The standard definition of foreign aid by the Development Assistance Committee (DAC) of the Organization for Economic Cooperation and Development (OECD) as financial flows, technical assistance, and commodities that are (1) designed to promote economic development and welfare as their main objective (thus excluding aid for military or other non-development purposes); and (2) are provided as either grants or subsidized loans(PAPER 1). Foreign aid is usually associated with official development assistance, which in turn is a subset of the official development finance, and normally targeted to the poorest countries (World Bank,1998)(TAB 1).
Controversies about aid effectiveness go back decades. Critics such as Milton Friedman, Peter Bauer, and William Easterly have leveled stinging critiques, charging that aid has enlarged government bureaucracies, perpetuated bad governments, enriched the elite in poor countries, or just been wasted. They cite widespread poverty in Africa and South Asia despite three decades of aid, and point to countries that have received substantial aid yet have had disastrous records such as the Democratic Republic of the Congo, Haiti, Papua New Guinea, and Somalia. In their eyes, aid programs should be dramatically reformed, substantially curtailed, or eliminated altogether (PAPER 1).
Supporters counter that these arguments, while partially correct, are overstated. Jeffrey Sachs, Joseph Stiglitz, Nicholas Stern and others have argued that although aid has sometimes failed, it has supported poverty reduction and growth in some countries and prevented worse performance in others. They believe that many of the weaknesses of aid have more to do with donors than recipients, and point to a range of successful countries that have received significant aid such as Botswana, Indonesia, Korea, and, more recently, Tanzania and Mozambique, along with successful initiatives such as the Green Revolution, the campaign against river blindness, and the introduction of oral rehydration therapy (PAPER 1).
Burnside and Dollar (1997) claim that aid works well in the good-policy environment, which has important policy implications for donors community, multilateral aid agencies and policymakers in recipient countries.(World Bank, 1998) (TAB 1).
Among early investigations for example, Papanek (1973) appeared to overturn the
negative results of Griffin (1970) and Griffin and Enos (1970) by disaggregating
capital flows into foreign aid, private capital and other inflows, reporting a positive
and significant aid coefficient. On the other hand Voivodas (1973) obtained a negative
impact of aid on growth (although not significant) for a sample of 22 LDCs for the
period 1956-1968. The ambiguity of these results may, however, arise at least in part
from the poor quality of the data for these early periods.
Using later data Dowling and Hiemenz (1983) tested the aid-growth relationship for
the Asian region on 13 countries using pooled data and found a positive and significant
impact of aid on growth. They also controlled for a number of policy variables such as trade, finance and government intervention. Singh (1985) obtained similar results for a
wider sample of 73 countries during 1960-70 and 1970-80 (particularly in the later
period). For Sub-Saharan Africa, Levy (1988) reports a significant positive
relationship in a regression model including aid (as a ratio of GDP) and income per
capita, for 1968-82. More recently Hadjimichael et al. (1995) find positive evidence
for the period 1986 to 1992 using a sample of 41 countries. Their model is more
sophisticated than most predecessors by attempting to capture potential side effects of
foreign aid (such as 'Dutch-Disease'effects) and other policy variables that are
hypothesised to affect growth. Similarly Burnside and Dollar (1997), using a model
including a variety of policy variables, find that though the ratio of aid to GDP often
does not significantly affect growth in LDCs, aid interacted with policy variables
does. Boone (1996) however has cast doubt on the growth effects of aid, arguing
that, for a sample of LDCs, aid has had no impact on either investment or income growth(tab 5).
A particularly
telling criticism of most of these studies concerns the underlying model of growth,
which is typically poorly specified. Most aid-growth investigations, for example,
either pre-date or ignore many of the recent advances in growth theory which have
allowed more sophisticated empirical growth equations to be specified. If aid is to be
reliably identified as a growth determinant it is important that it is included within a robustly specified empirical growth model(TAB 5).
Most of these studies can be criticised on a number of grounds. The endogeneity
problem of single equation models is well known, whereby the feedback of low growth
into larger aid allocations is ignored. Gupta (1975) and Gupta and Islam (1983) for
example showed that if indirect effects are included, early estimates of a negative
effect of foreign capital can be overturned. By contrast Mosley (1980), using a
simultaneous equation model, found a weak, negative correlation between aid and
growth, though he did find a positive, significant relationship for the 'poorest'
countries in his sample. However, Mosley recognised that even this analysis is
'seriously incomplete'.
