Company influence on foreign aid disbursement: is conditionality credible when donors have mixed motives?

• Author: Villanger, Espen

When donors enforce conditionality upon recipients who do not implement the conditions, companies can suffer from cancellation of their contracts with the recipient when aid dries up. A strategic recipient may avoid implementing controversial conditions by only granting a contract to a company that puts pressure on the donor to keep aid flowing. In our model, each of these three agents takes account of each of the two other agents' actions. We show that this triadic structure can be crucial when explaining recipients' use of companies to influence donors to give aid unconditionally, and we offer a time-consistent explanation for the failure of conditionality.

JEL Classification: E61, F35

1. Introduction

   Empirical evidence indicates that poor countries frequently abstain from implementing the conditions that donors have set as a requirement for granting foreign aid. Still, it is found that the aid is disbursed irrespective of the recipient's implementation record (World Bank 1992; Mosley, Harrigan, and Toye 1995; Collier 1997; Svensson 2000a). The World Bank (1992) concluded that even though the rate of compliance with World Bank conditions was only 50%, the release rate of loans was nearly 100%. In other words, despite the donors' intention to induce the recipients to undertake what are perceived by the donors to be "good policies," usually regarding fiscal, monetary, and trade policies designed to increase economic growth, it is found that aid does not induce these policies (Burnside and Dollar 2000). Even more uncontroversial conditions, like setting a certain minimum level of expenditure on health care and education, seem to fail (World Bank 1992; Mosley, Harrigan, and Toye 1995; Oxfam 1995).

   The malfunctioning of conditionality is a serious problem for the donor community and the multilaterals because this instrument is viewed as a necessity for achieving the goals of aid (Kanbur 2000). At the same time, receiving aid is a very important income source for poor countries. On average, aid accounted for more than half of central government expenditure for 50 of the most aid-dependent countries from 1975 to 1995 (World Bank 1998b), and a typical low-income country now receives around 7% to 8 % of GNP in foreign aid (World Bank 1998a). This gives rise to a puzzle: If it is vital for the recipients to get aid, and also essential for the donor to have the conditions implemented, why cannot the seemingly powerful donors force the seemingly weak recipients to implement the conditions before aid is disbursed?

   Ravi Kanbur's (2000) observations as a World Bank representative in Ghana in 1992 illustrate one potential explanation for the failure of conditionality. At that time, the Ghanaian government had refused to implement the conditions set by the World Bank for granting a loan, and the bank had to decide whether or not to disburse this loan. In this situation, private companies that had contracts with the Ghanaian government put pressure on the World Bank to release the loan because they were afraid of not getting paid. Eventually, the loan was disbursed without the implementation of the conditions, and Kanbur concludes that the pressure surrounding conditionality is important in explaining its failure. Thus, strategic recipients may refuse to implement the conditions and then threaten to cancel contracts with companies in order to put pressure on the donor to disburse aid. (2)

   Building upon the triadic (3) modeling structure of Basu (1986), we consider the interdependence that sometimes arises between donors, recipients, and large companies with interests in both countries. (4) In this model, the donor takes into account both its own and the company's relationship with the recipient when deciding on aid disbursement, and, more generally, each of the agents always takes account of the triadic structure when making their decisions. If the recipient can influence the company to put pressure on the donor to disburse the aid, we show that this could make the donor provide the aid even when the recipient has not implemented the conditions. We show that the recipient is not able to influence the company in a situation where the parties interact only once. However, donors usually give aid to the same recipients over time, and allowing for repeated interactions between the parties gives the result that the recipient is able to influence the company to generate pressure against conditionality. Hence, the recipient is not necessarily as weak as it may seem, because the recipient might be able to use the company's influence over the donor.

