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Description

Connexions module: m13519

Foreign Aid and Economic Growth in the Developing Countries

- A ∗

Cross-country Empirical Analysis

Vu Minh Duc This work is produced by The Connexions Project and licensed under the Creative Commons Attribution License † ABSTRACT OF THE THESIS Using cross-country data,

I examine how foreign aid aects economic growth in developing countries over the period from 1975 to 2000

I nd evidence that foreign aid signicantly and negatively correlates with growth in developing countries

However,

foreign aid to inland countries as well as to South Asian countries during the period of 1992-2000 is found to have a positive impact on growth

In addition,

a strong divergence trend is found among countries in the data set

The results suggest that (i) there may be problems in the present aid providing system,

where aid hinders growth of developing countries (ii) the successful experience of some inland countries and South Asian nations during the period of 1992-2000 could be a good lesson for other developing countries

Finally,

a strong evidence of divergence implies that if the condition is not improved in the least developing countries,

there would be a large income dispersion among developing countries in the future

Chapter I Introduction 1

Background Foreign aid is usually associated with ocial development assistance,

which in turn is a subset of the ocial development nance,

and normally targeted to the poorest countries (World Bank,1998)

How does foreign aid aect the economic growth of developing countries

This is a question which

has drawn the attention of many scholars over time

Papanek (1972) nds a positive relation between aid and growth

Fayissa and El-Kaissy (1999) show that aid positively aects economic growth in developing countries

Singh (1985) also nds evidence that foreign aid has positive and strong eects on growth when state intervention is not included

Snyder (1993) shows a positive relation between aid and growth when taking country size into account

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

Developing countries with sound policies and high-quality public in-

stitutions have grown faster than those without them,

One percent of GDP in assistance normally translates to a sustained increase in growth of 0

Some countries with sound policies received only small amount of aid yet still achieved 2

The good-management,

high-aid groups grew much faster,

2: Mar 17,

Connexions module: m13519

By contrast,

other people nd foreign aid has negative impact on growth

Knack (2000) argues that high level of aid erodes institutional quality,

increases rent-seeking and corruption,

Easterly,

Levine and Roodman (2003),

using a larger sample size to reexamine the works of Burnside and Dollar,

nd that the results are not as robust as before

Gong and Zou (2001) show a negative relation between aid and growth

Pedersen (1996) argues that it is not possible to conclude that the foreign aid has a positive impact on growth

Morrisey (2001) claims that aid works well conditional on other variables in the growth regression

Many other authors nd no evidence that aid aects growth in developing countries

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 inuential on economic growth but so far this factor normally is neglected in the growth analysis (Gallup,

Sachs and Mellinger,

My study departs from other works in model,

data set and approach of analysis

Research Objective Using an endogenous growth model for a data set of 39 countries over the period from 1975 to 2000,

I would like to address the following questions (i) what is the relation between foreign aid and economic growth in developing countries

? and (ii) how does this relation dier across regions

only these 39 countries have been chosen

To certain extent,

they represent various regions of the developing world with dierent characteristics and stages of development

Organization of the Study The study is organized as follows

Chapter II reviews the literature with various outcomes shown by

dierent authors with dierent views and models

Chapter III provides an overview of the regions in the study

Chapter IV describes the data and methodology

Empirical results and policy implications are

Chapter VI concludes the study

Chapter II Literature Review In general,

aid is found to have a positive impact on economic growth through several mechanisms (i) aid increases investment (ii) aid increases the capacity to import capital goods or technology (iii) aid does not have an adverse impact on investment and savings (iv) aid increases the capital productivity and promotes endogenous technical change (Morrissey,

Papanek (1973),

in a cross-country regression analysis of 34 countries in the 1950s and 51 countries in the1960s,

other ows and domestic savings as explanatory variables,

nds that foreign aid has a substantially greater eect on growth than the other variables

He explains that aid,

can ll the foreign exchange gap as well as the savings gap

Unlike foreign private investment and other foreign inows,

aid is supposed to be specically designed to foster growth and,

is biased toward countries with a balance-of-payment constraint

He also nds a strong negative correlation between foreign aid and domestic savings,

which he believes co-contribute to the growth performance

Fayissa and El-Kaissy (1999),

in a study of 77 countries over sub-periods 1971-1980,

show that foreign aid positively aects economic growth in developing countries

Using modern economic growth theories,

they point out that foreign aid,

human capital and export are positively correlated with economic growth in the studied countries

This is consistent with the economic theory of foreign aid,

which asserted that overseas development assistance accelerates economic growth by supplementing domestic capital formation (Chenery and Strout,

Snyder (1993),

taking country size into account,

nds a positive and signicant relationship between aid and economic growth

He emphasizes that previous econometric analysis has not made allowance for the fact that larger countries grow faster,

He also claims that donors favor small countries for a number of reasons

donors who are seeking support from recipient countries nd it better to

provide aid to many small countries than to focus on just few large countries

With the same amount of aid,

the proportion of aid over GDP will be bigger in small countries compared to that of larger countries and as a result,

