Economic Growth Of Developing Countries Foreign Aid Effect

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1.1 Background

Foreign financial aid is aid given from one country to another. Though the main aim is to benefit the recipient country, the giving country may expect certain favors from the receiving country. It can be divided into humanitarian and development aid. Humanitarian aid is given in times of humanitarian disasters such as drought and flood while development aid is given to help prevent such disasters or help the country undertake specific development programmes. Foreign aid can be given by individuals, firms, the government or international financial institutions. The latter accounts for the largest amount of aid given to developing countries.

International financial assistance begun after World War 2 to direct investments to the most affected countries. The International Bank for Reconstruction and Development (IBRD), now known as the World Bank, and the International Monetary Fund (I.M.F.) were the first financial institutions that were formed by the allied countries which were anti-German countries. The members of these institutions were those that signed the Bretton Woods Agreement in 1944, though other countries joined them as time went on. The two institutions were formed to accelerate investments in needy countries, ensure monetary co-operation and become international advocates of controversial economic policies in developing countries.

The I.M.F. was formed in 1944 but started its operations in 1947. Its major objectives were to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty in its member countries. Later on, in the 1970s, many countries' economies faced several disasters such as the oil crisis, the debt crisis, multiple economic depressions and stagflation. These disasters showed that not only were funds needed to improve a country's well-being, but also deeper intervention that involved formation of effective macro-economic policies was very necessary. This led to the introduction of the Structural Adjustment Programmes (SAPs) by the IMF. These policies state the conditions for obtaining new loans or getting lower rates for the existing ones. The rules are made to ensure that the funds are used to achieve their main objective. They include internal changes such as deregulation of certain sectors and privatization and/or external changes such as reduction of trade barriers and devaluation of the local currency. The borrowing countries have to follow these conditions or else they face severe fiscal discipline such as delay or in some extreme cases, denial of additional funds.

The World Bank was also formed at the Bretton Woods Conference in 1944. Its major role was to help its member countries in restructuring programmes especially after natural disasters and humanitarian emergencies. It has now evolved its main aim as that of eliminating poverty in member countries. The World Bank Group is comprised of five separate arms. Two of those arms, the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), work primarily with governments and together are commonly known as "the World Bank". Two other branches, the International Finance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA), directly support private businesses investing in developing countries. The fifth arm is the International Center for Settlement of Investment Disputes (ICSID), which arbitrates disagreements between foreign investors and governments. This bank also has the Structural Adjustment Policies which a borrowing country has to comply with.

Despite these differences, World Bank and IMF adjustment programs reinforce each other by "cross-conditionality." This means that a government generally must first be approved by the IMF, before qualifying for an adjustment loan from the World Bank. Their agendas also overlap in the financial sector in particular. Both work to impose both fiscal and monetary austerity. The market-oriented perspective of both institutions makes their policy prescriptions complementary (Colgan, 2002). 

In theory, foreign aid is known to increase the economic growth of a country. Increase in aid increases level of investments in a country due to increased incomes. Increase in investments lead to increased output hence increase in the G.D.P. of a country.  It also increases a country's ability to import capital goods or technologies which are relatively expensive for developing countries. Capital structures such as roads, bridges, electricity, schools and hospitals would be impossible to construct without financial funding. They facilitate communication, build confidence and achieve desirable productivity. This will also lead to increased investments hence increase in G.D.P. However, these are only the short-term effects of foreign aid.

In the long run, countries that borrow large amounts from financial institutions often end up being worse off than before. Conditions imposed by the lender may be more destructive though they were meant to enable the country use the funds for the sole purpose of what was intended. Over the years the Structural Adjustment Programmes have been faced with a lot of criticisms due to their stringent nature. The financial institutions impose policies which only aim to solve the balance of payment problems without considering the effects they have on other aspects of the economy. Most countries with these programmes only focus their attention towards maintain a Balance of Payment at the expense of other macroeconomic goals such as price stability, economic growth and increasing rate of employment. For instance, the IMF has frequently advised developing countries to devalue their currencies in order to make exports cheaper, while increasing the price of importing goods. These may adversely affect the price stability of the country as it exerts inflationary effects on the economy. Increase in prices of domestic goods without an equal increase in the incomes of the citizens will leave them worse off than they were in the first place.

