Foreign Aid To Bangladesh: Assessing Its Significance

Foreign aid plays a significant role in economic transformation, contributing ideas about development to support reform and expansion of public services. The study investigates the historical significance of aid in Bangladesh by using the data since her independence and finds out the relationship between aid and some key macroeconomic indicators. The paper finds that according to the trend of recent macroeconomic indicators, Bangladesh has been able to graduate from a highly aid dependent country. This paper also reveals that corruption is a major factor that is responsible for the existing savings-aid inverse relation in Bangladesh. This paper also opines that foreign aid has little impact in the improvement of social indicators of the country.

Keyword: Aid Attitude, Aid Recipients, Tied Aid, Untied Aid, Aid Conditionalities.

I. Introduction:

Foreign aid is a transfer of capital, goods, or services from one country to another. Development Assistance Committee (DAC) of the Organization for Economic Cooperation and Development (OECD) has defined foreign aid (or foreign assistance) as financial flows, technical assistance, and commodities that are-

Designed to promote economic development and welfare as their main objective (thus excluding aid for military or other non-development purposes); and

Provided as either grants or subsidized loans.

Aid has emerged as a more sophisticated instrument of foreign policy after World War-II, in the form of assistance to war-ravaged countries and newly independent former colonies. Several international organizations were created to facilitate aid distribution and programs (e.g., United Nations Relief and Rehabilitation Administration).

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Aid is of two types: concessional and non-concessional. Grants and subsidized loans are referred to as concessional financing, whereas loans that carry market or near-market terms are non-concessional financing (and therefore are not foreign aid). According to the DAC, a loan is counted as aid if it has a ‘grant element’ of 25% or more, meaning that the present value of the loan must be at least 25% below the present value of a comparable loan at market interest rates (usually assumed by the DAC – rather arbitrarily — to be 10% with no grace period). Thus, the grant element is zero for a loan carrying a 10% interest rate, 100% for an outright grant, and something in-between for other loans.

Since independence, Bangladesh received US$48035 million in aid, compared to a commitment of US$58101 million. It is ranked 38th among 76 aid recipient countries using the International Development Association (IDA) Resource Allocation Index. Table-1 presents data on aid flows (commitments and disbursements) into Bangladesh since 2000-01 fiscal years. It can be seen that disbursement as a percentage of commitment ranges between 53% and 164%. The highest percentage was in FY2001-02 (164.05%)), which seems to be an outlier as the commitment of aid was the lowest at US$879 only. In other cases, except for FY2005-06, the percentages were well below the 100% mark. This is an indication of Bangladesh’s failure to collect, or donor’s failure to disburse, the committed aid.

There exists a growing literature on the macroeconomic effects of foreign aid in Bangladesh. Islam (1972) analyzes the relationship between foreign capital (foreign public aid and foreign private investment) and gross domestic savings in the erstwhile East Pakistan and concludes that foreign capital had affected domestic savings negatively in the 1950’s, but positively in the 1960’s. A more rigorous approach is taken by Alamgir (1974) who econometrically investigates the effects of foreign capital on gross domestic savings and growth in East Pakistan during 1960-70. The estimated results show that foreign capital affects gross domestic savings positively, but Gross Domestic Product (GDP) growth negatively.

In an intriguing study of the role of aid in the development dynamics in Bangladesh, Sobhan (1982) concludes that the aid regime has grossly failed in promoting its development agenda. Quite contrary conclusions are drawn by Rahman (1984), which analyzes the effects of aid on domestic resource mobilization in the post-independence Bangladesh. He finds that over the 1972-82 periods, aid has promoted economic growth, and through higher income, aid has also expanded the tax base and raised domestic savings in Bangladesh.

Ahmad (1990) moves beyond the single equation estimation approach and estimates a simultaneous equation model grounded in the framework of two-gap analysis. The estimated results show that over the 1961-80 period, despite reducing domestic savings, foreign capital inflow has raised GDP growth by increasing output in the primary, manufacturing, and tertiary sectors. Islam (1992) estimates several single equation aid-growth models for Bangladesh with 1972-88 data and finds that the effects of aid on GDP growth are barely positive and highly insignificant.

