Foreign Aid vs. Economic Growth: A Critical

Foreign Aid vs. Economic Growth: A critical evaluation of the success/Failure of foreign aid in Africa (Ethiopia)

In this paper, explore the concept of foreign aid and economic development in an African. We focus on a critical evaluation of the success as well as failure of foreign aid in Africa (Ethiopia). What are investigated are the factors that affect growth, the scopes behind foreign aid and reasons for failure. The aim of the study however, is to explore and survey the impact of foreign aid on economic growth and the country as a whole. We then focus on five major objectives. The first one is such as the relationship that exists between foreign aid and a country's economic growth. The second objective is the investigation of the economic impact of foreign aid on consumption and investment. The third objective is the investigation whether recipient government misuse aid as a result of corruption and inefficiency of the governance. The fourth objective is then the investigation of the contribution/failure of aid conditionality in Africa as a result of lack of good domestic policies and institutional capabilities. We then evaluate if African countries really need foreign aid on order to survive as well as achieve economic growth.

Introduction

Financial aid also known as development assistance, or technical assistance or international aid, or overseas aid, or Official Development Assistance (ODA) refers to the assistance that is given by governments and other agencies to support the economic, political, social and environmental, developments of other developing countries. It can be distinguished from humanitarian aid by the fact that it lays much focus on the alleviation and eradication of poverty in the long-term, rather than a short-term response. The term financial aid, which is used, for instance, by the World Health Organization (WHO) expresses the idea that there should be partnership existing between the donor and recipient, instead of the traditional situation in which the relationship was dominated and was under the control of the wealth and specialized knowledge of one side. WHO (2008). Most financial aid comes from the Western industrialized countries but some poorer nations also contribute financial aid. Financial Aid may be bilateral. This is when it comes from one country directly to another; or it may be multilateral when it is given by the donor country to an international organization such as the World Bank or the United Nations Agencies which includes UNDP, UNICEF, UNAIDS among others, which later distributes it to the developing countries. The proportion currently lies at about 70% bilateral and 30% multilateral.

Aproximately between 80-85% of financial aid comes from government sources as official development assistance. The 15-20% that remains comes from privately owned organizations like non-governmental organizations (NGOs), other foundations and other development charities like the Oxfam. On top of that, remittances received from migrants working and residing in the Diaspora also form a considerable amount of international transfer.

Some governments also include military assistance in the notion of foreign aid, despite the fact that numerous NGOs try to disapprove and to oppose this.Privately owned consulting firms, like PricewaterhouseCoopers and Deloitte, are increasingly being contracted by donor agencies to effectively manage and implement elements of their aid program, due to their perceived ability to perform higher quality program management and delivery.

Scope of foreign aid

The aim of foreign aid in the growth process of developing nations in Africa has been a topic of great debate. Foreign aid has become an important topic because of its implications for the alleviation and eradication of poverty in the developing countries.

Recent empirical studies based on foreign aid and economic growth has generated mixed outcomes. For instance, Burnside and Dollar (2000), Papanek (1973), Karras (2006), Gomanee, et al. (2003), Hansen and Tarp (2000),Dowling and Hiemenz (1982), Gupta and Islam (1983), Dalgaard et al. (2004), find evidence for positive impact of foreign aid on growth. Burnside and Dollar (2000) and Brautigam and Knack (2004) find proof for negative effects of foreign aid and growth, while, Mosley, et al. (1987), Boone (1996), Mosley (1980)and Jensen and Paldam (2003) suggests that financial aid has no impact on growth. It should however be noted that, despite the fact that Burnside and Dollar (2000) summarized that foreign aid has got positive results, this summary is applicable only to economies which the foreign aid is combined with superb fiscal, monetary, and trade policies. Recent studies by Doucouliagos and Paldam (2009) stated that the effects of foreign aid on growth estimates differ considerably adding up to a negligible positive, but unimportant, effect on growth.

