Issues in Scaling-up of Development Aid Flows Benu Schneider The views expressed are those of the author and do not necessarily represent those of the Financing for Development Office, Department of Economic and Social Affairs, UN

1
Issues in Scaling-up of Development Aid
FlowsBenu SchneiderThe views expressed are
those of the author and do not necessarily
represent those of the Financing for Development
Office, Department of Economic and Social
Affairs, UN

• Second Committee Panel Discussion on 20 October
  2006, New York

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Recent Trends in ODA

• ODA rose 31.4 to 106.5 bn in 2005 or 0.33 of
  GNI (largely due to debt relief to Iraq and
  Nigeria and Tsunami aid)
• G8 pledged to double aid to Africa by 2010 to 50
  bn
• 150 bn are needed to reach the MDGs by 2015
• At 0.36 of GNI by 2010, ODA remains below the
  0.5 achieved in early years of DAC and below the
  0.7 target

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Paris Declaration on Aid Effectiveness

• Adopted at the Paris High-level Forum in 2005
• Partner countries donors committed to
• Implementing Partner Commitments and 12
  Indicators of Progress covering (i) Ownership,
  (ii) Alignment, (iii) Harmonization, (iv)
  Managing for results, and (v) Mutual
  accountability
• Periodically monitoring progress
• Several efforts, such as encouraging ownership
  of development strategy by untying aid, or
  monitoring, already made good progress
• But Declaration lacks targets to tackle
  volatility of aid, herding behaviors and
  selectivity

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Issues in ODA flows

• Aid is concentrated in a few selected countries
• Aid flows in some cases are large relative to the
  size of the economy
• Surges in aid flows have been problematic in
  spite of a countrys best efforts at
  macroeconomic management under IMF surveillance
  and policy advice

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Issues in ODA flows (contd.)

• Aid flows uncertain, volatile and herding
  among donors
• Management of surges of aid flows similar to
  managing surges in private capital flows
• Management in low income countries is exacerbated
  by underdeveloped financial sector
• Costs of surges illustrated with the case study
  of Uganda, Mozambique. Ghana and Tanzania.
• Sterilization of donor inflows through sale of
  government paper led to massive build-up of
  domestic debt and a rapid increase in interest
  payments on domestic debt.
• Sterilization of inflow through sale of foreign
  exchange to the banking sector led to high
  outflows of foreign exchange through the banking
  sector as there was little demand for foreign
  exchange in the domestic country.
• Proposal for a new mechanism to intermediate
  donor flows

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Selectivity

• Top 20 recipients received more than half of net
  bilateral ODA
• Less than 50 of aid recipients received 90 of
  all aid from DAC donors.

• Concentration of ODA in recipient countries,
  1981-2004

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Concentration of ODA
Source OECD/DAC
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Herding

• Herding behavior can be detected by the
  divergence of actual changes in ODA relative to
  average behavior. If all donors follow average
  behavior, the difference between actual and
  average behavior is zero and there is no herding.
  A value greater than 0.1 indicates significant
  herding.
• This figure analyses the behavior of 10 large
  and 13 small donors and confirms the existence of
  herding.

Source WESS 2005
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Volatility
Size is not the only important aspect of ODA
predictability is equally important Aid
selectivity causes volatility similar to that of
private capital flows to emerging market
economies The gap between aid commitment and aid
disbursement reduces predictability
10
Source Bank of Uganda
11
Uganda Commercial Bank Reserves
Source Bank of Uganda
12
Domestic Financing Foreign Financing
Budget Deficit without Grants Budget Deficit
13
The main challenge to monetary policy continued
to be the management of excess liquidity
injections, resulting from government
expenditure. Bank of Uganda, Annual Report
2004/2005, p. 16.
14

• Monetary and exchange rate policy geared
• to managing liquidity to keep inflation low and
  maintain competitiveness by
• Sale of foreign exchange (round-tripping of flows
  as banks invest them abroad)
• Sale of treasury bills

15
Source Bank of Uganda
16
Source Bank of Mozambique
Foreign Assets Commercial Banks (million)
Foreign Liabilities Commercial Banks (million)
17
Uganda Treasury Bills
Source Bank of Uganda
18
Source Bank of Uganda
19
Source Bank of Ghana
20
Source Bank of Ghana
Source Bank of Tanzania
21
? Domestic Interest Payments ? Foreign Interest
Payments
22
Source Bank of Uganda
23
Source Bank of Uganda
24
Classification by aid absorption and expenditure
Not Spent Partly Spent Mostly Spent Fully Spent
Not absorbed Ghana (0,7) Tanzania (0, 91)
Partly absorbed Ethiopia (20, 0) Uganda (27, 74) Mauritius
Mostly absorbed Mozambique (66, 100)
Fully absorbed
Source IMF (2005). The Macroeconomics of
Managing Increased Aid Inflows Experiences of
Low-Income Countries and Policy
Implications NOTE Spent variable Non-aid
fiscal balance deterioration as percent of
incremental aid inflow Absorb variable
Non-aid current account deterioration as percent
of incremental aid inflow
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Excess liquidity hampers financial market
development

