The Development Assistance Committee (DAC) of the OECD, a forum for the major bilateral aid donors, released, at the end of March, the 2008 figures of official development assistance. It announced it at $119.8 billion, the highest level ever recorded.

These numbers allow for some optimism about donors meeting their past aid pledges, but they refer to a different economic cycle, to a world where the financial crisis had barely started to gain momentum. The strain that the crisis is imposing on donor countries may well lead them to cut their aid effort, at the expense of developing countries. The whole aid community is now more concerned about the possible consequences of the crisis on aid, rather than commending itself for the high aid levels of 2008. But what consequences shall be expected?

Developing countries and the financial crisis

Developing countries are expected to be severely hit by the 2008 financial crisis. Capital flows and remittances to these economies are declining, while their own resources do not allow them to adopt the fiscal packages rich countries are putting in place. The crisis will also have consequences for debt sustainability as exports fall and fiscal deficits rise. Many developing countries would heavily suffer from the additional burden of aid cuts, when their sources of incomes are drying up because of the global growth slowdown.

To meet these dire financial needs, calls have been issued to increase development aid immediately. Birdsall (2009) estimates $1 trillion must be unlocked to help developing countries cope with the crisis. Kharas (2009) urges developed countries to accelerate disbursements of provisioned funds blocked by procedural requirements. The world's poorest countries do not have access to any lender of last resort and aid donors could play this role. Such calls are made forcefully especially because donors may not act accordingly. More worryingly, donors are actually expected to decrease their aid budgets. Despite the last encouraging figures, the DAC also warned that donor countries had to refrain from reducing aid budgets. Earlier on, the OECD's Secretary General and the Chair of the DAC sent in October 2008 a letter to heads of states to avert cuts in aid budgets. Aid budgets reduction would be especially unwelcome at a time where actually more aid, it is argued, is needed.

A first look at the data

David Roodman (2009) initiated a debate by arguing that aid budgets will drop because of the financial crisis. To illustrate his point, he looked at aid disbursements by Finland, hit by a severe banking crisis in the early 1990's. Those have dramatically fallen during the crisis and it took many years before they reached again their pre-crisis level. He observes the same patterns with Norway, Sweden, and Japan, which all experienced a financial crisis. On the other hand, these examples may be misleading. First, it may be that the crisis did not trigger the fall; during the same years many donors cut their aid budgets, even though they did not experience any financial turmoil. The "aid fatigue" of the 1990's is well-known and is usually explained by donors starting to be sceptical about aid efficiency, but also by the end of the Cold War. Looking at the past evolution of aid and GDP, Mold et al. (2009) offer a more contrasted view, arguing that aid seems quite resilient to recessions and is not correlated with GDP growth.

A closer look at the past

My research (Frot 2009) suggests that if donor countries behave as they did in the past, then the financial crisis will decrease aid budgets by sizable quantities. To derive this result it uses two different approaches. The first one is based on Roodman's argument, but establishes it on firmer grounds. It starts from the same observation that donors that experienced a crisis in the past significantly reduced their aid budgets in the years following the crisis. This is shown on the next figure, where six crises are exploited (US in 1988, Japan in 1990, Finland, Norway and Sweden in 1991, and South Korea in 1997). The vertical red lines indicate when the crisis broke out. The year it did is normalised to zero.

Source: Frot (2009)

But, as argued above, this does not constitute solid evidence. After all, all the donors may have decreased their aid disbursements during the very same years. This would invalidate the causality between the occurrence of the crisis and the aid cuts. In order to check this alternative explanation, I compare the evolution of aid in crisis-hit countries and in crisis-free countries. If the general trend is the same in all the countries, then financial crises in themselves do not affect aid budgets.

I find the opposite, such that crises have important consequences on aid. They decrease aid budgets by 13% on average. In a different estimation, I uncover that crises do not merely decrease aid, but that they change its evolution. In other words, donors tend to slow down, and sometimes reverse, the pre-crisis paths of aid budget expansion. These results are found holding GDP constant, such that they refer to a "pure" effect of the crisis, and not to a simple income effect whereby donors have less resources to spend on aid.

The second approach uses long-term data and relates variations in broad macroeconomic variables (GDP, unemployment, budget deficit) to aid budget variations. A higher GDP is equivalent to having more resources to spend on aid. However for a given GDP level, a larger budget deficit, and so a high debt servicing, may reduce the fiscal room the government has. Finally, a high level of unemployment usually indicates strong internal needs for government spending that may call for reduced aid. These three variables are expected to be, and have already been, strongly affected by the current crisis. I make use of vector autoregressions, a technique that allows the estimation of the consequences on aid budgets of a shock in any of the three macroeconomic variables. It answers the following question; if GDP growth turns out this year to be smaller than expected, how large will be the fall in aid budgets in the next few years? This is precisely the kind of question the crisis raises. I find that a negative shock in GDP growth significantly reduces aid budgets. Estimates differ across donors, but in many cases a 1% negative growth shock implies an 8% reduction in aid budgets five years after the shock. Not only is this estimate large, but it also shows that crises have long-term effects. Using data aggregated across all donors, I estimate that such a growth shock would decrease aid by some $7 billion.

Conclusion

Shall we expect aid to fall? The past suggests we should. The question then becomes whether donor countries will act as they used to. Given the scale of the current crisis, international institutions and donor countries have already taken actions, or at least made pledges, to tackle its consequences for developing countries. The World Bank has decided to increase its financial support up to $100 billion over the next three years, specifically to help developing countries cope with falling revenue. In December 2008, it unblocked $2 billion for the poorest countries. At the UN Conference on Financing for Development in Doha in November 2008, bilateral donor countries underlined the need to comply with their aid commitments, even amid the current economic slowdown. Whether these promises turn effectively into action remains to be seen. If they do not, then this research provides some indication about what should be expected from aid donors in the following years.

References

Birdsall, N. (2009). How to Unlock the $1 Trillion That Developing Countries Urgently Need to Cope with the Crisis. CGD notes, Center for Global Development.
Frot, E. (2009). Aid and the Financial Crisis: Shall we expect Development Aid to Fall?, working paper.
Kharas, H. J. (2009). The Financial Crisis, a Development Emergency, and the Need for Aid. Mimeo, Wolfensohn Center for Development, The Brookings Institution.
Mold, A., S. Paulo, and A. Prizzon (2009). Taking stock of the credit crunch: implications for development finance and global governance. Working Paper No.277, OECD Development Centre.
Roodman, D. (2008). History Says Financial Crisis Will Suppress Aid. Global Development: Views from the Center.