European Journal of Political Economy 24 (2008) 661674

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European Journal of Political Economy

j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e j p e

Motivation for bilateral aid allocation: Altruism or trade benets

Javed Younas
Department of Economics, Central Michigan University, Mount Pleasant, MI 48858, USA

a r t i c l e

i n f o

a b s t r a c t
This paper argues that OECD countries allocate more aid to recipient nations who import goods in which donor nations have a comparative advantage in production. The estimates indicate that a substantially larger amount of aid is provided to recipients who import capital goods, while imports by other category groups have no signicant effects. Given that developed donor nations are major producers and exporters of capital goods, this result at least partially supports their trade benets motive. Donors also appear to be more concerned about alleviating physical miseries (infant mortality) and rewarding good human rights conditions, but less towards reducing economic hardships (poverty). Moreover, the usual political and strategic considerations of donors continue to be the major determinants of aid allocation even in the Post Cold War era. 2008 Elsevier B.V. All rights reserved.

Article history: Received 11 July 2007 Received in revised form 15 May 2008 Accepted 26 May 2008 Available online 6 June 2008 JEL classication: F35 O1 Keywords: Bilateral aid Imports Capital goods Comparative advantage

1. Introduction Ofcial Development Assistance (ODA), commonly known as foreign aid, includes loans, grants and technical assistance on concessional nancial terms with the objectives of reducing poverty and promoting economic development in developing countries.1,2 However, despite its continued use, the role of aid for reducing poverty and enhancing well-being remains controversial. An inuential past literature on aid allocation concludes that political, economic and strategic interests of donors rather than the development objectives play a dominant role in their aid allocation decision (McKinlay and Little, 1977, 1979; Maizels and Nissanke, 1984; Dowling and Hiemenz, 1985; Svensson, 1999; Neumayer, 2003a,b). More recent studies nd that colonial ties and countries supporting donor countries in the U.N. voting receive more aid (Alesina and Dollar, 2000; Kuziemko and Werker, 2006). Examining whether less corrupt government are rewarded with increase in bilateral aid, Alesina and Weder (2002) nd that corrupt governments receive as much aid as less corrupt governments. Concerning the question of allocation of aid and good policy environment, Burnside and Dollar (2000) nd no signicant effect of later on the former. In retrospect to the aid literature, the following statement in the Human Development Report of United Nations Development Program (2005) is also worth noting: International aid is one of the most powerful weapons in the war against poverty. Today that weapon is underused and badly targeted. There is too little aid and too much of what is provided is weakly linked to human development.3 Existing studies also demonstrate that a higher total exports of donor countries to the recipient countries results in greater aid allocation (Dudley and Montmarquette, 1976; Neumayer, 2003a). However, to our knowledge no study provides a systematic analysis of whether recipient nations imports, aggregated as well as disaggregated, have an impact on the ow of bilateral aid.
Tel.: +1 989 774 2969; fax: +1 989 774 2040. E-mail address: youna1j@cmich.edu. 1 ODA/aid does not include loans, grants, and credits for military purposes. 2 For example, see DAC guideline for poverty reduction at http://www.oecd.org/dataoecd/47/14/2672735.pdf. 3 UNDP (2005) p. 75. 0176-2680/$ see front matter 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2008.05.003

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Table 1 Export of major products under machinery and transportation equipment category by the developed countries Machinery and transportation equipment (SITC 7) Export share in world (%) 1990 Engines and motors Agriculture machinery (excluding tractors) Tractors (non-road) Civil engineering equipment Paper etc mill machinery Print and book binding machinery Food machinery (non-domestic) Machinery for special industries Metal working machinery Pumps for liquids, etc Mechanical handling equipment Non-electric machinery Ofce machines Telecom Electro-medical equipment Passenger motor vehicles (excluding bus) Lorries Railway vehicles Aircrafts, etc. Ships, boats, etc. Note: Data was taken from Handbook of Statistics, UNCTAD (2005). 97 91 84 87 94 97 92 88 87 95 92 95 83 76 98 95 94 75 94 78 1995 93 94 92 87 93 96 92 89 90 92 89 92 71 68 97 92 88 88 94 71 2000 96 93 91 85 93 94 90 87 86 90 89 89 66 67 93 88 82 85 92 64 2003 93 91 87 82 92 91 92 85 83 89 88 87 58 54 93 89 79 86 91 63

We argue that donor nations' motivation for providing aid also arises from their interest in acquiring a larger share of the recipient nations' imports. The economics of aid, therefore, constitutes a part of donor nations commercial strategy to secure a larger trade benets. Besides pursuing political and strategic objectives, donors also use aid as an instrument for improving goodwill while expecting that recipients will reciprocate by buying more of their products. This perspective is similar to a monopolistic rm's marketing strategy of expending resources on promotional activities such as advertising, public relations, coupons, free gifts and charity. On the other hand, aid may also be given as a reward to the recipient nations for promoting imports and removing trade restrictions. This implies that donors can inuence recipients to get preferential treatment on the goods imported from them without entering a formal trade agreement.4 The economic benets in terms of higher foreign reserves and growing domestic export industries are largest when recipient countries import goods in which donor countries have a comparative advantage in production. Since all donor nations are developed OECD countries in this study, they tend to have a comparative advantage in the production of capital goods, but not in consumption goods. Table 1 shows world export share of major products of developed countries under the machinery and transportation equipment category, UNDP (2005). It reveals that developed countries export a substantially higher share of capital goods and, therefore, capture a larger share of the world market in these products.5 We present the following reasons to support the preceding argument. First, capital goods constitute a high share (value) of recipient nations imports and are mainly produced in the developed donor countries. Second, inuencing recipient nations to increase imports of capital goods seems relatively easier as few countries specialize in their production.6 Lastly, donor nations may also inuence recipient nations to lower tariff on their imports. This paper provides a systematic analysis of bilateral aid allocation by rst developing a theoretical model to derive simultaneous optimization decisions of donors. To verify the predictions of the theoretical model, we empirically estimate the determinants of aid allocation by 22-Development Assistance Committee (DAC) member countries of OECD to seventy eight net aid recipient countries over the period 19912003.7 The remainder of the paper is organized as follows. The next section lays out a theoretical model and some predictions. Section 3 describes the empirical methodology and data. Section 4 presents the estimation results including some sensitivity analysis and Section 5 concludes.

