Government

INTERNATIONAL DEVELOPMENT
Foreign aid an impetus for private investment, economist says

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

3/1/2001

CHAMPAIGN, Ill. -- Does old-fashioned foreign aid still have a place in today’s rapidly globalizing marketplace?

With private capital flowing to developing countries at a record pace, from $43 billion in 1990 to nearly $240 billion in 1999, some policy-makers in Washington and other western capitals have called for a reduction in foreign aid and development loans from the World Bank.

"Others taking a more radical stand have called for the abolition of the World Bank and regional development banks, arguing that ‘the market’ will direct capital flows appropriately," UI economist Anne P. Villamil writes.

But in a study of foreign investment and foreign aid, Villamil has found that public aid helps rather than hinders private investment in developing countries. In particular, technical assistance to a developing nation lessens the chance that the nation will default on its private debts.

Foreign aid also offers positive incentives for a nation to stabilize its institutions. Lack of institutional stability (due to corruption, civil war or authoritarian rule) is a leading cause of
third-world defaults as well as poor economic growth.

The less stable a country, the greater incentive its government has to "expropriate" foreign companies and renege on its debt payments. Public aid from western nations "can increase the welfare of both the recipient and the donor country," Villamil noted in a paper co-writtten by Elizabeth Asiedu, an economist at the University of Kansas.

Foreign aid serves as "an enforcement mechanism" in the absence of any global organization that can rule on private contracts across borders.

"Foreign aid is not motivated by altruism in our
model -- the rich country provides aid only if doing so increases its utility. If an altruistic motive to alleviate poverty is also present, this will result in an increase in aid and thereby further enhance the poor country’s welfare," the UI economist wrote.

Technical assistance and loans from multinational groups such as the World Bank tend to be more beneficial to third-world countries than aid coming from a single nation, according to Villamil. The most effective aid packages take into consideration "country-specific" characteristics as opposed to a "one-size-fits-all" policy.

Imposing trade sanctions on a debtor country is counterproductive because foreign capitalists have no chance to recoup their investment. "Given the limitations of direct punishments, the alternative solution is to reward borrowers for good behavior, of which foreign capital and foreign aid can play an important part," she concluded.

The title of her working paper is "Imperfect Enforcement, Foreign Investment and Foreign Aid."