The Impact of Foreign Aid on Trade Imbalances of Sub-Saharan Africa

Article excerpt

This study uses the Generalized Method of Moments (GMM) technique to determine the impact of Official Development Assistance (ODA) on trade balance of Sub-Saharan African countries, using annual data for the period 1980-2007. The result shows that ODA has positive effect on import and negative effect on export but are statistically insignificant. In the trade balance formulation, following its partial effect on export and import, it has a negative effect, but still statistically insignificant. Further study on the issue is justified, considering the specific mitigating factors, before coming to a final conclusion on the insignificant impact of ODA on balance of trade.

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Introduction

Most Sub-Saharan African (SSA) countries are struggling to come out of poverty. One of the bottlenecks in their development endeavor is presumed to be the shortage of development finance. Foreign capital in the form of Official Development Assistance (ODA) and Foreign Direct Investment (FDI) are the main forms of flow. ODA, commonly known as foreign aid, includes loans, grants and technical assistance on concessional financial terms, with the objectives of reducing poverty and promoting economic development in the developing countries. The main objective of aid and development policies should be that of helping the developing countries to integrate with the global mainstream. This would imply assisting them to implement programs of economic reform, and to create a trade and investment environment for them so that their development efforts can be sustained through increased resource flows and foreign exchange earnings. However, despite its continued use, the role of aid for reducing poverty remains controversial.

A key issue in assessing the macroeconomic implications of official resource transfers to Africa is the potential impact on the real exchange rate, export, import and competitiveness. Foreign aid flows augment domestic resources and therefore leave the economy, as a whole, better off. In practice, however, the macroeconomic impact of aid depends both on how a country spends the resources and on its policy response.

Aid absorption is defined as the extent to which a country's non-aid current account deficit widens in response to an increase in aid inflows. This captures the quantity of net imports financed by the increased aid and represents the additional transfer of real resources enabled by the aid. Absorption captures both the direct and the indirect increases in imports financed through aid, that is, the government's direct purchases of imports as well as second-round increases in net imports resulting from aid-driven increases in government or private expenditures.

The export version of the explanation, also called resource movement effect (Corden and Neary, 1982) states that as aid could disproportionately be targeted at expanding non-tradable services such as health care, and education for which there is substantial unmet demand, it will increase wages in that subsector (given a fixed supply of skilled labor in the short run), will draw skilled labor into the non-tradable subsector, and will increase overall wages. Since the international price of traded goods is fixed, the higher wage in traded goods sector will reduce its profitability, competitiveness, and lead to a decline in exports. This will further be intensified by the spending effect; the higher wages that start from the non-tradable subsector and spill over to the tradable subsector will be spent, raising the price of non-traded goods relative to traded goods (the real exchange rate). Further, the problem may get worse as most aids are restricted to specific spending areas which may render recipient countries' policy makers incapable of facilitating decision making toward the economic development of the recipient countries. An influential past literature on aid allocation concludes that political, economic and strategic interests of donors rather than the development objectives of the recipient country play a dominant role in aid allocation decision (Dowling and Hiemenz, 1985; Svensson, 1999; and Neumayer, 2003 among others). …