4 Studying trade agreements, Bagwell and Staiger (2001) argue that governments enter into reciprocal and mutually advantageous agreements to obtain a reduction of tariff and other trade barriers to expand their production and trade. They further state that such agreements are attractive as a means to achieve political objectives. 5 Table 4 shows that this share has witnessed some decline for a few products (ofce machines, telecom, lorries, ships, etc) which suggests that other countries also started specializing in their production. 6 Market for agricultural products (food items, agriculture raw material, etc) is considered to be fairly competitive. However, there may be a sufcient degree for market power in promoting manufacturing goods (particularly capital goods) because of specialization in their production and, therefore, exports by relatively few countries. 7 See Appendix A and B for the list of the 22-DAC countries and the seventy eight net aid recipient countries in our sample, respectively. Since containment of communism rather than development concerns was a major factor for providing aid during the Cold War era (see Boschini and Olofsgrd, 2007), we limit our analysis to the Post Cold War period. Another constraint was the non-availability of consistent yearly data for majority of developing countries on import by category groups prior to the 1990s.

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2. Theoretical model and predictions We extend Dudley and Montmarquette's (1976) model of a single donors bilateral aid allocation to one that combines aid from multiple donors. To our knowledge, previously Trumbull and Wall (1994) and Wall (1995) extended that model, and we also follow similar approach in the theoretical framework. However, they combine total ODA from all sources (bilateral and multilateral) for formulating a single donors objective function, while we do that by combining ODA from 22-DAC countries, which is more appropriate for the objective of our study. In this model, we assume that the objective of each donor is to maximize the utility based on the subjectively measured impact of aid on the well-being of the recipient nations residents. Therefore, a single objective function of the impact of aid from all j donors to m recipients is formalized. We assume that all donors pool their aid budget and a representative donor decides how much of that is to be allocated to a recipient every year. Supposing that aid is put into good use by the recipients and ignoring time subscripts for now, we can set up the objective function as follows: H wi hi wi hi ai ; yi ; ni ; mi ; pi
i1 i1 m m

i = 1,, m (the recipient countries) where, H = subjectively measured impact of aid on a recipient country hi = subjectively measured impact of aid on identical residents of a recipient country ai = aid per capita received by a recipient country yi = income per capita of a recipient country ni = population size of a recipient country mi = (vector of) imports, aggregated as well as disaggregated, of a recipient country pi = political liberties and civil rights in a recipient country wi = weights measuring importance of a recipient country in the eyes of donors The impact of aid is an increasing function of the aid per capita that a recipient nation receives. The impact of aid on income per capita depends whether it is a substitute of or complement to income per capita. They will be substitutes, if compassion or altruism is the driving force. In this case, more aid is given when per capita income falls. Otherwise, they are complements. Among other reasons, self-interest motives that tie developed and developing economies together may justify such behavior. Past studies nd a bias in aid allocation against countries with larger populations (Isenman, 1976; Dowling and Hiemenz, 1985; Trumbull and Wall, 1994; Wall, 1995; Alesina and Dollar, 2000; Bandyopadhyay and Wall, 2007). The literature offers the following explanations that consider both supply side and demand side factors: (1) the marginal impact of aid decreases as population increases; (2) high population countries lack administrative expertise to absorb large amounts of aid; and (3) it is relatively easier for donors to wield political inuence over a smaller country than a large country. We assume that donors' strategy of improving goodwill through the regular supply of aid aims to inuence recipient nations' to import goods in which donor countries have a comparative advantage in production, as argued in Section 1. Therefore, if goodwill has a positive inuence on the recipients' demand for imported goods in general and capital goods in particular, then the subjective impact of aid on imports is positive. Moreover, aid may also be given as a reward for promoting imports and following policies to liberalize trade. However, the reward can be signicant if donors are major beneciaries of trade policies of the recipient nations. The human rights variable captures the donor's perception about the objective function of the recipient government. If a recipient (government) values human rights, it is perceived to put a higher weight on the welfare of its people. In turn, it is likely that it will utilize the aid to improve their well-being. Furthermore, donors may provide more aid to the recipient nations showing greater respect for human rights because of their perception that the subjective impact of aid is higher when donors and recipient nations share common human values, Wall (1995). Following Trumbull and Wall (1994), we also assume that given the total budget of aid, donors maximize the weighted sum of the total impact of aid to a recipient each year. The weights reecting the importance of a recipient in the eyes of donors are determined by its colonial history, cultural afnity, political and strategic values, geographic location, etc. The above noted postulation can mathematically be expressed as follows: AH AH AH AH AH AH N 0; b 0 or N 0; V 0; N 0; N0 Aai Ayi Ayi Ani Ami Api Taking a specic functional form for hi: hi ai ; yi ; ni ; mi ; pi a m pi i i n y i i

0 b b 1, 0 b b 1, 0 b b 1, 0 b 1, 0 b || b 1.

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Aid and income per capita are considered substitutes if is positive, and complements if is negative. The total impact of aid as the sum of the impact on identical residents of a recipient country can be written as: H wi hi ai ; yi ; ni ; mi ; pi ni wi
i1 i1 m m

a m pi i i n y i i

! ni 4

As noted above, we express the supply behavior of aid from multiple donors as an impact maximization problem of the single donor where all donors pool their budget for aid. Thus, budget constraint of the jth donor takes the following form: ai ni B:
i1 m

Therefore, the maximization problem can be written as follows:

m m max H wi hi ai ; yi ; ni ; mi ; pi ni s:t: ai ni B ai i1 i1

Substituting Eq. (4) in Eq. (6) to set up the Langrangian and deriving rst order conditions gives: L wi
i1 m

a m pi i i n y i i

  m ni B ai ni
i1

a1 m p AL wi i 1 i i ni 0 Aai ni yi
m AL B ai ni 0: A i1

is the marginal impact of aid. The rst order conditions take the following forms: wi
m a1 m pi i i and B ai ni n y i1 i i

10

Solving Eq. (10) to get the optimal allocation of aid per capita, a, as: i a i m p wi i i ni yi

1 !1

11

Taking the natural log and introducing an error term, we write Eq. (11) as following: lna 0 i t 1 lnyi 2 lnni 3 lnmi 4 lnpi eit : i 12

