Foreign Aid, Public Investment and Capital Market Liberalization

This paper studies the impact of liberalization of capital market on the performance of foreign aid (FA). I consider two cases where FA is transferred to the households and where it is used to finance public investment. Two sources of endogenous productivity growth is considered: (i) public investment (ii) Learning-by-doing generated by tradable sector. Saving is endogenous. I compare two recipient economies with closed and open capital market. I show that transferred-aid reduces productivity and growth through de-industrialization if the capital market is liberalized. In the case of closed capital market transferred-aid can improve the growth (through improving the accumulation of capital) if LBD effect and consumption intensity to N-sector are small. On the contrary, the effect of invested-aid on growth is positive only if the quality of aid is high and the LBD effect and the intensity of public investment to N-sector are low. In this case, the effect of invested-aid on productivity is higher in the case of closed capital market. Nevertheless, productive foreign aid crowds out capital accumulation if capital market is closed while it leads to capital inflow if capital market is open. I show that the impact of invested-aid on GDP is more important for financially liberalized economy if LBD effect is low and private consumption is not very intensive to the N-sector.