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Part I
Environmental Issues and Macro Marketing
Section A: Environment
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1
Foreign Aid on Economic Growth in Africa
Does Its Effect Vary From Low- to Middle-Income Countries?
Aye Mengistu Alemu and Jin-Sang Lee
Introduction
The role of foreign aid in the growth process of developing countries has been a topic of intense debate. It is estimated that Africa has received more than one trillion US dollars during the last 50 years.1 However, many countries are still underdeveloped and depend on foreign aid to run themselves, indicating that this aid has not been effective.
The issue of aid effectiveness was brought vigorously to the fore in 2005 when the Paris Declaration (PD) was endorsed by Organisation for Economic Co-operation and Development (OECD) Development Assistance Committee (DAC) members. Despite continuous aid to African countries, some of them became worse off than they were in the early 1960s. From a recipient country’s point of view, aid should be short term when the country suffers a shock internally or externally. Likewise, many low-income countries in Africa do not have great opportunities for foreign direct investment (FDI) because they receive limited attention from multinational companies (MNCs). In such cases, most low-income African countries mainly tend to have foreign aid, at least to provide their population with basic services such as education, health, roads, and so forth, and possibly to build institutional capacity to govern their countries. Foreign aid to low-income countries may also flow in in various forms such as cash, projects, programs, education and training, technical assistance, and others.
Middle-income countries in Africa have a substantial quantity of natural resources that are economical and act as a ‘pulling’ factor for FDI. However, the majority of low-income African countries has very low levels of economic infrastructure such as transportation and basic services as well as low levels of human capacity in terms of elementary and secondary enrollment ratios as well as vocational and technical training opportunities. These economic and social environments make it difficult for low-income African countries to achieve economic development. Consequently, most of the low-income African countries are heavily dependent upon foreign aid, which is mostly channeled through humanitarian aid such as food and emergency needs, with only a small portion being utilized for economic infrastructure. However, empirical studies on foreign aid and economic growth in developing countries have generated mixed results that make it difficult to draw policy recommendations. The main objective of this study is, therefore, to investigate the effects of foreign aid on economic growth in low-income and non–low-income African countries.
Literature Review
Theoretically, the main role of foreign aid in stimulating economic growth is to supplement domestic sources of finance such as savings, thus increasing the amount of investment and capital stock. As Morrissey2 points out, there are a number of mechanisms through which aid can contribute to economic growth, including (1) increased investment, in physical and human capital; (2) increased capacity to import capital goods or technology; (3) lack of indirect effects that reduce investment or savings rates; and (4) transfer of technology that increases the productivity of capital and promotes endogenous technical change.
There are four strands of literature on the role of foreign aid on economic growth. The first studies claim that foreign capital inflow is necessary and sufficient for economic growth in less developed countries. Also, it has been confirmed that there is a positive relationship between aid and economic growth because it not only augments domestic resources but also supplements domestic savings, assists in closing the foreign exchange gap, creates access to modern technology and managerial skills, and allows easier access to foreign markets, ultimately leading to economic growth.3,4,5,6 By the same token, Pallage and Robe7 noted that foreign aid is a major source of economic growth for developing countries, especially in Africa, where it averages 12.5% of the gross domestic product and establishes by far the most important source of foreign capital. Under such circumstances, foreign aid has the potential to play a key role in boosting developing countries’ economic growth as well as reducing poverty. Similarly, Addison et al.8 examined the trends of official development assistance (ODA) to Africa over the period 1960 to 2002 and concluded that foreign aid does, in fact, promote growth and reduce poverty. It also has a positive impact on the public sector, contributing to higher public spending and lower domestic borrowing. Burnside and Dollar9 also examined the effect of aid on economic growth, using standard cross-country panel regressions that included an interaction term of aid with a policy index and found that aid has a positive impact on growth in developing countries as long as these countries have sound macroeconomic policies.
