use—drawing on input from development partners, in particular the World Bank? ### Methodology summary - Two elements: (i) broad examination of quantitative program conditionality and adjusters; and (ii) case studies. - Quantitative examination covers: first annual programs of 26 “first generation programs” (immediately following PRGF establishment) and all 34 current or most recent PRGF- or PSI-supported “second generation programs,” including successors to first generation programs. - Case studies include LICs with large or strongly increasing aid inflows (scaling up defined as an increase in aid by 5 percent of GDP or more) where aid management was a program design issue. - Central analytic focus: the extent to which program design has accommodated the full use of aid by allowing both spending and absorption (the “spend-and-absorb” framework). ### Key findings on program design and experience - Fund-supported programs have become more accommodating of the use of aid and more supportive of pro-poor spending since 1999. - Program design has changed to accommodate the spending of (more) aid in program baselines and there has been a partial move toward accommodating the spending of unanticipated aid and offsetting unanticipated shortfalls. - Aid volatility has often complicated fiscal policy design. - Coordination of fiscal, monetary, and exchange rate policies is critical to managing aid inflows. - Actual aid absorption was substantially smaller than projected and permitted under most Fund-supported programs. - A reluctance by monetary authorities to allow currency appreciation often led to larger-than-programmed international reserves, creating inflationary pressures. - Real appreciation has frequently been a concern but has rarely manifested as a problem. ### Boxed concept emphasized: Spending and Absorbing Aid - Definitions preserved from source: - Absorption: widening of the current account deficit (net of aid) due to incremental aid; measures real transfer of resources via higher imports or reduced domestic resources devoted to exports. - Spending: widening of the fiscal deficit (net of aid) accompanying an increment in aid. - Four short-run policy combinations and their effects (as summarized in the source): - Absorbed & Spent: central bank sells aid dollars and fiscal deficit rises as aid is spent. Aid used for public investment and consumption. No change in money supply. Risks Dutch disease. - Absorbed & Not Spent: central bank sells foreign exchange but fiscal deficit remains unchanged. Helps stabilization; provides resources for private investment. - Not Absorbed & 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; domestic debt accumulates. - 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). ### Best practices for future program design and policy advice (as stated) - Aid projections: - Fund aid projections, both in the immediate forecast and in subsequent years, should represent staff’s best estimate of the amount of aid that will materialize, based on all available information. - Programs should have one baseline, but Fund staff should assist authorities in preparing alternative scenarios of scaling up. - Spending aid: - Fund-supported programs should generally support the full spending and absorption of aid, provided macroeconomic stability is maintained, and taking into account specific country circumstances and development needs. - Programs should rarely constrain aid-based spending on the grounds of risks to competitiveness. - Micro-absorptive capacity constraints can argue for a gradual approach to raising public spending. - Specific conditionality (such as spending floors) can be incorporated to support the expansion of poverty-alleviating programs. - Absorbing aid: - Monetary programs should seek to combine absorption of aid with price stability and reserve adequacy. - Essential to have a clear and common understanding of the exchange rate regime and monetary policy objectives. - In general, scaling up strengthens the case for exchange rate flexibility, while managed floating can raise difficult challenges for program design. - Scaling up ties in with the “Net Foreign Asset/Net Domestic Asset” conditionality framework for monetary policy. - Aid volatility: - Although aid disbursements are often volatile, Fund-supported programs should promote a smooth path of fiscal spending. - Once reserve adequacy has been achieved, program adjusters should allow temporary deviations from programmed foreign financing to be absorbed through domestic borrowing, financed through reserve drawdowns. - Allocating expenditures, resource use, and meeting the MDGs: - Fund staff should collaborate closely with the World Bank, and rely on the Bank and other development partners for sectoral assessments. - Staff will continue to assist the authorities in monitoring the use of scaled-up resources using Poverty Reduction Strategy (PRS)-based definitions of priority spending. - Program transparency: - Program documents should provide better explanations of program design, particularly when deviating from the identified standard best practices. *Source: Executive Summary of IMF paper on operational implications of increased and volatile aid inflows (PRGF/PSI experience since September 1999).* ### 9. The degree to which programs accommodate higher aid can be assessed most ### 9. The degree to which programs accommodate higher aid can be assessed most ### Overview and purpose - Multi-year case studies of program design are the most effective way to assess how programs accommodate higher aid (Box 2). - Advantages: (i) aid need not be spent the year it is received and effective use may require prior macroeconomic stabilization; (ii) case studies permit examination of the interplay among the baseline aid projection, program conditionality design, and ultimate aid inflow. ### Case studies: summary findings (Box 2) - Inflows rose from an average of 15 percent of GDP in 2000 to 20 percent in 2004 (including debt relief). - Country experiences: - Burundi: two Fund-supported programs allowed full spending of anticipated aid and accommodated aid volatility through target adjusters; PRGF-supported program (2004–07) envisaged foreign exchange sales to control liquidity and financed a rapidly widening current account deficit; competitiveness concerns did not materialize. - Ethiopia: management varied under 2001–04 PRGF; initial use of external assistance to reduce fiscal deficit and stabilize the economy, later spending followed availability of aid; Ethiopia consistently “overperformed” on fiscal and international reserves targets and did not make full use of PRGF flexibility. - Ghana: two PRGF arrangements since 1999; emphasis on fiscal consolidation and domestic debt reduction limited spending and absorbing of aid inflows; cautious approach partly a response to aid volatility during 1999–2003; 2006 program first to actively encourage spend-and-absorb. - Madagascar: two PRGF arrangements since 1999 emphasized lowering very high initial levels of debt after substantial debt relief; fiscal and current account developments tracked changes in aid with somewhat greater share spent than absorbed; program design was not accommodative of using additional aid; 2006 arrangement showed greater evolution in treatment of scaling-up possibilities. - Mozambique: two PRGF arrangements since 1999; first and most recent programs designed monetary and fiscal targets to spend and absorb expected surge of aid; second arrangement targeted fiscal consolidation facing projected (and realized) decline in