Foreign Aid: Key Issues and Ongoing Debates

1
Foreign Aid Key Issues and Ongoing Debates

• Sherman Robinson
• University of Sussex
• Finn Tarp
• University of Copenhagen
• February 2007

2
Outline

• Introduction how is aid defined and how has it
  evolved?
• The rationale behind foreign aid why give aid?
• Assessing aid impact does aid work?
• Project level - micro
• Programme level - meso
• National level - macro
• Aid modalities how should aid be designed and
  implemented?
• Conclusion what lessons have we learnt?

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Introduction How is Aid Defined and How Has it
Evolved?

4
Definition of Foreign Aid - Official Development
Assistance (ODA)

• Grants or loans which are
• Undertaken by the official sector.
• With promotion of economic development and
  welfare as main objective.
• At concessional financial terms (a Grant Element
  of at least 25 per cent).
• In addition to financial flows, technical
  co-operation is included in aid.
• Military aid is excluded.
• See http//www1.oecd.org/scripts/cde/viewbase.asp
  ?dbnamecde_dac

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Grant Element Defined

• Reflects financial terms of commitment interest
  rate, maturity and grace period.
• Concessional element of a loan its present value
  at an interest rate below the market rate over
  the life of a loan.
• Conventionally the market rate is taken as 10 per
  cent. Thus
• The grant element is nil for a loan carrying an
  interest rate of 10 percent
• It is 100 per cent for a grant
• And it lies between these two limits for a soft
  loan.
• If the face value of a loan is multiplied by its
  grant element, the result is referred to as the
  grant equivalent of that loan.

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Aid Disbursement vs. Commitments

• The release of funds to, or the purchase of goods
  or services for a recipient by extension, the
  amount thus spent. Disbursements record the
  actual international transfer of financial
  resources, or of goods or services valued at the
  cost of the donor.
• Commitments are funds committed, but not
  necessarily spent.
• When to use commitments and when to use
  disbursements in economic analysis?
• Seehttp//www1.oecd.org/scripts/cde/viewbase.asp?
  dbnamecde_dac

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Trends in Foreign Aid and Development Economics

• The early years (after 1945).
• The golden age (from the early 1960s).
• Stabilization and structural adjustment (from the
  early 1980s)
• Conditionality as the key means to implement aid
  agreements and pursue policy changes.
• Aid fatigue (from the late 1980s).
• Finn Tarp (ed.) Foreign Aid and Development
  Lessons Learnt and Directions for the Future.
  London and New York Routledge, 2000.

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ODA as of GNI in Donor Countries
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ODA per Capita in Donor Countries
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Aid to Non-OECD Ratios to GDP and Population
(normalized to unity in 1971)
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The Rationale Behind Foreign Aid Why Give Aid?

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To Whom? DAC Disbursements 1960-03
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To Whom? DAC Disbursements 2003
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Bilateral ODA (million USD)
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Multilateral ODA (millions USD)
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Bilateral Disbursements as of ODA
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Basic Questions in Aid Allocation

• Aid a scarce resource why give it and how
  should it be allocated?
• Answer depends on what donors want to achieve
• Two approaches unselfish (promote a better
  world) and selfish (strategic political,
  commercial and other interests).
• Focus on the donor side
• strategic interests are often the driver (ex. US,
  France),
• strategic interests can vary (multilateralism).
• Focus on the recipient side the issue of needs
  versus potentials
• The IDA aid allocation formula Loan CPIA x
  income per capita. (CPIA Current Policy
  Institution Assessment).
• Performance criteria vs. incentives

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Assessing Aid Impact Does Aid Work?

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What Does Does Aid Work? Mean? (1) A
Generalists Answer

• No simple answer (depends on who is asking and
  why?) disagreement is to be expected! Why?
• Many interpretations, for example
• Does aid improve human development (ex. HDI, save
  human lives, improve nutrition, promote food
  security)?
• Does aid reduce poverty and inequality (ex.
  Headcounts, Gini, regional imbalances)?
• Does aid promote good policies (ex. CPIA)?
• Does aid promote democracy, freedom of speech and
  political rights?
• Does aid promote sustainable development?

20
What Does Does Aid Work? Mean? (2) An
Economists Focus

• High income (GDP) per capita associated with good
  standards of living. A lot of variation around
  means, but .
• How to get high income?
• Savings ? Investment ? Growth
• So does aid work often means
• Does aid increase savings?
• Does aid increase investment?
• Does aid increase growth?

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How Much Impact do We Expect?

