Why is there little robust evidence that foreign aid significantly enhances the economic growth of poor countries? For a while it appeared that we had learnt the answer; aid is frittered away by some recipient countries through corruption and mismanagement. So, while on average aid does not seem to have a positive impact on growth, in countries with good policies it does (see Burnside and Dollar (2000)). Recently, however, a number of studies question this explanation.1 These studies suggest that even in countries with good policies, there is no robust association between aid and growth. The search for an alternative explanation is becoming immensely important as industrial countries are being exhorted to increase their aid budgets in order to help developing countries achieve the Millennium Development Goals.
Perhaps a clue to where the explanation may lie is in Figure 1. We plot the log of the manufacturing to GDP ratio in a country against the log of the ratio of aid received to GDP for that country for two separate dates (the late 1990s and the early 1980s, separated by about 15 years), after correcting for the country’s per capita PPP GDP, per capita PPP GDP squared, and country and time fixed effects. As the figure suggests, the more aid a country has received, the smaller its share of manufacturing. The coefficient estimate suggests that a 1 percentage point increase in the ratio of aid-to-GDP is associated with a reduced share of manufacturing in total GDP of about 0.2-0.3 percentage points.
Without further analysis, we do not know if this relationship is causal – though the simple argument for reverse causality that as a country gets poorer (and manufacturing shrinks) it gets more aid is unlikely to be the entire explanation because we correct for per capita income. Yet the relationship if causal, offers a proximate explanation for why aid may not have led to substantial growth. As pointed out by Jones and Olken (2006) and Johnson, et. al (2006), virtually all countries that have had a sustained period of growth in the post-war period have seen a large increase in their share of manufacturing and manufacturing exports.
But what is the deep underlying cause? The one we focus on here is poor governance. By expanding a government’s resource envelope, aid reduces its need to explain its actions to citizens, which may reduce its need to govern well (Knack (2001) and Brautigam and Knack (2004)). In particular, poor governance could lead to a deterioration in the quality of institutions necessary for a good business environment, as the government falters in its responsibilities to maintain rule of law, ensure a predictable judiciary and contract enforcement, and limit corruption. In a companion paper (Rajan and Subramanian (2005b)), we examine another channel through which poor governance could affect manufacturing, the mismanagement of the real exchange rate.