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An empirical analysis of the effect of aid on growth.

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Abstract

The fact that so many countries register low per capita income after receiving enormous amounts of foreign aid questions its effectiveness as a tool for economic growth and consequently as an instrument of poverty alleviation. The impact of foreign aid on economic growth is ultimately an empirical question and one that will be addressed in this paper. The paper uses the most recent data and incorporates most of the salient features of the new growth literature to test the effect of aid on economic growth. Three important conclusions emerged from the empirical analysis of the paper. First, it shows that the effect of aid on growth is nonlinear. The nonlinearity of the relationship indicates a threshold for foreign aid beyond which more aid is detrimental to economic growth. Second, the empirical results of this paper support Burnside and Dollar's findings that a good policy environment is important for aid to work effectively. Aid effectiveness can only be sustained in an environment of good economic policy. Finally, using etholinguistic fractionalization as an instrument, the empirical results of the paper indicate that the relationship between AID/GDP and economic growth is sequential. More and more aid leads to lower economic growth. (JEL H11, 040)

Introduction

In the past 50 years, over 1 trillion dollars have been given in foreign aid. However, millions in third world countries still live in abject poverty. Today, more than one billion people live on less than $1 per day [World Bank, 1998]. The ineffectiveness of foreign aid in reducing poverty sparked a new debate on aid and its effect on growth. Because of this aid fatigue and the lack of results in terms of poverty alleviation, total aid disbursements of foreign aid have gone down from 0.33% of donor countries' gross national product (GNP) in 1990 to 0.24% of their GNP in 1999 [World Bank, 2001]. (1) The fall of foreign aid in the 1990s is noticeably significant in the case of Sub-Sahara Africa (SSA) and Middle East and North African (MENA) countries. In 1990, 37% of foreign aid went to SSA and 20% was given to MENA countries. By 2000, their share was reduced to 27% and 10%, respectively.

Proponents of foreign aid confessed to the failure of aid giving and its dismal rate of return. Project aid is suggested as a new approach that donors can ensure the effectiveness of their aid by carefully selecting projects and monitoring their implementation. However, the fungibility of foreign aid undercuts this strategy. Fungibility, in essence, means that "a dollar is a dollar" and allows governments to adjust their own expenditures taking into account the inflow of foreign aid. Aid can also be used to reduce taxes or the budget deficit and so it follows that the impact of aid cannot be measured by project outcomes alone. Using a sectoral decomposition of concessionary loans to 14 countries from 1971 to 1990, Feyzioglu et al. [1998] showed that a dollar increase in foreign aid leads to an increase of 0.95 cents in total government spending. More importantly, they showed that higher concessionary loans to a particular sector do not necessarily increase spending in that sector.

The fact that so many countries register low per capita income after receiving enormous amounts of foreign aid questions its effectiveness as a toll for economic growth and consequently, as an instrument of poverty alleviation. The impact of foreign aid on economic growth is ultimately an empirical question, and one that will be addressed in this paper. The paper uses the most recent data and incorporates most of the salient features in the new growth literature to test the effect of aid on economic growth. The rest of the paper is organized as follows. The following section highlights the alternative views on foreign aid from the first-generation studies of Chenery and Strout [1966] to the most recent studies of Burnside and Dollar [2000]. Then, the paper presents the methodology and defines the data. Next is an empirical examination of the effect of aid on growth. The last section concludes the paper and makes suggestions for further research.

Alternative Views of the Effect of Foreign Aid on Economic Performance

Foreign Aid as an Engine of Economic Growth

The notion that foreign aid increases economic performance and generates economic growth is based on Chenery and Strout's Dual Gap Model. Chenery and Strout [1966] claimed that foreign aid promotes development by adding to domestic savings as well as to foreign exchange availability, thus helping to close either the savings-investment gap or the export-import gap. Chenery and Strout [1966] pioneered the so-called Financial Two Gap Approach, which is an extension of the Harrod-Domar thesis. This approach is used to calculate the amount of foreign aid needed to complement the foreign exchange and domestic savings needs of developing countries. (2)

The Financial Two Gap Approach assumed that a gap exists either between saving and investment or between exports and imports. It posited that developing countries could not overcome the shortage of savings and foreign exchange on their own due to their limited resources. Thus, the rationale of the Financial Two Gap Approach is that foreign aid should make up the differences between either the saving-investment gap or the export-import gap.

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