A macroeconometric analysis of foreign aid in economic growth and development in least developed countries : a case study of the Lao People's Democratic Republic (1978-2001) : a dissertation presented in fulfilment of the requirements for the degree of Doctor of Philosophy in Economics at Massey University, Palmerston North, New Zealand
Despite receiving large quantities of aid, many developing countries, especially the Least Developed Countries, have remained stagnant and became more aid-dependent. This grim reality provokes vigorous debate on the effectiveness of aid. This study re-examines the effectiveness of aid, focusing on the ongoing debate on the interactive effect of aid and policy conditionality on sustainable economic growth. A theoretical model of the aid-growth nexus was developed to explain why policy conditionality attached to aid may not always promote sustainable economic growth. Noticeable methodological weaknesses in the aid fungibility and aid-growth models have led to the construction of two macroeconometric models to tackle and reduce these weaknesses. The Lao People's Democratic Republic's economy for the 1978-2001 period has been used for a case study.It is argued that the quality of policy conditionality and the recipient country's ability to complete specified policy conditions are the main factors determining the effectiveness of aid. Completing the policy prescriptions contributes to a stable aid inflow. The aid-growth nexus model developed in this study shows that stable and moderate aid inflow boosts economic growth even when aid is fungible. However, failure to complete the policy conditionality owing to inadequate policy design and problems of policy mismanagement caused by lack of state and institutional capability in the recipient country triggers an unstable aid inflow. The model shows that unstable aid flows reduce capital accumulation and economic growth in the recipient country. These empirical findings reveal that policy conditionality propagated through the "adjustment programmes" has mitigated the side effects of aid fungibility and "Dutch disease" in the case of the Lao PDR. Preliminary success in implementing the policy conditions in the pre-1997 period led to a stable aid inflow and contributed to higher economic growth. This favourable circumstance, however, was impaired by unstable aid flow in the post-1997 period. The lack of state and institutional capacity in the Lao PDR and the inadequate policy design to deal with external shocks triggered the instability of aid inflow, which in turn exacerbated the negative effects of the Asian financial crisis on the Lao PDR's economy.