Thorvaldur Gylfason Course on External Vulnerabilities and Policies Tunis, February 15-26, 2010

 Aid and other capital flows  History, theory, evidence  Foreign aid and economic growth  Effectiveness: Does aid work?  Macroeconomic challenges Dutch disease Aid volatility  Policy options in managing aid and other capital flows  Vulnerabilities  Monetary and fiscal policy options  Debt sustainability  Governance issues

 Unrequited transfers from donor to country designed to promote the economic and social development of the recipient  Excluding commercial deals and military aid  Concessional loans and grants included, by tradition  Grant element ≥ 25%

 Development aid can be  Public (ODA) or private  Bilateral (from one country to another) or multilateral (from international organizations)  Program, project, technical assistance  Linked to purchase of goods and services from donor country, or in kind  Conditional in nature IMF conditionality, good governance

 Moral duty  Neocolonialism  Humanitarian intervention  Public good  National (e.g., education and health care)  International Social justice to promote world unity UN aid commitment of 0.7% of GDP  World-wide redistribution  Increased inequality word-wide  Marshall Plan after World War II 1.5% of US GDP for four years vs. 0.2% today But this Think tank in Nairobi disagrees, see

 Objectives  Individuals in donor countries vs. governments in recipient countries Who should receive the aid?  Today’s poor vs. tomorrow’s poor Aid for consumption vs. investment  Conflicts  Beneficiaries’ needs  Donors’ interests

 Aid is a recent phenomenon  Four major periods since 1950  1950s: Fast growth (US, France, UK)  1960s: Stabilization and new donors Japan, Germany, Canada, Australia  1970s: Rapid growth in aid again due to oil shocks, recession, cold war  1980s: Stagnation, aid fatigue, new methods, new thinking

 Rapid growth of development aid  US provided 50% of total ODA  To countries ranging from Greece to South Korea along the frontier of the “Sino- Soviet bloc”  France provided 30%  To former colonies, mainly in West Africa  UK provided 10%  To Commonwealth countries

 Stabilization of aid from traditional donors and emergence of new donors  US contribution decreased considerably after the Kennedy presidency ( )  The French contribution decreased starting from the early 1960s  New donors included Japan, Germany, Canada, and Australia

 Rapid growth in aid from industrial countries in response to the needs of developing countries due to  Oil shocks  Severe drought in the Sahel  The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970  The deadline for reaching that target was the mid-1970s

 Stagnation of development assistance  Donor fatigue?  Private investor fatigue?

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 United States: largest donor in volume, but low in relation to GDP  US aid amounts to 0.2% of GDP  Japan: second-largest donor in volume  Nordic countries, Netherlands  Major donors to multilateral programs  Sole countries whose assistance accounts for 0.7% of GDP  EU: leading multilateral donor

 Even though targets and agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target  Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short

 Sub-Saharan Africa and Asia have received the most aid, the former a rising amount over time  Aid to Sub-Saharan Africa is high in relation to GDP  For the 44 countries in the IMF’s Africa Department, net official transfers are as follows: < 5% of GDP: 14 countries 6%-16% of GDP: 24 countries > 20% of GDP: 6 countries

Blair Report Sachs Report  The Blair Report and the Sachs Report called on world community to increase development aid (particularly for Africa) to enable developing countries to attain the MDGs by 2015  2005 G-8 Gleneagles communiqué called for raising annual aid flows to Africa by $25 billion per year by 2010  2005 UN Millennium Project called for $33 billion per year in additional resources For comparison, US gave $20 billion in 2004, not $70 billion as suggested by UN goal

 The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donors role  What is the role of aid? macroeconomic impact  What is the macroeconomic impact of aid?  Is the impact of aid necessarily positive, or could aid have adverse consequences?

