Underdevelopment and aid: search for a right balance - Part I

As the world is currently in the grips of a severe financial crisis, with its impact hitting the real economy almost everywhere, large divisions are emerging among rich country governments and economists as to how to deal with global poverty, not only for humanitarian but for enlightened self-interest reasons.

The crisis is likely to intensify these divisions, suggesting to some that this issue should be set aside until the storm passes, especially since there has long been scepticism all around as to the effectiveness of foreign aid in furthering our objectives.

Yet long before the latest crisis emerged, the terrorist attacks of 9-11 triggered thinking about the relationship between poverty and security.

The US National Security Strategy Memorandum of 2002 listed foreign aid as a critical anti-terrorism instrument and as one of the three main pillars of US foreign policy. Reinforcement followed from the Bono/Jeff Sachs/NGO quarters, seized with the priority of achieving the Millennium Development Goals set up by the United Nations. While not all promises have been kept, the volume of foreign aid has increased in recent years, despite mounting economic malaise in most OECD countries.

On the other hand, aid effectiveness has been subject to mounting doubts for several reasons:

William Easterly and Dani Rodrik, for example, have pointed out that aid is often counterproductive. In fact, there is general acknowledgement - even by the World Bank and the International Monetary Fund - of the failure of structural adjustment lending, tied to conditionality enshrined in the free-market principles of the Washington Consensus. This aid giving has often deteriorated into annual ritual dances, with donors initially insisting on reforms but ultimately yielding to the need to disburse - a feature well understood by recipients.

The joint World Bank/IMF Poverty Reduction Strategy Papers which followed in 1999 succeeded in slashing customary conditions by half to an average of 30 per country. However, most independent observers agree that these poverty-reduction plans are not really recipient “owned,” still prepared with the aid of massive manuals, subject to detailed approval by the World Bank and IMF. At a 2001 Kampala meeting, 15 African countries denounced the latest poverty-reduction strategy as the same old structural adjustment loans in sheep’s clothing.

Admittedly, there have been some innovative institutional changes on aid, including establishment of the US Millennium Challenge Corporation (MCC) which is supposed to reward countries for behaving well in relation to now 17 criteria, including, for example, trade policy and public expenditures on health, and thus represents a move in the direction of “ownership.” However, the MCC provides only project grants in recognition of past performance, not future intentions, and its record to date indicates exceptions are made to reward countries considered strategic friends. Moreover, the move of the US Agency for International Development deeper into the State Department, with its director now doubling as overall director of foreign assistance, suggests that short-term foreign policy objectives rather than poverty alleviation threaten to dominate.

Also fuelling scepticism is that aid can contribute to two versions of the so-called “Dutch Disease”. With respect to the better known first version, the impact of aid flows rendering the exchange rate too strong and thus discouraging labour-intensive exports, this risk has been documented by several cross-country studies, especially with respect to African countries. But a second strand, to my mind, is more harmful and difficult to avoid, and that’s its impact on decision-making. Instead of facilitating reforms, aid may, in fact, permit persistence with inappropriate policy regimes. Foreign aid flows can be accompanied by a relaxation of domestic development efforts, e.g., inducing a decline in domestic savings. It can also generate a spike in corruption and rent-seeking behaviour, even capital flight.

Another source of the scepticism on the effectiveness of foreign aid arises from the escalating number of public and private spigots, both within any one donor group and across the donor community. A multitude of principals, working with different recipient country agents, competing for projects and giving conflicting advice, escalates transactions costs and contributes to disillusionment with a process once viewed with such optimism in the 1950s. Some developing countries have indeed asked for vacation months from the onslaught of visiting missions. The still dominant US Foreign Assistance Act of 1961 is top-heavy with special interest barnacles accumulated over many decades.

Realistically, while a new administration will likely consider a major overhaul of US aid, there are clearly many more pressing issues on its platter. Moreover, one should not expect to “start from scratch”, either with respect to zero-based budgeting or the quality of foreign assistance. Donors and domestic lobbies have pet projects, and history exercises a heavy hand. We must therefore anticipate a continuation of some “business as usual” annual country aid programs, even if more limited in size, given budgetary pressures.

However, consistent with the need to enhance the quality of aid, opening of new aid windows, say by the World Bank and the European Union - initially on a pilot basis - could make a big difference. Such an initiative, however, must be consistent with the following conditions:

For one, it should be acknowledged that policy-based program lending remains the best instrument for achieving “growth with poverty alleviation” objectives in the developing world. Given the well-known fungibility of resources, the country is still the only sensible “project”, and the default position of some critics such as Easterly and Rodrik, to return to a “projects-only” approach, continues to make little sense.

Second, the donor community should permit such new windows to act like banks, or to be more passive, letting would-be borrowers take the initiative but ready to respond, if and when a would-be recipient presents a reform package deemed politically and economically viable. While admittedly large uncertainties attach to what is precisely the right reform package for a particular country at a particular time, such a package has a better chance if genuinely cobbled together by various domestic stakeholders.

Third, an applicant country needing help in formulating such a reform package should look to independent third parties, not the major donors who will find it difficult to avoid repeating the mistakes of the past. For the same reason, such help should preferably be financed by foundations or NGOs.

Fourth, the would-be borrowing country would present a “self-conditionality” list. Given the difficulty of any government to do everything at once on a number of policy fronts, realism calls for restricting this number to a few critical bottleneck areas over any three- to five-year period.

The donors, acting like banks, would not simply sign on the dotted line, but negotiate contents and conditions of the proposed reform package. In the final analysis, agreement may or may not be reached in every instance. There should be absolutely no compulsion to lend, and some countries may not be interested in or able to use the new windows over some periods of time. Consequently, prolonged fallow years should be viewed as normal, not failure.

The credibility of this new plan requires the ability to commit funds for successful applicants over a three- to five-year period, long enough to match domestic adjustment requirements occasioned by the reforms. The availability of several new windows would also reduce the current plethora of competitive spigots while avoiding donor monopoly.

The critical element of restored aid credibility also requires that if self-conditionality terms are not met, disbursements are indeed cut.

Admittedly, the obstacles to adopting such an initiative are formidable. It requires a change in the culture in both aid-giving and aid-receiving countries deeply embedded over five decades: OECD parliamentarians must be willing to give up some favourite physical demonstration projects; executive branches must be willing to give up using such flows as an instrument to enhance short-term foreign-policy objectives; and recipients must accept the notion that such aid is meant to reduce the inevitable adjustment pains caused by real reforms, not to take the pressure off.

The stakes are high, but if the current opportunity for change is missed, the sceptics will have had their way.