Foreign aid and economic development:

Can aid help poor countries?

The effectiveness of foreign aid in economic development remains a controversial issue.

More than five decades have passed in the debate about whether aid can bring economic
welfare to poor countries. While critics argue that aid flows, on average, have been
empirically ineffective in accelerating economic growth and alleviating poverty in the
recipient countries (Easterly 2007), and sometimes even worsened recipients’ economic
conditions (Moyo 2009), proponents of foreign aid argue that it is not possible to lift
more than half of the world’s population out of extreme poverty without the help of the
rich and therefore, they advocate for further expansion of aid (Sachs 2005). While the
debate goes on, flows of foreign aid have not declined over time but rather have
increased by more than twenty-fold in absolute value over the past five decades (OECD
2012).

Development experts have therefore become increasingly concerned if poor countries

need more foreign aid or they need more effective implementation of aid. If aid should
continue to help poor countries ‘climb up the ladder of economic development’, how it
should be done effectively. This essay argues that poor countries still need more foreign
aid to hasten their efforts in growth acceleration, poverty alleviation and social
improvements; however the desired success will depend broadly on effective
implementation bolstered by good governance, better policies, proper incentives, and
greater coordination.

The essay is structured as follows. The first section highlights the trends in official
development assistance (ODA) over the past five decades while the second provides a
theoretical framework that explains how aid can influence economic growth of recipient
countries. The third section briefly analyzes arguments and counter-arguments for aid.
In the fourth section, Bangladesh is taken as a case study to explain the importance of
aid for well performing developing countries. The fifth section offers some policy
recommendations to increase aid effectiveness in poor countries. Finally, the essay
concludes that more aid should flow to countries with better economic policies and
steady economic performance to accelerate their development efforts.
1
Theoretical framework

Theoretically foreign aid can have positive influence on economic growth of poor
countries through relaxation of constraints they face, for example, savings constraint
and foreign exchange constraint, enabling them to fill in the lacking resources (Arndt et
al. 2010, p. 2). According to the Harrod-Domar growth model (Harrod 1939; Domar
1946), increased savings lead to higher stock of capital and therefore higher level of
steady-state output. Therefore, Harrod-Domar model justifies the role of aid in
augmenting savings of poor counties. Hansen and Tarp (2000) find positive correlation
between aid flows and total savings. Role of aid in economic development can also be
explained by endogenous growth theories (Romer 1986; Lucas 1988) which stress the
importance of technology, physical and human capital in accelerating growth rate of
output. Foreign aid can therefore augment poor countries’ capacity to invest more in
human and physical capital which would be difficult in early stages of development
without donor support.

Trends in foreign aid

Aggregate official development assistance amounted to US $125.6 billion (0.29 per cent
of GNI) in 2012 (OECD 2012). In absolute value, ODA has increased sharply over time
from around US $6.5 billion in the 1960s to around 95.0 billion in the 2000s. Net ODA
received per capita also followed increasing trend over the last five decades, however
remained almost stagnant in terms of gross national income (GNI) (Table 1). Therefore,
it is difficult to conclude if the volume of development assistance has increased
substantially over time as argued by critics (Easterly 2007, p. 329).

Table 1 Total flows of official development assistance (1960s-2000s)

1960s 1970s 1980s 1990s 2000s

ODA (billion US $) 6.44 13.16 35.90 56.13 94.77
ODA per capita (US $) 1.83 4.43 7.75 9.72 14.76
ODA (% of GNI) 0.43 0.32 0.33 0.26 0.28
Source: OECD (2012); World Bank (2012).

2
Foreign aid and economic development of poor countries

Economists differ in views while analyzing the effectiveness of foreign aid in enhancing
economic growth of poor countries. It seems that the literature is weighted towards
confirming aid ineffectiveness (Doucouliagos & Paldam 2011, p. 403). Taking the
example of Africa, Easterly (2007, p. 329), argues that Africa has been one of the
highest aid recipients in the world over the last four decades and yet, per capita GDP
growth of African nations remains close to zero. Earlier, Easterly (2002, p. 115)
criticized the ‘adjustment lending’ program of the World Bank and IMF by arguing that
the program had no impact on per capita income of the recipients.

