Counterpart funding requirements and the foreign aid procyclicality puzzle

pallage, st�phane ; robe, michel a.;

Official development assistance is a key source of external finance in many developing countries. A striking feature of these aid flows is their positive correlation with business cycles in recipient countries. This pattern is puzzling in that it reinforces recipients� already strong and costly macroeconomic fluctuations.
We propose a simple model of investment financing and aid provision under asymmetric information that rationalizes such a pattern. We assume that donor agencies and recipient governments value projects differently, and that donors know less than recipients do about project characteristics. We show that donors can make a recipient government identify high-return projects by requiring that the latter contribute some of its own funds to projects. Providing these matching grants or �counterpart funds� is less affordable for recipients during
economic downturns, which leads to aid procyclicality. Our model produces aid contracts consistent with those used by aid agencies, rationalizes observed aid patterns, and yields a rich set of testable empirical predictions.