Article

The Role of Political South Asian Journal of

Macroeconomics
Regimes in the and Public Finance
4(1) 118–137
Macroeconomic © 2015 SAGE Publications India
Private Limited
Effectiveness SAGE Publications
sagepub.in/home.nav
of Foreign Aid DOI: 10.1177/2277978715574619
http://smp.sagepub.com
in Pakistan

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Muhammad Luqman1

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Mirajul Haq2
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Karim Khan3
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Abstract
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This study is an attempt to analyze the role of political regimes in

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the effectiveness of foreign aid. In particular, we focus on the role of

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foreign aid in economic growth under democratic regimes. The empiri-

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cal exercise is based on time-series data of the Pakistan economy over

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the period 1972–2011. To meet the objective of the study, an inter-

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active term of democratic regime and foreign aid is used as a regressor

in the growth equation. Our findings show that democratic regimes are
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harmful in the effectiveness of foreign aid as far as the economic growth

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of Pakistan is concerned. Moreover, the study suggests diminishing

returns to scale of foreign aid as the assumption of a linear relationship
between foreign aid and economic growth is relaxed. The other control

1
 Lecturer, Kashmir Institute of Economics, University of Azad Jammu & Kashmir,
Muzaffarabad, Pakistan.
2
  Assistant Professor, International Institute of Islamic Economics, International Islamic
University, Islamabad, Pakistan.
3
 Research Economist, Pakistan Institute of Development Economics, Islamabad, Pakistan.

Corresponding author:
Muhammad Luqman, Lecturer, Kashmir Institute of Economics, University of Azad
Jammu & Kashmir, Muzaffarabad, Pakistan.
E-mail: luqmanraja@gmail.com.
Luqman et al. 119

variables such as physical capital and human capital enter the model in a
significant way and with their expected signs in both the short and the
long run.

Keywords
The effectiveness of foreign aid, economic growth, democratic regimes
JEL Classification: F34, O4, O11, O43

Introduction

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The effectiveness of foreign aid has become the focal point of academi-

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cians, policy makers and development practitioners due to the excessive
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interconnectedness of the world economies. In recent years, the major
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focus of academic research is on the effectiveness of foreign aid as far
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as its impact on economic growth and development is concerned. In

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general, academic literature relevant to the effectiveness of foreign aid

falls into two groups. First are the studies that have investigated the
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impact of foreign aid on macroeconomic aggregates such as eco-

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nomic growth, savings and investment. Second are the studies that have
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analyzed the microeconomic effects of foreign aid. Most of the micro-

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economic studies are related to the project-specific aid. In the later

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case, most of the studies have found positive effects of foreign aid. In
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contrast, there is no consensus in the former case. For instance, the

macroeconomic implications of foreign aid can be divided into three
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subgroups. First, the studies, which are most optimistic about the effecti-
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veness of foreign aid, claim that aid always enhances economic growth
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(Gulati, 1975; Islam, 1992; Papanek, 1973; Thirlwall, 1999). Second, the
studies which assume non-linear relationship between foreign aid and
economic growth proclaim that there is diminishing returns to aid;
and therefore foreign aid may affect economic growth negatively
(Dalgaard and Hansen, 2001; Hansen and Trap, 2000a, 2000b; Lensink
and White, 2001). Third, the pessimistic view asserts that foreign
aid hinders long-run economic growth (Boone, 1996; Easterly, 2001;
Griffin and Enos, 1970; Mosely, 1986; Mosely and Hudson, 1995;
Weisskoff, 1972). The pessimistic view argues that foreign aid sub-
stitutes the domestic resource mobilization and expands public sector
which, in turn, discourages private investment and productivity.
In addition, it is generally designated that, in developing countries,
foreign aid encourages corruption and rent seeking, and thereby has
120 South Asian Journal of Macroeconomics and Public Finance 4(1)

severe implications for institutions (Djankov et al., 2003; Khan, 2012;

Knack, 2001; Williamson and Easterly, 2011). For instance, Dajankov
et al. (2008) conclude that foreign aid has a significant effect on demo-
cratic institutions. Similarly, Knack (2001) proclaims that aid flows
increase political risks for external investors. There is also an opinion
that foreign aid inhibits institutional reforms. Brautigam and Knack
(2004) report that the end of US aid to South Korea and Taiwan resulted
in their reforms in the 1960s. These contrasting views create a new ave-
nue for researchers and policy makers to investigate in detail the factors
that determine the effectiveness of foreign aid. Consequently, recently
some studies have attempted to examine the role of absorption capacity

