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How can aid be most effective in reducing poverty? Some people advocate substantially increasing the amount of aid while others argue developing countries do not have the capacity to effectively absorb this aid.

 Reconciling these positions requires more aid and reforms in the way aid is distributed and used.

A paper from the United Nations University World Institute for Development Economics Research (UNU-WIDER), based in Finland, examines the two opposing views that dominate the present aid debate: the ‘big push’ thesis and the absorptive capacity concern. The big push thesis, most recently articulated by Jeffrey Sachs, is based on the idea that developing countries are trapped in poverty. An increase in aid from rich countries is seen as essential for poor countries to escape from this trap. In the words of the United Nations, this amounts to ‘doubling aid to reduce poverty by half’.

Others believe not only that least developed countries (LDCs) are not in a poverty trap, but that increased aid will not be absorbed usefully and may even be harmful. The idea that there are limits to ‘absorptive capacity’ has four main meanings. First, the ‘pipeline’ effect describes the time lag between a commitment to aid and its disbursement. Second, some believe large aid inflows can cause macroeconomic problems such as loss of competitiveness in certain sectors through a strengthening of the local currency (the ‘Dutch disease’ effect), especially if aid flows are volatile. Third, researchers claim increased aid will have decreasing returns after a certain point. Finally, aid could lead to the weakening of institutions within recipient countries.

The authors consider whether these issues justify rejecting the ‘big push’:

• Many countries, particularly LDCs, are stuck in a poverty trap that increased aid could help them escape from.
• Aid is often underutilised because of conditions within recipient countries (such as weak administrative capacity) or because there are too many donors and aid systems.
• Evidence for ‘Dutch disease’ is conflicting; if balanced aid supports productivity increases, currency appreciation is not a problem and competitiveness will be unaffected.
• Aid may appear to be volatile, but this does not mean it is destabilising, nor is it likely to be so if levels are increased.
• Increased aid to poorer countries that currently receive smaller amounts of aid may lead to increasing rather than decreasing returns.
• Aid can have a short-term negative effect on private saving, state revenues, and accountability in management of public institutions, which can be reversed in the longer term.

The authors conclude absorptive capacity is strongly influenced by aid itself and how it is delivered. Recommendations include:

• balance aid to support activities that are directly productive and those that are social in nature, in order to avoid loss of competitiveness;
• enhance schemes that facilitate the use of aid as insurance against external shocks, as they lower the risk of Dutch disease and encourage faster, more equitable growth;
• replace traditional policy-based aid conditionality with a performance-based conditionality, whereby aid is given on the basis of achievements, not promises.