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Foreign Aid, Government Policies and
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Foreign Aid, Government Policies and Economic Growth
Foreign Aid, Government Policies and
Economic Growth
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Master
Supervisor1
: Y. Meulblok*/**
: Hoendervogellaan 14
4451 EM Heinkenszand
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: [email protected]
:
: 2008-2009
: Erasmus University Rotterdam, Erasmus
School of Economics
: International Economics and Business
Studies
: Dr. J. Emami Namini
Erasmus School of Economics
1
I would like to thank my supervisor, Dr. J. Emami Namini, for all his valuable comments and suggestions on
earlier drafts of this paper
*The author declares that the text and work presented in this master thesis is original and that no other
sources other than those mentioned in this text and its references have been used in creating this Master
Thesis
**The copyright of this Master Thesis rests with the author. The author is responsible for its contents. The
Erasmus University is only responsible for the educational coaching and beyond that cannot be held
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2
Foreign Aid, Government Policies and Economic Growth
Abstract
Is economic growth affected positively by foreign aid? And when this is the case, what role
does a good policy environment play? This is a heavily debated topic. While Burnside and
Dollar (1997) show that foreign aid only contributes to growth if recipient governments have
good policies, others disagree with this result and show that aid always contributes to
economic growth and that a good policy environment has no effect.
This paper presents another analysis on the already large literature of the aid-growth
nexus. It proposes new variables that might affect the relationships that exist between foreign
aid, government policies and economic growth. This paper produces OLS and TSLS
regressions for eight panels of four-years covering 107 countries between 1970-2001 while
taking into account more data that has become available through the years.
After controlling for the possibility of aid endogeneity, this paper shows that foreign
aid positively affects economic growth. However, the policy environment did not empirically
contribute to this positive effect. In addition, this paper examines the effects of the domestic
savings rate interacted with foreign aid and the results were very promising, producing highly
significant coefficients. The final hypothesis examined, was whether aid works in good policy
environments when taking diminishing returns on aid into account. Results show that even
when diminishing returns are added, the policy environment did not have any affect.
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Foreign Aid, Government Policies and Economic Growth
Table of contents
1
Introduction ................................................................................................... 5
2
Theoretic Framework ................................................................................... 7
2.1
2.1.1
Aid is absorbed and spent ................................................................. 9
2.1.2
Aid is spent, but not absorbed ......................................................... 10
2.1.3
Aid is neither absorbed nor spent ................................................... 12
2.1.4
Aid is absorbed, but not spent ......................................................... 12
2.2
3
4
Macroeconomic impact of foreign aid: absorption and spending ............ 7
Macroeconomic impact of foreign aid: growth ...................................... 16
2.2.1
Aid has a positive impact on growth ............................................... 17
2.2.2
Aid has no affect on growth............................................................. 18
2.2.3
Aid has a conditional relationship with growth .............................. 20
Data and empirical strategy ....................................................................... 24
3.1
Data description ...................................................................................... 24
3.2
Empirical model specification ................................................................ 27
Regressions and results............................................................................... 30
4.1
OLS Growth Regressions ....................................................................... 30
4.2
Two-Stage Least Squares Growth regressions ....................................... 33
5
Conclusion and remarks ............................................................................. 35
6
References .................................................................................................... 37
7
Tables ........................................................................................................... 45
Appendix A1: List of variables ........................................................................ 47
Appendix A2: List of countries ........................................................................ 48
4
Foreign Aid, Government Policies and Economic Growth
1 Introduction
Today, almost one billion people are living on less than $1 a day (World Bank, 2008). As can
be seen in table 1 below, developed countries spend more than $100 billion on Official
Development Assistance, further in this paper denoted as (foreign) aid.
Figure 1: Net Official Development Assistance in 2008
Source: Organisation for Economic Co-operation and Development Data
A major objective of foreign aid is to spur economic growth in the recipient nation through
various channels in order to close the gap between developed and developing countries.
Despite the high aid inflows to developing economies and the numerous econometric studies,
the various conclusions about the relationship between foreign aid and economic growth are
not without controversy (World Bank, 2008).
The traditional view is that foreign aid is an important instrument for countries to stimulate
development. Many developing countries are dependent on foreign aid programs as it brings
not only the desirable financial resources, but also the right arguments on how to spend those
resources. A combination between those two factors is necessary for economic development.
However this view has stirred a lot of criticism. Empirical proof is required to clear up this
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Foreign Aid, Government Policies and Economic Growth
discussion.
Probably the most influential paper that investigates the relationship between aid and
growth was written by Dollar and Burnside (1997). They set out an empirical model including
an index of inflation, budget balance and openness to measure policy. They find that although
foreign aid does not significantly affect economic growth in developing countries, aid
interacted with policy produces a positive effect on growth.
Their results has also had a tremendous impact on the way donor countries act
(Easterly, 2003). Poor countries know that foreign aid will only be addresses to countries with
a good policy environment and are at risk of losing foreign assistance. Since Burnside and
Dollar, many papers tries to review the robustness of this particular policy view, as well as to
assess the aid-growth relationship in this light. Research by the World Bank (1998), Collier
and Dollar (1999) and Svensson (1999) support the findings of Burnside and Dollar, while
Lensink and White (1999), Guillaumont and Chauvet (2001), Hansen and Tarp (2001), Lu
and Ram (2001), Easterly et al. (2004) and Dalgaard and Hansen (2005) to name a few,
oppose these results on statistical grounds and provide evidence that aid raises growth
regardless of the policy environment.
This paper examines four different hypotheses; firstly, aid has a positive impact on
economic growth. Secondly, aid works better in a good policy environment. Thirdly, aid
works better in good policy environments when taking diminishing returns on aid into
account and fourthly, domestic saving via foreign aid and FDI lead to higher growth.
Considering previous literature, this paper reexamines the aid-growth nexus
introduced by Burnside and Dollar (1997). It will critically evaluate the effects of foreign aid
on economic growth taking the role of a good policy environment into account. This paper
expands the dataset with 51 countries, increases observations to 451 and expands the time
period by eight years to 2001. New variables are included such as domestic saving and
Foreign Direct Investment.
The organization of this paper is as follows. Chapter two discusses the theoretical
background. Chapter three sets out the model and describes the data sources. Chapter four
discusses the results and the explanations behind the results. Finally, chapter five provides the
conclusions followed by some remarks.
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Foreign Aid, Government Policies and Economic Growth
2 Theoretic Framework
A variety of studies have intended to address the issue of whether foreign aid has an effect on
the macro economy in the long run, as well as the effect on institutions and policies. However
the literature on the short-run effect of foreign aid on key macroeconomic aggregates is
mostly limited to fiscal response literature. Nevertheless a 2005 IMF study examined the
impact of foreign aid in five relatively large African studies.
2.1
Macroeconomic impact of foreign aid: absorption and spending
The key point in managing aid inflows is the coordination of fiscal policy with the exchange
rate and monetary policy. To accentuate this relationship, it is useful to distinct between two
concepts: absorption and spending.
“Absorption is defined as the widening of the current account deficit (excluding aid)
due to incremental aid. It measures the extent to which aid engenders a real resource transfer
through higher imports or through a reduction in the domestic resources devoted to producing
exports. Spending is defined as the widening of the fiscal deficit (excluding aid)
accompanying an increment in aid.” (IMF, 2005)
The importance of this distinction is that foreign aid only gives a country the
possibility to increase the level of consumption and investment more by financing higher
imports. When foreign aid is only used to finance local goods and services, it does not help to
build up their supply. This will lead to inflationary pressures, except when an economy has
spare capacity (Foster and Kilick, 2006).
Because spending expresses the widening of the fiscal deficit, it depends on fiscal
policy. In addition absorption hinges upon exchange rate and monetary policy. Spending and
absorption could be equivalent if a government uses aid directly to finance imports or receives
aid-in-kind (aid received as charity, so with no money or debt in return). It is however
common that the government sells the received aid to the central bank and uses the local
currency counterpart to finance domestic goods.
The response of the central bank is consequential for absorption, because the foreign
exchange sales influence the exchange rate and interest rate policy that form aggregate
demand, including for imports. The combination of spending and absorption chosen by an
economy defines the impact of aid to macroeconomic aggregates.
7
Foreign Aid, Government Policies and Economic Growth
Figure 2 generally shows how governments can respond to aid inflows in the short run:
Figure 2
Absorption and government spending responses to aid flows
Source: Hansen and Heady (2007)
Notes: FEX = foreign exchange or foreign exchange reserves; LC = local currency; M = Imports; C =
Consumption; I = Investment; ER = Exchange rate; IR = Interest rate; π = inflation; nX = net exports.
Outcome 1. Aid-in-kind or aid that is completely used to finance imports is directly absorbed
and will not affect the ER or the IR (absorption and spending are equivalent). A similar outcome can
be achieved if aid is used to buy domestic goods and services after being converted to local currency.
This will lead to an appreciation, but indirectly to a depreciation when the demand for imports has
risen.
Outcome 2. If aid is spent but not absorbed, the aid will be used in the domestic market after
being converted to local currency. However, this does not give rise to higher imports, but will put
upward pressure on the exchange rate or interest rate. This will crowd out the private sector.
Outcome 3. If aid is neither absorbed nor spent, the FEX aid is put aside and accumulated in
order to increase the FEX reserves.
Outcome 4. If aid is absorbed but not spent, then aid could be spent to cut back on the current
fiscal deficit or to decrease debt. This may lead to the ‘crowding in’ of the private sector.
There are four possible combinations of absorption and spending. These four combinations
together with their macroeconomic impact will be described in the next four sections.
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Foreign Aid, Government Policies and Economic Growth
2.1.1 Aid is absorbed and spent
This is the situation assumed in most scenarios (Outcome 1). The government uses foreign aid
to buy domestic goods and services. In addition, the central bank sells the foreign exchange
and resulting in a widening of the current account deficit as the aid flows are absorbed by the
economy. Both spending and absorbing permits reallocating resources from the traded goods
sector to public spending. This reallocation of resources results in a foreign exchange gap,
that will be filled by foreign aid that has been received (Bevan, 2005).
Spending aid will generally result in more import. To import more goods and services
