An Empirical Investigation of Foreign Aid and Dutch Disease in Bangladesh

Bangladesh, like all other developing nations, is historically dependent on inflow of foreign capital to finance investments necessary for the nation’s development. Dutch disease has always been an interesting field of research for economists all over the globe. The effectiveness of foreign aid in attainment of development goals is often questioned in the light of this problem. Economists have endeavoured themselves in finding whether a sudden rise in external inflow of foreign currency into a country does affect its real exchange rate making its economy better or worse off than before. Thus, the aim of this paper is to investigate the existence of the “Dutch Disease” problem in context of Bangladesh using a multivariate framework incorporating annual time series data from 1980 to 2014. A simple linear regression model was presented which depicts Real Exchange Rate as a function of real fundamentals, as proposed by Edwards (1989) and Montiel (1999), such as Net Official Development Assistance inflow, Government Expenditure, Foreign Direct Investment inflows, Terms of Trade, Economics Openness, and Inflow of Remittance. Our model depicts the spending effect hypothesis put forward by Cordon and Neary (1982) which states that a rise in relative spending in the non-traded goods sector will have appreciative pressures on a country’s real exchange rate. Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) tests are used to test for the stationarity properties and it is found that they are stationary in the first differenced form. Moreover, using Granger causality test, we have observed various causal relationships between the model variables. Our results reveal that there is no evidence of Dutch disease following Foreign Aid inflow in Bangladesh during the period 1980-2014. Bangladesh’s appropriate exchange rate regime and the central bank’s tight grip over the exchange rate might have attributed to foreign aid being ineffective in appreciating the real exchange rate. Therefore, it is recommended that Bangladesh can continue to attract foreign development assistance from the developed world without the fear of losing export competitiveness. Moreover, the foreign aid received should ideally be invested in the tradable sector avoiding any appreciative pressure on the country’s real exchange rate