The Impact Of Foreign Aid On Economic Growth Essay

Abstraction

The monolithic outgos on foreign assistance plans by developed states and international establishments, in combination with the sensed deficiency of consequences from these expenses, raise of import inquiries as to the existent effectivity of pecuniary aid to less developed states ( LDCs ) . In this analysis, I focus on 119 low- and medium-development states, and mensurate the impact that foreign assistance has on their growing rates of gross domestic merchandise, utilizing dummy variables for geographics and struggle in a geometric slowdown theoretical account.

The consequences indicate that foreign assistance contributions do hold a positive impact on the economic growing of the recipient state. The consequence is highly modest, nevertheless, and other factors such as armed struggle and geographics can easy extenuate this impact, in some instances to the extent that foreign assistance becomes damaging to economic growing. Further analysis of the consequences indicate that this impact is rapidly felt, with half of the entire impact of foreign assistance felt in about six months.

Cardinal Wordss: Foreign assistance, economic growing, economic development

Table of Contentss

1. Introduction 5

2. Literature Review 6

3. Methodology 10

3.1 Datas 10

Table 1: Datas Beginnings 11

3.2 Model Specification 12

3.3 Expected Consequences 13

4. Consequences and Analysis 14

Table 3: Factors Influencing Aid Effectiveness 17

Graph 1: Accumulative Impact of Foreign Aid on Growth 19

5. Decisions and Suggestions for Future Research 19

Mentions 22

24

Appendix A: Included States 25

Appendix B: Autocorrelation Test Results 26

Appendix C: Heteroskedasticity Test Results 26

Appendix D: Correlation Matrix 28

1. Introduction

Over the last half century, foreign assistance has emerged as a dominant scheme for relieving poorness in the 3rd universe. Not coincidently, during this clip period major international establishments, such as the United Nations, World Bank, and International Monetary Fund gained prominence in planetary economic personal businesss.[ 1 ]Yet it seems that sixty old ages subsequently, the lesser developed states ( LDCs ) of the universe continue to endure from economic adversity, raising inquiries of whether foreign assistance is a worthwhile and effectual attack to hiking growing and development in recipient economic systems. Research on the topic has attempted to pull an empirical connexion between foreign assistance and economic growing. Despite these attempts, nevertheless, there is no solid consensus among bookmans on the existent effectivity of foreign assistance influxs.[ 2 ]

The term “ foreign assistance ” can connote a figure of different activities, runing from human-centered support in the aftermath of natural catastrophes to military aid and weaponries contributions.[ 3 ]For the intents of this analysis, nevertheless, I refer to the standard definition of “ official development aid, ” or help that is aimed at increasing economic development, and has a grant constituent of at least 25 % of the entire assistance bundle.[ 4 ]Critics of development aid cite a assortment of grounds why it is a hapless scheme for battling planetary poorness. Some argue that it can engender corruptness, weaken answerability, and do authorities to go overly big.[ 5 ]However, as research workers Hansen and Tarp ( 2000 ) write, “ it is neither analytically defendable or through empirical observation believable to reason from the beginning that aid ne’er works. ”[ 6 ]Indeed, a figure of surveies have shown a positive relationship between foreign assistance and economic growing, particularly in states which have responsible economic policies sing trade, rising prices, and other macroeconomic concerns.

The intent of this analysis is to analyze the effects of foreign assistance influxs on existent gross domestic merchandise growing rates. It differs from bing research in two cardinal ways. First, I utilize a geometric slowdown theoretical account to capture the continued impact of foreign assistance influxs for old ages after its initial debut into the economic system.[ 7 ]Second, I incorporate several silent person variables for geographics, political stableness, and development to find their extra impact on foreign assistance ‘s effectivity in turning GDP.

2. Literature Reappraisal

There are two contrasting sides to this argument: one which argues that assistance has a positive consequence on economic growing, with even more impact in states with sound economic and trade policies ; and another which contends that foreign assistance causes corruptness, encourages rent-seeking behaviour, and erodes bureaucratic establishments. A renewed involvement in explicating cross-country economic growing emerged in the early 1990s, with legion surveies trying to reply the foreign assistance inquiry. To day of the month, nevertheless, there is no consensus among bookmans as to the existent effects of foreign assistance on economic growing.

