US Aid To Pakistan; Bless or Curse

Since Osama bin Laden was discovered and killed in Abbottabad last year, there is an increasing pressure on Obama to justify by Congress to justify US aid being given to Pakistan. Although military assistance is currently the only form of US aid to Pakistan to be withheld, Congress is also considering the stoppage of US economic aid and civilian aid to Pakistan (Guardian, 1). It is very important to investigate that to what extent this decision of stoppage of aid will hurt Pakistan’s economy. This paper will try to analyze the impact of US foreign aid on the economic development as well as the economic growth in Pakistan. US aid due to its unreliability, inconsistency, and more importantly, its relation to the conditionality of the continuing War on Terror holds a special attention. In this paper it will be argued that, although US economic aid has positively affected economic growth in 1980s, yet it is unsustainable and has not contributed in economic growth of Pakistan in general. This paper will then specifically analyze the effectiveness of US aid to Pakistan after 9/11. It will be argued that US military aid after 9/11 proved to be disastrous due to its condition of the War on Terror. There is a huge indirect cost for Pakistan for continuing to assist US on its War on Terror, in terms of loss of lives, destruction of infrastructure and internal migration of people. Such costs and unreliability of US aid to Pakistan in near future, implies that policy makers should go towards more sustainable aid in place of military aid from US.  Instead of relying on US military aid, preference should be given to attract foreign direct investment (FDI), and exports to compensate for the trade and saving gap. Both the FDI and exports are linked to capacity utilization, research and development (R&D), They increase market access and technological spillover. These benefits are expected to be more stable than the temporary benefits of foreign aid.

This paper is divided into two sections. In section 1, the literature review for the relations between Foreign Aid and economic development will be discussed. In section 2, a brief history of US aid and its effect on economy will be discussed, followed by an extensive analysis of US foreign aid in post 9/11 scenario. In the end, conclusions will be drawn with policy recommendations; For example, after 9/11, military aid from US has severe indirect costs which should be considered in policy making process. Moreover, Pakistan should divert its attention from military to economic development from US. Furthermore, the main concern of Pakistan should be to promote sustainable inflows; foreign direct investment, and remittances from abroad.

1)   Literature Review:

Foreign aid may be defined as the transfers of governmental resources from one country to another country. According to the traditional two-gap theory, aid is necessary to bridge both the savings-investment gap and the trade gap in developing countries and was thus considered necessary. It however, has been mainly criticized because of one strong assumption common to both, that foreign assistance provides a one-to-one increment to the capital stock. It is also criticized due to the reason that there are ranges of mechanisms through which domestic capital formations of the recipient countries may be affected by incoming foreign aid. Also, the aid may be enhancing domestic consumption in these countries. In the neoclassical growth framework the benefits of foreign capital inflows are of temporary nature (Khan; Ahmed, 1). That is why the impact of foreign aid on economic development has always been a controversial issue. Some would argue that there is a positive correlation between the foreign aid and the economic development due to the Two Gap-Theory (Rostow, 1960). At the same time some would argue that the aid has a deteriorating effect on the economic development (Mosley (1980). Aid represents a package including policy parameters such as prescriptions about fiscal, trade and exchange rate policy. Due to which it distorts domestic economic distribution and hinders domestic savings and thus has an adverse effect on overall economic growth (Griffin and Enos, 1970).

Many economists assert that the foreign aid is necessary and sufficient condition for the economic growth in developing countries. They claim that there exist a positive correlation between foreign aid and economic growth because it complements domestic resources and also augments domestic savings to bridge saving-investment gap. Khan and Ahmed (2007) have quoted Easterly who asserts that the selective foreign aid has helped to lower the infant mortality rate and improve per capita income in the developing countries (Easterly, 2003). According to Easterly, selective foreign aid means that the donor nations put some conditions in the form of low inflation, no interferences in market prices, privatization and free trade (Easterly (2003). It provides additional financial resources which helps to achieve the short-term growth targets. It is also held that, foreign aid assists to close the foreign exchange gap, provide excess to modern technology and managerial skills and allow easier excess to world (Papenek, 1973). Chenery and Strout (1966) observed a positive relationship between foreign aid and economic growth. According to them there is positive growth rate for UK aided countries and negative for Scandinavian aided countries. Hansen and Tarp (2001) conclude that aid increases growth via capital accumulation and it does not depend on a good policy. Cassen (1994) argues that the relationship between aid and growth is rather weak, and it can be either positive or negative, depending on the country's absorption capacity of aid, and its economic as well as political structure. Studies based on time series data conclude that foreign aid has been an important determinant of economic growth. Khan and Ahmed (2007) quote Stevenson (1999) who says that foreign aid has a positive impact on the economic growth in democratic countries but it has a negative impact on authoritarian regimes.

