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Foreign Aid And The Business Cycle

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Author Info
Michel A. Robe () (American University)
Stephane Pallage

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Abstract

In this paper, we document some key business cycle properties of foreign aid flows to developing countries. We identify two striking empirical regularities. First, aid flows are highly volatile over time -- on average, two to three times as volatile as the recipient's output. Second, for most African countries, net aid inflows are strongly positively correlated with their domestic output. Outside of Africa, we find a similar, if somewhat less pronounced, pattern of aid procyclicality.To see why these empirical regularities are important, recall that output fluctuations in developing countries are much stronger than in industrialized economies. Indeed, we document that the gross domestic product of an aid recipient is on average six times as volatile as that of a donor. For developing countries, though, customary ways to smooth out the impact of output fluctuations on domestic consumption are likely to be very onerous. For instance, moral hazard and repudiation risk imply that heavily indebted nations are often denied new loans (or are asked to repay old ones) precisely when their economies suffer adverse shocks -- see, e.g., Atkeson-1991). At the same time, foreign aid is a sizeable source of income to recipients, especially in Africa, where it averages 12.5% of gross domestic product and constitutes the main source of foreign capital. In such an environment, foreign aid flows have the potential to play a key role in smoothing out developing countries' output fluctuations. Our results imply that, all in all, aid does not play that role.Admittedly, it might be argued that, except for emergency relief, the chief purpose of foreign aid is not to act as an insurance device but, instead, to fuel economic development, in which case it is not clear a priori whether one should expect aid flows to be procyclical or countercyclical. It is well known, however, that output fluctuations affect growth negatively -- see, e.g., Hamilton (1989) and Ramey&Ramey (1995). Hence, even if aid were meant solely to help foster growth, serious concerns should nonetheless arise from the fact that aid disbursement patterns contribute to the volatility of developing countries' disposable income.Our findings are robust. Our data set comprises various yearly aid and output series for sixty-three recipient and eighteen donor countries between 1969 and 1995. We find few differences between the cyclical behavior of multilateral as opposed to bilateral aid disbursements, even though multilateral aid flows are relatively more volatile than their bilateral counterparts. Likewise, aid commitments fluctuate more than actual net disbursements, but both commitments and disbursements are procyclical. We also pay special attention to Africa, because it is the region where aid is largest relative to recipient GDP and aid procyclicality is most striking. We show that, regardless of the domestic output measure used, net aid receipts are procyclical for at least two-thirds of the thirty-eight countries in our African subsample and are countercyclical for, at most, two of them. Key components of African aid, such as grants or technical assistance, are as strongly procyclical as total aid flows. Finally, we can find no evidence that, among African countries, the procyclicality of aid might be a function of the recipient's former colonial power, choice of exchange rate regime or some other criterion.We complete the paper by analyzing the cyclical properties of aid flows from the donors' perspective. For almost all donor countries, we find that total aid disbursements are strongly positively correlated with the donor's output. In a clear majority of cases, however, those same donors' bilateral aid flows to the sample countries are not positively correlated with the donor's output. A corollary is that the procyclicality of aid inflows experienced by aid recipients is not the mere result of the conjunction of (i) positive comovements between North-South business cycles [Kouparitsas (1998); Agenor&Prasad (1999)] and (ii) a positive correlation between donors' aid policies and their business cycles.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 107.

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Date of creation: 05 Jul 2000
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Publication status: forthcoming, Review of International Economics, 9 (4), pp. 637-668, November 2001 (version differs from working paper)
Handle: RePEc:sce:scecf0:107