Second,

there is pressure on multilateral donors to deliver aid to all member countries and due to their feasible project size,

small countries tend to receive more aid than

Connexions module: m13519

small countries tend to have historical colonial relations with donor countries,

which are somewhat inuential to donors' aid giving decisions

The last reason is that trade normally has larger fraction of GDP in small countries than in big ones and therefore,

these countries may be gaining more weight in donors' assessment

Based on the model developed by Papanek (1972,

Snyder analyzes the relation between foreign aid inow and the growth rate of gross domestic product in 69 developing countries over three periods (the 1960s,

incorporating country size (measured by gross domestic product) in the model

He argues that when country size is not included,

the eects of aid are small and insignicant but when this factor is taken into account,

the coecient of aid becomes positive and signicant

By contrast,

Knack (2000),

indicates that higher aid levels erode the quality of governance indexes,

corruption and the rule of law

He argues that aid dependence

can potentially undermine institutional quality,

encouraging rent seeking and corruption,

fomenting conict over control of aid funds,

siphoning o scarce talent from bureaucracy,

and alleviating pressures to reform inecient policies and institutions

Large aid inows do not necessarily result in general welfare gains and high expectation of aid may increase rent-seeking and reduce the expected public goods quality

Moreover,

donors take corruption into account seriously while providing aid (Svensson,

A permanent rise in foreign aid reduces long-run labor supply and capital accumulation,

increases longrun consumption and has no impact on long-run foreign borrowing

Using the optimal growth model with foreign aid,

foreign borrowing and endogenous leisure-and-consumption choices,

Gong and Zou (2001) show that foreign aid depresses domestic saving,

mostly channels into consumption and has no relationship with investment and growth in developing countries

Pedersen (1996) asserts that it is still not possible to conclude that aid aects growth positively

Using game theory,

he argues that the problems lie in the built-in incentive of the aid system itself

The aid

conditionality is not sucient and the penalties are not hard enough when recipient countries deviate from their commitments

In fact,

there are incentives for aid donating agencies to disburse as much aid as possible

This hinders the motivation of recipient countries and raises the aid dependency,

which in turn distorts their development

Commonly,

many authors nd the positive impact of foreign aid on growth subject to certain factors

Burnside and Dollar (1997),

in their well-known paper Aid,

Policies,

nd that aid has a positive impact on growth in developing countries with good scal,

monetary and trade policies but has little impact on countries where such policies are poor

They use data from 56 countries for six four-year periods from 1970-1973 until 1990-1993 and construct a growth convergence model,

in which growth depends on the logarithm of real per capita GDP at the beginning of the period,

incorporating the ratio of aid over GDP and an index measurement for macroeconomic policies in the right hand side of the equation

They explain that aid can aect output only through its eect on the stock of capital,

to the extent that it is used for investment rather than consumption

They argue that aid itself has small and insignicant impact but aid interacting with good policy has a signicant positive impact on growth

In fact,

seems more important for aid eectiveness in lower income countries

Moreover,

they show that aid follows diminishing returns to scale

Another nding is that there is no tendency for total aid or bilateral aid to favor good policy,

while multilateral aid is allocated in favor of good policy

Aid works well in a good policy environment and a poor country with good policy should get more aid,

which is not always the case in reality

A well-designed aid plan can support eective institutions

and governance by providing more knowledge and transferring technology and skills

It is recommended to decentralize the aid ows in recipient countries

Money aid is important but idea aid is even more important

Aid can be the midwife of good policy in recipient countries

In poor-policy countries,

idea aid is especially more essential than money aid

This implies that in a good-policy environment,

aid increases growth via the investment channel whereas in a poor-policy environment,

it nurtures the reforms through policymakers training or knowledge and technology transfer

These non-money eects are believed even more important and viable than the money value of aid

Aid works much better where the reform is initiated or internalized by local government rather than when it is imposed by outsiders

Therefore,

Connexions module: m13519

when it facilitates eciently and timely reforms triggered by the local authority (World Bank,

Foreign aid has a strong positive impact on economic growth in less developed countries (LDCs) for both periods 1960-1970 and 1970-1980 when state intervention is not taken into account

When the state intervention variable is included in the regression,

the eect of foreign aid gets statistically weak over time

Moreover,

foreign aid negatively aects the domestic savings rate whereas per capita income,

country's size and exports positively aect it (Singh,

Dierent types of aid have dierent impacts on growth

In a country analysis of Cote d'Ivoire from 1975 to1999,

Ouattara (2003) categorizes foreign aid into project aid,

technical assistance and food aid

Using a disaggregation approach with auto regressive techniques,

he nds that (i) project aid displaces public savings,

impact of program aid is almost neutral while technical assistance and food aid increase public savings,

and (ii) project aid and to a lesser extent,

worsen the foreign dependence of Cote d'Ivoire while technical assistance and food aid reduce the gap

On the contrary,

project aid and food aid are found to reduce public investment whereas program aid and technical assistance positively aect public investment in Uganda (Mavrotas,

Giles (1994),

applying a Granger causality test between foreign aid and economic growth and other diagnostic tests,

nds a causal relationship between foreign aid loans,

with economic growth in Cameroon,

which contradicts the previous work of John Mbaku in 1993

Domestic resources have positive and signicant impact on economic growth while foreign resources do not show any signicant contribution in Bangladesh from 1972 to 1988

