Modern Economy, 2012, 3, 567-577
http://dx.doi.org/10.4236/me.2012.35075 Published Online September 2012 (http://www.SciRP.org/journal/me)
Aid Effectiveness and Capacity Development: Implications
for Economic Growth in Developing Countries
Prabuddha Sanyal1, Suresh C. Babu2
1Resilience and Regulatory Effects, Organization 6921, Sandia National Laboratory, Albuquerque, USA
2International Food Policy Research Institute (IFPRI), Washington DC, USA
Received May 4, 2012; revised June 10, 2012; accepted June 20, 2012
ABSTRACT
In this paper, we present a stylized model for understanding the relationship between capacity strengthening and eco-
nomic growth in an endogenous growth framework. Endogenous growth theory provides a novel starting point for
combining individual, organizational, and enabling environmental issues as part of attaining the capacity-strengthening
goal. Our results indicate that although donors can play an important role in aiding countries to develop their existing
capacities or to generate new ones, under certain conditions, the potential also exists for uncoordinated and fragmented
donor activities to erode country capacities. From the policy exercises, we demonstrate that improving economy-wide
learning unambiguously increases the rate of growth of output, technology, 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 “crowding-out effects” when the economy’s capacity is moderately high. Under
such a situation, the economy never reaches a new steady state. Our results not only lend support to diminishing returns
to aid but also to an S model of development aid and country capacity relationship.
Keywords: Capacity Strengthening; Development Aid; Economic Growth; Learning
1. Introduction
Increased interest in capacity strengthening in recent years
is a response to widely acknowledged shortcomings in
development assistance over the past 50 years. For exam-
ple, the dominant role of donor-led development projects
with inadequate attention paid to long-term capacity is-
sues is often cited as a critical factor in the slow progress
[1]. The 2005 Paris Declaration on Aid Effectiveness em-
phasizes the need for significantly enhanced support for
country efforts to strengthen capacity and improve devel-
opment outcomes. The declaration calls for capacity stre-
ngthening to be an explicit objective of national devel-
opment and poverty reduction strategies. In Africa, for
example, the New Partnership for Africa’s Development
(NEPAD) has identified capacity constraints as the main
obstacle to economic growth and sustainable development.
Although a quarter of donor aid, or more than US$15 bil-
lion a year, has gone into “technical cooperation,”1 evalua-
tion results confirm that development of sustainable ca-
pacity remains one of the most difficult areas of interna-
tional development practice. Capacity strengthening has
also been one of the least-responsive targets of donor as-
sistance, lagging behind other slow areas such as infra-
structure development or improving health [2].
The motivation behind this study arises from the con-
trast between the increasingly recognized importance of
capacity in development outcomes and the difficulty of
achieving it. Several broad strategies can be followed,
either separately or in combination, to strengthen capac-
ity. If a simple deficiency in resources is the root cause
of weak capacity, then supplying additional financial and
physical resources will be beneficial. One variant of this
method would be to assist in improving organizational
capabilities so they perform better in terms of obtaining
its objectives. This may require providing technical assis-
tance or training, assuming the gaps are identified to
achieve better performance. A related strategy proposes
promoting innovations and providing opportunities for
learning and experimentation. Much of this strategy fo-
cuses on the promotion of social capital, including col-
laboration, civic engagement, and loyalty. These approa-
ches aim to encourage individuals and organizations to
work better together in order to promote a holistic view
of development [3].
1Estimates of donor-assisted capacity development efforts suggest that
more than a quarter of total net official development assistance is spent
on technical cooperation. In 2004, the total amount spent by DAC
members on technical cooperation with developing countries and mul-
tilateral or
g
anizations amounted to US$20.8 billion
[
2
]
. Strengthening the overall organizational system for work
C
opyright © 2012 SciRes. ME

