2 The central role of the RER is confirmed by evidence suggesting that protracted RER overvaluation tends to be associated with lower economic growth.<sup>2</sup> And, given that overall economic activities might be partially boosted by an overvaluation-driven growth in the non-tradable sector, the impact may be particularly harmful to export growth and economic diversification,<sup>3</sup> especially if export production is characterized by learning-by-doing externalities and capital market imperfections as in the cases of nontraditional and especially manufacturing exports.<sup>4</sup> In addition, the level of the real exchange rate affects competitiveness directly, through the return to investing in tradedgoods industries, and indirectly, by influencing exploitation of comparative advantage.<sup>5</sup> Although it may not be of immediate concern to low-income post-conflict countries, recent literature also finds that persistent RER overvaluation is a powerful predictor of currency crises.<sup>6</sup> Section 2 analyzes the size, timing, and composition of post-conflict aid during the postconflict cycle, as well as ODA-RER correlations, in a sample of 32 countries and with more detailed focus on 7 country cases. Section 3 reports estimation results for the RER, based on a world sample of 83 countries and annual 1980-2004 data, focusing on the role of aid on the long-term RER behavior. This allows subsequently to derive measures of RER misalignment for different sub-periods in the pre and post-conflict cycle and to trace the influence of large aid flows on RER overvaluation in post-conflicts. Section 4 reports estimation results for growth, based on a world sample of 78 countries and 5-year data spanning from 1970 to 2004.<sup>7</sup> The growth specification allows testing for the influence of the post-conflict cycle, foreign aid, and RER misalignment on growth, controlling for standard growth determinants and allowing for key interactions between post-conflict periods, aid, RER misalignment, and financial development. Section 5 concludes.

# **2. Aid and Dutch Disease during Post-Conflicts**

Post-conflict countries tend to experience substantial surges of aid flows, which have potential consequences for their competitiveness and growth behavior. To understand the latter, we start by reviewing briefly the basics of aid management and its implications for the RER.

The receiving government faces two basic choices in its use of aid: it can spend or save it. One extreme for the government is to spend aid fully, increasing its non-aid public deficit accordingly. If government spending falls entirely on traded goods (for example, on imports of school computers and textbooks), the trade deficit and hence the non-aid

> 2 See, for example, Edwards (1989), Cottani et al. (1990), Ghura and Grennes (1993), Razin and Collins (1997), Easterly and Levine (1997), and Aguirre and Calderón (2005).

> 3 See, for example, Nabli and Veganzsones-Varoudakis (2002) and Elbadawi (2002).

> 4 See, for example, van Wijnbergen (1986).

> 5 This problem has been extensively documented in the case of Africa by, among others, Elbadawi (2002), Mengistae and Pattillo (2004), and Dufrenot and Yehoue (2005).

> 6 See, for example, Kaminsky et al. (1998) and Merrill Lynch (1998).

> 7 The RER model can only be estimated for the shorter period (1980-2004) because the error-correction panel estimation methodology requires full data availability.  However, the estimated model can be used to construct indexes of RER equilibrium and RER misalignment for the longer 1970-2004 period.