The Dutch Disease in Ethiopia

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Aid and the Dutch Disease in Ethiopia
Monetary Policy and Economic Research Directorate
National Bank of Ethiopia
Teferi Mequaninte
May, 2005
Following the introduction of the Structural adjustment program (SAP) in 1992 to the Ethiopian economy, there was a massive inflow of foreign aid in the form of grants, concessional loans and technical assistance. Net aid1 inflows to Ethiopia during the Derg period were around 7 percent of GDP and are doubled to 14 percent of GDP during the EPRDF regime. These elevated flows have raised a number of concerns, ranging from fears about the effect of aid inflows on the real exchange rate and export performance. The source of anxiety for all this is the Dutch disease problem of foreign aid. While seemingly beneficial foreign aid inflows may generate undesirable effects in the economy. These undesirable effects include a decline in export performance and manufacturing production caused by appreciation of the real exchange rate and resources moving out of manufacturing into other sectors (Timothy,1997). There are also concerns about aid sustainability. Specifically, while LDCs have been forced to take on greater burden of global adjustment, most donor countries have been unwilling to expand financial support for adjustment in the LDCs (Bigsten, 2003). These could be due to different motives by the donor countries. Instead of addressing the most developmental constraints of a recipient country, donors may wish to enhance the military prow ness of a recipient country, to promote their commercial interest, to support a friendly government in power, and/or to acquire goodwill in the expectation that it would be politically valuable later (Krueger, 1991). As has been well documented in the works of Adams et al (1994), foreign aid inflows cannot continue indefinitely given donor fatigue and the growing competition for aid funds among LDCs. Still, there are concerns about the absorptive capacity of the recipient economy, and particularly of the government itself. The impact of aid is rather complex, since there are direct effects of aid disbursement as well as indirect effect on the spending patterns of the public sector of the recipient country and on government policy. The government may use aid to escape the burdens of their foolish economic policy. (Mosley et al,1999). The more general concern of Dutch disease is that whether external aid inflows have been temporary or permanent and weather they were spent on imports or domestically produced goods and services. The principal economic rationale for aid is to increase growth rates in recipient countries, usually measured by its impact on real exchange rate. Yet, after decades of capital transfer to Ethiopia, the effectiveness of achieving this objective remains questionable as conformed by numerous studies of the empirical relationship between aid and growth. In an effort to boost Ethiopia's economic growth the real exchange rate and its interplay with external aid inflows have been crucial for purposes of strategic economic decision making and efficient policy management. This paper attempts to develop an empirical model for the real exchange rate impact of foreign aid in Ethiopia. The paper then links this with an export performance model in order to identify policy implications and recommendation. Generally it is hypothesized ,first, that whether external aid inflows to Ethiopia results in real exchange rate appreciation or depreciation is an empirical question, and second, that exports respond positively to a good policy management of foreign aid. This paper has five sections. Following this introductory section, part two presents a review of the existing literature regarding pro-aid and contra-aid arguments. Section three is devoted to the discussion of model specification, data sources and methodology. The model specification is based on the Dutch...
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