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What are the main ways in which aid might hurt economic growth, and to what extent can they be mitigated? The effects of foreign aid on recipient countries is a highly debated topic and the literature remains inconclusive. Critics such as Bauer (1972; 1984), Easterly (1999; 2003), Knack (2001) and Rajan and Subramanian (2011) argue that aid has exacerbated poor governance, worsened economic growth while enriching political elites and has been significantly wasted due to enlarged government bureaucracies and corrupt officials (Radelet, 2006). On the other hand, supporters of aid attempt to demonstrate how despite its flaws, foreign aid contributes to economic growth and poverty reduction in certain countries and has limited the poor performance of others. Galiani et al. (2014) investigate the causal effect of aid on growth and determine that aid promotes growth by increasing physical investment. Similarly, Durbarry (1998, p. 27) utilises the Harrod - Domar model to argue that in the presence of a savings gap, foreign aid increases capital stock and hence accelerates the economic growth rate. There is evidence to support both arguments. It is clear that aid has hurt economic growth in some countries, notably the Democratic Republic of the Congo, Haiti and Somalia while in others it has promoted growth, for instance in Indonesia, Tanzania and Mozambique (Radelet, 2006, p. 3). There are many different factors which determine whether foreign aid will be successful at increasing the growth rate and these must be carefully evaluated in order to direct aid effectively. Additionally, policies to mitigate the negative impact of aid on economic development must be implemented. The first section of this essay focuses on the principal ways in which aid damages growth, followed by a discussion on how these can be moderated. Subsequently I offer counter arguments which challenge the rather pessimistic school of thought that asserts that foreign aid is bad for developing countries and their economies. Ultimately, I take the middle ground and argue that although there are adverse consequences of aid on growth, these are not a direct result of aid itself but rather due to underlying structural issues and poor governance found in many developing countries. According to Rajan and Subramanian (2011), the effects of aid on economic growth are similar to those of the Dutch disease (Corden, 1984, p. 359). Aid has the potential to adversely affect economic growth by causing an appreciation of the real exchange rate in the recipient country and ultimately resulting in a decline in the relative growth rate of the manufacturing sector and exportable industries (Rajan and Subramanian, 2011). Using a within-country cross-industry framework, Rajan and Subramanian (2011, p. 106) argue that through the resource movement effect and the spending effect, aid inflows cause a real exchange rate appreciation. The resource movement effect occurs when aid is directed at expanding the non-tradable sector which subsequently leads to a contraction of the tradable sector.

When aid is targeted towards non-tradable services, as it usually is (Chowdhury, 1999, p. 13), such as on improving health and education, assuming a fixed supply of labour in the short term the result will be an increase in wages in that sector. Higher wages will then attract a greater supply of skilled labour into the non-tradable sector thereby simultaneously pushing up wages in the tradable sector (Rajan and Subramanian, 2011). Since the price of traded goods are set by the international market, higher wages in the tradable sector reduces the competitiveness and profitability of exportable industries and causes a decline in exports (White, 1992, p. 226). A decline in exports reduces aggregate demand and therefore real GDP growth. Furthermore, according to Rajan and Subramanian (2011, p. 106), the increased wages will be spent, thereby pushing up the price of non-tradables relative to traded goods. This rise in the real exchange rate makes exports more expensive and thus reduces the tradable sector’s competitiveness. This is known as the spending effect. Rajan and Subramanian (2011, p. 107) conclude that countries that receive more aid have a smaller manufacturing sector and lower economic growth. Another interesting critique of aid put forward by Bauer (1979; 1984), Friedman (1958) and Krauss (1983) asserts that foreign aid increases the role of the recipient country’s government and consequently harms economic development. These critics of aid base their argumentation on laissez faire economic theory which maintains that economies function more effectively in absence of state interference. In this regard, aid should be eliminated as it impedes the efficiency of the free market (Bauer, 1979, p. 239) and supports “bureaucratic centralised states against the interests of economic development” (White, 1992, p. 163). Correspondingly, Krauss (1983, p. 90) argues that the absence of aid is necessary for economic development. He points to countries such as Taiwan and South Korea where significant economic growth occurred when aid was stopped and pro-market reforms were implemented (White, 1992, p. 160). Furthermore, Bauer (1984) postulates that aid allows governments to adopt policies which harm the competitive sectors of the economy and hence economic growth itself. For instance, a government may artificially maintain