Development economics- Foreign aid (Chapter six )

Development economics, chapter six

1. Foreign Aid, Debt, Financial Reform and Development CHAPTER 6

2. 6.1. Foreign Aid Foreign aid can be defined as the international transfer of public funds in the form of loans or grants either directly from one government to another (bilateral assistance ) or indirectly through the vehicle of a multilateral assistance agency such as the World Bank. However, we should not include all transfers of capital to developing countries, particularly the capital flows of private foreign investors.

3. 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. Commercial flows of private capital are not a form of foreign assistance, even though they may benefit the developing country in which they take place .

4. Economists have defined foreign aid, therefore, 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, and 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 Concessional terms : terms for the extension of credit that are more favorable to the borrower than those available through standard financial markets.

5. 6.2. Motivation for Foreign Aid Donor-country governments give aid because it is in their political, strategic, or economic self-interest to do so. Some development assistance may be motivated by moral and humanitarian desires to assist the less fortunate (emergency food relief and medical programs). We focus here on the foreign-aid motivations of donor nations in two broad but often interrelated categories: political and economic.

6. E conomic Assist with economic development and technology transfer Saving gap: The excess of domestic investment opportunities over domestic savings, causing investments to be limited by the available foreign exchange i.e. causing economic growth. So, 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 .

7. Foreign-exchange gap: The shortfall that results when the planned trade deficit exceeds the value of capital inflows , causing output growth to be limited by the available foreign exchange for capital goods imports i.e. aid improving the BOP Technology gap: facilitating industrialization given absorptive capacity limitation 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.

8. Political Use of aid to support regimes considered to be ‘friendly’ to the interests of the donor governments Promote “national security” by shifting FA from one country or region to another Humanitarian & moral motives Short term emergency assistance Long-term development assistance on debt relief and poverty alleviation

9. Factors limiting the effectiveness of aid Tied aid . In the context of bilateral aid: recipients must spend part of the borrowed funds on good and service from the donor country. Higher import costs. Purchase of inappropriate capital intensive technologies & development and use of skills inappropriate to local developing country conditions

10. 2. Conditional aid . Donors impose conditions to be met by recipients to ensure that funds are used effectively. Policies towards market orientation. Acceptance of projects decided by donors. Detailed reporting on spending, timetables, priorities. Problems with conditional aid: The preferences of the government or population group are not considered. Policy prescriptions by donors may be incorrect: May not fit in with the government’s priorities May undermine government’s authority

11. Aid volatility and unpredictability . Makes it difficult for recipient governments to implement policies that depend on aid funds 4 . Uncoordinated donors → inefficiencies in the use of aid resources 5. Aid substitutes rather than complements domestic resources → not enough effort to increase revenues through taxation.

12. Aid may not reach those most in need . Aid resources are not allocated on the basis of the greatest need for poverty alleviation: Bilateral donors guided by political & strategic interests. Recipient country’s gov may not be committed to poverty alleviation or lack expertise to design a poverty alleviation strategy. Aid associated with corruption. Misuse of aid funds by recipient countries

13. 13 Foreign debt may be defined as the amount of money that a country’s residents, both public and private, owe to the rest of the world. It is important to distinguish between gross and net foreign debt. Gross foreign debt is the total amount borrowed from non-residents. Net foreign debt is gross foreign debt minus resident’s lending to overseas . 6.2 FOREIGN DEBT

14. 14 Many people view foreign debt as a disadvantage for a country, although most countries do have a foreign debt. However, foreign debt can be an advantage since it can provide an increase in a nation’s productive capacity, output, employment and living standards.

15. A serious problem can arise , when ; the accumulated debt becomes very large. the sources of foreign capital switch from long-term “official flows” on fixed, concessional terms to short-term and at higher interest rate. the country begins to experience severe balance of payments problems. a global recession or some other external shock. a loss in confidence in the ability of a developing country to repay. a substantial flight of capital is precipitated by local residents .

16. 16 Repaying foreign debt requires payment of the original sum borrowed , plus interest on that debt . This is known as debt servicing. DEBT SERVICING

17. 17 Foreign debt can be seen as: (i) a nation’s imports and income paid to overseas residents is greater than the value of exports and income received. (ii) national expenditure exceeding national income , i.e. a nation spending more than it earns . (iii) The difference between national investment and national- savings . If a country does not have sufficient domestic savings, it must borrow to finance it’s investment which must come from overseas VIEWING FOREGN DEBT

18. 18 Foreign debt has several consequences for a country: 1. falling credit ratings – this will increase the interest rate that the country will have to pay on future borrowings since lenders perceive a greater lending risk 2. the increased interest payments lower the country’s standard of living as more income is diverted from consumption CONSEQUENCES OF FOREIGN DEBT

19. 19 There are several ways to reduce a country’s foreign debt: (i) Increasing international competitiveness (microeconomic reform). Growth in exports will reduce the CAD and hence foreign debt. (ii) Increasing the savings pool - this will reduce the borrowings required to fund investment REDUCING FOREIGN DEBT

20. 20 (iii). Monetary policy to maintain low inflation rates will improve export competitiveness – this will also preserve the real purchasing power of savings and will act to improve the level of domestic savings. ( iv ). Use of fiscal and monetary policy to reduce aggregate demand-this will discourage import demand which contributes to foreign debt.

21. 6.3.Foreign Direct Investment and MNCs International trade and movements of productive factors have very different economic effects on the nations involved. Few developments have played as critical a role in the extraordinary growth of international trade and capital flows during the past few decades as the rise of the multinational corporation (MNC). MNC is most simply defined as a corporation or enterprise that conducts and controls productive activities in more than one country. MNCs are the major force in the rapid globalization of world trade.

22. Large firms mostly from the U.S., Europe, and Japan MNCs and the resources they bring present a unique opportunity but may pose serious problems for the many developing countries in which they operate. 350 MNCs control 40% of international trade in primary and secondary products. There are two main types of foreign investments: Portfolio investment and direct investments Portfolio investments are purely financial assets, such as bonds and stocks, denominated and expressed in a national currency. They take place primarily through financial institutions (banks and investment funds).

23. Direct investments are real investments in factories, capital goods, land, and inventories where both capital and management are involved and the investor retains control over use of the invested capital. Direct investment usually takes the form of a firm starting a subsidiary or taking control of another firm (by purchasing a majority of the stock).

24. FDI Debate: Pros FDI fills the Saving gap: causing economic growth Foreign-exchange gap: improving the BOP Tax revenue gap: raising funds for public spending Management gap: improving entrepreneurship Technology gap: facilitating industrialization

25. FDI Debate: Cons MNCs Don’t reinvest their profit Return profits to their headquarters through transfer pricing Create income for semi-skilled labor with low saving propensities Deteriorate current account through importation of capital goods and intermediate products Deteriorate capital account through outflow of profits Receive investment tax credits and are exempt from tariffs Hinder development of domestic managerial skills Gain monopoly power Reinforce dualism, increase income inequality, and induce R-U migration Influence local politics and support “friendly” governments

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