Foreign aid, governance quality, and economic growth in developing countries : foreign aid and growth

Most poor developing countries, especially those with limited natural resources, low savings and investment levels, natural disaster stricken, need help from the affluent nations in order to meet some of their development objectives. Still, some that are rich in natural resources equally depend on some form of aid. Though most growth theories stress on investment as an important step to steady economic growth, they are mostly silent on the importance of aid as a component of in vestment and growth to developing countries. Like in other aid and growth literature, aid is viewed as a tool to relief most developing countries out of their resource constraint and human misery. The issue of foreign assistance originated as part of efforts to rebuild Europe after World War II and subsequently extended to developing countries. Two main rationales for foreign assistance are outlined by the south centre in an overview of financial flows to developing countries. The first reason was that developing countries had only a limited debt-servicing capacity which meant borrowing from commercial sources could ply only a relatively minor role in financing development. Secondly, for macro economic considerations, developing countries need financial aid to invest more than what their domestic savings could allow and also to help supplement the countries exchange resources which where generally severely constrained. Thus, development assistance constituted an explicit commitment by the industrialized nations to support financially the development of the south. This not withstanding, there has been heated debates amongst international aid agencies, donor governments, researchers and writers on foreign aid and growth if actually aid has and can contribute to growth. This debate and doubt spring from the rising and persistent misery in most parts of the developing world, notably sub-Saharan Africa. Blames have been laid on a long list of different causes: recipient governments, insufficient quantity and quality of aid, multiple purposes of aid ( that is unfocused aid). Most recent empirical work on the impact of aid on growth have found that lump sum aid in itself has very little or no impact on growth. They however, have found that foreign aid has a positive impact on growth but this positive impact is heavily dependent on recipient countrys specific characteristics characteristics. Worth mentioning in this work are: a sound policy environment (Burnside and Dollar (2000)); economic liberalization (Cungu and Swinnen (2003)); quality of institutions and bureaucracy (Moene K et al (2003)); among others. This thesis uses a similar technique as Burnside and Dollar (2000) to assess theoretically and empirically the role of foreign aid on the economic growth of developing countries. It focuses on the role of governance as a background characteristic on the effectiveness (ineffectiveness) of foreign aid on growth. The thesis uses data on the net aid flow from all donors as a percentage of recipient GDP [source: African Development Indicators World Bank Africa Database (2005)]. The aid data for the other countries are obtained from the World Development Report (2000/2001) and include Official Development assistance as a percentage of recipient s GNP. The data for Real GDP per capita is from Penn World Table, Heston et al (2006; Penn World Table Version 6.2) data set, source: www.pwt.econ. The growth of GDP per capita is the average increase of GDP per capita from 1998 to 2000 and from 2000 to 2002.The data on aggregates of 6 dimensions of governance indicators is from a research working paper by a World Bank Research group, D. Kaufmann et al (2005). The governance indicators include the control of corruption, voice and accountability, political stability, government effectiveness, regulatory quality, and the rule of law. The various data set was used in running linear regression of growth and aid models using Ordinary Least Squares regression method in STATA software. These econometric operations were done to investigate empirically the following questions: 1) Do poor countries receive more aid? And generally which other factors affect the allocation of aid? 2) How does foreign aid contribute to the economic growth of developing countries? 3) Has the improvement in governance contributed in any way to economic growth 4) Does the quality of governance contribute to the effectiveness of foreign aid vis-à-vis economic growth? . Empirical results of the linear regressions show that everything else equal, poor countries get more aid than rich countries. Average aid receipts varies across the regions in the from 1998 to 2000 at the tone of 9.6%, 4.17% and 7.74% for Sub-saharan Africa, south America and central America and the Caribbean respectively. Consistent with other works, the estimation results show that lump sum aid has had no positive impact on growth. The interaction terms between aid and rule of law (Aid/GDP*rl), aid and government effectives (Aid/GDP*ge) and, aid and voice and accountability (Aid/GDP*va) have small positive coefficient, these are however not significant. This implies that aid has some impact on growth in an economy where there is enforcement of rule of law, voice and accountability and the government is effective. Apart from control of corruption which has a small positive and non significant correlation with growth, all the others have no correlation with growth. Improvement in governance has had no direct impact on growth. From the results, it seems the debate over the issue that lump sum aid has and cannot contribute to growth might take quite a different turn. This is because most empirical works have found similar results, and most significant relations between aid and growth are dependent on some factors. Quite often the ineffectiveness of lump sum aid is blamed on the governance quality of the recipient economy, but this study cannot confirm this claim in spite the fact that there is said to have been improvement in governance over the period 1996 to 2005. The effect of the opposite movement of aid could be a likely cause of the strange relationship amongst aid, governance and growth (the declining trend of aid allocation since 1994). It could equally be that there is no link between governance and growth. The thesis concludes by noting that a few developing countries are on the tract for better growth. Furthermore, that there are prospects for a brighter picture in terms of aid effectiveness and growth if there can be some procedural adjustments, both by donors and recipients. Aid should set more modest goals, like helping some of the people some of the time, rather than trying to be the catalyst for society wide transformation ( Easterly, 1993