 Aid fills gap between investment needs and saving and, if well managed, can increase growth  Poor countries often have low savings and low export receipts and limited investment capacity and slow growth  Aid is intended to free developing nations from poverty traps  E.g., capital stock declines if saving does not keep up with depreciation

To understand the link between aid and investment, consider Resource Constraint Identity by rearranging the National Income Identity: Y = C + I + G + X – Z I = (Y – T – C) + (T – G) + (Z – X) private savingpublic saving foreign saving In words, investment is financed by the sum of private saving, public saving, and foreign saving  This is where aid enters the picture Aid is treated as part of government saving which increases domestic resources to finance investment. SpSpSpSp SgSgSgSg SfSfSfSf

Rearrange again: Y + Z = E + X E where E is expenditure E = C + I + G Y+ZE+X Total supply from domestic and foreign sources Y + Z equals total demand E + X ZX, incl. TR Aid increases recipient’s ability to import: Z rises with increased X, incl. TR Aid is treated as part of government saving which increases domestic resources to finance investment.

 Poor countries are trapped by poverty  Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty  Countries become stuck in poverty traps  Aid enables poor countries to free themselves of poverty by enabling them to cross the necessary thresholds to launch growth through  Saving  Technology  Human capital

all  Is it feasible to lift all above a dollar a day? How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs)  Number of people with less than a dollar a day is 1.1 billion  Their average income is 77 cents a day, they need 1.08 dollars Difference amounts to 31 cents a day, or 113 dollars per year  Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries Less than they promised! – and didn’t deliver

 Several empirical studies have assessed the impact of aid on growth, saving, and investment  The results are somewhat inconclusive  Most studies have shown that aid has no significant statistical impact on growth, saving, or investment  However, aid has positive impact on growth when countries pursue “sound policies”  Burnside and Dollar (2000)

 Regression analysis to measure the impact of aid on  Saving  Investment  Public finance  Economic growth

 Saving  Negative effect on saving Substitution effect? I.e., crowding out? Boone 1996; Reiche 1995  Positive effect for good performers E.g., South-East Asia, Botswana  Investment  No impact on private investment  Positive impact for good performers  Public finance  Uncertain effect on public investment  Positive effect on public consumption

 Growth: Mixed results  Most early studies showed no statistically significant impact  Some more recent studies show negative impact Selection bias and endogeneity issues  Need to distinguish between different types of aid  Leakages, cash vs. aid in kind

 Foreign aid has sometimes been compared to natural resource discoveries  Aid and growth are inversely related across countries  Cause and effect  156 countries, r = r = rank correlation Other people’s money

 No robust relationship between aid and growth  Aid works in “countries with good policies”  Aid works if measured correctly  Distinction between fast impact aid (infrastructure projects) and slow impact aid (education)  Infrastructure: High financial returns  Education and health: High social returns

 So, empirical evidence is mixed  Need to distinguish between different types of aid  Need to acknowledge diminishing returns to aid as well as limits to domestic absorptive capacity  Need to clarify interaction with governance and good policies  Special case: Post-conflict situations

 Aid may lead to corruption  Aid may be misused, by donors as well as recipients  Donors: Excessive administrative costs  Recipients: Mismanagement, expropriation  Aid may be badly distributed, sometimes for strategic reasons  Supporting government against political opposition

 Aid increases public consumption, not public investment  Aid is procyclical  When it rains, it pours  Aid leads to “Dutch disease”  Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows  Dutch disease may undermine external sustainability

 Aid volatility and unpredictability may undermine economic stability in recipient countries  Economic vs. social impact  Growth is perhaps not the best yardstick for the usefulness of aid  Long run vs. short run level of GDP growth of GDPParadox of Thrift E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run (Paradox of Thrift)

 Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness  In 1960s, Netherlands discovered natural resources (gas deposits)  Currency appreciated  Exports of manufactures and services suffered, but not for long  Not unlike natural resource discoveries, aid inflows could trigger the Dutch Disease in receiving countries See “Dutch Disease” in the New Palgrave Dictionary of Economics OnlineDutch Disease See “Dutch Disease” in the New Palgrave Dictionary of Economics OnlineDutch Disease

 Foreign exchange is converted into local currency and used to buy domestic goods  Fixed  Fixed exchange rate regime  Expansion of money supply leads to inflation and an appreciation of the domestic currency in real terms  Flexible  Flexible exchange rate regime  Increase in the supply of foreign exchange leads to a nominal appreciation of the currency, so the real exchange rate also appreciates

 Review theory of Dutch disease in simple demand and supply model

Foreign exchange Real exchange rate Imports Exports Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium

Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged e refers to foreign currency content of domestic currency

