AID, MACROECONOMIC POLICY ENVIRONMENT AND GROWTH: EVIDENCE FROM SUB-SAHARAN AFRICA. Afees Adebare SALISU 1

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1 AID, MACROECONOMIC POLICY ENVIRONMENT AND GROWTH: EVIDENCE FROM SU-SAHARAN AFRICA Y Afees Adebare SALISU 1 ASTRACT This paper is a contribution to the growing debate on aid-growth nexus. It examines the role of macroeconomic policy environment in aidgrowth nexus the area of which has received no serious attention in Sub- Saharan Africa (SSA). In a panel regression model covering twenty Sub- Saharan African countries, estimated wh the use of OLS and TSLS over a period of 1970 to 2001 (in nine- four year sub-periods), the paper finds that a sound macroeconomic environment is sine qua non for the effective contribution of aid to sustainable growth. The paper also finds that macroeconomic policy environment is an important determinant of growth. Overall, the paper concludes that the incessant socio-polical crisis, policy inconsistencies, bad governance, and macroeconomic instabily evident in many SSAs have crippled the effectiveness of aid in these countries. JEL Classification: C23, C33, F35, O16, P45 Key Words: Foreign Aid, Economic Policy, Economic Growth, Sub-Saharan Africa 1 Salisu Afees is a PhD Candidate and Junior Research Fellow, Centre for Econometrics and Allied Research, Department of Economics, Faculty of the Social Sciences Universy of Ibadan, Ibadan, Nigeria. adebare1@yahoo.com. Phone No.:

2 AID, MACROECONOMIC POLICY ENVIRONMENT AND GROWTH: EVIDENCE FROM SU-SAHARAN AFRICA 1.0 INTRODUCTION How does macroeconomic policy environment affect aid-growth nexus? Evidences in the lerature have remained inconclusive. On one side of the arguments are those who suggest that aid is effective only in a stable macroeconomic environment. 2 On the other side of the arguments are those who conclude that macroeconomic environment has no significant influence on the link between aid and growth 3. Evidently, however, this growing debate on aid-macroeconomic environmentgrowth nexus seems to have received no serious attention in Africa. Most papers often focus on the direct impact of aid on growth in Africa. In the present study, therefore, I intend to investigate the role of macroeconomic environment on aid-growth nexus in Sub-Saharan Africa. Developing countries are indeed characterized by low level of income, high level of unemployment, very low industrial capacy utilization, and high poverty level just to mention a few. The increasing prevalence of these economic problems has been ostensibly blamed on the low revenue base of most developing countries depriving them from meeting basic macroeconomic goals. Sequel to this view, the provision of foreign aid has been suggested as a verable option for augmenting the meagre domestic resources. While some countries that have benefed from foreign assistance at one time or the other have grown such that they have become aid donors today (South Korea, North Korea, China etc.), majory of countries in Africa have remained backward. Sub- Saharan African countries (SSAs) have continued to benef from all sorts of foreign assistance and in fact still collect at least as much as the amount collected in the early 1980s, yet socio-economic development has 2 Prominent among them include, urnside and Dollar (1997, 2000, 2004). 3 Prominent among them include Easterly, Levine, and Roodman (2003) and Dalgaard, Hansen and Tarp (2004) 2

3 remained dismal. This, therefore, suggests that there is more to the economic problems prevalent in Africa than the low revenue base or may be there is a disconnect between aid and growth in SSA. While there could be so many factors both qualative and quantative explaining these unfavourable trends, the incessant socio-polical crisis, policy inconsistencies, macroeconomic instabily and bad governance evident in many SSAs which are indeed indicators of poor macroeconomic policy and instutional environment, should give one a pause. To this end, therefore, this paper seeks to answer the following questions: -What is the relationship between aid and growth in Sub-Saharan Africa? -To what extent has the state of macroeconomic policy environment evident in SSAs affected aid-growth relationship? The rest of this paper is structured as follows: section two provides a review of relevant empirical lerature, section three sets out the methodology and data, section four provides the analysis of results and, section five concludes the paper. 2.0 A REVIEW OF EMPIRICAL EVIDENCE ON AID-MACROECONOMIC POLICY ENVIRONMENT-GROWTH NEXUS The empirical lerature on aid-macroeconomic environmentgrowth nexus is presented in table 2.1 below. I have categorized the empirical findings into the following: (i) Evidence on the posive relationship between aid and growth (ii) Evidence on the negative relationship between aid and growth (iii) Evidence on the significant role of macroeconomic environment in aid-growth nexus; (iv) Evidence on the irrelevance of macroeconomic environment in aid-growth nexus; (v) Other salient issues. 3