Thus, the decision of aid allocation each year is determined by the factors that inuence the perceived impact of aid. Considering that information about the recipients is available to donors with some time lag, we introduce a 1 year lagged time subscript for all right hand side variables in the Eq. (12).8 Therefore, the basic econometric model takes the following form: lna 0 i t1 1 ln yi;t1 2 ln ni;t1 3 ln mi;t1 4 ln pi;t1 eit it where, 0 1=1 ln; i 1=1 lnwi ; t1 1=1 ln ; t1 1 =1; 2 =1; 3 =1; 4 =1: As mentioned above, mi is a vector of a recipient nation's import variables containing aggregated as well as disaggregated goods by their individual commodity groups. The model in Eq. (13) predicts that higher total imports positively affect the allocation of aid per capita. A disaggregated analysis of imports shows the impact of imports of goods by their individual category group on aid per 13

8 The lagging of independent variables also reduces potential problem of simultaneity and contemporaneous correlation in the empirical model. Moreover, all estimates are calculated using robust standard errors techniques. Section 3 provides detailed discussion on this issue.

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capita. It is expected that, relative to others the imports of manufacturing goods, particularly capital goods, will have a greater impact on allocation of aid per capita by the donors, as argued in Section 1. The predictions about other variable are noted above. Eq. (13) also includes a period effect, t 1, that is common to all countries within a given year and i that determines the weights attached to each recipient nation (details to follow in Section 3). 3. The empirical methodology and description of data 3.1. The methodology We use various model specications by simultaneously controlling for altruistic as well as self-interest motives of donors, i.e., their economic, political and strategic considerations. This approach aims to correct the ad hoc econometric treatment and to appropriately assess the determinants of bilateral aid allocation. Regarding the choice of the model that ts the data well, we prefer using the pooled ordinary least squares (POLS) for deriving estimation results. The main appeal for using POLS model is that the impacts of recipient-specic and time-invariant variables which measure the political and strategic considerations for aid allocation can also be estimated. Moreover, POLS also provides a relatively precise measure of variables such as political rights and civil liberties that witness little variation over time.9 Before proceeding to estimations, we address the possibility of potential simultaneous causation between independent variable (aid per capita) and two independent variables (income per capita and imports). One may argue that income per capita and imports may be endogenous as they not only affect but may also be affected by the ow of aid.10 This may require a simultaneous estimation technique such as two-stage least squares (2SLS). However, the problems with 2SLS are the non-availability of valid instruments and their data for developing countries. Moreover, employing weak instruments can contaminate estimation results. Wooldridge (2003, p.541) states that if we assume that error term it is uncorrelated (a standard assumption) with all past endogenous and exogenous variables, then lagged endogenous variables in simultaneous models are treated as predetermined variables and they are uncorrelated with it.11 Therefore, we use a 1 year lagged value for all independent variables in our econometric model. This technique also makes more economic sense as information to the donors about a recipient is only available with some time lag. The sample includes countries that received positive amount of aid each year with the exception of only ve countries who received no aid for only 1 year out of the 12 years sample period. Dollar and Levin (2004), using log-log model for aid allocation, substitute a very small value (0.01 million) for a country not receiving aid from a donor in any year. We follow this approach for those ve countries in the sample. Per capita income may be an inadequate reection of economic needs for aid, especially in view of high income inequalities in several recipient countries. This prompted our use of the infant mortality rate, which relates to the concept of individual wellbeing.12 Moreover, Per capita income captures economic need while infant mortality signies physical need (Trumbull and Wall, 1994; Wall, 1995; Bandyopadhyay and Wall, 2007). Bandyopadhyay and Wall (2007) state that though economic and physical needs are clearly correlated in the long run, they do not necessarily move in the same direction over shorter period of time. In addition, we also include multilateral real aid per capita to a recipient country as an additional explanatory variable. Since multilateral aid adds to a recipients total aid, the bilateral aid may loose its importance. In this case, a recipient feels less constrained to import goods from bilateral donor countries or concur to their political and strategic concerns. The sign and signicance of the coefcient on multilateral aid will show whether bilateral donors try to maintain their inuence on the recipients who also receive more aid from multilateral agencies.13 To analyze whether donor nations provide more aid to recipient nations importing more goods in general or to those who have a tendency to import specic goods by individual category groups, we initially include import share of manufacturing goods and agricultural products in the regressions. Additionally, we subdivide manufacturing goods into basic manufacturers and machinery and transportation equipment.14

9 It is worth noting that including xed effects for all the countries at the cost of being able to estimate recipient-specic considerations such as colonial history, geographical location, cultural afnity and other politico-strategic concerns does not qualitatively change the basic pattern of our ndings. In addition, we also tried regressions by controlling for regional dummies. However, the results of our variables across all models remained robust with their inclusion. 10 Since the literature on aid consistently shows that aid does not cause growth, there is little reason to believe that there would be reverse causation from aid to income per capita or imports. It is also worth noting that if there is a strong enough endogeneity bias then we might observe positive relationship between aid per capita and income per capita. However, we nd negative relationship across all models. Moreover, using imports as share of GDP and individual imports category as share of total imports further reduces any potential endogeneity bias. 11 Maizels and Nissanke (1984), while citing Maddala (1977), state that, all estimation techniques, including 2SLS, are designed to deal only with the contemporaneous simultaneity and the lagged endogenous variables are treated in simultaneous models as predetermined variables along with other exogenous variables in the system. Therefore, if aid ows can be assumed to affect a countrys economic performance with some time lag, the problem of simultaneous bias is considerably lessened and the necessity of using 2SLS instead of OLS is accordingly greatly diminished. 12 The World Bank Report (2006) denes infant mortality rates as the number of infants dying before reaching one year of age per 1000 live births in a given year. 13 The multilateral aid is given by the World Bank, the IMF and the UN including their regional branches. We are thankful to an anonymous referee for providing insight for including multilateral aid in the regression. 14 Manufacturing goods include basic manufacturer goods, machinery and transportation equipment and chemical products. Agricultural products include all food items, agricultural raw material and ores and metals.

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Fig. 1. Distribution of average real aid (19922003).

