Foreign Aid and Economic Development

1 Introduction

The United Nations Human Development Report (UNDP, 1996) found that over the past 15 years (1981 - 1996) economic decline and stagnation has reduced the income of 1.6 billion people in Lower Developed Countries (LDCs). Furthermore, in 70 of these states, average incomes are now less than they were in 1980 and in 43 states less than in 1970. On the other hand, volume of foreign aid, which was at least partly meant to help economic growth and reducing poverty in developing countries has grown from an annual rate of US$4.6b in 1960 to US$58b in 1992. Thus, the persistently disappointing economic performance of LDCs since the early 1970s has raised growing international concern about the role and impact of concessional development aid and its effectiveness towards economic growth. The purpose of this paper is to seek answers to the question whether foreign aid supports economic growth in developing countries and what the empirical evidence shows. In part 2, I will focus on definitions of foreign aid, their targets and problems of measurement. Part 3 will discuss the effectiveness of aid by using the results of studies about the economic performance of aid recipient countries. Additionally, some new approaches of foreign aid will be discussed here. The conclusion in part 4 will finish off this essay.

2 Definitions and targets of foreign aid and problems with its measurement

Due to some problems, as to what should be subsumed under foreign aid, economists define it as any flow of capital from developing countries to LDCs which meet two criteria. Todaro (1997, p. 545) explains that first, its objective should be non- commercial from the point of view of the donor and second, it should be characterized by concessional terms (e.g. foreign aid loans carry interest rates that are lower than those available to the recipient country through the international capital market). The concept of foreign aid, which is now widely used and accepted is one that encompasses all official grants and concessional loans, in currency or in kind that are broadly aimed at transferring resources from developed to less developed nations on development or income distribution grounds.

Foreign aids features are broad. There are many different types of aid, such as balance of payment support, project aid, food aid, technical assistance, human development aid etc. (Brewster and Yeboah 1994). The sources of foreign aid can be roughly differentiated between public development assistance, i.e. from individual national governments (bilateral aid) and multinational donor agencies (e.g. World Bank) and private development assistance of non governmental organizations (NGOs) according to Todaro (1997, p 533).

There is also a wide range of goals that foreign aid is meant to reach. The provision of aid on the part of developing countries can be linked to the promotion of private enterprise and the market system, democratization and individual rights, population control and environmental sustainability (OECD 1990). A common principle objective has been the promotion of economic growth. One major rationale of aid has been to substitute for the lack of developed private capital markets that could benefit poor countries (Vasquez 1997). The scarcity of investment capital, both at their international level and within LDCs, has been said to have hindered growth prospects of poor countries and even condemned them to perpetual misery in a so called ‘vicious cycle’. Therefore, aid was supposed to complement domestic investment resources. The role of foreign saving (including aid) is to augment domestic saving and to increase investment and thus accelerate growth according to the neoclassical analysis, i.e. aid stimulates additional private capital flow since capital accumulation is essential for rapid and self-sustained growth (Levy 1987). Both are considered to raise the productive capacity of the economy and to promote technological change. Aid may also effect growth through the investment rate. Foreign transfers are supposed to complement domestic investment resources (Levy 1987).

Another argument often propounded in favor of aid is its influence in reducing poverty and redressing income inequality in developing countries, which is often associated with economic growth (UNDP 1996). Moreover, in the 1980s new emphasis on promoting democracy and human rights and environmental issues complicated these sentiments (Graham and O’Hanlon 1997). In the 1990s new priorities such as support for export markets in LDCs were set. It is not clear that aid can achieve all these goals simultaneously. Nowadays, aid is mainly seen as a means to improve the use of domestic resources in recipient countries. The focus of aid has changed from development related projects in health, education and agriculture to encouraging the adoption of growth-oriented fiscal, trade and monetary policies.

Some types of aid, welcome though they may be, may not have a significant effect on GNP growth, or may produce perceptible results only in the very long run (Levy 1987). Another problem is finding reliable and comparable data from LDCs, especially from some low income nations of Africa. Furthermore, some observers believe that there are definition and measurement complications, which cause statistical variance of up to 50% of the ‘true’ figures (Brewster and Yeboah 1994).

But the question is whether a positive relationship between savings, foreign aid, investment and growth in LDCs indeed exists at all.

