Chapter 6

Foreign Aid, Debt and

Development
 Foreign Aid
 Conceptual and Measurement Problems
• In addition to export earnings and
private foreign direct and portfolio
investment, developing countries receive
two major sources of foreign exchange:
– public (official) bilateral and
multilateral development assistance
– private (unofficial) assistance provided
by nongovernmental organizations.
• Both of these activities are forms of foreign
aid, although only public aid is usually
measured in official statistics.
• We should not include all transfers of capital
to developing countries, particularly the
capital flows of private foreign investors.

• Private flows represent normal commercial

transactions, prompted by commercial
considerations of profits and rates of return,
and therefore should not be viewed as
foreign aid. 3
• Economists have defined foreign aid as
any flow of capital to a developing
country that meets two criteria:
1. Its objective should be non-commercial
from the point of view of the donor,
2. It should be characterized by
concessional terms; that is, the interest
rate and repayment period for
borrowed capital should be softer (less
stringent) than commercial terms.
4
• Even this definition can be inappropriate,
for it could include military aid, which is
both noncommercial and concessional.
• Normally, military aid is excluded from
international economic measurements of
foreign-aid flows.

5
• The concept of foreign aid that is now
widely used and accepted, therefore, is
one that encompasses all official grants
and concessional loans, in currency or in
kind, that are broadly aimed at
transferring resources from developed
to less developed nations on
development, poverty, or income
distribution grounds.

6
• As there are problems associated with its
definition, there are also three major
problems in measuring(calculating)
actual development assistance flows.
1. We cannot simply add up the dollar
values of grants and loans; each has a
different significance to both donor and
recipient countries. Loans must be
repaid and therefore cost the donor and
benefit the recipient less than the
nominal value of the loan itself. 7
2. Aid can be tied either by source (loans or
grants have to be spent on the purchase
of donor-country goods and services) or
by project (funds can only be used for a
specific project,). In either case, the real
value of the aid is reduced because the
specified source is likely to be an
expensive supplier or the project is not of
the highest priority.

8
3. We always need to distinguish between
the nominal and real value of foreign
assistance. Aid flows are usually
calculated at nominal levels and tend to
show a steady rise over time. However,
when deflated for rising prices, the actual
real volume of aid from most donor
countries declined substantially in recent
decades despite a recent uptick.

9
 Why Donors Give Aid?
 Humanitarian(moral) Motivations
• Some development assistance may be
motivated by moral and humanitarian
desires to assist the less fortunate (e.g.,
emergency food relief and medical
programs).
• However, there is no historical evidence
to suggest that over longer periods of
time, donor nations assist others without
expecting some benefits in return. 10
 Political Motivations
• Political motivations have been more
important for aid-granting nations,
especially for the largest donor country,
the United States.
• For instance, the U.S. used the Marshal
Plan, which aimed at reconstructing the
war torn economies of Europe, as a
means of containing the international
spread of communism.
11
• In the 1950’s & 60’s the policy of
containment embodied in the U.S. aid
program dictated a shift in emphasis
toward political, economic and military
support for less developed nations,
mainly, those considered geographically
strategic like Israel, Egypt, Pakistan etc.
• The behavior of other major donor
countries such as Japan, Great Britain,
and France has been similar to that of
the United States. 12
Economic Motivations: Two-Gap Models
and Other Criteria
• Within the broad context of political and
strategic priorities, foreign-aid programs
of the developed nations have had a
strong economic rationale.
• This is especially true for Japan, which
directs most of its aid to neighboring
Asian countries where it has substantial
private investments and expanding trade.
13
 The principal economic arguments
advanced in support of foreign aid are
the following.
 The two-gap model
• External finance (both loans and grants)
can play a critical role in supplementing
domestic resources in order to relieve
savings or foreign-exchange bottlenecks.
This is the so-called two-gap analysis of
foreign assistance.
14
• The basic argument of the two-gap model is
that most developing countries face either a
shortage of domestic savings to match
investment opportunities or a shortage of
foreign exchange to finance needed imports of
capital and intermediate goods.
• Basic two-gap and similar models assume that
the savings gap and the foreign-exchange gap
are unequal in magnitude and that they are
essentially independent.
• The implication is that one of the two gaps will
be “binding” for any developing economy at a
15
• If the savings gap is dominant:
 It indicates that growth is constrained
by domestic investment.
 Foreign savings may be used as a
supplement to domestic savings.
 An outstanding example of savings-
gap nations would be the Arab oil
exporters during the 1970s.