an overvalued exchange rate in order to curb inflation or increase political stability (ibid.). However, an overvalued exchange rate may affect export competitiveness and reduce manufacturing sector output. Rather than rely on foreign aid, free market economists suggest that countries should borrow money to finance their investments (Riddell, 1987, p. 159). Finally, according to Knack (2001), Bauer (1984) and Yiew and Lau (2018), sustained flows of aid can lead to aid dependence and ultimately undermine the quality of governance in the recipient country. If a developing country is reliant on a more developed country for financial support, meaning a large proportion of government revenue is derived from foreign aid, then it is argued that self-sufficiency becomes less likely and GDP growth will not reach its full potential (Knack, 2001). This is especially true for food aid as it harms the domestic economy by reducing demand for domestically produced goods. Moreover, food aid can create competition and conflict as it did in Somalia (ibid., 312). Apart from its apparent direct impact on GDP growth itself, aid dependence allegedly poses other threats to economic development. One theory claims that too much foreign aid overwhelms the government with aid projects which subsequently causes ‘the business of government’ to shift its focus on satisfying the needs of donors rather than those of its citizens or its economy (Collier, 1999, p. 530). Knack (2001, p. 310) further states that aid dependence affects the quality of governance by “weakening accountability, encouraging rent-seeking and corruption, instigating conflict over control of aid funds, siphoning off scarce talent from bureaucracy, and alleviating pressures to reform inefficient policies and institutions”. With regard to accountability, foreign aid, unlike tax revenue does not create significant incentives for the state to act accordingly. Drawing on evidence from Somaliland, a study conducted by Eubank (2012) establishes that there is a significant link between taxation and political accountability as a result of revenue bargaining. Foreign aid on the other hand reduces political accountability as it removes the ability for citizens to bargain with their governments and make demands (Eubank, 2012, p. 478). There is evidence to suggest that aid effectiveness, often measured by economic growth, is conditional on political accountability and institutional quality (Winters, 2010, p. 226). This provides the basis for the ‘radical leftist criticism’ which maintains that the political and institutional restrictions of developing countries are too substantial for aid to be effective (Riddell, 1987, p. 153). Indeed, a great deal of aid is lost due to instability and conflict, notably in Sub-Saharan Africa (Bourguignon and Sundberg, 2007, p. 316). As mentioned by Knack (2001), rent seeking behaviour and corruption may also arise as a consequence of foreign aid. Shleifer (2009, p. 6) develops this argument further and argues that as a consequence of foreign aid, many leaders of developing countries have become a “billionaire”. If the money is not stolen by the leader, other officials and bureaucrats will do so. Another issue raised by Shleifer (2009) is that the priorities of the recipient government may not coincide with economic or development needs. For instance, governments may invest the money in the military, on foreign policies or simply give it to friends and political supporters, as is the case in many clientelist states. In an attempt to solve this principal agent problem, donors often impose conditions on aid and how it is spent (Tarp and Hjertholm, 2000, p. 324). However, there are many issues with conditionality, especially when corruption is rampant in the recipient country (Radelet, 2006, p. 13). It is without doubt that the quality of governance is a major determinant of aid effectiveness and this must not be overlooked. There are many ways in which the adverse effects of aid on economic growth can be reduced yet the extent to which these policies are successful depends on a number of factors. In response to the Dutch disease argument, White (1992, p. 226) proposes that the expenditure of aid funds by the recipient country must be injected into the non-tradable sector incrementally, and at a steady rate in order to circumvent substantial price increases of non-traded goods and thereby real exchange rate appreciation. Additionally, White (1992, p. 226) recommends implementing a managed float regime so that the exchange rate can be influenced, and large price increases avoided. If the real exchange rate can be prevented from increasing to the extent that it harms export competitiveness, economic growth will not suffer. Nevertheless, in order to sustain a managed floating exchange rate regime, sufficient foreign exchange reserves must be stored. Although developing countries may find it more challenging to maintain such reserves, financial globalisation has facilitated the aforementioned, explaining the rapid rise in foreign reserves held by developing countries since the 1990’s (Rodrik, 2006, p. 253). On the other hand, Rajan and Subramanian (2011, p. 115) proclaim that countries should target aid towards the sectors of the economy which are not functioning at full capacity so that large price increases can be avoided. For instance, if aid is directed to the agricultural sector where there is spare capacity, no full employment and