The downside of foreign aid and its impact on recipients

Abul Fadl

Jumada' al-Ula' 10, 1419 1998-09-01

Special Reports

by Abul Fadl (Special Reports, Crescent International Vol. 27, No. 13, Jumada' al-Ula', 1419)

Foreign aid, whether in the form of loans or grants, in cash or in kind, is often touted as a useful way to bring about an international redistribution of global wealth. One streak of classical economic growth theorization, known as the economic convergence theory, sells the virtues of aid arguing that the transfer of wealth from rich to poor countries through aid makes sense not only on moral and humanitarian grounds but also on purely economic grounds.

That is so because, as the theory argues, rates of return on capital are much higher in poor nations where private investors, fearing a high risk, might be loathe to commit their largesse.

In this line of reasoning, foreign aid is conceived of as a transfer of resources from rich to poor countries. It is believed to supplement the low levels of domestic savings in poor countries thereby enabling them to enhance their rates of investment. Subsequently, rates of domestic savings and economic growth are accelerated leading to a reduction in the level of poverty.

It would be nice if reality fit neatly within the confines of this theoretical model. But a closer look at the experience of many ‘third world’ countries, which have enjoyed decades of sustained foreign aid inflows, reveals that such aid has done little or nothing to stimulate the growth rates of their economies. It is true that aid has had some success in such areas as humanitarian relief and reducing infant mortality, however its record as a pivotal instrument for the promotion of economic growth and eradication of poverty has been dismal.

In fact, low-income countries where aid inflows have been high tended to experience falling levels of rates of output growth - a fact that has prodded even some foreign aid practitioners to question the effectiveness of such injections. It is noteworthy in this regard that there is a negative correlation between foreign aid flows and growth: that is, countries that receive greater amounts of aid do not undergo faster growth than those that receive less. For instance, African countries, which enjoy aid-to-GNP (Gross National Product) ratios more than ten times those of their Latin American or East Asian counterparts, suffer inferior economic performance.

For one thing, aid is inappropriate in amount. Global foreign-aid spending as a percentage of the combined GNP of donor countries has been declining continuously since 1987. Statistical figures of financial flows to developing countries in 1995 published by the Organisation for Economic Cooperation and Development (OECD) indicate that the largest rich countries allocate a lesser percentage of their GNP to aid than their smaller counterparts.

For instance, Japan allocates 0.28 percent of its GNP to foreign aid purposes, whereas the US allocates a paltry 0.10 percent, one of the lowest ratios for OECD countries. In contrast, the ratios of foreign aid to donor country GNP in the cases of Finland and Luxemburg are 0.32 and 0.38 respectively. The target set by donor countries for foreign aid is 0.7 per cent of GNP; however, only a few small donor countries, such as Norway, Sweden, Denmark and the Netherlands, have met it.

In addition, foreign aid is also defective in form. A significant portion of aid donated by rich countries is actually loans which must be paid back with interest. It is no surprise then that aid effectively drains more money out of poor ‘third world’ countries than it injects into their economies. For instance, in 1962, the total debt burden of all countries in sub-Saharan Africa stood at about US$3 billion. However, their current debt burden is estimated at $222 billion. Most of this debt was accumulated as these countries embarked on shopping sprees importing machinery in a bid to industrialize their economies following independence. Unfortunately, much of the borrowed money went into grandiose, mostly ‘white elephant’ projects that were absolutely inappropriate for the needs of developing countries.

Hence, as the African experience shows, in the end, aid emerges as a mechanism that accentuates international inequality as it allows the rich industrialized countries to become net recipients of foreign capital rather than net suppliers. It also helps perpetuate poor policies and weak economic performance through the subsidization of unsound and imprudent courses of economic policy.

Almost all injections of foreign capital through aid, moreover, are used to finance additional consumption rather than additional investment. That is why they often do not lead to the hoped for rise in domestic savings or output but rather end up increasing the cost of inputs.

Foreign aid, especially bilateral aid, usually acts as an effective way to subsidise business interests in donor countries. Most aid is tied to procurement in or purchases from the donor countries. These arrangements could sometimes drive the capital costs of aid-financed projects, especially when goods purchased under tied aid are priced higher than world market prices.

A cursory look at the way American aid to Egypt is spent helps illustrate this point. It is estimated that 58 percent of all aid donated by the US to Egypt between 1974 and 1989, totalling $8.7 billion, was spent directly in the donor country rather than on development projects in Egypt. The remaining 42 percent, totalling $6.3 billion, went mostly to the coffers of American contractors working on development projects in Egypt.

Similarly, the generous financial assistance extended by the US to Israel, whose GNP per capita stands at US$15,920, brings into sharp focus another sad reality about aid: donors usually do not extend aid with the goal of increasing efficiency or growth in mind. The primary motives of donors are often rooted in security, strategic and political concerns. That helps explain why a significant portion of aid goes to the richest 40 percent of the developing world or those who, in purely economic terms, need it least.

Furthermore, the experience of ‘third world’ countries with foreign aid helps dispel the presumption that foreign financial inflows are instrumental in reducing domestic poverty. There is little evidence to support the notion that aid reaches those in the poorest rungs of the socio-economic ladder. Aditionally, very few donors, if any, make an effort to ensure that the poor enjoy the benefits of the economic activity generated by their aid. Besides, the fact that a disproportionate portion of aid inflows invested in recipient countries is devoted to the industrial sector has contributed to the increase of inequality in these countries as a result of neglecting rural development.

Even when aid is earmarked for rural development, it goes to finance projects that result in high social costs and dislocations that ultimately lower rather than improve the living standards of the poorest sections of society. For instance, rural development projects financed by the World Bank tend to focus mainly on infrastructural projects such as dams, irrigation schemes, roads and power plants. A recent internal review conducted by the World Bank itself, titled Resettlement and Development: The Bankwide Review of Projects Involving Involuntary Resettlement, 1986-1996 (World Bank, April 1994), admits that many Bank-funded development projects result in the eviction and displacement of hunrdreds of thousands of people.

Needless to say that such evictions entail serious socio-economic dislocations that undermine the displaced groups’ social fabric and economic well-being. The report candidly acknowledges that in the rare cases when the evicted are compensated, usually at a substantially low rate, ‘long delays in paying compensation are common.’ In some cases, there is ‘an average delay of ten years between property expropriation and compensation’ (p. 5/18).

Abolishing aid altogether is not a prudent answer to the fact that it has generally failed or been counterproductive in promoting growth and alleviating poverty. Instead, this sad reality calls for a fundamental shift in aid practices. Donors, whether governmental or multilateral agencies, need to allocate resources more selectively based on a country’s needs and track record. They should also pay a closer attention to diagnosing and dealing with the potential and actual social costs of aid-funded projects.

Their increased domestic involvement in aid programs should also be used less as an instrument of political leverage and dependency and more as a way to support the adoption of sound and responsible economic policies and reforming the institutional and political conditions that stymie sound economic performance. Above all, aid funds ought to be devoted primarily to financing investment in recipient countries and enhancing their indigenous skills and resources.

Muslimedia: September 1-15, 1998