USING AID INSTRUMENTS MORE COHERENTLY

Transcription

1 20 Collier qxp 8/17/05 1:55 PM Page 429 USING AID INSTRUMENTS MORE COHERENTLY GRANTS AND LOANS PAUL COLLIER Public resource transfers from richer industrial countries to poorer developing countries are a standard means of fostering development. These transfers, usually grants or loans, are administered by a variety of multilateral and bilateral agencies. For many years there has been concern that the efficiency of the resource transfers is being compromised by the multiplicity of agencies and insufficient coordination among them. Much less attention has been paid to the multiplicity of instruments, largely because until recently the instruments were precisely partitioned by agency, at least among the multilateral agencies. The European Union and the United Nations system provided primarily grants, and the World Bank and the International Monetary Fund (IMF) provided mainly loans. The issue of the appropriateness of each instrument was therefore subsumed under more general issues of agency rivalries and coordination. In 2001, prompted by a U.S. initiative, the World Bank added a grant element alongside its concessional lending. The circumstances in which grants were introduced disagreement at a senior political level between the United States and the United Kingdom initially precluded sensible discussion of the criteria for using grants. Any suggestions about when grants would be particularly appropriate were treated in certain quarters as an argument for grants, while any suggestions about when loans would be particularly appropriate were treated in other quarters as an argument against grants. With the key personalities on both sides of the argument now no longer in public office, it is both feasible and urgent to address the issue lest the passage of time appear to legitimize current practice among both donors and beneficiaries. Resources for development are so scarce that it is imperative that they be used as well as possible. The current pattern of using grants and loans has little economic rationale. Injecting economic analysis into the discussion of instrument choice should considerably increase development effectiveness. The author would like to thank David Dollar and Anke Hoeffler for help with the data analysis, and Steve Radelet for comments on earlier drafts. 429

2 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE The key message here is that the characteristics for assessing whether a recipient is better suited to grants or to loans should determine the composition of resource transfers but not the overall volume of transfers. This proposition has powerful implications for the balance between grants and loans. A country with a high absorptive capacity for aid, but with low creditworthiness such as many post-conflict countries would receive large resource transfers in the form of grants. To avoid moral hazard, however, reforming governments with successful economies (and increasing creditworthiness) should not appear to be penalized by getting their aid as loans instead of grants. One way to avoid this is to make the grants and loans peak at the same time. Thus as a country progresses and the share of loans rises relative to that of grants, loans would not be substituted for grants, but both would rise and then fall together. Before starting the analysis, this chapter provides a basic classification of the stages of development that a typical aid-recipient country goes through. It then considers the concept of poverty-efficient transfers for determining the overall size of the resource transfer and the appropriate allocation of grants and loans that a country can productively absorb at each stage of development. The emerging ideal-type pattern of combining grants and loans then serves as a frame of reference for evaluating the actual composition of grants and loans. The analysis reveals much scope for reforming the deployment of these aid instruments. Some policy options for enhancing coherence and for better combining grants and loans are also discussed. BASIC PRINCIPLES OF AID ABSORPTION A useful approach to aid allocation is to imagine a country s gradual transition from severe poverty and a dysfunctional state to middle-income status and a relatively well functioning state. Although still evolving, the Country Policy and Institutional Assessment (CPIA) of the World Bank is one way to make these stages more concrete. 1 The CPIA suggests country rankings according to some 20 indicators of policy and institutional performance, with rankings from 1, low, to 4, high. Combining these rankings with levels of per capita income creates a sevenstage classification of the development process (table 1). At stage 1 a country has not only very low income but also extremely weak policies, governance, and institutions. It then begins a gradual process of reform, moving from stage 1 through stage 4 (shaded area of table 1). This is the first development phase, marked mainly by improvements in institutional and governance capacity and performance. To simplify the analysis, changes in per capita income during this initial reform phase are assumed to be sufficiently small to be ignored for purposes of aid allocation. This is roughly the sort of reform that Uganda went through from the end of the 1970s, when the country was in turmoil in the last stages of the Amin regime, and the end of