Another alternative strand of literature asserts that the foreign aid has a significant negative effect on the economic growth and development of the recipient countries. Mosley (1980) asserts that the aid could not improve the economic conditions in Bangladesh, India, Korea and Milawi. The foreign aid is fully consumed and substitutes domestic resources. It is argued that the foreign aid is used to import inappropriate technology, encourages an inefficient and corrupt government in developing countries, and thus distorts domestic income distribution. The foreign aid is also thought to displace domestic savings, which in turn retards investment and economic growth [Griffin and Enos (1970). Khan quoted, Boone (1996) who finds that the aid has no effect on investment and growth—his estimates show that the marginal propensity to consume from the foreign aid is insignificant and marginal propensity to investment is also zero. Singh (1985) concludes that slate intervention in the economy generate negative impact on the economic growth and makes the aid-growth relationship statistically insignificant. Khan quoted Mavrotas (2002) who finds that the policies affect aid effectiveness in case of India. Lensink and Morrissey (2000) analyze the impact of the aid’s uncertainty on the economic growth in developing countries. They find that the impact of the foreign aid on the economic growth depends on the level and the stability of the flow of the aid into the recipient country. The empirical studies also suggest that the foreign aid has not contributed profoundly to the economic growth and development of recipient countries and it has the tendency towards increasing the inequalities among different groups [Rana and Dowling (1990) and Griffin (1991)].

Khan quoted Pack (1994) who asserts that the foreign aid is fungible. According to them due to the exchangeability of foreign aid, the government income is crowded out. It is argued that the foreign aid represents a side payment to elites in recipient countries, so it is designed to buy allegiance in maintaining the economic and political dominance of the industrialized (developed) countries (Frank, 1966). Similarly Khan and Ahmed (2007) quoted Wolfensohn, the president of World Bank in 2002 who says that "we have learned that corruption; bad policies and weak governance will make aid ineffective" (Khan: Ahmed, 3). Khan (2007) says that foreign aid has negative impacts on the economic growth and inequality and richer recipient countries are worse off than poorer ones.

The bulk of the theoretical and empirical literature has so far produced inconsistent, divergent and elusive results regarding the relationship between foreign aid and the economic growth. Empirical findings are also mixed with respect to the impact of foreign aid in Pakistan. Iqbal concludes that in Pakistan, foreign assistance caused a strong shift of public domestic resources from development projects to social and non-development expenditures. Khan (2007) quoted Chishti and Hassan (1992) who concluded that 28 percent of the domestic borrowings go towards financing the non-development expenditures. Khan (1997) says that ineffectiveness of aid is attributed to diversion of the aid funds to non-productive activities and inefficiency in resource allocation especially in the public sector. Chishti and Hasan (1992) concluded that 28 percent of the domestic borrowings go towards financing the non-development expenditures.

Regarding US foreign aid, Khan (1997) says that it is ineffective and this ineffectiveness of aid is attributed to the diversion of aid funds to non-productive activities and inefficiency in resource allocation especially in the public sector. Khan on the basis of data on US foreign aid from 1972-1993 concluded that a ten percent increase in aid is associated with a 0.4 percent decline in GDP. On the other hand Haider Mullick study asserts that there was positive impact of US foreign aid on GDP growth during the period of 1980-2003. However his study also concludes that the economic cost of becoming a pioneer in the war against terrorism has exceeded the benefits during the period 2001-2003. On the basis of this and above conflicting views about the impact of foreign aid; it is very important to reinvestigate the role of US foreign aid in the case of Pakistan. According to Haider Mullick, the benefits of US aid in the period 2001-2003 are lower than costs so the emphasize of this paper will to analyze the benefits and costs of US aid after 2003.

