SOE 2007 Policy Brief - Reforming Aid

Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2007 Empowerment of the Poor
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10. Reform of the Donor-Recipient Nexus in Aid Delivery

10.1 Introduction Foreign aid can help to reduce poverty by boosting recipient countries growth rates. While more aid does not mean more growth studies that have failed to find a link between aid and faster economic growth, nonetheless have found evidence to suggest that countries with sound policies and good institutions tend to benefit more aid, if used effectively can have significant direct benefits to lifting people out of poverty. Foreign aid has also played a significant role in the Sri Lankan economy since independence. At present, it is estimated to make up 4.5 per cent of GDP, 17 per cent of government expenditure and 54 per cent of public investment. Aid to Sri Lanka has been dominated by Japan, the Asian Development Bank (ADB) and the World Bank (WB), in total contributing nearly 80 per cent of aid to Sri Lanka. Whilst Sri Lankas borrowing from such donors has not reduced, this may change in the future since the countrys access to concessionary finance is on the decline as per capita income increases. At the same time, Sri Lanka is set to embark on a major infrastructure development drive focusing on roads, the power sector and ports that would require a significant level of capital investment. The present status of government finances makes it challenging to continue to fund these projects in the context of declining concessional finance. As a result, the government has looked to alternative sources of foreign finance such as emerging donors including China and India whilst further exploring the avenue of commercial borrowing. Sri Lankas relationship with foreign donors is at an interesting juncture, and it would be prudent to explore this relationship further and consider options for reform on the part of donors and the government. 10.2 Aid Conditionality and Options 10.2.1 Political Conditionality It has long been recognized that strategic considerations on the part of donors can often outweigh developmental ones. In the same vein, donors have frequently made loans conditional on policy reform, be it economic or political. In the case of Sri Lanka, whilst the decline in availability of concessional funding is a key reason driving the search for alternative sources of finance, the government has also made reference to the need for increased policy space in aid relationships. There has been a significant increase in the tie up of aid to political conditions. For instance, at the Donor Forum held in January
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2007, donors emphasized the need to pursue a peaceful solution to the conflict in the North and East of the island. The WB representative1 was quoted as saying that "there is no way to politely skirt this issue, as a major development partner to Sri Lanka, the World Bank would be failing if we did not place the conflict front and centre in our deliberations." In addition, aid has also been cut back in some instances. The Minister for Overseas Development of Germany announced in December 2006 that tsunami aid to Sri Lanka would be halted until there is a resumption of peace efforts. More recently, the UK froze half of the US$ 5.9 million debt relief that was pledged to Sri Lanka given its concerns on issues of human rights. As an aid recipient, Sri Lankas stance is that aid should be delinked from domestic political processes given that domestic security concerns is a priority for any government. It is true that donors, especially bilateral donors, have a valid foreign policy concern regarding conflict and human rights in recipient countries. However, whether such concerns can be dealt with in the forum of development assistance relationships remains questionable. Most often, if the nature of a conflict is complex likely to have evolved over decades, if not longer the solutions are unlikely to be arrived at over a short period of time. External pressures can also prove counterproductive. Attaching political conditions to aid can strengthen the arm of governments that are trying to push through donor-friendly measures but remain otherwise unpopular. Conditional-driven reforms rarely succeed unless a government considers the reform programme essential, and its own. It could well be argued that if aid is being used to influence donor country foreign policy concerns, it should not be called aid or development assistance. This could be compared to the linking of labour and environmental issues to trade matters in the World Trade Organization (WTO). The bottom line is that effectiveness of linking aid beyond development assistance through conditions can be questioned, when it is often those most in need of humanitarian assistance that suffer as a consequence. 10.2.2 Alternative Sources of Finance
Praful Patel, South Asia Vice President, World Bank.