The main aim of foreign aid in invigorating economic growth is to complement domestic sources of finance like savings, thereby escalating the amount of investment and capital stock. As Morrissey (2001) states, there are numerous ways through which financial aid contributes to economic growth. First and foremost, financial aid increases investment not only in physical but also human capital. Secondly, financial aid improves the capacity of nations to import capital equipments and technology. Thirdly, financial aid has no indirect effects that reduce investment or savings rates and thirdly, financial aid is linked with technology transfer that is capable of increasing the productivity of capital and promoting local technical change.

According to McGillivray, et al. (2006), there are four main alternative views on the effectiveness of financial aid has been the following. Firstly, financial aid has declining returns. Secondly, financial aid's efficiency is determined by both external and climatic conditions, thirdly, financial aid's effectiveness is determined by political conditions, and finally, financial aid's effectiveness is dependent on institutional quality.It is fascinating to note that in the recent years there has been a great increase in financial aid flows to the developing nations despite the fact that other types of flows like foreign direct investment and other private flows are reducing. The budgets of numerous developing countries in Africa were hard hit by the increase in the prices of food and oil in the recent years and even up to now. Numerous countries are not in a strong fiscal position to look into the present financial crisis.

History of foreign aid

The history of foreign aid can be traced to the military assistance that was put in place in order to aid the parties that were at war and were considered to be strategically significant. Its application in the modern era commenced in the 18th century at a time when Prussia aided some of its important allies. Then the 19th as well as the 20th century European powers started providing huge amount of money to their various colonies in an effort to improve their infrastructure. The ultimate goal however is to increase the economic output of their colonies. The structure as well as scope of the foreign aid can be effectively be traced to two main developments that followed World War II. These are; The implementation of a package known as Marshal Plan which was sponsored by the U.S. In an effort to rehabilitate the poor economic status of 17 western as well as southern nations and the formation of important international organizations such as the United Nations (UN),World bank and the International Monetary Fund (IMF).These international organizations have a major role in the process of allocating funds internationally, determination of the qualifications for the aid's receipt as well as the assessment of the impact of the granted aid. The foreign aid that is granted in the contemporary society is meant to be a distinguished one and not just for the humanitarian purpose. This is to mean that the donor country has no self-interest. The granted aid should be offered with neutrality as well as utmost transparency. This is however marred with cases of ideological as well as political orientations/alignments continuing to be the decisive conditions for to the process of receiving the aid from both the donor countries and international organizations.

The recent news on foreign aid indicate that development aid did rise in 2009 and the report also indicated that most of the donor nations would meet their 2010 set donor aid targets (OECD,2010). The OECD figures also indicated that there is a continuing level of development aid growth despite the 2009 financial development aid.

Current issues surrounding foreign aid

There are various issues that surround the concept of foreign aid. The main ones include the main reasons behind the concept as well as if it is really important for the growth and development of the recipient countries. This is to say that it is debatable if foreign aid brings growth or lack of it as a result of political and ideological interference by the donor countries/organizations as well as corruption that is rife in the recipient countries.

Aim

The aim of this study is to explore the relationship between foreign aid and economic development. Previous studies that had been dedicated to the relationship between foreign aid and economic growth of a given nation have yielded mixed results and have in most cases been heavily criticized for having several methodological bottle-necks that are associated with performing a cross-country analysis[footnoteRef:1]. The nation specific studies too have not succeeded in the production of conclusive results. The example being the bivariate Granger causality test performed by Dhakal et al. (1996) that involved four Asian nations (India, Nepal, [1: The most up-to-date analysis is the one conducted by Burnside and Dollar (2000) with the sponsorship of the World Bank that concluded that the foreign aid only works well under favorable and good policy environment. These favorable policies include low inflation, liberalized financial sector, zero or very low deficits with a regime which is open trade and a government which is open sector friendly. This proposition/analysis has however been refuted on methodological grounds as well as contrary findings by other scholars. The literature that explores this is Hansen and Tarp (2000)]

Pakistan and Thailand).

