The shift in development thinking from a government-led accumulation strategy to a focus on fundamentals, effectiveness and efficiency […] requires reorienting the instrument of aid. In particular, it means reconsidering the method of financial assistance (project and program) […] and how they can be adapted to support the new development strategy (World Bank 1998, p. 96)
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We are grateful to Craig Burnside, Susan Collins, Ana Paula Fialho Lopes, Roberta Gatti, Norman Loayza, Domenico Lombardi, Humberto Lopez, Paolo Mauro, Gian Maria Milesi Ferretti, Ashoka Mody, Rodney Ramcharan, Alessandro Rebucci, Roberto Rigobon, Ratna Sahay, Philip Schellekens, Peter Wickham, and Jeromin Zettelmeyer, as well as seminar participants at the IMF Annual Research Conference, the World Bank, the European Meeting of the Econometric Society, the Lacea and Lacea-PEG meetings for useful comments and suggestions on earlier drafts.
As World Bank (1998) candidly recognizes, “If foreign aid has at times been a spectacular success…[it] has also been, at times, an unmitigated failure” (p. 1).
There is a quite vast empirical literature supporting such a view. Boone (1996) provides evidence that, on average, aid does not foster growth. Burnside and Dollar (2000) and Collier and Dollar (2002) find that, while in countries with sound economic policies, aid promotes growth, in countries with bad policy environments, aid is dissipated in unproductive government consumption. World Bank (1998) finds that large amounts of aid in countries with a poor policy environment, by delaying reforms implementation, can even potentially reduce growth. For a contrarian view see Hansen and Tarp (2001).
Conditionality in international lending is a widely discussed and controversial issue. Sachs (1989) provides a critical assessment of IFIs’ conditionality in the context of international debt crises. Killick (1997) focuses on the difficulties of properly enforcing conditionality, while Collier and others (1997) analyze how the imposition of increasingly detailed conditions may create serious incentive problems. The idea that excessive conditionality, by absorbing an excessive amount of scarce domestic resources (such as administrative capacity), can be distortionary is also made by Berg (1997). Cordella and Dell’Ariccia (2002) examine the limits of conditionality with observable and unobservable recipients’ types.
The problem of aid fungibility is discussed at length in World Bank (1998), Pack and Pack (1993), Khilji and Zampelli (1994), Feyzioglu and others (1998), Devarajan and Swaroop (1998), and Lahiri and Raimondos-Moller (2000).
In what follows, as standard in the recent theoretical literature on aid (see Svensson (2000), Azam and Laffont (2001), Federico (2001)) we focus on a single and fully altruistic donor. These assumptions are not meant to be realistic and are discussed in greater detail in the concluding section. See also Mayer and Mourmouras (2002).
This is consistent with the evidence in Pack and Pack (1993) who find that “the more important foreign aid as a source of public resources […], the more likely are the recipients to reflect donor’s intentions” (p. 264).
See also Isham and Kaufmann (1999) who show that the productivity of investments depends crucially on the presence of undistorted macroeconomic policies.
The assumption of substantial heterogeneity in recipients’ preferences is hardly a controversial one. For example, according to World Bank data for 1997, the ratio of health to military expenditure in highly indebted poor countries (HIPCs) varied from the 0.13 of Vietnam to the 4.3 of Guyana.
For simplicity we assume that all prices are equal to 1.
The symmetry assumption is not essential for our main results, but substantially simplifies the math. The linear homogeneity assumption is only necessary for a nonarbitrary comparison between program and project aid, see below.
We loosely indicate with V′ the first derivative of V with respect to any of its arguments, and with V″ the second derivative.
Our analysis hinges upon the fact that the objective function of the donor and those of the recipient differ. Our analysis would carry through if the donor cared about military expenses and the recipient about development programs.
For a recipient of type α = 1, the problem should be written as
In the context of macrostabilization programs, the choice between inflation targeting and monetary policy approaches based on the explicit targeting of some observable intermediate objectives provides a good example of the problem.
As noted by a senior official of a maj or aid recipient country.
In the Cobb-Douglas case,
The other important component is technical assistance.
The proof of such statements is straightforward if one notices that: (1) as long as there are inefficiencies associated with project aid, (λ < 1), for values of α close to one, conditional budget support yields a higher level of production of the social good than conditional project aid; (2) As long as α > 0, for values of λ close to zero, BS ≻ PA.
One exception is part (i) of Proposition 1. Under conditional project aid, for recipients with low levels of social commitment (small values of α) project aid can be always preferable to budget support, irrespective of the ammount of their own resources G.
We are very grateful to Craig Burnside and David Dollar for sharing their dataset with us and very kindly answering our queries.
DPD98 for Gauss in our case.
Note that, in this case, data requirements force us to drop all the observations pertaining to the outlier countries.
From this point of view the HIPC initiative seems to be a step in the right direction.
Note that the Inada conditions on V(·) guarantee that the first order conditions can always be satisfied for a k < G + A, so that a corner solution is excluded.