The effect of foreign aid on economic growth empirical evidence from east africa

ADDIS ABABA UNIVERSITY
SCHOOL OF GRADUATE STUDIES

THE EFFECT OF FOREIGN AID ON ECONOMIC GROWTH:
EMPIRICAL EVIDENCE FROM EAST AFRICA

BY:
Yoseph Weldemariam
ADVISOR:
Kidist Gebreselassie (PhD)

A Thesis Submitted to
The center for African and Oriental studies
Presented in Partial Fulfillment of the Requirements for the Degree of
Master of Arts (Human and Economic Development in Africa)

Addis Ababa University
Addis Ababa, Ethiopia
June, 2017


ADDIS ABABA UNIVERSITY
SCHOOL OF GRADUATE STUDIES

This is to certify that the thesis carry out by Yoseph Weldemariam entitled: The Effect of
Foreign Aid on Economic Growth: Empirical Evidence from East Africa. The research is
submitted in partial fulfillment of the requirements for the degree of master of art in (human
and economic development in Africa) complies with the regulations of the University and
meets the accepted standards with respect to originality and quality.

Signed by the Examining Committee:

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June, 2017


ACKNOWLEDGEMENTS
I sincerely wish to express my gratitude to both family members and my friends who
are always behind my success. My words of gratitude would go to my advisor Dr.
Kidist

Gebreselassie

for

her

supervision,

valuable

guidance,

intellectual

encouragement, and critical and constructive comments on the structure and
organization of this research. I want to express my maximum respect to her.
I am also grateful to Alemta Gerima, Yohaness Gebrezigiher and Friat Gebreslassie for
their encouragements throughout my study.

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Table of Contents
Contents

pages

Acknowledgements ...........................................................................................................i
Table of Contents .............................................................................................................ii
List of Tables .................................................................................................................... v
List of Figures..................................................................................................................vi
List of Acronyms ............................................................................................................vii
ABSTRACT ................................................................................................................. viii
CHAPTER ONE ............................................................................................................... 1
1. INTRODUCTION ........................................................................................................ 1
1.1. Background of the Study ....................................................................................... 1
1.2. Statement of the Problem ....................................................................................... 3
1.3. Objective of the study ............................................................................................ 6

1.4. Significance of the Study ....................................................................................... 6
1.5. Scope and Limitations of the study........................................................................ 6
1.6. Organization of the thesis ...................................................................................... 7
CHAPTER TWO .............................................................................................................. 8
2. Theoretical and Empirical Literature Review of Foreign Aid ...................................... 8
2.1 Introduction ............................................................................................................. 8
2.2. Concept of Foreign Aid ......................................................................................... 8
2.2.1 Advantages and dis advantages of Foreign Aid ............................................... 9
2.3 Aid Effectiveness .................................................................................................. 11
2.4. Theories of Foreign Aid and Economic Growth ................................................. 12
2.4.1 The Harrod-Domar Growth Model ................................................................ 12
2.4.2 The Solow Growth Model .............................................................................. 13
2.5. Foreign Aid and Economic Growth in Sub-Saharan Africa ................................ 17
2.5.1 Empirical literature on aid-growth relationship from East Africa ................. 19
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CHAPTER THREE ........................................................................................................ 24
3. Research Methods ...................................................................................................... 24
3.1 Introduction ........................................................................................................... 24
3.2. Data Source and Description of Variables ........................................................... 24
3.2.1 Data Source .................................................................................................... 24
3.2.2. Description of Variables ............................................................................... 25
3.3. Model Specification ............................................................................................. 28
3.4. Econometric Model.............................................................................................. 29
3.5. Estimation Method............................................................................................... 30
3.5.1 Generalized Method of Moments (GMM) ..................................................... 30
3.5.2 Testing the Estimation Method ...................................................................... 33
CHAPTER FOUR .......................................................................................................... 35
4. Data Analysis, Results and Discussions ..................................................................... 35