Critics argue that foreign aid can even thwart economic development of poor countries.
According to Moyo (2009), Africa has been receiving more than US $50 billion each
year as international assistance and yet Africa remains one of poorest in world with
higher degree of inequality and slower economic growth. She advocates for complete
withdrawal of aid from Africa and concludes that long run dependency on aid delays
economic progress of poor countries.

Better policy environment may not guarantee effective implementation of aid. Rajan
and Subramanian (2008, p. 644) applying cross country panel regression for the period
1960-1990 find no significant relationship between better policy or institutional
environments and aid effectiveness. Moss et al. (2008, pp. 259-262) concludes that aid
may lead to inefficient institutions and anti-developmental outcome.

Proponents of aid, on the other hand, find strong positive relationship between aid and
economic growth of poor countries. Burnside and Dollar (2000, p. 849) find positive
correlation between aid and growth, however conditional upon macroeconomic policies
of recipient countries. McGillivray et al. (2006) argue that there are limits for poor
countries to effectively absorb the flow of aid and therefore aid-growth relationship
exhibits diminishing returns; however aid to GDP ratio in poor countries still indicates
greater scopes for a ‘big push’ (2006, p. 59). In fact, McGillivray et al. (2006, p. 64)
estimate that aid exhibits diminishing returns when it accounts for more than 20.7 per
cent of GDP which is far below the prevailing aid-GDP ratio in developing countries.

3
Aid flows to poor countries are not substantial if measured in terms of per capita and
gross national income (Table 1). Sachs (2005) argues that international aid flows had
not been extensive over the past few decades rather were low in terms of per capita and
therefore, more aid should flow to poor countries to lift more than half of the world’s
population out of the ‘poverty trap’. According to Sachs, development aid needs to be
raised to 0.7 per cent of GDP of the developed countries to eliminate extreme poverty.

Aid can act as a stimulus to the recipient governments to engage in politically costly but
growth enhancing economic reforms (Bearce and Tirone 2010, p. 840). Sachs (2005)
argues that corruption which is one of the major reasons for non-performance of aid in
poor countries itself provides a rationale for expansion of aid in those countries to
enable them to invest more in improvement of governance.

While we find significant divergence in empirical findings on aid-growth relationship,

Clemens et al. (2011, p. 613) argue that most of the substantial divergence can be
eliminated if we allow for some adjustments in econometric techniques. They find that
by allowing lag effects of aid on growth, distinguishing between short run and long run
impact of aid and taking into account bilateral causation between growth and aid, most
of the disagreements disappear. They conclude that aid, on average, leads to an increase
in investment and growth, however with varying magnitudes across countries (2011, p.
613).

There are examples of many countries which have achieved desired success with aid,
for example, Korea and Botswana in the 1970s, Ghana and Bolivia in the late 1980s,
Vietnam and Uganda in the 1990s through innovation in technologies, expansion of
public services and extensive reforms in public policies (World Bank 1998).

Case Study: Bangladesh

Bangladesh is a remarkable example of economic turnaround with more than eighteen-

fold increase in nominal GDP, while only a little over two-fold increase in population
over the past four decades (World Bank 2012). While the development experts like
Henry Kissinger once labeled Bangladesh as a ‘basket case’ for economic development
immediately after its liberation in 1971 (The Economist 2012), Bangladesh has been

4
growing steadily at around 6 per cent per annum, on average, over the last 10 years with
sharp decline in poverty from 56.6 per cent in 1992 to 31.5 per cent in 2010.
Bangladesh is well on track to achieve most of the millennium development goals
(MDGs); recently been awarded for impressive performance in reducing child mortality
(United Nations 2012). Bangladesh performed well in human development indicators
with relatively lower level of income per capita than other South Asian countries
including India (Sen 2012).