4 Table 2.1: A summary of empirical evidence on aid-macroeconomic policy environment-growth nexus Empirical Evidence Description of Empirical Evidence Posive relationship Foreign aid accelerates between aid and growth economic growth by supplementing domestic capal formation. Negative relationship between aid and growth Macroeconomic environment affects aidgrowth nexus Macroeconomic environment has no significant influence on aid-growth nexus Mixed Evidence A permanent rise in foreign aid reduces long-run capal accumulation and labor supply and by extension reduces the rate of economic growth. Foreign aid does have some posive impact on growth, condional on a stable macro-economic policy environment. In addion, when country size is included the growth model, the effect of aid is posive, larger and significant. Aid-growth nexus is sensive to changes in data set. If the data set of studies suggesting posive and significant role of policy in aid-growth nexus is expanded, the role of policy disappears. The effect of foreign aid on growth depends on the nature of development of recipient nations. Foreign aid significantly and negatively correlates wh growth in developing countries. However, foreign aid to Inland countries as well as South Asian countries significantly and posively correlates wh Authors Chenery and Strout (1966); Papanek (1973); Singh (985); Fayissa and El-Kaissy (1999); Gomanee, Girma and Morrissey (2005). auer (1982, 1991), Gong and Zou (2001) Snyder (1993); urnside and Dollar (1997, 2000, 2004); Collier and Dehn (2001); Lensink and Morrissey (2000); Alvi, Mukherjee and Shukralla (2006) Easterly, Levine and, Roodman (2003); Dalgaard and Hansen (2001); Dalgaard, Hansen and Tarp (2004); Murphy and Tresp (2006) Chenery and Carter (1973) Vu Minh Duc (2006) 4

5 growth. Other salient issue Higher aid levels erode the qualy of governance and economic freedom of recipient nations. Source: Compiled by the author. Knack (2000) 3.0 METHODOLOGY AND DATA The empirical model for this study is based on the neoclassical growth model. The standard growth regression expresses the growth rate of per capa real GDP as a function of the inial level of income, the level of aid as a fraction of GDP, measures of macroeconomic environment (policy index) and some exogenous variables. Also incorporated in the model is a variable which enables aid to interact wh policy. g = go + y gy + a ga + P gp + a P gap + x gx + ε g..(1) Where: g represents the growth of per capa real GDP y is inial level of income a is foreign aid (real effective development assistant) as a percentage of real GDP P is the policy index x is the set of exogenous variables a P represents aid-policy interactions and ε is the regression error Although, aid and policy are exogenous in the growth model (1), they also affect each other. This implies that these variables also depend on a set of exogenous variables. 4 Thus, a = ao + y + P ap + x ax + ε a..(2) P = po + y py + a pa + x pa + ε D..(3) 4 See urnside and Dollar, 2000: p.11 5

