A Response to Joseph Hanlon's Recent Article, Donor Concern Over IMF Cap on Aid Increases

February 7, 2006

This letter was sent to Joseph Hanlon in response to a recent article, Donor Concern over IMF cap on aid increases that Mr. Hanlon, a writer on African issues, distributed through his newsletter on Mozambique and which can be found at www.open.ac.uk/technology/mozambique.

A Letter
By Perry Perone
IMF Resident Representative Mozambique
February 7, 2006

Dear Mr. Hanlon,

I read with interest your analysis of the IMF-supported program for Mozambique, but you present a misleading picture of IMF program support for Mozambique. The IMF is actively working with the Mozambique authorities to make good use of all available aid. I therefore disagree with your conclusion that the IMF is blocking more aid from getting to the country.

You rightly mention that the government sets a primary domestic deficit target, which is included in the IMF-supported program. This target does not act as a cap on budget support. In fact, the target takes into account the amount of foreign aid that is expected to be available. For example, the deficit in 2006 is somewhat higher than envisaged at the time of the last review of the IMF-supported program in June 2005 reflecting explicit donor commitment to higher budget support.

The deficit target is a fiscal means of ensuring continued macroeconomic stability, prudent debt management and an appropriate level of spending to meet the objectives set out in Mozambique's poverty reduction strategy paper (or `PARPA' in Portuguese). It is consistent with the authorities' budget, not pegged at some arbitrary level. If budget planning accurately reflects donor commitments, then a correctly set deficit target should not constrain corresponding spending and will reflect the priorities of the government. Only an unanticipated increase in donor assistance, coming, for instance, in the middle of the budget year, could push the primary domestic deficit over the target.

These unplanned surges in aid need to go through the budget; otherwise, the Mozambique authorities would lose all control over their own spending priorities. While indeed "donors are anxious to pump more money" into Mozambique, as you write, the Mozambican finance ministry must work with reasonable projections of both domestic and foreign revenues, and not with donor trends of the moment. Donors must also coordinate their pledges with the country's budget cycle, so that any new income and associated spending is supervised by parliament. It is also important to remember that they must not only promise but also commit, possibly over a multi-year cycle.

Nonetheless, when aid surprises happen, the authorities, and the IMF, need to adjust. The IMF is in constant touch with the Mozambican government and with the donors, including the World Bank, and it reviews the programs every six months. During such reviews the target is revisited and adjusted based on any new information that is available. So where there is a plan for spending the new aid, the deficit target can be relaxed.

Regarding your specific question on health, let me stress that the IMF is aware of the challenges facing the Minister of Health, and wants to be supportive of his efforts to expand the health program through greater donor funding. IMF reviews are done frequently enough to allow for adjustments of the primary domestic deficit targets should some donors disburse more funds than they previously indicated. Certainly, the IMF would not want the introduction of project funds into the budget to cause a reduction in health spending, and it would adjust the primary domestic deficit target accordingly.

At the same time, it is important to ensure that the Government of Mozambique has the capacity to finance a higher level of staffing with the necessary qualifications and training in the future. This is a critical point that should not be overlooked. Donors should be willing to guarantee future funding for this expanded staffing. If they are not, then this may call for some flexibility in hiring arrangements in order to provide the government sufficient confidence in broadening the program.

This brings me to one of the most relevant issues in the current debate on expanding aid, and that is the importance of aid coordination and harmonization, as well as the need for donors to make their aid payments more predictable.

Despite the excellent donor coordination in Mozambique, the government faces many constraints when preparing such multi-year plans. It is difficult for the government to be certain about the level of donor payments in the medium term, and it might not be prudent to make medium term expenditure commitments—especially when it comes to hiring more personnel—when there is uncertainty about whether the money will still be available over the next budget cycle.

There has been considerable discussion on how to resolve such timing problems. This has been part of the regular dialogue between the Mozambican government, bilateral donors and the IMF. We have had constructive dialogue on ways to improve the design of the IMF fiscal target, taking into account developments in aid in recent years. Donor aid, in particular, has increasingly moved away from lending to support capital investment projects, and toward direct budget support. Such aid has increasingly supported the hiring of personnel in health and education, and purchases of medicine. This has been in an effort to help achieve the Millennium Development Goals.

Finally, your article also mentions a recent IMF study on the macroeconomics of scaled-up aid. It however mischaracterizes the study as arguing that "periods of higher inflation actually achieve real growth, and this should be tolerated to keep the exchange rate from depreciating." In fact the study makes the more nuanced point that, under some circumstances, a permanent rise in the level of aid may require an appreciation of the equilibrium real exchange rate. An appreciated real exchange rate often involves some combination of nominal appreciation and inflation.

Countries can use monetary and fiscal policy to choose the combination appropriate to their circumstances. However, as the study points out, the choice should be conditioned by recent economic history. A country which is recovering from a period of high inflation should probably seek to keep inflationary expectations in check, and seek to adjust to scaled-up aid through the nominal exchange rate. Moreover, the study also emphasizes that if the aid is spent productively, the economy's supply response may, over time, greatly cushion the impact on the real exchange rate.

I hope that you will share my remarks with the readers of your newsletter. I will also be happy to meet with you to discuss these issues at your earliest convenience. However, I would like to inform you that my tenure as the Fund Resident Representative in Mozambique will end February 28, 2006. I hope that we can meet before my departure; but if this is not feasible, you can always contact my successor Mr. Felix Fisher.


Perry Perone
Resident Representative


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