into a country, there must be a higher aggregate demand together with a decrease of the
exchange rate. This decrease of the exchange rate is required to switch the demand from
domestic to imported goods and services. The higher demand can only be served when a
country has sufficient capacity and employment (Foster and Kilick, 2006).
However there could arise a situation when output may not be fixed and there is no
sufficient employment. A fiscal expansion could lead to a higher output. In the short run this
is established by the higher aggregate demand that will increase spending. In the long run this
is established by a higher capital stock. Through these two channels the current account does
not suffer a deterioration, but no aid is required to initiate the increase in aggregate demand
and capital stock. So aid is not fully absorbed, because to be absorbed aid has to finance the
changes in the current account deficit which was caused by the higher demand, investment
and output due to the aid inflows (Aiyar et al., 2008).
The absorption of aid depends on the level of decrease in the exchange rate. How large
this level must be is dependent on the amount at which aid is spent on imports and on how an
economy will react on the changes. For example, the decrease of the exchange rate is higher
when aid is mostly used to finance expenditures on non-traded goods. The decrease of the
exchange rate is lower when higher incomes result in an increase of import demand and the
prices strongly affect the non-traded goods supply (Berg, 2005).
In countries where the non-traded goods supply quickly can react to the changes, there
could occur an increase in production and employment when demand increases too. This is
accommodated with only a small appreciation and a small price increase. Investments that
result in higher productivity can cause the real exchange rate appreciation to reduce or even to
vanish in the long run (IMF, 2005).
The exchange rate regime is the key factor behind the mechanism for real
appreciation. In a pure floating regime, the central bank imposes an exchange rate
appreciation by selling foreign exchange that is related to the aid inflows. In a peg, the central
9
Foreign Aid, Government Policies and Economic Growth
bank accommodates the real appreciation with a rise in public expenditures during a period of
inflation. The real appreciation results in an increase of net import demand, whereupon the
central bank must defend the peg by selling foreign exchange (Buffie et al., 2004).
Countries can choose to spend the total amount of received aid on imports or goods
that are typically exported. This policy will have little effect on prices unless the country is
very large, but most countries are too small to have any influence on the international price
level. However, additional spending on non-traded goods and services is likely to lead to price
increases (inflation). Nevertheless there are various ways to avoid price increases when
foreign increase real resource availability.
Foreign aid is usually given in a foreign currency (FEX), which is normally converted
to local currency and used to expand government spending or lower taxes. By appreciating
however, a government can make its exports less competitive. In addition productivity and
growth may fall or slow down. This is known as the Dutch disease effect (Corden & Neary,
1982; Rajan and Subramanian, 2005; Bulir and Lane, 2002; Prati and Tressel, 2006).
Countries with a good economic environment could however partly offset the Dutch disease
effects by spending foreign aid on domestic resources. This should increase imports and
should compensate for the loss in export competitiveness. Smaller countries would be
expected to spend most FEX on imports. This should result in an increase in net imports as
well as in domestic demand (C+I).
2.1.2 Aid is spent, but not absorbed
This appears to be the most frequent outcome and is equivalent to deficit financing. This
scenario occurs when the government increases expenditures, but the central bank saves the
foreign aid as reserves and does not finance the arisen fiscal deficit. It can be seen as a fiscal
expansion. The macroeconomic impact of this scenario is equivalent to a situation when aid
does not flow in, apart from the higher FEX reserves. The aid inflows do thus not serve to
support the fiscal expansion. Due to the increasing expenditures, there will float more money
into the economy (Foster and Kilick, 2006).
However, there is no reallocation of real resources, because there are no increasing net
imports. Instead of financing these additional net imports, aid is used as an alternative for
domestic tax revenue. To finance their expenditures, the government does not use aid, but
simply borrows money from the central bank, i.e. enlarges the money supply. The aid rather is
aimed at providing the foreign exchange that is necessary to meet the increased demand for
foreign currency as a result of the increased import demand. (IMF, 2005)
10
Foreign Aid, Government Policies and Economic Growth
There are several monetary policy responses to a situation in which aid is being spent
by the government but not absorbed in the economy. When there is no selling of foreign
exchange, the best option is to monetize the fiscal expansion. The disadvantages of this
scenario are that inflation tends to increase and the nominal exchange rate tends to depreciate.
In addition, the larger money supply will increase the price of foreign exchange. As a result
there will be an inflation tax that initiates a lower private demand and will decrease the
absorption of aid and will decrease the real exchange rate. If the authorities instead withstand
nominal exchange rate depreciations, then the following inflation will give rise to a real
appreciation, the demand for imports will boost up in due course and exports will fall (IMF,
2005).
Eventually the foreign aid will be sold to finance the increasing net imports demand.
This will defend the nominal exchange rate and suppress inflation as it has a stabilizing effect.
In time aid thus will be used and absorbed. However, inflation is very high the period before
the aid inflows are absorbed. During this period a country can bear high costs (Aiyar et al.,
2008).
A second strategy for governments is to sell treasury bills in order to sterilize the
monetary expansion. The money supply will become smaller, but the interest rates will
increase. This will crowd out private investment. As a result the country will notice a switch
from private to public investment. However this strategy is expected to be difficult to realize
and will carry high costs. It is difficult to realize, because when the interest rate increases,
international capital will flow into the country and appreciate the exchange rate (IMF, 2005).
The spent-but-not-absorbed case (Outcome 2) is thus a less favorable scenario,
because aid is converted to the local currency and spent domestically, but import demand fails
to increase. When public expenditures do not affect import demand, an appreciation of the
exchange rate may occur (Hansen and Headey, 2007).
If aid is spent but not absorbed, the effect on the real exchange rate can either be
positive or negative. This effect depends on miscellaneous factors. On the on hand there
occurs an appreciation when the non-traded goods demand increases due to the fiscal
expansion. On the other hand does the fiscal expansion result in a depreciation, because
import demand increases which will decrease the export supply. The key factors that affect
the net effect are the price and income elasticity of a country’s import demand and export
supply(Aiyar et al., 2008).
Moreover, the net effect will depend on the exchange rate regime. In a float the real
exchange rate will depreciate in the short run due to liquidity injections that are aid-related.
11
Foreign Aid, Government Policies and Economic Growth
In the long run, the real exchange rate will appreciate due to the increased inflation and the
related inflation tax that decreased private demand. A similar outcome occurs when selling
treasury bills (IMF, 2005).
When the exchange rate is pegged, the only strategy is to sterilize through selling
treasury bills. The nominal exchange rate has to be fixed, so the authorities have to enlarge
the money supply which will increase the interest rate. This outcome may also ensue when the
foreign aid is not converted to local cuurency, but held as foreign exchange. The rise in public
expenditures will then be financed by increasing the money supply. This will result in
inflation, but is regarded by Foster and Killick (2006) as the only policy response which is not
well motivated.
2.1.3 Aid is neither absorbed nor spent
This scenario (Outcome 3) is the direct opposite of outcome 1. Aid inflows are used to
accumulate FEX reserves or to smooth volatile aid inflows. In this scenario aid does not have
any macroeconomic impact except some indirect effects such as a higher confidence due to
the increased FEX reserves (Aiyar and Ruthbah, 2008).
As aid is fully used on FEX reserves, the public expenditures and taxes will remain
their current level. Therefore the exchange rate or prices will remain stable and aggregate
demand will not increase. Nevertheless, not spending the aid is not favorable in the long run,
because donors are responsible for their expenditures. However, money is fungible, and not
spending the aid inflows coincides with engaging in donor’s favored projects. This is of
course dependent on the moderation of expenditures in other areas (Aiyar et al., 2008).
Although this scenario may seem extreme, it might be relevant if a country
experiences FEX shortages or excessive aid volatility. FEX shortages, excessive aid volatility
or homogeneous exports could cause problems in small countries, so that the accumulation of
FEX reserves may be provident for when a country exhibits problems.. However, a poor
macroeconomic climate might also result in this outcome as FEX shortages may be the
consequence of a weak policy environment, e.g. taxes on exports (Hansen and Headey,
2007).
2.1.4 Aid is absorbed, but not spent
This scenario (Outcome 4) substitutes aid for domestic financing of the government deficit. In
this scenario the government uses aid to finance the government deficit. The government
12
Foreign Aid, Government Policies and Economic Growth
finances an increase of net imports after having converted the aid flows in local currency, so
does not lower taxes or increase its expenditures. This outcome is relevant when government
goals contain lowering debt, attaining stabilization or when excessive spending results in the
crowding out of the private sector. Applying this scenario should result in an appreciation of
the exchange rate, a decline in monetary growth and in decreasing inflation (Gupta et al.,
2006).
As the inflation decreases, aggregate demand will increase which will result in
increasing private investment and more private consumption. This stabilization often
corresponds with a weakening of the trade balance, but the aid flows will defend the trade
balance and will finance the difference. (Buffie et al., 2004).
Aid also can be used as an instrument to reduce debt. This is the case in countries
where the government bears a large domestic debt. This would apt to affect private
investment and consumption positively, which would result in increased net imports via
higher private after-tax income on import demand. This increase in net imports demand
would be financed by the extra foreign exchange sold by the central bank. This rise in net
imports should however be accommodated by a real exchange rate appreciation to mediate the
effects. The success of this scenario is dependent on the consequences of lowering interest
rates. If they are accommodated by higher domestic consumption and investment than it could
be a success. In order to succeed there must be good private investment opportunities (Aiyar
et al., 2008).
When effective import demand is impeded by government crowding out, then there is
the possibility of an indirect effect on imports due to a decrease in debt. This eventually
would prevent a Dutch disease to occur. On the other hand, when a decrease in debt does not
result in affecting effective import demand, a Dutch disease still could arise, although the
effects on inflation and the domestic interest rates are usually ambiguous.
If the aid inflows are converted in local currency, private consumption and investment
could increase due to increasing interest rates, but it is also possible that imports are not
affected. This could result in an upward pressure on the exchange rate. When having a fixed
exchange rate regime, the government needs to react by using monetary policy. The exchange
rate will decrease, but the interest rates will be affected by an upward pressure. Thus the net
effects on the interest rates are ambiguous and could either be negative or positive (Hansen
and Headey, 2007).
To conclude there is a brief summary of what is entailed by different combinations of
absorption and spending. In this summary the macroeconomic consequences of policy choices
13
Foreign Aid, Government Policies and Economic Growth
involving different mixes of absorption and spending are outlined in figure 3. A note should
be made for the fact that these four outcomes, and the miscellaneous channels by which such
outcomes are reached, are not commonly exclusive. Aid can be spent partially on domestic
spending (with mixed effects on import demand), partially on imports, partially used to
accumulate FEX reserves and partially used to lower the government deficit or to retire debt.
Figure 3
Macroeconomic impact of different mixes of absorbing and spending
Absorbed
Spent
Not spent
Not absorbed