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like the development of local financial sector, political regimes, macro-
economic policy, political instability of aid receiving country, etc. This

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study is the continuation of this debate.
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Despite the growing concerns over the effectiveness of foreign aid in
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Pakistan, only few studies have examined the impact of foreign aid on
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the economic performance of Pakistan.4 Even in the case of Pakistan, the

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literature is controversial as far as the impact of foreign aid is con-

cerned. Some of the studies have found positive impact of forging aid
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on the economic growth of Pakistan (Mohey-ud-din, 2006; Shabir and

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Mahmood, 1992).5 Others have found negative relationship between

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foreign aid and economic growth (Ali, 1993; Javed and Qayyum, 2011;
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Khan and Ahmed, 2007; Khan and Rahim, 1993). However, to our
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knowledge, none of these studies have analyzed the role of political

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regimes in detail in the aid–growth relationship in the case of Pakistan.

Following Barro (1994) and Kosack (2003), this study hypothesizes that
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the continuous political process in a country develops institutions, which,

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in turn, mitigate the adverse consequences of foreign aid. Alternatively,

the extent to which a country can benefit from foreign aid is believed to
be sensitive to the type of political regime in the country. We are inter-
ested in assessing the role of political regimes in the aid–growth relation-
ship. The rest of the study is organized in five sections. The second
section provides a brief overview of the economic growth and foreign
aid inflows in Pakistan. We present the review of existing relevant litera-
ture in the third section. The fourth section discusses the model, method-
ology and the data that we use. The fifth section presents the empirical
findings of our analysis while the sixth concludes the article.

4
Pakistan is one of the largest aid-receiving countries in the world.
5
World Bank, Global Development Finance (2012).
Luqman et al. 121

Overview of the Economic Growth and Foreign

Aid Inflows in Pakistan
The overall economic performance of Pakistan has not been consistent
since the time of independence. Along with its incompatible economic
policies and political instability, its strategic location is the key deter-
minant that can explain the inconsistent economic performance of
Pakistan. Pakistan’s economy with its entire positive and negative signs
is the most captivating and charming area of study for socio-economic
analysis. The socio-economic and political challenges faced by Pakistan,
during the past six decades, are unparalleled. For instance, at the time of

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independence, there was a high influx of refugees coming to Pakistan
from the other parts of Indian subcontinent. This surge of refugees

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continued until 2000 from various parts of the world such as Afghanistan,
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Central Asian Republics and Kashmir. Besides the high influx of
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refugees, there has been continued political and social instability.
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In particular after 9/11 and the consequent involvement of Pakistan in

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the war against terror, the social and political instability have been
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increased significantly. In addition to the political factors, the devastat-

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ing earthquake of 2005 and the high floods of 2010 have resulted in
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the significant human losses as well as the destruction of physical and

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commercial infrastructure. All of these factors have detrimental effects

on the macroeconomic indicators of Pakistan.
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The history of Pakistan’s economic growth indicates a positive

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gross domestic product (GDP) growth rate; however, it is highly volatile.

This is shown in Figure 1. The magnitude of volatility is lower in the
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1960s and 1980s, that is the period corresponding to relatively lower

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sociopolitical instability. Similarly, the period of stability continued in

the first part of the 2000s; however, the trend of the growth did not
continue in the late 2000s. For instance, the growth of GDP declined
from the highest 8 per cent in 2003 to lowest 1.6 per cent in 2009.
As stated earlier, the key reason for this sharp decline was sociopolitical
instability.

