Abuzar Asra is Senior Statistician Econo

ERD Worki ng Paper No. 6 5

P OVERTY AND F OREI GN A ID

E VI DENCE FROM R ECENT C ROSS -C OUNTRY D ATA

A BUZAR A SRA ,G EMMA E STRADA ,Y ANGSEON K IM , AND M.G. Q UI BRI A

Marc h 2005

Abuzar Asra is Se nio r St at ist ician, Eco no mics and Re se arch De part me nt , Asian De ve lo pme nt Bank; Ge mma Est rada is St aff Co nsult ant , Eco no mics and Re se arch De part me nt , Asian De ve lo pme nt Bank; Yangse o n Kim is Le ct ure r, East We st Ce nt e r, Unive rsit y o f Hawaii; and M. G. Quibria is Adviso r, Ope rat io ns Evaluat io n De part me nt , Asian De ve lo pme nt Bank. The pape r re ce ive d he lpful co mme nt s fro m Frank Harrigan, Rana Hasan, Bruce Murray, and Gunt ur Sugiyart o . Chickie Cust o dio pro ce sse d wit h alacrit y succe ssive ve rsio ns o f t he pape r. The vie ws e xpre sse d in t his pape r are t ho se o f t he autho rs and do no t ne ce ssarily re fle ct the vie ws o r po licie s o f the Asian De ve lo pme nt Bank. This study is partly finance d

b y RETA 5 9 1 7 : Building a Po ve rt y Dat ab ase .

Asian De ve lo pme nt Bank P. O. Bo x 789 0980 Manila Philippine s

©2005 by Asian De ve lo pme nt Bank Marc h 2 0 0 5 ISSN 1655- 5252

The vie ws expre sse d in this pape r are tho se o f the autho r( s) and do no t ne c e ssarily re fle c t the vie ws o r po lic ie s o f the Asian De ve lo pme nt Bank.

FOREWORD

The ERD Wo rking Pape r Se rie s is a fo rum fo r o ng o ing and re c e ntly

c o mple te d re se arc h and po lic y studie s unde rtake n in the Asian De ve lo pme nt Bank o r o n its behalf. The Series is a quick- disseminating, info rmal publicatio n meant to stimulate disc ussio n and elic it feedbac k. Papers published under this Series c o uld subsequently be revised fo r public atio n as artic les in pro fessio nal jo urnals o r c hapte rs in bo o ks.

CONTENTS

Abstrac t vii

I. I ntro d uc tio n

3 III.

II. Empiric al Framewo rk and Estimatio n Issues

Data

A. Time Variant

B. Time Invariant

IV. Empiric al Analysis

A. Equatio ns 1 to 4: Witho ut Interac tio ns

B. Equatio ns 5 to 9: With Interac tio ns

V. Co nc lusio ns

18 Re fe re nc e s

ABSTRACT

This pape r take s a fre sh lo o k, fro m a mac ro pe rspe c tive, at the issue o f aid e ffe c tive ne ss. An impo rtant po int o f de parture fo r this study is that it ado pts po verty reductio n, as co ntrasted fro m eco no mic gro wth, as the metric fo r me asuring aid e ffe c tive ne ss. In c o nduc ting the e mpiric al inve stig atio n, the pape r e xpe rime nts with a numbe r o f diffe re nt re g re ssio n e quatio ns and use s a ne w pane l datase t o n po ve rty. It sho ws that aid and aid- square d bo th have sig nific ant c o e ffic ie nts b ut with diffe re nt sig ns ( po sitive fo r aid and ne g ative fo r aid- square d) . This re sult sug g e sts that aid is e ffe c tive whe n it is re lative ly mo de rate but be c o me s ine ffe c tive whe n the size o f aid e xc e e ds the c ritic al value de fine d b y the ab so rptive c apac ity. Our re sults furthe r suggest that while the macro po licy enviro nment and the quality o f go vernance have a sig nif ic ant b e aring o n po ve rty re duc tio n, aid e f f e c tive ne ss is no t critically co ntingent o n them. Aid has o n average been effective, o ur reg ressio n re sults c o nfirm, unde r a who le varie ty o f c irc umstanc e s— in te rms o f po lic y

e nviro nme nts and quality o f g o ve rnanc e — in a wide dive rsity o f de ve lo ping

c o untrie s. It also po ints to the limite d use fulne ss o f using ag g re g ative inde x o f ( mac ro ec o no mic ) po lic y and go vernanc e fo r po lic y insig hts. To derive useful po lic y insig hts, o ne ne e ds to lo o k b e yo nd the se ag g re g ate s. Ho pe fully, the pre se nt pape r, whic h make s an explo rato ry first atte mpt in dire c tly linking po ve rty re duc tio n ( rathe r than g ro wth) to aid, c o ntro lling fo r a numb e r o f mac ro e c o no mic po lic y variable s and g o ve rnanc e, wo uld inspire furthe r future re se arc h e ffo rts.

I . I NTRODUCTI ON

The re are fe w to pic s in de ve lo pme nt e c o no mic s that have g arne re d as muc h c o ntro ve rsy as the issue o f aid e ffe c tive ne ss. In the last 40 ye ars o r so , a large lite rature has e me rge d o n the to pic but with fe w firm c o nc lusio ns. 1 The lite rature has be e n marke d by a wide dive rsity o f appro ac he s, 2 o ften emphasizing widely divergent and co ntradicto ry co nclusio ns. The earlier literature has highlighted the c ritic al impo rtanc e o f fo reig n assistanc e in e c o no mic de ve lo pment. This has be e n c o difie d in the famo us two - g ap theo ry, which states that aid pro mo tes eco no mic develo pment by relaxing saving s and fo reign- exchange co nstraints to capital fo rmatio n and eco no mic gro wth ( Chenery and Stro ut 1966) . The o ptimism and e nthusiasm o f the two - g ap lite rature has, ho we ve r, be e n sho rt live d. It has g ive n way to wide spre ad ske ptic ism that has appe are d in the mo re re c e nt lite rature. In additio n to the mainstream eco no mics literature, aid has many ideo lo g ical detracto rs bo th fro m the left and the right. Inde e d, the se ide o lo g ic al c ritic s o f the le ft and the rig ht are unite d in the ir o ppo sitio n to fo reig n

assistance, which is co nsidered co unterpro ductive and o ften harmful. 3 Ho wever, this perspective co ntrasts with the mainstre am e c o no mic lite rature, whic h is mo re e vide nc e - b ase d and draws o n rig o ro us quantitative analytic al tec hniques. Co nsequently, the mainstream ec o no mic s literature has been mo re

g uarde d and te ntative in its c o nc lusio ns.