Net ODA in Bangladesh accounts for 2 per cent of GNI, on average, for the period
2000-2010 compared to 8.3 per cent in least developed countries (LDCs), 0.8 per cent in
South Asia, and 4.9 per cent in Sub-Saharan Africa (World Bank 2012). Aid-GNI ratio
has declined over time from more than 6 per cent in the 1980s to 2 per cent in the 2000s.
While net ODA has increased by more than four-fold in Sub Saharan Africa over the
last four decades, it has decreased in Bangladesh despite steady economic and social
performance (Figure 1).

Figure 1 Net ODA received per capita, 1970s-2000s (US$)

45.0
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
1970s 1980s 1990s 2000s
LDCs South Asia Sub-Saharan Africa Bangladesh

Source: World Bank (2012)

Aid in Bangladesh is mostly allocated for improvements in governance, private sector,

agriculture, infrastructure and social sectors including health, education, gender equity
and environmental protection (Quibria & Ahmad 2007, pp. 13-18). According to
donors’ evaluations, aid effectiveness has been mixed in Bangladesh; World Bank
regards its assistance program to Bangladesh as ‘mixed result’ (World Bank 2009).

5
Bangladesh is a net importing country which suggests that aid can play a significant role
in relaxing foreign exchange constraint. Collier (2013, p. 14) argues that development
assistance should target countries with long-term growth prospects which would
translate into massive reduction in poverty in the long run. Macroeconomic
performance, economic policies and steady improvement in social indicators therefore
label Bangladesh as a deserving candidate for foreign aid. While progress in poverty
alleviation has been noteworthy, still more than 30 per cent of population lives in
extreme poverty, indicating the need for expansion in aid to hasten Bangladesh’s efforts
in economic development.

How foreign aid implementation and effectiveness can be improved

Institution is an important determinant of aid effectiveness in poor countries. Easterly

(2002) identifies poor governance as one of the major reasons for non-performance of
‘adjustment lending’ in tropical countries (p. 107). Easterly recommends that aid should
be incentive based and linked to past economic performance allowing recipients to
compete to be considered for future allocation (p. 117). Corruption is another major
obstacle to effective implementation of aid in poor countries. Sachs (2005) argues that
corruption leads to poor governance and poor countries find it difficult to invest heavily
in improvement of governance with their resource constraint and therefore more aid
should be targeted towards improvement of governance. Morrissey (2002, p. 167)
suggests that aid conditionality should be country specific with greater coordination
among donors and recipient governments. Collier and Dollar (2001, p. 1428) argues that
large scale poverty and good policy are necessary conditions for aid to have significant
impact on poverty in poor countries.

To conclude, this discussion suggests that aggregate aid effectiveness remains a mystery
to the economists. However, there is strong empirical evidence of aid effectiveness in
countries with lower level of corruption and better institution. This paper therefore
argues that well performing poor countries with better policy and institutional
environment still deserve modest support from the rich to continue their efforts in
growth acceleration and poverty alleviation. Many poor countries with right economic

6
policies are performing well with aid and therefore a reduction in aid should not
jeopardize their development efforts.

References

Arndt, C, Jones, S & Tarp, F 2010, ‘Aid, growth, and development: have we come full
circle?’, WIDER Working Paper, no. 96, World Institute for Development Economics
Research, United Nations University, viewed 26 April 2013,
<http://hdl.handle.net/10419/54076>.

Bearce, DH & Tirone, DC 2010, ‘Foreign aid effectiveness and the strategic goals of
donor governments’, The Journal of Politics, vol. 72, no. 3, pp. 837–85.

Burnside, C & Dollar, D 2000, ‘Aid, policies, and growth’, The American Economic
Review, vol. 90, no. 4, pp. 847- 68.

Clemens, MA, Radelet, S, Bhavnani, RR & Bazzi, S 2011, ‘Counting chickens when
they hatch: timing and the effects of aid on growth’, The Economic Journal, vol. 122,
pp. 590-617.