There have been several outstanding surveies which find a causal nexus between foreign assistance and economic growing. Possibly the most well-known of these was performed by two research workers for the World Bank, Craig Burnside and David Dollar ( 1997 ) . They found that foreign assistance enhances economic growing, so long as “ good ” financial policies are in topographic point. These policies can include keeping little budget shortages, commanding rising prices, and being unfastened to planetary trade.[ 8 ]Durbarry, et. Al. ( 1998 ) besides found a positive association between foreign assistance and economic growing, and confirmed Burnside and Dollar ‘s determination of conditionality on good economic policy. The survey besides concluded, nevertheless, that the grade to which assistance impacts GDP depends mostly on other factors as good, such as geographics.[ 9 ]Ali and Isse ( 2005 ) further confirmed the findings of Burnside and Dollar. The survey besides demonstrated, though, that assistance is capable to diminishing fringy returns, bespeaking a threshold beyond which development aid can go damaging to economic growing.[ 10 ]

Not all research has shown a positive relationship to be between assistance and growing. Even before Burnside and Dollar ‘s monumental findings, a survey by Peter Boone ( 1994 ) found that aid-intensive African states experienced zero per capita economic growing in the 1970s and 80s, despite foreign assistance really increasing ( as measured by portion of GDP ) .[ 11 ]Additionally, Knack ( 2001 ) found that high degrees of foreign assistance can gnaw bureaucratic and institutional quality, triping corruptness, and promoting rent-seeking behaviour.[ 12 ]

There is besides grounds that the effects of foreign assistance can be mitigated by other non-economic factors. Situations of province failure, such as cultural struggle, race murder or politicide, and revolution can all potentially influence the extent to which assistance impacts growing. George Mason University ‘s Political Instability Task Force ( PITF ) created a binary dataset indicating in which states and during what old ages these events take topographic point. Harmonizing to the PITF, an cultural struggle requires the clang of two separate cultural, spiritual, or chauvinistic cabals, and besides must run into two threshold standards: 1,000 people must be mobilized for armed struggle, and at least 1,000 people per twelvemonth must hold died as a direct consequence of this struggle.

Similarly, revolutions are defined as episodes of violent struggle between political groups in hopes of subverting the current government, and must run into the same threshold standards as cultural wars. Finally, race murder and politicides are defined in a somewhat different mode. These events occur when the group in power carries out sustained policies that target cultural, spiritual, or political challengers, finally ensuing in the deceases of a “ significant ” part of one of those groups.[ 13 ]

Easterly and Levine ( 1997 ) studied the effects of high cultural fractionalization on economic growing. By fractionalization, they mean the chance that two indiscriminately chosen people from a population will be of different ethno-linguistic backgrounds. Easterly and Levine conclude that motion from heterogeneousness to homogeneousness ( diminishing fractionalization ) consequences in better schooling, more efficient substructures, and more developed fiscal systems and foreign exchange markets.[ 14 ]Harmonizing to their findings, so, it is wholly possible that cultural struggle, in its effort to travel off from cultural diverseness and towards cultural homogeneousness, will really better economic growing. Despite their findings, nevertheless, the instability of the government could still negatively impact the grade of assistance ‘s effectivity.

Not a batch of attending is paid to genocide, politicide, and revolution and their effects on growing in the literature. Furthermore, there has been virtually no research performed on this inquiry as it concerns the effectivity of assistance. It is sensible to believe, though, that resources ( including foreign assistance ) are siphoned off by the dominant party and used for single benefit instead than for economically efficient activities, as intended.

Furthermore, out of regard for province sovereignty, these events are non likely to motivate a major international response, which would possibly extinguish local control over resources and let them to be used fruitfully. Cultural struggle, on the other manus, typically ignores province boundaries. One survey by Gurr ( 1993 ) estimated that over two-thirds of identified cultural communal groups in the universe have kindred in another state. The spread across province boundary lines allows other provinces to step in without go againsting province sovereignty, which could positively impact how resources are used, and finally, economic growing.

