GRANTS OR LOANS! DITERMINANTS OF AID COMPOSITION

ABSTRACT

The figures illustrate that it is utmost importance to assess determinants of the grant-loan allocation. In particular, the composition of aid is more informative than aggregate aid allocation since grants and loans are associated with distinct implications. While a grant is a pure gift, loans add to debt stock of the recipient country, potentially generating future debt problems.

For more than fifty years the international development assistance industry has tried to see any alter condition of poor, but, unsurprisingly, the dismal number was constantly same. And this dismal number is drastically increasing day by day. Although successful implementation requires commitment built on stakeholder participation and local ownership, but development procedure emerged very critically- as an industry, as having its own imperatives, as having its own survival at stake, more increasingly, they have begun to understand that persistent poverty makes developing countries vulnerable to security and other threats. Therefore, rhetoric of foreign aid has been increasingly shifted toward the challenges of development. The quantity of foreign aid has hit record levels, exceeding those envisioned in donor promises even with the onset of global economic crisis. But the crucial question of foreign aid allocation remains outstanding. What should be the objective of foreign aid, and which selectivity criteria should be adopted to meet this end? Aid allocation is the vision of millennium development goal, and to meet the Millennium Development Goals, including cutting global poverty in half by 2015, donor countries have been called upon to allocate 0.7 percent of their GNP for official development assistance. But this raises the question of what form the aid should take—loans or grants? Moreover, is there any possibility in grants or loans to reduce poverty? Our experiment will not be far & out of reach, as we will diagnosis it by put some empirical experience and chronological history.

Objectives of the study:

• To gain in depth understanding of the existing status and conditions of Aid Determination;

• To capture the present level of aid allocation;

• To identify the level of awareness of community, including other relevant stakeholders regarding demand and the consequences on poverty;

• To identify the nature of assistance and their underlying causes, which prominently exists in the project poverty;

• To get information on the existing Govt. and Non Govt. Agencies ;

• To examine the current level of aid allocation in the facilities which contribute in poverty reduction, both at loans and grant level;

• To suggest necessary measures to improve the situation of inadequate level.

Key word: Grants and Loans, Foreign Aid, Donor Country and Recipient Country, Aid Allocation, Development Aid, Debt, Fragile State, Efficiency, Human Development Goal, Conflict, Developing Country.

• Introduction:

“Our first and foremost word: Aid never runs alone, by both, recipient or donor country; rather it is the mutual commitment for two parties.”

Different developing countries receive different amounts of aid. It is quiet hard to regard this allocation. In the late 1990s, several political and social debate terms heated up on the best form of aid provision. A vivid debate emerged of whether aid should be provided in the form of grants or loans? But the term was super controversial. However, the Meltzer Commission report argues that, poor countries are typically heavily indebted. To avoid a further increase of the debt burden, advocates advise that grants should replace loans for those countries.

After 2000, the grants-versus-loans controversy developed when an influential US Congress Report of the International Financial Institution Advisory Commission (better known as Meltzer Commission) concluded that total cancellation of poor-country debt was essential. One of the conclusions of the Meltzer Commission on reforming the World Bank and the International Monetary Fund was that development assistance should be administered through performance-based grants rather than (concessionary or soft) loans. Under this system, grants would be disbursed not directly to the government, but to a nongovernmental organization (NGO), charity, or private sector business that would offer the cheapest bid for a project. These recommendations were echoed in US President Bush’s proposal in 2001 during the negotiations for the 13th IDA replenishment that 50 per cent of IDA financing to poor countries should take the form of direct grants.

In the post-September 11 world, the perspectives of donor nations on foreign aid or official development assistance (ODA) have changed significantly. Consequently, several prominent observers—ranging from former Vice President Al Gore (2002) to President George W. Bush (2002a), as well as academics, including Joseph Nye, Dean of the Kennedy School of Government, Laura Tyson (2001), Dean of the London Business School, and Richard Sokolsky and Joseph McMillan (2002) of the National Defense University—have called for increased aid and educational assistance to end terrorism. While President George W. Bush refrained from drawing a connection between poverty and terrorism for a time, but on March 22, 2002, he announced in Monterrey, Mexico, “We fight against poverty because hope is an answer to terror.”

