Foreign aid’s impact on domestic business climates

Abstract

Purpose Existing literature has expressed significant pessimism about the outcomes of foreign aid received by developing nations. Foreign aid can lead to negative outcomes by generating greater rent-seeking opportunities and creating aid dependence. While aid’s negative impact has been explored in the context of growth, political institutions, and economic institutions, the literature has not investigated the effect of aid on business climate of recipient nations. The purpose of this paper is to explore foreign aid’s impact on government regulations on the business climate in Sub-Saharan African (SSA) and Middle East and North American countries. Design/methodology/approach The authors consider a panel of 64 countries over six years. Since foreign aid is most likely to be endogenous, as identified in most studies, the identification strategy follows two methodologies – system GMM estimator, that creates its own instruments via moment generating conditions and instrumental variable approach that relies on an external instrument. Findings The authors find that aid worsens the business climate by increasing government restrictions. Foreign aid provides the recipient governments and the political elite resources to strengthen their power and reinforce predatory policies that are harmful for the business climate. The results further show that in the presence of long-lasting and sustainable democratic regimes, the negative impact of foreign aid on business climate mitigates to a certain extent. Originality/value While aid’s negative impact has been explored in the context of growth, political institutions, and economic institutions, the literature has not investigated the effect of aid on business climate of recipient nations. The authors explore the impact of foreign aid on government regulations on the business climate in SSA and Middle East and North American countries.