INTERTEMPORAL COMPETITION AND AID EHTISHAM AHMAD AND LEONARDO MARTINEZ à We study donor–recipient relationships in which the donor finances aid programs from which recipients want to divert funds in order to meet their own objectives. We analyze two economies. In the first one, the donor commits to a program budget for each period. In the second economy, the donor commits to a program budget for two periods. This introduces intertemporal competition among recipient officials. We show that intertemporal competition may weaken recipients’ incentives to divert funds from aid programs. Furthermore, we show that this may occur even in the presence of regional competition among recipients. 1. INTRODUCTION WE STUDY donor–recipient relationships in which the donor finances aid programs that are executed by recipients. The objectives of the donor and the recipients are different: recipients may prefer to allocate funds they receive for the program to other uses, or may be unwilling to exert effort to implement the program. This moral hazard problem may be severe and it may have a significant effect on aid effectiveness (for literature reviews, see Drazen, 2000; World Bank, 2005). For example, in their study of education grants in Uganda, Reinikka and Svensson (2004, p. 679) conclude that ‘‘schools, on average, received only 13 percent of the grants. Most schools received nothing. The bulk of the school grant was captured by local officials (and politicians).’’ The donor would like to provide incentives to make recipients follow his interests. A typical response is for the donor to make future aid conditional to past performance (conditionality). However, in practice, aid distributed by the donor is often independent of the past success of the program. In a review of the literature, World Bank (2005, p. i) concludes: ‘‘The literature identified a number of cases where (a) recipient governments accept the conditions attached to aid in anticipation that they will renege, (b) donors fail to apply sanctions stipulated in the conditionality contract, and (c) recipient governments also anticipate that it will be granted funding in subsequent periods despite previous slippages.’’ Svensson (2000, 2003) explains that this is the case because of the spending-the-budget problem. Typically, in the donor organization, the allocation and disbursement decisions are separated. Those in charge of disbursement decisions may not want to reduce aid to punish recipients for previous bad performances because they are afraid reducing current aid may lower the amount of funds that will be allocated to them in the future. For instance, a former chief economist of the Swedish aid agency, Edgren (1996, p. 11), concludes from his experience that ‘‘both donor and recipient have incentive systems which reward reaching a high volume of resource transfer, measured in relation to a predefined ceiling .... Non-disbursed amounts will be noted by executive boards or parliamentary committees and may result in reduced allocations for the next fiscal year.’’ Similarly, Kanbur (2000, p. 5) concludes from his experience as a representative of the World Bank that bilateral donors have ‘‘‘fiscal year’ concerns – they feared the à Corresponding author: Leonardo Martinez, IMF Institute, International Monetary Fund. 700 19th St., NW Washington, DC 20431, USA. E-mail: leo14627@gmail.com r 2010 Blackwell Publishing Ltd. International Monetary Fund retains copyright and all other rights in the manuscript of this h chapter/article i as submitted for publication. 74 ECONOMICS & POLITICS DOI: 10.1111/j.1468-0343.2010.00374.x Volume 23 March 2011 No. 1