Foreign aid volatility and institutional development

Abstract

Existing explanations for why foreign aid can fail to achieve its objectives tend to highlight issues that have roots in recipient countries, e.g., corruption, misappropriation of aid funds. In this paper, I turn the focus to a source of inefficiency that is largely donor-driven: the volatility of foreign aid flows. I argue that aid volatility hinders the development of high-quality institutions in recipient countries. Unpredictable, highly variable aid flows make it difficult for recipient governments to allocate resources across government agencies, to set an efficient tax policy, and to easily coordinate with nongovernmental and civil society organizations about the specific goods and services they will provide. I conceptualize aid volatility as variability — the extent to which the aid flows a country receives vary from year to year; and unpredictability — the extent to which recipients are not able to predict the aid they should expect to receive in upcoming years. I propose measures of aid unpredictability and aid variability, leveraging both a time-series approach and the residuals of a predictive model of aid disbursements. I show evidence that the experience of greater aid volatility over time is associated with worse institutional quality outcomes. These adverse effects of aid volatility on institutional development seem to be particularly strong for more highly aid-dependent recipient countries.