P. SANYAL, S. C. BABU
568
synchronization and execution of complex tasks can
enhance preexisting systems to carry out certain key
functions [4]. In this approach, organizations are seen as
processing systems that change individual and system
capacities into organizational results. This approach seeks
to improve an organization’s overall performance by bre-
aking down its activities, making recommendations about
improvements, and then integrating these improvements
back into wider organizational performance. The role of
institutions is to provide knowledge of and access to “the
rules of the game,” thus empowering certain actors to
create, alter, and learn from the processes and rules that
govern society. However, equating institution building
with public sector reforms can be problematic, and reform
of entire systems or sectors, such as agriculture, education,
and health, is important for capacity strengthening [5].
The systems approach focuses more on transformation
change and the best ways to achieve it. In this approach,
capacity arises out of interrelationships and interactions
among the system’s various elements. An all-inclusive
strategy for capacity strengthening should be targeted at
multiple levels and actors, and it should include an at-
tempt to understand the linkages among them. In this
approach, capacity strengthening is a dynamic process
whereby complex networks of actors seek to enhance
their performance by doing what they do better, both by
their own initiatives and through interactions with out-
siders [6]. From this perspective, capacity strengthening
is achieved through combining individual and collective
abilities into a larger overall systems capacity.
In this paper, capacity strengthening is defined2 as the
process of developing human resources, creating new
forms of organizations and institutions, building innova-
tive networks, and integrating country ownership in order
to improve the efficiency of the learning activities (i.e.,
technical, organizational, institutional, and policy learn-
ing). The efficiency of these learning activities, in turn,
depends on the economic and political systems, as well
as on the social infrastructure and institutions. The im-
provement in learning activities results in better knowl-
edge about policy processes and program development,
leading to better development outcomes. Our definition
is based on two observations: 1) Country ownership is
critical to development performance, and this applies to
both generic capacities, such as the ability to plan and
manage organizational changes and service improvements
and specific capacities in critical fields such as health or
public sector management and 2) Country ownership of
policies and programs is the means to sustained develop-
ment effectiveness. Ownership will not begin to emerge
in the absence of sufficient local capacity.
The rest of this paper is organized as follows: In the
next section, we define capacity strengthening and em-
phasize its importance in development outcomes. Next,
we postulate an endogenous growth model to understand
how the relationship between own-country capacity re-
sources and donor-supported capacity resources affects
economic growth 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 em-
phasizing how our model lends support to not only di-
minishing returns to aid but also an S-model of the rela-
tionship between development aid and country capacity.
2. Brief Overview of the Literature
Although the concept of capacity strengthening has regai-
ned renewed interest among international development pra-
ctitioners, adequate national capacity remains a critical fac-
tor in the current efforts to meet the Millennium Devel-
opment Goals (MDGs). Yet even with increased funding,
development efforts will not be able to achieve their goals
if attaining sustainable capacity is not given greater and
more careful attention [2]. The issue is increasingly being
recognized by both donor organizations and developing
countries, as emphasized in the 2005 Paris Declaration
on Aid Effectiveness and Accra High Level Forum on
Aid Effectiveness held in Accra, Ghana during 2008 [2]3.
Capacity strengthening remains a major challenge for
many developing countries. At first, it was primarily
viewed as a technical assistance process, involving the
transfer of knowledge or organizational models from north
to south [7]. Technical cooperation and various forms of
capacity-strengthening activities have absorbed substantial
funds over many decades. Although a few countries have
used such funds effectively, donor efforts in many countries
have produced little or even negative results in terms of
sustainable local capacity [8]. This is particularly relevant
for many African economies, where, after investments of
millions of dollars to improve the capacity of African
governments, donors have begun to question the merits
of their policies in building capacity via technical assistance
[9]. Simultaneously, evidence suggests that development
aid is highly uncoordinated and fragmented [10]. With 56
bilateral donors and more than 230 international organ-
izations, there are currently about 60,000 development
aid projects. The average number of donors per country
3This declaration rests on five pillars: 1) ownership—developing coun-
tries exercise leadership over their development policies and plans; 2)
alignment—donors base their support on countries’ development
strategies and systems; 3) harmonization—donors coordinate their
activities and minimize the cost of delivering aid; 4) managing for
results—donors and developing countries orient their activities to
achieve the desired results; and 5) mutual accountability—donors and
developing countries are accountable to each other for progress in
mana
g
in
g
aid better and in achievin
g
develo
p
ment results.
2Although 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 strengthening.

