What Undermines Aid's Impact on Growth?

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"Aid inflows have systematic adverse effects on the growth of labor intensive and export sectors. Aid probably causes exchange rate overvaluation."

The question "Does aid lead to growth?" seems to have a patently obvious answer. In poor countries, schools need textbooks, clinics need medicines, and roads need maintenance. More aid to each of these areas, reason suggests, would lead to better education, healthcare, and transport and, subsequently, to economic growth.

Yet the literature on the impact of aid on long-run growth is inconclusive, with recent studies suggesting that even in countries with good policies, there is no robust association between aid and long-term growth. These recent studies suggest that corruption and mismanagement cannot be the only reasons why aid does not boost long-term growth.

In What Undermines Aid's Impact on Growth? (NBER Working Paper No. 11657), authors Raghuram Rajan and Arvind Subramanian examine one channel through which aid might have adverse effects in the long run: by adversely affecting a country's competitiveness. The authors take two complementary tacks to attack the issue. First, they examine in detail a specific channel through which aid might influence growth. Second, they examine the effects of another unrequited capital flow - remittances -- and ask whether it has effects similar to aid, and if not, why not.

The authors provide evidence that aid inflows have systematic adverse effects on the growth of labor intensive and export sectors. The evidence takes two forms -- relative and absolute. First, they show that in countries that receive more aid, the labor-intensive and export sectors, grow slower than capital intensive and non-export sectors. This by itself does not show that the impact of aid on export sectors is negative. But they provide additional evidence that the manufacturing sector as a whole grows slower on account of aid. The authors also show that the transmission mechanism is that aid probably causes exchange rate overvaluation. Remittances do not seem to have a negative competitiveness effect because remittances tend to slow when a country's exchange rate starts becoming overvalued.

Despite the fact that, for many aid-receiving countries, the manufacturing sector might be immediately less important than agriculture, it is worth remembering that that was also true for many of the fast-growing countries when they first embarked upon development. Manufacturing exports provided the vehicle for their growth take-off, so any adverse effects on such exports in aid-receiving countries should be a cause for concern about the effects of aid on long-term growth.

The slower growth of labor-intensive sectors induced by aid should be a source of concern for those who see aid as an instrument to reduce inequality, because labor-intensive sectors are the ones that can absorb the poor and landless who leave agriculture.

The authors caution that their findings do not establish that aid harms overall growth, or that the adverse effects on manufacturing competitiveness are not offset by other beneficial effects on social welfare. However, these findings raise the bar on the quality of government spending: aid has to be spent effectively so that the productivity or welfare improvements from increased public investment can offset any dampening effects from a fall in competitiveness.

More generally, however, the authors suggest that it may be more fruitful to move beyond the inconclusive debate of whether aid is effective and instead focus on specific ways it can be made to work better, by better understanding the reasons that might impair or enhance its effectiveness.

Thus, the authors suggest that policymakers should not lose sight of issues like how much aid can be handled to begin with, how the aid should be delivered, and when. At the very least, their findings suggest that a poor country taking in a massive quantity of aid up front can create substantial adverse effects on the country's export competitiveness. They believe it would be far better to build up the supply of the other critical resources that are needed to use aid effectively, such as a larger body of skilled workers. This might take time but will avoid the problems arising from a rapid ramping up of aid. It might be better to start slowly and accelerate as capacity is built. Even though the world is impatient for poor countries to develop, that development, especially when mandated from the outside, requires patience

-- Les Picker