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Attempts at aid conditionalities has led Sri Lanka to increasingly consider other emerging options such as bilateral aid from new donors like India and China. However, such an approach raises additional concerns. For instance, while there may be no political conditionality, a condition of aid could be that work is conducted using labour, consultancy, machinery or raw materials from the lending country. As a result, there might be a lack of competitive bidding or tender processes, unlike with multilateral lending agencies, resulting in a more expensive China to Sri Lanka is of this nature. In fact, the exact contractor or consultant to be used. With government can require that the contractor is procurement process. Most aid from government of China can specify the regard to aid from South Korea, the of Korean origin but there will be
competition between Korean producers to supply the service. Indian aid is often in the form of Indian lines of credit, where Sri Lanka can buy Indian imports under the support measure. In the long run, it could well turn out to be that bilateral aid is more expensive than borrowing on the commercial market. There are also possible detrimental effects to commercial borrowing. Sri Lanka obtained international credit ratings in late 2005 from Standard and Poor (B+) and Fitch (BB-) ratings, and went on to borrow US$ 680 million commercially in 2006. It could be argued that a move towards commercial borrowing may increase discipline in the usage of funds, and due to repayment requirements, there will be incentives to invest in commercially viable projects. However, at the same time, it is important to understand the dangers of this route. Commercial borrowing may create a bias towards projects with quick shortterm benefits and may make governments more reluctant to invest in the larger, more long-term projects with social rather than commercial benefits. In the event that there is any downgrading of the countrys sovereign rating, it would make it even more expensive to borrow commercially. This would be detrimental to long-term economic prospects since it would increase the debt burden in the future. As it stands, Sri Lanka has a public debt of around 95 per cent of GDP, but much of the international component of this is loans obtained on concessional terms. If this changes, it is likely that debt service payments would increase exponentially. 10.3 Reforms to the Aid Architecture 10.3.1 Recipient Voice in Aid
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Whilst political conditionality has been a concern, economic conditionality has been less of a concern for Sri Lanka in the recent past. Since the fold up of the Poverty Reduction Growth Facility (PRGF) process, Sri Lankas borrowing from donors has been dominated by project based loans rather than programme loans. This shift should in theory address one of the major concerns in the literature regarding aid relationships; that of the level of recipient voice in aid. Lending practices by the WB and the International Monetary Fund (IMF) in the 1980s and 1990s were criticized for the imposition of the development agenda upon the recipient, with little or no say on the part of the recipient. Today, Sri Lanka has in theory an organized system of generating locally driven projects supported by foreign funding. A line ministry will submit a project proposal to the Department of National Planning (NPD) who will then determine that the proposal is not a duplication of existing projects. If foreign funds are required, the project will be sent to the Department of External Resources (ERD) who will choose an appropriate donor. However, the reality is often different. The extent of actual domestic ownership of donor funded policies depends a great deal on the capacity of the relevant line ministry. What often happens is that the donor would approach the ministry with a background proposal, explaining the gaps in the system that have been identified, and proposals of how these can be remedied and the type of support they are willing to provide. The issue is then studied by the line ministry and their inputs are submitted. The line ministrys inputs and suggestions would be within a framework provided by the donor, such as limitations on the types of assistance that can be given.
Box 10.1: The Changing Role of the Multilateral Financial Institutions

The major Multilateral Financial Institutions (MFIs) the WB, IMF and the regional development banks such as the ADB have in the last decade or so reached a watershed in their history. As economies continue to progress and global financial markets evolve, the demand for the services supplied by these institutions have been changing. The WB was created in 1944 to provide access to credit for the reconstruction of countries ravaged by the Second World War. Since then, it has evolved to provide developmental assistance to developing nations which have limited access to international credit markets. The regional development banks were created as regional supplements to the services provided by the WB. The IMF was created in 1944 in order to prevent a repetition of the detrimental economic policies import restriction and exchange rate devaluations conducted by major countries during the inter-war years that culminated in the Great Depression. The IMF was charged with overseeing the stability of international monetary systems through ensuring exchange rate stability and elimination of exchange restrictions. However, since 1999 the IMF has also
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lent money to its poorest members under the poverty reduction growth facility (PRGF) with the aim of achieving poverty reduction through economic growth. Today, these roles are changing. With the strong emergence of major economies like China, India, and Brazil, there is less demand for the development assistance that the WB and ADB provide. To be sure, between 1999 and 2005, 75 per cent of WB lending was to 12 countries Turkey, Brazil, China, Argentina, India, Mexico, Indonesia, Cambodia, Russia, Romania, Korea and Thailand. As these countries continue to develop, demand for WB funding will continue to decline. The ADB is in a similar position. China, its largest borrower, is now its third largest lender and is in effect borrowing from itself and also competing with the ADB in lending to other developing nations. Emerging economies have unprecedented access to international capital markets, so much so that WB funds account for less than 1 per cent of private financial flows into these economies. Capital markets now offer longer repayment periods and do not come with conditionalities associated with the MFIs making them more attractive sources of capital. The IMF has seen its lending portfolio that totalled US$ 100 billion in 2003 fall to US$ 13 billion.2 The IMFs income stream continues to dry up as fewer countries take on large borrowing and more countries are completing repayment of old loans. In this context it was recommended, by a committee appointed to evaluate the Funds financial position, that the IMF sells 1/8th of the Funds holdings in gold (initially deposited as quota contributions by members) and invest the