The Effect of Aid on Growth: Evidence from a Quasi-Experiment

Sebastian Galiani, Stephen Knack, Lixin Colin Xu, and Ben Zou , 2014.

Identifying the causal effect of development aid on growth poses a serious challenge. It is not sufficient simply to observe how economic growth responds to changes in aid, as development agencies may vary their aid provision in response to changes in nations' underlying economic situations. Consequently, it is difficult to disentangle the effect of aid from other causes of growth. The key to identifying the causal effect is thus to find changes in aid provision that are not correlated with other determinants of economic growth.

Galiani et al exploit a rule of the International Development Association (IDA), a branch of the World Bank Group, that limits the majority of its aid to nations under a threshold level of per capita gross national income (GNI). Crossing this threshold significantly reduces the amount of aid a nation receives, as a number of other aid agencies follow the IDA's threshold as a guideline for their own award decisions. The threshold per capita GNI was set in 1987 at $580 in response to the IDA's need to ration limited funding. Since then, the threshold has only been adjusted for inflation, reaching a level of $1,175 in 2010. As the threshold itself was set essentially arbitrarily, its crossing is not likely to be accompanied by other structural economic changes. Galiani et al use the changes in aid resulting from crossing the threshold to estimate the causal impact of aid on economic growth within the sample of countries that climbed above the threshold between 1987 and 2010.

The authors found that a one percentage point decrease in the ratio of aid to GNI reduces annual real per capita growth in gross domestic product (GDP) by approximately 0.35 percentage points. This figure is larger than found in many other studies in the literature, potentially because conventional methods are likely to understimate the true effect if donors generally dispense more aid to economically distressed countries. Additionally, Galiani et al find that the impact of aid largely comes through physical investment, with a one percentage point decrease in the ratio of aid to GNI lowering the recipient nation's investment to GDP ratio by 0.54 percentage points.

The findings in the paper have important implications for aid policy. In addition to providing a more credibly estimated effect of aid, the results suggest that aid is still impactful for nations around IDA’s threshold level. As such, it may be desirable either to raise the threshold or to make the reductions in aid after crossing the threshold more gradual.

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