The Failure of Cross-country Regression Analysis in Measuring the Impact of Foreign Aid

Abstract

Foreign aid is publicly motivated by a moral obligation to help the poor and develop underdeveloped countries. Despite the vast amount of foreign aid spent annually to address the poverty of millions of people and the economic decline of underdeveloped countries, very little headway has been made. First, this article argues that aid does not work in isolation and many variables influence growth and development and thus the impact of foreign aid; and second that cross-country regression analysis is an inappropriate method to measure the effectiveness of aid. It emphasizes that the methodology used to measure the impact of foreign aid is too generalist. It concludes that foreign aid cannot be treated as a homogenous entity that works equally in all countries in all types of environment and across all times. There is an urgent need to develop a new methodology for measuring the effectiveness of foreign aid.

Keywords

cross-country regression analysis donor variables aid variables recipient variables external variables country case study

Introduction

First, this article focuses on the variables impacting on aid effectiveness and secondly on the methodology used to evaluate the impact of aid. Despite substantial investment, foreign aid has not produced the expected results in terms of economic growth or development. Why does foreign aid appear to be so ineffective? Since the early 1950s, researchers have tried to answer this important question. But after nearly 50 years of research, there is still no definitive answer. There is an increased “aid fatigue” as the public grow tired of providing aid that apparently is so inefficient. While the research has been inconclusive about the impact of foreign aid, the literature has demonstrated that aid does not work in isolation, and that a number of important variables influence and even dilute the positive effects of aid. Knowing how aid interacts with these variables is crucial, since it will help donors, recipient countries, and policy makers to take better decisions and implement processes that will improve the effectiveness of foreign aid. This article looks at donor variables, aid variables, recipient environment and actions, and external factors that impact on the effectiveness of aid on economic growth and development and come to the conclusion that cross-country regression analysis is an inappropriate method to measure the effectiveness of aid.

Explanation of Cross-country Regression Analysis

Cross-country regression analysis is a statistical econometric methodology that is used to measure the effectiveness of foreign aid. Conducting a cross-country regression means assembling large samples of data from a multitude of countries (sometimes up to 137 countries), all at various stages of development, and then statistically calculating whether foreign aid, on the whole, has had any impact on growth and development. This form of analysis treats all countries, aid types, and time periods as homogeneous units, which they certainly are not. Furthermore, foreign aid operates in a complex environment in which donor motives in providing aid and the recipient’s use of aid dilute the influence aid may have on growth and development. It is important to understand the effect that donors, aid inflows, and recipients have on the impact of aid on growth and development. There must be a better way to evaluate and measure the effectiveness of foreign aid than the endless stream of ambiguous cross-country regression analysis. Research and empirical conclusions on the influence of aid, based on cross-country regression analysis, depend on critical methodology choices. Roodman (2007, p. 18) suggests that cross-country regressions may have reached the limits of their ability to reveal how effective aid is in affecting growth. According to Bourguignon and Leipziger (2006, p. 6), evidence from specific programs and country case studies may provide a better understanding of aid efficacy. But even if researchers figure out a better methodology for measuring the impact of foreign aid on growth, there is still the question as to why the impact of aid is measured against the indicators of economic growth?

Foreign aid is still supplied to developing countries to serve not only the needs of these recipients but also the donor’s political, strategic, and economic objectives. Donors continue to provide foreign aid to serve their own objectives, and economic growth and development in the recipient country is a secondary aim. If donors provide aid to achieve their own objectives, then one cannot measure aid effectiveness solely against the indicators of economic growth. What we can expect to see is a proliferation of donors in recipient countries. If after more than 50 years of research, we still do not have a conclusive answer to the question of whether aid is effective, then we should examine whether the methodology currently used to measure the effect of foreign aid is the most appropriate.

Donor Variables

In this section, some of the motives behind foreign aid will be outlined. It is clear that donors provide aid for a number of reasons and that foreign aid is not given for the sole purpose of growth and development. Thus, measuring the impact of foreign aid against a growth indicator is inherently inaccurate, illogical, and misleading.

Donor Motives

Why do donors provide aid? According to Riddell (2007, p. 141), foreign aid is seldom provided for a single purpose, but rather based on a mixed agenda of objectives bundled together with the aid package. These objectives include the following: humanitarian motive; economic motive that serves to develop markets for the donor’s exports and secures access to scarce resources and raw materials from the recipient country; political and strategic motives to ensure international security, to achieve the donor’s global political aspirations, and to increase the donor’s influence in the developing world; cultural motive to promote the language and values of the donor; historical and colonial motives; and moral imperative (Rogerson, in Browne, 2006, p. 9; Riddell, 2007, p. 91; Lancaster, in Whitfield & Fraser, 2009, p. 27). Evidence supports the argument that foreign aid is used by donors for a number of reasons beyond economic growth and development in recipient countries. Despite the public rhetoric about solidarity and the moral imperative of foreign aid, the evidence in the literature paints a different picture and shows that aid is without a doubt used to serve the interests of the donors. The US, for example, provides approximately 30 percent of its aid to Egypt and Israel for strategic reasons. France gives substantial aid to its former colonies, while Japan’s aid is correlated with UN voting patterns. The result, according to Alesina and Dollar (2000, p. 55), is that there is a weaker relationship between foreign aid and growth and development in recipient countries.

