The effect of foreign aid on economic growth empirical evidence from east africa

In line with the theoretical a study by Moreira 2005 asserted the impact of foreign aid on economic growth of SSA using the GMM analysis on annual data covering the period from 1970 to 1

ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES

THE EFFECT OF FOREIGN AID ON ECONOMIC GROWTH: EMPIRICAL EVIDENCE FROM EAST AFRICA

The center for African and Oriental studies

Presented in Partial Fulfillment of the Requirements for the Degree of Master of Arts (Human and Economic Development in Africa)

Addis Ababa University Addis Ababa, Ethiopia June, 2017

ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES

This is to certify that the thesis carry out by Yoseph Weldemariam entitled: The Effect of

Foreign Aid on Economic Growth: Empirical Evidence from East Africa The research is

submitted in partial fulfillment of the requirements for the degree of master of art in (human

and economic development in Africa) complies with the regulations of the University and

meets the accepted standards with respect to originality and quality

Signed by the Examining Committee:

Name of Internal Examiner Signature Date

ACKNOWLEDGEMENTS

I sincerely wish to express my gratitude to both family members and my friends who are always behind my success My words of gratitude would go to my advisor Dr Kidist Gebreselassie for her supervision, valuable guidance, intellectual encouragement, and critical and constructive comments on the structure and organization of this research I want to express my maximum respect to her

I am also grateful to Alemta Gerima, Yohaness Gebrezigiher and Friat Gebreslassie for their encouragements throughout my study

Table of Contents Contents pages

Acknowledgements i

Table of Contents ii

List of Tables v

List of Figures vi

List of Acronyms vii

ABSTRACT viii

CHAPTER ONE 1

1 INTRODUCTION 1

1.1 Background of the Study 1

1.2 Statement of the Problem 3

1.3 Objective of the study 6

1.4 Significance of the Study 6

1.5 Scope and Limitations of the study 6

1.6 Organization of the thesis 7

CHAPTER TWO 8

2 Theoretical and Empirical Literature Review of Foreign Aid 8

2.1 Introduction 8

2.2 Concept of Foreign Aid 8

2.2.1 Advantages and dis advantages of Foreign Aid 9

2.3 Aid Effectiveness 11

2.4 Theories of Foreign Aid and Economic Growth 12

2.4.1 The Harrod-Domar Growth Model 12

2.4.2 The Solow Growth Model 13

2.5 Foreign Aid and Economic Growth in Sub-Saharan Africa 17

2.5.1 Empirical literature on aid-growth relationship from East Africa 19

CHAPTER THREE 24

3 Research Methods 24

3.1 Introduction 24

3.2 Data Source and Description of Variables 24

3.2.1 Data Source 24

3.2.2 Description of Variables 25

3.3 Model Specification 28

3.4 Econometric Model 29

3.5 Estimation Method 30

3.5.1 Generalized Method of Moments (GMM) 30

3.5.2 Testing the Estimation Method 33

CHAPTER FOUR 35

4 Data Analysis, Results and Discussions 35

4.1 Introduction 35

4.2 Descriptive Analysis 35

4.2.1 Summary Statistics of Variables included in the model 35

4.2.2 Trend in real per capita GDP growth 36

4.2.3 Trend in Official Development Assistance (ODA) 40

4.2.4 Aid Unpredictability and Paris Declaration on aid effectiveness 41

4.2.5 Other Variables Included in the Model 43

4.3 Test Results 43

4.3.1 Multicollinearity Test 44

4.3.2 Stationarity Test 44

4.3.3 Autocorrelation Test 45

4.3.4 Testing for Heteroscekasticvity 46

4.4 Econometric Analysis 46

4.4.1 The Effect of Foreign Aid on Growth 47

4.4.1.1 Regression Results of GMM Estimators 48

4.4.1.2 System GMM Estimation Techniques 50

CHAPTER FIVE 54

5 Conclusions 54

References 57

Appendexis 63

List of Tables

Table 3.1 Descriptive of Variables used in the regression model 25

Table 4.1 Summary Statistics for the Data of 4 East African Samples 36

Table 4.2 Mean of aid unpredictability for the four countries 43

Table 4.3 the Pairwise Correlation Test Matrix 44

Table 4.4 Levin-Lin-Chu unit root test 45

Table 4.5 Arellano-Bond test for zero autocorrelation in system GMM 45

Table.4.6 OLS, Fixed Effects (FE), Random Effects (RE), First Difference GMM and System GMM estimation: dependent variable GRPCGDP 47

List of Figures

Figure 2.1 Dynamics of the Solow model 15

Figure 2.2The relationship between foreign aid and saving rates in the Solow

diagram 16

Figure.2.3 Aid and growth relation in Africa (10 years moving average) 18

Figure 4.1 Trends of per capita GDP for the four countries over 1990-2014 (2010 $USA) 37

Figure 4.2 Trends of growth rate of per capita income for the four countries over 199-2014 period 39

Figure 4.3 Aggregate of GRPCGDP for the countries 40

Figure 4.4 Trends of net ODA flows to four of the countries (constant) 41

Figure 4.5 Flows of net ODA to four of the countries (constant) 41

Figure 4.6 The extent of aid unpredictability for individual countries during (1990-2014) 42

List of Acronyms

AAA Accra Action for Action

ARDL Autoregressive Distributed Lag

DAC Development Assistance Committee

ODA Official Development Assistance

OECD Organization for Economic Cooperation and Development OLS Ordinary Least Square

PD Paris Declaration

RE Random Effect

SSA Sub-Saharan Africa

WDI World Development Indicators

ABSTRACT

THE EFFECT OF FOREIGN AID ON ECONOMIC GROWTH: EMPIRICAL EVIDENCE

FROM EAST AFRICA Yoseph Weldemariam

ADDIS ABABA UNIVERSITY, 2017

There has been an increase in the inflow of Official Development Assistant (ODA) or commonly called foreign aid to less developed countries (LDCs) For the last 50 years, Countries from Sub-Saharan African (SSA) region have particularly been highly dependent on foreign aid to finance their development projects and cover their budget subsidies Several studies have been conducted to examine the impact of foreign aid on economic growth in SSA However, the impact of foreign aid on the region’s economic growth has been found to be inconclusive Some studies find evidence supporting the view that foreign aid is an important factor in driving economic growth while others find evidence suggesting the ineffectiveness of foreign aid in influencing the region’s economic growth In response to the mixed evidence on the economic effect of foreign aid, international initiatives such as the 2005 Paris Declarations have been pushing for reliable and indicative commitments of foreign aid albeit a limited success Other studies pointed to identification problems in the empirical studies, for instance endogeneity of foreign aid as causes, for the inconclusive results This study analyzes the trend of ODA and growth as well as the impact of foreign aid on four selected East African countries, namely Ethiopia, Kenya, Tanzania and Uganda using a panel data from 1990 to 2014 The ODA and growth have been increasing in the countries over the study period In doing so it compares the results of the different techniques i.e., OLS, FE, RE, difference GMM and system GMM used in the aid-growth literature Looking at the results of the various estimation techniques based on augmented Neo- Classical Growth theory expectation the system GMM techniques provide better estimation results in terms of expected signs and significance which may due to the capacity of system GMM technique to address endogeniety and other issues Accordingly, foreign aid was found to have a statistically positive and significant effect

on the growth of real per capita GDP of the countries included in the study The empirical model controls for gross fixed capital formation, human capital accumulation, population growth; international agreement made to improve aid effectives and disbursement i.e., the Paris Declaration (2005) The contributions of Paris Declaration on aid effectiveness and aid unpredictability are found to be statistically insignifican

