A quarterly magazine of the IMF

June 2002, Volume 39, Number 2

To enable the developing countries to achieve the Millennium Development Goals by 2015, the target date, the international community is calling for an increase in foreign aid to 0.7 percent of industrial country GNP from 0.24 percent of GNP at present. But a large increase in aid flows could pose a number of challenges for the poorest countries.

The long-standing goal of raising official development assistance (ODA) to 0.7 percent of industrial country GNP is an important element of the strategy for reducing global poverty and meeting the Millennium Development Goals by 2015 (see box). A dramatic growth in ODA can also lead to an expanded supply of needed global public goods. But the industrial countries must move quickly to mobilize these additional financial resources while they can, because they will face new budgetary constraints within 10-15 years, when the current baby boom generation begins to retire and collect state pensions and other benefits.

If the industrial world were to be successful in meeting its ODA targets, financial aid would increase to about $175 billion, slightly more than three times current levels. This could pose challenges—both macroeconomic and microeconomic—for developing countries, particularly if the funds were distributed primarily to the world's poorest countries. Transfers of money to a developing country in amounts that are large relative to the size of its economy can be problematic. Recent studies have provided evidence of "Dutch disease" (a term that broadly refers to the harmful consequences of large inflows of foreign currency into a country) in such aid recipients as Burkina Faso, C�te d'Ivoire, Ghana, Malawi, Senegal, Sri Lanka, Togo, and Uganda. To ensure that enhanced ODA is used efficiently in the fight against global poverty, it is crucial that the international community examine closely the different possible approaches it could take in deciding how to allocate aid, both among countries and among complementary global poverty reduction programs.

Millennium Development Goals At the Millennium Summit in September 2000, the world's leaders set seven goals for the international community to meet by the year 2015 that add up to an ambitious agenda for reducing poverty and its causes and manifestations. An eighth goal was added the following year. Progress toward the goals has been mixed thus far for a number of reasons, including insufficient and inefficient public spending and crippling debt burdens in the developing countries, inadequate access for developing country exporters to industrial country markets, and declining official development assistance. Goal 1 Eradicate extreme poverty and hunger Goal 2 Achieve universal primary education Goal 3 Promote gender equality and empower women Goal 4 Reduce child mortality Goal 5 Improve maternal health Goal 6 Combat HIV/AIDS, malaria, and other diseases Goal 7 Ensure environmental sustainability Goal 8 Develop a global partnership for development A UNDP-sponsored conference bringing together government officials from around the world and representatives from the international financial institutions to discuss the challenges of increasing financing for development was held in Monterrey, Mexico, in March 2002.

Potential challenges

Why are large aid flows to small economies problematic? What bottlenecks would have to be addressed if ODA increased for many countries? Economic theory suggests that whether or not economies have problems absorbing such aid flows depends on both the size of external resource transfers relative to the size of the recipient economies and the extent to which such transfers are spent on domestic goods and services rather than on imports. If ODA were spent entirely on imports, the country's balance of payments would be unchanged; any increase in imports would be completely financed by foreign inflows, and the inflows would have no direct impact on the country's money supply or on aggregate demand.

But, if a significant share of foreign inflows were spent on nontraded goods, the price of domestic goods and services would go up. The conversion of foreign exchange into local currency for the purchase of domestic products would expand the monetary base. This expansion would, in turn, fuel an increase in domestic demand, some of which would be met by expanded imports, contributing to a weakening of the trade balance. At the same time, demand for nontraded goods would also increase considerably. Because the worsening of the trade balance would be more than offset by foreign inflows, the pressure of demand for nontraded goods, coupled with supply constraints, would push up the prices of these goods, and the overall domestic price level would rise. In a country with a fixed exchange rate, the upward pressure of an expanded money supply on domestic demand and prices of nontraded goods would cause the currency to appreciate in real terms as domestic prices rise, while the nominal exchange rate would remain unchanged. In a country with a flexible exchange rate, the increased supply of foreign currency, not wholly absorbed by the purchase of imported goods and services, would drive up the value of the domestic currency, leading to an appreciation in both the nominal and the real exchange rates.

While foreign aid that eases local supply bottlenecks can have a deflationary impact, neither of the situations described above, in general, is conducive to growth or poverty reduction. When domestic inflation is high, poor and middle-income groups are likely to suffer. But the poor also suffer when the goods they produce become less competitive because of an exchange rate appreciation. Likewise, a poor country's capacity to compete in world markets—which would ultimately enable it to be weaned from ODA—suffers if the competitiveness of its exports is undermined by a real exchange rate appreciation.

