Working paper 07-1 Christina Bjerg, Christian Bjørnskov and Anne Holm

The rest of the paper is structured as follows. Section 2 outlines a simple 

theoretical explanation for the potential effects of foreign aid. Section 3 describes the 

data used in section 4 that presents the empirical evidence. Section 5 discusses the 

findings while section 6 concludes. 

 

2. Theory 

To illustrate the potential interaction between foreign aid and external debt, we devote 

this section to describing a small macroeconomic growth model. Our model includes the 

phenomenon of Dutch Disease (cf. Corden, 1984, Rajan and Subramanian, 2005). The 

model structure is illustrated in Figure 1. It should be stressed that for clarity, we keep 

the structure and the argument as simple as possible. 

 

Insert Figure 1 about here 

 

As a first possibility, foreign aid may be used as originally intended to finance 

productive investments although the extent to which this occurs is disputed. Since 

Friedman’s (1958) suggestion that foreign aid may be used to finance idle government 

consumption when aid enters the government budget constraint and is thus fungible, a 

number of studies have shown that a substantial part of foreign aid given to developing 

countries in general tends to finance government consumption instead of investments 

(cf. Boone, 1996, Remmer, 2004). Overall, the metaanalysis in Doucougliagos and 

Paldam (2006) sums up the empirical literature on the aid-investment association by 

concluding that increasing inflows of foreign aid in general do not lead to increased 

investment rates. However, it remains uncertain whether this conclusion also holds for 

 

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LDCs that are arguably more severely budgetary constrained. It therefore remains an 

open question how effective aid is in this particular sphere of the economy in the group 

of countries considered in this paper. To the extent that aid actually results in productive 

investments, it will tend to be positively associated with economic growth through this 

link. 

An accompanying possibility is depicted in the lower flows of Figure 1. One of 

the problems of foreign aid disbursements is that they need to be exchanged before 

being used in the economy of a developing country. As such, increased aid inflows have 

the effect of increasing the demand for the local currency, which in a country with a 

flowing exchange rate regime will result in an appreciation. In countries with fixed 

exchange rate regimes, the exchange rate will in general be defended by increasing the 

supply of local currency, which in the longer run tends to lead to inflation, all other 

things being equal. In both cases, the international competitiveness of the country 

therefore suffers and tends to result in a relatively smaller export sector and a possible 

balance of payments problem (cf. Corden, 1984).  Rajan and Subramanian (2005) 

presents concrete evidence of this effect, known as Dutch Disease, arguing that it may 

provide an important part of the explanation for the absence of growth effects of foreign 

aid in most empirical studies. 

As the final possibility to be particularly stressed in this paper, inflows of foreign 

aid may alternatively be used by governments to meet interest payments or cover part of 

the principal of their external debt. Many developing countries suffer from rather heavy 

debt burdens, which theoretically both limits governments’ ability to invest in 

productive public capital such as infrastructure and public institutions, may place a 

heavier tax burden on domestic firms to finance debt payments and thus drive some 

 

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economic activity underground, and potentially also harm exporters’ reputation to the 

extent that the debt burden lowers the international credit ratings of the country. Given 

the extent to which foreign aid is used to finance debt payments, it arguably alleviates 

the negative growth effects of having a heavy debt burden.  

However, in the context of using aid to finance the repayment of external debt, an 

additional complication is worth mentioning, which is the crux of the argument to be 

tested in this paper: external debt is most often denoted in US dollars or Euros. Any part 

of the inflow of foreign aid devoted to debt repayment in the end only temporarily 

enters the currency reserve of the country, but is not exchanged as it is necessary to use 

the foreign currency for debt repayment purposes. Logically, this means that only the 

part of aid inflows actually entering the economy can induce Dutch Disease while the 

part used to repay debts is free from this negative side effect of aid. 

This possibility comes out of simple national accounting as in Equation 1.

1

 The 

equation states that the inflows of currency from goods and capital, exports x and 

amount of foreign aid entering the country θa, has to equal the outflows of currency as 

imports m at import prices p

*

 and debt instalments erd + (1- θ)a, if the reserves of 

foreign currency are held constant. In the absence of sufficient flows of private capital, 

which seems a reasonable assumption in the present context of LDCs, this necessarily 

holds in the medium-to-long run. The mechanism for equating inflows and outflows is 

the exchange rate, e, thereby opening up for the possibility of Dutch Disease, as inflows 

of foreign aid a lead to an excess demand for the domestic currency and thus an 

appreciation. 

                                                 

1

 This is, of course, assuming that there is no net inflow of foreign direct investments, an assumption that 

seems reasonable given that the empirical evidence in the following comes from a sample of LDCs. 

 

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