The Effect of Foreign Aid on Governance in Developing Countries

Purpose – This paper studies the effect of foreign aid on the quality of governance in developing countries. Since the results on the effect of foreign aid on governance are often ambiguous, conflicting, and inconclusive, the objective of this study is to contribute to the existing literature by finding rigorous, systematic, and comprehensive assessments of the relationship between foreign aid and governance. Design/Methodology/Approach – We applied the system-GMM estimator and examined the panel data of 65 countries to provide empirical evidence over the period 1996-2016. Findings – Our findings provide evidence of a significant and positive effect of foreign aid on overall governance. While estimating the effects of aid on each of the six dimensions, we also find positive signs in all models, but they are not significant in all cases. Research Implications – The findings of this study imply that different dimensions of governance respond to aid differently. The empirical results of our study have important implications for both the donors and recipients of foreign aid. The paper suggests that policy actions oriented to the strengthening of good governance should get priority, as our results confirmed the effectiveness of aid in improving the quality of governance; improved governance may also positively impact the other macroeconomic indicators of recipient countries.