How Far Does Foreign Aid Contribute to the Economic Development of the Poor Countries

Prepared for:

Ehsanul Haque Adjunct Faculty Department of Social Sciences East West University, Dhaka.

Prepared by:

Name Arafat Rauf

ID 2009-2-10-345

GEN 210 Section: 2 Summer: 2011

Date of Submission: 9th August 2012

The Definition of Foreign Aid Foreign aid refers to transfer of real resources from governments or public institutions of the richer countries to governments of less developed countries (LDCs) in the third world. The flows of foreign resources can be of many types and it is important to know the different elements. Foreign capital flows are generally divided into two broad streams official and private. The official capital flows are in turn subdivided into bilateral and multilateral flows. Official bilateral flows consist of capital provided by government of donor to government of recipient countries. Multilateral flows consist of capital flows from multilateral organizations such as the World Bank, the United Nations, and the IMF. Both types of the official flow can take the form of grants, loans or grant-like contributions. Total foreign aid, the voluntary transfer of funds from richer governments for the purpose of assisting less fortunate countries, was $133.5 billion in 2011, up from $128.7 billion in 2010. Motives for Aid Richer countries embarking on aid programs are inspired by four broad motives, the emphasis of each varying greatly between donors, whilst buffeted by the prevailing global political and economic climate. The first is the desire to tackle extreme poverty on ethical grounds, often articulated through shared global ambition such as the Millennium Development Goals (MDGs). Governments may also be jolted into action by public response to humanitarian emergencies, accentuated through the lens of global media coverage. The second motive stems from recognition that, in a globalised world, countries large and small are interdependent, not just in the context of expanding economic opportunities but also in relation to environmental and security issues. Controlling the spread of disease, whether in humans, livestock or crops, requires competence in all governments. And excessive inequality between countries is known to increase the supply of migrant workers, not always welcome in richer countries. The third motive for donor countries is the pursuit of strategic political and economic interests. Aid is a tool for constructing alliances in the international domain, now as in the Cold War era. Chinas strategic aid model offers to finance and build infrastructure on condition that loan repayments are realised in equivalent value of oil, timber or other natural resources. A final motive has emerged in the decade since the 9/11 terrorist attack on New York. Donor countries recognize that fragile or post-conflict states are especially vulnerable to chronic poverty - which can renew the cycle of violence or, in some circumstances, inspire the foot soldiers of terrorism.

Aid Critics Can create Culture of Dependency: Government performance may also be undermined by a culture of aid dependency; in 2009 there were 30 countries dependent on foreign aid for more than 30% of their national budget. High aid dependency can restrict capacity for independent policy-making and institutional delivery. For example, Bangladesh is heavily dependent on foreign aid. The government makes their budget

consist with foreign aid without even knowing that they will get aid or how much they are going to get. Development programs are greatly hampered then when they dont get the aid. Lack of appropriate Framework Challenge of creating a framework of accountability which satisfies both the taxpayers in rich countries (who ultimately fund the aid) and the beneficiaries. Donors fear the political backlash from reports of aid propping up corrupt or despotic regimes. Some donor countries address this concern by imposing conditions for their aid, demanding standards of economic management, observance of human rights and democracy, or tying contracts to their own corporations and consultants. Conditionality creates problem: The effectiveness of aid, however, depends largely upon both the donor and recipient motives and how these may be aligned or conflicting with the objectives of aid. This is also depends on the extent to which aid is tied to capital projects rather than being disbursed in forms such as food aid, balance of payments support and debt relief which do not necessarily have any development component at all. Whether the recipient uses aid to increase savings and investment rather than switch aid resources to consumption and other nonproductive purposes, also determine the effectiveness of aid. Conditionality has proved to be a distraction from the goal of human and economic development, however rational its motive. For example, tied aid inevitably results in overpriced contracts or delivery of inappropriate goods, as well as inhibiting the development of domestic industries. However, evidence shows that donor countries are increasing aid tying. This is, of course, in the best of interest of the donor country as opposed to the poverty stricken recipient country. It does not serve to increase growth in LDCs but has an adverse effect on growth, employment and the balance of payments. Thus, it is suggested that donor countries must avoid tying of aid, especially joint tying by source and by commodity as it leads to monopolistic exploitation Information: Hayekian knowledge problems Hayek (1945) identified in his article The Use of Knowledge in Society the central problem to social coordination. This central problem, later known as the knowledge problem, identifies that every society faces decentralized knowledge. Information is discontinuous, dispersed across many individuals, and often contained in inarticulate forms. The success of foreign aid involves coordination from both the donors and the recipients. On both sides, information is dispersed, local, and decentralized. Donors are very good at specifying goals and what they hope to achieve with the aid, but they may not know where aid is required, who it is needed by, in what locations, and in what quantities. Similarly, the poor in the recipient countries know what they need and in what quantities, but they may not know who has the aid or how to get it. Recipient incentives Recipients of aid face their own incentive structure. These recipients include the receiving government, individual citizens, and special interests groups within these countries. Foreign aid disbursements go to the ruling governments in aid receiving countries. What incentive do these governments have to actually achieve results? Most of the governments receiving large sums of