A se e ming parado x that the aid e ffe c tive ne ss lite rature has thro wn up is the c o ntradic tio n in the finding s be twe e n mic ro - le ve l and mac ro - le ve l studie s. Ac c o rding to the po ste valuatio n studie s repo rted by aid agenc ies, a large majo rity o f the do no r- spo nso red investment pro jec ts are suc c essful,

with hig h e c o no mic re turns and sustainable be ne fits. 4 Ho we ve r, the quantitative studie s that re ly o n cro ss- co untry gro wth regressio ns do no t o ften yield a ro bust relatio nship between aid and eco no mic

g ro wth. This mic ro - mac ro parado x, a name due to Mo sle y ( 1987) , has he lpe d to ig nite a go o d de al o f re se arc h inte re st amo ng e c o no mists. Mic halo po ulo s and Sukhatme ( 1989) and White ( 1992) , who have surve ye d the e arlie r c ro ss- c o untry re g re ssio n- base d lite rature, attribute this se e ming parado x

to co nceptual, data, and technical eco no metric pro blems. 5 They further co nclude that the cro ss- co untry

e videnc e is ambig uo us.

1 Se e Hanse n and Tharp ( 2 0 0 0 ) , Easte rly ( 2 0 0 3 ) , and Quib ria ( 2 0 0 4 ) fo r re c e nt re vie ws o f the lite rature . 2 So me are mic ro - le ve l studie s while o the rs are mac ro , and ag g re g ative ; so me o f the se studie s are fo c use d o n a sing le co untry while o thers take a co mparative cro ss- co untry perspective; so me studies rely o n a bro ad qualitative, interdisciplinary frame wo rk; o the rs use so phistic ate d quantitative te c hnique s. 3 The c ritic s o f the left arg ue that the real o bjec tive o f aid is to extend and perpetuate internatio nal c apitalism and suppo rt the po litic al ag e nda o f the ne o - c o lo nial po we rs— and no t to he lp the po o r and disadvantaged. The c ritic s o f the rig ht argue that aid helps to extend the po wer o f the state to sustain bureaucratic centralism and hampers eco no mic develo pment.

4 This fac t is e vide nt fro m po ste valuatio n re po rts o f all majo r multilate ral de ve lo pme nt institutio ns suc h as ADB, Inte r- Ame ric an De ve lo pme nt Bank, and the Wo rld Bank ( se e, fo r example, ADB 2002) . This has also be e n hig hlig hte d in the

re vie w o f Casse n and Asso c iate s ( 1994) . 5 Casse n and Asso c iate s ( 1994) se e k to explain why the re latio nship be twe e n aid and g ro wth is ambig uo us and, in mo st

cases, weak. They hypo thesize that the relatio nship “can be either po sitive o r negative, depending o n the co untry gro upings and time perio d cho sen.” In additio n, they discuss the pro blems o f interpretatio n regardless o f the finding of the relatio nship

be twe e n aid and g ro wth, whic h inc lude suc h issue s as fungibility, histo rical cause s o f gro wth o r the ro le o f o the r facto rs in addit io n t o aid , and the scale o f aid. In c o nc lusio n, the y no te that the inc o nc lusive finding re g arding the impac t o f aid o n g ro wth is no t surprising , g ive n the e no rmo us varie ty o f c o untrie s and type s o f aid.

P OVERTY AND OREI GN F ID A E FROM VI DENCE ECENT R ROSS C -C OUNTRY

ATA D

A BUZAR SRA A , G EMMA STRADA E , Y ANGSEON IM K , AND

M. G. Q UI BRI A

Afte r a pe rio d o f re lative lull, the de bate o n aid e ffe c tive ne ss has pic ke d up ag ain in re c e nt ye ars. Appe aling to a se t o f c ro ss- c o untry re g re ssio n re sults, Bo o ne ( 1996) has arg ue d that aid is ine ffe c tive be c ause it te nds to financ e c o nsumptio n rathe r than inve stment. 6 Subse que ntly, a muc h publicized paper by Burnside and Do llar ( 2000) pro vides further, albeit qualified, suppo rt to the Bo o ne co ntentio n. By inco rpo rating eco no mic po licies into the reg ressio n equatio n and explicitly intro ducing an aid- po lic y inte rac tio n te rm, Burnside and Do llar c o nc lude that if aid is ac c o mpanie d b y go o d mac ro e c o no mic po lic ie s, it has a sig nific ant po sitive e ffe c t o n g ro wth. This, ho we ve r, streng the ns the c ase fo r targe ting aid to c o untrie s that have made impro ve me nts in e c o no mic po lic y. The re sults

o f Burnside and Do llar 7 have re c e ive d wide atte ntio n be c ause o f its appare nt plausibility and ability to pro vide a re so lutio n o f the mic ro - mac ro parado x.

In re ac tio n to the Burnside and Do llar pape r, a numbe r o f re c e nt pape rs have e me rge d that examine the pape r’s ro bustne ss. The se pape rs inc lude Hanse n and Tarp ( 2001) , Dalg aard and Hanse n ( 2001) , Le nsink and White ( 2001) , and Easte rly e t al. ( 2004) . Hanse n and Tarp ( 2001) find that aid has a po sitive but diminishing impact o n eco no mic gro wth. Ho wever, they find that this estimated impact is hig hly sensitive to the cho ice o f the estimato r— that is, whether it is Ordinary Least Squares ( OLS) o r Ge ne ralize d Me tho d o f Mo ments ( GMM) re g re ssio n— and the se t o f c o ntro l variable s. Fo r example, whe n the y c o ntro l fo r inve stme nt and human c apital, the y find no po sitive e ffe c t o f aid. Dalg aard and Hanse n ( 2 0 0 1 ) use the same mo de l spe c ific atio n as we ll as the data o f Burnside and Do llar. The y find that the princ ipal Burnside and Do llar c o nc lusio n— that the impac t o f aid is c o nting ent o n the mac ro ec o no mic enviro nment— is no t ro bust. It c ritic ally depends o n the c ho ic e o f o bse rvatio ns. The y no te that the five influe ntial o bse rvatio ns that Burnside and Do llar e xc lude fro m the ir pre fe rre d re g re ssio ns have a c ritic al be aring o n the re sults. With a diffe re nt c ho ic e o f o b se rvatio ns that re ly o n e qually valid and standard re g re ssio n diag no stic s, unlike Burnside and Do llar the y find that aid has a sig nific ant po sitive impac t o n e c o no mic g ro wth. The y also no te that the Burnside and Do llar data sug g e st a no nline ar re latio n be twe e n g ro wth and aid, implying diminishing re turns to aid. Le nsink and White ( 2001) also do no t find any e mpiric al c o rro bo ratio n in favo r o f the Burnside and Do llar pro po sitio n that aid is mo re e ffe c tive in a g o o d mac ro e c o no mic po lic y e nviro nme nt. The ir re sults pro vide suppo rt fo r the no tio n that the re are diminishing re turns whe n the le ve l o f aid inflo w is hig h. Ho we ve r, the se e mpiric al re sults se e m to be se nsitive to the se le c tio n o f c o untrie s as we ll as to mo de l spe c ific atio n.