aid. - Nicaragua: two PRGF arrangements since 1999 focused on medium-term fiscal sustainability and external viability; little spending and partial absorption of aid inflows initially with most aid substituting for domestic financing; more recent programs shifted toward spend-and-absorb, complicating monetary management under a crawling peg. - Rwanda: two PRGF arrangements since 1999; debt sustainability main objective leading to stringent limits on external borrowing and efforts to reduce domestic debt; shift to spend-and-absorb in 2004 with rapid aid increases creating fiscal and monetary coordination challenges. - Tanzania: two PRGF arrangements since 1999 emphasized managing aid inflows and supported spend-and-absorb; program design accommodated larger deficits financed by aid and included widening current account deficits to encourage absorption; aid fully spent but absorption lagged initially; later increases in programmed and actual aid absorption. - Uganda: poverty-related spending protected under PRGF arrangements since before 1999; aid largely spent but mostly not absorbed as authorities sterilized liquidity impact; program design shifted to a reserve money target and repeatedly relaxed international reserves conditionality to provide room while maintaining low inflation. - Zambia: two PRGF arrangements; aid shortfalls in first arrangement prompted above-program domestic financing and inflation; both arrangements focused on controlling inflation while permitting aid spending; aid was also absorbed as the nonaid current account broadly tracked aid changes. ### Distinctions among types of aid and implications - The report uses the term fiscal aid to denote budget support and project aid (to the extent it is channeled through the budget); it excludes balance of payments assistance and debt relief. - Rising share of program support (spending under government control) has supported budget flexibility and reduced transaction costs. - Project aid spending is largely controlled by donors and often not channeled through the budget; deviations from projected levels tend to be offset automatically through lower spending. - Distinction between grants and loans is crucial for assessing debt sustainability. - The budget support vs. project aid distinction is increasingly inadequate: more aid is being channeled through vertical funds to specific sectors and functions. - Debt relief is vital to restoring debt sustainability but its direct impact on “fiscal space” and foreign exchange markets is limited other than through subsequent reduction in debt service; debt relief is not a separate focus in this paper. ### Projecting aid: assessment of current practice - Projections of next-year aid inflows have become more accurate and less cautious in recent years (Figure 1). - Considerable aid uncertainty during ESAF led to cautious early PRGF projections; repeated underestimation prompted more accurate forecasts later. - Small-scale underestimation persisted in Nicaragua and Uganda in recent years due to donor-support concerns. - Projection errors remained sizeable in Ethiopia and Ghana because aid was exceptionally volatile. - For the medium term, aid was often under projected, although projections have become more accurate since 2005. - The IEO report noted Fund medium-term aid forecasts were often pessimistic in the past but had recently caught up as rising overall aid levels were considered. - Targeted donor policies led to sizeable increases in aid flows in selected countries with improved economic performance, but scaling up has not been widely observed across low-income countries. - Relative to GDP, a large majority of PRGF-eligible countries did not see aid flows from OECD-DAC members rise substantially in 2000–05. ### Box 3: recent developments and scaling-up statistics - Overall aid inflows have doubled in U.S. dollar terms since 2000. - Aid growth slowed annually (excluding one-off disbursements for Tsunami relief and debt forgiveness for Afghanistan and Nigeria). - Net ODA flows remained broadly unchanged as a share of PRGF-country GDP since 2002 (though U.S. dollar depreciation may partly explain this). - Aid volatility significant with standard deviations of several percentage points of GDP. - Less than 20 percent of PRGF-eligible countries saw a scaling up of aid relative to GDP over 2000–05; about half received less aid-to-GDP in 2005 than in 2000. - Most aid took the form of grants: excluding debt forgiveness, grants accounted for about 70 percent of DAC member and multilateral assistance to PRGF-eligible countries in 2005, up from less than 60 percent in 2000. - Estimates by the World Bank and the UN suggest extra ODA on the order of $40–60 billion a year could be needed to meet the MDGs. The OECD estimated ODA from OECD-DAC countries should rise by $50 billion in real terms between 2004 and 2010 to meet the Gleneagles commitment. ### Guiding principles for program design and projecting aid (recommendations) - First: Aid projections should represent staff’s best estimate of the amount of aid that will materialize, based on all available information (formal and informal donor indications, historical patterns, information from authorities). Aid projections should not be restricted to firm donor commitments. Many country teams already use this approach. - Second: Deliberate over- or underprojection requires explicit justification. - Downward bias systematically reduces current-year outlays and can prevent full spending of aid. - Upward bias can produce mismatches between revenues and financing, force future expenditure cuts, disrupt expenditure continuity, and may be unsustainable medium-term. - Prudence may call for projections based on donor commitments in highly uncertain cases (e.g., post-conflict). - Estimates of budget support deserve careful scrutiny because forecast errors may force spending cuts or increased domestic borrowing and have broader macroeconomic impact since they are not self-correcting. - Staff reports and MEFPs should state clearly the basis for aid projections for the next year and medium term; projections with significant staff judgment should be justified in program documents. - Third: Aid forecasts in a program context need to reflect debt sustainability concerns through a two-stage approach: - Stage 1: assessment of aid availability as above. - Stage 2: where debt distress risks argue for restricting concessional loans, staff should reiterate need for donors to consider joint Bank-Fund Debt Sustainability Analysis (DSA) results and increase concessionality of aid. If the overall grant element of the aid envelope is not raised sufficiently, projected foreign borrowing and related program targets should be set below potential available amounts. - Aid projections may not close fiscal or balance of payments financing gaps. - Realistic aid projections and a fiscal program consistent with resource availability should generally reduce need for a financing gap. - Financing gaps may emerge if: (i) sufficient aid has not been identified to cover recurrent costs in outer years; and (ii) domestic and external resources for outer years are insufficient to cover essential or “ring-fenced” expenditures. - Programs may need to include a “technical” financing gap reflecting anticipated Fund disbursements/drawings, associated Paris Club treatments, and World Bank budget support affected by program status; these should be shown “below-the-line.” - Fund staff should assist authorities in preparing alternative macroeconomic scenarios based on higher aid, presented