Keywords: Aid-unpredictability, Foreign-Aid,East Africa, Economic Growth, GMM

CHAPTER ONE

1 INTRODUCTION

1.1 Background of the Study

Foreign aid is the inflow of capital from foreign countries and institutions in the form of grants and loans to fill the gap in the recipient countries (Moreira, 2005) According to Brautigam and Knack (2004) foreign aid as institutional support started with the Marshal Plan for resource mobilization to rebuild European countries that are affected

by the WWII Immediately after the Marshal Plan had been completed, it expanded to the developing countries, especially to Sub-Saharan African (SSA) countries ( Rajan and Subramanian, 2008)

Sub-Sahara Africa has been the focus of the donors since 1960s due to the multidimensional problems the region is facing with (Abuzeid, 2009) In spite of the inflow of foreign aid, different views have been reflected on the effect of foreign aid on economic growth in sub-Saharan Africa While some argue that foreign aid has been effective at boosting real output of the receipt countries, many others strongly argue foreign aid has failed to bring the intended economic and social changes in many of the developing countries (Rajan and Subramanian, 2008) More specifically, writers like Salop and Kaufman (2007) stated that aid helps to improve the performance of many sub-Saharan African countries on their process of development by filing the financial and skills gaps They further claim that after the Heavily Indebted Poor Country (HIPC) initiative and the Multilateral Debt Relief Initiative (MDRI), the performance of donors and recipients has increased to the effectiveness of aid On the other hand, Nyatoro (2012) argues that foreign aid in Africa has not achieved growth and development rather it has created economies which are highly dependent on the performance of external environment In the same vein, Rajan and Subramanian (2008) assert that foreign aid has no positive effect in economic growth of SSA neither in any more favorable policy nor in geographical environment

Despite the controversial debate on the effectiveness of foreign aid on the economic growth of SSA, the flow of foreign aid to SSA has been increasing over time Based on

Brautigam and Knack (2004) in the 1980s, 13 countries of SSA were getting 10% of their GDP from foreign aid as net aid and in 1990s the figure became more than double

to 30 countries in the region They further discussed that the aid dependency in SSA had perpetuated more, for example, about 40% of government expenditure in countries like Malawi, Ghana and Zambia had been continuously funded from aid for more than

20 years

Aid may be provided for different reasons like it may for diplomatic, cultural, commercial, humanitarian and other strategic purposes Whatever the reason for foreign aid may be, its success should be evaluated in terms of its effectiveness or contribution

on the economic growth or development of the recipients However, as many studies indicate there are several circumstances for the foreign aid effectiveness in the developing countries

Boone (1996) and Burnside and Dollar (2000) have mentioned that the effectiveness of foreign aid is conditional and hence poor countries can only benefit from foreign aid when they have sound economic policy In cases of highly distorted economic policy, however, aid is financed to the unproductive activities of the government or it goes directly to the pocket of individual officials which this leads to inequality and instability (Burnside and Dollar, 2000))

Many scholars also have fear of the future debt burden as a result of the current international trade system Moussa (2016: 4) presented it as:

‘’chronic trade deficits of SSA for the past three decades are enough evidence

that domestic firms suffer from low productivity and cannot compete in the international trade Example, the average deficit ratio of SSA in the international trade has increased from 6 percent to 13 percent, from 1980s to the period of 2001-2013 While the average current account deficit ratio rose from 4 percent

& to 8 percent over the same period Further, as trade liberalizations increase and policy of IMF in such case is to stabilize budget deficit, there are concerned fear that the increasing current account deficits will increase SSA's future debt burden and make the region vulnerable to financial crises and finally increases import dependence and thus unemployment and poverty’'

Aid volatility is the other serious challenge facing SSA economic growth projects Gemmell and McGillivray (1998), Morrissey (2000) and Bulir and Hamann (2003) argue that the effect of foreign aid on economic growth of the recipient countries is positive when the probability of aid volatility is avoided in cross-countries regression Bulir and Hamann (2003) confirm that aid is more volatile than other government revenues and relatively grows more with aid dependent countries

Despite the concerns surrounding foreign aid, Sub-Saharan Africa has been receiving a substantial amount of aid since the 1960s and still continues to be a major aid recipient region in order to fill resource-gaps However, the impact of foreign aid in the economic growth of SSA is still very questionable This study aims to provide empirical evidence of aid-growth relationship from selected East African countries The countries are Ethiopia, Kenya, Tanzania and Uganda They all are aid dependent countries According to OECD (2015) report from 2011 to 2013 Ethiopia was the second next to Egypt out of the top ten aid dependent countries in Africa, with an average ODA disbursement estimated at USD 3542 million annually followed by Kenya and Tanzania with annual average of disbursement USD 2903 and 2791 million respectively The report also added that Uganda was ranked tenth with an annual average disbursement of USD 1642 million

1.2 Statement of the Problem

Sub-Saharan Africa has been receiving substantial foreign aid (FA) for many decades since the early 1960s, but still ranks one of the poorest regions of the world Sub-Saharan Africa records ever high unemployment, absolute poverty, high mortality rates and low level of education and lack of access to health care facilities (Ogundipe, Ojeaga and Ogundipe, 2014) The GDP per capita of the region is still the lowest And GDP growth has been going down markedly from 4.8 percent in 2013 to 3 percent in

2015 (World Bank, 2016) Also as the financial structure of the SSA is poor, the saving and investment correlation is negative and this might explain the dependency of the region’s economy on primary goods production (Cyrille, 2010) This poor economic performance is also great challenge to attract Foreign Direct investment (FDI) and transfer the economy

The classical models or theories of development point to the role of capital accumulation for creating an economically strong (wealthy) nation Harrod-Domor (1939) growth theory established that capital accumulation which is needed for growth

is dependent on the level of saving and capital output ratio This may be achieved through increasing domestic saving or foreign aid But, as Kabete (2008) asserts SSA countries have no adequate private and public saving and foreign exchange to finance grand economic projects and increase the accumulated capital This makes foreign aid

an important resource to fill the financial resource gap for investment and trade deficit The other neoclassical development theory that has received sufficient consent in many academic writings is the Solow (1956) growth model The model is concerned with the long run economic growth by increasing productivity and considers itself as catch up model for the poor countries to narrow the gap with rich countries According to Snowdon (2010), the augmented Solow model suggests that foreign aid stimulates the saving and investment opportunity of developing countries by providing the needed finance and foreign exchange for importing capital and investing in physical and social infrastructure

