The Relationship between Aid and Debt in Developing Countries
Cahill, Miles B., Isely, Paul N., American Economist
Miles B. Cahill [*]
Paul N. Isely [**]
This paper constructs a model in which debt and aid are complementary. Specifically, the model shows how aid can be extracted from industrialized country governments by LDCs to finance debts. Policy implications for understanding debt crises are outlined. Using recent World Bank data, the fundamental equations of the model are estimated. While it is found that the model overestimates the actual amount of aid and debt, the relationship between aid, GDP and absorption; and debt, aid, GDP and absorption is of the predicted direction.
Some recent papers have suggested a link between aid and external debt. This contrasts with traditional lending models in which debt is acquired to smooth consumption, substitute present for future consumption, build capital, or other reasons.  Aid has been associated with political goals, humanitarian goals, and debt relief, but few studies suggest that aid is specifically used to finance debt payments over extended periods. 
One model that does suggest that aid is used to finance debt is Bulow and Rogoff (1989c) (based on Bulow and Rogoff (1989a)). In this model, the debtor country is considered a developing country (LDC) because it is assumed that the discount rate of the LDC is above the world interest rate. This assumption also gives a rationale for the LDC to borrow. The Bulow-Rogoff model shows that debt can be supported by aid when the debtor country can extract side payments from an industrialized country's government. Side payments are given to ensure that any debt rescheduling agreements are settled in a timely manner, so trade is not interrupted. The industrialized country's government values trade because its constituents derive a consumer's surplus from consumed imported goods. When the side payments are anticipated, the debtor is able to borrow against future expected side payments. This gives the false appearance of a debt "overhang" problem, because while the developing country cannot sustain its loan payments wit h its own resources, it can rationally expect the aid extracted from the industrialized country's government. (Debt "overhang" is debt that a country is not expected to be able to repay.)
The Bulow and Rogoff model does have two drawbacks. First, any trading partner could extract side payments from the industrialized country's government by engaging in a debt agreement. Second, because the consumer's surplus derived from trade is not measured, the model cannot be directly tested.
We develop an alternate, testable framework in which aid is extracted for other equally compelling reasons. It is assumed that an industrialized country's government is willing to provide aid to keep the developing country stable, and stability is compromised if income is too low. We show that the LDC and creditors can extract the aid by engaging in a debt contract which apparently creates an overhang problem. Specifically, the debt contract specifies the LDC make payments so large that it would become unstable without the aid. In this way, the aid finances the overhang, and the overhang draws the aid payments. It is shown that this model has important policy implications for offering debt relief, as both "true" and "strategic" default announcements are possible.
Both the model in this paper and in Bulow and Rogoff (1989c) suggest there is a complementary link between aid and debt. This paper investigates this proposition by estimating the model with World Bank data. While the results suggest the model overestimates true debt and aid, the general nature of the complementary relationship is as the model predicts.
International Lending Models
There are two key issues that are particular to the market for loans to LDCs: the motivation for borrowing and the incentive to repay.  This section will briefly discuss these issues and review some of the associated literature. …