The Aid-Growth Nexus: The Role of Development Aid in the Economic Growth of Developing Economies

Introduction

Official development assistance (ODA) or foreign aid is defined by the Organization of Economic Cooperation and Development (OECD) as ‘government aid designed to promote the economic development and welfare of developing countries’. It excludes sums allocated as military aid. More comprehensively, foreign aid encompasses all resources: physical goods, skills, technical know-how and assistance, financial grants (gifts) or soft/concessional loans (where the grant component is at least 25% of the total).

Aid may be offered by donors for multiple reasons: (a) to provide assistance during emergencies or humanitarian crises; (b) to support developing nations to achieve their respective developmental( growth and poverty reduction) goals; (c) to display solidarity; (d) to secure political, commercial and strategic interests of the donor; (e) to strengthen historical ties (f) promoting human rights. More recently, aid to fight the war against terrorism is also being provided.

It is worthwhile to note that aid can be bilateral, extended from the donor to recipient or multilateral, channelled through a multilateral development agency like the United Nations and World Bank. In addition, aid may be given by private philanthropic organizations to developing countries. A leading example of the same would be the aid given by Bill and Melinda Gates Foundation for public health interventions such as immunizations in India.

Development aid can be deployed on a plethora of projects. These include infrastructure projects like roads and bridges, agricultural technology improvements. Aid may be used to expand educational and health-based interventions. Additionally, it may be given to address humanitarian crises and natural disasters which could provide life-saving support to those displaced due to natural disasters/ disaster-like situations or war.

A Historical Perspective

A relatively fresh concept in economics, the foremost legislation dealing explicitly with official aid was passed by the Parliament in the United Kingdom in 1929. Further, new laws were enacted in 1940 and 1945 to aid former British colonies thereby increasing the corpus of funds available for longer periods of time. A progressive feature of the 1945 statute was to prepare aid plans ‘in consultation with the representatives of the local population’ to suit local needs.

In the United States of America, 1948 saw the European Recovery Program(ERP also hailed as the Marshall Plan), the pilot initiative to rebuild Europe post World War II with the massive infusion of American aid to support developmental efforts in Europe.

Generally regarded as the result of the intensification of the Cold War, the US revised its position on bilateral aid. Along with other advanced countries, it laid the foundation of the Development Assistance Committee (DAC) at the newly formed OECD in order to reduce the influence of socialism and the USSR on poorer nations.

Theoretical foundation and the potential role of development aid

Influential academic research (Rosenstein-Rodan, 1943; Lewis, 1954) suggests that foreign aid renders the required capital to propel developing countries onto a path of self-sustained economic growth. They have argued for a ‘big push’ to enable poor countries to free themselves from the clutches of a poverty trap. In the 1950s and 1960s, aid policies were influenced by the Harrod–Domar growth model and by W. Arthur Lewis’ unlimited labour supply model. These studies provided intellectual support for development aid. Thus, most agencies funded very large capital-intensive projects and neglected policies, projects, and programmes related to labour, human capital, and productivity.

Robert Solow’s Nobel Prize-winning neoclassical model of growth, and the development of the ‘basic needs’ approach to welfare economics changed the course in the late 1960s and 1970s. Aid policies changed focus, and a higher percentage of funds were devoted to social programmes (health and education), programs aimed at directly reducing poverty, and programmes that strengthened skills and human capital.

The work of Anne Krueger and Jagdish Bhagwati that related openness and export expansion to productivity growth made international assistance increasingly conditioned on the recipient countries liberalizing their economies through the elimination of quantitative import restrictions and the reduction of import tariffs.

The Bitter Policy Duel between aid optimists and the aid pessimists

The debate on the effectiveness of development aid is as old as aid itself. Multiple studies and heated deliberations have led to the emergence of three distinct camps. Firstly, there are aid optimists. These proponents of foreign aid are of the opinion that aid levels have been too low and recommend that large increases in aid allocations would help reduce poverty. However, they urge a rethinking on the way in which aid is provided (Sachs, 2009 and Stiglitz, 2002). Secondly, there are aid pessimists, suggesting that official assistance is ineffective, and has harmed poor countries throughout the years. Lastly, there are those who take an intermediary position on the subject.

The debacle between the optimists and pessimists has been captured coherently in Nobel laureates Esther Duflo and Abhijeet Banerji’s book ‘Poor Economics’. Jeffrey Sachs of the Columbia University suggests that poor countries have remained poor because they are caught amidst unfavourable climatic and geographical conditions and are infested with communicable diseases. This, in turn, makes it difficult for them to be productive without an initial large investment to help them to overcome these endemic problems. However, “they cannot pay for the investments precisely because they are poor—they are in what economists call a poverty trap.” Until these issues are addressed (through development aid), neither free markets nor democracy can achieve much for these countries. In his best-selling 2005 book, The End of Poverty, Sachs argues that if the rich world had committed $195 billion in foreign aid per year between 2005 and 2025, poverty could have been entirely eliminated by the end of this period.