• Excess liquidity hampers the development of the
  short-end of the market
• Absence of term money market
• Segmented financial markets so that liquidity
  shortages/surpluses are not efficiently
  intermediated through money, capital, forex, and
  government securities market
• 91 T-Bill rate virtually the reference rate for
  lending and deposit rates
• Interest rate structure does not reflect the
  differences in liquidity, maturity and risk
• Lack of activity in secondary market due to ample
  liquidity

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• Lack of opportunities to lend in foreign currency
• Lack of opportunities to build assets in foreign
  currency
• Both the above lead to round-tripping of capital
  flows with banks holding assets abroad
• Investment in treasury bills and assets abroad
  reduce the incentive to lend

27
Source Bank of Uganda
28
Uganda Treasury Bill Yields
Note No issuance of 278 days T Bills in 2005
Source Bank of Uganda
29
Source Bank of Uganda
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Ugandan experience

• Overestimation of absorption and ability to raise
  domestic revenue in the expenditure framework
• A build of internal public debt negating the
  positive effects of debt relief
• Short-term choice between higher inflation or
  higher public debt
• Limit to the sale of foreign exchange by the
  authorities as there is very little demand for
  foreign exchange and banks invest it abroad.
  There are exposure limits to banks holding assets
  abroad, thereby posing a limit to the amount of
  foreign exchange the banks can buy.
• Increasing the import content of investments
  require the assured continuation of donor flows
• The signaling mechanism through the PRSP, PRGF,
  PSI, and CPIA leads to concentration of aid flows.

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Risk of reversal of donor flows in Uganda

• Amendment to the constitution to allow Musevenis
  third term and arrest of Musevenis rival Dr.
  Besigye caused withholding of aid by United
  Kingdom, the Netherlands, Norway and Sweden.
• There is close watch on government response to
  post-election civil unrest and further aid cuts
  are possible.

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On the risk of reversibility of aid flows in
countries with aid dependent budgets

• Time-consistent policies alone cannot reduce the
  risk of reversibility of donor flows as
  reversibility is determined by political factors
  as well
• A smooth transition to domestically financed
  budgets requires continuation of donor flows in
  the medium term
• Risk of huge fiscal and output contractions if
  aid flows go down with the risk of losing gains
  in poverty reduction

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Policy response

• Increase domestic savings in the interests of
  long-term viability.
• Augmentation of domestic revenue to avoid a
  sudden contraction of the economy.
• The partial use of donor funds for export
  diversification, infra-structure development and
  financial sector reforms import content of
  investments essential to shield the economy from
  their liquidity impact and as a secondary effect
  increase the demand for credit by the private
  sector.
• Keep volatility in interest rates in check to
  encourage take-off of credit.

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• International financial architecture is not well
  designed to control the volatility and herding of
  private capital flows from the supply side
• .. but donor flows emanate from the official
  sector
• International cooperation should aim at
  designing a framework that takes care of surges,
  volatility and herding behavior emanating from
  donor behavior

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Proposal for a new mechanism to intermediate
donor flows

• Proposal Establish a donor funded investment
  account outside the country for development
• To mitigate volatility of donor inflows
• To mitigate impact on liquidity through build-up
  of reserves and increased government expenditure
• Example Norway
• Who will be in control of such a fund?
• Board set up by donors, consisting of officials
  from the Ministry of Finance and Central Banks
• Portfolio management entrusted to BIS
• Donors can set up indicators to control spending

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Proposal for a new mechanism to intermediate
donor flows (contd.)

• The role of treasury bills
• Every converted donor dollar impacts monetary
  base
• Central Bank must fine tune timing of inflow,
  financing of fiscal deficit, and liquidity
  situation
• Dual role of treasury bills
• Source of funding for poverty reduction (in
  addition to initial dollar conversion)
• Mopping up of liquidity after the multiplier has
  been in operation, minimizing impacts on M2
• Additional benefit development of domestic bond
  market and other sectors of financial sector

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Proposal for a new mechanism to intermediate
donor flows (contd.)

• Implications of investment fund for central banks
• A central Bank can draw down on resources
  according to economys liquidity situation and
  timing of expenditure
• Allows for longer-term strategy for poverty
  reduction, independent of political climate or
  disbursement negotiations
• Current trade-off between social sector spending
  and macro-stability can be avoided
• Condition unused funds in a financial year must
  be allowed to contribute to stock-building

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Proposal for a new mechanism to intermediate
donor flows (contd.)

• The road ahead multi-stakeholder dialogue and
  research
• Donor community, IMF and World Bank are
  recommended to engage in dialogue and reach an
  agreement on this crucial issue
• Donors need to understand full implications of
  donor funds in an economy
• Further research needed
• To investigate concrete operation mechanisms of
  the proposed investment fund
• More generally, to design a new framework for
  financial intermediation of donor flow