1.e falls 1. Suppose e falls Then more dinars per dollar, X risesZ falls so X rises, Z falls 2.P falls 2. Suppose P falls X risesZ falls Then X rises, Z falls 3.P* rises 3. Suppose P* rises X risesZ falls Then X rises, Z falls Q falls Summarize all three by supposing that Q falls X risesZ falls Then X rises, Z falls

Foreign exchange Real exchange rate Imports Exports aid Exports plus aid Aid leads to appreciation, and thus reduces exports A CB

Foreign exchange Real exchange rate Imports Exports oil Exports plus oil Oil discovery leads to appreciation, and reduces nonoil exports A CB

Foreign exchange Real exchange rate Imports Exports oil Exports plus oil Composition of exports matters A CB

 A large inflow of foreign aid -- like a natural resource discovery -- can trigger a bout of Dutch disease in countries receiving aid  A real appreciation reduces the competitiveness of exports and might thus undermine economic growth  Exports have played a pivotal role in the economic development of many countries  An accumulation of “know-how” often takes place in the export sector, which may confer positive externalities on the rest of the economy

if  Aid is likely to lead to Dutch disease if  It leads to high demand for nontradables Trade restrictions may produce this outcome Recipient country uses aid to buy nontradables (including social services) rather than imports  Production is at full capacity Production of nontradables cannot be increased without raising wages in that sector  Aid is not used to build up infrastructure and relax supply constraints  Price and wage increases in nontradables sector lead to strong wage pressure in tradables sector

 The risk that aid flows might have an adverse impact on the economy as a result of aid-induced Dutch Disease crucially depends on how aid is used in the recipient countries four  We can identify four different cases on the basis of how the aid is spent, and in which the macroeconomic implications of aid flows are different

 Aid spending can take several forms, with different macroeconomic implications:  Case 1saved  Case 1: Aid received is saved by recipient country government  Case 2used to purchase imported goods  Case 2: Aid is used to purchase imported goods that would not have been purchased otherwise (grants in kind)  Case 3used to buy nontradables with infinitely elastic supply  Case 3: Aid is used to buy nontradables with infinitely elastic supply  Case 4used to buy nontradables for which there are supply constraints  Case 4: Aid is used to buy nontradables for which there are supply constraints

 Aid received is saved by recipient country government  Aid receipts leads to accumulation of foreign exchange reserves in Central Bank … and, unlike increased aid that is spent, are not allowed to enter the spending stream  No effect on money supply  No inflation  No appreciation of nominal exchange rate  No risk of Dutch disease

 Aid is used to purchase imported goods that would not have been purchased otherwise (grants in kind)  Import purchases lead to transfer of real resources from abroad, but not to increased spending at home  No effect on money supply  No inflation  No appreciation of nominal exchange rate  No risk of Dutch disease

 Aid is used to buy domestic nontradables with infinitely elastic supply due to underutilized resources (labor and capital) in economy  Increased demand for nontradables  Because some resources are unemployed, greater demand leads to increased supply  This has a positive impact on production without increasing the price of nontradables  No risk of Dutch disease

 Aid is used to buy nontradables for which there are supply constraints, since all available resources are already in use (e.g., social services)  Increased demand for nontradables  Increased prices for nontradables  Shift of resources away from the tradables (exports) and into nontradables  Real appreciation of the currency  Dutch disease!

 Monetary policy response determines if real appreciation of currency will be caused by inflation or by nominal appreciation  If foreign currency is used to increase the reserves of the Central Bank, aid spending on nontradables leads to an increase in money supply and to inflation  If Central Bank sterilizes the impact of aid spending in nontradables on money supply by selling foreign exchange, currency appreciates in nominal terms So, in either case, currency appreciates in real terms

 To recapitulate, the risk of Dutch disease varies, and depends on CASE 1  How aid is used (saved or spent) – CASE 1 CASE 2  The presence of an aid absorption constraint – CASE 2 CASE 3  The impact of aid on productivity in the nontradable goods sector – CASE 3 CASE 4  The existence of externalities in the nontradable goods sector affecting the rest of the economy – CASE 4

 Aid can give rise to Dutch disease when the recipient country’s government uses the aid to purchase nontradables rather than imported goods and when there are constraints on increasing production in the nontradables sectors  The risk of Dutch disease is greater when aid is used in social sectors that face constraints on increasing their production due to resource scarcity (aid absorption constraint)

