Foreign Aid and Economic Growth in the Developing Countries - a Cross-Country Empirical Analysis

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Using cross-country data, I examine how foreign aid affects economic growth in developing countries over the period from 1975 to 2000. I find evidence that foreign aid significantly 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


1.1. Background

Foreign aid is usually associated with
official development assistance, which in turn is a subset of the official development finance, and normally targeted to the poorest countries (World Bank,1998).

How does foreign aid affect the economic
growth of developing countries? This is a question which has drawn the attention of many scholars over time. Papanek (1972) finds a positive relation between aid and growth. Fayissa and El-Kaissy (1999) show that aid positively affects economic growth in

developing countries. Singh (1985) also finds evidence that foreign aid has positive and strong effects 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 institutions have grown faster than those without them, 2.7% per capita GDP and 0.5% per capita GDP respectively. One percent of GDP in assistance normally translates to a sustained increase in growth of 0.5% per capita. Some countries with sound policies received only small amount of aid yet still achieved 2.2% per capita growth. The good-management, high-aid groups grew much faster, at 3.7% per capita GDP (World Bank, 1998).

By contrast, other people find foreign aid
has negative impact on growth. Knack (2000) argues that high level of aid erodes institutional quality, increases rent-seeking and corruption, therefore, negatively affects growth. Easterly, Levine and Roodman (2003), using a larger sample size to reexamine the works of Burnside and Dollar, find 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 find no evidence that aid affects 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 influential on economic growth but so far this factor normally is neglected in the growth analysis (Gallup, Sachs and Mellinger, 1999). My study departs from other works in model, data set and approach of


1.2. 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 differ across regions?...
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