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Pro cyclical and volatile foreign inflows

Pro cyclical and volatile foreign inflows can have detrimental effects on the domestic economic system and in particular aid inflows is associated with declining domestic revenues. Outlined by resource flows; Official Aid, Remittances, Direct Investment, External Lending, Portfolio Equity brings in macroeconomic challenges such as; Exchange Rate Appreciation, Inflation, Interest Rates, Debt Sustainability, Domestic Resource Mobilization and Macroeconomic Volatility (UNDP, 2010). Fiscal impacts delineate the concept of “additionality” increase in aid inflow does not lead to equivalent increase in public expenditure rather raises tax displacement. Moreover, concerns about debt sustainability and aid fungibility are raised. Although, aid impacts are country specific, nevertheless the cost of Aid increases as the interest rate goes up. Scaling up of aid can range from the macroeconomic cost to the absorptive capacity (DFID Staff, 2004). Higher levels of Aid inflows according to the concept of absorptive capacity of Aid inflows show concerns about the potentially adverse affect on growth. The paper particularly discusses “Dutch Disease” and resultant undercutting performance of export sector. Accordingly, high level of Aid reduces domestic revenue mobilization and raises concerns about external debt sustainability. Volatile nature of aid can increases macro instability and thus the country might have adjustment cost. Economic Distortions (Marginal Cost) as highlighted in the text have concerns in Labor Market, Capital Goods Sector and Foreign Exchange Market. Though the policy paper briefly converse marginal cost, this paper concerns distortions in development sector of the economy.

Nature of IMF as an institution to support balance of payments has been highly criticized either because of faulty policy designed by IMF or poor implementation strategies ensuing cost to the receiver. Nevertheless few things must be considered that IMF funding is grappled to take out country from macroeconomic instability and expectations to turn around things in short term are unrealistic (Bird, 2004). Two options are undertaken; external financing and structural terms, blended by IMF to disperse to recipient country.

What Pakistan apart from IMF imposition of conditions is doing to itself is the inconsideration of is the Structural reforms imposed by Fund such as privatization, liberalization and deregulation which are assumed to be critical for attaining macroeconomic stability and economic growth in Pakistan. None of the political parties agree upon agenda although have these reforms have been implemented (Hussain, Pakistan’s economic achievements, prospects and challenges, 2005)

2.1.1 Politics of Aid

Aid as often regarded as political in nature, so what does it mean to say that aid is political? It is self explanatory proposition that aid donors are motivated by self-interest and in many cases consequences of foreign aid which might not be favorable for the recipient country as explained by (Baldwin, 1969). Different types of loans that are extended such as; loans and grants, economic or military aid, multilateral as opposed to bilateral aid, private or public aid, can serve and rather have served as a mechanism for intervention. Apart to aid influence, non-aid influence is important in this regard i.e. how and when not to give aid. As explained by Baldwin both the aid influence and non-aid influence is very much applicable in case of Pakistan. What Baldwin is trying to explain is that donors and recipients have widely conflicting objectives. As explained by (Kletzer, 2005) divergence in aim does not only distress use of aid Funds rather the changes of recipient’s policy. Thus sanctions are usually alternative to the interference tool used by donors. Potency of sanctions can be restricted by sovereignty of government and its control over the activities within the borders of the country.

What concerns few governments, is that borrowing from the Fund (including the implied conditionality and resultantly loss of sovereignty) is unpalatable whereas other governments may vigorously request the IMF endorsement as a tool to strengthen position against opposition groups (Bird, 2004).

Supply side of Foreign aid conceals the existence of distortions that create incentives of indirect gains from foreign aid apart from just caring about the recipient country (Wolfgang Mayer, 1999). Such indirect gains can be resultant of, for example, terms of trade effects which might be larger than the direct losses. Also the paper finds that the aid is resolute through the political procedure of the donor country.

Since 9/11 South Asia emerged as one of the highest USAID recipient, Pakistan being amongst top 10 recipients in 2004 (Curt Tarnoff, 2004). World Bank, IMF recently (2004) worked with United States to support Heavily Indebted Poor Country, in order to workout comprehensive debt structure.

