INTERNATIONAL AID AND PRINCIPAL-AGENT RELATIONSHIP: EVIDENCE FROM BOSNIA AND HERZEGOVINA

International aid to Bosnia and Herzegovina (B&H) since the end of war in 1995 was significant by any standards. Yet, this has not resulted in a significant poverty reduction outcome. According to all relevant indicators B&H is ranked near the bottom of all European countries. Even when we take into consideration the tremendous loss of wealth during the war, given the size of aid provided, the economic development has fallen below the expect rate of recovery. This is particularly evident in the areas of SME and formal enterprise development. In this paper we argue that the major reason for a sluggish recovery was failure to implement structural reforms and that this failure is in direct relation with the international aid in B&H. We suggest that the principal - agent relationship inherent in the international aid structure can be applied to the B&H experience in order to explain this phenomenon. Particularly revealing is the microfinance sector which was supposed to act as a catalyst for the poverty reduction. We find that the model of microfinance itself does not provide proper incentives for the actors involved in order to strengthen the sustainable SME sector. Instead, enterprise development policy should be based on the lessons learned from the venture capital model.