proceeds. That the IMF is considering the sale of its major cushion against systemic risk is indicative of the serious nature of its financial problems. In fact, in February 2007 as a part of its restructuring efforts, the IMF closed its Resident Mission in Sri Lanka since there was no longer a country programme. However, the IMF continues to have Article IV consultations with the country. Capital markets are not the only source of finance for developing countries today. Emerging global powers like China and India have been keen on providing capital to smaller developing countries in the form of aid and FDI. Furthermore, regional financial cooperation mechanisms such as the Chiang Mai initiative in Asia and Banco Del Sur in Latin America are pooling resources to support members in times of economic shock. It is clear that the role of the MFIs must evolve and keep pace with the changes in the global economic paradigm. The MFIs should not overlook the fact that poverty remains widespread, but needs to alter the way it approaches the problem. In many parts of Asia for instance, poverty is more due to mismanagement of existing resources rather than a lack of resources per se. This implies the need for a shift of resources to countries with less access to capital markets. Lending criteria such as the WBs CPIA (Country Policy and Institutional Assessment) and other performance based lending schemes will need to be reformed to reflect this need. The IMFs efficacy in crisis management can be called into doubt given its limited resources in comparison to the scale of financial flows associated with a crisis in the modern global economy. The improved capabilities of the modern central banker and economic leaders in developing countries have also made the IMFs role as economic
2
Wall Street Journal Online, Whats Left for the IMF, April 13th 2007.
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policeman in the developing world largely redundant. It seems evident that the IMFs comparative advantage will be in surveillance of risks to the open economy and providing timely information to forestall systemic crises. However, doing without MFIs also means that governments must stand or fall purely on their own reputations for financial soundness.
The capabilities of the ministry in question are the key here. If the ministry has experienced officers well versed in the country requirements, they will be able to effectively mould the donor suggestions into the type of action plan required by the country. If, however, the ministry lacks such capacity, there could well be a situation where the ministry accepts (in fact, proposes to the NPD) a project which is not in the countrys interest. The project implementation is carried out by the government, and it is at this stage that the donor influences the project the most. The donors have strong expertise and experience in the relevant area, with the requisite knowledge to influence the design of the plan. While plans produced are not necessarily opposed to the countrys interest, their design is often tailored towards the expectations and requirements of the donor. This again is inevitable given disparities between donor and recipient expertise. However, the concern is the possibility of misuse of this advantage in expertise. One way to overcome the donor-recipient capacity gap is to involve a broader group of stakeholders in meaningful discussions with donors and the government. As it stands, the donor-recipient dialogue is confined to donor representatives and government representatives. If experts in the field from outside the government could also be involved in discussions at a meaningful level (at present, there are some stakeholder discussions but these occur at a superficial level) it would improve the weight of experience and authority on the recipients side of the negotiating table. An example of this was the E-Sri Lanka project initiated in 2003 which had its origins in the private sector in collaboration with USAID. The WB supported the project as it was integrated into the Regaining Sri Lanka programme. The key element in this project design was the incorporation of a multi-stakeholder approach (including the Information and Communications Technology Agency team, representatives of the different sectors and stakeholders appointed to focus groups set up to guide the preparation of the programmes and major projects, and the WB) to ensure broad ownership and sustainability. The problem with involving multiple stakeholders is the difficulty in reaching a compromise. These could result in further unwanted delays in project implementation. However, a smoothly functioning
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stakeholder forum, with an appropriate number of experts will certainly improve the quality of projects implemented using donor funding. 10.3.2 Impact on Domestic Capacity The need for improvement in capacity of domestic institutions has long been seen as a priority in the international aid literature. Whilst some efforts in donor technical assistance have been successful in contributing to this, donor actions at times inadvertently undermine domestic capacity. The donors can, for instance, reduce the burden placed on domestic implementing institutions through extensive bureaucratic requirements of handling aid and the numerous missions that characterize lending practices (multilateral donors in particular) taking up a lot of time of government officers. For instance, implementing units in the government have to report back to the donor at multiple stages, providing details of progress and other information. Whilst some degree of project monitoring is important, donors need to rationalize the level of management. Furthermore, aid institutions tend to capture some of the best human resources from the government and civil society by employing them at far better salaries than available locally. This creates an internal brain drain of sorts, undermining country capacity. Here, the donors need to consider streamlining their role in the aid partnership; the greater the number of people involved in donor agencies, the greater the bureaucracy, the greater will be the transaction costs of the transfer of resources from lender to borrower. The bulk of the planning, implementation, and design of work needs to be from the recipients end. Whilst present capacity leaves much to be desired, part of the reason for this has been the lack of opportunities given for institutions to build their own capacity as donor agencies have historically dominated the intellectual input in the aid relationship. Whilst project based lending is not characterized by general macroeconomic conditions, the loan agreements are managed through loan covenants and safeguards agreements.3 A loan covenant is an agreement signed between the donor and the recipient government detailing agreed actions and reforms to be carried out along with the project. These are not conditions, in that funding will continue even if the covenants are not adhered to. The problem with covenants is the extent of paperwork and bureaucratic processes involved
Safeguards usually refer to environmental safeguards and resettlement and compensation of individuals disrupted by the project.
