A quarterly magazine of the IMF

September 2005, Volume 42, Number 3

Assessing the impact of a dramatic increase in aid on one of Africa's poorest countries

Ethiopia, among the poorest countries in Africa, presents one of the biggest development challenges in a region beset by frequent drought and food shortages and hobbled by inadequate roads and communications. A landlocked country of about 70 million people, sandwiched between Sudan and Somalia in the Horn of Africa, Ethiopia has suffered bloody upheavals and famine over the past two decades and is still recovering from a bitter border war with neighboring Eritrea. It ranks in the bottom 10 of the UN’s Human Development Index, a composite measure of per capita income, health, and education (in 2004, it was listed as 170th out of 177).

Donor countries have targeted Ethiopia for extra assistance because of its size and potential for growth. Symbolically, the United Nations has selected Koraro in Ethiopia as one of its test villages, singled out by economist Jeffrey Sachs in an experiment to monitor the scaling up of aid at the local level. On current trends, Ethiopia will not meet any of its UN Millennium Development Goals (MDGs) except for the target on primary school enrollment. Considerably faster economic growth, supported by a strong policy package, and higher inflows of net official development assistance (ODA) are therefore needed.

But will a dramatic scaling up of external assistance really help and what are the potential pitfalls of such an approach? After all, there is still considerable controversy surrounding the record of aid in many countries. Against this background, and in view of the possible lessons for other African countries, we undertook a study to assess the potential macroeconomic implications of scaling up assistance to achieve the MDGs. We looked at the potential impact of higher aid flows on the tradable goods sector and reviewed priorities for improving fiscal management and financial sector development. Our findings suggest that Ethiopia faces enormous challenges in boosting growth and meeting the MDGs, even with far higher levels of aid—in part because of the need to ensure that this aid is absorbed and used effectively.

Sources of growth

Reforms aimed at transforming Ethiopia from a centrally planned economy to a market-oriented one were launched in 1991 after the overthrow of the former pro-Soviet Derg regime, boosting the overall GDP growth rate to an annual 4.0 percent in 1991–2003 from 2.8 percent during the Derg rule (1974–91). The structure of the economy also changed, with the contribution of agriculture to real GDP falling from 57 percent in 1991 to 42 percent in 2003, while that of services rose from 34 percent to 47 percent. But the contributions of industry and the private services sector remained essentially unchanged, and Ethiopia’s growth potential remained largely untapped.

During 1991–2003, agricultural value added was driven mostly by increases in the area under cultivation, rather than improvements in productivity. While the area under cultivation increased at an average rate of 5.7 percent a year, crop yields rose on average by only 0.4 percent a year. Despite attempts to diversify, coffee still accounts for one-third of total exports, and agricultural output remains very variable and dependent on the climate. Because of the huge impact of the weather on overall GDP (see Chart 1), achieving growth of 7 percent a year on average without addressing the underlying causes of variability implies significantly higher growth in nondrought years.

In 2002, Ethiopia drew up a Sustainable Development and Poverty Reduction Program (SDPRP) that targets economic growth averaging 7 percent a year in order to halve income poverty by 2015. The strategy is premised on a transformation of agriculture from mostly subsistence to commercial production, which would act as a catalyst for the development of industry and exports, and the generation of off-farm employment and income. Specifically, the government aims to increase agricultural value-added growth from an annual 2.2 percent historically to 7.5 percent a year, and nonagriculture growth from 5.8 percent to 6.6 percent. In the agricultural sector, this strong improvement in real output is premised on productivity growth rising from an annual 0.4 percent historically during 1991–2003 to an average of 9.0 percent a year over the medium term.

Can such big increases in growth be achieved in a country where rainfall variability has such a big impact on agriculture and where agriculture still sustains around 80 percent of the population? The answer, according to an IMF study (see box), is that it would require major increases in public and private sector investment and productivity (see table on the next page). Public investment as a ratio of GDP would have to rise to an average of 15.8 percent over the next 15 years compared with 7.7 percent during 1991–2003. Private investment is expected to be stimulated by the government’s reform program. In our analysis, we assumed that private investment would rise broadly in line with public investment, increasing from an average of just over 9 percent in 1991–2003 to almost 16 percent during 2004–15.

The need for strong gains in productivity to attain higher growth highlights the importance of bold implementation of the reform agenda, especially in agriculture, private sector development, financial sector development, and external trade.

In agriculture, the ambitious objectives for growth underline the importance of reforms to enhance productivity (for example, by improving security of tenure, establishing appropriate risk management systems, improving access to rural finance, and reversing environmental degradation) and access to markets (for example, by improving the functioning of markets for both agricultural input and final goods, and improving rural infrastructure).

The required productivity gains also point to the need for significant progress in the privatization of remaining public enterprises; removal of impediments to private sector activity; development of the domestic financial sector; and improvement in access to urban land and Ethiopia’s infrastructure.