16
• If the foreign-exchange gap is binding:
 A developing economy has excess
productive resources (mostly labor),
and all available foreign exchange is
being used for imports.
 The existence of complementary
domestic resources would permit
countries to undertake new investment
projects if they had the external
finance to import new capital goods
and associated technical assistance.17
• Algebraically, the simple two-gap model can be
formulated as follows:
The savings constraint or gap.
• Starting with the identity that capital inflows (the
difference between imports and exports) add to
investible resources (domestic savings), the
savings-investment restriction can be written as
I  F  sY
where F is the amount of capital inflows.
• If capital inflows(F) plus domestic saving(sY)
exceeds domestic investment(I) and the economy
is at full capacity, a savings gap is said to exist.
18
The foreign-exchange constraint or gap
• If investment in a developing country has a marginal
import share m1 and the marginal propensity to
import out of a unit of noninvestment GNI is given by
the parameter m2, the foreign exchange constraint
or gap can be written as
(m1  m2 ) I  m2Y  E  F
where E is the exogenous level of exports.
• The term F enters both inequality constraints and
becomes the critical factor.
• If F, E, and Y are initially assigned an exogenous
current value, only one of the two inequalities will
prove binding; that is, investment (and thus the
output growth rate) will be constrained to a lower
level by one of the inequalities. 19
• Countries can therefore be classified
according to whether the savings or
foreign-exchange constraint is binding.
• More important from the viewpoint of
foreign-aid analysis is the observation
that the impact of increased capital
inflows will be greater where the foreign-
exchange gap rather than the savings gap
is binding.

20
• Two-gap models have been used to
provide rough estimates of the relative
impact of foreign aid on investment and
growth in developing nations.
• The problem is that such gap forecasts
are very mechanistic and are themselves
constrained by the necessity of fixing
import parameters and assigning
exogenous values to exports and net
capital inflows.
21
 Growth and Savings
• External assistance is also assumed to
facilitate and accelerate the process of
development by generating additional
domestic savings as a result of the higher
growth rates that it is presumed to
induce.
• Eventually, it is hoped, the need for
concessional aid will disappear as local
resources become sufficient to make
development self-sustaining. 22
 Technical Assistance
• Financial assistance needs to be
supplemented by technical assistance in
the form of high-level worker transfers to
ensure that aid funds are used most
efficiently to generate economic growth.
• Sustainable development impact
requires a focus on training in recipient
countries.

23
 Absorptive Capacity
• The amount of aid is considered in
relation to the recipient country’s
absorptive capacity, its ability to use aid
funds wisely and productively.
• Donor countries decide which developing
countries are to receive aid, how much,
in what form, for what purpose, and
under what conditions on the basis of
the donor countries’ assessment of
domestic absorptive capacities. 24
 The Effects of Aid
• The issue of the economic effects of aid, especially
public aid, is fraught with disagreement.
• On one side are the economic traditionalists, who
argue that aid has indeed promoted growth and
structural transformation in many developing
countries.
• On the other side are critics who argue that aid
does not promote faster growth but may in fact
retard it by substituting for, rather than
supplementing, domestic savings and investment
and by exacerbating balance of payments deficits
as a result of rising debt repayment obligations and
the linking of aid to donor-country exports. 25
 External Debt

 Accumulation of Debt and Emergence of the

Debt Crisis
• The accumulation of external debt is a
common phenomenon of developing countries
at the stage of economic development where:
– the supply of domestic savings is low,
– current account payments deficits are high,
and
– imports of capital are needed to augment
domestic resources. 26
• Prior to the early 1970s,
– the external debt of developing countries
was relatively small and primarily an official
phenomenon.
– the majority of creditors being foreign
governments and international financial
institutions such as the IMF, the World
Bank, and regional development banks.
– most loans were on concessional (low-
interest) terms and were extended for
purposes of implementing development
projects and expanding imports of capital
goods. 27
• However, during the late 1970s and early
1980s, commercial banks began playing a
large role in international lending by
recycling surplus OPEC “petrodollars”
and issuing general-purpose loans to
developing countries to provide balance
of payments support and expansion of
export sectors.