4.1 Introduction ........................................................................................................... 35
4.2. Descriptive Analysis ............................................................................................ 35
4.2.1 Summary Statistics of Variables included in the model ................................ 35
4.2.2. Trend in real per capita GDP growth ............................................................ 36
4.2.3. Trend in Official Development Assistance (ODA) ....................................... 40
4.2.4. Aid Unpredictability and Paris Declaration on aid effectiveness ................. 41
4.2.5. Other Variables Included in the Model ......................................................... 43
4.3 Test Results ........................................................................................................... 43
4.3.1 Multicollinearity Test ..................................................................................... 44
4.3.2 Stationarity Test ............................................................................................. 44
4.3.3 Autocorrelation Test....................................................................................... 45
4.3.4. Testing for Heteroscekasticvity..................................................................... 46
4.4 Econometric Analysis ........................................................................................... 46
4.4.1. The Effect of Foreign Aid on Growth ........................................................... 47
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4.4.1.1. Regression Results of GMM Estimators .................................................... 48
4.4.1.2. System GMM Estimation Techniques ....................................................... 50
CHAPTER FIVE ............................................................................................................ 54
5. Conclusions ................................................................................................................ 54
References ...................................................................................................................... 57
Appendexis ..................................................................................................................... 63

iv


List of Tables
Table 3.1 Descriptive of Variables used in the regression model .................................. 25
Table 4.1 Summary Statistics for the Data of 4 East African Samples .......................... 36

Table 4.2 Mean of aid unpredictability for the four countries. ...................................... 43
Table 4.3 the Pairwise Correlation Test Matrix ............................................................. 44
Table 4.4 Levin-Lin-Chu unit root test........................................................................... 45
Table 4.5 Arellano-Bond test for zero autocorrelation in system GMM ....................... 45
Table.4.6. OLS, Fixed Effects (FE), Random Effects (RE), First Difference GMM and
System GMM estimation: dependent variable GRPCGDP. ......................... 47

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List of Figures
Figure 2.1 Dynamics of the Solow model ...................................................................... 15
Figure 2.2The relationship between foreign aid and saving rates in the Solow
diagram ......................................................................................................... 16
Figure.2.3 Aid and growth relation in Africa (10 years moving average) ..................... 18
Figure 4.1 Trends of per capita GDP for the four countries over 1990-2014 (2010
$USA) ........................................................................................................... 37
Figure 4.2 Trends of growth rate of per capita income for the four countries over 1992014 period. .................................................................................................. 39
Figure 4.3 Aggregate of GRPCGDP for the countries ................................................... 40
Figure 4.4 Trends of net ODA flows to four of the countries (constant) ....................... 41
Figure 4.5 Flows of net ODA to four of the countries (constant) .................................. 41
Figure 4.6. The extent of aid unpredictability for individual countries during (19902014) ............................................................................................................. 42

vi


List of Acronyms
AAA

Accra Action for Action

ARDL

Autoregressive Distributed Lag

DAC

Development Assistance Committee

FA

Foreign Aid

FDI

Foreign Direct Investment

FE

Fixed Effect

GMM

Generalized Method of Moments

HD

Harro-Domar

HIPC

Highly Indebted Poor Countries

LR

Likelihood Ratio

ODA

Official Development Assistance

OECD

Organization for Economic Cooperation and Development

OLS

Ordinary Least Square

PD

Paris Declaration

RE

Random Effect

SSA

Sub-Saharan Africa

WDI

World Development Indicators

vii


ABSTRACT
THE EFFECT OF FOREIGN AID ON ECONOMIC GROWTH: EMPIRICAL EVIDENCE
FROM EAST AFRICA

Yoseph Weldemariam
ADDIS ABABA UNIVERSITY, 2017
There has been an increase in the inflow of Official Development Assistant (ODA) or
commonly called foreign aid to less developed countries (LDCs). For the last 50 years,
Countries from Sub-Saharan African (SSA) region have particularly been highly
dependent on foreign aid to finance their development projects and cover their budget
subsidies. Several studies have been conducted to examine the impact of foreign aid on
economic growth in SSA. However, the impact of foreign aid on the region’s economic
growth has been found to be inconclusive. Some studies find evidence supporting the
view that foreign aid is an important factor in driving economic growth while others
find evidence suggesting the ineffectiveness of foreign aid in influencing the region’s
economic growth. In response to the mixed evidence on the economic effect of foreign
aid, international initiatives such as the 2005 Paris Declarations have been pushing for
reliable and indicative commitments of foreign aid albeit a limited success. Other
studies pointed to identification problems in the empirical studies, for instance
endogeneity of foreign aid as causes, for the inconclusive results. This study analyzes
the trend of ODA and growth as well as the impact of foreign aid on four selected East
African countries, namely Ethiopia, Kenya, Tanzania and Uganda using a panel data

from 1990 to 2014. The ODA and growth have been increasing in the countries over
the study period. In doing so it compares the results of the different techniques i.e.,
OLS, FE, RE, difference GMM and system GMM used in the aid-growth literature.
Looking at the results of the various estimation techniques based on augmented NeoClassical Growth theory expectation the system GMM techniques provide better
estimation results in terms of expected signs and significance which may due to the
capacity of system GMM technique to address endogeniety and other issues.
Accordingly, foreign aid was found to have a statistically positive and significant effect
on the growth of real per capita GDP of the countries included in the study. The
empirical model controls for gross fixed capital formation, human capital
accumulation, population growth; international agreement made to improve aid
effectives and disbursement i.e., the Paris Declaration (2005). The contributions of
Paris Declaration on aid effectiveness and aid unpredictability are found to be
statistically insignifican.
Keywords: Aid-unpredictability, Foreign-Aid, East Africa, Economic Growth, GMM.

