The Implications of Foreign Aid Fungibility for Development Assistance

Abstract

To address the fungibility of foreign aid funds, a proposed new lending instrument - a public expenditure reform loan-would tie an institution's lending strategy to the recipient country's achieving mutually agreed-upon development goals.

A foreign aid or foreign lending policy that focuses exclusively on project financing may have unintended consequences, report Devarajan and Swaroop. New research shows that aid intended for crucial social and economic sectors often merely substitutes for spending that recipient governments would have undertaken anyway and the funds that are thereby freed up are spent for other purposes.

If the aid funds something that would have been done anyway, traditional ways of evaluating the aid's effectiveness are not really accurate. If aid funds are fungible and the recipient's public spending program is unsatisfactory, project lending may not be cost-effective. If the recipient's public spending program is satisfactory, perhaps the donor should finance a portion of it instead of financing individual projects. One solution to the problem of fungibility, then, is that donors could tie assistance to an overall public spending program (in the recipient country) that provides adequate resources to crucial sectors.

To make this kind of reform operational, Devarajan and Swaroop propose a new lending instrument: a public expenditure reform loan (PERL). A PERL would tie an institution's lending strategy to the recipient country's achievement of mutually agreed-upon development goals.

Everyone agrees that better donor coordination is needed, but it has been difficult to achieve because some donors tend to prefer projects (usually with the national flag flying over them). By agreeing on a public expenditure program and financing a portion of it, the Bank can credibly ask other donors to do the same.

This paper - a joint product of the Development Research Group and the Poverty Reduction and Economic Management Network - is part of a larger effort in the Bank to understand better the development impact of aid.