Assessing the causes of aid fungibility: Does institutional quality really matter?

Traditionally, aid fungibility has been considered a threat for effective development cooperation, because it implies partner countries allocate aid resources for different purposes than donors’ intentions. A stream of aid literature has attributed this phenomenon to low institutional quality in developing countries. By contrast, other scholars claim that aid fungibility does not necessarily worsen aid’s outcomes, rather reflects preferences’ divergence between donors and partner countries. Nonetheless, empirical evidence of the determinants of aid fungibility is scarce to support either of these positions. The aim of this research is to contribute to closing this gap, addressing the causes of aid fungibility in the education sector with special focus on the role of institutional capacity. In order to do so, time-series cross-section analysis is applied with information from 47 developing countries for the period 2000-2016. For first time in the literature, this study assesses the effects of different aid modalities on fungibility of sectorial ODA disbursements, and applies a Panel Coefficient Variable Model to identify the determinants of aid fungibility. The results demonstrate that total aid targeted to education is almost fully fungible, and that the degree of aid fungibility is highly variable across countries, but it has decreased slightly over time. In contrast with the literature on macro fungibility, bilateral aid is less fungible than multilateral aid, suggesting that the same aid modality can have different degrees of aid fungibility among sectors. The research also found that low levels of government effectiveness and rule of law increase aid fungibility, but the effect of corruption is insignificant. These results suggest that aid fungibility does not necessarily represent a consequence of “bad policy environment”, but rather weak planning and budgeting systems in partner countries, and lack of preference’s convergence between donors and partner governments about aid purposes. Based on these results, the study recommends that donors must implement development projects that are tailored to country-specific needs, in order to ensure the ownership of development priorities by developing countries, especially those with low institutional quality. In addition, if donors want their aid flows to be used according to their preferences, they should be aware about the quality of public management systems in the partner country, and make more efforts to reduce aid fragmentation in order to continue to align their preferences and development priorities with partner countries.