• The simple model Aid ? S, S ? I, I ? growth,
  hence Aid ? Growth.
• Complications
• Aid is not only given to increase savings and
  investment. Aid ? S link may be weak.
• Country circumstances (including the
  capital-output ratio) differ. I ? growth link.
• A lot of variation to be expected in the
  aid-growth link, depending on country
  circumstances.
• Analysis of aid and aid design at all levels
  (micro, meso, macro) is necessary.

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Does Aid Reduce Poverty?

• If aid helps growth aid will typically help
  reduce poverty, but a lot of variation
• An additional 1 rate of growth will bring
  anything from a modest annual drop in the poverty
  rate of 0.6 to a more dramatic 3.5 decline
• The nature of poverty reduction is related to
  micro, country-specific factors.
• Analysis of aid and aid design at all levels
  (micro, meso, macro) is necessary.

23
Project Evaluation (micro)

• Cost-benefit analysis
• Estimate costs (C) and benefits (B)
• Compare C and B plus a decision rule
• Cost-effectiveness analysis
• Estimate costs (C) and define output measure
• Seek lowest cost per unit of output
• In general many projects show respectable rates
  of private, economic, and social return
• Different projects may have different returns
  (and variation across countries), but overall it
  seems aid works!

24
Programme Evaluation (meso)

• As a sum of projects (the traditional approach),
  it seems aid works!
• More general program impact evaluation
• Targets versus outcomes not satisfactory why?
• Before and after not satisfactory why?
• Ask the counterfactual question
• How would people who benefited from a program
  have fared without? (Establish a comparison
  group)
• Study of Progresa Program in Mexico.
• Analytic methods and results still evolving, and
  so are results, but generally aid seems to work!

25
Analysis of Aid and Growth (macro) late 1970s
and 1980s

• Increasing disappointment with the traditional
  Aid a S one-to-one, so Aid a I one-to-one, and
  Aid a Growth model
• The aid-savings link does aid crowd out savings?
• The aid-investment link aid increases
  investment, but is investment productive?
• The aid-growth link a variety of cross country
  regression results published, in some cases
  showing no significant impact of aid on growth.
  The micro-macro paradox (Mosley and colleagues),
  but unease with methods. Yet aid fatigue was
  growing for many reasons.
• Easterly critique aid fails.
• See Hansen, H. and F. Tarp (2000) Aid
  Effectiveness Disputed. Journal of International
  Development, Vol. 12(3), pp. 375-98.

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The Modern Macro Debate (1)

• New work based on modern cross country
  econometric analyses using panel data.
• Boone (1996) Aid has no impact on growth,
  neither in theory nor in the data.
• Burnside and Dollar (1997, 2000) and World Bank
  (1998) Aid only works on growth in good policy
  countries (cutting the Gordian knot).
• Dollar and Svensson (2000) aid does not seem to
  affect policy.
• Fungibility of aid funds.

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The Modern Macro Debate (2)

• Aid allocation implications from conditionality
  to selectivity based on good policy performance
  criteria.
• But what about the poor? Collier and Dollar
  (2002) Aid allocation and poverty reduction.
• All this sparked a lively and heated academic and
  policy oriented debate and a lot of research
  that has actually effectively challenged the
  mainstream.

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The Modern Macro Debate (3)

• The aid-policy interaction term seriously
  challenged. It is very delicate and does not
  stand up to other specifications.
• There are many other Good and Bad aid
  environments
• Aid volatility/uncertainty
• Vulnerability to external shocks
• Diminishing returns to aid (level dependence)
• Geographical effects (the tropics)
• See C.-J. Dalgaard, H. Hansen and F. Tarp (2004)
  On the Empirics of Foreign Aid and Growth.
  Economic Journal. Vol. 114(496), pp. F191-F216
  for an overview.
• See also http//www.adb.org/Evaluation/working-pap
  ers.asp where Quibrias critical overview paper
  (Development effectiveness, selectivity, and
  conditionality) can be found.

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The Modern Macro Debate (4) National Level Aid
and Growth

• The micro-macro paradox.
• Aid only works on growth in good policy countries
  (cutting the Gordian knot).
• The aid-policy interaction very delicate - not
  robust.
• Overriding evidence that aid promotes growth
  (there is no paradox), but aid efficiency varies
  depending on circumstances.

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Aid Allocation Criteria

• The IDA formula as an illustration of the basic
  aid allocation dilemma.
• Millenium Development Fund (US).
• Score recipients on their ability to use aid
  effectively and allocate aid without conditions.
• Center for Global Development (CGD) studies on
  competence to use aid flows.
• MDGs, Debt forgiveness, and PRSPs.

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Aid Modalities

• How Should Aid be Designed and Implemented?
• What Should Donors and Recipients Do?