There are two very good papers by Taslim et al. (2000) and Razzaque et al. (2000) that show the savings-aid relation in Bangladesh. Taslim et al. (2000) use the time series data of savings and aid of Bangladesh over the period 1959-60 to 1994-95. They regress savings on GDP, aid and Gross Domestic Income (GDI). They use Augmented Dickey Fuller (ADF) and Phillips-Perron test for testing stationary of the variables. By using Johansen procedure, they find that the variables are cointegrated. They find the regression coefficient of savings is negative in the regression model. They also use an Error Correction Model (ECM) and find aid causes savings. Razzaque et al. (2000) use the time series data of savings and aid of Bangladesh over the period 1973 to 1997. They regress per capita savings on per capita real GDP and per capita real foreign aid. They use DF, ADF and Phillips-Perron test for testing stationary of the variables. By using Engle-Granger procedure, unrestricted ECM and Johansen procedure, they find that the variables are cointegrated. Their findings show significant negative relationship between domestic savings and foreign aid both in the short and long run. They also use Granger causality test and find per capita income together with per capita aid causes savings in the long run and there is bidirectional causality between domestic savings and foreign aid in the short run.

Some studies reflect that aid flow to Bangladesh has created a great load for the country. Gunter and Rahman (2008) show that the share of the domestic public debt continues to increase in Bangladesh, which is even more reflected in terms of interest payments as percent of government revenues. Gunter (2008) also expresses that comparing the results with other low income countries; Bangladesh is actually one of the highest indebted countries in terms of both net present value debt to government revenues and public debt service to government revenues. So, these studies concentrate on the drawbacks of receiving aid and opine that the burden of interest payments and debt service charge has become unbearable for Bangladesh economy.

Quibria (2010) provides a critical review of aid effectiveness in Bangladesh. In assessing aid effectiveness, the paper uses a qualitative triangulation approach based on the subjective judgments of donors and recipients. This paper also discusses the importance of foreign aid to Bangladesh as it has evolved over time. It also provides critical assessment of the economic and social impact of aid based on both donors’ and the recipient’s perspectives.

The objective of this paper is a little bit different from the papers discussed above. In discussing the effect of aid, most papers show the effect of aid on savings, investment and income. But this paper examines the historical significance of aid and the relationship between aid and some other important macroeconomic indicators of Bangladesh with a view to assessing aid utilization and aid effectiveness. Moreover, this study disagrees with the findings of Gunter (2008) and Gunter and Rahman (2008) and clearly points out the strength of Bangladesh economy to face the challenges of receiving aid. This paper also provides a mathematical model to show that corruption reduces savings under the presence of foreign aid inflow.

The study explores the trends and attitudes towards policies and distribution of aid based on the DAC data collected from OECD, World Bank’s World Development Indicator-CD ROM-2008, and External Resource Division (ERD) of the Bangladesh Planning Commission.

The paper is organized as follows. Including introduction as chapter one, chapter two describes the aid profile of Bangladesh. Chapter three shows the political economy of foreign aid. Chapter four focuses on aid utilization by explaining the correlation of aid with different important macroeconomic variables over time. Chapter five delineates who control aid and the effectiveness issues of aid in Bangladesh. Finally, chapter six concludes the overall discussion of this paper.

II. Aid profile:

From the independence of Bangladesh, aid plays a significant role in bringing economic and social development. Official development assistance is still a significant source of foreign exchange though its relative importance has declined over the years as other sources of foreign exchange such as exports and remittances have picked up. In addition, as the economy has grown, the flow of aid as a proportion of GDP or a percentage of investment has declined over time. In the 1970s through the early 1990s, the net flow of aid as a percentage of GDP was more than 6 percent, but this declined to about 2 percent in 2005. In recent years Bangladesh has received less foreign aid as a percentage of GDP than either Heavily-Indebted Poor Countries (HIPCs) or other Low-Income Countries (LICs) with the notable exception of India.

The multilateral International Financial Institutions are the principal source of aid for Bangladesh although the role of bilateral sources such the government of Japan, United Kingdom and Canada is also significant. Bilateral sources were almost as important as the multilateral through the early 1990s but now account for half of the amount of multilateral aid. Multilateral aid is more economically oriented and less political than bilateral aid. World Bank (WB) and Asian Development Bank (ADB), the principal sources, have provided assistance largely though not exclusively from their concessional windows. However the terms and conditions of the IDA and the ADB have somewhat hardened and in addition, ADB is now classifying Bangladesh as a blend country- a country that borrows from both concessionary and non concessionary sources which has contributed to the dilution the grant element of the foreign assistance it receives.

