Does Foreign Aid Promote International Trade Cooperation?
Recent empirical research suggests that wealthy donors use foreign aid to buy policy concessions from poor recipients. Unfortunately, both the nature and effect of these policy concessions have proven elusive. We investigate the role of foreign aid in promoting international trade cooperation. We develop a complete theoretical model of donor-recipient interactions that captures both the bargaining over and enforcement of preferential trading agreements. Our theoretical analysis indicates that donors can use foreign aid to help recipients undergo the costly adjustment that follows liberalization and enforce cooperation. This effect is contingent on various faces of good governance, such as transparency and administrative capacity, in the recipient country. Our empirical strategy is to combine data on the allocation (bargaining) and volatility (enforcement) of foreign aid with a new dataset on the design of preferential trading agreements. The results shed light on the ways donors can use foreign aid as an instrument of economic statecraft. Contravening the conventional wisdom, foreign aid allows developing countries to credibly commit to urgently needed economic and political reforms. These results can inform strategies to maximize the efficacy of international development assistance even though donors are primarily motivated by self interest.