Aid and Growth Chongsup Kim GSIS SNU

Introduction Prevailing perception of Aid Ineffectiveness Aid Effectiveness Disputes Aid, savings, investment and Growth Aid, poverty trap and Growth Aid, policies and Growth Prevailing perception of Aid Ineffectiveness Micro-macro paradox Corruption and aid dependency Aid fatigue Questions: inconsistency in empirical studies Why? Who are right? What should be policy lessons?

Aid-Growth Dispute 1 First generation studies: aid, savings and growth Harrod-Domar growth model: causal chain from aid to growth via savings and investment Aid increases savings and thus spurs growth Second generation studies: aid, investment and growth H-D model or a simple Solow growth model Aid leads to increase of investment, which results in growth Findings from the two-gap model: Aid leads to an increase in total savings but not by as much as the aid flows There is a positive link between aid and investment Therefore aid makes a positive contribution to growth Poverty-trap model Very low income →no saving or investment→depreciation→poverty maintained Hardly expect growth in the presence of poverty trap Poverty is due to unfavorable initial conditions Need a temporary injection of foreign capital to take off from the vicious circle with poverty and low-growth Role of Aid

Aid-Growth Dispute 2 Third generation studies: Aid, Policy and Growth New growth theory and different analytical basis Larger dataset Measures of economic policy and institutional environment Policy statement in Burnside and Dollar (2000) became very influential Introduce ‘good policy environment’ characterized by low inflation, low budget deficits, and Sachs Warner’s openness index Interactive term (aid*policy) as significant and positive Studies since B&D impact: Critics addressing different aspects Specification: failure of aid*policy when aid^2 added; low robustness Sample size: EDA instead of ODA and many control variables limit data availability especially for very low income countries Policy variables: opposite results with different measures for policy environment or institutional efficiency Causality and endogeneity problems of policy variables

Hypothesis and Results Burnside and Dollar (2000) Hypothesis and Results Earlier works: - Aid impact on savings investment, and growth in developing countries: (Griffin 1970, Weisskopf 1972, Chenery and Syrquin 1975, Mosley et al. 1987, Levy 1988) : Ordinary Least Squares - correlation problem? - Foreign aid has not raised growth rates in the typical poor country (Peter Boone 1995,1996): : Instrumental variables (IV) – interaction between aid & policies ? Key questions: - Is the effect of aid on growth conditional on economic policies? - Do donors allocate more aid to countries with good policies? - What are the factors affect growth and aid flows? Hypothesis: - Aid effectiveness maybe conditional. - Neoclassical Model: the impact of aid will be greater when there are fewer distortions. In general, developing country growth rates will depend on initial income, institutional and policy distortions, aid and aid interacted with distortions.

Hypothesis and Results Burnside and Dollar (2000) Hypothesis and Results Results: effectiveness and allocation Effectiveness : - Aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies but has little effect in the presence of poor policies. Quality of policy has only a small impact on the allocation of aid. - impact of aid in countries with average policy is zero - countries with good policies and significant amount of aid perform very well, explained better by aid than other variables in the growth regression Allocation : - no tendency to allocate more aid to countries with good policies - Bilateral donors most influenced by donor interest whereas multilateral donors are influenced by income level, population and policy. - aid tend to increase government consumption not just in sector that donors think they are financing. (explains to some extend that aid is not promoting growth in the average recipient country)

Burnside and Dollar (2000) Data and Methodology Source: World bank database for foreign aid. (Grant components of concessional loans are added to yield truer estimation) Data: Panel 56 countries and six 4-year time periods from 1970-73 to 1990-93. Economic policy variable: Budget Surplus, Inflation rate, openness dummy (by Sach and Warner 1995 ) and their interactive term with aid.

Models OLS and 2SLS: error term in (1) and (2) may be correlated Burnside and Dollar (2000) Models Aid receipts adjusted to GDP Policies that affect growth Log of initial per capita GDP Per capita GDP growth Interactive term Other exogenous variable that might affect growth Time-fixed effect to capture the impact of worldwide business cycle OLS and 2SLS: error term in (1) and (2) may be correlated Negative or positive: maybe more positive (i.e. commodity boom)

Aid Equation Y: logarithm of initial income Burnside and Dollar (2000) Aid Equation Y: logarithm of initial income Z: other variables - logarithm of population - regional dummy (donor’s strategic interest) Sub-Saharan Africa (European) Franc zone (France) Egypt (U.S) Central American countries (U.S.) P: policy variables

Policy variable endogenousity Burnside and Dollar (2000) Policy variable endogenousity Policy variables : interactive term correlation - budget surplus, inflation, openness correlation - weights the policy variables according to their correlation with growth. Infer coefficient from (3) and used the value pit=p’itbp

Burnside and Dollar (2000) Variables in test

Regression result (1): growth all Burnside and Dollar (2000) Regression result (1): growth all Consistent with Boone’s results on Aid doesn’t affect growth rate. * Policy index = 1.28 + 6.85 x Budget surplus -1.40 x inflation + 2.16 x openness constant 1.28 means that a country’s predicted growth rate- given Budget surplus, inflation, and openness- had the mean values of all other characteristics c c

Regression result (2a) c c c Burnside and Dollar (2000) Without 5 outliers c c c

Burnside and Dollar (2000) Regression Result (2b)

