Foreign Aid and Incentives in Commercial Credit Markets

The main question asked in this paper is: How is the relationship between a commercial lender and the government of a poor country affected by the fact that the government is a recipient of foreign aid? As long as the aid flows are exogenous we show that some types work well in the sense that the aid improves credit worthiness and leads to extra productive investment and higher welfare. Other types may be directly counterproductive. Endogenous aid, given by altruistic donors as part of a safety-net, tends to distort incentives, reduce credit worthiness and discriminate against productive investment. Welfare may increase or decrease.