Monetary Policy for Aid-Receiving
Countries
Matías Vernengo
Introduction



Most people would recognize the moral imperative of the world’s rich
to help the world’s poor. Even the anti-aid lobby accepts the notion that
humanitarian aid flows are important and useful in averting crisis, but
they believe it should not be used for long-term economic
development.
Over the last decade an intense debate on the effects of aid has led to
a more critical view of its effects on long term economic development.
Rajan and Subramanian (2005) suggest that aid inflows lead to
overvaluation of domestic currencies, and reduce external
competitiveness. In this view, a type of financial Dutch Disease is
behind the poor correlation between aid inflows and growth.
Monteray Policy: Theoretical Problems



There is a consensus that aid inflow may lead to an overvaluation of
the currency, but there is a clear disagreement about what countries
should do in that case.
Historically aid inflows are very volatile and monetary policy must be
used to minimize the effects of aid volatility on foreign exchange
markets and the balance of payments.
Rajan and Subramanian (2005) argue that aid inflows, which increase
the supply of foreign exchange, lead to an appreciation of the
currency, and, thus, foreign aid can hurt the traded sector and lead to
lower rates of growth (Dutch Disease).
Conventional View


An increase in aid inflows leads to an increase in money supply. This
situation is associated to a worsening of the trade balance, since the
increase in money supply reduces interest rates and stimulates
consumption. Consumption, in turn, promotes higher imports and a
negative impact on the trade balance.
In this view, if the central bank sells bonds to sterilize the increase in
money supply, it would undo the negative effects of aid inflows. Also,
foreign aid can be given as budgetary support, and fiscal spending can
be delayed, maintaining or even improving fiscal balances. In other
words, fiscal policy should be contractionary and complement the
contractionary monetary stance.
Alternative View


Aid inflows lead to an appreciation of the exchange rate. In contrast to
the conventional model, contractionary monetary policy, by raising the
rate of interest leads to an appreciation of the exchange rate. In
particular, if sterilization leads to lower prices for bonds and higher
rates of interest, then it leads to an appreciation of the currency. In
other words, contractionary monetary policy compounds the
appreciation caused by aid inflows, and further reduces the external
competitiveness of the economy.
It is possible that aid inflows go hand in hand with a depreciation of the
currency, if the effect of inflows on the exchange rate is relatively
small, and if money supply is not completely sterilized and, more
importantly, the central bank is not concerned about possible
inflationary pressures. In that case, a more loose monetary policy may
be pursued in spite of aid inflows, and lower rates of interest would
lead to depreciation.
Policies Compared



There might be a policy dilemma in the situation that monetary laxity is
required to maintain a depreciated exchange rate, and monetary
contraction is required because the economy is over-heated.
In the alternative model, an expansionary monetary policy, rather than
a contractionary one, is needed to maintain a competitive exchange
rate. This is probably the most significant difference in the two models.
This implies that one possible policy alternative would be to try to
maintain the exchange rate as depreciated as possible without leading
to inflationary pressures, what has been termed a stable but
competitive real exchange rate (SCRER) strategy (Frenkel and Taylor,
2006).
Aid and Overvaluation: Empirical
Relation


Rajan and Subramanian (2005) studied the relation between aid and
overvaluation, and found that there was a strong correlation. Also,
they tested the strength of the correlation and concluded that it
becomes stronger over time, in particular, the correlation was stronger
in the 1990s than in the previous two decades.
We find similar effects for a set of 74 countries in a cross country
regression. We find that an increase of 1 percent in the aid-to-GNI
inflow leads to an overvaluation of almost 1.6 percent of the domestic
currency. It is important to note, however, that an increase in 1 percent
of the aid-to-GNI inflow is sizeable whereas an appreciation of 1.6
percent is relatively small.
400
Real Overvaluation = 104.7 + 1.6 Aid
(20.8) (2.6)
300
32
200
73
59
646952
58
61
0
100
47
4349
66
48
63
35
62
27
68 29 20
39
22
41
26 74
51
45
34
65 44 42
33 30
6 46 55
70
18
40
60
28
5 19
56
21
25 15
388 71
54 7
53 57
1731224
37
13
36
1
9
14
50
31
23
164 11 2 10
72
67
0
10
20
aid
overvalue
30
Fitted values
40
Problems with the empirical analysis


However, the correlation vanishes when we break it by regional sets.
There is no correlation between aid and real overvaluation in Asian
and African cross-country data. The negative correlation suggests that
the opposite might be the case, and that aid inflows are associated
with real depreciation. However, the correlations are not significant in
statistical terms.
It seems that the general positive correlation is fundamentally
associated to the Latin American experience. One possible conjecture
about the strong correlation between real exchange rate overvaluation
and aid inflows in Latin America may be associated to a greater
concern with high inflation in the region. The long history of high
inflation might have produced an environment in which central banks
are overly cautious about inflationary pressures. In that case, it is likely
that relatively contractionary policies might have been pursued more
often in the region. If this is the case the Latin American experience
cannot be extended to other regions.
120
Asian Countries
ISR
IRN
100
KOR
SYR
JOR
TURIND
PHL
80
SGP
MYS
BHR
LKA
PAK
NPL
THA IDN
60
BGD
0
5
10
aid
overvalue
Fitted values
15
200
ZMB
COG
CMR
EGY
150
NGA
SLE
MRT
CIV
NER
SDN
DZAZWE
GAB
100
BFA RWA
TCD
GMB
BDI TZA
SEN CAF
ZAR KEN TGO
MAR BWA
LSO
TUN
MWI
GHAMDG GIN
ETH
UGA
ZAF
50
Real Overvaluation
250
African Countries
MOZ
0
10
20
Foreign Aid %GNI
overvalue
30
Fitted values
40
400
Latin American Countries
200
300
NIC
HND
BOL
SUR
HTI
0
100
SLV
CHL
ECU
PER
PAN
JAM
ARG
BRA
VEN BRB DOM
CRI
URY
TTO
MEX
COL
0
5
10
aid
overvalue
Fitted values
15
Conclusions



If one is concerned with the effect of scaling up aid inflows to finance
the HIV/AIDS pandemic it seems that Sub-Saharan Africa is the main
region that one must be concerned with, as indicated by the HIV
prevalence rates.
It would be particularly problematic if contractionary monetary policy is
used to control inflation, and restrict the possible effects on the
exchange rate in a region in which there is no evidence for
overvaluation.
The HIV/AIDS pandemic may very well have significant effects on
productivity and human development. Human capital development
would have a positive impact on productivity, which in turn would
translate into lower unit labor costs and higher competitiveness. Thus,
an expansionary monetary policy that supports fiscal expansion
associated with the combat of the pandemic may actually increase
labor productivity and reduce the risks of inflation and currency
overvaluation, which are often cited as reasons for monetary
contraction.