The Role of Foreign Aid in Economic Development of Pakistan

THE ROLE OF FOREIGN AID IN ECONOMIC DEVELOPMENT OF PAKISTAN (1960-61 TO 1994-95)
Author(s): AZHAR MAHMOOD

Source: Pakistan Economic and Social Review, Vol. 35, No. 1 (Summer 1997), pp. 57-90
Published by: Department of Economics, University of the Punjab
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Pakistan Economic and Social Review
Volume XXXV, No. 1 (Summer 1997), pp. 57-90
THE ROLE OF FOREIGN AID IN

ECONOMIC DEVELOPMENT OF PAKISTAN
(1960-61TO 1994-95)
AZHAR
MAHM00D*
Abstract. This paper presents an historical review of the

effectiveness of foreign aid in Pakistan's economic
development for the period 1960-61 to 1994-95. Aid had
positive as well as negative effects on Pakistan's economic
development. On positive side, it has helped in the structural
transformation of the economy, laid infrastructural and
institutional foundations for agricultural and industrial sectors,
provided technical assistance, policy advice and modern
technology, assisted in overcoming the budget deficits and the
balance of payments deficits and funded the projects for social
sectors development. On negative side, aid seemed to have
substituted for domestic savings. The debt servicing problem
has become immense due to mis-utilization and mis
management of FCIs. The use of aid in import substituting
industries by theGovernment of Pakistan resulted in efficiency
losses which retarded economic growth. The role of aid in the
development of social sectors is also not above criticism. To
maximize the benefits of aid, Pakistan's economy needs better
macroeconomic management, political stability, a sound
infrastructural and institutional set-up, and a highly skilled
manpower.
I. INTRODUCTION
The two-gap theory suggests that developing countries
have to rely on foreign capital inflows (FCIs) to fill two gaps:
the import-export gap and saving-investment gap. However,
there are some other determinants of FCIs, such as structural
adjustment programmes, emergency relief, transformationof
*The author is Research Economist at Pakistan Institute of Development

Economics, Quaid-i-Azam University Campus, P. O. Box 1091,
Islamabad, Pakistan.

58 Pakistan Economic and Social Review
economies, political objectives of the donors and the recipients

etc. After theWorld War II, the United States of America
(USA) started the Marshall Plan to rebuild the war-torn
European economies by providing direct assistance and by
establishing the International Bank for Reconstruction and
Development (IBRD). At that time, theUSA was the largest
exporter of capital. The colonial powers of the United
Kingdom, France, Germany etc. were also able to provide some
financial aid to their former colonies in the 1960s. So official
development assistance (ODA) gained popularity in the early
1960s. The patterns of international borrowing and lending
changed dramatically during the following decades due to
various factors: internationaloil price shocks; world debt crisis;
breakdown of the Soviet Union; large US budget deficits;
economic recession in Europe; emergence of transitional
economies in theCentral Asia etc.
Despite the fact that all developing countries need FCIs

for their development, the volume and the type (grants, loans,
foreign direct investment, export credit, project/non-project
assistance, technical assistance etc.) of these flows vary. The
country size and the state of economic development mainly

determine the size and type of FCIs. For instance, the least
developed countries of Africa have been relying on foreign aid,
whereas, the newly industrialized economies (NIEs) of East
Asia are the largest recipients of foreign direct investment
(FDI). Moreover, the external debt situation of an individual
countrymay not seem to be interestingwhen analyzed from an
international perspective but may be very interesting from its
national perspective. For example, the external debt situation of
the South Asian countries such as Pakistan, India, Sri Lanka
and Bangladesh may not be worth analyzing as compared to the
Latin American countries such as Mexico, Brazil, Chile and
Argentina in an international scenario, yet the external debt
situation of the individual South Asian countries has strong
repercussions on theirdevelopment.
This paper presents an historical review of the effects of
foreign aid on economic development in Pakistan. Foreign aid
is the largest foreign capital inflow to Pakistan and it has played

MAHMOOD: 77?^Role of Foreign Aid 59
a critical role in the country's development. The trends,patterns

and terms of borrowing have changed much in recent years.
Foreign direct investment (FDI), portfolio investment and
borrowing through private sources has also increased sharply.
But Pakistan is still unable to provide an attractive climate to
attract such private capital flows. Pakistan lacks physical,
financial and human capital infrastructure,and political and
macroeconomic stability. Its economic structure remains
inflexibleand foreign transactionsare regulated.
This paper is organized as follows. A detailed survey of
the existing literature on the effects of FCIs on economic
development at international level as well as at national
(Pakistan's) level is presented in Section II. The trends and
composition of aid are highlighted in the third section. The
fourthsection of thepaper analyzes the effectsof aid on various
sectors of Pakistan's economy and Section V concludes the
paper.
IL LITERATURE REVIEW
The role of FCIs in economic growth has been an area of
controversy both in theoretical and empirical terms. Mosley
(1980) presented an historical review of the important literature
on this issue. Chenery and Strout (1966) showed that foreign
capital exerted a positive effect on economic growth on the
basis of empirical evidence fromLDCs. But, their resultsmay
be sensitive to the assumptions that the FCIs fully augment
domestic capital formation and the incremental capital-output
ratio remains independent of these FCIs. Afterwards, Papanek
(1973), Voivodas (1974), Stoneman (1975), Mosley (1980),
Dowling and Hiemenz (1983), and Park (1987) all argued that
FCIs stimulate economic growth in the recipient countries.
However, a group of economists, the "Displacement

