How Foreign Aid Could Help Attract FDI

How Foreign Aid Could Help Attract FDI

photo: Nicolas Raymond

Official development assistance (aid) and foreign direct investment (FDI) are widely perceived to be alternative means of supplementing domestic savings and promoting economic development in low and middle income countries. Developing countries that attract FDI are often contrasted with those depending on aid. The argument for FDI is typically considered “compelling” (Stiglitz 2000) as it provides an attractive package of capital, technology, managerial know-how, and access to markets. By contrast, critics stress the disincentives of aid and contend that “successful cases of development happening due to large inflow of aid and technical assistance have been hard to find” (Easterly 2007: 329).

Theoretical and empirical ambiguities

The challenge of spreading the benefits of FDI across developing countries persists. Yet scant attention has been paid to the question of whether aid could help attract FDI to those developing countries that have remained on the sidelines in the worldwide competition for FDI. Theoretically, aid could have positive effects on FDI flows to these countries if aid increases the productivity of private investment by improving the supply of complementary factors of production (Selaya and Sunesen 2012). In contrast, aid could have adverse effects on FDI inflows by encouraging rent-seeking (Economides et al. 2008) and by crowding out private foreign activity in the tradable goods sector (Beladi and Oladi 2007).

The empirical evidence available from studies employing aggregate aid data is inconclusive and sometimes implausible. For instance, Harms and Lutz (2006) find that aid per se has no significant impact on foreign investment flows. Surprisingly, however, the effect of aid proves to be strictly positive “where firms have to cope with substantial restrictions on their activities” (Harms and Lutz, 2006: 780). Asiedu et al. (2009) find that aid per se is negatively associated with FDI in low-income host countries, but aid tends to mitigate the adverse effects of country risk on FDI.

Transmission mechanisms: two examples

The earlier literature largely neglects the sector-wise composition of aid and the transmission mechanisms through which aid may promote FDI. Sector-specific aid could remove critical bottlenecks that prevent higher FDI inflows. For instance, Donaubauer et al. (2012) hypothesize that aid for education is an effective means to increase FDI flows to host countries where schooling and qualification are considered inadequate by foreign investors. This appears to be the case in large parts of Latin America (Figure 1).[1] Indeed, employing panel data techniques covering 21 Latin American countries over the period from 1984 to 2008, Donaubauer et al. (2012) find that aid for education has a significantly positive effect on FDI. In contrast, other types of aid prove to be ineffective in attracting FDI to Latin American host countries.

Another study suggests that aid explicitly targeted at improving the recipient countries’ endowment with infrastructure could be particularly effective in stimulating FDI where poor infrastructure appears to be an important bottleneck. Donaubauer et al. (2016) use a composite index of infrastructure to estimate a recipient country’s specific need for aid in infrastructure. Similar to the case of education in Latin America, specific needs are derived from the ‘normal pattern’ of the endowment of countries with infrastructure. Figure 2 maps the need for aid in infrastructure by comparing the expected endowment with infrastructure – given the country’s GDP per capita, population and geographic area – and the actually observed index of infrastructure. The empirical estimations of Donaubauer et al. (2016) reveal that aid for infrastructure induces higher FDI through improving the recipient countries’ endowment with infrastructure. Again, other types of aid are not effective which suggests that only well targeted aid promotes FDI through the infrastructure channel.

Accounting for critical bottlenecks and aid targeting: the way forward

However, specific aid categories other than those analyzed by Donaubauer et al. (2012; 2016) could work through removing further critical impediments to higher FDI flows to developing countries. For instance, the attractiveness of some host countries may suffer primarily from corruption and bad governance. Aid for institution building might be required here. Elsewhere, aid targeted at fighting HIV/AIDS or other infectious diseases could be particularly effective in improving access to FDI for countries with serious public health problems. This invites the hypothesis that foreign aid attracts FDI, but only if sector-specific aid is well targeted and, thereby, removes critical impediments to higher FDI inflows.

Testing this hypothesis involves three challenges. First of all, future research would have to provide a fuller account of specific impediments to FDI. Major impediments are most likely to vary considerably across host countries. In addition to widely accessible data series on issues such as education and infrastructure, investor surveys and international country rankings – e.g., from the World Economic Forum’s Global Competitiveness Reports – provide useful information to portray the host countries’ competitive position along various dimensions and identify major factors that have hindered access to FDI in the past.

Second, it must be evaluated whether the country- and sector-specific aid patterns are aligned with FDI-related needs identified in the previous step. Ideally, the comparison between FDI-related needs for sector-specific aid and actual aid patterns would result in a comprehensive “mismatch index.” The mismatch would be smallest if the sectoral composition of aid were perfectly aligned with FDI-related needs, and largest if sectoral aid shares were uncorrelated with specific needs.

Finally, the mismatch index would be included among the determinants of FDI in regression analyses, in addition to the overall amount of aid. The impact of aid on FDI can reasonably be expected to be conditional on the degree of mismatch. In other words, the impact of aid should increase with stronger needs-based targeting of aid.

In summary, this approach allows for assessing synergies between aid and FDI. By correcting for mismatches donors could render aid more effective in promoting FDI. This would not only improve the chances of developing countries to compete successfully for FDI, but also offer new investment opportunities for firms based in the donor countries.

Figure 1 — Quality of education and GDP per capita across countries: Position of Latin American sample countries in the ‘normal pattern’


Source: World Economic Forum and World Bank (World Development Indicators)

Figure 2 – Mapping the needs for aid in infrastructure


Infrastructure needs are obtained as deviation from the normal pattern of the endowment with infrastructure. The map shows the need for aid in infrastructure for the year 2010. The map is colored according to average quintiles over the 1990-2010 period. The intervals on the left show the respective quintile ranges of the absolute index value of needs for aid in infrastructure, ranging from 0 (no needs) to 100.

[1] Almost all Latin American sample countries fall below the ‘normal pattern’ when the quality of education is related to the countries’ average GDP per capita. In other words, Latin American countries typically lag behind the quality of education to be expected at their level of economic development.


Asiedu, E., Y. Jin and B. Nandwa (2009). Does foreign aid mitigate the adverse effect of expropriation risk on foreign direct investment? Journal of International Economics 78(2): 268–275.

Beladi, H. and R. Oladi (2007). Does foreign aid impede foreign investment? In: S. Lahiri (Ed.), Theory and Practice of Foreign Aid. Amsterdam: Elsevier (pp. 55–63).

Donaubauer, J., D. Herzer and P. Nunnenkamp (2014). Does aid for education attract foreign investors? An empirical analysis for Latin America. European Journal of Development Research 26: 597-613.

Donaubauer, J., B. Meyer and P. Nunnenkamp (2016). Aid, infrastructure, and FDI: Assessing the transmission channel with a new index of infrastructure. World Development 78, 230-245.

Economides, G., S. Kalyvitis and A. Philippopoulos (2008). Does foreign aid distort incentives and hurt growth? Theory and evidence from 75 aid-recipient countries. Public Choice 134(3-4): 463–488.

Harms, P. and M. Lutz (2006). Aid, governance and private foreign investment: Some puzzling findings for the 1990s. Economic Journal 116(513): 773–790.

Selaya, P. and E.R. Sunesen (2012). Does foreign aid increase foreign direct investment? World Development 40(11): 2155–2176.