Risk sharing role of foreign aid in developing countries

The effects of foreign aid on economic growth have been extensively investigated over the past 40 years. However, even though foreign aid can be a significant source of insurance against domestic output shocks for developing countries, its risk-sharing role has not been well explored. Using a sample of 22 developing countries over the period 2003–2013, we estimate the degree of income smoothing generated by foreign aid serving as an effective channel of international income smoothing. In particular, for the period 2003–2008, we estimate that foreign aid offset about 4% of the domestic output shocks. Furthermore, we investigate the determinants of the extent of risk sharing via foreign aid, recognizing the diversification of the originating countries as a key factor. Surprisingly, humanitarian aid seems to have a negative effect, which might be explained by its predominant role in the short run.