P. SANYAL, S. C. BABU 569
almost tripled during 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,
developing country governments have adopted wide-ran-
ging reform programs, often on the advice of multilateral
institutions. The lack of country capacity to implement
these programs, however, has been alluded to as a major
factor behind the failure of the reform programs [12].
Finally, it is now well accepted that solutions imposed
unilaterally by donor agencies from outside the country
cannot address the problems and concerns of many dev-
eloping country governments. Thus, national governments
must be willing to take “ownership” of their programs and
control forces that affect the economy and polity [13].
The new consensus, as expressed in the 2005 Paris
Declaration on Aid Effectiveness, sees capacity strength-
ening as an endogenous process, strongly led from within
a country, with donors playing only a supportive role.
According to this idea, capacity strengthening involves
much more than enhancing the skills and knowledge of
individuals. Rather, it critically depends on the quality of
the organizations in which individuals work. In turn, the
effectiveness of those organizations is influenced by the
“enabling environment” in which they are embedded.
Capacity, in this view, is not only about skills and pro-
cedures, but also about incentives, organizational effect-
tiveness, and governance. Yet, it is not clear how com-
bining individual skills, organizational restructuring, and
an enabling environment could be enhanced through an
endogenous process.
In light of the above, several questions remain: What is
the optimal level of country capacity strengthening required
to achieve specific economic growth targets? What conce-
ptual approaches could help us understand the relation-
ship between national capacity and economic growth? Un-
der 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 under-
standing the relationship between capacity strengthening
and economic growth in an endogenous growth framework.
The motivation is that the development literature lacks a
theoretical framework for addressing capacity develop-
ment issues. Currently, most studies treat human capital
as individual skills. At the same time, the literature treats
the organizational culture, institutional arrangements, and
political processes under which capacity strengthening
operates as exogenous.
3. Theoretical Model of the Relationship
between Capacity and Economic Growth
This section presents a theoretical model for understand-
ing the relationship between capacity investments and gro-
wth outcomes. The model extends the framework devel-
oped by [14] and further extended by [15].
Let the economy comprise two sectors: a goods-pro-
ducing sector and a research and development (R&D)
sector. The former produces conventional output, while
the latter produces new technology, which adds to the
existing level of technology. Four factors of production
in the economy—namely, capital (K), labor (L), human
capital (H), and capacity resources (CK)4—are allocated
for use in either the goods or the R&D sector. The capac-
ity resources can be conceived of not only as sectoral
programs allocated by the government for health, water
and sanitation, and irrigation development (to name a
few) but also as improved learning that occurs from in-
teractions among the system of actors (firms, organizations,
government, consumers, etc.) that influence an economy’s
innovation performance. Capacity resource devoted to
program development is a process through which values
and resources are authoritatively allocated for the econ-
omy as a whole. It is a process whereby a representative
government puts forward measures to accomplish some
desired objectives. This process generally involves ex-
penditure of resources—whether in terms of extractive,
distributive, or other measures.
We let
aK denote the fraction of capital stock used in the R&D
sector;
aH denote the fraction of human capital used in the R&D
sector;
aL denote the fraction of labor used in the R&D sector;
aCK denote the fraction of capacity resources used in the
R&D sector;
This implies the following:


1aK is the fraction of capital stock used in the goods-
producing sector;


1aH is the fraction of human capital used in the
goods-producing sector;


1
L
a is the fraction of labor used in the goods-pr-
oducing sector;


1a
4Capacity strengthening can also be understood from a production
function perspective, in which overall capacity is produced as a func-
tion of individual, organizational, and enabling environment. Although
this approach can provide some additional insights into the dynamics o
f
capacity formation, we do not consider this approach in the present
p
aper, as our main purpose is to understand how capacity is related to
economic growth and under what conditions capacity leads to higher
steady-state growth.
CK is the fraction of capacity resources used in the
goods-producing sector;
Technology has the characteristic of being non-rival.
Hence, the entire level of technology (A) is used in both
sectors.
Output in time t is given by

P. SANYAL, S. C. BABU
570
 

11
11
tKt H
CK tt
YK
CK A


1
t
L t
H
L


 





(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 CK

is allocated (although in a more dynamic setting, how
CK

is allocated can have important implications for
economic growth). To the best of our knowledge, the
literature has not explicitly considered who allocates ca-
pacity 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 through choices regarding family size and in-
vestment in children. In their model, developing coun-
tries that have high 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 through
demographic transition to a low birth rate and the in-
centives to invest in physical capital.
We assume Cobb-Douglas technology for analytical
tractability. The level of innovation in the economy de-
pends not only on the amount of capital, labor, and hu-
man capital devoted to the R&D sector but also on the
capacity resources necessary to maintain and upgrade the
current level of technology5. We assume a generalized
Cobb-Douglas production function with increasing re-
turns for the R&D sector.