3 Performance of LDCs, effectiveness of aid and empirical evidence

A number of recent reports have already looked at the effectiveness of official development assistance, i.e. foreign aid. Boone (1994), Mosley (1987) and Vasquez (1998) concentrated in their studies on the correlation between aid flows from official sources and economic growth. Boone looked at aid flows to 97 countries during the period 1971 to 1990 and found that aid neither created nor could be correlated with those underlying factors that cause growth, such as private savings or foreign investment. Vasquez (1998) used a sample of 73 countries from 1971 to 1995 and looked again at the correlation between aid flows from all official sources and economic growth. Consistently, neither aid per capita nor aid as a percentage of GDP was positively related to economic growth in recipient countries. Hence, evidence has shown that multilateral aid does not stimulate additional capital flows and that it may even deter them (Rodrik 1996). Aid flows can also slacken the resolve for a more stringent form of budget constraint in the recipient country, i.e. causing ‘moral hazard’ problems. Due to such findings, a very strong statement against foreign aid in general was given by Mosley (1987) and the Congressional Budget Office of the USA (1997) by declaring that "foreign aid overall appears to have only a marginal effect" on development and may even hinder it.

Contrary to this, Levy (1987) found that aid correlated positively with investment and economic growth in Africa, particularly in the least developed countries of the sub- Sahara. Additionally, he suggested that fixed capital formation contributed to the rate of growth. Brewster and Yeboah (1994) established that most of the aid-favored nations, i.e. countries, which meet both criteria of above average aid growth and high aid/GNP ratio, had negative savings growth and a reduction in their per capita income during the last two decades. Furthermore, none of the independent variables, saving, investment and export growth were positively influential in respect of GNP growth. This contradicts the findings of Levy (1987) concerning fixed capital formation and economic growth.

At this stage, it can already be seen that the results of the different studies were controversial, sometimes diametrically opposed.

The case of foreign aid has been weakened by research that has identified sources of economic growth other than aid. Several recent studies (e.g. Gwartney and Lawson 1997, Hanke and Walters 1997) have found a strong link between economic freedom and economic prosperity and that achieving and maintaining high levels of freedom over time tends to produce high national income levels. Positive examples are Peru and Argentina. These findings were new, since previously the poor economic performance in developing countries was considered due to the nation’s initial conditions, such as low per capita income, few natural resources and insufficient human capital. Sachs and Warner (1995) disputed this within a study of 117 countries in which they found that policies matter more than initial conditions, i.e. that market- based policies induced faster economic growth. Further studies of this nature regarded the particular political environment that might be necessary for economic growth, namely, the need for market-oriented policies. They differentiated between countries with sound (good) economic policy and a bad policy environment.

Burnside and Dollar (1997) assembled data on 56 developing countries over 24 years (1970 - 1993) in order to find out whether more aid leads to higher economic growth. Former studies, which looked at this relationship aid and growth have generally found no evidence that more aid leads to higher growth. But Burnside and Dollar distinguished between countries on the basis of their economic policies. When they focused on low income countries with market-oriented economic policies, they found that those receiving large amounts of aid grew faster than those receiving small amounts of aid. (3.5 percent per capita growth per year compared to 2.0 percent.) Graham and O’Hanlon (1997) took a similar approach. They were also interested in the issue of why aid has succeeded in promoting growth in some countries but has failed in many others. In their study it was also found that foreign aid contributes to economic growth in countries with sound growth-oriented fiscal, trade and monetary economic policies.

As a result of these studies, a recognition in donor nations was already prevalent that aid would not do good in countries that had bad (i.e. non-market-oriented) policies (World Bank 1987). Policy-based lending seems to be highly cyclical due to the increasingly changing powers in LDCs, especially in the low-income countries of Africa. Vasquez (1997) suggested that aid could therefore contribute to instability and thereby becoming a source of economic crises. Schwalbenberg challenged with his findings this opinion. According to him, there is no significant evidence that foreign aid can induce a government to chose long-term harmful economic policies. Dollar and Burnside (1997) did not find systematic evidence of foreign aid encouraging poor policies.

In some other studies, aid itself has been singled out for another reason as a constraint on growth: It was claimed to proclude private sector investment (Mosley et al. 1990), i.e. foreign aid retarded economic growth by substituting for, rather than supplementing, domestic savings and investments. Whereas Brewster and Yeboah (1994) established that due to the structure of foreign aid, where aid for production has been averaging only about 23% of official development finance, this opinion seems to be improbable. But they admitted that foreign private investment has been minute in all aid-favored least developed countries. In their opinion, the lack of investment may rather have been as a result of a host of other reasons, having little to do with the inhibiting effect of aid, such as the absence of economic, politic and social conditions sufficiently attractive to private investors.

