The link between aid and private investment is not well understood. Could aid-financed infrastructure investments encourage higher foreign direct investment? The authors present the results of a new composite index of infrastructure to estimate direct and indirect impacts of aid for infrastructure on FDI

Donaubauer, Julian

Meyer, Birgit

Nunnenkamp, Peter

LSE Research Online

20/06/2017 Aid-financed infrastructure promotes foreign direct investments - IGChttp://www.theigc.org/blog/aid-financed-infrastructure-promotes-foreign-direct-investments/ 1/5Authors Julian DonaubauerResearcherHelmut-Schmidt-University Birgit MeyerAssistant ProfessorVienna University ofEconomics & Business PeterNunnenkampSenior EconomistKiel Institute for the WorldEconomyPublished on: 3 May 2016Countries: InternationalResearch themes: Inclusive Growth,Political Economy, State Aid-ﬁnanced infrastructurepromotes foreign directinvestmentsThe link between aid and private investmentis not well understood. Could aid-ﬁnancedinfrastructure investments encourage higherforeign direct investment? The authorspresent the results of a new composite indexof infrastructure to estimate direct and indirectimpacts of aid for infrastructure on FDI.Official development assistance (ODA) and foreign directinvestment (FDI) are widely perceived as alternative means ofsupplementing domestic savings and promoting economicdevelopment in low and middle income countries. Developingcountries that attract FDI are often contrasted with ODA-dependent ones. The argument for FDI is typically considered“compelling” (Stiglitz 2000) as it provides an attractive packageof capital, technology, managerial know-how, and access tomarkets. By contrast, aid critics stress the disincentives of ODAand contend that “successful cases of development happeningdue to a large inflow of aid and technical assistance have beenhard to find” (Easterly 2007: 329).How aid could promote FDIThe effects of ODA on FDI flows to developing countries aretheoretically ambiguous. Positive effects can be expected to theextent that aid increases the productivity of private investmentsby financing complementary factors of production, such asinfrastructure and human capital (Selaya and Sunesen 2012).Arguably, aid could also remove specific bottlenecks thatprevent higher FDI inflows. In contrast, aid could have adverseeffects on FDI inflows by encouraging rent-seeking (Economideset al. 2008) or crowding out private foreign activity in thetradable goods sector (Beladi and Oladi 2007). 20/06/2017 Aid-financed infrastructure promotes foreign direct investments - IGChttp://www.theigc.org/blog/aid-financed-infrastructure-promotes-foreign-direct-investments/ 2/5Komanda Bridge Zaire 1995. Encounter Overland Democratic Republic of the CongoImage credit:DAVID HOLTThe question remains, how exactly could ODA render recipientcountries more attractive to FDI? Evidence from earlier studies,employing aggregate aid data, is inconclusive (e.g., Harms andLutz 2006; Asiedu et al. 2009), and largely neglects thetransmission mechanisms through which aid may promote FDI.Aid that is explicitly targeted at improving the recipientcountries’ infrastructure endowments could be particularlyeffective since poor infrastructure is often cited by investors asan important constraint to FDI. Assessing this transmissionchannel has traditionally been difficult because of datalimitations and the lack of a comprehensive measure of thequantity and quality of a country’s infrastructure.New measure of infrastructure needsAgainst this backdrop, we constructed a composite index ofinfrastructure[1] based on a broad annual dataset of 30indicators of the quantity and quality of infrastructure for alarge number of countries (Donaubauer et al., 2016a). Theunderlying model closely resembles the well-known approach ofconstructing the widely used Worldwide Governance Indicatorsof the World Bank (see Kaufmann et al. 2011 for details).We use the infrastructure index to estimate a recipient country’sspecific need for aid in infrastructure at a particular point intime (Donaubauer et al., 2016b). The estimated need forinfrastructure is derived from what we term the ‘normalpattern’ of infrastructure endowment of countries, relative totheir wealth (GDP per capita), population, and geographic area,based on pooled annual data from 1990-2010. The specificneed for aid in infrastructure is then proxied by comparing theexpected endowment– given the above noted countrycharacteristics – and the actually observed index ofinfrastructure. Need is assumed to be zero when the actuallyobserved index value is higher than the value expected from thenormal pattern. When the actual index value is below theexpected value, the absolute deviation from the normal pattern(on a scale from 0 to 100) is taken as the measure ofinfrastructure needs.Mapping the results of this exercise, the figure below points topronounced infrastructure needs throughout Latin America.The situation in Asia and Africa is much more nuanced once thecountries’ endowment with infrastructure is judged relative totheir general stage of economic development. For instance,infrastructure in relatively advanced sub-Saharan Africancountries such as Botswana, Namibia and the Rep. of SouthAfrica is less developed than one would expect according totheir stage of economic development; the infrastructure gapappears to be less pronounced in poor countries such as theDem. Rep. of the Congo, Mozambique and Tanzania.20/06/2017 Aid-financed infrastructure promotes foreign direct investments - IGChttp://www.theigc.org/blog/aid-financed-infrastructure-promotes-foreign-direct-investments/ 3/5“Figure 1: Mapping the needs for aid in infrastructureSource: Authors’ calculations.Notes: Infrastructure needs are obtained as deviations from thenormal pattern of the endowment with infrastructure. The mapshows the need for aid in infrastructure for the year 2010. Themap is coloured according to average quintiles over the 1990-2010 period. The intervals on the left show the respectivequintile ranges of the absolute index value of needs for aid ininfrastructure, ranging from 0 (no needs) to 100.Aid allocation and effectivenessTo better understand the critical junctures in the transmissionof aid to FDI, our empirical analysis focuses on three keyquestions:Is aid effective at improving the recipient country’sinfrastructure?Is the allocation of aid, needs-based and targeted at recipientcountries with less developed infrastructure?Does aid impact on FDI via infrastructure?The results offer several interesting insights. First of all, aid forinfrastructure proves to be effective (and statistically significant)at improving the recipient country’s economic infrastructureendowments.  