Parth J Shah & Ali Mehdi: Foreign aid or economic freedom?

Aid leads to larger government while economic freedom eventually results in higher FDI and growth.

Amongst the developing countries, India has been the largest recipient of foreign aid. During 1951-2005, India has received Rs 2,260 billion as loan and Rs 242 billion as grants (about 10 per cent of total aid). It has managed to pay back Rs 1,669 billion as principal and Rs 768 billion as interest. Multilateral aid "" 90 per cent of which has been provided by the World Bank "" accounts for about 60 per cent of India's total aid. Amongst bilateral donors, Japan has been the most generous, giving India 23 per cent of the total bilateral aid used by India.

Has being the largest aid recipient helped India achieve economic growth more than economic freedom has? It is a fact that India's development and economic growth have been far more impressive since the liberalisation of the Indian economy. Supporters of foreign aid claim that while arguments against aid effectiveness are partially true, they are over-emphasised. Jeffrey Sachs and Joseph Stiglitz, both previously associated with the World Bank in different capacities, are two famous names in this context. Sachs, the director of Columbia University's Earth Institute, talks about "the poverty trap" in poor nations, requiring a "Big Push" from foreign aid, in his book, The End of Poverty. He says that the poor "are too poor to save for the future and thereby accumulate the capital that could pull them out of their current misery." Rich nations should increase official development assistance (ODA) from 0.3 per cent to 0.7 per cent of their GNP, as pledged by them in Monterrey Financing for Development Conference in 2002.

However, William Easterly, professor of Economics at New York University and the author of The White Man's Burden: How The West's Efforts To Aid The Rest Have Done So Much Ill And So Little Good, argues that foreign aid does not have any measurable impact on growth, and that it has miserably failed to reduce poverty, primarily because of it being tied to centralised, state planning (Economic Freedom of the World: 2006 Annual Report). According to him, "initially poor countries grow faster than rich ones, once you control for economic freedom."

In general, foreign aid has led to the burgeoning of government bureaucracies, with increasing state interference, inefficiency, lack of accountability, corruption, and so on. At the utilisation level, it has more often been used for consumption rather than investment, to serve political purposes rather than achieve development. Evaluation mechanisms have been weak, and so have been the feedback and improvement systems. On the other hand, "economic freedom gives markets, which are great feedback mechanisms for learning what is succeeding and what is failing," explains Easterly.

Already, in most South Asian countries, the flow of private capital is much higher than that of foreign aid. Between 2000 and 2004, India received $ 6 billion in foreign aid, $ 25 billion in FDI, and $ 86 billion as workers' remittances, the largest in the world. Governments in the region should therefore ease the restrictions placed on the flow of private capital, instead of seeking more aid. They should learn from the example of south-east Asian countries, where FDI has been a significant source of availing capital and technology for exports as well as economic growth. FDI and remittances have the potential to offset aid as important engines of growth and development in South Asia, and these countries need to develop conditions that bring in more FDI. At a macro level, to ensure aid effectiveness, South Asia in general, India in particular, needs to bring in good governance and sound macroeconomic policies, which not only make aid effective, but are also able to use aid for building infrastructure and other avenues which help in attracting FDI.

Nevertheless, until aid flows continue, it might be more effective to have direct transfers of cash or vouchers in targeting the affected population, and in achieving the targets set for development programmes. Mexico's PROGRESA scheme gives parents cash for sending their children to school and getting regular health check-ups. The Mexican government's programme has been extremely successful in enhancing enrollment as well as the quality of education for the poor. The Bangladesh Female Secondary School Stipend Programme paid school fees and transferred an incentive money directly into girls' bank accounts on condition of at least 85 per cent school attendance, staying unmarried until 18 years of age, and passing examinations. This has increased enrollment rates by 12 per cent a year in rural areas. India has announced a pilot program of food stamps, though it is yet to come into effect. Ideally, the issue of aid should be decided by individuals, communities and voluntary associations "" by civil society. Government-to-government aid should end.