AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 82

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 83

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 84

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 85

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 86

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 87

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 88

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

References

Asteriou, D. (2009). Foreign aid and economic growth: New evidence from a panel data approach for five South Asian countries. Journal of policy modeling, 31(1), 155-161.Bascle, G. (2008). Controlling for endogeneity with instrumental variables in strategic management research. Strategic organization, 6(3), 285-327.Bauer, P. T. (1976). Dissent on development. Harvard University Press.Bauer, P. (1991). Foreign aid: Mend it or end it. P. Bauer, S. Siwatibau et AW Kasper (éd.), Aid and Development in South Pacific, Centre for Independent Studies, Australie.Boone, P. (1994). The impact of foreign aid on savings and growth. London School of Economics and Political Science, Centre for Economic Performance.Brecher, I., & Abbas, S. A. (2005). Foreign aid and industrial development in Pakistan (Vol. 1). Cambridge University Press.Bulíř, A., & Hamann, A. J. (2003). Aid volatility: an empirical assessment. IMF Staff papers, 50(1), 64-89.Burnside, C., & Dollar, D. (1997). Aid Policies and Growth [Policy Research Working Paper No. 1777]. Washington, DC: World Bank.Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. American economic review, 90(4), 847-868.Celasun, O., & Walliser, J. (2008). Predictability of aid: Do fickle donors undermine aid effectiv- eness?. Economic Policy, 23(55), 546-594.Chenery, H. B., & Strout, A. M. (1966). Foreign assistance and economic development. The American Economic Review, 56(4), 679-733.Chishti, S., Hasan, M. A., & Khan, A. H. (1992). Foreign Aid, Defence Expenditure and Public Invest- ment in Pakistan [with Comments]. The Pakistan Development Review, 31(4), 895-908.Clemens, M., Radelet, S., & Bhavnani, R. (2004). Counting chickens when they hatch: The short term effect of aid on growth.Collier, P., & Dollar, D. (2001). Can the world cut poverty in half? How policy reform and effective aid can meet international development goals. World development, 29(11), 1787-1802.Collier, P., & Dollar, D. (2002). Aid allocation and poverty reduction. European economic review, 46(8), 1475-1500.Collier, P., & Dehn, J. (2001). Aid, shocks, and growth, World Bank Policy Research Working Paper Series n 2688. The World Bank.Dalgaard, C. J., & Hansen, H. (2001). On aid, growth and good policies. Journal of development Studies, 37(6), 17-41.Dalgaard, C. J., Hansen, H., & Tarp, F. 2004): On the empirics of foreign aid and growth. In Economic Journal.Dowling, J., & Hiemenz, V. (1982). Aid, Savings and Growth in the Asian Region: the Macroeconom- ic Impact of Development Aid: A Critical Survey. Journal of Development Studies, 28(2), 163-240.Durbarry, R., Gemmell, N., & Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth (No. 98/8). CREDIT Research paper.Gomanee, K., Girma, S., & Morrissey, O. (2005). Aid and growth in Sub‐Saharan Africa: accounting for transmission mechanisms. Journal of International Development, 17(8), 1055-1075.Griffin, K. B., & Enos, J. L. (1970). Foreign assistance: objectives and consequences. Economic