3 20 Collier qxp 8/17/05 1:55 PM Page 431 USING AID INSTRUMENTS MORE COHERENTLY 431 TABLE 1 Seven stylized stages of development Country Policy and Stage Institutional Assessment Per capita income ($ PPP) , , ,000 Note: PPP is purchasing power parity. the 1990s, under the very different style of government of President Yoweri Museveni. The second phase, stages 5 through 7, is one of growth following the reforms of phase one, which are assumed to continue. During this phase the country passes progressively from a per capita income of $500, right at the bottom of the range for developing countries, rising through $1,000, $2,000, and finally attaining $3,000, the threshold of middle-income status. How much aid in the form of grants and loans can a country productively absorb at each of these stages? Answering this requires first understanding how to determine the overall size of the resource transfer that is appropriate at each development stage. One criterion for determining how much of the available aid is to flow to a particular country is the poverty efficiency of such a transfer the number of people who would be permanently lifted out of poverty as a result of the development financed by the transfer. A poverty-efficient allocation of aid would distribute aid between countries in a way that maximizes the reduction in poverty, with the marginal dollar of aid being equally effective in each aid-receiving country. Collier and Dollar (2001, 2002) have developed a simple empirical analysis of absorptive capacity that derives such a poverty-efficient allocation. 2 The analysis finds that aid is on average quite effective in reducing poverty, even at the margin. Additional aid would further reduce poverty. However, the effectiveness of aid could be considerably increased if it were better allocated across countries. The single biggest mistake in aid allocation from the perspective of poverty reduction is that too much is allocated to middle-income countries relative to low-income countries. Among low-income countries there is also a tendency for too little aid to go to countries with reasonable policies, governance, and institutions.

4 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE Building on the Collier and Dollar (2001, 2002) analysis, figure 1 shows roughly how aid would be allocated across the seven development stages if it were to be poverty efficient, as defined above. The resulting pattern is unsurprising in its general shape. In the first phase of development, such as in Somalia, where needs are great but the capacity to absorb aid effectively is extremely limited, the margin at which further aid is ineffective is reached quickly. With income held constant at this very low level but with policy, governance, and institutions improving, the need remains the same but the scope for aid to meet these needs increases and so aid should increase. In the second phase, as income rises, aid per capita should start to decline. Aid may still be highly effective in the growth process, but less poverty reduction accompanies that growth because there are fewer poor people in the country. Aid should be lower for a country at stage 7 than for a country at stage 2. WHY BOTH GRANTS AND LOANS? Before looking at how best to combine grants and loans, it is important to consider why any public resource transfers to developing countries are made in the form of loans. After all, in recent years there have been two rounds of debt forgiveness for low-income countries the Heavily Indebted Poor Countries (HIPC) Debt Initiatives and resource transfers in the form of loans are becoming increasingly problematic. Since each round of debt forgiveness undermines the credibility of sovereign credit, debt forgiveness inadvertently generates a global public bad. Would anything be lost if the current flow of resource transfers through loans were stopped and replaced by grants? FIGURE 1 Poverty-efficient allocation of aid Aid per capita (US dollars) 10 8 Total aid Stages of development based on income and policy 7 Development phase 1 Development phase 2 Source: Based on Collier and Dollar (2001, 2002); also see appendix.

