The total amount of foreign aid has grown steadily in the post-war period, but what has it achieved? Empirical evidence suggests that there is no relationship between aid and growth, but that aid can have a positive impact on growth under certain circumstances. This paper, published in the Journal of Development Economics, proposes a key reform that could improve outcomes from the donor perspective.
Aid can boost growth and reduce poverty in certain conditions, but has not been systematically channelled to countries where those conditions are in place. One explanation is that aid is not always given with the aim of alleviating poverty. Another reason, explored in this paper, is linked to the fact that, in most donor organisations, allocation and disbursement decisions are separate. This has led to a strong bias towards disbursing committed funds to the designated recipient irrespective of performance. Thus, resources are not shifted towards countries where they can be effectively utilised. Modelling reveals the advantages of reforming this system by introducing a competitive element between recipients.
The paper proposes one major reform that could be applied to country programme funding and, in some cases, to project aid. Currently, committed funds have a low opportunity cost. This is because spending budgets has become a goal in itself, and in some cases, enforcing conditionality could conflict with other aims.
- The implication is that disbursement decisions are independent of reform efforts in recipient countries. Analysis of data from some 200 structural adjustment programmes supports this hypothesis.
- Under the proposed reform, the disbursement decision would be centralised, thus internalising the opportunity cost of aid.
- The donor would link allocation and disbursement decisions by committing an aggregate amount to a group of countries, but disbursing funds based on their relative performances.
- The higher opportunity cost gives donors stronger incentives to reward ‘good’ policies.
- Secondly, competition among recipients allows donors to better understand their choice of action in the face of common shocks, allowing more efficient disbursement.
The World Bank has argued that if aid is redirected towards countries with ‘good’ policies, more than 80 million people could be lifted out of poverty with the same level of aid. Thus, reforming current practices could result in large gains. There are, however, objections, some of which the paper attempts to counter:
- Competition between recipients could lead to uncertainty about financial flows. However, if the shocks facing them are correlated, competing for funds should reduce uncertainty.
- Reform implementation depends on domestic political economy forces rather than conditional aid. Nonetheless, under the new system, this would not prevent effective aid disbursement.
- Collusion among recipients could undermine competition. The assumption is that recipients act non-cooperatively, but further research is recommended.
- The potential cost of competitive aid schemes is seen as very high. However, the extent of competition and thus cost can be controlled by varying the share of aid disbursed in this way.
- The proposed reforms would change the power structure within donor agencies, reducing the discretionary power of managers and requiring them to make tougher choices. They might resist change of this kind.