in PRS and Article IV reports. - Alternative scenarios can show how additional aid would be used consistent with macroeconomic stability and debt sustainability and can support aid mobilization efforts. - Most useful scenarios focus on ambitious but controlled acceleration in aid inflows, rather than MDG- or needs-based scaling up that may entail financing gaps that cannot realistically be filled. - PRGF-supported programs should be based on a single, realistic baseline incorporating best available information because: (i) costs of meeting the MDGs are hard to assess; and (ii) deliberately optimistic projections might create recurrent donor shortfalls, disrupt fiscal management, and give insufficient guidance on prioritizing spending of lower actual aid received. ### Designing macroeconomic programs to support the use of aid - The extent to which Fund-supported programs should accommodate full use of aid through a spend-and-absorb approach is controversial. - The 2007 IEO report observed that inflation in excess of 5–7 percent and reserves below three months of imports seemed associated with a less accommodative stance on aid use in Fund-supported programs. - Fund policy advice and program design have shifted toward a spend-and-absorb approach in countries where macroeconomic stability has been established and fiscal vulnerabilities addressed; this shift is confirmed by case studies. *Source: _061407 - 9. The degree to which programs accommodate higher aid can be assessed most (PDF chapter/section).* ### 23. In terms of program design, a spend approach to increased aid would be ### 23. In terms of program design, a spend approach to increased aid would be ### Program design: spend versus absorb approaches - A spend approach to increased aid would be reflected in higher overall deficits before grants. - An absorb approach would be visible in an increase in projected net imports that matches the higher aid, and a corresponding programmed change of international reserves that reflects the extent of aid absorption. - Higher net imports result not only from the imported component of the aid-based spending, but also from the second round-effect as spending on domestic goods reduces the available resources for producing tradables. - While authorities control the spending of aid, aid absorption is also conditioned by private sector behavior. ### Empirical experience in PRGF-era case studies - Since the launch of the PRGF, programs have increasingly accommodated the spending of aid in the case study countries. - Targeted fiscal deficits were adjusted in line with the availability of additional donor support in Mozambique (following debt and disaster relief), Tanzania (following debt relief), Uganda, and Zambia. - Upward revisions of expected aid flows during fiscal years were largely incorporated into updated projections during program reviews. - In other countries, the degree of spending was limited in earlier years because aid projections were uncertain (Rwanda) or domestic debt was too high or reserves too low (Ghana, Nicaragua, and Rwanda). - Subsequently, the Rwanda program adopted a spend approach in 2004, followed more recently by Nicaragua (2005) and Ghana (2006). ### Monitoring aid absorption through monetary programs - Most monetary programs target price stability and the build-up of international reserves. - A high Net International Reserves (NIR) floor can block aid absorption, but a moderate floor cannot ensure absorption. - NIR floors allow above-target reserve accumulation, which implies that aid absorption can fall short of its baseline projection, without jeopardizing program targets. - Three-quarters of first generation programs adopted a NIR/Net Domestic Asset (NDA) framework that limited central bank domestic credit while setting a floor on the accumulation of international reserves. - Two-thirds of second generation programs continued to do so. - Nine second-generation programs lack monetary conditionality altogether because the countries are members of a currency union. - Seven first-generation and twelve second-generation PRGF-supported programs targeted reserve money. ### Actual outcomes on absorption - Almost all country cases show that NIR floors were exceeded and thus actual aid absorption was substantially smaller than projected and permitted under the program. - As a result, absorption lagged behind spending. - Of the country case studies, only in Zambia did aid absorption generally move in line with spending. - In the other cases, a reluctance by the monetary authorities to allow their currencies to appreciate in nominal and/or real terms led to higher-than-programmed international reserves. - Program documents have not always explained the degree to which the absorption of aid inflows should be accommodated. ### Guiding principles for program design - The Fund aims to bring all low-income members to the point where all aid can be fully and effectively spent and absorbed. - Fund-supported programs should support the full use of aid whenever this approach does not jeopardize macroeconomic stability. - If limits to microeconomic capacity to use the aid become evident, in particular in macroeconomic outcomes, staff should advise the authorities on ways to address these problems. - If microeconomic absorptive capacity constraints are not remedied, a spend-and-absorb strategy may allow unproductive spending and entail risks that would likely undermine progress. ### Preconditions and program documentation - Staff should assess carefully whether the preconditions for the effective and prudent full use of aid are met based on a range of country-specific considerations. - Given the variety of arguments, country circumstances, and development strategies, the appropriate policy mix can only be determined on a case-by-case basis. - Program documents should explain the strategy for spending and absorbing aid. - Deviations from an approach of full spending and absorption would warrant explicit justification in program documents. ### Explicit policy options and when they may be appropriate - A policy of partial spending and absorption is appropriate for countries with low reserves and/or high external debt. For countries emerging from instability and with low initial reserves, a prudent approach includes saving part of the aid inflows—through the build-up of a prudent reserve buffer and/or the early repayment of relatively expensive external debt. - The appropriate measure of reserve adequacy should be assessed in the context of aid volatility and other shocks. - Authorities may choose to smooth the use of aid over time; a spend-and-absorb approach should be implemented in a medium-term fiscal framework rather than matching annual aid flows and use. - An absorb but do not spend approach can be used to lower domestic public debt and/or reduce inflation. This involves purchasing (or reduced emission) of outstanding domestic public debt or base money in exchange for the foreign currency counterpart of aid received by the central bank. This approach was used in Rwanda before 2004 and in Ghana until 2006. - In evaluating inflation, available evidence broadly supports the use of single-digit inflation objectives. - A policy of sustained spending but not absorbing would be harder to justify: it is equivalent to higher domestically-financed fiscal spending combined with increased aid-based foreign exchange reserves, and risks unproductive outcomes. Nonetheless, it could exploit spare domestic production capacity with reserves providing the option of absorbing spending