The second group of studies assert that external capital has significant negative effects on the economic growth of recipient countries. According to this view, foreign aid is fully consumed; it substitutes rather than complements domestic resources, assists import of inappropriate technology, distorts domestic income distribution, and encourages a bigger, inefficient, and corrupt government in developing countries.10,11
The third view is that foreign aid has no impact on economic growth.12 This view is shared by Moyo,13 who argues that aid has not helped to improve social and economic conditions in Africa for several reasons: (1) sectors that are critical and important to the development of the country have rarely been allocated any resources, and less than 6.5% of development aid or assistance received by developing countries over the years has been allocated to areas that are critical to accelerated growth and economic development, such as education, health care, infrastructure, energy, agriculture, technology, and the environment; (2) the debt and aid resources have been stolen and corruptly squandered by government officials to enrich themselves, their families, and their friends instead of being directed to the productive sectors of the national economy; (3) during the Cold War, the policies of the developed countries favored African countries that were friendly with them, and as a result, official development assistance (ODA) was usually quite unpredictable and could not be depended on for making long-term development plans. In addition, many of the Western donors often attached conditions to aid that made its effective use for development difficult; and (4) in many instances, aid was driven by interest groups in the developed countries to sell their products, services, and technologies that were not suitable for African development because they were often obsolete and inappropriate for African conditions.
The fourth view is that the relationship between foreign aid and economic growth may depend on the quality of the recipient country’s institutions and economic policies, that is, integrated monetary, fiscal, and trade policies.14,15 McGillivray et al.16 suggested four different views from positive and negative perspectives and emphasized political conditions and institutional capacity. According to Mbaku,17 African countries failed to use aid efficiently because they lacked competent laws and institutions to use received aid appropriately and effectively. Kosack18 examined the impact on the human development index, but only in democratic countries. He found that aid has a negative impact in autocratic countries but a positive impact on the human development index and growth in democratic ones.
However, it must be borne in mind that regional differences in the effects of foreign aid among the recipient countries are inevitable. Effects could be influenced by income levels or levels of socio-economic development of recipient countries. Ekanayake and Chatrna19 analyzed 83 recipient countries in Asia, Africa, and Latin America and the Caribbean, using panel data series for foreign aid, and concluded that foreign aid brought mixed impact on the economic growth of recipient countries. Latin American and the Caribbean countries especially experienced adverse effects on economic growth, whereas African countries showed positive effects. De Ree and Nillesen20 studied the impact of foreign aid on civil conflict in sub-Saharan Africa but found no evidence that foreign aid has an impact on civil conflicts. Some studies show different evidence: negative effects in the short term but positive ones in the long term. For example, Moreira21 carried out a study of the impact of economic growth at the macro-level using a cross-country regression model and examined the short- and the long-term results. The long-term effects were found to be better than those in the short term. Juselius et al.22 also found that the impact of foreign aid was positive in the long term.
Methodology
Scope of the Study
Though often spoken of as a single, homogenous group, African countries are remarkably diverse and heterogeneous in historical, political, social, economic, linguistic, cultural, and geographical terms. The region includes both middle-income, lower middle-income, upper middle-income and higher-income economies, some with large and some with small populations, some with a store of natural resources and those with virtually none. Thus, it is important to examine in detail whether the effect of foreign aid on economic growth in Africa has been uniform. Accordingly, African countries have been categorized into low-income and non–low-income countries on the basis of the World Bank’s classification (low-income: Gross National Income (GNI) per capita ≤ $1,005; lower-middle income economies: $1,006 ≤ GNI per capita ≤ $3,975; upper-middle income African economies: $3,976 ≤ GNI per capita ≤ $12,275; and higher-income economies: GNI per capita ≥ $12,276; see Table 1.1).
Specifications of Model
This section discusses the model specifications to examine the relationships between foreign aid and economic growth. The empirical model for estimating the impact of foreign aid on economic growth is based on previous growth literature and other empirical studies. Therefore, in deriving our empirical model for estimating the aid-growth relationship, we posit that:
Table 1.1 List of Countries Included in the Study | Low-Income Africa (19 Countries) | Non–Low-Income Africa (20 Countries) |
Benin, Burkina Faso, Burundi, Chad, Democratic Republic of Congo, Ethiopia, Gambia, Guinea Bissau, Kenya, Malawi, Madagascar, Mali, Mauritania, Mozambique, Rwanda, Sierra Leone, Tanzania, Togo, Uganda | Higher-inco... |