1.2       Problem statement

  Despite the fact that foreign aid is given to improve the economic growth of developing countries, it ends up worsening the economic situation in the country. Most developing countries view foreign aid as a source of incomes for which they can use to develop their countries. They only look at the short term advantages of being given funds. However, they do not consider the long-term consequences of acquiring foreign aid.

A Factor such as Structural Adjustment Policies (SAPs) implemented by the lending financial institutions are not fully analyzed by the borrowing country before agreeing to take the funds. At other times, they must take the loans given to them or else they face stiff penalties despite the conditions given. The aim of this essay is to look at the long-term effects of foreign aid and compare them with the short term effects. Another factor such as dependence on the foreign aid once a country has started receiving funds is not taken into account. A minimum number of countries borrow loans on a one-time basis. Most countries take one loan after another due to growing dependence. The loans they get are not sufficient to be invested in projects that will enable repaying and keeping some extra funds.

1.3       Objectives

1.         To determine the impact of Structural Adjustments Programmes imposed by the World Bank and IMF on the economic growth of developing countries.

2.         To determine the effectiveness of the foreign lending given to the developing countries.

3.        To investigate the effects of lending by the IMF and World Bank on the overall standards of living of the residents of a borrowing country.


Alesina and Dollar (2000), found that foreign aid is "dictated as much by political and strategic considerations, as by the economic needs and policy performance of the recipients. Colonial past and political alliances are major determinants of foreign aid." However, they did find that countries that were more democratized received more aid, everything else being equal. They also looked at the flow of direct investment and found that "good policies" and the protection of private property rights were crucial to foreign investors.

Alesina and Weder (2002), found evidence that less corrupt governments do not receive more foreign aid than corrupt governments. This finding held for bilateral, multilateral, and individual donors, although evidence indicated that some individual donors, primarily Scandinavian countries, were more selective and gave less to more corrupt countries. In fact, their study showed that increased aid leads to increased corruption.

White (2004), reviewed trends in official flows to developing countries over three decades. He found that real aid levels declined in the 1990's and that the aid that was given has moved increasingly from the poorer countries, especially sub-Saharan Africa, and is driven more by political reasons. European donor countries appear to be donating more to European recipients, and aid in general is flowing more to areas where individual donors have a perceived interest, whereas multilateral donors still focus more on countries that appear to be more in need of assistance. Although the evidence is mixed, there does appear to be a growing recognition that need-based aid might be more effective in areas that are less corrupt and have more developed institutions. Many donors, especially multilateral donors like the World Bank are beginning to view corrupt, totally undeveloped countries as "rat holes" where money will simply disappear.

Additional evidence of this new "ideal" in the granting of aid is provided by the Key Principles of the Millennium Challenge Corporation (MCC). In January 2004, Congress passed a "new compact for global development" called for by President Bush which links greater contributions from developed nations to greater responsibility from developing nations. The President proposed a concrete mechanism to implement this compact--the Millennium Challenge Account (MCA)--in which development assistance would be provided to those countries that rule justly, invest in their people, and encourage economic freedom.

Jha and Saggar (2001), argued that financing of the IMF and World Bank play a central role in developing countries monetary system. They found that the reliance and dependence in the funding has been gradually increasing for developing countries but decreasing for OCED countries. Secondly, the effects of the lending on different macroeconomic variables are different from country to country. Thirdly, the macroeconomic variables that determined amount of loans to be given were insignificant hence concluding that there was arbitrariness in the giving out of the loans.

  How does foreign aid affect the economic growth of developing countries? This is a question, which has drawn the attention of many scholars over time. Papanek (1972), finds a positive relation between aid and growth. He asserts that foreign aids increases economic growth rate more than foreign direct investments and domestic savings. He explains that aid, unlike domestic savings, can fill the foreign exchange gap as well as the savings gap. Unlike foreign private investment and other foreign inflows, aid is supposed to be specifically designed to foster growth and, more importantly, is biased toward countries with a balance-of-payment constraint. He also finds a strong negative correlation between foreign aid and domestic savings, which he believes co-contribute to the growth performance.

