Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Managing Scaled-Up Aid

July 20, 2007

  • High aid inflows can challenge governments on best use of aid
  • IMF aims to help countries fully spend, absorb all aid
  • Long-term donor commitments can help reduce aid volatility

Boosting aid to low-income countries to help them whittle away grinding poverty seems like a no-brainer.

Managing Scaled-Up Aid

Red Cross immunization line at Tchadoua, Niger: governments often lack information on private aid flows (photo: Issouf Sanogo/AFP)

Role of fiscal policy

But high aid inflows can present governments with a series of challenges about how to best use the money for development.

Governments, for example, must decide how much of the aid inflows to spend domestically or to keep for later (spending of aid), and the central bank must decide how much of the aid-related foreign exchange to sell in the market (absorption of aid).Thus, fiscal policy in combination with monetary and exchange rate policy is critical in determining how much of the aid is spent and absorbed.

The IMF aims to help countries fully spend and absorb all aid, provided that macroeconomic stability is not compromised and that the aid can be used effectively. The IMF's Medium- Term Strategy calls on the Fund to help low-income countries put in place the policies and economic institutions that will permit them to absorb the projected scaling up of aid in a sustainable manner. This article discusses four questions that shape fiscal policy formulation in the context of scaled-up aid:

• How should the medium-term resource availability for the budget be determined?

• What considerations should influence the choice of a medium-term spending path for the budget?

• How should countries deal with the volatility and uncertainty of aid?

• What key fiscal institutions are needed for a country to use resources effectively, and how can these institutions be strengthened?

Assessing resource flows

The first step in the process is to collect information on the intention of official and private donors about prospective aid flows. Governments often lack information on private aid flows, and a part of official aid is also provided outside the budget. This makes it quite difficult to accurately estimate aid flows, thus complicating fiscal management. Based on available information on donor commitments and intentions, a medium-term projection for resource flows should be constructed, to be complemented with projected amounts of domestic resources (for example, taxes and other government revenue).

Sustaining and increasing the domestic revenue effort should be an integral part of countries' fiscal policy response to scaled-up aid. Because many projects financed by scaled-up aid give rise to future recurrent spending, such spending will need to be financed from domestic resources. Insufficient growth in domestic revenues will either constrain other spending or lower the productivity of existing programs by allocating inadequate resources for operations and maintenance.

Policies that broaden the tax base and strengthen revenue administration are therefore critical for fiscal sustainability and for eventually reducing long-term reliance on aid. Strengthening debt management capacity and fiscal institutions, including public financial management (PFM) systems are also critical elements of such a strategy. PFM systems refer to the institutional framework, systems, and procedures that govern the preparation, execution, and reporting of the budget.

Choosing an expenditure path

A given resource envelope is consistent with many different spending paths. The choice of a particular path will depend on country-specific factors, including macroeconomic conditions, the capacity of the economy and its different sectors to absorb additional aid, and debt sustainability. For example, countries with high inflation and a low level of foreign exchange reserves may need to raise spending gradually as macroeconomic stability is restored. In contrast, countries whose macro-imbalances have receded are in a better position to increase spending rapidly.

Other constraints (for example, a shortage of teachers or health workers, or a lack of domestic inputs to implement projects) may also require countries to raise spending gradually while focusing on alleviating those constraints in the interim. Limited capacity to effectively design and administer expenditure programs can further constrain aid-financed spending.

Given the volatility and uncertainty of aid flows, one key objective should be to smooth the expenditure path so that all programs undertaken are adequately funded. Under this approach, countries would respond symmetrically to aid increases and decreases. When aid is below projections, this approach allows countries to continue financing spending programs by drawing down reserves or by resorting to additional domestic financing, subject to macroeconomic considerations. When aid is higher than projected or absorptive capacity constraints prevent full spending of aid, part of the aid flows would be saved to be spent in the future.

Domestic political pressures

However, there are limits to how much aid a country can save. For example, the scope for saving project aid would be limited because its use depends on the project cycle. In addition, donors might become reluctant to continue providing aid if it is consistently used to build up reserves.

Finally, aid recipients face domestic political pressures to spend aid to improve economic and social outcomes. Ultimately, it is critically important to strengthen the capacity of these countries to use as much aid as they possibly can. The IMF, through its policy advice and technical assistance in areas such as public expenditure management, helps countries increase absorptive capacity to use aid inflows fully and effectively.

Casting the spending path in a medium-term context obviates the need for ceilings for specific expenditure categories such as wages. Such ceilings have occasionally been used in IMF-supported programs as a short-term measure when the size of the wage bill threatened macroeconomic stability and budgetary processes were weak. However, these ceilings tend to be inefficient and difficult to monitor, and their incidence in IMF-supported programs is rapidly declining.

In the future, wage bill ceilings will be used in IMF-supported programs only in exceptional cases when warranted by macroeconomic considerations. Their design should be flexible to accommodate spending of scaled-up aid, and their need and rationale will be reviewed periodically.

Dealing with uncertainty and volatility

Volatile aid flows present important challenges to fiscal policymaking. Aid flows are much more volatile than tax revenues and significantly more volatile than remittances. Such volatility can translate into expenditure volatility, with adverse consequences for social and economic outcomes. The implementation of a medium-term expenditure path is also likely to be challenging in an environment of volatile and uncertain aid flows.

Aid recipient countries can take a number of measures to mitigate the effects of aid volatility and uncertainty. These include the following

• Identifying the risks emanating from aid volatility through stress-testing of baseline projections.

• Self-insuring against aid volatility by building up reserves and strengthening domestic revenue mobilization.

• Enhancing expenditure flexibility by contracting out services and using temporary and flexible wage contracts.

• Protecting priority spending: All spending plans should be prioritized, and critical programs should be safeguarded from spending cuts in the event of an aid shortfall.

Long-term commitments from donor countries can help also reduce aid volatility. Some donors are already moving in this direction.

Strengthening financial management

Sound fiscal institutions, including PFM systems, are essential for improving the efficiency of spending in low-income countries. Most such systems in low-income countries are weak, and scaling up is likely to further stretch the capacity of such systems to manage the planning, allocation, and execution of budgetary resources. This brings up the risk that aid would be largely wasted if government operations and public expenditure management are not made more transparent.

It is therefore critical for the countries concerned to focus on strategic PFM reforms and sequence them appropriately, consistent with their capacity to undertake them. In the short term, these reforms should focus on improving budget classification systems, strengthening internal control on budget execution, accounting, and transparent reporting. Short-term priorities should also include developing capacity for preparing medium-term resource envelopes, sectoral expenditure ceilings, and revenue projections. Medium-term reforms should include strengthening treasury systems, debt management, and PFM systems in subnational governments.

Last, low-income countries should prepare appropriately sequenced and prioritized action plans for strengthening their PFM systems, based on a diagnostic assessment of existing systems. Most low-income countries are expected to require substantial technical assistance to strengthen their PFM systems. In this regard, the arrangements for coordinating technical assistance among the IMF, the World Bank, and other donors should be strengthened to ensure that the delivery of such assistance is efficient and effective. These issues are discussed in greater detail in the accompanying article.