Do Countries with Greater Credit Constraints Receive More Foreign Aid?

By Bandyopadhyay, Subhayu; Lahiri, Sajal et al. | Federal Reserve Bank of St. Louis Review, November-December 2012 | Go to article overview

Do Countries with Greater Credit Constraints Receive More Foreign Aid?


Bandyopadhyay, Subhayu, Lahiri, Sajal, Younas, Javed, Federal Reserve Bank of St. Louis Review


Donor nations may recognize that some developing nations face credit constraints in the world capital market. This knowledge may prompt donors to increase aid flows to alleviate the constraint. In such a situation, flows of foreign aid and foreign loans to developing nations may be substitutes for each other. The authors use data from 114 aid-recipient countries over the 1997-2008 period to investigate the relationship between foreign aid and foreign loans. The central finding is that this relationship is negative, lending support to the substitution hypothesis. (JEL F35, O16)

Federal Reserve Bank of St. Louis Review, November/December 2012, 94(6), pp. 481-93.

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Convinced that foreign aid does not work, Bauer (1971) argued that it should be replaced by free or easier access to the international credit market. He argued that foreign aid is misused by recipient countries and the need to repay loans would compel the recipients to use them more effectively. (1) Even when foreign aid is effective, it is not clear a priori that it is the best form of assistance from abroad. On the other hand, the development of financial markets, as measured primarily by better access to credit, is known to foster growth and reduce poverty (e.g., Beck, Demirguc-King, and Levine, 2007; Beck, Levine, and Loayza, 2000; Levine, 2003).

Foreign aid and foreign loans may be related through several channels. One possible channel is that developing nations may want to invest in infrastructure so they can be more productive in the future. Given their limited ability to raise resources from within their own countries, these nations may have to rely on foreign sources, which can take the form of aid inflows or loans. Depending on the creditworthiness of these nations, perhaps established by their history, such loans may or may not be available from the international capital market. If they are not available, or available at extremely high interest rates, the ability of nations to invest in public inputs may be limited. In such situations, there is an incentive for altruistic donor nations to step in and provide aid to alleviate this resource crunch for developing nations. If this is the case, then donor nations will have a larger incentive to provide foreign aid to nations that have more difficulty borrowing from the world capital market.

Extensive evidence suggests that private firms in many developing countries face severe credit constraints. Galindo and Schiantarelli (2003) provide supporting evidence of constraints for several Latin American countries. Harrison and McMillan (2003) find that many manufacturing firms in the Ivory Coast face severe credit constraints. Using firm-level data in the manufacturing sector for six African countries, Bigsten et al. (2003) estimate the extent of credit constraints among firms of various sizes. Hericourt and Poncet (2007) find binding credit constraints among private manufacturing firms in China. Finally, Rajan and Zingales (1998) provide extensive evidence of sector-level financial development (or the lack of it) for 41 developed and developing countries.

The discussion above implies that donor nations may try to compensate for the lack of access to capital markets for some developing nations. This type of compensation may show up in the data as increased availability of aid for the most credit-constrained nations. This is the focus of our empirical investigation in the remainder of the article.

Using a dynamic panel-data framework that draws on 114 developing countries for 1997 through 2008, we examine whether the flow of more loans reduces the flow of foreign aid. Data on foreign aid are collected from the Organisation for Economic Co-operation and Development (OECD); we use offshore bank loan data from the Bank for International Settlements (BIS) locational banking statistics to measure access to foreign borrowing. Our empirical procedure uses an advanced estimation technique on the data and attempts to address a host of estimation issues; ignoring these would risk estimation bias and inconsistency. …

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Do Countries with Greater Credit Constraints Receive More Foreign Aid?
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