 How can recipient countries avoid translating aid into Dutch disease?  Save aid received and increase central bank reserves (gross, not net) by not allowing the increased aid to enter the spending stream  Use aid to purchase imported goods  Boost aid absorption capacity in the nontradables sector

 Policymakers in recipient countries need to pay attention to potential early warning signals of aid-induced Dutch disease such as  A tendency for wages and prices in the nontradables sector to increase  A decline in the profitability and sales of the export and import-competing industries

 Once more, the macroeconomic impact of aid depends critically on the policy response to aid  Interaction between fiscal policy and monetary policy is crucial  To highlight this interaction, apply two related but distinct concepts  Absorption  Absorption: Monetary policy  Spending  Spending: Fiscal policy

 Absorption  Extent to which the non-aid current account deficit widens with increased aid Captures the amount of net imports financed by an increase in aid  Given fiscal policy, absorption is controlled by Central Bank’s decision about how much of the aid-induced foreign exchange to sell in the markets If Central Bank uses the full increment of aid- induced foreign exchange to bolster reserves, aid will not be absorbed

 Spending  Extent to which the non-aid fiscal deficit widens with increased aid Captures the extent to which the government uses aid to finance an increase in expenditures  Given monetary policy, spending is controlled by the government’s decision about how much of the aid to spend, on either imports or non-traded goods If the government decides to save the full increment in aid, aid will not enter the spending stream

 Different combinations of absorption and spending define the policy response to a surge in aid inflows equivalent  Absorption and spending are equivalent if aid is in kind or if it is spent on imports differ  Absorption and spending differ when the government provides the aid-related foreign exchange to Central Bank and chooses how much to spend on domestic goods while the Central Bank decides how much of the aid- related foreign exchange to sell in markets

 Studies assessing empirical relevance of Dutch disease as caused by aid flows have produced mixed results appreciation  Aid was associated with real appreciation in Malawi and Sri Lanka depreciation  Aid was associated with with real depreciation in Ghana, Nigeria, and Tanzania

 Ethiopia, Ghana, Tanzania, Mozambique, and Uganda experienced a surge in aid (Berg et al. 2007)  The net aid increment ranged from 2% of GDP in Tanzania to 8% of GDP in Ethiopia  High everywhere, from 7% to 20 % of GDP  In Ghana, sharp increase in 2001 followed by a slump in 2002 and another surge in 2003  In all other countries, the surge in aid was persistent, i.e., after the initial jump, aid inflows remained higher than before

 In the five countries, no evidence of aid-induced Dutch-Disease  Real exchange rates did not appreciate during the aid surges  Only Ghana had a small real appreciation while the others experienced a real depreciation From 1.5% in Mozambique (2000) to 6.5% in Uganda (2001)  Why?  The macroeconomic policy response was meant to avoid a real appreciation

 Countries were reluctant to absorb the surge in aid  Only Mozambique absorbed two-thirds  Aid surge led to reserve accumulation So, currency did not appreciate in real terms  Mozambique, Tanzania, and Uganda spent most of new aid  They had attained stability, so reducing domestic financing of the budget deficit was not a major goal  Ghana and Ethiopia spent little of the aid  They had a weak record of stability and low reserves, so reducing the domestic financing of the budget deficit was a consideration not to spend aid

Two types of policy response 1. In Ethiopia and Ghana, aid impact was limited because only a small part of it was either absorbed or spent New aid was saved and reserves built up 2. In Mozambique, Tanzania, and Uganda, spending exceeded absorption, creating a pressure on prices Money supply expansion was sterilized through treasury bill sales Foreign exchange sales were kept consistent with a depreciation of currency to maintain competitiveness

 Was aid-induced Dutch disease a problem?  No evidence of significant real appreciation following surge in aid  Macroeconomic policy response (fiscal and monetary policy mix) avoided real appreciation  “Not absorb and not spend” vs. “spend more than absorb”

 The choice in some countries to “not absorb and not spend” new aid preserved competitiveness while allowing the replenishing of international reserves  The choice in some other countries to “spend more than absorb” went along with sterilization of public spending that contained inflationary pressures

