The Agency Issue
While thinking of foreign aid and its utilisation in Nepal , the principal-agent framework which has been quite useful in examining a whole host of economic issues, is relevant. There are basically two actors - the donor government and the recipient government. Both work within the framework of a principal-agent relationship in the utilisation of aid money. In the donor country, the citizens are the principal and the government is the agent. Both agree to a set of relationships to produce development in another country, in this case the aid receiving country. So the expected output by the donor country is the economic development of another country. Naturally, the accountability involved in this type of principal-agent relationship is weak. Normally, for the people of the donor country, how the aid money in a third world country is used is not likely to be an issue of great priority when compared with pressing problems of domestic unemployment, health care, education etc. As human beings, they are naturally interested in their own bread and butter issues rather than the poverty of countries far away. Since it is an issue of lesser concern there is always a reluctance to allocate budget to this sector and it is amply reflected in the inability or unwillingness of a great many rich nations to allocate money as per their international commitments. For example, the richest country in the world, the United States , is committed to allocate 0.07 per cent of its GDP to foreign aid; but the actual allocation has remained below 0.03 per cent. EU’s record is similar.
Once money is allocated, the principals virtually lose interest about the way it is being spent. For all practical purposes, they delegate their authority to the agent, which in this case is the government, to spend the money the way it sees fit. This carte blanche authority by the principal is seldom objected by governments and they use it the way they think best. This partly explains why aid money that is supposed to help the poor in developing countries is easily diverted for buying guns and bombs or in supporting projects which assure that a lion’s share of the aid money goes back to the donor country in buying equipments at a price much higher than the international level or in supplying advisors and consultants for each and sundry issues in the name of development.
The second component of this principle-agent relationship framework is the aid recipient country. Here also, if we take the people as defining the principal then the government emerges as the agent and the expected output of this relationship is development. Foreign aid in many countries is an important component of development budget. Naturally one would expect the principal as well as the agent to be serious about the expected outcome since the basic bread and butter issues may be at stake. However, what we see in a many cases is that the nature of this agency relationship and its impact on output is weak. Numerous econometric studies have shown that the relationship between aid and development is weak and statistically insignificant. This applies to Nepal as well. In fact the West’s aid to the Rest has had very little impact on reducing poverty. For example $568 billion was the amount of aid money spent on Africa, but in terms of impact most African countries are as poor as they were 40 years ago (William Easterly in “Why Doesn’t Aid Work”). On the other hand, there are also cases where aid money has produced impressive results as will be shown later.
From an agency perspective there is one important element between the agent and the principal and that is the supervisory body created to carry out specific tasks on behalf of the agent/ principal and here it means the bureaucracy, the BONGOS, GONGOS, DONGOS and PONGOS (Business organised NGOs, Government Organised NGOs, Donor Organised NGOs, Party Organised NGOs) or even a combination of all of these. Now the relationship between the supervisor, agent and the principal is complex and fascinating. It is possible that the agent is duped by the supervisor because the latter may have control over the information – i.e. the informational asymmetry problem which can mean bureaucratic corruption. But in a developing country like ours where transparency and accountability to the principal remains weak, it is entirely possible for the agent and the supervisor to collude to extract maximum rent while providing incomplete information including manipulation to the principal who are in any case not alert enough to notice discrepancies and differences. A weak incentive scheme, both in terms of rewards and punishment, reduces the transaction cost of corruption to the supervisors/agents or both. We do not have to go very far. Any senior level politician in Nepal has ever been indicted and sent to jail on charges of corruption even though there is a widespread perception that top level corruption is the rule rather than an exception. Thus an iron triangle between the bureaucracy, politicians and limited business elite has made a complete mockery of the utility and productivity of aid. The latest to join this bandwagon have also been the NGOs. However, it should be mentioned that there are many NGOs that are performing their supervisory roles in a commendable manner but there are many more that are eager to ride on the foreign aid gravy train with no concern for the principal, i.e. the people. It should also be noted here that political parties that routinely profess their commitment to the people have not been averse to use this aid for their own purpose.
