Effectivess of Foreign Aid as a Form of Multinational Financial Assistanse - Essay Example

Introduction A country from the third world that feels difficulties with its budget may turn to the International Monetary Fund (IMF), World Bank orone of the Major Developed Countries (MDCs) for assistance. Since such assistance is usually given on some condition, it involves agreement to modify domestic economic policy. In this case creditor country (or organization) restricts free trade with protectionism in which barriers to imports (tariffs and quotas) are established in order to protect their industries from foreign competition. Government regulations also protect the environment, agriculture and workers of the donor country or organization. (Mosley 1987) One kind of financial aid gived to less developed country is tied aid that must be spent in the country providing the aid (the donor country). A developed country provides a bilateral loan or grant to a developing country, but mandate that the money be spent on goods or services produced in the donor country. Aid is usually tied to the benefit of the donor at the expense of the recipient. Often business lobbies advocate this kind of aid because it provides them an indirect subsidy if the funds are spent on their products. Sometimes tied aid is even used to unload excess goods which would not otherwise be sold. Tied aid does not help recipient countries as much as untied aid for two reasons. First, tied aid is less cost-effective because it does not allow the recipient to contract or buy from the lowest bidder. Second, the recipient is not able to buy local goods or hire local companies, which would be more beneficial for local economic development. (Wikipedia, 2006) Often donor countries give aid because it is in their own interest to do so. Undoubtedly some aid is given with humanitarian motives in mind; however, most foreign aid is given for variety of political, strategic and economic reasons that benefit the donor countries in the longer term. For example, IPS cited in Shah (2006) noted that aid tied with conditions cut the value of aid to recipient countries by some 25-40 percent, because it obliges them to purchase uncompetitively priced imports from the richer nations. IPS was citing a UN Economic Council for Africa study which also noted that just four countries (Norway, Denmark, the Netherlands and the United Kingdom) were breaking away from the idea of "tied aid" with more than 90 percent of their aid "untied". In the Reality of Aid 2000 (Earthscan Publications, 2000 cited in Shah 2006) reported in their US section that "71.6% of its bilateral aid commitments were tied to the purchase of goods and services from the US." That is, where the US did give aid, it was most often tied to foreign policy objectives that would help the US. Leading up to the UN Conference on Financing for Development in Monterrey, Mexico in March 2002, the Bush administration promised a nearly $10 billion fund over three years followed by a permanent increase of $5 billion a year thereafter. The EU also offered some $5 billion increase over a similar time period. History of Foreign Aid Countries of Latin America The Worlds debt crisis of the early 1980's was the culmination of a build up of external debt of developing countries, a large part of which was accounted by a progressively rising short-term debt. The debt of Less Developed Countries (LDCs) was triggered largely by demands from the balance of payments effects of the oil crisis that started in 1973/74. The debt build up became more apparent towards 1980 when third world borrowers resorted to rolling over their debts. (Stambuli 2002) A combination of very tight internal fiscal position and increasingly fragile balance of payments, most developing countries contracted new loans to liquidate maturing loans. In some cases, entirely new loans were contracted to service interest only. At the same time bankers in the western world ignored signals of an imminent debt crisis and remained more than willing to refinance maturing loans of developing countries, but with shorter maturities. In this process, third world debt snowballed from $130 billion in 1973 to about $612 billion in 1982. Between 1975 and 1980 four countries had to postpone amortization payments while servicing interest only. The spark that ignited the LDC debt crisis can be readily identified as Mexico's inability to service its outstanding debt to the U.S. commercial banks and other creditors. The crisis began on August 12, 1982, when Mexico's minister of finance informed