A Panel Data Analysis of the Fungibility of Foreign Aid

Abstract

The donor community has been increasingly concerned that development assistance intended for crucial social and economic sectors might be used directly or indirectly to fund unproductive military and other expenditures. The link between foreign aid and public spending is not straightforward because some aid may be fungible. This article empirically examines the impact of foreign aid on the recipient's public expenditures, using cross-country samples of annual observations for 1971-90. For the base sample of 14 developing countries, it finds that aid is not fungible at the aggregate level and there is no associated tax relief. Increasing the number of countries, however, makes aid fungible. Moreover, results based on the main sample indicate that aid is fungible in three out of five sectors examined. Developing country governments receiving earmarked concessionary loans for agriculture, education, and energy reduce their own resources going to these sectors and use them elsewhere; only loans to the transport and communication sector are fully spent on the purposes intended by donors. Because most aid appears to be fungible, the rate of return on a specific donor-funded project tells little about the impact of that assistance; a better approach may be to tie foreign aid to an overall public expenditure program that provides adequate resources to crucial sectors.