Impact of Foreign Aid2003

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Introduction

In this age of rapid growth and development in every walk of life, it is very difficult, rather

impossible for a country to finance all of its development expenditures with its own resources.

Therefore, to cover up the gap between its expenditures and revenues, it has to borrow somehow

from internal and external resources. This practice is normal in certain limits but from the last

few decades, we notice an extraordinary debt growth in all the countries generally, and less

developed countries in particular. The purpose of this paper is to elaborate the origin and impact

of the external debt on the developing economies.

The Emergence of the Dept

The third world countries, accumulating massive debts, are in the same situation. They do notearn enough from the exports of their f mineral and agricultural products to pay for the expensive

finished goods they import. The developed nations, through international banks and government

aid, lend them the difference. Each year they need more and more loans to make up their deficits,

and so their debt goes on accumulating. These less developed countries are obliged to supply

their low priced raw materials to their rich creditors and are unable to utilize their resources for

developing their own economies.

Several reasons are given of LDC's debt but, I) deficit in the budgets, 2) capital Night, 3) foreignexchange problems and 4) high interest raw of all, deficit in the federal budgets originates when

the federal revenues are less than federal expenditures. Nearly all other LDC's are facing this

problem. Federal revenues and expenditures often major LDC debtors can be seen in the table

below.

Secondary reason for the high growth of debt is the capital flight. Many LDCs kept their

exchange rates too high in late 70s and early 80s. So as a result there was a capital flight of $70

billion from Latin American countries only in early 80's.'The figure for all LDC's was muchhigher.

The third major reason is the shortage of foreign exchange. Due to high

deficits in balance of payments, most of the LDC's have to borrow from


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abroad to finance their projects fourthly, in the early 1980's, inflation fell

sharply but nominal interest rates remained high as 11 % in 1982.

Foreign aid plays very essential role in the overall development of a country provided it isutilized properly. Due to the scarcity of economic resources and others natural constraints everycountry needs the sufficient amounts of foreign funds in shapes of foreign aid. Generally foreignaid is granted to reduce the budget deficit, trade promotion and strategic considerations. Foreignaid can affect the macro and micro policies of the host country. Pakistan has been receivingforeign aid from many countries and international monetary agencies. It is also living fact thatPakistan has been graveyard of development projects financed by the many international donors.

In principle foreign aid could be a major source of capital, fueling the growth of developing

countries and helping to promote human development. To fulfill the two-gap theory developingcountries have to rely on foreign aid. These two important gaps are the import-export gap andsaving-investment gap. Pakistan like any other developing third world nation has been a recipientof foreign aid during its 50 years of existence. This aid has been in the form of grants, tied aid,

project aid and huge inflows intended to keep the foreign exchange reserves at a safe level tocope with industrialization related liberal import policy.

Foreign aid is a post World War II phenomenon. The World War II is supposed to be major pointin the evolution of the world economy. Priorities were changed and new regional alliances wereemerged in the world. New bitter economic realities were found and ties of friendship weretightened on the scale of loyalty and common interest. Motivating but confronting ideologies i.e.communism and capitalism were going parallel to parallel and waves of integration of the worldeconomy was also affected. All these factors ultimately alter the overall scenario of foreign aids

programs, diplomacy, and rules of the power. The motivation for foreign aid has evolvedspecially in during this period.

In this analytical study many new dimensions of global foreign aid is explored and efforts aremade to evaluate the worthiness of foreign aid. Pakistan is receiving foreign aid since the very

beginning. But the overall economic stability and industrial growth, financial soundness andinfrastructure strength is not good. Due to shortage of sufficient funds for economic developmentand poverty alleviation most of the countries of Africa, Asia and others parts of the world needforeign aid. In most of the case donors countries or international monetary agencies like IMF,World Bank, Asian Development Bank and Consortium imposed many conditions for foreignaid, which ultimately slow the economic development of these countries.