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CHAPTER ONE
1. INTRODUCTION
1.1. Background of the Study
Foreign aid is the inflow of capital from foreign countries and institutions in the form of
grants and loans to fill the gap in the recipient countries (Moreira, 2005). According to
Brautigam and Knack (2004) foreign aid as institutional support started with the
Marshal Plan for resource mobilization to rebuild European countries that are affected
by the WWII. Immediately after the Marshal Plan had been completed, it expanded to
the developing countries, especially to Sub-Saharan African (SSA) countries ( Rajan
and Subramanian, 2008).
Sub-Sahara Africa has been the focus of the donors since 1960s due to the
multidimensional problems the region is facing with (Abuzeid, 2009). In spite of the

inflow of foreign aid, different views have been reflected on the effect of foreign aid on
economic growth in sub-Saharan Africa. While some argue that foreign aid has been
effective at boosting real output of the receipt countries, many others strongly argue
foreign aid has failed to bring the intended economic and social changes in many of the
developing countries (Rajan and Subramanian, 2008). More specifically, writers like
Salop and Kaufman (2007) stated that aid helps to improve the performance of many
sub-Saharan African countries on their process of development by filing the financial
and skills gaps. They further claim that after the Heavily Indebted Poor Country (HIPC)
initiative and the Multilateral Debt Relief Initiative (MDRI), the performance of donors
and recipients has increased to the effectiveness of aid. On the other hand, Nyatoro
(2012) argues that foreign aid in Africa has not achieved growth and development
rather it has created economies which are highly dependent on the performance of
external environment. In the same vein, Rajan and Subramanian (2008) assert that
foreign aid has no positive effect in economic growth of SSA neither in any more
favorable policy nor in geographical environment.
Despite the controversial debate on the effectiveness of foreign aid on the economic
growth of SSA, the flow of foreign aid to SSA has been increasing over time. Based on
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Brautigam and Knack (2004) in the 1980s, 13 countries of SSA were getting 10% of
their GDP from foreign aid as net aid and in 1990s the figure became more than double
to 30 countries in the region. They further discussed that the aid dependency in SSA
had perpetuated more, for example, about 40% of government expenditure in countries
like Malawi, Ghana and Zambia had been continuously funded from aid for more than
20 years.
Aid may be provided for different reasons like it may for diplomatic, cultural,
commercial, humanitarian and other strategic purposes. Whatever the reason for foreign
aid may be, its success should be evaluated in terms of its effectiveness or contribution
on the economic growth or development of the recipients. However, as many studies

indicate there are several circumstances for the foreign aid effectiveness in the
developing countries.
Boone (1996) and Burnside and Dollar (2000) have mentioned that the effectiveness of
foreign aid is conditional and hence poor countries can only benefit from foreign aid
when they have sound economic policy. In cases of highly distorted economic policy,
however, aid is financed to the unproductive activities of the government or it goes
directly to the pocket of individual officials which this leads to inequality and
instability (Burnside and Dollar, 2000)).
Many scholars also have fear of the future debt burden as a result of the current
international trade system. Moussa (2016: 4) presented it as:
‘’chronic trade deficits of SSA for the past three decades are enough evidence
that domestic firms suffer from low productivity and cannot compete in the
international trade. Example, the average deficit ratio of SSA in the international
trade has increased from 6 percent to 13 percent, from 1980s to the period of
2001-2013. While the average current account deficit ratio rose from 4 percent
& to 8 percent over the same period. Further, as trade liberalizations increase
and policy of IMF in such case is to stabilize budget deficit, there are concerned
fear that the increasing current account deficits will increase SSA's future debt
burden and make the region vulnerable to financial crises and finally increases
import dependence and thus unemployment and poverty’'.