Theorists" [for instance, see Leff (1969), Griffin (1970) and
Weisskopf (1972)] argued that FCIs could adversely affect
economic growth by substituting for domestic savings on two
accounts: (/) theFCIs may encourage the recipient government
to ease its revenue generation efforts so that consumption
expenditures increase and/or imports are liberalized, and (//')to

the extent that savings are determined by the investment

opportunities, foreign investment may crowd out domestic
investmentand cause domestic savings to fall. Griffin and Enos
(1970),Fry (1980, 1984)andVos (1988) showedthattheFCIs
depressed the rate of growth of the recipient countries.
Moreover, FCIs may lead to inefficienciesdue to inappropriate
technology and management styles.
In short, the literature at international level remains
inconclusive on the role of FCIs in development. On one hand,
aid augments the domestic resources of the recipient, helps to
promote growth and structural transformation, assists to
overcome the balance of payments and government budget
deficits, transfers advanced technology and improves human
resources. On the other hand, foreign aid may distort domestic
savings, introduce inappropriate technology, increase the debt
burden of the recipient country, create a booming sector and
assist the donor to pursue its interestsabove the political and
economic interestsof the recipient. Thus, the effectiveness of
FCIs depends on the management and utilization styles of
capital inflows, the donor's and the recipient's economic and
political interests, the recipient's financial regulations and
system, macroeconomic and political stability etc. so, the role
of FCIs in development may vary from country to country due
to these factors.
has been relying on foreign aid to support

Pakistan
development since independence. Although the circumstances
have been changing rapidly in recent years, foreign aid still
comprises the largest share in FCIs to Pakistan.
In the 1960s, many studieswere conducted to estimate the
aid requirements of Pakistan. The aid requirements of Pakistan
were estimated to be zero in 1985 in thePakistan's Perspective
Plan (PPP) issued in 1965. The plan was the first authoritative
national effort to fix long run growth targetsand to project aid
requirements in termsof a dual gap model. The PPP assumed a
targetgrowth rate of GDP at 7.2 percent per annum, a capital
out ratio of 3, and a marginal saving rate of 18.4 percent in
1965 rising to 22.9 percent in 1985. The targetedgrowth rate of
GDP was higher than the average experienced in the past.

MAHMOOD: The Role of Foreign Aid 61
Moreover, no attempt was made to estimate the foreign aid

requirements at alternative growth rates of GDP. Chenery and
MacEwan (1966), on the basis of an optimizing model,
concluded that Pakistan's aid requirements would be zero in
1983. Rehman (1967) criticized both the studies mentioned
above, on the basis of ignoring the debt servicing. UNCTAD
(1968) estimated a smaller saving-investmentgap on thebasis of
a lower growth rate of GDP, viz. 5 to 5.7 percent. Naqvi
(1971), on the basis of a 7.2 percent compound growth rate of
GDP, a 25 percent marginal saving rate and a 2.9 capital-output
ratio, showed that the economy would still need huge volumes
of aid by 1985.
Kemal (1975) criticized all but UNCTAD's study on the
basis of using high growth rates of GDP (7.2 percent) instead of
a relatively sluggish actual average growth rate of 5.3 percent
for the period 1965-75. He found thatPakistan would require
huge aid inflows and for long periods to fill the resource gap.
Ali (1977) criticized Kemal for estimating investment-saving
gap only and used alternative growth rates of GDP, viz. 5, 6, 7,
8, and 9 percent at various incremental capital-output ratios to
measure investment-saving and import-export gaps. He found
both the trade gap and the resource gap to be very wide and
emphasized the need to improve the domestic saving
performance to narrow the gaps.
In the last decade, several economists have tried to

measure the role of foreign aid in economic development of
Pakistan. The literature shows that aid has accelerated the rate
of growth of GNP [for instance, see Shabbir and Mahmood
(1992), and Khan and Rahim (1993)]. Aslam (1987) examined
the impact of FCI on domestic investment.He found thatpublic
FCI did not affect the domestic investment significantly,
whereas, theprivate FCI complemented domestic investment.
Various attempts have also been made to study the impact
of aid on savings in Pakistan. Khan, Hasan and Malik (1992)
estimated that a one percent increase in FCIs reduced national
savings of Pakistan by 0.21 percent for the period 1959-60 to
1987-88. Shabbir and Mahmood (1992), in a simultaneous
equation model of GNP growth and national saving equations,

also found that the disbursements of grants and external loans

had a negative impact on national savings in Pakistan for the
same period. Khan and Rahim (1993) also found the
displacement theorist's hypothesis to be valid inPakistan.
Thus, the existing literatureindicates that thedisplacement

theorists' hypothesis seems to hold for Pakistan, i.e., the FCIs
in general and foreign aid in particular have substituted for
domestic savings. But this finding may be misleading for
various reasons. Firstly, all these studies are based on the data
before 1988, and do not include the recent years of high
financial deregulation, privatization, and liberalization of
various sectors of the economy. Secondly, there is a
methodological flaw in these studies as they did not include any
variable to capture the impact of liberalization, privatization and
deregulation on the effectiveness of aid flows and domestic
savings in economic growth. Thirdly, almost all these studies
have used a static modeling approach that did not capture the
dynamic effects of aid on development. Khan and Rahim (1993)
alluded to the problem of non-inclusion of the dynamic
characteristics of the relationship between aid, savings and
growth in the existing literature.
Moreover, the displacement theorists' argument has
proven to be invalid in the case of newly industrialized
economies (NIEs) of East Asia. FCIs supplemented domestic
savings instead of substituting for them, as found by Kruger
(1987: 159):
They sharply increased their rates of growth, and
returnson investment,by moving to integrate their
economies with the world economy, borrowing to
supplement domestic savings and, in some cases,
encouraging large flows of foreign direct
investment.
The main conclusions of the existing literature on the

impact of FCIs on economic development in Pakistan are: (/)
foreign aid has stimulated economic growth in Pakistan, (//)aid
has substitutedfor domestic savings, (Hi) Pakistan has to rely on
foreign aid for its future growth, and (z'v) Pakistan might get

