Dead Aid: Why Aid Is Not Working and How There Is a Better Way for Africa

by Moyo, Dambisa

  An April 2008 World Bank publication entitled ‘Beyond Aid: New Sources and Innovative Mechanisms for Financing Development in Sub-Saharan Africa’, estimated that sub-Saharan African countries can potentially raise as much as US$1–3 billion by reducing the cost of international migrant remittances, US$5–10 billion by issuing diaspora bonds (a bond issued by a country (or even a private company) to raise financing from its overseas diaspora), and US$17 billion by securitizing future remittances – not small change. Incidentally, India and Israel have raised as much as US$11 billion and US$25 billion, respectively, from their diaspora abroad, showing that these schemes can work, and work very well if executed efficiently.5

  On a household level, remittances are used to finance basic consumption needs: housing, children’s education, healthcare, and even capital for small businesses and entrepreneurial activities – the heart of an economy. More fundamentally, more remittances mean more money deposited in the bank, which means more cash that the banks have to lend. In Latin America, deposits-to-GDP ratios (a key indicator of a country’s financial development) markedly improved as a result of high remittances. Naturally, the most direct channel through which remittances have an impact on GDP is by increased spending by the recipient households.

  Remittances make an important and growing contribution to relieving poverty. According to a paper by World Bank economists, evidence shows that a 10 per cent increase in per capita remittances leads to a 3.5 per cent decline in the proportion of poor people. Household surveys in the Philippines indicate that a 10 per cent increase in remittances reduced the poverty rate by 2.8 per cent by increasing the income level of the receiving family but also via spillovers to the overall economy. Moreover, this 10 per cent increase led to a 1.7 per cent increase in school attendance, a 0.35-hour decline in child labour per household per week, and a 2 per cent increase in new entrepreneurial activities.6

  All of this is good news, but there is a price to be paid – and one that potentially constrains the growth of remittances to the continent. For every US$100 sent to Africa, only US$80 gets there – the middleman takes the rest – while from the US to Mexico US$85 gets home (that is, a 15 per cent charge), and from the UK to India as much as US$96 (just a 4 per cent tax) reaches its destination.

  This form of higher ‘taxation’ on monies sent to Africa throws up a double-whammy: it encourages those abroad to send money secretly and can ultimately discourage them from sending any money at all. In a survey, remitters said that they would send 10 per cent more money if costs were 50 per cent cheaper.

  The bulk of the transfer cost for remitting money from the sender abroad to the recipient at home is determined in the private markets. Therefore, the high remittance costs can really only be reduced by increasing access to banking and strengthening competition in the remittance industry.

  However, there is scope for African governments to encourage greater remittance flows by offering cheaper ways for money to be sent home. In Latin America, for example, the International Remittance Network facilitates remittance flows from the United States to Latin America. Similar initiatives in Africa would undoubtedly do the same. It is encouraging to note that innovative mobile phone technology is making it both cheaper and quicker for people to send and receive money. In April 2007, a money transfer system called M-Pesa was launched in Kenya enabling subscribers to send large sums of money in an instant transaction. Within just two weeks of the launch over 10,000 account holders were registered and more than US$100,000 had been transferred. At the moment the M-Pesa programme only facilitates money transfers within the country’s borders, usually from richer urban dwellers to their poorer rural relations. However, there are plans underway to roll the scheme out on an international basis, not only tapping the billions of international remittances Kenyans regularly send home, but doing it in the most competitive way – that is, getting more cash into the recipient’s pocket.

  Remittances are, of course, in some sense a form of aid (the recipient is essentially getting something for nothing). And like other forms of aid, there is the inherent risk that remittances encourage reckless consumption and laziness. In 2006, Jamaica’s finance minister, Dr Omar Davies, expressed concern that the multimillion-dollar flows of remittances to Jamaicans were instilling a culture of dependency over achievement.

  Perhaps this is true, but at least some part of the money is reaching the indigent and making its way to productive uses. And unlike aid it does not increase corruption. Indeed, Giuliano and Ruiz-Arranz, and Toxopeus and Lensink, conclude that remittances do have a positive impact on growth.

  Savings

  In April 2005, two young boys stumbled upon US$6,000 while playing football in Maiduguri, in north-east Nigeria. Maiduguri is not Nigeria’s bustling capital city of Abuja or its largest commercial city of Lagos; nor, for that matter, is it Nigeria’s third, fourth or fifth business hubs (those honours go to Port Harcourt, Kano and Ibadan). Yet it was here, in Maiduguri, that the US$6,000 was found.7

  This money hadn’t been lost. As it turns out, in the absence of a credible, formalized banking system the owner of the cash had opted to neatly wrap his savings in a black plastic bag and hide his stash near a rubbish dump.

  This incident raises a fundamental question: does Africa lack capital? Or might it be that there is a lot of cash in these poor countries – unseen, dormant cash, which simply needs to be woken? Could it actually be that the countless development agents and agencies and innumerable man-hours deployed to send cash to Africa have been for naught – attempting to address a problem that simply does not exist? That, in fact, the core problem with Africa is not an absence of cash, but rather that its financial markets are acutely inefficient – borrowers cannot borrow, and lenders do not lend, despite the billions washing about.

