Foreign aid and the quality of economic institutions

Identification of the causal effect that foreign aid has on the quality of institutions in recipient countries has been elusive in the aid effectiveness literature. The main reason is that aid is endogenous with respect to the development of institutions. Our paper examines the impact of foreign aid on economic freedom in the recipient countries at a disaggregated level using an innovative identifying strategy. To do so, we use recently innovated instruments for aid, exploiting the long lags between loan approval and disbursements by official creditors to developing countries. Using plausibly exogenous variations in predicted loan disbursements as instruments for actual aid, we find that foreign aid has a significant positive effect on the quality of economic institutions in recipient countries. The results are robust to alternative specifications and samples. By establishing the existence of a strong link between aid and the quality of economic institutions, we identify the main channel through which aid affects economic growth and development.