Association for Public Policy Analysis & Management

The study undertaken in this paper analyzes the dynamic effect and substitutability of foreign aid and foreign direct investment (FDI) on well-being in developing countries. As a measure of well-being, this paper will use the growth of Gross Domestic Product (GDP). However, further iterations will disaggregate foreign aid by sector to assess its effect on health outcomes and food security.  The effect of foreign aid and the substitutability of FDI for foreign aid can evolve as a country develops. Based on a country’s Gross National Income, as a country moves from the lowest level of development to higher levels, foreign aid will be less effective in promoting growth and FDI will be more effective in promoting growth. This paper disaggregates the whole sample into low income countries (LICs), lower-middle income countries (LMICs), and upper-middle income countries (UMICs), as defined by the Organization of Economic Cooperation and Development (OECD). Using a common correlated effects mean group estimator (CCEMG) for large dynamic panel data I account for a developing country’s institutional quality. The findings from the dataset of over 80 countries that spans 40 years show that there is no relationship between foreign aid and FDI on GDP growth for neither the whole sample nor the three levels of development used in the paper. Therefore, the dynamic effect and substitutability of foreign and FDI could not be confirmed.  Additionally, institutional quality was also found to have not affected the interpretations of the results. These findings are robust to several econometric specifications and measures of growth and foreign aid. The conclusion from a policy perspective is not necessarily an argument against the use of foreign aid to promote growth in developing countries.