As a result of this considerable change, the foreign aid has completely dividend into two groups - donor countries self interest, regarding strategic, political and economical view and on the other hand recipient needs- regarding poverty reduction, improving primary school enrollment, reducing maternal and infant mortality. Consequently, donor countries have begun to mobilize additional resources for the needs of developing countries. Several donors have pledged to reach the United Nation’s target level (0.7 percent of donor’s gross national income) for ODA over the next decade or so, and others have begun to significantly increase their commitments for development assistance (Heller 2005). And our skepticism has been raised from here, debt and debt cancellations are two complementary instruments which, if properly managed, perform better than either loans or grants taken in isolation. Now we will start our journey by the giving definition of Development aid, as it would be clear to understand first part of our hypothesis.

• Development aid:

Development aid is aid given by governmental and economic agencies to support the economic, social and political development of a developing country. It may be development assistance, international aid, overseas aid or foreign aid. Development aid may come from developed or developing country governments as well as from international organizations such as the World Bank, IMF, OECD or OEEC. It is distinguished from humanitarian aid as being aimed at alleviating poverty in the long term, rather than minimizing poverty for a short term.

• Principles of aid allocation

One principle which can guide aid allocation decisions is that of ‘poverty-efficiency’ (Collier and Dollar 2001). This can be stated simply: aid should be allocated so as to achieve the largest possible reduction in poverty at the global level.

The principle of poverty-efficiency requires that relatively more aid be allocated to countries with higher levels of poverty. However, it also requires that relatively more aid be given to countries in which the effectiveness of aid at reducing poverty – meaning the amount of poverty reduction achieved per dollar of aid – is higher. Among countries with similar levels of poverty therefore, poverty-efficiency requires that more aid be given to countries in which its effectiveness is relatively high, and less aid be given to countries in which its effectiveness is relatively low.

The appeal of the poverty-efficiency principle lies in its focus on achieving the largest possible reduction in poverty. This matches up well with the view that the over-riding purpose of aid is to eradicate poverty. It is also flexible. It can be applied using measures which reflect the depth or severity, as well as the incidence, of poverty (e.g. the poverty gap), which most observers now accept to be preferable to measures based only on the incidence of poverty (e.g. the poverty head count). It can also be applied to different dimensions of poverty (e.g. mortality or malnutrition as well as $1-a-day or $2-a-day), which is important since the poorest countries in one dimension are not always the poorest countries in another. Also, Adrian Wood (2006) has shown how the principle can be modified to take into account a country’s likely future as well as current level of poverty.

Nevertheless, the poverty-efficiency principle does have its critics. One concern is that its strict application would cause donors to neglect poor countries in which aid effectiveness is considered to be very low: difficult partnerships or fragile states, for example. An approach not subject to this problem would be to allocate aid so as to achieve, or get as close as possible to achieving, a similar reduction in poverty in all countries. However, such an approach would deviate from the poverty-efficiency principle, and therefore come at the cost of a smaller reduction in poverty at the global level.

A different concern is that poverty-efficiency fails to take into account the ‘unjust’ disadvantages that some developing countries face. Examples include location in the tropics and being land-locked, which tend to lower countries’ growth rates but are outside the control of government policy. An alternative approach which would take these factors into account is an ‘equal-opportunity’ aid allocation, proposed by Llavador and Roemer (2001). This would allocate aid so as to compensate countries in which high levels of poverty, or slow rates of poverty reduction, are the result of unjust disadvantages, but not those in which government actions are more responsible.

Which of these different principles – poverty-efficiency, country-by-country targets, or equal-opportunity – is right is of course a normative question involving philosophical and moral considerations. It is, however, a question certainly worth thinking more about, not least to see how much consensus exists on which principle is considered to be right.

The consequence of this paper will come as follows. We first review critically a few of the arguments weighting grants against lending to the poorest countries, notably the incentive effects of each instrument. We then address what we regard as the most serious criticism against loans, namely the issue of ‘defensive lending’. If lenders had to refinance by themselves their loans to the poorest countries, then it is clear that the instrument is equivalent to a grant. We show econometrically that this has not been the case in general. Defensive lending is an occasional, not a systematic feature, of loans to the poorest countries.

