A Primer on Foreign Aid – 2: Rationale and Results

With the basic definitions out of the way (A Primer on Foreign Aid – 1) we can move on to the rationale of foreign aid and its results and consequences.

Rationale of Foreign Aid

The rationale of foreign aid, at least in the beginning, was quite simple. It was believed that there was surplus labor in poor countries while capital was scarce and the ability to borrow commercially was limited. If enough capital transfers could be mobilized on softer terms, the process of development could be facilitated and such development would be in the interest of both the developing and the developed countries.

In a nutshell, the rationale was based on the identification of two gaps – this was often called the two-gap model. It was believed that in the early stages of development, domestic savings were not enough to finance the needed investments; and that foreign exchange earned from exports was not enough to finance the imports needed for investments. External assistance was needed to bridge both these gaps.

The Strategic Focus of Foreign Aid

Conceptually foreign aid is supposed to differ from charity: charity does not intend to eliminate a problem, only to alleviate it while foreign aid was aimed to initiate a self-reinforcing path to development. The oft-quoted aphorism, ‘don’t give a fish but teach how to fish,’ captures this difference.

A closer look at the numbers should help understand this distinction. Suppose Pakistan receives $1.5 billion a year in foreign aid and its population is 180 million. This translates to $8 per person per year or less than a dollar per capita per month. Clearly, if the foreign capital transfers are distributed across the population, it would not have any meaningful developmental impact. However, there could be considerable spill-over impacts if the capital transfers were concentrated on a few critical investments (a road, a power plant, an export industry) or strategically important sectors (power and transport, for example) Alternatively, there could also be significant impact if the aid were used to improve the productivity of labor (through better education and health, for example).

Such a conclusion argues that capital transfers were best utilized for strategic projects (project aid), important sectors (sector aid) or critical programs (program aid).

The Implementation of Foreign Aid

The pattern for the implementation of foreign aid was established early on with active donors who presumed to know what needed to be done and passive recipients who ostensibly did not recognize what was good for them or how to go about doing it. Donors, both bilateral and multilateral, decided what was of importance at a particular time, prepared feasibility studies, designed projects and programs and hired principal contractors from outside the recipient country for the execution, monitoring and supervision. The latter sub-contracted local firms or NGOs for implementation tasks as needed.

In recent years, a part of the aid was transferred directly to the budget of the recipient governments (budget transfers) to expand the resources for the government’s own projects and programs. The proportion of such aid has varied over time.

Results of Foreign Aid

The results can be disaggregated into two categories, direct and indirect. In this section we look at the direct results comparing the stated intentions of foreign aid against the project or program outcomes. There is general agreement that on the whole the direct results have been disappointing although there are some success stories that can be identified.

We can take the concrete case of Pakistan to assess the balance sheet. While some successful projects can be located, sector and program aid has been disappointing to say the least. Thus, for example, there have been over half-a-dozen development loans for the railways but its performance and viability have deteriorated significantly over the years. Aid has gone into water and sewage treatment plants a majority of which are to be found in a state of disuse. And while there have been billions of dollars in aid for the public education and health sectors, both are in a state of acute crisis.

Donors often claim that the results would have been even worse without aid but this argument cannot be taken seriously. It is hard to imagine how much worse the health and education sectors in Pakistan could be given their critical state.

Reasons for Poor Results

There is little doubt that if the results delivered in Pakistan (and many other countries) by bilateral and multilateral banks had been delivered by private firms, the latter would have gone out of business or had their managements fired. Donors rationalize the poor performance by arguing that they are in a very difficult business and have to work with agents in recipient countries who are corrupt, unmotivated and inefficient. This is not an acceptable rationalization because the projects and programs are designed by the donors with the foreknowledge of the corruption, inefficiency and lack of motivation; these cannot be claimed as a surprise. The solution would be either to design against these failings or to cease working in countries that are so ill-suited to benefiting from transfers of scarce capital.

Part of the reason for the poor performance has to do with the simplistic nature of the two-gap model. Capital is a necessary input for development but by no means the only one. How the capital is used is clearly of greater importance. This belated realization led to shifting a portion of the assistance to providing what were considered the missing ingredients – technical training, capacity building, improved governance, dispute resolution mechanisms, regulatory advice, etc.

However, the determining factor remained unaddressed. The reference to private firms is intended to highlight the fact that the key to poor performance is the nature of incentives on both the donor and the recipient sides. Neither is dealing with their own money and given that the lag between investment and outcomes is long, there is no effective accountability.

With minor variations, the links in the foreign aid chain are the same for bilateral and multilateral donors. Resources originate with the taxpayers of individual countries and are appropriated for foreign assistance by their national legislatures to be channeled through an agency of the country (in the case of bilateral aid) or through international institutions (in the case of multilateral aid). The funds then move through a combination of recipient governments, international contractors and local contractors to be used for the ultimate beneficiaries, the citizens of the recipient countries, who are liable for the debt in the case of development loans.

It is quite striking that neither the taxpayers in the donor countries nor the beneficiaries in the recipient countries, the two players with the most at stake, have much say or control over the use of the resources. All the other agents in the process stand to gain from the continued flow of funds and therefore have no incentive to demand any changes even if no tangible results are being achieved on the ground. There is always some excuse or rationalization that can explain away the gap between promises and outcomes. And while there is much profit and many perks involved in training, capacity building, etc. (think of study tours), a focus on incentives only threatens to choke the leaky aid pipeline which is the source of livelihood for many of the most powerful players many of whom revolve incestuously from one part of the chain to the other.

Once the funds are appropriated for aid the principal active agents are the bilateral agencies (like USAID) and the multilateral agencies (like the World Bank) on the donor side and government ministries or agencies on the recipient side. Quite irrespective of intentions, what defines all of them is the fact that they are large bureaucracies. The amount of funds disbursed and the number of loans signed become the key metrics for their internal evaluation of success and performance with predictable results.

Continued here.

For a case study of the interaction of foreign aid and individual incentives, see So Much Aid, So Little Development: Stories from Pakistan by Samia Altaf published by the Wilson Center/Johns Hopkins University Press, June 2011.



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