Foreign Capital Inflows to Developing Countries and Pakistan

Foreign aid, foreign private investment and workers’ remittances are
the three main sources of external finance to developing countries.
Foreign aid covers foreign grants and softer loans, while foreign private
investment comprises foreign direct investment (FDI) and foreign
122 South Asian Journal of Macroeconomics and Public Finance 4(1)

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Figure 1. Real GDP Growth Rate in Percentage

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Source: Handbook of Statistics on Pakistan Economy (2005) and Government of
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Pakistan (2012).
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Table 1. Foreign Capital Inflows in Developing Countries

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Year FDI FPI Grants Loans Remittances

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1990 24.1 2.8 28.2 – –

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2001 168.8 6.7 28.4 47.1 90.1

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2005 314.5 67.5 57.1 137.7 187.0

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2006 387.5 107.7 107.2 191.2 221.6

2007 534.1 133.0 76.4 466.1 276.4
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2008 624.1 –53.4 85.8 264.4 322.9

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2009 400.0 108.8 87.5 166.2 306.3

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2010 506.1 128.4 90.0 495.2 319.6

Source: World Bank (2012).

portfolio investment (FPI). Table 1 shows the trends and structure of

different sources of foreign capital inflows to developing countries.
Table 1 indicates that FDI flows to developing economies increased
almost 20 times from 1990 to 2010. Similarly, during the same period,
portfolio investment increased from US$ 2.8 billion in 1990 to US$ 133
billion in 2007. In a similar line, grants, loans and remittances increased
abruptly during the same period. Like other developing countries, in
Pakistan, foreign capital inflows have a positive trend since 1972. Among
different foreign inflows, remittances hold the highest 53 per cent
(see Figure 2).
Luqman et al. 123

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Figure 2. Distribution of Foreign Inflows to Pakistan
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Source: State Bank of Pakistan (2005), and updated with annual reports (various issues).
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Foreign Aid Inflow to Pakistan

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Just after independence, probably due to its shabby financial structure,

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Pakistan started to rely heavily on foreign aid. The consequence was that
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in the second decade of its independence, foreign aid became one of the
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important sources of capital formations in Pakistan. From the 1960s

onwards, Pakistan became one of the largest aid-recipient countries that
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the share of foreign aid increased to almost 6.6 per cent of gross national
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product (GNP; Khan and Ahmed, 2007). However, in the mid-1970s, the
share of foreign aid in total foreign inflow declined due to the Pakistan’s
nuclear initiatives. The Afghan war and the consequent geopolitical impor-
tance of Pakistan once again facilitated Pakistan’s accessibility to foreign
aid. In the 1990s, the USA curtailed aid to Pakistan partly due to the clo-
sure of Afghan war and partly due to the nuclear tests by Pakistan in 1998.
However, due to Pakistan’s involvement in the war on terror, foreign aid to
Pakistan increased significantly in the 2000s. The trends in the foreign aid
to Pakistan clearly show that the inflow of foreign aid to Pakistan is strictly
related to the geopolitical and strategic interests of donor countries espe-
cially those of the USA (see Figure 3). Figure 3 shows the association
between the level of foreign aid inflow to Pakistan and the strategic rela-
tion to the USA. It also indicates that foreign aid inflows are higher in
military regimes as compared to democratic regimes.
124 South Asian Journal of Macroeconomics and Public Finance 4(1)

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Figure 3. History of US Assistance and Reimbursement to Pakistan

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(Million Dollars)
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Source: Wilder (2010).

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Literature Review
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Several studies have investigated the role of macroeconomic policy in

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the effectiveness of foreign aid. For instance, Burnside and Dollar (2000)
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who used the dataset of 56 low-income countries have carried out one
comprehensive work. Their findings suggest that aid exerts positive
impact on the economic growth subject to good environment as far as
microeconomic policies are concerned. The policy index, constructed
in the study, includes components such as inflation, budget deficit and
trade openness. The study concludes that if foreign aid works only in
a good policy environment, then it must be diverted to low-income
countries with good policy environment and sound macroeconomic
management. In a country-specific analysis, the study of Tadesse (2011)
is notable which investigated the effects of foreign aid on investment
and on economic growth in Ethiopia. The findings of the study support
the hypothesis that good policy environment is enhancing the effective-
ness of foreign aid in Ethiopia. In the same way, Chauvet and Guillamont
Luqman et al. 125

(2002) examine the impact of political instability on the effectiveness of

foreign aid. His index of political instability is based on indicators like
regime change and coups. The results of the study show that frequent
regime changes and coups have a negative impact on the effectiveness of
foreign aid. Moreover, political stability also has a direct effect on the
performance of economic growth as it provides conducive environment
to investors.
Guillamont and Chauvet (2001) argue that the macroeconomic
effectiveness of foreign aid is crucially dependent on the structural vul-
nerability of the recipient countries. Structural vulnerability in the study
is measured by the external and climatic factors. The results indicate that