Early research concluded that donors were typically motivated by political, economic, and strategic objectives when they made their aid allocations. A number of studies concluded that the developmental or humanitarian motive played a relatively small role in the allocation of foreign aid (Ehrenpreis & Isenman, 2003, p. 8). Since the end of the Cold War, there had been a slight shift in donor aid allocations away from political motives toward more developmental objectives, and the US aid, once considered the least developmental, had increasingly begun to favor poor countries (McKinlay & Little, 1979, p. 243). There are indications in the recent literature (since early 2000s) that donors are beginning to afford higher priority to development and poverty reduction when making aid allocation decisions. However, economic, political, and strategic motives remain dominant almost across the board. A Department for International Development (DFID) 2002 survey also noted that among the large donors, politics and strategic interests continued to play a dominant role in determining donor aid allocations (in Ehrenpreis & Isenman, 2003, p. 9). This means that there are limits to the influence that development criteria will have on foreign aid allocations, and that aid will still be used to promote the interests of donor countries.

Since its inception, aid has been provided to serve the economic interests of the donor country. The most obvious form of economic interest is in tying aid to the purchase of services and products from the donor country (Riddell, 2007, p. 99). The tying of aid thus ensures that most of the aid money never leaves the donor country. For example, Jepma (1990, p. 11) found that 70 percent of bilateral aid from the European Union (EU) had led directly to procurement in the donor countries. This practice makes aid less effective and, according to Jepma (1991, p. 15), adds up to 20 percent to the cost of procurement. In other words, tying aid to the donor country makes aid up to 20 percent less effective. Donors also use aid to promote their own economic interests. For example, in 2002 the British Prime Minister, Tony Blair, refused to stop a major commercial deal to supply Tanzania with a £2.8 million British Aerospace System (BAe), used as a military air-traffic control system. BAe is a British multinational defense, security and aerospace company, headquartered in London with global interests, and is among the world’s largest military contractors. The World Bank and several other donors objected, stating that the sophisticated BAe system was unnecessary and beyond Tanzania’s means, but Tanzania, with British foreign aid, installed the system, even though it was not necessarily the most appropriate technology for the country (Porteous, 2005, p. 287). British economic interests took precedence over the effective use of foreign aid. If foreign aid is used to serve the interests of the donor, then it is our contention that the impact of foreign aid cannot be measured solely against the indicator of economic growth in the recipient country(ies). Foreign aid is being used to meet two different purposes and it is unsound to measure the impact of aid solely against the indicator of economic growth in recipient countries.

Donors use foreign aid as a tool to further their political and strategic agendas. Alesina and Dollar (2000, p. 33) found considerable evidence that foreign aid allocation decisions were determined by political and strategic motives. For example, donors use aid to reward a recipient’s loyalty for siding with them during crisis negotiations, in influencing decisions in international forums and for providing a base for information gathering (Sogge, 2002, p. 41). Donors also use foreign aid to develop relationships with the recipient countries in order to increase their own prestige and influence in the global economic, political, and military arena. Donors provide aid to steer economic and political agendas and to reinforce their economic and political status in the world (Sogge, 2002, p. 42). Some donors provide foreign aid to stem the unwanted and negative effects of migration and terrorism (Browne, 2006, p. 105; Riddell, 2007, p. 95; Sogge, 2002, p. 42). If foreign aid is provided to recipient countries to serve donors’ political and strategic objectives, then it is irrational to try to measure the impact of aid against economic growth indicators.

Some donors use foreign aid to maintain ties with their ex-colonies and promote their culture and influence. France, particularly in Africa, is inclined to bias its aid toward the former French colonies because of the emphasis on the spread of the French culture and language. In Africa, for example, more than 700 libraries and 70 cultural institutions have been established with French foreign aid (Degnbol-Martinussen & Engberg-Pedersen, 2003, p. 84). If foreign aid is being used to spread the influence and culture of the donor, one would need to consider the spread of French culture in addition to the impact of foreign aid on growth when calculating the impact of aid. The maintenance of historical and colonial ties with former colonies and protectorates is closely linked to the expansion and preservation of cultural influence. Most donors that had colonies retain ties with their ex-colonies. Degnbol-Martinussen and Engberg-Pedersen (2003, p. 86) pointed out that it was part of British foreign policy to give aid allocation preference to countries with close historical ties to Britain. Other countries with a strong bias toward ex-colonies include Belgium and France (Browne, 2006, p. 21). If countries are using foreign aid to extend their influence and maintain their colonial and historical ties, then aid is being used to serve more than one objective. Therefore, if foreign aid is used for multiple objectives, it should be measured against all objectives, and not solely against economic growth or development indicators.

Donor Fragmentation and Proliferation

As early as 1969, the Pearson Commission cautioned that too many donors were providing aid. Focusing on only the major donors, there are 37 major bilateral aid donors (excluding China) and 15 multilateral aid agencies. That is, up to 52 donors provide foreign aid to 180 recipient countries (Riddell, 2007, p. 52). If the major donors were to share the recipient countries among themselves, each would fund on average three or four countries. However, Riddell (2007, p. 52) points out that each developing country that is receiving foreign aid has up to 26 official donors. Too many donors providing aid reduce the impact of foreign aid and create coordination and program effectiveness problems in the recipient country. Too many donors result in high transaction costs, too many projects, parallel structures, the siphoning of top skills out of government service by the donors; hence, these issues reduce the impact of foreign aid on growth and development in the recipient country and aid becomes ineffective and costly (Djankov, Montalvo, & Reynal-Querol, 2009, p. 217).

