Dilemmas of externally financing domestic expenditures: Rethinking the political economy of aid and social protection through the monetary transformation dilemma

The external financing of domestic government expenditures, as exemplified by the financing of social protection with official flows (aid and other official flows), faces what can be called a monetary transformation dilemma. This refers to the fact that official flows are in foreign currency and hence cannot be directly used for expenditures in domestic currency. Nor do domestic expenditures require foreign currency given that they can be financed through conventional domestic monetary and fiscal operations. The extent to which official flows are actually able to fund domestic expenditures therefore involves a range of macroeconomic management concerns, which are in turn prone to exacerbate the already thorny political relations between donors and recipient governments. This calls for a serious rethink of many of the accepted premises in the political economy of aid and social protection literatures, particularly with respect to the dominant focus on domestic governance rather than a broader systemic understanding of the often convoluted and contradictory external dynamics that domestic actors must contend with in the power relations that condition official flows. Several examples can be highlighted. First, conventional measures of absorption, as used by the IMF, actually include income payments to foreigners, which seriously muddles our understanding of the extent to which aid flows represent actual redistribution. Second, large mismatches between the absorption and notional domestic spending of aid appear to be the norm in most of the countries studied in the macroeconomic literature on aid and, given the first point, absorption is generally overestimated in this literature. Third, the full absorption and spending of aid, as advocated by the IMF, is in contradiction with the need to accumulate reserves in the face of financial account liberalisations, as also advocated by the IMF and other IFIs. Fourth, the full spending of aid is similarly in contradiction with substitutive approaches to social protection, as commonly advocated by donors and IFIs, which imply no net increase in spending. Finally, the obscurity of these monetary transformation dilemmas exacerbates donor concerns about fungibility, transparency and accountability, thereby inciting donors to seek ways of strengthening their micro-control over the end uses of aid, as exemplified by recent innovations in aid modalities such as cash-on-delivery or payment-by-results. Impulses to control recipient countries obviously do not originate from the monetary transformation dilemma although the associated tensions nonetheless reinforce broader ideological predilections to subordinate recipient countries within donor-recipient power relations, in parallel with increasingly conservative reactions to welfare in donor countries, thereby running counter to donor commitments of respecting national ownership.