 Aid can play a key role in the development of recipient countries, but it can also generate macroeconomic vulnerabilities  Recipients need to implement appropriate policies to manage aid flows to avoid macroeconomic hazards  The appropriate policy response needs to take into account Potential impact of aid on competitiveness Existence of constraints to aid absorption Risks linked to aid volatility and to external debt sustainability

Aid flows surged in Aid was volatile and unpredictable Ghana avoided Dutch disease

Aid was saved cumulatively Aid was neither absorbed nor spent on average Aid volatility translated into public investment volatility and volatile policy responses

 Aid is increasingly volatile and unpredictable  Aid flows are 6-40 times more volatile than fiscal revenue  Volatility is largest for aid dependent countries (Bulir and Hamann 2003, 2007)  Volatility increased in the 1990s  Aid delivery falls short of pledges by over 40%  Reasons for aid volatility  Donors: Changes in priorities; administrative and budgetary delays  Recipients: Failure to satisfy conditions IMF conditionality often guides donors, helping them decide if the country’s policies are on track

Impact of large sudden inflows  Supply constraints in absorbing aid  Real exchange rate overshooting and volatility  Negative impact on budget management  Negative impact on export industries  Ratcheting up spending commitments without adequate consideration of exit strategy  Infrastructure investment without adequate planning for recurrent expenditure Maintenance

Impact of aid promised, but not disbursed  Mismatch between revenues and scheduled expenditures  Spending commitments cannot be financed  Necessitates difficult expenditure choices  Aid volatility translates into public expenditure volatility  Can be costly if it compels government to cut down on, delay, or abandon productive investments  To avoid this, government may resort to printing money or borrowing  Hence, negative impact on stabilization Volatility in money supply, inflation, exchange rates

 Donors need to disburse aid according to the agreed schedule and increase transparency toward recipient country governments  Recipient countries need to respect the conditionality of development aid disbursements  Recipients need to be granted more flexibility in their choices to spend or save aid flows, specifically in light of the time span for the aid they receive  E.g., during , Ghana chose to save unexpected aid increases and to supplement its Central Bank reserves

 Millennium development goals  Projecting macroeconomic impact of various aid levels  Targeting growth rates  Quantifying new aid flows  Level and time period of assistance  Return to normal levels  Type of assistance  Impact on sectoral budgets  Current vs. capital expenditures  Recurrent cost implications

 Absorbing aid inflows  Non-aid current account deficit widens by amount of aid inflow due to direct government purchases of imports or indirect effects on trade  Spending aid inflows  Non-aid fiscal deficit rises by amount of aid inflow  Possible policy combinations  Absorbing and spending  Neither absorbing nor spending  Absorbing, but not spending  Spending, but not absorbing

SpendDon’t spend Absorb Usual assumption with wider non-aid fiscal and current account deficits Higher government spending leads to more imports Sell forex, but no fiscal change Substitute forex for domestic financing of fiscal deficit Reduce money growth and inflation Lower domestic debt and interest rates Nominal appreciation Don’t absorb Higher fiscal deficit, but reserves increase Same macro effects as higher fiscal deficits without aid Inflation or interest rates rise Reserves build up at central bank Smooth volatile aid flows Build reserves and confidence No pressure on prices or exchange rate 82

Options SpendDon’t spend Absorb Central bank balance sheet NIR 0 M 0 NDA 0 Fiscal accounts Ext fin +100 Deficit +100 Dom fin 0 Central bank balance sheet NIR 0 M -100 NDA -100 Fiscal accounts Ext fin +100 Deficit 0 Dom fin -100 Don’t absorb Central bank balance sheet NIR +100 M +100 NDA 0 Fiscal accounts Ext fin +100 Deficit +100 Dom fin 0 Central bank balance sheet NIR +100 M 0 NDA -100 Fiscal accounts Ext fin +100 Deficit 0 Dom fin

 Domestic sterilization  Sale of domestic bond instruments  Reserve requirements  Central government deposits  Sale of foreign exchange  Objectives and economic impact of policies  Nominal exchange rate vs. inflation  Domestic interest rates

Options to reduce risk of Dutch disease  Save resources  Use aid to purchase imported goods  Spend on non-traded sectors with few supply constraints Other spending options  Spend on nontradables with supply constraints Infrastructure spending for future growth Social spending for poverty reduction

