FOREIGN AID AND GROWTH IN NEPAL: AN
Badri Prasad Bhattarai*
University of Western Sydney, Australia
Using cointegration and error correction mechanism, this paper investigates the effectiveness
of aid in Nepal during the period 1983-2002. Specifically, it examines the long-run
relationship between aid and per capita real GDP. To address the current debate on whether aid
works only in a good policy environment, we have included policy variables for
macroeconomic stability, financial sector development and openness in an extended model.
The results show that foreign aid has a positive and statistically significant effect on per capita
real GDP in the long-run. More importantly, aid effectiveness improves in the presence of
good policy environment.
JEL Classifications: F350; O230; O400
Keywords: Growth; Foreign Aid; Good Policy; Cointegration Test; Error Correction Model
Corresponding Author’s Email Address: email@example.com
Foreign aid to developing countries has been an important source of finance to
enhance economic growth.1 However, numerous studies of aid effectiveness have
failed to arrive at a consensus. For example, the early studies of aid effectiveness
within the framework of the two-gap model found that foreign aid adversely affected
domestic resource mobilisation (savings).2 Critics, however, pointed out a number of
methodological shortcomings that they claim may have produced negative results in
the earlier studies, notably of Griffin and Enos (1970). A number of studies,
following Papanek (1972, 1973) found a significant and positive relationship
between aid and domestic savings as well as economic growth. Notable among them
are Stoneman (1975), Over Jr. (1975), and Gupta (1975).
Later studies, such as Mosley (1980), Gupta and Islam (1983), Dowling and
Hiemenz (1983), Mosley et al. (1987) found conflicting results depending on the
model and estimation techniques used. Their results were also sensitive to the
selection of sample countries. Among the studies involving the Asian countries, for
example, Rana (1987) and Rana and Dowling (1988), generally found a positive
relationship between aid and economic growth.
One of the most influential recent studies is that of Burnside and Dollar
(2000). They find that aid works only in a good policy environment, defined as low
inflation and low or zero budget deficit, and a liberalised economy. However, the
Burnside and Dollar study has generated considerable controversy among policy
makers and academic researchers (see, for example, Hansen and Tarp 2000; Dalgaard
and Hansen, 2001; Guillaumont and Chauvet, 2001; Easterly, 2003 and Easterly et
al., 2003). The critics point out a number of methodological short-comings, and
argue against allocating aid only to countries with good policy.
While there is a renewed interest in aid-effectiveness, there are not many
studies of Nepal, which has been an aid-dependent country for a long time. Since the
early 1950s, almost all physical infrastructures