The two-gap theory suggests that foreign aid plays very important role in the development of developing countries. They have to rely on foreign capital inflows to fill two gaps: the import-export gap and saving-investment gap. However, foreign aid can also be granted for some othersdeterminate like structural adjustment programmes, emergency relief, transformation of economies, political objectives of the donors and recipients etc. Foreign aid has also transformedentire sectors. The agricultural innovations, foreign investments, and policies that created the


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green revolution improving the lives of millions of poor people around the world-were financed,supported, and disseminated through alliances of bilateral and multilateral donors like WorldBank, IMF, and Asian Development Bank The idea of foreign aid / assistance is very old inhuman history. Famous Marshall Plan was the key program to look after the basic needs of theeconomies of Western Europe countries. The main aim of that famous plan was to give help in

the process of rehabilitation and reconstruction of these destroyed economies.This plan was very successful in its aims (Bandow, 1985). Initially Bretton Woods conferenceand the International Bank for Reconstruction and Development [IBRD] made bilateral foreignaid very easy for the developing countries. After that many others financial institutions likeInternational Development Association [IDA], International Finance Corporation [IFC], Inter-American Development Bank [IDB], Asian Development Bank [ADB] and Islamic DevelopmentBank [IDB] were also established for the sake and attainment of economic growth of the poor countries via foreign aid (World Bank, 1992).

There are sharp differences upon the subject of foreign aid to the developing countries. Michael(1999) stressed that foreign aid is essential for resources mobilization and economic growth anddevelopment. According to Qudsia (1998) foreign aid promotes a culture of dependency insteadof encouraging the recipients countries to explore their own indigenous resources. Pakistan andmany countries of the Africa are the prime example. Richard and Robert (1973) concluded thatrapid inflows of foreign capital in shape of aid, grant, loan and project assistance can posenumerous problems for developing countries. Foreign aid is a political success; it is an economicand social failure. By increasing government power, destroying economic incentives, promotingunprofitable enterprises, and subsidizing misguided policies, foreign aid increases Third World

poverty.

Research scholars and economists are also differing in their opinions on the influences of foreignaid at macro and micro levels of development of the recipients countries. Official development

assistance in shape of foreign aid between 1960 and 1985 varied between 1.9 per cent of theGDP of developing countries in 1961 and 1962 and 0.8 per cent in 1985. But with an end of themutual struggle of supremacy between U.S.A and former USSR the rate of foreign aid hasdeclined (World Bank, 1986)

Foreign aid brought many multidimensional benefits to many countries of the global. Botswanaand the Republic of Korea in the 1960s, Indonesia in the 1970s, Bolivia and Ghana in the late1980s, and Uganda and Vietnam in the 1990s are all examples of countries that have gone fromcrisis to rapid development due to the contribution of foreign aid from donors countries andagencies (Mosley, 1987, April 17). Foreign aid played a significant role in each transformation,contributing ideas about development policy, and training for public policymakers, and financeto support reform and an expansion of public services. Foreign aid has also transformed entiresectors. The agricultural innovations, investments, and policies that created the green revolutionimproving the lives of millions of poor people around the world-were financed, supported, anddisseminated through alliances of bilateral and multilateral donors (World Bank, 1995).

Foreign aid is also is an unmitigated failure in many countries of the Africa and some countriesof the Asia and Latin America. There are many integrated reasons for that inefficacy of theforeign aid. These are corruption, ill intentions of the governing elite, political instability, ethnicviolence, dictatorship and inability to command over all the related social, economic and


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financial issues. In many cases the continuous flows of foreign aid put the burden of massivedebt on the host countries and the ratios of debt servicing increases all the time (Bovard, 1986January 31). The tied loans given to developing country tends to increase the inflation rate,increase the unwanted political exploitation and unsuited economic conditionality within thecountry. The removal of subsidiaries from health, education, utilities, public services,

downsizing of the employees, privatization of many state owned enterprises and corporations,imposition of general sale tax are the some but very strict measures that Government of Pakistanhas to take in order to fulfill the conditions imposed by World Bank and IMF (Hassan, Nation)

Many rulers of the Africa like former Zaires Mobuto Sese Seko, is just one of several exampleswhere a steady flow of aid ignored. Foreign aid in different times and different places has thus

been highly effective, totally ineffective, and everything in between. The checkered history of assistance has already led to improvements in foreign aid, and there is scope for further reform.The development experience of India provides a classic example of the failure of foreign aid.India receives more aggregate aid than any other developing nation on earth. It received a total of 55 billion U.S. dollars over a 43-year period (Kamath, 1995).

