Foreign Aid, Investment and

Development
 International flow of financial resources to developing countries

• International flow of financial resources to developing countries

•
1. Foreign direct and portfolio investment
2. Remittances of earnings by international migrants
3. Public and private (NGO) foreign aid
 International flow of financial resources to developing countries

• 1a. Private foreign direct investment (FDI)

• past few decades — fast growth of multi-national corporations (MNC) —
firms that conduct and control productive activities in more than one
country.
• accompanied with growth of private FDI to developing countries
— annual FDI rate of $2.4 bln in 1962 to $35 bln in 1990 to $147 bln in 2002, $335
bln in 2005
— reasons: globalization — MNCs but also developing countries ‘opening up’
•
• high variance of flows over different regions and times
— e.g. out of $335 bln in 2005; $118 went to China (incl. Hong Kong)
— Africa receives only about 3% of global FDI
 International flow of financial resources to developing countries

• • total world FDIs peaked in 2000, still not recovered — Fig. 14.1
• Fig. 14.2 — FDI inflows to developing countries remain small fraction of
their total investment
— note, however, FDI may be qualitatively different investment (e.g. hi-tech,
management know-how, etc.)
• Fig. 14.3 — FDI have become the largest source of foreign funds to LDCs
(72% of all flows in 2003)
• sharp contrast with the late 1980s- early 1990s when official flows were
as prominent.
 Figure 14.1 FDI Inflows, 1980–2012

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 Figure 14.2 Net Capital Flows to Developing Countries,2000–
2009

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 International flow of financial resources to developing countries

• Multinational corporations
• two defining characteristics: large size and high fraction of foreign trade
— 350 largest firms account for more than 40% of world trade
— size: 8 of the top 10 non-financial MNCs ranked by assets had worldwide sales
of more than $150 bln in 2004 (in total larger than the combined GDP of Sub-
Saharan Africa and India)
• most are global brands, immediately recognizable (Ford, BP, Honda, Nestle,
Siemens, etc.)
• their great size often yields high negotiating power with many governments of
small LDCs
• still, remember from fig. 14.1 that most FDIs are directed from developed to
developed countries, and (some) competition in virtually all sectors exists.
 International flow of financial resources to developing countries

• • Historically, in LDCs these firms were into extracting resources, but more
recently into manufacturing and services to use cheaper labor
• MNC controversy — mostly not about the economic impact but other
(social, equity, etc. reasons)
• Economic arguments in favor of FDI:
1. supplementing domestic savings to create higher investment which may
then lead to higher growth (remember the Solow, Harrod-Domar models)
2. alleviate current account deficit (goods imports > exports); generate
future exports
3. source of tax revenue
4. perhaps most important in the long-run — MNCs can help spread new
technologies and management techniques.
 Arguments Against Private FDI

• • Arguments against private FDI

1. constraining domestic firms, crowding out other investment
2. profits repatriation , royalties, etc. may not benefit the host nation
3. tax contributions are low due to concessions from government; tariff
protection, public subsidies
• 4. uneven impact on development — mostly urban focus, possible increase
in inequality
5. MNCs use their large bargaining and financial power to influence
government policies (tax rebates, transfer pricing; tax competition)
6. “defeating” local entrepreneurship.
 Reconciling the Debate

• Reconciling the debate

• markets vs. governments as driver of the development process
• growth vs. inequality
• hard to generalize but overall facts speak for themselves — countries that
‘opened up’ to MNCs and trade have growth at higher rates to those who did not
and have reduced poverty due to the beneficial effect of income growth
 International flow of financial resources to developing countries

• 1b. Portfolio investments (see fig. 14.3 again)

• a rising factor (at least up till 2008) in financial flows to LDCs
• consists of investment in stocks, bonds, commercial papers of LDCs firms
and governments
• very high returns on investment possible in so-called ‘emerging stock
markets’ (e.g. 39% in L. America 1988-1993)
• but also high risk and volatility
• frequent crises: Mexico (1994-95); East Asia (1997-98) and Russia (1998);
Argentina (2001-02)
• for investors: capital flows to productive uses; diversification
• possible instability in economies with structural weaknesses (e.g.
fixed/controlled exchange rates)
• Lesson: MNCs and portfolio investors often follow growth so put the
right pre-requisites for it and the flows will come
 International flow of financial resources to developing countries

