Abstract: Foreign aid plays an important role in many developing countries but little is empirically known how it affects incentives and behavior in public bureaucracies. This article aims to provide a model and case study to shed light on how incentive problems embedded in aid - particularly the moral hazard problem and aid fungibility – affect the incentives faced by public bureaucracies in developing countries. In this model are two players, the donors and the public agency. The public agency’s objective is to ensure bureaucratic survival while the donor seeks to grow its loan portfolio. Both players are engaged in a strategic game hypothesized to be fraught with the double moral hazard problem compounded by the fungibility of aid. To ensure bureaucratic survival, the public irrigation agency needs a steady stream of irrigation projects. This creates strong incentives for the agency to under invest in the maintenance of irrigation systems because this would justify new loans from donors which – because of aid fungibility – help ensure bureaucratic survival. This behavior by the irrigation agency is implicitly sustained by the double moral hazard problem found in aid: donors need irrigation agencies as clients to grow their loan portfolio while financially struggling irrigation agencies need donors to finance their capital expenditures and subsidize their operations. My findings are broadly consistent with these theoretical expectations.

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