A developing country would find it difficult to support its capital programmes exclusively from domestic resources even if it wanted to, for they usually involve the import of some capital goods. If such a programme of imports is financed entirely out of taxation, it is likely to be deflationary and to strain the balance of payments, the taxes which are levied to finance the imports would take some purchasing power out of domestic circulation, without putting anything in its place.
This unpleasant consequence can be avoided if home consumption falls and the goods so saved are exported, earning foreign exchange to pay for imports. If this does not happen, the adjustment will take longer to come into effect. The resulting deflation will lead to fall in prices of domestic goods, encouraging exports and rise in prices of imports and discouraging them. There will be a new equilibrium after the necessary adjustments have taken place. But the impact effect of stepping up the rate of capital formation is almost certainly to cause a shortage of foreign exchange, which has to be made up by running down the foreign exchange reserves.
Therefore, the consequence of undertaking a programme of economic development that is financed out of taxes is likely to be unsavory. The consequences of deficit financing are worse. The new money would generate new demand, part of which will be for imports, thus rendering the balance of payments position more adverse. So we come to an inevitable conclusion that it is very hard, if anything, to finance a development programme, involving imports, purely out of domestic resources. Therefore, foreign aid is a great assistance for a developing country.
It was with this consideration that the programme of assistance was evolved at Bretton Woods, in July 1944, resulting in the establishment of the International Monetary Fund and International Bank for Reconstruction and Development. The purpose for which the Fund was set up is to promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. Foreign aid offsets the foreign exchange deficit and deflationary tendencies in an economy which undertakes a programme for economic development involving imports.
It particularly applies to the economies of underdeveloped countries. The link between the foreign and domestic policy is stronger in these countries. A large share of their economic activity is composed of foreign trade and many of them depend upon their experts to sustain these economies. This is more so because the exports are, mostly, narrowly based, being either raw materials or food stuff. Now the demand for these commodities is subject to violent fluctuations which are very upsetting for the underdeveloped countries. Also, because of the nature of these commodities, the volume, terms, and balance of trade tend to move together. Therefore, when ‘exports collapse, the export surplus also decreases (or the import, surplus increases) because there is a tendency that imports lag behind exports as the prices of imports fall more rapidly than those of exports. For the same reason, terms of trade also decline in such a case. This discussion leads us to the conclusion that foreign aid would be necessary for an underdeveloped country if the deflation of foreign exchange reserves, deflation and violent fluctuations in their export earnings have to be offset.
But the quality and quantity of foreign aid that should be made available to a country depend upon its absorptive capacity which means the amount of technical and capital assistance that can be effectively used. In Economics, absorptive capacity can be defined as the amount of capital that can be absorbed without the marginal productivity of capital falling to zero. But this definition has a snag in the context of an underdeveloped country, because even if the marginal productivity of capital, at the time of application of aid, is zero, i.e. there is no increase in output with the application of foreign aid, it may result in considerably higher levels and rates of increase in income after a few years. This may also be one of the particular kinds of technical assistance. The advice given in one year may be put into effect a few years later. Therefore, we should keep in mind not only the immediate consequences of foreign aid but also those which would be realized in the long run.
There is another consideration related to this. The amount of assistance which can be absorbed in the sense explained above depends upon the form in which it is made available. Of course, capital assistance consists basically of foreign exchange which is, in itself, uniform. But the amount that can be absorbed will still depend upon the currency in which the aid is offered, whether it is “tied” to the donor country or free for expenditure anywhere, and the limitations imposed by donor country with regard to its use. In the case of technical assistance, this problem is more pertinent. This naturally raises the question.
