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Finance & Development, September 1973
Article

The Plight of Small Countries: Small countries receive more aid than big ones, on both a per capita basis and as a percentage of their GNP. But this may not be as unfair as it seems.

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1973
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Barend A. de Vries

The distribution of official development assistance from a variety of sources to recipient countries is a result of many interacting forces—political, technical, economic, and financial. Whatever the factors, small countries tend to receive more aid than large ones, both per capita and as a percentage of their gross national product (GNP). Is the more favorable treatment of small countries the result of a recognition of their greater needs?

This is a rather novel topic. Some studies of trade orientation and development patterns explicitly take the economic size of countries into account, and attention has been focused on the economic forces which make development in small countries more difficult. However, the theory of capital flows to developing countries makes little, if any, reference to the size of countries. In this respect, it is no exception to the more general theories of development which have been inspired and based on the experience of larger countries. While this lopsided attention can probably be explained quite simply, it nevertheless has tended to neglect a broad range of development issues that have only recently come to the foreground. The most urgent of these is represented by the plight of the small resource-poor country.

The “small country bias”

The following table summarizes data for 77 developing countries, arranged in six groups depending on size and income range. “Small countries” are defined as those with less than five million people. The income ranges are per capita GNP in 1966 of US$0-150, US$150-300, and higher than US$300.

The following conclusions may be drawn from these summary data:

(a) In each of the per capita GNP ranges, small countries receive more aid than large countries. This is true for aid (official grants and loans received) calculated on a per capita basis and as a percentage of GNP. It remains true when the concessionary element of aid is taken into account—e.g. by calculating the grant equivalent of aid, obtained by multiplying the face value of a loan by its concessionary or grant element. This conclusion is not invalidated by excluding India, Indonesia, and Pakistan from the category of large and poorest countries.

(b) As per capita GNP increases, aid as a percentage of GNP tends to decrease while aid per capita tends to increase. This is true for the nominal value of aid as well as its grant equivalent and for both small and large countries. Thus, the decline in aid as a percentage of GNP is not rapid enough to avoid an increase in the absolute value of aid receipts with rising GNP (and an increase in aid per capita with rising per capita GNP).

Table 1.Aid (Official Grants and Loans) and Grant Equivalent Per Capita and as a percentage of GNP in 1967-69
Country

group 1
PopulationGNP

per capital
Aid 2G.E. 3AidG.E.Grant

element3

aid
(millions)($)US $ per capitaPercentage of GNP Percentage
A1less than 51508.516.3611.38.474.8
A2more than 51503.072.172.92.170.7
(3.37)4(2.53)(3.7)(2.8)
B1less than 5150-30016.7710.877.14.664.8
B2more than 5150-3009.654.594.52.147.6
C1less than 530027.2613.264.62.248.6
C25 or more30014.603.852.50.626.4

Group averages are weighted by population for per capita data, by GNP for data on percentage of GNP, and by gross aid for grant element.

Annual average of official loans and grants in 1967-69.

Grant equivalent of grants and loans obtained by multiplying their nominal value by the grant element (at 10 per cent discount) shown in last column.

Data in parentheses exclude India, Indonesia, and Pakistan.

Group averages are weighted by population for per capita data, by GNP for data on percentage of GNP, and by gross aid for grant element.

Annual average of official loans and grants in 1967-69.

Grant equivalent of grants and loans obtained by multiplying their nominal value by the grant element (at 10 per cent discount) shown in last column.

Data in parentheses exclude India, Indonesia, and Pakistan.

(c) In all three income ranges, the terms of official assistance received by small countries are on the average more favorable—i.e. more concessionary—than those of large countries. As can be seen from the last column in the Table the difference in the concessionary element of aid to small and large countries becomes larger as the income level rises. One explanation of this phenomenon could be the recognition—when decisions on the terms of assistance are made—that as income rises, the development prospects and aid bearing capacity of small countries do not improve as rapidly as those of large countries.

