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Foreign Aid Is Far Less Effective In The Tropics

While foreign aid generally has been successful in spurring growth it has, on average, been far less effective in the geographical tropics, regardless of implemented policies. That is the conclusion of new research by Carl-Johan Dalgaard, Henrik Hansen and Finn Tarp, published in the June 2004 Economic Journal.

What this means is that allocations of aid based on rewarding countries with better policies and institutions will unavoidably lead to lower foreign aid inflows in poor, climatically challenged countries. From this perspective, the researchers argue, the policy-based allocation rule pursued by leading donor agencies may itself be a poor policy.

The United Nations General Assembly adopted the Millennium Development Goals (MDGs) in 2000. These are ambitious goals. At the UN Meeting on Financing for Development in Monterrey in 2002, the then World Bank Chief Economist Nicholas Stern therefore argued that the challenge is to scale up foreign aid donations. He outlined a framework for how to allocate aid well and suggested the key guideline should be to reward countries with better policies and institutions.

The World Bank recommendations follow a series of research studies, including contributions by Craig Burnside, David Dollar and Paul Collier. This work, which suggests that aid only works in countries with good policies and institutions, has gained significant influence in the international donor community. In fact, some important donor agencies are increasingly allocating aid on the basis of policy performance. Dalgaard et al argue that yes aid can work, even in a bad environment, but it is the geographical realities of the country rather than whether it follows good policies that determines its effectiveness. Hence, and this is critical, a reward/penalty-based aid allocation system based on countries'' policy records is both unfair and inefficient.

Dalgaard et al also argue that the the World Bank''s Country Policy and Institutional Assessment Index (which evaluates a country''s policy and institutional framework in 20 dimensions) correlates with the proportion of land in the tropics and it is this, rather than good policies, which acts as the catalyst for aid effectiveness. At the heart of their paper is a much more rigorous theoretical framework for analysing aid''s effectiveness than has traditionally been the case. This emphasises that strong fundamental structural characteristics, such as institutions and climate-related circumstances, may compensate for a bad policy environment.

This then raises the question as to what extent institutions are determined by accidents of history, geographical factors or respond to current realities including efforts to reform or change them.

On the Empirics of Foreign Aid and Growth'' by Carl-Johan Dalgaard, Henrik Hansen and Finn Tarp is published in the June 2004 issue of the Economic Journal. The authors are at the University of Copenhagen.