Threshold Effects in the Foreign Aid-Economic Growth Relationship: The Role of Institutional Quality and Macroeconomic Policy Environment

Abstract

Since the influential paper of [1], the issue relating to the conditions in recipient countries has become central in the foreign aid debate. Scholars and policymakers alike are interested in identifying the conditions which make foreign aid more effective. To contribute to this growing debate, this paper investigates the role of macroeconomic policy environment, institutional policy and a combination of these two previous variables in aid-growth relationship. The empirical analysis is based on a panel data set including 13 ECOWAS1 countries during the period from 1984 to 2010. Using a modified panel threshold model, the evidence strongly supports the view that the relationship between aid and economic growth is nonlinear with a unique threshold. The paper finds that a stable macroeconomic environment and better institutional quality are sine qua non for the effective contribution of aid to sustainable growth in ECOWAS countries. Furthermore, we find that institutional quality is an important determinant condition which allows aid affects economic growth. One of main contributions of this paper is to successfully identify the conditions under which the aid has a positive impact on economic growth. It is desirable to keep the combination condition in States II and IV (the macroeconomic policy environment is below or above and institutional quality above their threshold respectively) because it may be helpful for the achievement of sustainable economic growth. The results seem to indicate that bad institutional quality may have detrimental effects on economic growth. This will be an important result for the policymakers and international financial institutions, which increasingly favour conditionality and selectivity in the allocation of aid resources. The major policy implication of our results is not a call for a reduction of foreign aid but rather a call for rethinking strategies for international assistance and redesigning existing aid programs.