  In The Mystery of Capital, the Peruvian economist Hernando de Soto suggests that the value of savings among the poor of Asia, the Middle East and Africa is as much as forty times all the foreign aid received throughout the world since 1945. He argues that were the United States to hike its foreign-aid allocations to the 0.7 per cent of national income (as prescribed by the United Nations at Monterrey), it would take the richest country more than 150 years to transfer to the world’s poor resources equal to those that they already have.

  Evidence from India would seem to add weight to this theory. By some estimates, as much as US$200 billion worth of untapped investment potential is privately held in gold in India.8 In 2005, India introduced a policy which allowed Indians to exchange their physical gold holdings (often held in jewellery and coins) into ‘paper’ gold in denominations as low as US$2. Estimates suggest that this policy unlocked as much as US$200 billion worth of untapped investment potential privately held. The initiative promised to bring the poorest 700 million villagers, who purchase about two thirds of India’s gold, into the more formalized banking system. Moreover, this gold policy injected more money into the economy than the total FDI India received in 2004 – in that year Indians poured about twice as much money into gold (around US$10 billion) as the country received from foreign investors. With more than half of India’s savings tied up in physical assets, such strategies can bring millions of poor into the banking system, offering credit access to many Indians, and inject capital into the economy.

  The Indian experience is an example of how a government has successfully unlocked latent resources. Africa should take note and look for ways to bring the hidden money into the financial stream. Of course, Africans might not hoard gold to the same extent as Indians, but many of them do have access to (and nominal ownership of) the land they till. And this is de Soto’s main argument, that the inability of people across the developing world to secure their property rights is what prevents them from unlocking their vast capital. What is needed is a functioning and transparent legal framework so that Africans can convert that land into collateral against which they can borrow and invest.

  It is not the case that African countries do not
have legal frameworks (many inherited from their colonial past); it is, however, the case that in environments of rampant corruption the legal systems are often impotent.

  Savings are a hugely important part of a country’s growth, and a country’s financial development. Domestic saving is the most important source of financing investment and thus boosting growth. Looking back at the Grameen Bank model, it too includes a component to encourage saving amongst its borrowers – in fact, they are required to save and invest. Customers must save US$0.02 per week, and new members are required to buy a share of stock in Grameen for US$2; localized financial development at its best.

  What Africa desperately needs is more innovation in the financial sector. We can put a man on the moon, so we can most certainly crack Africa’s financing puzzle, jump-start economic growth and drastically reduce poverty. But herein lies the key – innovation. Innovation means breaking out of the mould, and finding more-applicable ways for Africa to finance its development. There is a history of financial innovation to draw from: the Soft Banks of America’s Wild West and the Scottish Banks of the eighteenth century. Both catered to the unsecured and traditionally unbankable.

  At the time of the gold rush in 1800s California, for example, one would have expected the well-established East Coast American banks to have simply migrated westwards, opening branches and setting up their lending shops on the West Coast to cater to the demand from those in search of yellow (and black) gold. Instead, what happened was that there emerged hybrid banking structures – a combination of venture capital, where the lenders would lend money with the prospect of a portion of the spoils when the borrower struck gold, and standard lending practices, where the borrower would have to pay back the principal plus some interest (in this case the lender got no share in the project). To illustrate, under a venture capital (VC) arrangement, the lender would give the collateral-less gold-seeker US$1,000 to invest in exploration and hiring all the staff he needed, and in return the lender would get 20 per cent of the gold project or all future profits emanating from the project. Naturally, this structure was very different to the standard banking practices which would have lent out the US$1,000 with an interest rate attached. But, of course, under standard banking practices most of the borrowers without collateral would have been excluded. In essence, as is the case in many places in Africa today, the gold-rushers of America’s Wild West had a good idea, but no collateral which standard bankers would feel happy to lend against.

  The financing revolution of eighteenth-century Scotland was not much different in its innovative thinking. By essentially becoming a fully fledged, all-service financial supermarket (providing all elements of banking – venture capital, standard commercial banking, investment banking, merchant banking, etc.), Scottish banks could customize the cash and liquidity needs of a whole range of businesses and individual entrepreneurs. Banking and finance are about risk – risk assessment, risk mitigation and risk estimation. Scottish financial engineers had figured it out. Even if a potential borrower did not meet a bank’s standard, prescribed risk profile (that is, had no collateral, no guarantees, no obvious ability to repay), rather than turn them away the bank would tailor a lending instrument to meet the risk profile of the borrower. Certainly, it might have meant infinite permutations to get the right structure, but there was never any doubt that a financing structure could be found.

  There is a story, for example, of how two independent farm owners each applied for financing to invest in their individual farms. The lender could not see how to lend to each farm individually, but somehow if the two farms were merged, their risks pooled, and therefore mitigated, a loan arrangement could be struck.