development and cultural change, 18(3), 313-327.Hansen, L. P. (2001). Generalized method of moments estimation: a time series perspective. Interna- tional Encyclopedia of Social and Behavioral Sciences, 9743-9751.Hudson, J., & Mosley, P. (2008). Aid volatility, policy and development. World Development, 36(10), 2082-2102.Ishfaq, M., & Ahmad, E. (2005). Aid effectiveness: The case of Pakistan. MIDDLE EAST BUSINESS AND ECONOMIC REVIEW, 17(2), 40.Javid, M., & Qayyum, A. (2011). Foreign aid and growth nexus in Pakistan: The role of macroec- onomic policies. Working Papers & Research Reports, 2011.Jones, S., & Tarp, F. (2016). Does foreign aid harm political institutions?. Journal of Development Economics, 118, 266-281.Khan, M. A., & Ahmed, A. (2007). Foreign aid—blessing or curse: Evidence from Pakistan. The Pakistan Development Review, 215-240.Khan, S. R., & Ahmad, E. (1997). Has aid helped in Pakistan?[with comments]. The Pakistan Deve- lopment Review, 947-957.Lensink, R., & Morrissey, O. (2000). Aid instability as a measure of uncertainty and the positive impact of aid on growth. The Journal of Development Studies, 36(3), 31-49.Lensink, R., & White, H. (2001). Are there negative returns to aid?. Journal of development Studies, 37(6), 42-65.McGillivray, M. (2005). Is aid effective?. Helsinki: World Institute for Development Economics Research (draft), ca. February (mimeo).Moreira, C., Svoboda, K., Poulos, A., Taylor, R., Page, A., & Rickard, M. (2005). Comparison of the validity and reliability of two image classification systems for the assessment of mamm- ogram quality. Journal of medical screening, 12(1), 38-42.Mosley, P. (1980). Aid, savings and growth revisited. Oxford Bulletin of Economics and Statistics, 42(2), 79-95.Mosley, P., Hudson, J., &Horrell, S. (1987). Aid, the public sector and the market in less developed countries. The Economic Journal, 97(387), 616-641.Papanek, G. F. (1972). The effect of aid and other resource transfers on savings and growth in less developed countries. The Economic Journal, 82(327), 934-950.Rajan, R. G., & Subramanian, A. (2005). What undermines aid's impact on growth? (No. w11657). National Bureau of Economic Research.Rostow, W. W. (1959). The stages of economic growth. The Economic History Review, 12(1), 1-16.

PAKISTAN BUSINESS REVIEW 89

Volume 20 Issue 1, April, 2018Research

AID VOLATILITY AND ECONOMIC GROWTH OF PAKISTAN: A MACROECONOMIC POLICY

FRAMEWORKSadia Mansoor 1, Muhammad Javid 2, Mirza Aqeel Baig 3

Abstract

This study explores the linkage among aid volatility, macroeconomic policies and economic growth of Pakistan (1972-2015). We have empirically analyzed the impact of foreign aid volatility on economic growth conditional to macroeconomic policy environment. For this purpose, we have constructed an index of macroeconomic policies through Principal Component Analysis. We find that volatile aid hinders the economic growth of Pakistan and impedes the expected positive outcomes of macroeco-nomic policies. By employing Generalized Method of Moments (GMM) technique, this study shows that foreign aid and foreign aid volatility both negatively affects economic growth under current macroeconomic policy framework of Pakistan. These results suggest that foreign aid inflows can only be supportive withhen finance development and social welfare projects.

Keywords: Foreign Aid, Volatility, Economic Growth, Endogeneity, Generalized Method of Moments, Macroeconomic Policy Index.

JEL Classification : F 350

Introduction

Like many other low and middle-income countries, the domestic saving rate has remained very low in Pakistan. Higher interest rates in the last decade could not attract savers to increase their savings. Due to low level of savings, low funds had been available for investment purposes that result-ed in low quantum of domestic production to export. For countries with low saving-low investment rate, Chenery and Strout (1966) present the rationale of foreign aid; they state that saving-investment gap can be filled through inflows of foreign aid and concessional loans. By definition, Foreign aid is a mobilization of concessional loans, funds and development grants from the developed countries to the developing and low income countries. According to the United Nation Development Program (UNDP), every developed country may transfer 0.7 percent of its GNI to the developing countries to help them in attaining economic growth by filling saving- investment gap.

1Also known as Sadia Anwar, Institute of Business Management (IoBM), Karachi, Pakistan. sadia.mansoor@iobm.edu.pk2 Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. javid@pide.edu.pk3 Institute of Business Management (IoBM), Karachi, Pakistan. aqeel.baig@iobm.edu.pk

The Harrod-Domar model exerts that every developing economy needs a big push in the form of funds for investment. Chenery and Strout (1966) extended the big push idea by providing the theoretical framework of foreign aid. They explain that every underdeveloped or developing economy faces two major gaps; the first gap ‘saving-investment’ creates the second ‘import-export’ gap. In the presence of twin gaps foreign aid inflows can help the economy to achieve economic growth as aid can be used for investment purposes.

The need for foreign aid depends on domestic saving rate, Pakistan has witnessed saving rate as low as 14.5 percent of GDP that is far lower than other developing and emerging economies that have 31.4 percent GDP as their average saving rate. On an average, the saving-investment gap has been 2.4 percent of GDP since 1980s. Literature has highlighted that the underdeveloped financial sector of Pakistan is the main culprit behind the historic low saving rates. For example, according to the World Bank database, Pakistan has the lowest bank deposit to GDP ratio (29.2 percent) in the region as India has 62.5 percent, Bangladesh 53.6 percent and Sri Lanka has 34 percent deposit to GDP ratio.

