1 Macroeconomic and Policy Challenges International Monetary Fund Disclaimer: The views expressed in this paper are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management. Scaling up for the MDGs

2 Overview 1.What do we understand by scaling up? 2.What is needed for scaling up 3.What policymakers will want to know 4.The Interaction of Fiscal, Monetary, and Exchange Rate Policy 5.Scaling up and Revenues 6.Scaling up and Growth 7.The need for supporting policies 8.Other fiscal challenges 9.Strengthening Governance 10.Debt Sustainability 11.Summing up

3 1.What do we understand by scaling up? Scaling up of aid offers considerable potential benefits and challenges Scaling up of aid offers considerable potential benefits and challenges The Fund is working to better understand these challenges and provide advice on how to manage higher aid inflows so as to realize the benefits of aid The Fund is working to better understand these challenges and provide advice on how to manage higher aid inflows so as to realize the benefits of aid Scaling up implies a significant rise in disbursements of highly concessional resource flows compared with recent history Scaling up implies a significant rise in disbursements of highly concessional resource flows compared with recent history This means different things for different countries This means different things for different countries For example, in Africa there are three clusters: current aid 5% or less (14 countries); aid 6-16% (24 countries); aid exceeding 20% (6 countries) For example, in Africa there are three clusters: current aid 5% or less (14 countries); aid 6-16% (24 countries); aid exceeding 20% (6 countries) Some previous aid surges, but small compared to what is now envisaged Some previous aid surges, but small compared to what is now envisaged

4 2.What is needed for scaling up? An explicit costing of a plan to reach MDG targets An explicit costing of a plan to reach MDG targets The level and duration of higher aid The level and duration of higher aid The sectors where it will be spent The sectors where it will be spent The manner in which it will be disbursed The manner in which it will be disbursed The current vs. capital share The current vs. capital share The matching with domestic public spending The matching with domestic public spending Whether spending will be maintained when scaling up has ended Whether spending will be maintained when scaling up has ended

5 3.What policymakers will want to know The impact of higher spending on growth, saving, and investment The impact of higher spending on growth, saving, and investment The impact on inflation The impact on inflation The impact on the real exchange rate, trade, and competitiveness The impact on the real exchange rate, trade, and competitiveness The implications for the interaction of fiscal, monetary, and exchange rate policy The implications for the interaction of fiscal, monetary, and exchange rate policy The implications for tax revenue and public sector performance The implications for tax revenue and public sector performance What supporting policies they can undertake What supporting policies they can undertake

6 4.The Interaction of Fiscal, Monetary, and Exchange Rate Policy Concerns about inflation and competitiveness must be balanced against the dangers of failing to absorb aid and crowding out the private sector Concerns about inflation and competitiveness must be balanced against the dangers of failing to absorb aid and crowding out the private sector Government has a choice to use aid for higher spending, lower taxes, or lower debt Government has a choice to use aid for higher spending, lower taxes, or lower debt Scaling up is expected to be used for higher public spending Scaling up is expected to be used for higher public spending This could result in a relatively high demand for non-traded goods This could result in a relatively high demand for non-traded goods... And thus might cause a real exchange rate appreciation & loss of competitiveness (Dutch Disease)... And thus might cause a real exchange rate appreciation & loss of competitiveness (Dutch Disease)

7 4.contd... But this prediction depends on the supply response of the sectors where the higher demand falls But this prediction depends on the supply response of the sectors where the higher demand falls A scaling up plan may incorporate investments in productive capacity that boost supply response A scaling up plan may incorporate investments in productive capacity that boost supply response And therefore mitigate the rise in domestic prices And therefore mitigate the rise in domestic prices Evidence of real appreciation in response to aid is mixed Evidence of real appreciation in response to aid is mixed Country cases where non-traditional exports increased as aid went up Country cases where non-traditional exports increased as aid went up

8 4.contd... Some studies of exchange rate impact

9 4.contd... Policymakers may want to offset excess liquidity due to aid Policymakers may want to offset excess liquidity due to aid Choice of selling foreign exchange or domestic bonds Choice of selling foreign exchange or domestic bonds The latter raises concerns about crowding out The latter raises concerns about crowding out So may also consider quantitative controls such as reserve requirements or shift of public sector deposits out of commercial banks So may also consider quantitative controls such as reserve requirements or shift of public sector deposits out of commercial banks These are very limited tools These are very limited tools Bottom line: Some impact on real exchange rate and traded goods sector can be expected. Monitor indicators such as export growth and private investment closely and strengthen domestic supply response Bottom line: Some impact on real exchange rate and traded goods sector can be expected. Monitor indicators such as export growth and private investment closely and strengthen domestic supply response

10 5.Scaling up and Revenues Concern that foreign aid may be seen as substitute for domestic revenue mobilization Concern that foreign aid may be seen as substitute for domestic revenue mobilization And that aid reduces domestic accountability And that aid reduces domestic accountability But domestic revenue is likely to be more stable than aid flows But domestic revenue is likely to be more stable than aid flows Some cross-country evidence of revenue offset from higher aid Some cross-country evidence of revenue offset from higher aid The offset seems to be worse in countries with weak institutions The offset seems to be worse in countries with weak institutions Bottom Line: Some loss of mobilization incentive, so direct attention towards areas of revenue potential Bottom Line: Some loss of mobilization incentive, so direct attention towards areas of revenue potential

