Issues in Scaling-up of Development Aid Flows Benu

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 Commonwealth Secretariat, London, 7 March 2007

Recent Trends in ODA Ø Ø 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) G 8 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

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

Issues in ODA flows (contd. ) Ø Aid flows – uncertain, volatile and herding among donors Ø Management of surges of aid flows similar to managing surges in private capital flows Ø Management in low income countries is exacerbated by underdeveloped financial sector Ø Costs of surges illustrated with the case study of Uganda, Mozambique. Ghana and Tanzania. Ø 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. Ø 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 foreign exchange in the domestic country. Ø Proposal for a new mechanism to intermediate donor flows

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

Concentration of ODA Source: OECD/DAC

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

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

Source: GDF

Financial Intermediation of Donor Flows • Excess liquidity hinders the development of the inter bank segment and evolution of the short term reference rate. Donor Flows Timing Uncertain Budgetary Support Deposit with Bank of Uganda Timing and volume of governmen t spending of donor funds for budgetary support is uncertain Project aid intermediated through the commercial banking system Fiscal Deficit Additions to liquidity through build up of reserves and additions to liquidity when the government starts spending Interest rate and exchange rate volatility Affects balance sheets of the banking system Take off of credit to private sector • Leave no incentives for the development of money market instruments. It also hinders the development of a secondary market in government securities. • Encourages banks to use treasury bill and foreign exchange mainly for asset management instead of loans to the private sector.

Source: Bank of Uganda

■ Domestic Financing ■ Foreign Financing ■ Budget Deficit without Grants ■ Budget Deficit

EXCESS RESERVES Source: GDF

“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.

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

Source: Bank of Uganda

Source: Bank of Mozambique ■ Foreign Assets Commercial Banks (million) ■ Foreign Liabilities Commercial Banks (million)

Uganda: Treasury Bills Source: Bank of Uganda

Source: Bank of Uganda

Source: Bank of Ghana

Source: Bank of Ghana Source: Bank of Tanzania

INTERNATIONAL RESERVES Source: GDF Source: Bank of Uganda

▬ Domestic Interest Payments ▬ Foreign Interest Payments

Source: Bank of Uganda

Classification by aid absorption and expenditure Not Spent Not absorbed Ethiopia (20, 0) Mostly Spent Ghana (0, 7) Partly absorbed Partly Spent Fully Spent Tanzania (0, 91) Uganda (27, 74) Mostly absorbed Mauritius 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

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

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

Source: Bank of Uganda

Uganda Treasury Bill Yields Note: No issuance of 278 days T Bills in 2005 Source: Bank of Uganda

Source: Bank of Uganda

Ugandan experience Ø Overestimation of absorption and ability to raise domestic revenue in the expenditure framework Ø A build of internal public debt negating the positive effects of debt relief Ø Short term choice between higher inflation or higher public debt Ø Limit to the sale of foreign exchange by the authorities as there is very little demand 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. Ø Increasing the import content of investments require the assured continuation of donor flows Ø The signaling mechanism through the PRSP, PRGF, PSI, and CPIA leads to concentration of aid flows.

Risk of reversal of donor flows in Uganda Ø Amendment to the constitution to allow Museveni’s third term and arrest of Museveni’s rival Dr. Besigye caused withholding of aid by United Kingdom, the Netherlands, Norway and Sweden. Ø There is close watch on government response to post election civil unrest and further aid cuts are possible.

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

Policy response Ø Increase domestic savings in the interests of long term viability. Ø Augmentation of domestic revenue to avoid a sudden contraction of the economy. Ø 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. Ø Keep volatility in interest rates in check to encourage take off of credit.

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

Proposal for a new mechanism to intermediate donor flows Ø 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 Ø 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

Proposal for a new mechanism to intermediate donor flows (contd. ) Ø 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 M 2 Ø Additional benefit: development of domestic bond market and other sectors of financial sector

Proposal for a new mechanism to intermediate donor flows (contd. ) Ø Implications of investment fund for central banks – A central Bank can draw down on resources according to economy’s 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

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