Aid, growth and institutions in Sub‐Saharan Africa: New insights using a multiple growth regime approach

• Author: Rasmane Ouedraogo,Hamidou Sawadogo,Windemanegda Sandrine Sourouema
• Published date: 01 January 2021
• DOI: http://doi.org/10.1111/twec.12968
• Date: 01 January 2021

World Econ. 2021;44:107–142. wileyonlinelibrary.com/journal/twec

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© 2020 John Wiley & Sons Ltd

Received: 28 May 2018

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Revised: 21 April 2020

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Accepted: 1 May 2020

DOI: 10.1111/twec.12968

ORIGINAL ARTICLE

Aid, growth and institutions in Sub-Saharan Africa:

New insights using a multiple growth regime

approach

RasmaneOuedraogo1

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Windemanegda SandrineSourouema2

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HamidouSawadogo2

1International Monetary Fund, Washington, D.C., USA

2Universite de Ouagadougou, Ouagadougou, Burkina Faso

KEYWORDS

economic growth, foreign aid, heterogeneity, institutions, sub-Saharan Africa

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INTRODUCTION

So far, the body of economic literature on foreign aid has mainly focused on foreign aid effectiveness,

in an attempt to answer the key question of whether aid, as it purports, indeed promotes growth. Most

of the literature addressed this issue within the aid allocation framework and provided mixed results.

Hansen and Tarp (2000), Burnside and Dollar (2000), Askarov and Doucouliagos (2015) shed light

evidence for positive impact of aid on economic growth; Mavrotas (2002), Brautigam and Knack

(2004), Ekanayake and Chatrna (2009) find evidence for the negative impact of aid on growth; some

authors including Boone (1996), and Jensen and Paldam (2003) argue that aid has no impact on

growth.

Instead, the role of institutions is most frequently cited in aid efficacy. The seminal work by

Burnside and Dollar (2000) found that foreign aid leads to more economic growth in countries with fa-

vourable macroeconomic environments (moderate inflation, lower fiscal deficits and trade openness).

In this regard, the World Bank (1998) concluded that financial aid works best in an encouraging policy

environment, and financial assistance must be targeted more effectively to low-income countries with

sound economic management. This conclusion led to significant controversy—and thus further em-

pirical studies on the effectiveness of foreign aid. Subsequent studies have shown that results depend

on the sampling, the time period, the empirical methodology, the definition of aid and the institutional

variables (see Easterly,2003; Easterly, Levine, & Roodman,2004).

Of course, the effectiveness of aid can be approached from myriad quantitative angles. Some fo-

cused on the non-linearity effect of aid by interacting aid with institutional and macroeconomic vari-

ables (see Burnside & Dollar,2000, 2004). Some studies looked for one or multiple thresholds which

empirically differentiated aid–growth relationships according to the level of aid or institutions (see

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Combes, Ouedraogo, & Tapsoba,2016; Gomanee, Girma, & Morrissey, 2003), while others included

aid variable and its square (see Burnside & Dollar,2000; Guillaumont & Guillaumont-Jeanneney,

2006a, 2006b; Guillaumont & Chauvet,2001, 2004). However, as pointed out by Guillaumont and

Guillaumont-Jeanneney (2006a), introducing squared and cubic aid terms could make it difficult to

simultaneously treat possible conditional effects of aid. Furthermore, studies employing threshold

models assume that the threshold is the same for all countries, which can be problematic given the

very specific circumstances of recipient countries (Guillaumont & Guillaumont-Jeanneney, 2006a,

2006b). Moreover, on the interactive variable between foreign and institutional variables, Dalgaard

and Hansen (2001) and Easterly (2003) highlighted that this specification does not allow disentan-

gling the effects of aid and institutions on growth given that institutions themselves affect growth.

Our paper proposes an innovative view by incorporating the possibility of heterogeneous effects

of foreign aid in a general and unspecified way, and then exploring whether the quality of institutions

is the source of such unobserved heterogeneity. We assume that there are multiple growth regimes

and that the impact of foreign aid on growth differs across regimes. The approach allows us to study

the role of governance by estimating whether the quality of governance affects the probability for a

country to be in a given growth regime. Previous studies used traditional econometric models (OLS,

IV, GMM) which impose a single model in the sample, and thus assume that the effect of foreign aid

is constant across the distribution. These models also disregard the possibility that heterogeneity may

exist along the distribution of the outcome itself.

We employ a finite mixture model, which relaxes the assumption of a single model and allows

unobserved heterogeneity in the sample. The finite mixture model incorporates a latent variable to

classify countries into different classes or regimes, and enables any possible unobserved heterogeneity

that may exist to be incorporated. In this semi-parametric model, countries are sorted into regimes or

classes depending on the similarity of the conditional distribution of their growth rates given all the

observed explanatory variables (Deb & Gregory,2016; Konte,2013). Finite mixture models are for-

mulated to identify heterogeneous effects, if they exist, and characterise that heterogeneity along di-

mensions of the outcome distribution, observed characteristics and unobserved characteristics. These

models are increasingly applied to different topics including health (see Conway & Deb,2005; Deb,

Gallo, Ayyagari, Fletcher, & Sindelar,2011; Deb & Gregory,2016), natural resources (Konte,2013),

and growth and institutions (Flachaire, García-Peñalosa, & Konte,2014).

