The Impact of Foreign Aid on Public Spending the Case of Ethiopia

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Addis Ababa University


This paper seeks to address the effect of foreign aid on public spending with particular reference to the case of aid fungibility in Ethiopia. In this paper, 4 developmental sector and 3 non-developmental sector were considered. Agriculture, construction, education and transport& communication were classified as developmental expenditure while, defense, general service and debt servicing were classified as non-developmental expenditure. For each developmental sector, GDP, sector specific aid and aid other than the sector specific aid variables are considered for explanatory variables and sector specific spending is considered as dependent variables. The analysis was done using OLS estimation. In estimating the long run model, first, the time series characteristic of the data is tested using ADF test and found that all the variables in developmental and non-developmental models are integrated order of one. Then, the cointegration test was conducted and concluded that there is one cointegrating vector between developmental spending, sector-specific aid, other aid and GDP. It is also found that there is one cointegrating vector b/n non-developmental spending, foreign aid and GDP. The test of weak exogenity indicate that all explanatory variables in developmental model are weakly exogenous. Before going to estimation, the following step is to test zero restriction on the coefficients of explanatory variables in which case, at least one of the explanatory variable coefficient is found to be significantly different from zero. In estimating the short run impact, ECM method was employed after knowing not only that there is one cointegrating vector between dependent and explanatory variables, but also the variables are integrated of order one I(1). Hence, the estimated result in education and agriculture sectors were marked by non-fungiblity in which case the sectoral aid impact on sectoral spending have crowding in effect. However, for transport & communication and construction sector, aid fungiblity seems to exist which means that there is crowding out effect. In this case, the sectoral aid impact on the sectors spending is negative. For non developmental expenditure, aid is found to be significantly affecting debt servicing expenditure but insignificant for general service and defense expenditures.



Foreign Aid on Public Spending