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foreign aid is more effective in those countries where the external and
climatic factors are more deteriorated. There are also studies that attrib-

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ute the effectiveness of aid to political factors. For instance, Boone
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(1996) analyzes the effectiveness of foreign aid in the context of political
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regimes in the aid-recipient countries. The study, used growth in per
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capita, regional dummies and measure of external shocks as control vari-

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ables, has three conclusions. First, economic growth is not significantly

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affected by foreign aid. Second, the aid does not benefit the poor, as
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it is not effective in improving variables such as primary schooling,

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infant mortality, and life expectancy. Third, the regime type such as
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liberal democracies or dictatorships does not affect the effectiveness of

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foreign aid. However, as an individual indicator, liberal democracies

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have on average 30 per cent lower infant mortality. The study also pro-
claims that foreign aid increases the size of government, benefits the
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political elite and increases rent seeking, and does not improve the living
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standards of masses irrespective of regime type. In a similar study,

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Kosack (2003) shows that democracy enhances the effectiveness of for-

eign aid in developing countries. Alternatively, the effect of foreign aid
on variables like per capita income and the quality of life is larger in
democratic regimes as compared to dictatorships.
There are also some studies that investigate the conditional effective-
ness of foreign aid in Pakistan. For instance, Javid and Qayyum (2011)
examine the role of macroeconomic policy in accelerating the positive
impact of foreign aid on economic growth in Pakistan. The study has
constructed a policy index including the components like inflation,
budget deficit and trade openness as indicators of macroeconomic
policy. The results of the study show that in the absence of sound macro-
economic policy, foreign aid has adverse effects on economic growth.
In other words, when the constructed index of policy interacts with
126 South Asian Journal of Macroeconomics and Public Finance 4(1)

foreign aid, it has a significant positive effect on economic growth in

both the short and the long run. According to Anwar and Michaelowa
(2006), the bilateral aid from the USA to Pakistan is driven by politi-
cal motives. According to the study, the main political factors that deter-
mine the amount of aid are ethnic lobbying and the business interests of
the USA.

Methodology and Data

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In this section, we provide the underlying theoretical framework of the
study. Besides, we define our variables and discuss the sources of data.

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In order to analyze the role of political regimes in the effectiveness of
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foreign aid, we estimate the following baseline model. We use time-
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series data of Pakistan covering the period from 1972 to 2011. Following
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Boone (1996) and Kosack (2003), we include the type of political regime
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in the model through an interactive term, that is, the interactive term of
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democratic regime with foreign aid:

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   LnYt = b o + b 1 LnX t + b 2 Ln (Ay) t + b 3 Ln (!Ay ) D)+ t + f t(1)

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where Yt is the real GDP, Xt is the vector of control variables that

include: gross fixed capital formation (Ay)t, human capital !(H+ t) and
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financial development (FD)t, Ayt is the foreign aid, (Ay * D)t is the
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interactive term of democratic regime with foreign aid and ft is the

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error term.
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The type of political regime is measured by a dummy, which takes

the value of 1 if we have democracy and 0 otherwise. In the estimation
process of our model, in the first step, we examine the stationary
properties of our data by employing the unit root tests of augmented
Dickey–Fuller (ADF) and Phillips–Perron (PP). Assuming that all of
our variables are not stationary at level or not integrated of order one
I (1), the auto-regressive distributed lag (ARDL) would be suitable to
estimate with. The ARDL approach is introduced by Pearson et al. (2001)
and our equation according to the approach is given as follows:

DY. t = v + | . (i = 1) - p = !b . iDY+ . (t - i) + R . (i = 0) - p = d . i
!D (Ky) + . (t - i) + R . (i = 0) - p = c . i !DH+ . (t - i) +
R . (i = 0) - p = m . i !D (FD) + . (t - i) .
Luqman et al. 127

where p is the lag length, and under the bound testing approach the
null hypothesis of no long-run relationship between Yt and its determi-
nants is as follows:

H0 = ai = 0 i = 1, 2, 3, 4, 5, 6
H1 = ai ! o i = 1, 2, 3, 4, 5, 6

The presence of co-integration can be checked by testing the above

null hypothesis while using F-test. According to Pesaran et al. (2001),
the test for co-integration is provided by the two asymptotic critical
value bounds when the independent variables are either I (0) or I (1). The

