Does foreign aid help?

• Author: Djankov, Simeon

Recently, Sachs et al. (2004) have argued in favor of a massive increase in foreign aid to Africa in order to escape from a supposed poverty trap. They propose to increase the capital stock in one step, through a large, well-targeted infusion of foreign assistance. (1) In their proposal "the flow of aid is targeted to a particular set of investments, and specifically public sector investments, so that the aid cannot be used for consumption" (pp. 144-45). This large amount of aid should be given in the form of grants rather than loans.

They believe that such a commitment can be enforced through "improved monitoring of budget processes and expenditures, perhaps with the help of local nongovernmental organizations" (p. 145). "Unconstrained aid flows would probably be consumed rather than invested. The strategy needs to be designed to ensure that the aid is properly invested, and there must be a credible mechanism for enforcing the strategy over a relatively long period" (p. 146).

However, the empirical evidence on the effectiveness of foreign aid is diseouraging. Recent literature on the topic provides ambiguous results on whether foreign aid helps or hinders developing countries. Foreign aid, however, may affect economic growth through indirect channels that cannot be captured by analyzing only the direct effect of aid on growth. Aid may alter the investment share of GDP, which indirectly affects economic growth, or may also affect government consumption, which is known to have a negative effect on economic growth. As Sachs et al. (2004) argued, unconstrained aid may increase public consumption rather than investment. The effect of aid on growth through these indirect channels is not captured in any of the studies on aid effectiveness.

There is a large body of literature that documents the so-called curse of natural resources. Foreign aid can also be understood as a sudden windfall of resources and, therefore, in principle could be subject to the same rent-seeking processes. Therefore, there may be also the "curse of unnatural resources." However, international donors argue that foreign aid has, in addition to the hypothetical benefit in terms of economic development, a positive impact on the process of democratization of developing countries. For this reason, they resist any attempt to impose conditionality in terms of the level of democracy in developing countries.

In this article we show that foreign aid has a negative impact on the democratic stance of developing countries, and on economic growth by reducing investment and increasing government consumption. Therefore, our empirical findings do not support the democratization effect of foreign aid nor the development effect. Because of these findings we propose and analyze other forms of helping poor countries. For example, the way in which aid is disbursed can also affect the effectiveness of aid. Maybe the mechanism to successfully encourage the government to invest rather than to consume has something to do with the way in which aid is disbursed. This topic has been largely omitted from the academic discussion of the effectiveness of aid, even though it is becoming the central topic in any international debate on aid effectiveness among policymakers. Indeed, a debate has recently emerged as to whether donors should give grants or loans. The G-7 called for an increased use of grants within IDA-13. Sachs et al. (2004) have also argued in favor of providing aid in the form of grants rather than loans. However, there is no empirical evidence that allocating aid in form of grants will improve economic development. We enter into the debate by considering the distinction between grants and loans, and we analyze their differential effect.

Finally, aid recipient countries also receive other resources in addition to foreign aid. Foreign direct investment (FDI) and remittances, for example, reach the private sector and the families of the recipient countries. Those flows of resources may also affect economic growth and, therefore, any meaningful analysis of the effectiveness of aid should take them into account.

Measuring Aid and Other External Resources

The measurement of foreign aid could be done in different ways. Traditionally the literature that analyzes the effect of aid on development has used the Official Development Assistance (ODA) measure. ODA flows include grants and concessional loans--that is, loans whose grant element is at least 25 percent. Burnside and Dollar (2000) use as a measure of aid flows the size of the Effective Development Assistance (EDA) initially constructed by Chang, Fernandez-Arias, and Serven (1999). There is one basic difference between ODA and EDA. ODA captures the flow of funds to the recipient country in a particular year minus what the country returns, while EDA reflects the portion of ODA that corresponds with a pure transfer of resources from donors to the recipient country. The subsidized interest rate of ODA is considered EDA. Therefore, EDA is the sum of grants and the grant element of loans. Recent studies (e.g., Collier and Dollar 2002), however, have relied on the traditional ODA measure of aid.