Since most explanatory variables vary across a wide range (such as population size, per capita income, infant mortality, human rights and imports by individual category groups), and also exhibit skewed distributions, we prefer to take natural log of all variables, except dummy variables. Log-log model also helps to reduce the outlier effects on estimations, and with that resulting coefcients can be interpreted as elasticities. However, the sign and magnitude of the coefcients on the dummy variables can provide an idea about their impact on aid. Moreover, we also carry out Akaike Information Criterion (AIC) test to ascertain the relative performance of the estimated models. A lower value of AIC is associated with an efcient model. 3.2. Description of data The data for net ODA from 22-DAC member countries of OECD to seventy eight recipient countries is taken from International Development Statistics (2005). This data contains aid for development purposes and does not include grants, loans, and credits for military purposes. Following Neumayer (2003a,b,c), we converted aid data into constant US$2000 using the unit value of the world import price index, and then divided by the recipient nations' population to express the dependent variable as real aid per capita. This serves best with the scope of this study because real aid per capita can be expressed in terms of its purchasing power for a representative bundle of imports.15 Moreover, such a dependent variable also controls for a recipient's size effect. Data for income per capita as measured by GDP per capita (purchasing power parity) constant US$2000, population, and infant mortality rates is taken from the World Bank Development Indicators (2006) CD Rom.16 For the human rights measure, we have used indices for political rights and civil liberties produced by Freedom House (2005). Political rights refer to the freedom of people to participate in the political process by exercising their voting right, being able to organize political parties to compete for public ofce, and forming an effective opposition and electing representatives who devise public policies and are accountable for their actions. Civil liberties entail freedom of expression and religious belief, the prevalence of rule of law, right to form unions, freedom to marry, and freedom to travel. It also signies the autonomy of people without interference from the state. These two indicators are derived from a cross country survey every year. Each of these indices is measured on a 1 (best) to 7 (worst) points scale. Following Trumbull and Wall (1994), Wall (1995) and Neumayer (2003a), we have constructed a combined freedom index by adding indices of political rights and civil liberties and then reverting that index, such that it ranges from 2 (worst) to 14 (best). Total imports are measured as a ratio to GDP. We use the Standard International Trade Classication (SITC) of UNCTAD (2005) to segregate imported goods by their individual category groups. As noted above, we initially divide total imports into manufacturing goods and agricultural products, both as a ratio to total imports. Later we further subdivide manufacturing goods into basic manufacturers and machinery and transportation equipment.17 We also control for the political and strategic values of a recipient nation in the eyes of donors. Existing literature provides some guidance in identifying those variables. Dummies for Israel and Egypt have been included as past studies nd that they receive signicantly greater proportion of aid due to their political and strategic importance in the Middle East (Alesina and Dollar, 2000; Burnside and Dollar, 2000). We also examine whether colonial experience of a recipient has an inuence on aid allocation as past studies nd that donors give more aid to their past colonies (Alesina and Dollar, 2000; Neumayer, 2003a). Information about a recipient's colonial history is taken from the CIA World Factbook (2006) and used as a dummy variable taking a value of 1 if a recipient had been a colony of any of the donors in our study, or 0 otherwise. Fig. 1 illustrates the distribution of average real aid per year over the period 19922003. The mean country in our sample received $259.5 million, while the median country (Guinea) received only $147 million, reecting that aid was skewed towards

The estimation results using GDP deator at constant US$2000 for converting aid into real term are similar. There are some missing data values for some countries for infant mortality rates. Since infant mortality rates change slowly over time, values for missing observations are interpolated by calculating averages from available values. 17 Basic manufacturer goods mainly include products such as leather, textile, rubber, iron, steel, and non-metallic mineral manufacturers. Machinery and transportation equipment include capital/investment goods such as power generating machinery and equipment, industrial and telecommunication machinery, and vehicles including aircrafts, railways and ships. Agricultural products include food items, agricultural raw material including live animals and ores and metals.
16

15

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Fig. 2. Distribution of average real aid per capita (19922003).

a top few countries. While a few countries received a signicantly large proportion of aid (China, $1630 million; Egypt, $1524 million; Indonesia, $1390 million; Israel, $994 million; Poland, $928 million), ten countries in the sample received less than $10 million on average. Fig. 2 shows the distribution of average real aid per capita per year over the same period. The mean country received $25 while the median country (Togo) received only $14. Israel stands at the top with $175 which is $50 higher than the second highest recipient country (Dominica $125). On the other hand, among the ve highest aid per capita recipients, Israel has the highest average real income per capita ($22,194) per year during our sample period, followed by Seychelles ($15,338), Suriname ($6210), Dominica ($5139) and Nicaragua ($3258). At the other extreme, seven countries with average real income per capita below $1450 received less than $10 real aid per capita on average.18 Fig. 3 illustrates the correlation between real aid per capita and some of the key explanatory variables. Panel 1 shows that most of the aid is concentrated towards the countries with lower levels of income per capita and countries with higher income per capita receive very little aid. However, a few countries with signicantly higher income per capita in our sample received a larger amount of aid, as noted above. Panel 2 suggests a positive correlation of aid per capita with the infant mortality rates. Panel 3 shows the correlation between aid per capita and population, suggesting that aid is mostly concentrated towards less populated countries. Panel 4 illustrates that there is a general positive correlation between aid per capita and human rights, which is pretty evenly distributed across countries. The correlations between aid per capita and ratio of total imports to GDP, and that with manufacturing imports to total imports appears to be positive (panels 5 and 6). 4. Estimation results Although the aid distributions and correlations discussed above provide some insight about donors behavior for aid allocation, they are inadequate for drawing a reasonable conclusion.19 Therefore, we need to simultaneously control all explanatory variables in the regressions to nd their individual effects on aid per capita.20 To compare our results with previous ndings, we initially include variables that were commonly examined in the previous literature (Maizels and Nissanke, 1984; Dowling and Hiemenz, 1985; Trumbull and Wall, 1994; Wall, 1995; Alesina and Dollar, 2000; Neumayer, 2003a,b,c). Qualitatively, our ndings largely support previously established results (Table 2, column 1). A signicant and negative coefcient on population variable suggests that donors perceive a diminishing marginal impact of aid as the population of a recipient nation increases, indicating a bias against larger countries. Both income per capita and infant mortality appear to be important indicators of well-being. A signicant and negative coefcient on income per capita suggests that aid is given as a substitute of economic well-being. All else equal, a 10% decrease in income per capita leads to a 1.9% increase in aid per capita, while a 10% increase in infant mortality is associated with a 3.5% increase in aid per capita. These initial ndings suggest that donors care about the economic and physical well-beings of the residents in the recipient nations. A greater respect for human rights by the recipients, as reected by positive and signicant coefcient on political & civil rights variable, results in receiving more aid. The positive and signicant coefcient on multilateral aid per capita suggests that donor countries, in order to maintain their inuence, provide more aid to the recipients who also receive more aid from multilateral agencies.21 The signicant coefcients on dummy variables for Israel and Egypt suggest that they receive a great deal of aid, likely