Fayissa and El-Kaissy (1999), show that aid positively affects economic growth in developing countries. Using modern economic growth theories, they point out that foreign aid, domestic savings, human capital and export are positively correlated with economic growth in the studied countries. This is consistent with the economic theory of foreign aid, which asserted that overseas development assistance accelerates economic growth by supplementing domestic capital formation.

Snyder (1993), shows a positive relation between aid and growth when considering country size. He points out that the same amount of aid will have more positive effect on a smaller country than a big one. He argues that when country size is not included, the effects of aid are small and insignificant but when this factor is taken into account, the coefficient of aid becomes positive and significant.

Burnside and Dollar (1997), claim that aid works well in the good-policy environment, which has important policy implications for donor community, multilateral aid agencies and policymakers in recipient countries. Developing countries with sound policies and high-quality public institutions have grown faster than those without them, 2.7% per capita GDP and 0.5% per capita GDP respectively. One percent of GDP in assistance normally translates to a sustained increase in growth of 0.5% per capita. Some countries with sound policies received only small amount of aid yet still achieved 2.2% per capita growth. The good-management, high-aid groups grew much faster, at 3.7% per capita GDP (World Bank, 1998).

    By contrast, other people find foreign aid has negative impact on growth. Knack (2000), indicates that higher aid levels erode the quality of governance indexes, i.e. bureaucracy, corruption and the rule of law. He argues that aid dependence can potentially undermine institutional quality, encouraging rent seeking and corruption, fomenting conflict over control of aid funds, siphoning off scarce talent from bureaucracy, and alleviating pressures to reform inefficient policies and institutions.

A permanent rise in foreign aid reduces long-run labor supply and capital accumulation, increases long-run consumption and has no impact on long-run foreign borrowing. Using the optimal growth model with foreign aid, foreign borrowing and endogenous leisure-and-consumption choices, Gong and Zou (2001), show that foreign aid depresses domestic saving, mostly channels into consumption and has no relationship with investment and growth in developing countries.

Pedersen (1996), asserts that it is still not possible to conclude that aid affects growth positively. Using game theory, he argues that the problems lie in the built-in incentive of the aid system itself. The aid conditionality is not sufficient and the penalties are not hard enough when recipient countries deviate from their commitments. In fact, there are incentives for aid donating agencies to disburse as much aid as possible. This hinders the motivation of recipient countries and raises the aid dependency, which in turn distorts their development. 

The IMF cannot seem to understand that investing in a healthy, well-fed, literate population is the most intelligent economic choice a country can make (Smith, 2005). The SAPs have been implemented to ensure a balanced or manageable balance of payments and economic restructuring. But by doing this many developing countries have had to reduce spending on many important things such as health, education and development, while debt repayment and economic policies have been made the priority. In effect, these programmes have forced the developing countries lower the standards of living of their people. A study carried out by analysts from Cambridge and Yale Universities concluded that strict conditions on international loans from IMF led to thousands of death in Eastern Europe due to tuberculosis as public health care had to be weakened. Tuberculosis rose by 16.6% in the countries that had been given loans by the IMF. In Africa an estimated 500,000 more children died from the imposed restructuring of their countries' economies to ensure increased flows of money to external banks, while spending on health care declined by 50 per cent and on education by 25 per cent since these structural adjustment programs began (Mcmurtry, 1998)

 The IMF's own review seems to agree with the fact that its policies are achieving what they are meant to achieve. An internal review indicated that countries that refrained from ESAF (IMF's Enhanced Structural Adjustment Facility) remained better off than those that joined it. According to the review, annual real per capita DGP growth averaged 0.0% for countries with ESAF programs over the period 1991-1995, whereas non-ESAF developing countries experienced, on average, 1.0% annual real per capita GDP growth. When used efficiently, the funds from the international financial institutions will greatly increase the economic growth of a country. However, it is clear that most developing countries which constantly borrow from these institutions have declining economic rates of growth. 