 Balancing growth and poverty reduction  Growth effects from infrastructure investment  Targeting spending to the poor  Dutch disease  Improving coordination  NGO activities  Subnational government activities  Private sector capacity

 A substantial acceleration in aid flows could adversely affect the external debt sustainability of recipients grantsloans  Development aid may take the form of grants or concessional loans  Grants are unrequited transfers  Concessional loans increase outstanding debt and the amount of resources needed to service that debt

 Studies have shown that debt sustainability may deteriorate even if loans are concessional  Daseking and Joshi (2005)  It is crucial for donors to choose an appropriate mix of grants and loans in order for recipients to achieve the MDGs without undermining their external debt sustainability

 Advantages of grants  Do not increase debt burden  Useful for social projects with uncertain or delayed returns (health care, education)  Advantage of concessional loans  Mobilize more resources  Increase debt management capacity  Useful for projects yielding quick returns (infrastructure)

 Choice between grants and loans must balance the benefits of larger available resources against the risk of a heavier debt burden  Since loans force recipients to repay in future, they have an incentive to  Choose more profitable projects This leads better allocation of aid  Improve external debt management

 Efforts to find an appropriate balance between loans and grants can be based on  Project-based approach  Country-based approach

 Grants social impact  To finance investments with a significant social impact but whose return is uncertain or difficult to appropriate or which need a longer period to be profitable E.g., education and health care  Loans profits  To finance projects that yield profits more quickly E.g., infrastructure

 An appropriate balance between grants and loans is determined case by case  Based on the sustainability of recipient’s debt as well as its exposure to revenue/growth volatility  Poorest countries receive a larger proportion of aid through grants  Countries with higher growth rates and sound economic policies receive a larger proportion of loans

 Loans vs. grants  Assessing external debt dynamics  Assessing fiscal debt sustainability  DSA framework for ensuring debt sustainability  Debt and debt-service thresholds  Public enterprises; net vs. gross debt; risk of distress  Strengthening debt management

 Negative impact on budgeting, planning, and stabilization  Debt relief vs. aid  Donor commitment and transparency  Respecting conditionality  Flexibility to spend or save

 Corruption and economic performance  Impact on growth  Likelihood of disbursement  Anticorruption strategies  Reduce state role  Improve regulatory environment  Punish offenders  Liberalize and reform institutions  Improving public expenditure management systems

 Preventing aid dependency  Protecting revenues  Composition  Corruption  Tax treatment of aid  The scaling down of aid  Private economic activity  Real spending and recurrent spending

 From aid fatigue to new initiatives  Aid effectiveness is ambiguous  Positive results likely with better policies and governance  Five Primary Guidelines  Minimize risks of Dutch disease  Enhance growth – Always a good idea!  Assess the policy mix  Promote good governance and reduce corruption  Prepare an exit strategy

 Bulir and Hamann, 2003, “Aid volatility: An empirical Assessment,” IMF Staff Papers.  ______, 2007, “Volatility of Development Aid: An Update,” IMF Staff Papers.  Daseking and Joshi, 2005, Debt and New Financing in Low- Income Countries, IMF.  Isard, Lipschitz, Mourmouras, and Yontcheva, 2006, Macroeconomic Management of Foreign Aid: Opportunities and Pitfalls, IMF.  Gupta, Powell, and Yang, 2006, Macroeconomic Challenges of Scaling up Aid to Africa: A Checklist for Practitioners, IMF.  Rajan and Subramanian, 2005, “Aid and Growth: What Does the Cross-Country Evidence Really Show?,” IMF Working Paper.  ______, 2005, “What Undermines Aid’s Impact on Growth?,” IMF Working Paper.