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lower bound assumes that all the independent variables are I (0), and
the upper bound assumes that they are I (1). If the test statistics

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exceeds their respective upper critical values, then the null hypothesis is
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rejected and we can conclude that there exists a long-run relationship
(Ang, 2010). On the other hand, if the calculated value of F-test falls
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below the lower-bound critical value, we conclude that there is no

long-run relationship among the variables. If the co-integration is estab-
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lished, then we can find out the long-run elasticities by normalizing on

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a1 as follows:
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a2 a3 a4 a5
Yt - 1 = a ^ Kyht - 1 + a H t - 1 + a ^ FDht - 1 + a Ay t - 1
R

1 1 1 1
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(3)
a6
^ h
+ a D ) Ay t - 1
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1
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After the long-run analysis, we do the short-run dynamics by using

the error correction mechanism. Error correction model (ECM) explains
the changes in the dependent variable due to the changes in explanatory
variables as well as due to the deviations from the long-run relationships
between the variables and their determinants. We formulate the ECM as
follows:
p p p
DYt = v + | b i DYt - i + | d i D (Ky) t - i + | c i DH t - i
i=1 i=0 i=0
p p p
+ | m i D (FD) t - i + | h t D (Ay) t - i + | t i D (D ) Ay) t - i
i=0 i=0 i=0
+ i (ECM) t - 1 + v
128 South Asian Journal of Macroeconomics and Public Finance 4(1)

where Δ is the difference operator and ECMt–1 is an error correction term.

The expected sign of the parameters θ should be negative, whereas the
ECM term is formulated as:

ECM = Yt - c a (Ky) t - 1 + a H t - 1 + a (FD) t - 1

a2 a3 a4
1 1 1
(5)
+ a (Ay) t - 1 + a (D ) !Ay)+ t - 1 m
a5 a6
1 1

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Variables of consideration are real GDP, gross fixed capital formation
(Ky)t, secondary school enrolment !(H+ t), foreign aid (Ay)t and financial

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development (FD)t. Data on these variables are collected from official
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sources including State Bank of Pakistan (2005), various annual reports
of the State Bank of Pakistan and World Bank’s World Development
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Indicators (WDI).6
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Empirical Findings
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Our empirical analysis comprises three phases. As stated earlier, first, we

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check the stationarity properties of our variables. Second, after checking

stationarity, we do the long-run analysis by using the approach of
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ARDL bound testing. Finally, the short-run analysis is carried out with
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the technique of ECM. In order to check the stationarity of variables,

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we use ADF and PP unit root tests. Table 2 shows the results of these
tests. As is evident from the table, all of our variables are integrated of
order one I (1) as gross fixed capital as ratio to GDP which is stationary
at level I (0). While the order of integration of all variables is less than
two, therefore the unit root test results suggest the use of the ARDL
bound testing approach.
As a first step in applying the ARDL bound testing approach, we need
to decide about the optimal lag length. This is because F-test is very
sensitive to the lag length. We use various criteria such as the Akaike

6
See Appendix 1 for detailed information.
Luqman et al. 129

Table 2. ADF and PP Unit Root Test Results

Null Hypothesis: Unit Root

ADF PP
Series Levels First Difference Levels First Difference
Ln Yt 1.207 4.246 1.207 4.242
(0.83) (0.000) (0.89) (0.009)
Kyt 4.855 – 2.344 –
(0.000) (0.005)
Ln Ht 1.477 4.865 1.816 4.912
(0.822) (0.000) (0.677) (0.000)
FDt 2.803 4.274 1.886 4.202

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(0.06) (0.00) (0.335) (0.00)

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Ayt 0.637 8.596 2.144 (11.038)
(0.84) (0.000) (0.222) (0.000
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Ayt2 1.460 7.901 2.566 6.015
(0.455) (0.000) (0.133) (0.000)
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(D*Ay)t 2.596 5.944 2.640 5.979

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(0.956) (0.044) (0.511) (0.000)

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Source: Authors.
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Note: P values in parenthesis.

