Foreign aid and economic growth in the developing countries - a  (Page 14/21)

The coefficients of other variables, i.e. GDP1975, TRADE and SCHOOL are positive and significant while thatof POPULATION, SAVING and FDI are insignificant across regressions for this overall period.

5.4. Policy Implications

5.4.i. Implications of the negative relation between aid and growth

From the above regression results, the following findings can be summarized (i) in general, economicgrowth has negative relation with foreign aid in the developing countries (ii) foreign aid to the studied inland countries as wellas South Asian countries during the period 1992-2000 has positive impact on growth and (iii) there is strong divergence trend amongcountries in the sample.

As discussed above, the foreign aid is likely to hinder the economic growth for some reasons. In countries wherethe institutional environment is distorted, aid could be fungible into financing the government’s consumption instead of beingeffectively invested. Saving displacement, aid dependency enhancement also badly affects growth of the recipient countries.Foreign aid and windfalls in countries characterized by a divided policy process are associated with increased corruption (Svensson, 1998). Foreign aid reduces long-run capital accumulation and laborsupply (Gong and Zou, 2001). Moreover, depending on the marginal propensity to spend on the export goods and the conditions of aid,the foreign aid can possibly improve the donor’s terms of trade while make the recipient worse off (Krugman and Obsfeld,2003).

The negative relation between aid and growth is nothing new in the aid literature and this is just an additionalevidence of this kind. However, it is noteworthy that the coefficient of aid is consistently negative and highly significantacross regressions. This results force us to think more carefully about how to improve the effectiveness of aid. Reforms arecertainly necessary, not only for recipients but also for donors, especially multilateral aid agencies. It is widely accepted thataid works well in good-policy environment and in reality there are many good examples of success, for instance Ethiopia, Uganda, VietNam, India etc (World Bank, 1998). Aid is more effective when it is used to facilitate timely and efficiently the reforms initiated bythe local governments, not to condition the reforms. Put it another way, the reform should be internalized, not imposed by outsiders.What aid does is “to help good governments to survive long enough to solve the problems” (World Bank, 1998). Countries may learn fromthe successful experiences of others, but need to tailor appropriately their own action plans. Aid is more effective andviable if it finances government bureaucrats training or policymakers’ overseas education and then nurtures the reformsinitiated by them.

In reality, the World Bank structural adjustment programs and IMF stabilization programs failed in manycases due to the lack of appropriateness and strict penalty upon bad performance. What important is the “ownership”, which infersthe commitment to prudent economic policies among the policymakers (Graham and O’Hanlon, 2001). Conditionality is unlikely to bringabout lasting reform if there is no strong domestic movement for change (World Bank, 1998). Therefore, conditionality should work inthe way that ensures the effectiveness of loan where the reforms are in place. Rewarding good performers in aid allocation is a goodway to encourage other recipient countries to learn from them. More importantly, the penalty should be implemented strictly upon theviolation of conditional terms. Loans should be postponed or even terminated unless further positive evidence is accorded.