caught in a severe debt servicing problem if macroeconomic

management, debt utilization, foreign trade and domestic saving
policies are not addressed properly [See Burney (1988) and
Chaudhary(1988)].
III. TRENDS AND COMPOSITION OF AID
In this section, the trends and composition of aid to
Pakistan are analyzed for the period 1960-61 to 1994-95 from
various angles, such as differentdebt indicators: grants, loans
and credits as percentages of total disbursed aid; project/non
project aid and food/non-food aid as proportions of total
disbursed aid (TDA); the sectoral distribution of project aid;
distribution of TDA by donor blocks; and TDA as a percentage
of total committed aid.
The external debt liability of Pakistan had a manifold
increase in the last decade. Disbursed and outstanding debt
increased from US$ 9732 million in 1984-85 to US$ 20322
million in 1993-94, an increase of US$ 10590 million in a
decade. The disbursed and outstanding debt grew at an average
compound rate of 7.2 percent for the period 1988-89 to 1994
95, while thedebt servicing rose at an annual compound growth
rate of 8.2 percent for the same period [Government of Pakistan
(1995)].
Various debt burden indicators are presented in Table 1
for Pakistan for the last decade. Total debt stock (EDT) and
total debt service (TDS) as percentages of exports of goods and
services (XGS) rose from 215.0 and 15.6 in 1982-83 to 300.4
and 34.8 percent respectively in 1994-95. Pakistan's EDT was
56.6 percent of its GNP in 1994-95. Figure 1 shows an
increasing trend inEDT/XGS, TDS/XGS and INT/XGS ratios.
It is also noteworthy in Table 1 and Figure 1 that concessional
debt (CON) has been sharply decreasing as a ratio of EDT in
recent years. All debt indicators in Table 1 and Figure 1 show
thatPakistan's debt burden is increasing over time.
The composition of aid has changed dramatically over
time. The grant element in aid has been substantially reduced
and replaced by hard term loans. The share of grants in total
commitments was 80 percent during the First Five Year Plan

10.70 7.00 7.00 7.70
RES/EDT15.6022.50
9.80 8.60 5.10 5.30 6.30
13.30 12.60
1.40 1.70 1.60 1.60 1.90 1.90 1.90 2.00 2.00 2.00 2.00 2.50
INT/GNP
1.70
7.70 7.60 8.90 10.00 10.2010.6013.20

INT/XGS
7.90 8.50 9.10 8.90 9.70
10.10
(%)
Debt
Indicators
1
TABLE
TDS/XGS15.6020.4018.6024.2025.3026.7024.6023.2023.2021.5024.0024.7034.80
EDT/GNP 42.2039.50 47.7051.2045.10 43.9049.1048.8049.7056.60 Exports

XGS
of
goods
and
services
=
GNP
=Gross
national
product
38.30 43.60 46.90 International
RES
reserves
=
Total
TDS
debt
service
= Concessional
=
CON
debt
INT payments
=
Debt
Source:
World
Tables,
1990-91,
1994-95,
1996. Interest
debt
EDT
Total
Where,
stock
=
EDT/XGS
190.00 246.20
229.10
228.10 230.80 244.50
248.80 261.20
245.60
185.60
215.00 239.90 300.40
87 88
1983-85
84 1984-
86
1985- 89 90
1989-
1988- 1990- 94 95
91 92 1992- 1994-
93 1993-
83
Year
1982- 1991-
1986-1987-

FIGURE 1
igure 1:
atpercent*
DebtStock
Total ftofBxporti andSttvicti
ofGoexit
^ 260
Total andInterest
DebtSetvioe aiPercent*
Paymeati get ofOoodi
ofBxporti A Servicei
. TDSyXGS (%) . INTyXGS(%)
D?bt asPercentageofTotalDebt Stock

Concessional

(1955-60) which declined to 46 percent during the Second Plan

(1960-65), 31 percent during theThird Plan (1965-70) and 12
percent during the non-plan period. During the Fifth Plan
(1978-83) and the Sixth Plan (1983-88) this share increased to
about 22 percent and 23 percent respectively, mainly due to
assistance for Afghan refugees. But it again dropped to 16
percent during the Seventh Plan (1988-89 to 1992-93)
[Government of Pakistan (1995)].
The shares of grants, loans and credits inTDA are shown
in Table 2 and Figure 2. Credit aid is harder as compared to
loans in that itmay carry a higher interestrate and/or is given
for a relatively shorterperiod. Table 2 shows that grants as a
ratio of TDA has fallen from 79.44 percent in 1960-61 to 8.24
percent in 1994-95, whereas loans and credits as ratios of TDA
have risen from 13.01 percent and 7.55 percent in 1960-61 to
69.27 and 22.49 percent in 1994-95 respectively. Figure 2
depicts this sharply changing pattern. Such a rapid increase in
TABLE 2
Shares of Grants, Loans and Credits
inTotal Disbursed Aid
Grants as Loans as Credits as

Year % of total % of total % of total
aid aid aid
1960-61 79.44 13.01 7.55

1965-66 18.05 65.02 16.93
1970-71 11.77 54.29 33.94
1975-76 11.02 70.52 18.46
1980-81 26.31 43.49 30.20
1985-86 33.11 46.22 20.67
1990-91 25.71 64.49 9.80
1991-92 16.93 74.29 8.78
1992-93 11.64 71.65 16.71
1993-94 9.36 70.39 20.25
1994-95 8.24 69.27 22.49
Sources: 1. Government of Pakistan, Economic Affairs Division.

2. UNDP, Government of Pakistan, 1990.

the shares of loans and credits and a decrease in the share of

grants inTDA may result in a rapid accumulation of debt if the
aid recipient fails to generate resources to service itsdebt.
FIGURE 2
Grants, Loans and Credits as Percentage
of Total Disbursed Aid
90
1960-61 1970-71 1980-81 1990-91 1994-95

YEARS
KB GRANTS
gH LOANS??S CREDITS
Project/non-project and food/non-food aid as percentages

of TDA are presented in Table 3. It is important to distinguish
project aid from non-project aid since the former directly adds
to the productive capacity of the aid recipient economy while
the lattermay not do so. So a large proportion of the non
project aid adds to the debt burden of the aid recipient country
as it is comprised of food aid, non-food aid, aid to overcome
balance of payments deficit, and refugee aid. Table 3 and
Figure 3 indicate a sharp rise in the share of project aid inTDA
(from 46.75 percent in 1960-61 to 79.99 percent in 1994-95)
and a sharp fall in the share of non-project aid in TDA (from
53.25 percent in 1960-61 to 20.01 percent in 1994-95).

