Endogeneity could run the other direction—from trade to aid—in that some donors allocate aid to those countries with whom they have the strongest trade ties.<sup>16</sup> Analysis that tests for the direction of causality generally conclude that it depends on the pair of donor and recipient countries.<sup>17</sup> Even if endogenous, the results suggest a positive relationship between aid and trade.

The literature on aid and growth disagrees on whether there is a positive relationship between aid and growth.<sup>18</sup> There may be many reasons for this, including the type of aid delivered (for example, humanitarian vs. policy relevant) and absorptive capacity in developing countries.<sup>19</sup> One reason cited for the lack of a positive relationship between aid and growth is an aid-induced appreciation of real exchange rates—e.g. the aidinduced Dutch disease or the ‘transfer paradox’.<sup>20</sup> Since the real exchange rate is a key channel through which aid for trade gains could be eroded, we are concerned about this issue in the context of our study of aid for trade facilitation.

Recent surveys conclude that the econometric estimates of whether aid induces a “Dutch disease” phenomenon can vary widely. This depends upon assumptions about the marginal productivity of additional aid and public expenditures, the complementarities between public and private capital, and the degree of flexibility of labor and other key resources.<sup>21</sup> In addition, Devarajan et al. (2008), using a CGE model, argue that an aidinduced real exchange rate appreciation is more likely if aid flows are volatile and thereby induce sub-optimal consumption and investment planning over time.

How does our paper bring together these two major research strands to address questions about the impact of aid on trade? The main purpose of our study is to evaluate the impact of aid flows targeted for trade facilitation measures on trade flows. We link “aid-for-trade facilitation” flows to trade flows through the black box that relates aid to trade facilitation reform: Certain types of aid flows promote certain reforms or change certain infrastructures which reduce trade transaction costs and thus enhance trade flows. We address the issue of causality by considering a subset of official development assistance, as well as through robustness checks. The issue of aid-induced Dutch disease, while relevant in a broader context, is not likely to be an issue in our analysis. Aid delivered for trade facilitation goals examined here, in contrast to other aid objectives, is numerically small and therefore very unlikely to precipitate any real exchange rate appreciation.

> such as political or economic considerations (Lloyd et al., 2000).  But also, see Nelson and Silva (2008) for a recent analysis that obtains much smaller number using a fixed effects gravity model estimation. 16Morrissey, 1993; Osei et al., 2004

> 17Lloyd et al. (2000) as well as Arvin et al. (2000).

> 18 See Rajan and Subramanian (2005a) for a survey and new assessment.

> 19 See Radelet, Clemens, Bhavnani (2005), Chapter 4 in OECD (2006).

> 20 The effect is well known: aid flows may be used to finance expenditures of non-tradable goods and services, leading to a rise of their relative price with respect to tradable goods and thus, to a real appreciation of the exchange rate. This causes a significant squeeze on the exporting sector, as resources are transferred from the tradable to non-tradable sectors.

> 21See Adam (2006), Radelet, Clemens and Bhavnani (2006),Rajan and Subramanian (2005b), Chatterjee and Turnovsky (2005).

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