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

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

IMF Survey: Helping Maximize the Benefits of Aid

July 20, 2007

  • Country policies need to take account of aid volatility
  • IMF can help with well-designed programs
  • IMF paper outlines best practices

The IMF is refining its approach to the design of macroeconomic programs to help low-income countries use aid more effectively.

Helping Maximize the Benefits of Aid

Aid-financed Hai Van tunnel near Danang, Vietnam: higher aid flows sometimes crowd out private sector investment (photo: Kham/Reuters)

IMF and low-income countries

The Executive Board recently reviewed the IMF's experience in advising low-income countries on the management of aid inflows.

The discussion focused on country experience under economic programs supported by the Fund and on how such programs can be designed to maximize the benefits of aid to help countries achieve their development objectives, including the Millennium Development Goals (MDGs).

Using aid effectively, while maintaining macroeconomic stability and debt sustainability, requires careful management of fiscal, monetary, and exchange rate policies. In some instances, higher aid flows have been accompanied by sharply rising inflation or higher interest rates, crowding out private sector investment.

Heart of IMF mandate

In many cases, swings in aid inflows have led to spending volatility, leaving key fiscal priorities unfunded. Such problems, which can severely undermine the effective use of aid, can be mitigated through well-designed and coordinated macroeconomic policies. Helping countries develop and implement these policies is at the heart of the IMF's mandate.

A clear approach to handling assistance is important, particularly if donor promises to scale up aid to developing countries are realized. Over time, as more low-income countries achieved macroeconomic stability, IMF-supported programs became more accommodative of higher aid flows.

The IMF's Executive Board, at its July 6 meeting, discussed best practices to promote the use of aid going forward. The goal is to strengthen how the IMF engages with low-income countries and to bring all such countries to the point where aid can be fully used.

Accommodating the use of aid

Since the launch in 1999 of the Poverty Reduction and Growth Facility (PRGF)—the IMF's primary lending instrument for low-income countries—Fund policies with respect to aid have evolved in a number of important ways.

    1. IMF-supported programs have become more accurate—that is, less cautious—in predicting aid flows, which facilitates planning and allows more effective use of external resources.

    2. Programs have increasingly allowed the spending and absorption of aid (see box).

    3. Increasingly, unanticipated aid flows can be spent and unexpected aid shortfalls can be offset through higher domestic borrowing.

    4. Priority spending is protected from budget cuts in most programs and very few now include ceilings on the public sector wage bill. Moreover, PRGF-supported programs have been successful in expanding social spending—on average, spending on education and health has risen by 0.6 percent of GDP a year, double the increase in non-PRGF countries.

    5. Debt issues have received more systematic treatment following introduction of the Debt Sustainability Framework for low-income countries, underscoring the importance of careful debt management and sufficiently concessional aid.

Spending and Absorbing Aid

The macroeconomic policy response to aid may be characterized by the fiscal and monetary authorities' decisions on spending and absorbing the aid—drawing on a useful analytical framework presented in a recent IMF paper on macroeconomic management of aid flows.

Spending is defined as the widening of the fiscal deficit (net of aid) accompanying an increment in aid. Absorption is defined as the widening of the current account deficit (net of aid) due to incremental aid - it measures the extent to which aid engenders a real transfer of resources through higher imports, or through a reduction in the domestic resources devoted to producing exports. The central bank determines absorption through its sales of foreign exchange and through monetary policy which influences aggregate demand, and hence the demand for imports.

To absorb and spend is the textbook response to aid. Absorption ensures that there is a real transfer of resources to the recipient country, while government spending allocates these resources to priority investment and consumption. Other responses to aid may be justified under particular circumstances for short periods (for example, to build international reserves, smooth volatile aid flows, or reduce domestic financing).

To spend and not absorb is a common but problematic response that may reflect a desire by countries to raise spending in light of higher aid, while seeking at the same time to use the aid to build international reserves (often with the aim of limiting appreciation of the exchange rate). However, a spend and not absorb approach is similar to a fiscal stimulus in the absence of aid. There is no real resource transfer from abroad while there is either a rise in interest rates or an increase in the money supply.

The review of experience under IMF-supported programs since 1999 included other key findings. For instance, competitiveness concerns due to appreciation of the real exchange rate (often referred to as "Dutch disease") have not led to limits on the use of aid. Instead, programs included targeted measures to minimize the effects on export industries and diversification. The review also illustrates that, contrary to popular perceptions, Fund-supported programs varied considerably in light of country-specific conditions and did not follow a "one-size-fits-all" approach to the use of aid.

Design principles

Building on the experience with IMF-supported programs, the Board endorsed a number of program design principles aimed at maximizing the effective use of aid while maintaining macroeconomic stability and debt sustainability.

In general, it was established that IMF-supported programs should promote the full use of aid—that is, the spending and absorbing of aid—provided macroeconomic stability is maintained and country-specific circumstances and development needs are taken into account. For countries not in a position to use aid fully (for example, when doing so would jeopardize macroeconomic stability), the Fund will provide advice on how to address constraints. Program documents will also be expected to explain clearly how programs are designed and to justify deviations from a full spend and absorb approach.

Beyond the emphasis on spending and absorbing, the paper lays out best practices for program design in a number of more specific areas. These include:

• Aid projections should reflect the best estimate of likely assistance based on all available information, not solely on firm commitments by donors. Deliberate over- or under-projection of aid should be explicitly justified.

• Fund staff should stand ready to help countries design alternative aid scenarios that would be consistent with macroeconomic stability. These scenarios are expected to be presented in PRSPs and/or Article IV reports.

• Programs should be based on a clear understanding of the authorities' exchange rate regime, since this determines how absorption might take place, and should encourage effective coordination of fiscal, monetary, and exchange rate policies

• Medium-term budget frameworks should be used to promote a smooth spending path in the face of potential aid volatility and also to prioritize poverty-reducing spending. In case of limited aid shortfalls, programs should allow additional domestic borrowing if the level of international reserves is adequate. Minimum levels of poverty-reducing spending could be used in IMF-supported programs to protect and expand priority outlays.

• Given the limited evidence of negative effects on competitiveness from increased aid inflows, spending should in general not be constrained due to Dutch disease concerns, unless a competitiveness problem emerges. Emphasis should be placed on steps to strengthen competitiveness, for example by channeling aid toward productivity-enhancing expenditures such as infrastructure investment.

• The Debt Sustainability Framework should be used to keep debt levels manageable and assess whether the concessionality of aid flows is appropriate.

• The IMF should coordinate with the World Bank and key donors if microeconomic concerns regarding the ability to use aid effectively arise.

• The IMF should consider the allocation of spending in particular areas such as health and education to the extent that it has macroeconomic impact. Poverty and social impact analysis (PSIA) should be taken into account where appropriate to incorporate the interests of the poor and help mitigate any adverse effects of reform measures. IMF staff would not be expected to conduct PSIA work, but to rely on the work the World bank and other development partners, with close collaboration expected on spending composition and PSIA.

• Ceilings in Fund programs that limit the public sector wage bill should be used selectively (with clear justification in program documents) and transparently.