However,

after foreign resources are decomposed into dierent categories,

we can observe that the loans are more eective than grants and food aid is more eective than project aid (Islam,

Aid might have dierent eects in dierent developing countries

Chenery and Carter (1973),

following the previous two-gap derived model of Chenery and Strout (1966) and using data from 50 countries over the period 1960-1970,

show that the eects of ocial development assistance (ODA) on the development performance of countries under study are dierent among certain groups of countries

In ve countries,

Thailand and Kenya,

foreign assistance accelerated economic growth whereas in six cases it retarded growth,

Colombia,

Tunisia,

Ceylon and Chile

In comparison to a no-aid pattern of growth,

post-aid growth rates can be higher or lower depending upon three factors (i) initial poverty of country (ii) additional rise of government consumption as percentage of aid received and (iii) the term of aid

Ceteris paribus,

a given amount of aid tends to increase post-aid growth if domestic savings ratio is higher,

the percentage of aid fungible into government consumption is lower and the term of aid is longer

The critical assumptions are that government replaces portions of its savings with aid then allocates this freed money to other programs,

which can not be cut back once started (Dacy,

Incorporating export price shocks into Burnside and Dollar's (1997) analysis,

Collier and Delh (2001) show a signicant and negative relation between negative shocks and economic growth

They argue that the adverse eects of negative shocks on growth can be mitigated by osetting increases in aid

Therefore,

they suggest that targeting aid towards negative shock experiencing countries could be more eective than towards good-policy countries

Using a 2

they nd 179 positive shocks and 99 negative shocks episodes

They indicate that the change in aid interacted with positive shocks is

while the interaction of negative shock with the change of aid is signicant at the 1% level

Additionally,

incorporating shocks into Alesina-Dollar's (1998) regression,

they show that so far donors have not taken shocks into account in aid allocation

Finally,

they claim that the aid eectiveness might be

increased signicantly if both policy and adverse export price shocks are considered upon determining aid allocation

In a recent paper,

Easterly,

Levine and Roodman (2003) conduct a new test on the previous work of Burnside and Dollar (1997)

With a larger sample size (1970 to 1997 compared to BD's 1970-1993),

they nd that the result is not as robust as before and therefore claim that the question of aid eectiveness is still inconclusive

In short,

the results of research on the relation between aid and growth vary depending upon the models,

data and countries of analysis

Therefore,

the debate over the impact of aid on growth is on-going and left

Connexions module: m13519

Chapter III Sampled Countries and Regional Characteristics In my data set,

there are 39 countries from dierent regions of various continents

Among them,

there are 5 countries from East Asia,

and 11 from Sub-Saharan Africa

Moreover,

Bolivia,

Botswana,

Jordan,

Paraguay and Rwanda

Appendix 2 and Appendix 3 provide brief regional prole and country information respectively

Developing countries share the following common characteristics (i) low standards of living,

and inadequate education (ii) low levels of productivity (iii) high rate of population growth and dependency burdens (iv) substantial dependence on agricultural production and primary-product export (v) prevalence of imperfect market and limited information and (vi) subordination,

dependence and vulnerability in international relations (Todaro and Smith,

Appendix 1 shows the percentage of population living below the poverty line (US$1 per day) in dierent regions of the developing world from 1987 to 1998

South Asia and the Sub-Saharan Africa account for the largest

proportion of poor people in the world,

0% and 46

East Asia & the Pacic

and South Asia performed very well in poverty reduction over this period,

while Sub-Saharan and Latin American countries made very little improvements

Geography,

along with economic and political institutions,

really matters for economic development

Each region has characteristics that contribute to its economic performance

Europe and East Asia have beneted from their favorable climate and population distribution

Sub-Saharan Africa has a high concentration of land in the tropics,

high population in the interior and low population in coastal regions

South Asia,

Eastern Europe and the former Soviet Union have more population in the interior than along the coasts

South Asia is partly tropical and the most densely populated region in the world whereas the transition economies are non-tropical and least densely populated

Latin America is highly tropical with low population density and moderately coastal population

Inland countries are traditionally believed to grow slower than other

countries due to the disadvantages in transportation and international trade access

Nowadays railroads,

air transport and telecommunications have reduced the advantages of coastlines relative to hinterlands,

but the advantages of sea-based trade remain (Gallup,

Sachs and Mellinger,

Therefore,

it is interesting to examine how the geographical features aect the aid-growth relation in developing countries

Understanding the characteristics of each specic region of the developing world is useful for this discussion

Therefore before proceeding,

it is necessary to briey go over each region's prole

East Asia and the Pacic East Asia and the Pacic has the largest population (1

Consequently,

the percentage of the population below the poverty line (US$1) in this region fell from 26

3% in 1998

Even though the region has suered from the 1997-1998 crisis,

and Thailand have now recovered

After the nancial crisis,

East Asia has reestablished itself as the fastest growing region in the world with a growth rate of 6

which is a surprisingly robust given the slow pace of global recovery and high levels of uncertainty in the world economy