(d) There is considerable difference in aid receipts between small and large countries. Moreover, this difference does not appear to decrease markedly with per capita income levels in recipient countries. Small countries receive 2.9 times as much aid (grant equivalent) per capita as large countries in the low-income group, 2.4 times as much in the middle income group, and 3.4 times as much in the higher income group. The corresponding ratios for the grant equivalent of aid as a percentage of GNP are 4.0, 2.2, and 3.7.

(e) The decline in aid as a percentage of GNP with rising income levels is less marked than the difference between small and large countries. Small countries in the highest income range receive more aid as a percentage of GNP than large countries in the lowest income range.

“Grant Element”

The grant element or concessionary element of a loan measures how concessionary the loan is. The more concessionary the loan, the higher its grant element. Technically the grant element may be defined as the difference between the face value of the loan and the present value, calculated at 10 per cent discount rate, of the stream of interest and amortization payments, expressed as a percentage of the face value. The Development Assistance Committee of the OECD defined a concessionary loan as one with a grant element of at least 61 per cent; an example would be a loan with 30 years maturity, 8 years grace on amortization, and 2.5 per cent interest. A more concessionary credit, say with 50 years maturity, 10 years grace, and 0.75 per cent interest has a grant element of 84 per cent.

Considerations in allocating aid

The bias in favor of smaller countries which emerges so clearly from the table need not, of course, reflect purely economic factors. The considerations underlying the global allocation of official development assistance are complex and are not based exclusively on an assessment of needs; indeed they do not fit into any precise model.

Bilateral relations exert considerable influence on the amount and character of assistance: e.g., former colonial ties (which may extend to more intensive cultural and educational contacts), present political-military alliances, and the investment interests of the donor country. Donor countries may possess deeper and broader knowledge about particular recipient countries (either historically or from more recent contacts) and therefore may be more interested in extending assistance to these countries. Donor countries may also give special attention to newly independent countries that suffer from weak administration and which face special difficulties in establishing social and economic unity. These considerations may weigh more heavily in the allocation of aid to the smaller countries.

On the other hand, the largest of the less developed countries tend to receive proportionally less aid because of the more substantial absolute amounts involved. Thus, while many small and poor African countries receive aid up to 8-10 per cent of gross domestic product (GDP)—and some as much as 25 per cent—three of the most populous in the poorest category (India, Indonesia, and Pakistan) received aid equal to only 2.8 per cent of GDP. Total aid to these countries amounted to US$2.3 billion or 23 per cent of the total annual aid received by all 77 countries. If these three large countries were to receive the same proportion of GNP as the smallest countries in this income group (11.3 per cent), the additional amounts involved (some US$8.5 billion) would dramatically change the entire world-wide aid picture.

A further important consideration is the availability of development projects or, more broadly, the absorptive capacity for aid. Most aid is provided for a specific purpose—a development project or sector program. Through technical assistance, donors can influence recipient countries’ ability to utilize aid. Thus, absorptive capacity, even over five to seven years, can be improved and may not operate independently of the allocation process. It has been argued that project assistance may increase the supply of aid to small countries. Donors prefer to make project loans in excess of a minimum amount so as to use staff and technical assistance resources more efficiently. Thus, a combination of project loans could easily overshoot a country’s overall requirements. It is difficult to prove this from available data, although it should be recognized that project lending may be bunched. The availability of many different types of projects in development programs, the lead-time involved in project preparation, and the possibility of varying the percentage of project cost to be financed with external funds permit, in practice, considerable flexibility in the phasing of aid.

Comprehensive assessment of a country’s development priorities and prospects and its overall financing requirements would seem to be the most fundamental and conceptually satisfying approach to determining the level and distribution of aid. On this basis, aid allocation would allow for all available relevant information including: achievable growth rate, natural endowment, plan preparation and project readiness, fiscal performance, likely composition of investment, production incentives, and private investment. It can, therefore, be considered as a starting point for deciding total requirements, with the contributions by individual, bilateral, and multilateral donors being decided through a process which involves the above mentioned considerations.