5 20 Collier qxp 8/17/05 1:55 PM Page 433 USING AID INSTRUMENTS MORE COHERENTLY 433 Rationale for loans over grants The arguments in favor of loans fall into three broad categories. Economic convergence. Conditional on policies, lower income countries tend to grow more rapidly than do richer countries they tend to converge on them. Looking to some distant future when once-poor countries have converged on rich countries, there is then nothing unreasonable in expecting these countries to repay resources that have assisted their catch-up growth. What converging countries need is not permanent charity but a temporary resource transfer. Donor country electorates may be willing to provide more funds on such a basis than they would be prepared to hand over as grants. However, convergence is far from certain. In 1960 Kenya and the Republic of Korea had the same level of income. Korea is now a member of the Organisation for Economic Co-operation and Development (OECD) whereas Kenya is still a low-income country. This could probably not have been anticipated in 1960, but clearly Korea is in a position to repay the public resource transfers it received when it was a low-income country, although Kenya is not. Convergence provides some rationale for loans that are repayable conditional on performance in the growth of income. The main multilateral loan instrument, that of the International Development Association (IDA), indirectly has this feature. The rules governing repayments of IDA loans IDA reflows require that all repayments be returned to the IDA pot for further lending. IDA eligibility is defined by the level of per capita income only low-income countries are eligible to borrow. In this sense, although not in the strict legal sense, IDA is a common pool resource of low-income countries and so is in effect collectively owned by them. Since IDA-eligible countries are the only ones to benefit from IDA repayments, IDA funds are like a rotating savings and credit association among poor households. Such an arrangement has one obvious disadvantage compared with the same pool of resources being distributed as grants: the ambiguous ownership of an undetermined share of the IDA common pool does not constitute a creditworthy asset, and so a debt is generated a legally clear structure of liabilities with no offsetting structure of entitlements. There is an offset to this disadvantage, however. Since IDA membership is determined by the criterion of income, when a country grows out of poverty it ceases to be IDA-eligible. An important recent example of such an evolution is China. China is thus now in the position of repaying IDA loans but not being able to reborrow from IDA. This structure in effect provides a resource flow from middle-income countries to low-income countries, which would not be the case were IDA transfers all grants. In the future this arrangement is liable to have desirable properties as many more substantial IDA borrowers, such as India, succeed in growing their way out of IDA eligibility, leaving the pool of IDA resources concentrated on a diminish-

6 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE ing group of countries at the bottom of the economic ladder. On present growth patterns IDA will gradually become concentrated on Sub-Saharan Africa. The conversion of IDA loans to grants, unless accompanied by offsetting changes, would therefore amount to a transfer from a future low-income Africa to a future middle-income Asia: a poor Africa would be forgiving a richer Asia its debts. One obvious offsetting change would be an increase in overall aid flows from donor countries to compensate for the loss of IDA reflows. In effect, by undertaking to compensate in this way, donor countries would be avoiding the global public bad of further sovereign defaults. Transition to capital markets. A much stronger rationale for loans over grants is that loans expand the size of resource transfers by enabling developing countries to tap into global credit markets. The loans provided by the World Bank Group s International Bank for Reconstruction and Development (IBRD) have such a rationale. IBRD loans are concessional only in the sense that, being ultimately guaranteed by all member governments, they have an AAA credit rating, enabling developing countries to borrow more cheaply than they would be able to do on their own. Other than this guarantee, which has never been exercised, there is no subsidy, so that IBRD loans are concessional but self-financing. They help introduce developing countries to the capital market, whereas grants, if provided for development purposes, tend to signal lack of creditworthiness. Resources during a crisis. A third powerful rationale for loans is that developing countries periodically encounter economic crises brought on by the policy errors of their governments. At such times countries need external resources, but providing the resources as grants might create a moral hazard by rewarding policy errors. But even loans carry a risk of moral hazard. For example, if the repayment period were as generous as for an IDA loan, the government committing the error would not itself be burdened by the repayment, which takes place years in the future. Hence, the terms of such crisis lending need to be much more severe than for IDA loans. The agency that specializes in such crisis lending is the IMF. Its concessional resources are much smaller and less readily supplemented than those of IDA. The advantage is that IMF resources can be provided very rapidly and in situations where a country is in economic difficulty this style of operation is the core business of the IMF. By comparison, the core business of the World Bank has traditionally been project lending. Although the World Bank now also provides nonproject loans, the Bank lacks traditional expertise in lending in crisis situations, which are inherently ill-suited to lending operations. Rationale for combining grants and loans Loans should not be the only instrument for resource transfers. Grants are important precisely because the development process is so uncertain. After more than