 The current patterns of channeling aid through centralized governments in recipient countries may reduce the timeliness and efficiency of aid. It is found that the aid is more effective if it is delivered directly to the working level local authorities. Hence, the emerging role of NGO community is widely attracting attention (World Bank, 1998). Most developing countries' governments have very corrupt officials who are there only to enrich themselves. Making them in charge of large amounts of money will only lead to embezzlement. Secondly, there are those officials who like to politicize everything hence in the end, very little is done with the funds positively.

Other researchers have found that foreign aid may affect economic growth through indirect channels that cannot be captured by analyzing only the direct effects of economic growth. Aid may alter the investment share of GDP, which indirectly affects economic growth positively. It may also affect government consumption which is known to affect economic growth negatively. As Sachs et al, argued, the effect on aid through the indirect channels is not considered by the borrowing and the lending countries.

There is also evidence that the effects of foreign aid can be mitigated by other non-economic factors.  Situations of state failure, such as ethnic conflict, genocide or politicide, and revolution can all potentially influence the extent to which aid impacts growth.  George Mason University's Political Instability Task Force (PITF) created a binary dataset indicating in which countries and during what years these events take place.  According to the PITF, an ethnic conflict requires the clash of two separate ethnic, religious, or nationalistic factions, and also must meet two threshold criteria: 1,000 people must be mobilized for armed conflict, and at least 1,000 people per year must have died as a direct result of this conflict.  Similarly, revolutions are defined as episodes of violent conflict between political groups in hopes of overthrowing the current regime, and must meet the same threshold criteria as ethnic wars.  Finally, genocide and politicides are defined in a slightly different manner.  These events occur when the group in power carries out sustained policies that target ethnic, religious, or political rivals, ultimately resulting in the deaths of a "substantial" portion of one of those groups.

Sachs et al (2004), have argued for an increase in foreign aid in African developing countries in order to refrain from the poverty trap. In their proposal, foreign aid is directed to a particular set of investments, specifically, public sector investments to prevent them from being used for consumption purposes. They argue that the aid should be in form of grants rather than loans. They believe that such should be accompanied by monitoring of the budgeting and expenditure process by non-governmental organizations to avoid consumption or embezzlement of funds by such.


Although the IMF lending was started to help countries to manage their balance of payment problems and manage a sustainable economic growth rate, research and evidence have shown quite the contrary. One of the most important reasons for this is due to the conditions that must be met for a country to get lending. One such condition is for the borrowing country must open up its markets by importing products from some developed countries. Most of the developed countries export capital-intensive products. According to Smith (1994), the developed countries grow rich by selling capital intensive goods which are relatively cheaper at a higher price and buy labor-intensive goods that are relatively expensive but a lower price. This enlarges the gap between the rich and the poor. The wealthy sell goods to be consumed and buy goods to produce which maintains monopolization of the factors of production and ensures a continued market for its goods. This eventually leaves the borrowing country worse off than it was before obtaining the loan. A large value of imports compared with the value of exports leads to decrease in money in circulation and quite contrary to the aim of obtaining the loan, increases its balance of payment deficit.

Secondly, it has been argued that Structural Adjustments encourage corruption and undermine democracy. As Ann Pettifor and Hanlon (2006) note, top-down conditionality has undermined democracy by making elected governments accountable to Washington-based institutions instead of to their own people. The potential for unaccountability and corruption therefore increases as well. Furthermore, the fund supports democratic institutions in the nations it assists. Ironically, it undermines the democratic process by imposing policies. Officially, of course, the IMF doesn't "impose" anything. It "negotiates" the conditions for receiving aid. But all the power in the negotiations is on one side-the IMF's-and the fund rarely allows sufficient time for broad consensus-building or even widespread consultations with either parliaments or civil society. Sometimes the IMF dispenses with the pretense of openness altogether and negotiates secret covenants. This was stated by Joseph Stiglitz who was a former chief economist at the IMF, but later resigned under pressure from criticisms he made of the IMF and World Bank.