In studies carried out by (Curt Tarnoff, 2004) (Woo, 2009), “reform-mindedness” of reciepient country appeared to be more likely to pursue more extensive reforms siding with IMF. Decisions to forgive Debt and repayment of debt follow the path of economic grounds and “reform-minded” countries. In context to Pakistan, political nature of Aid can be best observed in US aid Policy. Pakistan is ranked third largest recipient of US Aid and US Aid Policy is always used as a tool of persuasion in favor of promotion of national interests (Akbar, 2007). The political and economic performance of recipient country matters least in front of those interests. Aid to Pakistan, withdrawn during representative systems and extended during dictatorships, draws attention to core-periphery relationship. Use of aid has effectively used by America to serve its interest in the region.

Yet again, Politics of foreign Aid can be all well explained through IMF, US, War on Terrorism and Pakistan. United States after 9/11 believed Pakistan as principal support of its war on terrorism that would ultimately signal to the world that the US is not an adversary of Islam and Muslim which was need of time. Also perceived benefit of including Pakistan regime on its side was to further legitimized US geopolitical association in the region (Afghanistan). Thus to gain its benefits United States detached three special economic sanctions which were imposed on for testing and obtaining its nuclear arsenal which included the Symington Amendment (imposed in 1978), the Pressler Amendment (imposed in 1990), and the Glenn Amendment (imposed in 1998). Glen Amendment specially required U.S Government to reject any type of loan application of countries, such as Pakistan. Despite of all sanctions that Pakistan had to face previously, security and economic assistance from the US to Pakistan amounted greatest since the end of the cold war along with rescheduling of debt and other trade concessions (MOMANI, 2004).

2.1.2 Aid, Growth and Public Expenditures

In dealing with disequilibria of balance of payment, IMF opts for optimal blend of structural adjustment and external financing policy is to be reached for countries (Bird, 2004). New measure to look at BoP is rather to consider economic growth; productive potential to grow that may increase exports and reduce imports, seems a better measure than current account balance, which would be strengthened eventually. Any policy must be exclusive of stabilization and growth. In 1988-2001 the dominance of stabilization policy irrespective of forgone growth resulted in severe economic cost; increased poverty, unemployment (Kaiser Bengali, 2001). Thus the policy induced by the government though involved stabilization objective to decrease fiscal deficit and current account deficit but at the cost of economic growth; which dampened investment and also curtailed purchasing power. The paper proposes not the contractionary fiscal policy but to increase the development expenditure in order to generate crowd in effect for investment; enhancing productivity and employment opportunities.

Economic situation in Pakistan set back in eighties and Pakistan experienced its lowest GDP growth in nineties (Tahir Mahmood). This was the time Pakistan had to go through series of structural adjustment and stabilization programs. Despite the measures taken by policy makers and stabilization programs, whatever fiscal adjustment was achieved it was through cutting development expenditure on the expense of further development of country. High current expenditure, inadequate resource mobilization have always resulted in deficits and The policy makers have always been attracted by the idea of maximizing foreign assistance for financing budget deficit than finding some stable solutions. These big inflows of concessional foreign aid facilitated the policy makers in avoiding the restructuring of economy and taking steps for correction of imbalances in fiscal and external accounts. Though Mr. Mahmood takes into account overall economic position of country on different timelines, the article fails to mention the intervention of external agencies that led to influential macroeconomic policies.

Pakistan high fiscal and current account deficit (from 2007 onwards) along with increasing economic vulnerability again left Pakistan with no other option than to reach IMF for bailout package. IMF objectives included restoring macroeconomic stability through tightening of fiscal and monetary policy. Dr Khan first criticizes the attempt of IMF, by highlighting grave cost of tightening macroeconomic policy, eventually leading to less demand, less import growth and less revenues collections. On the same lines author agrees the necessity of tight fiscal and monetary policy to deal with acute deficits. However, what concerns now is the IMF leniency with non-performance of government and expansionary fiscal policy being externally financed. With such an attitude macroeconomic stability is bleak in future (Khan, 2009).

