Reforming Aid: Toward More Predictable, Performance-Based Financing for Development

SummaryWe explore ways of mitigating the costs of aid volatility: in particular, we show that these can be dramatically reduced by a flexible pre-commitment rule which adjusts flows in the case of drastic improvements or deteriorations in country performance ratings. Such a system can further reduce variability with only minor efficiency costs. Our simulations suggest that a buffer stock of the order of 50–100% of annual aid-financed spending might enable a corrective feedback loop, with the necessary buffer depending on the size and variability of aid flows. Our proposed mechanism is similar in principle to natural resource funds, which have worked well in some countries but not in others; we briefly discuss some issues in design and implementation.