China continued to emerge as a key regional locomotive,

growing by 8% and attracting nearly 40% of the growth in exports of other East Asian economies

Even though the recovery in the region has been aected by a number of unexpected shocks such as the events of September 11,

regional growth exceeded 5% in 2003

In the future,

the outlook for the region remains positive,

provided countries continue to focus on improving institutions,

maintaining sound macroeconomic management,

Furthermore,

countries need to complete the restructuring agendas left over from the crisis,

improve nancial sector supervision and regulation,

and undertake broader reforms to strengthen the investment climate

Europe and Central Asia The economies of Europe and Central Asia showed a good performance in 2002 with average GDP growth of 4

Sub-regional growth diered,

9% and 4

The Turkish economy showed an impressive return from

Connexions module: m13519

Eight of the region's economies exceeded 5%,

Nevertheless,

there are still huge dierences in the levels of poverty and human development and in the conditions necessary for sustainable growth

Per capita income ranges from $200 to $10,070 in Tajikistan and Slovenia respectively,

and the extent of poverty varies from more than 50% of the population in the poorer countries of the region to low single-digit levels in most countries in Central and Eastern Europe

Latin America and the Caribbean (LAC) LAC is a region of vast diversity,

with 526 million people who speak many dierent languages and dialects

It includes the entire continent of South America,

the Caribbean islands and Mexico

LAC is the most urbanized region in the developing world,

with three-quarters of its people living in and around cities,

but natural resources and agriculture remain crucial elements of many LAC economies

Despite immense resources and dynamic societies,

deep inequalities of wealth persist in most LAC countries,

with almost one-third of the region's people living in poverty

Economic performance has not been very good with the instability of some leading economies namely Brazil and Argentina

Over the period 19871998,

the share of the population living on less than US$1 per day in this region remains almost unchanged,

3% and 15

Middle East and North Africa (MENA) MENA is an economically diverse region that includes both oil-rich countries in the Gulf and resourcescarce countries such as Egypt,

Morocco and Yemen

The region's economy over the past years has been inuenced basically by two factors,

the oil price and the mix of economic structure and state policies

In the 1980s,

many countries in the region had undertaken reforms,

which induced tremendous improvements in economic growth by the late 1990s

However,

the region is still facing economic and social problems,

among which the most serious one is the unemployment,

estimated at about 15% of the workforce

There are as twice as many jobless young

people in some countries compared with regional average,

requiring the creation of 4 millions jobs a year in the next few years in order to accommodate new entrants into the labor market

The Iraq war and the ongoing Palestine-Israel conict also had a negative impact on the economic performance of the region in 2002

As a result,

regional economic growth fell from 3

Sub-Saharan Africa Africa has continued to make progress in many areas

Sixteen out of 47 countries achieved on average more than 4% growth over the last decade

Investment and trade trends have been steady

Net foreign

direct investment (FDI) to Africa rose to $6

Africa had the highest returns on FDI in the world,

and the ow of workers' remittances back to the continent doubled in only two years,

Nevertheless,

the continent continues to face enormous development challenges

Half the population lives on less than $1 a day

The share of poor population remains unchanged over the period 1987-1998

This is the region with lowest income per capita and highest population growth

Lack of safe water,

HIV/AIDS and political conicts are the burning issues of the region

Overall GDP growth is roughly 3%,

almost equaling the population growth

Even though the donor community has been providing huge aid amount to this region,

its economic performance is still very poor

Obviously,

the question lies not in the quantity of aid but in its eectiveness,

South Asia South Asia is the second largest region in terms of population in the developing world,

It experienced rapid economic and social development during the 1990s

Although it has been among the world's fastest growing regions,

it remains a region with second highest share of population living below the poverty line,

After years of inward-looking economic policies and tight regulation,

have been contributing largely to the acceleration of economic growth of the region

Connexions module: m13519

Asian nations reduced taris,

dismantled restrictions on domestic and foreign private investment,

and reformed their nancial systems

Average tari rates have declined from between 90% to 100% in the 1980s to between 17% and 32% today

As a result,

the region experienced rapid growth during the 1990s,

3% in 2002

Trade liberalization has been an important component of structural reform eorts among the South Asian countries since the mid-1980s,

with Sri Lanka leading the way

Merchandise trade as a share of

GDP has nearly doubled in some countries in the last decade

Trade liberalization played a positive role in supporting GDP growth rates of 5% and higher

However,

South Asia still has the lowest proportion of foreign direct investment to GDP in the world at just 0

5% of GDP

Despite great improvements in nutrition,

reproductive as well as children's health and education,

this is still a region with many serious problems

Child malnutrition still remains among

the highest in the world with almost 50% of children below the standards for weight by age

South Asian illiteracy rates,

are still the highest in the world

Due to the lack of data,

most of developing countries in Europe and Central Asia are excluded from the sample of this study

Therefore the focus of the study is the countries in East Asia,

South Asia,

Sub-Saharan Africa,

Latin America & the Caribbean and then inland countries

The purpose of the study is to investigate how aid aects growth and how this relation varies across regions of the developing world

Therefore,

the regional dummies and then the slope dummies,

interaction terms of foreign aid with corresponding regions are introduced in the regressions accordingly