Central bank sells foreign exchange
and fiscal deficit increases as aid is
spent

Central bank accumulates foreign
exchange as reserves; fiscal deficit
increases as aid is spent

Aid finances public consumption and
investment

No real resource transfer


Money supply unchanged. Dutch
disease may occur
Unsterilized: money supply
increases. Inflation may occur

Sterilized: crowding out of private
sector. Domestic debt accumulates

Central bank accumulates foreign
exchange as reserves; no change in
fiscal deficit net of aid

No real resource transfer

No Dutch disease

Equivalent to saving aid, or to
rejecting aid (in the long-run)

Central bank sells foreign exchange,
but fiscal deficit does not change

Instrument to attain stabilization,
provides resources to finance private
investment
Source: Aiyar and Ruthbah (2008)
The main questions remain: which of these combinations is best and how do they affect
growth ?
This depends on many factors, including the existing debt burden, the exchange rate
regime, the level of official reserves, the current level of inflation and the degree of aid
volatility. The IMF (2005) states that some situations require other responses than others:
14
Foreign Aid, Government Policies and Economic Growth

Absorbing and spending: this scenario is under “normal” circumstances the first-best
response. In this scenario aid finances the rise in net imports, which will cause a real
resource transfer. As a result government expenditures will increase.
In this scenario, aid may positively affect growth via government expenditures. These
expenditures increase growth in the short run through the effects of associated spending
on aggregate demand and in the long run through the increase in the capital stock
permitted by the associated investment (IMF, 2005).

Absorbing and no spending: This scenario would appear to be the best response when
inflation is too high (fiscal policy might be too expansionary), private investment is low
due to scarce resources and the return on government expenditures is relatively low. Not
spending the aid however is difficult, because donors have certain interests when granting
aid. Not spending is only possible when the government budget is fungible.
In this scenario, aid might positively affect growth due to the fact that aid is used to
achieve stabilization. Authorities sell foreign exchange to sterilize the monetary impact of
domestically-financed fiscal deficits. This will result in slower monetary growth and
lower inflation. As the inflation tax declines, demand will rise corresponding with an
increase in private consumption and investment. However the impact on growth depends
whether there are good private investment opportunities (IMF, 2005).

Neither absorbing nor spending: this scenario is a good response in the short run when
governments want to accumulate their FEX reserves or smooth volatile aid. When the
amount of received aid is high, but will fall in the short run, building up FEX reserves will
help to stabilize the real exchange rate. Nevertheless, this scenario is not appropriate when
the amount of received aid remains high in the long run. However this scenario could be a
good response when a Dutch disease seems to occur that will fully outweigh the gains of
the aid absorption.
This scenario only has a positive effect on growth in the long run. This scenario
simply implies that aid is used for saving. These savings may later be used to finance
investment, but in the short run this has no effect (IMF, 2005).