Too many donors can be a nightmare for the recipient government. Donor fragmentation causes high transaction costs for the recipient government since donors impose their own accounting, procurement, reporting, auditing, and evaluation procedures on the recipient country (Van de Walle, 2001, p. 202). Recipient governments are burdened with high numbers of donor delegations, missions, and meetings. For example, in the mid-1990s, Tanzania had approximately 1,500 projects, with their associated constraints, auditing, procurement, and reporting procedures. In 2001, the Tanzanian Ministry of Cooperation wrote more than 2,400 quarterly donor reports, and government officials met over 1,000 donor delegations (Birdsall & Deese, 2004, p. 39). This results in competent recipient officials spending more time attending to donors than managing the country causing a heavy administrative burden for the recipient country. In addition, too many projects cause a multitude of managerial and administrative activities. Too many donors, indirect administrative and managerial implications, and their associated transaction costs make aid ineffective. The effectiveness and impact of aid is reduced when donor fragmentation is high (Djankov et al., 2009, p. 228).

Having too many donors in a country inevitably results in a proliferation of projects because each donor follows its own agenda. Fragmented donor aid soaks up recipient government officials’ time as they track thousands of disjointed projects in their country. In 2003, more than 50 donors funded 35,000 projects in 150 developing countries. This generated 35,000 annual reports and evaluations per year (Birdsall & Deese, 2004, p. 40). The recipient country is thus overburdened by projects; development action is splintered and uncoordinated; and, in many cases, projects overlap. Donors, through their actions, dilute the ability of foreign aid to have a positive impact on growth and development. In other words, in attempting to advance their own agenda, donors are reducing the effectiveness of foreign aid. But the problem intensifies as donors, in an effort to deliver on the project goals, sometimes create parallel structures alongside the government system.

Government structures in many developing countries are weak, ineffective, and burdened with growing corruption (Van de Walle, 2001, p. 203). Because of these problems, and the need for donors to deliver tangible results to their home public, they tend to implement their aid projects through specifically created stand-alone project structures that replace the government or, worse, create a parallel system (Sogge, 2002, p. 91). According to Van de Walle (2001, p. 203) and Sogge (2002, p. 93), the creation of parallel structures is inefficient, and makes foreign aid less effective than it might have been, had there been fewer donors that were focused on developing local institutions and capacity in the recipient country.

All of the above result in a skills’ drain as civil servants leave government employment for the greener pastures of the aid industry. If the average developing country has 23 bilateral donors operating in it, each donor will have a complement of local staff, including managers, project officers, accountants, receptionists, secretaries, logisticians, and human resource managers (Van de Walle, 2001, p. 204). Donors, with their higher salaries, benefits, and skills development, drain away skilled staff from government service, thus undermining institution building in the recipient country and thereby simultaneously building and destroying institution capacity in the recipient country. Donor action in a recipient country can dilute the ability of foreign aid to have a positive impact on economic growth and development as skilled government officials are lured away from government service, thus robbing government’s the capacity to build strong institutions.

Foreign aid is used to serve a number of donor-driven objectives. If donors through their actions (as discussed earlier) make aid ineffective, then we argue that it is inappropriate to measure the impact of foreign aid solely against the indicators of economic growth. Furthermore, if donor actions and agendas dilute the impact of aid on growth and development, any methodology that attempts to measure the impact of foreign aid, must take these donor variables into account. But donor action is not the only cluster of variables that influences the impact of aid on growth and development; aid itself can have a negative impact on growth in a recipient country.

Predictability and Volatility of Aid Flows

Bulir and Hamann (2003, p. 66) found that aid was highly unpredictable and that donor disbursements were consistently lower than their aid commitments. Recipients therefore could not reliably predict their aid incomes. Lensink and Morrissey (2000, p. 31) demonstrated how aid flows could reduce the impact of aid on growth and development. If aid is unpredictable, then it cannot be reliably invested, since recipients are uncertain whether they will receive all the committed aid, so they tend not to make concentrated investment commitments, which is a contradiction to the early growth models. Therefore, the unpredictability of aid lowers the levels of investment, and this in turn has a negative impact on growth (Lensink & Morrissey, 2000, p. 31). Unpredictable foreign aid flows thus reduces the effectiveness of aid. However, if donors were to live up to their promises and deliver all the aid that is pledged, this raises the question of how much aid is enough to stimulate economic growth and development. Is it possible for a recipient country to receive too much aid?

Diminishing Returns of Aid

Too much aid can be ineffective, simply because the recipient country cannot use it efficiently. If a recipient country receives too much aid, a number of variables reduce the impact of aid on growth and development. High aid inflows may have a negative impact on the recipient’s economy. Too much aid capital can cause aid-induced Dutch disease, bring about exchange rate volatility and affect the recipient’s capacity for absorption. Thus, increased aid can be problematic and although there is some controversy regarding the question of diminishing returns, there is consensus that aid is subject to diminishing returns and that there is a threshold, which is dependent on the environment and characteristics of the recipient country. Lensink and White (1999, p. 19) recommended that a ceiling should be placed on the aid : GNP ratio, but exactly where that ceiling should be would depend on the specific contexts of individual countries. If aid is subject to diminishing returns, then researchers must include the diminishing returns variable in their models, once again demonstrating the problems with the current methodology of cross-country regression analysis.