TABLE 3
Project/Non-Project and Food/Non-Food Aid
as Percentage of Total Disbursed Aid
Proj. aid Non-proj. Food aid Non-food

Year as % of aid as % of as % of aid as % of I
totalaid totalaid totalaid total aid
1960-61 46.75 53.25 50.03 3.22

1965-66 68.85 31.15 10.73 20.42
1970-71 59.60 40.40 9.97 30.43
1975-76 36.55 63.45 15.07 14.56
1980-81 69.94 30.06 6.76 10.60
1985-86 69.06 30.94 16.02 6.09
1990-91 65.31 34.69 6.26 28.43
1991-92 71.47 28.53 11.49 17.04
1992-93 76.01 23.99 12.39 11.59
1993-94 76.93 23.07 9.85 13.22
1994-95 79.99 20.01 9.93 10.12

FIGURE 3
Project/Non-Project Aid as Percentage
of Total Disbursed Aid
1960-61 1970-71 1980-81 1990-91 1994-95

YEARS
I PROJECTAD I NON-PROJECTAD

of
Misc. 45.95 19.80 22.62
% aid
total 2.06 1.49 5.17 8.17 8.30
as
of 0 0 0
R
Dev
% total
aid 1.51 0.55
11.29
0.11 0.27
as
0
2.89 1.66
&T%
S of
as total
aid
0.79 0.71 2.31
2.23
3.23
Edu,
Welfare 0.57 0.69 1.19 5.10 4.91

Pop
and %
of
as aid
total 2.77 1.81 2.22
17.33 14.58
TABLE
4 Sectoral
Project
Disbursed
Aid TR&CO
Distribution
of
%
of
as total
aid 8.58
12.8826.1922.05 29.32 12.85
of
W&P
% aid
26.04 42.8728.5443.43 35.19
total
as 15.29 18.54 32.53
included
later
The
to
due
non-availability
not
data.
of
years
are
19.93 23.7040.8924.1914.48
Ind. %
of
as aid
total 8.90 9.91 UNDP,
Government
Pakistan,
1990.
of
39.36
of
2.68 14.242.09 18.1012.59
% total
aid
5.38 9.31 7.67
Agri. as
1960-61 1985-87
86 88
1987-
1986-
Year Source:
1980-81 Note:
1970-71
1965-66 1975-76

FIGURE 4
Sectoral Distribution of
Disbursed Project Aid (in Percentage)
1001
Hi t&c ?22! p&wEgg edu.
The sectoral distribution of total disbursed project aid

(TDPA) to Pakistan is shown in Table 4 and Figure 4. The
share of the agricultural sector (AGRI) in TDPA was quite low
in the 1960s, averaging around 10 to 12 percent in the 1970s
and 1980s. The share of industry (IND) in TDPA fell sharply
from an average of around 25 to 30 percent in the 1960s, 1970s
and early 1980s to only 9.9 percent in 1987-88. The share of
water and power (W&P) in TDPA remained around 33 percent
in the 1980s except for 1985-86 when itwas 43.43 percent. The
share of transportand communication (TR&CO) in TDPA first
rose from around 18 percent in the 1960s to around 30 percent
in the late 1970s and thendeclined to near 15 percent in the late
1980s. The shares of population and welfare (P&W) and
education (EDU) remained around one percent and below one
percent respectively for the 1960s and 1970s, but rose to around
4 and 2 percent respectively in the late 1980s. The share of
rural development (R Dev) remained below one percent for the

period 1960-61 to 1987-88 except for 1979-80 (18.74 percent)

and 1987-88 (11.29 percent). In summary, differentsectors can
be ranked according to their shares in TDPA in ascending
order: W&P, TR&CO, IND, AGRI, P&W, EDU, R Dev. It is
quite obvious that the social sectors have been given much less
attention.
TABLE 5
Distribution of Total Disbursed Aid
by Donor Blocks (in Percentage)
Non Other
Year Consortium Consortium donors
aid aid aid
1960-61 38.51 61.49 0.00

1965-66 85.56 14.44 0.00
1970-71 91.97 7.70 0.33
1975-76 41.24 23.97 34.79
1980-81 69.24 25.46 5.30
1985-86 83.66 14.52 1.82
1990-91 76.44 12.57 10.99
1991-92 71.75 23.19 5.06
1992-93 66.27 30.73 3.00
1993-94 76.07 20.83 3.10
1994-95 78.68 17.81 3.51

Foreign aid to Pakistan mainly comes from two major

sources: consortium and non-consortium. Table 5 and Figure 5
present distribution of TDA to Pakistan by donor blocks. It is
very clear thatconsortium countries have been themajor donors
of aid to Pakistan. The shares of consortium and non
consortium countries in TDA were 78.68 and 17.81 percent
respectively in 1994-95.

