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Growth, Foreign Aid and the Attribution Problem


By Mahima Yadav

Whether foreign aid is a prerequisite to economic growth has been a question mired in controversy for many years now. While some economists would say it has positive outcomes in terms of spurring investment growth or allaying poverty to some extent, others argue that no robust correlation has been observed between the amount of aid received and growth of the economy. It is nearly impossible to establish a causal relationship between aid and development because there is a host of factors contributing towards economic growth - foreign aid may or may not be a necessary condition for growth, but it is certainly not a sufficient one. Economic growth, therefore, cannot be attributed solely to the aid received by a country.

Riddell (2009) makes an important distinction between Official Development Assistance (ODA) and other types of aid such as humanitarian aid or emergency aid. When addressing the question of whether foreign aid propels growth, we are precisely talking about ODA, as opposed to all foreign aid combined, because it is this fraction of the aid that is directed towards economic development, poverty alleviation and growth acceleration. ODA may be extended through a direct route (government to government) or indirectly through development banks. Apart from ODA, there are international bodies such as the IMF and the World Bank that extend loans to governments, tailored to their specific circumstances - such as funding to avert an imminent financial crisis or credit granted for rural development projects. These loans from international bodies come with provisos attached - the governments ought to honour their commitment to maintaining economic stability, practice fiscal prudence and work closely with the loan-making entity to achieve desired macroeconomic objectives. Here’s the key takeaway - the aid is granted with a specific objective in mind, putting the recipient economy on the growth trajectory. However, it is expected that beyond a point, the economy will continue to thrive even after aid is withdrawn. That, indeed, is the true test of the efficacy of foreign aid.

One of the most vocal proponents of foreign aid has been Jeffrey Sachs. In his book ‘The End of Poverty’, Sachs uses a simple mathematical model to show that donor aid underpins economic growth. He illustrates how, “..donor-backed investments are needed to raise the level of capital per person”. That holds true but only in the case of a capital-starved country which is far from steady state, as argued by Prasad, Rajan & Subramanian (2007). In such an economy, addition to domestic resources helps to attain the steady state and thereby increase growth rate. But in an economy already in a steady state, the need is for better utilization of existing capital. A similar argument is formulated by Raghuram Rajan and Arvind Subramanian in a sensational research paper that went on to become one of the “most cited” papers of all time. They argue that while textbooks are necessary in schools but by focusing wholly on resources, we undermine the importance of teachers showing up in schools or proper pedagogic methods, for that matter. Drawing analogy, we conclude that we must not accord undue importance to resources. Instead, good governance and incentive policy should be instituted as well. To put it in simpler terms, aid works best in conjunction with sound economic policy, good governance and transparency. That is one point to which Sachs would concur too, for he does not believe aid to be the only driver of growth for low or middle-income economies. As has been in the case of Kenya, low income economies often fail to avail the amount of aid needed to break the poverty trap because of rampant corruption by the government. This sours the relation with donor countries, inhibiting them from offering aid for projects that may actually precipitate economic growth. Sachs points out that Kenya receives only one-fifteenth of the aid it demands.

It would be useful to dwell a little more on the controversial research paper titled ‘What Undermines Aid’s Impact on Growth?’ co-authored by Rajan and Subramanian, which touts that aid may in fact deter growth in certain scenarios. The first mechanism through which they suggest this happens is overvaluation of currency. Inflow of foreign exchange causes the currency to appreciate and unless wages adjust downwards, this renders the traded goods sector uncompetitive. This phenomenon of the rapid development of a particular sector at the cost of another (say the manufacturing sector), accompanied by currency appreciation is termed as the ‘Dutch disease’ in macroeconomic theory. The paper provides cross-country evidence that with huge foreign inflows, there is a deceleration of growth of labour intensive sectors, which are an essential driver of growth in these developing economies.

There is scarcely an econometric model that can be called perfect. Time and again, different studies have yielded conflicting results. It is intuitive because countries cannot be evaluated only based on a set of dependent and independent variables, without understanding the qualitative characteristics of the government and its economic policy. South Korea is an example of a country that was at a similar GDP level as Ghana back in 1975 but with foreign aid, it was able to chart an unprecedented growth path, going from being an aid recipient to becoming a donor at the Development Assistance Committee (DAC). It is not foreign aid that can work magic on its own but an interplay of many factors - good governance practices, fiscal responsibility, stable inflation and exchange rate - that are the true drivers of economic growth.


Mahima is a third year Economics honors student at HansRaj College and has a keen interest in financial economics, game theory, stock markets and macroeconomics


References -

‘The End of Poverty’ by Jeffrey Sachs

‘I Do What I Do’ by Raghuram Rajan

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