Leland & Pyle Meet Foreign Aid? Adverse Selection and the Procyclicality of Financial Aid Flows

Official development assistance (grants and subsidized loans from foreign aid agencies) is the main source of external finance in developing countries. These financial aid flows are positively correlated with the recipients' business cycles, which is puzzling because it reinforces already strong and costly macroeconomic fluctuations in the recipient countries. We propose an explanation related to a familiar corporate finance theory of inside equity commitments. We assume that donor agencies and recipient governments value projects differently, and that donors know less than recipients do about projects. We show that donors can make an aid recipient idientify high-return projects by conditioning aid on the recipient's committing some of its own funds to the selected projects. This commitment makes recommending bad projects costly. Contributing "counterpart funds" is more difficult during economic downturns, however - which leads to aid procyclicality. This simple model of investment financing and aid provision produces aid contracts consistent with those used by aid agencies, rationalizes observed aid flow patterns, and yields a rich set of testable empirical predictions.