Contrary to the above arguments in the theoretical literature the empirical literature presents mixed results on the aid-growth relationship In line with the theoretical a study by Moreira (2005) asserted the impact of foreign aid on economic growth of SSA using the GMM analysis on annual data covering the period from 1970 to 1998 found that foreign aid has positive impact on economic growth in the long run while its effect

is less in short run But, some writers do not agree on the positive effect of aid on the economies of the developing countries without some conditionality Mallaye and Thierry (2013) examined using OLS on 34 SSA countries from 1990-2010 and found that the effect of foreign aid on growth varies depending on the countries’ governance and education level This study indicates that the amount of aid received is not important in the difference of aid effectiveness but the governance and concludes improving the governance in post-conflict countries could help to increase the effectiveness of foreign aid.Ogundipe, Ojeaga and Ogundipe (2014) also confirm about

80 per cent of SSA countries have been identified as low human development and heavily indebted countries though the inflows of aid is substantial From this, it is clear

that even if there is a high inflow of foreign capital; most SSA countries are yet to experience any significant economic progress and human development

Ogundipe, Ojeaga & Ogundipe (2014, pp., 301) describe the adverse effect of foreign aid in SSA economy as follows:

‘’The inflow of foreign aid to SSA countries has recently amounted to about $1

trillion It is very huge amount but, its effect is reverse when it is compared with the experience in other countries In China As ODA increased from 0.2 percent

in 1980 to 3 percent in 1985, China’s economic growth rate increased from approximately 6 percent to 12 percent While The SSA situation is contrary, the economy grew to 1.1 from the state of declining when the proportion of ODA to the region decreased to 28 percent On the other hand, as the inflow of ODA to SSA started to increase, SSA’s growth once again went down ’’

However, there is no any theoretical ground justifying the assertion that aid goes against the economic growth of the developing countries Hansen and Tarp (2001) opposes the policy conditionality on the effect of aid on the economy of developing countries But, they suggested that aid effectiveness is highly sensitive to the estimator and variables controlled Finally, they advise the weight of techniques estimation and theoretical work for any research purpose before regression in the analyzing of aid-growth relationship

Such inconsistent results of foreign aid impact in the SSA economy pose a question why different studies result in different conclusions? Besides, the aid success in countries other than SSA like China raises doubt on the aid failing in SSA countries Also, as there is no any theory that supports foreign aid harms growth in developing countries, farther investigation on foreign aid impact in SSA is important to understand the true nature of foreign aid effectiveness at empirical level Generally, this paper does not attempt to resolve disputes in the aid-growth literature but tries to assess whether foreign aid has significant effect on economic growth in four aid dependent SSA countries The countries are Ethiopia, Kenya, Tanzania and Uganda They all are aid dependent East African countries but still they have been recording low human and socio-economic development To do so, this study presents various analysis of the effect of ODA on growth base on various models (techniques) which have been used by

previous studies These are FE, RE, OLS, difference GMM and system GMM techniques The other studies had been focusing on one of the techniques which show the issue surrounding methodological variations But, this study reaches at the most preferred technique of estimation after assessing the shortcomings in the other techniques of estimation

1.3 Objective of the study

The main objective of this paper is to investigate the contribution of foreign aid to economic growth in selected East African countries, Ethiopia, Kenya, Tanzania, and Uganda the specific objectives are to

i Examining the trend of economic growth and foreign aid (as represented by

Official Development Assistance) flows to East African countries

ii Investigating whether foreign aid has a significant effect on the economic

growth on selected countries of East Africa

1.4 Significance of the Study

The impact of foreign aid on economic growth has been investigated at both micro and macro levels by various studies However, the conclusion of these studies on the impact

of foreign aid on growth at macroeconomic level is mixed, in both the long and short run The situation of SSA is no exception This paper attempts contribution to the ongoing discussion on aid-growth relationship by investigating the macro level effects

of foreign aid on economic growth in four East African countries It is different from the others by using a more recent data as well as looking at alternative estimation techniques; OLS, FE, RE, difference GMM and system-GMM in the East African countries

1.5 Scope and Limitations of the study

The scope of this study focuses on four East African countries; namely Ethiopia, Kenya Tanzania and Uganda These countries are chosen for the study because they are among the high recipients of Official Development Assistance (ODA) (OECD, 2015) In terms

of time, the study uses panel dynamic data of macroeconomic model, for the period from 1990 to 2014 One challenge in getting the right data is that the data on all the variables were not available in a single data base This paper addressed the challenges

by obtaining the data for some of the variables from other credible databases for all countries

1.6 Organization of the thesis

This paper is organized as follows: Chapter two presents the theoretical and empirical literature reviews The research method is presented in Chapter three Then, chapter four show cases the analysis and results of the study Finally, chapter five provides the conclusions derived from the study

2.2 Concept of Foreign Aid

There are many definitions and forms of foreign Foreign aid is different in type and modality depending on the donor interests and the recipients’ need Because of the complexity in type and modality in foreign aid there has been difficulty in defining differentiating which kind of foreign aid is or not counted as real developmental aid According to Ajayi (2013) some inflows of resources, such as preferential tariff grants and investments from foreign privates on non-commercial basis, from the developed countries to less developed countries are not counted development aid

In comprehensive terms foreign aid is the movement of resources in the form of financial support and technical assistance for the purpose of filling the financial gap in recipient economies or sometimes for mutual benefit (ibidAjayi, 2013)) As stated in Randhawa (2012) the standard definition of foreign aid (or official development assistance) derives from Development Assistance Committee (DAC) under the Organization for Economic Cooperation and Development (OECD), which defines foreign aid as the transaction of any assistance in the form of financial, technical and commodities on the bases of non-commercial and non-military aid The purpose of aid

is to promote the welfare and economic power of the community in the recipient countries with 25 percent grant at least

As the literature on the relationship of foreign aid and economic growth indicates, the DAC definition of foreign aid has gotten convenience in term of its data availability and characteristics Qian (2015) has indicated from the OECD database that DAC has

29 member countries and the aid given to the developing countries from China is not counted as ODA even though it is growing recently This is because of incomplete and non-continuous data For purpose of this study foreign aid is approximated by the Official Development Assistance (ODA)

DAC has three criteria for foreign aid to be recorded as ODA (Qian, 2015) These are: 1) The aid transfer to the recipient countries should be through official agencies;

2) The objective of the aid should be to promote the welfare and economic power of the community in the recipient countries;

