Foreign Aid (Concessional financial flows)

Foreign sources of finance 1. Concessional financial flows: Foreign Aid Lower interest rates, longer repayment periods.  Soft loans / Grants (gifts)  Public: Official Development Assistance (ODA).  By an individual country (bilateral aid), or by international organizations (multilateral aid).  Loans / Grants  Private: NGOs → grants

2. Non-concessional lending Same terms as in the commercial banking systems  Public: multilateral organizations: World Bank, IMF  Private: commercial banks 3. Private investment  FDI  Foreign portfolio investment: Inflows of financial capital that is invested in the local stock and bond markets of LDCs.

Foreign finance can help LDCs to address three constraints: Foreign finance can help LDCs to address three constraints: 1.Insufficient domestic savings 2.Insufficient foreign exchange earnings 3.Insufficient technical skills, managerial skills & technology can be supplemented by the transfer of foreign skills & technology into the LDC.

Foreign Aid: Concessional loans & grants Largest share: ODA, including bilateral and multilateral soft loans (25%) and grants (75%). Largest share: ODA, including bilateral and multilateral soft loans (25%) and grants (75%). Donor countries: most of OECD countries, some OPEC countries and some Eastern countries. Donor countries: most of OECD countries, some OPEC countries and some Eastern countries.

Multilateral organizations providing ODA: Multilateral organizations providing ODA: –UN agencies –Single-issue funds (eg: global fund for AIDS) –International Development Association of the World Bank –Regional development banks –IMF assistance for debt relief

Purposes Purposes –Humanitarian aid –Debt relief –Development assistance: Financial support to sectors Financial support to sectors Financial support for specific projects Financial support for specific projects –Technical assistance (doctors, teachers, agronomists).

Donor motives Donor motives 1.Political & strategic motives. Use of aid to support regimes considered to be ‘friendly’ to the interests of the donor governments. 2.Economic motives. Assistance to countries with strong economic ties, such as Japan, with aid directed to neighbouring countries with trade and investment links. Tied aid: recipients must spent a portion of the borrowed funds on the purchase of g+s from the donor country.

3. Humanitarian & moral motives Short term emergency assistanceShort term emergency assistance Long-term development assistance on debt relief and poverty alleviationLong-term development assistance on debt relief and poverty alleviation Political & strategic interests predominate Political & strategic interests predominate

Factors limiting the effectiveness of aid 1. Tied aid. In the context of bilateral aid: recipients must spend part of the borrowed funds on g+s from the donor country. Higher import costs.Higher import costs. Purchase of inappropriate capital intensive technologies & development and use of skills inappropriate to local developing country conditions.Purchase of inappropriate capital intensive technologies & development and use of skills inappropriate to local developing country conditions. 2. Conditional aid. Donors impose conditions to be met by recipients to ensure that funds are used effectively.

a.Policies towards market orientation. b.Acceptance of projects decided by donors. c.Detailed reporting on spending, timetables, priorities. Problems with conditional aid: 1.The preferences of the government or population group are not considered. 2.Policy prescriptions by donors may be incorrect: – May not fit in with the government’s priorities – May undermine government’s authority

3. Aid volatility and unpredictability. –Makes it difficult for recipient governments to implement policies that depend on aid funds 4. Uncoordinated donors → inefficiencies in the use of aid resources 5. Aid substitutes rather than complements domestic resources → not enough effort to increase revenues through taxation.

6. Aid may not reach those most in need.  Aid resources are not allocated on the basis of the greatest need for poverty alleviation:  Bilateral donors guided by political & strategic interests.  Recipient country’s gov may not be committed to poverty alleviation or lack expertise to design a poverty alleviation strategy. 7. Aid associated with corruption.  Misuse of aid funds by recipient countries

Aid vs Trade debate Three different perspectives: Three different perspectives: 1.Trade, not aid 2.Trade and aid 3.Aid for trade

Trade, not Aid Proponents: development should be based on an expansion of int’al trade and increasing exports of LDCs, while aid should be curtailed or abandoned. Proponents: development should be based on an expansion of int’al trade and increasing exports of LDCs, while aid should be curtailed or abandoned.

Failures of foreign aid: Failures of foreign aid: 1.Aid is a breeding ground for corruption, as funds are misappropriated by corrupt leaders. 2.Aid substitutes for rather than complements domestic government revenues. Governments lose incentive to increase tax revenues and increase efficiency of tax system → dependency on aid funds. 3.Aid does not reach those most in need.

Countries need international trade: Success of East Asian countries: int’al trade contributes to growth and development. Countries need international trade: Success of East Asian countries: int’al trade contributes to growth and development. BUT: on the condition that DCs eliminate their trade barriers and protection of their agricultures. BUT: on the condition that DCs eliminate their trade barriers and protection of their agricultures.

Trade and Aid International trade and an export orientation are indispensable to growth and development, but not enough by themselves in the case of LDCs. International trade and an export orientation are indispensable to growth and development, but not enough by themselves in the case of LDCs. Foreign aid has not failed. Many of its weaknesses (tied aid, conditional aid, lack of coordination, volatility) are the responsibility of donors and there is pressure to correct these problems. Foreign aid has not failed. Many of its weaknesses (tied aid, conditional aid, lack of coordination, volatility) are the responsibility of donors and there is pressure to correct these problems.

Foreign aid is necessary to help LDCs to escape the poverty cycle to increase provision of basic services. Aid can make resources available for investments in health, education and infrastructure, helping the poor to improve employment opportunities and improve their incomes.

3....to improve income distribution, by focusing on the most disadvantaged groups for growth. Aid makes possible increased investment and consumption levels. Mozambique, Tanzania, Uganda, which rely heavily on aid, have achieved high growth rates for the achievement of the MDGs.

6....for debt relief purposes. Aid helps countries reduce their debt burden and releases resources that can be used for poverty reduction and economic growth and development.

Int’al trade may be of little use 1. Elimination of agricultural subsidies would have mixed effects for food importers (Africa): positive for producers, negative for consumers. 2. Countries may have little to export: –Limited access to credit –Difficult to move into production of goods that can be exported.

3. Geographically isolated countries and communities: no access to markets, urban centres or to ports → unable to compete in international markets. Investments in communications and transportation are necessary to benefit from trade → aid can provide the resources.Investments in communications and transportation are necessary to benefit from trade → aid can provide the resources.

Aid for trade Consensus among development economists: Consensus among development economists: In order to benefit from from int’al trade, LDCs must have the institutional capacity to increase their exports. A portion of aid should be used to support the development of institutions that improve a country’s abilities to export. A portion of aid should be used to support the development of institutions that improve a country’s abilities to export.

Institutional constraints: Institutional constraints: –High transport costs due to poor transport networks –Limited access to credit –Poor power supplies → higher production costs – High administrative costs (border procedures) – Lack of capacity to meet technical and sanitary standards

Aid and trade policies should be integrated. Aid and trade policies should be integrated. The aid for trade would be ‘in addition to’ and not a replacement for ODA. The aid for trade would be ‘in addition to’ and not a replacement for ODA. Efforts to address institutional constraints to trade should also focus on middle income developing countries, which do not qualify for ODA funds. Efforts to address institutional constraints to trade should also focus on middle income developing countries, which do not qualify for ODA funds.