The effects of foreign aid on economic growth in developing countries

Decades of research regarding the effect of foreign aid on economic growth in less developed countries have produced inconclusive results. Research in this literature has been plagued by a variety of empirical impediments. Among them, measurement and endogeneity issues, sparse sets of control variables that may be correlated with both foreign aid and economic growth such as institutional quality, and disagreements regarding the appropriate econometric methodology. This paper highlights a further issue: the heterogeneous effects of foreign aid on growth across less developed countries. Previous studies have pooled all of the developing countries together, treating them as homogenous, despite that developing countries are vastly different across both observable and unobservable dimensions. Developing countries differ in their stages of development, per capita income, socio-economic, financial, and political characteristics. For this reason, the World Bank (2012) broadly classifies the developing countries into two categories: low income developing countries (LIDCs) and high income developing countries (HIDCs) based on per capita income. Our hypothesis is that the relationship between foreign aid and economic growth should be different among LIDCs and HIDCs. For this reason, we analyze the relationship between foreign aid and economic growth separately for LIDCs and HIDCs, producing estimates using samples which are more likely to be homogenous. Integrating the fullest set of control variables thus far in the literature such as unemployment rate, capital formation, government budget surplus, inflation rate, degree of trade openness, and corruption, and using GMM methodology in a dynamic setting we find that foreign aid has positive effects on growth in high-income developing countries and negative effects on growth in low-income developing countries. We also find that higher unemployment rates, higher inflation, and higher levels of corruption reduce economic growth in both LIDCs and HIDCs. Additionally, higher level of capital formation, a larger budget surplus, and higher degrees of trade openness contribute positively to economic growth in both LIDCs and HIDCs. We do not find any evidence that time trends in the data affect our results. The result remains after accounting for endogeneity concerns and when a measure of institutional quality proxied by corruption. The finding implies that foreign aid has beneficial effects in high-income developing countries which are at latter stages of development. This suggests that countries need to gain some "traction" before foreign aid can help.