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10 March 2021updated 04 Sep 2021 8:30am

Why privatising foreign aid doesn’t work

Rather than triggering a surge in private sector investment, foreign aid cuts risk deterring businesses from investing in poorer nations.

By Ben van der Merwe

The aid budget has been hit twice this past year. The government’s decision not to meet the legally mandated spending target of 0.7 per cent of GDP (instead aiming for 0.5 per cent) has come as GDP itself undergoes a major contraction. The result has been an estimated 30 per cent cut to the aid budget just as developing countries struggle to emerge from the pandemic.

The changes have been mooted as a temporary response to the UK’s fiscal situation, but over five years the expected savings from the cuts are likely to amount to just under 1 per cent of the UK’s debt, according to the Center for Global Development

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There is also no sound economic reason to reduce the UK’s debt while the world remains in recession and interest rates remain at historic lows. France, Italy and Japan all have higher debt levels than the UK, but are expected to increase their aid budgets this year.

Nevertheless, the move has been welcomed by laissez-faire conservatives who predict that funding gaps created by the cuts will be filled by a surge in private sector investment. But it is likely to have the opposite effect, harming the programmes that pave the way for further investments from industry, while protecting initiatives that crowd out private sector investors. 

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Aid austerity is a British phenomenon
Forecast government debt as a % of GDP in G7, 2021
Source: Centre for Global Development/IMF/Donor Tracker

The government says it remains committed to international development, albeit through other avenues. As the Minister for Africa James Duddridge told January’s Africa Investment Conference, “We need to look […] beyond aid, beyond pure development and look to the private sector to be the driver of growth across the continent.”

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The government’s thinking echoes a long-held view in conservative circles: that the private sector is the real engine of international development, but is crowded out by government aid.

The implication is that withdrawing aid will result not in recipient countries being starved of funds in the midst of a pandemic, but in a renaissance of private sector activity in areas once dominated by inefficient government programmes.

The reality is more complicated. Studies looking at the overall effect of aid on private investment have produced no clear answers – some have found that aid does crowd out the private sector, whereas others have found that aid increases investment.

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What does seem to matter is where the aid is directed. Danish researchers found that aid directed towards directly productive capital such as factories and machinery does substitute for private investment, reducing foreign direct investment (FDI) inflows by $0.84 for every dollar spent.

On the other hand, the researchers found that aid directed towards public goods such as infrastructure or education attracts foreign investors, generating an additional $1.09 of FDI for every dollar spent.

Only aid to industry crowds out private capital
Modelled effect of $1 of foreign aid on FDI inflows to recipient, by sector

Source: Selaya and Sunesen (2012)

“Different types of finance certainly aren’t interchangeable,” says Daniel Coppard, director of research and analysis at Development Initiatives. “If you cut areas of public spending you certainly cannot expect private sector finance to be able to step in and deliver the same kind of investments with the same kind of outcomes.”

Even the most laissez-faire conservative accepts the need for state spending in areas which the market cannot adequately serve. When developing countries can’t raise sufficient revenues to fulfil these needs, aid serves a crucial role. Urgent humanitarian aid is one example, but so too is aid in infrastructure, health, education, social security and other core state functions taken for granted in the Global North.

Leaving these financing needs unmet will not spur private sector development but constrain it, creating productivity bottlenecks that the private sector is ill-equipped to solve.

The UK’s aid strategy has long sought to take this into account by seeking to promote FDI rather than replacing it. Aid given directly to industry, where it is most likely to crowd out private capital, accounted for just 8 per cent of the bilateral aid budget in 2019.

UK aid has long aimed to complement, not replace, private capital
Allocation of UK bilateral aid by category, 1967–2019

Source: OECD

The speed of the cuts increases the risk of the government’s strategy backfiring significantly. Part of the aid budget includes commitments to multilateral institutions such as the World Bank, which cannot be changed at short notice. Bilateral programmes are therefore likely to bear the brunt of the cuts, while programmes aimed at women and girls have also been hit particularly hard.

The Center for Global Development estimates that the proportion of the UK’s aid budget destined for bilateral programmes is likely to decline from 68 per cent in 2019 to less than 34 per cent in 2021, based on the UK’s pre-existing multilateral commitments at the time the cuts were announced.

Yet, aid from multilateral organisations is much more likely to be spent in areas where it could crowd out private investment. It also tends to be much less targeted towards poverty relief.

Making UK aid more multilateral won’t make it more investor-friendly
Bilateral aid allocations by donor and category (% of total), 2019

Source: OECD

“The bilateral donors tend to be much stronger in targeting the poorest countries,” says Coppard. 

“Roughly half of their spending goes to countries with poverty rates above 20 per cent. IFIs [international financial institutions] are a very different story. Over 80 per cent of IFI aid, collectively, goes to middle income countries.”

Multilateral aid is less targeted at poverty relief
Aid commitments of international financial institutions (IFIs) and bilateral donors by destination country income level, 2020

Source: Development Initiatives

“The commitments to multilaterals seem to be unchanged by the cuts, and so the cuts are happening in bilateral aid,” says Bill Anderson, data and information architect at Development Initiatives.

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“In the numbers published recently, £8bn is allocated for 2021/22 to the DFID [Department for International Development] section of the Foreign Office, £6bn of which is already budgeted. That excludes [major multilateral commitments], so there’s a huge hole.

“The bottom line is, the numbers don’t add up. There is no way that DFID can meet its £8bn limit without major cuts to bilateral programmes.”