In recent times, besides Government, Non-Government Organizations (NGOs) in Bangladesh have been a major recipient of aid. According to a WB estimate in 2005, the total aid to NGOs in Bangladesh rose from USD 232 million between 1990-1995 to USD 320 million between 1996 and 2004 while total aid to Bangladesh as a whole declined. The share of aid to NGOs as a portion of total aid to Bangladesh has increased from 14.4% in the first half of the nineties to 24.5% in the year 2005. This means that whereas the overall aid to Bangladesh, as a component of GDP has decreased, the proportion of aid that is provided through NGOs has increased by this time. In other words, the decreasing proportion of aid to Bangladesh has not resulted in a fall of aid flow to the NGOs. Over the years it has been seen that the nature of donor support has been to support NGO activities as a mechanism for reaching greater numbers of poor people than focusing on the state (World Bank, 2005).

The over time aid profile of Bangladesh will now be discussed with the help of some macroeconomic indicators. Aid as a percentage of Gross National Income (GNI) was 5.21 in 1973. It then followed almost a downward trend and it became 1.85 in 2006. Aid as percentage of gross capital formation was 75.75 in 1972, showed a cyclical pattern, became highest as 85.15 in 1975 and became 8.01 in 2006. Aid as a percentage of import was 50.34 in 1976, showed a cyclical pattern, became highest as 62.06 in 1977 and it became lowest as 6.86 in 2006. Again it rose to 10 in 2008. Per capita aid was US $ 3.04 in 1972. It gradually increased up to US $ 18.51 in 1990 and then started to decline and became US $ 7.83 in 2006. Aid-GDP ratio was 0.05 in 1976. Its trend was almost constant up to early 1090s. Then it started to decline and became 0.02 in 2006, 0.017 in 2007 and 0.026 in 2008. Aid-budget deficit ratio was positive in the late 1970s. Suddenly it was negative around the year 1983. From mid 1990s this ratio is very close to zero. Aid-Current Account Balance (cab) ratio shows a cyclical pattern. It was -1.8 in 1976, -22.76 in 1983, the highest as 29.08 in 1991, the lowest as -32.93 in 1998, 1.02 in 2006, 1.23 in 2007 and 3.007 in 2008. Aid-Government expenditure ratio was 1.21 in 1976. The ratio continued to be greater than 1 up to 1994. Then it gradually started to decline and became 0.36 in 2006. Figure-1 shows the trend of some of the above mentioned indicators.

The share of grants which was 89 per cent in 1971/73 reduced to only 31.9 per cent in 2005/06. The declining share of grants resulted in a larger share of loans in the total aid package, implying that Bangladesh is no longer seen as a “basket case” by the donor community. [1] It is perceived as capable of servicing non-concessional loans.

Food, commodity and project aid: Table-2 shows a declining trend of food aid. Food aid received by Bangladesh in 1973 was $182.55 million; it doubled within two years and continued to remain at that level up to 1980. Since then there has been a declining trend, and the annual food aid remained well below the $200 million level. However, there had been some individual years when the food aid inflows were relatively higher to meet larger food shortages due to natural calamities. The declining trend in food aid has coincided with an increasing trend in the expenditure of food import for Bangladesh (Figure-3). This once again indicates Bangladesh’s ability to graduate from a highly aid dependent country.

Commodity aid, including food aid, has been used in Bangladesh to meet the balance of payments gap, and also to generate local currency in the form of counterpart funds for financing development. Bangladesh received no commodity aid in FY2005-06, as a sign of its ability to manage balance of payments without much donor support. Major commodity aid donors to Bangladesh included Japan, Germany, Netherlands, UK and USA.

Figure-4 shows the year wise food (rice plus wheat) aid from donors. It shows that though the trend is downward with time, Bangladesh has been benefited with food aid when she desires it most. For example, food aid increases at the famine of 1974-75, at the floods of 1986-87, 1998-99 and at the cyclones of 1990-91 and 2000-01.

