Domestic investment and aid: The role of political instability

While past studies have contradicted in their viewpoints regarding the impact of foreign aid on growth and development of a nation, recent studies have tried to delve deeper into the question, ‘what makes aid work?’(see, Dutta, Leeson and Williamson, 2012; Burnside and Dollar, 2004 ;2000; Svesson, 1999). In a similar context, this paper tests the impact of aid on domestic capital accumulation. Using dynamic panel estimators, we explore how political instability affects aid effectiveness with regards to aid’s impact on capital formation. The paper considers a broad view of political instability and, thus, considers a vast range of measures. They range from type of regime (civilian or military), process of legislative selection, presence of uncertainty in the top authority. We hypothesize that such uncertain circumstances affect policy selection by the government and might result in government choosing sub-optimal or inefficient policies and, thus, misuse of public resources like foreign aid. Thus, aid effectiveness will be affected negatively. The other set of measures of political instability reflect citizens’ resentment towards the political system. We hypothesize such resentment will make the current party change their course of action or will over throw them. In either case, public resources like aid will be put to right use and aid effectiveness should improve. While constitutional uncertainties and weaker or unsustainable political systems reduce aid effectiveness, non- violent protests by the masses raise aid effectiveness. Hence, depending on the nature of political instability, aid’s impact on capital accumulation is improved or hampered. Our results are robust to alternate sub-samples and alternate model specifications.