The objective of this paper was to take a careful look at the relationship between foreign aid,

economic growth and quality of institutions in sub-Saharan Africa. The paper differs from previous

studies in three ways. First, previous studies employed traditional OLS, panel fixed effects, 2SLS and

GMM methods, which impose single growth model in the sample and constant impact of aid across

the distribution. To address this shortcoming, we use the finite mixture model which relaxes the single

growth model, and allows unobserved heterogeneity in the sample. Finite mixture models have several

advantages. Covariates are allowed to have different marginal effects across groups—so in this case,

foreign aid may have a positive impact in one group and a negative or insignificant impact in another

group. Furthermore, finite mixture models take into account profiles of the different groups (Flachaire

etal.,2014).

Second, we explore whether the quality of institutions can help explain the variations between the

different growth regimes. Previous studies have addressed this estimation by including an interactive

variable between foreign aid and the institutional variable. However, as Easterly (2003) and Dalgaard

and Hansen (2001) have shown, this specification could lead to inconsistent and ambiguous results.

In this paper, we include the institutional indicator as a concomitant variable, not just as an explan-

atory variable. In a multiple growth regime model, a concomitant variable is designed to explain

group membership, contrary to the standard covariates which explain variation within regimes (Deb

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& Gregory,2016; Flachaire etal., 2014). Thus, the values of the concomitant variables will partly

determine the probability that a given country belongs to one group or another. Third, we focus on the

sub-Saharan African continent which is highly dependent on foreign, aid but few studies have yet to

focus on the region.

Using a sample of 25 sub-Saharan African countries over the period 1970–2015, we find that our

model is best grouped into three different classes. In the first two classes, foreign aid is negatively

associated with economic growth, but the impact is higher in the first class than in the second one.

In the third class, the results show that foreign aid is positively associated with growth. Our findings

highlight that there is an observed heterogeneity on the impact of foreign aid on economic growth in

sub-Saharan Africa. Moreover, we use various metrics of institutional variables, including democracy,

checks and balances, law and order, regulatory quality, government effectiveness, economic freedom

and control of corruption, to explore whether they explain group membership of countries. We find

that the results depend on the institutional variable: countries with strong regulatory quality, high

government effectiveness and low corruption are more likely to be in the group where foreign aid

positively affects economic growth. This finding confirms previous studies that highlight that foreign

aid is effective in countries with good governance measures. This paper underscores the importance

of heterogeneity in the relationship between foreign aid and growth. The results also highlight that

for sub-Saharan African countries to benefit from foreign aid, they need to improve the quality of the

regulatory systems, strengthen government effectiveness and step up the fight against corruption.

The paper is organised as follows. Section 2 presents a brief review of the literature. Section 3

describes the data sources and the variables used in this paper. In Section 4, we specify our empirical

estimation strategy, while Section 5 discusses the main results. We undertake an extensive robustness

exercise in Section 6 and provide some policy implications. Section 7 concludes.

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BRIEF REVIEW OF THE LITERATURE

The literature on aid effectiveness defined as its impact on economic growth is not clear-cut. Aid may

affect economic growth through the increase in the amount of capital stock and its effect on economic

activities. Morrissey (2001) enumerates several mechanisms through which aid can contribute to eco-

nomic growth. These mechanisms include the increase in physical and human capital, the increase in

capacity to import capital goods or technology, and technology transfer that increases productivity of

capital and promotes endogenous technical change. In fact, foreign aid can contribute to boost social

infrastructure (education, water supply, sanitation) and economic infrastructure (energy, transport,

communications) and therefore support the development of producing sectors such as the agriculture

and industry sectors. Furthermore, foreign aid can support institutional reforms and foster national

efforts to benefit from trade opportunities, diversify exports and effectively integrate into the multilat-

eral trading system (Ouedraogo, Sourouema, & Zahonogo,2018). Foreign aid often plays a catalytic

role as institutional change that expands national opportunity sets (improved economic infrastructure,

more stable administration, etc.) can help attract greater foreign private flows, which are essential to

economic growth. A recent study found that foreign aid has a significant positive effect on financial

development and thus enhance access to finance for small and medium enterprises and boost eco-

nomic growth (Maruta,2019). Finally, foreign aid can reduce poverty and income inequality (Kaya,

Kaya, & Gunter,2013; Shafiullah, 2011), which are key to sustained long-term growth, and help

developing countries to better mobilise domestic revenue and finance development-related spending

(Clist,2016; Clist & Morrissey, 2011).