Aid ‘surges' benefit countries where currency or inflation is allowed to rise

'Surges' in financial aid from overseas can be almost entirely absorbed under a floating exchange rate or a peg, absent sterilisation, but if they result in a large accumulation of reserves, they are welfare reducing, according to an IMF working paper published last week.

In Policy Responses to Aid Surges in Countries with Limited International Capital Mobility: The Role of the Exchange Rate Regime, authors Andrew Berg, Rafael Portillo and Luis-Felipe Zanna study the role of the exchange rate regime, reserve accumulation and sterilisation policies in the macroeconomics of aid surges.

They find that absent sterilisation, a peg allows for almost full aid absorption – an increase in the current account deficit net of aid – delivering the same effects as those of a flexible regime, but with a necessary increase in inflation.

Regardless of the regime, policies that limit absorption – and result in large accumulation of reserves – are welfare-reducing: they help reduce the real appreciation (and inflation under the peg), at the expense of reducing private consumption and investment, and therefore medium-term growth.