Foreign Aid’s Impact on Governance

1. Foreign Aid’sImpact on Governance Maj Justin LeMire

2. Sources • Stephen Knack: “Aid Dependence and the Quality of Governance: Cross-Country Empirical Tests” • Sophal Ear: “Does Aid Dependence Worsen Governance?”

3. Introduction • Foreign Aid/Aid Dependence - Definition • International Country Risk Guide (IRCG) • Positive Influences of Aid • Negative Influences of Aid • Policy Implications • Conclusion

4. Definitions • “Foreign Aid has long been justified as essential for development under incomplete market conditions in which investment is missing (hence the need for aid).” Boone (1996) • Aid Dependence - a specific condition that results from a pathology in the aid giving process • Quality of governance is measured by subjective indices from the ICRG

5. ICRG • International Country Risk Guide (ICRG) • Analyzes the financial, economic and political environments in over 130 developed and emerging countries • Provides insight into investment risks and business opportunities • Gages the impact of current and future worldwide events • Incorporates several economic risk factors to determine a country’s investment potential • including loan default, delayed payment of suppliers’ credits, political leadership, inflation and international liquidity ratios

6. Six Dimensions of Governance Control of Corruption (CC): Perceptions of corruption, conventionally defined as the exercise of public power for private gain. Despite this straightforward focus, the particular aspect of corruption measured by the various sources differs somewhat, ranging from the frequency of ‘‘additional payments to get things done,’’to the effects of corruption on the business environment, to measuring ‘‘grand corruption’’ in the political arena or in the tendency of elite forms to engage in ‘‘state capture’’ Voice and Accountability (VA): Measures various aspects of the Process, civil liberties and political Rights, and independence of the media Political Stability(PS): Measures the perceptions of the likelihood that the government in power will be destabilized or overthrown by possibly unconstitutional and/or violent means, including terrorism Governance is the Traditions and Institutions by which Authority in a Country is Exercised Rule of Law (RL): Perceptions of the incidence of both violent and non-violent crime, the effectiveness and predictability of the judiciary, and the enforceability of contracts Government Effectiveness (GE): Perceptions of the quality of public service provision, the quality of the bureaucracy, the competence of civil servants, the independence of the civil service from political pressures and the credibility of the government’s commitment to policies Regulatory Quality (RQ): Measures the incidence of market-unfriendly policies such as price controls or inadequate bank supervision, as well as perceptions of the burdens imposed by excessive regulation in areas such as foreign trade and business development Source: Adapted from Kaufmann, Kraay, and Zoido-Lobaton (1999b).

7. Positive Influence of Aid • Aid is used for improving training and increased salaries for public employees: Including police, judges, and tax collectors • As salaries increase, more competent bureaucrats can be recruited and bribe solicitation reduced • Improvements in the investment climate and higher tax collections in turn produce additional revenues…improving the government’s credit worthiness

8. Positive Influence of Aid • Programs to strengthen the legal system, public financial management, and other responsibilities of the public sector • Could also improve the quality of governance through conditionality effects • The World Bank lends about $6 billion/year to its poorest members on highly concessionary terms, with allocations based in large part on the assessments of the quality of policies and public sector institutions • These conditions can increase the incentives of aid-recipient governments to implement pubic sector reforms • Aid can relieve pressure on recipient governments to establish the efficient policies and institutions necessary for attracting private capital

9. Negative Influence of Aid • Aid can increase political instability • Making control of the government a more valuable prize • Political scientists argue that aid retards the development of a healthy “civil society” underpinning democracy and rule of law • For example: Rule of law in the west was critically related to monarchs’ needs for tax revenues. In turn, those who provided the majority of taxes, demanded accountability from the government • Aid therefore reduces the government’s dependence on its citizenry for tax revenues • Can weaken the state bureaucracies of recipient governments • Siphoning away scarce talent from civil service to be hired by the donor organizations

10. Negative Influence of Aid • Aid represents a potential source of rents • Creates adverse effects on the quality of the public sector and on the incidence of corruptions • Rent-seeking - Takes the form of increased public-sector employment. Aid is then used for patronage purposes. • Aid often times enables governments to undertake investments that would otherwise be made by private investors • As rents available to those controlling the government increase, resources devote to obtaining political influence increase • As aid expands, workers face incentive to reallocate time from acquiring knowledge and skills specific to manufacturing, toward skills useful for obtaining a share of aid revenues

11. Policy Implications • The conclusions of Stephen Knack: Aid Dependence and Governance • Aid Variability: If aid is highly variable over time within a country, dependence might be lessened in the sense that aid cannot be relied on as a stable source of funds • Aid should be directed at quality of governance: Establishing more meritocratic bureaucracies and strong, independent court systems • Greater selectivity by donors: Targeting aid to countries that take specific steps to reduce corruption, improve fiscal accountability, and implement merit based recruitment and promotion in civil service • Depoliticizing the distribution of rents from aid funds: Selective allocation of aid would reduce its propensity to politicize life, and thereby reduce the extent and intensity of political conflict

12. Policy Implications • Emphasis on “social capital”: Aid in the form of micro enterprise loans may improve government accountability in the long term by building up the private sector, thereby increasing the demand locally of r good governance • Aid directly targeted to the start-up of small businesses is less fungible and more difficult for governments to expropriate • Technological Advance: The internet may mitigate the negative consequences of expensive technical assistance • Ex: The World Bank is developing a Knowledge-Sharing Program • Interactive toolkits for governance assistance • The intent is to improve the capacity of client governments, through better knowledge, to use donor technical assistance effectively, and where necessary to challenge donor-proposed solutions

13. Conclusion • Foreign aid can help when used appropriately • As donors our responsibility is to ensure that funds are used, not for corruption, but stabilization of a recipients economy • Using the conditionality principle of aid does not seem to work because the lack of credibility of the punishment • Therefore, using loans instead of grants may help induce some discipline and effective use of the funds, since they have to be returned