Explanation of Foreign Aid

Published: 13th December 2011
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In addition to export earnings and private foreign direct and portfolio investment, the final two major sources of LDC foreign exchange are public (official) bilateral and multilateral development assistance and private (unofficial) assistance provided by nongovernmental organizations. Both of these activities are forms of foreign aid, although only public aid is usually measured in official statistics.

In principle, all governmental resource transfers from one country to another should be included in the definition of foreign aid. Even this simple definition, however, raises a number of problems. For one thing, many resource transfers can take disguised forms, such as the granting of preferential tariffs by developed countries to LDC exports of manufactured goods. This permits LDCs to sell their industrial products in developed-country markets at higher prices than would otherwise be possible. There is consequently a net gain for LDCs and a net loss for developed countries, which amounts to a real resource transfer to the LDCs. Such implicit capital transfers, or disguised flows, should be counted in qualifying foreign-aid flows. Normally, however, they are not.

However, we should not include all transfers of capital to LDCs, particularly the capital flows of private foreign investors. Private flows represent normal commercial transactions, prompted by commercial considerations of profits and rates of return, and therefore should not be viewed as aid to the LDCs. Commercial flows of private capital are not a form of foreign assistance, even though they may benefit the developing country in which they take place.

Economists have defined foreign aid, therefore, as any flow of capital to LDCs that meets two criteria: (1) its objective should be noncommercial from the point of view of the donor, and (2) it should be characterized by concessional terms; that is, the interest rate and repayment period for borrowed capital should be softer (less stringent) than commercial terms. Even this definition can be inappropriate, for it could include military aid which is both noncommercial and concessional. Normally, however, military aid is excluded from international economic measurements of foreign-aid flows. The concept of foreign aid that is now widely used and accepted, therefore, is one that encompasses all official grants and concessional loans, in currency or in kind, that are broadly aimed at transferring resources from developed to less developed nations on development, poverty, or income distribution grounds. Unfortunately, there often is a thin line separating purely developmental grants and loans from sources ultimately motivated by security or commercial interests.

Just as there are conceptual problems associated with the definition of foreign aid, there are measurement and conceptual problems in the calculation of actual development assistance flows, in particular, three major problems arise in measuring aid. First, we cannot simply add up the dollar values of grants and loans; each has a different significance to both donor and recipient countries. Loans must be repaid and therefore cost the donor and benefit the recipient less than the nominal value of the loan itself. Conceptually, we should deflate or discount the dollar value of interest-bearing loans before adding them to the value of outright grants. Second, aid can be tied either by source (loans or grants have to be spent on the purchase of donor-country goods and services) or by project (fund can only be used for a specific project, such as a road or a steel mill). In either case, the real value of the aid is reduced because the specified source is likely to be an expensive supplied or the project is not of the highest priority (otherwise, there would be no need to tie the aid). Furthermore, aid may be tied to the importation of capital-intensive equipment, which may impose an additional real resource cost, in the form of higher unemployment, on the recipient nation. Or the project itself may require the purchase of new machinery and equipment from monopolistic suppliers while existing productive equipment in the same industry is being operated at very low levels of capacity. Finally, we always need to distinguish between the nominal and real value of foreign assistance. Aid flows are usually calculated at nominal levels and tend to show a steady rise over time. However, when deflated for rising prices, the actual real volume of aid from most donor countries has declined substantially in recent decades despite a recent uptick.


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HTML clipboard Rashid Javed is an Asian author. He writes articles about economics and accounting such as cash flow statement.

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