Decoding the Efficacy of Foreign Aid: A Developmental Perspective

April 27, 2017 | Dr. Dhananjay Samant (Economist)

Setting the tone


At least a billion people on the planet continue to live in despicable conditions resembling those that prevailed centuries ago. Our failure to alleviate their plight is not only morally inexcusable but also dangerous for global social stability. Most of these nameless and faceless millions are to be found in developing countries. However, the pertinent data is not easy to come by and even more difficult to interpret. That may be especially true for India, where, from being the world leader in statistical surveys, we are now a country with a serious data credibility issue for some key economic indicators.

Enhancing the effectiveness of foreign aid means ensuring that aid helps developing countries to improve the welfare of the weakest sections of their society in a measurable and sustainable manner. Hence, aid has to be genuinely focused on the developmental priorities of the concerned nations. To make this a reality, both donors and developing countries need to establish genuine economic partnerships in which they are mutually responsible for developmental outcomes, which will, amongst other things, boost employment and growth in the recipient nations. This often means undertaking a fundamental shift in the way those countries conduct business, both within their boundaries as well as with the outside world. In this context, the GST is going to be a game-changer for the Indian economy by considerably enhancing the ease of doing business in the long run.


Boosting aid effectiveness is also necessary in case of challenging and complex situations caused by random acts of nature, including earthquakes, hurricanes, and floods. A recent example is the tsunami disaster that struck countries of the Indian Ocean rim in December 2004 and led to massive destruction of life and property.  Under any circumstances, worldwide developmental and humanitarian assistance must be coordinated within the growth and poverty reduction strategies of the developing nations, many of whom are facing long-standing environments of weak governance and internal strife. If foreign aid is to be effective, it must give increased importance to such unpredictable situations, as and when they may arise.


The effectiveness of foreign aid increases considerably if the recipient nation’s own cultural and institutional setup provides some sort of assurance that the assistance will be used only for the mutually agreed purposes. Such a framework also strengthens the partner country’s sustainable capacity to develop, implement and account for its socioeconomic policies to both its citizens and its legislature. Unfortunately, much of this basic requirement is also not guaranteed in many developing nations. Such countries need to undertake urgent socioeconomic reform to ensure that national systems, institutions and procedures for managing foreign aid and other developmental resources are effective, accountable and transparent. In this regard, even though many developing countries have improved their management of public funds, a lot more needs to be done to convince the global community about the long-term efficacy of foreign aid. India is also one of those nations needing to undertake a serious introspection of its socio-political ethos if it is to genuinely benefit from the foreign funding it receives.


The issue of fungibility adds to the difficulties of accurately tracking the deployment of foreign aid. Even if aid is narrowly targeted at priority sectors like healthcare and education, a government can easily curtail non-essential expenditures and direct it elsewhere, into relatively less economically productive avenues … for example, the military or espionage activities. This defeats the entire purpose of the foreign funding.


The Dutch Disease


The Dutch disease is the apparently causal relationship between the economic development of a specific sector (usually, natural resources) and a decline in other sectors of the economy (like agriculture or manufacturing)[1]. The putative explanation is that as revenues increase in the emerging sector, the concerned nation’s currency appreciates vis-à-vis that of other nations. This leads to the nation’s exports becoming more expensive for others to buy and its imports becoming cheaper, thus jeopardizing its trade balance in the long run. In India’s case, for example, capital inflows usually lead to an appreciation of the rupee, which in turn gradually diminishes the competitiveness of Indian manufacturing goods. To resolve this problem, the government may need to emphasize an MSME focused development strategy, which will also help tackle the key issue of jobless growth.


Some economists believe that the Dutch disease is not inherently a bad thing. After all, logic suggests that economies should focus on what they are most efficient at producing. The issue with this line of thought is that since the prices of natural resources fluctuate, most countries today need some back-up industries also. Furthermore, when the supply of commodities is exhausted, there will be little left to sustain the economy if a prior strategy of market diversification – or at least containment of the real exchange rate – is not already firmly in place. There is a striking resemblance between many of the domestic and trade issues caused by foreign aid inflows and the Dutch disease.



