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The paradigm shift in development aid towards the financing of ‘global common goods’

Wolfgang Mostert, development economist and historian. December 2023

In the 1960s, development in the developing countries was interpreted as synonymous with economic growth and a narrowing of the income lead of the developed countries. The challenge was seen as manageable. According to the growth theory formulated by Solow in the 1950s, growth is created by three factors: the level of savings, increases in productivity and the size of the workforce. In line with the US Marshall Aid to Western Europe from 1948-51, development assistance (ODA), therefore, consisted of a mixture of financial and technical assistance. The external finance was supposed to raise the recipient country’s investment rate beyond the level which the country’s own savings could finance (cover an investment-savings gap) and provide international currency to pay for necessary imports (cover an import-export gap). The technical assistance was expected to generate significant productivity gains because the new states that emerged in the wake of post-war decolonization had a large capacity backlog. Congo, for example, had at independence only 18 university graduates.

In addition, humanitarian aid was an appendage of around 10% of the aid budget, reducing extreme poverty and promoting gender equality was a cross-cutting special theme almost from the start.

Seen through these lenses, foreign aid has an end date. Increasing economic growth would lift the national income of the poor countries and thus their ability to finance themselves.  Aid needed only to push the developing countries forward to the stage, by the American economic historian W.W. Rostow called the “take-off” phase, where social transformations, incipient industrialization and a national savings rate of approximately 20% of gross domestic product (GDP) together create a self-sustaining economic growth which takes the country on to the next stages of development.

The financial prerequisites for mobilizing sufficient donor funding existed. Marshall aid amounted to 1.1% of US GDP. In 1960, the ‘industrialized countries’ had a share in the world’s GDP of almost 80%; so the 0.5% of their GDP that was given as aid in the 1960s corresponded to a fifth of the developing countries’ GDP. The finance optimism was reflected in the UN resolution adopted in 1970, which asked the industrialized countries to provide 0,7% of their GDP in development aid.  However, in the 1970s and 1980s, aid fell to 0.32% of the OECD-DAC countries’ GDP.

At the end of the 1980s, it became clear that the sum of the bilateral aid and the development banks’ loan financing was insufficient, together with the developing countries’ own savings, to finance necessary infrastructure investments in energy, transport, telecommunications and water. The conclusion of Western donors was that private capital had to take over part of infrastructure financing. This required that the recipient countries implemented structural reforms that privatized previous monopoly markets and opened their economies and financial markets to easier access to foreign capital and trade.  Risk-mitigating subsidies were introduced as an instrument for the ‘mobilization of private capital’ for investments in the ‘South’.  In parallel, donors and development banks reduced their financing of infrastructure projects and increased the share of the funds allocated for budget support, education and health.

The financial crisis in 2008 created favorable conditions for developing countries access to private finance. The fall in interest rates in the OECD countries increased investors’ appetite for risk, which made it possible for a large number of countries to issue government bonds on the international capital market at interest rates that were not far above those offered by the World Bank. In 2010, funding from public sources was double that of private investors; in 2019 their shares were equal.

After the year 2000, China became the world’s single largest supplier of development finance through the loan financing of large infrastructure projects on largely commercial terms; aid is a fraction of China’s funding. The loans were popular because project preparation and implementation through Chinese construction companies take place at a faster pace than for Western development banks and projects are approved without requiring national structural reforms as a condition.  Other providers of ‘South- South’ development finance included India,Brazil and the Gulf states.

The United Nations Conference on Environment and Development (UNCED) in Rio de Janeiro in 1992 adopted the ‘UNFCCC Convention on Combating Climate Change’ and the ‘Convention on the Protection of Biodiversity’.  With this the financing of ‘global common goods’ on the basis of the principle of “common but differentiated responsibilities and respective capacities” became a new aid component, which immediately led to discussion about the consequences for traditional development aid. At the COP-15 climate meeting in Copenhagen 2009, the DAC countries pledged to provide ‘additional climate finance’ for ‘climate mitigation’ (CO2 reductions), and for ‘climate adaptation’, with the annual amount rising to 100 billion dollars by 2020 . The creation at COP-28 in 2023 of a fund for ‘losses and damages’ to compensate countries affected by climate change, expanded climate finance to comprise three categories. In 2020, the coronavirus highlighted the existence of yet another global common good: ‘fighting epidemics’.

