The effectiveness of foreign aid : a case study of Nepal

Abstract

This thesis examines the effectiveness of foreign aid in Nepal, and adds to the growing literature on the issue of aid effectiveness. Until the mid 1960s, almost all development projects in Nepal were financed by foreign aid. Since 1970, the average aid/GDP ratio remains at over 6 per cent, and in 2002 foreign aid financed over 50 per cent of Nepal’s development expenditure. Despite the constant flow of foreign aid and decades of aid-financed development efforts in Nepal, it remains one of the poorest countries in the world, with per capita income of about US$ 243 and almost 40 per cent of the total population living in absolute poverty. A casual observer of these facts could easily conclude that foreign aid to Nepal has not been effective, though they would not be able to say what would have happened in the absence of aid. This thesis is the first rigorous study of aid effectiveness in Nepal. It examines the issue from three complementary perspectives. First, it looks at aid’s contribution to per capita GDP within the framework of the neoclassical production function. Aid is assumed to contribute to technological progress via technical assistance and importation of capital goods. Second, it examines aid’s contribution to Nepal’s gross domestic investment within a framework of the two-gap model. Since aid is channelled through the government, the thesis lastly examines the impact of foreign aid on government expenditure and revenue efforts. Our study uses time-series data for the period 1970-2002, and employs cointegration and the error correction mechanism as the estimation procedure. The results show that aid has a positive and significant relationship between per capita real GDP, savings and investment in the long-run. Fiscal response analysis indicates that more aid is spent on non-development expenditure than development expenditure and that aid does not impact negatively on revenue raising efforts. In addition, we find that aid effectiveness improves in a good policy environment, that is, one characterised by a stable macroeconomy, openness to trade and a liberalised financial sector. The study also finds that bilateral and multilateral aid are equally effective in the long-run. However, grants aid has a stronger positive association with per capita real GDP in the long-run than loans aid. Finally, the relationship between aid and per capita real GDP in the short-run is found to be negative in both aggregate and disaggregated forms. This implies that Nepal, as in the case of most other developing countries, suffers from lack of absorptive capacity and high aid volatility.

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