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Fridays Academy: Development Aid, Economic Growth and Poverty Reduction

Ignacio Hernandez's picture

Like every Friday, from Raj Nallari and Breda Griffith's lecture notes


Against the backdrop of a mixed record of the effectiveness of aid, the scaling up of aid flows poses a daunting policy challenge for both developing countries and donors alike. 


To understand how future aid flows might best be used, in this and upcoming weeks we will examine the record of aid provision from the 1950s onwards, comparing trends in both official and private capital flows to developing countries. We will show how private capital flows have become far more important in recent decades, but that official aid flows have recovered since the mid-1990s. Given these trends, and the need to scale up aid if the Millennium Development Goals are to come close to being met, it is important to examine the efficacy of aid flows. While the vast literature in this area is inconclusive, a key finding, which has been picked up by policymakers, is that aid flows work best if in good policy environments. Recent literature also suggests that the type of aid matters, with not all aid being aimed at achieving higher growth (e.g. humanitarian aid). We will end with a consideration of competitiveness, or “Dutch Disease” concerns, which naturally arise as aid is being scaled up. Recent research suggests that generally aid should, over the long run, be spent by government, with the liquidity impact managed by the sale of foreign exchange (the aid) by the central bank. This, of course, requires an improvement in coordination of fiscal and monetary policies.


Capital flows to developing countries can, if wisely used, help developing countries invest and devote expenditures to high priority current spending.


To put development aid flows in context, the exhibit below shows the source and composition of net flows to developing countries for 2004, broken down by private and public capital flow providers.

Source and composition of net capital flows to developing countries Amounts for 2004 in US$billion


* refers to Total Foreign Aid (grants) excluding technical cooperation grants



On the public side, three groups set broad guidelines for new policies or arrangements for development aid.  These are the G-8 who meet annually and the Development Committee and the International Monetary and Financial Committee who meet twice a year, advising the World Bank and the International Monetary Fund on critical issues of development and the resources needed.  Among the multilaterals, there is the IMF, the World Bank Group, the four regional development banks, the specialized UN agencies and the EU group. Bilateral donors comprise specialized departments in the relevant ministry in developed countries and/or specialized agencies dealing with development.  On the private side, no specialized institution exists for channeling private flows, although some institutions such as the International Finance Corporation of the World Bank Group facilitate private investment in emerging markets. 


Private net capital flows far outweigh official development flows. For example, the breakdown of the total amount of flows in 2004 (US$323.8 billion, as shown in the exhibit) shows that net private flows (and foreign direct investment in particular) account for more than US$300 billion of this.  The role of private flows became increasingly important from the 1990s, outpacing substantially flows of public aid. 


Public aid has, however, recovered in recent years from recent decades of relative decline.  In particular, flows of public aid have increased from 2001 as donors begin to fulfill their commitments made at the Monterrey summit in 2002 at which the actions needed to reduce global poverty and meet the Millennium Development Goals were discussed.  It is safe to say that poverty reduction is now firmly back on the global policy agenda, this time with specific targets and deadlines and commitments by rich countries to boost development aid, cancel debts and promote trade access for developing countries. 


This scaling up of aid presents many challenges for the developing country.  The Millennium Development Goals, a set of eight objectives for poverty reduction, improvement in indicators of well-being (health, education, infant mortality) and the promotion of sustainable development represent the international community’s commitment to narrow the gap between rich and poor countries.    


Development aid has, however, a mixed track record in bridging the gap between rich and poor countries, calling into question the effectiveness of aid.  The aid and growth debate has been studied widely generating conclusions on the relationship between aid and growth and by extension, poverty reduction that have held sway at different points in time over the past three decades.  One of the main contributions of the work on aid and growth has been in linking the effectiveness of aid to conditions prevailing in the recipient country and/or on donor behavior. 


One of the key developments in aid in recent years has been the formalized involvement of the recipient country through the country strategy paper process. Under this process, the recipient country sets out its development strategy, taking into account the country context, and the assistance needed to achieve its objectives (growth, debt reduction, poverty reduction, improvement in well-being). Increasingly the country strategy paper is prepared in consultation with the donors—multilateral and bilateral—and civil society.


Next Friday: Aid and Growth -  Developing Country Experience 1950 - 2005


From the Desk of
G. Moheyuddin
Research Fellow | Student PhD Economics
Department of Economics, GC University, Lahore

There are some positive as well as the negative effects of foreign aid on the economic development in the Underdeveloped Countries (UDC). Foreign aid, on positive side, has helped in boosting the GDP Growth through structural transformation of the economy, laid foundations of the industrial and agricultural sectors, provided technical assistance, policy advice and modern technology, assisted in overcoming the budget deficits and the BOP deficits and has also funded the projects for the social sector development projects. As some empirical studies confirms the positive affect of Aid on the GDP. Thus, the overall impact of the aid on the economic growth is positive.  
But on the negative side, aid seemed to have substituted for domestic savings, increase debt burden. As the various debt indicators, in most of the UDCs depict that their debt burden increased over time and the country may caught in severe debt servicing problem if the macroeconomic management, foreign trade and domestic saving policies are not designed and implemented appropriately.
The policies are also important in the effectiveness of foreign aid, as the aid has a more positive impact on growth in with good fiscal, monetary, and trade policies. In the presence of poor policies, on the other hand, aid has no positive effect on growth. Accordingly, there is a need of not only good policies but also the implementation of these policies as well as the proper monitoring of the aid-utilizing projects is necessary in order to avoid the misutilization  and the mismanagement of the foreign capital resources. Consequently we can say, the aid may be helpful in boosting economic growth only under the presence of appropriate monetary, fiscal and the trade policies.

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