Closing the Gap: Aid, Debt Relief, and Microfinance

Closing the development gap means reducing the differences in income and living standards between countries, using approaches such as aid (transfers of money, goods or expertise), debt relief (cancelling or reducing debts owed by poor countries) and microfinance (small loans and financial services for poor people who lack access to banks). In brief: aid can be bilateral (from one government to another), multilateral (through organizations such as the World Bank) or from charities; debt relief frees government money for health and education; and microfinance, pioneered by Muhammad Yunus and the Grameen Bank in Bangladesh, helps poor people start small businesses. Each has benefits and limits, and none works well without good governance and local involvement.

Governments, international organizations and communities use many tools to promote development. This guide explains the main types of aid, how debt relief and microfinance work, evaluates their advantages and problems, compares them in a table, works through example calculations, outlines the history and corrects common mistakes.

How does aid work?

Official development assistance (ODA) is aid from governments to promote the economic development of low- and middle-income countries. In 1970, the UN set a target for rich countries to give 0.7% of their gross national income as ODA, which only a few countries, such as Sweden, Norway, Luxembourg and Denmark, have regularly met.

• Bilateral aid: from one country directly to another, such as aid from the United Kingdom to Kenya. It can be influenced by political and trade interests.
• Multilateral aid: pooled money given to organizations, such as the World Bank, UN agencies and the African Development Bank, which then distribute it.
• Non-governmental (NGO) aid: charities such as Oxfam and Médecins Sans Frontières raise money from the public and often work directly with communities.
• Emergency (short-term) aid versus development (long-term) aid: food, shelter and medicine after disasters, versus building schools, roads and clinics and training people.
• Tied aid: the donor requires that the money be spent on its own goods or companies, which reduces its value to the recipient.

Advantages: aid can save lives, fund infrastructure, health and education and support the poorest. Vaccination campaigns and the eradication of smallpox are successes. Problems: aid may be lost to corruption, create dependency, undermine local producers (for example, free food that lowers local prices), be tied to donor interests or fail to reach those in need. Critics such as Dambisa Moyo argue that aid can harm long-term growth, while others, such as Jeffrey Sachs, argue that more well-targeted aid is needed. Evidence suggests that results depend on the type of aid and on local conditions.

What is debt relief?

Many poor countries borrowed from foreign governments, banks and institutions in the 1970s, and later found that debt payments were too high, especially when commodity prices fell and interest rates rose. A large part of national income was going on repayments, leaving little for services. Debt relief reduces or cancels some of this debt. The Heavily Indebted Poor Countries (HIPC) initiative began in 1996 and was enhanced in 1999, and the Multilateral Debt Relief Initiative of 2005 canceled debts owed to the IMF, World Bank and African Development Fund by many countries. The Jubilee 2000 campaign, supported by churches and celebrities, helped to build public pressure. Relief usually comes with conditions, such as spending the savings on poverty reduction. The benefits are more money for health and schools, but critics note that countries may borrow again, and new lenders such as private creditors and China have complicated the situation. Debt problems have returned for a number of countries since the 2010s.

What is microfinance?

Microfinance provides small loans (microcredit), savings accounts and insurance to people who are too poor for bank services and who have no collateral. Muhammad Yunus began lending small sums to women in Bangladeshi villages in the 1970s and founded the Grameen Bank, which received the Nobel Peace Prize together with Yunus in 2006. A typical model is group lending: a few borrowers guarantee each other’s loans, which creates social pressure to repay. Loans may fund a sewing machine, livestock or a market stall. Many borrowers are women, and studies show that microcredit can help households smooth their income and start small businesses, although the average effect on poverty reduction has been smaller than early hopes.

Problems: interest rates can be high because of the high cost of small loans, borrowers can fall into over-indebtedness (as in a crisis in Andhra Pradesh, India in 2010), loans may be used for consumption and not business, and not all borrowers have good business opportunities. Today, microfinance is combined with training, savings and mobile payments.

What other approaches are used?

• Fair trade: a guaranteed minimum price and premium for producers of goods such as coffee, cocoa and bananas.
• Intermediate or appropriate technology: simple, low-cost tools that local people can build and repair, an idea promoted by E. F. Schumacher in 1973.
• Foreign direct investment and trade: investment and market access can create jobs and growth.
• Remittances: money sent home by migrants.
• Investment in education, health, infrastructure and good governance: long-term foundations of development.

The approaches compared

Worked example: aid targets, debt service and microloans

The values are hypothetical and illustrate the arithmetic.

1. Meeting the aid target: a donor country has a GNI of 500 billion. At 0.7%, its target ODA is 500 × 0.007 = 3.5 billion. If it actually gives 1.5 billion, that is 1.5 ÷ 500 = 0.3% of GNI, and the gap to the target is 2 billion.
2. Aid per person: 600 million of aid to a country of 30 million people is 600 ÷ 30 = 20 per person.
3. Debt service before relief: a country with export earnings of 3 billion pays 900 million per year in debt service. The ratio is 900 ÷ 3,000 = 30%.
4. After relief: relief cuts payments to 360 million. The ratio is 360 ÷ 3,000 = 12%, and the saving is 900 − 360 = 540 million, which could pay 18,000 teachers a salary of 30,000 each (540,000,000 ÷ 30,000 = 18,000).
5. Microloan: a woman borrows 100 at 20% annual interest for one year. The interest is 100 × 0.20 = 20, so she repays 120. If the loan helps her to make 45 extra profit a month for 12 months (540), the net gain is 540 − 20 = 520, a return of 520 ÷ 100 = 520% in this very favorable case. If she earns only 3 extra a month (36), the net gain is 36 − 20 = 16.
6. Group repayment rate: if 970 of 1,000 loans are fully repaid, the repayment rate is 970 ÷ 1,000 = 97%.

How have these approaches developed?

International aid grew after the Second World War with the Marshall Plan (1948), which helped to rebuild Europe, and with the creation of the World Bank and IMF in 1944. In the 1960s and 1970s, aid went toward large infrastructure projects, and from the 1980s, structural adjustment programs imposed conditions such as cuts in public spending. The debt crisis of the 1980s and the Jubilee 2000 campaign led to relief in 1996, 1999 and 2005. Microfinance grew from the 1970s in Bangladesh and spread worldwide, reaching hundreds of millions of customers. The Paris Declaration of 2005 called for aid to be more effective, with ownership by recipient countries, and the Sustainable Development Goals of 2015 call on all countries to cooperate through aid, trade and investment.

Which mistakes are common?

Mistake 1: Treating aid as a single thing

Emergency aid, long-term development aid, tied aid and loans have different effects, so conclusions about “aid” in general can be misleading.

Mistake 2: Thinking that debt relief ends debt problems

Relief helps in the short run, but countries can fall into debt again if borrowing, prices and growth conditions do not improve.

Mistake 3: Believing that microfinance alone ends poverty

It helps many households, but evidence shows modest average effects, and it works best with training, markets and social support.

Mistake 4: Ignoring local ownership

Projects designed without local people often fail. Success is more likely when communities and governments lead them.