• 2. Remittances
• in 2007 there were 200 mln migrants worldwide
• huge differences in incomes between HICs and LDCs
• fig. 14.4 — steep growth in remittances after 1990 (currently higher than
aid and portfolio flows); some of this due to improved accounting and
recording of financial transactions
• uneven distribution — fig. 14.5
 Figure 14.3 Sources of External Financing for Developing
Countries, 1990–2008

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 Table 14.1 Major
Remittance-Receiving
Developing Countries, by
Level and GDP Share, 2008

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 International flow of financial resources to developing countries

• 3. Foreign aid : Conceptual and Measurement Problems

• Foreign aid: The international transfer of public funds in the form of loans or
grants either directly from one government to another (bilateral assistance) or
indirectly through the vehicle of a multilateral assistance agency such as the
World Bank.
• In addition to export earnings and private foreign direct and portfolio
investment, developing countries receive two other major sources of foreign
exchange:
• public (official) bilateral and multilateral development assistance and private
(unofficial) assistance provided by nongovernmental organizations (NGOs).
• Both of these activities are forms of foreign aid, although only public aid is usually
measured in official statistics.
 Foreign aid : Conceptual and Measurement Problems (Cont…..)

• In principle, all governmental resource transfers from one country to

another should be included in the definition of foreign aid.
• Even this simple definition, however, raises a number of problems.
• For one thing, many resource transfers can take disguised forms, such as the
granting of preferential tariffs by developed countries to exports of manufactured
goods, particularly from the least developed countries.
• This permits developing countries to earn more foreign exchange from selling
their industrial products in developed-country markets at higher prices than
would otherwise be possible.
• There is consequently a net gain for developing countries and a net loss for
developed countries, which amounts to a real resource transfer to the developing
world.
• Such implicit capital transfers, or disguised flows, should be counted in qualifying
foreign-aid flows. Normally, however, they are not.
 Foreign aid : Conceptual and Measurement Problems (Cont…..)

• However, we should not include all transfers of capital to developing countries,

particularly the capital flows of private foreign investors.

• Private flows represent normal commercial transactions, prompted by commercial

considerations of profits and rates of return, and therefore should not be viewed
as foreign aid.

• Commercial flows of private capital are not a form of foreign assistance, even
though they may benefit the developing country in which they take place.
 Foreign aid : Conceptual and Measurement Problems (Cont…..)

• Economists have defined foreign aid, therefore, as any flow of capital to a

developing country that meets two criteria:
• (1) Its objective should be noncommercial from the point of view of the donor,
and
• (2) it should be characterized by concessional terms; that is, the interest rate and
repayment period for borrowed capital should be softer (less stringent) than
commercial terms.
• Even this definition can be inappropriate, for it can include military aid, which
is both noncommercial and concessional. Normally, however, military aid is
excluded from international economic measurements of foreign-aid flows.
• The concept of foreign aid that is now widely used and accepted, therefore,
is one that encompasses all official grants and concessional loans, in currency
or in kind, that are broadly aimed at transferring resources from developed
to less developed nations on development, poverty, or income distribution
grounds.
 Foreign aid : Conceptual and Measurement Problems (Cont…..)

• Just as there are conceptual problems associated with the definition of

foreign aid, there are measurement and conceptual problems in the calculation
of actual development assistance flows.
• In particular, three major problems arise in measuring aid.
• First, we cannot simply add up the dollar values of grants and loans; each has a
different significance to both donor and recipient countries.
• Loans must be repaid and therefore cost the donor and benefit the recipient less
than the nominal value of the loan itself.
• Conceptually, we should deflate or discount the dollar value of interest-bearing
loans before adding them to the value of outright grants.
• Second, aid can be tied either by source (loans or grants have to be spent on the
purchase of donor-country goods and services) or by project (funds can only be
used for a specific project, such as a road or a steel mill).
 Foreign aid : Conceptual and Measurement Problems (Cont…..)