7 20 Collier qxp 8/17/05 1:55 PM Page 435 USING AID INSTRUMENTS MORE COHERENTLY years of development efforts some countries are as poor as they were at the outset or even poorer. Some countries may be so badly endowed in the broadest sense of physical and social resources that for the foreseeable future they will not develop. In some high-risk, low-income environments, such as in countries after conflict, substantial lending is inappropriate for both creditor and borrower. The risk level is sufficiently high that default is likely, further damaging rather than restoring the reputation of the borrower. A resource transfer is needed, but not in the form of loans. What, then, would be a desirable balance between grants and loans at each of the seven stages of development? Recall that poverty-efficient aid can be determined in total (grants plus loans) without reference to its composition. This has the powerful implication that if there is some appropriate ceiling to the amount of loans that a country should take on notably because of creditworthiness the residual between that and poverty-efficient aid should be in the form of grants. So what should determine the grant and loan composition of this amount? One possible answer is that it depends on the purpose of the resource transfer. For example, objectives such as basic health care are better suited to grants than to loans if only because donor country electorates are better able to consider such expenditures as meeting basic human needs for which they are willing to pay than as investments. Since the case for aid cannot deviate too far from what electorates are willing to finance through taxation, this argument is compelling. However, the high degree of the fungibility of aid, and the tendency of even basic social expenditures to be inefficient in some countries, suggest that much of the case for grants over loans will rest not with the ostensible use of the aid but rather with the characteristics of the user. The user should be identified at both the country and the agency level, which will usually be the government, but not always. What, then, are the characteristics that make a user more or less suitable for a loan or a grant? The answer is clearest at each end of the spectrum depicted in figure 1. At the lowest of the seven stages very low-income countries with very weak governments aid should be entirely in the form of grants. At this end of the spectrum, where the government is very weak, it may be desirable that aid intended for the delivery of basic services should by-pass the government, instead going directly to nongovernmental organizations (NGOs), local authorities, or churches. This is part of the World Bank s strategy for low-income countries under stress (World Bank 2002). 3 Since official lending can be only to governments, or guaranteed by governments, assistance must be in the form of grants if it is to go directly to such agencies instead. Loans are also not appropriate because these environments are highly risky. And because these are the areas of most manifest need, donor country electorates support for grants is at its strongest. At the other end of the spectrum aid should be entirely in the form of loans. At this end of the spectrum the country should be creditworthy and already tran-

8 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE sitioning into IBRD lending. Because per capita income is relatively high, such countries are the least likely to touch the hearts of donor country electorates on the basis of need, and so grants are difficult to justify. Combining grants and loans coherently: the ideal-type allocation At some level of income and competence higher than that which justifies grants, loans should commence, and at some point before loans cease, grants should cease. Within the range over which both instruments are used, the ratio should presumably change continuously, with the proportion of grants falling steadily. A priori there is one further feature of a desirable system of deployment. In the early range in which loans start to come in, grants should still be increasing in absolute terms, to reduce the incentive problem that could arise if improvements in income were met by a substitution of loans for grants. If grants and loans peaked at the same level of income, there would never be a range over which better policies or income growth led to a substitution of loans for grants, which is the core fear of those concerned with the disincentive effects of allocating grants purposively. Even with a common peak, loans would increase more rapidly than grants once the country entered the range in which it was creditworthy. Similarly, beyond the level of income at which grants and loans jointly peaked, grants would diminish more rapidly than loans until the all-loan point was reached. Such a coherent pattern of grants and loans is illustrated in figure 2. The outer envelope is simply replicated from the poverty-efficient allocation in figure 1, and the hypothetical disaggregation into grants and loans illustrates one possible pattern that is consistent with the criteria previously argued as desirable. FIGURE 2 Ideal-type allocation of grants and loans Aid per capita (US dollars) Grants Loans Stages of development based on income and policy Development phase 1 Development phase 2 Source: Based on Collier and Dollar (2001, 2002); also see appendix.

