The effects of foreign aid: Dutch Disease

This blog post was written by Arvind Subramanian, Senior Fellow at the Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor at Johns Hopkins University.

The voluminous literature on the effects of foreign aid on growth has generated little evidence that aid has any positive effect on growth. This seems to be true regardless of whether we focus on different types of aid (social versus economic), different types of donors, different timing for the impact of aid, or different types of borrowers (see here for details).  But the absence of evidence is not evidence of absence. Perhaps we are just missing something important or are not doing the research correctly.

One way to ascertain whether absence of evidence is evidence of absence is to go beyond the aggregate effect from aid to growth and look for the channels of transmission. If we can find positive channels (for example, aid helps increase public and private investment), then the “absence of evidence” conclusion needs to be taken seriously. On the other hand, if we can find negative channels (for example, aid stymies domestic institutional development), the case for the “evidence of absence” becomes stronger.

One such channel is the impact of aid on manufacturing exports. Manufacturing exports has been the predominant mode for escape from underdevelopment for many developing countries, especially in Asia. So, what aid does to manufacturing exports can be one key piece of the puzzle in understanding the aggregate effect of aid.

In this paper forthcoming in the Journal of Development Economics, Raghuram Rajan and I show that aid tends to depress the growth of exportable goods. This will not be the last word on the subject because the methodology in this paper, as in much of the aid literature, could be improved.

But the innovation in this paper is not to look at the variation in the data across countries (which is what almost the entire aid literature does) but at the variation within countries across sectors. We categorize goods by how exportable they could be for low-income countries, and find that in countries that receive more aid, more exportable sectors grow substantially more slowly than less exportable ones. The numbers suggest that in countries that receive additional aid of 1 percent of GDP, exportable sectors grow more slowly by 0.5 percent per year (and clothing and footwear sectors that are particularly exportable in low-income countries grow slower by 1 percent per year).

We also provide suggestive evidence that the channel through which this effect is felt is the exchange rate. In other words, aid tends to make a country less competitive (reflected in an overvalued exchange rate) which in turn depresses the prospects of the more exportable sectors. In the jargon, this is the famous “Dutch Disease” effect of aid.

Our research suggests that one important dimension that donors and recipients should be mindful of (among many others that Bill Easterly has focused on) is the impact on the aid-receiving country’s competitiveness and export capability. That vital channel for long run growth should not be impaired by foreign aid.