pressure through higher imports rather than inflation. ### Implementation challenges with project aid and revenue mobilization - Attempts to smooth spending of project support are challenging because projects are “lumpy,” donors and countries often agree on fixed disbursement schedules, and adjusting timing requires negotiation with donors. - Strengthening revenue mobilization remains critical in the wake of scaled-up aid. - Foreign aid could undermine efforts to mobilize domestic resources, leading to long-term aid dependency and aggravating resource volatility. - Domestic revenue mobilization should not be weakened, especially if domestic revenues are below, about 15 percent of GDP. - In cases of relatively distortive taxation, there can be a case for using part of the aid to lower tax rates. ### Coordination of fiscal, exchange rate, and monetary policies - Absorbing large aid inflows raises challenges for managing the appropriate mix of nominal appreciation of the exchange rate and inflation. - The spending of aid can lead to a real appreciation—i.e., higher inflation and/or a nominal appreciation. - If the aid is absorbed (the foreign exchange reaches the market rather than being accumulated by the central bank), it can lead to nominal (and real) appreciation pressures, at least in the short run. - The interplay of these forces depends on the exchange-rate regime. ### Regime-specific implications - Floating exchange rate regime: - Real appreciation pressures are channeled through a nominal appreciation. - Monetary and inflation objectives need not be affected if monetary authorities sell foreign exchange received as aid and avoid building reserves that fuel money supply growth and inflation. - Exchange rate pegs/currency unions: - Temporarily higher inflation would be expected as higher spending leads to higher nontradables prices and reserves and money supply respond endogenously. - Managed floats: - Pressures for nominal appreciation could be dampened if part of the aid-related foreign exchange is not sold by the central bank, implying an increase in reserves and money supply and higher inflation. - In the absence of an actual resource transfer from abroad (rising net imports), higher public spending is necessarily offset by reduced private spending. - Real resources for private sector spending are squeezed by the inflation tax or, in case of sterilization using domestic instruments, by the reduced availability of credit. ### Assessment of current practice and policy adjustments - Attempts by monetary authorities to stabilize nominal exchange rates by accumulating foreign exchange have often led to foreign aid not being fully absorbed. - Monetary authorities in many cases resisted nominal appreciation pressures resulting from aid inflows. - In Ethiopia, Ghana, and Rwanda, the exchange rate was kept stable relative to the U.S. dollar, and in mid-2006, their exchange rate regimes were reclassified by the Fund from managed floating with no predetermined path to a conventional fixed peg. - Sterilization was used to offset inflation pressures in Mozambique (2000–03), Tanzania (2000), and Uganda (1999–2004). - In some cases (including Rwanda in 2005) monetary authorities refrained from sterilizing excess liquidity despite rising inflation because of high sterilization costs. - Incomplete absorption may result from diverging priorities between fiscal and monetary authorities. ### Program design responses and trade-offs - In several cases, the monetary program design was modified to allow or promote the sale of foreign exchange by the central bank. - Nicaragua and Ghana programs lowered international reserves targets during subsequent program reviews even when aid flows were revised upward. - In Tanzania and Uganda, limited aid absorption due to exchange-rate targeting led to significantly higher inflation; PRGF-supported programs switched to reserve money targets and lowered international reserves targets repeatedly. - Containing inflation in these cases came at the cost of higher and more volatile domestic interest rates and some crowding out of private investment. ### Further guiding principles for practical implementation - A clear understanding of the exchange rate regime and the objectives of monetary policy is a prerequisite for managing scaling-up challenges. - Effective program design requires that authorities and staff share an understanding of the regime and that actual monetary management be in line with it. - A strategy of spending and absorbing aid can, in principle, be implemented under each standard exchange rate regime, but each regime poses different challenges for reconciling full absorption with avoiding high inflation or excessive exchange rate volatility. - Floating regimes generally allow full absorption while supporting price stability, though with lumpy and volatile aid there may be sharp exchange rate movements that could justify stabilizing interventions without altering real exchange rate trends. - Fixed pegs provide a viable framework for scaling up but absorption would lead temporarily to higher inflation; the likely higher inflation under a peg in the presence of large aid inflows should be a criterion in the choice of exchange rate regime. - Scaling up under managed floating is relatively hard to manage well: lack of transparency, refraining from selling aid-based foreign exchange, reserve money growth, and sterilization costs can undermine efforts to reduce inflation and can crowd out private investment. - Monetary–fiscal policy coordination is important to match spending and absorption. *Source: IMF staff chapter text.* ### 39. Therefore, program design in the context of managed floating requires special ### 061407 - 39. Therefore, program design in the context of managed floating requires special ### Program design under managed floating - Targeting a certain exchange rate path or band can be acceptable provided the regime, including subordination of inflation objectives to exchange rate stability, is clearly spelled out. This case would be akin to a formal peg, in which case no specific conditionality should be set to control money creation. - If the intervention strategy is not clear, the monetary program may be of little value for guiding monetary management, and NIR targets would be exceeded as long as the monetary authorities give priority to resisting aid-induced appreciation pressures. - To address these complications and effectively promote aid absorption, it is important to have a clear understanding of the monetary authorities’ objectives and reaction functions regarding: - inflation, - real and nominal exchange rate stabilization, and - reserve accumulation. - Policy coordination between the fiscal and monetary authorities should be ensured in the context of the program discussions. In case of persistent problems, the central bank’s formal objectives could be reevaluated, since the pursuit of multiple monetary policy objectives can complicate policy making in the event of a conflict. ### NIR/NDA conditionality framework and monetary policy - The NIR/NDA conditionality framework is considered most conducive to supporting scaling up by: - Ensuring reserve adequacy through the floor on NIR. - Promoting a prudent monetary stance aimed at price stability via a ceiling on NDA or reserve money. - Choice considerations between NDA and a reserve money ceiling: - A reserve money ceiling provides a monetary anchor that can help curtail money growth and can promote foreign exchange sales, and hence absorption. - Aid volatility may complicate