Aid, Policies and Growth

Views expressed are those of the authors and do not necessarily represent official opinions of the World Bank. Abstract This paper uses a new database on foreign aid to examine the relationships among foreign aid, economic policies, and growth of per capita GDP. In panel growth regressions for 56 developing countries and six four-year periods (1970-93) the policies that have a large effect on growth are fiscal surplus, inflation, and trade openness. We construct an index of these three policies, interact it with foreign aid, and instrument for both aid and aid interacted with policies. We find that aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies. In the presence of poor policies, on the other hand, aid has no positive effect on growth. This result is robust in a variety of specifications that include or exclude middle-income countries, include or exclude outliers, and treat policies as exogenous or endogenous. We examine the determinants of policy and find no evidence that aid has systematically affected policies-either for good or for ill. We estimate an aid allocation equation and show that any tendency for aid to reward good policies has been overwhelmed by donors' pursuit of their own strategic interests. In a counterfactual we reallocate aid, reducing the role of donor interests and increasing the importance of policy: such a reallocation would have a large, positive effect on developing countries' growth rates. 1 The global economy governed by international financial institutions, the World Trade Organization, and Multinational Corporations proposes structural adjustment for countries in the South in the name of fiscal health. The result is increasing poverty, debt, and unemployment. Enormous and steady flows of concessional external finance from developed countries have permitted Third World governments to pursue " development " policies that have been wasteful, ill-conceived, unproductive-or even positively destructive.