ab
tKtHtCK

cd
tLtt
A
BKHCK LA

 


tt
(2)
with B, a, b, c, d, σ > 0.
The savings rate is exogenous and constant, and depre-
ciation is assumed to be 0 for simplicity. This implies that
K
sY

ttt t
LH mH

tttt
HCK Y


(3)
with 0 ≤ s ≤ 1
We treat population growth and human capital growth
to be constant and exogenous, so that
Ln
 (4)
with n, m ≥ 0
The equation for motion of capacity strengthening is
given by
CK
 (5)
with λ,  > 0
We treat
 as exogenous to the host country’s decision
to invest in capacity resources. However, in a more real-
istic setting, where the government seeks to maximize a
utility function that depends on capital expenditures, the
government’s recurrent expenditure, tax and nontax
revenues, and various kinds of aid (e.g., project aid, pro-
gram aid from all donors, technical assistance, and food
aid subject to the government’s budget constraints), 
will depend on the above factors and will be endogenous
(see, for example [17]). It will also depend on the coun-
try’s balance of payments situation. We assume away
such complexities from the present model, because our
main focus is to understand the relationship between ca-
pacity resources and economic growth.
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
long periods, with λ denoting the learning aspects of ca-
pacity through formal education, job training, and non-
formal education, while
 denotes a parameter that cap-
tures how capacity resources devoted by an external agent
(e.g., a donor agency) are utilized by the host country
government for improving country capacity over time.
The implicit assumption made here is that aid is absorbed
and spent by the recipient. In this case, the foreign ex-
change is sold by the central bank and absorbed into the
economy, and the government spends the associated re-
sources. The challenge faced by monetary authorities is
to manage the real exchange 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 do-
mestic and external capacity resources, because capacity
strengthening can be understood as individuals, organiza-
tions, and institutions trying to improve capacity without
external intervention. However, under the donor mandate,
capacity can also be formed over time by utilizing pro-
gram aid and technical assistance6.
Proposition 1: For the steady-state rate of capacity to
maintain or grow over time, there exists a

* satisfying


2



, such that if
 > 
*, then the economy’s ca-
pacity declines, thus affecting the economy’s steady-state
rate of growth in the long run.
The intuition of Proposition 1 can be understood in the
following context: Suppose the economy’s capacity is really
low, in that it lacks financial, human capital, and techni-
cal resources. In this case, donors can play an important
role in aiding countries develop their existing capacities
by providing aid, such as program aid and technical as-
sistance. 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 existing capacity that is moderately high, but donors
5For example, if a significant number of scientists and engineers 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 innova-
tions may decline.
6We derive the steady state conditions for capital accumulation, tech-
nological growth, and capacity. These results can be obtained from the
authors upon request.

P. SANYAL, S. C. BABU 571
still try to control the projects (more project aid) until
completion. As the wages and salaries in these projects
are paid by donors at much higher rates than what the
recipient government can afford, this process can possi-
bly lead to “brain drain” away from the public services.
If the country is in the midst of a prolonged adverse ex-
ternal shock, the recipient country may be forced to re-
duce its expenditures further. The combination of grow-
ing costs and diminished budgets can result in a gradual
erosion of the recipient country’s ability to meet its basic
recurrent expenditures. Aid dependence then becomes a
strategy for donors to keep projects alive so the recipient
government’s recurrent costs are sustained. However,
through the control of projects and programs, the donors
erode the country’s capacity even further.
We also derive the steady-state relationship between
the growth rate of capital accumulation and growth rate
of capacity and based on this relationship, we have the
following proposition:
Proposition 2: There exist critical values 
* and γ* such
that if

21

  is satisfied, then the economy’s
steady-state growth rate of capital stock unambiguously
increases, improving the economy’s growth rate in the
long run.
Proposition 2 states that as long as the elasticity of
output with respect to capacity-strengthening resources
does not come in conflict with the recipient country’s
utilization of aid resources7, then the rate of growth of
capital stock will improve in the long run.
Next, we examine the steady-state relationship between
the growth rate of technology and the growth rate of ca-
pacity. Based on this relationship, we have the following
proposition:
Proposition 3: There exist critical values 
* and γ* such
that if
 