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Aid volatility is the other serious challenge facing SSA economic growth projects.
Gemmell and McGillivray (1998), Morrissey (2000) and Bulir and Hamann (2003)
argue that the effect of foreign aid on economic growth of the recipient countries is
positive when the probability of aid volatility is avoided in cross-countries regression.
Bulir and Hamann (2003) confirm that aid is more volatile than other government
revenues and relatively grows more with aid dependent countries.

Despite the concerns surrounding foreign aid, Sub-Saharan Africa has been receiving a
substantial amount of aid since the 1960s and still continues to be a major aid recipient
region in order to fill resource-gaps. However, the impact of foreign aid in the
economic growth of SSA is still very questionable. This study aims to provide
empirical evidence of aid-growth relationship from selected East African countries. The
countries are Ethiopia, Kenya, Tanzania and Uganda. They all are aid dependent
countries. According to OECD (2015) report from 2011 to 2013 Ethiopia was the
second next to Egypt out of the top ten aid dependent countries in Africa, with an
average ODA disbursement estimated at USD 3542 million annually followed by
Kenya and Tanzania with annual average of disbursement USD 2903 and 2791 million
respectively. The report also added that Uganda was ranked tenth with an annual
average disbursement of USD 1642 million.

1.2. Statement of the Problem
Sub-Saharan Africa has been receiving substantial foreign aid (FA) for many decades
since the early 1960s, but still ranks one of the poorest regions of the world. SubSaharan Africa records ever high unemployment, absolute poverty, high mortality rates
and low level of education and lack of access to health care facilities (Ogundipe,
Ojeaga and Ogundipe, 2014). The GDP per capita of the region is still the lowest. And
GDP growth has been going down markedly from 4.8 percent in 2013 to 3 percent in
2015 (World Bank, 2016). Also as the financial structure of the SSA is poor, the saving
and investment correlation is negative and this might explain the dependency of the
region’s economy on primary goods production (Cyrille, 2010). This poor economic
performance is also great challenge to attract Foreign Direct investment (FDI) and
transfer the economy.

3


The classical models or theories of development point to the role of capital
accumulation for creating an economically strong (wealthy) nation. Harrod-Domor

(1939) growth theory established that capital accumulation which is needed for growth
is dependent on the level of saving and capital output ratio. This may be achieved
through increasing domestic saving or foreign aid. But, as Kabete (2008) asserts SSA
countries have no adequate private and public saving and foreign exchange to finance
grand economic projects and increase the accumulated capital. This makes foreign aid
an important resource to fill the financial resource gap for investment and trade deficit.
The other neoclassical development theory that has received sufficient consent in many
academic writings is the Solow (1956) growth model. The model is concerned with the
long run economic growth by increasing productivity and considers itself as catch up
model for the poor countries to narrow the gap with rich countries. According to
Snowdon (2010), the augmented Solow model suggests that foreign aid stimulates the
saving and investment opportunity of developing countries by providing the needed
finance and foreign exchange for importing capital and investing in physical and social
infrastructure.
Contrary to the above arguments in the theoretical literature the empirical literature
presents mixed results on the aid-growth relationship. In line with the theoretical a
study by Moreira (2005) asserted the impact of foreign aid on economic growth of SSA
using the GMM analysis on annual data covering the period from 1970 to 1998 found
that foreign aid has positive impact on economic growth in the long run while its effect
is less in short run. But, some writers do not agree on the positive effect of aid on the
economies of the developing countries without some conditionality. Mallaye and
Thierry (2013) examined using OLS on 34 SSA countries from 1990-2010 and found
that the effect of foreign aid on growth varies depending on the countries’ governance
and education level. This study indicates that the amount of aid received is not
important in the difference of aid effectiveness but the governance and concludes
improving the governance in post-conflict countries could help to increase the
effectiveness of foreign aid. Ogundipe, Ojeaga and Ogundipe (2014) also confirm about
80 per cent of SSA countries have been identified as low human development and
heavily indebted countries though the inflows of aid is substantial. From this, it is clear