Collier, P & Dollar, D 2001, ‘Aid allocation and poverty reduction’, European
Economic Review, vol. 46, pp. 1475–1500.

Collier, P 2013, ‘Aid as a catalyst for pioneer investment’, WIDER Working Paper, no.
004, World Institute for Development Economics Research, United Nations University,
viewed 22 April 2013,
< http://www.wider.unu.edu/stc/repec/pdfs/wp2013/WP2013-004.pdf>.

Doucouliagos, H & Paldam, M 2011, ‘The ineffectiveness of development aid on

growth: an update’, European Journal of Political Economy vol. 27, pp. 399–404.
Easterly, W 2007, ‘Was development assistance a mistake?’, The American Economic
Review, vol. 97, no. 2, pp. 328-332.

Easterly, W 2007, ‘Was development assistance a mistake?’, The American Economic

Review, vol. 97, no. 2, pp. 328-332.

________2002, The elusive quest for growth: economists’ adventures and

misadventures in the tropics, The MIT Press, Cambridge, Massachusetts, pp. 101-333.

Feeny, S & McGillivray, M 2011, ‘Scaling-up foreign aid: will the ‘big push’ work?’,
The World Economy, Blackwell, Oxford.

Hansen, H & Tarp, F 2000, ‘Aid effectiveness disputed’, Journal of International

Development, vol. 12, pp. 375-398.

Morrissey, O 2002, ‘Conditionality and aid effectiveness re-evaluated’, The World

Economy, vol. 27, no. 4, pp. 153-171.
7
Moss, T, Pettersson, G & van de Walle, N 2008, ‘An aid-institutions paradox? A review
essay on aid dependency and state building in Sub-Saharan Africa’, in W Easterly (ed.)
Reinventing foreign aid, MIT Press, Cambridge, MA.

Moyo, D 2009, ‘Why foreign aid is hurting Africa’, The Wall Street Journal, viewed 3
May 2013,
<http://online wsj.com/article/SB 123758895999200083.html>

Quibria, MG & Ahmad, S 2007, ‘Aid effectiveness in Bangladesh’, MPRA Paper, no.
10299, Munich Personal RePEc Archive, viewed 6 May 2013,
<http://mpra.ub.uni-muenchen.de/10299/>.

Rajan, RG & Subramanian, A 2008, ‘Aid and growth: what does the cross country
evidence really show?’, The Review of Economics and Statistics, November 2008, vol.
90, no. 4, pp. 643-665.

Sachs, J 2005, The end of poverty: economic possibilities for our time, Penguin, New
York.

Sen, A 2011, ‘Quality of life: India vs. China’, The New York Review of Books’, viewed 10
May 2013,
<http://www.nybooks.com/articles/archives/2011/may/12/quality-life-india-vs-
china/?pagination=false>.

The Economist 2012, ‘Bangladesh: out of the basket’, 2 November, viewed 5 May
2013,
<http://www.economist.com/blogs/feastandfamine/2012/11/bangladesh>.

The Organisation for Economic Co-operation and Development 2013, International

Development Statistics, viewed 26 May 2013,
<http://www.oecd.org/dac/stats/international-development-statistics.htm>.

The World Bank 2009, The IEG report: Bangladesh country assistance evaluation,
2001-08, The World Bank, viewed 23 May 2013,
< http://ieg.assyst-uc.com/Data/reports/FTB-
FY2010%20Bangladesh%20desk_to_desk_06_04_10.pdf>.

The World Bank 2012, World Development Indicators, The World Bank, viewed 23
May 2013,
<http://data.worldbank.org/news/world-development-indicators-2012-now-available>.

United Nations 2012, Millennium Development Goals Report 2012, United Nations,
viewed 19 May 2013,
<http://mdgs.un.org/unsd/mdg/Resources/Static/Products/Progress2012/English2012.pdf>.