Policy Research

Does Foreign Aid Increase Foreign Direct Investment?

Pablo Selaya, Eva Rytter Sunesen

Summary

The article attempts to estimate the effect that foreign aid has on foreign direct investment in developing countries of various wealth. The study finds evidence that the effect of aid on foreign investment is highly dependent on the type of aid supplied. Foreign aid allocated towards capital improvements such as buildings and crop technology tends to have strong negative effects on the level of foreign direct investment. The study estimates that for every dollar spent on capital improvements $0.81 in foreign investment is reduced. However, when foreign aid is spent on so called complements to capital such as roads and infrastructure the opposite effect is seen and foreign investment increases likely due to increased value of capital investment. Overall, the study also found evidence that the net effect of aid on investment is small but positive.

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Policy Implications

This article can be used in trying to allocate foreign aid efficiently. The results from this study suggest that in order to maximize the efficiency of money spent on aid, aid should be allocated to public goods that complement capitol like roads and other things private actors have no incentive to provide. Additionally the study finds evidence that these effects are true regardless of the country’s wealth.