Foreign aid, or official development assistance as it is more formally known, has long played a significant role in developing countries, through alleviating poverty, funding infrastructure projects and combating epidemics such as ebola and malaria. Not without its critics, aid from developed countries into developing economies nevertheless grew steadily between 1997 and 2010. The effects of the global economic downturn dented flows between 2011 and 2012, but foreign aid from the Organisation for Economic Co-operation and Development’s development assistance committee member states rebounded to record levels in 2013, reaching $134.8bn. 

Aid has historically been the largest source of international financial inflows into emerging regions, but in 2013 FDI into developing countries eclipsed aid figures, reaching a record high of $778bn. Analysis of the relationship between foreign aid and FDI is scarce, although research on the topic has been growing in recent years. The existing literature on the issue presents a complex image of the interaction between these two financial flows.

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Overcoming bottlenecks

Poor infrastructure is considered by many to be a key area holding back economic development in a number of emerging countries. Would-be investors in some developing locations argue that they may otherwise prove strong contenders for FDI. Therefore, aid that can assist in overcoming such infrastructural deficiencies is of particular importance. “To a large extent, aid can be used to finance projects where social returns are larger than private returns,” says Pablo Selaya, associate professor at the University of Copenhagen. “The positive externalities of those types of aid investments are potentially large.”

Developmental assistance, whether given through loans or grants, is frequently used to improve infrastructure in emerging countries. As infrastructure projects are relatively easy to track, and allow investors to see what has been built on the ground, they counter some of the criticisms levelled at other aid methods, which are not so easily tracked. 

Aid-funded infrastructure projects also have another value. “My study shows that information dissemination through infrastructure projects is important in attracting FDI. Firms often hesitate to invest in developing countries because they have little information about them,” says Yasuyuki Todo, a professor at the faculty of political science and economics at Waseda University in Tokyo, and co-author of the report 'Is foreign aid a vanguard of FDI?'.

Incomplete information

In countries with inaccurate or poor-quality financial data, foreign aid is used as an indicator to investors as to whether the country may be a reliable partner for their projects. As aid frequently comes with strict stipulations, it is widely seen as demonstrating that donor governments have a level of trust in the recipient to follow through on their commitments.

According to a research paper entitled 'Foreign aid as a signal to investors', published in the Journal of Conflict Resolution, this can be especially true in post-conflict countries. "Post-conflict environments are especially information poor, so signals should matter more in post-conflict countries," it says. 

A welcome side-effect of some aid obligations is the removal of government policies that are perceived as being detrimental to the business climate. While these preconditions are ostensibly aimed at encouraging good governance, they can sometimes be a major catalyst for FDI.

The so-called ‘vanguard’ effect, by which aid provides investors from donor countries with valuable investment insights, is another way foreign aid may give rise to increased FDI.

“When particular countries enter into providing foreign aid to some developing countries, they develop knowledge about the economy that may result in FDI later on,” says Dr Helga Kristjánsdóttir, an economist specialising in international trade and investment at the University of Iceland. “Successful projects may not need financial aid after some years and can be seen as a business opportunity for investors, especially if they are expanding.”

Aid substituting FDI

Tony Addison, chief economist at the UN University World Institute for Development Economics Research, says: “If you look at large aid recipients in Africa over the past 30 years, namely Uganda, Kenya, Tanzania and Ghana, they now receive much more FDI after aid helped reform programmes in the 1990s to generate more growth." 

However, research carried out by Ms Kristjánsdóttir indicates that in Ghana FDI and aid substituted each other, whereas in the cases of Mozambique and Malawi the flows were complementary.

In many developing countries, foreign aid and FDI inflows are in theory complementary, with the benefits of aid enhancing the FDI profile of the recipient country. “This is true in practice, but the opposite can also be true, namely that aid can substitute or crowd out FDI in cases where aid is used to finance projects that could be financed by private investors,” says Mr Selaya.

The proportion of overall capital inflows to developing countries accounted for by aid has fallen from more than 80% in the 1980s to below 20% in 2014. According to Mr Todo: “Aid should play a complementary role to FDI.” 

The purpose of the aid can also have a major impact on whether it helps to promote FDI. Countries such as the US often provide aid based on geostrategic reasons, which will affect things differently to aid given for infrastructure improvements and other vital developments in the impact it will have on FDI. Another possibility is that foreign investors in mining, oil and gas are less likely to view foreign aid as a potential investment competitor, but rather they might benefit from the effects of developmental assistance, as it may create a supportive investment environment.

The challenges facing investors in developing countries are numerous, including corruption, government instability and a lack of accurate financial information. Foreign aid often lays the groundwork for FDI in many emerging countries, by assisting in the development of infrastructure and providing reliable information about the business environment. Although aid is not a ‘silver bullet’ that can remedy all issues about investing in developing markets, it can help create conducive business environments for FDI.