3
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in tackling them. As a result, large amounts of time and energy are spent simply understanding the agreements in question. This contributes to delays in project implementation, and often before the project is completed, the repayment of the loan has commenced. Whilst these broad objectives are often important and required, it could be argued that the state is in the best position to decide what is required for its own people in the long-run. A government has the democratically elected mandate to look after the concerns of the population and, therefore, the development agencies do not always need to ensure safeguards for a population over which they have no mandate. A government is accountable to the people if their conduct in development projects incurs any damage; however, the development agencies are not accountable to anyone for the delays and costs inherent in the implementation of safeguards. Since a government is obtaining a repayable loan, it should have the freedom to decide how best to allocate expenditure, taking into account the short-term and long-term costs and benefits to the people concerned. Some of the suggested safeguards may not be in the long term interest of developing countries which have different preference sets compared to developed nations. Unfortunately, governments may be rushed into agreeing to loan agreements given urgencies of projects, without fully taking into account the implications of safeguards and covenants. 10.3.3 The Paris Declaration The Paris Declaration is an international agreement signed in March 2005 between representatives of recipient governments and donors, detailing commitments to improve aid management with a set of targets and actions. This agreement addresses most of Sri Lankas concerns with regard to aid relationships including pledges by donors to align aid with country development plans, increased accountability (donors and recipients) to citizens and the need for increased authority for donors field staff (as opposed to boardrooms in Washington or Manila). To quote a few examples from the Paris Declaration, Donors agree to; Base their overall support country strategies, policy dialogues and development co-operation programmes on partners national development strategies.
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Avoid activities that undermine national institution building, such as bypassing national budget processes or setting high salaries for local staff. Strengthen capacity by avoiding parallel implementation structures avoid, to the maximum extent possible, creating dedicated structures for day-to-day management and implementation of aid-financed projects and programmes.
Unfortunately, there is very limited usage of the Paris Declaration as a negotiating tool by the government in aid negotiations. It is important that officers involved in aid negotiations, particularly at the External Resources Department (ERD) and key line ministries, have increased awareness of the Paris Declaration and its efficacy in strengthening the negotiating position of the aid recipient. Whilst many of the Paris Declaration commitments have been implemented unilaterally by the major donors in Sri Lanka, there remain concerns about harmonization of aid, duplication and inefficient use of funds with regard to the smaller donors. Many of the bilateral aid partners channell aid through international and local NGOs, and whilst there is a system by which they report these activities to the government, it is often the case that reporting is incomplete or delayed, undermining attempts of aid coordination. According to the Paris Declaration, the donors in question would need to ensure that all steps are taken to support the ERD in eliminating duplication of efforts and rationalising donor activities Alignment of donor activities to national development strategies is emphasized in the literature and is reflected in the Paris Declaration as well. However, in Sri Lanka there have been three separate development frameworks in the last four years (Regaining Sri Lanka, Rata Perata and Mahinda Chinthanaya). It is not plausible to expect donor alignment when there is a change in the national development plan with each change in government. In this context, it is important that country development plans attempt to capture a greater degree of political consensus and reach a compromise that will result in general continuation of the programme despite changes in government. The present development plan was framed primarily by the Department of National Planning with inputs from relevant line ministries. Enhancing greater stakeholder inputs from academia, civil society and political parties may be one means by which national ownership can be better reflected. It is encouraging to note that the present draft of the Mahinda Chinthanaya is at present undergoing revision along these lines. The development framework can provide the clearest possible indications to donors of where they can make a contribution to the countrys development.
