AID-GROWTH NEXUS: EMPIRICAL EVIDENCE FROM CARIBBEAN

STATES

Abiodun O. Folawewo

Outline of Presentation

Introduction Objectives of the study Aid-Growth literature: theory and empirics Analytical framework and data Empirical results Conclusion

Introduction

The importance of finance as a significant engine of economic growth is embedded in the role of savings in growth

Domestic savings are grossly in adequate in many developing countries, hence, the reliance on foreign sources of development finance

Foreign aid is a major source of development finance; it comes in the form of ODA, ODF, grant, and other forms of transfers.

Introduction (contd.)

There are some benefits associated with the flow of aid, likewise there are some disadvantages of aid to any recipient country

The impact of aid on growth depends on existing macroeconomic environment in the recipient country

Caribbean states have enjoyed relative good inflows of foreign aid as a result of their peculiar nature

The extent to which aid has impacted on economic growth remains largely unclear

Aim of the study

The main of the study is to analyse the relationships among foreign aid, macroeconomic policies, and economic growth within the Caribbean region

Aid-Growth literature

Theory The aid growth debate has its origin in the classical

growth model – rate of growth is determined by annual saving ratio (Harrod-Domar model)

Foreign aid and domestic saving are complements. Foreign aid increases total saving, but also increases

consumption. Thus, aid and domestic saving ratio are negatively correlated, while aid and total investment are positively correlated.

Aid will only lead to improved rate of growth if domestic saving does not fall by the amount of aid.

Aid-Growth literature (contd.)

Empirical evidence While growth rate in some recipient countries has improved, aid has

had little or no impact on rate of growth on many recipient countries (Dacy, 1975; Boone, 1995, 1996; Burnside and Dolar, 2000).

Aid effectiveness could be affected by macroeconomic policies (Sachs and Warner, 1995; Burnside and Dollar, 2000; Collier and Dollar, 2002; Luthria and Dhar, 2005.

Measuring the extent to which policies could affect aid effectiveness is subject to methodological approach, in terms of the construction of policy index (Dalgaard and Hansen, 2001; Denkabe, 2004, Easterly et al, 2004; Dalgaard et al, 2004; Antipin and Mavrotas, 2006)

Institutional factors also play a crucial in the aid-growth nexus (World Bank, 1998; Svensson, 2003; Ram, 2004; Antipin and Mavrotas, 2006)

Analytical framework and data

The analytical framework for investigating the relationship between aid and growth is based on a production function in which aid enters as input

Expressing the production function in growth rate per capita, and assuming that individual country growth rate depends on its initial level of income following Burnside and Dollar (2000), we have

Also, since the flow of aid is endogenously determined by prevailing policies and some other factors, thus aid can be expressed as

)1(1 LAKY

)2(''' 1 itg

tzitititpitaityityit gzpapayg

)3(ita

tzitpityitit azpya

Analytical framework and data (contd.)

Data Data for the study is sourced from IFS and ranges over the period of

1980 to 2005. The data covers six Caribbean states – Belize, Dominican Republic, Guyana, Haiti, St. Kits and Nevis, and St. Vincent and Grenada.

Empirical results

The estimation of the growth equation using all the measures of policy shows that Aid/GDP has both positive and negative relationships with growth subject estimation techniques.

Table 1: Estimation of the Growth Equation (1) (2)

Estimation method OLS 2SLS LINGDP 77.55 18.64 (3.40)*** (2.34)** Surplus -0.01 0.78 (-0.19) (0.26) M2/GDP(-1) 44.88 28.16 (3.19)*** (1.9) Inflation -8.22 -2.06 (-1.82)** (-1.24)* Openness -7.59 2.06 (-2.02)** (1.21)* Population 1.59 7.28 (1.30)* (1.36)* Aid/GDP 0.41 -1.56 (1.03) (-1.01) Observation 150 150 R2 0.29 0.26

Note: t-statistic in parenthesis. *, **, *** indicate 10%, 5% and 1% significance levels.

Empirical results (contd.)

The estimation of the growth equation using the policy index indicates the policy variable has a positive and significant relationship with growth rate of GDP per capita, while the value of

Aid/GDP reduces. Table 2: Estimation of the Growth Equation

(1) (2) Estimation method OLS 2SLS LINGDP 75.47 63.87 (5.39)*** (2.34)** M2/GDP(-1) 42.06 46.07 (3.18)** (2.15)** Population 1.44 1.62 (1.26) (1.34) Policy 14.91 5.67 (3.35)** (1.21)* Aid/GDP -0.73 -0.42 (-0.32)* (-0.18) (Aid/GDP) x Policy 0.02 0.05 (0.14) (0.54) (Aid/GDP)2 x Policy 0.01 0.01 (0.11) (0.07) Observation 150 150 R2 0.27 0.23

Note: t-statistic in parenthesis. *, **, *** indicate 10%, 5% and 1% significance levels.

Conclusion

The study have produced some interesting preliminary implications about the interactions among aid, policy and growth in the Caribbean states. Some of these implications are: there is a positive, but insignificant relationship between aid

and growth. policy index and the interaction term of ratio of aid to GDP and

policy have positive effect on economic growth. However, while the policy index has a significant impact on growth, the interaction term of ratio of aid to GDP and policy does not have important effect.

size effect of aid on growth and the pattern of effect, that is, either positive or negative, are to large extent dependent on the existing macroeconomic policies.