The UN’s adoption in 2015 of seventeen global sustainable development goals for 2030 expresses a multidimensional understanding of development as consisting of an economic, a social and an environmental dimension. The goals are assumed to be achieved in a “Global Partnership for Sustainable Development”, where “each country has the primary responsibility for its own economic and social development”, but “public funding, both national and international, will play a vital role in providing essential services and public goods”. The broad portfolio raises the issue of the balance in the support given to “equality pillar” and “sustainability pillar” goals respectively.

During the 1990s, Western donors’ belief in the universal applicability and superiority of the Western political system led them to include the promotion of Western values as a theme in their aid.  Buzz words such as ‘rights-based aid’ and ‘value-based aid’ emerged. Democracy programs were implemented to accelerate changes towards democracy and respect for human rights in the partner countries and, as a side effect, increase their economic growth rate. However, evaluations of the programs have difficulty in demonstrating impact, and irritation over teachings about values from former colonial powers causes African voices to criticize that “China provides bridges, the EU exhorts lectures”.

From 2000 to 2020, the world’s 69 low-income countries (IMF definition) experienced a 50% increase in the number of their migrants, which had the positive side effect of increasing the annual remittances from their diaspora from 5 billion to 70 billion, equal to twice the amount of ODA aid which they received in 2020.  During the same period, the DAC countries experienced increasing internal costs for the reception and integration of refugees and irregular migrants.  In 2022, these expenses, accepted as ODA by DAC, amounted to 29 billion dollars, meaning that 14% of reported ODA that year does not involve any transfer of resources to developing countries.

In the 2020s, international development finance faces three major challenges.

Firstly, the development strategy of-financing ‘soft national common goods’ (budget support, health, etc) partly with ODA, partly with development bank loans and ‘hard infrastructure’ with private and Chinese bank debt finance and development bank loans has failed to deliver the desired results. The greatest economic progress has been made in countries where development aid made a modest contribution to the state budget: India, China and Southeast Asia. The countries in Africa south of the Sahara received the largest contributions as a percentage of their state budgets (25-60%) and as a percentage of GDP (10%). Despite considerable progress in health and education, they achieved modest growth in income per capita and in eradicating extreme poverty. Model calculations by university economists specialized in development economics, such as Henrik Hansen and Finn Tarp from the University of Copenhagen, usually show acceptable economic rates of return from international development aid. Other economists, such as Nobel laureate Angus Deaton and Zambian economist Dambisa Moyo, deny that ‘national common good’ funding has a positive effect. Inter alia based on the argument that external support undermines the government’s responsibility for proving national goods to its citizens, Moyo wants this form of aid to be phased out completely; Deaton recommends that a state does not receive more than 20% of its state budget from outside for a long time.

The financing of infrastructure with private capital and Chinese bank loans led several countries into a debt trap: in 2023, 56% of low-income countries are in a critical debt situation. In 2022, developing countries paid 444 billion dollars in interest and repayments on their public debt, of which the 75 low-income countries eligible for loans from the World Bank’s IDA branch accounted for 89 billion. This is more than the 52 billion in development aid that went to the low-income countries in 2021. Private finance reacts quickly to changes in risks: the net inflow of private funds during the 2010s has been replaced by a net outflow each year since 2019.

Structural factors explain the underperformance of low-income countries. Among internal factors, three can be highlighted. (i) Corrupt regimes enrich themselves to the detriment of the country’s development. (ii) Persistently high population growth impairs growth per capita. (iii) Because foreign loans are invested in prestige projects with a rate-of-return than lower than the interest-rate on the debt, the national debt increases as a percentage of GDP and of the state budget, which leads to an increased share of the national budget going to interest and repayment of debt, which crowds out spending on ‘national common goods’ ‘. Among external factors, two should be mentioned. (i) The combination of a high national interest rate, a modest domestic market and deficiencies in infrastructure for transport and communication make it difficult for domestic firms to compete on the world market. This maintains the country in a position of raw material supplier with little further transformation of extracted minerals to add value to the country.  (ii) The geographical location far from countries with a high standard of living reduces the potential for the exchange of goods and services with neighboring countries.  This prevents scale economies and specialization from being achieved.

The second major reform trigger is the lack of correspondence between the level of finance needed to achieve the global development goals, and the level of North-South finance. OECD-DAC reports North-South finance of 468 billion dollars in 2021, consisting of 185 billion in ‘development aid’, 14 billion in ‘export credits’ and 254 billion in ‘private financing flows’. The ‘global common goods’ alone need much larger amounts. The need for climate investments in the ‘developing world outside China’ is estimated at 2,400 billion dollars in 2030, of which the external share is 1,000 billion; UNEP estimates the biodiversity annual funding gap at $600-800 billion by 2030; UN requests $46 billion for humanitarian aid for 2024; additional $15 billion per year are needed to avoid future pandemics.

