Foreign aid, institutional quality and government fiscal behavior in emerging economies: An empirical investigation

Following the aid disbursements, if the total government spending increases less than the total amount of foreign aid in the recipient developing economies, foreign aid is presumed to be fungible. In this case, aid becomes substitute for the domestic government spending rather than supplement and fails to fully achieve the provision of goods and services intended by the donors. This paper examines the link between foreign aid and government spending in the presence of fungibility and how the quality of governance and institutions affects the degree of aid fungibility. Our results show that fungibility is still an existing problem for the aid recipient economies with higher governance quality but the degree of fungibility (substitution away from the domestic government spending in response to aid inflows) is lower (foreign aid crowds out government spending less) in those countries. We find that government spending is more responsive to increases in foreign aid (i) in the presence of is political stability and free media, (ii) while corruption is reduced, contracts are enforced, property rights are protected and (iii) when the government has a higher regulatory power in implementing sound policies. These results suggest that poor governance quality might be one of the neglected measures in aid’s (in)effectiveness riddle.