Additionally, a state ‘s geographic location can act upon economic public presentation ; states that are landlocked, for case, are at a natural disadvantage in planetary trade. Sachs and Warner ( 1996 ) write,

Landlocked states, in peculiar, face really high costs of transportation, since they must pay route conveyance costs across at least on international boundary in add-on to sea cargo costs. Although air cargos can assist get the better of many of these jobs, merely certain goods can be economically shipped by air, and most states still import and export the bulk of goods by the sea.[ 15 ]

A study by the UN Economic and Social Commission for Asia and the Pacific ( 1999 ) specifically mentions the positive relationship between assistance and growing in landlocked states, observing that they are at a disadvantage for these grounds, every bit good.[ 16 ]Due to their geographical place, so, landlocked states could potentially profit from foreign aid, as it may make full the spread in trade that they experience comparative to states with easy entree to international trade.

3. Methodology

3.1 Datas

I direct the focal point of this analysis to low- and medium-development states as defined by the United Nations Development Programme ( UNDP ) in its Human Development Index ( HDI ) .[ 17 ]These states were selected since they are the most likely to be receivers of foreign assistance, whereas high-development states are the most likely to be givers. I select the HDI as a footing for categorization because in add-on to income, the index histories for life anticipation as measured by infant mortality rates, and educational attainment as measured by grownup literacy rates and gross registration ratios for primary, secondary, and third schools. This provides for a more thorough apprehension of a state ‘s phase of development and a comprehensive step of quality of life.[ 18 ]In all, 119 states of the 177 analyzed by the UNDP ( 67 % ) meet the development standards and were included in this survey.[ 19 ]

Due to informations handiness issues, I restrict the scope of this survey to the period from 1980 to 2003. With 119 cross subdivisions, there is a possible 2,856 observations over this clip span. After taking into history losing informations for the independent variables included in the theoretical account, 1,760 remain, or about 62 % . A huge bulk of the losing information is a consequence of the overall deficiency of information sing Sub-Saharan Africa and Soviet axis states during the early 1980s. Furthermore, I aim to mensurate the impact of foreign assistance on norm, across both clip and states. Therefore, I employ pooled informations analysis.

I collect the information in one-year format from several beginnings. Most of the informations come from the United Nations Conference on Trade and Development ( UNCTAD )[ 20 ]and the International Monetary Fund ( IMF ) .[ 21 ]Table 1 below lists the variables included in this survey and the beginning from which they were gathered:

Table 1: Datas Beginnings

Variable

Unit of measurement

Beginning

Gross Domestic Product

Growth Rate

International monetary fund

Official Development Assistance

Millions $ US

UNCTAD

Family Consumption

Growth Rate

UNCTAD

Government Outgos

Growth Rate

UNCTAD

Exports*Petroleum Exporter

Growth Rate

UNCTAD

Imports

Growth Rate

UNCTAD

Agricultural Production

Growth Rate

UNCTAD

Gross Capital Formation

Growth Rate

UNCTAD

Inflation

Growth Rate

International monetary fund

Openness to Trade[ 22 ]

Share of GDP

UNCTAD

Energy Consumption Per Capita

Millions of BTUs

Energy Information Agency, U.S. Dept of Energy

Major Petroleum Exporter Dummy

1=Yes, 0=Otherwise

UNCTAD

Non-Tropics Dummy[ 23 ]

1=Yes, 0=Otherwise

IUCN World Conservation Union

Foreign Direct Investment Inflows

Millions $ US

UNCTAD

Cultural Conflict Dummy

1=Yes, 0=Otherwise

Political Instability Task Force, University of Maryland

Genocide Dummy

1=Yes, 0=Otherwise

Political Instability Task Force, University of Maryland

Revolution Dummy

1=Yes, 0=Otherwise

Political Instability Task Force, University of Maryland

Landlocked Country Dummy

1=Yes, 0=Otherwise

UNCTAD

Low Development Dummy

1=Yes, 0=Otherwise

United Nations Development Programme

Data for family ingestion, authorities outgos, exports, imports, agricultural production, and gross capital formation were merely available in portion of GDP format. Since I aim to explicate growing rates in GDP, nevertheless, per centum alterations in the dollar sums of each of these variables would be more appropriate. Therefore, I transform these Numberss into growing rates every bit good.[ 24 ]