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that even if there is a high inflow of foreign capital; most SSA countries are yet to
experience any significant economic progress and human development.
Ogundipe, Ojeaga & Ogundipe (2014, pp., 301) describe the adverse effect of foreign
aid in SSA economy as follows:
‘’The inflow of foreign aid to SSA countries has recently amounted to about $1
trillion. It is very huge amount but, its effect is reverse when it is compared with
the experience in other countries. In China As ODA increased from 0.2 percent
in 1980 to 3 percent in 1985, China’s economic growth rate increased from
approximately 6 percent to 12 percent. While The SSA situation is contrary, the
economy grew to 1.1 from the state of declining when the proportion of ODA to
the region decreased to 28 percent. On the other hand, as the inflow of ODA to
SSA started to increase, SSA’s growth once again went down ’’.
However, there is no any theoretical ground justifying the assertion that aid goes
against the economic growth of the developing countries. Hansen and Tarp (2001)
opposes the policy conditionality on the effect of aid on the economy of developing
countries. But, they suggested that aid effectiveness is highly sensitive to the estimator
and variables controlled. Finally, they advise the weight of techniques estimation and
theoretical work for any research purpose before regression in the analyzing of aidgrowth relationship.
Such inconsistent results of foreign aid impact in the SSA economy pose a question
why different studies result in different conclusions? Besides, the aid success in
countries other than SSA like China raises doubt on the aid failing in SSA countries.
Also, as there is no any theory that supports foreign aid harms growth in developing
countries, farther investigation on foreign aid impact in SSA is important to understand
the true nature of foreign aid effectiveness at empirical level. Generally, this paper does
not attempt to resolve disputes in the aid-growth literature but tries to assess whether
foreign aid has significant effect on economic growth in four aid dependent SSA
countries. The countries are Ethiopia, Kenya, Tanzania and Uganda. They all are aid

dependent East African countries but still they have been recording low human and
socio-economic development. To do so, this study presents various analysis of the
effect of ODA on growth base on various models (techniques) which have been used by
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previous studies. These are FE, RE, OLS, difference GMM and system GMM
techniques. The other studies had been focusing on one of the techniques which show
the issue surrounding methodological variations. But, this study reaches at the most
preferred technique of estimation after assessing the shortcomings in the other
techniques of estimation.

1.3. Objective of the study
The main objective of this paper is to investigate the contribution of foreign aid to
economic growth in selected East African countries, Ethiopia, Kenya, Tanzania, and
Uganda the specific objectives are to
i.

Examining the trend of economic growth and foreign aid (as represented by
Official Development Assistance) flows to East African countries

ii.

Investigating whether foreign aid has a significant effect on the economic
growth on selected countries of East Africa.

1.4. Significance of the Study
The impact of foreign aid on economic growth has been investigated at both micro and
macro levels by various studies. However, the conclusion of these studies on the impact
of foreign aid on growth at macroeconomic level is mixed, in both the long and short

run. The situation of SSA is no exception. This paper attempts contribution to the
ongoing discussion on aid-growth relationship by investigating the macro level effects
of foreign aid on economic growth in four East African countries. It is different from
the others by using a more recent data as well as looking at alternative estimation
techniques; OLS, FE, RE, difference GMM and system-GMM in the East African
countries.

1.5. Scope and Limitations of the study
The scope of this study focuses on four East African countries; namely Ethiopia, Kenya
Tanzania and Uganda. These countries are chosen for the study because they are among
the high recipients of Official Development Assistance (ODA) (OECD, 2015). In terms
of time, the study uses panel dynamic data of macroeconomic model, for the period
from 1990 to 2014. One challenge in getting the right data is that the data on all the
variables were not available in a single data base. This paper addressed the challenges
6


by obtaining the data for some of the variables from other credible databases for all
countries.

1.6. Organization of the thesis
This paper is organized as follows: Chapter two presents the theoretical and empirical
literature reviews. The research method is presented in Chapter three. Then, chapter
four show cases the analysis and results of the study. Finally, chapter five provides the
conclusions derived from the study.

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CHAPTER TWO

2. Theoretical and Empirical Literature Review of Foreign Aid
2.1 Introduction
This chapter presents the literature review for the study. The chapter is divided into five
sections. Section 2.2 covers the conceptual literature, while section 2.3 presents the aid
effectiveness literature. The other two sections 2.4 and 2.5 discuss the theoretical and
empirical literatures respectively. Section 2.4 is divided into two sub-sections Subsection 2.4.1 presents the Harrow-Domar Growth Theory while sub-section 2.4.2
presents Solow growth Theory. Section 2.5 also divided in to two sub-sections. Subsection 2.5.1 presents the general empirical literature review of foreign aid in subSaharan Africa while 2.5.2 presents the empirical literature review of foreign aid in East
Africa.