There are, however, two main problems with this aid-growth nexus: (a) it fails to directly address the primary objective of aid allocation, which is poverty reduction; (b) there is an implicit assumption that aid reduces poverty through growth (Burnside & Dollar, 2000; Collier & Dollar). However, the idea that aid promotes growth which in turn implies poverty reduction is not completely satisfactory because aid can affect poverty directly or through other channels. This idea is documented in Mahembe and Odhiambo (2017): channels through which foreign aid affects poverty include economic growth, pro-poor public expenditure (such as education, health and other social programmes), macroeconomic stabilization effect, and funding of infrastructure and other development initiatives.

William Easterly from the New York University and Dambisa Moyo, a former economist at Goldman Sachs have both propounded that aid does more bad than good. Moyo launched a scathing attack against the aid industry—calling it not just ineffective, but “malignant” in her latest book ‘Dead Aid’. Moyo suggests that when markets are free and the right incentives are provided, problems can be solved. According to Peter Bauer, a pioneering critic of foreign aid and the ‘big push’, ‘government-to-government aid is neither necessary nor sufficient for development, as it only entailed the danger of increasing the government’s power, promoting corruption and the misallocation of resources, destroying economic incentives, eroding civil initiatives and dynamism.’  

William Easterly has attempted to corroborate his claim with empirical evidence from Africa, the recipient of significant development aid and a suitable economic laboratory for testing aid effectiveness which is given below:

The data above shows that the claims of the aid community were sometimes not borne out. Even as the level of foreign aid into Africa soared through the 1980s and 1990s, African economies were doing worse than ever. However, this was not confined to just Africa. Arvind Subramanian and Raghuram Rajan have shown that countries receiving huge sums as foreign aid tended to be correlated with lower economic growth as in the figure below.

Raghuram G. Rajan and Arvind Subramanian, “Aid and Growth: What Does the Cross-Country Evidence Really Show?”

The countries that receive less aid, those on the left-hand side of the regression, tend to have higher growth — while those that receive more aid, on the right-hand side, have lower growth. Nobel Prize awardee Angus Deaton has provided an interesting explanation for the above illustrated trends. According to him, foreign aid changes the relationship between a government and its subjects. Normally, a government relies on tax collections from the citizens thereby making governments more accountable to the citizens. In other words, the citizens exercise a certain amount of power on their government. An acute ‘dependency syndrome’ (on foreign aid) leaves governments less accountable to the people thereby altering the relationship.

However, it must be noted that econometric results produced by the research community may be inconclusive as they are based on aggregate data. Bourguignon and Sundberg (2007) suggest that aid impacts economics performance both directly and indirectly through a myriad of channels. Treating all development aid as homogeneous can be deeply misleading and hence recommend a ‘deconstructed’ analysis. This research can throw light on the effectiveness of specific aid mechanisms such as technical assistance, conditionality, level of donors’ involvement and understanding of the local conditions and requirements and the quality of governance in the recipient country to successfully implement policies.

The intermediate camp of economists does not look at the effectiveness of aid from a strictly dichotomous lens. Paul Collier in his influential book ‘The Bottom Billion’ analyses evidence and suggests that over the past 30 years official assistance has helped boost GDP growth amongst the poorest countries of the world- mostly in the African continent approximately by 1% per year which is significant as this period has witnessed the most impoverished nations with a stagnant aggregate per capita growth. This implies that ‘in the absence of official assistance, the billion people that live in these nations – the so-called ‘bottom billion’ – would have seen their incomes retrogress year after year.’

In Africa, development aid has contributed crucially to reduce the outbreak of HIV-AIDS. It is estimated that up to 4 million Africans have received life-saving HIV/Aids treatment (increased from 50,000 in 2002) by the Global Fund alone. These conclusions are evidence that development assistance can have a positive impact on the developing countries of the world, especially if it is shared with devoted and evident leadership and policies intended for economic growth.

In the book ‘Poor Economics’, Duflo and Banerji advocate a “radical rethinking of the way to fight poverty.” According to them an aggregate view on aid or the Sachs-Easterly debate misses the point. The central focus should be in the evaluation of the specific programs funded by aid. This is because some projects are a success while some fail miserably.

Aid and India

For three decades post independence, India’s economic growth rate remained arrested at 3.5% per annum popularly called the Hindu Rate of Growth, a moniker coined by renowned economist Raj Krishna. However, the LPG reforms of the 1990s ushered in a new era of growth. India became the poster child of the successes of globalization. In 2006-07 India had touched double-digit growth rates. Until recently, India was one of the fastest growing nations of the world. Despite these economic gains, India continues to be a recipient of development aid. This is on account of various reasons which include obscene levels of disparities in income and wealth as well high levels of human depravation. A summary of the inequality prevalent in India that has been prepared by Oxfam is given below:

The top 10% of the Indian population holds 77% of the total national wealth. 73% of the wealth generated in 2017 went to the richest 1%, while 67 million Indians who comprise the poorest half of the population saw only a 1% increase in their wealth

Billionaires’ fortunes increased by almost 10 times over a decade and their total wealth is higher than the entire Union budget of India for the fiscal year 2018-19, which was at INR 24422 billion.