In the use of foreign aid there are, as mentioned above, two sets of principals and agents - one in the donor and another in the recipient country. The agents in the donor country and the recipient country are their respective governments. What can we say about the objectives of the two agents? Formally, it is to serve the principals’ interest, i.e. the people of both these countries. It is not, however, necessary that the interests of both are always aligned in a manner that serves the principals’ interest. The crucial element here is the ability of the recipient country to articulate its priorities and ask the agent of the donor country to organise its aid programme accordingly. When this is missing there is the possibility of the supervisory level interest on both sides to be involved in maximising their own respective interests leading to different forms of rent extraction, inefficient use of aid money and the implementation of development programmes that are neither sustainable nor replicable.
Aid Receiving Categories
In terms of categories, there are four different types of countries that are the recipient of foreign aid. First, some countries have received high per capita foreign aid over the last few decades and yet remain mired in poverty. They fall under the category of high per capita aid and low rate or no rate of growth. Call this country category A. Nepal along with many African countries falls under this category and they have been stuck at this level for a long time. Second, there are countries that started with high per capita foreign aid but gradually reduced their dependency to the point that they no longer rely on this source to finance and sustain their growth. Call this the B group. This is the case of high per capita aid leading to high growth rate and declining aid over time. South Korea is a prime example of this group. South Korea was heavily dependent on foreign aid when it first started on the development path after the Korean War. In 1957, the share of foreign aid in total imports was almost 87 per cent. Since 1958, the percentage of aid financed imports started to decline(Il Sakong in Korea in the World Economy, Institute of International Economics , 1993. p.101 ) and it was zero in the year 1972. It was a remarkable transition from a heavily aid dependent country. Gradually, South Korea shifted from aid to loan to finance imports: Imports from loan was non existent in 1961, but it reached 14 per cent of GDP in 1973. The key to South Korea ’s successful transition was the ability of the country to use borrowed capital not for consumption but for creating future debt servicing capacity. A third category of countries includes those with low per capita aid and low rate of growth. India until the end of the 1970s was an example of this mode. Finally, there are countries that receive low per capita aid and yet maintain high economic growth rates. China from the mid-1970s and India after the mid 1980s are examples of this type. It may be interesting to note here that India’s per capita growth rate for a period of 30 years, from 1951 to 1981 was a mere 1.48 per cent, almost the same as per capita growth from 1885 to 1910. However the scenario started changing in the 1980s. Between 1981 and 2000, the per capita growth rate increased to 3.5 per cent and after 2000 the rate has gone up to an impressive 5.8 per cent. In this unfolding drama of rapid growth, foreign aid per capita has become irrelevant. The graph below shows the different categories:
What the above categorisation shows is that high per capita aid is not a sufficient condition for sustained growth. Nepal is at point A and has been stuck there for decades. India was at point D until the early 1980s. Since then the situation has changed and it is reflected in the new line C. South Korea has followed the path from A to B ending its link to bilateral aid by the early 1970s. The crucial factor is the agency relationship, i.e. the relationship between the principal, agent and the supervisors at various levels. This is where the main problem lies and its resolution, in Nepal , will have to be sought by the Nepalis themselves. Unless this is done, aid in Nepal will be a vehicle for agency collusion as well as friction between donors and recipients, aid ineffectiveness and the use of aid to avoid making decisions in favour of the people. This was the situation in the Panchayat era when the king was the leader and sadly it did not change even after the restoration of democracy. Thus Nepal now is stuck in a relatively high per capita aid and a low growth mode because the whole host of issues related with the agency problems have yet to find a resolution. In the meantime the country has not only been aid dependent but is in the stage of aid addiction that can be both humiliating as well as distressing. Even for drafting an Act to be presented to the Parliament the tendency now is to give the responsibility to foreigners and rely on foreign aid for finance. Economic thinking in Nepal so far is simply not willing to visualise the time when we will not have to go stretching our hands for bilateral aid. We may be reaching the status of an aid junkie (Michael Thompson and Deepak Gyawali in "The Toad Beneath The Harrow: How To Make The End Of The Age Of Aid" Paper presented to the Adam Project Workshop, Kathmandu Nepal March 2007). Meanwhile, the disconnect between the agent and the principal on the other hand has taken a heavy toll on transparency and accountability.