• Depth of Hypothesis

1. Efficiency

Does grants are more effective than loans in fighting poverty? So many arguments have existed in several articles, including Google search, but no result we have found to write down, almost in every case the result was skeptical. The Grants versus Loans debate is concerned with a comparison between ODA instruments. This is not how the OECD Development Assistance Committee (DAC) defines ODA, and that very fact may well contribute to explaining why there ever was a debate between loans and grants. Instead of counting ODA as the actual budgetary cost for donor countries, the DAC defines it as the sum of grants and concessional loans (i.e. loans carrying an element of subsidization ). Nunnenkamp, Thiele and Wilfer (2005/2007) conduct a simple correlation analysis to explore whether loans and grants have different impacts on economic growth. They look, on the one hand, at the relation between total net ODA, total net loans, total grants and the grant element in ODA commitments (computed as the product of the grant element as defined in DAC statistics and ODA commitments), and, on the other, average per capita growth in gross national income over the subsequent five years. Their analysis finds no substantial difference in the impact on economic growth between ODA distributed through grants and ODA distributed through loans.

 

Secondly, it may think that ODA always relates with local fiscal discipline. Various studies shows that grants and loans are associated with distinct growth effects. While grant is a pure gift, it is need not to be repaid, so critics fear that it can do entail a potential disincentive on the mobilization of public revenues and on the quality of public spending. Increased dependency on external aid may result. On the other hand, loan is not a gift, it has to be repaid. So it has own responsibility. It could be help build financial discipline and promote the efficient use of funds. To arise from this problem Daniel Cohen, Pierre Jacquet, and Helmut Reisen suggested for dynamic operation, like they tried to get the answer first- in which beneficiary countries rely on the continuation of grants and in which development institutions are keen on producing a given level of ODA. Final they come to upon the answer- ‘grant pushing’ behavior by development institutions might again weaken that incentive.

 

Odedokun (2003), using yearly panel data from 1970 to 1999 for 72 ODA beneficiaries, finds that concessional loans are typically associated with higher fiscal revenues, lower public consumption, higher investment rates and lower dependency of the public deficit on external financing. In poor countries, a higher level of grants in total ODA is associated with a lower tax effort. Gupta et al. (2004) look at a set of 107 countries that benefited from ODA between 1970 and 2000, assessing the impact of grants and loans on the domestic fiscal effort. They find that an increase in total ODA (sum of grants and concessional loans) leads to a decline in fiscal receipts in the beneficiary country.

In summary, the argument according to which loans are equivalent to grants is not warranted from these analyses, at least from the point of view of the incentives that each instrument carries.

2. Aid composition matters

Aid composition is matter, as there has several points of view, what we’ve asserted in the first in this article. From the point of view of efficient aid, each of the “big three” donors- US, Japan, and France- has a different distortion: the US has targeted about one-third of its total assistance to Egypt and Israel; France has given overwhelmingly to its former colonies; and Japan’s aid highly correlated with UN voting partners. These countries’ aid allocation may be very effective at promoting strategic interest, but not the actual form of loans or grants and the result is that bilateral aid has only a weak association with poverty, democracy, and good policy. Practically, richer countries have more reasons than ever to address this new world disorder. But the record has been uneven, to say the least. The world power has helped to create a failed state, for a variety of self-interested motives, contributing to even greater global insecurity. The aid supposed to support Iraqi reconstruction has been mired in distortions designed to maximize the benefits for US companies. Elsewhere, donors have been inconstant partners. Many of the most fragile countries receive little assistance. Just as with all developing countries, donors have many criteria for allocating—or not allocating—aid. So regarding again to Collier and Dollar 2001, what we’ve mentioned before, while they tried to shows- more aid to be allocate to countries with higher levels of poverty, but by showing Alesina & David report, what could bring answer for “big three”?