2.2. Concept of Foreign Aid
There are many definitions and forms of foreign. Foreign aid is different in type and
modality depending on the donor interests and the recipients’ need. Because of the
complexity in type and modality in foreign aid there has been difficulty in defining
differentiating which kind of foreign aid is or not counted as real developmental aid.
According to Ajayi (2013) some inflows of resources, such as preferential tariff grants
and investments from foreign privates on non-commercial basis, from the developed
countries to less developed countries are not counted development aid.
In comprehensive terms foreign aid is the movement of resources in the form of
financial support and technical assistance for the purpose of filling the financial gap in
recipient economies or sometimes for mutual benefit (ibid Ajayi, 2013)). As stated in
Randhawa (2012)

the standard definition of foreign aid (or official development

assistance) derives from Development Assistance Committee (DAC) under the
Organization for Economic Cooperation and Development (OECD), which defines
foreign aid as the transaction of any assistance in the form of financial, technical and
commodities on the bases of non-commercial and non-military aid. The purpose of aid
is to promote the welfare and economic power of the community in the recipient
countries with 25 percent grant at least.

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As the literature on the relationship of foreign aid and economic growth indicates, the
DAC definition of foreign aid has gotten convenience in term of its data availability
and characteristics. Qian (2015) has indicated from the OECD database that DAC has
29 member countries and the aid given to the developing countries from China is not
counted as ODA even though it is growing recently. This is because of incomplete and
non-continuous data. For purpose of this study foreign aid is approximated by the
Official Development Assistance (ODA).
DAC has three criteria for foreign aid to be recorded as ODA (Qian, 2015). These are:
1) The aid transfer to the recipient countries should be through official agencies;
2) The objective of the aid should be to promote the welfare and economic power of the
community in the recipient countries;
3) The aid should be long run with at least twenty five percent or more grants.

2.2.1 Advantages and dis advantages of Foreign Aid
The actual role of foreign aid is subject to a strong dispute among academicians and
politicians. The results of a significant number of researches on the relation of foreign
aid and growth are not conclusive. The major premise of foreign aid for growth is to
expand scarce domestic capital to invest in public infrastructures like education, health,
transport, and water (Koeberle and Stavreski, 2005). Reddell (2014, pp. 7) mentions
that ‘’the overall contribution of aid is to poverty reduction’’. He elaborates that even if
there is a serious problem in delivering aid to poorest and most marginalized due to
misunderstanding in the aid-poverty relationship; aid really works in reducing the
number of people living in poverty. Also as Reci (2014) argues foreign aid has
significant role in substituting private capital by providing resources for investment in
public goods.
From the early times, economic growth theories have concerns about how a developing
economy can solve constrains of capital formation. The main concern has been to state

the means of filling resource gap in countries which have insufficient private and public
savings to fund economic projects, public expenditure and importing capital goods and
promote growth (Reci, 2014).

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According to Koeberle and Stavreski (2005), the budget support modality of foreign aid
has received a growing support. Budget support modality helps to stabilize fiscal and
macroeconomic policy of the recipients which has a potential to improve governance
through reform of public sectors and efficient financial management.
Moreover, as part of foreign aid the advantage of technical assistance, building capacity
and fighting poverty has received a due attention by the donors and recipient countries.
Greenhill (2006) states that technical assistance is very important to speed up the
development process as it works directly in building human capital and filling the skills
gap.
The most obvious purpose of foreign aid is to increase the government resources for
investment and to treat budget deficit and thereby enhance development. But, this
character of foreign aid is not constant and there are a lot of distortions going on
aspects (Nielsen et al., 2011).
A large number of studies find that foreign aid could have adverse effects on the growth
of recipient countries. For example, Easterly (2003) and Roodman (2007) examined the
controversial results of a number of studies by slightly changing the instruments and
samples. They confirm that the positive impact of foreign aid on the growth of the
recipient countries is inconclusive. The results are fragile depending on the internal and
donor conditionality.
Ferreira and Simoes (2013) have proved that foreign aid can also increase the difficulty
in the recipient countries. The study focused on 44 SSA and 31 Asian countries for the
period 1972-2007 as these regions are major aid recipients. Using Generalized Method
of Moments (GMM) estimation, they found a negative effect of foreign aid on the

