Aid, foreign capital, debt and the Bretton Woods institutions

Hollis Chenery and Alan Strout (1966) saw foreign assistance as filling two distinct shortages. The first is the familiar saving gap: to grow at rate g with a capital–output ratio v, the economy must invest v·g of its output, and if domestic saving s is less, the gap is v·g − s (all as shares of output). The second is a trade gap, or foreign-exchange gap: development needs imports, such as machinery and fuel, that cannot be made at home, and exports may not earn enough to pay for them. If imports needed are m and exports are x, the gap is m − x.

In accounting terms both gaps are equal after the event, since saving plus foreign borrowing equals investment, and imports equal exports plus foreign borrowing. But before the event they can differ, and the one that is larger decides how much foreign capital is needed (the other is then met with room to spare). If the trade gap binds, extra aid for investment will not be spent usefully unless it comes as foreign exchange; if the saving gap binds, policies to raise saving matter more than exports. Rosenstein-Rodan (1961) had earlier argued the case for aid as a way to finance the big push of Lesson 5.

The lab is a one-year snapshot with all quantities as shares of output. In the base case an economy wants to grow at 7 per cent with a capital–output ratio of 4, so it needs to invest 28 per cent of output; saving is 20 per cent, a saving gap of 8 points. It needs imports of 25 per cent of output and earns exports of 10 per cent, a trade gap of 15 points. The trade gap is larger, so foreign capital of 15 per cent of output is needed, and it must come as foreign exchange. Try raising exports and watch the binding gap switch.

Aid (official development assistance, ODA) is official finance given on concessional terms to promote development. It is bilateral (donor to recipient) or multilateral (through the World Bank, regional banks or the UN). The UN General Assembly adopted in 1970 a target that rich countries give 0.7 per cent of their gross national product as ODA. Aid is tied when the recipient must spend it on goods and services from the donor, which raises its real cost. Since 2018 the OECD counts the grant element of loans differently by income group, so that long-run comparisons need care.

Foreign direct investment is investment in which the foreign investor holds 10 per cent or more of the voting power in the enterprise (the IMF’s balance of payments manual), which gives a lasting interest and some control; a smaller holding in shares or bonds is portfolio investment. FDI brings management and technology as well as capital and is less volatile than portfolio flows, which can reverse quickly in a crisis. Remittances are the money sent home by migrants (the World Bank’s series, personal remittances, adds personal transfers to the compensation of employees); they go directly to households and are often more stable than other flows. Debt is the fourth: loans must be repaid, so a country that borrows for investment needs growth and exports to service it. The debt crises of the 1980s led to the structural adjustment lending of Lesson 6, and later to the Heavily Indebted Poor Countries Initiative (1996; enhanced 1999) and the Multilateral Debt Relief Initiative (agreed in 2005).

Use the panel to compare. Aid was a sizeable part of national income for many African countries: Kenya received 14.4 per cent of GNI as net ODA in 1990, Ghana 12.4 per cent in 2000, Ethiopia 9.3 per cent in 2010; India’s fell from 2.0 per cent in 1960 to 0.07 per cent in 2023. FDI inflows in China reached 3.9 per cent of GDP in 2010 and Vietnam’s 5.4 per cent, while India’s were 1.6 per cent. Remittances are very large for some small countries: 26.2 per cent of GDP in Nepal in 2023, against 3.4 per cent in India and 9.0 per cent in the Philippines.

Craig Burnside and David Dollar (2000) found that aid raises growth in countries with good fiscal, monetary and trade policies and does little under poor policies, which supported the argument that aid should be directed to countries with good policies. Easterly, Levine and Roodman (2004) re-estimated their results with more countries and years and found that the interaction between aid and policy did not hold up (summarised in Easterly 2003). Rajan and Subramanian (2008) used a different approach and found little firm evidence of a positive or negative effect of aid on growth. Jeffrey Sachs (The End of Poverty, 2005) argues that a large and well-planned increase in aid could end extreme poverty and break poverty traps; William Easterly (The White Man’s Burden, 2006) and Dambisa Moyo (Dead Aid, 2009) argue that aid has failed or harmed.

Two mechanisms are often cited against aid. Dutch disease: a large inflow raises the real exchange rate and makes exports uncompetitive (Corden and Neary, 1982, describe it for a resource boom). And aid can weaken the accountability of governments that rely on it more than on taxes. For the countries that have grown fast, aid played a small part; India is among the countries that have moved from aid recipient to little aid. The Lucas paradox, that capital does not flow to poor countries as theory expects, is in the growth module.

The two institutions were planned at the Bretton Woods conference (1–22 July 1944) (UOH 2010: the Bretton Woods institutions are the IMF and the IBRD). They have different jobs.

• IMF (financial operations began 1 March 1947): supports members with balance of payments problems through short and medium-term loans, watches members’ policies (surveillance), and issues the Special Drawing Right (created 1969). It gives stabilisation loans (UOH 2010) and attaches conditions: for structural adjustment loans, devaluing an overvalued exchange rate and reducing the fiscal deficit (UOH 2012). The Extended Fund Facility, set up in 1974, supports structural reforms to address balance of payments problems of a long-term character (UGC NET 2023).
• World Bank Group: long-term finance for development. The IBRD began operations in 1946; the IFC (private sector) in 1956; the IDA (concessional credit to the poorest countries) in 1960; ICSID (settlement of investment disputes), whose convention entered into force in 1966; and MIGA (guarantees against political risk) in 1988. The Bank began structural adjustment lending in 1980.

India is a member of the IMF (it joined in 1945) and of the IBRD, IDA, IFC and MIGA; it has neither signed nor ratified the ICSID Convention (UGC NET 2024 asks which World Bank Group institutions India belongs to: IDA, IFC, MIGA and IBRD). Headquarters: the IMF, the World Bank and the IDA are in Washington DC, GATT was in Geneva, and the Asian Development Bank is at Mandaluyong, in the Philippines; the IDA is not in New York (UGC NET 2023). Questions on the Bretton Woods exchange rate system are in the exchange-rate regimes lesson.

Questions on the IMF, the World Bank Group and structural adjustment. Questions on exchange-rate systems and the balance of payments are in the exchange-rate regimes lesson and the balance of payments lesson. Indian FDI rules and figures change often and are not tested here.