FIGURE 5
Distribution of Total Disbursed Aid
by Donor Blocks (in Percentage)
1001-?
Table 6 shows TDA as a percentage of total committed

aid to Pakistan by type. This ratio can be used as a proxy for
the donor's attitude (favourable or unfavourable). It is obvious
fromTable 6 that the donor's attitude remained quite favourable
in the case of non-project aid, and its food and non-food
components (/.e., the ratio of disbursed aid as a percentage of
committed aid is near or even above 100). However, the donors
of project aid remained unfavourable formost years under study
(i.e., the disbursement/commitment ratio remained well below
100).
IV. THE IMPACT OF AID ON ECONOMIC

DEVELOPMENT
The flow of foreign aid to Pakistan started in the early
1950s. Since then the reliance on foreign borrowing has been
continuously increasing. The increasing external indebtedness
has also increased the liability of debt service payments,

TABLE 6
Disbursed Aid as Percentage of Committed Aid by Type
Non Non
Year Project Project Food Food
aid aid aid aid
1960-61 49.54 116.67 285.00 11.46

1965-66 99.59 99.51 97.96 100.35
1970-71 59.22 96.23 45.86 150.29
1975-76 72.84 162.17 109.85 64.44
1980-81 114.45 77.08 89.48 56.43
1985-86 58.30 97.66 150.08 50.00
1990-91 72.76 116.69 101.50 120.67
1991-92 79.55 150.32 88.20 286.39
1992-93 157.39 86.17 67.91 120.92
1993-
94 107.63 77.47 76.29 78.37
1994-
95 76.63 167.20 92.47 121.88
implying a falling inflow of net resources. One of the

conclusions of the literaturereview section of this paper is that
both theoretical and empirical literatureon the role of FCIs in
development is inconclusive. Foreign aid has some positive as
well as some negative effects on economic development. The
sign of net effect depends on the relative sizes of the positive
and negative effects. The existing literatureon the subject of the
role of aid in economic development of Pakistan mainly
analyzes the effects of aid on the growth rates of GNP or GDP
and national or domestic savings.
One of the main conclusions of the literature is that
foreign aid has accelerated the pace of economic growth but
displaced domestic savings in Pakistan. But this conclusion may
be misleading for various reasons mentioned in the literature
review section.Moreover, this conclusion is very general in the
sense that it relates to the overall level of the country's
economic growth on the basis of some macroeconomic

variables, such as growth rate of GNP (or GDP), national (or

domestic) savings, inflows of foreign aid etc. However, it does
not mean at all that every experience of aid has been
.... a good deal of what has been done has 'worked',
positive
but many thingshave not been done or even attempted, and it is
not easy to separate the donors' from the country's respective
responsibilities, (UNDP, Government of Pakistan, 1990:x).
The effects of aid on the overall economy (the
macroeconomic effects), as well as on different sectors of the
economy, are analyzed in this section.
The Macroeconomic Effects of Aid

As indicated by the literatureon the role of FCIs in the
overall economic growth of Pakistan, aid has contributed
positively. Aid has been very helpful in the structural
transformation of Pakistan's economy, accompanied by a
reasonable average growth rate of GNP. In the 1950s, aid
helped lay a physical infrastructuralbase, a pre-requisite for
rapid futuregrowth. In the 1960s, aid was a key factor for the
accelerating growth of the commodity producing sectors. Aid
provided resources for thedevelopment of a capital goods sector
in the 1970s. During the 1980s and 1990s, aid helped in the
revival of the private sector and in the maintenance of an
impressive growth momentum. Moreover, non-project aid
helped to overcome food shortages, balance of payments (BOP)
deficit, and Afghan refugee problems.
Along with the above-mentioned positive contributions of

aid in overall economic growth of Pakistan, there are some
negative contributions as well. The Government of Pakistan
seemed to reduce its revenue generation effortsand increase its
consumption expenditure, resulting in large government budget
deficits. Debt servicing has become a crucial problem for the
Government of Pakistan in 1996-97. The interest payments
constitute 31.5 percent of the current government expenditure,
38.8 percent of the tax revenue and 5.8 percent of GDP
[Government of Pakistan (1997)].
Burney (1988) studied the determinants of the debt

problem and debt servicing capacity of Pakistan for the period

MAHMOOD : The Role of Foreign Aid 75
1959-60 to 1986-87 by using different debt indicators and

critical interest rate (CIR) approach. He found that Pakistan
faces both liquidity and solvency problems associated with its
foreign debt. He found the value of CIR to be very low,
indicating an extremely low long-rundebt servicing capacity of
the country. He suggested to enhance themarginal saving rate
to improve the long-run debt servicing capacity. Chaudhary
(1988) found that if foreign borrowing followed the past trend,
Pakistan could accumulate foreign loans up to 67 percent of its
GNP by the year 2009-10 and the debt outstanding, debt
servicing and per capita debt outstanding would grow by 4.4,
9.5 and 1.5 percent more than the growth of GNP respectively.
The author suggested that appropriate trade and saving policies
could significantlyreduce foreign dependence.
Another negative contribution is related to mis
management and mis-utilization of aid. As indicated by Khilji
and Zampelli (1991), US-aid to Pakistan is highly fungible and
a large proportion of non-defense aid has been utilized for
defense purposes. The share of defense in the government
expenditure is estimated to be 28.3 percent (second largest after
the share of interest payments) [Government of Pakistan
(1997)].
Moreover, large sums of aid were wasted in inefficient
import substituting industries in the 1970s, such as thePakistan
Steel Mills. In addition, other interventionistpolicies of the
government, such as controlled interest rates and exchange
rates, use of tariffand non-tariffbarriers in international trade,
credit rationing, and other forms of price controls (subsidization
and taxation) affected the overall economic environment
negatively, resulting in less productive aid flows. Thus, the
objectives and policies of the donors and the recipients play a
critical role in the effectiveness of aid.
The appropriate macroeconomic management of aid can
enhance the effectiveness of aid in future.As argued by Hughes
(1988:121):
The extent to which a country saves, invests and
obtains capital abroad, and whether or not it does so

optimally, depends principally on its domestic

policy framework. That is the mix, intercon
nections, and consistencies of a country's financial,
monetary, trade, fiscal (and public ownership),
exchange rate, manpower, and other policies
determine the level of capital inflows and their
impact on growth.
The areas which require the donors1 and recipients'
attention can be classified as: (a) encouragement of liberalized
trade and industrial policies to encourage exports and reduce
bias towards an import substitution strategy; (b) institutional
reforms in the financial sector to encourage private sector
investmentand efficiency of thepublic sector; (c) improvement
of domestic resource mobilization; and (d) price de-controls and
movement of the economy towards a more open market
economy.
Aid and Agricultural Development

