© World Health Organization 2007
The comments and suggestions of C. Lane, B. Killen and R. Dodd are gratefully acknowledged.
Thanks are also due to Pat Butler for editorial assistance.
The views expressed in this "Technical Brief for Policy-Makers" are those of the authors, and do not necessarily reflect the official position of the World Health Organization.
AID FOR HEALTH:
SHOULD POLICY-MAKERS WORRY ABOUT ITS
MACROECONOMIC IMPACT?
by
Eleonora Cavagnero, David B. Evans, and Guy Carrin
GENEVA 2007
3
AID FOR HEALTH: SHOULD POLICY-MAKERS WORRY ABOUT ITS MACROECONOMIC IMPACT?
Many developing countries need to substantially increase expenditure if they are to achieve significant improvements in population health, and financial assistance provided by multilateral or bilateral external partners is becoming a major source. However, a large increase in such aid could theoretically lead to increased inflation, problems with the balance of payments and slower growth. This policy brief examines the possible effects of aid flows on the wider economy, and suggests that it is possible to minimize and even eliminate any possible adverse effects. Countries should not, in general, be concerned about accepting more aid for health from this perspective.
Many developing countries need to substantially increase expenditure if they are to achieve significant improvements in population health, such as those targeted by the Millennium Development Goals. In most countries this will mean that both overall health spending and government health spending need to increase.
In order to increase their health spending, governments need to create fiscal space, i.e. to be able to make available the desired resources without threatening economic stability (see the forthcoming Technical brief for Policy-Makers). One way of doing this for health, is simply to allocate a greater share of the overall government budget to health. In 2000, for example, African Heads of State, through the Organization of African Unity, agreed to allocate at least 15% of their national budgets to the health sector, in the Abuja Declaration on HIV/AIDS, tuberculosis, malaria and other infectious diseases. Other ways of creating fiscal space more broadly include: (i) mobilizing additional domestic revenues by raising tax rates, increasing the tax base, or being more efficient in tax collection; (ii) improving the efficiency of public spending and reducing waste and corruption; (iii) increasing borrowing; (iv) seeking debt relief and (v) increasing donor funds and ensuring more predictability.
Almost all the countries with the most pressing health needs are relatively poor, and unlikely to be able to raise the necessary funds exclusively from domestic sources in the short to medium term. Increased aid will be required to supplement domestic funds. This option is the focus of this policy brief.
The effects of increased aid
There is a concern that the arrival of large amounts of external aid could lead to macroeconomic instability, regardless of whether this aid is channelled through the government or the nongovernmental sector. A rapid increase in foreign exchange earnings could, in theory, lead to upward pressures on prices (i.e. inflation), and an
5 increase in the real exchange rate (appreciation). In turn, this may cause exports to become less competitive, resulting in a lower economic growth rate.
Economic theory suggests that inflows of foreign exchange can influence many economic variables, including interest rates and the price of government bonds. However, attention is most commonly focused on inflation, the real exchange rate and the economic growth rate.
Impact on domestic demand and prices
Inflows of foreign exchange made available through aid will be used to purchase goods and services. Some will be used to purchase imports, such as drugs; some will purchase local goods that are also exported, e.g. agricultural products, such as coffee; and some will be used to purchase domestic goods and services that are not exported, e.g. labour.
Most countries are too small in relation to the global economy for the increase in domestic demand to increase the price of imported goods although the increase in the cost of labour in particular could well increase the cost of producing exported goods.
As a result of increases in the prices of non-traded goods and possibly exported goods, domestic inflation may increase. Moreover, the reduced profitability of exported goods due to the higher cost, and the higher profitability of non-traded good due to their higher prices, leads to a switch in domestic production from exports to the production of goods for local consumption. This reduces foreign exchange earnings.
Governments can also seek to control inflation through a tighter monetary policy, i.e. by increasing interest rates. This makes it more expensive to borrow money and dampens down both consumption and investment. However, this could have a negative impact on growth, as discussed below.
Impact on international competitiveness
As explained above, the prices of domestic non-traded goods and services are likely to increase with the arrival of high levels of aid and this might flow into the prices of exports. In small countries in particular, this increase in prices will, in the short term, be reflected in a rise (appreciation) in the real exchange rate (RER). The RER differs to the nominal exchange rate and sounds complicated, though the concept is relatively simple.
It is a measure of trade competitiveness, which compares the price of a basket of domestic goods with the price of a basket of foreign goods.
The increase in the price of domestic goods means that domestic consumers will want to shift from domestically produced to foreign goods whenever possible, reducing a country's foreign exchange reserves. The combination of a switch of production from exported goods to goods aimed at domestic consumption, inflation and an appreciation of the RER has sometimes been called Dutch disease, after the macroeconomic impact of inflows of foreign exchange to the Netherlands in the 1960s, linked to the discovery of natural gas. It is of concern because high levels of inflation are not conducive to economic growth. Moreover, open trading economies are commonly believed to grow
6 increase production in the longer run, stimulating growth and generating foreign exchange. Investments in health, education, water supply, sanitation, and human capital in general will increase productivity as will investments in physical capital.