Those countries are Bangladesh, Burundi, Ethiopia, Kenya, Nepal, Togo and Yemen. The correlations among majority of the independent variables are not very high with the exception of one between real income per capita and infant mortality rates, and another between real income per capita and real total reserves per capita. To check whether multicollinearity poses a problem for the estimations, the eigenvalues for correlations among explanatory variables were tested and found to be low. Moreover, past studies also routinely include income per capita and infant mortality rates in the same regression, suggesting that they provide different information for aid allocation behavior of the donors. 20 All regressions are estimated with heteroscedasiticity-robust standard errors using Huber-White sandwich estimator technique. Liug-Box Q-statistics rejects the presence of autocorrelations and partial autocorrelations in the residuals. 21 Since bilateral donor countries provide funds to multilateral agencies such as World Bank, IMF, the U.N., etc, their likely inuence over the aid allocation decisions of these agencies may also be a factor causing this result.
19

18

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Fig. 3. Correlations of real bilateral aid per capita and the key explanatory variables (country averages).

due to their political and strategic importance in the Middle East.22 The former colonies are also rewarded with more aid due to their historical and political link with their respective donors. Though these results largely support previous ndings, we need to include the key variables of interest for this study which are recipients imports by its individual category group to assess their impact on aid. Later, we also include other control variables to check the robustness of our results. First, total imports as a ratio to GDP of a recipient is included in the regressions to see whether donor countries respond to higher imports in general (column 2). However, its coefcient is statistically insignicant. Next, we include two broader imports categories in the regression: manufacturing goods and agricultural products, both as a ratio to total imports.23 Column 3 shows that the estimated coefcient on manufacturing imports is positive and signicant at the 5% level, indicating that donors provide more aid to the recipients importing more of manufacturing goods. All else equal, a 10% increase in manufacturing imports results in a 5.8% increase of bilateral aid per capita. On the other hand, agricultural imports have no signicant impact on aid. The results for all other variables remain about the same except that sign and signicance of the coefcient on income per capita has dropped, while the one for infant mortality has increased. This regression explains about 48% of the variance in bilateral aid per capita. The regression results above show that donors provide substantially larger amount of aid to the recipient nations' importing manufacturing goods. Since capital goods constitute a signicantly larger share (value) of manufacturing imports, donors seem to have their economic interest in encouraging their imports through aid as high valued added manufacturing goods are typically produced/exported by the donors (see Table 1). Irrespective the self-interest of donors in promoting import of manufacturing goods, the recipient nations also gain as imports of those goods help increasing their production (and consumption) and they also receive a larger amount of aid. Further, we divide manufacturing imports into two category groups: (1) basic manufacturing, and (2) machinery and transportation equipment. The estimated coefcient on machinery and transportation equipment is positive and signicant at 1% level, while the coefcient on basic manufacturing goods is insignicant (column 4). This result further supports our hypothesis
22 23

We also tried regressions by excluding Israel and Egypt from our sample. However, qualitatively the results remain about the same. We dropped from the regressions the imports of fuel, chemical products, and goods falling under unallocated category to deal with the problem of multicollinearity among import variables. Moreover, we choose to drop only those imported goods that are least relevant to the argument we make in the paper above.

J. Younas / European Journal of Political Economy 24 (2008) 661674 Table 2 Dependent variable: Bilateral real aid per capita Independent variables Population Income per capita Infant mortality Pol. & civ. rights Multilateral aid per capita Imports/GDP Mfr. imports/imports B. mfr. imports/imports M&TE imports/imports Agr. imports/imports Reserves per capita Distance Domestic PP (per dollar) Israel Egypt Colony Muslim Roman Catholic R2 Observations AIC (1) 0.222 (7.17) 0.190 (2.58) 0.350 (3.38) 0.353 (4.09) 0.281 (7.26) 3.843 (12.38) 1.402 (17.57) 0.201 (2.07) 0.476 936 2918.2 (2) 0.203 (6.37) 0.148 (1.99) 0.434 (3.65) 0.380 (4.30) 0.279 (7.11) 0.206 (1.38) 3.873 (12.52) 1.401 (17.67) 0.171 (1.74) 0.477 936 2918.3 (3) 0.227 (6.80) 0.166 (2.15) 0.507 (4.08) 0.356 (3.82) 0.289 (7.31) 0.148 (1.33) 0.578 (2.37) 0.152 (1.12) 3.840 (12.02) 1.583 (13.98) 0.167 (1.68) 0.483 936 2912.5 (4) 0.237 (7.11) 0.220 (2.71) 0.423 (3.30) 0.392 (4.36) 0.301 (7.16) 0.098 (0.98) 0.198 (1.24) 0.413 (2.76) 0.073 (0.56) 4.023 (12.14) 1.562 (13.65) 0.176 (1.80) 0.490 936 2909.2 (5) 0.245 (6.01) 0.176 (1.94) 0.393 (2.92) 0.416 (4.44) 0.288 (6.00) 0.122 (1.02) 0.201 (1.26) 0.504 (3.01) 0.025 (0.17) 0.074 (1.26) 0.037 (0.34) 0.009 (0.47) 4.049 (12.36) 1.598 (12.29) 0.198 (1.79) 0.491 936 2912.8 (6)

669

0.209 (4.99) 0.156 (1.71) 0.460 (3.25) 0.274 (2.83) 0.290 (5.94) 0.269 (2.09) 0.182 (1.18) 0.431 (3.91) 0.008 (0.05) 0.063 (1.05) 0.031 (0.29) 0.007 (0.36) 4.253 (12.85) 1.578 (12.27) 0.259 (2.77) 0.055 (0.57) 0.391 (3.64) 0.510 936 2897.3