Aid Variables

The transfer of aid funds from a donor country to a recipient country can cause havoc within the recipient’s economy and reduce the impact of aid on growth and development. Large injections of aid capital into a recipient economy can result in aid-induced Dutch disease and too much foreign aid for too long can create dependency, remove incentives for investment, savings, and tax collection, and result in aid fungibility. In this section, we examine the evidence from the literature to determine the impact of aid variables, namely Dutch disease, aid dependency, removal of incentives, and aid fungibility on economic growth and development.

Aid-induced Dutch Disease

The evidence in the literature draws attention to the challenges of too much aid, particularly the recipient country’s capacity to absorb aid and the potential effects of aid-induced Dutch disease. Heller (2005, p. 7) and Adam and Bevan (2006, p. 261), evaluating the impact of aid-induced Dutch disease, found that when there was an increase in aid inflows, aid caused short-term Dutch disease in the economy. Similarly, Rajan and Subramanian (2005, p. 31) found that a large inflow of aid induced an overvaluation of the local currency resulting in Dutch disease. Rajan and Subramanian (2005, p. 32) also noted that too much aid and the negative impacts of Dutch disease caused a decline in the growth of the manufacturing sector of the economy. More recently, Arellano, Bulir, Lane, and Lipschitz (2009, p. 87) also found that foreign aid increased the risk of Dutch disease, which had a negative impact on economic growth and development. Since economic theory argues that the injection of aid into the recipient country should result in economic take-off to sustained growth, we can conclude that high volumes of foreign aid, if not carefully managed, can have a negative effect on the economic growth in the recipient country. Furthermore, if we wish to determine the impact of foreign aid on growth and development, then the methodologies that are used to measure this effect must make allowances for the effects of aid-induced Dutch disease. Too much aid can also remove incentives from recipient countries to increase tax income, increase domestic savings, and invest in infrastructure.

Aid Removes Incentives

Governments of developing countries that receive high volumes of foreign aid lose the incentive and ability to rigorously manage the state budget and collect taxes. In an aid-dependent budget, there is little relationship between expenditure and the generation of state income through tax collection. Researchers such as Griffin (1970, p. 106), Ghura (1998, as cited in Moss, Petterson, & van de Walle, 2006, p. 13), and Knack (2001, p. 313) all found that aid reduced taxation, and that the recipient made less effort to collect income tax. Similarly, Brautigam (2000, p. 48) observed that 71 percent of African countries with an aid:GNP ratio above 10 percent had underperformed in their tax collection efforts. Therefore, aid, especially too much aid, can have a negative impact on growth and development through the removal of incentives to increase tax income, domestic savings, and productive investments.

Economic theory and the use of foreign aid were intended to fill the savings, investment, and foreign exchange gaps. However, we have a situation in which aid in itself is causing effects that are the opposite of what it was intended to do. Foreign aid can remove the incentives from recipient governments to save and invest. This is a direct contradiction of the principle of foreign aid and economic development. Therefore, any attempt to measure the impact of foreign aid on growth and development must take into account that aid may be causing effects that are contrary to economic theory. If foreign aid is given with the intention of creating economic growth and development, then we must assume that it is used exactly as intended. However, as we will see in the next section, recipient governments can divert aid to unproductive investments (aid fungibility). Aid fungibility contradicts economic theory and growth models that assumed that all foreign aid was provided with the intention of filling the savings and investment gaps.

Aid Fungibility

Griffin (1970, p. 103) was one of the first researchers to identify the problem of aid fungibility. Donors assume that aid capital will be used by recipients to fill savings and investments gaps, as dictated by the early growth models. However, aid is fungible when it replaces expenditure that the recipient would otherwise have undertaken (Feyzioglu, Swaroop, & Zhu, 1996, p. 2). Donors are sometimes misled into thinking that providing foreign aid to fund a specific project will reduce the problem of aid fungibility because their aid money will be spent on a specific measurable and identifiable set of activities. But this is an illusion, according to Griffin (1970, p. 103), World Bank (1998, p. 61), and Collier (2006, p. 1486). If a donor, for example, refuses to provide aid for military expenditure, but continues to provide development aid, this does not stop the recipient from spending money on the military (Khilji & Zampelli, 1991, p. 1096).

The degree of fungibility depends on the characteristics and context of the recipient country; the type of aid that donors provide (e.g., direct budget support, sector aid, loans, grants for projects); and the levels of aid dependency of the recipient country. Therefore, if aid fungibility is a variable that reduces the impact of foreign aid on growth, we can argue that in each study that attempts to measure the impact of foreign aid on growth and development, the methodology must take cognizance of aid fungibility and its potential effects on the impact of aid on growth and development.

Recipient Actions and Context

The impact of foreign aid on growth and development can also be affected by the recipient country’s environment, institutions, and ability to absorb foreign aid. Additionally, external variables outside the control of recipient countries can also contribute to a reduction of the impact of foreign aid. In this section, we will look at how recipient variables may dilute the impact of foreign aid in terms of the policy environment, governance and institutional capacity, the recipient’s absorption capacity, and the use of foreign aid to fund public consumption. These variables are important since they demonstrate that foreign aid does not operate in a vacuum.