the Federal Reserve chairman, the secretary of the treasury, and the IMF managing director that Mexico would be unable to meet its August 16 obligations to service an $80 billion debt. Then by 1983 the number of countries defaulting on their repayments reached twenty one, and some third world countries had instituted state criminal processes against public figures on account of alleged negligence and mishandling of public money. The fact that the 1982 crisis occurred when there was a sharp rise in interest rates in the U.S. underscores the significance of the capital outflow element of a financial crisis. The appreciation of the dollar at that time also means that repayments magnified the capital outflow in domestic currency terms. At the same time, the accompanying drop in dollar prices of internationally traded commodities undermined inflows derived from exports. It is also necessary to mention that the satiation described above is also reflected in the 1994 financial crises in Mexico, Turkey and Venezuela equally attributed to dramatic reversal of large scale lending to emerging markets, as well as the experience of Argentina in 1995 and East Asian economies in 1997. There is the argument that most of that crises were characterized with large amounts of international loans to forestall default, hence the rebuke of Mexico at the onset of the 1982 crisis worsened a financial condition that was potentially manageable. Around the globe, raw material prices fell sharply, meaning poor countries had even less money to repay their debts. For example, both Brazil and Mexico nearly defaulted on their loans; and, according to international law, there was no option for these poor countries to declare bankruptcy. Commercial banks rescued their own situations and prevented default. However, many developing countries were left in great debt, and as a result, could no longer get loans. With nowhere else to turn, these nations have relied heavily on the World Bank or the International Monetary Fund (IMF). The IMF required structural adjustment programs in these countries. Debtor countries had to agree to impose very strict economic programs on their countries in order to reschedule their debts and/or borrow more money. Put simply, countries had to cut spending to decrease their debt and stabilize their currency. The governments limited their costs by slashing social spending; education, health and social services, devaluing the national currency via lowering export earnings and increasing import costs, creating strict limits on food subsidies, cutting workers jobs and wages, taking over small subsistence farms for large-scale export crop farming and promoting the privatization of public industries. Most countries have suffered a recession and often depression; and the poor are most affected. The number of the poor in LDCs was growing, "Despite repeated promises of poverty reduction made over the last decade of the twentieth century, the actual number of people living in poverty has actually increased by almost 100 million. This occurred at the same time that total world income increased by an average of 2.5 percent annually." (Stiglitz, 2002, p.5) Faced with the rapidly increasing crisis, LDCs had two options. Either they could have attempted to curtail imports through restrictive monetary and fiscal policies, thus impeding their attempts to develop. Or they could attempt to finance their widening deficits through more external borrowing - with the objective of growing out of the crisis. Most countries adopted the second policy - often for domestic political reasons. But such a response was unsustainable. As a result financial transfers from developed to developing world declined and even turned negative in 1983-84. Therefore more and more countries were forced to turn to the IMF or the World Bank for assistance. Countries of Asia As Osman (1998) writes, 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 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. (Osman 1998) Similarly, Osman (1998) describes 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. Osman (1998) finds little evidence to support the notion that aid reaches those in the poorest rungs of the socio-economic ladder. Aditionally, very few donors, 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 1994 cited in Osman 1998), admits that many Bank-funded development projects result in the eviction and displacement of hunrdreds of thousands of people. IMF Special Conditions of Foreign Aid The IMF typically offered financial assistance to LDCs conditional on the government adopting a so-called stabilization program. It does this by using a "one size fits all" (Stiglitz. 