Overcoming the Challenges of the Transition and Exit from Aid

By Annalisa Prizzon, Senior Research Fellow, Overseas Development Institute 

ODI transition finance
Flat stairs, Sao Paulo by Jared Yeh / Flickr CC-BY-NC-ND

Since 2000, the number of low-income countries (LICs) has more than halved — from 63 to 31 — and have now joined the ranks of middle-income countries (MICs). Typically, these economies have strengthened their macroeconomic management, played a stronger and more visible role in global policy, diversified their sources of finance and received less external development assistance (or ceased to benefit materially from it).

As developing countries become richer and address their own development challenges, donors usually reconsider their programming and interventions. And so, transition and exit from bilateral development co-operation programmes should rightfully be celebrated as an indicator of success in economic and social development.

Challenges facing financing for development

However, as countries graduate from soft windows of multilateral development banks or as bilateral donors cut their country programmes — or they shift to loans if that is an option — the financing mix changes. Reliance on tax revenues and commercial finance when aid starts falling inevitably expands, and so does the costs to service debt obligations. Tax revenues do not necessarily increase to fill the gap.

As their economies grow, MICs can also become stuck in what has been called the ‘missing middle’ of development finance. Meaning, the total public resources available to a country fall as a share of Gross Domestic Product (GDP) once it transitions from LIC status, and they recover only when it is well into MIC status.

Moving away from the LIC group, the share of official development finance funnelled into the infrastructure sectors is likely to rise. Infrastructure projects have greater potential returns and ability to generate cash flows than investment in the social sectors – especially in MICs expected to rely more on loans than grants.  Indeed, resource allocation in most MICs tends to shift towards infrastructure development. In Papua New Guinea, for example, government officials and development partners raised this concern due to its correlation with deteriorating health indicators.

Finally, when a country crosses the World Bank’s operational cut-off threshold for International Development Association (IDA) eligibility, bilateral Development Assistance Committee (DAC) donors regard it as a signal that the country is in less need of aid, thereby reinforcing the (negative) impact on ODA (Official Development Assistance) flows. There are also many examples where several development agencies exited simultaneously from an MIC, or from specific sectors within a recipient country.

Three recommendations for a successful transition and exit from aid

What should governments and development partners do to address these challenges? How can they ensure the development results achieved over time are sustained, and maximise the impact of aid when it starts falling? To overcome them, I outline three recommendations for both governments and their development partners, stemming from the analysis and evidence of a research project I led at ODI that looked into these challenges.

Plan the transition from aid

Governments should articulate and be clear on priorities for external development finance and develop a strategy for managing the transition from aid. The terms and conditions are, in most cases, likely to change at the global level (especially a rise in interest rates), and official public finance as a share of GDP is likely to fall.

Governments should plan ahead for the changes in the composition of development finance to mitigate financial risks and rising costs. This is especially the case when a country has limits to its external borrowing, such as a debt-to GDP cap, and when favourable borrowing terms and conditions, such as loans from the hard windows of Multilateral Development Banks (MDBs), could be an option to commercial markets.

Furthermore, governments should reflect on the implications of transition from aid for gains achieved in the social sectors by protecting the share of government spending that goes to the education and health sectors.

From the perspective of development partners, transition and exit from aid should be planned well ahead of implementation and be part of a long-term strategy. This was a key determinant of the successful transition and exit process of DFID and Sida in Vietnam and DANIDA in India.

The exit plan should include mapping out projects to be phased out and identifying which organisation (government or other development partner) should take over responsibilities. It should also ensure continuity, focusing on the sustainability of development programmes (as was the case of Denmark in India) and manage potential risks.

Prioritise tax revenue mobilisation

Governments should also prioritise tax mobilisation and tax administration as a key element of the financing strategy; more so as part of the strategic approach in the transition from aid. The Republic of Korea — on top of liberalising its capital markets — followed this approach, and is one of the few countries that demonstrated a successful strategy towards ending aid dependency.

To help address the ‘missing middle’ of development finance and with tax revenues falling as a share of GDP, development partners should also focus on how to support efforts to boost tax revenue.

Co-ordinate decisions and actions both between and among the government and development partners

In the transition away from aid, co-ordination between government and development partners remains important and should be improved. Co-ordination is key for sharing information about development partners’ plans, when they intend to change their programme orientation, or decide to withdraw their development projects from the country.

Development partners should also co-ordinate among themselves, including handing over to other donors, multilateral organisations or the government, or consider regional approaches to development programmes.

What’s next?

Many countries will start their transition from aid soon or have already begun it; a few of them are expected to graduate from ODA by 2030. The universality of the 2030 Agenda for Sustainable Development has shifted attention from a more traditional approach to development co-operation, towards somewhat uncharted (or less familiar) options for international co-operation and partnerships.

But we could do better to understand the challenges posed by the transition from aid and exit from bilateral programmes and overcome them. We must listen and learn more from the experiences of countries and development partners that have already gone through it, ultimately to sustain development outcomes achieved, maximise the benefits of falling aid, and identify new ways for policy dialogue and co-operation beyond aid.