The Macroeconomics of Foreign Aid to Ethiopia: Internal Balance and Fiscal Response-An Alternate Framework

Foreign aid recipient fiscal response in developing countries is studied using utility/welfare maximization principle. The underlying assumption of this function (utility/welfare can be maximized by narrowing the deviations of the actual values from their desired values subject to the constraints of finance) doesn’t capture the interplay between project aid inflows and the adjustment process of the government budget. This paper proposes an alternative framework in conceptualizing the recipients fiscal response. This was possible due to the special feature of this paper that aid is disassociated from foreign capital inflow and also identified by its usage which is not the case in other similar studies. This makes one of the strong point and hence the advantage of this paper. Ethiopia in the pre-EPRDF regimes received project aid. The alternative conceptual framework is that project aid is an investment support which pays only for foreign exchange cost component of the investment program. This kind of aid requires the recipient government to generate local resource in order to finance the local currency component of the investment cost and recurrent costs to keep the created capacity running. In this context the change in investment will be greater than the change in project aid inflow. Hence, domestic savings will increase and government tries to improve both tax collection effort and rate and in the context of burgeoned public sector, the government will also try to raise its non-tax revenue through public enterprises surplus transfer (this has never been an issue of the fiscal response literature) to finance the difference. The results were entirely contrary to the conventional claims. Project aid has no ‘displacement effect’. Government was responding positively to project aid by improving both tax collection effort and tax rates and by increasing its non-tax revenue. In the absence of real savings, the government, however, finances the local currency component of the investment cost by domestic bank borrowing: transferring private resources and printing money. It is argued that transferring of resources from private budget surplus to the public sector was carried out through distorted preferential domestic credit policies by crowding-out private investment and depressing personal consumption. Distorted domestic credit policies (rationing with preferential treatment to public sector) was, therefore, unintended outcome the fiscal adjustment to the aid inflow, generating the local fund for local currency costs of the aid-financed public investment in excess of real public savings.