Spending and not absorbing: This scenario is the least attractive one. It indicates the lack
of coordination between fiscal and monetary policy. It is inappropriate to accumulate
reserves and to finance the government expenditures by increasing the money supply.
15
Foreign Aid, Government Policies and Economic Growth
Applying sterilization by selling treasury bills will also not have the desirable effect as it
will cause a switch in resources from the private to the public sector.
This scenario is unlikely to have a positive effect on growth. Fiscal deficits rise, there
is a chance on inflation and domestic debt accumulates. These effects all have a negative
impact on growth (IMF, 2005).
2.2
Macroeconomic impact of foreign aid: growth
Most literature concerning foreign aid is focusing on the relationship between foreign aid and
economic growth. The question whether foreign aid helps countries growing in a sustainable
way is therefore one of the most important topics in economics. However, this question has
been discussed for years and no one came up with a final solution. Some researchers conclude
that foreign aid has no positive impact on growth or even has a negative impact under the
wrong circumstances. Others found that aid has a positive effect on growth or that growth in
the absence of aid would have been much worse.
Nevertheless it is not surprising that this research has various outcomes for several
reasons. Some observers just look at the facts and see that aid misses its objective, namely
spurring economic growth. However, others indicate that other factors also may affect both
aid and growth. Countries that suffered an endemic disease or a lengthy civil war may have
received a large aid inflow which positively affected economic growth, although the overall
growth rate was low or even negative (Radelet, 2006). Moreover, one could point out that
growth is not the main objective of aid at all. For example, countries which are suffering from
natural disasters. In that case, aid is aimed at humanitarian needs and supporting direct
consumption, not at building productive capacity. In addition, aid can also be aimed to
countries that try to build political systems, support a democracy or can flow for political
reasons (Alesina and Dollar, 2000).
Other studies showed that the conditions also play an important role when it comes to
the positive impact of aid on growth. Aid might tend to increase growth in countries with a
good economic policy environment, but might fall short in countries in which this is not the
case, for example when there is a high level of corruption (Burnside and Dollar, 1997).
The debate on whether aid helps spurring growth or not, the conditions under which
aid works or does not work and on what steps can be taken to make aid more effective, has
been ongoing for decades and will continue in the future. The empirics on these issues are
mixed, reaching different conclusions under various scenarios (time frame, countries and
16
Foreign Aid, Government Policies and Economic Growth
other factors). However, three views have become widely accepted. These three views will be
discussed in the next sections.
2.2.1 Aid has a positive impact on growth
There are three main channels through which aid might stimulate growth:
• First, early studies assumed that foreign aid increases savings, finances investment and
raises the capital stock. Chenery and Strout (1966) incorporated this idea into a theoretical
framework, the so-called “two-gap” theory. This model used the growth process of the
Harrod-Domar growth model, which considers the level of investment in physical capital
(measured by the ratio of physical capital to GDP) and the incremental capital output ratio
(ICOR) as the key factors to spur growth. Developing countries have surplus labor but their
ability to invest is constrained by a lack of domestic savings (saving gap) and foreign
exchange availability (trade or foreign exchange gap). Thus there are not enough relevant
resources to lead to the achievement of higher levels of growth. In this context, the two-gap
model illustrates that aid inflows would supplement domestic savings and foreign exchange
earnings one-for-one. Therefore, more aid inflows will lead to higher investment and
ultimately to higher growth.
However, this theoretical view has been challenged on various grounds. Poor countries
are incompetent to generate sufficient amounts of saving to finance investments that are
essential to spur growth (Sachs et al., 2004). Furthermore there is criticism on the assumption
of the two-gap model which states that aid inflows will be matched by a one-for-one increase
in investment. Much of the aid effectiveness literature points out that there are possibilities
that this assumption may be incorrect (White, 1998).
• Second, aid might help financing health or education projects that may lead to an increase in
worker productivity. Health is one of the building blocks for human capital. With a better
health status, workers can increase their productivity as their physical capability such as
endurance or strength and mental capability such as awareness, insight, faster process of
information grows (Bloom and Canning, 2005).
Moreover, education is important to build human capital. Workers that have had a
better education generally have a higher rate of literacy and numeracy. Better-educated
workers have less problems adapting to more difficult assignments. Countries with well-
17
Foreign Aid, Government Policies and Economic Growth
educated labor have a better chance of catching up with more advanced economies when they
have a stock of labor with the necessary skills to develop new technologies themselves or to
adopt and use foreign technology (World Bank, 2004).
• Third, aid could finance the import of capital by transferring new technologies or assistance
in how to use the technical equipment. Therefore there will be a transfer of knowledge or
technology from donor to recipient countries (Radelet, 2006).
In early literature many researchers found a positive relationship between aid and growth. In a
cross-country analysis Papanek (1973) showed that aid fills both the savings as well as the
exchange gap and is best given to countries with a small balance-of-payment. Singh (1985)
and Snyder (1993) extended his model with state intervention and country size respectively,
and came to the same conclusion. However in the mid 1990s researchers started to test not
only for a linear relationship, but also focused on diminishing returns or on conditional
relationships. Numerous studies also found a positive relationship in the aid-growth nexus
when taking these two matters into account (Hadjimichael et al., 1995; Durbarry et al., 1998;
Dalgaard and Hansen 2000; Hansen and Tarp, 2000; Lensink and White, 2001; Dalgaard and
Tarp, 2004; and Clemens et al., 2004). Nevertheless, the overall conclusion was not that aid is
effective in every single country, but that an increase in aid in combination with other factors
on average resulted in a higher growth rate. This research shows that other factors, for
example geography (Gallup, Sachs and Mellinger, 1999), political instability (Oechslin,
2006), policy environment (Burnside and Dollar, 1997 and World Bank, 1998 among others),
institutions (Knack, 2001) and government interventions in the private sector
(Ruhashyankiko, 2007) account for the differences in growth rates among countries that
receive aid.
2.2.2 Aid has no affect on growth
One of the first researchers who questioned the positive relationship between aid and growth
was Bauer (1972). However, he could not emphasize his argument with systematic empiric
evidence. Later, many empirical studies agreed on Bauer’s view, which incorporated the
empirics to show that there was no relationship between aid and growth (Mosley, 1980;
Mosley et al., 1987; Dowling and Hiemenz, 1982; Singh, 1985; Boone, 1994; Rajan and
Subramanian, 2005).
18
Foreign Aid, Government Policies and Economic Growth
These studies came up with miscellaneous reasons why aid might not affect economic
growth:
• First, aid simply could be wasted, for example on benefits for government members
(luxurious cars and houses) or it could promote corruption (Tavares 2001 and Kasper 2006)
• Second, aid can assist incompetent governments to maintain control. In other words, serving
to continue leading the country with a poor economic policy climate without intentions to
reform this climate. Some researchers even lay out that aid flowing into countries which are
suffering from war might support the war, because aid is used to buy weapons. This leads to
further instability (Radelet, 2006).
• Third, countries may have problems to use aid efficaciously due to absorptive capacity
constraints. These absorptive capacity constraints are factors which limit the ability of
recipient countries to put aid flows to good use. These factors include relatively few skilled
workers, weak infrastructure or constrained delivery systems. It implies that there are
diminishing returns to aid after it reaches a certain level (Guillaumont and Jeanneney, 2007).
• Fourth, foreign aid can decrease domestic savings, both private saving (through a decline in
interest rates/rate of return on investment) and government saving (through a fall in tax
revenue). Furthermore financing of the returning projects costs, for example, would lead to
higher government consumption and thus a fall in government savings. Ceteris paribus, this
would tend to reduce domestic savings (Ouattara, 2004). Nevertheless, there is some criticism
on this point, because aid inflows could also be aimed at stimulating consumption and not at
investment. For example food aid, immunization programs, purchase of textbooks and
technical assistance (Radelet, 2006).
• Fifth, foreign aid inflows could weaken private sector incentives for improvements in
productivity or investment. When aid flows are spent on the non-traded sector rather than on
imports, it could lead to an appreciation of a country’s real exchange rate in the short run.
This will make export less competitive, so exports will fall. If aid does not lead to a rise in the
non-traded goods supply, the real exchange rate could be higher. This could lead to a long-run
loss of competitiveness proportional to the aid received and spent. Because these tradable
activities are the main reasons behind increasing productivity, economic growth might be
19
Foreign Aid, Government Policies and Economic Growth
affected negatively in the long run. As mentioned before, these effects are called Dutch
disease (Corden & Neary, 1982; Rajan and Subramanian, 2005; Bulir and Lane, 2002; Prati
and Tressel, 2006).
These are the main five reasons found in literature why there is no relationship between aid
and growth. Nevertheless, not many studies have reached this conclusion. This is due to the
fact that most research does not take diminishing returns into account and instead uses a
model with the restriction of a linear relationship between aid and growth.
Furthermore, most studies only analyze aggregate aid, assuming that all aid effects
economic growth in a similar way. This is not realistic, since famine relief, immunization
programs, and infrastructure projects tend to effect economic growth in different ways
(Radelet, 2006).
2.2.3
Aid has a conditional relationship with growth
This view has had most support in literature. It holds that under certain circumstances aid
works better than under others. Furthermore this view looks for main characteristics to
explain the difference. This view has three subcategories which determine aid effectiveness:
recipient country characteristics, the donor practices and procedures, or the type of aid.
Recipient country characteristics
The first researchers emphasized this conditional view were Isham, Kaufmann and Pritchett
(1995). They questioned the effect of civil liberties in the aid-growth nexus. Their results
show that aid spent on World Bank projects in countries with stronger civil liberties had
higher rates of returns. However, the most influential paper on this conditional strand came
from Burnside and Dollar (1997). In “Aid, Policies and Growth” they concluded that aid
promotes growth in countries with good fiscal, monetary and fiscal policies. Their model was
further examined by the World Bank (1998), Collier and Dollar (1999) and Svensson (1999)
who support the Burnside-Dollar view. However, their conclusion also resulted in some
criticism. Lensink and White (1999), Guillaumont and Chauvet (2001), Hansen and Tarp
(2001), Lu and Ram (2001), Akhand and Gupta (2002), Easterly et al. (2004) and Dalgaard
and Hansen (2005) to name a few, oppose these results on statistical grounds and provide
evidence in favor of the hypothesis that aid raises growth regardless of the quality of the
policy environment. Easterly, Levine and Roodman (2004) stand out for using the same
20
Foreign Aid, Government Policies and Economic Growth
econometric technique, specification and data. They conclude that Burnside and Dollar’s
results do not hold up to modest robustness checks.
After Burnside and Dollar (1997) many researchers addressed different country
characteristics that might affect the aid-growth relationship. For example, export price shocks
(Collier and Dehn, 2001) , climatic shocks (Guillaumont and Chauvet, 2001), the terms of
trade (Guillaumont and Chauvet, 2002), institutional quality alone (Burnside and Dollar,
2004), policy and warfare (Collier and Hoeffler, 2002), type of government (Islam, 2003) and
location in the tropics (Dalgaard, 2004).
Nevertheless, Burnside and Dollar’s view that aid is more effective in countries with a
sound policy environment has widely been adopted by donors. The popularity of this
approach is that it illustrates why aid seems to have a positive impact on growth in countries
with a good policy regime. Furthermore this approach has been adopted by the World Bank in
their Performance Based Allocation (PBA) system for allocating concessional International
Development Association (IDA) funds and was the foundation for the United States’ new
Millenium Challenge Account (Radelet, 2003).
Donor practices and procedures
Numerous studies have showed that donor practices and procedures have a strong impact on
the effectiveness of aid. For example, multilateral aid (aid given a country to an international
agency, such as the World Bank or IMF) might have a stronger impact than bilateral aid (aid
given by one country directly to another), since countries normally spend bilateral aid on
military, political and economic interests which tend to have lower returns on aid than
multilateral aid which has weaker donor control and neutralized ulterior motives (Ram, 2003).
Furthermore it is argued that ‘untied’ aid (aid given to developing countries which can
be used to buy goods and services in all countries) is thought to have higher returns than ‘tied’
aid (aid given to developing countries which can be used to purchase goods and services in
the donor country or in a limited selection of countries). These limitations hinders a country in
finding the most cost-effective way to spend the received aid. In addition, tied aid is mostly
spent on capital-intensive goods that are coming from the donor country’s sector that is most
profitable. This may result in purchases that are not necessary for realizing their development
goals. Furthermore untied aid is much more efficient than tied aid, which needs larger
bureaucracies in both the recipient and the donor country to administrate the aid activities.
Moreover, untied aid gives countries greater freedom to allocate their received aid. They can
purchase goods and services in the most cost-effective way (OECD, 2007).
21
Foreign Aid, Government Policies and Economic Growth
Similarly, it is argued that donors with large bureaucracies, a lack of coordination with
other donors or ineffective monitoring and evaluation systems receive lower returns on their
aid programs (Radelet, 2006). To make aid more effective the World Bank organized a
meeting in order to improve aid effectiveness. This resulted in the Paris Declaration (2005).
The Paris Declaration states that countries are responsible for their own development. They
should establish partnerships with other countries, while donors might support them with
better coordination among them, capacity development and more predictable aid flows. This
resulted in five principles: ownership, alignment, harmonization, managing for results and
mutual accountability. In short, this means that countries need to strengthen their capacity to
manage development and need to establish effective partnerships with donors.
Type of aid
There are various types of aid that might influence economic growth in several ways.
Clemens, Radelet and Bhavnani (2004) divide aid into three categories that are most or least
likely to have an impact on growth. The three categories are:

