Why Ethiopia needs to reduce its overdependence on foreign aid, now more than ever
Foreign aid has multiple professed benefits for developing countries. In developing countries, capital is scarce precisely because they are poor. Moreover, the infant financial sector in these countries does not provide much help even to mobilize the existing limited financial resources to avail them for productive investments. Thus, foreign aid is assumed to fill the saving-investment gap and increase economic and social output, thereby generating self-sustaining economic growth. Also, foreign aid may help to finance foreign goods and services that are badly needed for economic and social development, which their acquisition would otherwise be impossible since developing countries struggle to generate sufficient foreign currency. Lately, one of the stated objectives of foreign aid is also to promote good governance.
Is aid aiding economic growth or hindering it in practice?
Many studies tend to indicate that foreign aid does not promote economic growth. In a few cases, aid has been found successful, but only when the recipient countries have good governance. The lesson from these findings is, then, as William Easterly argues, one of the main reasons poor countries are poor is because they have bad governance. He further argues that a country will likely develop if it gets its governance right, even without the support of foreign aid.
As indicated earlier, lately, aid is also used to promote good governance. This seems good news since bad governance is the main culprit behind underdevelopment. Unfortunately, foreign aid has shown a lackluster performance on this front as well.
So, what is wrong with foreign aid, given its noble objectives?
In many ways, the problems associated with foreign aid parallel with that of resource abundance in developing countries. Resource abundance in sub-Saharan Africa is often inextricably linked with poor development. In the development literature, this phenomenon is called the resource curse. Various explanations are given why resource abundance is a curse rather than a blessing for development. These explanations are also helpful to explain why foreign aid fails to live up to expectations.
First, foreign aid could cause the Dutch disease problem, named after the country where it was first observed. Following the discovery of natural resources, the Netherlands generated a huge amount of foreign currency by exporting its newfound fortune, leading to the appreciation of its local currency. This, in turn, led to the drop in the demand for goods and services of the other sectors of its economy in international markets. This is because their prices overseas became more expensive, although their prices remained the same in terms of local currency.
Like the discovery of natural resources, a country could receive a large amount of foreign currency from foreign aid. In 2020 alone, Ethiopia received about $4.81B net official development assistance. This huge flow of foreign aid has the potential to result in the appreciation of Birr, thereby limiting the non-aid sectors of the economy from accessing the international market. But since the Ethiopian government controls the forex market, the exchange rate would remain unaffected by aid.
Yet, the huge aid flow to the country is creating attractive employment opportunities. As a result, the aid sector is snatching the best and the brightest from the government and the private sector. This would be fine as long as it is reallocating labor from less productive to more productive sectors. But anecdotal evidence seems to suggest the opposite is happening. (Worse, those who could have questioned foreign aid make their living from it).
Second, aid could engender conflicts and promote bad governance. Wide-spread conflicts in the form of coups and rebel movements are commonplaces in resource-rich developing countries. The resource abundance gives political opportunists incentive to use any avenues to capture the state to funnel a country’s resources for their personal uses. This could endanger the stability of the state. According to Paul Collier, aid money like natural resources can be more easily embezzled by government officials than tax revenue, thus raising the incentive to capture state power in aid-dependent countries.
Like resource-rich countries, governments in aid-dependent countries do not bother themselves about expanding the tax base and increasing the tax rate as foreign aid could easily be used to fill the gap between government revenue and expenditure. In Ethiopia, the tax-to-GDP ratio is usually less than 10%, which is very small even compared to other SSA countries (see Figure 1). On the other hand, studies show that Ethiopia has the potential to increase its tax-to-GDP ratio up to 26%.
The problem with low tax is that it undermines the tacit pact between government and society. In well-governed countries, citizens raise the revenue that government needs to provide its services in the form of tax. And that tax gives the citizens the leverage to hold their government accountable. In an aid-dependent country, on the other hand, the government is likely to fear its donors, not its citizens. For example, a key opposition figure claims that PM Abiy discussed his government’s intention regarding the postponement of 2020’s election with western embassies before he did with the opposition parties.
Figure 1: Some SSA countries’ foreign aid and tax revenue during 2018
Figure 2: Ethiopia’s foreign aid and tax revenue over the years
Aid also has additional side effects. Foreign aid usually comes with strings attached to it. One of the strings is to force the recipient countries to source goods and services from donor countries. This sometimes comes at the cost of the domestic industry. For example, in one of his interviews, Ermias Amelega, a businessman, recounts how the USAID’s aid in the form of US imported edible oil in the 90s severely affected the domestic edible-oil factories. His edible-oil factory was one of the victims. Perhaps, this could be one of the main reasons Ethiopia still lacks a well-functioning edible oil industry, despite the country’s huge potential to produce a variety of oilseeds. Currently, edible oil is one of the biggest imported items—draining the government’s coffer.
Behavioral issues could also be at play in limiting the effectiveness of foreign aid. The aid model is based on the presumption that any resource available to humans will be used to generate the highest return or welfare. But the Economist Nobel Laureate Herbert Simon argues that we humans are satisficers, not maximizers. Meaning, we humans tend to achieve some basic goals needed to lead a decent life. We do not necessarily go for the best possible.
Consider this example to see how such behavior coupled with aid could hinder development. If we know that the west will rescue us with food aid if the rain fails, the incentive to develop our irrigation system or seed varieties that could withstand harsh climate scenarios will be dwarfed. In the process of ignoring bad weather and relying on aid, we miss the opportunity to develop innovations and produce entrepreneurs that may be very useful to transform agriculture and other sectors of our economy.
Overall, the story of foreign aid is not that positive in its current form, except in some isolated cases. There is a limited scope that aid will be reconfigured to serve the real interests of developing countries, given the geopolitical interests of developed countries, which might contradict the interests of the aid recipient country’s citizens. Moreover, aid has already become a big industry, and according to some observers, the aid industry tends to mainly serve its staff and other stakeholders, rather than the very people it came to help.
The ball is thus in our court. Can Ethiopia reduce its overdependence on foreign aid? I argue that the current political situation the country finds itself in can provide a window of opportunity to do so.
The government is at loggerheads with the west—our main donors, in part because of the conflict in the northern part of the country. Some claim that the west is demanding not short of government change. It is not in the incumbent government’s best interest to relinquish power so that Ethiopia continues to receive aid, even for Ethiopians for that matter. Interestingly, most of the people are rallying behind the government. Public support could thus serve as an important fallback to absorb the shock ensuing the sudden withdrawal from aid overdependence.
By reducing foreign aid overdependence, Ethiopia may also have a chance to shed some of its notoriously corrupted politicians from its body politics since the incentive to hold office for funneling aid money for personal uses would be significantly diminished. This, in turn, may open opportunities for those who have a keen interest in public service. More importantly, promoting self-reliance is the pathway towards building innovative capabilities and incubating many more entrepreneurs that could help to grow the existing industries and create new ones.
