Association for Public Policy Analysis & Management

Developed countries offer foreign assistance to developing countries typically to help ease humanitarian burdens and facilitate human development. Often, foreign assistance is so large that the transfer becomes a substantial share of the recipient country’s GDP. For example, Afghanistan’s GDP in 2013 was $20.34 billion, of which $13.4 billion was US civilian aid alone (US Agency for International Development 2018). In theory, aid not only spurs economic activity but may also be correlated with aid waste, mismanagement, or corruption. The private wealth thus generated must find an outlet, which often manifests itself in the shape of transfers abroad.

An increase in capital flight after the receipt of large amounts of aid can be thought of as a manifestation of aid leakage. Gauging it with a reasonable degree of accuracy gives us a measure of aid effectiveness by allowing us to see how much aid is redirected away from its original purpose.

The US model of foreign aid – henceforth referred to as the OECD model – generally comes with conditions relating to humanitarian or human rights reforms. On the other hand, “new donors” such as China exhibit a different disposition toward foreign aid, caring less for the recipient county’s need and “exhibiting a weaker bias toward badly governed countries” (Dreher, Nunnenkamp and Thiele 2010, 1961). With these two broad models of foreign aid, it is worth asking whether both are associated with capital flight and, if so, if their comparative magnitudes differ.

This paper, therefore, aims to determine how much of the development aid leaks from recipient countries and ends up abroad. The paper defines capital flight due to foreign aid as the difference between monetary outflow from private sources in a country before and after the receipt of aid, controlling for economic growth, foreign direct investment, regime type and other factors. Using cross-border transaction data from the Bank of International Settlements and overseas development assistance data from the US and China, the paper seeks to understand the relative impact of each country's aid on capital flight. The paper tests two hypotheses: 1. Large amounts of aid delivered to poor countries suffering from political instability, policy volatility and economic unpredictability is associated with aid leakage in the form of capital flight. 2. American foreign aid, by virtue of being more sustainably offered, produces less capital flight compared to Chinese aid.

The policy implications from the research could inform the length of time during which foreign aid is provided (sustainability), the mechanisms and conditionalities based on which it is delivered, and the magnitude of elite capture of aid.