Emergency and humanitarian aid: this type of aid would have a negative simple
relationship with growth, since an economic shock would simultaneously cause growth to
fall and aid to increase. Aid is aimed at humanitarian needs and supporting direct
consumption, not at building productive capacity.

Short-impact aid: this type of aid will positively affect growth rates fairly quickly. Aid
that will build infrastructure, support productive sectors and support the balance-ofpayments should be expected to positively affect growth immediately if it is to do so at
all. Research shows that there exists a strong positive relationship between this type of aid
(about half of all aid) and growth, a result that remains intact after testing for robustness.

Long-impact aid: this type of aid might affect growth, but if so only indirectly and over a
long period of time. Aid that supports democracy or protects the environment is unlikely
to affect growth in the short-run. Similarly, aid that strengthens health and education is
likely to affect labor productivity over many years, but not immediately.
22
Foreign Aid, Government Policies and Economic Growth
Figure 4 shows the relationship between the three categories of aid and economic growth as
constructed by Clemens, Radelet and Bhavnani (2004).
Figure 4
The relationship between three types of aid and growth
Source: Clemens, Radelet and Bhavnani (2004).
To sum up the aid and growth research, there is not yet established consensus on the
relationships between aid and growth. Aid is dependent on many factors to be effective.
However, must studies show that aid positively affects growth when taking various
circumstances into account. A different model, data or countries of analysis may result in very
different conclusions. Since the debate continues about the determinants of economic growth,
it is not surprising that the aid-growth relationship is left open to further research.
As this study is motivated by the influential paper of Burnside and Dollar (1997), it
will reexamine their research and test four hypotheses:
 Does aid affect growth?
 Does aid affect growth when it is dependent on good policies?
 Does aid affect growth when it is dependent on good policies and is being controlled
for diminishing returns?
 Do domestic saving via foreign aid and FDI lead to higher growth?
23
Foreign Aid, Government Policies and Economic Growth
3 Data and empirical strategy
This chapter will elaborate on the methodological approach used to find support for any of the
four hypotheses by using ordinary least squares (OLS) and Two-Stage least squares (TSLS)
regressions with input of empirical data. The methodological approach is based on the study
of Burnside and Dollar (1997). The results of the used methodology are shown in the next
chapter.
3.1
Data description
The regressions are based on data of the 20th century. Since data on various control variables
is scarce and in most cases only available in national databases, this paper makes use of a
already existing set of data from different sources collected by Roodman (2004). Their dataset
contains, in addition to self gathered data, data on openness, assassinations, institutional
quality and fractionalization taken from datasets of Sachs and Warner (1995), Banks (2002)
Knack and Keefer (1995) and Roeder (2001). This adds up to a dataset existing of 458
observations covering 107 countries over the period 1970-2001.
Dependent variable
The dependent variable in this dataset is GDP per capita growth. This variable is used as a
measure of economic growth and indicates the level of total economic output. It reflects changes
in the amount of goods and services produced. Data are obtained from the World Bank’s World
Development Indicators (2008).
Independent variables
The choice of the control variables is mainly based on the findings of Burnside and Dollar.
Their set of control variables is expanded with two additional variables. All included variables
are averaged over four years per country. The following paragraph will elaborate on the
choice of control variables.
Aid is measured by total aid as a share of recipient GDP, but there is a split in defining
numerator and denominator. Burnside and Dollar (1997) use Effective Development
Assistance in the numerator while others use net Official Development Assistance. However
24
Foreign Aid, Government Policies and Economic Growth
Dalgaard and Hansen (2002) show that there exists a correlation of 0.98 between EDA and
ODA and that they yield approximately similar results. Furthermore there is no consensus
which denominator to use. Burnside and Dollar (1997) use real GDP from the Penn World
Tables, while others use GDP converted to dollars using market exchange rate. This paper
will follow the line of Burnside and Dollar, thus will be using EDA as a share of real GDP.
This paper also includes a quadratic term in aid to capture the possible presence of
diminishing returns.
The initial GDP per capita indicates the conditional rate of convergence, i.e. closing
the gap between low-income and middle- income countries. To close this distance between
the poor and less poor, the very poor countries have to grow much faster than the less poor.
Thus countries with a higher initial GDP per capita will grow less than countries with a lower
initial GDP per capita. This variable is thus ought to be negative.
Institutional/political variables
Knack and Keefer (1995) indicated that security of property rights and efficiency of
government bureaucracy are good instruments to measure institutional quality. Governmental
institutions are important for a stable economic climate where economic activity,
inventiveness, growth and development can flourish. Intuitively this variable will have a
positive effect on growth.
Another variable which remains relatively constant over a long period is an index of
ethno-linguistic fractionalization and has been used by Easterly and Levine (1997). A high
level of this ethno-linguistic fractionalization often means that there is no sound policy
environment and the growth performance is poor.
In addition, the “assassination” variable is used, since numerous studies have shown
that this variable involves civil discontent. Furthermore there will be an interaction between
ethnic fractionalization with assassinations (Burnside and Dollar, 1997). These variables are
included to capture the effects of political and social conditions on growth, which will
intuitively have a negative effect. Data are obtained from the dataset of Roodman (2004).
Missing values for ethno-linguistic fractionalization are filled in from Roeder (2001).
Economic policy variables
This paper will follow the line of Burnside and Dollar (1997) and will construct a policy
index. This index is defined as the weighted sum of budget surplus/deficit, inflation rate and
the Sachs-Warner openness index where each component is weighted by its coefficient in the
25
Foreign Aid, Government Policies and Economic Growth
growth regression. Data for the budget balance and inflation rate are obtained from the World
Bank’s World Development Indicators (2008). Data on openness are obtained from the
dataset of Roodman (2004).
Openness is used to indicate international trade. Various channels, such as access to
foreign technology, greater access to miscellaneous production inputs and access to broader
markets which are specialized and increase the efficiency of domestic production have a
psotive impact on economic growth. Economies are considered closed when average tariffs
on machinery and materials are above 40%, or when the black market premium is above 20%,
or when key tradables are strictly controlled by the government.
Fiscal policy is measured by the budget surplus (fiscal balance) as a percentage of
GDP. This indicator was first introduced by Easterly and Rebelo (1993) and later used by
Dollar and Burnside (1997). The budget surplus is ought to be a stabilizing instrument for the
government. Furthermore, monetary policy is represented by inflation as suggested by Fischer
(1993), as it is considered to be an indicator of stability. A stable government is ought to
affect growth positively.
Other variables
The total government expenditure as a percentage of GDP indicate the share of the public
sector in the economy. This variable is ought to be negatively related to economic growth,
because poorly operating public firms and large bureaucracies create impediments to the
process of spurring growth.
Moreover the money supply (M2) as a share of GDP is used, to proxy for distortions
in the financial system (King and Levine, 1993). To overcome the problem of endogeneity
this variable is lagged one period. Small values are associated with repression and large
values with liberalism. Small values are expected to be detrimental to economic growth. Data
are obtained from the World Bank’s World Development Indicators (2008).
Two additional variables
In this paper FDI is introduced as a new control variable. FDI has a positive impact on growth
through various channels. First, FDI increases the export of manufactured products when a
country can utilize its comparative advantage. Second, productivity may increase through a
technology spillover effect as the result of FDI. Third, FDI can bring better market conditions
and better management knowledge as domestic firms observe these new activities, this is also
known as the demonstration effect (Campos and Kinoshita, 2002).
26
Foreign Aid, Government Policies and Economic Growth
A second newly added variable is domestic saving. Early literature pointed out that
domestic savings spur economic growth via investment. As most countries are importers of
