Foreign Aid And The Business Cycle

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  • 1 January 2000
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      • Published in RePEc
Abstract
In this paper, we document some key business cycle properties of foreign aid flows to developing countries. We identify two striking empirical regularities. First, aid flows are highly volatile over time -- on average, two to three times as volatile as the recipient's output. Second, for most African countries, net aid inflows are strongly positively correlated with their domestic output. Outside of Africa, we find a similar, if somewhat less pronounced, pattern of aid procyclicality.To see why these empirical regularities are important, recall that output fluctuations in developing countries are much stronger than in industrialized economies. Indeed, we document that the gross domestic product of an aid recipient is on average six times as volatile as that of a donor. For developing countries, though, customary ways to smooth out the impact of output fluctuations on domestic consumption are likely to be very onerous. For instance, moral hazard and repudiation risk imply that heavily indebted nations are often denied new loans (or are asked to repay old ones) precisely when their economies suffer adverse shocks -- see, e.g., Atkeson-1991). At the same time, foreign aid is a sizeable source of income to recipients, especially in Africa, where it averages 12.5% of gross domestic product and constitutes the main source of foreign capital. In such an environment, foreign aid flows have the potential to play a key role in smoothing out developing countries' output fluctuations. Our results imply that, all in all, aid does not play that role.Admittedly, it might be argued that, except for emergency relief, the chief purpose of foreign aid is not to act as an insurance device but, instead, to fuel economic development, in which case it is not clear a priori whether one should expect aid flows to be procyclical or countercyclical. It is well known, however, that output fluctuations affect growth negatively -- see, e.g., Hamilton (1989) and Ramey&Ramey (1995). Hence, even if
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