Measuring the Cost of Aid Volatility

EDITOR’S NOTE: Flows of official development assistance to recipient countries have been highly volatile and this reduces their value, says Homi Kharas, senior fellow at the Brookings Institution’s Wolfensohn Center for Development. In his paper, Kharas notes that donor policies contribute to aid volatility, and he develops a metric for policy makers to measure the cost of aid volatility. A few excerpts:

Recent work has shown that aid flows to developing countries are highly volatile, much more so than other macroeconomic variables such as public sector revenues, consumption or Gross Domestic Product (GDP) (Pallage and Robe 2001, Bulir and Hamann 2006, Fielding and Mavrotas 2005). This volatility has been of great concern to researchers and policy makers: it is well known that volatility has a cost. More recently, the Paris Declaration on Aid Effectiveness-an agreement in March 2005 of more than 100 ministers and senior aid agency officials-underscored the determination of aid donors to make aid more predictable.

Despite this determination, there has not been much progress in actually reducing aid volatility and some researchers, like Bulir and Hamann (2006), have argued that aid volatility has actually become worse in recent years. This is disappointing as the benefits from reducing volatility and using aid as a smoothing device are thought to be very high. Pallage, Robe and Berube (2006) conclude that the welfare gain from improving the timing of aid flows could reach 5.5 percent of permanent consumption in aid-recipient countries. In this paper we propose a metric for measuring aid volatility with a focus on aid as a smoothing device for developing countries.

Several studies have documented the cost of aid volatility and the channels through which this operates. This literature systematically suggests that volatility is costly, particularly in less developed countries with weak institutions.

Despite this evidence, aid volatility has not been taken seriously by policymakers. There are several explanations as to why.

First, the policy conclusion from the finding that high aid volatility reduces growth is blurred. A second problem is that not all aid volatility is bad. A third problem is that the nature of evidence on the costs of aid volatility is often questioned.

In this paper, we try to overcome these problems by applying a new approach based on a capital asset pricing model (CAPM) to calculate the deadweight loss from aid volatility. Such an approach provides a simple, quantitative measure of the cost of aid volatility in a framework that differentiates between “good” and “bad” volatility for each recipient country and that is decomposable in terms of the contribution of each donor country to volatility. In this way, policymakers can understand both the aggregate inefficiencies of the current system, the distribution of costs across recipient countries and the contribution of major donors to these costs.

Data is drawn from the Organization for Economic Co-operation and Development’s Development Assistance Committee (DAC). This is a creditor reporting system, under which each donor country reports on its aid to different countries.

The DAC statistics allow us to define aid in a number of different ways. First, the amount of net Official Development Assistance (ODA) received by a country can be determined.

The advantage of using net ODA is that it is the most comprehensive measure of support to a country.

Much of the aid included in net ODA or gross disbursements does not actually involve a cross-border transaction.

To see how deadweight losses manifest themselves in the real world, it is useful to make an analogy to corporate finance. There, it is common to analyze the problems faced by a firm raising finances for investment. Typically, such analysis focuses on the transaction costs of raising money and the uncertainty as to how much money needs to be raised. If there were no transaction costs to raising money, firms would simply wait to see what they needed and then raise that amount. In practice they do not do this because there are fixed costs of negotiating with bankers so they want to minimize the number of transactions. This gives rise to a decision to maintain financial slack, or to preserve a certain amount of liquidity by raising resources even before they are required. These idle resources have an opportunity cost that, coupled with the transaction costs of raising money, becomes a deadweight loss for the firm.

We recommend that official aid donors agree on a target for reducing these losses over the next five years.

If policymakers should choose to respond, there are a number of technical proposals that could be implemented to help limit volatility.

Donors could also coordinate aid better to smooth aggregate volatility. The current system of proliferating donors and projects with lumpy shifts in aid is too clumsy to achieve smooth resource transfers. Donors are unwilling to make individual long-term commitments to aid recipient countries because of their domestic budget procedures. But they could perhaps do considerably better in indicating amounts they would support as a collective over the medium term.

Re-published with permission by the Wolfensohn Center for Development at Brookings. Visit the original article.

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