In other mind, the revenue performance of developing countries in the past decade has been disappointing. Although country experiences have varied, tax revenue in the poorest developing countries and regions has, in most cases, been stagnant or has declined. What happens when a country’s financial aid is increased, and is the effect different if the aid takes the form of grants or of loans? We distinguished between the effects of loans and grants on revenues, holding constant other variables that have a bearing on a country’s ability to raise taxes (including per capita income, shares of agriculture and industry in the country’s GDP, and a ratio of a sum of imports and exports to its GDP). And merely effect different if the aid takes the form of grants. Rather, again, it depends on country’s local policy, efficiency, per head income, birth & mortality rates, and consciousness, as we said before; fragile states are merely paying tax, that is why they are poor and so it should not be comparable with grants or loans.

The relationship between revenues and foreign aid is fraught with difficulties. Foreign aid may respond to shortfalls in domestic revenue mobilization, suggesting that the causation may run from revenues to foreign aid, rather than vice versa. Benedict Clements, Sanjeev Gupta, Alexander Pivovarsky, and Erwin R. Tiongson, addressed this issue in the empirical results by checking how the results differ when statistical techniques are used that correct for any simultaneous causality (that is, endogeneity) between aid and revenues.

The empirical results suggest that an increase in overall aid (net loans plus grants) causes a country’s domestic revenues to decline, although the separate effects of its two components are different. An increase in loans causes government revenues to increase, whereas an increase in grants causes revenues to decline. Thus, if the loan amount were increased from an average of 1.5 percent of GDP to, for example, twice that level, revenue would increase by 0.35 percentage points of GDP. If grants were doubled from an average of 4 percent of GDP, revenue would fall by about 1.1 percent of GDP. This implies that for each additional dollar in aid in the form of grants, 28 percent is offset by lower domestic revenues. The doubling of grants from the sample average would also increase a country’s dependence on aid because the ratio of grants to domestic revenues would rise from 18 percent to 39 percent.

• Why the proposed shift of aid from loans to grants?

Some recent initiatives have called for a shifting of foreign aid toward grants while increasing overall assistance to developing countries. These initiatives are driven, in part, by the belief that excessive lending has led to massive debt accumulation in many developing countries and has not helped them reach their development objectives. In response to these initiatives, some donor countries and researchers have expressed concern that a significant shift to grants would make it difficult for the International Development Association, the World Bank’s concessional lending arm, to maintain lending at the existing level.

Lerrick and Meltzer (2002) as well as Radelet (2005) argue that loans carry perverse incentives, in particular linked to the pressures on creditors to make new loans to allow countries to repay old ones, whereas grants can be devised to generate positive incentives. Contrary to loans, grants do not contribute to the debt overhang.

However, the core meaning of this above shifting is very clear, humanitarian aid for poor country. But the question has remained on this shifting, is it the actually shifted for poor people rights? Or are there has some another reason? Today we are living very complicated world, where the system is very easy and naive, but the management is super critical.

The Grants VS Loans are very critical and complex subject. Whether, the term has very highlighted after 2000, especially post 911. And before 2000, there are so many articles has been published that, “large portion of foreign aid flowing developed to developing countries is wasted and only increase unproductive public consumption”. But after having all of those words, there has been a big change in foreign aid industry….that is transformation from loans to grants. So ultimately the question can be rise that, do developed countries respond to the economically correct incentives in giving foreign aid? Or, instead, is the pattern of aid flows dictated by political and strategic considerations which have little to do with rewarding good policies and helping the more efficient and lees corrupt regimes in developing countries?

Strong powers used to fear each other. Now their concerns emanate from states that are fragile and which threaten global stability. These states are still numerous; by most definitions, at least one-third of all developing countries. And they harbor up to 1.5 billion people, almost a quarter of the world. Poor institutional development, corruption, inefficiencies and bureaucratic failures in those developing countries are often cited as reasons for these results. Fragile states are of universal concern because they are the source of many of the most challenging global problems. Many are chronically prone to conflict—with more than a dozen civil wars raging at any one time. Some are major exporters of narcotic drugs (Afghanistan, Burma, Colombia) and some are developing nuclear weapons and exporting the capability to develop them (North Korea and Pakistan). They are incubators of violence and terrorism, such as Afghanistan under the Taliban regime and Somalia today. In the zones of death, people are displaced, property is destroyed and natural resources are plundered. So the question is going to loom large, as one third population of the world are poor and maximum states of them are frequently going under military law, so is foreign aid has been used to foster the process of democratization or not?

