Fiscal Effects of Foreign Aid Flows in Ethiopia: Evidence from Econometric Analysis

Abstract

This paper investigates the fiscal effects of foreign aid flows in Ethiopia for the sample period of 1974 – 2014 using annual data. The paper used Cointegrated Vector autoregressive (CVAR) methodology to investigate dynamic relationship in long run as well as in the short run among the variables: aggregated government expenditure, revenue, domestic borrowing, aid grant and aid loan. The paper also used descriptive analysis for brief exploration of fiscal performance in Ethiopia.The econometric analysis indicates three cointegrating long run relationship among variables. The main findings of the econometric analysis result suggest that aid components have positive and significant effect on total expenditure in long run as well as short run; and aid loan is the adjusting variable in this relation. Because it is the loan variable that adjusts to the equilibrium when the expenditure relation out of the steady state. Also it is found that aid components have positive and significant effect on revenue, with aid grant having strong effect. On the other hand the study found that aid grant has a positive and significant effect on domestic borrowing in the long run but there is found ‘substitution’ effect of grant on domestic borrowing in short run. On the other hand aid loan have found insignificant effect on domestic borrowing both in long run and short run. The policy implication for this finding is that the government policy makers have to adopt and implement appropriate strategy to reduce expensive domestic borrowing. It can be done by emphasizing on domestic resource mobilization like mobilizing domestic saving and deeply reforming and mobilizing taxation revenue rather than borrowing.