The effect of IMF programs has usually been scrutinized, studying its impact on intermediate variables such as fiscal deficit, monetary growth and exchange rates and finally the outcome is assessed by balance of payment, inflation and economic growth. The cost-benefit analysis of IMF programs discussed by (Bird, THE IMPLEMENTATION OF IMF PROGRAMMES: A CONCEPTUAL FRAMEWORK AND A POLICY AGENDA) highlights the advantage of implementation is actually the continuation of access to IMF. Also further financing that is provided in order to facilitate policy options that otherwise would be unavailable. On the other hand the costs of programs are the imposed conditionality that takes the shape of either sub-optimal strategy as perceived by governments or the loss of sovereignty over policy design of recipient country.

In case of Pakistan, many studies conducted on foreign aid and economic growth suggests ineffectiveness of aid is on macroeconomic conditions of the country. Sustainable amount of foreign assistance received by Pakistan over the years has resulted in little improvement in socio-economic development. (MUHAMMAD ARSHAD KHAN, 2007) (Iqbal, 1997) (Khan S. R., Do World Bank and IMF policies Work?, 1999) . Taking new stance in this regarded (Muhammad Javid, 2009) disaggregated aid in its types; bilateral and multilateral component. The regression results of the study showed significant positive affect of aid in the short run whereas multilateral aid turned to be insignificant while interactive term is positive in both cases. Thus it strongly supports the view that aid inflow does positively impact economic growth provided that Pakistan remains under sound macroeconomic policies.

Iman Sugema and Anis Chowdhury in their study (Chowdhury, June 2007) focus on fiscal response of aid in context to Indonesia. Using vector auto-regression framework the paper demonstrates the effect of aid on development expenditure. It highlights the fungibility of aid which implies that that aid increases the routine expenditure thus effectiveness of aid in invigorating growth comes to risk. Also the idea of Aid availability has made Indonesian government “lazy”, as aid is seen as demand driven and it poses disincentives for the government to strive for greater resource base which is quite likely the case in Pakistan as well.

Fiscal behaviors and capital inflows in Pakistan has been discussed in Foreign Aid and Public sector (Iqbal, 1997) validating the results of study under taken by (Chowdhury, June 2007) for Indonesia. The paper uses three-stage least square method to find out foreign assistance impact on social, development and non-developmental expenditure. Though the framework does not take into account the requisites as imposed by agencies yet it accentuates no positive impact on development expenditure as for non-development expenditure.

2.1.3 Budget Support and Critical Conditions

Critical IMF conditions not only interfere in the economic process of a country it signals as a traffic light for other donors as well as specified by Nuria in report to EURODAD. The report shed light on highly sensitive and treacherous consequences of terms and conditions attached with Aid inflow, whose compliance results in vigorous forceful decrease in public spending and promoting highly regressive tax structure. However, non-compliance would ultimately result in stoppage of inflows thus, provoking volatility of Aid inflow (Nuria Molina, April 2008).

IMF conditions are assumed to be little different from private lending decisions as outlined by (Khan M. S., 2001) which involves assessment of macroeconomic imbalances, valuing of conditionalities is difficult and also that IMF is cooperative institution; in case of defaulting borrower, it has no court to appeal to. Yet (Raymond Saner) explaining Fund’s use of “conditionalities” for lending, has been concerned that Fund has stepped beyond its core legal consent, by particularly harming the least developed countries’ economic progress as illustrated in most of terms and conditions the dictation of their trade policies.

IMF terms and conditions principally are applied in such a way as to support international banks and investors rather than country in need of stabilization. Imprudent lending and investment usually look over the communities in the crisis-hit economies. Thus, Fund has its restricted ability to achieve its major purposes and consequently to assist deficit and crisis-hit economies accurately. Accordingly, during the dynamic stabilization program, the explicit structural characteristics of addressee, and its social costs of stabilization necessarily should be taken into consideration while evaluating IMF policy package (Xiqin Hu, 2007).

Hussain in this lecture discusses the structural reforms of Pakistan (Hussain, 2005), and addressing external debt problem he outlined credibility gap which Pakistan had to face from international agencies after 1990’s. An interesting feature of foreign inflows i.e. inflows coming in after September 11 as to fight against terrorism, in Pakistan is negated by Mr. Hussain explaining pre-requisites for obtaining long-term debt which were already being met. However, Pakistan had to face with onerous condition of IMF in its stand-by agreement. Along with other structural reforms such as privatization, financial sector reforms, trade liberalization, investment regime, deregulation policy and social reforms, Fiscal policy Reforms as debt restructuring instrument are seen vital; cutting expenditures, subsidies and raising tax revenues by introducing new measures of increasing efficacy and transparency yet resulted in no improvement in tax to GDP.