  It is this type of innovation, providing micro-loans as well offering hybrid venture capital structures (in addition to standard banking fare), that Africa should look to replicate in order to bring its masses into the global fold. No country has economically succeeded without finding a way to funnel the risk capital to finance its small and medium-sized enterprises. For Africa, this is an imperative that must be heeded.

  Dongo Revisited

  After sixty years of dead aid, Dongo is regressing. Its finances stand as follows: roughly 75 per cent of the money coming into the economy is from foreign aid (essentially, all of which accrues to the government), capital markets 3 per cent, trade 5 per cent, foreign direct investment (including micro-finance) 5 per cent, and the rest from remittances and savings. This financing portfolio has been costly, and Dongo is going nowhere fast.

  If Dongo is to survive, development finance demands a new way of thinking. It needs to abandon the obsession with aid and draw on proven financial solutions. Dongo should aim for just 5 per cent of its total development financing to come from aid, 30 per cent from trade (with China as the lead partner), 30 per cent from FDI, 10 per cent from the capital markets, and the 25 per cent that is left should emanate from remittances and harnessed domestic savings. The key is to wean countries off aid by putting them on a tight schedule instead of continuing to give them open-ended commitments.

  Clearly, however, not all African countries are equal, and what might be right for Dongo may not be suitable for land-locked Zambia, Zimbabwe and Chad, versus oil-rich Sudan, Nigeria and Angola. But the point is that, in order to succeed and escape the mire of poverty and despair, they need a mix of each of these solutions and an end to aid-dependency.

  It has been shown, from case to case and example to example, that this can be done. In fact, in many African countries some of this is already being done, but on nowhere near the scale that is needed. Implementation (as we shall see) will be challenging, but not impossible.

  The transition from today’s low equilibrium to tomorrow’s economic promise requires proper and active management, as challenges will inevitably arise. As described earlier, large capital inflows, whatever the source, can introduce the risk of Dutch disease (although Rajan and Subramanian have found no evidence that remittances hurt export competitiveness). But where private capital trumps aid every time is on the question of governance. You can steal aid every day of the week, whereas with private capital you only get one shot. If you steal the cash proceeds of an international bond issue, you most certainly will not be able to get more cash this way. The capital markets may be forgiving, but not so forgiving as to be fooled by the same culprit twice. And without cash to assuage the restlessness of an army, no despot can stand.

  Besides, whereas earnings from trade filter through to many thousands of exporters and remittances accrue to innumerable households, foreign aid almost exclusively lands up in the hands of a ‘lucky’ few. Quite simply, investment money is not as easy to steal.

  Africa’s time is now. In the past five years there has been good economic and political news from the continent. Helped, in part, by soaring commodity prices, African countries are posting solid growth numbers, and, although nascent, positive political changes have swept across the continent. But these will count for little if the proposals set out here, essential for Africa’s growth trajectory, are not implemented. Opportunities abound; investment prospects lie all around, in every sector – agriculture, telecommunications, power, infrastructure, banking and finance, retail, property. How can they not? With roughly a billion people Africa is a big continent. This continent needs everything: roads, hospitals, schools, airports, food, houses, cars, trains, aeroplanes. There is inordinate demand, and supply is not coping.

  In the near term, external forces like the Chinese can and should play a key role in jump-starting Africa’s renaissance. But African countries would be wise to prepare for the eventuality that China could pack up and leave – Africa may not always be the belle of the ball. Countries must after all face up to the reality that circumstances change – their resource endowments are not infinite, and commodity prices could tumble from the highs of today; but the good news is that some countries are already hedging against this possibility by saving their commodity windfalls.

  The Dead Aid strateg
ies, if embraced wholeheartedly, will not only turn the economic tide in the short term, but also promise longer-term growth. And as the growth pie expands, so too does a country’s tax base – another reliable source of development finance.

  Good governance trumps all. In a world of bad governance the cost of doing business is much higher, on every level. This is true even when investments are securitized (that is, backed by a specific asset), since the risk premium associated with the unpredictable behaviour of a bad government always looms large. As long as issues of bad governance linger overhead (guaranteed to be the case in a world of aid-dependency), the cost of investing in Africa will always be exorbitantly high even when the social benefits (such as skill transfer, education and infrastructure) are taken into account. Yet in a world of good governance, which will naturally emerge in the absence of the glut of aid, the cost (risk) of doing business in Africa will be lower (whether the investment is securitized or not).

  The absolute imperative to make Africa’s positive growth trajectory stick is to rid the continent of aid-dependency, which has hindered good governance for so long.

  10. Making Development Happen

  It’s time to stop pretending that the aid-based development model currently in place will generate sustained economic growth in the world’s poorest countries. It will not.

  The question is how do we get African countries to abandon foreign aid and embrace the Dead Aid proposal? They can do it voluntarily – as South Africa or Botswana have done – but what if they don’t, choosing the soft option of aid instead?