Strong fiscal management needed

Achieving the MDGs will require a significant rise in public expenditure. In the absence of a comprehensive analysis of the costs of achieving the respective MDGs, the IMF study assumed a doubling of official development assistance as a share of GDP to meet the MDGs, in line with the Ethiopian government projections. It was thus assumed that ODA would rise from 11 percent of GDP in 2003 to 22 percent by 2015, allowing poverty-reducing spending to rise from about $20 per capita in 2003 to about $78 per capita by 2015. The projected increase in public expenditure reflects an increase in recurrent expenditure—as the public wage bill rises to accommodate the increase in the number of teachers and health workers—and an increase in public investment in infrastructure. The envisaged increase in social spending would therefore reorient spending toward recurrent expenditure, owing primarily to higher wages and salaries. For example, the reallocation of spending to primary education and health services entails wage components of about 95 and 60 percent respectively. Capital spending is projected to increase by 8 percent of GDP. In this context, the overall fiscal deficit (excluding grants) rises sharply to about 23 percent of GDP by 2015 (see Chart 2).

Given the expected strong increase in donor aid to achieve the MDGs, the capacity of fiscal institutions would need to be strengthened to secure the desired poverty reduction outcomes. Strengthening public expenditure management in the areas of budget formulation, execution, and reporting is particularly important to ensure proper allocation and monitoring of poverty-reducing expenditure. Following the extensive decentralization of fiscal functions to regions and districts, which have assumed primary responsibility for poverty-reducing expenditure, a key challenge will be to develop the capacity of these authorities to ensure effective implementation of poverty-reducing policies.

In view of the uncertainty about the form of additional aid flows (grants or loans), development of a clear public debt strategy covering both domestic and external debt, and strong institutions to ensure its implementation, would be key to avoiding an excessive buildup of debt in a scaling-up scenario. Continued concern regarding public debt sustainability in Ethiopia, even following debt relief under the enhanced Heavily Indebted Poor Countries initiative, led the IMF team to assume, for simplicity, that all of the additional external financing would be in the form of grants. Domestic borrowing was contained to below 1 percent of GDP, consistent with a decline in the ratio of domestic debt to GDP. While these assumptions take care of concerns regarding debt sustainability, there remain concerns regarding continued aid dependency. Although large aid inflows can potentially reduce the domestic revenue mobilization effort, the exercise assumed that revenues would be held at 19 percent of GDP, maintaining Ethiopia’s performance over the last five years. However, even with this assumption—so that strong growth in real GDP would yield a corresponding rise in domestic tax revenues—the budget deficit (excluding grants) would remain high after 2015, reflecting the impact on recurrent expenditure of commitments created by MDG-related expenditures.

Trade repercussions

Would this projected sharp increase in aid flows hurt Ethiopia’s competitiveness by boosting the real exchange rate and thus dampening exports? We found that the rise in aid flows through 2002 did not adversely affect Ethiopia’s export competitiveness (see Chart 3). An econometric analysis of the main determinants of the real exchange rate in Ethiopia found that although aid inflows had been associated with an appreciation of the real exchange rate during the period including the Derg regime, aid had been correlated with a depreciation of the real exchange rate during the post-Derg reform period. Moreover, on average, the growth rate of Ethiopia’s noncoffee exports exceeded the growth in world noncoffee imports (see Chart 4). However, it was recognized that this experience might not be a reliable guide to the impact of a much larger increase in aid flows.

In addition, Ethiopia’s use of part of the aid inflows in recent years to build international reserves also mitigated pressures for a real appreciation of the exchange rate (see "The Macroeconomic Challenge of More Aid" on page 28 of this issue). Thus, the potential for wage and price pressures from high aid flows in the future points to the need for reforms to alleviate pressure for a real exchange rate appreciation, particularly through further liberalization of the trade regime, elimination of exchange restrictions, and streamlining customs procedures. These steps would help ensure that part of the increased domestic demand would be channeled abroad. The IMF study therefore projected a significant widening in the external current account deficit from about 13 percent of GDP in 2003 to 21 percent by 2015.

The bottom line

The scaling-up scenario that we have discussed is not a forecast. It does, however, help illustrate the considerable challenges that Ethiopia and its development partners face in ensuring that higher aid inflows result in faster growth and rapid progress toward meeting the MDGs.

Raising the level of growth to 7 percent annually, as targeted under the government’s medium-term scenario for achieving the MDGs, would represent a substantial improvement over the experience of the past 13 years. But is it really possible? Achieving the targeted growth rate would require not just additional external resources, but also a marked acceleration of reforms aimed at supporting agricultural production, private sector development, and exports.

Given that the amount of external aid required to achieve the MDGs would be much higher than in the past, upward pressure on wage and price levels could potentially cause a real exchange rate appreciation. It would thus be prudent to implement policies to counter such pressure, both by further opening up the economy to foreign trade and by boosting productivity and cost efficiency to help increase the supply of goods produced domestically.

Government institutions will also have to be strengthened to cope with higher aid flows. Advancing structural reforms in the areas of fiscal decentralization, public expenditure management, and revenue administration will represent key aspects of a broader reform agenda. In addition, pursuing these reforms will support decentralized democratic governance, strengthen budgeting capacity, and build institutions that foster private sector development.