An increase in aid for infrastructure of onestandard deviation is associated with an infrastructureimprovement of 1.7 index points (or 0.2 standard deviations).In sharp contrast, other types of aid have no significant effecton recipient countries’ infrastructure endowments.Our findings show that aid for infrastructure, unlikeother types of aid, helps attract FDI, both directly andindirectly through improving recipient countries’endowment with infrastructure. ”Second, it appears that aid for infrastructure is well-targeted tothe needs of recipient countries. A 1% increase in per-capitaincomes (the commonly used indicator of general need) lowersthe inflow of aid for infrastructure by 2.4%. More importantlyin the present context, we find aid for infrastructure increasesby 2.1% (or 1.15 standard deviations) when the gap betweenthe expected and actual endowment of infrastructure widens by10 index points – a modest, but far from negligible effect.Taken together, our results imply that aid for infrastructure iseffective and is well-targeted to countries where need for such20/06/2017 Aid-financed infrastructure promotes foreign direct investments - IGChttp://www.theigc.org/blog/aid-financed-infrastructure-promotes-foreign-direct-investments/ 4/5effective and is well-targeted to countries where need for suchaid is most pressing.Direct and indirect effects on FDIRegarding FDI as our dependent variable of principal interest,we find both indirect and direct effects of aid for infrastructureon FDI (Donaubauer et al., 2016b). The indirect effect of aidfor infrastructure promotes FDI inflows through its impact onthe host country’s endowment of economic infrastructure. Thequantitative impact is considerable: A 10-point improvement ina country’s infrastructure, as reflected in our index rangingfrom 0-100, is associated with an increase of 5.1 percentagepoints in the ratio of FDI inflows to the host country’s GDP. Figuring in the above noted effects of aid on infrastructure, thisfinding implies that a 10% increase in aid for infrastructurewould increase FDI by about 4.7 percentage points through theinfrastructure channel.Aid for infrastructure also directly impacts FDI inflows, unlikeother types of aid. Taking the estimation results at face value, a10% increase in aid for infrastructure leads to an increase inFDI inflows, in percent of GDP, of 14-15 percentage points(i.e., about 2 standard deviations).The strong direct effect of aid for infrastructure on FDI suggeststhat foreign investors anticipate longer-term effects on thecountry’s endowment that are not yet reflected in our index ofinfrastructure. This is consistent with Mayer (2006: 45) whoargues that aid commitments “can have a large signaling rolefor foreign investors.” Foreign investors may be confident thataid-financed infrastructure serves them particularly well,compared to locally financed infrastructure. Aid-financedinfrastructure may focus more strongly on FDI-related needs, beof superior quality, or be better maintained due to externalcontrol and oversight.[2] Such differences between aid-financedand locally financed infrastructure would largely escape ourmeasurement of infrastructure and could be captured directlyby the aid variable in our estimations.SummaryOur findings show that aid for infrastructure, unlike other typesof aid, helps attract FDI, both directly and indirectly throughimproving recipient countries’ endowment with infrastructure.Our estimates are robust to various modifications,specifications, and country samples. Well-targeted aid promotesFDI through investments in infrastructure.Arguably, other specific categories of aid could also work byremoving critical impediments to higher FDI flows indeveloping countries. Future research could provide a fulleraccount of country-specific impediments, and may facilitatecomparisons of FDI-related needs for sector-specific aid withactual aid patterns. Correcting for mismatches could render aidmore effective at promoting FDI, by re-directing aid to the mostrelevant sectors. This could activate further transmissionmechanisms, in addition to aid working through theinfrastructure channel.[1] In the unobserved components model used to construct theindex, observed data of each aspect of infrastructure are a linear20/06/2017 Aid-financed infrastructure promotes foreign direct investments - IGChttp://www.theigc.org/blog/aid-financed-infrastructure-promotes-foreign-direct-investments/ 5/5index, observed data of each aspect of infrastructure are a linearfunction of unobserved infrastructure and an error term.[2] For instance, FDI-related needs may be particularly pressingwith respect to sea and air transport, while local authoritiesmay be mainly concerned about roads. Foreign investors maycare more about transport and communication networks in thehost country’s economic centers, whereas host countrygovernments must also prioritise connections to more remoteareas.

Aid-financed infrastructure promotes foreign direct investments

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