adherence to a reserve money ceiling: as aid is received and deposited, NIR rises and NDA falls with no change in their sum (i.e., reserve money). Subsequent spending may involve a temporary rise in reserve money as fiscal authorities draw down aid-based deposits (bringing NDA back up) while net imports have not yet moved up in response (leading to a fall in NIR). Selling foreign exchange early to adhere to a reserve money ceiling could entail sharp exchange rate swings. - On balance, in most cases, the optimal design may involve NDA and NIR performance criteria complemented by an indicative ceiling for reserve money. - The importance of maintaining an adequate reserve buffer for handling shocks—including temporary aid shortfalls—supports the need for a floor on NIR. - In the context of large scaling up, problems have often involved excessive rather than too little reserve accumulation. NIR-based conditionality cannot by itself address excessive accumulation given the unpredictability of foreign exchange inflows from many sources beyond aid. These concerns should be addressed through: - an understanding with the monetary authorities on absorption and exchange rate flexibility, or - with the fiscal authorities on matching limited absorption with spending restraint. - These issues highlight the importance of coordination concerning the policy mix between the fiscal and monetary authorities. ### Managing aid volatility — key characteristics - Aid inflows tend to be both volatile and unpredictable. Bulir and Hamann (2006) show that: - aid inflows are typically much more volatile than domestic tax revenues, - commitments are a poor predictor of disbursements, and - both volatility and unpredictability have been increasing in recent years. - The recent shift from project to program support can raise volatility because program aid tends to be subject to annual approval and can be sensitive to political considerations, whereas project aid is often committed in advance for several years. - Unpredictability concerns both aid commitments and subsequent disbursements. - Aid volatility complicates fiscal policy given the desirability of a smooth expenditure path: - Flexibility to reduce budgetary expenditures when aid falls is limited in practice, especially for entitlements and wages. - Cutting back on operations and maintenance can significantly reduce the rate of return on aid-financed projects. - Sectoral dimensions matter: aggregate aid may materialize as expected while there is less aid than budgeted in important sectors where expenditures (e.g., HIV/AIDS treatment) are difficult and costly to cut back temporarily. ### Assessment of current practice in Fund-supported programs - Case studies: large aid volatility during the first years of the decade complicated aid forecasting in Ethiopia and Ghana, resulting in cautious baseline projections and a build-up of a prudent reserve buffer. Both programs continued to underestimate aid flows even recently. They limited spending and absorption of aid to rebuild reserves, which had fallen to two months of imports or less. Early on, the Ghana program also adopted a domestic debt repayment strategy for the use of windfall revenue from incremental aid. As aid flows became more predictable, Ghana increasingly spent scaled-up aid. - Review of program adjusters across 60 programs (26 first-generation and 34 second-generation PRGF-supported programs) shows differing treatments of unanticipated aid between program reviews: - Fifty-two out of the 60 programs in the sample accommodated unlimited spending of additional project support grants in between program reviews. This included 22 first-generation and 30 second-generation programs. - Half of the programs—22 first-generation and 30 second-generation programs—accommodated unlimited spending of additional project support loans in between program reviews (provided borrowing was concessional). - Almost half of the programs—12 first-generation and 13 second-generation programs—accommodated unlimited spending of additional budget support grants. In addition, one first-generation and five second-generation programs allowed the spending of additional funds up to a limited amount. - Several programs with mature stabilizers accommodated unlimited spending of additional budget support loans—two first-generation and five second-generation programs. Furthermore, one first-generation and five second-generation programs allowed the spending of additional funds up to a limited amount. - On aid shortfalls: - Three-quarters of PRGF-supported programs allowed at least some spending to continue in the face of shortfalls of budget support. Only a few programs, including Afghanistan, Guyana, and the Kyrgyz Republic, allowed project spending to continue on the same scale when foreign funding fell short of programmed amounts. - Since 1999, PRGF-supported programs have become more accommodative of spending unanticipated inflows of program aid, and offsetting shortfalls in program support: - Twenty-one out of 34 second-generation programs permit domestic borrowing up to the full amount of an unexpected shortfall in budget support compared to seven out of 26 first-generation programs. - The share of programs that do not accommodate additional aid has fallen. - Six recent programs set a floor on poverty-related spending levels compared to two earlier programs. - The prevalence of program ceilings on the public sector wage bill decreased from late 2006 to March 2007, from eight programs to three, compared with two first-generation programs. - Monetary adjusters for above- and below-program budget support mirrored fiscal ones: - About half of the first- and second-generation programs allowed additional budget support grants to be at least partially absorbed (i.e., did not require a matching accumulation of international reserves). - Twelve percent of first-generation and 30 percent of second-generation programs allowed additional budget support loans to be at least partially absorbed. - About two-thirds of second-generation PRGF-supported programs relaxed international reserves conditionality for some or all of a shortfall in budget support grants or loans. This compared to 54 percent of first-generation programs in case of a shortfall in grants and 81 percent in case of a shortfall in loans. ### Guiding principles for program design - Fund-supported programs should promote a smooth path of fiscal spending in the context of a medium-term budget framework (MTBF). - Temporary deviations from the predefined medium-term path of foreign financing are best absorbed through domestic borrowing, financed through reserve drawdowns, so spending plans are not interrupted while preventing inflation or crowding out. - Persistent shortfalls will eventually require gradual and well designed expenditure adjustments, as reserves cannot close a lasting financing gap. - Staff advice on medium-term expenditure path and adjustment strategy should incorporate: - Identification of aid shocks: - The possibility that shortfalls may be temporary supports short-term financing of deviations until persistence can be determined. - It is often difficult to distinguish temporary from permanent aid shocks; authorities and Fund teams should stay in close contact with major donors to understand the nature of aid fluctuations. - Self-insurance: - Expenditure smoothing using central bank reserves calls for prior build-up of sufficient international and fiscal reserves, which may require initial deferral in spending and absorption of scaled-up aid. - The use