How to spend it?

UNU-WIDER / Jun 2012

A donor dilemma: aid effectiveness in fragile states.

Donors are often faced with the dilemma that those countries most in need of aid are often those least likely to spend it effectively. This dilemma can be characterized as an instance of the Tingenberg rule which states that for policy objectives to be attainable there must be at least as many policy instruments as objectives. Given this rule if the only policy instrument donors have is volume of aid then the dual objectives of responding to need and effective use of donor money cannot both be met. Attempts to overcome this dilemma by using capacity building and policy conditionality have proved ineffective and a new approach is required.

In a recent UNU working paper 'How to Spend it: The organization of public spending and aid effectiveness' Paul Collier first addresses the donor dilemma and then goes on to suggest a menu of new organizational designs for ensuring that recipient countries spend aid efficiently.

The donor dilemma

For there to be a reasonable prospect of aid being well spent by recipient countries two conditions need to be met. First the intentions of government need to be aligned with the interests of citizens. Second the government needs to control an effective system of public spending. The donor dilemma is that those countries in greatest need are often those where one or both of these conditions are not met.  Consequently the objective of addressing need has to be supplemented by that of achieving effectiveness. Donors cannot attain both objectives with the single instrument of the volume of aid and therefore a second instrument is necessary.

The potential for a second instrument to deal with governments whose intentions are not in line with the interest of its citizens is limited as improvement in overall governance is largely an internal struggle and there are limits both to what donors can do and to what they should aspire to do in this area. The scope for an effective second donor instrument is best confined to cases where the first condition is already met but where the second is not. In these instances what is required is specific institutional mechanisms which enable money to be spent effectively and it is at this practical level at which donors can have an effect.

The paper suggests three new mechanisms which together could constitute a second effective policy instrument and be used to achieve the objective of aid being spent effectively. First, a mechanism allowing donors to get independent ratings of a countries public spending processes. Second the creation of independent public service agencies in countries where current public spending processes are inadequate. Third, the creation of sovereign development funds in fragile sates to ensure that investments are made in national infrastructure.

Reforming public spending systems

1. Independent ratings of public spending systems

Budget support, the favored modality of many donors, obviously depends for its effectiveness on the quality of the budget system in the recipient country. Donors however chronically lack the necessary information and skills to make judgments about this matter and there is currently no international agency with the capacity to do so either. The International Monetary Fund's (IMF) Public Expenditure and Financial Accountability (PEFA) programme considers system design but lacks an audit function and an overall rating system tied to donor behavior.

If an institution with the capabilities described above existed donors could make achieving a certain rating level from the organization a condition of budget support. Such as system would then allow donors to provide budget support with more confidence and would incentive governments to get their public spending systems in order. It would not however mean a return to political conditionality as the purpose of the ratings would not be to judge what governments spend the money on, but how they spend it.  In other words this would be a way to ensure that the countries own laws are being enforced.

The major reason donors might be wary of such a system is that they are aware that in many fragile states budget systems are not fixable within a reasonable time frame. Donors are rightly reluctant to reduce the allocation of aid to countries in need and fear that requiring a rating threshold be met would force them to do so. The next two institutions described address this problem by setting out mechanisms which will allow for aid to be spent effectively in countries with inadequate budget systems

2. Independent public service agencies

An Independent Public Service Agency (IPSA) is a public agency independent of the civil service. While it is a government agency, its board of directors can include non-government appointees such as representatives of donor agencies and civil society. These appointees help to ensure that IPSAs are structurally transparent.

An IPSA works by receiving funds from government and donors and purchasing services from primary providers, they do not provide services directly. This ensures that an IPSA can focus on negotiating and monitoring the performance of the primary providers. Primary providers can be NGOs, local communities, local government, or private organizations. Ideally an IPSA will experiment with multiple channels of provision of the same service and identify those approaches that are most effective.

An IPSA provides various advantages to donors looking to provide direct budgetary aid to states with fragile budgetary systems. First the ability to monitor and evaluate the effectiveness of various approaches to service provision enables a gradual improvement in overall efficiency. Competition amongst private providers acts as a disciplinary mechanism and, more importantly, resources can gradually be assigned to those providers which prove most effective. Second, as an IPSA is a state organization, citizens are able to see the government doing something that is beneficial to them. Third, an IPSA generates performance information which donors have full access to. This transparency can substitute for a donor’s lack of trust in a government's ability to spend aid effectively. Fourth, an IPSA allows spending to be centrally planned rather than being an aggregation of individual donor decisions. Finally an IPSA provides the opportunity to develop a new staff that can be motivated through pay structures linked to rewards and penalties, and through the internalization of organizational objectives.

An IPSA provides a mechanism, with all the above mentioned benefits, through which donors can continue to channel aid to countries in need but whose budgetary system does not meet a required threshold.

3. Sovereign Development Funds

The final tool needed for donors to be able to meet the dual goals of providing aid to the countries in most need and ensuring effective spending is a way to ensure public investment in infrastructure. There is an increasing trend for aid to fragile states to focus on infrastructure rather than social spending. However, this funding can potentially be undermined by governments that choose to reduce their own investment in response to increased revenue from alternative sources.

In response to an increase in revenues from natural resources a number of countries, such as Nigeria and Ghana, have established variants of Sovereign Wealth Funds which are guaranteed to receive a certain proportion of revenue from natural resources. In turn these funds can only be used for the accumulation of national assets, including foreign financial assets and domestic public investment. A Sovereign Development Fund would operate in a similar way but limit spending to public investment as the accumulation of long term foreign investments is unwarranted in capital scarce countries. A SDF could then be used for donor finance of investment as well as for government revenues from natural resources.

Such a mechanism would allow donors to incentivize investment in infrastructure through offering to match government contributions to the fund. More importantly, if donors contribute financially to an SDF they can also contribute technically and politically and help overcome the poor management of public investment often associated with natural-resource rich countries.

Taken together independent ratings, independent public service agencies and sovereign development funds would provide donors with both additional information and alternative mechanisms through which to channel aid. As such they constitute a second policy instrument and thus allow donors to meet the dual objectives of providing aid to those countries most in need and ensuring that aid is spent effectively.

This report by James Stewart summarizes UNU-WIDER working paper no. 2012/05, 'How to Spend it: The organization of public spending and aid effectiveness', by Paul Collier. It originally appeared in the June-July 2012 issue of the WIDERAngle newsletter.