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  21. Hansen, Henrik & Tarp, Finn, 2001. "Aid and growth regressions," Journal of Development Economics, Elsevier, vol. 64(2), pages 547-570, April. [Downloadable!] (restricted)
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  25. Easterly, William, 1999. "The ghost of financing gap: testing the growth model used in the international financial institutions," Journal of Development Economics, Elsevier, vol. 60(2), pages 423-438, December. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Benedict J. Clements & Sanjeev Gupta & Erwin Tiongson, 2003. "Foreign Aid and Consumption Smoothing: Evidence from Global Food Aid," IMF Working Papers 03/40, International Monetary Fund. [Downloadable!]
  2. Stan du Plessis, 2006. "Business Cycles in Emerging market Economies: A New View of the Stylised Facts," Working Papers 02/2006, Stellenbosch University, Department of Economics. [Downloadable!]
  3. Fleck, Robert K. & Kilby, Christopher, 2009. "Changing Aid Regimes? U.S. Foreign Aid from the Cold War to the War on Terror," Villanova School of Business Department of Economics and Statistics Working Paper Series 1, Villanova School of Business Department of Economics and Statistics. [Downloadable!]
  4. Hansen, Henrik & Headey, Derek, 2007. "The Short-Run Macroeconomic Impact of Foreign Aid to Small States: An Agnostic Timeseries Analysis," Working Papers UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER). [Downloadable!]
    Other versions:
  5. Headey, Derek & Malaiyandi, Sangeetha & Fan, Shenggen, 2009. "Navigating the perfect storm: Reflections on the food, energy, and financial crises," IFPRI discussion papers 889, International Food Policy Research Institute (IFPRI). [Downloadable!]
  6. Claudia M. Buch & Anja Kuckulenz & Marie-Helene Le Manchec, 2002. "Worker Remittances and Capital Flows," Kiel Working Papers 1130, Kiel Institute for the World Economy. [Downloadable!]
  7. Sayan, Serdar & Tekin-Koru, Ayca, 2007. "Remittances, Business Cycles and Poverty: The Recent Turkish Experience," MPRA Paper 6029, University Library of Munich, Germany. [Downloadable!]
  8. Addison, Tony & Mavrotas, George & McGillivray, Mark, 2005. "Development Assistance and Development Finance: Evidence and Global Policy Agendas," Working Papers RP2005/23, World Institute for Development Economic Research (UNU-WIDER). [Downloadable!]
  9. Tony Addison & George Mavrotas & Mark McGillivray, 2005. "Development assistance and development finance: evidence and global policy agendas," Journal of International Development, John Wiley & Sons, Ltd., vol. 17(6), pages 819-836. [Downloadable!]
  10. Guillaumont, Patrick & Guillaumont Jeanneney, Sylviane, 2007. "Big Push versus Absorptive Capacity: How to Reconcile the Two Approaches," Working Papers UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER). [Downloadable!]
    Other versions:
  11. Serdar Sayan, 2006. "Business Cycles and Workers' Remittances: How Do Migrant Workers Respond to Cyclical Movements of GDP at Home?," IMF Working Papers 06/52, International Monetary Fund. [Downloadable!]
  12. John Serieux, 2007. "Managing the Exchange Rate Consequences of an MDG-Related Scale-up in HIV/AIDS Financing," Conference Paper 1, International Policy Centre for Inclusive Growth. [Downloadable!]
  13. Stephane Pallage & Michel Robe, 2000. "Magnitude X on the Richter Scale: Welfare Cost of Business Cycles in Developing Countries," Cahiers de recherche CREFE / CREFE Working Papers 124, CREFE, Université du Québec à Montréal. [Downloadable!]
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  14. Odedokun, Matthew, 2003. "Analysis of Deviations and Delays in Aid Disbursements," Working Papers UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER). [Downloadable!]
  15. Smita Wagh & Sanjeev Gupta & Catherine A. Pattillo, 2006. "Are Donor Countries Giving More or Less Aid?," IMF Working Papers 06/1, International Monetary Fund. [Downloadable!]
  16. K C Neanidis & D Varvarigos, 2005. "The Impact of Foreign Aid on Economic Growth: Volatility of Disbursements and Distribution of Receipts," Centre for Growth and Business Cycle Research Discussion Paper Series 56, Economics, The Univeristy of Manchester. [Downloadable!]
  17. Rune Jansen Hagen, 2002. "Marginalisation in the Context of Globalisation: Why Is Africa so Poor?," Nordic Journal of Political Economy, Nordic Journal of Political Economy, vol. 28, pages 147-179. [Downloadable!]
  18. Almuth Scholl, 2009. "Aid Effectiveness and Limited Enforceable Conditionality," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 377-391, April. [Downloadable!] (restricted)
    Other versions:
  19. Cristina Arellano & Aleš Bulir & Timothy D. Lane & Leslie Lipschitz, 2005. "The Dynamic Implications of Foreign Aid and Its Variability," IMF Working Papers 05/119, International Monetary Fund. [Downloadable!]
    Other versions:
  20. Kyriakos C. Neanidis & Dimitrios Varvarigos, 2007. "The Allocation of volatile aid and economic growth: Evidence and a suggestive theory," Discussion Paper Series 2007_07, Department of Economics, Loughborough University, revised Mar 2007. [Downloadable!]
  21. Alex Cobham (QEH), . "Tax Evasion, Tax Avoidance and Development Finance," QEH Working Papers qehwps129, Queen Elizabeth House, University of Oxford. [Downloadable!]
  22. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Vegh, 2004. "When it Rains, it Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Working Papers 10780, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  23. Chauvet, Lisa & Guillaumont, Patrick, 2008. "Aid, Volatility and Growth Again: When Aid Volatility Matters and When It Does Not," Working Papers RP2008/78, World Institute for Development Economic Research (UNU-WIDER). [Downloadable!]
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