Multilateral and Bilateral Loans versus Grants: Issues and Evidence

Abstract

This paper examines a wide range of issues relating to the mix between loans and grants as well as the degree of concessionality of loans. A number of empirical tests are carried out based on annual panel data over 1970 to 1999 for 22 donor countries and 72 recipient countries. Based on the tests, we observe that for bilateral donors, past grant‐loan mix (and, hence, reflows from past transfers) do not influence the volume of current resource transfers. Our tests also show that the rate of official borrowing by the recipients (and, by deduction, the extent of their past debt burden) is positively influenced by the extent of the concessionality of such loans – irrespective of whether it is in the form of subsidised interest rates or longer grace periods. The paper concludes with a review of the circumstances in which grants, soft loans and non‐concessional loans might have their respective comparative advantage, as well as a discussion of the need, so as to overcome the negative incentive problems of soft loans, for a typical concessional loan package to be separated into two constituent parts. This would enable the recipient to be given the grant component and the option to take from the non‐concessional loan component as much as desired.

Complementarities between grants and loans

“…27 The higher tax rate and grant element are likely to be associated with the large amount of ODA loans, reflecting the high borrowing and repayment capability of recipient countries. This is consistent with Odedokun (2004). Of particular note, the positive impact of the grant element in favor of concessional loans is statistically significant when aid is measured in per-GDP terms.…”

“…Gupta et al (2003), in addressing the effect of aid decomposition from the fungibility viewpoint, find that concessional loans are associated with higher domestic revenue mobilization, but grants are completely offset by a decline in revenue. Odedokun (2004) finds the similar result. Thus, loans are more effective in terms of a recipient governments' fiscal response.…”

Grants vs. Loans

“…In particular, Odedokun (2004) finds that grants reduce tax efforts and government spending on investment and increase fiscal deficit. Similarly, Clements and others (2004) find that loans lead to increases in government revenues whereas grants tend to decrease them.…”

Remittances and the Effectiveness of Foreign Aid

“…More specifically, it has been discussed whether donors could render aid more effective by: (i) selecting sectors where aid is more likely to have short‐term effects (Clemens et al, ); (ii) offering appropriate aid modalities, e.g. by untying aid (Clay et al, ), replacing loans by grants (Odedokun, ), and providing general budget support instead of project‐specific support (Koeberle et al, ); (iii) optimizing aid delivery, e.g. through non‐governmental organizations (NGOs) (Dietrich, ; Acht et al, ) and so‐called performance based aid (Svensson, ); (iv) reducing the volatility and unpredictability of aid disbursements (Lensink and Morrissey, ; Kodama, ); and (v) improving donor coordination (Easterly, ; Knack and Rahman, ).…”