Resolving the macroeconomic policy challenges posed by significant external resource transfers is difficult, given the limits to which direct commodity imports can be absorbed without adverse macroeconomic effects in the countries receiving aid. In most poor countries with underdeveloped infrastructure and human capital, the bottlenecks that result from a limited capacity to absorb aid flows cannot be removed quickly.

A substantial increase in aid flows could also produce a number of challenges at the microeconomic level. First, studies show that large aid inflows can overwhelm the administrative capacity of governments, leading to waste and inefficient and ineffective projects and programs. Second, it is critical to ensure that an increase in aid does not reduce a country's incentives to adopt good policies and reform inefficient institutions. Third, experience indicates that dependence on aid may weaken accountability, encourage rent seeking and corruption, and impede the development of a healthy civil society if a recipient government is more accountable to its donors than to its own citizens.

The scope of the problem

To gauge the magnitude of the potential problem, let us assume that the full 0.7 percent of GNP in aid is distributed to the world's least developed countries—those with annual per capita incomes of less than $500—and that this aid is made conditional on these countries' satisfying certain governance criteria or establishing a track record of successful policy implementation. The transfers would be massive relative to the size of these countries' economies. Moreover, applying such a criterion for distributing aid would result in enormous differences in the scale of per capita transfers to the "absolute poor" (individuals with incomes of less than $1 a day) of the world. It would mean that no transfers would go to poor people living in countries with per capita incomes above $500. Some of the largest countries in the world would thus be excluded—those with annual per capita incomes of $500-$800, which are classified as "other low-income countries" (India, Nigeria, Pakistan, and Vietnam), and "lower-middle-income countries" with annual per capita incomes above $800 (China, Indonesia, and the Philippines).

If the increased ODA resources were distributed according to a different criterion—for example, to countries with a greater concentration of the absolute poor—the macroeconomic issues associated with resource transfers would be significantly diminished. However, the bulk would not go to the poorest countries in the world but to the larger countries listed above.

These results can be readily illustrated. Paul Collier and David Dollar of the World Bank recently carried out an analysis of how aid (based on 1996 allocations) might be reallocated if countries with severe poverty and good policies were targeted and if countries with civil strife or poor policies were excluded. Based on their results, we imagine three scenarios.

In the first scenario, based on Collier and Dollar's criterion, aid goes to the least developed countries—those with annual per capita incomes below $500—that have good economic policies, but the amounts are scaled up to reflect the amount of aid that would become available if the industrial world were to increase ODA to 0.7 percent of GNP. As shown in the chart, the average ratio of ODA to GDP in recipient countries would be 32 percent, almost two and a half times what it is now, and the revenues available for government programs would almost triple. For many countries, however, the ratio of ODA to GDP would be much higher—90 percent in Ethiopia, 52 percent in Uganda, 60 percent in Burundi, 48 percent in Vietnam, 43 percent in Nicaragua, 57 percent in Guyana, and 74 percent in the Kyrgyz Republic. One problem with Scenario 1 is that aid to China and India—countries that have large numbers of absolute poor and that have pursued good policies—would account for no more than 11 percent of total ODA.

In Scenario 2, the Collier-Dollar criterion is used, but, with the allocation to China and India allowed to increase, ODA averages about 12 percent of GDP, diminishing problems related to absorption, with some exceptions among the least developed countries (for example, ODA transfers would be 33 percent of Ethiopia's GDP). China and India together would receive about $116 billion of the projected total of $175 billion, while Nigeria, Pakistan, the Philippines, and Vietnam would receive about $25 billion. Only about $30 billion of the increased ODA would be allocated to the least developed countries, and about one-third of this would go to Bangladesh. Sub-Saharan Africa would receive no more than $20 billion, of which $4 billion would go to Nigeria.

Even in Scenario 1, the bulk of the ODA would be allocated to countries that are not classified as least developed countries. China, India, Indonesia, Nigeria, Pakistan, the Philippines, and Vietnam together would receive about $86 billion; sub-Saharan Africa about $52 billion (of which $10 billion would go to Nigeria). The greater the share of aid allocated to the least developed countries, the greater the likelihood of macroeconomic problems related to these countries' limited absorptive capacity. Similarly, the larger the share of ODA allocated to the next tier or tiers in the per capita income scale—"other low-income countries" and "lower-middle-income countries"—the smaller the scale of the macroeconomic absorption problem because of the greater absolute size of these economies.

A case could easily be made for not using a per capita income cut-off of $500 in determining how to distribute ODA. Absolute poverty is not limited to the poorest countries. Indeed, in the third scenario (not pictured in the chart), if ODA were distributed to countries in relation to the proportion of the population living on less than $1 a day, China and India together would receive about $112 billion—almost the same total as in Scenario 2. However, India would receive more ($73 billion) than China ($39 billion) because it has a greater concentration of individuals in absolute poverty, whereas, in Scenario 2, China would receive $76.4 billion and India $40 billion. Similarly, using the criterion of the number of individuals living in absolute poverty, sub-Saharan African countries would receive no more than $33 billion in ODA. Recipients among the least developed countries would receive ODA transfers averaging about 32 percent of GDP, compared with 8 percent for low-income countries.

