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

Overall, a comparison of the point estimates thus indicates that the most effective 

way of raising the growth rate of the LDCs in this sample is to increase trade volumes, 

i.e. to liberalize trade policy. A one standard deviation shock to openness produces an 

increase in the investment rate of roughly 56 percent of a standard deviation, which in 

turn raises the growth rate by approximately a fourth of a standard deviation. As such, 

the sizes of the marginal effects are fairly standard. For equivalent changes, no other 

variable has comparable effects. The estimates nevertheless also reveal an alleviating 

effect of foreign aid given to heavily indebted countries, which we discuss in the next 

section. 

 

5. Discussion 

Many developing countries today face the consequences of past debt accumulated over 

decades through the burden of persistently high interest payments. This burden, it is 

often argued, prevents poor countries from making potentially beneficial public 

investments with a longer time perspective. Instead, countries’ scarce public resources 

flow back to developed countries and global financial institutions in the form of interest 

payments.  

In the situation when foreign aid is given to heavily indebted countries, part of the 

amounts actually never cross the borders but is sent more or less directly back to 

international lenders. The result of this limited cash inflow to the developing countries 

is that Dutch Disease problems never become an important topic, because there is no 

real currency transfer. Thus, no appreciation of the real exchange rate occurs, and no 

off-putting macroeconomic effects arise from this particular share of the development 

aid. All other things being equal, development aid can therefore indirectly affect the 

 

13

---

growth performance of LDCs by buying them financial leeway even if inflows of aid 

could potentially also cause governments to postpone taking action to reduce the debt or 

the financial problems causing the debt.

5

 Yet, we need to emphasize that our estimates 

do not provide information on whether increasing aid can cause governments to ignore 

debt problems or even cause countries to take up new loans, thus prolonging their debt 

problems (cf. Easterly, 2002). 

On the other hand, one can imagine a number of additional beneficial effects that 

more likely occur in the longer run. When, for example, LDCs experience lower 

external debt due to the cancellation of debt from Western countries or their own efforts 

at reducing their external debt, the country credit ratings might be re-evaluated on the 

basis of the debt reduction, given that the lower debt levels are taken to be a signal of 

lower risk. For this to happen, it is nevertheless necessary that international creditors 

gain some credible assurance that the political and institutional failures leading to the 

debt in the first place have been or will be corrected in the near future, which need not 

be the case (Easterly, 2002). Yet, if this happens, the newly gained confidence in the 

particular developing country may attract attention from foreign investors who will be 

willing to invest in the country. Placing investments in property, plants, equipment, 

participation in joint ventures and other FDI activities will probably strengthen the 

economy in the long run due to inflows of not only capital but technology and 

                                                 

5

 In a series of additional fixed effects estimates, we find that the trend in real exchange rates as given by 

the Penn World Tables depend on the initial level, i.e. persistent trends as would be caused by high 

inflation rates (coefficient 10.711; standard error .728), the initial debt level (12.986; 10.866), initial 

foreign aid (-34.307; 40.106) and an interaction term (-.297; .119). These simple estimates therefore 

provide tentative support for our conjecture in equation 1 that aid inflows to highly indebted countries can 

counteract Dutch Disease. 

 

14

---

management science as well. As it is today, a virtually negligible share of worldwide 

FDIs go to LDCs, potentially preventing highly beneficial technology transfers. 

The bottom line of the recent literature on aid effectiveness is that foreign aid is 

not associated with growth in general, but may be so under specific conditions, which 

the literature explores. The present findings can be taken to illustrate how inflows of aid 

may serve to alleviate other problems limiting the growth performance of LDCs. Most 

of the literature has investigated theoretically valid conditions under which aid works as 

intended. However, the present findings reveal that foreign aid can have beneficial 

growth effects when used against the stated intentions. Indeed, the set of simple 

theoretical considerations indicate that the positive growth effects of aid in LDCs occur 

when it is used to alleviate debt problems and thereby does not enter the economy. As 

such, inflows of foreign aid will be deemed a failure if donors attempt to evaluate the 

volume of the intended project output in a given country, but can paradoxically have 

beneficial effects above the project level precisely when aid is not used according to 

donor intentions. This and other apparent inconsistencies should probably be 

reconsidered in other studies on the elusive growth-aid nexus. 

 

6. Conclusions 

This paper has explored whether foreign aid can alleviate the detrimental effects of 

large debt burdens in least developed countries. Based on the existing literature, we first 

argue that part of the potentially positive effects of foreign aid may be undermined by 

Dutch Disease – when inflows of foreign aid cause the international competitiveness of 

developing countries to deteriorate. However, we note that when aid disbursements are 

used to repay external debt, it serves not only to alleviate the growth-depressing effects 

 

15

---