The other nations involved in their analysis were four African nations (Botswana, Kenya, Malawi as well as Tanzania). These studies however failed to produce a causal correlation between foreign aid and economic growth in the countries involved. On the contrary, Levy (1988) did find out that aid has positive and significant correlation with the level of investment as well as economic growth in African nations. Gounder (2001), by means of an Autoregressive Distributed Lag (ARDL) model found that foreign aid has a positive as well as significant effect on the economic growth in a specific country (Fiji). On the same note Murty, Ukpolo and Mbaku (1994) have found that the per capita real gross domestic product, rate of savings as well as foreign aid is highly correlated. Their study also found out that foreign aid has positive long-term effects on countries such as Cameroon between 1970 and 1990. By means the cointegration as well as error correction analysis by Nyoni (1998) in Tanzania that found that there is a positive long run effect of aid on the overall equilibrium real exchange rate[footnoteRef:2]. The multi-country analysis conducted by Burnside and Dollar (2000) did find out that foreign aid have been very effective in the promotion of economic growth un countries that have favorable policies. By means of a simultaneous-equation model, the authors Burke and Ahmadi-Esfahani (2006) failed to find a sufficient evidence necessary for deducing that foreign aid can significantly affect the level of economic growth in Indonesia, Philippines and Thailand between the periods running 1970 up to 2000. The main aim of the study is to examine if there is a correlation between the foreign aid and economic growth in Africa (Ethiopia). This is in light of the fact that after an excess of thirty five years of various forms of development assistance as well as the spending of more than one trillion dollars in foreign aid, an excess of one billion individuals still live on less than a dollar (U.S.) per day (World Bank,1998). This therefore raises the doubt on the real effectiveness of foreign aid. From the earlier periods of 1965, the level of real per capita income of most Sub-Saharan nation has experienced a decline or has been stagnant. The economist of that time did however attribute this problem of economic growth to lack of capital (as a result of low savings) as well as foreign exchange constraints. In this light, the concept of foreign exchange has been viewed as being vital to the process of eliminating low growth as well as the vicious circle of poverty. [2: The equilibrium real exchange rate refers to the observed real exchange rate .]

The aim of this paper is to thoroughly explore and to critically survey the various impacts and effects of foreign aid on economic growth and the country as a whole.

Objectives

The main objectives are to investigate the existence of a relationship between foreign aid and economic growth. Similarly, the paper endeavors to investigate the economic impact of foreign aid on consumption and investment. Thirdly, it tries to determine whether the recipient governments misuse aid as a result of corruption and inefficiency of the governance. This paper also tries to investigate the contribution or the failure of financial aid conditionality in Africa. And finally, it tries to investigate whether African countries need financial aids to survive and grow.

The relationship between foreign aid and economic growth

The Economic growth rate in Sub-Saharan African countries like Ethiopia which stood at 2.17% on average over the period 1980-89 increased by 3% over the period 1990-06. On the contrary, investment over Gross Domestic Product which was averagely 20% over the period 1980-89 reduced to 18% in the period between 1990-1906. Similarly, savings over the Gross Domestic Product for all the Sub-Saharan Africa countries reduced from 18 becoming 15% over these two periods. There has been many works in the assessment of foreign aid and economic growth. Earlier research in the assessment of the relationship between financial aid and growth has produced confusing results and has received criticism for procedural problems that are as a result of cross-country studies. Some observed assessments have indicated that there is no fundamental relationship between foreign aid and economic growth. However, works such as; Burnside and Dollar (2000), Nyoni (1998) and Levy (1988) found that financial aid is positively linked with investment and economic growth in African countries.

