Daily News: "26/04/2005 BY SUBHASHINI Abeysinghe, Economist
THE costs and benefits of foreign aid has been a subject for debate for some time. Yet, the implications and benefits of aid on growth and development has not been very visible, simply because the amount of aid received by developing countries, has been too small to make a significant change in their economies.
Despite calls for a contribution of 0.7% of Gross National Product of donor countries for aid since 1970, only five countries are said to be meeting the target. These are Denmark (1.06%), Netherlands (0.82%), Sweden (0.81%), Norway (0.80%) and Luxemburg (0.7%). The percentage of US income going to poor countries remains as low as 0.14 percent of its GNP.
The topic is of interest to Sri Lanka because the country is expected to receive US$1.5 million from donors after the tsunami on December 26, 2004 for rebuilding and reconstruction.
This is deemed to have a significant impact on the economy, because this is about 7% of GDP of the country. The donors have pledged a total US$ 2.5 billion for all tsunami affected countries.
Foreign aid refers to international transfer of public and private funds in the form of loans or grants without expecting full payment.
To be considered foreign aid a flow of funds should meet two simple criteria: It should be non-commercial from the donors point of view and it should be confessional so that the interest and repayment is less stringent or softer than commercial terms. Most studies consider confessional loans to have a grant element at 25% or more.
A considerable amount of foreign aid is tied aid, which means the grants or concessionary loans have conditions laid down by the donor country about how the money should be used.
Tied aid by source means that the recipient country receiving the aid must spend it on the exports of the donor country. Tied aid by project means that the donor country requires the recipient country to spend it on a specific project such a road or a dam.
Some aid is given with humanitarian motives in mind. Humanitarian aid will flow into countries at times of crises such as natural disasters, political instability or civil conflict. The aid Sri Lanka receives after the tsunami is largely humanitarian aid.
However, most foreign aid is given for a variety of political, strategic and economic reasons that benefit the donor countries in the longer term.
Filling the gap theory is brought forward by many to support foreign aid. The funds can be used to fill the gap between savings and investment in developing countries.
The aid would raise the level of investment in the economy by easing the constraints on public funds available for necessary public investments such as roads. Aid would also limit the strain on the domestic tax base.
However, the success of foreign aid in supporting public investments also varies widely. Major drawback cited is that most infrastructure built are not maintained by the recipient country, hence the projects fail to deliver the expected long-term benefits.
Supporting education and healthcare is an area where foreign aid has been more effective in achieving its objectives than any other. Foreign aid has played a role in sponsoring education and immunization programs that have increased literacy and led to the control of various diseases such as smallpox, polio, diphtheria and measles.
Although these improve living standards of people, this does not necessarily help economic growth. The higher aspirations of people created through education, not met by the policy and the political environment of the country could lead to social unrest.
Facilitating transfer of technology is also been a success, especially in the field of agriculture. However, for transfer of technology to be really beneficial, the technology transferred should be appropriate and the capacity to adopt the technology should be increased through training and skill development.
Aid as a tool to influence political and economic reform - The notion that in countries whose political and policy environment is highly unfavourable to growth, aid is less likely to be productive and contribute to long-term economic growth is the logic behind using aid to improve governance and accelerate economic reforms.
The donors can encourage policy reform through policy dialogue (i.e. aid to create opportunities for policy discussions and interactions on key issues) and conditionality (i.e. donors release aid only if recipients meet certain economic criteria e.g. reduce budget deficit).
The effectiveness of policy dialogue and conditionality has not been very clear and whether this influence is in the best interest for the developing country or the donor country has been a topic for debate.
How can foreign aid be ineffective?
Tied aid - A UN study on African economies states that the value of aid when it is tied is reduced by about 25-40% by obliging countries to purchase uncompetitively priced imports from the donor country. Also it leads to waste of valuable time and money in transporting these to the recipient country.
The goods and services that come in may not be useful and appropriate and may not be consistent with the needs of the country. Sourcing material from the recipient country on the other hand would have the added advantage of boosting local industries, increasing employment and accelerating growth.
These benefits are lost when aid is given expecting the country to purchase goods and services from the donor country. The costs are higher when the developing countries do have ample supply of local expertise and local material to meet the needs.
According to Emira Woods of Institute of Policy Studies in Washington, 72 cents out of every US foreign aid dollar is spent on US goods and services. About 65-75 percent of Canadian aid is tied according to Talif Deen reporting at Global Policy Forum.
Capacity constraints - The type of aid that a country receives determines the effectiveness of aid to a significant extent. At the same time how the recipient country spends that aid and the capacity of the country to absorb and utilize aid is equally important determinant of the effectiveness of aid.
When a country does not have the technical or administrative ability to absorb and use the aid properly, the money can be wasted. In such circumstances, the projects funded could fail because they are poorly conceived and badly planned.
Institutions and polices - It is widely accepted that aid is more effective when received by countries with better institutions and policies.