An important limitation of much of this literature is the incompleteness of the
underlying growth models. Many studies model growth as a function of capital
accumulation only, and few have addressed model specification issues seriously.
Dowling and Hiemenz (1983) and Mosley (1987), however did introduce variables
capturing the role played by government and trade, while Hadjimichael et al. (1995)
and Burnside and Dollar (1997) are among the first to include macroeconomic policy
variables. On the other hand, the largely separate literature on growth determinants in
LDCs which has examined the role of policy has not examined the impact of aid,
generally including only aggregate savings/investment variables (see, for example, Fischer, 1991, 1993; Easterly, 1993; Barro and Sala-i-Martin, 1995) (TAB 5).
By contrast, other people find foreign aid has negative impact on growth. Knack (2000) argues that high level of aid erodes institutional quality, increases rent-seeking and corruption, therefore, negatively affects growth. Easterly, Levine and Roodman (2003), using a larger sample size to reexamine the works of Burnside and Dollar, find that the results are not as robust as before. Gong and Zou (2001) show a negative relation between aid and growth(TAB 1).
This paper seeks to explore, by examining aid's growth impact within
augmentations of a prominent endogenous growth model: the 'Fischer-Easterly
model' (Fischer, 1991, 1993; Easterly, 1993). This model stresses
the role of stable macroeconomic policies for sustained growth - has found increasing
empirical support in the recent literature. With its emphasis on the role of economic
policy, the Fischer-Easterly model provides a natural context within which to study the
aid-growth relationship, since many have argued that the developmental impact of aid
is conditioned by the policy environment in recipient countries. Indeed since the
1980s, much aid from the multilateral lending agencies has been linked explicitly to
macroeconomic policy reform and structural adjustment (see Krueger 1997,
Greenaway 1998, McGillivray and Morrissey 1998).
Secondly, we seek to overcome some of the criticisms of previous econometric aidgrowth
studies by comparing panel data and cross-section econometric techniques for
a large sample (68 developing countries) over a long period (1980-2005). We examine
robustness to equation specification, sample composition and alternative time periods(TAB 5).
By and large, the relation between aid and economic growth remains inconclusive and is worth being studied further. In addition, geography is found to be influential on economic growth but so far this factor normally is neglected in the growth analysis (Gallup, Sachs and Mellinger, 1999). The study departs from other works in model, data set and approach of analysis (TAB 1). In this paper we attempt to improve model specification further by examining the growth impact of aid
within a model including both policy variables and all the major sources of investment finance - foreign aid, private and other inflows, and domestic savings. (TAB 5)
RESEARCH QUESTIONS:
Does foreign aid have a positive impact on economic growth across developing countries?
Does foreign aid have a diminishing return as volume of aid increases?
RESEARCH OBJECTIVES:
RESEARCH STRATEGY & METHODOLOGY:
The variables to be used in the augmented Fischer-Easterly model are:
DATA COLLECTION AND ANALYSIS:
The data trend in foreign capital flow to 60 developing countries (number of countries may reduce due to unavailability of data) between 1980- 2005 will be analysed. These figures will be in nominal rates to avoid appropriate deflator problems.
MODEL SPECIFICATION:
Cross section techniques will be used to examine the impact of the data averaging through 1980-2005 and for comparism with previous research. It will take the form:
Yi = ï¡i + ï¢'Xi +ï§'Zi + ui ......(1)
Where Y= average growth rate of GDP 1980-2005
X= vector capital source (foreign and domestic)
Z= vector of controlled variables (trade and macroeconomic variables)
U= error term
CONCLUSION:
This paper seeks to make a contribution to the empirical debate over the ability
of foreign aid to developing countries to stimulate faster growth. We have used an
augmented Fischer-Easterly type growth model in which macroeconomic and policy
variables, in addition to foreign aid and other (domestic and foreign) source of
investment, are allowed to affect long-run growth rates(TAB 5).