The IMF has also been known for lending money to countries that face very tough economic times. The 'bailouts' as they are known, undermine one of the fundamentals of a free economy by overriding market mechanisms. They are expensive, bureaucratic and cut investors' losses rather than allow them to bear full responsibility for their bad decisions, leaving the obligation to repay the subsequent debt to that country's taxpayers.  They say bailouts also hinder free-market reforms. The bailouts often end up enriching the few rich in the borrowing countries who tend to use the money to help out their own companies in the name of restructuring the economy hence ends up not reaching the poor. On contrary, the poor face the high taxes imposed needed to pay off the money lent.

The IMF structural policies have also made it difficult for countries in its debt to avoid ecosystem-damaging projects. Such projects may involve oil, coal, forest destroying lumber and agriculture projects. For instance, Ecuador had to frequently defy the IMFs advice to protect its rain forests. In the end the IMF decided to set up the IMF green fund that was specifically meant to pay for climate harm and protection and any other ecological protection while in pursuit of environmental finance. The World Bank is also known to encourage the development of coal plants and other large emitters of greenhouse gas and operations that are proven to pollute or damage the environment. For instance, protesters in South Africa and abroad have criticized the 2010 decision of the World Bank's approval for a $3.75 billion loan to build the world's 4th largest coal-fired power plant in South Africa. The plant will greatly increase the demand for coal mining and corresponding harmful environmental effects of coal.

Countries that constantly borrow from the IMF have been frequently advised to devalue their currency and increase the tax rate so as to reduce their balance of payments deficits. Devaluation will make export cheaper while make imports relatively expensive hence increase foreign currency inflow and decrease outflow. However, currency devaluation is inflationary as residents in a country need more of their local currency to purchase goods and services. This reduces the economic posterity of such economies. The developing countries which receive the funds from these institutions are characterized by a very large gap between the rich and the poor. The majority in these countries are the poor who live on less than a dollar a day. An increase in the tax rate will therefore adversely affect them as they already cannot afford basic necessities. These two policies greatly decreases the standards of living of the country a s a whole.

   The IMF in 1999 replaced Structural Adjustments with Poverty Reduction Growth Facility (PRGP) and Policy Framework Papers with Poverty Reduction Strategy Papers (PSRP) as the new preconditions for loan and debt relief. However, the effect is still the same as the preceding disastrous structural adjustment policies, as the World Development Movement reported. Many civil society organizations are increasing their critique of the PSRPs. The PRSP process is simply delivering repackaged structural adjustment programmes (SAPs). It is not delivering poverty-focused development plans and it has failed to involve civil society and parliamentarians in economic policy discussions.

  According to sociologist Michael Goldman, industry analysts predict that private water will soon be a capitalized market as precious, and as war-provoking, as oil. Goldman says "These days, an indebted country cannot borrow capital from the World Bank or IMF without a domestic water privatization policy as a precondition". The Bank is utilizing "the 'Washington Consensus' model of "development" to promote water privatization. Following this model, the World Bank is forcing many countries to commodify their water resources, rather than using their expertise in the public sector to acknowledge water as a universal human right and an essential public service. The push for water privatization development plays upon "the shocking tragedy that much of the world lacks affordable clean water". This image creates new opportunities in development, though it may have little to do with ultimately quenching the needs of impoverished countries. The problem of water scarcity for the world's poor has been analyzed by the World Bank as one in which the public sector has failed to deliver, and has therefore prevented development from "taking off", and the economy from modernizing. If the state cannot deliver something as basic as water and sanitation, the argument goes; it is a strong indication of a general failure of public-sector capacity. However, with the sale or lease of a public good comes more than simply a privatized service; alongside it comes a wide set of postcolonial institutional forces that intervene in state-citizen relations and North-South dynamics. One notable example is the privatization of water forced upon Bolivians by the World Bank which led to multiple protests including the 2000 Cochabamba protests.

The World Bank's credibility has also hit a new low as it has been exposed for continuing to support projects that violate its own codes and stated goals, and has so visibly failed to be reformed, despite the best efforts of its energetic President. At this key juncture, instead of genuinely addressing the problems they face, the people who run these institutions and their political allies, the vast majority of whom are from wealthy industrialized countries, have resorted to promising cosmetic changes and employing a form of emotional blackmail designed to preserve the status quo.