Recipient Policy Environment

Burnside and Dollar (2000, p. 847) found that “aid has a positive impact on growth in developing countries with good fiscal, monetary and trade policy, but has little effect in the presence of poor policy.” Their study provided donors and supporters of foreign aid with the evidence they needed to prove that aid could be effective. Here was an explanation as to why aid was not delivering the expected results. The study proposed a fix to the problem of foreign aid ineffectiveness. Foreign aid worked better in countries with a good policy environment; therefore, the recommendation was that donors should provide aid only to countries with a good policy environment. Their conclusion was corroborated by a number of studies that found that a good policy environment improved the impact of foreign aid on growth and development. But the Burnside and Dollar’s (2000) study did not go unchallenged in the literature.

Two groups of researchers disagreed with the importance of the policy environment. The first group agreed that in principle the policy environment was important, but that its significance was less clear or less robust than suggested by Burnside and Dollar. For example, studies by Ehrenpreis and Isenman (2003, p. 15) and Dalgaard, Hansen, and Tarp (2004, p. 212) found that aid had a positive impact on growth, but the relationship between aid and policy was weak. Similarly, Easterly et al. (2004, p. 779), in an evaluation of the aid–policy relationship, found that there was no relationship between foreign aid and the recipient’s policy environment. Furthermore, a number of studies found aid had a positive impact on economic growth, irrespective of the policy environment, including Hansen and Tarp (2000, p. 123), Mavrotas (2002, p. 46), Clemens, Radelet, and Bhavnani (2004, p. 38), Islam (2005, p. 1467), and Rajan and Subramanian (2008, p. 643). The argument that aid works only in a good policy environment is debatable, but perhaps the answer can be found in the conclusion of the next two studies in which the researchers acknowledged that the policy environment may be an important factor for growth. Gomanee, Girma, and Morrissey (2003, p. 15), in a study of 131 aid-recipient countries, found that the impact of aid on growth was not dependent on a good policy environment. However, they agreed that economic policies might influence growth, and possibly some policies might improve the effectiveness of aid. Similarly, Guillaumont and Chauvet (2001, p. 87) found no evidence that a good policy environment improved the impact of foreign aid, but they agreed that “of course improved policy is an important factor of growth.”

The links between aid policy and growth are complex. To conclude that aid works only in a good policy environment is perhaps being too simplistic. However, we can conclude that the recipient’s policy environment is important to growth and that countries with good economic policies will probably use aid more effectively while a poor policy environment could reduce the impact of aid on growth and development. The questions to be asked are: What is a “good policy environment”? and “Is neoliberal economic policy the right policy for economic growth and development in underdeveloped countries?”

Foreign aid underpinned the imposition of neoliberal economic policies which were forced upon aid recipients in the form of structural adjustment programs (SAPs). However, neoliberal economic policies are being criticized for hindering growth as foreign aid is not having a positive impact on growth. According to Reinert (2007, p. xxvii), for example, the promotion of neoliberalism and the use of foreign aid to enforce donor policies create a form of welfare colonialism in which the rich countries maintained their political and economic dominance over poor countries rather than creating development and growth. Neoliberalism, forcing poor countries to adopt “good policies,” results in opening their markets to cheap products manufactured in rich countries. Poor countries are not allowed to impose import tariffs, subsidies, emerging industry protection or control foreign exchange. This strategy, which incidentally is opposite to the way in which developed countries industrialized, ensures that poor countries remain poor and unlikely to industrialize.

Evidence from the Southeast Asian countries (where economic growth occurred through ignoring the neoliberal economic model) also supports the argument that the neoliberal policies are the “wrong policies.” Through a combined centralized state system with the market economy (Chang, 2005, p. 50) in China, Japan, Korea, Taiwan, and Thailand, subsidies and performance standards were maintained to encourage growth and development. The state played a key role in the gradual transition from a central planning economy to a market economy in Southeast Asia. The non-neoliberal policy model (1960–2000) for growth and development in Asia resulted in the poverty rate falling from 65 percent to 17 percent; infant mortality shrinking from 141 to 48 per 1,000 births; and life expectancy increasing from 41 to 67 years (Amsden, 2007, p. 9). The Korean economic miracle is a good example of a blend of state intervention and market incentive, encouraging businesses in Korea to make profits and prosper. State support was maintained only long enough for the emerging industries to absorb new technology, to develop skills and become internationally competitive (Chang, 2007, p. 15). Tariff protection, state subsidies, and cheap credit were used for a limited time to nurture emerging industries and protect them from stiff external competition. Korea, however, is not an exception to the rule. Nearly all developed countries, including Britain, the US, Sweden, and Denmark, used protection and subsidy mechanisms, while resisting direct foreign investment that could threaten their local industry. For a long time, Britain and the US were among the most protected economies in the world (Chang, 2007, p. 17). Successful industrialization, economic growth, and development did not happen because of neoliberal economic policy; it was achieved in a policy environment that is the exact opposite of the neoliberal economic model. Neoliberal policy reform strategies, supported by foreign aid, ensure that poor countries remain locked into exporting raw materials and consuming products manufactured in developed countries. Donors created a system in which the economic policies they are promoting ensure that developing countries do not industrialize (Reinert, 2007, p. xxvii). Donors who use aid to serve their own interests through their inappropriate actions and through the promotion of neoliberal economic policy have set up a foreign aid system that is unlikely to have any positive impact on growth and development. Without any form of intervention or protection, developing countries have little prospect of building their critical industrial base. The adoption of neoliberal policies may well condemn aid-recipient countries to a slower, less effective growth path.