Tho ug h all the abo ve me ntio ne d studie s raise que stio ns abo ut the ro bustne ss o f the Burnside and Do llar finding s, the c ritique o f Easte rly e t al. ( 2004) ho we ve r was the mo st de vastating . The y to o k a diffe rent but simple r ro ute to ro bustne ss. The y re taine d the Burnside and Do llar mo de l and the me tho do lo g y, but adde d ne w data that we re no t available to Burnside and Do llar. The y find that

6 Bo o ne de rive s his re sults fro m pane l data re g re ssio ns base d o n a sample o f 90 c o untrie s c o ve ring o ve r 20 ye ars. The validity o f the e mpiric al re sults o f Bo o ne has be e n wide ly que stio ned. A numbe r o f e mpiric al studie s, whic h are in many

ways similar to that o f Bo o ne in te rms o f o ve rlapping sample s and e stimatio n me tho ds, do find a po sitive impac t o f fo re ig n assistanc e. 7 The finding s o f the wo rking pape r ve rsio n o f the Burnside and Do llar study we re g ive n wide r public ity in a subse que nt Wo rld Bank public atio n, Asse ssing Aid ( Wo rld Bank 1998) . The princ ipal pro po sitio ns o f the study c an be summarize d as fo llo ws: ( i) financ ial aid wo rks in a go o d po lic y e nviro nme nt; ( ii) e ffe c tive aid c o mple me nts private inve stme nt; and ( iii) aid can nurture refo rm even in disto rted enviro nments, if it is fo cused o n ideas and pursued with patience. Co nsequently, thre e o f the five po lic y re fo rms pro po se d are ( i) financ ial assistanc e must be targ e te d mo re e ffe c tive ly to lo w- inc o me

c o untries with so und ec o no mic management; ( ii) po lic y- based aid sho uld be pro vided to nurture po lic y refo rms in c redible re fo rme rs; and ( iii) the mix o f aid ac tivitie s sho uld be tailo re d to c o untry and se c to r c o nditio ns.

2 M ARCH 2005

S ECTI ON II E MPI RI CAL F RAMEWORK AND E STI MATI ON I SSUES

o nc e the ne w data are adde d, the sig nific ant re latio nship b e twe e n “ g ro wth” and “ aid and po lic y interactio n” ceases to exist. In o ther wo rds, by applying the mo del to a larger dataset, they demo nstrate that this muc h- to uted pro po sitio n— that fo reig n aid will enhanc e ec o no mic g ro wth o nly in c o untries with go o d po lic ie s— is e mpiric ally all to o frag ile.

The pre se nt study lo o ks at aid e ffe c tive ne ss fro m a pe rspe c tive diffe re nt fro m that o f the

e arlie r studie s disc usse d abo ve. Vie wing po ve rty reduc tio n as the me tric fo r me asuring de ve lo pme nt, this pape r explo re s the ro le o f fo re ig n aid in addre ssing po ve rty. The use o f po ve rty re duc tio n as the me tric fo r me asuring de ve lo pme nt was mo tivate d by the re c e nt shifts in e mphasis o f the inte rnatio nal de ve lo pme nt c o mmunity. Inte rnatio nal de ve lo pme nt age nc ie s have in re c e nt ye ars fo c use d o n po ve rty re duc tio n, as o ppo se d to e c o no mic g ro wth, as the o ve rarc hing g o al o f e c o no mic develo pment. This is reflec ted in the ado ptio n o f the Millennium Develo pment Go als as the o bjec tive o f the inte rnatio nal c o mmunity, as we ll as in the visio n state ments o f the multilate ral de ve lo pme nt inst it ut io ns. Fo r e xamp le, t he Wo rld Bank e nvisio ns “ a wo rld f re e o f p o ve rt y” and t he Asian De ve lo pme nt Bank has ado pte d po ve rty re duc tio n as its o ve rarc hing de ve lo pme nt o b je c tive. In lig ht o f this, it is appro priate that an e nquiry o n aid e ffe c tive ne ss sho uld be frame d in te rms o f po ve rty re duc tio n than e c o no mic g ro wth.

This is the first study to lo o k at the que stio n o f the e ffe c tive ne ss o f fo re ig n aid fro m the pe rspe c tive o f po ve rty re duc tio n. 8 In partic ular, the study trie s to answe r suc h que stio ns as: Ho w do e s aid affe c t po ve rty re duc tio n? Do e s aid e ffe c tive ne ss de pe nd o n the size o f aid? Do e s aid

e ffe c tive ne ss vary by re g io n? What me asure s c an c o untrie s take to impro ve aid e ffe c tive ne ss? What is the ro le o f quality o f go vernance in po verty reductio n? To what extent is aid effectiveness dependent upo n po lic y? Give n the vario us data c o nstraints and the explo rato ry nature o f the pre se nt exe rc ise, the e mpiric al answe rs to the ab o ve que rie s sho uld b e vie we d as te ntative.

The o rg anizatio n o f the pape r is as fo llo ws. Se c tio n II lays o ut the basic mo de l and Se c tio n

III de sc ribe s the data so urc e s. Se c tio n IV re po rts the e mpiric al re sults. Finally, Se c tio n V pro vide s the c o nc lusio ns,

I I . EMPI RI CAL FRAMEWORK AND ESTI MATI ON I SSUES

The re is no t muc h g uidanc e available fro m the o ry re g arding the appro priate spe c ific atio n fo r the po ve rty e quatio n. Ho we ve r, so me re c e nt c ro ss- c o untry e mpiric al wo rks o n po ve rty ( fo r example, Do llar and Kraay 2 0 0 2 and Hasan e t al. 2 0 0 3 ) e mphasize the ro le o f initial c o nditio ns, po lic ie s, and institutio ns in de te rmining inte rc o untry po ve rty pro file s.

