The Effectiveness Of Aid In Promoting Private Foreign Investment

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 effectivewhen 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. 

''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.