 Definition flow of financial claims between lenders and borrowers o International capital movements refer to the flow of financial claims between lenders and borrowers o The lenders give money to the borrowers to be used now in exchange for IOUs or ownership shares entitling them to interest and dividends later  Benefits of international trade in capital specialization o Allows for specialization, like trade in commodities intertemporal trade o Allows for intertemporal trade in goods and services between countries diversification of risk o Allows for international diversification of risk

The case for free trade in goods and services applies also to capital comparative advantageeconomies of scale competition Trade in capital helps countries to specialize according to comparative advantage, exploit economies of scale, and promote competition Exporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know- how, technology volatile But financial capital is volatile

The balance of payments  R = X – Z + F where  R  R = change in foreign reserves X X = exports of goods and services Z Z = imports of goods and services F F X F Z F = F X – F Z = net exports of capital Foreign direct investment (net) Portfolio investment (net) Foreign borrowing, net of amortization X includes aid

B = X – Z The current account of the balance of payments is defined as B = X – Z Y = E + X – Z National income is Y = E + X – Z Therefore, current account is B = X – Z = Y – E Two sides of the same coin: Z > X E > Y Deficit means that Z > X and E > Y X > Z Y > E Surplus means that X > Z and Y > E

Trade in goods and services depends on Relative prices Relative prices at home and abroad Exchange rates Exchange rates (elasticity models) National incomes National incomes at home and abroad distance Geographical distance from trading partners (gravity models) Trade policy Trade policy regime Tariffs and other barriers to trade

Again, capital flows consist of foreign borrowing, portfolio investment, and foreign direct investment (FDI) Trade in capital depends on Interest rates Interest rates at home and abroad Exchange rate expectations distance Geographical distance from trading partners policy regime Capital account policy regime Capital controls and other barriers to free flows

Facilitate borrowing abroad to smooth consumption over time Dampen business cycles Reduce vulnerability to domestic economic disturbances Increase risk-adjusted rates of return Encourage saving, investment, and economic growth

Emerging countries save a little Saving Investment Real interest rate Loanable funds

Industrial countries save a lot Saving Investment Real interest rate Loanable funds

Emerging countriesIndustrial countries Saving Investment Real interest rate Borrowing Lending Loanable funds Financial globalization encourages investment in emerging countries and saving in industrial countries

 Since 1945, trade in goods and services has been gradually liberalized (GATT, WTO)  Big exception: Agricultural commodities  Since 1980s, trade in capital has also been freed up  Capital inflows (i.e., foreign funds obtained by the domestic private and public sectors) have become a large source of financing for many emerging market economies

Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP A stylized view of capital mobility Capital mobility First era of international financial integration Capital controls Return toward financial integration

112 Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.1.

Source: IMF, World Economic Outlook database.

Source: IMF WEO

Capital flows result from interaction between supply and demand pushed  Capital is “pushed” away from investor countries supply Investors supply capital to recipients pulled  Capital is “pulled” into recipient countries demand Recipients demand capital from investors

pulled Internal factors “pulled” capital into LDCs from industrial countries  Macroeconomic fundamentals in LDCs  More productivity, more growth, less inflation  Structural reforms in LDCs  Liberalization of trade  Liberalization of financial markets  Lower barriers to capital flows  Higher ratings from international agencies

pushed External factors “pushed” capital from industrial countries to LDCs  Cyclical conditions in industrial countries  Recessions in early 1990s reduced investment opportunities at home  Declining world interest rates made IC investors seek higher yields in LDCs  Structural changes in industrial countries  Financial structure developments, lower costs of communication  Demographic changes: Aging populations save more

 Institutional investors, banks, and firms in mature markets increasingly invest in emerging markets assets to diversify and enhance risk-adjusted returns (i.e., to reduce “home bias”), owing to  Low interest rates at home, high liquidity in mature markets, stimulus from “yen” carry trade  Demographic changes, rise in pension funds in mature markets  Changes in accounting and regulatory environment allowing more diversification of assets

 Institutional investors, banks, and firms in mature markets increasingly invest in emerging markets assets to diversify and enhance risk-adjusted returns (i.e., to reduce “home bias”), owing to  Sovereign wealth funds  Sovereign wealth funds (e.g., future generations funds) need to invest abroad as the domestic financial market is too small or too risky  Need to invest the windfall gains accruing to commodity producers, in particular oil producers (e.g., Norway)

 Structural changes in emerging markets  Better financial market infrastructure  Improved corporate and financial sector governance  More liberal regulations regarding foreign portfolio inflows  Stronger macroeconomic fundamentals  Solid current account positions (except in emerging European countries)  Improved debt management  Large accumulation of reserve assets

Improved allocation of global savings allows capital to seek highest returns Greater efficiency of investment More rapid economic growth Reduced macroeconomic volatility through risk diversification dampens business cycles  Income smoothing  Consumption smoothing