Fo llo wing this lite rature, we po stulate a po ve rty e quatio n:

Po ve rty Re duc tio n = β 1 + β 2 ( Initial Co nditio ns) + β 3 ( Aid) + β 4 ( Po lic y Variab le s) + β 5 ( Go ve rnanc e Variab le s) + β 5 ( Re g io n Dummie s) + ε ( t)

8 Burnside and Do llar ( 1998) make a c irc uito us atte mpt to examine aid e ffe c tive ne ss fro m the po int o f vie w o f po ve rty reduc tio n. Rathe r than using standard po ve rty me asure s, the y use infant mo rtality as the indic ato r o f po ve rty fo r the ir

re g re ssio n analysis. In additio n to the po o r quality o f inte rnatio nal data o n infant mo rtality, the se re sults se e m to be hig hly se nsitive to c hange s in mo de l spe c ific atio n and inc lusio n o f variable s.

ERD W ORKI NG APER P ERI ES S O N . 65

P OVERTY AND OREI GN F ID A E FROM VI DENCE ECENT R ROSS C -C OUNTRY

ATA D

A BUZAR SRA A , G EMMA STRADA E , Y ANGSEON IM K , AND

M. G. Q UI BRI A

If all rig ht- hand- side ( RHS) variab le s in the po ve rty e quatio n are e xo g e no us, the n we c an

e stimate the po ve rty e quatio n inde pe nde ntly fro m a se parate aid e quatio n. 9 Ho we ve r, this may no t be the c ase. Inde e d, it has be e n sug ge ste d in the lite rature that po ve rty and aid te nd to be

de te rmine d simultane o usly. While aid may c o ntrib ute to po ve rty re duc tio n, it is c o nte nde d that the re c ipie nt’s po ve rty is an impo rtant c o nside ratio n in aid allo c atio n. In o the r wo rds, aid is g ive n to lo w- inc o me c o untrie s that are manife stly po o r. Sinc e aid allo c atio n is pre sumab ly affe c te d b y re c ipie nt’s ne e ds, whic h are de sc rib e d b y its initial c o nditio ns, co v ( aid, ε ) mig ht no t b e ze ro — that is, aid is e ndo ge no us in the po ve rty e quatio n. To addre ss this issue, we ne e d to instrume nt aid in the analysis. The instrume nt Z sho uld satisfy fo llo wing two c o nditio ns: ( A) co v ( Z, aid) ≠ 0, and ( B) co v ( Z, ε ) =0, i. e. , the instrument sho uld be hig hly c o rre late d with the de pe ndent variable ( aid) b ut unc o rre late d with the e rro r.

Our se arc h fo r ide al instrume nts ho we ve r has be e n so me what frustrating . Po te ntial c andidate s fo r instruments include po pulatio n, friend o f do no r dummy, arm impo rt ( military impo rtance) , mo rtality rate, and life expe c tanc y, all o f whic h are kno wn to influe nc e the allo c atio n o f aid. That is, the se variables are c o rrelated with aid— in o ther wo rds, they satisfy c o nditio n ( A) . Ho wever, mo st o f these variables also have an impact o n po verty reductio n, thus vio lating co nditio n ( B) . Amo ng the po tential instrume nt variable s ide ntifie d, do no r’s frie nd dummy and arm impo rt are le ss like ly to be c o rre late d with ε , the re by making the m plausible instruments. Ho we ve r, in the e stimate d aid re g re ssio n, the se two variables do no t exhibit any sig nificant explanato ry po wer. This, o f co urse, co mplicates o ur effo rts at imple menting Two - Stage - Le ast- Square s ( 2SLS) in the e stimatio n o f the po ve rty e quatio n.

Given these diffic ulties in finding the rig ht instrumental variables we c o ntro lled fo r a number o f initial c o nditio ns to he lp c o pe with the e ndo gene ity issue in the po ve rty e quatio n, that is, to

re duc e the po ssibility o f co v ( aid, ε ) ≠

0. The se initial c o nditio ns, whic h re late to fac to rs that mig ht affe c t the allo c atio n o f aid in o ur re g re ssio ns, inc lude : po ve rty in the be g inning ye ar; lo g o f pe r

c apita GDP in the be g inning ye ar; lo g o f po pulatio n in the be g inning ye ar; infant mo rtality rate in the be g inning ye ar; life expe c tanc y in the be g inning ye ar; and the Gini c o e ffic ie nt in the be g inning ye ar. The se initial c o nditio ns he lpe d sig nific antly re duc e the e ndo gene ity pro ble m, but no t to tally. To g uard ag ainst this po ssibility, we c o ntinue to apply e ndo gene ity te sts to o ur e mpiric al re sults.

In the analysis, we use as the de pe ndent variable po ve rty re duc tio n, whic h has be e n me asure d in terms of abso lute, rather than pro po rtio nate rate o f change. 10 Since mo st o f co untries have experienced re duc tio n in po ve rty o ve r time, the c hange in po ve rty [ Po ve rty ( t) - Po ve rty ( t- 5) ] is mo stly ne g ative. Fo r e asie r inte rpre tatio n, we use po ve rty re duc tio n as the ne g ative o f abso lute c hange in po ve rty. That is, if the po ve rty le ve l o f c o untry A has falle n fro m 20 to 10 pe rc e nt, the n “c hange in po ve rty” is indic ate d by –10, and po ve rty re duc tio n by +10. In this way, po sitive c o e ffic ient is inte rpre te d as a po sitive e ffe c t o n po ve rty re duc tio n. 11

9 The aid equatio n is defined as fo llo ws: Aid/GNI = γ 1 + γ 2 ( Initial Co nditio ns: Rec ipient’s need) + γ 3 ( Po litic al Determinants) + γ 3 ( Po lic y Variable s) + γ 4 ( Go ve rnanc e Variable s) + ν it . The initial c o nditio ns inc lude d in the e quatio n are “ po ve rty in

the be g inning ye ar” ; “ lo g o f pe r c apita GDP in the be g inning ye ar” ; “ lo g o f po pulatio n in the be g inning ye ar” ; ” infant mo rtality rate in the beg inning year” ; “ life expec tanc y in the beg inning year” ; and “ the Gini c o effic ient in the beg inning ye ar. ” Po litic al de te rminants inc lude d are “ share o f arm impo rt in to tal impo rt” and “ Franc e zo ne ” , while po lic y and

g o ve rnanc e variable s and re g io ns dummie s are the same as tho se fo r the po ve rty e quatio n. 10 A pro ble m with using the ( annual) pro po rtio nate rate o f c hang e as the inde pe nde nt variable is that it do e s no t pro vide

any indic atio n o f the exte nt o f po ve rty reduc tio n, i. e. , it tre ats a reduc tio n in po ve rty fro m 4 to 2 pe rc e nt the same as a reduc tio n fro m 50 to 25 pe rc e nt. Fo r this re aso n, it se e ms that the abso lute c hang e in po ve rty is a be tte r me asure o f po ve rty reduc tio n fo r o ur purpo se. 11 Thus, we expe c t po sitive ( +) c o e ffic ie nt if the variable has a po sitive impac t o n po ve rty reduc tio n.

