Aid works: rates of return of 20-30%

Donor agencies have tried to measure the rates of return on investment in individual, aid-financed projects, and have typically estimated ex post rates of return ranging from 10 to 30 percent. Studies of the macroeconomic impact of aid up to now have run growth regressions in which aid is one among many explanatory variables for growth. This gives a measure of the overall impact of aid on the economy, but it does not provide estimates of the rate of return of aid investments in their own right. (There are lots of reasons why there might be differences – in either direction – between the rate of return on the individual investments and the impact on the economy as a whole – for example, if there are crowding in effects or positive externalities from aid-financed investment on other investments, or conversely if there are crowding out or dutch disease effects.) See here for a separate analysis of the overall impact of aid on growth. A new study by Carl-Johan Dalgaard and Henrik Hansen (both at the Institute of Economics, University of Copenhagen) fills this gap with a new approach. It estimates the return on investments financed by foreign aid as well as by domestic resources, using crosscountry aggregate data. The paper’s principal finding is remarkably robust: the average aggregate gross return on aid-financed investments (in physical capital) is in the range 20-30 percent range. This finding is well in accord with micro estimates of the economic return to aid. It turns out that the estimated rate of return is roughly the same as the return on investments funded by other sources than aid. This is an interesting new approach, which opens the door to a range of further work – for example, looking at the returns to investment in human capital (eg health and education spending) as well as physical capital; and investigating the differences between countries and over time in rates of return, to give us a better handle on when aid is, and when it is not, effective. These results suggest that evaluations of project level investments are not overstating the effectiveness of those investments, and that aid-financed investments do indeed earn a high rate of return. The similarity of the aid-financed and domestic-financed estimates suggest that aid-financed investments are as productive as private investments. The comparison between the micro estimates and macro estimates suggest that there is neither a strong crowding in, nor strong crowding out, of private investment.

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