3.2 Model Specification

I assume that influxs of foreign assistance will go on to impact the economic system for old ages after its initial debut, but at a diminishing rate. It would hence be unsuitable to utilize an ordinary least squares theoretical account, since it would merely take into history assistance influxs in the twelvemonth they were received and ignore the continued impact that foreign assistance has on the economic system in the old ages after its debut. To efficaciously capture this principle, I use a geometric slowdown theoretical account which incorporates an infinite figure of slowdowns for each variable, but weights each slowdown in a geometrically worsening manner. The general signifier of this type of theoretical account is:

( 1 )

Note that in the theoretical account a weight is attached to each slowdown ( I» ) , a value between zero and one that diminishes geometrically as clip base on ballss. Mathematically, this theoretical account is the same as:[ 25 ]

( 2 )

This simpler signifier, nevertheless, shows the dependent variable Yttrium on the right side of the equation. Since Y is already shown to hold an mistake constituent in ( 1 ) , this simplification introduces a stochastic regressor into the theoretical account, necessitating two-stage least squares ( TSLS ) arrested development. In order to guarantee the instruments required for TSLS are non-stochastic, I lag each one period. Therefore, to the perceiver at clip T, values for instruments at t-1 are fixed. In other words, these instruments are stochastic but predetermined.

3.3 Expected Consequences

I expect to happen a positive relationship between foreign assistance and economic growing on norm, as indicated by most anterior research on this topic. I farther anticipate, nevertheless, that assistance will hold a damaging consequence on low-development states since they lack efficient substructures and establishments which might do foreign assistance contributions more effectual. I expect cultural struggle, race murder and revolution to negatively act upon the effectivity of foreign assistance, but leave unfastened the possibility that cultural struggle could positively act upon assistance ‘s impact based on Easterly ‘s survey. Furthermore, I expect landlocked states to see extra positive additions from foreign assistance, since they are at a trade disadvantage.

4. Consequences and Analysis

The consequences of the TSLS arrested development are shown below in Table 2:

Table 2: TSLS Regression Consequences

Parameter

Estimate

Std. Mistake

t-Statistic

Prob.

Changeless Term

0.091

0.400

0.228

0.820

GDP ( -1 ) [ Lambda ]

0.233

0.087

2.692

0.007

Family Consumption

6.307

2.241

2.814

0.005

Government Outgos

4.505

1.305

3.452

0.001

Exports*Petroleum Exporter

9.825

1.866

5.266

0.000

Imports

-3.746

0.963

-3.891

0.000

Agricultural Production

10.976

1.992

5.510

0.000

Gross Capital Formation

7.262

0.834

8.703

0.000

Inflation

-0.001

0.000

-2.282

0.023

Openness to Trade

0.020

0.005

4.301

0.000

Energy Consumption

-0.013

0.004

-3.212

0.001

Energy Cons. *Low Dev.

-0.052

0.014

-3.822

0.000

Less than Half of Land in Tropics ( 1=Yes )

0.742

0.326

2.275

0.023

Foreign Direct Investment

0.000

0.000

2.124

0.034

Foreign Aid

0.001

0.000

3.233

0.001

Foreign Aid*Ethnic Conflict

0.001

0.000

2.202

0.028

Foreign Aid*Genocide*Low Dev.

-0.017

0.009

-1.948

0.052

Foreign Aid*Revolution

-0.001

0.000

-2.731

0.006

Foreign Aid*Landlocked

0.002

0.001

1.847

0.065

Foreign Aid*Landlocked*Low Dev.