Objective assessment of a country’s aid requirements cannot be expected to be more definitive than the knowledge of the development process itself. It involves a projection of the economy for which no generally accepted or fully satisfactory methodology has been worked out. These projections are subject to conceptual and methodological difficulties which have been extensively discussed in the literature (see “Measuring Capital Requirements,” E. K. Hawkins, Finance and Development, June 1968.) The projections are also subject to data problems and a wide range of value judgments. Built into the assessment of a country’s development program and its domestic and external financing requirements, one finds judgments and assumptions about that country’s policies and performance. These judgments may be based on what will or what should happen. Clearly, the projections of future policy intentions are highly uncertain.

Against the complexities of aid allocation and the conceptual and practical difficulties of determining overall financing requirements of country programs, the test of how much aid each country receives per capita would appear to be rather simple and straightforward. This test also has a welfare connotation, assuring that each national gets an appropriate share of global aid regardless of his country’s size. Yet its simplicity hardly excuses its many shortcomings—it does not, for example, allow for self-help, natural or locational endowment, and the stage of development. Furthermore, it does not account for the impact of country size on overall aid requirements discussed below.

Do small countries require more aid?

The demand for aid might best be determined by estimating the resource gap which would prevail were a country to maintain a reasonable pace of growth compatible with its natural resources and absorptive capacity. The resource gap would be the balance of requirements for its development, which it cannot provide from its own resources—in practice, the gap between investment and domestic savings or between imports and exports of goods and services.

The gap is determined by many factors, including resource endowment, policy orientation, stage of development, trade position, location, and economic size. Economic size itself may affect the other factors, in particular, trade position and policy orientation. For the present purpose, a distinction should be made between the magnitude of the gap at any given moment and a country’s ability to reduce the gap. The following considerations suggest that small countries may have a larger gap and may find it more difficult to reduce their dependence on external capital. It would appear that the “small country bias” in aid allocation is consistent with the larger needs of small countries or their greater difficulties in reducing the external resource gap.

The small size of the domestic market is an obstacle to diversified industrial development in small and poor countries. The few small less-developed countries which have been able to develop export-oriented industries have had advantages of location and/or a beneficial resource base, particularly human resources (e.g., in education). In general it is difficult and more costly to develop economic import substitutes in small and poor countries. Consequently, the most direct way to reduce the external resource gap is closed to small countries. This sharply contrasts with the success of some larger countries in constraining their import growth in the development process. Admittedly, import substitution in the larger countries has been associated with many uneconomic practices and has often led to increased, rather than reduced, import pressure. Yet their economic size and diversity enables them to overcome these difficulties. Despite past “mistakes,” they have a rather diversified industrial structure which makes possible growth with reduced dependence on external aid.

Industrial diversification permits large countries to develop exports of manufactured goods. For many countries manufacturing growth may well be the most favorable base for long-term export growth. This view is supported by the more dynamic growth of world trade in manufactured goods and the sluggish growth of many agricultural staples. As industrial development is less feasible and more costly in small countries, they have poor prospects for exports of manufactured goods. Thus, countries such as Brazil, Korea, and the Republic of China which recently have been able to undertake a rapid increase in manufactured exports, have a far better chance to close their gaps than countries like Chad, Mauritania, or Mali, which are still far removed from diversified industrial development.

Larger countries may also be in a better position to close their domestic resource gap. Domestic savings are of course determined mainly by income—people generally save more as they earn more. However, it is increasingly recognized that a financial system with suitable institutions and the development of popular attitudes towards the facilities they offer plays a crucial role in the growth and efficient utilization of financial assets and savings. Larger and more diversified countries, although poor, already have a sizeable urban and industrial sector which enables them to build up the financial institutions needed in a modern system—domestically-owned commercial banks, savings institutions, and viable specialized credit institutions. Furthermore, with their broader economic and regional diversification, larger countries have greater scope for fiscal measures to increase savings and channel resources to selected activities or regions.