(Hussain, 2005) Where discussed generally the SAP and its consequences for Pakistan (H.Khan, 2009)highlighting two major objectives of IMF SBA in November 2008: first, restoring macroeconomic stability and investor confidence secondly, doing it in a manner which ensures social stability and sufficient support for the poor during the process talked about inconsistent targets of IMF programs. Discussing one of the important objectives of the Program: i.e. to restore macroeconomic stability using the tight macroeconomic policies, he emphasized that tight monetary policy would result in curbing aggregate demand which would consequently slow down import growth and resultantly reduce trade balance deficit. However what IMF failed to realized is the fact that more than 40 percent of revenue (indirect tax revenues) originates from import. Therefore, any such policy that limits import growth would accordingly also hurt revenue collection of the country.

2.1.4 marginal cost of aid on development expenditure

What has been put forward to discover the meaningful analysis of aid inflows is to question what fundamental domestic and international resources shift occurs after international transactions. This involves the reaction of public, policymakers and private investors to these inflows (Naheed Z. Khan, 1993).

Donor community recently is sterner about fiscal regulation and good policies that has directed freezing of donor funds to the recipient governments that do not conform to conditionalities imposed by disbursing agency. Empirical analysis of aid inflow and total expenditure is important to appraise the impact of aid in developing countries. A strong relationship of aid with higher government consumption (current consumption) rather than with public outlay proposes both a “flypaper effect” and fungibility of aid (Njeru, 2003).

Multilateral aid appeared to be fungible in time series data of 1960-97 for Philippine as well (McGillivray). Structural and reduced-form equations displayed a very bleak picture of the effectiveness of Aid inflows to the country in general. According to the study bilateral and multilateral aid flows along with economic reform program, are associated with diminishing public fixed capital expenditure, also decline in tax collections and other recurrent revenue and decreases in public sector saving

The impact of foreign aid on public sector investment using nonlinear iterative three stages least square method revealed that foreign aid does not have significant impact on public investment. Spending on “front-line” (defense expenditure) rather than public assumes fungible nature of Aid (Salim Chisti, 1992). However the paper fails to mention the impact domestic savings and economic growth in relation to the public investment and foreign aid. Similarly, (SUSANA FRANCO-RODRIGUEZ, 1998) used reduced form, and exposed that the total impact of aid on public expenditure was negative. Also the effect of aid on Taxation was found to be negative to greater extend. More than half of foreign aid for the time series data of 1956-95 revealed that it was used up in current consumption, highlighting the fact that aid id usually ineffective if allocated to consumption.

Zafar Iqbal developed fiscal model for Pakistan; accentuating foreign aid and its impact on social expenditure, non-development expenditure and development expenditure (Iqbal, 1997). Using econometric technique; iterative three stages least square method, as used by Salim Chisti, for the period of 1976-1995, it was concluded that aid had very little effect on the developmental expenditure in Pakistan. It was further uncovered that ample part of government revenues goes to social and non-development sector, thus there is strong shift of public domestic resources from development to non-development areas.

Another study concerning four policy variables of SAP; budget deficit, indirect taxes, exchange rate and subsidies, has taken into evaluation there impact on employment, per-capita income, income distribution and inflation in context to Pakistan (Rana Ejaz Ali Khan, 2011). All policy instruments except the adjustment of exchange rate resulted in adversely affected unemployment and per capita income, thus revealing that SAP negatively affects socio economic variables of the economy.

When aid is fungible it specifies that foreign aid acts as a substitute for domestic spending, rather than supplementing it (Santanu Chatterjee). This study provides that investment aid is certainly the most fungible amongst all other type of aid categories: approximately $0.90 of every dollar of investment aid is fungible. Thus when aid is fungible, which in most cases is, subsequent diminution in domestic productive public spending of the receiver government results in complete off sets any optimistic impact that aid might have on economic growth or development.

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