DF201|Q6 | Part I

#6. Discuss Howard White's view that the aid literature has failed to advance our understanding of the macroeconomics of aid because it neglects the mechanisms by which aid may affect savings.

There are three common sources of External Finance:
1. aid or foreign assistance
2. debt
3. direct (foreign) investment (FDI)
Official Development Assistance (ODA for short):
1. grants (including technical assistance)
2. concessionary loans
3. contributions in kind
4. suppliers' credit
5. reparations payments
(not all are 'give aways', to qualify for ODA the grant element of flows must be at least 25%)

Capital Bottleneck Theories like the Dual Gap Model-Three Gap...

Harrod-Domar type model of growth.
g=s/c
g: growth rate (dY/y)
s: net investment or savings ratio (dK/Y)
c: incremental capital-output ratio or ICOR (dK/dY)
Three ways to overcome this gap:
1. increasing domestic savings (assumed to be impossible-LICs by definition)
2. reducing capital-output ratio
3. resorting to overseas savings
g=i*m
i: import ratio
m: is the incremental out-import ratio (dY/dM)

...dual gap model explained in simple terms:
if the export-import gap is larger than the saving-investment gap, then growth will be trade-limited. This means that unless additional external resources are provided, part of the mobilized domestic savings will go un-utilized.
...
The reason why the largest of the two gaps applies is because the two gaps are not additive since domestic investment requirements can be met by imported capital goods.

If the capital-output and import-output ratios are flexible there can only be one gap, not two.

There are at least two reasons why concessional loans (or grants) may be preferable to non-concessional loans.
First reason-many aid programs fund projects with a strong element of externality- in such areas health, education, social services and infrastructure.
Furthermore, given the long gestation period over which benefits accrue, there may also be a debt-servicing mismatch for commercial loans.
Second reason, concerns the difficulties in servicing debt in foreign currency and possible implications for 'crowding out' domestic investment.

Four adverse affects of foreign aid are postulated:
1. Lowering domestic savings.
2. Distorting the composition of investment.
3. Frustrating the emergence of an indigenous entrepreneurial class.
4. Inhibiting institutional reforms. (Democracy for one.)


Notes:
1. RIMSM model is the World Bank's dual gap model.
2. The third gap of the government budget deficit has been used by Taylor [1990] for the purpose of forecasting aid requirements.
3. The rapid increase in aid during the second half of the 1970s was accompanied by deteriorating growth performances. Several countries in Africa have experienced negative income growth during the 1980s, despite high and rising aid inflows.