Does foreign aid impede economic complexity in developing countries?

Foreign aid is one of the most important policy tools that developed countries use to help poor countries improve population well-being and facilitate economic and institutional development. However, the effectiveness of aid as an instrument of development has been questioned several times, especially for its deleterious effects on governance. This study examines the effect of foreign aid on economic complexity in 78 developing countries over the period 1990–2017. We combine different identification strategies and the following results are established. First, we find evidence that foreign aid reduces economic complexity. Second, we show that the effect of foreign aid on economic complexity is heterogeneous to the level of economic complexity and to the nature of aid received. More specifically, we show that while foreign aid reduces economic complexity in countries with lower levels of economic complexity, the effect is positive in countries with higher levels of economic complexity. Additionally, we show that while foreign aid in the energy and education sectors increases economic complexity, the effect is negative for agricultural and humanitarian aid. Three, we further find a U-shaped relationship between foreign aid and economic complexity. Finally, the empirical results of this paper show that democracy mitigates the negative effect of foreign aid on economic complexity. Thus, in order to benefit from the effects of foreign aid for better economic complexity, the governments of developing countries would benefit from putting more effort into improving democracy.