a large supply of low-skilled labour then wages will not increase, and prices will only rise by a small amount. As a result, there will be less real exchange rate appreciation, less damage to exportable industries and thus a reduced impact on economic growth. This form of “planning of expenditure” (White, 1992, p. 226) put forth by Rajan and Subramanian (2011) suggests that if aid causes negative economic growth, it is not due to an inherent feature of aid but rather due to poor allocation on the part of both the donor and recipient (Clist, 2011, p. 1724). Consequently, aid allocation should be the focal point when discussing negative growth mitigation policies. While the aid dependency critique proves interesting at a theoretical level, there is little evidence to establish a concrete relationship between aid and dependency (Collier, 1999). Notwithstanding, I will nevertheless provide mitigation strategies to reduce aid dependency and its associated consequences. For critics of aid such as Bauer (1979, p. 239) and Krauss (1983, p. 90), aid dependency can only be averted by completely abolishing aid altogether. Elsewhere in the “aid dependency school” (Collier, 1999, p. 528), Knack (2001, p. 326) proposes that a significant proportion of aid be directed at improving the quality of governance to ensure greater accountability and counter corruption. As previously mentioned, despite its flaws, conditionality may also help to improve aid allocation. Similar to conditionality, another potential solution advocated by Rosenstein-Rodan (1961, p. 107) and Brautigam (2000) involves implementing selective allocation of aid. In this regard, aid should only be granted to countries that take measures to reduce corruption and improve governance. This line of reasoning emerges from a theory discussed by Collier (1999, p. 530). The theory states that aid is only effective at increasing economic growth in good environments, not in poor ones. A ‘good’ environment consists of a strong macroeconomic framework along with a wide range of policies and institutions. Collier (1999, p. 530) deduces that aid is typically ineffective due to substandard aid allocation to poor economic and political environments. On the other side of the debate, foreign aid is believed to, in most cases, either have no effect on economic growth, or a positive one. The Harrod-Domar growth model is used to explain how aid affects growth through savings and investment. According to the Harrod-Domar model, savings and investment are key determinants of economic growth, hence the rationale holds that aid increases savings which in turn finances investment and raises the capital stock in a one for one increment (White, 1992, p. 223). This transfer of capital from developed to developing countries theoretically enables greater GDP growth which should then lead to higher savings and more growth until self-sufficiency occurs (Durbarry, 1998, p. 27). The model assumes that developing countries have low growth rates because they are unable to generate enough domestic savings to finance investment (ibid.). Consequently, foreign aid removes this “capital bottleneck” and provides countries which have a savings gap with the necessary savings to achieve greater economic growth (ibid.). In a more simplistic model, aid directly increases the availability of funds that can be used to finance investment and stimulate economic growth. Galiani et al. (2014, p. 21) determine that a one percent increase in the aid to Gross National Income (GNI) ratio leads to an annual real GDP rise of approximately 0.35 percent through its effect on increasing physical investment. Clemens et al. (2012) concur that foreign aid to countries which are financially and fiscally constrained raises access to funds and hence increases investment and GDP growth however, they observe relatively insignificant results.

This report has demonstrated the controversy surrounding aid and its effects on economic development. Early critics of aid have adopted a free-market approach to advocate for the abolishment of aid entirely, arguing that it increases the role of the state and prevents market forces from performing optimally. Others assert that continuous flows of aid creates aid dependence. Aside from its direct impact on the domestic economy, aid dependence threatens the quality of governance, particularly when it comes to corruption and accountability. More recently, aid is said to damage the manufacturing sector and exportable industries by reducing export competitiveness in the recipient country. While there are strategies that can be put in place to mitigate the negative effects of aid on economic growth, the extent to which aid will be effective largely depends on the quality of governance and the state of the political and economic environment. On the other hand, supporters of aid contend that although aid has been considerably wasted due to inefficient allocation, it can encourage growth and has done so in countries such as Botswana and Indonesia. Although aid effectiveness is conventionally measured by associated economic growth, it is worth noting that not all aid is aimed at increasing growth thus we cannot assume this to be the end result. I share a similar view as Riddell (1987, p. 176) and believe that “aid is neither necessary nor sufficient for development to occur”. “Aid’s potential adverse consequences do not necessarily mean that it is a bad thing” (White, 1992, p. 227).