Foreign aid or external financial assistance refers to only that part of the capital inflow, which is not based on normal market incentives but is made on concessionary terms. Thus, grants of freely convertible currency constitute aid in t5he full sense. Foreign loans contain only an element of aid. The difference between aid and loan can be identified on the basis of three factors, i.e., grace and maturity period, as well as interest rate. Normally in case of aid these factors are lower when compared with loan. However, in case of both, aid and loan, private foreign investment and short-term capital movements are excluded.
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The need for foreign aid arises when domestic capital formation falls short of developmental-programme requirement. The developing and LDCs during the 1950s to 1970s were caught in a typical situation: mass poverty, unemployment, surplus labour in agriculture, high birth rate, famine and hunger, low agricultural productivity and inadequate industrialization. Coupled with these problems he financial market and banking networks was extremely insufficient to attract either FDI or portfolio investment. To overcome shortfall in domestic capital formation developing and LCDs approached the developed countries for assistance.
They also approached the international and multilateral financial institution such as the World Bank, Asian Development Bank; US aid organization, etc. for help. Recognizing their concerns the developed and the aforesaid organization too came forward and provided the help. Their financial assistance was either in the form of aid or loans. The borrowed resources were mainly meant for three purposes
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firstly to supplement national income by making available (the borrowed) foreign exchange to be deployed in developmental programmes
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secondly for importation of strategic capital goods or foreign materials to be used to expand production base by utilizing domestic raw materials that would otherwise remain unused;
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and thirdly to remove a balance of payments bottleneck which was almost the usual feature of the developing and LCDs.