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10.3.4 Transparency The need for improved transparency at all levels of donor activity is a theme that recurs frequently in the aid literature, and it is no different in Sri Lanka. The greatest need for transparency is in its role in reducing transaction costs and wastage in aid relationships. A concern with major donors, INGOs, and the UN system is the bureaucracy that characterizes their activities. Phantom Aid is defined by Action Aid as aid that never materializes to poor countries but is instead diverted for other purposes within the aid system i.e., tied to goods from donor countries, over-priced technical assistance, administration costs and transaction costs. In Sri Lanka, the administration costs make up the greatest segment of Phantom Aid. Large salaries are paid to international consultants who do not necessarily add an equivalent amount of value to the development process. Costly per diems, vehicles, excess staff and projects with weak cost-benefit ratios remain prevalent in the aid bureaucracy in the country. Transparency is the key here. Institutions need to be audited; projects should clearly specify the details of operational costs incurred, salaries paid to consultants need to be publicized and justification should be provided for the need to hire foreign consultants. Transparency is important on the part of the government as well as donors. This is particularly true of bilateral aid projects where there are inherently less transparent bidding practices. These need to be publicized so as to minimize loss of public funds through wastage or corruption. Systems such as PETS (Public Expenditure Tracking Systems) have been used in Sri Lanka; however, it would be advisable to have this kind of information for public knowledge rather than just information between donors and the implementing agency. 10.3.5 Decentralization of Aid Management A major debate in aid reform is on the necessity of change in governance structures of the major multilateral donors such as the Bretton Woods Institutions and the regional development banks. Focusing too much on leadership of the relevant institutions masks a more pertinent concern. Aid must be provided based on a countrys specific requirements and not determined at the governing board room in Washington or Manila. Therefore, the weight of decision making should shift towards country offices, and it is in these offices that increased recipient voice is needed, particularly in leadership. Whilst local staff is
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recruited into the local units of the donors, the major decision making positions are occupied by foreign nationals. Even local staff who are hired are often entrenched in donor systems and toe the line of donor policy. As a result, locally generated knowledge and debate is often excluded from decision making processes within donors even at the country level. To include a greater degree of local debate and input into the design of country assistance strategies, their creation should involve a broader range of domestic voices, beyond representatives of the government and locals in the employ of donors. Along with decentralization of decision making on the part of donors, it is important that the government too considers the possibility of some degree of decentralization in aid management. For instance, donor coordination at the provincial level would in an ideal world be handled by provincial governments. Whilst the major projects such as highways, power plants and public infrastructure projects should be handled at the centre, the smaller micro level assistance provided by INGOs and smaller bilateral donors could in theory be better handled by provincial governments. Provincial governments are better placed to understand the needs of the community and should be better able to handle donor coordination within a smaller geographic area. Furthermore, it would provide a closer linkage between donor, government and recipient, allowing for greater feedback from recipients of aid. As it stands, capacity may be a problem in implementation of such a decentralization of aid management; however, it would be a worthwhile endeavour to work towards. 10.4 Conclusions The priorities for reform on the part of donors would be to reconsider the usage of aid as a political lever in fulfilling foreign policy agendas; these are ineffective at best and detrimental to the poor in reality. Donors need to streamline project management practices so as to avoid extensive micromanagement which further stretches already constrained domestic capacity. The usage of safeguards and covenants needs to be designed so as to avoid putting pressure on governments to accept agreements that are not priorities in development. Furthermore, the bureaucratic processes inherent in these agreements must be streamlined as envisaged in the Paris Declaration. Donors channelling funds through NGOs should ensure that these implementing bodies provide timely and accurate reporting of proposed activities to the government so as to
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prevent duplication and facilitate harmonization. Increased transparency in operational processes and incorporating legitimate local voices into the design of country assistance strategies and project planning are very important as well. The governments major priority is to ensure sensitization of aid negotiators to the Paris Declaration and to fulfil its potential as a key negotiating tool. In order to improve negotiating strength it is important to make use of available local capacity in the form of experts in the relevant field who work outside the government. The government has a role in ensuring increased transparency for public knowledge and debate of foreign funded projects and their implementation. Finally, steps should be taken to decentralize the management and coordination of some aid to the sub-national government.
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Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2007 Empowerment of the Poor

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10. Reform of the Donor-Recipient Nexus in Aid Delivery

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Praful Patel, South Asia Vice President, World Bank.

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Box 10.1: The Changing Role of the Multilateral Financial Institutions

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