Thorvaldur GylfasonStellenbosch, South Africa

2-13 November 2009

Capital flowsHistory, theory, evidence

Foreign aidEffectiveness: Does aid work?Macroeconomic challenges

Dutch disease Aid volatility

Policy options in managing aid flows Preparing for scaling up aid Monetary and fiscal policy options Debt sustainability Governance issues

Conclusions and guidelines

3

Definitiono International capital movements refer to the flow flow

of financial claims between lenders and borrowersof financial claims between lenders and borrowerso 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 capitalo Allows for specializationspecialization, like trade in

commoditieso Allows for intertemporal trade intertemporal trade in goods and

services between countrieso Allows for international diversification of riskdiversification of risk

11

The case for free trade in goods and services applies also to capital

Trade in capital helps countries to specialize according to comparative advantagecomparative advantage, exploit economies of scaleeconomies of scale, and promote competitioncompetitionExporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technologyBut financial capital is volatilevolatile

The balance of payments R = X – Z + FR = X – Z + Fwhere

RR = change in foreign reservesXX = exports of goods and servicesZZ = imports of goods and servicesFF = FFXX – FFZZ = net exports of capital

Foreign direct investment (net)

Portfolio investment (net)

Foreign borrowing, net of amortization

X includes aid

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 abroadGeographical distancedistance from trading

partners (gravity models)

Trade policy Trade policy regimeTariffs and other barriers to trade

Again, capital flows consist of foreign borrowing, portfolio investment, and foreign direct investment (FDI)

Trade in capital depends onInterest rates Interest rates at home and abroad

Exchange rate expectationsExchange rate expectationsGeographical distancedistance from trading

partnersCapital account policy regimepolicy regime

Capital controls and other barriers to free

flows

Facilitate borrowing abroad to smooth consumption over timeDampen business cyclesReduce vulnerability to domestic economic disturbancesIncrease risk-adjusted rates of returnEncourage saving, investment, and economic growth

Emerging countries save a little

Saving

Investment

Real

inte

rest

rate

Loanable funds

Industrial countries save a lot

Saving

Investment

Real

inte

rest

rate

Loanable funds

Emerging countries

Industrial countries

Saving

Saving

Investment Investment

Real

inte

rest

rate

Real

inte

rest

rate

Borrowing

Lending

Loanable funds 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 8846.

A stylized view of capital mobility 1860-2000

Cap

ital

m

ob

ilit

y

First era of internationa

l financial integration

Capital controls

Return toward

financial integration

15

Sourc

e:

IMF

WEO

, O

ct.

200

7,

Chapte

r 3

, Fi

gure

3.1

.

-50

50

150

250

350

450

550

0

10

20

30

40

50

60

70

80

Net private capital flows

cumulative share of selected countries as a proportion of total net private capital flows to emerging markets

Source: IMF, World Economic Outlook database.

-250

-150

-50

50

150

250

350

450

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

USD

Bil

Bank loans and other Net portfolio investment Net foreign direct investment

Source: IMF, World Economic Outlook database.

Source: IMF WEO

Africa: Net Capital Flows 1980-2008Africa: Net Capital Flows 1980-2008

-20

-10

0

10

20

30

40

50

Bill

ions

of U

SD ($

)

0

50

100

150

200

250

300

Deb

t Rat

ios i

n Pe

rcen

t (%

)

Direct investment, net (left axis) Other private, net (left axis)

Official capital flows, net (left axis) Debt Service/Exports of G&S (right axis)

Capital flows result from interaction between supply and demandCapital is “pushedpushed” away from investor countries Investors supplysupply capital to recipients

Capital is “pulledpulled” into recipient countriesRecipients demanddemand capital from

investors

Internal factors “pulledpulled” capital into LDCs from industrial countries

Macroeconomic fundamentals in LDCsMore productivity, more growth, less

inflation Structural reforms in LDCs

Liberalization of tradeLiberalization of financial markets Lower barriers to capital flows

Higher ratings from international agencies

External factors “pushedpushed” capital from industrial countries to LDCs

Cyclical conditions in industrial countriesRecessions in early 1990s reduced investment

opportunities at homeDeclining 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

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 returnsGreater efficiency of investment More rapid economic growthReduced macroeconomic volatility through risk diversification dampens business cyclesIncome smoothingConsumption smoothing

Open capital accounts may make receiving countries vulnerable to foreign shocks Magnify domestic shocks and lead to contagionLimit effectiveness of domestic macroeconomic

policy instrumentsCountries with open capital accounts are vulnerable to Shifts in market sentiment Reversals of capital inflowsMay lead to macroeconomic crisisSudden reserve loss, exchange rate pressureExcessive BOP and macroeconomic adjustmentFinancial 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.

