Aid is effective in promoting private foreign investment – but only in countries where
market-unfriendly policies curtail competition, prevent market entry and constrain the scope
for entrepreneurial decisions. That is the surprising conclusion of new research by
Professor Philipp Harms and Dr Matthias Lutz, published in the July 2006 issue of the
Economic Journal.
The researchers’ explanation for their finding runs like this: a heavy regulatory burden
hampers private sector activities in many ways, such as preventing firms from setting up
infrastructure and other services that the government fails to provide. Aid-financed public
infrastructure can in those circumstances alleviate the resulting bottlenecks and thereby
stimulate private foreign investment.
Harms and Lutz emphasise that their results do not imply that countries should further turn
the regulatory screw to attract foreign firms. Rather the opposite: as their empirical
evidence shows, removing institutional frictions is still an important way to increase the
volume of foreign investment.
In this respect, their findings are in line with conventional wisdom. Where they differ is in
the implication that, in a bad regulatory environment, aid can stimulate private foreign
investment.
Does official aid pave the road for private foreign capital flows, is it completely ineffective or
does it even deter foreign investors by reinforcing harmful ‘rent-seeking’ activities? While
the potentially ‘catalysing’ effect of aid on private foreign investment is frequently mentioned
as a rationale for giving aid to developing countries, the empirical evidence on this question
is rather scant.
Harms and Lutz’s research shows that there is no simple relationship between aid and
private foreign investment. But they argue that this is due to previous studies’ neglect of the
political and institutional framework in recipient countries.
The starting point of their own study is the hypothesis that aid should be most effective
when it meets a healthy institutional environment. They then test this hypothesis by using
time series data on aid, foreign direct investment and private equity investment as well as a
recent dataset on the quality of institutions.
Surprisingly, their empirical results grossly contradict the hypothesis that aid should have
the biggest impact on private foreign investment in a healthy institutional environment. As it
turns out, the effect of official aid on private foreign investment is close to zero for a country
with average institutional characteristics.
But and this is what they term their 'puzzling finding', the effect of aid is strictly positive in
economies that hamper private activities by imposing a high regulatory burden. As they
demonstrate, this result is stubbornly robust across samples, specifications and estimation
methods.
ENDS
Notes for editors: ‘Aid, Governance and Private Foreign Investment: Some Puzzling
Findings for the 1990s’ by Philipp Harms and Matthias Lutz is published in the July 2006
issue of the Economic Journal.
Harms is at RWTH Aachen University. Lutz is at the Swiss National Bank.
For further information: contact Philipp Harms on +49-241-80-96203 (email:
harms@rwth-aachen.de); Matthias Lutz on +41-44-63-13619 (email:
matthias.lutz@snb.ch); or Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).