capital, a higher level of domestic saving is required to bring more capital from abroad into
the country in order to stimulate investment (Carroll and Weil, 1994). Data for both variables
are obtained from the World Bank’s World Development Indicators (2008).
Following Burnside and Dollar (1997), regional dummy variables for East Asia and
sub-Saharan Africa are also used.
Definitions and sources for all the variables used in the data sample are provided in appendix
A1. A list of all included countries is given in appendix A2. A data set covering the eight
four-year periods from 1970-2001 for 107 aid-receiving countries is used. Data is mainly
obtained from the World Development Indicators (WDI, 2008). As some data are missing for
some countries, because they are either not available or not disclosed, the total number of
observations is reduced.
3.2
Empirical model specification
The empirical model applied to estimate the relationship between foreign aid, the policy
environment and economic growth can be written as follows:
git= β0 + β1Yit + β2ait + β3Pit + β4aitpit + β5a²itpit + β6xit + μit
(1)
where
git represents the real per capita GDP growth rate,
Yit is the initial level of real per capita GDP,
ait is the foreign aid as a share of GDP,
Pit is the P x 1 vector of policies that influence growth,
Xit is the K x 1 vector of other exogenous variables that might influence growth and
the allocation of aid,
Aitpit is the interaction term which measures aid effectiveness in a good policy climate
μit denotes the error term which captures all the unobservable factors that affect the
growth rate
a²itpit is the quadratic aid term interacted with policy to measure diminishing effects of
aid conditional on good policy
27
Foreign Aid, Government Policies and Economic Growth
β represent the coefficients of the various independent variables
i and t index country and time respectively.
Equation (1) is similar to the growth model that Burnside and Dollar (1997) estimated. The
main objective of this paper is to analyze whether aid works better in a good policy
environment. Therefore the coefficient of (Aid*Policy) must be strongly significant as
Burnside and Dollar found or not as others like Easterly, Levine and Roodman (2004) found.
Following Knack and Keefer (1995), Easterly and Levine (1997), Burnside and Dollar (1997),
World Bank (1998), Hansen and Tarp (2001) and Easterly et al. (2003), this paper also
captures a vector of exogenous variables (Xit). The per capita growth rate or foreign aid do not
affect these variables. This vector contains include various institutional and political variables
that might have an impact on growth.
To illustrate the impact of foreign aid on economic growth when accounting for a
good policy environment, the first order derivative of the economic growth model is taken:
∂git / ∂git = β2 + β4pit
(2)
This derivative expresses hypothesis two, which states that the impact of aid on growth
depends on a good policy environment.
As the empirical growth model is set out to run OLS regressions, the concern over
endogeneity has not been tackled yet. Endogeneity occurs when the independent variables are
correlated with the error term. This implies that the regression coefficient is biased in the OLS
regression. In this case, it is possible that the aid variable is not completely endogenous and
therefore uncorrelated with the error term. To solve this problem instrumental variables can
be used to create a source of exogenous variation in the aid variable. A valid instrument must
meet two conditions: relevance and validity. Firstly, the instrument that may be used has to
be correlated with aid, and secondly this instrument must be exogenous i.e. uncorrelated with
growth and the error term (μit).
The first stage equation yields the following outcome:
28
Foreign Aid, Government Policies and Economic Growth
Âit = β0 + β1Yit + β2pit + β3Xit + β4Zit + μit
(3)
where μit expresses all the unobserved factors that have an impact on foreign aid. Yit
represents the initial level of real GDP per capita, Pit is a constructed policy index and Xit is a
vector which denotes all the exogenous variables. The Zit variable expresses the instruments
that are required in the TSLS regressions to instrument for aid. The outcome of the OLS
regression of equation (3) is used to create TSLS model:
git= β0 + β1Yit + β2âit + β3Pit + β4âitpit + β5â²itpit + β6xit + μit
(4)
Equation (4) is practically similar to equation (1), except that the original aid variable is now
replaced by an instrumented aid variable. Equations (1) and (4) will be used to examine the
effects of aid on economic growth empirically.
A concern when applying TSLS regressions is the robustness. This relies on the
availability and quality of the instruments. However, it is hard to find variables that are
correlated with foreign aid, but uncorrelated with economic growth. Nevertheless, previous
literature (Boone, 1996) has offered various appropriate instruments. The first instrument is
the natural logarithm of population. This instrument accounts for the fact that countries with a
larger population need to have more foreign aid. However, institutions prefer to give foreign
aid to smaller countries, because this is cheaper. As Boone (1996) exclaims, “minimal
amounts can be transferred due to fixed costs of entry.” Similarly, the infant mortality rate is
used as an instrument to account for growth-inducing characteristics.
Other instruments are the proxies for donors’ strategic interest. The specific donor
interest variables that will be used are dummies for Central American countries (which are in
the U.S. sphere of influence), the France Zone in Africa and Egypt. These instruments are
included to capture the political ideas behind the allocation of aid. The strategic interest of
donors will be uncorrelated with growth only if the recipient country is given aid only for
historical and political reasons.
29
Foreign Aid, Government Policies and Economic Growth
4 Regressions and results
The following chapter will describe the empirical research which is conducted in line with the
strategy described in chapter three.
4.1
OLS Growth Regressions
First, following Burnside and Dollar (1997), equation (1) is estimated excluding aid and the
policy index by using a simple OLS model for an unbalanced panel of 107 aid receiving
countries across eight four-year periods. The regression results are presented in column 1 of
table 1.
Regression (1.1) is run to examine whether the independent variables have a
significant impact on growth. The independent variables explain 33.2% of the variation in the
real GDP per capita growth rate with a R² of 0.332. Variables that are very robust in
regression (1.1) are institutional quality, inflation, initial level of per capita GDP, domestic
saving and the dummy for Sub-Saharan Africa which are generally significant in the growth
regression. Various other studies show similar results concerning coefficients of these
variables. The initial level of GDP for example, which has a negative coefficient (-1.27). This
implies that on average, whilst controlling for other variables, a 1% increase in the initial
level of GDP results in a 1.27% decrease of the growth rate. This supports the theory that a
high initial level of GDP has a negative impact on economic growth.
The next step is to construct a measure for policy. Therefore a policy index is built, which
consists of budget balance, inflation and openness. To form the index, regression coefficients
are used from column 1 of table 1:
Policy = 1.55 + 4.45 Budget Balance – 2.36 Inflation + 0.39 Openness
Thus regression (1.1) gives weight to the three different components of the policy index. The
constant indicates the effect of the remaining variables when the mean of these variable is
taken to run the regression. The policy index expresses the forecasted growth rate of a country
given its budget, inflation and openness policies, assuming that the other variables had their
mean values. The index can either be negative if inflation is high or if the budget deficit is
very large.
30
Foreign Aid, Government Policies and Economic Growth
In comparison with Burnside and Dollar (1997) the budget balance (coefficient of
5.35) and openness (coefficient of 2.07) of a country have less impact on policy, but inflation
(coefficient of -1.41) has a larger effect. This as the result of expanding the dataset with more
countries. Openness for example does not have a large impact, due to the fact that
globalization has even more expanded and countries tend to be more and more open, so that
there is less difference between countries.
In regression (1.2) aid is included to test the hypothesis that foreign aid has a positive
effect on economic growth. This hypothesis is tested against a two-tailed alternative.
H0 : βa = 0
(5)
HA : βa ≠ 0
(6)
The regression results reveal that aid has a significant positive effect on economic growth.
Aid has a t-statistic of 2.34 which means that is significant at the 5% level. Therefore the null
hypothesis can be rejected showing that aid has indeed affects economic growth. This is not
consistent with the results of Burnside and Dollar (1997) which state that aid alone has no
effect on growth. Other significant variables are the initial level of GDP per capita,
assassinations, institutional quality, inflation and the Sub-Saharan Africa dummy.
Regression (1.3) tests the hypothesis that aid effectiveness increases when a country
has a sound policy climate. Again, this hypothesis is tested against a two-tailed alternative:
H0 : βap = 0
(7)
HA : βap ≠ 0
(8)
Column three in table 1 however shows that the term Aid x Policy is insignificant. The null