Impact on growth
If inflation leads to an increase in interest rates and appreciation in the RER, there would be negative pressure on economic growth. This would be offset, at least to some extent, by the increased expenditure resulting from the inflow of foreign exchange. Moreover, in countries where there is high unemployment or underemployment, and where other types of excess production capacity exist, inflows are unlikely to result in large general wage increases or in a RER appreciation. Rather, they would simply create additional employment and stimulate production.
In the longer run, investments that increase productivity could reduce or even eliminate any price increases. The contribution of aid to overall productivity will depend on what proportion is used to finance investments in infrastructure, sanitation, education, and health projects. Nonetheless in order to foster growth aid must be sustained and predictable until the benefits of the investments are realized. However, aid has traditionally been very unpredictable and quite volatile, especially, for the poorest countries, which are in turn those most dependent on aid. This unpredictability has meant that ministries of finance have been quite reluctant to allow ministries of health to make long term spending commitments from aid inflows, which would improve productivity and stimulate economic growth.
Country experiences
The evidence from countries is mixed, but there is no consistent relationship between aid, inflation and RER appreciations. In some countries such as Malawi, Pakistan and Sri Lanka, the Dutch disease phenomenon has been observed. However, in others, such as Ethiopia, Mauritania, Mozambique, Nigeria and Sierra Leone, no evidence of weakness in the export sector or economic stagnation is evident after an increase in aid flows.
A few countries, such as Ghana, Uganda and the United Republic of Tanzania, have initially shown signs of the Dutch disease phenomenon but were able to reverse the situation by following sound fiscal and monetary policies. The experiences of different countries are summarized in Table 1.
7 Implications for ministries of health
In theory, it is possible that inflows of foreign exchange could increase inflationary pressures, cause real exchange rate appreciation and reduce economic growth. However, there are ways of overcoming these effects and the experience of a number of countries suggests that, if the aid is used appropriately and if domestic fiscal and monetary policies are well adapted, these effects can be kept to a minimum. In some settings, they have even been totally eliminated, and economic growth has increased after the arrival of external funding.
Ministries of health need to be aware that there is little argument for restricting the use of foreign aid provided by external partners on the grounds of Dutch disease. Moreover, they should be aware that Dutch disease can be prevented by spending the available inflows on economically productive activities, and there is now general consensus internationally that health expenditures can stimulate economic growth. WHO/HSF can help ministries of health to make the case that investments in health stimulate economic growth if they need assistance. Obviously spending on infrastructure, or on imported drugs or equipment, is another way of ensuring that Dutch disease is avoided.
At the same time, it is important for ministries to ensure the efficient use of the new resources that are channelled through government - this effectively increases the fiscal space available to the health sector. International partners also have an important role to play. Donor funding has been very unpredictable, to the extent that ministries of finance have been reluctant to allow these funds to be used to build physical infrastructure or invest in human capital on the grounds that they cannot be certain the funds for upkeep will be available in the future. More predictable flows of donor funding will allow more investment in physical and human capital, something that will also contribute to ensuring there are few harmful macroeconomic effects of increases in aid.
8
1 RER= real exchange rate
infrastructure and human capital.
Mauritania 1999–2002 Since 1995 the RER1 has steadily depreciated as a result of inflows of external aid. Inflation was controlled.
Mozambique 2000–2002 During the years of aid surge, the RER depreciated and export performance was strong.
Nigeria 1960–1990 Aid inflows were related to RER depreciation and growth of non-oil exports.
Sierra Leone 2002–2003 The RER depreciated, partly reflecting the relief provided after the war. Inflation was substantially reduced.
1967–1993 1996–2000 2000–2003
The RER depreciated sharply in 1985–93, despite a significant increase in aid inflows.
In the second half of the 1990s, aid resulted in an RER appreciation of 25%.
After 2000 the Bank of Tanzania was able to reverse the appreciation. Exports in all sectors increased.
No Dutch disease
1970–1996 1991–2001 2000-2003
A small but positive relation between aid inflows and the appreciation of the real exchange rate was found.
However, between 1991 and 2003 the RER remained broadly stable and non-traditional exports increased remarkably. There was not increase in inflation.
United Republic of
Tanzania
Uganda
Ghana
1981–1987
2001–2003
Aid inflows were associated with high inflation and appreciation of RER.
However, between 2001-2003, as a result of sound policies, Dutch disease was avoided and a very small real appreciation was observed. Inflation declined.
Malawi 1990–1998 Exports decreased as a consequence of the appreciation of RER due to high inflows of aid.
Pakistan 1970–1990 Aid inflows generated fairly strong Dutch disease, with a decrease in exports and loss of
competitiveness.
Dutch disease
Sri Lanka 1974–1988 Inflows of external funds were associated with inflation and Dutch disease phenomenon.
