Most donor countries place some restrictions on the use of their aid contributions. These restrictions fall into two broad categories: restrictions with respect to the purposes for which assistance may be used, and the limitation of aid-financed imports to procurements in the donor country. The two may be combined in any given instance.
[Restriction to specific uses] Donors may restrict the use of aid contributions to the financing of specific projects or they may provide assistance for general developmental purposes. In either case, they may limit their contributions to the financing of identifiable imports or they may provide foreign exchange resources to cover imports as well as local expenditures of a project or programme.
Several donor countries and virtually all multilateral lending agencies provide assistance primarily or exclusively for specific development projects, because project financing involves close cooperation between the donor and the recipient country, its results can be readily identified and evaluated, and it facilitates the coordination of technical and financial assistance. However, the project approach has a number of drawbacks to the recipient country, especially if its investment policy is based on an overall plan. While some major projects can be effectively carried out in isolation, there are many that require the execution of complementary or otherwise related projects in order to yield the best results. In such cases the need to negotiate the financing of each project separately, possibly with more than one donor, gives rise to problems of timing and coordination. If, as is frequently the case, project assistance covers only the direct import requirements (machinery, equipment and materials needed for the execution of the project), the recipient may also be faced with the problem of finding supplementary foreign exchange resources to meet the additional import requirements arising from the increased income generated by the domestic investment expenditure.
The widespread practice of providing project assistance to cover only direct import requirements is based on the consideration that the recipient country should engage its own resources to the fullest possible extent in the execution of investment projects. Nevertheless, the financing of additional imports to meet the demand generated by local expenditure may be beyond the capacity of the assisted country. In that event, the project may have to be abandoned or the recipient country may be obliged to resort to short-term external credits, thereby adding to its future balance-of-payments problems. Because of the potential burden of local cost financing on the foreign exchange resources of developing countries, the practice of limiting project assistance to direct import requirements has tended to encourage the execution of projects with a relatively large import component at the expense of many equally important projects which involve relatively large local expenditures.
[Procurement restrictions] Most donor countries restrict at least part of their bilateral aid contribution to purchases of their own products. Reasons given for applying such restrictions include balance-of-payments difficulties or the existence of idle capacity or unemployment in the donor country. Factors such as a desire to promote domestic exports or to compensate exporters for the loss of sales in traditional markets which may have resulted from procurement restrictions of other donor countries have also influenced government policies with respect to aid tying.
The tying of contributions to exports from the donor country has taken various forms. Most commonly, loans and grants for the financing of specific imports have been tied by contractual agreements which provide that all or part of the assistance will be used exclusively for procurement in the donor country or in countries specified by the donor. It has been more difficult to tie assistance which is not specifically linked with imports, such as budgetary support payments or general development loans and donations, but it is for this reason that donor countries have tended to shift from this type of assistance to loans and grants earmarked for specific imports. Another type of aid which is in most respects indistinguishable from formally tied aid is the official export or import credit. It has been claimed that such credits do not belong to the category of tied aid because they are granted after the borrower has selected his source of supply. In practice, the availability of credit has tended to influence the choice of supplier to a greater extent than have price or quality considerations. In these circumstances, it seems appropriate to treat such credits as a form of tied aid. Contributions in kind might also be termed tied aid, but since such aid is dependent upon the existence of surpluses in the donor country, it is in a separate category.
The adverse impact of procurement restrictions on recipients arises chiefly from the fact that such restrictions reduce competition between potential suppliers and may render impossible the procurement of imports from the optimum source of supply. The effect of this is greater when aid is given for the purchase of equipment required for a specific project than in the case of general development assistance which gives the recipient a wider choice of commodities to be imported. Procurement restrictions may involve not only higher costs, and hence a larger loan to be serviced, but also the purchase of equipment manufactured in the donor country which may not meet fully the recipient's requirements. Moreover, the availability of aid may encourage the execution of those projects for which suitable equipment can be readily obtained in the donor country, even if the recipient's development programme did not assign the highest priority to such projects.
In the case of the USA, aid may be defined to include security assistance and balance of payments support for Israel and Egypt, rental of military bases, as well as disaster and famine relief, AIDS counseling, family planning support and encouragement of the recipient country's private sector. Special interest provisions may also be added to foreign aid appropriations bills. In 1992 it was noted that four small Caribbean island states, which were recent recipients of aid from Japan had joined the International Whaling Commission, and joined the lobby attempting to block attempts to outlaw commercial whaling.