Is Foreign Aid a Vanguard of FDI? A Gravity-Equation Approach

This paper investigates whether and how foreign aid facilitates foreign direct investment (FDI) flows into less developed countries. We employ a large data set of source-recipient country pairs and conduct gravity equation-type estimation. Our empirical methodology enables us to distinguish among three effects of aid on FDI: a positive "infrastructure effect," a negative "rent-seeking effect," and a positive "vanguard effect," which is specific to the same source-recipient country pair of aid and FDI. According to our empirical analysis, foreign aid in general does not necessarily have an infrastructure, rent-seeking, or vanguard effect. However, we find robust evidence that foreign aid from Japan has a vanguard effect, while aid from other donor countries reveals no such effect. This vanguard effect seems to be peculiar to the Japanese foreign aid.