Growth Equation Burnside and Dollar (2000) P: policy variable - Trade openness (dummy) - Inflation : as a measure of monetary policy - Budget surplus and government consumption relative to GDP: two strongly negatively correlated, budget surplus marginally significant but government consumption was not. Therefore, only get surplus. Z: exogenous variable - variables not affected by shocks to growth and level of aid, institutional, political factors - IQ: security of poverty rights, efficiency of bureaucracy - Ethnolinguistic fractionalization - Assassinations and its interactive term with ELF - M2/GDP: proxies for the development of the financial system (lag by one period due to endogeneity problem) Regional dummy Education variable considered but dropped due to little explanatory power and observation decrease

Regression results (3) : growth lower-income countries Burnside and Dollar (2000) Regression results (3) : growth lower-income countries c (R2 all 0.42)

Interpretations and questions Burnside and Dollar (2000) Interpretations and questions Aid itself still has a small and insignificant coefficient Aid interact with policy has significantly positive coefficient, whereas quadratic term has a significantly negative coefficient => impact of aid on growth is a positive function of the level of policy and a negative function of the level of aid (diminishing return) Is the slope of this derivative in the policy dimension significantly positive? (Aid is more effective in good policy environment than in bad environment) Is the derivative positive when evaluated at a good level of policy? (standard deviation above the mean)

Results compared (4): Burnside and Dollar (2000)

Burnside and Dollar (2000) Interpretations Derivate of growth with respect to aid is positive at a good level of policy (at 2.4) Compare single interaction term and outliers excluded, the derivative of growth with respect to aid is significantly higher in a good policy environment in an average one. Policy seems to be more important in lower income countries: cross-derivative of growth with respect to aid and policy is 0.23 for whole sample, and 0.33 for lower-income countries

Regression Result (5): Allocation of Aid Burnside and Dollar (2000) Regression Result (5): Allocation of Aid

Interpretation and simulation Burnside and Dollar (2000) Interpretation and simulation Arms imports relative to total imports lagged one period : strategic interest Helps to explain allocation of aid to middle-income countries but less relevance to low-income countries Policy has positive coefficient One SD above the mean results in about 12 percent more aid for average country (0.09 SD of aid) Donor interest played more in bilateral than for multilateral aid. (coefficient of policy close to 0) Multilateral aid and the WB, 1SD above the mean results in 24% more and 30% more repectively. World bank aid is most sensitive to initial income when scaled appropriately.

Regression (6): Government consumption and aid Burnside and Dollar (2000) Regression (6): Government consumption and aid

Interpretation Lower-income country sample Burnside and Dollar (2000) Interpretation Lower-income country sample Positive return of aid on government consumption Bilateral aid has large positive association with government consumption while multilateral aid has not Government consumption included in growth equation never significant. This is probably why aid is not effective in the typical recipient country.

Aid, policies and growth: comment Eaterly, Levine, Roodman (2003) Aid, policies and growth: comment

Aid, policies and growth: reply Burnside and Dollar (2004) Aid, policies and growth: reply Focusing only 1990s - one standard deviation on the indices of rule of law and of democracy corresponds to 28% of more overall aid and 50% more finance from the World Bank IDA facility (part of foreign aid) With 1990s data set, using IV institutions-aid interaction to be more robust than institutions by themselves. Original argument holds with new data set. Donors behavior seemed to change from 80s to 90s

Following studies Hansen and Tarp, Aid and growth regressions (2001) Comprehensive examination of previous results 1) Non-linearity of aid effect + aid-policy effect ( quadratic aid ) (policy index with aid policy interaction) 2) Endogeneity of aid and country specific effect 3) Main determinants of capital accumulation including impact of aid on investment

Endogeneity and country effect Hansen and Tarp (2001) Endogeneity and country effect

Aid2 and policy interaction Hansen and Tarp (2001) Aid2 and policy interaction

Impact of aid on investment Hansen and Tarp (2001) Impact of aid on investment

Following studies Dalgaard, Hansen and Tarp (2004) Climatic circumstances (fraction of land in tropical areas) as proxy for ‘deep’ structural characteristics Strong negative correlation between climate conditions and CPIA (thus effect of aid on productivity robust in climate conditions)

Dalgaard, Hansen and Tarp (2004)

SUMMARY OF STUDIES

Roodman (2004) (from Anarchy of numbers by Roodman)

Conclusion Frustration in empirical investigations: Who are right? Aid is effective only in a country with good policies Aid has a significant positive and non-linear effect on growth, rather reflecting diminishing returns or deep structural differences than importance of ‘good policies’ There is no robust effect of aid on growth unless using artificially restricted sample Tendency for negative studies to dominate the debate, but they are in the minority. Problems Models sensitive to data and without careful specification Development is a complex process: are there regularities in the impact of aggregate aid across countries? For future studies Careful in interpreting data and regression results More careful in drawing policy lessons Consider various aspects of policies/institutions, structural aspects of recipient countries Desirability of taking a more disaggregate view: Different components of aid, saving and investment effects, by sectors, etc.

References Aid, Policies and Growth (2000) by Burnside and Dollar Comments on Burnside and Dollar (2000) by Easterly, Levine and Roodman Aid, Policies and Growth: reply (2004) by Burnside and Dollar Aid and growth regressions (2001) by Hansen and Tarp Aid effectiveness disputed (2001) by Hansen and Tarp (cf) Aid allocation and poverty reduction (2001) by Collier and Dollar