A multipronged approach

The international community has a number of options for addressing these challenges. We believe that the optimal strategy would be based on the following five elements:

Reconsidering the distributional criteria for expanded ODA. Donors could channel some of the increased ODA funds to countries that are not normally counted among the poorest but that nonetheless have large numbers of absolute poor. This would mean a significant expansion of ODA to countries in South and East Asia. An important corollary would be a requirement that low- and middle-income countries with high concentrations of poverty use ODA to address income inequalities and the causes of endemic poverty.

Carefully monitoring the macroeconomic situation and the use of ODA. A higher concentration of imported goods and services may be necessary in the short term, limiting the proportion of ODA used to finance domestically produced, nontradable goods and services, particularly within the public administration. Fortunately, it is not difficult to conceive of many necessary imported goods that could make an enormous difference in addressing critical shortages in many poor countries (for example, pharmaceutical products, including the antiretrovirals used to treat HIV/AIDS). Some macroeconomic pressures in the form of inflation and real exchange rate appreciation are probably inevitable, but care needs to be taken that such effects are not so severe as to undermine the sustainability of development efforts. Gradual augmentation of ODA levels may need to be considered for some countries, particularly if simply increasing imports does not target their development needs.

The poverty reduction strategy paper (PRSP) process in low-income countries is critical, both to ensure local ownership in terms of decisions on how to use the enhanced resources and to provide some checks on governance. Some aid flows should be allocated to strengthening public institutions and improving the quality of governance. We advocate targeting aid to countries that have taken steps to reduce corruption and increase accountability and transparency. Finally, it is important to ensure that aid flows do not create perverse incentives for the recipients. Good economic performance would have to be an explicit criterion for allocating aid.

Increasing technological innovations to benefit the poorest countries. Some ODA could be used to produce and provide global public goods. For example, the World Health Organization�sponsored Commission on Macroeconomics and Health argues for expanded outlays on a significant research and development (R&D) effort directed at the principal diseases affecting the poorest countries, as well as the provision of commercial distribution incentives for any drugs and vaccines developed under such a program. R&D on alternative energy sources to replace fossil fuels could be particularly important in the coming decades in devising low-cost alternatives for developing countries seeking substitutes for inefficient and carbon-emitting energy facilities or technologies. R&D on agricultural technologies could facilitate adaptation by tropical countries to the already foreseeable extent of climate change.

Setting up trust funds for the accumulation of ODA resources. Although most industrial countries are likely to have more budgetary room for an expanded ODA effort now than in the future, the poor countries' current limited ability to absorb large ODA flows may undermine the effectiveness of expanded aid. The international community could consider developing mechanisms like global trust funds that allow aid to be disbursed years before it will be spent. Such specialized trust funds for financing selected global public goods have already begun to emerge; these endowments for future earmarked pro-poor programs are sometimes focused on specific sectors. For example, a global fund was recently set up to pool, manage, and allocate new resources to fight AIDS, tuberculosis, and malaria.

Reducing trade barriers that keep exports from the poorest countries out of industrial country markets. Industrial countries have to invest more in social safety nets to soften domestic opposition to the removal of trade barriers. Most observers recognize that the opening up of industrial country markets to the products of the developing world is as essential as additional ODA for engendering self-sustaining development. Poor countries also need to address the anti-export bias in their own policies.

In conclusion, there must be a concerted effort by all partners in the development community to anticipate the macro- and microeconomic challenges associated with using expanded external resources effectively. Addressing these challenges will entail collaborative partnerships among bilateral and multilateral donors, aid recipients, nongovernmental organizations, civil society, and the private sector. But it will not be easy to secure a consensus on either the allocation or the institutional modalities for creative and effective use of expanded ODA resources. At the same time, the importance of moving quickly to achieve such a consensus is great. Much goodwill would be lost if additional resources were inefficiently used or diverted from their principal objectives.

This article is based on Peter S. Heller and Sanjeev Gupta, 2002, "Challenges in Expanding Development Assistance," IMF Policy Discussion Paper 02/5 (Washington).

Paul Collier and David Dollar, 1999, "Aid Allocation and Poverty Reduction," World Bank Policy Research Working Paper No. 2041 (Washington).

Commission on Macroeconomics and Health, 2001, Macroeconomics and Health: Investing in Health for Economic Development (Geneva: World Health Organization).

William Easterly, 2001, The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics (Cambridge, Massachusetts: MIT Press).