-3 -2 -1 0 1 2 3 4 5 6 70

100

200

300

400

500

600

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

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 1978-81 Mexico

Chile 1989-94

Finland

Large deficitsCurrent account deficitsGovernment budget deficits

Poor bank regulationGovernment guarantees (implicit or explicit),

moral hazard

Stock and composition of foreign debtRatio of short-term liabilities to foreign reserves

MismatchesMaturity mismatches (borrowing short, lending

long)Currency mismatches (borrowing in foreign

currency, lending in domestic currency)

Guidotti-Greenspan rule

Source: Finance and Development, September 1999.

Mexico, '93-95

Korea, '96-97

Mexico, '81-83

Thailand, '96-97

Venezuela, '87-90

Turkey, '93-94

Venezuela, '92-94

Argentina, '88-89

Malaysia, '86-89

Indonesia, '84-85

Argentina, '82-83

0 10 20 30 40 50 60Billion dollars

10% of GDP

12% of GDP

9% of GDP

18% of GDP

15% of GDP

11% of GDP

6% of GDP

10% of GDP

7% of GDP

5% of GDP

4% of GDP

External or financial crisis followed capital account liberalization E.g., Mexico, Sweden, Turkey, Korea, Paraguay,

Iceland

Response Rekindled support for capital controls Focus on sequencing of reforms

Sequencing makes a differenceStrengthen financial sector and prudential framework before removing capital account restrictionsRemove restrictions on FDI inflows earlyLiberalize outflows after macroeconomic imbalances have been addressed

Transitory

High degree of risk sharin

g

Permanent

No risk

sharing

Foreign direct

investment

Long term debt

(bonds)

Portfolio equity

Short term debt

Pre-conditions for liberalizationSound macroeconomic policiesStrong domestic financial systemStrong 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 stabilityThese 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 includeProtecting a fragile banking systemAvoiding 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 controlsOutright bans, quantitative limits, approval

procedures Market-based controls

Dual or multiple exchange rate systemsExplicit taxation of external financial

transactions Indirect taxation

E.g., unremunerated reserve requirement Distinction between

Controls on inflowsinflows and controls on outflowsoutflowsControls 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)

Capital flows can play an important role in economic growth and developmentBut they can also create

macroeconomic vulnerabilities Recipient countries need to

manage capital flows so as to avoid hazardsNeed sound policies as well as effective

institutions, including financial supervision, and good timing

Development aid 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%

22

Development aid can bePublic or privateBilateral (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 redistributionIncreased inequality word-wideMarshall Plan after World War II

1.5% of US GDP for four years vs. 0.2% today

Think tank in Nairobi disagrees, see www.irenkenya.com

ObjectivesIndividuals in donor countries vs. governments in recipient countriesWho should receive the aid?

Today’s poor vs. tomorrow’s poorAid for consumption vs. investment

ConflictsBeneficiaries’ needsDonors’ 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, Australia1970s: Rapid growth in aid again due to oil shocks, recession, cold war

1980s: Stagnation, aid fatigue, new methods

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 (1961-63) 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 shocksSevere drought in the Sahel

The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970The deadline for reaching that target

was the mid-1970s

Stagnation of development assistanceDonor fatigue?Private investor fatigue?

56

United States: largest donor in volume, but low in relation to GDPUS aid amounts to 0.2% of GDP

Japan: second-largest donor in volume

Nordic countries, Netherlands Major donors to multilateral programsOnly 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

0

5

10

15

20

25

30

35

40

sub-Saharan Africa

Asia Oceania MEDA Latin America Europe

1985 1990 2000

The Blair Report Blair Report and the Sachs Sachs ReportReport 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

Aid fills gap between investment needs and saving and increases growthPoor 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 trapsExample: Capital stock declines if saving does not keep up with depreciation

The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donorsWhat is the role of aid? What is the macroeconomic impact of

aid? Is the impact of aid necessarily positive,

or could aid have adverse consequences?

To understand the link between aid and investment, consider resource constraint identity by rearranging the National Income Identity:

Y = C + I + G + X – ZY = C + I + G + X – ZI = (Y – T – C) + (T – G) + (Z – X)I = (Y – T – C) + (T – G) + (Z – X)

In words, investment is financed by the sum of private savingprivate saving, public savingpublic saving, and foreign savingforeign saving

Aid is treated as part of government saving which increases domestic resources to finance investment.

Rearrange again:

Y + Z = E + XY + Z = E + X

where EE is expenditure

E = C + I + GE = C + I + G

Total supply from domestic and foreign sources YY ++ ZZ equals total demand EE ++ XX

Aid increases recipient’s ability to import: ZZ rises with increased XX

Aid is treated as part of government saving which increases domestic resources to finance investment.