The regional dummies enable us to distinguish the intercepts of the focused regions with that of other regions while the slope dummies dierentiate the slope of coecients of those regions with that of the others

East Asia,

South Asia and the Sub-Saharan Africa regions have been chosen for their typical geographical characteristics and dierence in economic performance

Inland (or landlocked) countries are also included to explore how geographical disadvantages aect the aid-growth relation

Chapter IV Methodology and the data 4

Model Based on the endogenous growth theory,

I construct my model following the one that Barro (1991) developed and then incorporate foreign aid as an additional explanatory variable

The major dierence

between endogenous models and the neoclassical ones is that the concept of capital in the endogenous theory is broader in the sense that it includes human capital and there are increasing instead of diminishing returns to scale

Endogenous models rely on the existence of externalities,

increasing returns and a lack of inputs that can not be accumulated (Sala-i-Martin,

On the other hand,

the key assumption of the neoclassical model is that the only dierence across countries lies in their initial level of capital

In reality,

may dier in many other ways such as level of technology,

Therefore,

they may have dierent steady states and the growth rate of an economy is positively related with the distance from its own steady state

A poor country tends to grow faster than a rich country,

but only for a given quantity of human capital (Barro,

In other words,

Barro's model has the following form: where is country i's growth rate of GDP per capita between times t-T and t,

is its level of per capita GDP at time t-T,

and is a vector of other explanatory variables

Compared to the traditional neoclassical models,

this model allows for increasing returns to scale and permanent eects of aid on growth

If the imported capital is of a higher level of technology than domestic capital,

then aid can increase the long-run growth rate

My model takes the following form: where

GROWTH is GDP per capita growth,

INITIALGDP is the GDP per capita

at the beginning of the study period,

SAVING is gross domestic savings over GDP,

FDI is foreign direct investment over GDP,

ODA is ocial development assistance over GDP,

SCHOOL is the number of secondary pupils over population,

TRADE is percentage of trade to GDP,

POPULATION is the population growth rate and

ε is the disturbance term

SAVING and FDI are proxies for physical capital accumulation while SCHOOL

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TRADE is expected to aect growth positively whereas POPULATION does so adversely

ODA (or foreign aid) can go either into physical capital formation if the aid is capital-intensive or into human capital investment if the aid is knowledge or technology intensive

As Burnside and Dollar (1997) indicate,

aid is eective only if it is invested,

I would stress that aid is even more

eective and viable if it is invested in human capital rather than in physical capital of the recipient countries

Barro (1991) argues that economic growth is negatively related with initial GDP per capita holding human capital constant,

while it is positively related with human capital holding initial per capita GDP constant

This implies that the growth rate is expected to be negatively related with the initial level of

income only if countries are similar in investment,

human capital accumulation and population growth rate

The growth rate of those countries,

which have the same level of per capita GDP,

tends to dier depending upon the human capital accumulation

Empirically,

evidence for convergence is found among the US states,

the Japanese prefectures and within OECD countries

The savings rate positively aects growth and the population growth rate does so inversely

Savings

raises capital stock and helps to improve social and economic infrastructure

Theoretically,

high population growth normally entails economic,

social and environmental problems

This implies that countries with

higher savings rates grow faster and those countries with higher population growth rates tend to grow slower

However,

and along with it the rise in the labor force,

is considered to contribute positively to economic growth thanks to the lager pool of available productive labor and greater potential domestic market

whether population growth aects economic growth positively or negatively in labor-surplus developing countries remains a controversial issue (Todaro and Smith,

Trade is the engine of growth,

as seen in the development history of the advanced nations in the nineteenth and early twentieth centuries

Countries benet from trade thanks to the specialization of production based on their comparative advantages and economies of scale

Furthermore,

trade is expected to have a positive impact on growth in the long-run in terms of positive externalities such as imported technology and increased knowledge base

However,

developing countries are currently facing the problem of declining terms of trade,

in which the price of their exports relative to their imports price falls

Trade barriers imposed by the

developed countries are pressing issues nowadays

Theoretically,

foreign direct investment (FDI) is believed to enhance economic growth through improvement in technology,

In short,

it is a channel through which advanced technology and management practices are transferred from developed to developing countries

The impact of ODA or foreign aid though,

still remains ambiguous but likely to be positive in good-policy countries where the reform is initiated by local government and supported timely and eciently by donors

However,

a number of factors such as the fungibility of aid,

poor institutions and corruption or the likes,

may hinder the eciency of aid

How does foreign aid aect growth in developing countries and how does this relation vary across regions

? These are the issues that the study will focus on

Investments in human capital are supposed to be positively related with growth

It is the key input to the research sector,

which generates the new products or ideas that underlie technological progress

Other things being equal,

countries with higher human capital tend to grow faster (Barro,

This implies that the coecient of SCHOOL is conventionally expected to be positive

As mentioned earlier,

in order to investigate the impact of aid on growth across regions,

SOUTHASIA and SUBSAHARA are used for East Asia,

South Asia,

Sub-Saharan Africa regions respectively

Additionally,

an INLAND dummy for inland countries under study is also included

the slope dummies for these respective regions,

ODA*SOUTHASIA,

ODA*SUBSAHARA and ODA*INLAND are incorporated

Estimation techniques The Ordinary Least Squared (OLS) technique is used to estimate the eects of explanatory variables on the GDP per capita growth