-0.003

0.001

-2.320

0.021

R-squared

0.415

S.E. of arrested development

4.535

Adjusted R-squared

0.408

Durbin-Watson stat

2.069

The theoretical account can be written as in general footings as follows:

( 3 )

Where:

GDP = Gross Domestic Product Growth Rate ( for state I at clip T )

ODA = Official Development Assistance ( for state I at clip T )

DUMMY = Vector for Dummy Variables ( for state I at clip T )

Z = Vector for All Other Variables ( for state I at clip T )

The consequences of the arrested development indicate that about 42 % of the fluctuation in GDP growing rates is explained by the variables included in the theoretical account, as evidenced by the R-squared value. Further, each coefficient estimation is important at the 0.05 degree, with the exclusion of a few boundary line instances and the changeless term. These coefficients are besides consistent with my outlooks, nevertheless the coefficient for the cultural struggle silent person did turn out to be in harmoniousness with Easterly ‘s survey of cultural fractionalization.

The Durbin-Watson statistic fails to once and for all find the presence of consecutive correlativity. Further analysis of the remainders, nevertheless, indicates that it is non a statistically important job.[ 26 ]The theoretical account was besides tested for the presence of heteroskedasticity, both across clip and cross subdivisions utilizing the Breusch-Pagan Test. The consequences of this trial fail to demo statistically important grounds of heteroskedasticity.[ 27 ]Multicollinearity was investigated utilizing a correlativity matrix of the regressors, but no major grounds of this anomalousness was detected, either.[ 28 ]

The consequences provide insight as to foreign assistance ‘s effectivity in a figure of ways. Most obvious is that it is has a positive, though modest consequence on economic growing, important at the 0.01 degree. Increasing foreign assistance by $ 1 million US will ensue in an addition in GDP of about 0.001 % , ceteris paribus. Harmonizing to the information, the mean one-year sum of official development aid received over all old ages and states is about $ 570 million US. In this instance, assistance is estimated to increase growing in GDP by about 0.6 % .

As shown in Table 3, nevertheless, this impact can be greatly diminished by other factors, in some instances to the point where assistance really becomes damaging to growing. Using the baseline instance of a state with no cultural struggle, revolution, or race murder, which is non landlocked, and does non endure from low development, I estimate the extra impacts of any of those fortunes on economic growing. Those factors with N/A listed under “ Impact ” were non statistically important at the 0.05 degree.[ 29 ]

Table 3: Factors Influencing Aid Effectiveness

Factor

Impact

Overall Impact of Aid + Additional Factor ( s ) on GDP

Cultural Conflict

0.001

0.002

Cultural Conflict in Low Development Countries

N/A

N/A

Genocide/Politicide

N/A

N/A

Genocide/Politicide in Low Development Countries

-0.017

-0.016

Revolution

-0.001

0.000

Revolution in Low Development Countries

N/A

N/A

Landlocked State

0.002

0.003

Landlocked Country with Low Development

-0.003

-0.002

The theoretical account indicates that foreign aid really becomes damaging to growing in state of affairss where there is genocide or politicide in low development states, as predicted. I attribute this to the fact that resources are typically controlled by the dominant party in genocidal struggles, and it is likely that assistance dollars are siphoned off and used for their ain benefit alternatively of productive and efficient activities. Revolutionary struggle eliminates wholly the impact assistance has on the economic system, ensuing a net consequence of about nothing. I argue that this is the instance because the establishments required to efficaciously use foreign aid are in hazard during a major transportation of power, cut downing their ability to move expeditiously and administer assistance dollars harmonizing to the state ‘s best involvements. Interestingly, cultural struggle really increases the effectivity of assistance. This determination is consistent with Easterly ‘s survey of cultural fractionalization and its impact on economic growing.

In landlocked states, assistance is peculiarly effectual, trebling the extent to which it impacts economic growing. As Sachs and Warner pointed out, landlocked states are limited in their ability to prosecute in planetary trade. Therefore, it seems sensible that foreign assistance positively impacts growing in these countries since their capacity to prosecute in trade is restricted. However, in low-development states that are landlocked, this relationship no longer holds. This indicates that whatever benefits assistance has in landlocked states is reversed in low-development states, perchance due to hapless institutional quality, corruptness, or other factors.

