Institutional Quality, Foreign Aid and Economic Growth in Recipient Countries

Abstract:

Foreign aid is an important aspect of China’s Belt and Road Initiative (BRI) for enhancing two-way cooperation with BRI countries. Based on the panel data of China’s foreign aid over the period 2000-2014, this paper employs the Worldwide Governance Indicators (WGI) to conduct an empirical study on the economic growth effects of China’s foreign aid and recipient countries’ institutional quality with the endogeneity of aid taken into account. Results of our empirical study suggest that (i) China’s foreign aid, especially infrastructure aid, can effectively promote economic growth in recipient countries; (ii) sound institutional development offers an important assurance for economic growth in recipient countries; (iii) sample-specific regression reveals that the institutional quality of recipient countries can significantly influence the economic growth effects of China’s foreign aid, especially economic infrastructure aid for recipient countries in Asia and Europe. To improve aid effectiveness and quality, China needs to improve aid structure, supervise aid program implementation, and mitigate the impact of institutional risks in recipient countries.

Keywords:

田思远

foreign aid, institutional quality, economic growth, BRI JEL Classification Codes: F35, F43, O47

DOI: 10.19602/j.chinaeconomist.2020.11.06

1. Introduction

王孝松

As the world’s largest developing country, China takes an active part in international development cooperation and provides assistance to other developing countries, especially the least developed countries (LDCs). While seeking self-development, China strives to link its own interests with those of other countries. With China’s growing economic prowess and friendly ties with other countries, China’s increasing overseas aid has drawn extensive attention from the international community. The White Paper on China’s Foreign Aid (2014) (“White Paper”) reported a continuous rise in China’s foreign aid from 2010 to 2012. According to Aid Data, most recipients of Chinese aid are countries in Africa, Asia, South America and the Caribbean region. From 2000 to 2014, China implemented 5,466 aid projects worth 350 billion US dollars in 140 countries and regions. China’s foreign aid includes economic infrastructure aid, social infrastructure aid, physical capital aid to production sectors, as well as debt

relief and emergency aid to recipient countries’ governments. Among them, economic infrastructure has always been a key priority and accounts for 22.6% of total projects and 67.7% of total aid value.

Most aid recipients are developing countries with inadequate institutions and infrastructure, rampant corruption, and significant political risks. Many scholars believed that foreign aid could support economic growth in recipient countries under the “infrastructure effect” (Lin, 2016). After investigating how corruption in host countries impedes enterprises’ outward foreign direct investments (OFDI), Wei (2000) concluded that corruption had increased firms’ sunk cost and investment uncertainties. Compared with OFDI, aid projects and funds from other countries are often handled by host-country governments and more subject to recipient countries’ institutional quality. Despite the great importance of the above questions to China’s BRI development and foreign aid quality, few Chinese scholars have explored the relationship between China’s foreign aid and institutional risks and economic growth in host countries.

2. Literature Review

This paper aims to investigate how foreign aid and institutional quality influence economic growth in aid recipient countries. Related literature primarily includes studies on the economic growth effects of institutional quality and those on the economic effects of foreign aid for recipient countries.

2.1 Institutional Quality and Economic Growth

Existing studies have explained the determinants of a country’s economic growth from various dimensions. According to the neoclassical macroeconomic theory and development economics, longterm economic growth is primarily subject to changing economic structure, capital accumulation and technology (Harrod, 1939; Solow, 1957); while short-term growth determinants include consumption, export, domestic investment, and foreign direct investment (FDI) (Keynes, 1936). Yet poor institutional systems, corruption and inefficiency have restrained growth potentials in most developing countries, drawing attention from academics to the economic growth effects of these non-economic factors. G. Myrdal (1957) made an early discovery of the institutional factor’s effects on developing countries, and explained why the capital circulation accumulation theory could not explain the secular stagnation of developed countries. North (1990) described institutions as a set of rules that influence economic growth in equally significant ways as population and savings. Like other tangible resources, the quality of institutions varies as well. Effective institutions are a comparative advantage for a country or region and can raise resource allocation efficiency and economic growth. As demonstrated by extensive empirical research by Chinese and international academics, institutional quality is a key determinant of regional economic growth (Knack et al., 1995; Hall et al., 1999; Acemoglu et al., 2001). However, the effect of institutions varies across countries at different levels of development. Bouis et al. (2011) ascribed such differences to a country’s development stage.

Aside from institutional quality, some academics have also investigated the economic growth effects of corruption. Leff (1964) and Lui (1985) put forth the “effective corruption theory”, which argues that in developing countries with poor institutional systems, corruption may help firms obtain market access first and bypass inefficient administrative control, that is, corruption acts as a “lubricant.”. An opposite theory is the “friction effect theory,” i.e., some scholars argued that rent seeking not only leads to monopoly but causes resources to be wasted as well (Krueger, 1974). Extensive empirical research after the 1990s has supported corruption’s negative effect on economic growth. For instance, Mauro (1985) found a significant negative correlation between corruption and the investment/GDP ratio based on data from 58 countries.

