Download aid volatility, macroeconomic policy and economic growth in pakistan

AID VOLATILITY, MACROECONOMIC POLICY AND
ECONOMIC GROWTH IN PAKISTAN
Sadia Mansoor1, Muhammad Javid2, Mirza Aqeel Baig3
Abstract
Like other developing countries, Pakistan also suffers from low saving base. Historically, foreign aid has
played a crucial role in filling the gap between saving and investment in case of Pakistan, albeit with
considerable volatility. We analyze the impact of foreign aid and its volatility in on economic growth in
Pakistan over the period of 1972-2015; foreign aid effectiveness has been evaluated in the presence of
sound macroeconomic policies by constructing an index of macroeconomic policy using principal
component method. The study concluded that foreign aid and its volatility has negative impact on
economic growth in Pakistan under currently prevailing macroeconomic policies. This study departs
from existing studies in two ways. First, Generalized Method of Moments (GMM) approach has been
used in this study to control for potential endogenity related to aid inflow. Secondly, aid volatility,
measured through Hodrick–Prescott (HP) filter, has been incorporated in aid-growth nexus to gauge its
impact of growth performance of the country.
Keywords: Foreign aid, economic growth, macroeconomic policy, generalized method of moments,
endogenity, volatility, principal component method.
1
Lecturer, Department of Economics, Institute of Business Management, Karachi, [email protected]
Research Economist, Pakistan Institute of Development Economics, Islamabad, [email protected]
3
Assistant Professor, Department of Economics, Institute of Business Management, Karachi,
[email protected]
Note: This paper has been presented in Conference at Institute of Business Management, Karachi on 27 and 28
September 2016.
2
1. Introduction
Foreign aid is a transfer of funds from developed countries and financial organizations to
developing countries in the form of grants, loans or technical assistance. The basic rationale of foreign
aid is based on two-gap model which depends on saving-investment and export-import gaps.4 In
developing countries, budget and trade deficits are prevalent and, therefore, require financial resources
to fill these gaps. Considering limited ability of developing countries to borrow from international
capital market or financial institutions, the foreign aid act as a major source of financing to developing
countries for financing their internal and external deficits.
An ample literature is available which aimed at evaluating the impacts of foreign aid on
important macroeconomic variables such as economic growth, saving, investment, consumption,
poverty and trade. The results of literature on aid effectiveness, however, are not unanimous. According
to some studied the foreign aid benefits domestic economy in terms of reduction in poverty and
supports developmental goals of health and education (McGillivary, 2005). Other studies suggest
negative effects aid by highlighting increase in corruption and decrease in government revenue
generation (Butt and Javid, 2013). However, the current literature is focusing more on aid effectiveness
by incorporating volatility in aid inflows. It is argued that sudden increase or decrease in inflows
increases the possibility of aid disbursement and make it ineffective to contribute in economic growth
(Celasun and Walliser, 2008).
Historically, Pakistan has been a major recipient of aid from both multilateral and bilateral
sources. In real terms, Pakistan has received around USD 86.1 billion during 1974-2014. The amount of
aid received by Pakistan is significantly higher compared with peer countries. For example, the average
share of Net Official Development Assistance (ODA) as % of Gross Capital Formation in case of
Pakistan during 1974-2014 is 14.6 percent compared with 2.6 percent of India and 4.8 percent for low
4
Chenery and Strout (1966) presented theoretical framework and stated that aid positively contributes to growth by
filling twin gaps of saving-investment and import-export.
and middle income countries.5 However, despite receiving significant foreign aid, Pakistan has been
unable to increase domestic savings and investment to foster sustainable economic growth. It is
observed that almost all the episodes of high growth in case of Pakistan coincide with high foreign
inflows in the form of foreign aid, grants, and loans.
In this background, the volatility of aid flows takes centre stage in explaining growth spurts and
its sustainability in case of Pakistan. This paper is an attempt to provide an empirical study on aid
effectiveness in the presence of aid volatility for Pakistan. Although a review of existing empirical
literature in case of Pakistan highlights the importance of aid inflows, the literature is relatively young
in exploring the impact of foreign aid and its volatility on long run economic growth of Pakistan.
The objective of this study is to analyze the impact of foreign aid and its volatility on growth in
Pakistan over the period from 1972-2015. The study further explores the impact of foreign aid on
economic growth in the context of stable macroeconomic policy. This study is different from earlier
studies in two ways. First, Generalized Method of Moments (GMM) approach has been used in this
study to control for potential endogeneity related to aid inflow. Earlier studies on aid-growth
relationship can be questioned for endogeneity problem and explicitly consider simultaneity bias due to
endogeneity of aid (for example Boone, 1994; Hadjimichael et al. 1995; Burnside and Dollar, 2000).