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Four Directions for Improving Aid Policy

• Better aid allocation criteria.
• Increasing policy coherence.
• Adapting to the changing role of aid in the
  global economy.
• Exploiting microeconomic understanding.

33
Macroeconomic Criteria, Misallocation, and
Rationing

• Aid and macroeconomic performance
• Macro criteria generally inappropriate for aid
  allocation.
• Macro literature does not give clear and robust
  prescriptions/guidelines.
• Microeconomic agents (or agents that behave like
  such) receive and use aid.
• Need to understand micro behaviour

34
Lack of Policy Coherence

• Donors should do more to reconcile or at least
  clarify policies that are in partial or direct
  conflict with generally accepted principles of
  development and humanitarian assistance.
• Conflicting signals from bilateral and
  multilateral institutions, and NGOs.

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Example 1 Rich Farmers, Poor Farmers

• OECD agricultural support repressing rural
  incomes in poor countries.
• A huge tax on the worlds poor.
• A double tax!

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Example 2 Tied Aid and the WTO

• Tied aid inconsistent with principles of
  competitiveness.
• No place in the aid business.
• But, political process in many countries forces
  tied aid.
• Need to learn to live with it. A political fact
  of life in bilateral aid programs.

37
Aid in a Globalizing Economy

• The relative significance of public development
  assistance much smaller.
• There are important new agents on the
  international scene that affect the developing
  worlds prospects.
• Foreign direct investment (FDI)
• Private bank lending
• Portfolio investment

38
FDI and aid trends for non-OECD economies
(normalized from constant USD to unity in 1971)
39
The Age of Complementarity

• New environment, public aid agencies must
• Focus on core priorities (public goods,
  externalities etc.).
• Sharpen implementation skills.
• Develop new strategic capacity for complementary
  relationships.

40
Micro-perspective as a Key to Restructuring Aid
Arrangements

• In essence, aid is a contractual relationship
  among two or more parties (or partners) (but
  watch out for ownership rhetoric).
• Microeconomics offers many insights about how to
  improve the effectiveness of contracts.
• Decentralize lending arrangements as much as
  possible.
• Loans and performance-based grants with clear
  statutory contract mechanisms.
• Decentralize financial responsibility as much as
  possible.

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Conclusion What Lessons Have We Learnt?
42
Looking Back

• Spectacular progress in many countries.
• But too many people lagging behind.
• Poverty is still widespread
• Regional variations. Africa.
• A transition from colonialism, via bilateralism,
  to a more multilateral agenda in foreign aid. But
  probably changing.

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Is Aid Effective?

• Academic and public debate often confused and
  contradictory.
• But, aid has worked in the past. The aid-growth
  link is there.
• Yet, aid can be made to work better at many
  levels.

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What to Do?

• Give up excessive preoccupation with macro.
• Millennium Development Goals (MDGs)
• Promote aid effectiveness, recognizing three
  concerns
• Coherence
• Complementarity
• Restructure and remember contracts

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Readings

• Burnside, C. and Dollar, D. 2000. Aid, Policies,
  and Growth. American Economic Review 90, 847-68.
  
• Collier, P. and Dollar, D. 2001. Can the World
  Cut Poverty in Half? How Policy Reform and
  Effective Aid Can Meet the International
  Development Goals. World Development, 29,
  1787-1802.
• Devarajan, S., Dollar, D. and Holmgren, T. (eds.)
  2001. Aid and Reform in Africa. Oxford Oxford
  University Press for the World Bank.
• Easterly, W. 2001. The Elusive Quest for Growth.
  Cambridge, Massachusetts The MIT Press.
• Easterly, W. 2006. The White Mans Burden Why
  the Wests Efforts to Aid the Rest Have Done So
  Much Ill and So Little Good. Oxford University
  Press.

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Readings

• Robinson, S. and Tarp, F. 2000. Foreign Aid and
  Development Summary and Synthesis. In F. Tarp
  (ed.) Foreign Aid and Development Lessons Learnt
  and Directions for the Future. London and New
  York Routledge.
• Economist (2005). Recasting the case for aid.
  The Economist, January 22, 2005.
• Sachs, Jeffrey. 2005. The End of Poverty How We
  Can Make It Happen in Our Lifetime. Penguin
  Books.
• UN. 2002. The Millennium Development Goals and
  the United Nations Role. Fact sheet at
  http//www.un.org/ millenniumgoals/MDGs-FACTSHEET1
  .pdf accessed 16.02.05.
• World Bank. 2002. A Case for Aid Building a
  Consensus for Development Assistance. Washington,
  D.C. World Bank.