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A Failing Grade for Foreign Aid

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Image: FMSC
In discussions about development, foreign aid is heralded as a remedy for the severe poverty facing hundreds of millions around the world. International organizations often assert that aid is a tested path to success, and that the main problem with foreign aid is that there is not enough of it going around to alleviate the world’s problems. 

Every humanitarian crisis leads to more urgent calls for aid money from organizations such as the United Nations and the World Bank. There are indeed some resounding success stories. The Economist recently noted that foreign aid transformed Taiwan and South Korea into prosperous nations, and that it essentially eliminated smallpox and polio.  

Foreign aid is conceived with lofty and noble ideals. The defined objective of aid is to alleviate poverty and to put underdeveloped nations on a path to prosperity. There is consensus that aid should not be distributed with an underlying aim of advancing the donor nation’s own political interests. 

Many economists, however, have criticized aid as an enabler of corruption and a detriment to the very people it seeks to help.

A look at the data show that the over USD 130 billion of development aid distributed annually does not have a net beneficial effect to recipient countries’ economies. A study by economists Raghuram Rajan and Arvind Subramanian found that the more aid a country received as a percentage of GDP, the less its GDP growth was. 

Angus Deaton, a Nobel prize-winning economist, says that aid is by its nature likely to cause harm. Governments that receive enough aid to cover a large portion of their budget do not need to tax their citizens much. This may not sound too bad. Deaton notes, however, that taxation makes governments accountable to their citizens. A government fulfilling its financial needs through aid has less incentive to help its people. 

Aid sustains corrupt governments by providing them with financial resources their citizens and the international bond market would not. Aid to war-torn countries allows despotic governments to fund and prolong their war efforts. A much healthier way to raise money, some argue, would be to ask governments to sell bonds—IOUs with a fixed interest rate and termination date—on the market. To lower the interest rate demanded by investors, governments would have to provide an assurance that their country is being run well.

Besides being ineffective, aid also harms local businesses and creates dependency. A classic example is of the mosquito net company in a poor country. If an international aid agency donates 10,000 free nets, that company will soon find itself out of business. Employment is lost and, a few years later, once those nets have worn out and new ones are needed, the company will not be there to supply them. Thus, the country becomes dependent on transfers of mosquito nets, and local businesses suffer. 

Domestic export businesses are harmed as well: an influx of foreign money leads to an appreciation of local currency, which makes a country’s exports more expensive on the international market. Foreign aid can inadvertently snuff out a nascent export sector.  

And although governments stress that they distribute aid without geopolitical considerations, there is strong evidence to suggest that donations are higher to countries with political interests that align with their donors’. A recent study concluded that China, for example, donated disproportionately more to countries which voted with it in the United Nations.   

The focus should be less on aid and more on improving the business environment and government efficiency. Nurturing homegrown entrepreneurship and making governance more effective will foster growth more healthy and sustainable than will flooding the coffers of incompetent governments. 

Where aid is necessary, donors should avoid direct government transfers. Although giving cash is ostensibly more efficient—the government can itself decide how best to allocate its resources—it is unsuitable when corruption is rampant and civil services unreliable. Instead, aid can come as funding for specific projects: vaccination programs, infrastructure development, and so on. 

Only with international cooperation and support will it be possible to lift out of poverty the billions still in its thralls. But foreign aid, as it is done currently, risks exacerbating the problems being faced. The architects of aid need to rethink its design. 
A version of this article also appeared in the South China Morning Post's Young Post on Thursday, June 23. http://yp.scmp.com/over-to-you/columns/article/103736/failing-grade-foreign-aid-donor-nations-need-rethink-their   

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