Second, aid volatility has been incorporated in aid growth relationship.
This paper is structured as follows. In section II, we have provided a broad discussion on
theoretical and empirical literature related to aid-growth nexus, aid volatility, and aid effectiveness. In
section III, we have explained methodology and data, while the section IV discusses results and policy
implication are given in section V, which is followed by the concluding section.
5
Source: World Bank, 2015 World Development Indicators (Washington, D.C.: World Bank, 2015), tables 1.1 and
6.11.
2. Literature Review
A large body of literature is available on relationship between aid and growth, and the findings and
conclusions are displaying different relationship between them. Results vary from country to country due
to different geographical, political and macroeconomic policy conditions. According to some studies, aid
has positive impact on growth, while other strand of literature opine that aid is relatively ineffective in
promoting saving and investment or other socio economic goals. There is another school of thought which
takes a middle ground by stating that aid effectiveness is conditional to sound domestic macroeconomic
policy environment.
Papanek (1973) was first to explore empirical relationship between aid and economic growth and
asserted positive relationship. The study emphasized for direct aid from developed countries to deficit
suffering countries. Similarly, Levy (1988) found aid to be pro-cyclical and pro-growth for sub-Saharan
African countries and also attributed aid as a potential inflow to fill saving-investment gap. Other studies
which support positive impact of aid on growth include Brecher and Abbas (1972), Dowling and Hiemenz
(1982), Chishti and Hasan (1992), Khan et al., (1992) and Gomanee et al (2005).
However, for aid to be effective the receipt country must also have the required infrastructure to
absorb foreign inflows. The ability of absorb foreign aid was also highlighted by Dalgaard and Hansen
(2001), Hansen and Tarp (2001), Clemens et al (2004) and Asterious (2009). It has been argued that aid
inflows reflect in high investment and growth when an economy has potential to absorb aid positively.
On the other hand, according to some studies aid has negative impact on growth. They argue that
aid inflows results in increased consumption, higher public expenditures while most of public funds
make its way into corruption. This idea was initially espoused by Griffin (1970) , Griffin and Enos
(1970) and Heller (1975) which was later supported by Mosley (1987). Hadjimichaelet al. (1995) also
found negative impact of aid on domestic savings. Boone (1994, 1996) found aid to be ineffective for
poverty reduction as well as for economic growth. Their results show that aid inflows increase the
government size in recipient countries. Ishfaq and Ahmad (2005) stated that due to diversion of aid
flow to non-productive plans, aid has been unable to foster economic growth in Pakistan. Rajan
and Subramanian (2005) and Balde (2011) also reached to similar conclusion that aid negatively affects
the growth process of domestic economy. Khan and Ahmed (2007) found aid as a curse for growth
in Pakistan by pointing out its negative impacts on exports, domestic investment, and economic
growth. Recently, Sabra and Sartawi (2015) and Sabra and Eltalla (2016) concluded that in Arab
countries aid does not work because increase in aid flows increases exports of donor countries to
recipient countries so that aid does not contribute to saving or investment of recipient countries.
Literature on aid effectiveness is also conditional to the policies of recipient countries. Sound fiscal,
monetary and trade policies provide base for aid effectiveness (Burnside and Dollar, 1997, 2000, 2004,
Collier and Dollar, 2001, 2002, Collier and Dehn, 2001). Durbarry et al (1998) added that along with good
policies geographical location, income level and allocation of aid to sectors are also few determinants
which make aid effective. But, at the same time, there are studies which concluded that aid works in
countries irrespective of the quality of policy regime; Hansen and Tarp (2000, 2001) work posit that aid
works even in those countries where policies are weaker or unfavorable for growth.
The current literature has focused on volatility of aid inflows to gauge if it is their underlying
volatility which renders aid as ineffective. Lensink and Morrissey (2000) attributed volatile aid for its
ineffectiveness on growth. Bulir and Hamann (2003) find that aid inflows are more volatile than domestic
revenues. Hudson and Mosely (2008 a) said that volatile aid decreases aid effectiveness as well as it
reduces the ability of progress of recipient countries. It is argued that volatile aid prolongs and sometimes
hampers the ongoing aid depended plans of recipient countries and lags in aid inflows creates a volatile
policy environment (Hudson and Mosely, 2008b). Arellano et al (2009) even showed that volatility of aid
triggers the disruptions in exports related manufacturing products and also hurts economic growth. Celasun
and Walliser (2008) argue that sudden increase in aid boosts the public expenditures and sudden fall in aid
can make the recipient government to cut their ongoing investments. Neanidis and Varvarigos (2009) and
Markandya et al (2010) also showed that aid volatility makes it ineffective for long run growth.