Billionaires’ fortunes increased by almost 10 times over a decade and their total wealth is higher than the entire Union budget of India for the fiscal year 2018-19, which was at INR 24422 billion.

Many ordinary Indians are not able to access the health care they need. 63 million of them are pushed into poverty because of healthcare costs every year – almost two people every second.

It would take 941 years for a minimum wage worker in rural India to earn what the top paid executive at a leading Indian garment company earns in a year.

In their widely acclaimed book ‘An Uncertain Glory’, Dreze and Sen(2013) have shown how India ranks worse than its neighbors, Bangladesh, Sri Lanka, Nepal and Bhutan on almost all human development indicators. India is a country with a mounting population pressure reeling under the stress of chronic poverty and poor governance. Hence, it is not shocking that aid economists, quite paradoxically, call India a ‘Needy Donor’. It has continued to receive development aid since independence. Post reaping gains from the economic reforms it began to disburse aid in the South Asian region. This the country did in order to change its world image from a recipient of aid to that of a donor. Aid received and given by India is shown in the figures below.

Source: The Business Standard

India, an aspiring global power can be described as a regional hegemon in South Asia. Aid extended by India to other countries has crucial underpinnings and is a critical instrument of foreign policy. It serves the dual purpose of preserving old ties and builds the opportunity to forge new alliances. As a donor, it is imperative for India to identify and understand the country-specific needs in each recipient country before deploying funds. Not only would this lead to efficient spending of taxpayer money, but also ensure that Indian aid generates maximum positive impact. Aid and foreign policy experts suggest that India should continue disbursing aid at the existing pace in order to contain the Chinese Belt and Road Initiative juggernaut.

Aid in the times of COVID-19

Since the deadly pathogen does not acknowledge international boundaries, the pandemic has put uncertainty on the future of globalization. However, multilateral action may be the best way to tackle the invisible enemy. Globally, the battle against the outbreak of the novel coronavirus is severely straining public finances. The world’s best health care systems in the OECD countries are scrambling to ‘flatten the curve’ in their respective countries. It is certain that the world is headed towards a recession and COVID-19 is posing as a significant threat to the donor community as many OECD member states are struggling with the pandemic’s dire economic consequences as well. Despite this, the DAC countries can assist in the times of crisis as the poorer nations are stuck with dilapidated healthcare systems and are more financially fragile. Existing ODA commitments must be protected and channeled towards health systems and vulnerable sections in developing countries. Annual concessional finance for health from all donors that averaged $26 billion per year between 2016 and 2018 and aid for infectious diseases was $4.4 billion in 2018 must be protected. Recent announcements by the World Bank of a $12 billion response package and by the International Monetary Fund to activate $50 billion through its rapid-disbursing emergency financing facilities are steps in the right direction. Moreover, the current global distress demands coordination between humanitarian and development aid supplemented by good governance.

Concluding thoughts

One can think of development aid as a ‘get-rich-quick-scheme’ or the exogenous stimulus that can bolster growth. However, I believe that this exogenous stimulus is impacted by endogenous factors like the quality of governance, transparency and political stability.  Africa’s heavy dependence on aid has corrupted various governments in the continent. This ‘dependency syndrome’ has proven to be an impediment in African industrialization and has stalled its indigenous development. However, individual examples like Rwanda exist. It received plenty of aid in the years immediately after the genocide and prospered. Now that the economy is thriving, President Paul Kagame has initiated a move towards self-reliance by weaning the country off aid. In my opinion, we cannot comment on the usefulness of development aid in a black and white fashion. As clichéd as it may sound, the effectiveness of aid is very ‘contextual’: it may be a Western power attempting to increase its clout in an underdeveloped nation to satisfy its own commercial interests or a global community of multilateral donors helping the world combat a pandemic.

References

1. https://data.oecd.org/oda/net-oda.htm
2. file:///C:/Users/Dr%20Rakesh%20Srivastava/Downloads/DAC-List-of-ODA-Recipients-for-reporting-2018-and-2019-flows.pdf
3. Edmore Mahembe, Prof Nicholas M. Odhiambo & Robert Read (Reviewing editor) (2019) Foreign aid and poverty reduction: A review of international literature, Cogent Social Sciences, 5:1, DOI: 10.1080/23311886.2019.1625741
4. https://borgenproject.org/why-foreign-aid-is-important/
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6. https://www.weforum.org/agenda/2015/10/does-foreign-aid-always-help-the-poor/
7. https://ssir.org/books/reviews/entry/dead_aid_dambisa_moyo
8. https://www.intelligenteconomist.com/foreign-aid/
9. Banerjee, Abhijit V.Duflo, Esther. (2011) Poor economics :a radical rethinking of the way to fight global poverty New York : PublicAffairs
10. https://factly.in/does-india-receive-aid-from-foreign-countries/
11. https://www.oxfam.org/en/india-extreme-inequality-numbers
12. https://www.devex.com/news/opinion-aid-in-the-time-of-covid-19-3-things-donors-can-do-now-96848
13. https://www.epw.in/engage/article/india-funds-world-neighbourhood