2002) kind of process, in the mind set that the economic situation. Poverty has to get really worse, before it can get better. The four components of a typical stabilization programme are: 1. Removing tariff protections and increasing exports, to try and devalue the official foreign exchange rate. 2. Reduction in the exchange rate. The value of the pound would not be as strong in comparison to the value of other currencies. This would be so as to reduce demand for foreign imports, because they would be more expensive comparatively. 3. A stringent domestic anti-inflation program, consisting of: a) Less bank credit, raising interest rates, to control for inflation and attract foreign investment. This would increase the likelihood of bankruptcy, corruption and a worsening of the economic situation. b) Control of budget deficit, often through drastic reduction in Government spending, which proves to hit the lower to middle income people particularly. c) Either Control of wage increases or wage reduction; d) Dismantling various price controls and ensuring a freer market so big business can go to town exploiting the poor even further. 4. Encouragements of foreign investment, opening up the economy to international trade so multi-national corporations can crush them and developed country governments. Given that an IMF program is in place, countries have found it possible to restructure their debt deferring repayment or agreeing debt-for-equity swaps or other such arrangements. It is not clear that this has resolved the debt crisis since the loans will still have to be repaid sometime. Further, debt-for-equity swaps have placed (or run the risk of placing) much of the assets of third world countries in foreign hands creating a hostage for future economic nationalists to hold to ransom. For years the World Bank and IMF loaned money to LDCs and looked the other way as these countries practiced policies that the Bank is now wisely criticized. By allowing the LDC governments to avoid for so long the consequences of their actions, these policies continued and economic reform was impeded. The new World Development Report therefore is a welcome sign that the World Bank not only understands the disastrous mistakes of LDC financial policy but also has learned that lending to countries even as they continue such practices only throws good money after bad. Recipient Countries' Economic Dependency Donor countries often require a recipient to spend some or all of its foreign aid on goods and services produced in the donor's country, a practice known as tying aid. In a newer form of tied aid, the donor offers aid as subsidized credit for the purchase of its exports. Donor governments then justify aid budgets by arguing that they promote their commercial objectives and exports. (CBO 1997) The degree to which Organization for Economic Cooperation and Development (OECD) countries tie their aid varies considerably and changes from year to year. In 1992, Spain tied nearly 86 percent of its official development assistance, compared with Norway at only 20 percent. The United States tied approximately 50 percent - nearly $6 billion - of its official development assistance. In 1993, however, those figures fell to 33 percent for Spain, 29 percent for the United States, and 11 percent for Norway. (CBO 1997) The tying of funds may have hidden costs for the recipient. The Development Cooperation 1994 report, put out by the OECD's Development Assistance Committee cited in CBO (1997), says the following: The aid may be given with the best interests of the donor in mind, not those of the recipient country. The subsidy involved in concessional aid may benefit the exporter rather than the recipient. Linkages between the development projects and the local economies are not formed. Thus, the local economy derives little long-term benefit from the projects. No consensus exists, however, as to whether tying aid undermines its effectiveness. On the one hand, recipient countries sometimes manage to evade the tying effect of aid when it is imposed. On the other hand, studies of individual countries have found that tying aid increases the costs of goods purchased with foreign assistance by as little as 12 percent or by as much as 80 percent. The Development Cooperation 1994 report cited in CBO (1997) argues, however, that the tying of aid matters less than the degree of competition in the procurement process for aid contracts. Competition in awarding aid