Aid and FDI: Does Targeted Development Assistance Enhance FDI in Developing Countries

Official development assistance (ODA) is increasingly understood as a vehicle to foster foreign direct investment (FDI) in aid-recipient countries. However, both theoretically and empirically the relationship between the two is unclear. While ODA could remove barriers to FDI or signal confidence to investors, it might also crowd out private investment. Using data for aid recipient countries for the years 1995 to 2014, this paper sheds light on the potential transmission channels between aid and FDI. Specifically, it shows that aid spending on governance and health is positively associated with foreign direct investment inflows to aid recipient countries. Education ODA might also be associated with higher FDI flows, however more ambiguously than spending on health and governance. All of these associations decrease as aid flows increase, suggesting that the efficiency of aid spending in fostering FDI is diminishing. Surprisingly aid spent on infrastructure is not associated with enhanced FDI inflows. Overall, however, this study suggests that targeted ODA can leverage FDI and, therefore, help increase the impact of aid spending on FDI and economic development.