of a target level of reserves from a fiscal viewpoint, in addition to the traditional external viewpoint (in months of imports), can guide these efforts. - Expenditure flexibility: - Examine realism and flexibility of expenditure paths for broad spending categories (wages, entitlements programs, and major investments). - Discuss recurrent costs of capital projects proposed for scaling up, such as operations and maintenance, which may curtail budgetary flexibility over the longer term. - Program conditionality implications: - Program adjusters should allow shortfalls in program aid to be financed domestically once reserve adequacy has been achieved; at the next review, missions and authorities should assess needed changes in the spending path. - Project spending is relatively flexible and often donor controlled; adjusters may assume project spending tied to actual disbursements with no impact on domestic financing and NIR. - Best practice in most cases would allow short-term spending increases in case of higher-than-expected program grants, though logic of expenditure smoothing calls for saving positive aid surprises until permanency can be assessed. - Authorities and staff could discuss in advance plans for supplementary expenditure guided by expenditure priorities in PRSPs and MTBFs; programs could incorporate adjusters to allow higher spending (possibly with a cap) covered by higher-than-expected program grants (and loans—in the absence of debt sustainability concerns). This approach has been followed in the Mozambique and Tanzania programs. - For countries where aid volatility is high and international reserves are low, a case can be made for a more symmetric approach to aid surprises. Adjusters could be more liberal combined with cautious (commitment-based) aid forecasts. ### Protecting essential expenditures and prioritization - To protect essential expenditures against large and sustained aid shortfalls, program design should: - Draw on prioritization of expenditures in the authorities’ medium-term framework. - Ensure an operational framework for expenditure prioritization to facilitate expenditure-switching to critical sectors. - Use MTBF to identify ring-fenced priority spending that should be protected from cuts. - If resources are projected to fall below the level required for safeguarding essential expenditures, staff could alert donors to the need for additional financing, and the program could accommodate domestic borrowing and/or a drop in reserves to lower levels. ### Safeguarding competitiveness - Increased aid-based spending could induce a real appreciation that might adversely impact export growth (the Dutch disease). - Exports and manufacturing production are often considered to have positive externalities on longer-term productivity (e.g., through learning-by-doing). - A real appreciation resulting from a temporary surge in aid could be short-lived but still entail high adjustment costs if exporting firms lay off skilled workers, or close down, thereby hindering a subsequent recovery. *Source: IMF PDF chapter/section — _061407 - 39. Therefore, program design in the context of managed floating requires special* ### 53. While risks of Dutch disease are a concern, the case studies suggest that they ### _061407 - 53. While risks of Dutch disease are a concern, the case studies suggest that they ### Dutch disease: evidence and program responses - Finding: There is some cross-country econometric evidence that higher aid has undermined growth in labor-intensive export-oriented sectors. - Finding: There have been no clear country case studies demonstrating aid-induced Dutch disease. - Program practice: Programs have not restricted the use of aid because of a need to avoid or cure Dutch disease; instead they have included targeted measures to minimize risk to export industries and support diversification by enhancing competitiveness. - Example: PRGF-supported program for Rwanda included development and execution of action plans for promoting exports in 2004 and 2005 while accommodating a large increase in aid inflows. - Example: Zambia (June 2006 program) emphasized the authorities’ financial sector development plan, supported by conditionality, to allow firms to finance temporary losses due to real appreciation. - Guiding principle: Given scant empirical evidence, Fund-supported programs should not constrain aid-based spending on the grounds of risks to competitiveness; only in exceptional cases would such risks provide a compelling argument against scaling up. ### Guidance on assessment and monitoring (including Box 4) - Staff role: Help countries assess risks to export competitiveness and closely monitor related evidence after scaling up. Staff are not required to predict the magnitude of a possible real appreciation resulting from programmed higher aid. - Baseline macro assumption: In the absence of reliable exchange rate projections, the baseline macroeconomic framework could remain based on the standard assumption of a constant real exchange rate, while the report text would flag whether changes are likely and provide some indication of direction and possible magnitude. - Box 4 — When adverse effects of higher aid on competitiveness merit close scrutiny: - Conditions warranting scrutiny: - The increase in public spending is concentrated on nontraded goods and services (including labor). - There is little or no spare capacity in the economy; analysis may need to focus on critical components in short supply. - Consumers’ ability to switch from domestic to imported goods is limited due to trade restrictions or high transportation costs. - Firm-level investment climate surveys indicate that real wages pose a binding constraint on exports. - Signs of actual Dutch disease: - A severe real appreciation of the exchange rate (preferably measured using relevant production costs, including wages, rather than the CPI). - A strong contraction in manufacturing production or exports (unrelated to other exogenous events). - Signs of emerging bottlenecks in manufacturing production or exports, including declining investments. - Exporters’ inability to withstand temporary appreciation due to insufficient access to credit. - Possible approaches to limit risks: - Promote adaptability of export sector by enhancing availability of bank credit (while safeguarding credit quality). - Limit real appreciation by: - Trade liberalization, easing pressure on the nontradable sector as more goods effectively become tradable. - Increasing productivity in nontraded goods production to limit resource shifts away from traded goods. - Boost medium-term exports by supporting productivity in tradable sectors through: - Targeting expenditure increases to overcome bottlenecks (for example, infrastructure or education). - Improving the business climate, guided by a recent Diagnostic Trade Integration Study. ### Use of aid and long-term competitiveness - Finding: Possible adverse effects of aid on competitiveness underscore importance of using aid well; even with an initial contraction of exports, net effect of scaling up on long-term growth could be positive if aid is used effectively. - Mechanism: Aid can address infrastructure bottlenecks and contribute to lowering production costs and promoting exports over the medium term. ### Maintaining debt sustainability (Section F) - Objective: Ensure scaling up is consistent with a sustainable debt position. HIPC Initiative and MDRI debt relief have created room for substantial new borrowing to help progress toward the MDGs; excessive borrowing, particularly