the following, are development aid (in particular aid coming directly from governments, ODA); and foreign direct investment (FDI). ODA should here perhaps be expected to have the greater effect on growth as its basic premise and purpose is usually to promote economic development in the receiving countries. FDI is motivated much more by profit seeking of the international corporations making the investments, and a substantial fraction of the return to FDI is likely to flow out of the country of investment to owners. On the other hand, FDI involves investment that typically increases output in the target country.

# **7.2 Foreign aid**

A variety of views and results on the effects of FDI on long-run economic growth have recently been formed, and it is fair to say that no very strong general consensus on causal relationships has been formed. In analyzing such effects, one first needs to separate between main categories of finance, principally two types: cash transfers to governments, versus in-kind support (directly in the form of goods, investments or technical assistance, or as full or partial financing of such goods and services). Arguably, aid provided “in kind”, in particular for investments, should “safer” in their long- run positive effects on receiving country governments.

The earlier empirical literature, prior to around year 2000, on the relationship between aid and growth, was on the whole weak. Most studies report small or weak general aid-growth relationships; see Mosley et al (1992), Boone (1996) and Hadjimicael et al (1995); and more recently, Easterly (1999, 2003), and Easterly, Levine and Roodman (2004).

Three main arguments have been offered to explain the lack of a strong effect of aid on GDP growth: a) aid is misallocated by donors, as these pursue largely non-developmental objectives; b) aid is misused by receiving governments, as these pursue non-developmental agendas; and c) GDP growth is not the proper measure of development.

Some of this literature however does purport to indicate positive (general, and unconditional) growth effects of aid; examples are Hansen and Tarp (2000, 2001), and Dalgaard, Hansen and Tarp (2004).

A more recent wave of literature has however provided new insights into these relationships. Its main contribution is to analyze and throw light on the relationship between the growth effects of aid, and governance issues, distinguishing in particular between “good” and “bad” governance receiving countries. Particularly important has been work by Burnside and Dollar (2000, 2004), who find convincing evidence of such effects.<sup>24</sup> The definition of “good governance” is here, as in most of this literature, taken from the World Bank’s own governance index, ranking countries with respect to corruption and rule of law. Note that only the second of the explanations offered above is directly relevant for explaining the difference between good and poor governance regimes; while the two other explanations are generic. Overall, the three explanations thus indicated that the aid-growth relationship may be quite fragile, even for good-governance countries.

A closely related issue is the effect of aid in “weak” or “fragile” economies, versus more robust ones. As a first cut, being an IDA country signals “weakness” and is an obvious target for analysis. Ruhasyankiko (2005), studying long-run effects on growth of aid for IDA and non-IDA countries separately (with sample period 1984-2002), finds substantial differences between the two groups in the impact of ODA on growth. He finds in particular that a 1 percent increased aid share in GDP raises the growth rate by 0.12 percentage points in IDA countries; and by 0.47 percentage points in non-IDA countries. Thus, the marginal growth effect of aid transfers is thus four times as great in non-IDA

> 24 See also subsequent related work by Collier and Dollar (2001, 2002) and Collier and Hoeffler (2004).

> .

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