9 20 Collier qxp 8/17/05 1:55 PM Page 437 USING AID INSTRUMENTS MORE COHERENTLY 437 There is no way for aid to avoid all incentive problems even were it entirely in the form of either grants or loans. At some stage aid has to taper off and then end in response to a rise in income, and this is a disincentive to such an improvement. In reality, though, it is a weak disincentive, since the implicit tax rate on increases in income can be set at very modest levels. However, by making the peak of aid coincident with the peaks for both grants and loans the disincentive effects of the composition of aid the substitution of loans for grants as development proceeds becomes subsidiary to the disincentive effect of reductions in the volume of aid. Since aid should be tapered in during the first phase of development and tapered off during the second, its incentive effects will be favorable during the first phase and unfavorable during the second. This is true whatever the composition of aid between grants and loans. The overall incentive effect of aid is the difference between these two opposing effects. There is some evidence that each of these incentive effects of aid is modest, so that the net effect is likely to be small, with an ambiguous sign (see, for example, Collier and Dollar 2004). As suggested, the incentive effect of changes in the composition of aid can be designed so as not to alter the sign of the incentive effect of changes in the volume of aid. Thus although incentive effects often loom large in popular discussion, the proposed changes in the composition of aid are unlikely to have strong net incentive effects. THE ACTUAL ALLOCATION OF GRANTS AND LOANS How does the actual allocation of grants and loans compare with the allocation proposed in figure 2? At the beginning of this chapter total aid (grants plus loans) was shown to be misallocated when judged by the criterion of poverty efficiency. Here the focus is on the composition of aid, its allocation between grants and loans. There is a large institutional problem that reduces the coherence of the deployment of grants and loans in aid allocation. The two largest multilateral aid institutions are the European Union and the World Bank. The European Union is a political multilateral organization, so its aid program is in part intended to strengthen relations between the European Union and recipients. Perhaps as a result, its allocation of aid has not been very poverty efficient, much of it being allocated to middle-income countries. This is particularly anomalous since EU aid is in the form of grants. By contrast, IDA is about the most poverty efficient of the large aid programs, with resources heavily targeted to low-income countries with reasonable institutional and policy ratings. Yet until very recently IDA has been entirely a lending institution. Given their respective aid instruments, the European Union and the World Bank thus have remarkably ill-fitting strategies. In effect, the European Union is providing grants to middle-income countries while the World Bank is providing

10 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE loans to low-income countries. This is precisely the opposite of what the analysis in this chapter suggests would be a coherent use of aid instruments. And the problem of incoherence in the use of aid instruments is not limited to these two organizations. So it is not surprising to find that actual grant and loan allocations are both quite different from the proposed pattern (figure 3). In the first phase of improving policy, the actual pattern has the same general shape as the ideal-type pattern, with grants and loans both rising and with loans rising more rapidly. However, except in stage 1 the ratio of grants to loans does not differ substantially across stages. In particular, it is surely questionable whether at stage 2, when governance, institutions, and policies are still very poor, it is appropriate for a country to receive as much as a third of its resource inflows as loans. However, the problems of the first phase are dwarfed by the problems of the second. While income increases from $500 per capita to $3,000 per capita, the ratio of grants to loans remains virtually constant. Worse, above $1,000 per capita the proportion of grants is even increasing. So, while the pattern of grants and loans during the policy-improvement phase looks a little worrying, that during the income-growth phase looks wildly inappropriate a gross misallocation. What would be the implications of a move to a more strategic deployment of grants and loans, with grants targeted to the lowest income countries? MOVING TOWARD GREATER COHERENCE The implications of the proposed, more coherent use of grants and loans that are likely to generate the most controversy are not those for poverty reduction but FIGURE 3 Actual allocation of grants and loans, 2001 Aid per capita (US dollars) Loans Grants Stages of development based on income and policy Development phase 1 Development phase 2 Source: OECD 2002.

11 20 Collier qxp 8/17/05 1:55 PM Page 439 USING AID INSTRUMENTS MORE COHERENTLY 439 those for development agencies. Right now all the multilateral agencies are fairly heavily involved in all countries, the only limitation being geographic in the case of the regional development banks. Suppose that grants were concentrated among the lowest income countries, while concessional loans were concentrated among the somewhat higher income countries. One implication is that the multilateral institutions that provide only grants (the European Union and the United Nations Development Programme) would concentrate on the lowest income countries, while those that make only loans (the regional development banks) would concentrate on the higher income countries. The IMF would have a specialized loan-making role, concentrating its resources on low-income countries that had just crossed the threshold from grantonly finance to borrowing. Since its concessional resources are quite limited, it would taper off its funding fairly rapidly once a country was judged suitable for credit from the development agencies. The World Bank, by virtue of its having both grant and loan instruments, would play a key role in getting coherence into the composition of aid. For this to happen, however, the Bank would need to unbundle its virtually fixed-coefficient packaging of grants and loans, so that some countries would get substantial grant-only financing. Finally, there is the issue of whether some agency should be in charge of coordinating donors, so that overall aid and especially its composition between grants and loans broadly conformed to reasonable magnitudes. To an extent, donor coordination occurs without a coordinator. Each agency can see what the others are doing and infer the gaps that represent the highest returns to assistance. What is needed for such coordinatorless coordination to work is that all the agencies broadly share the same normative model of aid allocation and the same information. Historically, this has not worked very well. The obvious coordinator for the grant and loan composition of aid is the IMF, since this is but a small extension of its existing role of assessing debt sustainability. Indeed, when a ceiling on debt sustainability was binding, the IMF might prefer to inform agencies that planned loans should be replaced by grants rather than telling them that the overall magnitude of development assistance needs to be reduced. The IMF would, in effect, attempt to guide donor agencies into collectively fulfilling the sort of aid allocation depicted in figure 2. The spectacular mismatch between the ideal-type pattern of figure 2 and the actual pattern of figure 3 suggests that it is time to give up on coordinatorless coordination. The IMF would be assisted in this role by a change in its practice of accounting for fiscal deficits, which is biased against concessional loans relative to grants. When government expenditure is financed by grants, the amount of the grant is not treated as adding to the fiscal deficit, but when it is financed by a concessional loan, the face value of the loan is treated as adding to the deficit its concessional nature is ignored. By contrast, in calculations of debt sustainability, concessional loans are correctly treated differently from nonconcessional loans. For example, an IDA loan