During the past 60 years, the DAC countries’ development assistance has been below 0.35% of Gross National Income (GNI). Pledges at COP meetings on climate finance and at COP meetings on biodiversity do not raise the DAC countries’ overall willingness to pay. as illustrated by the fate of the ‘additional’ climate finance pledge: the ‘additional’ climate finance reported by DAC comes primarily from the aid budget of DAC countries.

The political attention to ‘global goods’ raised their share in DAC bilateral aid from 30% during 2006-2010 to 57% during the 2016-2020 period. The trend will continue.  As a side effect, because the right to climate finance is legally strong according to the ‘polluter pays’ principle, the ‘South’ will insist on and get greater influence over the use of development funding. The North-South difference in interests is substantial. The DAC countries prefer to spend climate finance on CO2 reductions (a global good for all); the developing countries prefer that the money be used to cover the damage and adaptation costs which climate change is imposing on them here and now (national goods for them). In 2021, the DAC countries reported 90 billion dollars in ‘additional’ climate finance, of which 60% went to climate mitigation, 27% to climate adaptation, 13% to projects having both aspects. The developing countries want the opposite composition.

The third major challenge is to adapt the ‘international governance’ structure established by the Bretton-Woods conference in 1944 and by the Kyoto Protocol in 1998 to contemporary conditions. In 2020, the ‘South’ produced 50% of the world’s GDP, the ‘North’ 42%, and ‘European developing economies’ (the Balkan countries, Turkey, etc.) 8%. However, due to an agreement from 1944, the United States elects the director of the World Bank, the Western European countries the director of the IMF. The United States is the only country with a voting share of more than 15% in both institutions, which enables it as the only country to block important decisions at their Boards of Governors and Boards of Executive Directors.

China’s frustration with the United States’ refusal to accept IMF and World Bank capital expansions that drop US equity holdings below 15.1% has motivated the creation of rival institutions: the Asian Infrastructure Investment Bank (AIIC) and the New Development Bank (NDB). China, the world’s largest single lender, refuses to enter into negotiations on debt restructuring of developing countries under the overall management of the IMF (seen dominated by US interests) and conducts separate bilateral negotiations.

The Kyoto Protocol from 1997 imposes legally defined targets for absolute emission reductions for a small group of industrialized countries, seen as being responsible for most of the exponential increase in global CO2 emissions that occurred from 1950 to 1997.  At the annual UNFCCC-COPs the protocol undergoes adaptations which increase the obligations of the ‘South’ for action. But countries like China, Saudi Arabia and Qatar will not recognize the full implications of the fact that the exponential increase in emissions that is taking place in the South since 1997; has increased the annual emissions of the ‘South’ to a level greater than those of the ‘North’ and that the accumulated ‘Southern emissions’ will match the Northern historical emissions in a few years time; China’s emissions since 1850 already equal those of the EU.

A look into the crystal ball for changes towards 2030.

The ideal reorganization of global governance would be for the Western countries to drop their voting majority in the IMF and in the World Bank, and for the biggest climate sinners in the ‘South’ to accept responsibility for the co-financing of climate adaptation and climate damage funds. The prospects for that are uncertain and will in any case take time. In the meantime, the South’s greater influence over the use of development finance will result from an increasing share of it being administered by specialized funds which are not dominated by Western votes.

The finance deficit of the sustainable development goals will lead to the increased application of innovative finance instruments such as ‘debt for nature swaps’. The IMF will issue new “special drawing rights” (money creation) and encourage wealthy countries in the world to pass part of their allocation on to low-income countries. Through a mixture of new equity capital contributions from their members, risk-limiting subsidies from donors and greater risk taking in their lending and in in their finance structure (higher debt/equity ratio), the development banks’ annual lending can be tripled by 2030. Donor financing of risk-hedging subsidies for the mobilization of private investments will continue.  Sooner or later, the opposition to the introduction of a global CO2 tax on shipping and on international flights to generate revenues for climate funds will be broken.

For the least developed countries a new development strategy is needed, which assists them in achieving a more favorable integration into the global economy; promotes the share of local private capital in the financing of ‘global common goods’ projects; and reduces the gap between the interest rate level of developed countries and low-income countries.

Combating extreme poverty will continue to be a component of aid. Financing of ‘national common goods’ will become a minor item; it is time for Governments also in low-income countries to be solely responsible for their supply.