4 M ARCH 2005

S ECTI ON III D ATA

I I I . DATA

Fo r po ve rty, we use a datase t re c e ntly c o mpile d by Hasan e t al. ( 2003) . 12 This pane l datase t

c o ve rs mo re than 8 0 c o untrie s o ve r the pe rio d 1 9 6 0 - 1 9 9 8 . Fo r the purpo se o f the pre se nt study, we exc lude all de ve lo pe d c o untrie s and transitio nal c o untrie s. This datase t is, ho we ve r, so me what unb alanc e d due to missing data po ints. The numb e r o f o b se rvatio n pe r c o untry rang e s fro m 1 to 22. Ho we ve r in this study, we to o k o ne o bse rvatio n in e ve ry 5- ye ar pe rio d. This he lps no t o nly to pre ve nt the re sult fro m b e ing do minate d b y fe w c o untrie s, b ut also to smo o th o ut irre g ular ye arly c hang e s. It le ave s 1 4 7 o b se rvatio ns c o ve ring 4 9 c o untrie s. 13

The e mpiric al analysis in the pape r make s use o f two type s o f variable s, so me o f whic h are time - variant and so me time - invariant. The fo llo wing pro vide s a brie f list o f the princ ipal variable s. The c o mple te list o f the variable s use d in the analysis is g ive n in Table 1.

A. Ti me Vari ant

( i) Po ve rty: Use d as the de pe nde nt variable, po ve rty is me asure d by the he adc o unt index, whe n the po ve rty line is se t at $ 2 pe r day. 14

( ii) Aid: The vo lume o f aid is indic ate d b y e ffe c tive de ve lo pme nt assistanc e ( EDA) 15 as a pe rc e ntag e o f g ro ss natio nal inc o me ( GNI) , expre sse d as ave rage o f e ac h 5- ye ar pe rio d.

( iii) Ope nne ss: Trade as a pe rc e ntage o f GDP, 16 expre sse d as an ave rage o f e ac h 5- ye ar pe rio d.

12 Fo llo wing a me tho d that has no w be c o me the industry standard ( se e fo r e xample , Che n e t al. 2000 and 1994) , Hasan e t al. de rive d po ve rty e stimate s using the fo llo wing info rmatio n: ( i) data distributio n by quintile , ( ii) me an pe r c apita

e xpe nditure s, and ( iii) po ve rty line . The y e stimate po ve rty using the alg o rithm and so ftware POVCAL. Sinc e Hasan e t al. use private c o nsumptio n e xpe nditure s ( PCE) pe r c apita fro m natio nal ac c o unts as pro xy fo r me an pe r c apita c o nsumptio n, the ir e stimate s o f po ve rty te nd to b e lo we r whe n c o mpare d to the surve y- b ase d e stimate s o f me an

PCE use d by Che n e t al. No te that the se e stimate s by Che n e t al. have be e n the subje c t o f tre me ndo us c o ntro ve rsy in re c e nt ye ars, as the y te nd to o ve re stimate po ve rty ( se e fo r example, Sala- i- Martin 2 0 0 2 ) . Furthe r, sinc e de riving statistically reliable estimates is mo re difficult the clo ser the po verty line is to the lo wer tail o f the expenditure distributio n, Hasan e t al. c o nside r $ 2 a day e stimate s as statistic ally mo re re liab le . 13 This c o unts o nly o b se rvatio ns that are use d in the final re g re ssio ns. This datase t is availab le fro m the autho rs o n

re q ue st . 14 The main re aso n we use the hig he r $ 2 - a- day po ve rty line rathe r than the $ 1 - a- day po ve rty line is that the latte r

yie lds fe we r te c hnic ally re liable e stimate s o f po ve rty than the fo rme r. In additio n, the $2 po ve rty line is inc re asing ly be ing use d as the thre sho ld o f c ho ic e in inte rnatio nal disc ussio ns; fo r e xample , the 13 th

re ple nishme nt o f re so urc e s fo r the Inte rnatio nal De ve lo pme nt Asso c iatio n ( IDA1 3 ) was pre mise d o n suc h a thre sho ld. 15 This data se t was c o mpile d by Chang e t al. ( 1998) . Burnside and Do llar we re the first to make use o f this ne w me asure o f effective fo reig n assistance. Ho wever, Chang et al. further manipulate this data to derive real aid ( measured in co nstant 1985 do llars, using the unit value o f impo rts pric e index) and re al e ffe c tive de ve lo pme nt assistanc e ( by dividing re al aid b y re al GDP, using the Pe nn Wo rld tab le s) . 16 Trade share s are no t a dire c t me asure o f trade po lic y. Fo r this re aso n, we have also expe rime nte d with a mo re dire c t me asure o f trade po lic y— name ly, impo rt dutie s as a share o f to tal impo rts. Ho we ve r, this me asure pre se nts thre e pro ble ms. First the numbe r o f o bse rvatio ns re duc e s drastic ally by half due to missing data o n impo rt dutie s. Se c o nd, this re late s to a larg e r c o nc e ptual pro b le m: this me asure do e s no t c apture the e ffe c ts o f no ntariff b arrie rs. Third, this me asure unde re stimate s ac tual pro te c tio n whe n hig h tariff rate s drive c o rre spo nding impo rts do wn. Fo r the se re aso ns, we stic k to trad e share s.

ERD W ORKI NG APER P ERI ES S O N . 65

P OVERTY AND OREI GN F ID A E FROM VI DENCE ECENT R ROSS C -C OUNTRY

ATA D

A BUZAR SRA A , G EMMA STRADA E , Y ANGSEON IM K , AND

M. G. Q UI BRI A

T ABLE 1 V ARI ABLE D EFI NI TI ON AND S OURCE

VARI ABLE DEFI NI TI ON

UNI T

SOURCE

Po ve rty Pe rc e ntag e o f the po pulatio n who se inc o me falls be lo w Pe rc e nt Hasan e t al. $2 me asure d in purc hasing - po we r parity do llars.

