Economic crisis and foreign aid

Repost from WIDER Newletter 

How Aid Supplies from Donor Countries Respond to Economic Crisis

Joanna Gravier-Rymaszewska

The strong interdependent relationship between the developed and developing countries made itself visible again with the recent economic downturn. Due to the now truly global character of the economy, the crisis did not only affect the North, where the first signs of crisis were seen in 2007, but also the South through decreasing trade volumes and investments. Concurrently, Official Development Assistance (ODA) is subject to a pro-cyclical trend. That is, it falls when the donors encounter an economic recession. In the presence of crisis, developing countries rely crucially on aid for their expenditures, while developed countries reduce aid volumes.

The interconnected crises of climate change and food provision also continue. The resulting self-amplifying triple crisis (finance, climate and food) confronts and overwhelms the South with economic hardship, rising food prices and more frequent climatic events like droughts and floods. The South increasingly relies on aid, and ODA remains the main channel for donor countries to assist development in the South. For the donors, the financial aspect of the triple crisis is crucial for their decisions on aid budgets. Aid is often one of the first items to be cut during fiscal restraint in donor countries.

It is important to understand how the crisis affects aid flows, and determine how financial, political and social forces within donor countries influence budgetary decisions on development aid.

The recent UNU-WIDER working paper ‘How Aid Supply Responds to Economic Crises: A Panel VAR Approach’ explores the channels and behavioural consequences of unexpected financial shocks on aid budgets. A simple theoretical consumption model is proposed to capture donor decisions on aid disbursements versus other variables: domestic social needs, financial conditions and political preferences. The evolution and magnitude of the response of aid flows to shocks applied to various macroeconomic variables including GDP, fiscal balance, unemployment, financial volatility, trade, etc can be observed due the dynamic approach taken. The study aims at determining whether the dynamics of aid vary for crises of differing severity, or before and after the crises, and if the relationship is purely economic or is also directly influenced by politics.

It is found that crises affect development aid budgets and their trend. This influence takes place through two channels: directly via lower revenues, and indirectly; by increasing fiscal costs, through exchange rates and financial volatility.

In aggregate, at the general level, there is a positive and significant relationship between ODA and GDP. That is, the higher the GDP of a donor country, the higher their development aid contribution. Prolonged recessions and banking crises have a lasting and negative effect on the behaviour of donors and aid supply. This relationship between aid and the donor economy is not of a purely economic nature, as the donor’s internal politics play an important role. The paper shows that models solely using donors’ economic and international strategic interests as determinants of their aid policy may not be complete. Donor countries’ own financial conditions as well as political determinants, such as the ideological inclination of donor governments, play an important role in the allocation of aid budgets. Furthermore, it seems to be that social conditions, for example unemployment and inflation rates, in the donor countries do not have an effect on the size of aid budgets. It seems that the types of parties in government drive decisions on development aid rather than any particular consideration of the social needs of the donor country’s population. Specifically, right-wing and center governments cut aid in response to  economic distress, while left-wing governments tend not to. Center parties are more driven by economic conditions than left- and right-wing governments, which tend to take aid budget decisions in accordance with their ideologies.

Financial factors also matter for aid. Stock market volatility increases aid uncertainty, while exchange rate movements due to crisis and the resulting appreciation of the dollar against other currencies depress the value of aid. Thus, exchange rate movements have a strong explanatory power on the variation in aid. However, increasing inflation in donor countries does not lead to contraction in aid budgets.

The results of the paper deepen the concerns about falling development aid. Contracting aid budgets in the North add to the spillover effects of the financial crisis onto the developing countries.

Joanna Gravier-Rymaszewska is Doctorate Researcher at Nanyang Technological University, Division of Economics in Singapore.

This working paper was prepared during a PhD research internship at UNU-WIDER and within the UNU-WIDER project
‘ReCom - Research and Communication on Foreign Aid’.

WIDERAngle newsletter
March 2012
ISSN 1238-9544