12 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE adds to the net present value of debt by only about a third of the face value of the loan. Thus the impact on the fiscal deficit appears to be exaggerated by a factor of about three. Since EU aid is in the form of grants, whereas World Bank aid is in the form of loans, a country favored by the European Union will appear to have a much lower fiscal deficit than one favored by the World Bank, even if the impact of the total aid inflow on the net present value of their debt is identical. CONCLUSION Aid is transferred using the instruments of grants and loans in combinations that are difficult to justify. Loans have been made to countries with such low incomes and weak governance that the risk of default was extraordinarily high. If a resource transfer was justified in these situations and sometimes it was it would have more appropriately been in the form of grants. Conversely, grants have been distributed across the spectrum of per capita income, rather than being narrowly focused on high-risk countries in deepest poverty. The main argument of the chapter is that the criterion of creditworthiness, which should clearly be one factor in the allocation of loans, should affect the composition rather than the amount of the total resource transfer. A country with a high absorptive capacity for aid, but with low creditworthiness such as many post-conflict countries should, on this analysis, receive large resource transfers in the form of grants. There has been considerable reluctance to face the issue of the proper assignment of grants and loans, in part because historically some agencies have provided only grants and others only loans. While such institutional specialization may appear to assist proper focusing, in practice the bureaucratic temptation for each major agency to operate in virtually all countries leads to most countries receiving both grants and loans. In part the reluctance to consider a more specialized use for each instrument is also a reaction to fears of moral hazard effects. Reforming governments with successful economies (and increasing creditworthiness) should not appear to be penalized by receiving aid as loans instead of grants. This problem could be overcome by letting the point at which grants peak coincide with the point at which loans peak.as a country progressed and the share of loans relative to that of grants rose, at no point would loans be substituted for grants both would rise and then fall together.

13 20 Collier qxp 8/17/05 1:55 PM Page 441 USING AID INSTRUMENTS MORE COHERENTLY 441 APPENDIX.REGRESSIONS OF POVERTY-EFFICIENT AID, ACTUAL GRANTS, AND ACTUAL LOANS ON INCOME AND POLICY, 2001 Table A.1 reports on regressions of poverty-efficient and actual aid on income and policy. The first two columns report regressions of poverty-efficient aid (per capita) on some basic country characteristics. Poverty-efficient aid is a hypothetical aid flow that would maximize global poverty reduction given the overall amount of global aid available. It is generated by the analysis reported in Collier and Dollar (2002). The second column adds the square of the log of per capita income and is reported for comparability with subsequent regressions. However, since the squared term is insignificant, the regression reported in column 1 is used in figure 1. The third and fourth columns report regressions of actual aid per country on the same characteristics.only the regressions with the addition of the quadratic effect of income are reported since the term is highly significant. The dependent variable is no longer poverty-efficient aid, but actual grants (column 3) or actual loans (column 4). The data relate to 2001 and are for aggregate aid, multilateral and bilateral, from all OECD countries (OECD 2002). Their implied allocation at each of the seven stages of development is depicted in figure 3. Thus, the regression in column 3 is used to infer the typical flow of grants that a country would receive at each of the seven stages, and the regression in column 4 is used to derive the typical flow of loans. TABLE A.1 Regression results Poverty-efficient aid Variable 1 2 Actual grants Actual loans Constant * * * (5.26) (0.32) (2.99) (3.57) Log population * 0.517* (0.05) (0.06) (13.83) (7.98) Log GNI per capita (PPP) 2.817* * 7.310* (9.78) (0.55) (2.56) (3.11) Square of log GNI * 0.515* per capita (PPP) (1.17) (2.88) (3.44) Log CPIA 5.995* 6.510* 1.429** 3.926* (4.81) (4.93) (4.00) (5.92) R *Significant at the 10 percent level. **Significant at the 5 percent level. Note: Numbers in parentheses are t-statistics. All regressions are based on 120 observations. Source: Author s calculation based on Collier and Dollar (2002) and data from OECD (2002) and World Bank, World Development Indicators, various years.