Poor countries are trapped by povertyDriving 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 growthSavingTechnologyHuman capital

Is it feasible to lift allall 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 billionTheir 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 inconclusiveMost 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 onSavingInvestmentPublic finance Economic growth

Saving Negative effect on saving

Substitution effect? Boone, 1996; Reichel, 1995

Positive effect for good performers E.g., South-East Asia, Botswana

InvestmentNo impact on private investmentPositive impact for good performers

Public financeUncertain effect on public investmentPositive effect on public consumption

Growth: Mixed results Most early studies showed no statistically significant impact

Some more recent studies show negative impact

Bias and endogeneity issues Need to distinguish between

different types of aidLeakages, cash vs. aid in kind

Foreign aid has Foreign aid has sometimes been sometimes been compared to compared to natural resource natural resource discoveriesdiscoveries

Aid and growth are inversely related across countries

Cause and effect 156 countries,

1960-2000

-8

-6

-4

-2

0

2

4

6

-20 0 20 40 60 80

Foreign aid (% of GDP)

Per

cap

ita g

row

th a

djus

ted

for

initi

al in

com

e (%

) r = -0.36

r = rank correlation

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 returnsEducation 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 costsRecipients: Mismanagement, expropriation

Aid is badly distributed, sometimes for strategic reasonsSupporting government against political

opposition

Aid increases public consumption, not public investment

Aid is procyclicalWhen 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 countriesEconomic vs. social impact

Growth is perhaps not the best yardstick for the usefulness of aidLong run vs. short run

E.g., increased saving reduces level of level of GDP GDP in short run, but increases growth of GDPgrowth of GDP in long run

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 Online

Review theory of Dutch disease in simple demand and supply model

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports

Earnings from exports of goods, services, and capital

Payments for imports of goods, services, and capital

Equilibrium

*P

ePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports

Exports plus aidaid

Aid leads to appreciation, and thus reduces exports

A

C B

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports

Exports plus oiloil

Oil discovery leads to appreciation, and reduces nonoil exports

A

C B

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports

Exports plus oiloil

Composition of exports matters

A

C B

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 growthExports 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

Aid spending can take several forms, with different macroeconomic implications:Case 1: Aid received is saved by recipient

country government Case 2: Aid is used to purchase imported

goods that would not have been purchased otherwise (grants in kind)

Case 3: Aid is used to buy nontradables with infinitely elastic supply

Case 4: Aid is used to buy nontradables for which there are supply constraints

Studies assessing empirical relevance of Dutch disease as caused by aid flows have produced mixed resultsAid was associated with real appreciation in Malawi and Sri Lanka

Aid was associated with with real depreciation in Ghana, Nigeria, and Tanzania

Ethiopia, Ghana, Tanzania, Mozambique, and Uganda experienced a surge in aid 1998-2003 (Berg et al. 2007)The net aid increment ranged from 2% of

GDP in Tanzania to 8% of GDP in EthiopiaHigh 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-DiseaseReal exchange rates did not

appreciate during the aid surgesOnly 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 aidOnly Mozambique absorbed two-thirdsAid 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 response1. 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 up2. 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 aidMacroeconomic policy response (fiscal

and monetary policy mix) avoided real appreciation

“Not absorb and not spend” vs. “spend more than absorb”

Advantages of grantsLower debt burdenUseful for social projects with uncertain

or delayed returns (health care, education)

Advantage of concessional loansIncrease total flow of resourcesProject allocationIncrease debt management capacityUseful for projects yielding quick returns

(infrastructure)

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 hazardsThe 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 is increasingly volatile and unpredictableAid flows are 6-40 times more volatile than

fiscal revenueVolatility is largest for aid dependent

countries (Bulir and Hamann 2003, 2007)Volatility increased in the 1990sAid 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 inflowsSupply constraints in absorbing aidReal exchange rate overshooting and volatilityNegative impact on export industriesRatcheting up spending commitments without

adequate consideration of exit strategy Infrastructure investment without adequate

planning for recurrent expenditure

Impact of aid promised, but not disbursedSpending commitments cannot be financedVolatility in money supply, inflation, and

exchange rates

From aid fatigue to new initiatives Aid effectiveness is ambiguous

Positive results likely with better policies and governance

Five Primary GuidelinesMinimize risks of Dutch diseaseEnhance growthPromote good governance and reduce

corruptionPrepare an exit strategyAssess the policy mix

Aid can play an important role in the growth and development of recipient countries …… but it can also create macroeconomic

vulnerabilities Recipient countries need to

manage aid flows so as to avoid hazardsNeed to consider potential impact of aid on

Competitiveness Constraints to aid absorption Risks linked to aid volatility and to external

debt sustainability

THE END

These slides will be posted on my website: www.hi.is/~gylfason