Governments and donors must manage transitions away from aid

Vendors in Muara Karang market, Jakarta, Indonesia. Photo: Frank Yowono CC BY-NC-ND 2.0

Many countries are moving away from development aid and many more will do in the future. For countries transitioning to middle-income status, this shift is good news: it reflects their strong economic performance and greater access to a more diverse set of financing options than aid.

At the same time, donors often cut their budgets in middle-income countries, assuming these economies have enough resources to fund their own development projects and programmes.

Transition and graduation from aid are not linear paths and we should not be complacent once a country has achieved middle-income status. For example, after the financial crisis in 1997, Indonesia was made eligible once again for soft loans from World Bank.  

A couple of years ago, we found very little research had been devoted to analysing how both recipient countries and development partners can best plan the transition away from aid. This is also the case for how bilateral donors decide to phase out from a country, beyond political and security reasons. 

The lack of evidence, lessons and recommendations surprised us. We decided to start filling these gaps by looking at eight lower middle-income countries, 10 bilateral donors and the European Union.

Here are four things we discovered – and implications for governments and donors:

1. Transition to lower middle-income country status does not necessarily lead to less international public finance

Official development finance rose in several of the countries reviewed following transition to lower-middle income status because of the rise in non-concessional flows and geostrategic relevance.  However, the terms and conditions worsened (for example, as grants gradually shifted to loans, those loans became more expensive).

To militate against financial risks and rising costs, governments need to plan for changes in the composition of development finance.

2. The sectoral allocation of resources has changed

In nearly all the countries we reviewed, the sectoral allocation of resources – both external assistance and public finance – tends towards infrastructure development, with falling shares towards health and education.

These trends mean gains achieved in the social sectors should be protected by ring-fencing the share of government spending that goes to the education and health sectors.

3. Tax ratios have slowly risen in most countries and, in some cases, even declined

In this 2014 ODI paper, we found that lower middle-income countries experience the ‘missing middle’ of development finance – where the rise in tax revenues is not enough to compensate for the fall in official external finance as a share of GDP.

In this new ODI paper, we found that the missing middle of development finance is even more severe, with both official development finance and tax revenues as a share of GDP falling when we look at specific countries (as in the cases of Nigeria, Papua New Guinea and Sri Lanka).

Challenges in expanding the tax base and increasing tax rates are the main factors behind these trends. This evidence suggests that governments and donors should prioritise tax revenue mobilisation as a key element of financing strategies and of donor support.

4. Recipient countries do not have a strategy in place to transition from aid

Usually, countries do not have a strategy to address potential challenges and plan ahead for the transition from aid. Most development partners do not have a formal and clear strategy and criteria on transition and exit either.

Both recipient countries and donors should identify priorities for external development finance and develop a strategy for managing the transition away from aid.

Many countries will start their transition from aid soon or have already begun it. We must learn from the experiences of countries and donors that have already gone through it, not to jeopardise results achieved so far.

Authors

Senior Research Fellow
Annalisa Prizzon is a Senior Research Fellow in the Development Strategy and Finance Programme. She [...]