Foreign Aid and Economic Development: Empirical Evidence from Select South Asian Economies

Abstract

The present study has considered both the pros and cons of foreign aid program, thereby aiming to examine the long run causal relationship between economic development and foreign aid providing impetus to the effects of selected macroeconomic indicators in three major South Asian economies such as, India, Pakistan and Sri Lanka from 1970-71 to 2013-14. Besides these rudiments, we also examine the impact of aid volatility on economic growth of the aforesaid developing economies. Foreign aid or Official Development Assistance (ODA) is considered as an essential foreign capital in the modern era of global development finance. The primary purpose of the foreign aid program to the developing economies is to accelerate their economic development such that the threshold level is confined where a satisfactory rate of growth can be achieved on a self-sustainable basis. Thoughtfully, the aftermath of the World War II has urged developed economies to accumulate billions of dollars in terms of foreign aid to the emerging economies for that promulgates the economic growth initiative. Ironically, even after accumulating significant amount of foreign aid, the sad demise elicits that, nearly 3 billion people in the entire world population still live on less than $ 2 per day; with 840 million suffering from hunger, above 10 million children die from various kinds of preventable diseases and more than 1 billion adults are still illiterate. These hindrances posits the radical on the effectiveness of the foreign aid program that exemplifies whether any sort of long run impact on economic development of the recipient economies has been realized or not. There is very limited research done on the empirical analysis of the aid effectiveness. Prior work portrays cross country analysis along with heterogeneous data set, mismatch in time period, homogenous economic and political turmoil. To agree, very few studies evident the country specific studies that have considered homogenous data set and uniform time period. Likewise, there are very few studies that have empirically examined the impact of foreign aid on economic development of an individual country over a longer time period. We have used unit root test, optimum lag order selection criteria, Johansen-Juselius multivariate cointegration test (Johansen and Juselius, 1990) and Vector error Correction Mechanism (VECM) test to examine the long run causal relationship between economic development and foreign aid keeping in compliance the effects of selected macroeconomic variables. Further, we also employed Granger-causality test to identify the direction of causality between the variables. We have used diagnostic tests and stability test to check the reliability of the fitted model. Succinctly, we have used Ordinary Least Squares (OLS) test and the coefficient of variation method to measure the impact of aid volatility on economic growth of three South Asian countries, such as, India, Pakistan and Sri Lanka. Giving sufficient insights on the prior empirical works, the study concludes that foreign aid is unarguably considered as an important determinant of economic development of all the three countries such as, India, Pakistan and Sri Lanka. The key findings of our study highlights, foreign aid with domestic investment, trade liberalization and the investment mechanism made by the private sectors have played a significant impact on economic development for the selected south Asian economies such as, India, Pakistan and Sri Lanka. The empirical results found that aid volatility has shown significant negative impact on economic growth of Pakistan and Sri Lanka. One of the major contributions of this study relies in the statistical inference that envisages analyzing the impact of foreign aid on economic development of three major South Asian economies, such as, India, Pakistan and Sri Lanka. In the light of the empirical findings, we suggest that these south Asian economies should spend their foreign aid in developmental activities such as health, education and infrastructure. An effective foreign aid policy should be formulated and implemented giving prior impetus to the welfare of all the citizens creating huge amount of employment opportunities. The findings of the study will be a value addition to the literature of aid effectiveness. Empirical findings of this study could be used to formulate development strategies to enhance the effectiveness of the foreign aid program in these three economies. [math mode missing closing $]