Counterpart funding requirements and the foreign aid procyclicality puzzle

Official development assistance is a key source of external finance in many developing countries. A striking feature of these aid flows is their positive correlation with business cycles in recipient countries. This pattern is puzzling in that it reinforces recipients’ already strong and costly macroeconomic fluctuations. We propose a simple model of investment financing and aid provision under asymmetric information that rationalizes such a pattern. We assume that donor agencies and recipient governments value projects differently, and that donors know less than recipients do about project characteristics. We show that donors can make a recipient government identify high-return projects by requiring that the latter contribute some of its own funds to projects. Providing these matching grants or ‘counterpart funds’ is less affordable for recipients during economic downturns, which leads to aid procyclicality. Our model produces aid contracts consistent with those used by aid agencies, rationalizes observed aid patterns, and yields a rich set of testable empirical predictions.