ECON20332/60282: Lecture 6 FOREIGN AID AND DEVELOPMENT Katsushi Imai Office Hours: Tuesday: pm

2 1. Source of Capital Inflow to LDCs (a) Foreign Direct Investment (FDI) (b) Borrowing from Commercial Banks (c) Official Financial Flows: 1) Bi-lateral + Multi-lateral 2) Concessional + non-concessionhal 3) Project Aid + Programme Aid (d) Grants and Loans from non- governmental organisations (NGOs) -See Table 15.2 (Thirlwall)

Definition of ODA ODA needs to contain the three elements: (a) undertaken by the official sector; (b) with promotion of economic development and welfare as the main objective; and (c) at concessional financial terms (if a loan, having a grant element of at least 25 Oper cent). Other Official Flows (OOF): Transactions by the official sector with countries on the List of Aid Recipients which do not meet the conditions 3

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6 -Table 15.5 (Todaro)--- ODA by Major Donor Countries -ODA by Region (Table 15.6) Does not reflect poverty-reduction needs. -Declining Trend of Net Resource Transfer -Aid-Dependency (Table 15.7)

7 2. Motives for Aid (a) Redistributive (moral case) Redistribute income globally and often within recipient LDC. (b) Allocative/ growth Positive macroeconomic impact on recipient LDC. (c) Stabilisation (Commercial) Boost world demand, esp. LDC recpient ’ s demand for donor exports- to reduce donor unemployment. (d) Geo-political (geographical/ historical) (e) Emergency Aid (war, cyclone, flood, etc.)

8 3. Dual Gap Analysis and Foreign Borrowing (a) -National Income Identity for an Open Economy Y = C + I +G + EX- IM (1) EX: Export IM: Import -Current Account and Foreign Debt CA = EX- IM CA = Y- (C+ I+ G) Let S stand for national savings. S = Y- C- G From (1): S= I +EX- IM I –S = IM- EX (2) LHS: An excess of investment over savings RHS: A surplus of imports over exports.

9 A surplus of imports over exports financed by foreign borrowing allows a country to invest more than it produces. But ex ante, LHS and RHS does not have to equal. (b) Harrod Model: g = s/ k where g = growth rate of GDP s= savings ratio =S/Y k =K/Y (capital to output ratio) g = s*p (3) where p = Y/K (productivity of capital) Likewise: g = i *m ’ (4) where i = M/Y (import ratio: ratio of investment-good imports to GDP)

10 From g = i *m’, m’=g/i = (dY/Y) / ( M/ Y) m ’ = dY/M (incremental output-import ratio) Assumption: Lack of substitutability between domestic and foreign resources. Growth will be Either Savings-constrained (--- Foreign exchange unconstrained) --A part of foreign exchange is unused. (or ) Foreign exchange-constrained (--- Savings- unconstrained) -A part of domestic savings is unused.

11 Now suppose a country sets a target rate of growth, r. Required savings ratio: s* = r/p (3)’ Required import ratio: i* = r/m ’ (4)’ ---Investment-savings gap exists if s*> s savings gap = s*- s = a a is a grant of aid. MPS (Marginal Propensity to Save)=dS/dY > APS (Average Propensity to Save) =S/Y Role of Aid: (1) Aid leads to a higher rate of accumulation. (2) Aid raises income.

12 ---Import-export gap (foreign exchange gap) exists if i*> i. If Foreign Exchange-constrained : Foreign borrowing can supplement not only deficient domestic savings but also foreign exchanges.

13 4. Models of Capital Imports and Growth O = Y + rD (2) where O is output, Y is income, r is the interest rate and D is debt. rD is factor payments abroad. From equation (2): dO = dY + rdY Also, dO = p* I (3) where p is the productivity of capital. I = sY + dD = s(O- rD) + dD = sO + dD - srD (4) where s is the propensity to save.

14 Substituting (4) into (3) and dividing by O gives: dO /O = p ( s + (dD – srD)/ O ) (5) ---Growth of output will be higher than the rate obtainable from domestic savings alone as long as dD> srD From (2): dY = dO – rdD (6) Substituting (4) into (3) and the result into (6) gives: dY = p(sO + dD – srD) – rdD (7) Using Y = O- rD, (7) can be rewritten as dY = psY + dD (p – r)

15 Then, we will get: dY/ Y = ps + (p – r)*(dD /Y) ---The growth rate of income with capital imports will be higher than that obtained alone as long as p (the productivity of capital imports) exceeds r (the rate of interest on foreign borrowing). Import surpluses have great potential in promoting growth in general. ---However, the import surpluses financed by foreign capital inflows increase the capital- output ratio (or reduce the productivity of capital) and discourage domestic saving.

16 ---A large fraction of capital inflows is consumed rather than invested. An empirical question: “ Aid will increase or decrease savings ” Griffin (1970): Griffin, 1970Griffin, 1970 K.B. Griffin, Foreign capital, domestic savings and economic development, Oxford University Institute of Economics and Statistics 32 (1970), pp. 99–112. Savings Function: Coefficient on Aid Flows /GNP= to S/Y = A/Y; R 2 = 0.54 (32 LDC data in )

17 Griffin ’ s Results and Other Works Suggested causes of domestic savings displacement: a. Gov. reduces taxation. b. Gov. reduces tax collection effort. c. Aid may cause inflation and will reduce tax receipt if tax system is inelastic. d. Gov. may switch expenditure to consumption (fungibility).

18 Criticisms of Griffin (1970): a. Total savings still increase unless MPS (marginal propensity to save) =dS/dY =0 -Aid is likely to have some positive effect on total savings and hence investment. b. Does not allow for aid multiplier feedback effects on s. - Multiplier and feedback effects can boost growth and future domestic savings. c. Fungibility is not possible in some LDCs.

19 d. Growth does not just depend on savings. Consumption can raise growth. e. Savings function may be mis-specified due to simultaneity problem. f. Correlation is different from causation. Aid may be an endogenous variable. g. Inter-country differences regarding any of above make cross-section studies inappropriate. ----Is There A Macro-Economic Case Against AID?---NO.

20 5. Country Differences in Aid Impact a) Which gap is binding (greater aid effectiveness if foreign exchange gap is binding) b) Marginal propensities to save and import differ. c) Sectoral allocation of aid. d) Allocation between recurrent and capital budgets. e) Influences on relative prices and hence on investment. f) Crowding-out effect. Rate of return on private capital differs. g) Foreign trade regime.

Yet, is there any general pattern? “ Aid Effectiveness Cycle ” (virtuous circle or vicious circle)

22 6. Effects of Tied Aid on Recipients Tied Aid: Definition (by OECD) Tied aid credits are “official or officially supported Loans, credits or Associated Financing packages where procurement of the goods or services involved is limited to the donor country or to a group of countries which does not include substantially all developing countries.”

23 Source: OECD 2006

24 6. Effects of Tied Aid on Recipients a) Reduces real value of aid resource flow – higher priced imports. b) Bias toward foreign exchange intensive and capital intensive projects. c) Donor reluctance to allow large domestic component. d) Inappropriate equipment--- high recurrent costs. e) Proliferation of different forms of same input which makes backward linkages difficult. f) Undermines domestic production efforts. g) Projects and inputs not tailored to recipient ’ s development priorities.