Foreign aid and economic growth in the developing countries - a  (Page 9/21)

After years of inward-looking economic policies and tight regulation, intensive reforms, which started inthe 1990s, have been contributing largely to the acceleration of economic growth of the region. South Asian nations reduced tariffs,removed trade barriers, dismantled restrictions on domestic and foreign private investment, and reformed their financial systems.Average tariff rates have declined from between 90% to 100% in the 1980s to between 17% and 32% today.

As a result, the region experienced rapid growth during the 1990s, averaging 5.9% annually and 4.3% in 2002.Trade liberalization has been an important component of structural reform efforts among the South Asian countries since the mid-1980s,with Sri Lanka leading the way. Merchandise trade as a share of GDP has nearly doubled in some countries in the last decade. Tradeliberalization played a positive role in supporting GDP growth rates of 5% and higher.

However, South Asia still has the lowest proportion of foreign direct investment to GDP in the world at just0.5% of GDP. Despite great improvements in nutrition, reproductive as well as children's health and education, this is still a regionwith many serious problems. Child malnutrition still remains among the highest in the world with almost 50% of children below thestandards for weight by age. South Asian illiteracy rates, 45%, are still the highest in the world.

Due to the lack of data, most of developing countries in Europe and Central Asia are excluded from the sampleof this study. Therefore the focus of the study is the countries in East Asia, South Asia, Sub-Saharan Africa, Latin America&the Caribbean and then inland countries.

The purpose of the study is to investigate how aid affects growth and how this relation varies across regions ofthe developing world. Therefore, the regional dummies and then the slope dummies, i.e. the interaction terms of foreign aid withcorresponding regions are introduced in the regressions accordingly. The regional dummies enable us to distinguish theintercepts of the focused regions with that of other regions while the slope dummies differentiate the slope of coefficients of thoseregions with that of the others. East Asia, South Asia and the Sub-Saharan Africa regions have been chosen for their typicalgeographical characteristics and difference in economic performance. Inland (or landlocked) countries are also included toexplore how geographical disadvantages affect the aid-growth relation.

Chapter IV

Methodology and the data

4.1. Model

Based on the endogenous growth theory, I construct my model following the one that Barro (1991) developedand then incorporate foreign aid as an additional explanatory variable. The major differencebetween endogenous models and the neoclassical ones is that the concept of capital in the endogenoustheory is broader in the sense that it includes human capital and there are increasing instead of diminishing returns to scale.Endogenous models rely on the existence of externalities, increasing returns and a lack of inputs that can not be accumulated(Sala-i-Martin, 1994). On the other hand, the key assumption of the neoclassical model is that the only difference across countrieslies in their initial level of capital. In reality, countries may differ in many other ways such as level of technology, propensityto save, population growth rate, etc. (Sala-i-Martin, 1996). Therefore, they may have different steady states and the growthrate of an economy is positively related with the distance from its own steady state. A poor country tends to grow faster than a richcountry, but only for a given quantity of human capital (Barro, 1991). In other words, there is a conditional convergence.