2) US Aid to Pakistan:

  The United States and Pakistan established diplomatic relations in 1947. The U.S. agreement to provide the economic and military assistance to Pakistan and the latter's partnership in the Baghdad Pact/CENTO and SEATO strengthened relations between the nations and there was a consistent flow of economic aid till 1965. However, the U.S. suspension of economic assistance after the 1965 Indo-Pakistan war had led to huge losses in Pakistan, the economic aid was dropped to .8 billion in 1966 as compared to about 2 billion in 1965, but after that the relation between the two developed and the aid continued (Table 1, Appendix) . In 1979, under the Symington amendment, US decreased the economic aid due to nuclear proliferation allegation, but after the Soviet invasion of Afghanistan in December 1979 the interests of Pakistan and US converged. In 1981, the United States and Pakistan agreed on a $3.2 billion military and economic assistance program aimed at helping Pakistan to deal with the heightened threat to security in the region and its economic development needs. After the approval of $7.4 billion aid (1982-90), Pakistan become the second largest taker of US aid after Israel, though this whole 7.4 billion were not received. Congress waived restrictions (Symington Amendment) on the military assistance to Pakistan and in March 1986, the two countries agreed on $4 billion economic development and security assistance program (Hilali, 7). On October 1, 1990, however, the United States suspended all military assistance and economic aid to Pakistan. Pakistan had only received about $600 million in economic aid in the period between 1990-2000, as opposed to about $5.5 billion as an economic aid in the previous decade, and about 8 billion in the next decade (2001-2011).

                                                                                         

            Graph 1          

Pakistan has historically been among the top recipients of US aid - since 1948, the US has sent more than $40bn in economic aid to Pakistan (Table 1. Appendix), but the benefits of this aid vary significantly between different periods. Above graph shows that the US assistance (both economic and military) to Pakistan has fluctuated considerably but it was high in two decades; 1980-1990, and 1990-2000. US assistance in these two periods is 5.5 and 8 billion respectively. In both of these periods, Pakistan was an ally of US, but the benefits of this alignment and getting aid differs very much. The above graph shows that the military aid has exceeded economic aid in the period of 2000-2010. In 1980-90, 5.5 billion economic aids to Pakistan had contributed much to GDP growth. (Mullick, 1). Pakistan had increased nuclear proliferation in this period, due to the aid (Huggert, 82). There was a significant economic growth due to the aid from US. The US aid has not contributed to economic growth in post 9/11 scenario.

In the period of 2000 to 2010, Pakistan has received more economic aid than in the period of 1980 to 90. The economic assistance has increased since 2001, and it helped in poverty reduction from 34% to 24% in 1st 4-5 years after 2001(Nabi, 17). Poverty was reduced after 4-5 years due to clustering effect: as more people were on poverty line so this aid has raised their income temporarily and reduced the poverty figure (Nabi, 17). Apart from it no one can deny that this dependence on US aid has also caused more long term damage to the Pakistan's economy (Guardian, 1). It is due to reason that with the economic aid, rhe military aid has also increased the cost of which are unbearable for Pakistan (Graph1).  The benefits from this aid has not contributed to economic growth due to indirect costs, associated with about $12 billion military aid in the same period and due to the reason that during Soviet invasion of Afghanistan (1980-1990), the interests of both countries were same but in 2000-2010 period it was not the case. Afghanistan government was also an ally of Pakistan and there was no internal insurgency in Pakistan in 1980-90.  But in the period 2000-10 Pakistan’s support of war in Afghanistan proved to be counterproductive as compared to the similar support in 1980-90 periods.  The military aid has compelled Pakistan to do some unpopular actions like drone attacks within its own territory. These attacks are a threat to Pakistan’s internal security. No doubt these attacks kill many innocent people, the rage of which is highlighted by attacking government and carrying out suicide bombings.