If the goals of the World Bank, IMF and WTO were to alleviate poverty even according to their own narrow, monetary-based definition of the term their policies have failed to do so. The world has more poor people than ever: 1.3 billion people over a fifth of the world's population, now live on less than $1 a day and a further 1.6 billion, another quarter of the world's population, survive on between one and two dollars.

Moreover, the plight of the citizens of many poor countries has become worse under the policies of economic globalization prescribed by the World Bank, IMF. More than 80 countries now have per capita incomes lower than they were a decade or more ago, and as the United Nations Development Programme (UNDP) points out, it is often the countries that are becoming even more marginal which are highly 'integrated' into the global economy. While exports from Sub-Saharan Africa, for example, have reached nearly 30 per cent of GDP (compared to just 19 per cent for the leading industrialized countries of the OECD), the number of people living in poverty there has continued to grow.

Other indicators of poverty have also worsened under economic globalization. According to the UNDP, financial volatility, job and income insecurity, crime, threats to health, food insecurity, loss of cultural diversity, community disintegration and environmental degradation have all increased. The greatest losers from all these trends are the poor.

Though the IMF and World Bank have started discussions on reforms, the proposed reforms are a source of concern due to several reasons. Firstly it threatens to replace inappropriate IMF conditions with inappropriate conditions dictated by the G7 countries. It also fails to address the real policy issues at the heart of the IMF's failure as a poverty reduction agency. It does not address the politicization of IMF loans, especially with regard to the US Treasury's influence. It does not adequately consider the "democratic deficit" which prevents poor countries from having an effective voice in the IMF.


Overall, IMF's and World Bank's success rate are perceived as limited. Since 1980, most of their members have registered decline in the GDP growth rate by 4% or more. This is mostly due to the considerable delay to correct any crisis. A second reason for this is that they only tend to correct the problem at hand without thinking of how their actions will affect other areas of the economy. Lastly, the IMF takes measures only when a problem arises rather than try to help the country to prevent it in the first place.

For these two institutions to be effective, they must undertake reforms that include changes in their governance to include the developing countries in the decision making process. This will help make decisions in line with the country's needs and capability. In 2010, the G24 ministers pointed out that shifts in voting power in the IMF should not come at the expense of the developing countries. They concluded that a third chair representing sub-saharan Africa should be added to create stronger representation in the Finance committee. At the same time,  it called for an increase by 3%  in voting power for developing and transition countries in the World Bank. Secondly, the IMF have started emphasizing on protection of social and other priority spending, in line with the borrowing country's priorities as set out in their  poverty reduction strategies.

Another reform is to set up policies that increase efficiency of their core mandates which is helping member countries to adopt policies which will enable them reduce poverty and sustain economic growth. The IMF and World Bank are slowly overhauling their lending framework to include less stringent conditions to the borrowing countries. This will greatly improve the welfare and the standards of living of the residents of the country. This is because the problem with the aid was not the funding itself but the conditions given for the aid to be granted. Therefore, if the conditions are removed or made less stringent, the funding will go a long way in helping the country maintain a balance of payments and at the same time achieve economic growth and maintain price stability. Policies such as reciprocity, if removed, would enable the borrowing country conserve its foreign exchange by not having to import capital goods from industrialized countries.

They can also decide to incorporate Non-governmental Organizations in their plans. This is because, NGOs have a comparative advantage over governments in a number of areas such as local accountability, expertise, independent assessment of issues, provision and dissemination of information and lastly awareness-raising. They are effective in showing that poverty can be tackled by involving project beneficiaries in planning and implementation of projects.

In conclusion, the IMF and World Bank need to undertake major reforms that will increase effectiveness of their core mandates if they are to succeed in their endeavors. They have to stop thinking politically and think for the betterment of the poor who have led them to be there. The institutions should work hand in hand with the governments of the borrowing countries so as to ensure that the fund s are used in the right way and for the right purpose.