Foreign Aid and the Business Cycle

Abstract

In this paper, we document empirical regularities in the foreign aid flows to developing countries over the last three decades. In spite of a large body of literature on foreign aid and its impact on recipients, surprisingly little is known about its business cycle characteristics. We show that for the vast majority of African recipients, aid flows are a major source of income that is highly volatile and, most importantly, overwhelmingly procyclical. For recipients outside of Africa, we find a similar -if somewhat less pronounced -pattern of aid procyclicality. In contrast, there is little evidence of aid procyclicality with the business cycle of donors. In light of the very high volatility of output in developing countries, the procyclicality of foreign aid flows from the recipients' perspective raises serious questions related to their welfare and growth.

Business Cycles in Developing Countries: Are They Different?

“…This result modifies the Pallage and Robe (2001) conclusion that aid commitments are not counter-cyclical. We cannot rule out that this may be so in the Asian and North African countries in our sample.…”

“…Output is generally much more volatile than that of industrialized countries. However the magnitude of the standard deviations of output in Sub-Saharan Africa is much less than that reported by Pallage and Robe (2001). They estimate that shocks to poor countries are about six times more severe than shocks to industrialized countries.…”

“…The correlation between Official Development Assistance (ODA) and GDP is also documented in Table 7a and 7b. Pallage and Robe (2001) show that for a majority of the Sub-Saharan African countries aid flows are pro-cyclical. 13 This finding is not supported by our analysis.…”

“…13 This finding is not supported by our analysis. Pallage and Robe (2001) note the magnitude of output fluctuations 13 Pallage and Robe (2001) base their analysis on both ODA commitments and disbursements. They generally find that commitments are "less clearly" pro-cyclical than disbursements.…”

“…Yet, existing literature is almost exclusively concerned with developed countries. Only scant attention has so far been paid to macroeconomic fluctuations in developing countries, the notable exceptions being Agénor, McDermott and Prasad (2000) and Pallage and Robe (2001). 1 In these contributions, it is assumed that the length of the cycles is comparable to the duration in developed countries.…”