112 c

    is satisfied,
then the economy’s steady-state growth rate of technol-
ogy will improve over time.
The steady-state conditions is found by solving two
equations with two unknowns—namely, the steady-state
relationship between growth rate of capital accumulation
and growth rate of capacity (proposition 2) and the steady-
state relationship between the growth rate of technology
and the growth rate of capacity. This is succinctly stated
in proposition 4.
Proposition 4: For the steady-state solution to exist8,
the critical values of  and γ must satisfy the following
condition:



4. Policy Exercises
In this section, we consider the steady-state effects of
three scenarios that could result from different develop-
ment policy interventions. The first exercise9 examines
what happens if the rate of learning from human capital
accumulation increases exogenously, which could result
from a country experiencing an increase in the number of
new schools or new adult educational programs. In the
second exercise, we examine the role of the recipient
country in asking for more aid from the donor and dou-
bling its commitment to invest in capacity resources ( 
increasing 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 dou-
bling of investment in capacity resources by the recipient
country, but with the elasticity of output with respect to
capacity being high (we assume γ = 0.35). We show that
the predictions are very consistent with our theoretical
model.
4.1. Increase in the Rate of Learning in the
Economy

**
ac
c
  
0
A
g


0
0g


1
0g

0g
*
*
2
12

  

Consider an exogenous increase in the rate of learning (λ)
from greater human capital formation in the economy.
From Figure 1, we find that an increase in λ results in
decreasing the intercept of the locus; thus, there
is a parallel downward shift from A to A.
At the same time, an increase in λ results in an upward
shift of the K

0
0g


1
0g

0
locus from

K to K.
Thus, the economy moves from E0 to E1 with the cones-
quence that both the steady-state growth of technology
and the growth rate of capital also increase, improving
the growth rate of capacity.
The intuition for this result is as follows: First, an in-
crease in learning results in a larger stock of human
capital in the economy. Assuming that the share of hu-
man capital in the R&D sector remains unchanged, the
increase in human capital resulting from an increase in
the growth rate of learning leads to an increase in the
growth rate of technology, from A
g
1
to A
g
. The larger
growth in human capital also results in an increase in the
amount of resources being used in the conventional goods-
producing sector. For this sector, the larger growth of the
human capital stock that arises from greater learning and
from the interactions among individuals and organiza-
tions, accompanied with more rapid technological growth
from the R&D sector, leads to an increase in the growth
8For the sake of brevity, we do not provide the proofs of the above
p
ropositions. These proofs can be obtained from the authors upon
r
e-
quest.
9Throughout the exercises, we assume the following values of the pa-
rameters for the hypothetical economy: α = 0.3; β = 0.2; γ = 0.1 and
0.35 in the low- and high-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.
7For example, if the recipient government plans to obtain more project
aid and food inflows, this can reduce public investment and govern-
ment consumption. If the reduction in public investment outweighs the
decline in government consumption, growth rates can fall.

P. SANYAL, S. C. BABU
ME
572
g
0
Copyright © Sci 2012
0
Res.
rate of output. The rate of capital accumulation also in-
creases with greater output growth, which leads to a shift
of the K locus from
K
g
1
to
K
g
0g
. Thus, an exoge-
nous increase in learning leads to an increase in the long-
term capacity, technology, capital stock, and output.
to greater technology absorption, resulting in resources
being efficiently used in the goods-producing sector.
This shifts the K
4.2. Doubling 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 following experiment of
doubling of capacity resources i.e., increasing  from 0.8
to 1.6. The capacity of the recipient country is low in this
situation. As shown in Figure 2, for the same level of α,
an increase in recipient country resources devoted to ca-
pacity leads to greater learning and knowledge interact-
tions among agents in the economy, which leads to greater
human capital accumulation.
The increase in human capital accumulation also leads

