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3.2 Financing Development III: Economic Report on Africa 2007

Emerging issues on aid and debt

In recent years, there have been discussions on the impact of new aid and debt initiatives
on recipient countries. There is no doubt that African countries need more aid
flows to enable them to increase the likelihood of achieving the MDGs. However,
more aid flows will also impose serious challenges on African economies, and policymakers
must prepare themselves to deal with these challenges if they are to maximize
the benefits of aid and minimize the costs. Several papers have tried to identify the
challenges facing African countries as a result of the decision by donors to scale-up
aid to the region (Bourguignon and Sundberg 2006; Heller 2005). These challenges
include how to increase the absorptive capacity for aid in recipient countries and
how to ensure that aid does not lead to loss of competitiveness through real exchange
rate overvaluation. In this section, the economic consequences of scaling-up aid and
debt relief to African countries are examined.

Economic impact of aid

The impact of the scaling-up of aid has been a major preoccupation of researchers
and policy-makers in recent years as reflected in the growing literature on the subject.
Several papers have addressed the main issues including the “Dutch disease”
problem, the effect on growth, the impact on fiscal sustainability and the issue of
predictability of aid.

Dutch disease

The Dutch disease effect is probably the most widely discussed potential adverse effect
of an increase in aid flows. The idea is that in a small open economy where prices of
traded goods are determined on the world market, an increase in aid inflows may
lead to an increase in the price of non-traded goods resulting in a real exchange rate
appreciation. This appreciation of the real exchange rate will have a negative impact
on the competitiveness of the economy. The assumption here is that a large part of
the inflows is spent on non-traded goods. In addition, the Dutch disease effect and
the impact of aid flows on relative prices and exchange rates are not automatic and
depend on several factors including the share of aid spent on productive investment
relative to that spent on consumption of final goods. If the aid is financing productive
investment, it will improve productivity, enhance growth and have less impact
on prices and on the real exchange rate.

The evidence from empirical studies on the impact of scaling-up aid on the real
exchange rate and relative prices are mixed. In a recent study of 13 African countries
by Chowdhury and McKinley (2006), eight countries had a positive correlation
between net aid inflows and real exchange rates, suggesting that increased aid flows
were accompanied by depreciation, rather than appreciation of the real exchange rate.

In five countries, the correlation was negative. For the link between the aid inflows
and the inflation, the study suggested that the correlation for all the countries was
positive, indicating that increasing aid is associated with an increase in inflation, and
this has consequences for competitiveness of the economy. The potential for Dutch
disease is a real concern for African economies. However, the risk could be mitigated
by increasing the level of aid directed to productive investment, to improve productivity
and to help the economy respond to pressure from the demand side.

Aid and growth

An important and compelling reason for increasing aid to Africa is to accelerate
growth and increase the likelihood of attaining the MDGs in the region. Assessments
of the performance of African countries show that it would be difficult for
them to achieve the MDGs if current trends continue. High and sustained growth
is needed to reduce poverty in African economies. Thus, it is important to know
if scaling-up aid will accelerate growth in Africa. This issue has been discussed at
length in several papers (Clemens et al. 2004; Burnside and Dollar 2000; Easterly
et al. 2003).

There are three main views on the relationship between aid and growth. The first is
that aid has a positive effect on growth, but with diminishing returns as the volume
of aid increases. The channels through which aid has a positive effect on growth
include: augmenting savings and making it possible to finance investments; increasing
worker productivity through investments in health or education; and providing
a channel for the transfer of technology from rich to poor countries. The second
view on the link between aid and growth is that aid has no effect on growth. Arguments
put forward to support this view are that aid is often wasted, supports bad
governments, reduces domestic savings, and undermines private sector incentives for
investment. In addition, it is often argued that recipient countries do not have the
capacity to absorb large amounts of aid. The third view on the relationship between
the two variables is that aid has a conditional relationship with growth. It works best
in countries with good institutions and policies. For example, a recent study on aid
to African countries showed that in 11 “good performance countries” high growth is
linked to high aid flows (Bourguignon et al. 2005; World Bank 2005).

Aid and fiscal sustainability

The debate on the challenges of increasing aid has raised the issue of fiscal sustainability
(Heller 2005). One of the key concerns here is the impact of increased aid
on fiscal attitudes as well as on the efforts of the recipient countries to collect tax
and increase government revenues. There is a fear that an increase in aid will not
encourage countries to increase their fiscal revenues. However, these views are not
supported by the findings of recent studies indicating that the relation between aid
and tax collection is very weak (Bourguignon et al. 2005). Another noteable issue is
that of public expenditure management. It has been argued that if higher aid inflows
are used to finance labour-intensive public services (e.g. schools or clinics) that have
large recurrent costs, then if there is an unexpected fall in aid levels, the ability of the
government to continue with the provision of these services may be limited. Consequently,
effective fiscal planning is crucial for economies dependent on aid flows.

