Aid, debt, and public expenditure allocation

UNU-WIDER / Oct 2012

It is predicted that the global financial crisis will negatively affect developing countries in Sub-Saharan Africa both through a reduction in Overseas Development Assistance (ODA) caused by the shrinking (or stagnating) of the economies of many major donors, and by a reduction in overseas trade due to a general drop in global demand. Despite some positive signs of growth in the Sub-Saharan region, financial risks remain, and there is concern that the progress made on debt may be reversed in the face of increasingly adverse fiscal conditions.

In particular, there is evidence that export shocks often worsen debt problems as countries are forced to take on additional borrowing to fill a revenue gap. This revenue gap can also delay the introduction of restrictive fiscal policies, potentially pushing back improvements in economic governance and consequently increasing a country’s debt burden. Furthermore given the current crisis, any further loans taken by developing countries are likely to be subject to more stringent financial conditions, potentially increasing the risk of debt distress. Historically, high debt burdens have tended to reduce public expenditure on both health and education, and possibly on public investment; on the other hand, it is clear that such spending is critical in terms of poverty reduction.

In their WIDER Working Paper 'On the Impact of External Debt and Aid on Public Expenditure Allocation in Sub-Saharan Africa after the Launch of the HIPC Initiative', Maria Quattri and Augustin Fosu investigate the effect that both debt and ODA have on how governments in Sub-Saharan Africa allocate expenditure.  Their focus is on two types of expenditure that are key in terms of poverty reduction: social spending on health and education, and public investment in fixed assets such as factories, hospitals, schools and railways.

Aid, Debt and Public Expenditure

This paper can be seen as an extension of Fosu’s previous analysis of the relationship between debt, ODA, and spending priorities in the pre-1995 period. This analysis showed, amongst other things, that debt servicing constraints shift public spending away from the social sector, and in these situations ODA serves as a partial negation of this effect with a positive effect on social-sector spending. ODA was also found to encourage public investment. Given these results, the deteriorating debt and ODA situations, brought about by the current crises, seem likely to lead to a reduction in social-sector spending and public investment. The authors extend this previous analysis both by taking into account the effect of the Heavily Indebted Poor Countries (HIPC) initiative, the shift towards ODA being delivered as budget support, and variables such as government effectiveness, age-dependency, and ethnic fractionalization, which were not considered in the original paper. The authors also disaggregate the effects of bilateral and multilateral aid.

The HIPC programme, initiated by the International Monetary Fund and the World Bank, was first introduced in 1996 with the aim of aiding countries with unsustainable debt burdens. The strategy appears to have resulted in a significant reduction of the debt burden indicators in most Sub-Saharan African countries, with the average debt service ratio of the region falling from nearly 14.0 in 1995 to around 5.0 in 2009. This at least indicates that the introduction of the HIPC may have helped to reduce the negative effect debt servicing previously had on social-sector spending. Furthermore the increasing tendency for ODA to be channeled towards general budget support rather than specific projects means that there is more leeway for governments to choose how aid is spent. Consequently it cannot be taken for granted that in the current context ODA will have the same positive effects previously identified by Fosu.

Results

Quattri and Fosu’s analysis is based on panel data from 1995-2009 for over 40 SSA countries, 29 of which are HIPC-eligible. Their key findings are as follows:

  • Debt servicing continues to display a negative effect on social-sector public expenditure and in particular on spending on education.
  • This negative effect of debt servicing on both health and education expenditure is significantly smaller in the post-HIPC period.
  • Contrary to previous findings, the effect of ODA on education and health expenditure is now quite minimal.
  • Foreign aid, particularly multilateral aid, exhibits a positive impact on public investment to the same degree as in the pre-HIPC period.
  • Ethnic fractionalization directs public expenditure away from the social sector.
  • Government effectiveness has a positive impact on both spending in the social sector and public investment.

Quattri and Fosu suggest that their results show that the HIPC programme has been successful in making debt servicing more manageable for SSA countries, and that this has had a positive impact on public expenditure allocation. However they point out that the debt reduction associated with HIPC is short-term in nature; a country’s debt service ratio typically begins rising again after around six years in the programme. There is, therefore, a need for measures that counter this problem. Furthermore, the probable fall in ODA following the global economic crises is particularly worrisome given the likely impact this will have on public investment, especially in terms of poverty reduction.

This report by James Stewart summarizes UNU-WIDER working paper no. 2012/42, 'On the Impact of External Debt and Aid on Public Expenditure Allocation in Sub-Saharan Africa after the Launch of the HIPC Initiative' by Maria Quattri  and Augustin Kwasi Fosu.

Related articles: The Macroeconomic Management of Foreign Aid, Taxation, public expenditure and aid effectiveness