Can foreign aid motivate institutional reform? An evaluation of the HIPC Initiative

Publication Date21 Aug 2017
DOIhttps://doi.org/10.1108/JEPP-03-2017-0007
Pages242-258
AuthorMinh Tam Schlosky,Andrew Young
SubjectStrategy,Entrepreneurship,Business climate/policy
Can foreign aid motivate
institutional reform? An
evaluation of the HIPC Initiative
Minh Tam Schlosky
Department of Economics, Sewanee: The University of the South, Sewanee,
Tennessee, USA, and
Andrew Young
Department of Business Economics, Texas Tech University, Lubbock, Texas, USA
Abstract
Purpose A number of political economy concerns are associated with the provision of foreign aid to
developing economies. These concerns suggest that foreign aid is likely to have harmful effects on a
recipients institutional quality, and that attempts to give aid conditional on policy and institutional reforms
are unlikely to succeed. Established in 1996, the Heavily Indebted Poor Country (HIPC) Initiative is a
comprehensive, structured attempt to provide multilateral foreign aid conditional on reforms in recipient
countries. The purpose of this paper is to evaluate its effectiveness at affecting institutional reform in
participating countries.
Design/methodology/approach The authors document how participating countries fared in terms of the
quality of their policies and institutions. The authors employ the Fraser Institutes Economic Freedom of
the World index as a measure of economic institutions, and the Freedom House political rights (PR) and civil
liberties indices as measures of PR and protections. Based on these measures, the authors report
unconditional statistics (e.g. average changes) and also regressions of changes in the measures on HIPC
Initiative aid allocations and other controls.
Findings The authors find that most participating countries experienced either meager increases or
outright decreases in institutional quality. The regression results provide no evidence that the Initiative
affects meaningful reforms.
Originality/value The potential for foreign aid to have deleterious effects on the institutional quality of
recipient countries has been of increasing concern to students of economic development.Such effects can have
important implications for entrepreneurial activity in these countries. The HIPC Initiative is specifically
designed to acknowledge and, indeed, overcome these concerns, leading to actual increases in institutional
quality of recipient countries. To the authorsknowledge, this work is the first to assess whether the promise
of the HIPC Initiative is being fulfilled.
Keywords Institutional quality, Economic freedom,Foreign aid, Conditionality, Debt relief,HIPC Initiative
Paper type Research paper
1. Introduction
In the 1970s, Peter Bauer (1972) was a rarityamong economists due to his questioning of the
desirability and effectiveness of foreign aid programs. Mainstream development experts
discounted his perspectives. Walt Rostow (1990, p. 386) alleged a gap between the market
economist and the wider but somewhat casual commentator on the human condition,and
that Bauer seemed most comfortable as a neoclassical gadfly on the rump of what he
regarded as the international liberal establishment.However, more than two decades later
Boone (1996) provided empirical support for Bauers views. He demonstrated that cross-
country data did not evidence a positive relationship between aid and economic growth in
poor economies. Bauers views suddenly became respectable among mainstream economists.
Bauers ideas combined with Boones findings spawned a large literature on the effectiveness
of foreign aid in promoting development. Notably, Burnside and Dollar (2000, 2004) reported a
positive aid-growth relationship based on cross-country data when the relationship was
estimated conditional on recipients having good policy environments (e.g. low rates of inflation;
liberal trade policies). However, Easterly (2003) and Easterly et al. (2004) demonstrated that these
Journal of Entrepreneurship and
Public Policy
Vol. 6 No. 2, 2017
pp. 242-258
© Emerald PublishingLimited
2045-2101
DOI 10.1108/JEPP-03-2017-0007
Received 1 March 2017
Revised 7 April 2017
Accepted 8 April 2017
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2045-2101.htm
242
JEPP
6,2
results were not robust to small changes in the time period and the countries included in the
sample. Rajan and Subramanian (2008) also failed to report a positive aid-growth effect, even for
recipients with good policy environments. Brumm (2003) went further and argued that if
long-run averages rather than panel data are employed, then both the Burnside and Dollar and
Easterly et al. samples indicate a significantly negative effect of aid on growth, regardless of
the policy environment[1].
A number of political economy concerns are associated with the provision of foreign aid
to developing economies. These concerns suggest that foreign aid is likely to have
deleterious effects on recipientsinstitutional quality. North and Thomas (1973) and
North (1990) were seminal in focusing researchersattentions on the role of institutional
quality in economic development. They emphasized the importance of the rules of the
gameand how they shape human action, channeling it toward relatively productive or
unproductive endeavors. Studies by Knack and Keefer (1995), Barro (1996), Hall and Jones
(1999), Acemoglu et al. (2001, 2002), Rodrick et al. (2004), and Acemoglu and Johnson (2005)
subsequently reported evidence of a robust, positive relationship between the strength of
property rights and the rule of law on the one hand, and income levels and growth on the
other. A large empirical literature now supports the consensus view that institutions rule
(Rodrick et al., 2004).
If aid is, at best, effective in promotingeconomic growth in good policy environments, then
the potential for aid flows to cause deteriorations in institutional quality is doubly troubling.
Aid may tend to degrade the very institutional arrangements that are necessary for it to be
potentiallyhelpful. Moreover, the cold hard fact is thatcountries tend to be poor because they
have poor institutional qualityin the first place. This suggests that tobe effective, aid must be
conditional on improvements in the policies and institutions of recipients.
In this paper, we review the political economy concerns associated with foreign aid and
the existing evidence suggesting that they are important. These concerns suggest that aid is
likely to have harmful effects on recipientsinstitutions, and that attempts to give aid
conditional on reforms are unlikely to succeed. Then we turn our attention to a recent
multilateral aid program that is explicitly designed to foster improvements in policies and
institutional quality and to monitor the progress of those improvements. Established in
1996, the Heavily Indebted Poor Country (HIPC) Initiative aims to help low-income countries
(LICs) burdened with large amounts of debt achieve robust economic growth and
development. The HIPC Initiative represents the best attempt by the IMF and the
World Bank to acknowledge and overcome the political economy concerns associated with
foreign aid. To date it has provided over $76 billion in debt relief, conditional (at least
nominally) on recipient reforms.
We present evidence that the track record of the HIPC Initiative has been lackluster.
On examination of measures of economic and political institutional quality, it was found
that about one-third of countries experienced decreases while participating in the Initiative.
In almost every single case where participating countries experienced increases in these
measures, the increases were negligible. Furthermore, we present the results of regressions
that relate changes in the institutional measures to the HIPC Initiative aid. The partial
correlations between aid and institutional change are never statistically significant.
When the point estimates are positive, they suggest miniscule effects. The best shot by the
IMF and the World Bank to link foreign aid to policy and institutional reforms has failed to
overcome the perverse incentives that aid creates.
2. Foreign aid and institutional quality
The ostensible motivation for developed economies and international agencies to give
foreign aid is twofold. First and foremost, donors desire that poor economies do not remain
poor. Poverty is characterized by a lack of income and wealth; rich economies can fill the gap
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HIPC Initiative

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