• In either case, the real value of the aid is reduced because the specified source is
likely to be an expensive supplier or the project is not of the highest priority
(otherwise, there would be no need to tie the aid).
• Furthermore, aid may be tied to the importation of capital-intensive equipment,
which may impose an additional real resource cost, in the form of higher
unemployment, on the recipient nation.
• Or the project itself may require the purchase of new machinery and equipment
from monopolistic suppliers while existing productive equipment in the same
industry is being operated at very low levels of capacity.
• Finally, we always need to distinguish between the nominal and real value of
foreign assistance.
• Aid flows are usually calculated at nominal levels and tend to show a steady rise
over time.
• However, when deflated for rising prices, the actual real volume of
aid from most donor countries has declined substantially in recent decades
despite a recent uptick.
 International flow of financial resources to developing countries

• Data on public aid (Tables 14.2 and 14.3)

• the official name of ‘foreign aid’ is official development assistance
(ODA) = bilateral grants + loans + technical assistance + multilateral
flows (e.g. IMF, WB)
• grew from $5 bln in 1990 to $100 bln in 2005 (nominal values)
• as % of developed countries GDP, fell from 0.5% in 1960 to 0.33% in
2005
• “ODA is allocated in some strange and arbitrary ways” (not really)
— S. Asia where more than 50% of the world’s poorest people live receives
$6 per person in aid
— Middle East and N. Africa with well over triple S. Asia’s GDP per
capita receive 14 times the per capita aid (Table 14.3)
— Iraq ($750 per capita) and Afghanistan ($93 per capita) are the largest
recipients in 2005; vs. India ($2 per capita)
 Table 14.2 Official Development Assistance Net Disbursements from Major
Donor Countries, 1985, 2002, and 2008

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 Table 14.3 Official Development Assistance (ODA) by
Region, 2008

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 International flow of financial resources to developing countries

• — 1976-2004 Israel (not an LDC) and Egypt were the two countries
receiving the most of US foreign aid; now Iraq
— obviously the allocation of aid is mostly politically (militarily)
determined, not by need
 Why Donors Give Aid?

• Why donors give aid?

• primarily because of political, strategic, or economic self-interest
• very little ‘humanitarian’ reasoning (mostly disaster relief)
• Political motives:
— the Marshall Plan (restart the economies of Western Europe to contain
spread of communism)
— special interests: over the period 1950-2000 US aid patterns switched
from S. Asia, S-E. Asia, L. America, Middle East, Central America, Eastern Europe,
Middle East again
— similar patterns in the aid by other major donor countries like Japan, Britain,
France — mostly propping up ‘friendly’ regimes, former colonies, etc.
• Economic motives for aid.
 Why Donors Give Aid?

• — based on the ‘financing gap’ model; aid as supplement to domestic

savings in investment
— zero empirical support for this theoretical model — aid uncorrelated with
subsequent investment and investment uncorrelated with subsequent
growth
 14.4 Foreign Aid: The Development Assistance Debate

The two-gap model:

savings constraint

I  F  sY (14.1)

Where
I is domestic investment
F is the amount of capital inflows
s is the savings rate
Y is national income
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 14.4 Foreign Aid: The Development
Assistance Debate
The two-gap model:
foreign-exchange constraint
(m1  m2 ) I  m2 Y  E  F (15.2)

Where
I is domestic investment
F is the amount of capital inflows
E is the level of exports
Y is national income
m1 is the marginal import share
m2 is the marginal propensity to
import
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 Why Developing Countries Accept/ Ask for Aid?

• Why developing countries accept/ ask for aid?

• LDCs willing to accept aid even under seemingly stringent terms
• the economic rationale — aid as supplement to domestic resources...
• LDCs would like less tied-aid and longer-term loans
• a moral hazard problem — if no conditions attached, would this money
be used for what is promised?
• but a moral hazard problem often exists on the donor’s side (especially
IMF, World Bank) — they need to spend the aid budget no matter what
otherwise it may get cut next year — hard to impose conditionality
• many times LDCs take aid because it is readily given and no one is held
accountable
 Why Developing Countries Accept/ Ask for Aid?

