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Letting Your Good Intentions Backfill My Budget

Researchers investigate whether that dollar of foreign aid just frees up money for the recipient to spend elsewhere.

Donors in the world's richest nations send tens of billions in aid to developing countries every year, and it's no secret that corruption and malfeasance hinder those efforts.

But there's another, less well-known predicament that affects aid to poor nations: fungibility. Instead of supplementing the money that a government spends for a particular purpose — like fighting HIV/AIDS — donor dollars may just replace local outlays. Donations intended to boost the amount of money devoted to a worthy cause might actually reduce it.

Development economists and experts disagree on how common and severe fungibility may be, how to combat it and even whether it exists.

Researchers at Brandeis University and the Bill and Melinda Gates Foundation have released the results of a substantial, worldwide effort to measure the phenomenon. Their findings signify donor substitution is a considerable problem in many countries.

"When you give donor aid to help problems, governments are taking some of that money and putting it somewhere else," says Marwa Farag, the Brandeis health policy doctoral candidate who led the research.

Major donors typically pledge money abroad to combat a specific social ill, but they're also often hoping such funding will prompt a consequent increase in local government expenditures. This is called the flypaper effect, because the donor money "sticks where it hits." Yet numerous studies have failed to document such increases, and sometimes they've shown even a decrease in public funding — presumably because of the fungibility of grant and government money.

No one is certain, though, and a lack of comprehensive analysis has left research on fungibility in health spending particularly inconclusive. Farag and A.K. Nandakumar, a Gates Foundation senior program officer, worked with three Brandeis professors on a far-reaching examination of the sector. They analyzed panel data on government health spending and donor aid for 144 countries over 12 years.

From the early 1990s through 2006, donor funding for health quadrupled to $13.7 billion annually in low-income and middle-income countries. By the end of the period Farag studied (1995-2006), governments on average were spending slightly more on health as a percentage of GDP, but their share of total health spending had fallen by several percentage points.

The numbers show that in many countries, as donors increased funds, governments were reducing spending. In low-income countries, a $1 donation was associated with a 63-cent reduction in government funding; in middle-income countries, the average reduction was 27 cents. Farag cautions that the magnitude of reductions (or increases) in the 144 countries varied widely. What's important, she says, is that the data exhibit clear evidence of fungibility.

"Sometimes, if you give too much money and attention to a health issue, in the long run you're going to hurt that area," Farag says.

For budget officials, it's rational behavior: If there's a pressing need elsewhere, such as in public schools, they would be foolish not to take advantage of the situation. But for donors, that means money spent on health may unintentionally augment the finances of a country's military. Worse, once donors are gone, they may leave behind a hole in the government budget.

"It's very difficult for a ministry of finance to move money that's been taken away from health back to the health sector," says Pablo Gottret, a World Bank economist and former financial official in Bolivia.

This is especially relevant in many African countries, where outside money can account for half of all health spending.

Fungibility may pale in comparison to some of the field's broader challenges, such as the difficulty of showing that aid works in the long term. Yet many donors have become more aware of the problem recently and are working to deal with it.

Farag and her colleagues view the situation from an economic perspective, recommending that donors find a way to "align incentives" with the governments of recipient countries or risk seeing their funding diverted. The simplest method of doing this is to donate money where governments ask for it, but often, donors hope to persuade political leaders to spend in new areas.

To convince them, some funders have developed innovative financing mechanisms that attempt to limit aid displacement. Many have focused on performance-based grants, which outline a set of potential outcomes beforehand and then give money based on achievement. For instance, the World Bank's credit buy-down program helped combat polio by giving out loans which, once polio eradication efforts successfully ended, were converted into grants.

Such an approach isn't appropriate for every development aid project, but Farag says applying incentives to even a portion of donor funding will help keep money flowing where givers intend it to go. And as a side benefit, tying money to outcomes just might cut down on fraud.

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