Foreign Aid and the Sustainable Development Goals (SDGs)


The UNDP’s recent announcement of the SDGs has created a quantum change in the global attitude towards foreign aid and international development. The SDGs came into effect in January 2016 and they will continue to guide UNDP policy and funding for the next 15 years. They comprise a list of 17 fundamental socioeconomic objectives that all countries (and not just the developing nations) have to work towards and achieve by 2030. No country has yet completed the SDGs. While all countries must strive to complete them, some countries are naturally more equipped to do this than others. For many countries, an appropriate funding will be critical to achieving the SDGs. As of now, it costs $30 billion per year to eradicate global hunger and another $66 billion per year to provide a social safety net to help those in extreme poverty. Obviously, foreign aid has an increasingly important role to play in the coming years.


To meet the SDGs, annual investments in infrastructure alone will need to be to the tune of around $7 trillion. These investments will be necessary for meeting global targets on water, electricity, agriculture and transportation.  This massive cost will need to be shared amongst nations, but how it will be is still not clear. In this regard, the development assistance commitment of the first world to share 0.7% of their GNP with the developing nations is a promising start, though it remains to be seen how the actual situation eventually unfolds.  


While FDI inflows to developing nations have been increasing over the past fifteen years, they are also heavily concentrated in a relatively few resource-rich nations. This does not bode well to the objective of achieving the SDGs. In reality, many developing nations remain heavily dependent on Official Development Assistance (ODA), which is widely used as an indicator of international aid flow. However, it is clear that the considerable investment requirements of the SDGs will not be met though the ODA alone. Most developing nations will also need to make effective use of other official and private flows, including debt and equity.


The Development Financing Landscape


The development financing landscape has become much more diversified and sophisticated over time. New players, both public and private, have emerged and/or expanded their international development programmes. New financing instruments have emerged both within, and in addition to, ODA. They include blended finance, green bonds, guarantees, local currency financing, impact investing, diaspora financing, and debt swaps/buy-backs amongst several others. Specialized financial instruments to help countries better manage risk and vulnerability to shocks have also emerged or been proposed such as GDP-indexed bonds, countercyclical loans and weather/catastrophe insurance. New partnerships between public and private finance providers are becoming increasingly common and innovative. It is a dynamic landscape that continues to evolve rapidly.


It is obvious that new financing instruments and approaches must be tailored innovatively to the specific needs and characteristics of developing countries and must be used in ways that appeal to them. Some of these instruments are complex to understand and/or to implement, especially in settings with infrastructural limitations and weak regulatory oversight. They may also increase fragmentation and transaction costs, reduce transparency and increase debt burdens (since many are debt instruments). The opportunities, risks and limitations associated with each financial instrument should be carefully evaluated and due diligence must be undertaken before it is actually put into practice. Needless to say, any form of international aid must be compatible with the recipient’s domestic development strategies and socioeconomic priorities.




A large body of contemporary econometric research has attempted to analyze whether foreign aid is effective in generating higher growth and better developmental outcomes for the recipient nations. However, their results have been largely inconclusive. According to many of these studies, aid affects economic performance, directly and indirectly, through a variety of channels, some of which are obvious and others are not. Treating all foreign aid as homogeneous – regardless of whether it is emergency assistance, programme aid, or project-based aid – can be a serious mistake. Most academics now prefer to take intermediate positions on the issue of the effectiveness of foreign aid. After all, some projects financed officially by foreign aid work reasonably well and are effective in poverty reduction and moving the domestic populations towards sustainable development, while others fail miserably. The issue now is not how foreign aided programmes have fared in the past, but rather how to evaluate whether specific developmental projects currently under consideration are likely to be effective in meeting their objectives.


We also need to realize that foreign aid is only one component affecting a nation’s overall development prospects.  All over the world, a vibrant democracy, steady economic growth, gender equality, the freedom to think innovatively, and environmental concern are the key determinants of socioeconomic progress. Given the complexity of the developmental process, addressing issues of income and opportunity inequality at the national level is a prerequisite to any kind of international progress. Unflinching respect for human rights and environmental sustainability are the keystones for achieving an enduring impact on the lives and potential of the deprived millions all over the world. It is also vital that all of a nation’s resources and public policies address these concerns in depth and in an increasingly humanitarian framework. Today, more than ever, countries across the world need to be proactively assisted through international partnerships to build the successful future all responsible people want to see … a future based on a shared commitment to eliminating inequality and poverty, a future in which no country will depend on foreign aid.



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