Project aid comprises the largest share of foreign aid inflows into Bangladesh, which shows an ever increasing trend. ADB, IDA, International Fund for Agricultural Development and OPEC are the major multilateral project aid donors and Japan has emerged as the leading bilateral donor. Worth mentioning among others are France, Saudi Arabia and China. In 2005/06, project aid accounted for 93.8 per cent of the total indicating its significant role in the economy.

Sectoral distribution:

The allocation of foreign assistance is mainly on public administration, education, health, power and transport sector (Table-3). Though rural development (whose mainstay is agriculture) has been recognized as ‘a pillar of effective poverty reduction’, support for agriculture has declined over the past ten years by almost a half.

Foreign assistance disbursement in health, population and family welfare sector in recent years is very notable. Table-3 reflects that disbursement has been declining in this sector since 1998-1999 up to 2004-2005 and then gained a momentum, but still the allocation is low compared to other neighboring countries of Bangladesh. But surprisingly, in the last couple of decades Bangladesh has made significant social improvements despite the myriad challenges it faced in the forms of famines, natural disasters and political and social instability. According to the latest available statistics (BBS 2007a), the incidence of poverty declined by 9 percentage points within the period 2000-2005. If the higher (national) poverty line is used, the incidence of poverty declined from about 49 to 40 percent of the population; if the lower poverty line is used, it declined from about 34 to 25 percent of the population during the same period.

Bangladesh has also made impressive improvements in the last decade or so in key social indicators such as fertility, life expectancy, school enrollment for girls, and child immunization, which compare favorably with other low-income countries, including its South Asian neighbors (with the exception of Sri Lanka). All these improvements are the fruit of the concerted effort of the Government and the NGOs. These improvement in social indicators occurred when there was a concomitant decline in foreign aid as a source of investment finance. This would seem to suggest anything but the critical role of foreign aid in the improvement of social indicators of the country (Quibria, 2010).

III. Political economy of foreign aid:

This section provides a brief spotlight regarding the aid summary by different political Governments after the independence of Bangladesh.

After the liberation war, Sheikh Mujibur Rahman took the leadership of the country when she was facing three major gaps such as food, fiscal and balance of payments. Micro-economy of the country was also characterized by low per capita income, low savings, low investment, and low productivity, which are identified as the elements of vicious poverty circles. During his regime, Bangladesh received 2184 million US Dollar of foreign economic assistance (Ministry of Finance, Government of Bangladesh). Mujib government adopted populist economic measures that pursued a development strategy of state intervention and controls over trade sectors, service sectors, industrial enterprises, agriculture inputs, price etc. from 1972-1975 (CPD, 2004: 295).

The Zia government focused on private sector based economic performance. The policy was aiming at reducing the budget deficit, reforming the public sector, withdrawal of subsidies on food, fertilizer, and petroleum, and liberalizing trade regime under the impact of the conditionalities imposed in the IMF/WB initiated reform programs. As the government during this period began to the implement the reform programs, both multilateral and bilateral donors which mainly included the IDA, IDB, the USA and USSR responded with providing aid in the forms of import programs credit, project aid, food aid and commodity aid (Quadir, 2002). During his regime, Bangladesh received 6809 million US Dollar of foreign economic assistance (Ministry of Finance, Government of Bangladesh).

Ershad government declared the New Industrial Policy (NIP) in 1982 to intensify the privatization programs and allocate the private sector the major role for making rapid progress towards industrialization by providing credit facilities to the private sector, disinvesting state owned jute and textile mills and activating EPZs for attracting foreign investment. Ershad also followed measures like liberalizing import procedures, bringing change in the incentive structure for private investment, greater autonomy to public sector management (Shahabuddin et al, 2004). During Ershad period, macro-economic indicators like savings and investment did not experience any significant change on the one hand, performance in domestic resource mobilization, on the other, remained dismal. As a result, dependence on foreign aid reached a crisis point. During the period of Ershad government, 60 per cent of its investment, 85 per cent of its development budget and 68 per cent its commodity imports came from foreign aid. Also, the country’s debt-service ratio reached at 30.6 in FY 1987 (Quadir, 2002).

From 1991 to onwards, democracy has been established in Bangladesh. Two major political parties, BNP and Awami League, both have won two times in this period. During the last twenty years, Bangladesh has been facing an increasingly competitive aid environment, especially after the collapse of the Soviet Union. Aid flow has been shrinking due to an increase in the number of countries requiring aid. Moreover, at present, donors’ assistance to Bangladesh is now contingent on implementation of reform programs and efficient utilization of foreign aid.

