Foreign aid and economic growth in the developing countries - a  (Page 3/21)

Snyder (1993), taking country size into account, finds a positive and significant relationship between aidand economic growth. He emphasizes that “previous econometric analysis has not made allowance for the fact that larger countriesgrow faster, but receive less aid”. He also claims that donors favor small countries for a number of reasons. First, donors whoare seeking support from recipient countries find it better to provide aid to many small countries than to focus on just few largecountries. With the same amount of aid, the proportion of aid over GDP will be bigger in small countries compared to that of largercountries and as a result, give them more credits. Second, there is pressure on multilateral donors to deliver aid to all membercountries and due to their feasible project size, small countries tend to receive more aid than they expected. Third, small countriestend to have historical colonial relations with donor countries, which are somewhat influential to donors’ aid giving decisions. Thelast reason is that trade normally has larger fraction of GDP in small countries than in big ones and therefore, these countries maybe gaining more weight in donors’ assessment. Based on the model developed by Papanek (1972, 1973) and then extended by Mosley(1980) and Mosley et al. (1987), Snyder analyzes the relation between foreign aid inflow and the growth rate of gross domesticproduct in 69 developing countries over three periods (the 1960s, the 1970s and 1980-1987), incorporating country size (measured bygross domestic product) in the model. He argues that when country size is not included, the effects of aid are small andinsignificant but when this factor is taken into account, the coefficient of aid becomes positive and significant.

By contrast, Knack (2000), in a cross-country analysis, indicates that higher aid levels erode the quality ofgovernance indexes, i.e. bureaucracy, corruption and the rule of law. He argues that “aid dependence can potentially undermineinstitutional quality, encouraging rent seeking and corruption, fomenting conflict over control of aid funds, siphoning off scarcetalent from bureaucracy, and alleviating pressures to reform inefficient policies and institutions”.

Large aid inflows do not necessarily result in general welfare gains and high expectation of aid may increaserent-seeking and reduce the expected public goods quality. Moreover, there is no evidence that donors take corruption intoaccount seriously while providing aid (Svensson, 1998).

A permanent rise in foreign aid reduces long-run labor supply and capital accumulation, increases long-runconsumption and has no impact on long-run foreign borrowing. Using the optimal growth model with foreign aid, foreign borrowing andendogenous leisure-and-consumption choices, Gong and Zou (2001) show that foreign aid depresses domestic saving, mostly channelsinto consumption and has no relationship with investment and growth in developing countries.

Pedersen (1996) asserts that it is still not possible to conclude that aid affects growth positively. Using gametheory, he argues that the problems lie in the built-in incentive of the aid system itself. The aid conditionality is not sufficientand the penalties are not hard enough when recipient countries deviate from their commitments. In fact, there are incentives foraid donating agencies to disburse as much aid as possible. This hinders the motivation of recipient countries and raises the aiddependency, which in turn distorts their development.