A Cross-Country Investigation of Foreign Aid and Dutch Disease: Evidence From Selected SAARC Countries

Abstract

The efficacy of foreign aid inflow with regards to dictating the development of the recipient nations is often questioned in the light of the Dutch disease problem whereby a surge in such inflows tend to appreciate the respective real exchange rates of the recipient nations, bottlenecking their export competitiveness. Against this prelude, the main aim of this paper is to investigate the causal relationship between FAID inflow and RER movements in context of the four SAARC countries that have been traditionally dependent on foreign development assistance. The countries considered in this paper include Bangladesh, India, Pakistan and Sri Lanka. The econometric model is structured using a multivariate framework incorporating annual time series data of all these four nations from 1980 to 2014. Following Edwards (1989) and Montiel (1999), real exchange rates were expressed as country-specific functions of foreign aid and other real fundamentals as control variables. Augmented Dickey-Fuller unit root test, Johansen cointegration test, vector error correction model approach and Granger causality test are considered. The corresponding results reveal that both in the cases of Bangladesh and India, the inflow of foreign aid in the form of official development assistance is statistically insignificant in explaining the movements in the respective real exchange rates, neither in the short run nor in the long run. A possible reason behind this similarity could be the fact that the central banks in both these nations managed to maintain a strong grip over their exchange rates which worked as a cushion against RER misalignments and avoided Dutch disease problems in these countries. In contrast, foreign aid inflows are found to stimulate appretiative pressures on the real exchange rates of Pakistan and Sri Lanka, imposing the threats of potential Dutch disease problems within these nations.

Keywords: Dutch Disease, South Asia, Real Exchange Rate, Foreign Aid, Causality, Cointegration

JEL Classification: C32, C35