Journal Article
The Return to Foreign Aid

We estimate the average rate of return on investments financed by aid and by domestic resource mobilisation, using aggregate data. Both returns are expected to vary across countries and time. Consequently we develop a correlated random coefficients model to estimate the average returns. Across different estimators and two different data sources for GDP and investment our findings are remarkably robust; the average gross return on ‘aid investments’ is about 20 per cent. This is in accord with micro estimates of the economic rate of return on aid projects and with aggregate estimates of the rate of return on public capital.

Developing countries are not starved of capital because of credit-market frictions. Rather, the proximate causes of low capital-labor ratios in developing countries are that these countries have low levels of complementary factors, they are inefficient users of such factors (as Lucas, 1990 suspected), their share of reproducible capital is low, and they have high prices of capital goods relative to consumption goods.

As a result, increased aid flows to developing countries are unlikely to have much impact on capital stocks and output, unless they are accompanied by a return to financial repression, and in particular to an effective ban on capital outflows in these countries. Even in that case, increased aid flows would be a move towards inefficiency, and not increased efficiency, in the international allocation of capital. (Caselli and Feyrer, 2007, pp. 565–566.)

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