Research Brief
Responding to Aid-Induced Dutch Disease

In the WIDER Working Paper 'Aid and the Fiscal and Monetary Responses to Dutch Disease' Alan Roe looks at the ways in which aid-induced, and mineral export-induced Dutch Disease (DD) are similar, and the ways in which they differ. He argues that many countries will experience both kinds of DD simultaneously, as economies reliant on aid are often also reliant on mineral exports. However, he suggests that the appropriate responses to aid-induced DD will often differ from the current recommended responses to mineral export-induced DD.

Aid and Dutch disease

The phenomenon of the so called DD has received significant attention in the macroeconomics literature, and there is strong support for the claim that a natural-resource curse does exist. In simple terms DD refers to the phenomena of increases in the volume of revenue a country receives for the export of natural resources leading to an appreciation of the country's real exchange rate, and a consequent decline in the export, followed by a drop in production levels of manufactured and agricultural goods. After the Gleneagles summit of 2005, the question of whether the proposed large increases in aid flows could have a similar DD effect on the recipient countries was raised.

To address this question Roe looks at data from a sample of 108 low and middle income countries. From the analysis Roe is able to draw two general conclusions about the likely relationship between foreign aid and DD. First, his results show that in some cases aid can cause a Dutch Disease like effect. Second, many of the low income countries who are heavily dependent on aid are also heavily dependent on mineral exports, and as such may face Dutch Disease problem caused by both.

Mineral resource exports are typically thought to cause DD through a combination of their economic impact, their effect on governance, and their encouragement of corruption. Roe argues that all three of these factors also represent mechanisms through which aid flows could cause DD.

1. The most basic way in which aid could cause DD is through its impact on the recipient countries’ economy.
   The aid flow into a country could result in the appreciation of the country’s exchange rate. This appreciation could simply represent a new equilibrium. However if the aid is not spent on imports or invested into the private sector, the appreciation could have a negative impact on the export of goods from the country.
2. Aid may cause governments to make poorer economic decisions which contribute, or do not counteract, DD.
   When a government feels its funds are a result of a windfall, rather than sound economic management, it is less likely to feel pressure to manage the economy well. This can lead to a number of things, including the government relaxing its tax effort, or embarking on new capital spending projects, without regard of the implication this has for future spending. A poorly managed economy is unlikely to be able to adjust to neutralize the potentially negative effects of a rise in real exchange rates.
3. Aid may lead to an increase in corruption that diverts money away from investment and towards personal wealth accumulation thus reducing the recipient country’s international competitiveness and contributing to DD.
   When large revenues are available there are both more incentives, and fewer risks, for those seeking to increase their personal wealth through the misappropriation of aid funds.

Responses to aid-induced Dutch Disease

An exchange rate appreciation caused by an increase in mineral exports cannot be counteracted by directly targeting the exchange rate. Instead it must be influenced via intermediate variables such as nominal exchange rate, moderating government expenditure, and shifting government focus to areas often affected by DD. Consequently much of the literature on mineral export-induced DD is concerned with fiscal policy measures which offset the effect of DD. If volatility is likely to be frequent then the introduction of fiscal rules regarding balancing the budget, debt levels, government expenditure, and government revenue can have a positive impact. A long sustained positive shock can be adapted to via the creation of a futures fund, allowing short term spending to be reduced in order to fund larger expenditures during a future slump.

Roe argues that such techniques will not always be the appropriate response to aid-induced DD. He suggests that the optimal response to aid-induced DD will often be donors working together with recipients to ensure that aid is used in ways which don't cause DD. As discussed above, only certain kinds of aid are likely to cause DD, other aid simply has little effect on the exchange rate, or leads to a new equilibrium. Furthermore, aid flows are easier to predict and influence than revenue from mineral exports, and so making an accurate diagnosis of the problem is likely to be easier. Consequently when DD does occur the best response may be to alter either the amount of aid being given, or the way in which the aid is being used.

Similarly the use of mechanisms such as future funds is unlikely to be appropriate in the case of a surge of revenue caused by aid, as the same mitigating effect can be achieved through better management of aid flows. Consequently donors must be, to at least some extent, responsible for helping to mitigate aid-induced DD. This responsibility entails not only ensuring that aid flows from various different donors are well coordinated, but also allowing aid recipients to use aid flows to build reserves rather than forcing them into immediate expenditures.

Roe also suggests that in cases where the recipient country has weak governance, attempting to address DD via fiscal and monetary interventions will simply be ineffective. A more effective approach would be for donors and governments to attack the underlying problem of weak governance. In doing so they can reduce the likelihood of this weak governance undermining the intentions with which aid is given.

In conclusion, Roe’s argument is that while aid-induced and mineral export-induced DD have many of the same causes, the appropriate responses to aid-induced DD differ in a number of ways from the recommended responses to mineral export-induced DD. In particular in many cases the best way to respond to aid-induced DD may not be through monetary and fiscal implementation, but instead through careful examination of how aid is being used, and the microeconomic effects of this. Consequently at least some of the responsibility for avoiding aid-induced DD lies with donors, who need to coordinate their aid flows, and allow recipient countries greater flexibility in how they use aid.