Foreign Aid and the Future
For the present, Nepal will need aid for sustenance and survival given the nature of its political problems. This is a transition period - a period of recovering from a serious struggle to create a new principal-agency relationship where the supervisors cannot enrich themselves without being exposed. It will take time, perhaps two to three years, provided the leadership shows sagacity and wisdom. These are qualities that are really in short supply at the moment. Hopefully, once the country finds its political moorings, planners in Nepal must seriously start aiming for the time when we can do without bilateral aid. It is possible especially in view of the fact that we are no longer a land-locked state but a link state with vast water resources and tourism potential linking the two most dynamic economies of the world. The synonym for growth is in some sense energy and Nepal has a lot to offer to both these countries. As a link and a transit state Nepal should be able to take advantage of the new economics in the neighbourhood to quit aid addiction in favour of trade and investments. The aim should be to shift from bilateral aid to FDI to the tune of 4 per cent of GDP from India , China and beyond. This is an achievable goal because both China and India have made the strategic choice to accept globalisation as the pathway to economic and social transformation. Globalisation as a strategic choice is breaking down barriers to the flow of FDI and FII in both China and India . Nepal must therefore start viewing the regional economic environment as opening more opportunities than constraints in creating new wealth and income essential for poverty alleviation Both China and India know that the objective of emerging as a great power in the world system can no longer follow the experiences of the European nations in the past. The challenge of getting enough energy and raw materials now has to be handled not through imperialistic expansion and devastating wars but through cooperation, both regional and global. It is this setting that should make it easy for Nepal to think of development with FDI as a major driving instrument. At present the country is mired in confusion and violence and the proposed prescription may sound like a pipe dream. Well, it isn't. We have to make a national commitment to get rid of bilateral aid within a decade because it is taking us nowhere no matter how many donor harmonisation meetings we organise.
(Dr. Lohani is former Finance & Foreign Minister)
While thinking of foreign aid and its utilisation in Nepal , the principal-agent framework which has been quite useful in examining a whole host of economic issues, is relevant. There are basically two actors - the donor government and the recipient government. Both work within the framework of a principal-agent relationship in the utilisation of aid money. In the donor country, the citizens are the principal and the government is the agent. Both agree to a set of relationships to produce development in another country, in this case the aid receiving country. So the expected output by the donor country is the economic development of another country. Naturally, the accountability involved in this type of principal-agent relationship is weak. Normally, for the people of the donor country, how the aid money in a third world country is used is not likely to be an issue of great priority when compared with pressing problems of domestic unemployment, health care, education etc. As human beings, they are naturally interested in their own bread and butter issues rather than the poverty of countries far away. Since it is an issue of lesser concern there is always a reluctance to allocate budget to this sector and it is amply reflected in the inability or unwillingness of a great many rich nations to allocate money as per their international commitments. For example, the richest country in the world, the United States , is committed to allocate 0.07 per cent of its GDP to foreign aid; but the actual allocation has remained below 0.03 per cent. EU’s record is similar.
Once money is allocated, the principals virtually lose interest about the way it is being spent. For all practical purposes, they delegate their authority to the agent, which in this case is the government, to spend the money the way it sees fit. This carte blanche authority by the principal is seldom objected by governments and they use it the way they think best. This partly explains why aid money that is supposed to help the poor in developing countries is easily diverted for buying guns and bombs or in supporting projects which assure that a lion’s share of the aid money goes back to the donor country in buying equipments at a price much higher than the international level or in supplying advisors and consultants for each and sundry issues in the name of development.