3) The aid should be long run with at least twenty five percent or more grants

2.2.1 Advantages and dis advantages of Foreign Aid

The actual role of foreign aid is subject to a strong dispute among academicians and politicians The results of a significant number of researches on the relation of foreign aid and growth are not conclusive The major premise of foreign aid for growth is to expand scarce domestic capital to invest in public infrastructures like education, health, transport, and water (Koeberle and Stavreski, 2005) Reddell (2014, pp 7) mentions that ‘’the overall contribution of aid is to poverty reduction’’ He elaborates that even if there is a serious problem in delivering aid to poorest and most marginalized due to misunderstanding in the aid-poverty relationship; aid really works in reducing the number of people living in poverty Also as Reci (2014) argues foreign aid has significant role in substituting private capital by providing resources for investment in public goods

From the early times, economic growth theories have concerns about how a developing economy can solve constrains of capital formation The main concern has been to state the means of filling resource gap in countries which have insufficient private and public savings to fund economic projects, public expenditure and importing capital goods and promote growth (Reci, 2014)

According to Koeberle and Stavreski (2005), the budget support modality of foreign aid has received a growing support Budget support modality helps to stabilize fiscal and macroeconomic policy of the recipients which has a potential to improve governance through reform of public sectors and efficient financial management

Moreover, as part of foreign aid the advantage of technical assistance, building capacity and fighting poverty has received a due attention by the donors and recipient countries Greenhill (2006) states that technical assistance is very important to speed up the development process as it works directly in building human capital and filling the skills gap

The most obvious purpose of foreign aid is to increase the government resources for investment and to treat budget deficit and thereby enhance development But, this character of foreign aid is not constant and there are a lot of distortions going on aspects (Nielsen et al., 2011)

A large number of studies find that foreign aid could have adverse effects on the growth

of recipient countries For example, Easterly (2003) and Roodman (2007) examined the controversial results of a number of studies by slightly changing the instruments and samples They confirm that the positive impact of foreign aid on the growth of the recipient countries is inconclusive The results are fragile depending on the internal and donor conditionality

Ferreira and Simoes (2013) have proved that foreign aid can also increase the difficulty

in the recipient countries The study focused on 44 SSA and 31 Asian countries for the period 1972-2007 as these regions are major aid recipients Using Generalized Method

of Moments (GMM) estimation, they found a negative effect of foreign aid on the growth of the regions They conclude that policy, institutional quality and financial development have significant impacts on aid management

Moyo (2009) and Asongu (2014) have studied the relationship between foreign aid and corruption in Africa They conclude that foreign aid has a significant positive impact on promoting corruption in Africa Moyo (2009) asserts that foreign aid, as it is easily misused and redirected, makes African leaders corrupt Asongu’s (2014) argument also shows foreign aid facilitates corruption as long as the African cultural and institutional benchmark is not improved

Other serious problem of foreign aid is dependency As long as the aid management is not effective aid does not reduce poverty rather it intensifies the economic crises of recipient countries Bräutigam (2000) discussed the vicious circle, or growing amount

of official debt in poor countries, especially on the countries whose yearly aid is 10 or more percent of GNP, in what is called ‘’high aid dependency’’ Based on this, many African countries have lost their autonomy to address national issues independently This has led them to increase dependency on foreign aid even for undertaking the basic government activities

According to Moyo (2009) the unlimited aid money creates an irresistible environment and conflicts among ethnic groups of the recipient countries for sharing resource Additionally, Nielsen et al (2011) says aid shocks also promote armed conflict as severe reduction in aid may pose disturbance and shift the domestic balance of power from the government to rebel groups thereby inducing violence and civil unrest

Moreover, foreign aid dependent countries are also highly vulnerable to aid uncertainty According to Bräutigam (2000) aid volatility creates difficult condition in which government’s commitments and national projects may fail due to financial problem This may also push the leaders to adopt authoritarian tactics, rather than fighting corruption and improving civil service

2.3 Aid Effectiveness

Sub-Saharan Africa is the major region that has been enjoying a substantial foreign aid

as source of finance for development since the end of World War II (Abuzeid, 2009) But, foreign aid has been under questions in terms of its effectiveness to bring the desired result in the region A number of, research results have concluded the foreign aid has no any positive effect on the economic growth in the region Easterly (2003), Collier (2007), and Rajan and Subramanian (2008) have strongly argued that foreign aid has failed to bring the intended economic and social changes in many of the developing countries like SSA Corresponding to the controversial academic debates on foreign aid success, a series of summits have been held to promote responsible partnership among the recipient and donor countries on the issue of aid effectiveness The Paris Declaration (PD) (2005) is the high level summit on aid effectiveness that forwarded core principles, based on the Marrakech Roundtable (2004), to reduce

poverty and inequality in the recipient countries, generally to increase the development results The aim of PD is to improve the aid effectiveness in the form of ‘’better harmonization and alignment, promoting country ownership, managing results, and increasing mutual accountability’’ (Getnet, 2009, p.6) The other forum on foreign aid

is the Accra Agenda for Action (AAA) (2008) to accelerate and deepen implementation

of PD (2005) on effectiveness of foreign aid The target of AAA (2008) is on the issue

of monitoring the implementation of Paris declaration on aid effectivenss through joint and equal participation of stakeholders

However, the empirical literature on foreign aid effectiveness is inadequate and often contradictory Official Development Assistance is often criticized for not having contribution in poverty reduction or for not having clear system of execution to finance

on the intended objectives or programs Being inspired by contradictory research findings Wako (2011) has tried to assess the effectiveness of foreign aid in SSA and found that aid is ineffective at enhancing economic growth, in both the bilateral and multilateral aid modalities Additionally, as there is no evidence about the aid effectiveness in some projects he recommends the recipients to possess better governmental accountability, transparency and ownership on aid management

Regardless of, the controversy in the literature, foreign aid effectiveness has obtained adequate focus after the PD (2005) Donors and recipients initiative to monitor and assess the aid implementation has increased, especially at sector level So, aid effectiveness is considered as an important issue concern to the aid-growth relationship

2.4 Theories of Foreign Aid and Economic Growth

2.4.1 The Harrod-Domar Growth Model

One of the economic models that have explained the significance of foreign aid in development economics is Harrod-Domar (HD) (1939) growth model As this model explains the growth of one nation depends on the level of investment and productivity

of the economy In the state of inadequate domestic saving, foreign aid can substitute the gap; thus, increasing the investment and productivity, i.e., the capital-output ratio Easterly (2003) expressed the HD growth model as given in (2.1):

g (I/Y)/ (2.1)

Where I is required investments, Y is output or GDP; g is target of GDP growth and μ

is the incremental capital output ratio (ICOR) That is, GDP growth, g, is proportional

to the share of investment spending in GDP, I/Y, just when μ-the incremental output ratio (ICOR) is constant In case of aid dependent countries investment is the sum of foreign aid, A, and domestic saving, S, given by:

