The macroeconomics of development financing
09 Jul 2015 by Degol Hailu, Senior Advisor, UNDP
- strengthen domestic resource mobilization capacity;
- increase the availability of external funds such as official development assistance (ODA) and foreign direct investment (FDI);
- reduce the cost of sending remittances;
- and tackle illicit financial flows.
However, all of the above measures will be futile if countries adopt macroeconomic policies that are not developmental.
Let us examine the recent history of macroeconomic policies in ten selected low-income countries. They have had very restrictive monetary policies with lending interest rate averaging 21.6% between 2007 and 2013. All of them had inflation targeting as a major policy objective. They kept their claims on the central government to less than 1% of GDP.
Now let's look at their macroeconomic performance. Yes, they did well when judged against the mantra of macroeconomic stability. Economic growth has been medium to high, averaging 5.4% between 2007 and 2013. During the same period, inflation remained below 8% and their fiscal deficit was 2.1% of GDP.
These ten countries implemented what is known as restrictive macroeconomic policies. However, their development outcome is not different from middle-income countries that implemented relaxed macroeconomic policies. These countries have had a lending interest rate averaging 8.6% between 2007 and 2013. They did not have inflation targeting as a major policy objective. They kept their claims on the central government to 21.5% of GDP.
Between 2007 and 2013, average economic growth for both groups of countries was approximately 5.4%. Both groups of countries showed improvements in Human Development Index scores at roughly the same rate. The difference in the unemployment rate between the two groups stood at less than 1 percentage point, as was the difference between net FDI inflows (% of GDP). But mean years of schooling in countries employing more relaxed policies are 1.5 years higher than in those adopting more restrictive policies. Similarly, under-5 mortality rate is three times higher in countries implementing restrictive policies.
However, the current account deficit for countries implementing relaxed policies is double that of countries with restrictive monetary policies. This is a direct result of a restrictive macroeconomic policy that typically encourages reserve accumulation.
Both historical and empirical evidence demonstrate that macroeconomic policy in low-income countries becomes developmental:
- when fiscal policies focus on scaling up public investments, especially unlocking supply bottlenecks such as poor infrastructure and low human capital;
- when monetary policy is relaxed and credit is targeted to incentivize the flourishing of small and medium enterprises, the policy lending rate being the instrument;
- and when exchange rate policies encourage export orientation and discourage short terms speculative capital flows.
When the development community meets in Addis, they should go beyond simply pledging to increase financing and agreeing to change the rules that govern financial flows. They should go further and reach a consensus on the fact that macroeconomic policies in low-income economies need to also jettison the conventional wisdom of undue restrictiveness.