Aid Volatility, Human Capital, and Growth
Aid remains an important component of capital flows to low-income countries. Empirical contributions show that there is robust statistical evidence that aid volatility tends to have an adverse effect on economic growth. However, the channels through which such volatility operates have not been fully articulated in endogenous growth models. This paper studies the effect of aid volatility on growth, in a model where the decision to invest in skills is endogenous. The analysis focuses on a low-income economy where the cost of acquiring education benefits from public subsidies, which are partly financed through foreign aid.
Aid Volatility, Wages and Skills Acquisition
Empirical contributions show that there is robust statistical evidence that aid volatility tends to have an adverse effect on economic growth. However, the channels through which such volatility operates have not been fully articulated in endogenous growth models. The author develops a stochastic growth model where skills acquisition is endogenous. Specifically, aid volatility may adversely affect growth (and possibly welfare) when the decision to invest in skills is endogenous. To understand how this can occur, consider a low-income economy where the cost of acquiring education benefits from public subsidies, which are partly financed through domestic taxes and partly through aid. Aid is subject to random shocks.
Using a combination of analytical derivations and numerical experiments, the key insights derived are as follows:
- By creating uncertainty about the net return to education, a high degree of aid volatility mitigates agents’ incentives to invest in skills.
- If savings and growth depend on the composition of the labor force, and if more skilled workers are more productive, aid volatility may therefore have an adverse effect on the mean growth rates of investment and output.
- Aid volatility is also bad for the welfare of skilled households (directly) and unskilled households (indirectly, through output volatility).
Aid volatility creates significant macroeconomic management challenges for recipient governments in low-income countries, whose ability to raise resources through domestic taxation and to borrow on domestic and international capital markets is limited. The education incentive-human capital and physical capital channels highlighted in this paper offer an alternative view regarding the potential impact of aid volatility on growth in low-income countries. When promised aid is not provided or when additional aid is disbursed unexpectedly, productive public spending may need to be adjusted abruptly with potentially large social and economic costs.
To improve aid predictability, two approaches can be considered. The first has been to urge recipients to protect themselves from fickle donors by saving aid windfalls in a reserve or stabilization fund. The second approach is to promote more stable donor-recipient relationships, that is, to encourage donors to move away from fragmented, conditionality-based funding and make multi-year pre-commitments, with appropriate safeguards, to ensure a longer time horizon (Eifert and Gelb (2006)).