Note: Estimated with heteroscedasticity-robust standard errors. Year dummies included but not reported. Columns 1 through 4 test basic model while columns 5 and 6 include additional control variables for testing robustness. Absolute t-values are shown in parentheses. Superscripts , and indicate signicance at 1, 5 and 10% levels, respectively. Pol. & Civ = Political and Civil; Mfr = Manufacturing; B = Basic; M&TE = Machinery & Transportation Equipment; Agr = Agricultural.

that donors seek to increase their trade benets by encouraging the imports of goods typically produced by them. Aid seems to be used as an instrument by donors to improve their goodwill so that the recipients confer economic benets by buying more of their products. The course of cultivating friendship and improving goodwill continues even if a recipient imports less from a donor in any year. Therefore, it does not matter how much a recipient currently imports from a donor. Instead, donors provide aid every year and gradually improve their goodwill with the expectations that the recipients demand more of their products in future. 4.1. Sensitivity analysis To test the robustness of the results, we include additional control variables expected to have inuence on the aid allocation behavior of donors. Therefore, we include three variables in the regression: log of real total reserves per capita, log of air distance (in kilometers), and log of real domestic purchasing power per dollar.24,25,26 Although the signs with their coefcients are as expected, but they are insignicant (column 5). However, inclusion of these control variables yields two interesting changes in our
24 Total reserves of a country include monetary gold, special drawing rights, reserves with IMF, and foreign exchange holdings with monetary authorities. Its data was taken from WDI (2006) CD Rom and transformed into constant US$2000 by using the unit value of world import index and then divided by a recipients population to express as real total reserves per capita. 25 Geographical proximity is measured as the minimum air distance, in kilometers, of a recipient country from New York, Rotterdam, and Tokyo. Its data was taken from Gallup and Sachs (1999). Following Neumayer (2003a,b,c), we used existing data for a geographically close country (neighboring), if distance data for a particular country is not available. 26 Purchasing power conversion factor is a dollar equivalent units of domestic currency required to buy the same amount of goods and services that a dollar will buy in U.S. Its data was taken from WDI (2006) CD Rom and converted into a real term by using the consumer price index base year 2000 for a recipient.

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Table 3 Dependent variable: bilateral real aid per capita Independent variables Population Income per capita Infant mortality Pol. & civ. rights Multilateral aid per capita Imports/GDP Mfr. imports/imports B. Mfr. imports/imports M&TE imports/imports Agr. imports/imports Reserves per capita Distance Domestic PP (per dollar) Israel Egypt Colony Muslim Roman Catholic R2 Observations AIC (1) 0.186 (4.47) 0.141 (1.35) 0.341 (2.28) 0.320 (2.46) 0.344 (6.33) 3.914 (11.75) 1.360 (12.97) 0.192 (1.32) 0.563 312 873.9 (2) 0.163 (3.71) 0.088 (0.80) 0.449 (2.58) 0.357 (2.68) 0.340 (6.15) 0.186 (1.13) 3.949 (12.00) 1.359 (12.86) 0.155 (1.05) 0.564 312 874.4 (3) 0.187 (3.88) 0.104 (0.95) 0.536 (2.98) 0.327 (2.29) 0.355 (6.35) 0.191 (1.10) 0.710 (2.01) 0.162 (0.76) 3.922 (11.51) 1.563 (9.32) 0.146 (0.97) 0.572 312 873.0 (4) 0.200 (4.17) 0.164 (1.39) 0.426 (2.24) 0.361 (2.63) 0.377 (6.21) 0.119 (0.70) 0.291 (1.13) 0.452 (1.99) 0.095 (0.47) 4.153 (11.25) 1.540 (9.41) 0.160 (1.10) 0.577 312 871.8 (5) 0.196 (3.27) 0.109 (0.81) 0.361 (1.92) 0.390 (2.64) 0.370 (5.22) 0.176 (0.92) 0.293 (1.10) 0.543 (2.01) 0.005 (0.02) 0.083 (0.96) 0.041 (0.26) 0.010 (0.32) 4.185 (11.41) 1.589 (8.35) 0.146 (1.01) 0.578 312 876.7 (6) 0.157 (2.51) 0.085 (0.62) 0.433 (2.20) 0.238 (1.69) 0.368 (5.26) 0.336 (1.68) 0.275 (1.05) 0.420 (1.99) 0.028 (0.12) 0.069 (0.80) 0.050 (0.33) 0.007 (0.23) 4.391 (11.92) 1.561 (8.20) 0.214 (1.51) 0.062 (0.45) 0.392 (2.61) 0.591 312 870.3

Note: Estimated with heteroscedasticity-robust standard errors. Year dummies included but not reported. Columns 1 through 4 test basic model while columns 5 and 6 include additional control variables for testing robustness. Absolute t-values are shown in parentheses. Superscripts , and indicate signicance at 1, 5 and 10% levels, respectively. Pol. & Civ = Political and Civil; Mfr = Manufacturing; B = Basic; M&TE = Machinery & Transportation Equipment; Agr = Agricultural.

results: First, the signicance of coefcient on income per capita drops. Second, the coefcient on machinery and transportation equipment becomes more signicant and also increases by 22% (from 0.41 to 0.50). This suggests that, all else equal, donors are more interested in increasing their trade benets and less towards responding to adverse income shocks in the recipient countries. This result also conrms that gaining trade benets are at least a partial motivation behind aid allocation. Following Alesina and Dollar (2000), we also consider that cultural afnity, as proxied by religious differences, may have an impact on aid allocation. To do this we use a dummy variable value of 1 if the majority of a recipient nations' population is of Catholic faith or 0 otherwise. We follow the same for Muslims. While the coefcient on the Catholic is positive and signicant, it is insignicant for the Muslim (column 6), indicating that religion may have a role in aid ows, as recipient nations with a Catholic majority receive more aid. It may be noted that Alesina and Dollar (2000) do not nd a signicant effect of Catholic or Muslim majority population of the recipients on aid. The difference of this result may be attributable to the analysis of different time period as our study completely focuses aid allocation in the Post Cold War era, while their sample period mostly includes observations during the Cold War period. However, this result is no way conclusive and needs to be analyzed under domestic political economy framework in a separate study. The coefcient on the variable of total import to GDP ratio becomes signicant, suggesting that bilateral aid is positively related to total imports of a recipient country. Moreover, the size of the coefcient on political & civil rights variable also drops substantially. However, the sign, size, and signicance of all other variables remain about the same. This regression explains 51% of the variance in bilateral aid per capita, indicating a better t among all other regressions. Moreover, lowest AIC value of this regression also suggests that it is a more efcient model. We also consider nding the estimation results by taking 3-year averages of the data which is aimed to reduce the effect of unusually high or low levels of aid allocation as donors may lack information about a recipient in any 1 year. The estimation results are presented in Table 3. Interestingly, the coefcient on income per capita not only drops substantially but also becomes insignicant in all