Agriculture is the largest sector of Pakistan's economy. It
contributed 24 percent of GDP and accommodated 47.54
percent of the employed labour force in 1994-95 [Government
of Pakistan (1995)]. It is also the single largest source of
foreign exchange earnings. Foreign aid has contributed a lot in
the rapid development of Pakistan's agricultural sector. A
significantproportion of aid goes to the agriculture sector (see
Table 4 and Figure 4).
In the 1950s, the Government of Pakistan favoured
industrial development and paid little attention towards the
agricultural sector. At that time, the agricultural sector was
characterized by traditional backward production technology,
non-existence of input supply, credit and other supportive
facilities (such.as infrastructure,research, etc.), and regulated
inputand outputmarkets. For these reasons, the average annual
growth of agricultural production was only 1.58 percent. The
USA was the largest donor to agriculture during the 1950s,
financing different projects of rural development, canal
building, fertilizer production and imports, and agricultural
research. Moreover, the USA also provided food aid to

overcome food shortages. These factors contributed to

agricultural development.
The change of government in 1958 provided a stimulus to
the agriculture sector. The IndusWaters Agreement was signed
in 1960 and the Indus Basin Development Fund of US$ 2.5
billion was set-up with multi-donor support. The new
government improved the terms of trade for agriculture and
partially eased the restraints on input distribution and output
marketing. In addition, benefits from earlier investments in
physical infrastructurestarted to come on stream. Agricultural
growth reached an average of 3.2 percent during thefirsthalf of
the 1960s. The main reasons for such a jump in agricultural
growth were yield increases due to greater inputs such as
fertilizer, irrigationwater and spread of tubewells. Mexi-Pak
wheat and IRRI rice varieties were introduced in themid-1960s.
In addition to the above factors, the completion of theMangla
Dam enhanced irrigation facilities. At that time, aid was doing
its best in Pakistan's agriculture by building the physical
infrastructure, providing funds for import of fertilizers,
insecticides and pesticides, and establishing the research
institutions,such as agricultural research universities.
The first half of the 1970s brought political instability to
the country. Agricultural growth slowed to an average annual
growth rate of 1.7 percent between 1970 and 1974. The
nationalization policy of the new government and controls on
input and output prices and quantities depressed the agricultural
growth. That was a time of uncertainty for the donors and their
objectives clashed with the nationalization policy of the
government.
The agricultural sector regained its growth momentum in

the early 1980s after an intensivemacroeconomic stabilization
programme. The growth rate of the agriculture sector rose to 4
percent per annum along with the attainmentof self-sufficiency
in grain production, rising rice exports, and decreasing wheat
imports. During the last two decades, the focus of aid for
agriculture is towards policy framework and institution
building.

In summary, aid has contributed significantly to

Pakistan's agricultural growth by providing funds for
infrastructurebuilding, technical assistance and policy advice,
rural development, and institution building. However, the
impact of aid on rural poverty is mixed. On one hand, aid has
brought growth of the agriculture sector, resulting in its
expansion, implying an increased demand for labour. On the
other hand, aid has done nothing for land reform to improve the
access of thepoor to land.Moreover, thebig landlordswere the
main beneficiaries of the subsidized credit and other inputs.
The effectiveness of aid can be improved in future by
designing the policies for more efficient use of the existing
resources. This objective can be attained by: {a) removal of
distortions introduced by government at national and
international levels, such as credit rationing, input and output
price and quantity controls, tariff and non-tariff barriers,
exchange rate controls, etc., (b) encouraging the private sector
and reducing the size of the public sector, which is responsible
for high budget and balance of payments deficits, and (c)
establishing and strengthening the institutions, such as courts,
financial institutions, research organizations, etc. to provide a
productive environment.
Aid in the Industrial and Energy Sectors

The history of industrial development is quite interesting
in Pakistan. Large-scale industrywas very small at partition in
1947. The country lacked key raw materials, entrepreneurs,
skilled workers, and industrial and institutional infrastructure.
However, despite all these problems, Pakistan's large-scale
industryexpanded enormously. The share of manufacturing was
18.5 percent in real GDP and 64 percent in total exports in
1994-95. Different governments adopted contradictory
.
industrial policies (/.e., substitution and export
import
promotion policies) during their regimes. Foreign aid donors
responded to these policy changes and Pakistan's industrial
sector had to pass throughbooms and crises.
The import substitution strategy (ISS) was the centerpiece
of Pakistan's industrialpolicy during the 1950s. By the 1960s a

very large fraction of consumer goods imports had been

replaced by domestic products. However, the intermediateand
capital goods sectors could not be substitutedby theirdomestic
counterparts since they require capital, technology and
managerial skills that Pakistan did not have at that time. The
newly established import substituted industrieswere protected
behind tariffs and non-tariff barriers, and therefore lacked
economic efficiency due to their isolation from international
competition.
The ISS became an important tool of many governments

of the developing world from the 1950s to 1970s, and in the
1980s in some countries. Prebish, Myrdal and Nurkse prepared
grounds for the ISS. The main arguments for protecting some
industries behind tariffs and non-tariff barriers were
employment creation, economies of scale, externalities, a source
of government revenue, to overcome balance of payment
deficit, infant industry protection, self sufficiency, political
status, national defense and pride etc. But the ISS failed in
almost all the countries which adopted itbecause it resulted in a
loss of internationalcompetitiveness, general rise in cost levels,
low levels of capacity utilization, taxes on exports, balance of
payments constraint, rent seeking activities etc. Many Latin
American countries used FCIs to set-up import substitution
industriesand faced a serious debt crisis in the 1980s due to the
above-mentioned factors.
On the other hand, the NIEs of East Asia adopted the

outward oriented export promotion strategy and grew very
rapidly. Almost all countries realized, sooner or later, theworst
effects of the ISS and moved or have been moving towards
outward oriented trade and industrial strategies.
Foreign aid played a relatively small role in Pakistan's

industrial development before the 1960s. Only theUSA, UK
and World Bank provided some assistance for starting a few
small industrial projects. However, the aid donors helped
establish a basis for institutional infrastructurethatprovided a
platform for industrial lending in the 1960s. Almost one thirdof
US assistance to the industrywas in the form of institution
building grants for the projects such as the IndustrialTechnical