14 20 Collier qxp 8/17/05 1:55 PM Page THE NEW PUBLIC FINANCE NOTES 1. The Country Policy and Institutional Assessment (CPIA) is undertaken annually by the World Bank (2003a,b) to determine its borrowers policy and institutional performance in areas relevant to economic growth and poverty reduction. The assessment takes into account 20 criteria grouped into four clusters: economic management (management of inflation and macroeconomic imbalances; fiscal policy; management of public debt; management and sustainability of the development program); structural policies (trade policy and foreign exchange regime; financial stability; financial sector depth, efficiency, and resource mobilization; competitive environment for the private sector; goods and factor markets; policies and institutions for environmental sustainability); policies for social inclusion and gender equity (equity of public resource use, building human resources, social protection and labor, monitoring and analysis of poverty outcomes and impacts); and public sector management and institutions (property rights and rule-based governance; quality of budgetary and financial management; efficiency of revenue mobilization; quality of public administration; and transparency, accountability, and corruption in the public sector). 2. The Collier and Dollar analysis is based on four properties. One is that within a country and time period aid is subject to diminishing returns: the last $1 million of aid is less effective in raising growth than the average. Two, the contribution of aidinduced growth to poverty reduction in a country will tend to be greater the lower is the per capita income of the country and the more equally is income distributed. These two effects-diminishing returns and poverty-tend to offset each other. To avoid diminishing returns, aid per capita needs to be higher in higher income developing countries. To best reach the poor, aid per capita needs to be higher in lower income developing countries. Three, aid will tend to be more effective in inducing growth and in reducing poverty the better are policies, governance, and institutions. And four, although aid has various effects for good and for ill on policies, governance, and institutions, the net effect is on average sufficiently small to ignore. 3. The World Bank defines countries that rank lowest on the CPIA as lowincome countries under stress. These countries tend to have weak policies, institutions, and governance and to lack the capacity or inclination to use finance effectively to reduce poverty. A special initiative, including a trust fund, was launched to move the development agenda in these countries forward despite the constraints to poverty reduction. The objective is to reduce the risk that these countries will become further marginalized by being excluded from aid that is becoming increasingly performance oriented. The initiative assists countries in strengthening institutions; initiating basic economic, social, and governance reforms; and building capacity for social service delivery-moving out of stage 1 and on to a path that might gradually lead the country through the seven stylized stages of the development process discussed in this chapter.

15 20 Collier qxp 8/17/05 1:55 PM Page 443 USING AID INSTRUMENTS MORE COHERENTLY 443 REFERENCES Collier, Paul, and David Dollar Can the World Cut Poverty in Half? World Development 28(11): Aid Allocation and Poverty Reduction. European Economic Review 46(8): Development Effectiveness: What Have We Learnt? Economic Journal 114(496): F OECD (Organisation for Economic Co-operation and Development) International Development Statistics. Paris. World Bank World Bank Group Work in Low Income Countries Under Stress: A Task Force Report. Washington, D.C. [www1.worldbank.org/operations/ licus/documents/licus.pdf] a. Allocating IDA Funds Based on Performance: Fourth Annual Report on IDA s Country Assessment and Allocation Process. Washington, D.C. [ 2003b. Country Policy and Institutional Assessment 2003: Assessment Questionnaire. Washington, D.C. [ Resources/CPIA2003.pdf].. Various years. World Development Indicators. Washington, D.C.