White Correction of Standard Errors,

Ramsey RESET and Jarque-Bera tests are conducted to check for the problems of autocorrelation,

wrong functional form use and residual non-normality respectively

A multicollinearity test and F-test for every regression are also conducted correspondingly

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Data description Initially,

I tried to collect data on GDP,

ocial development assistance,

trade and population for 137 developing countries over the period from 1975 to 2000 from World Development Indicators (WDI)

Due to the limitation of data,

nally a sample of 39 countries was obtained

GDP is measured in 1995 constant US$,

whereas gross domestic savings,

FDI and ODA are available in current US$

Therefore the values of these latter three variables has been converted into constant 1995 US$,

using a deator and then computed as a fraction of GDP

The ratio of secondary school pupils to population is used as a proxy for human capital accumulation

The trade variable is measured as the percentage of

GDP and the population variable is the population growth rate

Based on the World Bank (1998) statistics that 1991 is the year when the world foreign aid reached its peak (see Figure 1),

the data set is divided into three subsets,

the sub-periods of 1975-1991 and

Since the focus of the study is the impact of foreign aid on economic growth,

I will concentrate on the coecients of ODA,

the regional dummies and their slope dummies

Other variables will also be discussed from time to time

Chapter V Empirical results and policy implications This chapter describes the regression output for each sub-period 1975-1991 and 1992-2000 as well as the overall period from 1975 to 2000

Based on the empirical results,

the policy implications are discussed correspondingly

In total,

there are 9 regressions for 3 respective periods meaning that there are 3 regressions for every period

Regressions 1,

The regression process is repeatedly similar for each period

In the rst regression of each period,

4 and 7,

has been regressed on the explanatory variables,

namely initial GDP per capita,

SAVING,

SCHOOL,

TRADE and POPULATION

Then regional dummies and their slope dummies,

ODA*SOUTHASIA and ODA*SUBSAHARA,

are included in the second regression of each period,

Finally dummy for inland countries and its slope dummy,

ODA*INLAND are included in the last regression of each period,

Those slope dummies indicate by how much the slope coecient of countries from the above-mentioned regions diers from that of countries in other regions

In the regression analysis,

the White's Correction of Standard Errors have been used whenever heteroskedasticity problem arises

Sub-period 1975-1991 In regression 2,

the Jarque-Bera statistic is 6

which is larger than the critical value at the 5% level,

rejecting the null hypothesis that the residual follows normal distribution

Consequently,

outliers are found in observations 6,

34 and 36

dummies for these outliers are used to detect this non-normality problem

As a result,

the Jarque-Bera statistic then falls to 2

No evidence of autocorrelation,

multicollinearity or wrong functional form was found based on Breusch-Godfrey,

correlation and Ramsey RESET tests respectively

For the period from 1975 to 1991,

there is a strong negative correlation between economic growth and foreign aid (ODA)

The coecient of the ODA variable is consistently negative and signicant at the 10% level across regressions

The coecients of both regional dummy and slope dummy for Sub-Saharan Africa are negative and signicant at the 10% level with t-statistics 1

65 and 1

The INLAND dummy and its slope dummy,

ODA*INLAND,

are positive and signicant at the 15% and 10% levels respectively in regression 3

These results strongly suggest that there are dierences in aid-growth relation between inland countries as well as those in Sub-Saharan Africa and the rest of developing countries from 1975 to 1991

Aid to the sampled inland countries contributes to growth while aid to Sub-Saharan

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Across regressions in Table 1,

the sign of the explanatory variables are basically consistent with the theory

The strongly positive coecient of initial GDP per capita shows a divergence instead of convergence among the countries in the sample

Since these developing countries have dierent levels of technology,

investment and population growth,

they have dierent steady states

Those countries that have higher initial GDP level will accelerate faster

TRADE and SCHOOL have positive impact on economic growth but SAVING,

FDI and POPULATION are insignicant

Sub-period 1992-2000 As shown in Table 2,

the coecient of ODA is negative and signicant in regressions 4 and 6

Note that slope dummies ODA*SOUTHASIA and ODA*EASTASIA are signicant at the 15% level in regression 5 with t-statistics 1

15 and 1

The sign of slope dummy ODA*SOUTHASIA is positive while that of ODA*EASTASIA is negative

However,

the dummies for these two regions,

SOUTHASIA and EASTASIA,

are not signicant suggesting that they have the same intercept but dierent slope

Dummy INLAND and its slope dummy ODA*INLAND are positive and signicant at the 10% level with t-statistics 1

39 and 1

This implies that during the period 1992-2000,

aid has a positive impact on growth in the studied inland countries and a dierentially positive impact on growth in South Asian countries

The coecients SUB-SAHARA and of ODA*SUBSAHARA are insignicant in regression 5

Other explanatory variables are consistent across regressions with positive coecients of initial level of GDP per capita (i