0
locus from
K
g
1
to
K
g

0g
. For the
same level of technology intensity (σ) in the R&D sector,
because the domestic level of capacity is low, a signify-
cant increase in capacity resources also leads to greater
human and physical capital accumulation. Thus, the slope
of the A

 locus becomes flatter, and the economy
slowly converges over time from point E0 to E1. As a
consequence, there is a significant increase in capacity,
capital stock, technology, and output. The impact can also
be understood by considering the steady-state condition
for the growth rate of capacity10. Because the elasticity of
output with respect to capacity (γ) is extremely low, an
increase in
 leads to greater human capital accumulation,
higher growth rates of technology, and a higher rate of
capital accumulation. All of this contributes to a signify-
cant increase in the growth rate of capacity, leading to
higher economic growth.
A
g
(
K
g

= 0)
1
(
K
g

=0)
0
E
1
E
0
(
A
g

= 0)
1
A
g
*1
A
g
*0
K
g
*0
K
g
*1
K
g
(
A
g

= 0)
0
K
g
Figure 1. Effects of an increase in the rate of learning in the economy.
10This condition can be stated as follows:

***
1
22 2
CKK A
mg gn
 
 
  
 
 
 
 
g
.

P. SANYAL, S. C. BABU 573
(
A
g

=0)0
A
g
(
A
g

=0)1
(
A
g

=0)0
E1
E0
(
g
A

=0)1
A
g
*1
A
g
*0
K
g
*0
K
g
*1
K
g
K
g
Figure 2. Donor intervention when capacity of the economy is low.
4.3. Donor Intervention When Elasticity of
Output with Respect to Capacity Is High
We now consider the final case, in which the elasticity of
output with respect to capacity is moderately high, i.e., γ
= 0.35. We consider the same experiment as before—of
doubling of capacity resources by the recipient country’s
government. Because the economy’s capacity is already
quite high, the recipient government needs to coordinate
the activities in a more effective and efficient way, rather
than depending on more donor resources. The following
is what happens in this case: Initially, the economy is at
point E0. Because the economy is already at quite a high
capacity, an increase in donor intervention without any
preplanning and coordination leads to a decline in both
the human capital stock and the accumulation of tech-
nology. This leads to resources being inefficiently used
with the consequence that capital stock is depleted sig-
nificantly, as shown by the locus in Figure 3.

1
0g

0
K
g
K
At the same time, an increase in donor intervention
with multiple projects leads to a decline in the technol-
ogy sector. This can be coined as the “crowding-out ef-
fect” of donors driving the recipient government out of
projects and programs. Although the decline in the tech-
nology sector is not as significant as in the commodity
sector, it is still negatively sloped and flatter than the

0g 
0g
locus. In other words, the A locus and the
K

 locus do not intersect, with the consequence that
the economy never reaches a new steady state.
4.4. Implications for Donor Agencies
As pointed out by [20], the impact of development aid on
growth shows a positive but insignificant effect, while

P. SANYAL, S. C. BABU
574
(
K
g

=0)
1
(
g
K

=0)
0
g
A
(
A
g

=0)
1
(
A
g

=0)
0
E
0
K
g
K
g
Figure 3. Donor intervention when capacity of the economy is high.
studies of the effect on growth that is conditional on ei-
ther good policy or development aid itself have shown
weak results. For example, [12] noted that “aid is more
effective in fostering growth and improving service de-
livery in countries with better policies and institutions. It
is also more effective when it is aligned with recipients’
priorities, when it reduces transaction costs through har-
monized and coordinated donor processes, when it is
predictable, and when there is a clear focus on results.”
Our result blends the above findings 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 eligibility for substantial aid.
We thus propose an S model of aid effectiveness on the
lines of [21], where country ownership and need (high
poverty rates) determine the level of development aid.
The first segment of Figure 4 covers the pre-reform
stage, where country ownership is really low and the state
itself may be failing. The level of human resources at this
stage is very low in part because a significant portion of
the population is illiterate or barely has a primary educa-
tion, institutions may be failing, and there are virtually no
public or private sector organizations. Under these condi-
tions, the recipient country would first need to develop
its own strategy, programs, and projects in consultation
with both its own constituencies and donor agencies. It
would then present its plans to the donors, who would
put unrestricted and untied financing into a common pool.
The level of aid would be low at this stage and would
come mainly in the form of technical assistance, policy
advice, or grants [22]. Donors should support the efforts
of the recipient countries and actively support reformers
and visionary leaders.
The first-stage reforms should consist of human re-
source development, accompanied with better public sector