3. Data and Methodology
In order to investigate impact of foreign aid on economic growth, two separate models have been
introduced. In first model we incorporate the aid inflow and aid volatility along with other standard
control variables of growth literature. In the second model, we incorporate the Burnside and Dollar
definition of good policy to examine the relationship between aid and real GDP growths in presence of
macroeconomic policy environment.
LYt = β1 + β2 LK t + β3 LLt + β4 LTt + β5 Laidt + β6 AidVol + μt (1)
Where LYt is the real GDP per capita, LK log of grass fixed capital as percentage of GDP, LL is
the log of labor force, LT is log of trade openness which measure as export plus import ratio to GDP,
Laid is the log of Aid as ratio of aid inflow to gross domestic product, AidVol is the log of aid volatility.
Following Mills (2000) and Afonso and Furceri (2010), Hodrick-Prescott (HP) filter has been used for
the calculation of aid volatility.
In order to examine impact of aid inflow on growth conditional on macroeconomic policies, we
specified the following model.
𝐿𝑌𝑡 = 𝛽1 + 𝛽2 𝐿𝐾𝑡 + 𝛽3 𝐿𝐿𝑡 + 𝛽4 𝐿𝑇𝑡 + 𝛽5 𝐿𝑎𝑖𝑑𝑡 + 𝛽6 𝐴𝑃 + 𝜇𝑡 (2)
Where AP is the aid*policy interactive term. Following Burnside and Dollar (2000) we introduce aid and
policy (Aid*policy) interactive term in our regression model along with other determinants of economic
growth. In the present study taking the lead from Burnside and Dollar (2000) we construct the
macroeconomic policy index by using principal component analysis. Burnside and dollar preferred to find
overall measure of economic policy by using the regression coefficients of inflation, budget deficit and
trade openness. Unlike Burnside and Dollar (2000) in this study policy index is constructed by using the
principal component methodology. The Policy index for period is based on the formula:
Policy Index = -1 inflation + 2 budget surplus + 3 trade openness
Where 1, 2, 3 are represents of the weights of the first component. Sign of parameters 1, 2, 3 are
very important in the construction of policy index. On the basis recent studies we take 1 <0 and 2 >0
and 3>0.we construct the policy index using the principal component methodology. In order to
find the weights of three variables inflation, budget deficit and trade openness, first principal
component represents the high correlation so we use the first components to construct policy
index.
Policy Index = -0.562819* inflation +0.105368* budget surplus+ 0.542549* trade openness
Easterly and Rebelo (1993) suggest that the effect of most of fiscal variables has statistically
fragile and negative effects on economic growth. Ali and Isse (2005) study shows that that fiscal
volatility is strongly and negatively correlated with economic growth. Iqbal and Zahid (1998)
study regarding Pakistan, conclude that budget deficit is negatively related with growth rates in
per capita real income and real GDP. Two reasons were mentioned about negative relationship
between fiscal deficit and growth in context of Pakistan. First is that when fiscal deficit is
financed through distortion taxation, it would lower the incentive for saving and investment,
thereby lowering the rate of capital accumulation and economic growth. The second argument is
that higher budget deficit crowds out private investment.
3.1 Estimation Methodology
The econometric procedure for estimation of aid-growth relationship highly criticized for
endogenity problem. Numerous previous studies (for example Boone, 1994; Hadjimichaeleyet al, 1995;
Burnside and Dollar, 2000, Moreira, 2005) have raised issue of endogeneity of aid inflow. Burnside and
Dollar (2000) highlighted the reasons for the possible endogeneity of aid in the growth regressions. They
argue that that it is hard to consider that aid inflow as a lump-sum transfer, independent of the level of
income. If aid depends on the level of income it cannot be exogenous with respect to growth. Similarly,
Moreira (2005) pointed out that foreign aid inflow may have issue of reverse causality because aid
depends on level of income and if aid depends on level of income it will necessarily depend on economic
growth. Due to issue of reverse causality estimated coefficients not only become inconsistent but also
magnitude and meaning of aid parameters changed (Moreira, 2005).In order to find the consistent and
efficient estimation of the relationship between GDP and foreign aid Arellano and Bond’s GMM-type
technique is more appropriate to deal with the issue of endogeneity (Hansen, 2001; Bascle, 2008;
Moreira, 2005; Jones and Tarp 2016).GMM approach can handle endogeneity problem by taking lagged
variables as instrument in the regression model that is often raised in the estimation of aid growth
relationship. Therefore GMM approach is appropriate to examine the relationship between aid and
growth.