Assistance Centre (1954), Industrial Productivity Centre (1956),

and various survey and consultancy organizations. The USA
and World Bank established the Pakistan Industrial Credit and
Investment Corporation (PICIC) in 1957. The performance of
the industrial sector was quite impressive from 1949 to 1959.
Large-scale value added grew at an average annual growth rate
of better than 25 percent (Lewis, 1970).
The 1960s brought a major change in Pakistan's industrial
policy. The Government of Pakistan decided to reduce direct
controls and liberalize the economy. The Export Bonus Scheme
was introduced in 1959 to reward exporters with import license
entitlements in proportion to their shares in exports. This
scheme encouraged manufactured exports and eased the foreign
input imports. Aid donors formed the Pakistan Consortium in
1960 and lobbied the government on both the Export Bonus
Scheme and open general licensing. As a result, by the end of
1964, two-thirds of all private imports were free of strict
licensing. Pakistan's large-scale industry grew at an average
annual growth rate of 13.3 percent during the 1960s. In this
way, Pakistan moved away from the ISS to the export
promotion strategy in slightly less thana decade.
The new government once again moved towards the ISS
in the 1970s. The internationaloil crisis and subsequent world
recession added salt to the injury. The government started
nationalizing heavy industry and industrial investment shifted
from the private to thepublic sector. By 1976, the government
owned more than 25 percent of large-scale industry.The large
scale sector expanded at an annual average rate of only 2.0
percent between 1970 and 1976. The small-scale industrial
sector performed better than its large-scale counterpart for the
first time by expanding at an average rate of 4.3 percent during
the same period. Donor's interest in the industrydeclined due to
adoption of the ISS. World Bank lending to Pakistan declined
by almost 40 percent.
At the end of 1970s, the change of government shifted the
direction of the industrialpolicy from the public to the private
sector. At that time, the ISS became quite unpopular at the
world level also. The policies of deregulation, privatization and

liberalization became an important targetof theGovernment of

Pakistan in the 1980s and especially in the 1990s. The
government is reducing controls on trade, foreign exchange,
prices etc. to integrate the national economy with the global
economy. The main target of Government of Pakistan is to
encourage foreign direct investment to accelerate industrial
growth.
In summary, the effectiveness of aid in industrial

development depends upon industrial policy choices. Donors
increased flows of aid in response to a liberalized industrial
policy. Whereas, they cut down aid flows during the times of
ISS. To increase the effectiveness of aid in the industrial sector
in future, the government and the donors should concentrate on
export promotion, removal of international trade and non-trade
restrictions, adoption of deregulation and privatization, and
encouragement of the small-scale industrial sector.
The energy sector of Pakistan has been an area of interest
for donors. The World Bank directed a nine-year negotiation
process that resolved a very sensitive problem of dividing the
water rights between India and Pakistan. The Indus Basin
Treaty was signed in 1960. During the 1947 to 1958 period,
one quarter of total aid to Pakistan was for power and
irrigation.The World Bank played an importantrole in building
the Mangla and Tarbella dams. The Bank introduced the
structuraladjustment lending in the 1970s to assist countries in
undertaking sectoral policy reforms. The Bank asked the
Government of Pakistan to eliminate subsidies on oil, gas and
electricity to increase the efficiency of the energy sector. In the
recent years, the government has started to decrease subsidies
on electricity, gas and oil to overcome its deficits and fulfill the
donors' conditions. The Asian Development Bank and other
bilateral donors have also stepped in to provide aid for the
energy sector of Pakistan in the last decade.
In short, foreign aid played an important role in
establishing a physical as well as an institutionalframework for
the energy sector of Pakistan. This is one of the least
controversial sectors of lending and has yielded close
cooperation between the donors and the recipient. Institutional

inadequacies (insufficientmanagerial and technical skills) and

poor policies (especially in the area of pricing) are the areas
which require special attention to increase the effectiveness of
aid to the energy sector in the future.
Aid in theDevelopment of Social Sectors

The Government of Pakistan (GOP) has given a very low
priority to the social sectors in termsof its budgetary allocation
to these sectors. A mixture of competing demands by other
sectors such as agriculture, industry and energy and built-in
constraints such as poverty and lack of physical and human
infrastructurehave left little funding for the social sectors. The
percentage shares of the education and health sectors in GNP
are presented inTable 7.
TABLE 7
Expenditure as % of GNP
Years Education Health
1980-81 1.4 0.6
1985-86 2.3 0.7
1990-91 2.1 0.7
1994-95 2.4 0.7
Source: Government of Pakistan (1995).
Although aid has played a constructive role in shaping revised

government thinking on the importance of the health and
education sectors in sustaining economic development, these
sectors have not been themain priority for thedonors.
A healthy and educated population accelerates thepace of
economic development. However, it seems from facts and
figures that the GOP does not see the importance of human
capital other than for humanitarian reasons. It was in the early
1980s when GOP started to gradually increase the expenditure
on thedevelopment of social sectors.

