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Leland & Pyle Meet Foreign Aid? Adverse Selection and the Procyclicality of Financial Aid Flows

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  • Stéphane Pallage
  • Michel A. Robe

Abstract

Official development assistance (grants and subsidized loans from foreign aid agencies) is the main source of external finance in developing countries. These financial aid flows are positively correlated with the recipients' business cycles, which is puzzling because it reinforces already strong and costly macroeconomic fluctuations in the recipient countries. We propose an explanation related to a familiar corporate finance theory of inside equity commitments. We assume that donor agencies and recipient governments value projects differently, and that donors know less than recipients do about projects. We show that donors can make an aid recipient idientify high-return projects by conditioning aid on the recipient's committing some of its own funds to the selected projects. This commitment makes recommending bad projects costly. Contributing "counterpart funds" is more difficult during economic downturns, however - which leads to aid procyclicality. This simple model of investment financing and aid provision produces aid contracts consistent with those used by aid agencies, rationalizes observed aid flow patterns, and yields a rich set of testable empirical predictions.

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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 0327.

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Date of creation: 2003
Date of revision:
Handle: RePEc:lvl:lacicr:0327

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Related research

Keywords: Aid; Altruism; Adverse selection; Counterpart funds; Capital flow procyclicality;

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Cited by:
  1. Kletzer, Kenneth, 2005. "Aid and Sanctions," Santa Cruz Department of Economics, Working Paper Series qt5hq5d9gp, Department of Economics, UC Santa Cruz.
  2. Eifert, Benn & Gelb, Alan, 2005. "Improving the dynamics of aid : towards more predictable budget support," Policy Research Working Paper Series 3732, The World Bank.
  3. Wezel, Torsten, 2004. "Does co-financing by multilateral development banks increase "risky" direct investment in emerging markets?," Discussion Paper Series 1: Economic Studies 2004,02, Deutsche Bundesbank, Research Centre.

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