P. SANYAL, S. C. BABU 575
Figure 4. Relationship between aid effectiveness and country capacity.
management. These reforms are important, as the recipe-
ent country’s monetary need is high, and aid effective-
ness is increasing. This learning can be conducive to rais-
ing productivity in the public sector. This situation is
demonstrated in Figure 2, in which development aid has
high and positive marginal returns. Both the donor’s and
the country’s own resources can be allocated to high-pr-
iority areas to generate higher economic growth and de-
velopment effectiveness.
The second-stage reforms should emphasize building
new institutions and restoring existing ones. At this stage,
aid intensity needs to be maintained or even increased, as
the effectiveness is very high. In addition, donors can
improve on development outcomes by creating effective
links between civil society organizations (such as NGOs)
and other partners. Because these civil society organiza-
tions have links both up and down the ladder of interact-
tion, the countries effective capacity can be strengthened.
Donors can provide their expertise on public sector man-
agement to NGOs in order to facilitate activities and im-
prove upon development effectiveness.
The final stage (the post-reform period) occurs when a
country owns its policies and programs. This stage is
demonstrated in Figure 3, in which diminishing marginal
returns to aid set in and other sources of investment be-
come the dominant form of financing. Because this stage
is characterized by an improved organizational structure
of public sector institutions, a strong supply of profess-
sional and technical personnel, and the presence of strong
institutions, donors are better off by letting recipient coun-
tries own their own policies and programs. At this stage,
donors should develop exit strategies to minimize the
disruptions of transition and to smooth the way for new
capacity-building initiatives.
There will be substantial revamping of the international
aid architecture under the above arrangements. Donor
agencies (both bilateral and multilateral) will still play a
critical role, but their ownership of policies and the pro-
grams of recipient countries will be substantially dimin-
ished. Donors will learn from their past mistakes and
change their ways of managing aid and improving coun-
try ownership of policies and programs. They may help
organize knowledge management, assist in operation of
public sector organizations, and support civil society
organizations for improved reforms in judiciary and legal
systems. Although development aid can be justified dur-
ing the first and second stages of reform for improving
country capacity, less aid will be necessary in future stages.
The interaction between development aid and learning by
recipient countries is important and should be cultivated
in a manner that promotes country and institutional ca-
pacity building instead of the capacity erosion that is
evident in many sub-Saharan African countries at present.
5. Summary and Conclusions
Resources devoted to capacity strengthening remain a major
challenge in many developing countries, and accounting
for them can provide some additional insights about de-
velopment processes. This is important because excessive
donor interventions in multifarious projects and programs
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 goods and ser-
vices and to generate new technologies, but also to em-
phasize its role in improving economy wide learning
outcomes, which eventually influences the innovation
performance of an economy. Although the literature has
strongly emphasized how capacity is formed, a theoretic-
cal perspective of its role in development outcomes has
not yet been demonstrated. We consider capacity to be an
endogenous process that is not only generated by country
governments, but also strongly related to learning. We

P. SANYAL, S. C. BABU
576
show that in the steady state, the growth rate of capacity
is critically dependent on the learning parameter, the
elasticity of output with respect to capacity resources,
and how the resources are utilized by the recipient coun-
try 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 de-
voted for capacity strengthening. However, if the actual
value exceeds this critical value, the country’s capacity
will decline over time, affecting the long-run growth rate
of the economy.
Undertaking some of the policy exercises, we first found
that increasing learning capabilities in an economy raises
the human capital stock and unambiguously increases the
rates of growth of output, technology, 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 growth rate of output, technol-
ogy, and capacity.
Finally, if the country’s domestic capacity is moderately
high, excessive donor intervention can actually lead to
crowding-out effects, in which the economy never reaches
a new steady state. The consequence is that the rate of
growth of technology, output, and capacity will continu-
ously 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 agen-
cies—based on the level and stage of a country’s owner-
ship of policies and programs. During the pre-reform stage,
when the level of ownership of policies and programs is
very low, the level of aid should be low and should come
mainly in the form of technical assistance, grants, or pol-
icy advice. During the first and second stages of reform,
aid should increase to address human resource develop-
ment, better public sector and organizational manage-
ment, and enhancement of the institutional capacity of
the recipient country. However, during the post-reform
period, the need for development aid diminishes substan-
tially. Donors are better off developing an exit strategy to
let recipient countries own their policies and programs.
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