The second component of this principle-agent relationship framework is the aid recipient country. Here also, if we take the people as defining the principal then the government emerges as the agent and the expected output of this relationship is development. Foreign aid in many countries is an important component of development budget. Naturally one would expect the principal as well as the agent to be serious about the expected outcome since the basic bread and butter issues may be at stake. However, what we see in a many cases is that the nature of this agency relationship and its impact on output is weak. Numerous econometric studies have shown that the relationship between aid and development is weak and statistically insignificant. This applies to Nepal as well. In fact the West’s aid to the Rest has had very little impact on reducing poverty. For example $568 billion was the amount of aid money spent on Africa, but in terms of impact most African countries are as poor as they were 40 years ago (William Easterly in “Why Doesn’t Aid Work”). On the other hand, there are also cases where aid money has produced impressive results as will be shown later.
From an agency perspective there is one important element between the agent and the principal and that is the supervisory body created to carry out specific tasks on behalf of the agent/ principal and here it means the bureaucracy, the BONGOS, GONGOS, DONGOS and PONGOS (Business organised NGOs, Government Organised NGOs, Donor Organised NGOs, Party Organised NGOs) or even a combination of all of these. Now the relationship between the supervisor, agent and the principal is complex and fascinating. It is possible that the agent is duped by the supervisor because the latter may have control over the information – i.e. the informational asymmetry problem which can mean bureaucratic corruption. But in a developing country like ours where transparency and accountability to the principal remains weak, it is entirely possible for the agent and the supervisor to collude to extract maximum rent while providing incomplete information including manipulation to the principal who are in any case not alert enough to notice discrepancies and differences. A weak incentive scheme, both in terms of rewards and punishment, reduces the transaction cost of corruption to the supervisors/agents or both. We do not have to go very far. Any senior level politician in Nepal has ever been indicted and sent to jail on charges of corruption even though there is a widespread perception that top level corruption is the rule rather than an exception. Thus an iron triangle between the bureaucracy, politicians and limited business elite has made a complete mockery of the utility and productivity of aid. The latest to join this bandwagon have also been the NGOs. However, it should be mentioned that there are many NGOs that are performing their supervisory roles in a commendable manner but there are many more that are eager to ride on the foreign aid gravy train with no concern for the principal, i.e. the people. It should also be noted here that political parties that routinely profess their commitment to the people have not been averse to use this aid for their own purpose.
In the use of foreign aid there are, as mentioned above, two sets of principals and agents - one in the donor and another in the recipient country. The agents in the donor country and the recipient country are their respective governments. What can we say about the objectives of the two agents? Formally, it is to serve the principals’ interest, i.e. the people of both these countries. It is not, however, necessary that the interests of both are always aligned in a manner that serves the principals’ interest. The crucial element here is the ability of the recipient country to articulate its priorities and ask the agent of the donor country to organise its aid programme accordingly. When this is missing there is the possibility of the supervisory level interest on both sides to be involved in maximising their own respective interests leading to different forms of rent extraction, inefficient use of aid money and the implementation of development programmes that are neither sustainable nor replicable.
Aid Receiving Categories
In terms of categories, there are four different types of countries that are the recipient of foreign aid. First, some countries have received high per capita foreign aid over the last few decades and yet remain mired in poverty. They fall under the category of high per capita aid and low rate or no rate of growth. Call this country category A. Nepal along with many African countries falls under this category and they have been stuck at this level for a long time. Second, there are countries that started with high per capita foreign aid but gradually reduced their dependency to the point that they no longer rely on this source to finance and sustain their growth. Call this the B group. This is the case of high per capita aid leading to high growth rate and declining aid over time. South Korea is a prime example of this group. South Korea was heavily dependent on foreign aid when it first started on the development path after the Korean War. In 1957, the share of foreign aid in total imports was almost 87 per cent. Since 1958, the percentage of aid financed imports started to decline(Il Sakong in Korea in the World Economy, Institute of International Economics , 1993. p.101 ) and it was zero in the year 1972. It was a remarkable transition from a heavily aid dependent country. Gradually, South Korea shifted from aid to loan to finance imports: Imports from loan was non existent