While we accept that the recipient’s policy environment is an important variable for foreign aid effectiveness, there are two challenges to this position. First, poorly governed countries should not receive less money; they should receive more aid, but aid should be disbursed through adapted or different aid strategies. Second, if the policy environment is important to economic growth and development, there are question marks over what constitutes a good policy environment and what economic policies aid-recipient countries should adopt. If foreign aid is provided only to countries with good policy – which in donor terms means a neoliberal economic one – it has been shown that neoliberal economics is not necessarily the best growth path for developing countries to follow.

Absorptive Capacity of Recipients

Since the early 2000s, there has been a big push for doubling foreign aid especially to meet the Millennium Development Goals (MDGs) (Moss & Subramanian, 2005, p. 3; Vasquez, 2003, p. 1). While increasing foreign aid might result in higher growth and poverty reduction, the evidence shows that developing countries’ capacity to receive and use aid effectively is one of the causes of the ineffectiveness of aid. Absorptive capacity refers to the ability of a country’s economy to use aid efficaciously and it includes short-term and long-term constraints. These involve inadequate managerial capacity; lack of infrastructure and equipment; ineffective technical and managerial skills to scale up public services; slow institutional development; and lack of institutional capacity to manage aid inflows effectively (Killick, 1991, p. 1). Being unable to absorb and use aid effectively can result in a number of macroeconomic problems. Without the capacity to manage large aid inflows, countries experience problems with the unpredictable and volatile nature of aid. Aid inflows can negatively affect the macroeconomy, triggering inflation, and raising interest rates and exchange rate appreciation (aid-induced Dutch disease). A large inflow of aid can swamp the management and institutional capacity of a recipient country, limiting the effective use of aid income. Foreign aid in the form of loans raises the problem of debt sustainability. High levels of aid can destabilize the local labor market, since aid increases demand for skilled labor, thus rocketing up wages (De Renzio, 2005, p. 2). A sudden increase in aid may be proving unproductive, since the recipient country lacks the capacity to scale up infrastructure and public services in line with the increased income (De Renzio, 2005, p. 2). Inefficient absorptive capacity impacts on the country’s ability to take advantage of higher incomes and reduces the recipient’s ability to convert aid into the infrastructure and public services that could raise the wellbeing of the population. Too much aid can cause bottlenecks as the country struggles to deliver on public services (Heller & Gupta, 2002, p. 138).

A further element is the unpredictability and volatility of foreign aid that impedes the recipient’s medium- and long-term planning and investment strategies (Clemens & Radelet, 2003, p. 5; De Renzio, 2005, p. 2). Poor planning and low investment reduce the effectiveness of aid. Absorptive capacity and the fact that aid is subject to diminishing returns can result in aid being less effectual, particularly in countries that receive high levels of sustained foreign aid.

Aid Used for Consumption

According to the Harrod-Domar and two-gap growth models, foreign aid was provided to developing countries based on the assumption that increased capital would lead to a rise in investments, which in turn would promote economic growth. Initially, foreign aid was meant to supplement domestic savings, but according to Griffin (1970, p. 102), aid was often used to fund public consumption, rather than productive investment. Recipient governments of foreign aid often reacted to the increased income by changing state budget allocations to increase public consumption rather than productive investment (aid fungibility). Using foreign aid to fund public consumption instead of investments, or if donors specifically provide a portion of their aid for public consumption, we can conclude that this portion of the aid capital will not have any impact on growth. But as Burnside and Dollar (1998, p. 11) point out, the consumption of aid “might be helping the poor through social expenditures.” Foreign aid is not given to recipient countries for the sole purpose of stimulating economic growth or promoting investment. Donors provide a portion of their aid for public consumption. Any impact of foreign aid invested in human capital (health, education, and welfare) will take a long time to produce results or impacts on growth (Morrissey, 2001, p. 48). According to Gomanee et al. (2003, p. 3), this phenomenon may explain why, although growth has not been spectacular in the developing world, there has been an improvement in social indicators in most developing countries since the 1960s. Therefore, if donors provide aid funds for public consumption, then why do we measure the impact of foreign aid against the indicator of economic growth?

Aid cannot be provided for one objective (poverty reduction or social welfare in the form of public consumption) and then be measured for its effectiveness against a completely different indicator (economic growth). If donors are providing aid for consumption, and aid is being measured solely against economic growth indicators, then it is hardly surprising that aid is not performing as expected. If recipient countries are using aid for consumption, and if donors are providing a portion of their aid capital for public consumption (poverty reduction and welfare), then there is no real problem, other than a methodological problem, when trying to measure the impact of foreign aid against the sole indicator of economic growth.

External Variables

Foreign aid does not function in a vacuum and a number of external variables may influence the impact aid has on growth. These include trends in terms of trade, volatile export commodity income, economic shocks, disasters, and possibly even geography and climate (Guillaumont & Chauvet, 2001, p. 66). External variables such as economic shocks or natural disasters have a negative impact on growth and development and should not be ignored in the measurement and evaluation of the effectiveness of foreign aid, since they influence growth, and, if left unconsidered can lead to inaccurate conclusions about the impact of foreign aid on growth. In this section, we briefly look at economic and natural shocks, climate and geography to determine the role that these variables play in diluting the ability of foreign aid’s positive impact on growth and development.