I/Y  A/Y S/Y (2.2)

What is different in equation (2.2) is that investment is the sum of the domestic saving and capital earned from foreign aid This explains the state in which there is no enough domestic saving to invest Based on this, there is proportional growth between the added capital and the growth of GDP such that the amount of foreign aid to GDP and its contribution to the growth of GDP is proportional

But, under normal condition the increment in capital-output ratio is not constant as it is stated in the above formula And this is the major criticism of HD growth model in the literature of development economics According to Griffin (1971) and Ajayi (2013) foreign aid has a potential to increase ICOR in the economy of the recipient countries which adversely affects the efficiency of capital-output ratio Thus, if the effect of aid

on the efficiency of capital-output ratio is negative, absolutely the relationship between foreign aid and growth could not be absolute positive with the increase in aid

2.4.2 The Solow Growth Model

The Solow growth model has received broad dealing in most modern development economics literature Solow (1956) suggests that the long run productivity of a single commodity depends more on the rate of technological progress than on the increase of the capital or labor force The Solow model of growth has not degraded the HD theory

of economic growth, but casts doubt on the assertion that long run rate of growth depends on saving and investment The main driving force for the development of the Solow growth model is the idea of fixed proportions in the HD growth model which is only determined by the level of factors of production According to Snowdon (2010), Solow growth model basically emphasizes on the controversy of incremental capital-output ratio (ICOR) and sustainable development due to limited resources (e.g finance and land) Hence, without technological progress economic growth cannot be sustained That is, economic growth that depends on the saving and investment of inhabitant

households and firms could not last long as the diminishing law of marginal productivity of capital and labor

The Solow growth model defines the neoclassical production in terms of capital and labor combinations and assumes that these factors of production are substitutable and their increment is subjected to the law of diminishing returns to scale as given in (2.3)

     1   ; 0 0 1

and A

L AK

labor at time, t A is technology and α is the share of capital in the output This is the equation of production function which displays constant returns to scale such that if all the technological input of production increases by N times, the output also increases by

N times (Sørensen & Jacobsen, (2010) They also explained that the prosperity of a nation in GDP is not identical with the GDP per capita growth In line with this argument, Solow equation is explained in terms of output per worker, Y Y /L, and capital per worker, K  K/Las follows

According to Ray (1998) the interest of investors is to expand their production and to accumulate capital by buying new machineries This means, the economy needs to change the capital accumulation per unit of labor Huggett (2015) specifies the equation

of capital accumulation as:

1nK t11 K tsA K t  (2.5)

Equation (2.5) is mostly considered as the full (general) Solow growth model and accounts for the effects of population and technology growth rate on the total output over time TheK t1 capital per labor depends on capital per labor in K t minus the depreciation,1 K t, plus any additional capital (savings) per labor,  

1nk

Y  

t

k A

 

t

k sA

Figure 2.1 is an example of neoclassical (Solow) production function

The amount of investment (saving) per labor  

t

k

sA is greater than the quantity required to keep capital per labor n k t at k0 Therefore, the capital deepening, k, continuously increases over time until k=k* at which the change in capital is equal to depreciation,sA  k t   n k So, the capital accumulation is zero, i.e., theK dK 0 This is the maximum level of production using capital in any given economy which the Solow model Calls steady state

Generally, the augmented Solow growth model explains that capital accumulation is achieved with increasing capital investment but, it is up to some point i.e., the steady state and hence change in technology becomes necessary to change the steady state and have continuous economic growth in the long run (Snowdon, 2010) However, the developing countries have not sufficient domestic capital that enable them to reach the steady state using their labor force They need capital to use their labor maximally and think about technology

The role of foreign aid for growth is embedded in the neoclassical (Solow) growth model Boone (1996) has given an example of the situation where foreign aid could help economic growth Assume that potential investment may give a great profit or additional capital accumulation is not undertaken due to inadequate domestic saving to employ the labor force fully Thus, the financial source that can fill the inadequate domestic saving to invest in the profitable project most likely relies on foreign aid Moreover, foreign aid provides the foreign exchange needed to finance imports of capital and intermediate goods, and allows governments to improve the fiscal policy and financial management and enhances economic growth

Armah & Nelson (2008) and Ajayi (2013) also discuss the relationship of foreign aid and growth in developing countries in the context of the growth theories They explain the meaningful effect of large aid-financed investment for the poor countries in Africa

to get out of the poverty trap Equally, the Solow model has a great concern in the importance of foreign aid while discussing the income and saving relationship in generating multiple capital stock equilibriums in economic growth of the poor countries

Generally, as various debates in economic growth literature shows, the augmented Solow growth model advices poor countries to look for foreign aid to solve the inadequate domestic saving and to make the long run growth persistent

Y 1nK

 

t

K A s'

 

t

K sA

K* K** K

Figure 2.2The relationship between foreign aid and saving rates in the Solow diagram

Source: Sørensen & Jacobsen (2010, pp.80) Introducing advanced macroeconomics Figure

Figure 2.2 shows the long run effect of foreign aid inflow on saving levels of the poor countries i.e., inflow of foreign aid can shift the capital accumulation (investment) of poor countries upward in the long run from  

At the beginning, the level of capital accumulation at k* started to rise after the foreign aid inflow Then, the investment in capital deepened and continued to rise until the new steady state, K**, at which the  

tK A s' = n K

However, Solow growth model has its own limitations Basically, the model worries about the long run growth of any progressive economy A capital investment can bring

a growth but it is only up to some point, which is the steady state Solow model argues that as more capital is invested the growth falls due the diminishing marginal return to capital Then, after it reaches at its steady state the growth is even less than the depreciation of the capital used in the production of the economy However, as Weil, (2009) explains the model does not have any example in which its thought of economic growth has occurred before, either from the developing or developed nations

In order to ensure continuity of the growth of an economy, the Solow model suggests the necessity of technology in changing the growth of an economy in the long run The model also assumes that technology is exogenous (Sørensen &Jacobsen, 2010) But, it does not explain the source of the technology The other limitation of Solow growth model is related with the human capital The introduction of human capital in Solow model as one of the factors of production raises accuracy issues in the model as the diminishing marginal return does not concern to the human capital (Weil, 2009)

2.5 Foreign Aid and Economic Growth in Sub-Saharan Africa

Economists assert that capital and foreign exchange constraints are the crucial problems facing the economic growth policy of developing countries In line with this, a number

of academicians and policy makers have proposed foreign aid as a solution to the capital and foreign exchange constraints Following this different studies have forwarded different conclusions on the effectiveness of foreign aid on the economic growth of SSA