11 6.Scaling up and Growth Some studies look at growth impact of aid flows Some studies look at growth impact of aid flows Growth impact of aid depends on type and purpose of aid and can be difficult to detect statistically Growth impact of aid depends on type and purpose of aid and can be difficult to detect statistically Some studies find positive growth impact & rates of return, and positive interaction with good policies Some studies find positive growth impact & rates of return, and positive interaction with good policies But recent studies note the fragility of these conclusions But recent studies note the fragility of these conclusions For public spending, studies find growth impact of a one percent of GDP increase in social sector or public investment in the range percent over 5 years For public spending, studies find growth impact of a one percent of GDP increase in social sector or public investment in the range percent over 5 years

12 6.contd.. Public Investment and Growth

13 6.contd... Social Sector Spending and Growth

14 7.The need for supporting policies These are average effects across countries for small changes in public spending and hold constant the other determinants of growth These are average effects across countries for small changes in public spending and hold constant the other determinants of growth Other policy measures can enhance the effectiveness of spending and offset the decline in returns to spending when spending is high Other policy measures can enhance the effectiveness of spending and offset the decline in returns to spending when spending is high Examples: tackling supply bottlenecks, financial deepening, stronger public expenditure management systems Examples: tackling supply bottlenecks, financial deepening, stronger public expenditure management systems Bottom Line: Scaling up can boost growth when complementary policy actions are taken Bottom Line: Scaling up can boost growth when complementary policy actions are taken

15 8.Other fiscal challenges The exit strategy: what happens when aid tapers off? The exit strategy: what happens when aid tapers off? How will spending and taxes adjust? Will the government be locked in to higher spending? How will spending and taxes adjust? Will the government be locked in to higher spending? What are the recurrent cost implications of aid-financed spending? What are the recurrent cost implications of aid-financed spending? Potentially large gains from making existing spending more effective Potentially large gains from making existing spending more effective Distribution of benefits: current primary education and hospital spending are relatively poorly targeted in Africa Distribution of benefits: current primary education and hospital spending are relatively poorly targeted in Africa

16 9.Strengthening Governance Strengthening governance would enhance the efficiency and targeting of existing and anticipated aid flows Strengthening governance would enhance the efficiency and targeting of existing and anticipated aid flows The growth impact of corruption is estimated to be substantial; a one unit improvement on a corruption index (scaled 1-10) can raise growth by around 1 percent The growth impact of corruption is estimated to be substantial; a one unit improvement on a corruption index (scaled 1-10) can raise growth by around 1 percent Corruption lowers private investment and diverts effort and resources into rent-seeking... Corruption lowers private investment and diverts effort and resources into rent-seeking... But may increase the quantity (not quality) of public investment But may increase the quantity (not quality) of public investment Corruption is also associated with higher income inequality, higher military spending, worse social indicators, and poorer infrastructure Corruption is also associated with higher income inequality, higher military spending, worse social indicators, and poorer infrastructure Bottom Line: Supporting policies should include institutional strengthening, including checks and balances, transparency, and accountability Bottom Line: Supporting policies should include institutional strengthening, including checks and balances, transparency, and accountability

17 10.Debt Sustainability Even with scaled up concessional aid, debt accumulation may still constrain growth Even with scaled up concessional aid, debt accumulation may still constrain growth A recent IMF study finds that sustained growth accelerations in Africa are associated with lower debt burdens A recent IMF study finds that sustained growth accelerations in Africa are associated with lower debt burdens Good debt management should be oriented towards concessional foreign finance and avoid overuse of high- cost domestic or foreign borrowing Good debt management should be oriented towards concessional foreign finance and avoid overuse of high- cost domestic or foreign borrowing Good policies will support debt-carrying capacity Good policies will support debt-carrying capacity Bottom Line: Use grants rather than loans where possible; monitor debt level and structure carefully Bottom Line: Use grants rather than loans where possible; monitor debt level and structure carefully

18 11.Summing up Impacts on inflation, the exchange rate and competitiveness are a legitimate concern, but should be balanced against the dangers of failing to absorb aid and crowding out the private sector Impacts on inflation, the exchange rate and competitiveness are a legitimate concern, but should be balanced against the dangers of failing to absorb aid and crowding out the private sector The adverse impact of appreciation on exports and investment should be addressed by supply-side reforms to improve efficiency and productivity The adverse impact of appreciation on exports and investment should be addressed by supply-side reforms to improve efficiency and productivity Maintain attention on domestic revenue while shifting taxes away from more burdensome sources Maintain attention on domestic revenue while shifting taxes away from more burdensome sources The broader supporting environment for scaling up is crucial: good policies mean more long-lived growth impact and more effective spending The broader supporting environment for scaling up is crucial: good policies mean more long-lived growth impact and more effective spending Strengthened governance will enhance the effectiveness of existing and new spending Strengthened governance will enhance the effectiveness of existing and new spending

19 11.contd... Recipient governments will need to consider the exit strategy, especially in terms of domestic revenue Recipient governments will need to consider the exit strategy, especially in terms of domestic revenue Careful consideration to the pace of scaling up – any of the challenges we have discussed may be exacerbated by rapid growth in spending Careful consideration to the pace of scaling up – any of the challenges we have discussed may be exacerbated by rapid growth in spending Reduction of bottlenecks, especially those that are policy- induced (e.g. import restrictions, costs of doing business) Reduction of bottlenecks, especially those that are policy- induced (e.g. import restrictions, costs of doing business)