Economic Shocks and Natural Disasters

The economies of many low-income countries are vulnerable to economic shocks and natural disasters. For example, low-income countries tend to rely on one or two export commodities as their primary source of export earnings and are exposed to sudden economic shocks leading to a sharp decline in their export earnings, a shrinking economy and an escalating balance of payments problem. Economic shocks and natural disasters have adverse and negative effects on the economy and therefore on growth. If an economy is perceived to be vulnerable to shocks or a high risk for investment, then foreign investments are discouraged with a consequent negative impact on economic growth. Easterly, Kremer, Pritchett, and Summers (1993, p. 481) found that shocks to the terms of trade were a significant cause of variations in growth rates. Researchers use the economic growth indicator as a measure of the effectiveness of foreign aid. However, if shocks or disasters impact negatively on economic growth, then this negative influence will be reflected in the calculation of the effectiveness of aid, without being specifically included as a variable unless the researcher makes allowances for the impact of the shocks in the methodology. This is yet another example of how variables that have no link with foreign aid can affect economic growth in a recipient country. Recent research indicates that climate and geography, like economic shocks and natural disasters, influence the ability of aid to have a positive impact on growth and development. Without considering all possible variables that may affect the relationship between foreign aid and growth, research results may lead to an inaccurate conclusion. Ignoring economic shocks and natural disasters in the measuring of the impact of aid lead to inaccurate analysis and conclusions, which may, to a certain degree, explain why the measurement of the impact of aid on growth and development has been so inconclusive and controversial. The methodology of cross-country regression analysis is inappropriate. The consideration of economic shocks and natural disasters reinforces the argument that calls for a discontinuation of cross-country regression analysis and a switch to the use of country-specific case studies. A country-specific case study will enable the researcher to include the impacts of economic shocks and natural disasters in calculating the impact of aid on growth and development for the country under review.

Climate and Geography

Some researchers have turned to determine whether the climate and geography of an aid-recipient country influence the effect of aid on growth and development. Dalgaard et al. (2004, p. 192), for example, found that if they allowed for a climate variable in their model, then their results indicated that foreign aid appeared to be less effective in the tropics. A possible explanation presented by Dalgaard et al. (2004, p. 192) was that climate may have an influence on productivity of the country. Similarly, Sachs and Warner (1997, as cited in Temple, 1998, p. 310) found that if they used a geographic variable in their model, then aid appeared to be less effective in certain locations. They noted that many African countries are land locked, have tropical climates and specialize in exporting raw materials and primary goods. These factors collectively could be contributing to slow growth in Africa. But, as Gounder (2001, p. 1017) rightly points out, there may be a number of plausible reasons that growth may be higher outside the tropics but the rationale for the effectiveness of aid outside the tropics or its ineffectiveness in the tropics is unclear. Similarly, in agreement with Gounder and refuting the argument that geography may influence the effectiveness of foreign aid, Rajan and Subramanian (2005, p. 5) concluded in their study that there was “virtually no evidence that aid works better in better policy or institutional or geographical environments.” There are some indications that geography and climate may influence the impact of foreign aid on growth and development, but it could be equally classified as anecdotal evidence, and is not relevant to the discussion, other than to serve as further proof that the use of country-specific case studies is a more appropriate methodology to measure the impact of foreign aid on growth and development. Using the case study methodology will allow researchers to include variations such as climate and geography in their analysis.

Country-specific Case Study as Alternative to Cross-country Regression Analysis

The increasing number of variables led us debate the value of cross-country regression analysis as a methodology for measuring the impact of aid on growth and development. The methodology amounts to a generalization of the impact of foreign aid, measured across a large number of countries, which tends to average out data differences between countries. Cross-country regressions must therefore be supplemented by other methods of analysis or replaced by a more appropriate methodology, such as country-specific case studies as evidence from specific program and country case studies may provide a better understanding of the impact of foreign aid. Case studies, rather than using data from multiple countries and over long periods, evaluate the impact of foreign aid, based on the data from one country. The case study analysis is therefore more focused and not subject to the complexities of using data from over 100 countries. Case studies have the advantage that they can take into consideration the particular characteristics, variables, and environment of an individual country, rather than treating all countries, aid and donors as homogenous groups that act in uniform ways. Country-specific case studies offer enhanced insight into the impact of aid on growth and development. Finally in a country-specific case study, the researcher will be able to disaggregate foreign aid into at least two categories: (1) aid for growth; and (2) aid for public consumption (welfare). In this way, it may be possible to measure the impact of foreign aid against economic growth and welfare indicators. But all this measuring of the impact of aid on growth and development may be redundant anyway, since donors use foreign aid to serve their own interests first. Therefore, measuring the performance of foreign aid that is used to primarily to serve the interests of the donor country, instead of growth in a recipient country, does not make sense, since aid is used to serve a donor agenda and therefore cannot and should not be measured against growth in recipient countries.

