What undermines foreign aid’s impact on growth?

What long run adverse effects might foreign aid have on a country's competitiveness? Authors Raghuram Rajan and Arvind Subramanian provide evidence that it has systematic adverse effects on the growth of labour intensive and export sectors.

This evidence takes two forms, say the authors:

In countries that receive more aid, the labour-intensive and export sectors grow slower than capital intensive and non-export sectors. This by itself does not show that the impact of aid on export sectors is negative. But they provide additional evidence that the manufacturing sector as a whole grows slower on account of aid.

Aid probably causes exchange rate overvaluation.

Remittances do not seem to have a negative competitiveness effect because remittances tend to slow when a country's exchange rate starts becoming overvalued.

Despite the fact that, for many aid-receiving countries, the manufacturing sector might be immediately less important than agriculture, that was also true for many of the fast-growing countries when they first embarked upon development, say the authors.

Slower growth of labour-intensive sectors induced by aid should be a source of concern for those who see aid as an instrument to reduce inequality, because labour-intensive sectors are the ones that can absorb the poor and landless who leave agriculture.

The authors caution that aid has to be spent effectively so that the productivity or welfare improvements from increased public investment can offset any dampening effects from a fall in competitiveness.

Source: Les Picker, What Undermines Aid's Impact on Growth? NBER Digest, April 2006; based upon: Raghuram G. Rajan and Arvind Subramanian, What Undermines Aid's Impact on Growth? National Bureau of Economic Research, Working Paper No. 11657, October 2005.

For text: http://www.nber.com/digest/apr06/w11657.html

For study abstract: http://papers.nber.org/papers/w11657

For more on International: http://www.ncpa.org/pi/internat/intdex1.html

FMF Policy Bulletin/ 4 July 2006