(2003) Inc o me

Gro ss do me stic pro duc t pe r c apita Re al pe r c apita Pe nn Wo rld GDP at 1996 US

Table s do llar purc hasing po we r parity

Gini Co e ffic ie nt A me asure o f the size distrib utio n o f inc o me Gini value Autho rs o r expe nditure

c alc ulatio n Infant Mo rtality

Infant mo rtality rate pe r 1 , 0 0 0 live b irths Numb e r o f Wo rld Bank Rate

infant mo rtality

c ase s

Wo rld Bank Aid

Life Expe c tanc y Life e xpe c tanc y at b irth, to tal

Ye ar

( EDA/ GNI) * 100 Pe rc e nt Wo rld Bank Ope nne ss to

Sum o f impo rts and e xpo rts as share o f GDP Pe rc e nt Pe nn Wo rld Trade

Table s Go ve rnme nt

Go ve rnme nt expe nditure s as share o f GDP Pe rc e nt Pe nn Wo rld Expe nditure s

Table s Inflatio n Rate

Pe rc e ntage g ro wth in c o nsume r pric e indic e s Pe rc e nt Pe nn Wo rld ( 100 in 1996)

Table s Quality o f

Co mbinatio n o f the fo llo wing go ve rnanc e me asure s: Index numbe r Kauffman e t. Go ve rnanc e

al ( 2003) Co nt ro l o f Co rrupt io n:

Me asure s pe rc e ptio n o f c o rruptio n,

c o nve ntio nally de fine d as the exe rc ise o f public po we r fo r private g ain. Go ve rnme nt Ef f e ct ive ne ss: b ase d o n the re spo nse s o n the quality o f public se rvic e pro visio n, quality o f b ure auc rac y, c o mpe te nc e o f c ivil se rvants, inde pe nde nc e o f the c ivil se rvic e fro m po litic al pre ssure s, and c re dib ility o f the g o ve rnme nt’s

c o mmitme nt to po lic ie s. Re g ulat o ry Qualit y: Me asure s o f the inc ide nc e o f marke t- unfrie ndly po lic ie s suc h as pric e c o ntro ls o r inade quate b ank supe rvisio n, as we ll as pe rc e ptio ns o f the b urde ns impo se d b y e xc e ssive re g ulatio n in are as suc h as fo re ig n trade and b usine ss

de ve lo pme nt. Rule o f Law: Indic ato rs me asuring the e xte nt to whic h ag e nts have c o nfide nc e in and ab ide b y the rule s o f so c ie ty. The se inc lude pe rc e ptio ns o f the inc ide nc e o f c rime , e ffe c tive ne ss and pre dic tab ility o f the jud ic iary, and e nfo rc e ab ility o f c o ntrac ts.

Frie nds o f Franc zo ne dummy

Burnside and Do no rs

Do llar ( 2 0 0 0 ) Military

Share o f arm impo rt in to tal impo rt Pe rc e nt Wo rld Impo rtanc e

De ve lo pme nt I ndicat o rs , Wo rld Bank

6 M ARCH 2005

S ECTI ON III D ATA

( iv) Go ve rnme nt Exp e nd it ure : Go ve rnme nt e xp e nd it ure is p e rc e nt ag e o f g ro ss d o me st ic pro duc t ( GDP) , e xpre sse d as an ave rag e o f e ac h 5 - ye ar pe rio d.

(v) Inflatio n: lo g ( inflatio n) , e xpre sse d as an ave rag e o f e ac h 5 - ye ar pe rio d. 17

B. Ti me I nvari ant

( i) Qualit y o f Go ve rnanc e ind e x: Enc o mp asse s f o ur d ime nsio ns: c o nt ro l o f c o rrup t io n,

g o ve rnme nt e ffe c tive ne ss; re g ulato ry quality, and rule o f law ( ii) Re g io n Dummie s: Inc lude s six re g io nal dummie s: EAP: East Asia and Pac ific ; ECA: Euro pe

and Ce ntral Asia; LAC: Latin Ame ric a and Caribbe an; MENA: Middle East and No rth Afric a; SA: So uth Asia; and SSA: Sub- Saharan Afric a

We use a new measure o f aid c alled effec tive develo pment assistanc e ( EDA) generated by Chang et al. ( 1998) . The EDA fo cuses o n the o verall grant equivalence o f o fficial financial flo ws and excludes lo an c o mpo ne nt o f c o nc e ssio nal lo ans. 18 This ne w me asure is available fo r 133 de ve lo ping c o untrie s fro m 1975 to 1995. The EDA, as it has been argued, o verco mes so me of the sho rtco mings o f co nventio nal me asure s o f aid [ ODA] b ase d o n the OECD’s Offic ial De ve lo pme nt Assistanc e. 19

Our data o n g o ve rnanc e — and the inde xe s we use in this pape r to me asure the quality o f go vernanc e— are all derived fro m the dataset repo rted by Kaufmann, Kraay, and Zo ido - Lo bato n ( KKZ) ( 1999a, 1999b, 2002) ; and updated in Kaufmann, Kraay, and Mastruzzi ( 2003) . The KKZ dataset pro vides six go vernance indicato rs, which are : ( i) vo ice and acco untability, ( ii) po litical stability, ( iii) go vernment

e f f e c t ive ne ss, ( iv) re g ulat o ry q ualit y, ( v) rule o f law, and ( vi) c o ntro l o f c o rrup t io n. 20 The se go ve rnanc e indic ato rs are time - invariant. The Wo rld Bank we b site re po rts the se KKZ g o ve rnanc e indic ato rs at disc re te inte rvals fo r limite d ye ars: o nly fo r 1996, 1998, 2000, and 2002. Sinc e o ur data fo r the dependent variable c o ver the perio d 1975 to 1995, it is inappro priate to use g o vernanc e

17 Whe n the annual inflatio n was le ss than 1 pe rc e nt, it was se t to 1 to pre ve nt it fro m b e ing dro ppe d. Dummy fo r ne g ative inflatio n was inc lude d whe n applic ab le .