Open capital accounts may make receiving countries vulnerable to foreign shocks  Magnify domestic shocks and lead to contagion  Limit effectiveness of domestic macroeconomic policy instruments Countries with open capital accounts are vulnerable to  Shifts in market sentiment  Reversals of capital inflows May lead to macroeconomic crisis  Sudden reserve loss, exchange rate pressure  Excessive BOP and macroeconomic adjustment  Financial crisis

 Overheating of the economy  Excessive expansion of aggregate demand with inflation, real currency appreciation, widening current account deficit  Increase in consumption and investment relative to GDP  Quality of investment suffers  Construction booms – count the cranes!  Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend on exchange regime  Fixed exchange rate: Inflation takes off  Flexible rate: Appreciation fuels spending boom

Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.

130 Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.2. (Percent of Emerging Market GDP)

Increase in quasi-fiscal deficit Following from sterilization operations by central bank Expansion in bank lending To finance consumption and investment booms Reduced loan quality Increased maturity mismatch and foreign exchange mismatch in bank balance sheets Bidding up of asset prices: Bubbles Including those of stock market and real estate, especially in urban financial centers

Year with respect to start of inflow period Note: The index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the 1980s and 1990s and for Venezuela is shown on the right. Source: World Bank (1997). Sweden Venezuela Chile Mexico Chile Finland

Large deficits  Current account deficits  Government budget deficits Poor bank regulation  Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt  Ratio of short-term liabilities to foreign reserves Mismatches  Maturity mismatches (borrowing short, lending long)  Currency mismatches (borrowing in foreign currency, lending in domestic currency)

Guidotti-Greenspan rule

External or financial crisis followed capital account liberalization  E.g., Mexico, Sweden, Turkey, Korea, Paraguay Response  Rekindled support for capital controls  Focus on sequencing of reforms Sequencing makes a difference  Strengthen financial sector and prudential framework before removing capital account restrictions  Remove restrictions on FDI inflows early  Liberalize outflows after macroeconomic imbalances have been addressed

Transitory High degree of risk sharing Permanent No risk sharing Foreign direct investment Long term debt (bonds) Portfolio equity Short term debt

Pre-conditions for liberalization  Sound macroeconomic policies  Strong domestic financial system  Strong and autonomous central bank  Timely, accurate, and comprehensive data disclosure

 Financial globalization is often blamed for crises in emerging markets  It was suggested that emerging markets had dismantled capital controls too hastily, leaving themselves vulnerable  More radically, some economists view unfettered capital flows as disruptive to global financial stability  These economists call for capital controls and other curbs on capital flows (e.g., taxes)  Others argue that increased openness to capital flows has proved essential for countries seeking to rise from lower-income to middle- income status

 Capital controls aim to reduce risks associated with excessive inflows or outflows  Specific objectives may include  Protecting a fragile banking system  Avoiding quick reversals of short-term capital inflows following an adverse macroeconomic shock  Reducing currency appreciation when faced with large inflows  Stemming currency depreciation when faced with large outflows  Inducing a shift from shorter- to longer- term inflows

 Administrative controls  Outright bans, quantitative limits, approval procedures  Market-based controls  Dual or multiple exchange rate systems  Explicit taxation of external financial transactions  Indirect taxation E.g., unremunerated reserve requirement  Distinction between inflowsoutflows  Controls on inflows and controls on outflows  Controls on different categories of capital inflows

 IMF (which has jurisdiction over current account, not capital account, restrictions) maintains detailed compilation of member countries’ capital account restrictions  The information in the AREAER has been used to construct measures of financial openness based on a 1 (controlled) to 0 (liberalized) classification  They show a trend toward greater financial openness during the 1990s  But these measures provide only rough indications because they do not measure the intensity or effectiveness of capital controls (de jure versus de facto measures)

 Aid and other capital flows can play an important role in the growth and development of recipient countries …  … but it can also create vulnerabilities  Recipient countries need to manage aid and other capital flows so as to avoid hazards  Need to consider potential impact of aid on competitiveness, constraints to aid absorption, and risks linked to aid volatility and to external debt sustainability  Need sound policies and effective institutions, incl. financial supervision, and good timing THE END These slides will be posted on my website: