Aid Effectiveness and Capacity Development: Implications for Economic Growth in Developing Countries

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1 Modern Economy, 2012, 3, Published Online September 2012 ( id Effectiveness and Capacity Development: Implications for Economic Growth in Developin Countries Prabuddha Sanyal 1, Suresh C. Babu 2 1 Resilience and Reulatory Effects, Oranization 6921, Sandia National Laboratory, lbuquerque, US 2 International Food Policy Research Institute (IFPRI), Washinton DC, US psanyal@sandia.ov Received May 4, 2012; revised June 10, 2012; accepted June 20, 2012 BSTRCT In this paper, we present a stylized model for understandin the relationship between capacity strenthenin and economic rowth in an endoenous rowth framework. Endoenous rowth theory provides a novel startin point for combinin individual, oranizational, and enablin environmental issues as part of attainin the capacity-strenthenin oal. Our results indicate that althouh donors can play an important role in aidin countries to develop their existin capacities or to enerate new ones, under certain conditions, the potential also exists for uncoordinated and framented donor activities to erode country capacities. From the policy exercises, we demonstrate that improvin economy-wide learnin unambiuously increases the rate of rowth of output, technoloy, capital stock, and capacity. Moreover, a donor s intervention has the maximum impact on the above variables when the economy s capacity is relatively low. In contrast, donor intervention can lead to crowdin-out effects when the economy s capacity is moderately hih. Under such a situation, the economy never reaches a new steady state. Our results not only lend support to diminishin returns to aid but also to an S model of development aid and country capacity relationship. eywords: Capacity Strenthenin; Development id; Economic Growth; Learnin 1. Introduction Increased interest in capacity strenthenin in recent years is a response to widely acknowleded shortcomins in development assistance over the past 50 years. For example, the dominant role of donor-led development projects with inadequate attention paid to lon-term capacity issues is often cited as a critical factor in the slow proress [1]. The 2005 Paris Declaration on id Effectiveness emphasizes the need for sinificantly enhanced support for country efforts to strenthen capacity and improve development outcomes. The declaration calls for capacity strenthenin to be an explicit objective of national development and poverty reduction strateies. In frica, for example, the New Partnership for frica s Development (NEPD) has identified capacity constraints as the main obstacle to economic rowth and sustainable development. lthouh a quarter of donor aid, or more than US$15 billion a year, has one into technical cooperation, 1 evaluation results confirm that development of sustainable capacity remains one of the most difficult areas of interna- 1 Estimates of donor-assisted capacity development efforts suest that more than a quarter of total net official development assistance is spent on technical cooperation. In 2004, the total amount spent by DC members on technical cooperation with developin countries and multilateral oranizations amounted to US$20.8 billion [2]. tional development practice. Capacity strenthenin has also been one of the least-responsive tarets of donor assistance, lain behind other slow areas such as infrastructure development or improvin health [2]. The motivation behind this study arises from the contrast between the increasinly reconized importance of capacity in development outcomes and the difficulty of achievin it. Several broad strateies can be followed, either separately or in combination, to strenthen capacity. If a simple deficiency in resources is the root cause of weak capacity, then supplyin additional financial and physical resources will be beneficial. One variant of this method would be to assist in improvin oranizational capabilities so they perform better in terms of obtainin its objectives. This may require providin technical assistance or trainin, assumin the aps are identified to achieve better performance. related stratey proposes promotin innovations and providin opportunities for learnin and experimentation. Much of this stratey focuses on the promotion of social capital, includin collaboration, civic enaement, and loyalty. These approaches aim to encourae individuals and oranizations to work better toether in order to promote a holistic view of development [3]. Strenthenin the overall oranizational system for work

2 568 P. SNYL, S. C. BBU synchronization and execution of complex tasks can enhance preexistin systems to carry out certain key functions [4]. In this approach, oranizations are seen as processin systems that chane individual and system capacities into oranizational results. This approach seeks to improve an oranization s overall performance by breakin down its activities, makin recommendations about improvements, and then interatin these improvements back into wider oranizational performance. The role of institutions is to provide knowlede of and access to the rules of the ame, thus empowerin certain actors to create, alter, and learn from the processes and rules that overn society. However, equatin institution buildin with public sector reforms can be problematic, and reform of entire systems or sectors, such as ariculture, education, and health, is important for capacity strenthenin [5]. The systems approach focuses more on transformation chane and the best ways to achieve it. In this approach, capacity arises out of interrelationships and interactions amon the system s various elements. n all-inclusive stratey for capacity strenthenin should be tareted at multiple levels and actors, and it should include an attempt to understand the linkaes amon them. In this approach, capacity strenthenin is a dynamic process whereby complex networks of actors seek to enhance their performance by doin what they do better, both by their own initiatives and throuh interactions with outsiders [6]. From this perspective, capacity strenthenin is achieved throuh combinin individual and collective abilities into a larer overall systems capacity. In this paper, capacity strenthenin is defined 2 as the process of developin human resources, creatin new forms of oranizations and institutions, buildin innovative networks, and interatin country ownership in order to improve the efficiency of the learnin activities (i.e., technical, oranizational, institutional, and policy learnin). The efficiency of these learnin activities, in turn, depends on the economic and political systems, as well as on the social infrastructure and institutions. The improvement in learnin activities results in better knowlede about policy processes and proram development, leadin to better development outcomes. Our definition is based on two observations: 1) Country ownership is critical to development performance, and this applies to both eneric capacities, such as the ability to plan and manae oranizational chanes and service improvements and specific capacities in critical fields such as health or public sector manaement and 2) Country ownership of policies and prorams is the means to sustained development effectiveness. Ownership will not bein to emere in the absence of sufficient local capacity. 2 lthouh there are various definitions in the literature (for example, [3,7,8]), we chose the above definition as it emphasizes the country ownership and system definition of capacity strenthenin. The rest of this paper is oranized as follows: In the next section, we define capacity strenthenin and emphasize its importance in development outcomes. Next, we postulate an endoenous rowth model to understand how the relationship between own-country capacity resources and donor-supported capacity resources affects economic rowth and state a few propositions related to the steady state solutions of the model. In Section 4, we undertake some comparative static exercises and derive some implications of the results. Section 5 concludes emphasizin how our model lends support to not only diminishin returns to aid but also an S-model of the relationship between development aid and country capacity. 2. Brief Overview of the Literature lthouh the concept of capacity strenthenin has reained renewed interest amon international development practitioners, adequate national capacity remains a critical factor in the current efforts to meet the Millennium Development Goals (MDGs). Yet even with increased fundin, development efforts will not be able to achieve their oals if attainin sustainable capacity is not iven reater and more careful attention [2]. The issue is increasinly bein reconized by both donor oranizations and developin countries, as emphasized in the 2005 Paris Declaration on id Effectiveness and ccra Hih Level Forum on id Effectiveness held in ccra, Ghana durin 2008 [2] 3. Capacity strenthenin remains a major challene for many developin countries. t first, it was primarily viewed as a technical assistance process, involvin the transfer of knowlede or oranizational models from north to south [7]. Technical cooperation and various forms of capacity-strenthenin activities have absorbed substantial funds over many decades. lthouh a few countries have used such funds effectively, donor efforts in many countries have produced little or even neative results in terms of sustainable local capacity [8]. This is particularly relevant for many frican economies, where, after investments of millions of dollars to improve the capacity of frican overnments, donors have beun to question the merits of their policies in buildin capacity via technical assistance [9]. Simultaneously, evidence suests that development aid is hihly uncoordinated and framented [10]. With 56 bilateral donors and more than 230 international oranizations, there are currently about 60,000 development aid projects. The averae number of donors per country 3 This declaration rests on five pillars: 1) ownership developin countries exercise leadership over their development policies and plans; 2) alinment donors base their support on countries development strateies and systems; 3) harmonization donors coordinate their activities and minimize the cost of deliverin aid; 4) manain for results donors and developin countries orient their activities to achieve the desired results; and 5) mutual accountability donors and developin countries are accountable to each other for proress in manain aid better and in achievin development results.

3 P. SNYL, S. C. BBU 569 almost tripled durin the past 50 years from 12 in the 1960s to 33 in recent years. The proliferation of the number of donors has created chaos in donor practices and has led to inefficient aid-delivery mechanisms [11]. In addition, after several decades of economic crises, developin country overnments have adopted wide-ranin reform prorams, often on the advice of multilateral institutions. The lack of country capacity to implement these prorams, however, has been alluded to as a major factor behind the failure of the reform prorams [12]. Finally, it is now well accepted that solutions imposed unilaterally by donor aencies from outside the country cannot address the problems and concerns of many developin country overnments. Thus, national overnments must be willin to take ownership of their prorams and control forces that affect the economy and polity [13]. The new consensus, as expressed in the 2005 Paris Declaration on id Effectiveness, sees capacity strenthenin as an endoenous process, stronly led from within a country, with donors playin only a supportive role. ccordin to this idea, capacity strenthenin involves much more than enhancin the skills and knowlede of individuals. Rather, it critically depends on the quality of the oranizations in which individuals work. In turn, the effectiveness of those oranizations is influenced by the enablin environment in which they are embedded. Capacity, in this view, is not only about skills and procedures, but also about incentives, oranizational effecttiveness, and overnance. Yet, it is not clear how combinin individual skills, oranizational restructurin, and an enablin environment could be enhanced throuh an endoenous process. In liht of the above, several questions remain: What is the optimal level of country capacity strenthenin required to achieve specific economic rowth tarets? What conceptual approaches could help us understand the relationship between national capacity and economic rowth? Under what conditions does donor intervention improve or displace country capacity? Currently, little attention is paid to these questions in the economic development literature. The next section presents a stylized model for understandin the relationship between capacity strenthenin and economic rowth in an endoenous rowth framework. The motivation is that the development literature lacks a theoretical framework for addressin capacity development issues. Currently, most studies treat human capital as individual skills. t the same time, the literature treats 4 Capacity strenthenin can also be understood from a production function perspective, in which overall capacity is produced as a function of individual, oranizational, and enablin environment. lthouh this approach can provide some additional insihts into the dynamics of capacity formation, we do not consider this approach in the present paper, as our main purpose is to understand how capacity is related to economic rowth and under what conditions capacity leads to hiher steady-state rowth. the oranizational culture, institutional arranements, and political processes under which capacity strenthenin operates as exoenous. 3. Theoretical Model of the Relationship between Capacity and Economic Growth This section presents a theoretical model for understandin the relationship between capacity investments and rowth outcomes. The model extends the framework developed by [14] and further extended by [15]. Let the economy comprise two sectors: a oods-producin sector and a research and development (R&D) sector. The former produces conventional output, while the latter produces new technoloy, which adds to the existin level of technoloy. Four factors of production in the economy namely, capital (), labor (L), human capital (H), and capacity resources (C) 4 are allocated for use in either the oods or the R&D sector. The capacity resources can be conceived of not only as sectoral prorams allocated by the overnment for health, water and sanitation, and irriation development (to name a few) but also as improved learnin that occurs from interactions amon the system of actors (firms, oranizations, overnment, consumers, etc.) that influence an economy s innovation performance. Capacity resource devoted to proram development is a process throuh which values and resources are authoritatively allocated for the economy as a whole. It is a process whereby a representative overnment puts forward measures to accomplish some desired objectives. This process enerally involves expenditure of resources whether in terms of extractive, distributive, or other measures. We let a denote the fraction of capital stock used in the R&D sector; a H denote the fraction of human capital used in the R&D sector; a L denote the fraction of labor used in the R&D sector; a C denote the fraction of capacity resources used in the R&D sector; This implies the followin: 1 a is the fraction of capital stock used in the oodsproducin sector; 1 a H is the fraction of human capital used in the oods-producin sector; 1 al is the fraction of labor used in the oods-producin sector; 1 ac is the fraction of capacity resources used in the oods-producin sector; Technoloy has the characteristic of bein non-rival. Hence, the entire level of technoloy () is used in both sectors. Output in time t is iven by

4 570 P. SNYL, S. C. BBU Y 1 1 t t H 1C Ct t 1L Ht Lt 1 with 0 < α < 1, 0 < β < 1, 0 < γ < 1, α + β + γ < 1. In Equation (1), it is not important to know how C is allocated (althouh in a more dynamic settin, how C is allocated can have important implications for economic rowth). To the best of our knowlede, the literature has not explicitly considered who allocates capacity resources. This person or entity can be the social planner or even the donor. [16] provided the only model that identifies ways in which policymakers can influence the trajectory of their economies. This mechanism works mainly throuh choices reardin family size and investment in children. In their model, developin countries that have hih levels of political capacity, protect civil liberties, and have low levels of political instability are the ones most likely to develop successfully. The political factors influence development outcomes throuh demoraphic transition to a low birth rate and the incentives to invest in physical capital. We assume Cobb-Doulas technoloy for analytical tractability. The level of innovation in the economy depends not only on the amount of capital, labor, and human capital devoted to the R&D sector but also on the capacity resources necessary to maintain and uprade the current level of technoloy 5. We assume a eneralized Cobb-Doulas production function with increasin returns for the R&D sector. a b c d B H C L (2) t t H t C t t t L t t with B, a, b, c, d, σ > 0. The savins rate is exoenous and constant, and depreciation is assumed to be 0 for simplicity. This implies that sy (3) with 0 s 1 We treat population rowth and human capital rowth to be constant and exoenous, so that L nl H mh (4) t t t t with n, m 0 The equation for motion of capacity strenthenin is iven by with λ, > 0 t t t t (1) C H C Y (5) 5 For example, if a sinificant number of scientists and enineers move out of the country for better job prospects, then capacity re-sources invested in the country can erode over time, and the level of innovations may decline. 6 We derive the steady state conditions for capital accumulation, technoloical rowth, and capacity. These results can be obtained from the authors upon request. We treat as exoenous to the host country s decision to invest in capacity resources. However, in a more realistic settin, where the overnment seeks to maximize a utility function that depends on capital expenditures, the overnment s recurrent expenditure, tax and nontax revenues, and various kinds of aid (e.., project aid, proram aid from all donors, technical assistance, and food aid subject to the overnment s budet constraints), will depend on the above factors and will be endoenous (see, for example [17]). It will also depend on the country s balance of payments situation. We assume away such complexities from the present model, because our main focus is to understand the relationship between capacity resources and economic rowth. The rationale for Equation (5) is derived from [18], in which an individual capital investment model is used to study social capital formation. Capacity formation takes lon periods, with λ denotin the learnin aspects of capacity throuh formal education, job trainin, and nonformal education, while denotes a parameter that captures how capacity resources devoted by an external aent (e.., a donor aency) are utilized by the host country overnment for improvin country capacity over time. The implicit assumption made here is that aid is absorbed and spent by the recipient. In this case, the forein exchane is sold by the central bank and absorbed into the economy, and the overnment spends the associated resources. The challene faced by monetary authorities is to manae the real exchane rate that may result. This assumption is reasonable, unless Dutch disease is a major concern or the return to public expenditure is extremely low [19]. We make this crucial distinction between domestic and external capacity resources, because capacity strenthenin can be understood as individuals, oranizations, and institutions tryin to improve capacity without external intervention. However, under the donor mandate, capacity can also be formed over time by utilizin proram aid and technical assistance 6. Proposition 1: For the steady-state rate of capacity to maintain or row over time, there exists a * satisfyin 2, such that if > *, then the economy s capacity declines, thus affectin the economy s steady-state rate of rowth in the lon run. The intuition of Proposition 1 can be understood in the followin context: Suppose the economy s capacity is really low, in that it lacks financial, human capital, and technical resources. In this case, donors can play an important role in aidin countries develop their existin capacities by providin aid, such as proram aid and technical assistance. The host/recipient country can use the aid to invest in material resources, infrastructure, and human capital resources, such as education and health services. Suppose, on the other hand, that the recipient country has an existin capacity that is moderately hih, but donors

5 P. SNYL, S. C. BBU 571 still try to control the projects (more project aid) until completion. s the waes and salaries in these projects are paid by donors at much hiher rates than what the recipient overnment can afford, this process can possibly lead to brain drain away from the public services. If the country is in the midst of a proloned adverse external shock, the recipient country may be forced to reduce its expenditures further. The combination of rowin costs and diminished budets can result in a radual erosion of the recipient country s ability to meet its basic recurrent expenditures. id dependence then becomes a stratey for donors to keep projects alive so the recipient overnment s recurrent costs are sustained. However, throuh the control of projects and prorams, the donors erode the country s capacity even further. We also derive the steady-state relationship between the rowth rate of capital accumulation and rowth rate of capacity and based on this relationship, we have the followin proposition: Proposition 2: There exist critical values * and γ * such that if 2 1 is satisfied, then the economy s steady-state rowth rate of capital stock unambiuously increases, improvin the economy s rowth rate in the lon run. Proposition 2 states that as lon as the elasticity of output with respect to capacity-strenthenin resources does not come in conflict with the recipient country s utilization of aid resources 7, then the rate of rowth of capital stock will improve in the lon run. Next, we examine the steady-state relationship between the rowth rate of technoloy and the rowth rate of capacity. Based on this relationship, we have the followin proposition: Proposition 3: There exist critical values * and γ * such that if 1 2 c1 is satisfied, then the economy s steady-state rowth rate of technoloy will improve over time. The steady-state conditions is found by solvin two equations with two unknowns namely, the steady-state relationship between rowth rate of capital accumulation and rowth rate of capacity (proposition 2) and the steadystate relationship between the rowth rate of technoloy and the rowth rate of capacity. This is succinctly stated in proposition 4. Proposition 4: For the steady-state solution to exist 8, the critical values of and γ must satisfy the followin condition: * a 2 1 * 2 * * 7 For example, if the recipient overnment plans to obtain more project aid and food inflows, this can reduce public investment and overnment consumption. If the reduction in public investment outweihs the decline in overnment consumption, rowth rates can fall. c c 4. Policy Exercises In this section, we consider the steady-state effects of three scenarios that could result from different development policy interventions. The first exercise 9 examines what happens if the rate of learnin from human capital accumulation increases exoenously, which could result from a country experiencin an increase in the number of new schools or new adult educational prorams. In the second exercise, we examine the role of the recipient country in askin for more aid from the donor and doublin its commitment to invest in capacity resources ( increasin from 0.8 to 1.6), when the elasticity of output with respect to capacity is low (we assume γ = 0.1). In the final exercise, we consider a similar situation of doublin of investment in capacity resources by the recipient country, but with the elasticity of output with respect to capacity bein hih (we assume γ = 0.35). We show that the predictions are very consistent with our theoretical model Increase in the Rate of Learnin in the Economy Consider an exoenous increase in the rate of learnin (λ) from reater human capital formation in the economy. From Fiure 1, we find that an increase in λ results in decreasin the intercept of the 0 locus; thus, there is a parallel downward shift from to. t the same time, an increase in λ results in an upward shift of the 0 0 locus from to. Thus, the economy moves from E 0 to E 1 with the conesquence that both the steady-state rowth of technoloy and the rowth rate of capital also increase, improvin the rowth rate of capacity. The intuition for this result is as follows: First, an increase in learnin results in a larer stock of human capital in the economy. ssumin that the share of human capital in the R&D sector remains unchaned, the increase in human capital resultin from an increase in the rowth rate of learnin leads to an increase in the 0 1 rowth rate of technoloy, from to. The larer rowth in human capital also results in an increase in the amount of resources bein used in the conventional oodsproducin sector. For this sector, the larer rowth of the human capital stock that arises from reater learnin and from the interactions amon individuals and oranizations, accompanied with more rapid technoloical rowth from the R&D sector, leads to an increase in the rowth 8 For the sake of brevity, we do not provide the proofs of the above propositions. These proofs can be obtained from the authors upon request. 9 Throuhout the exercises, we assume the followin values of the parameters for the hypothetical economy: α = 0.3; β = 0.2; γ = 0.1 and 0.35 in the low- and hih-capacity levels, respectively; = 0.8 and 1.6; σ = 0.6; a = 0.25; b = 0.3; c = 0.15; λ = 0.05 and 0.2; and d = 0.2.

6 572 P. SNYL, S. C. BBU rate of output. The rate of capital accumulation also in- to reater technoloy absorption, resultin in resources creases with reater output rowth, which leads to a shift bein efficiently used in the oods-producin sector of the 0 locus from to. Thus, an exoe- This shifts the 0 locus from to. For the nous increase in learnin leads to an increase in the lonterm capacity, technoloy, capital stock, and output Doublin of Capacity Resources When the Elasticity of Output with Respect to Capacity Is Low In this case, we assume the parameter value of γ to be equal to 0.1. We consider the followin experiment of doublin of capacity resources i.e., increasin from 0.8 to 1.6. The capacity of the recipient country is low in this situation. s shown in Fiure 2, for the same level of α, an increase in recipient country resources devoted to capacity leads to reater learnin and knowlede interacttions amon aents in the economy, which leads to reater human capital accumulation. The increase in human capital accumulation also leads same level of technoloy intensity (σ) in the R&D sector, because the domestic level of capacity is low, a sinifycant increase in capacity resources also leads to reater human and physical capital accumulation. Thus, the slope of the 0 locus becomes flatter, and the economy slowly converes over time from point E 0 to E 1. s a consequence, there is a sinificant increase in capacity, capital stock, technoloy, and output. The impact can also be understood by considerin the steady-state condition for the rowth rate of capacity 10. Because the elasticity of output with respect to capacity (γ) is extremely low, an increase in leads to reater human capital accumulation, hiher rowth rates of technoloy, and a hiher rate of capital accumulation. ll of this contributes to a sinifycant increase in the rowth rate of capacity, leadin to hiher economic rowth. *1 ( = 0) 0 E 1 ( = 0) 1 ( = 0) 1 ( =0) 0 *0 0 E *0 *1 Fiure 1. Effects of an increase in the rate of learnin in the economy * * * This condition can be stated as follows: m n C Copyriht 2012 Sci Res.

7 P. SNYL, S. C. BBU 573 *1 ( =0) 0 E 1 ( =0) 1 ( =0) 1 ( =0) 0 *0 E 0 *0 *1 Fiure 2. Donor intervention when capacity of the economy is low Donor Intervention When Elasticity of Output with Respect to Capacity Is Hih We now consider the final case, in which the elasticity of output with respect to capacity is moderately hih, i.e., γ = We consider the same experiment as before of doublin of capacity resources by the recipient country s overnment. Because the economy s capacity is already quite hih, the recipient overnment needs to coordinate the activities in a more effective and efficient way, rather than dependin on more donor resources. The followin is what happens in this case: Initially, the economy is at point E 0. Because the economy is already at quite a hih capacity, an increase in donor intervention without any preplannin and coordination leads to a decline in both the human capital stock and the accumulation of technoloy. This leads to resources bein inefficiently used with the consequence that capital stock is depleted sinificantly, as shown by the 1 0 locus in Fiure 3. t the same time, an increase in donor intervention with multiple projects leads to a decline in the technoloy sector. This can be coined as the crowdin-out effect of donors drivin the recipient overnment out of projects and prorams. lthouh the decline in the technoloy sector is not as sinificant as in the commodity sector, it is still neatively sloped and flatter than the 0 locus. In other words, the 0 locus and the 0 locus do not intersect, with the consequence that the economy never reaches a new steady state Implications for Donor encies s pointed out by [20], the impact of development aid on rowth shows a positive but insinificant effect, while

8 574 P. SNYL, S. C. BBU ( =0) 0 ( =0) 0 E 0 ( =0) 1 ( =0) 1 Fiure 3. Donor intervention when capacity of the economy is hih. studies of the effect on rowth that is conditional on either ood policy or development aid itself have shown weak results. For example, [12] noted that aid is more effective in fosterin rowth and improvin service delivery in countries with better policies and institutions. It is also more effective when it is alined with recipients priorities, when it reduces transaction costs throuh harmonized and coordinated donor processes, when it is predictable, and when there is a clear focus on results. Our result blends the above findins and indirectly implies that development aid should be conditional on a country s level of capacity for it to be more effective. Under this framework, a country s level of capacity should be the primary criterion for eliibility for substantial aid. We thus propose an S model of aid effectiveness on the lines of [21], where country ownership and need (hih poverty rates) determine the level of development aid. The first sement of Fiure 4 covers the pre-reform stae, where country ownership is really low and the state itself may be failin. The level of human resources at this stae is very low in part because a sinificant portion of the population is illiterate or barely has a primary education, institutions may be failin, and there are virtually no public or private sector oranizations. Under these conditions, the recipient country would first need to develop its own stratey, prorams, and projects in consultation with both its own constituencies and donor aencies. It would then present its plans to the donors, who would put unrestricted and untied financin into a common pool. The level of aid would be low at this stae and would come mainly in the form of technical assistance, policy advice, or rants [22]. Donors should support the efforts of the recipient countries and actively support reformers and visionary leaders. The first-stae reforms should consist of human resource development, accompanied with better public sector

9 P. SNYL, S. C. BBU 575 Fiure 4. Relationship between aid effectiveness and country capacity. manaement. These reforms are important, as the recipeent country s monetary need is hih, and aid effectiveness is increasin. This learnin can be conducive to raisin productivity in the public sector. This situation is demonstrated in Fiure 2, in which development aid has hih and positive marinal returns. Both the donor s and the country s own resources can be allocated to hih-priority areas to enerate hiher economic rowth and development effectiveness. The second-stae reforms should emphasize buildin new institutions and restorin existin ones. t this stae, aid intensity needs to be maintained or even increased, as the effectiveness is very hih. In addition, donors can improve on development outcomes by creatin effective links between civil society oranizations (such as NGOs) and other partners. Because these civil society oranizations have links both up and down the ladder of interacttion, the countries effective capacity can be strenthened. Donors can provide their expertise on public sector manaement to NGOs in order to facilitate activities and improve upon development effectiveness. The final stae (the post-reform period) occurs when a country owns its policies and prorams. This stae is demonstrated in Fiure 3, in which diminishin marinal returns to aid set in and other sources of investment become the dominant form of financin. Because this stae is characterized by an improved oranizational structure of public sector institutions, a stron supply of professsional and technical personnel, and the presence of stron institutions, donors are better off by lettin recipient countries own their own policies and prorams. t this stae, donors should develop exit strateies to minimize the disruptions of transition and to smooth the way for new capacity-buildin initiatives. There will be substantial revampin of the international aid architecture under the above arranements. Donor aencies (both bilateral and multilateral) will still play a critical role, but their ownership of policies and the prorams of recipient countries will be substantially diminished. Donors will learn from their past mistakes and chane their ways of manain aid and improvin country ownership of policies and prorams. They may help oranize knowlede manaement, assist in operation of public sector oranizations, and support civil society oranizations for improved reforms in judiciary and leal systems. lthouh development aid can be justified durin the first and second staes of reform for improvin country capacity, less aid will be necessary in future staes. The interaction between development aid and learnin by recipient countries is important and should be cultivated in a manner that promotes country and institutional capacity buildin instead of the capacity erosion that is evident in many sub-saharan frican countries at present. 5. Summary and Conclusions Resources devoted to capacity strenthenin remain a major challene in many developin countries, and accountin for them can provide some additional insihts about development processes. This is important because excessive donor interventions in multifarious projects and prorams have often been in direct conflict with recipient country policies and objectives. The novelty of this paper is to consider capacity not only as a resource that is used to produce oods and services and to enerate new technoloies, but also to emphasize its role in improvin economy wide learnin outcomes, which eventually influences the innovation performance of an economy. lthouh the literature has stronly emphasized how capacity is formed, a theoreticcal perspective of its role in development outcomes has not yet been demonstrated. We consider capacity to be an endoenous process that is not only enerated by country overnments, but also stronly related to learnin. We

10 576 P. SNYL, S. C. BBU show that in the steady state, the rowth rate of capacity is critically dependent on the learnin parameter, the elasticity of output with respect to capacity resources, and how the resources are utilized by the recipient country with the help of donor funds. We demonstrate that for the recipient country s capacity to be maintained over time, there exists a critical value of utilized resources from donor funds that needs to be devoted for capacity strenthenin. However, if the actual value exceeds this critical value, the country s capacity will decline over time, affectin the lon-run rowth rate of the economy. Undertakin some of the policy exercises, we first found that increasin learnin capabilities in an economy raises the human capital stock and unambiuously increases the rates of rowth of output, technoloy, capital stock, and capacity. Second, a donor s intervention is most desirable when country capacity is low. In this case, an increase in resources utilized efficiently by the recipient country has substantial effects on the rowth rate of output, technoloy, and capacity. Finally, if the country s domestic capacity is moderately hih, excessive donor intervention can actually lead to crowdin-out effects, in which the economy never reaches a new steady state. The consequence is that the rate of rowth of technoloy, output, and capacity will continuously decline. Under such situations, donor projects will only be relevant if they fit into the recipient countries policies and objectives. Our results have indirect implications for donor aencies based on the level and stae of a country s ownership of policies and prorams. Durin the pre-reform stae, when the level of ownership of policies and prorams is very low, the level of aid should be low and should come mainly in the form of technical assistance, rants, or policy advice. 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