Counterpart funds generated through foreign currency or commodity aid have again become an issue of interest as a result of the substantial buildup of these funds in developing countries, notably in Africa. Previous studies concluded that counterpart funds have an inflationary impact on the economy and that tied and irregular aid should be avoided. Those conclusions were derived in a partial equilibrium context and implicitly assumed that governments do not react optimally.
This paper develops a small general equilibrium model that includes not only the key government instruments and constraints but also a wide range of effects that counterpart funds and the underlying aid exert on the economy (supply-side, money demand, money supply, and balance of payments effects). It demonstrates that credit to the government adjusted for counterpart funds is relevant for the inflation rate, the foreign reserve position, and other variables in the economy. Counterpart funds have no independent role to play and hence do not give a government any extra degree of freedom or room to maneuver. This implies that, if the role of counterpart funds is well understood, they need not harm, nor provide any leverage to, donors.
The aid underlying the counterpart fund creation has real effects. For foreign currency aid, the effects on the economy can be delayed because the aid can effectively be “stalled,” just as if it is held in a foreign account. Commodity aid, however, cannot be stalled once it is sold or handed out in the recipient country. If donors want counterpart funds resulting from the sale of commodity aid to be spent on earmarked targets not included in the standard government budget, they should be spent when the commodities are sold, and not later, when the resources in the economy are expanded and government revenue increases. The establishment of a regular, well-planned aid process is required. Irregular, nonfungible, tied commodity aid poses a problem in that it might lead to an irregular budget deficit and thereby to irregular taxation or credit to the private sector. Various practical issues that are sometimes seen to obscure the impact of counterpart funds do not substantially alter these conclusions.
The model developed in this paper also yields some conclusions regarding unexpected aid and program design. Reducing credit ceilings by the amount of unexpected aid, a requirement sometimes included in Fund programs, is found to be suboptimal. In this model, a different set of contingency rules or program requirements is derived, which allows the recipient country some freedom in using unexpected aid if other circumstances permit it, and makes it more enticing for donors to give additional aid.