nonconcessional, could reemerge unsustainable debt burdens. - Historical practice: Prior to the Debt Sustainability Framework (DSF) in 2005, programs focused on short-term constraints; all programs included a performance criterion limiting new nonconcessional external debt, sometimes to zero, but most members faced no ceiling on medium- and long-term concessional borrowing. About half of pre-2005 PRGF programs had fiscal conditionality extending to the overall deficit. - Post-2004 Board guidance: Strengthen control over excessive borrowing, guided by structured debt sustainability analysis; use limits on overall fiscal deficit (including grants) and conditionality related to NPV of external debt. - Implementation note: NPV-based conditionality is difficult to use; only PRGF arrangements for Guyana and Rwanda have had indicative ceilings on NPV of external public and publicly guaranteed debt (introduced July 2004 and January 2007, respectively). The 2005 arrangement for the Kyrgyz Republic has a separate ceiling on contracting or guaranteeing concessional external debt in addition to a zero ceiling on nonconcessional borrowing. - Complementary structural measures to contain debt distress risks: - Procedures for approving and monitoring external debt (example: Uganda 2006). - Strengthening investment project selection and prioritization with independent feasibility studies (examples: Albania 2004; Guyana 2006). - Developing sustainable medium-term debt strategies, possibly requiring technical assistance. - Guiding principle: Using the DSF (updated in 2006), programs can use various tools to limit debt distress risk. Close scrutiny of scaling-up scenarios is suggested when: - (i) current or projected risks of debt distress are above or close to the high end of the moderate range or the country moves to a higher risk category; - (ii) scaling-up scenarios imply sharp shifts in fiscal policy, the investment rate, the financing mix, productivity growth, or other key variables; - (iii) key assumptions from the previous two or three DSAs, and hence debt projections, have proven significantly too optimistic; or - (iv) debt has grown rapidly—defined as an annual change in the NPV of debt of 5–7 percent of GDP or more. - Box 5 — Supporting Debt Sustainability (summarized recommendations): - For most low-income countries, nonconcessional borrowing should in general be discouraged. - For countries with debt burdens well below thresholds, adequate policy environment, and viable projects lacking concessional finance, nonzero limits may be appropriate. - For countries with moderate or high risk of debt distress, programs may incorporate conditionality on total or external borrowing or on the NPV of external debt; not necessary where absorptive capacity and debt-management framework are adequate. - In countries with high or rapidly growing domestic debt and/or limited debt management capacity, conditionality may reflect desire to lower domestic debt stock by limiting aid-based spending in the short run—shifting from domestic to lower-cost foreign debt. - Scenario analysis: When scaling up using borrowed resources, scenario analysis can help assess risks. Include an alternative “high investment-low growth” scenario when baseline assumes ambitious scaling up will lead to sizeable growth dividends. ### Managing limits to micro-absorptive capacity (Section G) - Finding: Limits to returns on public investment and micro-absorptive capacity constraints can argue for gradual approaches to raising public spending. Literature is inconclusive but bulk supports that aid can positively influence growth conditional on good policies and institutions. - Risks: Large aid inflows can strain administrative capacity and some evidence suggests efficiency declines with volume of investment. Fund staff are not expected to evaluate absorptive capacity (requires in-depth microeconomic assessments); collaboration with World Bank and donors is important. - Governance and institutions: Weak governance and poor fiscal institutions argue for gradual increases in aid-financed spending; relative efficiency of pro-poor spending strongly correlated with governance and fiscal institutions. Medium-term fiscal planning and capacity to estimate sectoral resource needs are priorities. Large spending initiatives should be preceded by pilots when possible. - Fiscal institutions needing attention to maximize benefits of scaled-up aid include: - (i) expenditure planning instruments; (ii) budgeting processes aimed at improving results orientation; (iii) expenditure tracking systems; and (iv) accounting, control, and reporting systems. ### Allocating expenditures and monitoring resource use (Section H) - Staff coordination: Fund staff should be mindful of distributive consequences and expenditure allocation effects on macro performance; collaborate closely with World Bank and rely on Bank and development partners for sectoral assessments. - PSIA: Poverty and Social Impact Analysis helps design programs to incorporate interests of the poor and mitigate adverse impacts; staff should be proactive in discussing PSIA needs with authorities and development partners and take into account PSIA results. - Progress toward MDGs: PRGF-supported programs have been broadly successful in expanding social spending—on average, education and health spending has risen by 0.6 percent of GDP a year, double the increase in non-PRGF countries. - Reporting and conditionality guidance: - Staff reports should discuss increases in donor resources—including resulting from HIPC and MDRI relief—and macro effects of scaling up on expenditure allocations and key projects, emphasizing poverty-reducing activities. There should be no requirement to specifically identify what spending items relate to MDRI relief. - Floors for anti-poverty or social sector spending should be incorporated to support expansion of social programs and priority spending; five out of 25 PRGF programs in Africa during 2001–05 included these (Ghana, Mauritania, Rwanda, Sierra Leone, and Uganda). Three further PRGF programs had quantitative targets for increasing poverty-reducing or social spending (Democratic Republic of Congo, Ethiopia, and São Tomé and Príncipe). - When conditionality seeks to limit spending to protect fiscal or macro stability, social sectors need protection; in spending cuts, staff supports identifying wasteful spending and restricting cuts to nonpriority outlays. - Wage bill ceilings: - Used selectively and made more transparent. As of June 2007, conditionality on the wage bill was in place in eight out of 29 PRGF arrangements, of which four were performance criteria. These generally did not impose ceilings (or hiring freezes) on health or education sectors and have been revised during program reviews to incorporate new information on expected aid flows and desired staffing/wage levels. Recent Fund guidance emphasizes avoiding wage bill ceilings over extended periods, flexibility in application with safeguards for priority sectors, and clear justification in program documents. - Reporting definitions: - Reporting and conditionality should, in principle, make use of PRSP-based definitions of priority spending. Where national definitions lack cross-country comparability, country reports should continue to show expenditures on health care and education. Staff will endeavor to undertake periodic systematic assessments of poverty-reducing expenditures to assess the use of aid across recipient countries. *Source: _061407 - 53. While risks of Dutch disease are a concern, the