Financial aid is misused by the governments

From our research, the recipient governments misuse the financial assistance accorded to them due to rampant corruption that has rocked this countries. While the financial aid is an extremely important source of investment for poor and often insecure nations, its complication and the always expanding budgets leave it exposed to corruption, yet it cannot be discussed because of rampant corruption remains a taboo subject. Bailey (2008). It is so hard to quantify corruption because it is always difficult to differentiate it from other problems that affect the developing nations like Ethiopia, like wastage of resources, mismanagement besides inefficiency. Usually, absence of understanding of the process by the people who should be receiving the financial aid results into cynicism and firm belief that greed and rampant corruption are the major failures. Non-governmental organizations have in the recent past years made huge efforts to improve participation, accountability and transparency. Financial aid continues to be misunderstood by those who should be receiving it. Greater investments are required to be made into researching and investing in applicable and efficient accountability systems. Bailey (2008). Some researchers from the overseas Development Institute have highlighted the need to tame corruption using the following methods. Firstly they suggest that the governments should refuse to admit the pressure to spend aid rapidly. They respective governments should also try to continue to invest in inspection capacity, further than the simple paper trails. Bailey (2008). To minimize the rampant corruption that is widespread in the financial aid, privately owned consulting firms, like PricewaterhouseCoopers and Deloitte, are increasingly being contracted by donor agencies to effectively manage and implement elements of their aid program, due to their perceived ability to perform higher quality program management and delivery.

Why African countries need financial aid

Millions of African children are dying from preventable and curable diseases and illnesses. Gordon Brown. Gordon brown, the former United Kingdom Chancellor of the Exchequer called for a doubling of foreign aid that is extended to African countries in January 2005. He gave hope by stating the ease and importance of doing good. Medicine that is capable of preventing half of all malaria deaths is costing 12 cents only per dose. A net capable of preventing malaria costs only $4. Spending $3 only on every new mother is capable of preventing 5 million child deaths up to the next ten years. In 2005, the West tried harder than any other ever to save Africa. The British Prime Minister Tony Blair, by then called at the World Economic Forum in Davos in January 2005 for a great push forward in Africa to bring to an end the rampant poverty. This was to be financed by an increment of the foreign aid. Secondly, Tony Blair commissioned a Report on Africa, which publicized its findings in March 2005, similarly, calling for a "great push." Gordon Brown and Tony Blair put the cause of bringing to an end the rampant poverty in Africa the top of the list of items of the G-8 Summit in Scotland in July 2005. In July 2005, the G-8 came to an agreement to double foreign aid to Africa, from the $25billion which used to be given annually to $50 billion to finance the big push of making poverty in Africa a history. Africa was already the mainly aid-intensive section in the world prior to the efforts of 2005. September 2005, the world's leaders made a gathering at the United Nations to further discuss the progress on putting to end poverty in Africa. This aid came because the tragedy of Africa has been well-known for quite sometimes. Sub-Saharan Africa has 11% of the world's population though it produces only one percent of the world's Gross Domestic Product. In any African's nation, approximately 43% of the population lives on less than a dollar on daily basis. The World Food Programme's list of 23 countries with more than 35% of the population malnourished has 17 of the total 23 countries are in Africa.

AIDS and malaria kill more victims in Africa than any other continent. There are unending brutal civil wars in several African countries like Sudan, Angola, and Chad, not to mention the Rwanda's genocide and the current carnage that is happening in the Democratic Republic of Congo .: Angola, Burundi, Liberia, Sudan, Sierra Leone, Somalia, and Zaire/Congo also have a series of civil strife. The Kenyan post election violence that erupted in 2008 can also not be forgotten.

Life expectancy is also another indicator that highlighting the Africa's tragedy, thanks to the twofold blow of soaring infant mortality and the soaring adult mortality as a result of AIDS. It is possible to pick a threshold for life expectancy (58 years) in which every African country is below that threshold and only a handful of other very dysfunctional societies elsewhere. The response of the Westtern Africa's tragedy has been constant throughout the years, from economist Walt Rostow and John F. Kennedy in 1960 to economist Jeffrey Sachs and Tony Blair in 2005: give more aid. Walt Rostow, motivated by acceleration of Cold War, called for doubling foreign aid in 1960; World Bank President McNamara by then called for doubling the financial aid in 1973: the World Bank again called for doubling aid with end of Cold War in 1990. World Bank President Wolfensohn called for doubling of financial aid with beginning of terrorist war in 2001. As just noted, G-8 Summit in July 2005 agreed to double aid to Africa. Financial Aid to Africa did indeed rise. Easterly, (2005).