28
• The mechanics of petrodollar recycling

29
• Although foreign borrowing can be highly
beneficial, providing the resources
necessary to promote economic growth
and development, when poorly
managed, it can be very costly.
• In recent years, these costs have greatly
outweighed the benefits for many
developing nations. The main cost
associated with the accumulation of a
large external debt is debt service.
30
• Debt service is the payment of
amortization (liquidation of the principal)
and accumulated interest; it is a
contractually fixed charge on domestic
real income and savings.
• As the size of the debt grows or as
interest rates rise, debt service charges
increase.

31
• Debt service payments must be made
with foreign exchange. In other words,
debt service obligations can be met only
through export earnings, curtailed
imports, or further external borrowing.
• However, should the composition of
imports change or should interest rates
rise significantly, causing a ballooning of
debt service payments, or should export
earnings diminish, debt-servicing
difficulties are likely to arise. 32
 Tactics for Debt Relief
 Restructuring
• It is altering the terms and conditions of debt
repayment, usually by lowering interest rates or
extending the repayment period.
• Most notable have been the Paris Club arrangements,
offering highly concessional conditions, the so-called
Toronto terms. These bilateral arrangements for public
loans permit creditor governments to choose from
three alternative concessional options:
– partial cancellation of up to one-third of
nonconcessional loans,
– reduced interest rates, or
– extended (25-year) maturity of payments—to generate
cash flow savings for debtor countries. 33
 Debt-for-equity swap
• It is the sale at a discount of questionable
developing- country commercial bank debts to
private investors (mostly foreign corporations) in
secondary trading markets. These corporations
then trade a debtor’s IOU for a local state-owned
asset, such as a steel mill or a telephone company.
• Much of the privatization that has occurred in
Latin American debtor countries has been
financed through these swap arrangements.
• The flip side of these benefits, however, is the fact
that foreign investors are buying up the state-
owned real assets of developing nations at major
34
discounts.
 Debt-for-nature swap
• It is the exchange of foreign debt held by an
organization for a larger quantity of domestic debt
that is used to finance the preservation of a natural
resource or environment in the debtor country.
• Most debt-for-nature swaps are carved out by
nongovernmental organizations such as the World
Wildlife Fund or the Nature Conservancy. They
purchase the debtor nation’s IOU at a discount from
a local bank and then restructure it into local-
currency payments, which are then used, say, to
preserve an endangered natural resource.

35
 Debt Relief Under the Heavily Indebted
Poor Countries (HIPC) Initiative
• The HIPC Initiative was launched in 1996 by
the IMF and World Bank
• Designed to ensure that no poor country faces
a debt burden it cannot manage.
• To date, debt reduction packages under the
HIPC Initiative have been approved for 36
countries, 30 of them in Africa, providing $76
billion in debt-service relief over time.
• Three additional countries are eligible for HIPC
Initiative assistance.
 HIPCs Initiative
• First step: decision point (Interim debt relief)
o Be eligible to borrow from the World Bank’s International
Development Agency(which provides interest-free loans
and grants to the world’s poorest countries) and from the
IMF’s Poverty Reduction and Growth Trust (which provides
loans to low-income countries at subsidized rates)
o Face an unsustainable debt burden that cannot be
addressed through traditional debt relief mechanisms
o Have established a track record of reform and sound
policies through IMF- and World Bank–supported
programs
o Have developed a Poverty Reduction Strategy Paper
(PRSP) through a broad-based participatory process in the
country.
 HIPCs Initiative
o Second step: completion point (full debt relief)
o Establish a further track record of good performance
under programs supported by loans from the IMF and
the World Bank
o Implement satisfactorily key reforms agreed at the
decision point
o Adopt and implement its PRSP for at least one year.
• Of the 39 countries eligible or potentially eligible
for HIPC Initiative assistance, 36 are receiving full
debt relief .
• Three countries, which have been identified as
potentially eligible for HIPC Initiative assistance,
have not yet reached their decision points.