What Undermines Aid’s Impact on Growth?

IMF Working Papers, June 1, 2005

Source details

Authors: Arvind Subramanian, Raghuram Rajan
Date: June 1, 2005
Core question: Why is it hard to find a robust effect of aid on the long-term growth of poor countries, even those with good policies?
Approach: Exploits both cross-country and within-country variation to search for offsets to the beneficial effects of aid.

Aid inflows have systematic adverse effects on a country's competitiveness.
Manifestation: A decline in the share of labor intensive and tradable industries in the manufacturing sector.
Evidence suggests these adverse effects stem from the real exchange rate overvaluation caused by aid inflows.
Private-to-private flows like remittances do not seem to create these adverse effects.
The paper offers an explanation for the difference between aid and remittances and concludes with policy implications.

Utilizes variation across countries and within countries to isolate the effects of aid inflows on sectoral composition and competitiveness.

Real exchange rate overvaluation caused by aid inflows is the likely channel through which aid undermines competitiveness.
Resulting sectoral impact: lower share of labor-intensive and tradable manufacturing industries.

Aid inflows: associated with real exchange rate overvaluation and adverse effects on competitiveness and manufacturing composition.
Remittances (private-to-private flows): do not exhibit the same adverse effects on competitiveness or sectoral shares.

Need to recognize and address the competitiveness effects of aid-induced real exchange rate overvaluation.
Policy responses should account for differential impacts of public aid versus private transfers (remittances) on tradable and labor-intensive sectors.
The paper concludes with a discussion of specific policy implications based on the identified mechanism.