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The effects of foreign aid: Dutch Disease

This blog post was written by Arvind Subramanian, Senior Fellow at the Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor at Johns Hopkins University.

The voluminous literature on the effects of foreign aid on growth has generated little evidence that aid has any positive effect on growth. This seems to be true regardless of whether we focus on different types of aid (social versus economic), different types of donors, different timing for the impact of aid, or different types of borrowers (see here for details).  But the absence of evidence is not evidence of absence. Perhaps we are just missing something important or are not doing the research correctly.

One way to ascertain whether absence of evidence is evidence of absence is to go beyond the aggregate effect from aid to growth and look for the channels of transmission. If we can find positive channels (for example, aid helps increase public and private investment), then the “absence of evidence” conclusion needs to be taken seriously. On the other hand, if we can find negative channels (for example, aid stymies domestic institutional development), the case for the “evidence of absence” becomes stronger.

One such channel is the impact of aid on manufacturing exports. Manufacturing exports has been the predominant mode for escape from underdevelopment for many developing countries, especially in Asia. So, what aid does to manufacturing exports can be one key piece of the puzzle in understanding the aggregate effect of aid.

In this paper forthcoming in the Journal of Development Economics, Raghuram Rajan and I show that aid tends to depress the growth of exportable goods. This will not be the last word on the subject because the methodology in this paper, as in much of the aid literature, could be improved.

But the innovation in this paper is not to look at the variation in the data across countries (which is what almost the entire aid literature does) but at the variation within countries across sectors. We categorize goods by how exportable they could be for low-income countries, and find that in countries that receive more aid, more exportable sectors grow substantially more slowly than less exportable ones. The numbers suggest that in countries that receive additional aid of 1 percent of GDP, exportable sectors grow more slowly by 0.5 percent per year (and clothing and footwear sectors that are particularly exportable in low-income countries grow slower by 1 percent per year).

We also provide suggestive evidence that the channel through which this effect is felt is the exchange rate. In other words, aid tends to make a country less competitive (reflected in an overvalued exchange rate) which in turn depresses the prospects of the more exportable sectors. In the jargon, this is the famous “Dutch Disease” effect of aid.

Our research suggests that one important dimension that donors and recipients should be mindful of (among many others that Bill Easterly has focused on) is the impact on the aid-receiving country’s competitiveness and export capability. That vital channel for long run growth should not be impaired by foreign aid.

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2 Comments

  1. Robert Tulip wrote:

    Aid is not about economic growth it is about political relationships. Competitiveness is anathema to aid bureaucracies who prefer to encourage cooperation. Growth needs a pioneer spirit, but aid often avoids work with pioneering entrepreneurs on the basis of a spurious poverty analysis (that firms are doing okay and don’t need help). It is no surprise that the “neo-communist” trend in overseas aid has failed to promote exports and instead has fostered economic stagnation.

    Posted December 18, 2009 at 2:50 am | Permalink
  2. Luis Enrique wrote:

    At risk of being too simplistic, this and the blogosphere’s other recent discussion of the effect of aid upon growth, suggest two simple conclusions: 1. aid should include measures to help exporters 2. aid should include measures to reduce the fertility rate.

    The first can be done without trying to be a ‘planner’, the second is likely to fall foul of our host, and I know there are many other objections to attempting population control. But I don’t know what the right conclusion is.

    Posted December 18, 2009 at 6:32 am | Permalink

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  1. By uberVU - social comments on December 18, 2009 at 10:42 am

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  2. [...] respected Journal of Development Economics has just accepted the final version, and Arvind today blogged it at Aid Watch as a guest of JDE co-editor Bill [...]

  3. By Some offshore blogs « catallaxy files on December 20, 2009 at 4:33 pm

    [...] This provides a critical appraisal of the effectiveness of aid and a search for aid that works. Very little aid does help, in fact most is counter-productive as Peter Bauer reported many years ago. [...]