6 The exogenous variables in the model are a measure of instutional qualy that capture secury of property rights and efficiency of the government bureaucracy 5, ethno linguistic fractionalization variable 6, assassinations variable to capture civil unrest; and the instutional variable (which is broad Money Supply over GDP) as a proxy for distortions in the financial system (King and Levine, 1993). I employ the policy index created by urnside and Dollar [D] (2004). The policy index is a combination of fiscal policy (using udget Surplus as a proxy), monetary policy (using inflation as a proxy) and trade policy (using trade openness as a proxy). In addion to the D s policy index, I also consider an alternative measure of policy as suggested by Easterly (2003) which involves substuting broad money supply as a percentage of GDP for trade openness. Data used for estimation cover twenty SSAs spanning the period 1970 to I utilize urnside and Dollar data and I consequently update the data using the World ank data, International Financial Statistics, National archives and moving average in suations where data are not readily available. In urnside and Dollar work, data used were computed over successive six four-year periods i.e , ,, This helps to lessen the influence of short-term fluctuations in growth that are not related to longer-term forces (see Murphy and Tresp, 2006). Easterly (2003), however, argues that a six four-year period may capture business-cycle fluctuations and may not be long enough for a period of good policy to setup beneficial effects of aid. ased on this, I lengthen the sample period to nine four-year periods. In the estimation of the model, I employ both the Ordinary Least Square (OLS) and the Two Stage Least Square (TSLS) based on the fact the former does not consider the endogeney of aid. 5 The instional qualy was developed by Knack and Kefer, This was developed by Easterly and Levine (1996) 6

7 4.0 ANALYSIS OF RESULTS AND POLICY IMPLICATIONS The results of the growth regressions carried out (using both OLS and 2SLS) are presented in tables 4.1 and 4.2 The OLS regression results as presented in table 4.1 show that foreign aid and policy are posively related to growth. Even when aid was interacted wh policy, the posive association is still recorded. The results were in fact more robust when the 2SLS is considered. The policy index estimated here is D s which combines inflation, budget surplus and openness as proxies for monetary, fiscal and trade policies respectively. My findings further validate the empirical evidence of urnside and Dollar (1997, 2000, 2004) that macroeconomic policy environment is an important determinant of aid effectiveness. When M 2 GDP is incorporated into the policy index of D s as a substute for Sach s-warner trade openness an alternative measure of economic policy as suggested by Easterly (2003), the interaction between policy and aid is still significant and posive too (see table 4.2). And the overall results (as presented in table 4.2) do not seem to be significantly different from what we obtained when the D s policy index is used. This confirms the evidence of Easterly that the alternative policy index can still capture some real effects. Also instructive in our findings is that an expanded data set (drawing evidence from Sub-Saharan Africa) does not seem to affect aidpolicy interaction effect on growth. Invariably, my findings do not support the argument raised by Easterly (2003) and Murphy and Tresp (2006) that if the data set is expanded, the significant effect of aid-policy interaction disappears. 7

8 Table 4.1: PANEL GROWTH REGRESSIONS Dependent Variable: Growth Rate of Per capa GDP Time Dimension: Nine four-year periods, Countries: Sub Saharan Aid R ecipients OLS Regression (Using D Policy index) 2SLS Regressions (Using D Policy index) Variable Policy (2.635) (2.637) (2.402) Aid (0.207) (1.525) Aid*Policy (1.178) (2.358) Ethnl ( ( ( 0.452) ( 0.131) (1.228) ( 1.047) 0.131) 0.065) Assess ( ( ( 0.137) ( 0.674) ( 0.756) ( 0.289) 0.674) 0.678) Ethnl*Assess (0.500) (0.514) ( 0.232) (0.500) (0.957) ( 0.136) Instutional Qualy (2. 053) (2. 037) (2.687) (2.053) (1.271) (2.151) M 2 GDP ( ( (0.064) ( 0.415) ( 1.149) (0.515) 0.415) 0.439) Inial Capal (1.729) (1.679) (1.479) (1.729) (1.950) (0.729) No. of Observations R Adj R2 Note: Figures in parentheses are the T-test results. 8

9 Table 4.2: PANEL GROWTH REGRESSIONS [Considering an Alternative Policy definion by Easterly (2003)] Dependent Variable: Growth Rate of Per Capa GDP Time Dimension: Nine four-year periods, to Countries: Sub-Saharan Aid Recipients 2SLS Regressions ( using alternative Policy index) OLS Regression (using altern ative Policy index) Variable/Registra tion Number Policy (2.255) (2.247) (2.255) (2.181) Aid (0.016) (0.781) Aid*Policy (1.374) (2.401) Ethnl (0.433) ( (0.362) (0.433) (0.303) ( 0.575) 0.412) Assass ( 0.605) ( ( 0.145) ( 0.605) ( ( 0.252) 0.603) 0.660) Ethnl*Assass (0.366) (0,365) ( 0.168) (0.366 (0.554) (0.008) Instutional Qualy (2.635) (2.026) (2.474) (2.035) (1.804) (1.705) Inial Capal (1.840) (1.706) (2.050) (1.840) (1.583) (2.459) No. of Observations R Adj R Note: Figures in parentheses are the T-test results. In terms of statistical significance, economic policy is statistically significant in all the regressions while the statistical significance of aid and aid-policy interaction estimates is recorded when the 2SLS regression is computed. 9