   This article is related to the literature on foreign aid in general and to the work on the failure of aid conditionality in particular. Despite its importance, conditionality has received little attention with regard to theoretical modeling (Drazen 2000). The main contribution to the understanding of the failure of aid conditionality is Svensson's (2000c) principal-agent model where he illustrates how altruistic donors' time inconsistency problem gives rise to continued aid even when conditions are not implemented. (5) In Svensson's framework, the donor and the recipient share the perception that implementing the conditions improves the well-being of the recipient, so the recipient would implement some of the conditions even if the donor did not exist. The failure of conditionality arises because the level of poverty determines the amount of aid, and this gives incentives for the recipient not to implement costly poverty-reducing policy conditions. Another contribution that illuminates the problem is Mosley, Harrigan, and Toye (1995), who model the interaction between the donor and recipient as a dyadic bargaining game. They find that there will always be some slippage on the conditions that the recipient has agreed to implement.

   In our model, we incorporate the empirical finding that, frequently, there are disagreements between the donor and the recipient on what constitute "good policies" (Mosley, Harrigan, and Toye 1995; Dollar and Svensson 2000; Kanbur 2000). One reason for the unwillingness of the recipients to implement the conditions is that this change in policies will often harm politically important groups in the recipient country (Summers and Pritchett 1993). (6) Another reason could be that it is not in the recipient country's interest to implement these policies, as could be the case when the poor country maintains import barriers to protect "infant industries." The donors, on the other hand, would profit from having access to another foreign market and would put pressure on the recipient country to liberalize trade. Thus, whether some of the conditions are imposed for the donor's own benefit, or the benefit of its allies, or whether they are imposed for the good of the recipient, is an open question. In our model, we assume that the recipient would prefer not to implement the conditions, ceteris paribus.

   To illustrate conditionality, we assume that the donor follows the World Bank (1998a) in adhering to the empirical findings of Burnside and Dollar (2000) that aid only increases economic growth if the tight macroeconomic policies are sustained. Thus, the donor makes aid conditional upon these policies, believing that implementation of the policy conditions is essential in order to achieve the intended effects from aid. So, even if aid has some positive effects if the conditions are not implemented, the donor's assessment is that granting aid is wasted in this situation. With this divergence of opinion, it is not necessary to restrict our focus to Samaritan donors, and this differs substantially from the existing work on foreign aid policy, in which time inconsistency is crucial (see Mosley, Harrigan, and Toye 1995; Pedersen 1996, 2001; Svensson 2000c). Hence, our results are not related to the Samaritan's dilemma.

   Obviously, as Svensson (2000c) and World Bank (1998a) also note, donors' rationale for giving aid may, in reality, be guided both by altruistic and self-interested motives. Thus, both motives will naturally be reflected in the conditions attached to aid. The empirical studies of Burnside and Dollar (2000), Trumbull and Wall (1994), and Alesina and Dollar (2000) all suggest that both motives are present among donors. Thus, we incorporate a self-interest motive and an altruistic motive in the donor's preferences. So, if a donor has self-interests with regard to its own domestic industries, and an altruistic motive for maintaining aid conditionality, we show how recipients can grant contracts strategically to companies with origins in the donor country and that this may cause a time-consistent failure of conditionality.

   In general, the literature on foreign aid uses traditional dyadic models to explore the donor-recipient relationship, and we show why the triadic framework may be important in explaining the failure when companies are able to influence the donor's disbursement decision. In our model, restricting the donor, the recipient, and the company's interaction to being dyadic yields the opposite results in comparison to allowing for triadic relations: Assuming dyadic interactions implies that the recipient is unable to influence the company's eventual pressure on the donor; this causes the recipient to implement the conditions, and conditionality becomes successful. Our framework should thus be regarded as complementary to Mosley, Harrigan, and Toye (1995) and Svensson (2000c). One novel policy implication that may be important for the players on the foreign aid scene is that this setup provides a rationale for donor guarantees to companies (from the donor countries) that operate in the recipient country.

   This article is organized as follows. A simple introduction to the triadic structure of the problem is given in section 2, and a formal game-theoretical framework that models the interdependency between donors, recipient, and companies is proposed...