As for other variables besides foreign assistance, the theoretical account shows the consequence of foreign direct investing ( FDI ) on economic growing is surprisingly little ; an addition of merely 0.00003 % in GDP for every $ 1 million US invested. In contrast, foreign assistance encouragements GDP by 0.001 % with the same sum of money. This indicates that foreign assistance has a well greater impact on growing than foreign direct investing, all else equal. Harmonizing to the theoretical account, being unfastened to merchandise seems to be a much more effectual scheme in turning the economic system, even more so than foreign assistance and FDI. It is of import to observe, nevertheless, that since openness to merchandise is measured as a portion of GDP, the impact is non straight comparable that of foreign assistance or FDI, since economic systems included in this survey vary greatly in size.

To quantify how rapidly foreign assistance impacts the economic growing of a state, I calculate the average slowdown as outlined by Davies and Quinlivian ( 2006 ) .[ 30 ]This step estimates how rapidly half of the impact of foreign aid is felt, and is calculated as follows:

Median Lag = = 0.477 ( 4 )

A average slowdown of 0.477 indicates that in about 5.7 months, half of the full impact of foreign assistance on GDP growing will be realized. One-half of the staying impact is so felt in another 5.7 months, and so on, as the cumulative impact of the assistance asymptotically approaches 100 % . This phenomenon is illustrated in Chart 1 below.

Graph 1: Accumulative Impact of Foreign Aid on Growth

The average slowdown indicates that assistance can rapidly impact an economic system, but for a comparatively short sum of clip. After merely two old ages of circulation in the recipient economic system, over 95 % of the entire impact of foreign assistance is experienced.

5. Decisions and Suggestions for Future Research

The intent of this analysis was to find the effects of development aid on economic growing. The theoretical account developed in this paper provides grounds back uping the contention that foreign assistance positively impacts economic growing in the underdeveloped universe. Therefore, it is non in the involvement of developed states and international organic structures to stop assistance plans. Furthermore, as Gunning ( 2004 ) points out, it would be highly hard for a donor state to halt assistance since it would be seen by both the domestic and foreign populations as penalizing an already hapless state.[ 31 ]

The theoretical account besides shows, nevertheless, that the effects of assistance on economic growing are modest, and “ purchasing ” economic growing through foreign assistance would be improbably inefficient and expensive. For case, utilizing foreign assistance entirely to increase GDP by 1 % in a state would necessitate a foreign assistance bundle of about $ 1 billion US. With about 120 states identified as low- and medium-development, spurring economic growing in developing universe to desirable degrees would be an tremendous outgo. This besides assumes that the negative effects of struggle and geographics shown to be important in the theoretical account do non use, and ignores the possible jobs of assistance dependance, corruptness, and bureaucratic eroding that research has associated with high degrees of foreign assistance.

The aforesaid surveies by Burnside and Dollar ( 1997 ) and others have shown assistance to be more effectual in sound economic policy environments. Therefore, donor authoritiess and many-sided establishments should go on to force economic reforms and trade liberalisation on recipient authoritiess. Not merely will this better the effectivity of foreign assistance harmonizing to these surveies, but it will besides ensue in less assistance being required.

The armed struggle silent persons indicate, with the exclusion of cultural struggle, that province failure and political instability reverse the positive consequence of assistance, even doing it damaging to economic growing in some instances. Therefore, donor authoritiess should be cognizant of the political state of affairss in receiver states, and work with international organic structures to guarantee as much stableness as possible. Further, since geographics is basically fixed, foreign assistance contributions to landlocked states should be designed to ease betterments in transit substructures, which increase their capacity to prosecute in trade.

Future research should farther research the function of sound economic policies and good administration in assistance effectivity. Scholars should besides research other ways of quantifying clime, tropical geographics, and administration to supply for extra testing of possible impacts on the effectivity of foreign assistance. Finally, future survey of foreign assistance should besides look into its effects on economic development, alternatively of growing. Doing so will cast visible radiation on the inquiry of whether assistance really improves the quality of life in lesser developed states.

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