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Abstract

When allocating their aid budget, development agencies need to decide whether to give outright grants or use concessional loans that blend a grant and credit element. Theory suggests that the degree of concessionality should be negatively correlated with debt sustainability. Several donors use the World Bank/IMF Debt Sustainability Framework to guide their aid decisions. They give loans to low-risk countries, a blend of loans and grants to medium-risk countries, and only grants to high-risk countries. The paper shows that there are problems with this approach and proposes an alternative allocation mechanism based on GDP-indexed concessional loans.

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