However, donors have often subsidized unsound economic policies. Furthermore, in some examples such as Zaire, Mozambique, The Philippines etc., foreign aid transfers were benefiting small elite groups, which were in many cases richer than people in the donor’s nations. Vasquez established that aid agencies were not in fact reducing their level of funding to countries maintaining anti-growth policies in the period 1990 - 1995 and therefore ignored their own advice.

The empirical evidence on aid and the causes of economic growth have led to calls for aid to focus on promoting economic reforms and on supporting countries that introduce such reforms (Burnside and Dollar 1997). Therefore, loans from aid agencies should be conditional upon policy reform. But in practice, these conditions, such as progress in reforming the tax system or civil service, can be very difficult to implement, to assess or to enforce. On the other hand, this approach has not been successful since there is no systematic effect of aid on policy (Mosley, Harrigan and Toye 1995). Furthermore, the need to lend (in order to remain in operation) might overcome the need to ensure the meeting of conditions stipulated. Weak borrower commitment compounded by poor donor confidence has led to a mushrooming of conditions. According to Dollar and Svensson (1998), almost all adjustment loans disburse fully, even if the policy conditions are not met.

In the study of Burnside and Dollar (1997), no per capita growth was found in developing countries with poor policies without distinguishing between the amounts of aid that flowed to those countries. They concluded that a logical response to the failures in implementing a sound market-oriented policy is to stop funding countries with poor policies and withholding disbursement entirely. But while cutting off aid may result in the formation of a reform-minded consensus in some countries, in others it may exacerbate social tensions beyond crisis point, perhaps necessitating humanitarian intervention, e.g. Sudan etc. The ‘social cost’ of such selectivity would be immense.

To understand why foreign aid might not have helped economic growth in at least some countries, its amount and allocation has to be considered. The volume of official development assistance has grown from an annual rate of $4.6b in 1960 to $58b in 1992. But in terms of the percentage of developed country GNP allocated to official development assistance (ODS), there has been a steady decline from 0.51% in 1960 to 0.32% in 1992. Regarding how foreign is allocated, it is rarely determined by the relative needs of developing countries. The Middle East, for instance, receives US$55 per capita while South East Asia receives only US$5, despite having only a third of the per capita income of the Middle East (Todaro 1997, p 549). Most bilateral aid seems unrelated to development priorities and is based largely on political, strategic or military expediency. Obviously, this approach has not altered greatly since the end of the cold war. Still, donors largely determine to whom aid is given and for what purposes it is used. In the 1990s, both bilateral and multilateral aid made conditional upon a recipient country's willingness to promote free markets, open its economy and structure itself in accordance with the donor’s capitalist and democratic principles, which might not suitable for the stage of development in all countries.

Some types of foreign aid are not meant to support economic growth (e.g. food aid) or may produce perceptible results only in the very long run. The USA, for instance, as the largest aid donor contributes only 8 percent of its aid program as ‘development assistance’ to low income countries (World Bank 1990). Another example is technical assistance, which has not only reached high levels but a significant proportion of which fails to reach the recipient country.

5 Conclusion

Everything about foreign aid seems to be controversial. While aid has succeeded in promoting economic growth in some countries in many others it has failed. It is disappointing though perhaps not surprising that the use of econometric methods should lead to such diametrically different answers to the question of the effectiveness of aid to developing countries according to the studies conducted on this subject. The exclusion or inclusion of any of the various components of aid in econometric researches and models is not well established (Cassen 1986) and is not yet a feature of econometric models of aid effectiveness. Also the policies, factors and circumstances vary among countries. Thus, there are no pre-determined norms for the aid-growth relationship but the correlation between them may be overwhelmed by the effect of other influences. In general, it seems unlikely that the use of econometric methods alone, however complex they may be, would receive conclusions of satisfactory reliability. Hence, there can be no ultimately correct answer given to the question whether foreign aid helps economic growth in developing countries since this depends on the point of view and the individual conditions of the particular aid-favored nation and the world markets.

A lower total volume of aid from the developed nations that is geared more to the real development needs of recipients and permits them greater flexibility and autonomy in meeting their development priorities might represent a positive step. The rising proportion of development assistance now being channeled through multilateral assistance agencies like the World Bank means that the political motivation is perhaps less narrowly defined compared with those of individual donor nations. It is also a welcome change that a growing number of private NGOs in both developed and developing countries are involved and supported by the donor governments.

In the future, foreign aid is likely to be linked to market reforms and to effective forms of government policy. This should be accompanied by giving the LDCs more access to the markets of the wealthier nations, i.e. further reducing of their trade barriers according to the aims of the WTO.

REFERENCES

Books

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