The health standards inPakistan are very low as compared

to international levels, characterized by very high infant/child
mortality rates and low life expectancy. The main problems of
the health sector are lack of funds, skilledman-power, research
and trainingfacilities, infrastructuraland institutionalset-up and
policy making.
The donors have been able to influence policy making
through programme initiatives and exposure to international
thinking in the health sector, especially WHO and UNICEF.
However, the funds for the health sector are still scarce. The
element of vbrain drain' causes negative effects of aid on the
health sector as many Pakistani nationals do not return to
Pakistan after completing their training in foreign countries.
The changed policy of the donors and thatof theGOP to shift
from curative to preventive health care has yielded positive
results.
Rapid population growth is a serious impediment to

Pakistan's development. Although Pakistan received a
substantial amount of funds over the last one and half decade
under the heading of Population Planning Programme, the
population growth rates remain unchanged. This sector requires
more research and appropriate policy making.
The education sector is also neglected by GOP as well as

by the donors. Table 4 Clearly shows that thedonors have given
the lowest importance to the education sector of Pakistan.
Despite a very low literacy rate (estimated at 38.9 percent in
1996-97) [Government of Pakistan (1997)], donors' behaviour
remained quite ignoring for the education sector of Pakistan.
"Furthermore, small fraction of foreign aid allocated to
education was used, for the most part, to finance higher
education, very often overseas" (Khan and Ali, 1994).
This sector suffered from less government attention,
persistent underfunding, wrong policy making, infrastructural
and institutional deficiencies, etc. Both donors and the GOP
gave priority to tertiaryeducation over primary education from
the 1960s to the early 1980s. Major donors were theWorld
Bank, the Asian Development Bank, and the United States

Agency for International Development (US-AID). Most

bilateral donors concentrated on providing technical assistance
(e.g. scholarships) and institutionbuilding. UNICEF focused on
primary education. These contradictory objectives of different
donors (i.e. which one should be given priority, primary
education or secondary education?) confused the GOP as
regardingwhich way to go. In recent years, both thedonors and
theGOP have agreed to give priority to primary education.
The current literacy rate of Pakistan is 37 per cent. The
GOP is committed to increase the share of the education sector
from 2.5 per cent to 3.0 per cent of GNP by theyear 2000. The
year 1995-96 had been declared as the year of "Basic Education
forAll". The futureobjectives for theGOP and donors should
be to increase the literacy rate, plan an education system
according to the country's needs, remove differences between
male/female, urban/rural and inter-provincial educational
standards, and improve the quality of education in addition to
its quantity.
V. CONCLUSIONS AND POLICY

RECOMMENDATIONS
The theoretical and empirical literature remains
inconclusive on the role of FCIs in economic development of
the recipient country. On one hand, aid augments the domestic
resources of the recipient, helps to promote growth and
structural transformation, assists to overcome the balance of
payments and government budget deficits, transfersadvanced
technology and improves human resources. On the other hand,
foreign aid may distort domestic savings, introduce
inappropriate technology, increase the debt burden of the
recipient country, create a booming sector and assist the donor
to pursue its interestsabove thepolitical and economic interests
of the recipient. While taking care of the findings of the
literature, this paper has presented an historical review of the
effectiveness of foreign aid in Pakistan's economic development
for theperiod 1960-61 to 1994-95.
Various debt burden indicators indicate that Pakistan's

debt burden has increased over time and the countrymight get

caught in a severe debt servicing problem in future if

macroeconomic management, foreign trade and domestic saving
policies are not designed and implementedappropriately.
While analyzing the trendsand composition of aid for the
period under study, some interestingpatterns emerged. The
shares of loans and credits in TDA have increased while the
share of grants has decreased rapidly which resulted in a rapid
accumulation of debt. The proportion of project aid as
compared to non-project aid in TDA has risen sharply which
added to the productive capacity of the country. The sectoral
shares in TDPA in ascending order are as follows: water and
power, transport and communication, industry, agriculture,
population and welfare, and education and rural development.
This indicates very less attention for the social sectors. Patterns
of sources of aid show that the consortium countries remained
the major donors of aid to Pakistan. While analyzing the
attitudes of donors by looking at disbursed aid as a percentage
of committed aid, the donors of non-project aid seemed quite
favourable while thedonors of project aid did not.
The overall impact of foreign aid on Pakistan's economic
development remained positive in the sense that it has helped in
the structuraltransformationof the economy, laid infrastructural
and institutional foundations for agricultural and industrial
sectors, provided technical assistance, policy advice and modern
technology, assisted in overcoming the budget deficits and the
balance of payments deficits and funded the projects for social
sectors development.
However, this does not mean that the role of aid in

Pakistan's development is above criticism. Along with the
increase in the rate of economic growth, aid seemed to have
substituted for domestic savings according to existing literature
on the subject. The debt servicing problem has become
immense due to mis-utilization and mis-management of FCIs.
The GOP chose the ISS by using foreign aid which resulted in
efficiency losses and retarded economic growth, the role of aid
in the development of social sectors is also not above criticism
because the GOP and donors gave much less importance to
these sectors.

What comes out of the above discussion is thataid itself is

neither good nor bad but it is the objectives and policies of the
donors and the recipients thatmake aid a blessing or a curse.
Whether aid substitutes for domestic savings or complements it
is totally associated with the recipient government's
macroeconomic management policies. The choice of industrial
policy (i.e. import substitution or export promotion) is the
recipient government's duty and affects the contribution of aid
to its industrial development. The distribution and allocation of
aid funds among different sectors of the economy is also in the
hands of thedonors and the recipients.
To maximize the benefits of aid, strong coordination is
required between the donors' and the recipient's objectives. The
overall economic and political environment of the recipient
country determines the effectiveness of aid in that country's
development. A politically and economically stable economy
can enjoy the full benefits of foreign aid. Pakistan's economy
has already started its journey towards an open, outward
oriented market economy but is still in need of better
macroeconomic management, political stability, a sound
infrastructural and institutional set-up, and highly skilled
manpower to utilize domestic and foreign resources more
efficiently.

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THE ROLE OF FOREIGN AID IN ECONOMIC DEVELOPMENT OF PAKISTAN (1960-61 TO 1994-95)

Author(s): AZHAR MAHMOOD

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