EC336 Economic Development in a Global Perspective

1. EC336Economic Development in a Global Perspective Abhishek chakravarty 2013-14 Lecture 6

2. Lecture Outline • We will look at the determinants of foreign aid, and whether it truly helps developing countries achieve higher economic growth. • The material is from Todaro and Smith Ch 14, and the starred papers in the reading list.

3. The Basics of Foreign Aid • The widely used definition of foreign aid is 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 and/or income distributional grounds. • Official (public) debt can be divided into Official Development Assistance (ODA) and Official Development Finance (ODF). The ODF includes all financial flows from the developed country governments and multilateral agencies to the developing world; while the ODA (subset of ODF) includes only grants and concessional loans (with at least 25% grant component) . • Multilateral aid: Aid administered by agencies like the World Bank and the United Nations. Bilateral aid: Aid provided from an individual country to another.

4. The Basics of Foreign Aid • There can be problems in measuring the actual flow of assistance because: • A one-dollar grant and a one dollar loan might have different significance to both aid-giving country and aid-receiving country (measuring costs, benefits, repayments, etc.) • Aid can be tied either by source (purchase of goods and services in donor country) or by project (e.g. money used only for a road). • The difference between nominal and real aid flows. Once inflation is taken into consideration, the real volume of aid has fallen in many donor countries.

5. Official Development Assistance: Net Disbursements from Major Donor Countries

6. Official Development Assistance: ODA by Region in 2008

7. The Basics of Foreign Aid • The share of aid as a proportion of donor GNP is below the UN target of 0.7% of GNP except for the Nordic countries (first table) • There are great disparities in the per capita allocation of aid and the most generous per capita allocations do not necessarily go to the poorest countries (second table). Some middle countries received more aid per capita than many least developed countries. • This suggests that most aid programmes in donor countries might cover different initiatives (say commercial and strategic) which often have very little connection (if some) with development.

8. The Basics of Foreign Aid • Although foreign aid provision dates from early times, it was institutionalised in the 1940s after the World War II with the Marshall Plan (bilateral assistance from the USA to European countries) and the creation of institutions to provide multilateral assistance (UN, World Bank, IMF). After the reconstruction of Europe, attention turned to developing nations. • During the 1940s-1950s, the main aim of western aid in the Cold War was to prevent developing countries from embracing communism • However, during the 1960s, researchers like Rosenstein-Rodan (“big push” theory) and Chenery and Bruno (two-gap models) claimed that the main constraint to economic development was lack of capital accumulation and foreign aid was required to supplement domestic savings.

9. The Basics of Foreign Aid • Donor’s motives for giving aid: • Political: The flow of funds varies in accordance with the donor's political assessment of changing international situations and not the relative need of different potential recipients. Foreign aid can be aimed to protect national security (e.g. foreign aid was justified during the Cold War and in Latin American countries during the 1960s to guard developing countries against the threat of communism.) • Economic: The basic framework used is the "dual gap" analysis of foreign assistance pioneered by Chenery and collaborators (e.g. Chenery and Strout; AER, 1966). Algebraically, the simplest version of dual-gap model can be formulated as: Y = C+I+X-M and Y = C+S Therefore: I-S = M-X

10. The Basics of Foreign Aid • This identity says that if foreign flows finances the excess of imports over exports, a country is allowed to spend more than it produces or to invest more than it saves. The equality between the savings gap (I-S) and foreign-exchange gap (M-X) follows from accounting procedures and says that ex post they must be equal. • However, there is no reason why ex ante (in the planned sense) they must be equal. Let F be the amount of capital inflows, then I-S ≤ F is the savings gap M-X ≤ F is the foreign exchange gap where given initial values of I, X and Y, only one of the two inequalities will be binding and output growth will be constrained to a lower level by the relevant constraint. In order to achieve the desired target rate of growth, the constraint must be lifted (i.e. the gap filled) with foreign flows of aid and borrowing.

11. The Basics of Foreign Aid • Self Interest: There is an increasing tendency in providing interest bearing loans rather than outright grants and towards tying aid to the exports of donor countries. Also, donors allocate aid with the aim of to expanding their own markets creating sources of cheap imports from developing countries, protecting private foreign investment abroad, etc. Therefore, benefits accrue to donors as a result of their aid programmes. • Recipient’s motives for accepting aid: • Economic: The idea is that aid helps in the development process. Conflicts arise not out of any disagreement about the role of aid but over its amount and conditions. • Political: Aid can provide greater political support to the existing leadership and suppress political opposition or could help the opposition to overthrow the leader in charge. • Moral: It is related to the humanitarian responsibility of the rich nations towards the poor, and the belief that developed countries owe developing countries for past exploitation

12. The Effects of Aid on Savings and Growth • Hansen and Tarp (2000) reviewed a total of 131 cross-country regression studies of the impact of aid on savings, growth and investment between late 1960s and late 1990s. • They concluded that there is large evidence from these studies is that aid leads to an increase in total savings but in less proportion. Studies focusing directly on aid and investment suggested that the relationship is a significantly positive one. The link between this investment and growth however is a more complicated one. • Hence, although aid may raise savings and contribute to investment, not all of the aid money materialises into investment and growth.