Many international economists and prominent international financial analysts demand the greater flows of foreign assistance to deprived regions of the world like Rwanda, Somalia, Zaire, Bosnia,Chechnya; Bangladesh, and the Haiti because all these countries are facing daunting problems of extreme poverty, over-population, under-education, environmental degradation, disease, civildisorder, and crumbling public infrastructures (The Economist, 1994 May 7).

The Foreign Assistance Comes In Three Ways

---FOREIGN GRANTS------FOREIGN LOANS------FOREIGN INVESTMENT---

a. Foreign Grants: The Foreign Grants are free and are not to be returned. These can be in the

form of goods or economic grants.

b. Foreign Loans: The Foreign Loans are to be returned. There are two types of loans Soft Loansand Hard Loans. Loans can be bilateral and multilateral.a) Soft Loans: In soft loans Interest Rate is very low and Time period to return loan is long andalso there are no strict instructions interims of usage of these loans.

b) Hard Loans: Where as on the other hand in hard loans The Interest Rate is very high, time toreturn the loan is short and there are strict policies on the usage of loan.

c. Foreign Investment: The Foreign Investment is brought in to a country for business purposes.Foreign Investment can be Direct and Indirect and it can also be Public Investment and Private

Investment.a) Direct Investment: In Direct Investment the control over the capital lays in the hands of investor.

b) Indirect Investment: Where as in Indirect Investment the investor just has some shares, justlike a sleeping partner.

a) Public Investment: In Public Investment the investment is done while considering the needs of


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the peoples. It is important in accelerating economic development. b) Private Investment: In Private Investment the investors invest in the fields which they think can yield maximum profit, irrespective of how this investment is going to affect the peoples.

BNEFITS and COSTS FOREIGN AID

Prominent economists and research scholars share different opinions about the impact of foreignaid to host countrys macro and micro policies. According to White (1992), Mosley (1987) andCassen (1986) foreign aid plays very important role at the micro levels policies of the hostcountries however, at the macro level the evidence is much more ambiguous. According toSargent, Thomas (1993), Gang and Khan (1986, 1991), and Khan (1994, 1996), foreign aid playsvery little impact on the macroeconomics policies due to the complexity and constraints facing

by the host countries.

Foreign aid plays very important role in the development of a country and its benefits are givenbelow:

According to Chenery and Bruno (1962) and Chenery and Strout (1966) foreign loans andassistances bridge saving gap. Foreign aid/loans supplement domestic saving and help in

bridging the resources gap.

According to Lance Taylor (1993), Bacha (1984) foreign aid pals pivotal role to fulfill internaland external balances.

Heller (1975) Taylor 1993, pp. 11-12). Increase productivity of various economic sectors

Cashel-Cordo and Craig, 1986; Booth, (1988) Increase in tax collection Binh, Tran-Nam andMark McGillivray, (1993). The foreign assistance helps in the establishment of industrialization

in the country. The flows of technical knowledge improve the quantity and quality of manufactured goods and makes them available at lower prices to the domestic consumers.

Foreign aid helps in increasing marginal productivity of labour in the recipient country. Thereal wages of the workers are increased by the induction of foreign aid.

Foreign aid stimulates domestic enterprises. The firms avail of the benefits of externaleconomies like that of training of labour, introduction of new technology, new machineryForeign aid plays very important role in the reduction of poverty and other socio-economic

problems and efficient economic institutions and macro economic and fiscal policies in thedeveloping world are the key to utilize the flows of foreign aid properly. Good governance andquality economic policies may increase the chances of bright future the future that will be free

from poverty, economic dependency, political exploitation, and scarcity of the resources(Richard, & Robert, 1973).