Pakistan has been among the top recipients of bilateral as well as multilateral foreign aid. Even after receiving nearly USD 86.2 billion, Pakistan is still lagging behind in terms of economic growth. During 1960s, Pakistan was heavily dependent on foreign aid to increase investment. Pakistan had 41.3 percent of aid to gross fixed capital formation (GFCF) ratio in 1960s. This ratio decreased over the period of time but remained double digit until 2000s. In comparison to other low and middle income countries, Pakistan witnessed more than average aid to GFCF ratio. During 2000s, aid to GFCF ratio remained 9.3 percent while India had 0.7 percent and low and middle income coun-tries had 3.6 percent only. Considering that aid can fill the saving-investment gap to promote econom-ic growth, Pakistan could not experience stable and above average economic growth despite of heavy aid inflows. This study intends to explore the underlying reasons behind aid ineffectiveness in case of Pakistan. Historically, Aid inflows have been volatile in Pakistan. During 1970s, Pakistan received aid to overcome the issues emerged due to the arrival of refugees, being conditional that aid could not fill investment-saving gap. On many occasions, Pakistan faced freeze in aid that resulted in extreme delays of aid dependent projects along with rise in government size. During 1990s, sanctions and freeze in aid landed Pakistan into debt crisis. Literature highlights that volatile aid can cause debt trap and increment in government size. This study is considering aid as a leading determinant of economic growth and volatility can reverse the positive effects of aid. An ample literature maintains that volatile aid negatively impact the economic growth of developing countries. Considering that, Pakistan has also received volatile aid inflows, it is important to assess empirically the dynamics and consequences of this volatile aid on GDP per capita of Pakistan.

Significance and Objectives of the Study

This study makes track from the existing empirical literature available on Pakistan economy in three ways. First, we have empirically estimated the effect of foreign aid volatility on the economic growth of Pakistan. Second, this study addresses the issue of potential endogenity in aid-growth

relationship (highlighted by Hansen and Tarp (2001), Rajan and Subramanian (2005), Moriera et al. (2005) by employing Generalized Methods of Moments (GMM) methodology.

There are four broader objectives of this study. First, this assessed the impact of aid inflows on economic growth (1972-2015) of Pakistan. Second, the effect of economic policies on growth has estimated through the construction of macroeconomic policy index. The third objective is distinguish-ing this study from other available studies in case of Pakistan; we have empirically estimated the impact of volatile aid on economic growth of Pakistan. The last objective is to analyze the impact of macroeconomic policies on growth in the presence of volatile aid inflows.

Structure of the study This study has four sections. The second section of this study presents literature on aid- growth relationship, effects of volatile aid inflows and the role of macroeconomic policies in making aid effective. In the third section of the study, we have explained the methodology and construction of macroeconomic policy index to assess the second and fourth objective of the study. In the last part, empirical results have been presented followed by discussion and policy implications.

Literature Review

Literature shows that economic growth can be achieved through physical and financial capital. The financial capital depends on the availability of savings and other financial resources. Considering that in most of the developing countries, governments receive low taxes hence they rely on foreign aid and debt to initiate development and non-development projects to attain growth. Foreign aid helps countries to accelerate economic growth when they suffer with low financial resources for pro-growth projects. Literature highlight the positive impact of aid on economic well-being but aid-growth literature is still inconclusive. An ample literature is available on the relationship of foreign aid and economic growth. There are mainly three strands in literature. The first strand of literature presents the positive and favorable impact of aid on growth. The second strand presents no or negative impact of aid on development. While the third strand make aid effectiveness conditional to policy environment.

Theoretical framework of aid asserts that foreign aid helps economies to come out of traditional societies (Rostow, 1959). The idea of ‘big push’ also advocates the need of foreign aid flows to developing economies. Many empirical studies also confirm the significant impact of aid on developing economies growth. Papanek (1972) empirically establish positive relationship between foreign aid and economic growth. Becker and Abbas (1972) estimate positive influence of aid on GDP growth of Pakistan. Similar results for sub-Saharan Africa have been reported by Levy (1988), Levy states that aid is pro-cyclical and pro- development in case of sub-Saharan Africa. Moreover, Chisti and Hasan (1992), Khan et al. (1992) state that aid increases savings and investment in Pakistan. They state that foreign aid inflows helped Pakistan economy in filling the twin gaps and encourage econom-ic development. Gomanee et al. (2005) establish positive impact of aid on growth and investment in pooled panel study of 25 sub-Saharan African countries. McGillivary (2005) examines the spillover effects of aid and suggests that aid helps in reducing regional poverty. Moreover, it promotes develop-

ment goals of education and health in the long run. According to Sachs (2014), properly designed aid and grants helps in reducing poverty and attaining economic growth.

