Introduction

Since 1960 nearly $1.7 trillion (measured in 1995 dollars) in foreign aid has flown from rich to poor countries – much of it as project assistance. As the leading project lending agency, the World Bank has, along with other donors, begun asking questions about whether this assistance is as effective as possible in promoting economic growth and reducing poverty. One source of concern has been whether aid projects actually finance what they are intended to, or whether development assistance earmarked for critical social and economic sectors directly or indirectly funds unproductive expenditures including those on defence. What has aid financed in developing countries? What is the evidence on the ‘fungi-bility’ of aid? What are the implications of aid fungibility for donors in assessing the impact of their assistance programmes? These are the issues this chapter addresses. In section 2, we first define aid fungibility and then analyse its consequences. Section 3 provides a review of the literature on fungibility of foreign aid and reports some results. The review examines the evidence – both cross-country and country-specific – on the link between foreign aid and the recipient country's public spending. In section 4 we develop a link between fungibility and a donor agency's lending strategy. Moreover, in the light of the empirical findings on aid fungibility, we draw lessons for donor assistance and make recommendations for designing better lending instruments. In this section, we also provide a blueprint of a new lending instrument – a public expenditure reform loan (PERL) and discuss its strengths and potential shortfalls. Section 5 provides some concluding remarks.