in 1961, but it reached 14 per cent of GDP in 1973. The key to South Korea ’s successful transition was the ability of the country to use borrowed capital not for consumption but for creating future debt servicing capacity. A third category of countries includes those with low per capita aid and low rate of growth. India until the end of the 1970s was an example of this mode. Finally, there are countries that receive low per capita aid and yet maintain high economic growth rates. China from the mid-1970s and India after the mid 1980s are examples of this type. It may be interesting to note here that India’s per capita growth rate for a period of 30 years, from 1951 to 1981 was a mere 1.48 per cent, almost the same as per capita growth from 1885 to 1910. However the scenario started changing in the 1980s. Between 1981 and 2000, the per capita growth rate increased to 3.5 per cent and after 2000 the rate has gone up to an impressive 5.8 per cent. In this unfolding drama of rapid growth, foreign aid per capita has become irrelevant. The graph below shows the different categories:
What the above categorisation shows is that high per capita aid is not a sufficient condition for sustained growth. Nepal is at point A and has been stuck there for decades. India was at point D until the early 1980s. Since then the situation has changed and it is reflected in the new line C. South Korea has followed the path from A to B ending its link to bilateral aid by the early 1970s. The crucial factor is the agency relationship, i.e. the relationship between the principal, agent and the supervisors at various levels. This is where the main problem lies and its resolution, in Nepal , will have to be sought by the Nepalis themselves. Unless this is done, aid in Nepal will be a vehicle for agency collusion as well as friction between donors and recipients, aid ineffectiveness and the use of aid to avoid making decisions in favour of the people. This was the situation in the Panchayat era when the king was the leader and sadly it did not change even after the restoration of democracy. Thus Nepal now is stuck in a relatively high per capita aid and a low growth mode because the whole host of issues related with the agency problems have yet to find a resolution. In the meantime the country has not only been aid dependent but is in the stage of aid addiction that can be both humiliating as well as distressing. Even for drafting an Act to be presented to the Parliament the tendency now is to give the responsibility to foreigners and rely on foreign aid for finance. Economic thinking in Nepal so far is simply not willing to visualise the time when we will not have to go stretching our hands for bilateral aid. We may be reaching the status of an aid junkie (Michael Thompson and Deepak Gyawali in "The Toad Beneath The Harrow: How To Make The End Of The Age Of Aid" Paper presented to the Adam Project Workshop, Kathmandu Nepal March 2007). Meanwhile, the disconnect between the agent and the principal on the other hand has taken a heavy toll on transparency and accountability.
Foreign Aid and the Future
For the present, Nepal will need aid for sustenance and survival given the nature of its political problems. This is a transition period - a period of recovering from a serious struggle to create a new principal-agency relationship where the supervisors cannot enrich themselves without being exposed. It will take time, perhaps two to three years, provided the leadership shows sagacity and wisdom. These are qualities that are really in short supply at the moment. Hopefully, once the country finds its political moorings, planners in Nepal must seriously start aiming for the time when we can do without bilateral aid. It is possible especially in view of the fact that we are no longer a land-locked state but a link state with vast water resources and tourism potential linking the two most dynamic economies of the world. The synonym for growth is in some sense energy and Nepal has a lot to offer to both these countries. As a link and a transit state Nepal should be able to take advantage of the new economics in the neighbourhood to quit aid addiction in favour of trade and investments. The aim should be to shift from bilateral aid to FDI to the tune of 4 per cent of GDP from India , China and beyond. This is an achievable goal because both China and India have made the strategic choice to accept globalisation as the pathway to economic and social transformation. Globalisation as a strategic choice is breaking down barriers to the flow of FDI and FII in both China and India . Nepal must therefore start viewing the regional economic environment as opening more opportunities than constraints in creating new wealth and income essential for poverty alleviation Both China and India know that the objective of emerging as a great power in the world system can no longer follow the experiences of the European nations in the past. The challenge of getting enough energy and raw materials now has to be handled not through imperialistic expansion and devastating wars but through cooperation, both regional and global. It is this setting that should make it easy for Nepal to think of development with FDI as a major driving instrument. At present the country is mired in confusion and violence and the proposed prescription may sound like a pipe dream. Well, it isn't. We have to make a national commitment to get rid of bilateral aid within a decade because it is taking us nowhere no matter how many donor harmonisation meetings we organise.
(Dr. Lohani is former Finance & Foreign Minister)
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