The Cost of Foreign Aid to Recipient Country

The cost of foreign aid is very heavy on the recipient country if it is not utilized properly. It has been observed that most of the most of the developing countries including Pakistan are not fullyutilizing the foreign aid.


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The burden of debt servicing increases all the time.

The tied loans given to developing country tends to increase the inflation rate

Increase the unwanted political exploitation

Unsuited economic conditionality (Kamath, 1995).Role of Foreign Aid in the Development of Pakistan

Pakistan has been a recipient of foreign aid since its existence. This aid has been in the form of grants, tied aid, project aid and huge inflows intended to keep the foreign exchange reserves at asafe level to cope with industrialization related liberal import policy. Foreign aid has played veryimportant role in the economic development of Pakistan. In the beginning Pakistan received verysmall aid from the rest of the world and international monetary agencies like World Bank andIMF. Industrialization process began in Pakistan after the late 50s and to fulfill the demand of intense development activity, increased reliance on foreign resources became virtually inevitable.In the economic history of Pakistan five-year planning scenario is also responsible for foreignaid. Government of Pakistan had to request for the foreign aid for the completion of the fiveyears targets and the volume of foreign aid increased with the introduction of every five-year

plan.Many economists share the same views about the foreign aid and economic development. Manythird world countries received substantial foreign aid from the developed countries for theeconomic stability and development but political considerations strategic alliances has been

partly responsible for the level of aid flows to different countries at different points of time.Due to geo-political developments around its borders Pakistan received liberal assistance

packages during the decade of 60s and 80s. Pakistan has been closed ally of western world inorder to stop the onward march of communist menace. There was lavish foreign aid and militaryassistance to Pakistan due war in Afghanistan. The inflows of generous foreign aid reached itsclimax in the ear of Zia. With the end of war in Afghanistan, policy of isolation and lesser interests of God Fathers Pakistan could not have economic and materialized aid on softer terms(Kardar, 1995). The composition and terms of foreign aid has changed considerably from grantsand grant like assistance to hard term loans over the years. The share of grants and grant likeassistance in the total commitments was 80% during the first five-year plan (1955-60). It wasdropped to 46% during the second five year plan (1960-65) and continued to decline thereafter,averaging 31% during the third five year plan (1965-70) and 10% in the fourth five year plan(1970-75). There were many geo-political aspects for that down ward trend in foreign aid inshape of grant or grant like (Abbas, Brecher, 1992).Foreign aid in shape of loans, and credit has been granted on easier conditions during the 1960sand the 1970s. During the 1980s and the first eight years of the 1990s (1990-98) the source andavailability of foreign aid has made very harder and difficult for Pakistan. The rate of interest of foreign aid has been on the move during the last 50 years. Furthermore, the repayment period of loans/credit has been reduced by the international monetary agencies and western world(Qureshi, 1997).

Main Merits and fields of Foreign Loan:1) Accelerates Economic Development.


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2) Helps in setting up Industry.3) Helps in Capital Formation.4) Employment Opportunities Increase.5) Transfer of Technology & Knowledge takes place.6) Peoples Purchasing Power Increases.

7) Helps in Industrialization.8) Helps in Building Economic & Social...

Effect of Foreign Debt

a developing nation has to use all the available and possible resources to raise funds for theimplementation of its development plans. it hs to utilized surplus revenues, tax revenues,seek for externalaid and borrow in addition. public borrowing can be domestic or foreign.in LDC's savings are too low,therefore the Govt. has to borrow from abroad.Foreign debt has two dimensions, on one hand it is helpfulin development process and on other hand, excessive borrowings can cause many serious problems.on th first instance, foreign loans help to bridge up the gap between govt. expenditures and revenueswhich may not be covered by domestic savings. secondly, foreign debt help the economu to import thecapital goods which is mostly impossible for LDC's without foreign aid. thirdly, foreign dabt can be usedfor export promotuion. on the other hand, external debt transfer wealth when the loans are repaid withinterest.

