Aid Volatility and Structural Economic Transformation in sub-Saharan Africa

To what extent does Official Development Assistance (ODA) volatility affect sectoral growth in developing countries? Interrogating this question is crucial as sustained economic growth is a necessary condition for poverty reduction and other development outcomes. To this end, many SSA countries are highly dependent on ODA and it therefore comes as no surprise that the sub-region is the largest recipient of ODA such as country programmable aid in the world.

The burgeoning literature on aid has mostly focused on the totality of aid and its effects on macroeconomic indicators such as economic growth to the neglect of the effects of aid volatility on specific sectors including agriculture, service and industry. Nonetheless, the discussion on aid sector volatility is important as it could have serious implications on growth.
In the literature, it is often assumed that aid flow is predictable which makes it possible for recipient countries to factor such inflows into their development planning because of the close elision between aid commitment and disbursement. Our purpose in this paper is to go beyond the debates on aid volatility–growth nexus and to examine the effect of aid and aid volatility on sectoral outputs. Indeed, individual sectoral effects of aid volatility matters in the same manner as total aid volatility because merely regressing aid on economic growth is not instructive, hence the need for an in-depth knowledge and understanding into how individual sector is uniquely affected. In this paper, we focus on aid unpredictability disbursement relative to commitments.
We contribute significantly to literature. Incorporating aid volatility into the standard aid–growth framework will provide an indication of the extent to which aid vagaries may have eroded sectoral output over the period under consideration, where the region has received substantial ODA. Undoubtedly, our study provides a strong alternative to examining aid–growth relationship in SSA. More specifically, our study focuses on sub-sector effects of aid and aid volatility and how financial sector development impact on volatility–sector output nexus. To the best of our knowledge, this is the first study attempting to quantify the unique impact of aid and its volatility of the various sectors of SSA. In doing so, we deal with the question of whether aid and its volatility have counteracting effect on each sector. Apart from this, our study empirically examine whether development of the financial sector which has been low in SSA relative to other emerging economies mitigates or amplifies the potential impact of volatility in the region’s structural economic transformation process.
This paper therefore examines the effect of aid and its volatility on structural economic transformation in SSA using on a panel dataset of 37 countries for the period 1980–2014. We resolve potential endogeneities in aid–sectoral growth nexus by employing the system generalised methods of moments (GMM) while dealing with country-specific effects. Our findings show a positive and significant impact of aid on agricultural, service and manufacturing output suggesting that aid inflows to SSA propels economic transformation. In other words, foreign inflows spur both the tradable and non–tradable sectors revealing some degree of interdependence. This notwithstanding, aid volatility deteriorates sectoral value additions with huge impact on the non–tradable sector. However, excessive aid vagaries do not appear to impact on the agricultural sector. The immunity of this sector from the ravages of the unpredictable pattern of aid can be attributed to the comparative advantage the region already enjoys hence any volatility in aid inflows does not seem to matter for agricultural output. To the extent that aid provides more resources to governments of the recipient countries by far reduces the crowding out of the private sector stemming from government borrowing from financial sector consequently freeing credit to the private sector. Consistent with our hypothesis, the damaging effect of aid volatility on structural economic transformation in SSA is weakened by a well-developed financial system with a large dampening impact on the tradable sector (such as manufacturing) and a no apparent influence on agriculture. Our evidence therefore provides unequivocal support for the notion that development of domestic financial markets enhances aid effectiveness.
Research Brief 121
1 July 2017

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