hypothesis cannot be rejected, which indicates that foreign aid does not depend on a good
policy environment to be effective. Inserting the interacted Aid x Policy term vanishes the
significance of aid on its own. Furthermore it is interesting that this is also the case with the
budget balance. This result opposes the outcome of Burnside and Dollar (1997). Their
regression showed that aid interacted with policy was significantly positive. The result of this
paper however are in line with papers that showed that aid interacted with policy has no
influence on growth (Easterly et al., 2004; Hansen and Tarp, 2000; Dalgaard and Hansen,
2005 among others).
31
Foreign Aid, Government Policies and Economic Growth
Regression (1.3) is expanded in regression (1.4) with quadratic aid interacted with the
policy term. This variable implies whether aid is effective in a good policy climate if the
possibility of diminishing returns is taken into account. The null and alternative hypothesis
are as follows:
H0 : βa²p = 0
(9)
HA : βa²p ≠ 0
(10)
It can be seen from column 4 in table 1, that aid indeed is effective in a good policy
environment when controlling for diminishing returns. It is remarkable that including the Aid²
x Policy term changes the sign of the Aid x Policy term. It is turned from a insignificant
positive variable into a negative significant variable. This results now that on average, holding
the other variables constant, 1% more foreign aid results in a decline of 0.24% of economic
growth when foreign aid being directed is aimed at countries with a good policy climate. This
is not in line with the conclusion reached by Burnside and Dollar which states that the policy
environment has a positive impact on aid effectiveness.
The variables which differ from Burnside and Dollar, FDI and domestic saving, show
mixed results. FDI is insignificant and has no effect on economic growth. Due to its low
explanatory power, FDI will be dropped in the TSLS regressions. In addition government
consumption will be left out, because this variable is also insignificant. Excluding these two
variables do not affect results. Domestic saving however has a positive coefficient and is
highly significant. This is in line with the theoretical literature regarding this matter.
Two variables that show a high level of significance in all four OLS regressions are
inflation and institutional quality. This result implies that financial stability and the fact that
there are stable and good institutions do help in attaining economic growth. Moreover, both
the Sub-Saharan Africa and East Asian dummy are significant. This is conform theory, that
countries located below the Sahara have lower economic growth and countries in East Asia
have higher growth in comparison to countries located elsewhere.
Another variable that stands out in the OLS regressions is the initial level of GDP per
capita. It is revealed that the initial level of income is statistically significant, thus indicating
conditional convergence among the countries in the sample, which contradicts the general
findings of previous studies.
32
Foreign Aid, Government Policies and Economic Growth
Previous research has had some problems with the endogeneity of the results of the
OLS regressions. Section 4.2 will examine whether the endogeneity is an important concern
and tries to address it.
4.2
Two-Stage Least Squares Growth regressions
There are several reasons to be skeptical about the OLS results presented above. The likely
endogeneity of aid was not taken into account. This section will try to address whether there
are unobserved factors that are correlated with foreign aid and have an impact on economic
growth. Not only the endogeneity of aid is a problem, but also the endogeneity of the policy
index. The belief that aid effectiveness increases when it is allocated to countries with a good
policy environment becomes weaker when it is known that the allocation of aid is influenced
by the policy level. In other words, countries that do not have sound institutions and a good
policy environment are maybe not granted aid at all. However it is difficult to find policy
instruments, so the assumption is made that the policy level is totally exogenous.
TSLS regression (2.1) mainly follows the line of the original OLS regression results.
Remarkable is that the financial quality variable (M2/GDP) has turned from a negative to a
positive sign. Conventional wisdom states that as financial liberalization increases, a country
is able to spur growth (King and Levine, 1993). Previous studies all showed that this variable
is significantly positive and this paper is no exception. This adds that the TSLS results are
more robust in comparison with the OLS results. Similarly ethnic-linguistic fractionalization
stands out. In the OLS regression this variable was already significant at the 10% level, but
applying TSLS this becomes significant at the 1% level, which increases the robustness of the
result.
In addition the aid variable remains statistically significant. This empirical evidence
gives a positive answer to hypothesis 1 which assumes that aid positively affects growth. On
average, whilst controlling for the other variables, increasing the amount of foreign aid with
1% results in an 0.54% increase of economic growth. This is consistent with the majority of
previous literature.
OLS regressions refuted the belief that aid granted to countries with a good policy
environment works better in spurring growth. When applying TSLS regressions the same
result pops up. The TSLS regression also does not provide any significant evidence that aid
works better in a good policy environment. Regression (2.2) tests the hypothesis that a stable
33
Foreign Aid, Government Policies and Economic Growth
policy environment promotes more effective foreign aid. The test statistic (1.42) in regression
(2.2) is smaller than the critical values at the 10%, 5% and the 1% levels and is therefore
insignificant. This implies that aid effectiveness is not conditional on good policies.
As can be seen in column 3 of table 2, this result still holds if aid is controlled for
diminishing returns. This variable is also not significant and follows the line of the many
criticasters of the results of Burnside and Dollar, that aid does not help spurring growth in a
good policy environment.
A variable that was very significant in the OLS regressions and that remains
significant applying TSLS, is domestic saving. The level of the domestic savings rate thus
positively affects growth. On average, holding everything else constant, a 1% increase in the
domestic savings rate corresponds to a 0.25% increase in growth. This is in line with the
theory of Carroll and Weil (1994).
34
Foreign Aid, Government Policies and Economic Growth
5 Conclusion and remarks
Many papers have yet tried to solve the aid-policy-growth nexus. Nevertheless, a common
conclusion has not been established yet. Results so far have been ambiguous and this paper
joins other work that has not come up with an overall conclusion. This paper examines the
aid-policy-growth nexus on the basis of four important hypotheses: firstly, aid has a positive
impact on growth. Secondly, the impact of aid depends on a good policy environment.
Thirdly, foreign aid helps in a good policy environment when taking diminishing returns into
account and finally, domestic saving and FDI lead to economic growth
The first hypothesis is whether aid positively affects growth. When applying OLS, this
paper shows that on average, foreign aid has a small explanatory power which is in line with
other studies such as Easterly, Levine and Roodman (2004) that tried to reestablish the
Burnside and Dollar estimates. When applying a TSLS approach this power becomes even
stronger, implying aid on its own has a positive effect on growth. However, it is incorrect to
claim that aid positively affects growth in all cases. Aid can take many forms - like bilateral
or multilateral and tied or untied – but the model do not use these forms as estimators.
Furthermore, EDA does not register all foreign aid flows. This may also had impact on the
outcome.
The second hypothesis states that aid granted to countries with good policy climates
causes growth to spur more rapidly. Unlike the results of the first hypothesis, the results of the
second hypothesis are mixed The OLS regressions show that aid in a good policy
environment has a detrimental effect (when taking the Aid² x Policy term into account), but
the TSLS regressions show that policy conditions have no explanatory power at all. This
result is not consistent with the conclusions reached in Burnside and Dollar, but is in line with
the main criticasters of their paper like Easterly, Levine and Roodman (2004) and Hansen and
Tarp (2000). A possible explanation for this is that this paper expanded the Burnside and
Dollar dataset with new data that might have an influential impact in reaching different
results. In addition, policy was set to be exogenous in my model and thus did not correct for
endogeneity. This may have influenced the robustness of the results.
The third hypothesis states that foreign aid helps in a good policy environment when
accounting for diminishing returns. Including this variable does not change results. This term
remains insignificant in both the OLS and TSLS regressions and thus has no effect. This gives
rise to a negative answer to hypothesis three.
35
Foreign Aid, Government Policies and Economic Growth
Finally, this paper hypothesized that FDI and aid directed to countries with a higher
rate of domestic saving would positively affect the growth rate of GDP per capita. Including