10 Other explanatory variables among which include Ethnicfractionalization and assassination a measure of polical instabily, show the anticipated negative association wh growth and instutional qualy - a measure of the nature of governance, has the expected posive sign in all the regressions carried out. The implication of this finding is that incessant incidence of polical and social crises and poor instutional qualy are capable of hampering the effectiveness of aid. y and large, evidence obtained from my analysis indicates that economic policy is a good determinant of aid effectiveness and growth. Also, foreign aid is expected to enhance the actualization of sustainable growth and development in a country wh a sound macroeconomic policy environment. Wh the increasing incidence of slow growth rates in many SSAs, the posive association among aid, macroeconomic policy environment and growth may suggest that poor inconsistent economic policies evident in many of these countries are responsible for the sluggish and weak contribution of aid to growth. 5.0 CONCLUDING REMARKS The empirical evidence obtained in this study is an indication that aid flows into sub-saharan Africa will be effective condional on a stable macroeconomic policy environment. In other words, the increasing flows of aid into Africa have not promoted meaningful development due to the unstable macroeconomic environment. Most SSAs are characterized by policy inconsistencies, poor instutional framework, high level of corruption, incessant polical crises, civil unrest and ethnic fractionalization. In the midst of current efforts to achieve Millennium Development Goals (MDGs) in Sub-Saharan Africa, the need for foreign assistance is inevable. However, no amount of foreign assistance will promote sustainable growth and development in SSA if the problem of unstable 10

11 macroeconomic environment persists. It is, therefore, crucial for respective governments in SSA to pursue economic policies that at least reflect low inflation rate, productive budgetary balance, competive and unimpaired exchange rate, and to attend to the incessant civil unrests and polical instabily, otherwise, the problem of slow growth rate will remain unabated. REFERENCES Alvi E., Mukherjee D. and E. K. Shukralla (2006). Foreign Aid, Growth, Policy and Reform. Economics ulletin, Vol. 15(6). auer, Peter T. (1982), ''Equaly, The Third World and Economic Delusion'', Harvard Universy Press. auer, P. (1991). The Development Economics. The MIT Press, Cambridge, M. A. urnside, Craig and Dollar, David (1998). Aid, the Incentive Regime, and Poverty Reduction. Policy Research Working Paper World ank, Development Research Group, Washington D. C. urnside, Craig and David Dollar (2000). Aid, Policies, and Growth. American Economic Review, September, 90:4 pp urnside, Craig, and David Dollar (2004). Aid, Policies, and Growth Revised. American Economic Review, 94: Chenery, Hollis. and Alan M. Strout (1966). Foreign Assistance and Economic Development. American Economic Review, September, 56:4, pp Chenery, Hollis. and Alan M. Strout (1968). Foreign Assistance and Economic Development: Reply. American Economic Review, September, 58:4, pp Chenery, Holis. and Carter, Nicholas G. (1973). Foreign Assistance and Development Performance, American Economic Association, Vol. 63, No.2. Collier, Paul and Dollar, David. (2002). Aid Allocation and Poverty Reduction. Development Research Group, World ank. Collier, Paul and Jan Dehn (2001). Aid, Shocks and Growth. Working Paper No. 2688, World ank, October. Collier, Paul and David Dollar (2002). Aid Allocation and Poverty Reduction. European Economic Review. September, 46:8, pp Dalgaard, Carl-Johan and Henrik Hansen (2001). On Aid, Growth and Good Policies. Journal of Development Studies, August, 37:6, pp

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