18 This EDA definitio n o f aid differs fro m the standard definitio n o f aid ado pted by the Organisatio n fo r Eco no mic Co o peratio n and Develo pment ( OECD) . The OECD definitio n inc ludes bo th g rants and c o nc essio nal lo ans net o f repayment o f previo us

aid lo ans. This OECD me asure o f aid is c alle d ne t Offic ial De ve lo pme nt Assistanc e ( ODA) , whic h pro vide s a me asure o f ac tual financ ial transfe r to a c o untry. In o the r wo rds, the main diffe re nc e b e twe e n the EDA and the standard me asure ODA is that the fo rme r is the sum o f g rants and g rant e quivale nts o f o ffic ial lo ans and the latte r is the sum o f g rants and lo ans fo r whic h the g rant e le me nt is mo re than 2 5 pe rc e nt. 19 As no te d by Dalg aard and Hanse n ( 2000) , de spite the valuable e ffo rt by Chang e t al. ( 1998) to c o nstruc t an impro ve d me asure o f aid f lo ws, the d if f e re nc e b e twe e n EDA and ODA ap p e ars to b e no mo re than a simp le mathe matic al transfo rmatio n. Mo re o ve r, simple statistic al pro pe rtie s o f diffe re nt aid me asure s sug g e st that the aid e ffe c tive ne ss re sults o btaine d by Burnside and Do llar are no t sig nific antly diffe re nt fro m tho se that use no minal o ffic ial de ve lo pme nt assistanc e . 20 Kaufmann e t al. ( 2003) c autio n, ho we ve r, that de spite the inc re ase in pre c isio n in the late st go ve rnanc e indic ato rs, the marg ins o f e rro r still re main substantial re lative to the units in whic h the se indic ato rs are me asured. Ac c o rding ly, the ranking o f c o untrie s b ase d o n the se ind ic ato rs is sub je c t to sig nific ant marg ins o f e rro r. The marg ins o f e rro r ne e d to be take n se rio usly whe n c lassifying c o untrie s into g ro ups base d o n the ir quality o f g o ve rnanc e , as has be e n pro po se d fo r the ne w aid pro g ram o f the US Go ve rnme nt, the Mille nium Challe ng e Ac c o unt ( MCA) . No te that in Marc h 2002, the US Go ve rnme nt anno unc e d that the MCA wo uld be “ de vo te d to pro je c ts in natio ns that go ve rn justly, inve st in the pe o ple and e nc o urag e e c o no mic fre e do m. ” The pro po se d c rite ria fo r c o untry e lig ib ility unde r the MCA c o ve r vario us g o ve rnanc e me asure s, inc luding five o f the six KKZ me asure s.

ERD W ORKI NG APER P ERI ES S O N . 65

P OVERTY AND OREI GN F ID A E FROM VI DENCE ECENT R ROSS C -C OUNTRY

ATA D

A BUZAR SRA A , G EMMA STRADA E , Y ANGSEON IM K , AND

M. G. Q UI BRI A

T ABLE 2 S UMMARY S TATI STI CS (M EAN V ARI ABLES ) BY R EGI ON

REGI ON

SSA TOTAL

Po ve rty 32.76 9.05 19.96 20.16 59.24 66.46 36.69 Chang e in Po ve rty

- 1. 58 2. 86 Pe r Capita Inc o me

1,269 3,126 Lo g ( Pe r c apita inc o me )

7.99 8.50 8.41 8.23 7.24 7.15 7.91 Po pulatio n ( 10 6 )

68.41 45.22 7.04 7.90 72.36 10.08 28.07 Po pulatio n ( lo g )

17.63 15.77 15.88 18.10 16.13 16.60 Gini Co e ffic ie nt

42.57 45.12 42.20 32.75 44.13 41.57 Infant Mo rtality Rate

18.04 17.63 15.77 15.88 18.10 16.13 16.60 Life Expe c tanc y

64.11 61.62 65.14 62.48 55.95 46.73 59.72 Aid

0.53 0.32 1.86 3.58 3.94 6.89 2.99 Op e nne ss

62.78 24.28 60.18 78.02 33.01 51.60 55.17 Go ve rnme nt Expe nditure

19.29 15.74 21.59 28.00 19.44 20.96 20.97 Inflatio n

8.21 42.04 25.93 8.48 9.41 13.78 17.68 Inflatio n ( lo g )

3.26 2.14 2.24 2.62 2.75 Quality o f Go ve rnanc e

-1.60 -0.07 Co untrie s

1.26 0.96 0.24 0.18 -0.69

7 1 18 5 5 13 49 Ob se rvatio ns

25 4 60 8 20 30 147 EAP: East Asia and the Pac ific ; ECA: Euro pe and Ce ntral Asia; LAC: Latin Ame ric a and Caribbe an; MENA: Middle East and No rth Afric a;

SA: So uth Asia; SSA: Sub - Saharan Afric a. No te : De sc riptive statistic s f o r quality o f g o ve rnanc e c o ve r o nly 1 4 9 c o untrie s with data.

ind ic ato rs that re late to the p o st- 1 9 9 5 p e rio d in o ur analysis. As it is wid e ly p re sume d that

g o ve rnanc e indic ato rs c hange ve ry slo wly o ve r time, we inc lude the 1 9 9 6 g o ve rnanc e indic ato rs ( whic h is c lo se st to o ur pe rio d o f inve stig atio n) in the re g re ssio ns.

Fo r o ur analysis, we have e mplo ye d thre e indexe s o f the quality o f go ve rnanc e. The first two inde xe s o f the g o ve rnanc e quality we use are base d o n all the six g o ve rnanc e indic ato rs o f KKZ. One is the c o mpo site KKZ inde x o f the quality o f g o ve rnanc e use d by Burnside and Do llar ( 2004) and the o ther is an ag g reg ate index that we derived by applying the princ ipal c o mpo nents appro ac h using all six indic ato rs.

