The role of foreign aid in reducing poverty: time series evidence from Ethiopia

Abstract

Being one of the developing countries Ethiopia had received a large amount of foreign aid (ODA) since WWII, which was targeted towards fostering economic development and poverty reduction. Driven by recent shifts in international financial flows towards poverty reduction and the concentration of previous studies on aid economic growth relationships, this study took a new metric to investigate aid’s effectiveness, that is poverty reduction. Accordingly, the study has examined the role of foreign aid in reducing poverty in Ethiopia over the period 1974/75 to 2009/2010 using multivariate cointegration analysis. Based on the unit root test result which confirmed that all the variables considered are integrated of order one (I (1)), the Johansen maximum likelihood procedure have been employed to test for the presence and rank of cointegration. The test was conducted for three models each having different measures of poverty - infant mortality rate, gross primary enrollment ratio and real household consumption expenditure. Conducted for the three models, the cointegration tests indicated the presence of one cointegrating equation in each model. And by applying the weak exogeneity test the variables that are endogenous to the system were identified. As to the results of weak exogeneity test the three measures of poverty found to be endogenous in each model. The empirical results from the cointegration analysis indicated that foreign aid has a significant effect on poverty reduction, by reducing infant mortality rate and increasing household consumption expenditure. On the other hand, its impact found to be negative when poverty is measured by gross primary enrollment ratio. Nonetheless, when augmented by macroeconomic policy index the impact turned to be positive. Furthermore the result indicated the presence of diminishing returns to the inflow of foreign aid. The results also revealed that economic growth has a significant contribution for poverty reduction, while poor quality of governance exacerbates poverty. Thus, to achieve the poverty reduction objectives, measures have to be taken in the area of aid allocation, quality of governance and macroeconomic policies that can ensure sustainable economic growth.