IV. Aid utilization:

The International Monetary Fund (IMF, 2005) provides a useful macro economic framework for analyzing the use of foreign aid. [2] It defines two aid-related concepts – absorption and spending. Absorption captures both direct and indirect increases in imports financed by aid, and shows how much in additional imports are possible due to the availability of aid. Similarly, spending refers to additional government spending that aid finances. In other words, these two terms capture the way that aid helps finance a widening foreign exchange (trade) gap and an increasing savings gap (specifically, a larger government deficit).

Absorption and spending can be defined as:

Absorption = Δ (current account deficit without aid) / Δ Aid

Spending = Δ (budget deficit without aid) / Δ Aid

Where Δ denotes change.

‘Without aid’ signifies the size of the respective deficits before aid financing is taken into account. Thus, the current account deficit excludes official grants and interest on external public debt while the budget deficit equals total government expenditure minus domestic revenue when no aid is registered. [3] 

From the balance of payments side, an increase in aid can be utilized (absorbed) in some combination of (a) an increase in the rate of reserve accumulation, (b) an increase in capital outflows and (c) an increase in the current account deficit. However, not all of these options will allow effective absorption of aid.

Development economists believe that developing countries suffer from absorptive capacity constraints, that is, they are limited in terms of the amount of foreign assistance they can productively utilize. It is also widely believed (for a review of this literature, see Quibria and Murshid 2007) that there are diminishing returns to aid; that is, as developing countries have low levels of human capital and limited physical infrastructure, the returns from foreign assistance decline as the flow of aid increases (this idea originally dates back to Chenery and Strout 1966; Millikan and Rostow 1957; and Rosenstein-Rodan 1961). Besides absorptive capacity constraints, donor agencies often highlight aid absorption problems, which are reflected in delays in implementing programs and in achieving sufficient development impact. The aid absorption problems reflect the human resource and bureaucratic constraints to a great extent but attributing all the problems to the recipient country is unfair. Many of the problems also stem from the cumbersome policies, procedures, and practices of donor agencies each of which have copious reporting demands and insist on their particular ways of doing things. (For an interesting account of the bureaucratic rigmarole surrounding the delivery of foreign assistance, see Easterly 2006a.).

Foreign aid continues to play an important role in Bangladesh’s development efforts. Aid finances about one-third of the total fiscal deficit of Bangladesh (the projected share of net foreign financing in Budget for FY2009-10 is 29.7 per cent); about a-half of ADP is financed by Aid. During the first five months of FY2009-10, 23 percent of the project aid

allocation has been utilized (CPD, 2010).

This section describes the correlation of aid with some important macroeconomic variables. Before examining the correlation between aid/gdp ratio and some important macroeconomic indicators, it will be worthy to concentrate on the trends of budget deficit ratio, current account balance ratio and import ratio. Figure-5 shows that budget deficit-GDP ratio has been always positive except the year 1983. It shows an upward trend since 1992. The Current Account Balance (CAB)-GDP ratio also shows an upward trend. This ratio became positive after the year 2000 with an exception in the year 2004. On the other hand import-GDP ratio shows a constant rising trend from early 1990s.

Table-4 shows that there is a positive correlation between Aid/GDP and Budget deficit/GDP ratios, meaning that higher aid led to higher budget deficit (spending). The negative correlation between Aid/GDP and CAB/GDP ratios implies that aid was not used to fund more imports. The negative relation of aid and reserve occurs because of a decreasing trend of food aid. So every year Bangladesh has to import a large amount of food items using its reserve. This is the reason for the inverse relation between the variables.

The negative correlations between aid and saving and gross capital formation indicate that, contrary to expectation, aid did not supplement capital formation or national savings. Instead larger aid flows may have encouraged conspicuous spending, particularly higher government non-development expenditure. In recent years, aid has accounted for less than 10 percent of gross investment and financed a smaller proportion of total import bills compared to the 1980s or the 1990s (WDI, 2009). Various empirical evidences find that the importance of aid as a source of investment has waned over the years. Rajan and Subramanian (2007) suggest that foreign aid has a negative effect on economic growth through its adverse impact on governance. They argue that as the volume of aid increases, it reduces the government’s accountability. In particular, the government slackens its efforts to maintain the rule of law, ensure predictable judicial outcomes, enforce contracts and limit corruption. Quazi (2009) develops a simultaneous growth model to capture the effects of aid on GDP growth and domestic savings in Bangladesh. He finds significant inverse relation between savings and aid. Taslim et al. (2000) and Razzaque et al. (2000) also find the inverse savings-aid relation in Bangladesh.