J. Younas / European Journal of Political Economy 24 (2008) 661674 Table 4 Dependent variable: Real aid per capita from individual donor countries Independent variables Population Income per capita Infant mortality Pol. & civ. rights Multilateral aid PC Other bilateral aid PC Imports/GDP B. mfr. imports/imports M&TE imports/imports Agr. imports/imports Reserves per capita Domestic PP (per dollar) Colony Muslim Roman Catholic Israel Egypt Adjusted R2 Observations Canada 0.199 (4.78) 0.100 (0.72) 0.173 (1.17) 0.193 (1.49) 0.101 (2.21) 0.365 (6.03) 0.512 (4.01) 0.126 (3.41) 0.109 (2.91) 0.029 (0.86) 0.241 (3.88) 0.087 (3.50) 0.264 (2.10) 0.440 (3.37) 0.544 684 France 0.335 (5.48) 0.082 (0.40) 0.347 (1.29) 0.022 (0.16) 0.134 (2.22) 0.222 (3.20) -0.219 (0.97) 0.378 (4.67) 0.225 (2.81) 0.147 (1.76) 0.083 (0.93) 0.027 (0.79) 1.144 (4.45) 0.186 (1.09) 0.565 (2.85) 0.531 672 Germany 0.034 (0.59) 0.838 (5.51) 0.284 (1.72) 0.096 (0.64) 0.013 (0.21) 0.550 (7.36) 0.292 (1.68) 0.193 (1.87) 0.196 (1.99) 0.086 (1.42) 0.183 (2.23) 0.002 (0.04) 0.278 (1.52) 1.198 (7.37) 0.367 720 Japan 0.141 (2.01) 0.156 (0.54) 0.347 (1.01) 0.259 (1.33) 0.293 (3.01) 0.216 (2.91) 0.015 (0.06) 0.093 (1.01) 0.368 (2.88) 0.059 (1.37) 0.029 (0.33) 0.015 (0.37) 0.0785 (0.37) 0.022 (0.10) 0.241 648 U.K. 0.007 (0.12) 0.321 (1.94) 0.732 (3.59) 0.340 (2.32) 0.100 (1.69) 0.278 (4.49) 0.917 (4.03) 0.079 (0.80) 0.753 (6.92) 0.086 (1.22) 0.019 (0.24) 0.134 (3.98) 1.833 (11.91) 0.612 (3.52) 0.710 (3.55) 0.556 720 U.S.

671

0.063 (0.60) 0.284 (1.26) 0.566 (2.03) 0.045 (0.23) 0.350 (3.71) 0.522 (6.18) 0.711 (3.00) 0.088 (1.01) 0.027 (0.31) 0.132 (1.44) 0.270 (3.34) 0.111 (2.34) 0.137 (0.75) 0.942 (4.31) 8.267 (9.83) 2.022 (6.57) 0.470 528

Note: Estimated with heteroscedasticity-robust standard errors. Year dummies included but not reported. Absolute t-values are shown in parentheses. Superscripts , and indicate signicance at 1, 5 and 10% levels, respectively. Pol. & Civ = Political and Civil; Mfr = Manufacturing; B = Basic; M&TE = Machinery & Transportation Equipment; Agr = Agricultural.

regressions. This suggests that over the long-run, donors show minimum interest in reducing economic hardships and poverty in the poor recipient countries. Moreover, the impact of political rights and civil liberties on aid allocation also decreases (column 6). The sign and signicance of all other variables remain about the same as in the regressions using yearly data.27 These nding, combined with the ndings of donors self-interests, may help to understand why foreign aid remains ineffective in promoting economic growth and development in the aid-receiving countries, as concluded by most inuential aid studies (Alesina and Dollar, 2000; Alesina and Weder 2002; Boone 1996; Burnside and Dollar, 2000). In a comprehensive analysis of aid effectiveness literature, Doucouliagos and Paldam (2008) conclude that development aid has failed to achieve its stated objectives of improving growth and living standard in developing countries. The ineffectiveness of aid has also been attributed to poor governance mechanism, corruption of ruling elites and aid fungibilitiy issues in the recipient countries. Our results indicate that the failure of bilateral aid also lies in the fact that donor countries, while allocating aid, attach greater priorities to their economic and political self-interests rather than to increasing development in developing countries. 4.2. Estimations by individual donor countries Although the results of aggregate bilateral aid from 22-DAC countries suggest that aid ows are largely determined by the commercial and strategic self-interests of donors. However, those considerations for aid allocation may vary for an individual donor country. A recipient receiving aid from several sources might feel less constrained to import goods from a donor country.

27 Note that the regression in column 6 in Table 3 explains 59% of variance in the bilateral aid per capita. Its lowest AIC value also suggests that among all others this model is relatively more efcient.

