Aid can be better used if it is predictable. When aid flows wax and wane with international economic cycles or with unexpected shifts in donor policy, recipients often see aid decline when they need it most. If aid is used for domestic investment, volatility can generate uncertainty, discourage investment, and impede growth.
16Aid volatility also complicates the conduct of fiscal and monetary policy. Tax increases and 104
Figure 5.7 Global military spending and aid, 1992–2003
ODA as percentage of donors’ GNI
Sources: Stockholm International Peace Research Institute; OECD Development Assistance Committee.
0.20 0.34 0.32 0.30
0.26
0.22 0.28 0.36
0.24
650 700 750 800 850 900
2002
2003 1992
1993 Post–Cold
War era
1994
1995 2001
War on terror and Iraq
Global military expenditure ($ billions)
M E E T I N G T H E F I N A N C I N G N E E D S O F P O O R C O U N T R I E S
government spending cuts frequently follow aid shortfalls (Gemmell and McGillivray 1998). Fur-thermore, aid-dependent countries are often unable to offset an unexpected aid shortfall by borrowing and must resort to unplanned and costly fiscal adjustment—especially damaging when aid flows are procyclical.
Despite these damaging effects, aid to poor countries tends to be volatile.
17• Aid has been more volatile than GDP (fig-ure 5.8) in virtually all of the poor countries in our sample. Earlier studies showed similar results. Pallage and Robe (2001) showed that aid was highly volatile compared to recipients’
output. Bulir and Hamann (2003) found that it was more volatile than fiscal revenues, par-ticularly in highly aid-dependent countries.
Gemmel and McGillivray (1998) found that aid was significantly more volatile than revenue. Only Collier (1999) found that aid (to Sub-Saharan Africa) was less volatile than tax revenues.
• Aid flows to poor countries have become more volatile over the 1990–2002 period (figure 5.8), although they are less volatile than for other low-income countries.
18The increased volatility could reflect changing donor sentiments, better linkages with coun-try performance, or other factors. For the
105
P roponents of innovative financing mechanisms—such as the International Finance Facility, global taxes, and various voluntary giving arrangements—argue that such mechanisms can partly offset shortfalls in official develop-ment assistance (ODA).
International Finance Facility. As proposed by the British government, the IFF is designed to front-load aid flows in the short term to help reach the MDGs. Donors’
multiyear aid commitments would be used to back AAA-rated bonds. Bond proceeds would be channeled through existing aid programs. Over time, the IFF would draw down the donor pledges to pay off its bonds. Future aid budgets would thus be used to support aid disbursements as and when they are needed in the short term. Critics of the proposal charge that bond repayments, as well as the transaction costs of issuing the bonds, would put pressure on aid budgets in the years ahead.
Technical aspects of the IFF proposal are being worked through in a pilot project. The IFF for Immuniza-tion (IFFIm) seeks to raise front-loaded, reliable funding over several years to expand global immunization and so help achieve the MDG on child health. IFFIm will use off-budget donor pledges of future aid increases as back-ing for AAA bonds, relyback-ing largely on the existback-ing gover-nance structure and country programs of the Global Al-liance for Vaccines and Immunization (GAVI) and the Vaccine Fund.
Global taxes. Proposals have been made in the past to raise funds for development through new global tax instru-ments, but most have suffered from technical obstacles and all have faced varying degrees of political opposition. One
prominent example is the proposed “carbon tax” on con-sumption of hydrocarbons. Such a tax could generate sub-stantial revenue and help arrest climate change, but it would be very difficult to achieve politically. On a smaller scale, a recent proposal in the European Union would, for the first time, tax the jet fuel used in airliners and address the environmental harm caused by air transportation. Pro-ponents observe that the revenues raised from global taxes could complement the IFF by generating aid funds in the medium to long term, as IFF flows diminish with repay-ment of bonds.