Ho we ve r, the final index o f the quality o f go ve rnanc e that we use in this pape r is base d o n fo ur o f the six KKZ go ve rnanc e indic ato rs— namely, c o ntro l o f c o rruptio n, go ve rnme nt e ffe c tive ne ss, re g ulato ry quality, and rule o f law. 21 This ne w index, whic h re lie s o n the princ ipal c o mpo ne nts

21 In devising this new index, we exc lude o utrig ht vo ic e and ac c o untability and inc lude g o vernment effec tiveness, bec ause whe n we use all six g o ve rnanc e indic ato rs as se parate explanato ry variab le s ( se e e quatio n 2 in Tab le 3 ) , we find

that vo ic e and ac c o untab ility has a ne g ative sig nific ant c o e ffic ie nt, while g o ve rnme nt e ffe c tive ne ss has a po sitive sig nific ant c o e ffic ie nt. Ne xt, we e xpe rime nt with vario us amalg ams that c o mbine g o ve rnme nt e ffe c tive ne ss with the re maining fo ur g o ve rnanc e indic ato rs ( i. e . , an ag g re g atio n o f fo ur to five indic ato rs to c apture as muc h g o ve rnanc e indic ato rs as po ssible ) . The c o mbinatio n o f five indic ato rs witho ut vo ic e and ac c o untability pro ve s to be insig nific ant, while the c o mbinatio n o f fo ur indic ato rs— name ly, c o ntro l o f c o rruptio n, g o ve rnme nt e ffe c tive ne ss, re g ulato ry quality, and rule o f law— is fo und to b e a sig nific ant pre dic to r o f po ve rty re duc tio n.

8 M ARCH 2005 8 M ARCH 2005

I V. EMPI RI CAL ANALYSI S

This se c tio n re po rts the re sults o f nine e quatio ns 23 that fall into two c ate g o rie s, tho se with and witho ut inte rac tio ns. The y are liste d as fo llo ws:

A. Equat i ons 1 t o 4 : Wi t hout I nt eract i ons

( 1 ) Po ve rty re duc tio n = f ( initial c o nditio ns, mac ro e c o no mic po lic y variab le s) ( 2 ) Po ve rty re duc tio n = f ( initial c o nd itio ns, g o ve rnanc e me asure s) ( 3 ) Equatio n ( 1 ) + aid + aid- square d + quality o f g o ve rnanc e ( 4 ) Equatio n ( 3 ) + re g io n fixe d- e ffe c ts

B. Equat i ons 5 t o 9 : Wi t h I nt eract i ons

( 5) Equatio n ( 3) + aid- go ve rnanc e inte rac tio n ( 6) Equatio n ( 3) + aid- po lic y inte rac tio n ( 7) Equatio n ( 4) + aid- go ve rnanc e inte rac tio n ( 8) Equatio n ( 4) + aid- po lic y inte rac tio n ( 9) Equatio n ( 4) + aid- re g io n inte rac tio n Equatio n 1 is the base regressio n, which is used to determine whether it is appro priate to co nstruct

a po lic y index o ut o f the thre e mac ro e c o no mic po lic y variable s, fo llo wing the appro ac h o f Burnside and Do llar. We, ho we ve r, abando n this plan to c o nstruc t suc h a po lic y index sinc e no t all o ur po lic y variab le s are sig nific ant: o ne o f the po lic y variab le s ( o pe nne ss) turns o ut to b e insig nific ant in the re g re ssio n ( Tab le 3 ) .

22 No te that the first princ ipal c o mpo ne nt attac he s almo st e qual impo rtanc e to e ac h o f the fo ur g o ve rnanc e indic ato rs, as the c o rre latio n b e twe e n the m and the first princ ipal c o mpo ne nt rang e s fro m 0 . 8 6 to 0 9 3 .

23 To c o ntro l fo r the initial c o nditio ns o f the c o untry, we use the fo llo wing variable s ( with the value s o f the variable s in the b e g inning ye ar) as instrume nts: po ve rty, lo g o f pe r c apita GDP, lo g o f po pulatio n, infant mo rtality rate, life

expe c tanc y, and Gini c o e ffic ie nt.

ERD W ORKI NG APER P ERI ES S O N . 65

S ECTI ON III A BUZAR SRA A , G EMMA STRADA E , Y ANGSEON IM K , AND

P OVERTY AND OREI GN F ID A E FROM VI DENCE ECENT R ROSS C -C OUNTRY

T ABLE 3 B ASE R EGRESSI ONS

( 1 ) I NI TI AL CONDI TI ONS AND

( 2 ) I NI TI AL CONDI TI ONS AND

MACROECONOMI C POLI CY

GOVERNANCE

Init ial Co ndit io ns: Po ve rty

(4.82) Pe r Capita GDP

(3.12) Po pulatio n

(0.61) Infant Mo rtality Rate

(1.77) Life Expe c tanc y

( 2.66) Gini Co e ffic ie nt

( 0.01) Ma c ro e c o no m ic Po lic y : Ope nne ss

Go ve rnme nt Expe nditure

Inflatio n

Go ve rnance : Vo ic e and Ac c o untability

Po litic al Stability - 1. 487 (1.08)

Go ve rnme nt Effe c tive ne ss 5.632* (1.93) Re g ulato ry Quality

2. 043 (0.84) Rule o f Law

1.531 (0.59) Co ntro l o f Co rruptio n

0.502 (0.26) Ob se rvatio ns

208 R- square d

0.24 0.26 * me ans sig nif ic ant at the 1 0 % le ve l

* * me ans sig nif ic ant at the 5 % le ve l * * * me ans sig nif ic ant at the 1 % le ve l No t e :

Po ve rty re duc tio n= [ po v ( t )- po v ( t - 5 ) ] . Ab so lute value o f t

statistic s in pare nthe se s.

10 M ARCH 2005

S ECTI ON IV E MPI RI CAL A NALYSI S

In e quatio n 2, all six go ve rnanc e me asure s are e nte re d se parate ly in the re g re ssio n. We find vo ic e and ac c o untability to have a sig nific ant but ne g ative c o e ffic ie nt ( whic h is unexpe c te d, with

a wro ng sig n) , go ve rnment e ffe c tive ne ss is po sitive and sig nific ant, and all o the r me asure s are no t sig nific ant. Apprehending that this re sult may simply be an artifac t o f the hig h c o rre latio n amo ng the go vernance measures, we go o n to co nstruct an index co mbining the different go vernance measures that he lps e liminate this hig h c o rre latio n ( se e Se c tio n III o n data) .

The aid- po verty reg ressio ns beg in with equatio ns 3 and 4, where bo th OLS and 2SLS are applied. We instrument fo r aid with “ Franc zo ne dummy” and “ Share o f arm impo rt in to tal impo rt. ” To te st the e ndo ge ne ity o f aid with o r witho ut quality o f go ve rnanc e, the Hausman te st was applie d fo r OLS and 2SLS e stimate s. The e stimate d Hausman te st statistic s sug g e st that the aid variable c an

be safe ly re g arde d as e xo g e no us thro ug ho ut all o ur spe c ific atio ns. Thus, o nly the OLS is use d in the suc c e e ding e quatio ns.

1. How Does Ai d Af f ect Povert y Reduct i on?