Conclusion

This article addressed the variables impacting on aid effectiveness and the methodology used to evaluate the impact of aid. Foreign aid is provided to developing countries to serve not only the needs of recipient countries but also donors’ own political, strategic, and economic agendas and it is therefore inappropriate to measure the impact of foreign aid merely against the indicator of economic growth in developing countries. Donors state publicly that foreign aid is provided to developing countries to promote economic growth, development, and poverty reduction, but the evidence from the literature indicates that there is still a significant relationship between foreign aid and donor interests (Berthelemy, 2005, p. 20; Ehrenpreis & Isenman, 2003, p. 8; Riddell, 2007, p. 98). Foreign aid is not supplied solely to support a development agenda, but rather serves a donor agenda, while at the same time providing assistance to the recipient country. Therefore, one cannot expect foreign aid’s performance to be measured and judged solely against the indicators of economic growth, especially if foreign aid is used to support the economic, strategic, influence, and political interests of the donor countries. Donor motives, donor actions and even the inflows of foreign aid reduce the impact of foreign aid on growth. Based on the evidence, it is our argument that every study that attempts to measure the impact of foreign aid must take all these variables into consideration.

The methodology used to measure the effectiveness of aid must take cognizance of the donor variables and the aid variables. Because donors use foreign aid to serve their own agendas, this raises serious doubts about the rationale of measuring the impact of foreign aid solely against the indicators of economic growth. However, recipient action, the country environment, and other external variables can further reduce the impact of foreign aid on growth and development. Donor motives, donor behavior, the management of aid itself and the specific conditions and environment in each recipient country influence the impact of foreign aid on growth and development. All these variables contribute to some degree to the dilution of aid’s ability to have a positive impact on growth and development. But we have also repeatedly argued that the current methodology of cross-country regression analysis used to measure aid effectiveness is questionable. Donors do not provide foreign aid solely for investment by filling the savings, investment, and foreign exchange gaps, but also for consumption. Foreign aid cannot be provided for one objective (poverty reduction or social welfare in the form of public consumption) and then measured for its effectiveness against economic growth, which is a completely different indicator. If recipient countries are using aid for consumption, and if donors are providing a portion of their aid capital for public consumption, then the problem lies with the methodology being followed in measuring the impact of aid against the sole indicator of economic growth.

The recipient country’s environment, institutions, and ability to absorb foreign aid can also contribute to a reduction of the impact of foreign aid on growth and development. Additionally, external variables outside the control of recipient countries reduce the impact of foreign aid. The recipient’s policy environment is important to growth, and a poor policy environment could reduce the impact of aid on growth and development. While we accept that the recipient’s policy environment is an important variable for foreign aid, it raises the question of what constitutes a “good policy environment.” Neoliberal economic policy may not be the most appropriate growth path for developing countries to follow as the adoption of good neoliberal policies may well condemn aid-recipient countries to a slower, less effective growth path. Donors have created a system in which the economic policies they are promoting may be hindering growth and industrialization in aid-recipient countries (Reinert, 2007, p. xxvii). Therefore, aid is less likely to have a positive impact on growth and development owing to the enforced adoption of neoliberal economic policy.

Furthermore, the capacity of the recipient country can hinder foreign aid’s impact on growth and development. If the recipient country does not have a sound policy environment (however policy is defined), has a weak system of governance, and the state institutions lack the ability to absorb aid effectively, then it is unlikely that foreign aid will produce the expected results in terms of economic growth and development. An increase in aid inflow may be beyond the recipient’s capacity to absorb additional aid effectively. In an evaluation of the impact of foreign aid on growth and development, the methodology used by the researcher must take cognizance of the absorptive capacity of the recipient countries.

The recipient environment, and the particular characteristics of the recipient country play a role in determining the ability of aid to influence growth and development. Each developing country has specific characteristics and conditions, which are not stagnant and change with time. This is another important consideration that supports the argument that country-specific case studies may be a more appropriate methodology for measuring the impact of foreign aid. Furthermore, economic shocks and natural disasters have a negative impact on economic growth. Similarly, there are some indications that geography and climate may influence the impact of foreign aid on growth and development. All of these reinforce the methodological argument calling for a discontinuation of cross-country regression analysis and a switch to country-specific case studies. Using a country-specific case study will enable the researcher to include the impacts of economic shocks and natural disasters in the calculation of the impact of aid on growth and development for the recipient country under review.

In light of the above, it is clear that foreign aid will only have a positive impact if donors (1) reduce the number of countries and projects in which they are engaged; (2) limit their aid inflows to match the absorptive capacity of the recipient country; and (3) separate their foreign policy and political objectives from foreign aid. This will diminish the skills drain and strengthen the institutional and governance capacity of the recipient country. Donors should develop a long-term exit strategy by building the institutional and state capacity as they slowly withdraw their aid. The methodology used to measure aid effectiveness must take into account that aid serves a number of objectives, and therefore should be measured against the indicators of those objectives and not solely against the indicator of economic growth. Finally, cross-country regression analysis should be replaced with individual country case studies or sector-specific studies.

In conclusion, to accurately measure the impact of aid on a developing country is probably impossible. Aid is but one factor in the complex process of economic growth and development. Many variables influence growth and development in a developing country, and it is extremely difficult to measure the effectiveness of foreign aid through the use of cross-country regression analysis. The methodology is too generalist, and treats foreign aid as a homogenous entity that works equally in all countries in all types of environment and across all periods, which of course it does not. There is an urgent need to shed the burden of cross-country regression analysis and switch to individual country- or sector-specific case studies. When doing a country case study, there is still a need for robust statistical analysis, and many of the problems highlighted in this study will apply. Researchers, however, will have an easier task of detangling the unique development issues that are specific to the country under evaluation. There is an urgent need for experienced researchers and economists to develop a more appropriate methodology that can measure and assess the impact of foreign aid by evaluating the impact of foreign aid on an individual country.

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