The second strand advocates the conclusions of Friedman (1958) and Baure (1971). Fried-man (1958) state that aid is a tax collected from the poor people of developed countries to finance the luxurious spending of the poor country’s elite class. Baure also consider aid as an ineffective tool to promote economic growth. Among the first empirical studies in this line, Griffen and Enos (1970) establish that aid has significant negative impact on growth of 27 developing countries. One of the reasons behind ineffectiveness of aid is misallocation of aid in developing countries. Mosely (1980) highlights that corrupt governments of recipient countries increase the aid fungability. Dowling and Heiemenz (1982) also empirically prove that aid has been ineffective to foster growth in many devel-oping countries due to misallocation of aid and corrupt governing elite class. Baure (1991) maintains that aid promotes corruption and patronage in recipient country. Diversion of foreign grants to non-de-velopment projects in Pakistan reduced the effectiveness of aid (Ishfaq and Ahmad, 2005). Khan and Ahmed (2007) employee ARDL methodology to empirically estimate the relationship of aid and growth in Pakistan, they refer aid inflows as a curse for Pakistan economy.

The third strand of literature addresses the supportive constituents to make aid effective. Dalgaard and Hansen (2001) mention that aid effectiveness depends on the ability to absorb foreign aid. The role of sound macroeconomic policies has been supported by many studies. Aid inflows can foster growth if economy can absorb aid (Clemens et al., 2004 and Asterious, 2009). Low absorption capacity of aid increases government size of recipient economy (Boone, 1994). Collier and Dollar (2001) identify that economic policies and geographical location play a vital role in making aid useful. Burnside and Dollar (1997, 2000) has directed this strand by constructing an index of macroeconomic policies. They state that in weak economic policy environment aid cannot be effective. A higher rate of inflation and budget deficit can reduce positive effects of foreign grants. Following Burnside and Dollar, Javid and Qayyum (2011) have constructed macroeconomic policy index for Pakistan econo-my to estimate the impact of aid on growth in existing policy environment. They establish that due to unfavorable policy environment aid has been ineffective in Pakistan. In this study, we have recon-structed the macroeconomic policy index of Javid and Qayyum to examine the impact of aid and its volatility on economic growth.

This study has focused on the effects of aid volatility on economic development of Pakistan. Literature maintains that volatile aid reduces the expected favorable outcomes of investment projects. Volatile aid hampers economic growth by delaying development plans (Lensink and Morrissey; 2000, Builr and Hamann; 2003). Fluctuations in aid inflows increase government size and fungability hence negatively affect developmental investment (Hudson and Mosely, 2008; Celasun and Walliser, 2008).

Data and Methodology

This study has empirically estimated the aid-growth relationship for Pakistan economy (1972- 2015). We have employed GMM method to handle potential aid-growth endogeneity. Accord-ing to Boone (1994), Hansen and Tarp (2001), Rajan and Subramanian (2005) and Bruckner (2010), economic growth and foreign aid has endogenous relationship which implies that aid itself depends

on the income level of recipient economy and its economic policies. Considering that economic growth also depends on aid inflows can increase the reverse causality problem in aid-growth relation-ship. Suggested by many studies, instruments variables can be used to minimize endogenity problem in panel data. While, in country specific analysis, we can overcome endogeneity issue by taking lags of variables.

Estimation Methodology and Construction of Index

In this study, we have empirically estimated five equations. First equation estimates the impact of foreign aid inflows (FAt) on economic growth (Yt) of Pakistan. In equation 3.1, labor force (LFt), capital 4 i.e. Moreira, 2005, Bascle, 2008, Jones and Tarp, 2016 formation to GDP ratio (GFCFt), trade openness to GDP ratio (Tt) and foreign direct investment to GDP ratio (FDIt) have been used as control variables. By using lags of variables as instruments, we have estimated following equation:ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + μt Eq (3.1)