Finally, the diseconomies of government in the smallest countries also enlarge their needs for external assistance. The task of building up the machinery of public administration is more extensive” in most smaller countries than in larger countries. This expands both the current and the capital cost of government administration in general and of development in particular. It would also seem that larger countries can better overcome shortages of administrative, managerial, and tech-nical skills. Consequently, the need for technical assistance is larger in smaller countries—increasing both the cost of development and the amount of external assistance required.

Reducing aid requirements through export development

Since the possibilities of reducing the dependence on aid in small countries through import substitution are limited by the small size of the domestic market, export growth may be the key to achieving this. However, the contribution of export growth to development will hinge on its impact on the income and employment of broad layers of the population.

Development of natural, particularly mineral, resources has provided considerable export impetus in many small countries. It is widely recognized that the often spectacular resource development in enclaves (e.g., mines owned by foreign interests) still leaves countries with a major problem of structural transformation. Enclave development may accentuate and aggravate the dualistic nature of the economy. An adequate contribution by the enclave to fiscal revenues provides countries with financial resources needed to accelerate their structural transformation. Consequently, the relations between en-clave companies and national governments are a critical element in development. This assumes special importance when enclave operations are large in relation to the rest of the economy. It may be noted that in a number of small countries, the enclave contribution to fiscal revenue is proportionally below its share of total gross domestic product (GDP). Small countries may find it harder to cope-with enclave problems than large countries. Because of their lack of diversification, small countries are more dependent on enclave earnings and therefore have less bargaining power with the enclave company because of their small economic power and their limited alternatives.

Countries whose primary exports form a relatively small share of the total world market for particular commodities may be in a stronger position to expand their exports than countries which have relatively large market shares. Smaller countries can be expected to have smaller market shares than large countries, although there are significant exceptions (e.g., Mexico with small and Ghana with large market shares). On the other hand, small countries are relatively more dependent on trade than large countries. Export instability may have greater consequences for economies of smaller countries which, then, may have greater need for extraordinary assistance to overcome the effects of instability. Furthermore, over the longer run, the growth of commodity exports must depend on the relative cost-advantage of the supplying countries and there is no reason why small countries would be in a stronger position.

Ivory Coast is an example of a small country which has successfully improved its share in the world markets for its exports of coffee and cocoa. Its recent experience shows, however, that rapid export growth leaves many development problems still to be tackled. Despite its diversification efforts, the country is crucially dependent on commodity markets: its three major export commodities—coffee, cocoa, and timber—still account for 80 per cent of export earnings. The decline in cocoa prices during 1969—71 caused a reduction in import capacity equivalent to 3.8 per cent of GDP and 36 per cent of public investment in 1972. Continued diversification efforts are not likely to increase export earnings for some years, even though the level of investment should remain high. Thus, the need for external assistance is growing rather then declining. At the same time, despite its rapid output growth, Ivory Coast suffers from increasing problems of unemployment and the presence of many immigrant workers (who account for some 25 per cent of the total labor force).

The economic rationale

Small countries have received more aid, on a per capita basis, than large countries. This “small country bias” in aid allocation has a strong economic rationale, even though many other factors—political, technical, and historical—also come into play. The higher cost of development in small countries is a main reason why their aid needs are higher. Small countries face higher costs in diversifying their economies and their small market size reduces their industrialization potential, the scope for economic import substitution, and export diversification. Public administration is weaker in small countries and, with smaller reservoirs of trained talent, they are more in need of technical assistance. Usually their savings potentials are lower: the higher cost of government reduces the availability of resources for development and the relatively small size of the modern sector limits the possibilities of mobilizing institutional savings. In all, these factors increase the aid requirements of small countries, particularly those with a poor resource base, undeveloped infrastructure and disadvantages of location.

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