2.2 Economic Effects of Foreign Aid

The economic effects of international aid recipient countries have drawn extensive attention among

scholars, who have sufficiently studied the relationship between aid and economic growth but reached different conclusions. Clemens et al. (2012) and Galiani et al. (2017) examined the positive effects of foreign aid from developed countries on economic growth in recipient countries. Munemo (2006) and Helble et al. (2012) investigated how international aid influenced foreign trade in recipient countries, and found that aid could boost recipient countries’ exports. Yet Rajan et al. (2008) and Doucouliagos et al. (2009) found no actual positive effect of international aid on economic growth. Voivodas (1973) found that aid exerted significantly negative effects on recipient countries’ economic growth based on data from 22 countries over the period 1956-1978.

The above studies primarily focused on the effects of foreign aid from developed countries. With increasing economic strength, some developing countries are emerging as aid providers, attracting a growing body of research from Chinese and international scholars. Compared with aid from developed countries, China’s foreign aid puts a greater premium on economic and social infrastructures (Tierney et al., 2011). There are two predominant views in the academia about the economic effects of foreign aid from China. One thinks that infrastructure investment from China may boost economic growth in recipient countries, i. e. significant “infrastructure effect” exists ( Deininger and Okidi, 2003). As for studies conducted by Chinese scholars, based on China’s aid projects in Africa and calibrated nightlight data over the period 2001-2013, Zhu et al. (2018) created an analytical framework on the economic growth effects of China’s aid to Africa, including effects on material capital, human capital, and technology transfer and spillover, and found that steady infrastructure and financial aid from China had significantly increased economic growth in recipient countries. The other view suggests that aid from China could not promote economic growth in recipient countries (Crouigneau et al., 2006). Some even argued that China’s aid, especially aid to Africa, was primarily intended to access mineral resources in recipient countries and would condemn recipient countries to a resource curse (Taylor, 2006). In addition, Pattillo et al. (2003) found that aid from China would inhibit FDI in recipient countries.

2.3 Summary Comments

Based on the above survey of existing studies, we have discovered that existing research on foreign aid from China is focused on aid to Africa and whether China’s aid to Africa was conducive to economic growth in African countries, without identifying the differentiated effects. Most target recipient countries are developing countries, whose economic development and benefits from aid are limited by institutional drawbacks. For instance, Yang and Li (2018) found that corruption in African countries exerted a “friction effect” on Chinese investments in Africa and aid to Africa led to significantly more indirect Chinese investments in Africa through the “infrastructure effect”. In examining the economic effect of China’s foreign aid, existing studies did not take institutional quality in recipient countries into account, thus leaving defects in relevant empirical studies. In the context of the BRI, China’s foreign aid has entered an important period of transition characterized by changing amount and regional distribution of aid (Bai, 2015). Hence, it is of great practical relevance to fully assess the economic effects of China’s foreign aid on recipient countries.

This paper examines the economic effects of aid from China based on data of China’s aid to 130 countries over the period 2000-2014. This paper offers the following contributions: First, unlike existing studies that focus on China’s aid to African countries, this paper adopts a broader scope of research subjects, including countries in Asia, Africa, Oceania, and South America, for a more comprehensive assessment of the economic effects of aid from China, taking into account regional differences that are also compared. Second, this paper evaluates the interactive effect between aid from China and host countries’ institutional quality, i.e., whether institutional quality would influence the economic growth effect of aid from China, and such interactive effect is also examined to see in which regions and with which types of aid it is more significant.

3. Model Specification and Data 3.1 Model Specification

Based on this paper’s research priorities and referencing Barro (1999) and Anyanwu (2014), we create the following two regression equations: lnGDPit= β0+β1numberit+β2insit+ ΣβmXmt+ μi+νi+ϵit (1)

lnGDPit= β0+β1numberit+β2insit+β3numberit ×insit+ΣβmXmt+ μi+νi+ϵit (2) Subscripts i and t respectively denote recipient country and year; explained variable GDP denotes economic growth; number means the number of projects aided by China in a host country in a given

1 year; ins is the institutional quality of a recipient country; number×ins is the interaction term between aid and institutional quality. X is a set of control variables, including the amount of aid from OECD countries to a recipient countries ( oecd), trade openness ( open), resource endowment ( resource), labor status ( labor), and foreign direct investment ( fdi). μi is the individual fixed effect of different countries; νt is the fixed effect of time; ϵit is stochastic disturbance term.

Equation (1) is more focused on the direct effects of China’s foreign aid and recipient countries’ institutional quality on their economic growth. By introducing the interaction term between aid and institutional quality on the basis of equation (1), equation (2) reflects the interactive effect between aid and institutions:

The interaction term’s coefficient is the impact of institutional quality on the marginal economic growth effect of aid. If β3> 0, the implication is that the recipient country’s institutional quality will increase the economic effects of aid from China.

In order to reflect the actual effects of aid from China and avoid potential two- way causality between institutional quality, economic growth and between foreign aid and economic growth, this paper conducts a regression analysis with two-year-lagged data from recipient countries followed by a robustness test. Revised regression models are as follows:

lnGDPit= β0+β1numberit − 2+ β2insit+ ΣβmXmt+ μi+νt+ϵit

3.2 Data

lnGDPit= β0+β1numberit− 2+ β2insit+β3numberit − 2×insit−2+ ΣβmXmt+ μi+νt+ϵit (3)

(4)

The explained variable is economic growth in the recipient country, which is measured by the 2 logarithm of per capita real GDP. Core explanatory variable data ( number) is from Aid Data database, and institutional quality data ( ins) is from the Worldwide Governance Indicators (WGI), which include