The donor community has pledged to double aid to Africa by 2010. This presents Africa with great opportunities. But it can also make life harder for exporters and the private sector. Their production costs will have to be lowered but can aid help achieve that?

An article in the journal Development Policy Review, examines how African governments might manage large and increasing aid inflows.

A thriving commercial sector is vital to Africa’s future development. Aid can help the private sector in two main ways: improvements to physical infrastructure (roads, ports, telecommunications and power) can help directly while social sector investments can provide an educated, healthy workforce.

But large aid increases coming on top of the already heavy reliance on aid, can have negative economic effects. In 2004, the ratio of aid to national income in the top half of Africa’s aid recipients averaged 22 percent. Doubling aid by 2010 would result in levels between 29 and 35 percent.

The central issue addressed by the researchers is: aid creates extra local liquidity. It only adds to a recipient country’s resources to the extent that it is used to finance extra imports. Most aid goes to governments but most imports are attributable to the private sector. To induce businesses and consumers to use more imports it will probably be necessary to make them cheaper and that may entail an appreciation of the exchange rate, making foreign currencies cheaper relative to the national currency. But doing that will be detrimental to exporters, whose profits will be eroded.

Central banks will try to avoid this currency appreciation by cutting back on credit and raising interest rates. This too will have an adverse effect on the private sector. Either way, the private sector is at risk. Using extra aid to improve the business environment is the best long-term way of off-setting the risk. But past aid has not shown great ability to reduce producers’ costs in this way and more aid is nowadays being channelled into social services, with little going to directly productive sectors.

The researchers review the responses of seven African governments to earlier episodes of large aid increases: Ethiopia, Ghana, Mauritania, Mozambique, Sierra Leone, Tanzania and Uganda.

Key findings include:

• Aid inflows are not completely absorbed by extra imports: in most cases, extra government spending exceeded the increase in net imports, creating an inflationary potential.
• Although it does not seem aid inflows so far have pushed up the real exchange rate or prices, larger further aid might.
• Aid inflows are not getting through to the private sector or being used by the government to promote private sector development.

The policy implications of the research include:

• Governments should take up policies to raise productivity in the private sector, particularly exporters, for example, through infrastructure investments and trade liberalisation.
• Strong public institutions will be necessary to manage aid effectively.
• Donors should review the balance between aid used for social services and more directly productive purposes.
• Donors should ensure that governments have well-prioritised spending plans and effective ways of dealing with increases in foreign exchange.

Source(s):
‘The Macroeconomics of Doubling Aid to Africa and the Centrality of the Supply Side’, Development Policy Review, 25.2, pages 167-192, by Tony Killick and Mick Foster, 2007
Free online access to this article for HINARI subscribers Full document.

Funded by: UK Department for International Development

id21 Research Highlight: 15 Aug 2007

Further Information:
Tony Killick
Karibu, Standard Hill,
Ninfield
Battle TN33 9JU
United Kingdom

Tel: + 44 (0)1424 892184
Fax: + 44 (0)1424 893873
Contact the contributor: t.killick@odi.org.uk

Overseas Development Institute, UK