When is foreign aid policy credible? : aid dependence and conditionality

Disbursements of foreign aid are guided (in part) by the needs of the poor. Anticipating this, recipients have little incentive to improve the welfare of the poor. The welfare of all parties might be improved by tied project aid and by delegating part of the aid budget to an (international) agency with less aversion to poverty.

Svensson studies foreign aid policy within a principal agent framework. He shows that one reason for foreign aid's poor overall record may be a moral hazard problem that shapes the aid recipient's incentive to undertake structural reform. The model's basic prediction is a two-way relationship: Disbursements of foreign aid are guided (in part) by the needs of the poor. Anticipating this, recipients have little incentive to improve the welfare of the poor.

Preliminary econometric work shows that the data support this hypothesis.

In principle, conditionality could partly solve this problem, but only if the donor can make a binding commitment to increase disbursements in good relative to bad states. Without such a commitment technology, aid disbursements remain guided by the needs of the poor and recipient countries maintain a low effort to reduce poverty.

Contrary to the conventional wisdom found in the aid literature, Svensson shows that the welfare of all parties might be improved by using tied project aid or by delegating part of the aid budget to an (international) agency with less aversion to poverty.

This paper a product of the Macroeconomics and Growth Division, Policy Research Department is part of a larger effort in the department to study the effectiveness of foreign aid. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rebecca Martin, room N11059, telephone 2024739026, fax 2025223518, Internet address rmartin1@worldbank.org. (32 pages)

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