Comparative impact of foreign aid, FDI, and foreign debt on economic growth: Evidence from Sierra Leone

In 2009, Dambisa Moyo published Dead Aid: Why Aid is not Working in Africa and How there is a Better Way (Douglas and Mcintyre Ltd., London), in which she argued that foreign aid has been ineffective in promoting economic growth and poverty alleviation in Sub-Saharan Africa. Instead, she argued, aid has promoted corruption and bad governance, poor economic performance and increased poverty in the region. She therefore suggested its replacement with non-concessionary loans.

Moyo’s hypothesis (MH) is in stark contrast to the Financing Gap Hypothesis (FGH) proposed by early development economists. The FGH principally holds that poverty and low incomes in developing economies lead to low savings and therefore low domestic capital accumulation. Hence, there is a financing gap that must be filled by foreign resources in order to promote economic growth and poverty alleviation in the developing world. Because of underdeveloped capital markets in those countries, FDI and international debt were deemed less effective in filling the financing gap. Consequently, foreign aid was proposed for that task. In toher words, the FGH holds that foreign aid first impacts the fixed capital stock of recipient countries. This then leads to economic growth and (possibly) improvements in the quality of life.

This paper tests these opposing hypotheses by using Johansen’s cointegration analysis to estimate long-run relationships between foreign aid flows, net foreign direct investment (FDI) flows, and net international debt found in the World Bank's World Development Indicators and three dependent variables (real GDP, real fixed capital stock, and real household consumption found in the Penn World Tables 9.0) in Sierra Leone. It finds positive and significant long-run relationships between foreign aid and FDI and the three variables, and a negative and significant long-run relationship between them and net international debt flows. For instance, whereas a percentage increase in foreign aid raises real fixed capital stock, real GDP, and real household consumption by 0.37, 0.29, and 0.18 percent respectively, a similar increase in net international debt flows lowers them by 0.12, 0.24, and 0.06 percentage points. Thus, reducing foreign aid by one percent and replacing it with a percentage increase in loans would lead to a 0.49 decrease in Sierra Leone’s real fixed capital stock, a 0.53 percent decrease in real GDP, and a 0.24 decrease percent decrease in real household consumption. In short, therefore, the evidence supports the FGH over MH.