Securing Foreign Aid Impact in a Time of Fiscal Austerity

November 19, 2012

With a global financial crisis stripping investor confidence and budget cuts looming for traditional donor countries struggling under mountains of debt, it’s reasonable to be concerned about potential decreases in foreign aid.

Even Bono, the famous frontman for the rock band U2, is campaigning on the issue, appealing to US policymakers this month “to spare U.S. development assistance programs from cuts as Congress tries to avert the looming ‘fiscal cliff’” (Reuters).

This begs the question: what aid investments make the most significant economic impact in developing countries?

Kamiljon Akramov, senior researcher for the Development Strategy and Governance Division at IFPRI, has been examining this question.

His recent study, “Foreign aid allocation, governance, and economic growth,” summarized in a new IFPRI Issue Brief, divides aid into three major sectors: economic, social, and other—and ranks each one’s effectiveness for improving economic growth.

Economic aid includes help for a country’s production such as agriculture, manufacturing, and trade projects as well as helping to build energy, road, communication, and financial infrastructure. He defines social aid as investments in such sectors as education, healthcare, sanitation, and drinking water. (The “other” category mainly represents emergency aid, which he argues was never really intended to foster long-term economic growth.)

The results are striking.

From the early 1980s to the early 2000s, development aid moved away from investments in production and infrastructure—dropping almost 20 percent—and doubled in social interventions. The reasons for this are varied: agricultural failings made donors wary of investing in the sector, numerous crises required emergency responses, and geopolitical and commercial interests also played a role. Whatever the reason, Akramov’s paper suggests this evolution pushed development in a less economically impactful direction.

According to the findings, the most immediate investment returns happen when money is pushed through the production sector, where it generates growth in areas like agriculture and manufacturing to stimulate an economy.

An almost equal (but less immediate) return can be seen when aid is funneled toward economic infrastructure—roads, storage, energy, and communication networks—to bolster a country’s capacity for production and provide incentives for investment by reducing transaction costs for everyone in the value chain on down to the small-scale farmer.

Social sector investments in areas like education are shown to have the least impact on economic growth and a surprisingly limited contribution to human capital.

Why? The author recognizes that “social aid might affect economic growth by building additional human capital,” but surmises that education is only enticing if there are labor-market benefits, and that without the economy to support a strong labor market, incentive to seek education goes out the window.

In the end, Akramov concludes what IFPRI has been arguing since its founding: promoting growth and reducing poverty in less-developed countries must involve increasing investments to agriculture and other production sectors. This pragmatic view of investment may be a hard pill to swallow for proponents of social interventions; however, the publication does end on a hopeful note. In order for these aid increases to be effective, Akramov argues, they must take into account the needs and conditions of the recipient countries, and balance attention to different sectors of economy – including the social sectors.

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