In this paper, the negative correlation between aid and savings will be explained by the prevalence of corruption and bribe. Let Government of Bangladesh (GoB) tries to fill part of the investment-saving gap (I-S) with a portion (k) of aid (A) it receives. Then: I-S ≥ kA. Now holding other things constant, investment can be treated as a function of bribe (B) because in a corrupted country like Bangladesh, the investor has to pay bribe to financial institutions to get loans, to government officials to get a business permit and to local miscreants in order to run business smoothly. So we can write:

I(B) -S ≥ kA when I/(B) < 0

Now take total derivative on both sides.

I/dB-dS ≥ kdA

So, dS ≤ I/dB- kdA

So, dS/dA ≤ I/dB/dA- k

Empirically no relation is found between aid and bribe. So dB/dA = 0. So we get dS/dA< 0 as k > 0.

V. Control of aid and aid effectiveness:

WB, ADB and Japan are the three major donors to Bangladesh and they control the lion’s share of aid Bangladesh receives each year.

WB is the largest as well as the most influential lender to the country. In the 1970s, the WB concentrated largely on project lending for achieving food self-sufficiency, mobilizing domestic resources, improving social indicators, and enhancing project implementation. In the late 1980s, the WB focused on policy reforms to create an environment conducive to private sector development. These reforms were addressed at removing the distortions in trade, pricing, credit allocation, and interest rates. During the 1990s, governance became the principal emphasis of the WB assistance program in Bangladesh; other areas of focus include human resource development, environmental management and gender equity, integrated rural advancement and private-sector growth by strengthening the financial sector and promoting private investment in energy, infrastructure, manufacturing and services (World Bank 1998b).

ADB is the second largest lender to Bangladesh after the World Bank. The principal focus of ADB lending was in agriculture, energy, transport and education (ADB, 2003). A recently completed subsequent evaluation of ADB (2009b) finds that its operation became more expanded in recent years. It provided assistance to diverse sectors like energy, transport, education, disaster-management, agriculture, urban development and sanitation, law, economic management and public policy. Despite broadening its focus, ADB found more of its projects and programs successful (79% between 1999-2008).

Japan is the largest bilateral donor to Bangladesh and accounts for a sizable portion (about 14 percent through FY 2008) of the country’s foreign assistance (GoB, 2009). The objective of Japanese assistance program is to support Bangladesh to achieve economic growth, social development and human security (including health, education, gender equity and environmental protection) and governance. The actual assistance program includes financial and technical assistance in the areas of physical infrastructure, agricultural development and social sector at a highly concessional rate.

In recent times, donors control the use of aid by imposing conditionality that includes the process of designing and delivering of aid. Rahman (2008) provides an interesting personal account, based on his own experience as the top civil servant coordinating foreign aid resources of the country. He notes that, during his tenure, while Bangladesh government officials collaborated with donor agencies in the design of programs and reform agenda in different sectors like jute, energy, railways, industries, telecommunication, health and education, the role and participation varied significantly from sector to sector . He also notes that though donors and recipients always agreed on the desirability reforms at the general level, they often tended to diverge significantly on specifics. However, when it came to resolving the divergences, it is the donors who prevailed at the end. So, he concludes that while government participation enhances the probability of success of a reform agenda, it does not by any means guarantee it.

Donors now undertake “independent” reviews of their programs through their in-house evaluation departments with some regularity. From the donors’ perspective, aid effectiveness has been mixed in Bangladesh. Donors consider their investment projects to have been more successful than their policy loans. In the area of investment projects, the performance of Bangladesh has improved over the years, although there are persistent concerns regarding implementation delays and development impact. In the area of policy loans, the country’s failure to implement policies is not particularly unique to Bangladesh. However, many high-performing economies of Asia such as China and India have either totally avoided policy loans or have been highly discriminatory in accepting them. This reflects a desire to exert a degree of autonomy in formula