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Therefore, at the margin, the effect of donor's goodwill to inuence a recipient can be lower than expected. Realizing the diminishing marginal impact of goodwill, a donor country may increase aid allocation to a recipient getting more aid from other donor countries as well as multilateral agencies. Fortunately, bilateral import data by category groups on yearly basis exist for a majority of recipient countries in our sample from the top six individual bilateral donors, i.e., Canada, France, Germany, Japan, United Kingdom and United States. Aid from these countries accounts for more than 70% of total bilateral aid. For measuring aid concentration, we have added two variables which are total bilateral aid from other countries and total aid from multilateral agencies, both as per capita. Table 4 shows the estimation results. The regression results largely substantiate the ndings for aggregate bilateral aid (Tables 2 and 3). Except for United States, all individual donors provide more aid to the recipients importing machinery and transportation equipment from them. For United States, political and strategic concerns appear to be stronger than economic gains from aid allocation.28 Moreover, individual donor countries, in order to maintain their inuence, appear to provide larger amount of aid to a recipient receiving more aid from other bilateral donor countries and/or multilateral agencies. Canada, France and Germany also provide more aid to recipients who import basic manufactured goods from them. However, imports of agricultural products have no signicant effect on aid allocation by any of these donor countries. Another interesting nding is that, except Germany and United Kingdom to some extent, no other individual donor country seems to care about adverse income shocks in poor countries. On the other hand, only United Kingdom and United States appear to concern about alleviating physical miseries (increasing infant mortality rate). Moreover, all individual donor countries, in order to maintain their inuence, provide larger aid to a recipient also receiving more aid from other bilateral donors and/or multilateral agencies. The larger size and signicance on dummy variables for colonial history, Israel and Egypt suggest that usual political interests dominate aid allocation decisions of these donor countries.29 Interestingly, except Japan, all others provide more aid to the recipient with majority of Roman Catholic population, while United Kingdom appears to provide less aid to the Muslim majority recipient countries. However, this nding is not conclusive and needs to be investigated in a separate study. 5. Conclusion This paper argues that bilateral aid from developed OECD countries is disproportionately allocated to recipient nations who have a greater tendency to import goods in which donor nations have a comparative advantage in production. We rst develop a theoretical model to derive simultaneous optimization decisions of donors. To verify the predictions in the theoretical model, we empirically estimate the determinants of aid allocation by simultaneously controlling for altruistic and self-interest motives of donors. This approach aims to correct the ad hoc econometric treatment and to appropriately assess the determinants of aid allocation. The empirical results largely conrm the theoretical predictions in our model. The estimations indicate that a substantially larger amount of bilateral aid per capita is provided to the recipients who import capital goods, while imports by other individual category groups have no signicant effects. Given that developed donor nations are major producers and exporters of capital goods, this result at least partially supports their trade benets motive. On the other hand, aid may also be given as a reward to the recipient nations for promoting imports of capital goods and removing trade restrictions. The recipient nations also gain because greater imports of machinery and transportation equipment help increasing their production (and subsequently consumption), and in turn, they receive more aid. On the ip side, poor countries lacking resources, both private and public, to import capital goods get penalized in two ways: First, their production capacity remains low without importing those goods and, second, they receive a lower amount of aid. Our ndings also suggest that donors are more concerned about alleviating physical miseries (infant mortality) and rewarding good human rights conditions, but they are less focused on reducing economic hardships (low income per capita). This implies that residents of the recipient nations with bad human rights conditions endure sufferings both at the hands of their rulers who deny them basic freedoms, and also by donors who curtail aid. Our study also indicates that economic and political self-interests of donor countries dominate their stated objectives for reducing poverty and promoting development through aid in developing countries. This also provides some insight into the fact that why the majority of the authors seem to agree that aid has no signicant effect on growth. This study does not delve into the political economy aspects of trade and aid allocation, however, this can be an interesting area for future research. Acknowledgements I am grateful to Ronald Balvers, Subhayu Bandyopadhyay, Arabinda Basistha, James Irwin, Peter Leeson, Russell Sobel and Jason Taylor for helpful suggestions. I have greatly beneted from the insightful comments of the Editor and two anonymous referees of this journal. I also appreciate comments of the conference participants at Southern Economics Association 2006 Meetings in Charleston and seminar participants at Central Michigan University 2007.

28 We also run a separate regression for United States bilateral aid per capita by excluding Israel and Egypt from the data set to see if that changes the signicance and magnitude of coefcients on other variables. However, the results for other variable remain about the same. 29 Since only France and United Kingdom among these individual donors have been colonizers, we introduced colonial dummy for their past colonial links with the recipient countries.

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Appendix A. The 22-DAC member countries of OCED in our sample

Australia Austria Belgium Canada Denmark Finland France Germany Greece Ireland Italy Japan Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom United States

Appendix B. Aid recipient countries in our sample

Algeria Argentina Bangladesh Belize Benin Bolivia Brazil Burkina Faso Burundi Cameroon CAR Chile Chile Colombia Cote d'Ivoire Croatia Cyprus Czech Republic Dominica Ecuador Egypt El Salvador Ethiopia Gambia Grenada Guatemala Guinea Honduras Hungary India Indonesia Israel Jordan Kenya Kuwait Latvia Lithuania Macedonia Madagascar Malawi Malaysia Maldives Malta Mauritius Mexico Moldova Morocco Nepal Nicaragua Niger Oman Pakistan Paraguay Peru Philippines Poland Romania Saudi Arabia Senegal Seychelles Singapore Slovenia South Africa Sri Lanka St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines Suriname Tanzania Thailand Togo Tunisia Uganda Uruguay Venezuela Yemen Zambia Zimbabwe

Appendix C. Data sources

Variables Net aid from 22-DAC member countries of OECD Population (millions) GDP Per Capita PPP ($2000) Political Rights and Civil Liberties GDP (current US $) Net aid from multilateral agencies Total Imports Total Exports Imports by Commodity Groups Unit Value of World Import Price Index Total Reserves (including gold) Domestic PP (Per Dollar) Infant Mortality Rates Air Distance (in kilometers) Colonial Past Roman Catholics Population Muslims Population Note: DAC = Development Assistance Committee. Data sources International Development Statistics, OECD (2005) World Bank Development Indicators (2006) CD Rom World Bank Development Indicators (2006) CD Rom Freedom in the World, Freedom House, New York (2005) World Bank Development Indicators (2006) CD Rom International Development Statistics, OECD (2005) UNCTAD (2005); World Bank Development Indicators (2006) CD Rom UNCTAD (2005); World Bank Development Indicators (2006) CD Rom Handbook of Statistics online, United Nation Conference on Trade and Development (2005); UN Comtrade Database (2005) Handbook of Statistics online, United Nation Conference on Trade and Development (2005) Handbook of Statistics, UNCTAD (2005): World Bank Development Indicators (2006) CD Rom World Bank Development Indicators (2006) CD Rom World Bank Development Indicators (2006) CD Rom Gallup and Sachs (1999) Central Intelligence Agency (2006). The World Factbook. Central Intelligence Agency (2006). The World Factbook. Central Intelligence Agency (2006). The World Factbook.

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