Malik (2008) has investigated the impact of foreign aid on economic growth in SSA Mainly this study focused on examining the effect of foreign aid on economic growth

in six poorest and highly aid dependent countries over the period of 1965-2005 using a co-integration analysis The countries are Sierra Leon, Niger, Mali, Malawi, Togo and Central African Republic After using the error correction model of co-integration techniques, the foreign aid and investment variables are used to measure quantitatively the effect of foreign aid on economic growth in the long run and short run The evidence from this empirical studies indicated that in the long run foreign aid has significantly negative impact on the economic growth of the five countries out of the six, except Togo in which it has a positive effect This positive effect in Togo might be the result of good economic policy in the country In the short run, except for Niger, foreign aid has neutral effect on the economic growth of the five other countries Generally as several researchers tried to state the aid dependency in SSA, Malik (2008) also shows that more aid recipient countries in SSA could not get out of the poverty trap; rather they are getting in to other serious trap, the aid trap But, this might not be the true nature of aid; this result might have come due to implicit problems such as methodological and double counting Farther, the historical evidence presented by Abuzeid (2009) has shown that foreign aid has failed to bring a sustainable economic growth in sub-Saharan Africa for about the past half of a century; rather it intensified the aid dependency and corruption and weakened the governance system in the region This has also been demonstrated by Easterly (2003) in his comparison of aid flow with growth of GDP in Africa as given in Figure 2.3

Figure.2.3 Aid and growth relation in Africa (10 years moving average)

Source: Easterly (2003)

Based on the figure, though Africa has been receiving a substantial aid but still the aid could not bring the expected result on the economic growth Rather, the growth of per capita had been going down while the aid increased

On the other hand, other studies on foreign aid-growth relationship have pro-foreign aid conclusions on the development of the SSA countries Armah and Nelson (2008) made

a study on the role of foreign aid in expanding the scarce domestic capital and enhancing growth using data on 21 SSA countries over the period 1995-2003 Based on the panel framework static, the result shows that foreign aid has a significant role for promoting economic growth of poor countries if the given countries have good governance Moreover, Ajayi (2013) have studied the effect of foreign aid in SSA over the period 1996-2010 He adapted the Generalized Method of Moments (GMM) techniques to examine the challenge of endogeneity on the effectiveness of foreign aid

in sub-Saharan countries The study found that foreign aid has meaningfully influenced real GDP per capita in SSA depending on the variables like rule of law, level of corruption and human capital, and generally on the strength of institutions

2.5.1 Empirical literature on aid-growth relationship from East

Africa

The East African literatures on foreign aid-growth relationship also have the same characteristics with that of SSA literature Hatemij and Irandoust (2005) have examined the relationship between foreign aid and economic growth over the period 1974-2005 using co-integration analysis for six developing countries, of which the three are from east Africa (Ethiopia, Kenya and Tanzania) The study focused on the aid that flowed from Sweden to these six developing countries over the period Estimation results based

on the co-integration panel system indicated the long run elasticity for both the individual and group has a positive and significant impact on the economic growth of the recipient countries They found elasticity of real income with respect to foreign aid for each country to be close to one for each country For example, the income elasticity with respect to foreign aid is 0.595 for Ethiopia, 0.905 for Kenya and 0.873 for Tanzania The study concluded that foreign aid flows can have a positive effect on real income by supplementing domestic savings But, this study does not examine or control for the characteristics of multidimensional issues of aid effectiveness (like the aid fragmentation, coordination and volatility problems)

i Ethiopia

Martin (2007) has made assessment on the impact of foreign aid inflows on the public expenditure, revenue and domestic borrowing in Ethiopia By reviewing the fiscal history in Ethiopia the study concludes that foreign aid has increased public investment But, the effect on domestic borrowing is strongly negative As the foreign aid and domestic financing are substitutable, the study suggests higher foreign aid inflow has dropping effects on the domestic revenue In addition, the study finds that grants have

no significant effect on public expenditures However, this study does not specify clearly the model and data analysis techniques used

Moreover, Ejigu (2015) has supported the positive and significant contribution of foreign aid on investment in the long run in Ethiopia He examined the Ethiopian aid-investment relation from 1980/01 to 2013/14 using multivariate co-integration analysis and showed that foreign aid enhances economic growth in Ethiopia by filling saving gaps The study further remarks that the country has no capacity constraint to absorb the inflows of foreign aid But, this result is not supported by other research findings which attach the positive impact of foreign aid in Ethiopia’s economic growth with some conditionality, especially with the policy issue For example, Girma (2015) has investigated whether the effect of foreign aid on growth in Ethiopia is conditional on policy using a time series data for the period of 1974 to 2011 in the Autoregressive Distributed Lag (ARDL) model He finds negative coefficient of foreign aid on economic growth when aid is regressed separately and positive coefficient in the aid and policy interaction on economic growth Based on this, he concluded that the positive contribution of foreign aid in Ethiopian economic growth is conditional on macroeconomic policy

ii Kenya

Much of the aid-growth literature focuses on the of foreign aid drive to bring economic growth in the recipients economy but Ojiambo (2013) have included the effect of aid unpredictability on economic growth in Kenyan Using autoregressive distributed lag model they found that the effect of aid unpredictability is conditional on the macroeconomic stability The study found that as aid unpredictability increases, it has reducing impact on economic growth in Kenya; but it improves economic growth

during periods of macroeconomic instability This helps the government to manage limited resources wisely in the micro economic policy

Njeru (2003) explored government expenditure response with respect to the aid fluctuation in Kenya and showed that the government expenditure has significant reaction to the foreign aid fluctuation Statistically the share of net disbursement of ODA has significantly positive effect on the Kenyan expenditure This study presented evidence that tax relief opportunity is very little in Kenya as the government tries to reduce aid fungible in governmental expenditure

Based on the foreign aid-growth literature, the challenges to foreign aid effectiveness in Kenya are unstable macroeconomic policy and aid unpredictability But, the literature does not explain the relationship between unstable macroeconomic policy and aid unpredictability Aid unpredictability itself may disorder the established macroeconomic policy

iii Tanzania

Kabete (2008) asserts that Tanzania is one of the aid dependent countries, as it has huge volumes of foreign aid inflows from both multilateral and bilateral donors After the independence of Tanzania, the agriculture and manufacturing sectors of the economy as well as the national budget finance is highly dependent on foreign aid.However, Nyoni (1998) has released evidence against the effects of increase in aid flows to Tanzania He applied co-integration techniques and an error-correction model to estimate the long-run and the short-run effect on the real exchange rate The results show that foreign aid inflows lead to depreciation of the real exchange rate, while government expenditure rate has positive response to real exchange Moreover, Bondarenko, Nkyabonaki and Mkunde (2013) have assessed the effect of foreign aid on the self-reliance of Tanzania after the socialist regime using OLS panel data They found that the culture of dependency on foreign aid increased at the expense of original cultures and economic activities of Tanzanians This made the people and the national government to be dependent on foreign aid rather than on their hard work At the end they concluded as a result of the problems with the pre-conditions of the donors and the corrupt officials; foreign aid has become a setback on the socio-economic progress in Tanzania

iv Uganda

Munabi (2012) assesses the relationship between foreign aid, economic policy and economic growth in Uganda for the period from 1982 to 2008 Based on the two gap model and co-integration analysis, the study assessed the interaction of foreign aid with per capita national income, policy and institutional variables The interaction of aid and policy index has given significantly negative foreign aid coefficient in relation to economic growth But, in general foreign aid had a positive impact on economic growth

of Uganda regardless of the poor economic policy, inflation rates and persistent budget deficits However, other previous research findings have produced evidence against the positive foreign aid impact on the social, political and economic growth of Uganda For instance, Mwenda (2006) has evaluated the relationship of foreign aid with the democratic accountability in Uganda using trend analysis Researcher found that the increasing aid and aid relief is an instrument to sustain corrupt and incompetent regimes

in power in Uganda This situation has been beating the economic development and political freedom of the Ugandan people

