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The Case for Increased Aid

Research reports

This is the final report of a study commissioned by the Department for International Development to explore whether a case can be made for a substantial ($50bn) increase in aid flows, to finance the incremental costs of achieving the Millennium Development Goals. It is based entirely on review of secondary sources.


The balance of evidence strongly suggests that Aid has been a good investment. Econometric studies, project evaluations, and country case studies find typical rates of return above 20%. Aid has also contributed to a doubling of school enrolments and halving of infant mortality since 1970.


Returns have been higher in better- managed economies, though recent studies suggest positive results are also achieved in weaker environments.


Poor performance of most African economies reflects a wide range of negative shocks including conflict and political instability, associated governance problems, climate shocks, terms of trade losses, and the burdens of HIV/AIDS and other diseases. Recent econometric research suggests that performance would have been worse without aid, while the example of Uganda and Mozambique shows that aid can help reasonably well- managed African countries to achieve rapid poverty reduction.
Donor imposed policy conditions have had little success in improving policy, whereas there is strong evidence that interruptions to aid flows have been very damaging to economic performance. There is some evidence that institutional effectiveness may be a better predictor of aid effectiveness than specific policy choices that can be unstable. We propose that population and poverty should mainly determine aid allocations, but taking account of institutional effectiveness as a constraint on the quantity of aid that countries can make good use of. Where key institutions are missing or weak, capacity building support may need to precede expansion of aid transfers.


In extreme cases of weak institutions or conflict, donors may be unable to work with Governments, but should stay engaged by working with civil society and possibly with local Government. The most important role may be to support those who are pressing for peace and for fundamental reform, bringing knowledge of what has worked elsewhere and facilitating discussion. Donors can also play a limited role in helping to maintain or even develop some vital services using mainly non-Government channels, but sustainability will not be feasible, and coverage will not be consistent with achieving the MDGs.


The proposed $50bn increase in aid is intended to match international estimates of the cost of achieving the millennium development goals. Though useful as a starting point, these estimates need qualification. They are based on average costs, but there are big differences in the efficiency with which Governments spend money, and marginal costs are likely to rise as services are extended to hard to reach groups.
The main concern with such a large increase in aid flows is the risk that the marginal benefits of aid will reduce as the amount of aid increases. High levels of aid may strain the capacity of Governments to manage it, reduce the international competitiveness of the economy by appreciating the real exchange rate, make macroeconomic management more difficult, and can damage the development of domestic institutions of accountability. Some studies have found empirical evidence of the benefits of aid eventually reducing and even turning negative, though the critical threshold varies between studies, with most finding negative returns do not set in before aid reaches 25-50% of GDP.


These empirical findings of diminishing returns in the past are not a basis for predicting what will happen in the future . Although economic theory predicts that, if nothing else changes, diminishing returns will set in at some point, this will be very context specific, and there is ample scope for offsetting actions. Some studies have found that countries with a good policy and institutional environment are able to sustain good marginal returns to aid even at very high aid: GDP ratios. Problems of diminishing returns can be overcome through improvements in Government policy. Key reforms include sound management of the macro-economy, good allocation and management of public expenditure and aid to overcome supply constraints, and improvements in the management of aid, requiring increased donor willingness to reform their own aid practices. Making good use of large aid flows relative to the size of the economy requires a substantial shift away from projects in favour of more programmatic forms of aid, using Government institutions and reducing the burden that donors place on Government capacity.
Low-income countries receive less than half of global aid. A $50bn increase targeted on achieving the MDGs would need to be concentrated on low-income countries, and would imply tripling their aid receipts.


To explore the implications of an extra $50bn, we looked at the scope for increased aid in countries that together represent 80% of the population living on less than $1 per day For several major African countries that would be candidates for receiving a large share of the proposed increase in aid, there are major issues of fiscal sustainability. In order to absorb even a doubling of aid ($13bn) in Africa, the proposed increases would imply aid financing the majority of public expenditure, including a significant share of recurrent financing. Governments may well shrink from the prospect of rendering themselves so vulnerable to future donor policy, since public expenditures once increased are politically difficult to cut in an efficient manner. Further work on the demand side and political implications of higher aid flows is needed.


However, the majority of the world’s poor are in South Asia. India alone has more poor people than Africa, and this will still be the case in 2015 even if the MDG target is met. India receives less than 1% of GDP in aid, compared to 10% in the median sub-Saharan African country. The size of the Indian economy, and the capacity of Indian administration, mean that a rapid increase in aid could be readily absorbed. If focused, together with Government funds, on meeting the MDGs, it could achieve a significant global impact. For example, India accounts for over 20% of out of school children, but the 2% of GDP increase in spending required to achieve UPE is within reach if India receives a reasonable share of increased aid funding. Other populous countries in Asia have also been under-aided in the past, and could make good use of significantly increased funding. Bangladesh in particular is very under –aided and has faced long-term decline in aid flows, yet has achieved a performance in economic management and poverty reduction that would merit a very large increase.


The case for the proposed $50bn increase thus comes down in part to the willingness of the donor community to allocate higher funding to South Asia.


The IFF proposes to borrow funds in order to increase aid in the medium term, with the expectation that future aid levels can be reduced. India and Vietnam will both be middle-income countries by 2015. A boost to aid today will accelerate achievement of the MDGs, but the aid requirements should reduce rapidly from 2015 as rapid growth shrinks the population of poor people and increases domestic financing capacity. Other fast growing countries will also see their financing needs diminish over time, though others in the core group that accounts for 80% of the non-China poor population will still be in the low income group by 2015, even with rapid growth, and will continue to need and merit substantial aid flows.


On plausible assumptions, if Africa uses aid to increase public spending, the continent as a whole should be able to sustain the increased per capita spending levels from domestic revenues within 8-10 years if aid is doubled, and within 12-15 years if it is tripled. Unfortunately, this reassuring conclusion needs to be modified in the case of several of the major recipients of increased aid. A combination of low domestic revenue, high public spending following the aid increase, and relatively rapid population growth, implies that it will be many years before revenue growth in countries like Tanzania and Ethiopia catches up with and begins to overhaul the annual increases required simply to maintain the higher per capita spending levels.


The increased level of per capita spending could only be sustained if the higher aid levels are maintained for 20 years or more in the case of Ethiopia and Tanzania, with the absolute aid need continuing to grow for several years even though the percentage of spending financed from domestic revenue is falling. This creates a major challenge for donors- the MDGs are a long-term goal for the international development community, and require predictable long-term flows if they are to be met and then sustained.


Provided the good historic benefits from aid continue to be enjoyed, there is a strong case for an arrangement like the IFF that increases aid to benefit the current generation, even at the cost of lower aid available for the next, and hopefully wealthier, generation. However, unless donors can improve the reliability of their commitments, especially very long term ones, limits may need to be placed on the increased aid to at least ensure that the increased per capita spending levels can be maintained. This may imply constraining aid to levels below those that would be implied by aid allocation models, and may have implications for the size of the fund that is required or can be absorbed. More detailed country level assessments are needed.


Of course, there will still be serious poverty in many countries when the IFF comes to be repaid, even though the absolute numbers as well as the proportion of the world population living below the poverty line should have reduced. The population requiring aid should thus be smaller, the wealth of the aid givers will have increased, and new countries will become donors as they join the ranks of the wealthy. The IFF proposal makes clear that it should be possible to service the IFF obligations while maintaining aid flows for those that continue to need them.

Mick Foster with Andrew Keith