these two variables gave mixed results. FDI had no explanatory power at all and proves
empirically to have no significant effect on growth when implementing it as an additional
variable in the Burnside and Dollar model. On the other hand aid is more effective if given to
countries with a higher domestic savings rate. It is however hard to compare this result,
because no other paper has implemented this variable in an aid-policy-growth model.
Although this paper did not find any statistical evidence for the results of Burnside and
Dollar that aid spurs growth in a good policy environment, it does not imply that aid should
be ignored as an instrument for policy makers. As shown in both the OLS and TSLS
regression, aid on its own has a positive effect on growth, thus can be effective.
One problem that occurs while examining the aid-growth-policy nexus is the lack of
cohesion between the various papers on this matter. Each paper differs from another by using
different variables and different definitions, that no robust conclusion can be set yet. Further
empirical research, where a critical note can be made to the lack of cohesion between
previous studies, need to occur for setting an overall conclusion.
This lack of cohesion and the lack of an overall conclusion imply that a different
approach needs to be adopted. However, there is one variable that appears to be significant in
almost every study: the policy variable. This implies that a stable government adds to
increasing economic growth. This gives rise to maybe an important question: is it not better to
put emphasis on aid inflows that improve the political environment in a country instead of
direct financial flows?
This current situation where countries are just given cash is not a sustainable solution.
Recipient countries become dependent on these aid inflows and will not give an incentive to
governments to start positively affecting growth. As set out in the theoretic frame, aid can be
wasted easily on the enrichment of the government itself, but not on the country as a whole.
There has to be a reform concerning the targeting of aid before sustainable growth could
become realistic.
36
Foreign Aid, Government Policies and Economic Growth
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Foreign Aid, Government Policies and Economic Growth
7 Tables
Table 1: OLS panel growth regression
Dependent Variable: per capita GDP growth
Time dimension: eight four-year periods, 1970-1973 to 1998-2001
Regression Number
Observations
Constant
(1.1)
451
(1.2)
446
9.6781
(4.2540)
(1.3)
446
8.1065
(3.3416)
(1.4)
446
8.0309
(3.3080)
10.0135
(3.9534)
Initial GDP per capita
-1.2771 ***
(-3.9004)
-1.0666 ***
(-3.1102)
-1.0710 ***
(-3.1222)
-1.3074
(-3.7030)
***
Ethnic fractionalization
-1.4253 **
(-2.0104)
-1.3032
(-1.8235)
*
-1.2920
(-1.8072)
-1.3701
(-1.9271)
*
Assassinations
-0.3527
(-1.4970)
-0.3898
(-1.6537)
*
-0.3930
(-1.6667)
-0.3432
(-1.4600)
Ethnic x Assassinations
0.2745
(0.5368)
0.3152
(0.6165)
0.3104
(0.6068)
0.2423
(0.4761)
Institutional quality
0.3249
(3.2880)
0.3192 ***
(3.1610)
0.3171 ***
(3.1391)
0.3506
(3.4635)
M2/GDP (lagged)
Budget balance
***
-0.0141
(-1.3672)
-0.0161
(-1.5395)
-0.0156
(-1.4878)
-0.0158
(-1.5149)
5.2282
(1.5379)
6.3495
(1.8643)
*
-2.5463
(-4.5785)
***
*
Inflation
-2.3613
(-5.5056)
***
Openness
0.3888
(1.1191)
0.4184
(1.1388)
0.3636
(0.9764)
0.3875
(1.0472)
Government consumption
0.0362
(1.0790)
0.0041
(0.1110)
0.0075
(0.2010)
0.0098
(0.2649)
FDI inflow
0.1088
(1.4423)
0.0562
(0.7062)
0.0065
(0.8106)
0.0628
(0.7875)
Domestic saving
0.0883
(2.8327)
0.1018 ***
(3.1804)
0.1009 ***
(3.2839)
0.1038
(3.6751)
***
-2.2237 ***
(-4.1714)
-2.2479 ***
(-4.2109)
-2.1008
(-3.9378)
***
East-Asia
-2.0650
(-3.9293)
***
1.0174
(1.7352)
*
Aid/GDP
*
***
4.4470
(1.7228)
Sub-Saharan Africa
5.7830
(1.7290)
*
-2.3226 ***
(-5.5229)
-2.0375 ***
(-3.8962)
1.0039
(1.7146)
*
1.0751
(1.8199)
0.2565
(2.3447)
**
0.1857
(1.3874)
0.0954
(0.6931)
0.0724
(0.9173)
-0.2446
(-1.6712)
*
0.0500
(1.5653)
**
Aid x Policy
Aid² x Policy
*
0.8437
(1.4208)
R-squared
0.3312
0.3207
0.3121
0.3126
Adjusted R-squared
0.3087
0.2863
0.2860
0.2853
a T-statistics (in parentheses) have been calculated with White’s heteroskedasticity-consistent
standard errors, for all regressions in this paper
b *** significant at <0.01, ** significant at <0.05, * significant at <0.1
45
Foreign Aid, Government Policies and Economic Growth
Table 2: TSLS panel growth regression
Dependent Variable: per capita GDP growth
Time dimension: eight four-year periods, 1970-1973 to 1998-2001
Regression Number
(2.1)
(2.2)
(2.3)
Observations
446
446
446
Constant
11.2754
11.4165
13.3354
(3.4947)
(4.0937)
(4.1086)
-1.8638
-1.6290
-1.8734
Initial GDP per capita
(-2.1359)
Ethnic fractionalization
*
-1.5146
-0.2839
(-1.9362)
Ethnic x Assassinations
Institutional quality
*
Policy
(-1.4600)
(0.6156)
(0.4378)
0.2851
0.3359
0.2136
(3.3499) ***
0.0867
*
0.2114
-1.3601
(-1.7549)
(3.1157) ***
0.0938
*
0.2345
(-1.6183)
(3.1794) ***
-1.4460
(3.4641) ***
-1.3112
(-2.3098) **
(-2.3160)
0.9127
0.9053
(1.2256)
(1.3967)
(1.3431)
0.8340
0.5941
0.5172
0.5364
(2.8630) ***
Aid x Policy
(1.9341)
*
**
(1.5025)
0.8369
0.3427
(1.5347)
(0.8984)
0.1978
0.2784
(1.2278)
(-0.0056)
Aid² x Policy
*
0.2199
0.9232
(3.9042) ***
Aid/GDP
(-2.0562) **
(0.4485)
(-2.3655) **
East-Asia
-0.4507
0.0644
0.0491
*
(-2.8117) ***
0.1109
(3.2661) ***
Sub-Saharan Africa
(-2.7055) ***
0.1956
(-1.6648)
Domestic saving
(-2.2578)
-1.5668
0.4962
(2.8265) ***
M2/GDP (lagged)
*
-1.4807
(-2.6822) ***
Assassinations
(-2.2136)
-0.0962
(1.2451)
R-squared
0.28569
0.29257
0.2846
Adjusted R-squared
0.26743
0.27432
0.2615
Instruments: Pop (Ln population), Pop², Inf (infant mortality beginning of period), Inf², Pop x Policy,
Inf x Policy, arms imports (lagged), dummies for Egypt, franc zone countries, Central American
countries
46
Foreign Aid, Government Policies and Economic Growth
Appendix A1: List of variables
All World Bank Data is taken from the WDI Online statistic database. Organisation for
Economic Cooperation and Development Data, from the OECD statistic database and the
other variables are taken from the Roodman (2004) Dataset.
Variable
Growth
Initial GDP per capita*
Description
Per-capita GDP growth
Natural logarithm of GDP/capita for
first year of period; constant 1985
dollars
Source(s)
World Bank data
Summers and Heston Penn World Tables,
World Bank data
Aid (Effective
Development Assistance)/
GDP*
Fractionalization*
Effective development assistance as a
share of GDP
Chang, Fernandez-Arias, and Serven 1998;
OECD-DAC 2002; IMF 2003;
Probability that two randomly chosen
individuals differ ethnically
Roeder 2001
Assassinations*
Number of assassinations per 100,000
population
Banks 2002
Institutional quality*
Security of property rights and
efficiency
PRS Group’s IRIS III data set (see Knack
and Keefer 1995)
M2/GDP (lagged)
M2 as a share of GDP, lagged one
period
World Bank data
Budget balance*
Budget surplus as a share of GDP
International Monetary Fund data, World
Bank data
Inflation
Openness*
Natural logarithm of 1 + inflation rate
Dummy variable for trade openness
World Bank data
Sachs and Warner 1995; Easterly, Levine,
and Roodman 2004; Wacziarg and Welch
2002
Government consumption
Government consumption as a share of
GDP
World Bank data
FDI inflow
Foreign direct investment as a share of
GDP
World Bank data
Domestic saving
Sub-Saharan Africa*
Domestic saving as a share of GDP
Dummy variable for Sub-Saharan
Africa
Dummy variable for East-Asia
Dummy variable for Central America
Dummy variable for Franc Zone
Dummy variable for Egypt
Arms imports as a share of total
imports, lagged one period
World Bank data
World Bank data
Natural logarithm of population
Initial level of infant mortality
World Bank data
World Bank data
East-Asia*
Central Emerica*
Franc zone*
Egypt*
Arms imports*
Population*
Infant mortality
World Bank data
World Bank data
World Bank data
World Bank data
U.S. Department of State, various years
*Taken from the Roodman (2004) dataset
47
Foreign Aid, Government Policies and Economic Growth
Appendix A2: List of countries
An economy is defined as low income, middle income (subdivided into lower middle and
upper middle), or high income on the basis of GNI per capita.. Economies are classified
according to 2007 GNI per capita, calculated using the World Bank Atlas Method. The groups
are: low income, $935 or less; lower middle income, $936 - $3,705; upper middle income,
$3,706 - $11,455, and high income $11,456 or more (World Bank). High income countries
are left out in this study.
Low-income economies (41)
Bangladesh
Haiti
Papua New Guinea
Benin
Kenya
Rwanda
Burkina Faso
Lao PDR
Senegal
Burundi
Liberia
Sierra Leone
Central African Republic
Madagascar
Solomon Islands
Chad
Malawi
Somalia
Comoros
Mali
Tanzania
Congo, Dem. Rep
Mauritania
Togo
Côte d'Ivoire
Mozambique
Uganda
Ethiopia
Myanmar
Vietnam
Gambia, The
Nepal
Yemen, Rep.
Ghana
Niger
Zambia
Guinea
Nigeria
Zimbabwe
Guinea-Bissau
Pakistan
Lower-middle-income economies (40)
Algeria
Guatemala
Paraguay
Angola
Guyana
Peru
Bhutan
Honduras
Philippines
Bolivia
India
Samoa
Cameroon
Indonesia
Sri Lanka
Cape Verde
Iran, Islamic Rep.
Sudan
China
Iraq
Swaziland
Colombia
Jordan
Syrian Arab Republic
Congo, Rep.
Lesotho
Thailand
Djibouti
Maldives
Tonga
Dominican Republic
Mongolia
Tunisia
Ecuador
Morocco
Vanuatu
Egypt, Arab Rep.
Namibia
El Salvador
Nicaragua
48
Foreign Aid, Government Policies and Economic Growth
Upper-middle-income economies (27)
Argentina
Grenada
Seychelles
Belize
Jamaica
South Africa
Botswana
Lebanon
St. Kitts and Nevis
Brazil
Libya
St. Lucia
Chile
Malaysia
St. Vincent and the Grenadines
Costa Rica
Mauritius
Suriname
Dominica
Mexico
Turkey
Fiji
Panama
Uruguay
Gabon
Romania
Venezuela, RB
49