IGC on the link between Aid and FDI

The International Growth Centre recently published an interesting and informative read on their findings about the relationship between aid and foreign direct investment in developing countries:

“Aid-financed infrastructure promotes foreign direct investments”

The link between aid and private investment is not well understood. Could aid-financed infrastructure investments encourage higher foreign direct investment? The authors present the results of a new composite index of infrastructure to estimate direct and indirect impacts of aid for infrastructure on FDI.

Official development assistance (ODA) and foreign direct investment (FDI) are widely perceived as alternative means of supplementing domestic savings and promoting economic development in low and middle income countries. Developing countries that attract FDI are often contrasted with ODA-dependent ones. The argument for FDI is typically considered “compelling” (Stiglitz 2000) as it provides an attractive package of capital, technology, managerial know-how, and access to markets. By contrast, aid critics stress the disincentives of ODA and contend that “successful cases of development happening due to a large inflow of aid and technical assistance have been hard to find” (Easterly 2007: 329).

How aid could promote FDI

The effects of ODA on FDI flows to developing countries are theoretically ambiguous. Positive effects can be expected to the extent that aid increases the productivity of private investments by financing complementary factors of production, such as infrastructure and human capital (Selaya and Sunesen 2012). Arguably, aid could also remove specific bottlenecks that prevent higher FDI inflows. In contrast, aid could have adverse effects on FDI inflows by encouraging rent-seeking (Economides et al. 2008) or crowding out private foreign activity in the tradable goods sector (Beladi and Oladi 2007).

The question remains, how exactly could ODA render recipient countries more attractive to FDI? Evidence from earlier studies, employing aggregate aid data, is inconclusive (e.g., Harms and Lutz 2006; Asiedu et al. 2009), and largely neglects the transmission mechanisms through which aid may promote FDI. Aid that is explicitly targeted at improving the recipient countries’ infrastructure endowments could be particularly effective since poor infrastructure is often cited by investors as an important constraint to FDI. Assessing this transmission channel has traditionally been difficult because of data limitations and the lack of a comprehensive measure of the quantity and quality of a country’s infrastructure.

“Our findings show that aid for infrastructure, unlike other types of aid, helps attract FDI, both directly and indirectly through improving recipient countries’ endowment with infrastructure.”

To read the article in full, click here 

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