However, countries with better institutions and policies may do well even without aid. The irony is that the countries that need aid most and has more acute poverty are those without proper institutions and policies in place.
Another reason that reduces the effectiveness is that the governments of recipient countries using the aid to further their political interests than the economic interests of the country, leading to aid money being wasted.
It is said that aid generally increase the power, resources and patronage of the governments of recipient countries and divert attention, energy and resources of people who try to focus on the outcome of political and administrative decisions.
Foreign aid as a tool to further donor country interests - Aid is not always aimed at reducing poverty and promoting growth in developing countries. Most instances foreign aid serves as a political and economic tool to further interests of the donor countries.
Some reasons that would compel a donor country to give more to one country and less to another, does not necessarily depend on the need, but more on the strategic importance of the recipient countries.
The donor countries could use aid to gain political support/ political ally and for trade and service liberalisation in areas which are of interest to the donor country.
Discouraging domestic savings and increasing consumption - A theory against the filling the gap theory is that in reality foreign aid may permit domestic resources to be diverted from investment to consumption with no net effect on growth.
Increase in borrowing by recipient country - Aid and borrowing is sometimes considered as substitutes. However, there are studies that challenge this view. Some studies have revealed that aid can induce overspending by recipients, which results in borrowing in addition to aid loans already received.
This could be because the officials may not have a proper estimation of the amount of aid they would receive. This is referred to as the aid illusion, hence, the officials may not have a proper understanding of their budget constraint.
Also, when large volumes come from different parties, it is difficult to understand the nature of restrictions of the aid grant.
Appreciation of foreign exchange - The amount of foreign aid received by developing countries like ours has been relatively small compared with the size of the economy. Hence, the aid has not had much impact on growth and has not been a threat to the macroeconomic stability of the country.
The countries receiving a significant inflow of foreign aid would experience real exchange rate appreciation. Sri Lanka also experienced similar appreciation of about 6 percent from 3rd January to 11th January 2005.
In such instances sterilization of the money supply can help reduce appreciation and make aid more effective. A study has revealed that sterilization policy to be quite effective in preventing real appreciation.
This can lead to an increase in national savings by leading to an accumulation of international reserves. Sterilization would increase welfare, only if the Dutch decease costs (i.e. rise in the price of non-traded goods relative to traded goods drawing resources out of traded goods into non-traded goods sector) is larger than consumption and productivity benefits of foreign aid.
Also, the case for sterilization is said to be weaker when aid is in the form of grants rather than loans or when sterilization crowds out private investment. The study concludes that exact policy prescriptions could only be based on country-specific assessments of costs and benefits of aid flows.
THE costs and benefits of foreign aid has been a subject for debate for some time. Yet, the implications and benefits of aid on growth and development has not been very visible, simply because the amount of aid received by developing countries, has been too small to make a significant change in their economies.
Despite calls for a contribution of 0.7% of Gross National Product of donor countries for aid since 1970, only five countries are said to be meeting the target. These are Denmark (1.06%), Netherlands (0.82%), Sweden (0.81%), Norway (0.80%) and Luxemburg (0.7%). The percentage of US income going to poor countries remains as low as 0.14 percent of its GNP.
The topic is of interest to Sri Lanka because the country is expected to receive US$1.5 million from donors after the tsunami on December 26, 2004 for rebuilding and reconstruction.
This is deemed to have a significant impact on the economy, because this is about 7% of GDP of the country. The donors have pledged a total US$ 2.5 billion for all tsunami affected countries.
Foreign aid refers to international transfer of public and private funds in the form of loans or grants without expecting full payment.
To be considered foreign aid a flow of funds should meet two simple criteria: It should be non-commercial from the donors point of view and it should be confessional so that the interest and repayment is less stringent or softer than commercial terms. Most studies consider confessional loans to have a grant element at 25% or more.
A considerable amount of foreign aid is tied aid, which means the grants or concessionary loans have conditions laid down by the donor country about how the money should be used.
Tied aid by source means that the recipient country receiving the aid must spend it on the exports of the donor country. Tied aid by project means that the donor country requires the recipient country to spend it on a specific project such a road or a dam.
Some aid is given with humanitarian motives in mind. Humanitarian aid will flow into countries at times of crises such as natural disasters, political instability or civil conflict. The aid Sri Lanka receives after the tsunami is largely humanitarian aid.
However, most foreign aid is given for a variety of political, strategic and economic reasons that benefit the donor countries in the longer term.
Filling the gap theory is brought forward by many to support foreign aid. The funds can be used to fill the gap between savings and investment in developing countries.
The aid would raise the level of investment in the economy by easing the constraints on public funds available for necessary public investments such as roads. Aid would also limit the strain on the domestic tax base.
However, the success of foreign aid in supporting public investments also varies widely. Major drawback cited is that most infrastructure built are not maintained by the recipient country, hence the projects fail to deliver the expected long-term benefits.
Supporting education and healthcare is an area where foreign aid has been more effective in achieving its objectives than any other. Foreign aid has played a role in sponsoring education and immunization programs that have increased literacy and led to the control of various diseases such as smallpox, polio, diphtheria and measles.