4.
Empirical Results
The effectiveness of foreign aid has varied impacts on economic growth. While some studies
shows its positive effects, especially on Sub-Saharan African countries, other questioned the role of aid
in promoting growth for developing economies. The literature on effectiveness of aid in case of Pakistan
also has disagreement.
Employing the GMM technique, we estimated equation 1 and 2 in order to gauge the impact of
aid volatility on economic growth using data from 1972 to 2015.Our results suggest that aid inflows have
negative and significant relation with growth in case of Pakistan. This results is similar to Chishti and
Hasan (1992), Khan (1997), Ishfaq and Ahmed (2005), Khan and Ahmad (2007) and Javid and Qayyum
(2011). They all found that aid is not effective for growth in Pakistan. Other control variables such as,
capital formation, labor force and exports exerts positive and significant impact on economic growth.
Positive impact of trade openness on growth confirms the earlier findings of Khan and Ahmad
(2007).The volatility of aid also found to be negatively related with economic growth in Pakistan (Table
1). Our results are consistent with Lensink and Morrissey (2000) as well as with Hudson and Mosely
(2008a, 2008b). The results does not change even if we include the policy index or interaction term of
aid*policy, which suggest robustness of coefficients (Table 2).
Table 1: Estimated Regression Coefficients with Dependent Variable of GDP per capita
Variables
Estimated Coefficients
0.132
(3.73)
Gross fixed capital (as % of GDP)
0.11 (4.90)
0.782 (50.29)
Labor force
0.79 (96.47)
0.467 (7.08)
Trade openness
0.39 (6.02)
-0.083 (-3.72)
Aid inflow (as % of GDP)
-0.13 (-3.39)
Aid volatility
Constant
2.159 (8.08)
-0.09 (-2.60)
2.79 (6.22)
Diagnostic Tests
R2
Adjusted R2
0.986
0.98
0.973
0.98
Durbin–Watson Statistic
1.83
1.85
J-Statistic
3.55 [0.737]
3.92 [0.560]
Note: Variables are in log form,.and t-values are given in parentheses, while p-values are
given in brackets
Table 2: Estimated Regression Coefficients with Dependent Variable of GDP per capita
Variables
Estimated Coefficients
Gross fixed capital (as % of GDP)
Labor force
Trade openness
Aid inflow (as % of GDP)
Aid volatility
Policy Index
Aid*Policy Index (Interactive term)
Constant
R2
Adjusted R2
Durbin–Watson Statistic
J-Statistic
Regression 1
Regression 2
Regression 3
Regression 4
0.12 (2.51)
0.73 (38.15)
0.15 (1.89)
-0.067 (3.67)
0.17 (3.48)
0.73 (47.7)
0.14 (1.82)
-0.17 (8.18)
0.09 (2.62)
0.75 (67.2)
0.30 (5.64)
-0.06 (3.16)
-0.04 (1.78)
0.01 (3.51)
0.11 (3.66)
0.76 (80.4)
0.30 (5.91)
-0.13 (8.05)
-0.04 (1.90)
0.12 (5.31)
0.10 (5.68)
2.159 (8.08)
3.05 (10.07)
Diagnostic Tests
0.981
0.979
0.978
0.976
2.14
2.16
6.31 [0.388]
5.63 [0.465]
2.74 (14.7)
0.06 (5.00)
2.61 (14.0)
0.987
0.985
1.99
6.44[0.489]
0.987
0.985
2.09
6.10[0.527]
Note: Variables are in log form,.and t-values are given in parentheses, while p-values are given in brackets
5. Conclusion and Policy Implications
This study is an empirical investigation in Pakistan which attempts to explore the impact of aid volatility
on growth in presence of prevailing macroeconomic conditions. It is found that both aid inflows and
volatility in aid flows are negatively related with growth in case of Pakistan. Trade openness, human capital
and capital formation have significantly positive relationship with growth. All the diagnostic tests are
showing significance to support the results of this study. Usually, political economists consider that,
sometimes, conditional aid turn out to be a threat to political sovereignty but even when we have not used
any conditional dummy variable in our analysis, aid is not pro-growth for Pakistan. The results question the
effectiveness of large aid inflows historically received by Pakistan. For further research, it would be
enlightening to explore the sector-wise analysis of aid inflows and their relative effectiveness.
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