ECON20332/60282: Lecture 6 FOREIGN AID AND DEVELOPMENT

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ECON20332/60282 Lecture 6 FOREIGN AID AND
DEVELOPMENT

• Katsushi Imai
• Email katsushi.imai_at_manchester.ac.uk
• Office Hours Tuesday 3.30-5.30 pm

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1. Source of Capital Inflow to LDCs

• (a) Foreign Direct Investment (FDI)
• (b) Borrowing from Commercial Banks
• (c) Official Financial Flows
• 1) Bi-lateral Multi-lateral
• 2) Concessional non-concessionhal
• 3) Project Aid Programme Aid
• (d) Grants and Loans from non-governmental
  organisations (NGOs)
• -See Table 15.2 (Thirlwall)

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Definition of ODA

• ODA needs to contain the three elements
• (a) undertaken by the official sector
• (b) with promotion of economic development and
  welfare as the main objective and
• (c) at concessional financial terms (if a loan,
  having a grant element of at least 25 Oper cent).
• Other Official Flows (OOF)
• Transactions by the official sector with
  countries on the List of Aid Recipients which do
  not meet the conditions

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• -Table 15.5 (Todaro)--- ODA by Major Donor
  Countries
• -ODA by Region (Table 15.6)
• Does not reflect poverty-reduction needs.
• -Declining Trend of Net Resource Transfer
• -Aid-Dependency (Table 15.7)

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2. Motives for Aid

• (a) Redistributive (moral case)
• Redistribute income globally and often within
  recipient LDC.
• (b) Allocative/ growth
• Positive macroeconomic impact on recipient LDC.
• (c) Stabilisation (Commercial)
• Boost world demand, esp. LDC recpients demand
  for donor exports- to reduce donor unemployment.
• (d) Geo-political (geographical/ historical)
  
• (e) Emergency Aid (war, cyclone, flood, etc.)

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3. Dual Gap Analysis and Foreign Borrowing

• (a)

-National Income Identity for an Open Economy
Y C I G EX- IM (1)
EX Export IM Import -Current Account and
Foreign Debt CA EX- IM
CA Y- (C I
G) Let S stand for national savings.
S Y- C- G From (1) S I EX- IM
I S IM- EX
(2) LHS An excess of investment over
savings RHS A surplus of imports over exports.

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• A surplus of imports over exports financed by
  foreign borrowing allows a country to invest more
  than it produces. But ex ante, LHS and RHS does
  not have to equal.
• (b) Harrod Model g s/ k
• where g growth rate of GDP
• s savings ratio S/Y
• k K/Y (capital to output
  ratio)
• g sp (3)
• where p Y/K (productivity of
  capital)
• Likewise
• g i m (4)
• where i M/Y (import ratio ratio
  of investment-good imports to GDP)

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• From g i m, mg/i (dY/Y) / ( M/ Y)
  
• m dY/M (incremental output-import ratio)
• Assumption Lack of substitutability between
  domestic and foreign resources.
• Growth will be Either
• Savings-constrained (--- Foreign exchange
  unconstrained)
• --A part of foreign exchange is
  unused.
• (or )
• Foreign exchange-constrained (---
  Savings-unconstrained)
• -A part of domestic savings is
  unused.

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• Now suppose a country sets a target rate of
  growth, r.
• Required savings ratio s r/p (3)
• Required import ratio i r/m
  (4)
• ---Investment-savings gap exists if sgt s
• savings gap s- s a
• a is a grant of aid.
• MPS (Marginal Propensity to Save)dS/dY
• gt APS (Average Propensity to Save) S/Y
• Role of Aid (1) Aid leads to a higher
  rate of
• accumulation.
• (2) Aid raises
  income.