Conclusion

From the preceding literature reviews, there are diverse studies on the aid-growth nexus These have been characterized into various aid-growth indicators relations Many studies examined the aid, savings and growth relationship; several other also examined the aid, investment and growth relationship while some studies also looked at the aid, policy and growth relationship

The studies on the effect of aid on growth have used various models For instance, the Harrod-Domar model, by linking growth to aggregate investment, provided the core of the underlying economic paradigm for analyzing the impact of aid and aid effectiveness

at the macroeconomic level Its extensions into the augmented Solow Model growth provided the analytical basis for empirical studies at individual countries In line with theoretical assumptions some studies related the aid effectiveness issue with policy conditions of the individual countries The Burnside and Dollar (1997) study marked a turning point in the aid-growth debate due to its emphasis on stable macroeconomic policy environment

As shown in the empirical literature in SSA most of the studies are cross-country and time series Cross-country and time series studies have the advantage to identify factors that help to explain cross-country variations in growth performance However, this has not been without any problems they fail to account for cross-country heterogeneity in aid effects and the endogeneity problem of weak instruments

It could be concluded that the SSA empirical literatures on the aid-growth nexus have also not been without any problems The challenge has been due to the shorter duration

of study, omission of variables and the estimation techniques used The studies reviewed so far have shown divergence in terms of the findings, with some showing a negative relationship between foreign aid and growth, while others found a positive relationship These studies have assumed that the aid flows have been predictable, a situation which is not the case Studies that have been specific on unpredictability of aid flows have also been reviewed This study, therefore, sought to fill the knowledge gap that exists in the aid-growth nexus in four East African countries (Kenya, Ethiopia, Tanzania and Uganda) through the examination of the aid effects on economic growth

by including control variables ( aid unpredictability and Paris declarations, 2995) thatindicate aid effectiveness The empirical review indicated that a number of studies had used Generalized Method of Movements (GMM), an approach that was relevant to the study The next chapter presents the methodology used in the study

3.2 Data Source and Description of Variables

3.2.1 Data Source

The selection of the variables is based on their theoretical and empirical importance in the foreign aid-growth literature The variables are often used in many previous empirical researches on foreign aid-growth relationship Nevertheless, the time dummy before and after of Paris Declaration (2005) as well as the aid predictability variables are unique for this study In addition to the impact of ODA on economic growth this study aims to investigate further whether the Paris Declaration on aid effectiveness and the degree of aid predictability have any significant effect on growth in their own right and in shaping aid-growth relationship based on data from countries This study uses secondary data covering the period 1990-2014 on four East African countries (Ethiopia, Kenya, Tanzania and Uganda)

The data for growth rate of real GDP per capita, net official development assistance, gross fixed capital formation, population growth and human capital are sourced from the World Bank’s Global Development Indicators (GDI) databases for all the countries studied (1990-2014) And the other complementary source of data for aid predictability is the Organization for Economic Corporation and Development (OECD), online database

3.2.2 Description of Variables

Table 3.1 Descriptive of Variables used in the regression model

sign Growth of real Per capita GDP

Aid unpredictability Indicator

(UNPREDAID)

Percentage of disbursements (whether aid flow as pledged by donors)

-

Human capital (TEREDU) Tertiary education enrollment +

Population growth (POPGRWTH) Population annual fertility rate +/-

Paris Declaration on aid

Source: Ouwn compulation

Growth rate of real GDP per capita: one of the measurements of economic

performances is growth of real GDP per capita Real GDP per capita is an important national account that helps to judge whether the national economy expanding or contracting and how big each person’s share of GDP is (Sulzenko and Kalwarowsky, 2000) Therefore, in this particular analysis annual growth of real GDP per capita obtained from WDI database is the measurement of the economic growth (see table 3.1)

Lagged value of real GDP per capita growth: including lagged value growth of real

GDP per capita as one of explanatory variable in this regression helps to examine whether the observed economic growth rate is convergent or divergent in the long run According to McKinnish (2002) the effects and elasticities of lagged value helps to realize largely the full effect of economic activities as compared to the estimation on short term economic conditions Based on this, the measurement of physical capital growth is largely affected by the initial capital and technology stock Therefore, lagged

value of GDP per capita is important in the consecutive economic performances of the developing countries This may have negative sign or may show convergence on the

economic growth of the study countries

Net official development assistance (ODA): foreign aid is becoming the main source

of finance to the development trajectory of the developing countries Based on OECD (2015), Africa is the most aid dependent continent As the amount of foreign aid has been increasing, several studies have taken interest to evaluate the effectiveness of foreign aid on the economic growth of the developing countries like sub-Saharan Africa However, the finding was mixed Though, the amount of foreign aid is so much, several researchers like Easterly (2003) and Collier (2007) have found very little effect

of foreign aid on economic growth or poverty reduction in sub-Saharan Africa On the other hand, studies like Nyatoro (2015) and Salop & Kaufman (2007) argue that foreign aid has been effective at boosting real output of the recipient countries Additionally, Boone (1996) and Burnside and Dollar (2001) have mentioned that the effectiveness of foreign aid is conditional on the economic policy of the recipient countries This controversial argument coupled with the increasing inflows of aid makes the issue of foreign aid high in the development agenda of the sub-Saharan Africa The arguments regarding foreign aid effectiveness should rely on the empirical realm of countries under study In this study, as the theoretical literature says, the expected sign for ODA

in the regression is positive

Aid unpredictability: foreign aid effectiveness is a hot issue in the aid-growth debate

The Paris Declaration (2005) has launched multidimensional framework to improve aid effectiveness Aid predictability is one of the components of the framework that is expected to affect aid effectiveness Aid Predictability states the arrival of aid exactly in the fiscal years as the commitments of partner countries (OECD, 2006) Ojiambo (2013) measured aid unpredictability as the difference between aid commitments and disbursements as a percentage of disbursements (unpredictability per unit of aid dollar) Mathematical,