Alberto Alesina, David Dollar shows a data from Development Assistance Committee of the OECD, while they have converted the flows into constant 1985 dollars and for much of their analysis average these for five year periods beginnings with 1970-74 and ending with 1990-94. They have shown that, 70% of the total accounted for by four countries: US, Japan, France, and Germany. Even they have also shown in their article is that, their (donor country) have very creative politics while they deal for multi or bilateral aid. Sometimes each country has each own interest. Such as UN voting system, while there are deeply relation between voter country and leading country, its call UN friend.

There are so many witness can be providing favor of actual interest of foreign aid. Probably it can be question here that, why we are arguing about foreign aid, candidly can be provide answer that, the meaning of transformation from loans to grants is not new idea. Rather it is a continual process of foreign aid industry. By giving that illustration we can catch some ethnical character of foreign aid industry and what is the answer for transform. As we’ve mentioned before that, the shifting term derive a question whether it could be more efficient or not for recipient country and it is also may worry that, such a shift could dampen public support in donor countries for transfers to developing countries.

In contrast, grants are viewed as free resources and could therefore substitute for domestic revenues. The strength of these arguments depends on how strongly policymakers perceive loans, in practice, as being different from grants. If a large share of these loans is provided on highly concessional terms, and loans are frequently forgiven, policymakers may come to view them, over time, as roughly equivalent to grants.

However, finally it could be say that, the main fact for shifting was not a humanitarian answer, rather it implies to pull of terror form the world, or it could be way of another political interest what we are not arguing in this article.

• Conclusion: beyond grants versus loans, towards modern development finance

How donors meet the challenges of fragile and failing states provides the acid test for aid. While most aid has been a vehicle for donors to build relationships with individual developing countries, the predicament of the fragile states presents two outstanding justifications for activism. One is obviously humanitarian, since development failure has continued to impoverish the lives of many hundreds of millions of people. The other is self-interest, given the dangers posed by the fragile states to global security and health.

The basic message of our paper is that the grants-versus-loans debate as it was cast during the IDA13 replenishment has been misleading and largely irrelevant. It came in a context where most multilateral and, even more, bilateral ODA was already delivered as outright grants. It broadly disregarded financial and economic analysis and reached one sided conclusions that do not fit well with empirical observations. By putting the focus on ODA instruments, however, it has helped to raise awareness about the link between such instruments and aid effectiveness. Our main conclusion is that there is a rationale for loans as effective ODA delivery mechanisms and that there is also a rationale for development institutions to provide concessional loans.

A further reason for limited aid effectiveness may be that, donors are not only led by altruistic motives but also pursues economic and political interests when giving aid. Modern ODA should build on the capacity of donors to use a wide range of financial instruments, from direct subsidies to market loans, guarantees, and state contingent debt. The key and the originality, therefore, lie in mixing taxpayers’ money with a number of financial instruments, in a flexible and innovative manner. This is, of course, a major departure from the conventional conception of ODA instruments as either direct grants or concessional loans.

The obstacle of our conclusion goes beyond of grant VS loan. While after IDA13, the terms of aid has little bit changed. From then, the maximum portion of grants, for example, has been received not only by governments rather by the particular NGOs also and while NGOs doesn’t have any complexity by the fiscal revenues and public consumption, so spontaneously a question can derive, why the ambition was not succeed? Its probably raise the question what is the actual reason for shifting grants after 2000, and how the actors are acting throw maintaining the commands of political governance. At first, we have mentioned that- Aid never runs alone, by both, recipient or donor country; rather it is the mutual commitment for two parties- the mean of this word is, the success will never come until mutual commitment between donor and recipient country. Today donor country try to reduce the poverty by diminishing terror from the world throw giving grants, but we should not forget that poverty is not occurred from terror, so our foremost wants should be reduce the poverty and when we will achieve it then automatically the other problem will cure. But today our word definition has been changed. We need to rethink again. So, a question frequently murmurs to our ear, despite of good intention why development assistance has failed?