growth of the regions. They conclude that policy, institutional quality and financial
development have significant impacts on aid management.
Moyo (2009) and Asongu (2014) have studied the relationship between foreign aid and
corruption in Africa. They conclude that foreign aid has a significant positive impact on
promoting corruption in Africa. Moyo (2009) asserts that foreign aid, as it is easily
misused and redirected, makes African leaders corrupt. Asongu’s (2014) argument also
shows foreign aid facilitates corruption as long as the African cultural and institutional
benchmark is not improved.
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Other serious problem of foreign aid is dependency. As long as the aid management is
not effective aid does not reduce poverty rather it intensifies the economic crises of
recipient countries. Bräutigam (2000) discussed the vicious circle, or growing amount
of official debt in poor countries, especially on the countries whose yearly aid is 10 or
more percent of GNP, in what is called ‘’high aid dependency’’. Based on this, many
African countries have lost their autonomy to address national issues independently.
This has led them to increase dependency on foreign aid even for undertaking the basic
government activities.
According to Moyo (2009) the unlimited aid money creates an irresistible environment
and conflicts among ethnic groups of the recipient countries for sharing resource.
Additionally, Nielsen et al. (2011) says aid shocks also promote armed conflict as
severe reduction in aid may pose disturbance and shift the domestic balance of power
from the government to rebel groups thereby inducing violence and civil unrest.
Moreover, foreign aid dependent countries are also highly vulnerable to aid uncertainty.
According to Bräutigam (2000) aid volatility creates difficult condition in which
government’s commitments and national projects may fail due to financial problem.
This may also push the leaders to adopt authoritarian tactics, rather than fighting
corruption and improving civil service.

2.3 Aid Effectiveness
Sub-Saharan Africa is the major region that has been enjoying a substantial foreign aid
as source of finance for development since the end of World War II (Abuzeid, 2009).
But, foreign aid has been under questions in terms of its effectiveness to bring the
desired result in the region. A number of, research results have concluded the foreign
aid has no any positive effect on the economic growth in the region. Easterly (2003),
Collier (2007), and Rajan and Subramanian (2008) have strongly argued that foreign
aid has failed to bring the intended economic and social changes in many of the
developing countries like SSA. Corresponding to the controversial academic debates on
foreign aid success, a series of summits have been held to promote responsible
partnership among the recipient and donor countries on the issue of aid effectiveness.
The Paris Declaration (PD) (2005) is the high level summit on aid effectiveness that
forwarded core principles, based on the Marrakech Roundtable (2004), to reduce

11


poverty and inequality in the recipient countries, generally to increase the development
results. The aim of PD is to improve the aid effectiveness in the form of ‘’better
harmonization and alignment, promoting country ownership, managing results, and
increasing mutual accountability’’ (Getnet, 2009, p.6). The other forum on foreign aid
is the Accra Agenda for Action (AAA) (2008) to accelerate and deepen implementation
of PD (2005) on effectiveness of foreign aid. The target of AAA (2008) is on the issue
of monitoring the implementation of Paris declaration on aid effectivenss through joint
and equal participation of stakeholders.
However, the empirical literature on foreign aid effectiveness is inadequate and often
contradictory. Official Development Assistance is often criticized for not having
contribution in poverty reduction or for not having clear system of execution to finance
on the intended objectives or programs. Being inspired by contradictory research
findings Wako (2011) has tried to assess the effectiveness of foreign aid in SSA and

found that aid is ineffective at enhancing economic growth, in both the bilateral and
multilateral aid modalities. Additionally, as there is no evidence about the aid
effectiveness in some projects he recommends the recipients to possess better
governmental accountability, transparency and ownership on aid management.
Regardless of, the controversy in the literature, foreign aid effectiveness has obtained
adequate focus after the PD (2005). Donors and recipients initiative to monitor and
assess the aid implementation has increased, especially at sector level. So, aid
effectiveness is considered as an important issue concern to the aid-growth relationship.

2.4. Theories of Foreign Aid and Economic Growth
2.4.1 The Harrod-Domar Growth Model
One of the economic models that have explained the significance of foreign aid in
development economics is Harrod-Domar (HD) (1939) growth model. As this model
explains the growth of one nation depends on the level of investment and productivity
of the economy. In the state of inadequate domestic saving, foreign aid can substitute
the gap; thus, increasing the investment and productivity, i.e., the capital-output ratio.
Easterly (2003) expressed the HD growth model as given in (2.1):

g  (I / Y ) / 

(2.1)

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Where I is required investments, Y is output or GDP; g is target of GDP growth and μ
is the incremental capital output ratio (ICOR). That is, GDP growth, g, is proportional
to the share of investment spending in GDP, I/Y, just when μ-the incremental capitaloutput ratio (ICOR) is constant. In case of aid dependent countries investment is the
sum of foreign aid, A, and domestic saving, S, given by:
I /Y  A/Y  S /Y

(2.2)

What is different in equation (2.2) is that investment is the sum of the domestic saving
and capital earned from foreign aid. This explains the state in which there is no enough
domestic saving to invest. Based on this, there is proportional growth between the
added capital and the growth of GDP such that the amount of foreign aid to GDP and
its contribution to the growth of GDP is proportional.
But, under normal condition the increment in capital-output ratio is not constant as it is
stated in the above formula. And this is the major criticism of HD growth model in the
literature of development economics. According to Griffin (1971) and Ajayi (2013)
foreign aid has a potential to increase ICOR in the economy of the recipient countries
which adversely affects the efficiency of capital-output ratio. Thus, if the effect of aid
on the efficiency of capital-output ratio is negative, absolutely the relationship between
foreign aid and growth could not be absolute positive with the increase in aid.

