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Counterpart Funds and the Foreign Aid Procyclicality Puzzle

23 Pages Posted: 16 Jan 2015  

Stephane Pallage

University of Quebec at Montreal - Department of Economics; Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Michel A. Robe

University of Illinois at Urbana-Champaign

Date Written: January 14, 2015

Abstract

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 the business cycle of 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 recipients identify high-return projects by requiring recipient governments to make matching grants. Providing those "counterpart funds" is less affordable 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.

Keywords: Foreign aid, Adverse selection, Contracts, Matching grants, Capital flows, Business cycles

JEL Classification: G15, D82, E32, F35, O19

Suggested Citation

Pallage, Stephane and Robe, Michel A., Counterpart Funds and the Foreign Aid Procyclicality Puzzle (January 14, 2015). Available at SSRN: https://ssrn.com/abstract=2549925 or http://dx.doi.org/10.2139/ssrn.2549925

Stephane Pallage

University of Quebec at Montreal - Department of Economics ( email )

P.O. Box 8888, Downtown Station
Montreal, Quebec H3C 3P8
Canada
514-987-3000 ext. 8730 (Phone)
514-987-8494 (Fax)

Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Pavillon De Sève
Ste-Foy, Quebec G1K 7P4
Canada

Michel A. Robe (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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