To estimate the impact of aid in existing macroeconomic policies on economic growth, we have re-estimated the equation (3.1) by adding macroeconomic policy index (Pol) in equation (3.2) and aid-policy interactive (Pol-Aid) term in equation (3.3). Following Burnside and Dollar, aid- policy interactive terms implies the effectiveness of aid in existing macroeconomic policy environ-ment.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( FAt) + α6 ln( Polt) + μt

Eq (3.2)

ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4FDIt + α5 ln( Pol − Aidt) + μt Eq (3.3) Equation (3.4) presents the impact of volatile aid on economic growth.ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + μt Eq (3.4)

Aid volatility has been estimated through Hodrick-Prescott (HP) filter method. Moreover, to investigate the impact of volatile aid on growth in current policy environment, we have empirically estimated equation (3.5).ln(Yt) = α0 + α1LFt + α2 ln(GFCFt) + α3 ln(Tt) + α4(Vol − Aidt) + α5(Polt) + μt Eq (3.5).

We have followed Burnside and Dollar (2000) to assess the impact of policies on growth. We have used Principal Component Analysis (PCA) for index construction. Following the literature, we have added inflation, budget surplus and trade openness as policy variables to construct macroeco-nomic policy index for Pakistan. Following equation represents the construction of index whereas β1, β2 and β3 show the weights of first components of PCA:Policy Index = β1 (budget surplus/ GDP ratio) - β2 inflation + β3 (trade openness/ GDP ratio)

The signs of each variable represent the economic association of that particular variable with economic growth.Policy Index = 0.105368* (budget surplus/ GDP ratio) - 0.562819* inflation + 0.542549* (trade open-

ness/ GDP ratio)

Data sources and Stationarity Analysis

This study is a time series analysis of Pakistan from 1972-2015. The data series of labor force, GDP per capita, gross fixed capital formation have been taken from different issues of the economic survey of Pakistan. However, data series of inflation, trade openness, budget surplus and foreign direct investment have been taken from the State Bank of Pakistan. Moreover, we have used the World Bank data series of Official Development Assistance (foreign aid) in our analysis. All the series have been included in analysis after making them stationary through Augmented Dicky Fuller (ADF) method for unbiased estimators.

Empirical Results

The impact of foreign aid on economic growth varies from country to country and time to time. This study has empirically investigated the relationship between aid inflows and economic growth of Pakistan from 1972-2015. Our results in line with Ishfaq and Ahmad (2005), Khan and Ahmed (2007), Javid and Qayyum (2011), foreign aid inflows have been ineffective to accelerate economic growth rate in Pakistan. Table 4.1 shows that labor force, capital stock and trade openness have significant positive impact on growth of Pakistan. Moreover, results highlight that current macroeconomic policies are pro-growth and have positive association with GDP per capita. Unfortu-nately, in current policy environment, foreign aid inflows are unable to foster economic growth but if we can utilize aid inflows in combination with good pro-growth policies then their impact on growth can be positive. Aid-policy interactive terms have significant positive impact on GDP per capita in case of Pakistan. These results are similar to findings of Burnside and Dollar (2000), Javid and Qayyum (2011), these results imply that aid can be only effective in case of Pakistan if utilized in sound macroeconomic policy environment.

Table 4.1

Dependent Variable: Gross Domestic Product (GDP) per capita (1972-2015)

By employing GMM methodology, we have empirically establish that foreign aid volatility hampers the economic growth. Results presented in table 4.2 imply that foreign aid volatility is the main underlying reason behind aid ineffectiveness. Moreover, results also highlight that volatile aid inflows also make policies ineffective to promote economic growth in Pakistan. This study maintains the findings of Bulir and Hamann (2003), Hudson and Mosely (2008) that volatile aid inflows hamper economic growth of recipient countries. Some of the reasons behind volatile aid inflows can be condi-tional aid, which Pakistan has received mainly from bilateral sources. After 9/11, aid has been mainly subject to coalition support fund and that could not help economy to grow. By controlling volatility of aid inflows, Pakistan economy can achieve sustainable economic growth with help of aid to fill saving-investment gap.

Table 4.2

Dependent Variable: Gross Domestic Product (GDP) per capita

Conclusion and Policy Implications

This study is an empirical investigation to assess the underlying factors of aid ineffectiveness in case of Pakistan. The results of the study establish that volatile aid is the main reason behind making aid ineffective. Furthermore, volatile aid inflows impede the positive effects of macroeco-nomic policies and negatively affect Pakistan’s economic growth. This study suggests that aid donors may consider reducing aid fluctuations to Pakistan to make aid effective.

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