13. The Effects of Aid on Savings and Growth • For example, Easterly (1997) calculates the loss of the Zambia government-led development strategy which relied on aid-financed investments during 1961-1994. • If development aid would have financed only investment and investment would have been a key factor in growth, then aid to Zambia should have financed rapid growth, which would have raised per capita income above US $20,000. • In reality, per capita income stagnated at around $600.

14. The Effects of Aid on Savings and Growth What should have happened based on aid received. What actually happened despite aid received.

15. The Effects of Aid on Savings and Growth

16. Who Gives Foreign Aid to Whom and Why? (Alesina and Dollar, 2000) • They examine the motives for providing aid over the period 1970-1994, and find evidence that the pattern of allocation of foreign aid follows political and strategic considerations (lobbying) much more than economic needs and policy performance of the recipient. • In particular, they find that colonial past and political alliances are main determinants of foreign aid allocation. • Moreover, they also discover that donors exhibit significant different behaviour. Nordic countries give aid much more on the basis of income levels and good policies, whereas many countries with former colonies give aid with the motive of maintaining or strengthening political alliances.

17. Who Gives Foreign Aid to Whom and Why? (Alesina and Dollar, 2000)

18. Who Gives Foreign Aid to Whom and Why? (Alesina and Dollar, 2000) • They have data on bilateral aid flows for 1970-1994 for five year periods provided by each donor to each country. Using data for all countries, they regress the level of per capita aid on indicators like poverty, policies and strategic interests of donors using a basic OLS model. • They include the following variables: • Initial real GDP per capita (in first year: 1970) of recipient country • Population of recipient • Openness: dummy (0-1), based on proportion of years recipient country is “open” • Democracy: An index of democracy recipient country • Civil liberties: An index of civil liberties (highly correlated with democracy index) • UN Friend: An indicator of donor-recipient friendship based on correlation in voting patterns • Index for Rule of Law in recipient county • Colonial status. The number of years the recipient country was a colony in the 20th century. • Dummies for Egypt and Israel, Muslim and Roman Catholic country.

19. Who Gives Foreign Aid to Whom and Why? (Alesina and Dollar, 2000) • The results show that per capita aid tends to be higher in countries: • with high initial per capita income (but at decreasing rate) • small population • colonial past • more “open” • democratic. • Political and strategic motives are important i.e. other things equal, longer former colonies and a country that voted relatively often with Japan in the UN receive more aid. Friends of Japan received more aid than friends of the USA but these variables seem to be correlated with the controls for Egypt and Israel which suggest that issues of the Middle East are important determinants of UN votes. Egypt and Israel receive much more aid than other countries taking into account the characteristics controlled for in the regression.

20. Aid Matters in a Good Policy Environment(Burnside and Dollar, 2000) • Burnside and Dollar (2000) create an annual dataset of 56 aid receiving developing countries for 1970-93 and aim to explain the effect of aid on growth and other variables over 4 years averages. • The theoretical framework is a neoclassical growth model with convergence to the steady state growth. Poor countries have a high return to capital – potential to catch up in income levels with rich countries. Because of imperfect international capital markets, poor countries will tend to grow slowly. • Foreign aid can accelerate growth rates but institutional and policy distortions can lower the return to capital. Therefore, the impact of aid is greater in low distortion environment.

21. Aid Matters in a Good Policy Environment(Burnside and Dollar, 2000) • They created an “economic management index” based on the coefficients in a standard growth regression which included among other variables, the Sachs–Warner measure of openness, budget surplus/GDP, and inflation rate. Policy index = 1.28 + 6.85 x Budget surplus - 1.40 x Inflation + 2.16 x Openness • Splitting countries between good and poor management groups, they show that the good management group grow faster at all income levels.

22. Aid Matters in a Good Policy Environment(Burnside and Dollar, 2000)

23. Aid Matters in a Good Policy Environment(Burnside and Dollar, 2000) • Using regression analysis and controlling for other variables, they show that: • Per capita growth and the economic management index are positively correlated • Aid/GDP on its own was not statistically correlated with per capita growth. • Aid/GDP interacted with the economic management index had a positive and statistically significant relation with per capita growth. • For countries with poor economic management, whatever the amount of aid, growth was very small or negative. • There are diminishing return to aid i.e. the benefit of aid declines as aid is increased • Aid allocation is explained by donor’s strategic interests in the case of bilateral aid it rewards good policies only in the case of multilateral aid • World Bank estimates: In countries with sound policies: • 1% aid/GDP → 0.5% increase in GDP growth • 1% aid/GDP → 1% reduction in poverty