SAVING,

TRADE and SCHOOL

The coecients of FDI and POPULATION are insignicant

Overall period 1975-2000 As Table 3 shows,

the coecient of ODA is consistently negative and signicant at the 5% level across all regressions

The coecients of regional dummy SUBSAHARA and its slope dummy ODA*SUBSAHARA are negative and signicant at the 10% and 15% level respectively in regression 8

Dummy INLAND and its slope dummy ODA*INLAND are positive and signicant at the 10% level in regression 9

These are

evidences further consolidate the results of previous regressions that aid to the studied inland countries contributes to growth while aid to Sub-Saharan Africa hinders growth

The coecients of other variables,

GDP1975,

TRADE and SCHOOL are positive and signicant

SAVING and FDI are insignicant across regressions for this overall period

Policy Implications 5

Implications of the negative relation between aid and growth From the above regression results,

the following ndings can be summarized (i) in general,

economic growth has negative relation with foreign aid in the developing countries (ii) foreign aid to the studied inland countries as well as South Asian countries during the period 1992-2000 has positive impact on growth and (iii) there is strong divergence trend among countries in the sample

As discussed above,

the foreign aid is likely to hinder the economic growth for some reasons

In countries where the institutional environment is distorted,

aid could be fungible into nancing the government's consumption instead of being eectively invested

Saving displacement,

aid dependency enhancement also badly aects growth of the recipient countries

Foreign aid and windfalls in countries characterized by a

divided policy process are associated with increased corruption (Svensson,

Foreign aid reduces longrun capital accumulation and labor supply (Gong and Zou,

Moreover,

depending on the marginal propensity to spend on the export goods and the conditions of aid,

the foreign aid can possibly improve the donor's terms of trade while make the recipient worse o (Krugman and Obsfeld,

The negative relation between aid and growth is nothing new in the aid literature and this is just an additional evidence of this kind

However,

it is noteworthy that the coecient of aid is consistently negative and highly signicant across regressions

This results force us to think more carefully about how to improve the eectiveness of aid

Reforms are certainly necessary,

not only for recipients but also for donors,

especially multilateral aid agencies

It is widely accepted that aid works well in good-policy environment and in reality there are many good examples of success,

Uganda,

Viet Nam,

India etc (World Bank,

Aid is more eective when it is used to facilitate timely and eciently the reforms initiated by the local governments,

Put it another way,

the reform should be internalized,

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What aid does is to help good governments to survive long enough to solve the problems (World Bank,

Countries may learn from the successful experiences of others,

to tailor appropriately their own action plans

Aid is more eective and viable if it nances government

bureaucrats training or policymakers' overseas education and then nurtures the reforms initiated by them

In reality,

the World Bank structural adjustment programs and IMF stabilization programs failed in many cases due to the lack of appropriateness and strict penalty upon bad performance

What important is the ownership,

which infers the commitment to prudent economic policies among the policymakers (Graham and O'Hanlon,

Conditionality is unlikely to bring about lasting reform if there is no strong domestic movement for change (World Bank,

Therefore,

conditionality should work in the way that ensures the eectiveness of loan where the reforms are in place

Rewarding good performers in aid allocation is a good way to encourage other recipient countries to learn from them

More importantly,

the penalty should be implemented strictly upon the violation of conditional terms

Loans should be postponed or even terminated unless further positive evidence is accorded

The current patterns of channeling aid through centralized governments in recipient countries may reduce the timeliness and eciency of aid

It is found that the aid is more eective if it is delivered directly to the working level local authorities

the emerging role of NGO community is widely attracting attention (World Bank,

The present coordination and cooperation among donors is problematic

Most of donors and aid agencies have their own objectives and dierent plans in providing aid

Raising ag is a common phenomenon among donors and aid agencies

Therefore,

they are normally stepping on each other's toes by undertaking dierent approaches

As a result,

the overall aid eectiveness on the growth of the nation most of the time fails to succeed,

even though many aid projects are assessed eectively

This explains

while receive so much aid from dierent resources,

Moreover,

it has been found that program aid and technical aid are more eective and sustainable than project aid (Marvrotas,

it is better to nance long-term and strategic programs rather than short-term projects

But what matters here are the incentives of donors,

in disbursement rather than in compliance enforcement

Short-term projects are likely to provide them quicker and more easy-to-achieve results than long-term,

Donors have strong

incentives to continue lending even though the conditions are not met

For instance,

World Bank must make loans to remain in operation (Graham and O'Hanlon,

The results that foreign aid to Sub-Saharan Africa has negative impact on growth (regressions 2 and 8) are consistent with previous nding of Collier and Gunning (1999)

As the matter of fact,

the aftermath of colonialism is more serious in Africa than anywhere else

Sub-Sahara Africa is especially hindered by its tropical location,

small portion of people living near the coast,

and low coastal population density (Gallup,

Sachs and Mellinger,

Weak institutions,

widespread corruption and various ethnic,

political and religious conicts are holding up this region for long time

Africa is especially vulnerable to terms of trade shocks,

It is found that African nations have aid-to-GNP ratios more than ten times that of

Latin America or East Asia,

but still suer inferior economic performance

Problematically,

countries with poor economic policies have received more aid per capita than those with responsible policies (Graham and O'Hanlon,