After 9/11, Pakistan had to assume the role of a frontline state in the War against Terror. The onset of the war disrupted Pakistan’s normal trading activities. Decline in tax collection and inflows of foreign investment were naturally adversely affected, accentuated by the travel bans issued by western governments to its entrepreneurs. Pakistan continued to pay a heavy price in terms of both the economic and security terms. A large portion of its resources, both men and material are being consumed by this war for the last several years. The economy was subjected to enormous direct and indirect costs which continued to rise from $ 2.669 billion in 2001-02 to $ 13.6 billion by 2009-10, projected to rise to $ 17.8 billion in the current financial year (2010-11) and moving forward (Economic survey 2011-12). The direct and indirect costs to the economy are most likely to rise further. The comparison of cost for 2001-02 and 2010-11 is given in Table-1. The year-wise cost of war on terror is documented in Table-2.

Pakistan’s economy is under pressure of the War on Terror intensifying for ten years in Afghanistan. Since 2001, the War has spread into settled areas of Pakistan. It has so far, cost the country more than 35,000 citizens, 3500 security personnel, destruction of infrastructure, internal migration of millions of people from parts of northwestern Pakistan(Economic Survey 2009-10). The attrition of investment climate, nose diving of production and growing unemployment and above all brought economic activity to a virtual standstill in many part of the country. Pakistan had never witnessed such devastating social and economic catastrophe in its industry (Economic Survey 2009-10). Pakistan cannot afford loss of more lives and associated indirect cost, which has disturbing effects on economy of Pakistan.

This war has disrupted Pakistan’s normal trading activities, as the cost of trading increased significantly because of higher insurance barriers. Consequently, the economic growth has slowed, demands for imports has reduced. In addition to it there is a consequential decline in tax collection. The inflows of foreign investment were naturally adversely affected. Travel bans issued by western governments to the Pakistan’s entrepreneurs have augmented the costs. Moreover there are many sanctions by US on Pakistan due to this dependency on the US aid. Pakistan is being criticized by US for negotiating with Iran regarding Pak-Iran Gas pipeline.

Pakistan internal insecurity is due to the military aid from US. Pakistan army did not want the Afghan war to have an end, because it was benefitting from it due to the US aid. Pakistan army is sponsoring Afghan Taliban, because it did not want the conflict between NATO/US and Afghan Taliban to end, because in that case the whole military aid will be stopped (Secret Pakistan). Pakistan army is benefitting from this aid at the cost of erosion of economic development because this sponsored Afghan Taliban by Pakistan’s Army is indirectly a threat to Pakistan’s economic development.  

Conclusion and Policy Applications:

On the basis of above discussion it can be asserted that the costs of war against terrorism is exceeding the benefits in post 9/11 period. In 1980-90 US aid had augmented growth but in 2000-2010 aid is not a blessing, because major proportion of it has gone to military, which is in favor of war for its own benefits.  Pakistan has got only $8 billion aid, but has faced the cost of $16 billion by being a part of the US War on Terror. Moreover, the aid also has no reliability of continuity. On the basis of this, it is the right time for Pakistan to divert its attention from this costly and unreliable military aid to more sustainable aid. The most important policy implication derived from the discussions will be to reduce dependency on US foreign aid and focus on those external financing resources that are much stable, sustainable and have positive impacts on growth rather than depending on the volatile and unstable sources like the US aid. Pakistan should focus more on FDI. It has direct impacts on overall development and it is also sustainable. During the 2001-2006, in addition to the economic and military aid, there was significant FDI which has augmented growth rate during this period. To improve the growth prospects in the country which provides supporting environment for domestic investment, expansion of export-oriented industries and foreign direct investments (FDI) should be encouraged, and for that Pakistan needs to enhance its internal security.

Furthermore, internal security is the pre-requisite for FDI. So the Pakistan’s immediate concern should be to eliminate this internal insurgency. The reason for this internal insurgency is the military aid. The Pakistan Army does not want to stop this aid and is augmenting this internal war. So the stoppage of this military aid can decrease Pakistan Army’s role in increasing internal as well as the external insurgency. The two variables, i.e., exports and FDI have not only exerted positive impact on growth but have also generated spillover effects (Khan,Ahmed, 2007). Hence, there is intense need to focus on these sectors.