case studies suggest that they* ### 69. Concerns about overly-constraining definitions of priority spending will need to ### _061407 - 69. Concerns about overly-constraining definitions of priority spending will need to ### Priority spending definitions and PRSPs - Paragraph 69: Concerns about overly-constraining definitions of priority spending will need to be addressed through PRSPs, where such spending is defined. - Recent IEO report: growing recognition by all stakeholders that more fiscal space is needed for infrastructure spending. - Fund and donor flexibility: incorporated changes in the definition of priority spending where authorities’ classifications evolved: - Rwanda: energy-related outlays were included in priority spending when shortages and blackouts threatened growth. - Chad: priority spending expanded to include judicial reforms important to establishing rule of law. - Uganda: priority spending expanded to include infrastructure spending in rural areas. - Tradeoff noted: a too-expansive definition of priority spending might introduce rigidities and limit the scope for adjustment, either to shocks or changing objectives. ### Collaboration with World Bank, donors, and other partners - Paragraph 70: Fund staff should collaborate closely with Bank staff to take account of analysis and advice on how aid, revenue, and the composition of public expenditure might be used to improve growth prospects. - World Bank findings: fiscal policy design is a determinant of growth; specific influences include: - The quality of governance and management in the public sector; - The composition of expenditure; - The level of expenditure; - Tax policy; and - Budget processes. - Recommendation: develop explicit growth-oriented fiscal policy scenarios to inform the design of an overall macroeconomic policy package. - Paragraph 71: Staff should address whether aid is supporting growth and helps achieve the MDGs; staff reports should address progress toward achieving the MDGs and the extent to which additional resources are guided by medium-term planning. - Collaboration: work with authorities, the World Bank (developing a more comprehensive results reporting system), and local NGOs and other groups for information on spending effectiveness. ### Role of the Fund and evolution since PRGF - Paragraph 72: The Fund plays an important role in helping LIC members manage aid inflows effectively; higher aid can allow faster progress toward the MDGs but can create macroeconomic challenges. - Paragraph 73: Since the introduction of the PRGF in 1999, the Fund’s approach to aid management has evolved: - Program design changed to accommodate the spending of (more) aid in program baselines; - Partial move toward accommodating spending of unanticipated aid and offsetting unanticipated shortfalls; - Aid volatility has often complicated fiscal policy. - Paragraph 74: Actual aid absorption was substantially smaller than projected and permitted under most Fund-supported programs. - Reluctance by monetary authorities to allow currencies to appreciate often led to larger-than-programmed international reserves, creating inflationary pressures. - Real appreciation has often been a concern, but rarely a problem. ### Best practices for program design and policy advice (Paragraph 75) - Aid projections: - Fund aid projections should represent staff’s best estimate of the amount of aid that will materialize, based on all available information. - Programs should have one baseline, but Fund staff should assist authorities in preparing alternative scenarios of scaling up. - Spending aid: - Fund-supported programs should generally support the full spending and absorption of aid, provided macroeconomic stability is maintained and taking into account specific country circumstances and development needs. - Fund-supported programs should rarely constrain aid-based spending on the grounds of risks to competitiveness. - Micro-absorptive capacity constraints can argue for a gradual approach to raising public spending. - Specific conditionality (such as spending floors) can be incorporated to support the expansion of poverty-alleviating programs. - Absorbing aid (monetary program design): - The monetary program should seek to combine absorption of aid with price stability and reserve adequacy. - Essential to have a clear and common understanding of the exchange rate regime and monetary policy objectives. - Scaling up strengthens the case for exchange rate flexibility; managed floating can raise difficult challenges for program design. - Scaling up ties in with the NFA/NDA conditionality framework for monetary policy. - Aid volatility: - Fund-supported programs should promote a smooth path of fiscal spending despite volatile aid disbursements. - Once reserve adequacy has been achieved, program adjusters should allow temporary deviations from programmed foreign financing to be absorbed through domestic borrowing, financed through reserve drawdowns. - Allocating expenditures, resource use, and meeting the MDGs: - Fund staff should collaborate closely with the World Bank and rely on the Bank and other development partners for sectoral assessments. - Staff will continue to assist authorities in monitoring the use of scaled-up resources using PRSP-based definitions of priority spending. ### Program documentation, resources, and operational implications - Paragraph 76: Importance of better explanations of program design in program documents, especially when deviating from identified standard best practices. - Paragraph 77: Narrow implementation of recommendations should not entail considerable additional resource needs. - Paper seeks to support quality of program design and policy advice by clarifying analytical framework and best practices, but does not call for additional exercises. - Assumes adequate resources are available for effective collaboration with the World Bank, donors, and other development partners—an issue to be discussed in a forthcoming paper on the role of the Fund in the PRS Process. ### Issues for discussion (Paragraph 78) - Projecting aid inflows: - Do Directors agree with projecting aid inflows based on a comprehensive assessment of the best available information, and explaining the use of deliberately cautious or optimistic assumptions? - Framework for spending and absorption of aid: - Do Directors agree that Fund-supported programs should generally support the full spending and absorption of aid—in the context of a multi-year fiscal framework—provided macroeconomic stability and spending effectiveness are maintained? - Do Directors agree that strategies for spending and absorbing aid should be explained clearly, in particular when full spending and absorption is not recommended for the near term? - Coordination of fiscal, monetary, and exchange rate policies: - Do Directors agree with recommendations aimed at reconciling aid absorption with price stability, while avoiding the crowding out of private sector investment? - Program adjusters: - Do Directors agree with the proposed application of program adjusters to support a smooth path of fiscal spending, subject to reserve adequacy? - Distributive consequences and reliance on partners: - Do Directors agree that staff should be mindful of distributive consequences and aspects of expenditure allocation that affect macroeconomic performance, while generally relying on the Bank and other development partners for specific analyses? *Source: IMF document excerpt (paragraphs 69–78).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/2007/eng/_061407.pdf_