Low-income developing countries need to substantially increase expenditure to meet universal coverage goals for essential health services and to achieve significant improvements in population health, such as those targeted by the Millennium Development Goals. (1-3) Almost all the countries with the most pressing health needs have very low incomes and are unlikely to be able to raise adequate funds exclusively from domestic sources in the near future. (4) Increased development assistance will be required to supplement any increase in domestic funds. The international community has responded by substantially increasing commitments to development assistance for health in selected low-income countries (Fig. 1). (6)
However, there has long been concern that the rapid arrival of large amounts of foreign exchange in a country could lead to an increase in inflation and loss of international competitiveness, with an adverse impact on exports and economic growth. (7-9) This paper examines the risks that aid flows for health pose for key macroeconomic variables, reviews the recent cross-country and country-level empirical studies and suggests how adverse effects could be minimized. It also illustrates how concerns with macroeconomic consequences of aid flows are linked to the question of fiscal space and budget ceilings in the public sector.
Effects of increased aid
Macroeconomists argue that spending large windfalls of foreign exchange may make countries less competitive, either by raising inflation or by appreciating the exchange rate. As a result, exports, productivity and growth may fall or slow. This so-called 'Dutch disease' is named after the macroeconomic impact of natural gas discoveries in the Netherlands in the 1960s, which caused appreciation of the exchange-rate and shrinkage of the manufacturing sector. (10) Dutch disease has since been linked to other types of foreign exchange inflows, particularly commodity booms and rapid increases in external assistance.
Foreign-exchange windfalls may result in domestic inflation and/or exchange-rate appreciation. In both cases, the tradable sector (firms that export goods or that compete against imported goods) becomes less competitive and less profitable. Attention is most commonly focused on inflation in goods and services, international competitiveness and the economic growth rate.
Domestic demand and prices
If inflows of aid received as foreign exchange are saved by the government there will be no direct macroeconomic impact, but this is not the purpose of aid. If it is used to purchase goods and services, a share will normally be used to purchase imports, such as drugs. The remainder would be spent on domestically produced goods and services--some that are internationally traded (e.g. bandages or cotton) and some that are not (e.g. many medical and transport services), which are known as non-traded goods.
If aid inflows are spent almost entirely on imports or goods that are typically exported, there will be little effect on prices unless the country is very large; most are too small to influence the international price. However, additional spending on non-traded goods and services is likely to lead to price increases (inflation) and have follow-on macroeconomic problems. Therefore the extent to which aid poses a macroeconomic risk depends first on whether it is saved or spent. If aid is spent, the impact depends on whether it is spent on goods and services that are traded or non-traded.
An increase in domestic prices (or wages) relative to foreign prices is called a rise (appreciation) in the real exchange rate (RER). The RER differs from the nominal exchange rate, being simply a measure of trade competitiveness that compares the price of a basket of domestic goods with the price of a basket of foreign goods. (11) With an appreciation of the RER, domestic consumers will shift some of their consumption from the higher priced, domestically produced goods to foreign goods. …