Effect of foreign aid on recipient countries

Foreign aid refers to the provision of resources from one government or organisation such as the European Union to another. In this context, resources include financial aid, human capital or technical assistance, grants and loans.

It mainly intends to promote economic development to the recipient countries. These aid is given to underdeveloped and developing countries free of charge, or in the form of loans at low interest rates by developed countries or international organisations as foreign direct investment. Foreign aid is beneficial for developing countries, and causes increased investment and decreases foreign borrowing. At the same time, foreign aid increases public consumption.

Since the establishment of the World Bank and the United Nations, economic growth and development have been a top priority for all countries, and foreign aid has been central to developing countries in achieving the result. The first serious inflow of foreign aid dates back to the end of WWII, whereby the USA started its first international aid initiative called the Marshal

Plan for the period of 19481951. In 1948 alone, the USA provided over US$12 billion for the programme in the form of aid to rebuild Western European economies from the destruction caused by WWII. According to Eichengreen

(2011), the programme was successful and since then, many countries showed interest to replicate it.

Foreign aid to developing countries has averaged between 3.7% and 6.7% of

GDP during 1980–2009, a mounting to around 20–40% of average tax revenues. The relatively high share of aid in government budgets in some countries has raised concerns about the detrimental effects of foreign aid dependency on domestic revenue efforts, spending programmes and budget planning.

Sub-Saharan Africa comprises 49 countries, and most of these countries are categorised as low-income countries, according to the World Bank. It is one of the poorest and least developed regions in the world, where more than half of its population lives under extreme poverty (below the poverty threshold of US$2). Consequently, the region is one of the highest recipients of foreign aid in the world. Every year, billions of dollars flow to this region to promote economic growth and reduce poverty. However, the effectiveness of aid in the sub-Saharan region is still doubtful since the region is behind in economic development. More than 50% of the world’s poor live in this region alone. Therefore, it is legitimate to question the effectiveness of foreign aid in subSaharan Africa. Several studies are showing that the effectiveness of aid in boosting economic growth is not as expected.

According to the researchers, foreign aid has a negative impact on economic growth because of economic and political instability, corruption and weak institutional quality, which leads to the inappropriate usage of foreign aid in the host nation. Nyoni (1998) conducted research on the aid-growth relationship in Tanzania, and the result shows that an increase in foreign aid inflows raises the value of their domestic currency (appreciates the exchange rate), which increases the price of their exported goods and reduces domestic investment. He concluded that foreign aid has a negative effect on growth through deteriorating investment in the country. Moreover, he stated that government intervention is important to reform and implement convenient policies, which enable aid to be more effective and offset the exchange rate problem and play a positive role in promoting growth. As a result, aid promotes the consumption of imported commodities by alleviating foreign exchange constraints which impede consumers from importing goods and services.

Foreign aid has a crowding-out effect over domestic investments. Hence, the crowding-out effect hurts the domestic economy and develops foreign dependency over time. Foreign aid has not only restrained the economic growth of the region, but also crowded out financial and human capital. Foreign aid causes the hosts to be more dependent on foreign financial resources.

Aid can be more effective in promoting growth in recipient countries with good macroeconomic policies. In most developing countries, foreign aid increases household and government consumption but not investment, and aid has a negative impact on growth. Foreign aid will reduce tax revenue and increase dependency on foreign aid, which afterwards reduces investment and growth. Political economy considerations provide additional support to the argument that foreign aid may discourage taxation by recipient governments. A key argument of the aiddependency literature is that foreign aid lowers tax revenue because it undermines the development of domestic institutions which support tax administration and good governance.

Total net foreign aid has a negative association with government revenues and changes in tax revenue, and the negative effect is stronger in countries with weak institutions. Foreign aid has resulted in increased public or private consumption rather than in increased investment, and has contributed less to growth than was anticipated. As a result of the above, foreign aid causes the deterioration of the internal income distribution in recipient countries, and interferes with the country’s economic and political policies.

This suggests that foreign aid has a negative and statistically significant effect on public sector borrowing. Overall, this supports the view that governments in developing countries are likely to reduce other forms of borrowing. Foreign aid has a positive and significant effect on public investment expenditure, which in turn crowds-out private investments. This also supports the view that foreign aid loans are not used to increase current expenditure. Foreign aid crowds out government revenue as revenue collected is negative and statistically insignificant, suggesting that authorities in developing countries reduce their efforts to collect revenue when foreign aid is made available to them.