In a distorted environment of Africa,

if donors just simply provide aid with the same uniformed conditionality like elsewhere,

Figure 2 shows a typical example of Zambia,

received such a huge amount of aid,

yet the income per capita is only around US$600,

not US$20,000 as expected (World Bank,

Nigeria,

Tanzania may also be examples of failures

Even though there some success stories,

Mauritius,

Ethiopia,

Rwanda,

Mali and Uganda,

they account for such a small number out of aid recipient countries in the continent

The major cause is that donors do not favor good policy countries and penalize the poor performers

Consequently,

the aid dependency is getting more and more serious

Widespread corruption and fungible aid also make the situation worse

The policy implication here is that for Africa,

the money aid is necessary but the idea aid is even more important

It would be more sustainable if aid supports the policymakers training or education and then

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nurtures institutional reforms initiated by these well-trained policymakers

Put it another way,

aid better be the midwife of a good policy

There may be an urgent need of a special mechanism for Africa focusing on education reforms based on successful cases of some countries

Leaders in African countries should

play an active role in initiating and sustaining anti-corruption campaigns,

public administration and legal system reforms

From the experience of Indonesia,

where overseas educated bureaucrats ignite and sustain the institutional reform process,

aid could be more eective to nance the overseas education of young and potential leaders

However,

this is a very long-term human capital investment,

of which the outcomes are still ambiguous

Therefore,

it is unlikely that donors have any interest in these types of programs,

unless they really think strategically and forego their short-term incentives

Additionally,

better conditionality is certainly important,

in the sense that it should be persistent and strict,

rewarding good performers and strictly penalizing bad ones

By and large,

there are many things that need to be improved by both donors and recipients

For recipients,

the policy and institutional environment must be improved with willingness and a strong commitment to reform

For donors,

better assessment criteria and conditionality must be applied,

more ecient coordination and cooperation and last but not least,

Experience of inland countries and South Asian nations during the period 1992 to 2000 Based on the results that foreign aid to the studied inland countries and South Asian nations during the period of 1992-2000 has positive impacts on growth,

it is interesting to review the experience of those countries recently

Let's look at the recent experience of inland countries rst

Among 7 inland countries in the study,

there are 2 Latin American countries,

Bolivia and Paraguay,

Botswana,

Mali and Rwanda and 1 country from Middle East,

Most of these countries have undergone successful institutional and nancial reforms,

and intensive investments in human capital recently

Therefore,

despite the unfavorable natural conditions of the landlocked location,

many of them have achieved tremendous economic performance

Botswana is one of the fastest growing countries in the developing world with a GDP growth rate of 7% over the past two decades

Benin achieves a 4

Rwanda has grown at between 6 to 9% during the period 1994 to present

Jordan and Mali attain 4

38% and 2

Bolivia and Paraguay are recovering from recession

With the exception of diamond trade in Botswana,

are endowed with very scare natural resources and disadvantages in climate and international sea transportation access

However,

each of them has their own approach to economic improvement

Jordan has been investing intensively in education and trade promotion

Mali concentrates on macroeconomic stabilization and economic liberalization

Rwanda focuses on policy and institutional reforms for instance rationalizing the tax system,

improving expenditure management,

removing ghost workers from public service payrolls,

launching privatization program,

granting independence to the Central Bank,

liberalizing exchange rates and prices,

implementing nancial reform and reducing taris

Benin has been strengthening economic management since 1990s

The government of Botswana has managed the country's resources prudently,

controlled expenditure and invested in human and physical capital

Bolivia,

after a time of diculty and uncertainty,

has paid much attention to improving its critical infrastructure,

expanding the basic services and strengthening public institutions

The donor

and NGO community plays an important role in the reform process in most of these countries,

Benin and Botswana

Recent experience of some South Asian countries in the study is another good example of success

Bangladesh has performed relatively well over the last decade with average annual GDP growth of 5% with more and more entrepreneurs emerging recently

Good macroeconomic management has kept ination relatively low

Recent reforms in scal management,

telecommunication and energy have shown promising results

Increasing FDI ows with the amount of private FDI of nearly US$ 400 million in scal year 1997-1998 strengthened infrastructure,

energy and export-oriented industries (World Bank,

The National Strategy for Economic Growth,

Poverty Reduction and Social Development,

which is Bangladesh's Interim Poverty Reduction Strategy,

aims to substantially reduce chronic poverty and in-

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It focuses on ve key areas (i) pro-poor economic growth for increasing income and employment of the poor (ii) human development of the poor through education,

and social interventions (iii) women's advancement and closing of gender gaps in development (iv) social safety nets for the poor and (v) participatory governance for enhancing the voice of the poor and improving well being in areas such as security and social inclusion and removing institutional hurdles to social mobility

The strategy also sets a medium-term macroeconomic framework and addresses the issues of trade reforms,

It is noteworthy that the NGO community in Bangladesh is one of the most active in the world

The strong partnership between government and NGO community in many areas such as micro-credit,

non formal education and assistance with social mobilization has contributed eectively to the successful economic performance of the country

Pakistan has made signicant development progress in its 56 years since independence

Health and

education services have expanded and improved,