• • in fact, by remaining poor you can secure more foreign funds than if you
grow
•
• military aid — accepted/given for security/strategic reasons
•
• role of NGOs — growing but small-scale relative to bilateral and multilateral
assistance flows ($1 bln in 1970 to $14 bln in 2005)
•
• randomized trials and field experiments — new promising methods of
policy evaluation (but can these small-scale results be scaled up?)
 Why Developing Countries Accept/ Ask for Aid?

• The loans that were, the growth that wasn’t

• 1980s — push for aid/loans to developing countries conditional on their
implementing packages of ‘reforms’
• triggered by some countries unable to service their foreign debt by private
borrowing
• idea of adjustment loans — money lent on the condition that recipients
will adjusts their policies and promote growth
• in 1980s IMF and the World Bank gave an average of 6 adjustment loans
to each country in Africa; 5 to each in L. America; 4 in Asia.
• result: figure 6.1 — ‘much lending, little adjustment and little growth’
(only some E. Asian countries grew)
 Why Developing Countries Accept/ Ask for Aid?

• — behind these average are some success stories (Ghana improved to

1.6% GDP growth from -1.6%; Thailand, Korea, Peru)
— ...but many failures: Zambia (12 adj. loans in 1980-1994 equaling 1/4
of its GDP yet inflation was over 40% most of the time)
— countries with triple-digit inflation received as much lending as those
with single-digit — what happened to the conditionality?
— similar experience in Eastern Europe in the early, mid- 1990s — many
loans, little ‘adjustment’; high inflation
• Aid systematically going to countries with bad policies as indicated by
the ‘black market premium’
• budget deficits? Cote d’Ivoire received 18 adj. loans 1980-1994 while
the country’s budget deficit ran at 14% of GDP 1989-1993; Pakistan —
still receiving loans to adjust its budget deficit (which is not adjusting)
• negative real interest rates, Table 6.2 (huge signal for a non-growing,
badly functioning economy) — continuing recipients of aid without
showing any improvement
 Corruption and Aid

• corruption and aid

— Congo, Bangladesh, Liberia, Haiti, Paraguay, Guyana and Indonesia were
topping the corruption rankings in late 1980s-early 1990s
— together these countries received 46 adj. loans from IMF and WB,
• pretending to adjust — Easterly goes over various accounting and other
tricks countries do to justify receiving the next loan
— governments who are irresponsible before receiving the loan have no
incentive to change after receiving it (e.g. cut public goods, road maintenance)
— governments who eat away at the future by incurring debt find ways to eat
away the future in various other ways
• the ‘who guards the guardians’ problem — no incentives for WB, IMF to
do due diligence on their loans
 Foreign aid — a plethora of badly aligned incentives

• Foreign aid — a overabundance of badly aligned incentives

• if donors did care about the poor this makes threats of cutting off future
aid not credible (‘lack of commitment’)
• since countries with the largest poverty problems get more aid, they have
little incentive to improve a little (and get less aid)
• How to fix this? Paradoxically, the poor would be better off if an agency
who did not care about them were in charge of distributing aid (can credibly
commit to withhold aid if conditions not met)
• country departments in IMF, WB and their budgets dependent on loan
activities performed — if you cut loans, get lower budget next year
• new loans often given for countries to pay back interest on old loans so
that no loans are declared ‘non-performing’ (bad publicity)
 Easterly’s aid reform proposal:

• Easterly’s aid reform proposal:

• rank countries according to actual policy performance (not promises) and
give aid to those higher up the list
• in the 1980s — no correlation between policy performance (measured by
standard indicators, e.g. corruption, inflation, black market premia) and
aid given
• reversing the direction from past good policy (improvement) to aid
instead of what currently is past bad policies (to be poor now) to aid
• aid should increase as incomes rise in poor countries, not decrease as
now
• align incentives and help countries by giving them incentives to help
themselves.
 A Word on Debt-Forgiveness

• A word on debt-forgiveness
— “debt forgiveness grants aid to those recipients who have best proven
their abilities to misuse the funds”
— debt-relief may only work if (1) there has been a proven change (i.e.
need to wait and see) in government to one with good policies and (2)
it is a one-time measure that will never be repeated (to avoid moral
hazard problems)
— in practice (2) above is pretty much impossible to implement politically