aid are already corrupt, contributing to why they are poor in the first place. According to Coyne and Ryan (2009), the worlds worst dictators have received $105 billion dollars under the guise of official development assistance. Instead of helping the poor, development assistance is aiding the ability of dictators to remain in power. Also, Alesina and Weder (2002) do not find any evidence that aid donors give less to corrupt governments. They actually find in some cases that donors give more. Donor incentives Donor countries and aid agencies face their own incentives when developing foreign aid policy that ranges from special interest groups, bureaucrats, and government strategic interests. Politicians within donor governments are constrained to some extent by public opinion and by a larger extent, special interests. Individual voters do not have the incentive to become informed about foreign aid policy and remain rationally ignorant. However, special interests groups within the donor countries do have the incentive to become informed in order to secure large benefits while dispersing the costs among the larger population. It follows that we should not expect politicians in donor countries to actually form foreign aid policies that will promote development due to special interests influence. To illustrate this point, consider the following example. Producers in the donor countries are interested in affecting various development supplies and projects. They are interested in securing rights to supply aid-allocated resources in recipient countries. These producers find it in their best interest to lobby the donor government for projects that will benefit their specific purpose. These lobbying efforts need not align with the best aid projects being implemented or with the most efficient producer securing the rights to provide these services. In fact, if the producers are very successful, they may even be able to secure unnecessary, expensive projects. Donor governments submit to these lobbying efforts to appease politically important domestic producers. Supporting this argument, Younas (2008) provides empirical evidence indicating that aid allocation motivation stems partly from potential trade benefits that accrue to the donor country. Foreign aid is dispersed more to recipient nations who import capital goods from the donor country. So it can be concluded that, although foreign aid has tremendous effect and advantage on a LCDs economy but it also has some big problems. The issues discussed in the Aid Critics section undermine the advantages of foreign aid. If government cannot spend aid wisely, the money may be wasted. When the money in question is lent rather than donated outright, the society faces a financial burden that it must repay. Some analysts support the idea of aid but believe that the shortcomings of aid are so common and in practice aid does more harm than good. Economist William Easterly charges that one of the best economic ideas of our time, the genius of free market, was presented in one of the worst ways, with unelected outsiders imposing rigid doctrines on the xenophobic unwilling.

Reference 1. E. M. Ekanayake, Bethune-Cookman University Dasha Chatrna, University of Florida, The effect of foreign aid on economic growth in developing countries, Journal of International Business and Cultural Studies See http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=4&ved=0CIwBEBYwAw&ur l=http%3A%2F%2Fwww.aabri.com%2Fmanuscripts%2F09359.pdf&ei=nsVUM3PGIP0mAX37oGgBg&usg=AFQjCNE3ONjAw67nmDB1NoyDhF_873h9XA&sig2=l6EP Zlf9WGU8GaXx6pj9uA accessed 7th August 2012

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3. Claudia R. Williamson, Exploring the failure of foreign aid: The role of incentives and information See http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=10&ved=0CKABEBYwCQ &url=http%3A%2F%2Fdri.fas.nyu.edu%2Fdocs%2FIO%2F12361%2FWilliamsonRAEAid.pdf&ei =-nsVUM3PGIP0mAX37oGgBg&usg=AFQjCNGQRioY_ZeKeQPw1N6wieCOCQH7g&sig2=fnskDuFvz_zJgxjjUtgOuA accessed 7th August 2012