Although these improve living standards of people, this does not necessarily help economic growth. The higher aspirations of people created through education, not met by the policy and the political environment of the country could lead to social unrest.
Facilitating transfer of technology is also been a success, especially in the field of agriculture. However, for transfer of technology to be really beneficial, the technology transferred should be appropriate and the capacity to adopt the technology should be increased through training and skill development.
Aid as a tool to influence political and economic reform - The notion that in countries whose political and policy environment is highly unfavourable to growth, aid is less likely to be productive and contribute to long-term economic growth is the logic behind using aid to improve governance and accelerate economic reforms.
The donors can encourage policy reform through policy dialogue (i.e. aid to create opportunities for policy discussions and interactions on key issues) and conditionality (i.e. donors release aid only if recipients meet certain economic criteria e.g. reduce budget deficit).
The effectiveness of policy dialogue and conditionality has not been very clear and whether this influence is in the best interest for the developing country or the donor country has been a topic for debate.
How can foreign aid be ineffective?
Tied aid - A UN study on African economies states that the value of aid when it is tied is reduced by about 25-40% by obliging countries to purchase uncompetitively priced imports from the donor country. Also it leads to waste of valuable time and money in transporting these to the recipient country.
The goods and services that come in may not be useful and appropriate and may not be consistent with the needs of the country. Sourcing material from the recipient country on the other hand would have the added advantage of boosting local industries, increasing employment and accelerating growth.
These benefits are lost when aid is given expecting the country to purchase goods and services from the donor country. The costs are higher when the developing countries do have ample supply of local expertise and local material to meet the needs.
According to Emira Woods of Institute of Policy Studies in Washington, 72 cents out of every US foreign aid dollar is spent on US goods and services. About 65-75 percent of Canadian aid is tied according to Talif Deen reporting at Global Policy Forum.
Capacity constraints - The type of aid that a country receives determines the effectiveness of aid to a significant extent. At the same time how the recipient country spends that aid and the capacity of the country to absorb and utilize aid is equally important determinant of the effectiveness of aid.
When a country does not have the technical or administrative ability to absorb and use the aid properly, the money can be wasted. In such circumstances, the projects funded could fail because they are poorly conceived and badly planned.
Institutions and polices - It is widely accepted that aid is more effective when received by countries with better institutions and policies.
However, countries with better institutions and policies may do well even without aid. The irony is that the countries that need aid most and has more acute poverty are those without proper institutions and policies in place.
Another reason that reduces the effectiveness is that the governments of recipient countries using the aid to further their political interests than the economic interests of the country, leading to aid money being wasted.
It is said that aid generally increase the power, resources and patronage of the governments of recipient countries and divert attention, energy and resources of people who try to focus on the outcome of political and administrative decisions.
Foreign aid as a tool to further donor country interests - Aid is not always aimed at reducing poverty and promoting growth in developing countries. Most instances foreign aid serves as a political and economic tool to further interests of the donor countries.
Some reasons that would compel a donor country to give more to one country and less to another, does not necessarily depend on the need, but more on the strategic importance of the recipient countries.
The donor countries could use aid to gain political support/ political ally and for trade and service liberalisation in areas which are of interest to the donor country.
Discouraging domestic savings and increasing consumption - A theory against the filling the gap theory is that in reality foreign aid may permit domestic resources to be diverted from investment to consumption with no net effect on growth.
Increase in borrowing by recipient country - Aid and borrowing is sometimes considered as substitutes. However, there are studies that challenge this view. Some studies have revealed that aid can induce overspending by recipients, which results in borrowing in addition to aid loans already received.
This could be because the officials may not have a proper estimation of the amount of aid they would receive. This is referred to as the aid illusion, hence, the officials may not have a proper understanding of their budget constraint.
Also, when large volumes come from different parties, it is difficult to understand the nature of restrictions of the aid grant.
Appreciation of foreign exchange - The amount of foreign aid received by developing countries like ours has been relatively small compared with the size of the economy. Hence, the aid has not had much impact on growth and has not been a threat to the macroeconomic stability of the country.
The countries receiving a significant inflow of foreign aid would experience real exchange rate appreciation. Sri Lanka also experienced similar appreciation of about 6 percent from 3rd January to 11th January 2005.
In such instances sterilization of the money supply can help reduce appreciation and make aid more effective. A study has revealed that sterilization policy to be quite effective in preventing real appreciation.
This can lead to an increase in national savings by leading to an accumulation of international reserves. Sterilization would increase welfare, only if the Dutch decease costs (i.e. rise in the price of non-traded goods relative to traded goods drawing resources out of traded goods into non-traded goods sector) is larger than consumption and productivity benefits of foreign aid.
Also, the case for sterilization is said to be weaker when aid is in the form of grants rather than loans or when sterilization crowds out private investment. The study concludes that exact policy prescriptions could only be based on country-specific assessments of costs and benefits of aid flows.