What are the factors on which absorptive capacity depends? The first factor is the unutilized capacity of some kind which can form a suitable combination with additional capital that comes in the form of foreign aid. If such capacity exists, the results of foreign aid are immediate and spectacular. It has been observed quite often that a country receives-certain capital goods which it fails to make use of and, therefore, these go waste. Then there should be a well-constructed development plan backed by domestic financial resources. This would ensure the right form of assistance in the right direction. There should also be simple and obvious opportunities for improvements in technique, coupled with a technology-minded and development-minded people. If this condition is not satisfied, as has been the experience particularly in the backward economies, the offers of technical assistance go waste. Given the absorptive capacity, the consequences of foreign aid also will be determined by the kind of aid-investment, grant or loan. Each of these will have to be considered separately.
As far as the foreign direct investment is concerned, it has played a very important role in those countries which are now called developed. England borrowed in the seventeenth and eighteenth. centuries and the U.S.A., now the richest country in the world, was borrowing heavily till the nineteenth century. Of course, at present both these countries have become lenders. The favorable consequences of direct foreign investment are It provides foreign exchange, raises domestic income, and increases domestic skills. The foreign exchange that it makes available is inherent in its very nature, the rise in domestic income results from the expenditure incurred locally by foreign investors. This is in the nature of autonomous investment which leads to induced investment. There is also a rise in the level of savings because of the increase in income. But there is also an increase in demand for consumers’ goods which, in the absence of increased supplies, leads to inflation. The most important consequence is that if this investment is not made available, the resources of the country may lie undeveloped. Contribution to skill is potentially more important because improvements in technique are the basic requisite for development.
But foreign investment is feared in the underdeveloped countries both for economic and political reasons. The economic reason is the belief that foreign investments yield higher profits: Firstly, this is not always justified by actual experience. Secondly, the government of the country in which investment is made can regulate the profits, if really excessive. Thirdly, the country which is inviting such investments must remember that it cannot eat the cake and have it too. It will have to offer incentives to investors, the bulk of which are private because the latter bears great risks the greatest being of nationalization. The political fear is that it may lead to loss of independence. This fear is too much magnified because foreign investment is not likely to be a significant part of total investment.
Coming to the question of grants, it is obvious that they would be welcome since there is no economic obligation involved in their case. There are, however, two other factors which can lead to unfavorable consequences, of grants are accepted but these arise only in case of grants with strings. The first is the likelihood that the grants may be ‘tied’. Now such grants should be accepted only if they conform to the overall developmental pattern of the country.” Otherwise, they would upset the development programme and may do more harm than good. Also, the grants sometimes carry political strings. The receiving country is, in such a case, placed under an obligation to tow the political line of the donor country. This again is not acceptable to a country unless it is already politically committed. or does not wish to be that independent in its foreign policy.
Loans also give rise to the same two questions as the grants do and whether they would be acceptable or not would be determined by the same considerations as grants. There is, however, less likelihood of a loan being as much ‘strung’ as a grant. This is because of the nature of loans. They involve a financial obligation to pay the interest and to repay the loan when it matures. Therefore, there is not as much sense of obligation as would be in the case of grants. But loans give rise to certain consequences peculiar to themselves. The payment of interest involves the transfer of foreign exchange or commodities to the lender country. The repayment of the loan would entail much larger transfers. These would cause great hardships to the debtor country which would be already experiencing a shortage of foreign exchange or commodities. This can be avoided in two ways.
Either the debtor country should keep on receiving new loans so that the old loan be serviced by the new loans. If loans flow in a steady and increasing stream until the debtor country has raised its output sufficiently to permit net repayment, loans will hardly be more burdensome than grants. However, the lending countries must follow a policy of liberal imports from the debtor countries in case the loans are to be repaid in the currency of the lender country. The other way out is that the loans should be soft and not hard. Hard loans are those which have to be repaid in terms of foreign exchange and soft loans are the ones which are repayable in domestic currency In such a case, no transfer of foreign exchange or goods and services has to take place. The repayments are gradually absorbed in the debtor country itself.
There is, however, one danger of foreign assistance generally and of soft loan particularly. It lies in the tendency of the country which is assisted to take things easy and become lax in its own efforts. Therefore, the maxim for those who give foreign economic aid should be that they should help only those who help themselves. After all, even God helps only those who help themselves.