2.4.2 The Solow Growth Model
The Solow growth model has received broad dealing in most modern development
economics literature. Solow (1956) suggests that the long run productivity of a single
commodity depends more on the rate of technological progress than on the increase of
the capital or labor force. The Solow model of growth has not degraded the HD theory
of economic growth, but casts doubt on the assertion that long run rate of growth
depends on saving and investment. The main driving force for the development of the
Solow growth model is the idea of fixed proportions in the HD growth model which is
only determined by the level of factors of production. According to Snowdon (2010),
Solow growth model basically emphasizes on the controversy of incremental capitaloutput ratio (ICOR) and sustainable development due to limited resources (e.g. finance
and land). Hence, without technological progress economic growth cannot be sustained.
That is, economic growth that depends on the saving and investment of inhabitant
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households and firms could not last long as the diminishing law of marginal
productivity of capital and labor.
The Solow growth model defines the neoclassical production in terms of capital and
labor combinations and assumes that these factors of production are substitutable and
their increment is subjected to the law of diminishing returns to scale as given in (2.3)

Y t  AKt  L1t  ; A  0and0    1

(3)

Y (t) = output at time t, K (t) and L (t) are the perfectly substitutable inputs capital and
labor at time, t. A is technology and α is the share of capital in the output. This is the
equation of production function which displays constant returns to scale such that if all
the technological input of production increases by N times, the output also increases by
N times (Sørensen & Jacobsen, (2010). They also explained that the prosperity of a
nation in GDP is not identical with the GDP per capita growth. In line with this
argument, Solow equation is explained in terms of output per worker, Y  Y / L , and
capital per worker, K  K / L as follows.

y  A(k t )

(2.4)

If A is assumed constant in (2.4) the increase in output can be achieved as a result of
the increase in capital per labor. However, the law of diminishing return assumes that
as the investment in capital increases, marginal production decreases until the
additional investment profit becomes zero. The zero profit point is the steady state
where an additional investment does not help to accumulate more capital than its exact
preceding point. Therefore, the net capital investment increases economic growth but

only for a while because of diminishing marginal returns (Snowdon, 2010).
According to Ray (1998) the interest of investors is to expand their production and to
accumulate capital by buying new machineries. This means, the economy needs to
change the capital accumulation per unit of labor. Huggett (2015) specifies the equation
of capital accumulation as:

1  nK t 1 1   K t sAK t 

(2.5)

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Equation (2.5) is mostly considered as the full (general) Solow growth model and
accounts for the effects of population and technology growth rate on the total output
over time. The K t 1 capital per labor depends on capital per labor in K t minus the
depreciation, 1   K t , plus any additional capital (savings) per labor, sAK t  .


The stock of capital per labor is also subject to reduction due to population growth (n).
According to Ray (1998) if population growth, in any growing economy, is high, the
amount of capital stock in the next period is going to be lower.

1  nk

Ak t 

Y

sAk t 



ko

k*

k

Figure 2.1 Dynamics of the Solow model
Source: Ray (1998, pp 38).
Figure 2.1 is an example of neoclassical (Solow) production function.
The amount of investment (saving) per labor sAk t 



is greater than the quantity

required to keep capital per labor n   k t at k0. Therefore, the capital deepening, k,
continuously increases over time until k=k* at which the change in capital is equal to
depreciation, sAk t   n   k . So, the capital accumulation is zero, i.e.,


the K  dK  0 . This is the maximum level of production using capital in any
given economy which the Solow model Calls steady state.
Generally, the augmented Solow growth model explains that capital accumulation is
achieved with increasing capital investment but, it is up to some point i.e., the steady
state and hence change in technology becomes necessary to change the steady state and
have continuous economic growth in the long run (Snowdon, 2010). However, the
developing countries have not sufficient domestic capital that enable them to reach the

steady state using their labor force. They need capital to use their labor maximally and
think about technology.
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