Financing growth through foreign aid and private foreign loans: Nonlinearities and complementarities

Are the growth consequences of foreign aid and foreign private loans different for the recipient nations? In this study, we analyze in a unified way, how these two instruments affect economic growth of 131 developing nations over the period 1996-2010. We find that there are diminishing returns to foreign aid, while there are increasing returns to foreign loans. Using these estimated non-linearities, we find a critical level of international financial transfer, where the marginal effect of foreign aid is larger than that of loans if and only if the transfer (loans or foreign aid) is below this critical level. In addition, we analyze the interaction between these two types of transfers, and find evidence of complementarity. Disaggregation of aid into grants and concessional loans suggests that it is in fact the former that exhibits concave relationship with growth.