Counterpart Funds and the Foreign Aid Procyclicality Puzzle
23 Pages Posted: 16 Jan 2015
Date Written: January 14, 2015
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
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