Unpredictability it = (C itD it)/D it*100

Where Unpredictabilityit is a predictability indicator for country i, at time, t; Cit is Commitments for country i, at time t; and Dit is disbursements for country i, at time t

This formula helps to calculation for aid predictability indicator But, shown in appendix (A1) there are some years where the aid disbursement is greater than commitment This study censored the minimum value of the aid unpredictability at 0 and the maximum value at 1 i.e., it gives 0 for the exceptional years when aid disbursements were equal to or greater than the commitments for the study countries and 1 for the years when the disbursement is less than half or equal to half of the commitment Proportional approach was used to the years the commitment is greater than the disbursement and when disbursement is less than half of the commitment Ojiambo (2013) study on foreign aid unpredictability effect on Kenya’s economy growth and found a negative impact as aid is unpredictable In this study also aid predictability is expect to have adverse effect on GDP per capita

Paris Declaration on aid effectiveness (2005): in the aid effectiveness debate, 2005 is

an important time where the donor and recipient countries have entered to sign their pledge in improving aid effectiveness in economic and human developments of developing countries (Paris Declaration, 2005) And this variable is included in this study as an explanatory variable to see whether there is a significant improvement in role of aid for growth in the recipient economies due to aid the Paris Declaration This mummy takes a value of 1 if the year is after 2005and 0 otherwise The effect of this dummy variable is expected positive for the study countries

Gross fixed capital formation: the share of gross fixed capital formation in GDP is

taken as proxy for the investment-GDP ratio Gross fixed capital formation is the total outputs produced in processes of production that are themselves used repeatedly or continuously in other processes of production for more than one year (Saleh, 1997) Ekanayake and Chatrna (2010) have found a positive effect of gross fixed capital formation on GDP per capita for Africa In this study, the effect of gross fixed capital formation on GDP per capita is expected to be positive for the study countries

Human capital: human capital is also included as an explanatory variable in the

estimation Education and health are the components that measure human capital in a given country (Barro, 2003) A Developing economy needs healthier and technologically and analytically skilled people to facilitate growth In this study education is used as a proxy explanatory variable for human capital The level of education that exists within the people also matter for the status of the health and skill

of the people that enables to participate in available opportunities Therefore, this study uses the percentage of enrollment in tertiary education to examining the stock of skilled labor in individual countries The sign of this variable is also expected to be positive in this study

Population Growth: the role of population on development is surrounded by a

controversial debate The classical economists or natural science perspective argues development is not achieved with rapid population growth as the resource of the earth

is limited The prominent classical economist Thomas (1914) argued that sustainable development could not be achieved with the rapid population as the supply of production at diminishing return Based on this, even if there is a growing of production, the growth of production follows an arithmetic progression while population follows geometric progression According to this theory, controlling population is one of the issues in development trajectory On the other hand, the neo-classic economic theory, argues that population growth plays positive role on development in the long run Simon (1981) argues population growth stimulus economic growth in long run as the increase in population leads to increased demand which induces producers to expand production and innovate new production Based on this discussion, the sign of this variable could be either positive or negative

3.3 Model Specification

In the previous chapter the two growth theories, the Harrod-Domar (HD) (1939) and Solow (1956) theories have been raised with the discussion of the role of foreign aid for economic growth in the developing countries HD (1939) suggests a proportional growth between the added capital and the growth of GDP This means the amount of foreign aid as a share of GDP is proportional to its contribution to the growth of real GDP Solow (1956) theory doubts on the HD principle of proportionality of growth to the added capital due to the incremental capital output ratio (ICOR) which causes diminishing marginal productivity For Solow technology is the key driving force in economic growth But, the augmented Solow model (1956) does not ignore the importance of capital accumulation in growth and it argues that additional capital accumulation is important to increase investment capital until the economy achieves its steady state Hence, Solow model implicitly recognizes the importance of capital earned from foreign aid in filling the capital scarcity in developing countries In line

with this Boone (1996) found that foreign aid is important in economic growth where potential investment that may give a great profit per unit labor is not undertaken due to inadequate domestic saving Based on these arguments the Solow theory recognizes the role of foreign aid for economic growth as long as it enhances investment capital of developing countries in the long run

The Solow model can be expressed in the following Cobb Dauglass specification

 t AK t L1 t ;

and labor at time, t Parameters A and α represent technology and share of capital in the output respectively This Cobb Dauglass specification of production function displays constant returns to scale but K (t) and L(t) are perfectly substitutable (Snowdon, 2010)) Therefore, from this equation the effect of the output per unite of labor and capital per unite of labor can be derived as follow:

y t  Ak t (3 2)

3.4 Econometric Model

In line with the theoretical model presented in section 3.1 above and specification equation (3.2), this study develops an empirical model to estimate the effect of foreign aid on economic growth by incorporating some control variables

it it it

Yit is growth of real per capitaGDP for country i at time t and Yit-1 is the lagged value

of growth of real per capita GDP for country i at time t and ODAit the official development assistance to country i at time t the control variable Xit is the matrix of annual values of the control variables; Gross fixed capital formation (GFCFit) for country i at time t, gross enrolment ratio of tertiary education (TEREDUit) for country i

at time t, population growth (POPGRWTHit) for country i at time t, aid unpredictability

(UNPREDAIDit) for country i at a time t, and PARIS2005it is the time before or after Paris Declaration (PARIS2005it) for country i at time t αi and eit also represents the fixed effects and the disturbance terms of a country i at a time t The advantage of including the lagged value of the dependent variable in the right hand side of the equation is to control for the lagged effects of some of the macroeconomic and technology variables on growth and to observe possibility for convergence or divergence

Although technology is not explicitly modeled in the empirical model it is captured in the ODA variable which is partly used to buy technology intensive capital goods and

technical assistance and partly in the lagged dependent and human capital variables

3.5 Estimation Method

3.5.1 Generalized Method of Moments (GMM)

The major objective of the study is to investigate the effect of foreign aid on economic growth in a state of robust estimation by controlling for other explanatory variables In time series data there is high probability of facing the problem of unobserved heterogeneity Panel data regression has the advantage over the other methods (time series and OLS) to control for the issues of unobserved heterogeneity (Hansen and Tarp, 2001) According to Arellano and Bond (1990), the unobserved heterogeneity in panel data is solved by transformation instrument which is the first difference Generalized Method of Moments (GMM) GMM estimation was first developed by Hausman and Tayor (1981) but the way they originally they developed the method is such that the technique applies only for the data within the model and hence it could not

be applied farther However, it has given enough concepts to other scholars to study it further Hansen (1982) is pioneer in formalizing GMM estimation for economic and financial models by allowing lagged dependent variable and some non-serial correlation Arellano and Bond (1981) and Arellano and Bover (1995) have also developed the Generalized Method of Moments to more advanced estimation by allowing for extra information in the regression of panel data Generally, GMM is constructed on robust assumption to specify econometric models and instruments of estimation (Greene, 2003)