contracts, even if they must be awarded to the companies of the donor country, may provide better value than untied aid contracts that are not subject to a bidding process Conclusion As a condition for aid money, many donors apply conditions that tie the recipient to purchase products only from that donor. In a way this might seem fair and "balanced", because the donor gets something out of the relationship as well, but on the other hand, for the poorer country, it can mean precious resources are used buying more expensive options, which could otherwise have been used in other situations. Furthermore, the recipient then has less control and decision-making on how aid money is spent. In addition the very nations that typically promote free-markets and less government involvement in trade, commerce, etc., ensure some notion of welfare for some of their industries. The cross-national analysis of Schraeder et al (1998) clearly demonstrates that the origins of the foreign aid policies of the northern industrialized democracies are complex and varied. Despite the fact that the four donor countries under review maintained shared democratic values and a common industrial base of development, notable differences as concerns historical background (for example, French colonialism in Africa) and positions within the international system (for example, the US strategic hegemon and Sweden as a middle power) ensured that foreign aid policies were influenced by different combinations of foreign policy interests. . Appendix A Official Development Assistance (ODA) from 2002 to 2005 Official Development Assistance (ODA) from 2002 to 2005 ODA in U.S. Dollars (Millions) ODA as % of GNI Country 2002 2003 2004 2005 2002 2003 2004 2005 1. Australia 962 1,237 1,460 1,666 0.25 0.25 0.25 0.25 2. Austria 475 503 678 1,552 0.23 0.2 0.23 0.52 3. Belgium 1,061 1,887 1,463 1,975 0.42 0.61 0.41 0.53 4. Canada 2,013 2,209 2,599 3,731 0.28 0.26 0.27 0.34 5. Denmark 1,632 1,747 2,037 2,107 0.96 0.84 0.85 0.81 6. Finland 466 556 655 897 0.35 0.34 0.35 0.47 7. France 5,182 7,337 8,473 10,059 0.36 0.41 0.41 0.47 8. Germany 5,359 6,694 7,534 9,915 0.27 0.28 0.28 0.35 9. Greece 295 356 465 535 0.22 0.21 0.23 0.24 10. Ireland 397 510 607 692 0.41 0.41 0.39 0.41 11. Italy 2,313 2,393 2,462 5,053 0.2 0.16 0.15 0.29 12. Japan 9,220 8,911 8,906 13,101 0.23 0.2 0.19 0.28 13. Luxembourg 143 189 236 264 0.78 0.8 0.83 0.87 14. Netherlands 3,377 4,059 4,204 5,131 0.82 0.81 0.73 0.82 15. New Zealand 124 169 212 274 0.23 0.23 0.23 0.27 16. Norway 1,746 2,043 2,199 2,775 0.91 0.92 0.87 0.93 17. Portugal 282 298 1,031 367 0.24 0.21 0.63 0.21 18. Spain 1,608 2,030 2,437 3,123 0.25 0.25 0.24 0.29 19. Sweden 1,754 2,100 2,722 3,280 0.74 0.7 0.78 0.92 20. Switzerland 933 1,297 1,545 1,771 0.32 0.38 0.41 0.44 21. UK 4,749 6,166 7,883 10,754 0.3 0.34 0.36 0.48 22. USA 12,900 15,791 19,705 27,457 0.12 0.14 0.17 0.22 Source: OECD Web site cited in Shas 2006 References CBO (1997). The Role of Foreign Aid in Development. (online). Available: http://www.cbo.gov/showdoc.cfmindex=8&sequence=0&from=0#anchor Edwards, S. (2000). Does the current account matter University of California, Los Angeles and National Bureau of Economic Research (online). Available: http://www.anderson.ucla.edu/documents/areas/fac/finance/currentaccount5.pdf Federal Deposit Insurance Corporation (2002). History of the 80s. Vol.1, Part 2, Section 5. (online). Available: http://www.fdic.gov/bank/historical/history/vol1.html Mosley, P. (1987). Foreign Aid: Its Defense and Reform. Lexington, Ken.: The University Press of Kentucky Osman, K. (1998). The downside of foreign aid and its impact on recipients. Muslimedia (online). Available: http://www.muslimedia.com/archives/special98/fore-aid.htm Shas, A. (2006). The US and Foreign Aid Assistance. Globalissues.org (online). Available: http://www.globalissues.org/TradeRelated/Debt/USAid.asp#AidMoneyOftenTiedtoVariousRestrictiveConditions Schraeder, Peter J., Steven W. Hook and Bruce Taylor, 1998, Clarifying the Foreign Aid Puzzle:. A Comparison of American, Japanese, French and Swedish Aid. World Politics, 50.2, pp. 294-323 Stambuli P.K. (1998). Causes and consequences of the 1982 Third World Debt Crisis. Pre-doctoral Research Paper. Department of Economics, University of Surrey, Guilford, UK (online). Available: http://econwpa.wustl.edu:8089/eps/if/papers/0211/0211005.pdf Stiglitz, J.E. (2003). Globalization and Its Discontents. W. W. Norton & Company; 1st edition Wikipedia (2006). 'Tied Aid'. Wikipedia (online). Available: http://en.wikipedia.org/wiki/Tied_aid Read More