Effects on consumption and spending:foreign debt has two sides effects on consumption and spending. on one hand , govt. of debtor countryspends more to complete its projects. more money means more income and more income means moreconsumption. if the aggerate supply is not enough to satisfy the increased aggregate demand, it willcreate inflation in the country. on the other hand it has indirect negative effect on consumption. we knowthat debt is the burden that requires higher taxes to meet indirect payments; therefore more taxes leaveless disposeable income which will reduce the consumption too.

Effects on Saving:effects of foreign debt again depends on use of debt. if the debt is used to finance the investment whichwill further increase the income of the people, then saving will increase out of increased income. on theother hand, if it is used on non-productive projects, it will depress saving by increasing aggregate demandand creating inflation.

Effects on investment:if foreign debt is used for capital investment, it will further increase the priovate domestic investmentbecause increased aggregate supply will balance the increased aggregate demand, caused by increasedincome. on the other hand, increased expenditure on non productive projects will cause highere interestrates which will depress incentives for investment.

Effects on monitory policy:if the borrowed money is used on non productive issues,the new expenditure will shift the IS curveupword, increasing the dificite and higher interest rates with reduced investments. therefore centeral bankwill increase the money supply therefore LM curve move forward causing new equilibrium with interestrates at its initial levels but at higher income and output level. if centeral bank does not increase themoney supply, additional demand created by increased expenditure will cause inflation.

In summary, in eddition to the efects on saving, consumption, in vestment and monetary system, foreigndebts has far reaching effects on the financial system. if the cash flows available to the countries is


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interrupted for any reason the some of the LDC's find no other way but to default in their debt obligations.therefoe they will be forced to reduce the demand for goods & services causing serious recession.

RECOMENDATION

Many of the LDC's have learned experience from default countries and have started improving their debtsituation but still a lot is needed to be done on this issue to avoid the future crises. following are some of the policy solutions which can help in reducing the debt problem.

Elimination of federal budget deficit:federal budget is the major source of foreign debt. therefore, if a govt. really wants to halt the high growthof debt, the first is to eleminate the bidget deficit. this step will keep the domestic savings free for theinvestment purposes which can further genrate foreign exchange to keep the economy out of the "debttrap" in the future. this can be done by reduction in spending.

Foreign Exchange shortages:the second issue in adjusting to debt regards the fact that the country need to earn foreign exchange nottheir own currency. in other words, it needs to genrate the trade surplus. in LDC's much of the foriegndebt is used to build non -productive projects. if the same capital is used in productive projects, the debtburden will be less. because the new investment will create or save enough foreign exchange to make thefuture payments without creating the additional tax burden on the community or society.

Revision of the tax policies:Some of the LDC's yax policies encourage the loan because it is exampted from tax. such policiec shouldbe eliminated.

Reversial of capital flight:because of the unfavourable investments climate and political instability in the country, there is a hugecapital flight in the country. reversing these capital flights would make it almost possible to pay off theexternal debt. positive real stable interest rates will help a lot in this regard.

Need for international cooperation & coordination:

developed countries can play a key role in the developing countries. international banks should changetheir policies while lending to LDC's. they should borrow according to their needs and on low interestrates. IMF should help LDC's in accomodating their balance of payments. IMF plays a good role to assistrich industrial nations of the world but it is reluctant to help LDC's. large and develpped nations shouldhelp LDC's to perform industrial reforms in LDC's economies.

Debt-Equity swaps:another solution that is finding a lot of favour in the financial community is the system of debt-equityswaps. in this system an invester of a creditor nation purchases in the second hand market the debt of thedebtor nation at a 30% discount. this debt then is presented to the debtor nation's federal bank for redumption at par into their currency units at a premium prevailing in the arket. that amount is then spenton purchasing some assets being liquidated by the public sector. when the accounts are done, theexternal debt is reduced. it may be an exopensive way to clean up the balance sheet. but it will promote

foreign investment, both direst and portfolio investment.

Documents

Impact of Foreign Aid2003