Can aid for financial sector buy financial development?

Abstract

Most of the aid literature focuses on the potential growth effects of aggregate aid, with mixed results. Considering that donors have repeatedly asserted the multidimensionality of their purposes, a much-disaggregated analysis of aid effectiveness is necessary. The effect of aid targeted to financial sector is examined empirically for almost 70 developing countries during the period 1980–2016. The effectiveness of aid targeted to financial sector is assessed here within the framework of cross-country regression. Numerous indicators of financial development, particularly private credit provided by the banking sector, are considered as outcome variables. Further, this analysis exploits an instrumental variable based on the fact that donors provide large amount of aid targeted to financial sector to countries which have similar voting positions in the United Nations General Assembly. The analysis suggests that aid targeted to financial sector has a significantly positive effect on financial development. This result is robust with different sensitivity checks such as using alternative measures of financial development, measures of aid, estimation methods and dropping outliers. The finding has strong policy implications for donor countries and international aid organisations.