How to Break the Impasse in Development Aid

In the war on terrorism, President George W. Bush prefers alliances but is willing to act alone. Fighting terrorism and fighting poverty go hand in hand, which is why Mr Bush, and secretaries Paul O'Neill and Colin Powell, are attending the Monterrey conference on development aid this week.

The US will face a hostile reception there from its European allies, who oppose Mr Bush's common-sense proposals for reforming the World Bank. The president should use the opportunity to express his willingness to act alone when it comes to fighting poverty, too.

A recent public flap between European officials and Mr O'Neill highlighted sharp differences. The Europeans appear bent on opposing Mr Bush's core initiative: relying more on grants rather than loans in areas where grants would be more effective.

The compelling logic behind the proposal was spelt out by Mr O'Neill. Grants work better when assistance does not lead to immediate pecuniary gains that pay debt service costs. In areas such as primary education, sanitation and healthcare there is only an indirect and delayed connection between aid and increased income that could service new debt. Many poor countries simply cannot afford new debts, even at concessional interest rates.

Mr O'Neill rightly argues that lending money to insolvent governments while simultaneously forgiving their debts (under the current HIPC programme) is nonsense. Even in the case of International Development Agency loans from the World Bank (where only 10 per cent of the present value lent is ever repaid, given the 40-year maturity and low interest rates on those loans), it is undesirable to saddle future governments with unpayable debt service. And there are other benefits from using grants. As the Meltzer commission stressed, grants can be better targeted and controlled, thus avoiding waste. Money lent to governments is fungible, and can be redirected to unintended uses. Grant aid paid direct to service providers upon completion of projects is more likely to achieve the desired results.

The Bush administration is offering to increase the amount of funding for aid to poor countries through the World Bank's IDA programme by 30 per cent over four years if agreement can be reached to increase the proportion of grant aid from its current 2 per cent to 50 per cent--and if the IDA proves itself capable of implementing the new grant approach. The 50 per cent target reflects the proportion of programmes in sanitation, education, healthcare and other areas in which grants would clearly work better than loans. The European response, typified by Hilde Johnson, Norway's finance minister, has been stunningly obtuse. The Europeans insist that IDA grants should not exceed 10 per cent of aid. Why? First, European opponents claim that grant programmes make sense only if aid is substantially increased--and the US, which, being a democracy, must rely on Congress to approve future aid, cannot guarantee that aid will increase and remain high in the distant future.

Second, they argue that grants are the purview of the United Nations and it would be wrong for the World Bank or other development banks to encroach on UN turf. The first objection is based on an arithmetic fallacy in measuring aid flows. The European position seems to be that aid is measured by the annual flow of dollars (whether grants or loans) to poor countries. By this measure, since loans are returned and lent again, grants provide less aid than loans. But aid is properly measured by the value of resources transferred to poor countries, whether in the form of outright grants or implied loan subsidies. Dollar for dollar, loans transfer less of a subsidy than grants because subsidies are only a fraction of the amount of the loans. Reallocating money from loans to grants has no effect on the present value of the amount of resources transferred by aid providers to poor countries. Indeed, as Adam Lerrick has shown, grants result in greater overall assistance, since concessional loans absorb some of the sovereign debt capacity of recipients.

Clearly, no matter what amount the US commits to aid now or in the future, grants are a better mechanism than loans for most purposes and channelling assistance through grants does not reduce the amount of assistance that is transferred. Furthermore, if grants are more effective, members of Congress will be more likely to increase the amount of aid.

The desire to preserve UN turf at the expense of improving the effectiveness of aid elicited Mr O'Neill's fury recently, when he accused opponents of caring more about bureaucracies than helping people. If the Europeans persist in this nonsense, the US may simply go it alone. We do not need to rely on global institutions as vehicles for providing aid. The US could channel more aid bilaterally, or through grant funding for regional development banks, where European obstructionism is less of a problem.

It is also worth considering mechanisms for reforming the World Bank that could permit the US and Europe to continue to finance it without having to agree on the appropriate mechanism for aid. George Soros (who spends $500m a year on aid to poor countries) has a new proposal for channelling aid, elements of which could overcome the impasse between the US and Europe.

In spite of some flaws in the Soros plan (notably the reliance on IMF money creation as the financing tool), the basic idea is brilliant. Countries would pool resources in a fund but channel aid to the projects they liked best. The US could focus resources on grants, while Europe could continue to support existing programmes. Competition would bolster performance and accountability. And it would put an end to the squabbling that has prevented urgently needed reform and growth in development aid.

Charles W. Calomiris is the Arthur F. Burns Scholar in Economics at AEI.

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