Voluntary contributions. Private contributions al-ready fund development in various ways (see box 5.2) that could be expanded, encouraged, or made more effec-tive. Some mechanisms, such as the establishment of affin-ity credit cards that provide funding for development through voluntary surcharges, could be undertaken by interested banks or companies. Others, such as the cre-ation of a special-purpose global lottery or premium bond, would require regulatory action by participating countries, either unilaterally or acting in concert. As with global tax mechanisms, it would be important—and not easy—to ensure that voluntary contributions resulted in additional flows, rather than substituting for some por-tion of existing flows or overemphasizing some needs at the expense of others.
Although such innovative mechanisms offer some po-tential to expand the resources available to support devel-opment efforts, the legal and political obstacles to their im-plementation suggest that their practical significance in the short term will likely be limited.
Box 5.8 New sources of financing
G L O B A L D E V E L O P M E N T F I N A N C E 2 0 0 5
other low-income countries, this rise in aid volatility may be explained by the fact that many of these countries experienced conflict in 1990–2002 period, which disrupts aid operations and disbursements.
• Among the several types of aid, humanitarian aid and emergency assistance are by their nature volatile (figure 5.9).
19But even when emergency aid is excluded, aid disbursements are more volatile than other flows, such as remittances.
Greater predictability in aid flows is one of the touted benefits of the proposed International Finance Facility (IFF), sponsored by the British government. The IFF would require donors to out-line their intended contributions to aid over the long term and would then issue bonds backed by those pledges (see box 5.8).
Volatility of aid need not seriously affect out-put or growth in developing countries, provided it offsets fluctuations in GDP. Intuitively, this makes sense—if flows of external finance are counter-cyclical to the business cycle (and thus help offset the downturns), they can help to smooth out fluc-tuations. But ensuring that aid will be countercycli-cal implies donor control over volatility, which, of course, has been lacking. In fact, there are good reasons why aid flows tend to be procyclical. First,
when donors are unable to adequately monitor the recipient country’s reform effort, aid disburse-ments may be implicitly tied to economic perfor-mance, thus making aid procyclical (Svensson 2000). Second, donors may try to link aid flows to country performance using measures that are inde-pendent of domestic economic cycles. When coun-tries are hit by unforeseen adverse shocks, compli-ance with donor conditionality may be affected, which may reduce aid disbursements. Finally, some donors require matching grants by the recipient. If more matching resources are available during cyclical upturns, some procyclicality of foreign aid disbursements may follow.
In recent years there appears to have been a shift away from procyclical aid flows—which should be encouraged.
20Ratha (2001) found that multilateral lending played a countercyclical (sta-bilizing) role relative to private flows, with rising official flows during periods of private credit re-duction. Multilateral lending also complemented private flows with a time lag. Empirical work on the cyclical character of ODA flows in 1970–90 and 1990–2002 found less evidence of procyclical-ity in the latter period, although short estimation periods affect the robustness of these estimates.
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Note: LICUS Low-Income Countries Under Stress. Figure measures median volatility for each group of countries. Volatility is equal to the standard deviation of the cyclical component of the Holdrick-Prescott filtered indexed series. Only countries with data available for both periods are included.
Source: World Bank staff estimates.
GDP
Poor countries 9.7 10.6
16.4 21.2
10.9
16.2 17.3
48.7
LICUS
ODA GDP ODA
Figure 5.8 Change in volatility of aid, 1970–2002
Volatility (standard deviation)
0 10 30
20 40 50
1990–2002 1970–90
Note: IDA International Development Association. Figure measures median volatility for each group of countries. Volatility is equal to the standard deviation of the cyclical component of the Holdrick-Prescott filtered indexed series. Only countries with data available for both periods are included.
Source: World Bank staff estimates.
ODA Structural Emergency
IDA Remittances
FDI
Figure 5.9 Volatility of different components of aid, remittances, and FDI, 1990–2002
Volatility (standard deviation)
0 10 30 20 40 80 70 60 50
71.1
19.7 21.4 39.6
16.3 40.0
M E E T I N G T H E F I N A N C I N G N E E D S O F P O O R C O U N T R I E S
Strengthening the framework for aid
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