Priming the Pump. Does Aid Pave the Way for Local Investment?

Abstract

Recent data advances have opened exciting new avenues for analyzing the political economy of foreign aid. Recent papers have looked at the social, environmental or welfare implications of aid. This paper, however, combines geo-referenced data on foreign aid with a similarly coded dataset of FDI project locations, to employ a quasi-experimental, spatial-temporal, identification strategy that evaluates if the location of foreign aid projects presages later FDI. The paper develops theoretical expectations about how foreign aid can attract FDI via signaling or functional mechanisms. The paper also investigates if different donors use aid to boost their own FDI (“1st party effect”) and/or that of others (“3rd party effect”). The paper finds strong overall support that aid boosts FDI, albeit as much, if not more, via a signaling mechanism as a functional one. Aid from the US, and to a lesser extent China, shows strong positive 1st party effects, while decreasing the amount of local 3rd party FDI. Aid from the EU and its member states, in contrast, promotes 3rd party FDI, even at the expense of FDI from EU states. These findings are robust to a number of alternative specifications and estimation techniques.