Volatility of aid

Aid recipients have to deal with the uncertainty surrounding both aid commitments
and disbursements. This concern is serious because recipient countries have to formulate
and implement medium-term development strategies and it is difficult to
do this effectively if they are not certain about the timing and amount of aid that
would be available to them over the time horizon considered. The uncertainty surrounding
aid is also a problem because studies have shown that it can have negative
consequences for output (Lensink and Morrisey 2000). Added to the volatility problem
is the inefficiency resulting from conditions and procedures associated with aid
delivery. In several countries, the multiplicity of donor programmes and their poor
alignment with recipient government priorities often lead to inefficiencies. This inefficiency
contributes to the weak impact of aid on growth and development.

Provision of social services

Aid is often used to finance the provision of social services, especially health and education.
The idea is that these investments have a positive effect on productivity and
hence on growth and poverty reduction. The correlations between aid and health
and education expenditures for African countries indicate that there is a strong, positive
and statistically significant relationship between health expenditure per capita
and aid per capita. This relationship holds for both contemporaneous and lagged
aid. The correlation coefficients are 0.28 and 0.33 for contemporaneous and lagged
aid, respectively. With regard to education, the results indicate that there is no statistically
significant relationship between aid per capita and the share of education in
total government expenditure. Despite the need to use aid for increasing provision
of social services, it is important that this is not done in a way that reduces investments
in infrastructure because this is likely to have a long-run negative impact on
growth in the region.

Economic impact of debt relief

Debt relief is also one of the major components or sources of the expected increase
in resources to African countries to help them finance activities and actions needed
to meet the MDGs. As at mid-July 2006, total HIPC initiative assistance commitment and assistance delivered or expected to be delivered to African countries under
MDRI was about $50 billion. If donors follow through on their commitments, this
will represent a significant inflow of resources to eligible African countries. It will
also present challenges to these countries, including:
• How to manage the additional resource flows emanating from debt relief
and ensure that they are effectively used for poverty reduction;
• How to increase domestic absorptive capacity to absorb these inflows and
ensure that they do not result in real exchange rate appreciation and a reduction
in export competitiveness; and
• How to ensure that current debt relief does not encourage excessive new
borrowing and the accumulation of further debt.

As indicated earlier, one of the main objectives of debt relief is to free up resources
for financing social programmes that are expected to have significant impact on poverty
reduction. In this section, the links between debt relief and social expenditure,
inflation and growth are examined.

Debt relief and social expenditure

One of the compelling arguments for debt relief is that it will free up resources for
financing social programmes that are vital for alleviating poverty. There is a general
belief that an increase in expenditure on education and health will have positive
effects on productivity and on poverty reduction. Despite the popularity of these
views, it is not clear that an increase in debt relief will actually boost social expenditure.
Recent empirical studies have tried to examine the extent to which debt relief
leads to an increase in social expenditures. Chavin and Kraay (2005) examined the
link between debt relief and social expenditure. They found no evidence of a statistical
relationship between debt relief granted over 1989-1993 and the share of government
expenditure on health and education during 1994-1998.

That said, they also found that debt relief over the period 1994-1998 was associated
with an increase in the shares of education and health in total spending during
1999-2003, although the evidence is not robust. In terms of country-specific evidence,
Nannyonjo (2001) argues that in Uganda, debt relief had a positive impact
on social expenditure in the late 1990s, particularly in the education and health sectors.
Dessy and Vencatachellum (2006) have also examined this issue using African
data. They found that debt relief had a positive impact on the share of education and
health in total spending over the period 1989-2003.

Debt relief and growth

One of the concerns about the high external debt of poor countries is that it stifles
growth and so makes it even more difficult for a country to generate enough resources to repay its existing stock of debt. High debt can reduce growth through its negative
impact on investment. It can also reduce growth by reducing the incentives of
governments to adopt structural reforms. Several attempts have been made to examine
the link between debt and growth. However, until recently, most of the studies
use data for both emerging markets and low-income countries without taking into
account the fact that the heterogeneity between emerging markets and low-income
countries has implications for the relationship between debt and growth. Unlike
emerging markets, low-income countries have very limited access to international
capital markets. In addition, they have relatively different economic structures and
rely on foreign aid. These differences suggest that the relationship between debt and
growth will differ across the two groups of countries.

In a recent study, Pattillo et al. (2002) found that external debt has a negative effect
on growth after a critical threshold for debt is reached. In particular, they found that
when the net present value of debt is greater than 160-170 per cent of exports and
35-40 per cent of GDP, external debt stifles growth. With regard to the link between
debt relief and growth, Clements et al. (2005) present evidence suggesting that debt
relief under the HIPC initiative will add 0.8-1.1 percentage points to the annual per
capita GDP growth rates of the countries in their sample. These findings support
the widely held view amongst African policymakers that debt relief will increase the
prospects for growth and development in the region.

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