According to the so-called Monterrey Consensus achieved at the UN summit on Financing for Development in 2002, foreign direct investment (FDI) is “especially important for its potential to transfer knowledge and technology, ... enhance competitiveness and entrepreneurship, and ultimately eradicate poverty through economic growth and development” (United Nations 2003:9). This raises the question of whether the international community could support the diffusion of FDI-related benefits by using aid as a means to ease access to FDI.

Theoretically, foreign aid has ambiguous effects on FDI (e.g., Harms and Lutz 2006). On the one hand, aid may increase the productivity of private capital by improving the supply of complementary factors of production. On the other hand, aid could have adverse effects on FDI by giving rise to rent-seeking and by crowding out foreign investment in the tradable goods sector (Beladi and Oladi 2007). Yet a widely cited report by the OECD (2002) called on donors to improve the synergies between FDI flows and official development assistance.

In a recent paper, we argue that this could be achieved if well targeted foreign aid removed critical impediments to higher FDI inflows, for instance by improving the endowment of host countries with sufficiently skilled labour on which foreign direct investors draw (Donaubauer et al. 2012). Regarding Latin America, we hypothesize that aid for education is an effective means to increase FDI flows to host countries where schooling and qualification can reasonably be considered inadequate from the viewpoint of foreign direct investors.

According to the World Business Environment Survey, more than half of the firms rated education in Latin America to be ‘slightly bad,’ ‘bad,’ or ‘very bad’ (World Bank 2003). Importantly, this share was higher than in any other region, including Africa. Figure 1 reveals that almost all Latin American sample countries fall below the ‘normal pattern’ when the quality of education is related to the countries’ average GDP per capita. In other words, Latin American countries typically lag behind the quality of education to be expected at their level of economic development.

Figure 1: Quality of education and GDP per capita across countries: Position of Latin American sample countries in the ‘normal pattern’

Excl. developed countries with GDP per capita higher than 20000$. Cuba excluded due to missing data.
Source: World Economic Forum and WDI of the World Bank

The hypothesis that aid for education helps attract FDI inflows – notably to where schooling and education are deficient – appears to be plausible. True, it cannot be taken for granted that the link between aid for education and educational outcomes would hold in the specific Latin American context. However, Figure 2 indicates that the increase in aid for education is correlated positively with completion rates at the secondary and tertiary levels of schooling in the region.

Figure 2: Aid for education and highest schooling level attained (% of population age 15 and more that completed schooling levels):  Average of 21 Latin American sample countries, 1985 – 2010
 

Solid line gives five-year averages of aid education, starting with 1984-1988 (see Donaubauer et al. 2012 for details); right-hand scale.
Source: Barro-Lee data and CRS database of the OECD

We employ panel data techniques covering 21 Latin American countries over the 1984-2008 period to systematically assess the effects of aid on FDI. Net FDI inflows relative to GDP represent the dependent variable, while net aid flows relative to GDP are the explanatory variable of principal interest. Importantly, we separate aid for education from all other aid items. We control for various variables which are commonly used in the related literature; the effects of most of the control variables on FDI are in line with previous studies.

As concerns the aid variables of principal interest, we do not find any statistically significant influence of aid to sectors other than education on FDI inflows. This is in line with the ambiguous results of previous studies using aggregate aid data. By contrast, aid for education is positively associated with FDI in Latin American countries. The coefficient on aid for education is highly significant, and the point estimate implies that an increase by one standard deviation increases the FDI-to-GDP ratio by more than one percentage point – an economically large effect.

For a start, we assess the effects of aid granted during a five-year interval on FDI inflows in the same five-year interval. This approach probably fails to capture delayed effects on FDI. It takes time until committed aid is disbursed, and still more time until disbursed aid eventually improves the education of the workforce.

Therefore, we modify the estimation approach to assess delayed effects more fully. Nevertheless, the results are strikingly similar across different lag structures. This suggests that foreign investors anticipate the effects of aid for education on the country’s endowment of sufficiently qualified labour. We thus corroborate Mayer (2006: 45) who argues that “aid commitments can have a large signaling role for foreign investors, who can be affected by them even if not all commitments actually end up in disbursements.”

Our estimation results prove to be surprisingly robust in various other respects. Importantly, the positive effect of aid for education on FDI is not due to potential outliers, sample selection within Latin America, the choice of control variables, or the method of estimation. In summary, the estimations provide strong and robust empirical evidence that aid for education is indeed associated with higher net FDI inflows to Latin America countries. Aid for education proves not only statistically significant but also has a quantitatively important positive impact.

This invites the conclusion that aid can be effective even though the relation between aggregate aid and economic growth often appears to be elusive. Our study underscores the need to disaggregate aid and assess its effects on more specific outcome variables. Deeper insights into the relationship between aid and FDI may be gained where inward FDI can be differentiated by sectors and industries. It clearly deserves more attention whether sector-specific aid such as aid for education attracts FDI to certain sectors and particular types of FDI, though not necessarily other types.
 

References:

Beladi, H. and Oladi, R. (2007). Does foreign aid impede foreign investment? In: S. Lahiri (ed.), Theory and Practice of Foreign Aid. Amsterdam: Elsevier: 55-63.

Harms, P. and Lutz, M. (2006). Aid, governance and private foreign investment: Some puzzling findings for the 1990s. Economic Journal 116(513): 773-790.

Donaubauer, J., Herzer, D. and Nunnenkamp, P. (2013). Does aid for education attract foreign investors? An empirical analysis for Latin America. European Journal of Development Research, forthcoming; revised version of Kiel Working Paper 1806.

Mayer, T. (2006). Policy coherence for development: A background paper on foreign direct investment. OECD Development Centre, Working Paper 253. Paris.

OECD (2002). Foreign Direct Investment for Development: Maximising Benefits, Minimising Costs. Paris: OECD.

United Nations (2003). Financing for development. Monterrey consensus of the international conference on financing for development. https://selectra.co.uk/sites/selectra.co.uk/files/pdf/MonterreyConsensus.pdf (accessed: October 2012).

World Bank (2003). Investment Climate around the World. Voices of the Firms from the World Business Survey. Washington, DC: World Bank.