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---Import-export gap (foreign exchange gap)
exists if igt i. If Foreign Exchange-constrained
Foreign borrowing can supplement not only
deficient domestic savings but also foreign
exchanges.
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• 4. Models of Capital Imports and Growth

O Y rD (2) where O is
output, Y is income, r is the interest rate and D
is debt. rD is factor payments abroad. From
equation (2) dO dY rdY Also, dO
p I (3) where
p is the productivity of capital. I sY dD
s(O- rD) dD sO dD - srD (4) where
s is the propensity to save.
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Substituting (4) into (3) and dividing by O
gives dO /O p ( s (dD srD)/
O ) (5) ---Growth of output will be higher
than the rate obtainable from domestic savings
alone as long as dDgt srD From (2) dY
dO rdD (6) Substituting (4) into (3) and
the result into (6) gives dY p(sO dD
srD) rdD (7) Using Y O- rD,
(7) can be rewritten as dY psY dD (p
r)
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Then, we will get dY/ Y ps (p
r)(dD /Y) ---The growth rate of income with
capital imports will be higher than that obtained
alone as long as p (the productivity of capital
imports) exceeds r (the rate of interest on
foreign borrowing). Import surpluses have
great potential in promoting growth in
general. ---However, the import surpluses
financed by foreign capital inflows increase the
capital-output ratio (or reduce the productivity
of capital) and discourage domestic saving.
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• ---A large fraction of capital inflows is
  consumed rather than invested.
• An empirical question Aid will increase or
  decrease savings
• Griffin (1970)
• Griffin, 1970 K.B. Griffin, Foreign capital,
  domestic savings and economic development, Oxford
  University Institute of Economics and Statistics
  32 (1970), pp. 99112.
• Savings Function Coefficient on Aid Flows
  /GNP
• -0.73 to -0.84
• S/Y 11.2- 0.73A/Y R2 0.54
• (32 LDC data in 1962- 64)

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Griffins Results and Other Works Suggested
causes of domestic savings displacement a. Gov.
reduces taxation. b. Gov. reduces tax collection
effort. c. Aid may cause inflation and will
reduce tax receipt if tax system is inelastic. d.
Gov. may switch expenditure to consumption
(fungibility).
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Criticisms of Griffin (1970) a. Total
savings still increase unless MPS (marginal
propensity to save) dS/dY 0 -Aid is
likely to have some positive effect on total
savings and hence investment. b.
Does not allow for aid multiplier feedback
effects on s. - Multiplier and feedback
effects can boost growth and future domestic
savings. c. Fungibility is not
possible in some LDCs.
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• d. Growth does not just depend on savings.
  Consumption can raise growth.
• e. Savings function may be mis-specified due
  to simultaneity problem.
• f. Correlation is different from causation.
  Aid may be an endogenous variable.
• g. Inter-country differences regarding any
  of above make cross-section studies
  inappropriate.
• ----Is There A Macro-Economic Case Against
  AID?---NO.

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• 5. Country Differences in Aid Impact
• a) Which gap is binding (greater aid
  effectiveness if foreign exchange gap is binding)
• b) Marginal propensities to save and import
  differ.
• c) Sectoral allocation of aid.
• d) Allocation between recurrent and capital
  budgets.
• e) Influences on relative prices and hence on
  investment.
• f) Crowding-out effect. Rate of return on
  private capital differs.
• g) Foreign trade regime.

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----Yet, is there any general pattern?
Aid Effectiveness Cycle
(virtuous circle or vicious circle)
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• 6. Effects of Tied Aid on Recipients

Tied Aid Definition (by OECD) Tied aid credits
are official or officially supported Loans,
credits or Associated Financing packages where
procurement of the goods or services involved is
limited to the donor country or to a group of
countries which does not include substantially
all developing countries.
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Source OECD 2006
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• 6. Effects of Tied Aid on Recipients
• a) Reduces real value of aid resource flow
  higher priced imports.
• b) Bias toward foreign exchange intensive and
  capital intensive projects.
• c) Donor reluctance to allow large domestic
  component.
• d) Inappropriate equipment--- high recurrent
  costs.
• e) Proliferation of different forms of same
  input which makes backward linkages difficult.
• f) Undermines domestic production efforts.
• g) Projects and inputs not tailored to
  recipients development priorities.