In our analysis we use ODA, but we distinguish between the grant and loan components. Data are in current U.S. dollars. Following Burnside and Dollar (2000), we use the International Monetary Fund's Unit Value Import (UVI) index to transform data into constant dollars and purchasing power parity (PPP). The UVI index is the ratio between the import unit values and import prices. In order to have the data on aid in constant dollars and PPP, we multiply by the 1985 UVI index for the world and divide by the current year UVI index for the world. Finally, we divide the aid value by real GDP in constant 1985 prices from Summers and Heston (1991: Penn World Table 5.6).

Recipient countries also receive resources that do not come from official institutions, and that do not go to governments, but to the private sector and to families. Moreover, they also receive flows from the private sector that go to the government. In our analysis we consider the effect of these other resources flows that we classify as follows: flows from the private sector to the private sector (PrivtoPriv), resources from the private sector to the public sector (PrivtoPnbl), and remittances. The private to private flows include foreign direct investment, portfolio equity flows, private non-guaranteed (PNG) bonds, and PNG commercial bank loans. Data come from the World Bank's Global Development Finance (GDF) database. The private to public flows include public and publicly guaranteed (PPG) bonds, PPG commercial bank loans, and PPG other private creditors. Data also come from the GDF database (see Appendix 1 for definitions of each variable).

Not all countries that receive ODA receive the same proportion of grants versus loans. The type of concessionality of ODA may vary depending on the proportion of loans versus grants the country received. We define the ratio of grants to gross ODA as a measure of concessionality. Table 1 lists the ranking of the 20 largest recipients of ODA. Column 1 reports the average amount of ODA as a percentage of GDP for each period. Column 2 presents the average ratio of grants to gross ODA the country received. Finally, column 3 specifies the country and the period. Cape Verde during 1985-99 and Jordan during 1960-64 received the largest amounts of ODA as a percentage of GDP.

Table 2 lists the smallest ODA recipients. Papua New Guinea during 1960-64, China during 1975-79, the Republic of Korea during 1985-89, and the Bahamas during 1960-64 received the least amounts of ODA as a percentage of GDP. On average the largest recipients of ODA have a ratio of grants to gross ODA of 0.79, and the smallest recipients of ODA have a ratio of grants to gross ODA of 0.83.

Countries that receive ODA could also receive other types of foreign flows. The fact that recipient countries are also recipients of many other flows has been overlooked in most of the studies on aid effectiveness. Tables 3 to 6 show the ranking of the largest recipients of these other flows--PrivtoPriv, FDI (the main component of PrivtoPriv), PrivtoPubl, and remittances--as well as the average amount of ODA as a percentage of GDP.

Table 3 lists the largest recipients of private to private flows. Angola, Seychelles, Dominica, Lesotho, Chile, and Vanuatu during 1995-99, are on the top of the list. Again, the largest recipients of these flows are not on the list of the largest ODA recipients. However, on average, they received a significant amount of ODA (5 percent of GDP).

Table 4 lists the largest recipients of FDI. The 15 largest recipients of FDI received, on average, ODA corresponding to 5.75 percent of GDP. Table 5 lists the largest recipients of private to public flows. Togo during 1975-79, Gabon 1980-84, Algeria 1975-79, and Panama 1975-79 are on the top of the ranking. The average ODA received by the largest private to public recipients was 2.63 percent of GDP, half of the average ODA received by the largest private to private recipients.

Finally, Table 6 shows the ranking of the largest recipients of remittances. Among them Lesotho, Cape Verde, and Jordan top the ranking. In contrast with previous tables, in the ease of remittances, the largest recipients also received large amounts of ODA. The average ODA received by the 16 largest recipients of remittances was around 10.5 percent of GDP.

The Unexpected Consequences of Foreign Aid

Aid and Democracy

Many recent studies have found a negative correlation between economic growth and natural resources in developing countries. The bad economic performance of countries rich in natural resources is usually referred to as the curse of natural resources. However natural resources may not be the only source of the curse. In developing countries the amount of international financial aid is generally very large in terms of...