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Table 3. Selection of Lag Length

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Lag Ln L LR FPF AIC SC HQ

0  16.62 NA 1.4209 –0.50 –0.21 –0.39
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1 269.67 399.55 3.2214 –11.25 –8.83* –10.39

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2 341.92 87.46* 1.2414* –12.47* –7.94 –10.86*

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Source: Authors.
Notes: *indicates lag order selected by the criterion.
LR: Sequential Modified LR, AIC, Akaike Information Criterion,
SC: Schwarz Information Criterion, FPE: Final Prediction Error,
HQ: Hannan-Quinn Information Criterion.

information criterion (AIC) and Hannan–Quinn information criterion

(HQIC) for selecting the appropriate lag length. The results of these
criteria are shown in Table 3.
After the selection of lag length, in ARDL bound testing approach,
the next step is to estimate the unrestricted error correction model
(ECM), which is specified by equation (5) in the previous section. We
estimate equation (5) with ordinary least squares (OLS). Following the
130 South Asian Journal of Macroeconomics and Public Finance 4(1)

general-to-specific approach, the first difference variables, which are

insignificant, are deleted from the model. In this way, we have selected
the most parsimonious model for our analysis. In order to check the
robustness of our specified model, we use a number of diagnostic tests
such as Lagrange multiplier (LM) test for autocorrelation, White hetero-
scedasticity test for heteroscedasticity, Jarque–Bera for normality, cumu-
lative sum (CUSUM) and QUSUMQ for structural stability and Ramsey’s
Reset test for misspecification of the model. After satisfying these tests,
we show the results of unrestricted ECM of ARDL in Table 4.
We use Wald test to compute the F-statistic in order to find the
co-integration in the bound testing approach. This result, given in

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Table 5, shows that the computed value of F-statistic is larger than the
upper-bound critical value. Therefore, we conclude that there exists

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Table 4. Results of Unrestricted Error Correction Model of ARDL
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Variables Results
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Intercept –0.564
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(0.152)
Dln(Y)t–1 –0.277
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(0.112)
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Dln(H)t–1 0.1402
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(0.062)
R

D(FD)t–1 0.324
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(0.030)
D(FD)t–1 –0.1497
(0.0519)
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0.0064
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Dln(Ay)t–1
(0.090)
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ln(Y)t–1 0.0792
(0.030)
ln(Ky)t–1 –0.0603
(0.042)
ln(H)t–1 –0.0655
(0.094)
(FD)t–1 0.0923
(0.080)
ln(Ay)t–1 0.0049
(0.143)
ln(Ay2)t–1 –0.0256
(0.0812)
ln(Ay*D)t–1 0.0137
(0.101)
(Table 4 continued)
Luqman et al. 131

(Table 4 continued)
Variables Results
R2 0.654
Adjusted R2 0.451
DW-Test 2.0237
Serial Correlation LM test 2.141
(0.1582)
Jarque–Bera Test 1.525
(0.4662)
White Heteroskedasticity 30.511
(0.6452)
Ramsey Reset Test 1.582

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(0.254)
F-Statistic 2.369

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(0.034)
Source: Authors.
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Note: P values in parenthesis.
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Table 5. Bounds Testing Approach of Co-integration

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Specification Lower Bound Upper-Bound F-statistic Decision

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(Yt, Kyt, Ht, FDt, 2.27 3.28 5.2 Co integration

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Ayt, Ayt2, Ay*Dt)

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Source: Authors.
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co-integration among the set of variables under our analysis. The long-
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run estimates of our baseline model are given as follows:

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lnYt = 0.75 (Ky) t + 0.82lnH t - 1.16 (FD) t - 0.06 (Ay) t

+ 0.32 (!Ay)+ t2 - 0.17 (Ay ) D) t

The results show that the ratio of gross fixed capital formation to
nominal GDP, and secondary school enrolment, are significantly contrib-
uting to the real GDP in the case of Pakistan. However, the effects of
financial sector and foreign aid are adverse. However, the square term
of foreign aid enters the model with positive sign, which shows that for-
eign aid has a diminishing return in the case of Pakistan. The estimate
corresponding to the interactive term of foreign aid and democratic
regimes is significant and has a negative sign. There may be several jus-
tifications for this result. First, the democratic process is discontinuous in
Pakistan which results in lower political maturity as far as the politicians
132 South Asian Journal of Macroeconomics and Public Finance 4(1)

are concerned. Consequently, corruption and rent seeking has been fre-
quent during democratic regimes in Pakistan. Second, the endogenous
resources are not potentially utilized in Pakistan. As a result, Pakistan’s
economy is a foreign aid-driven economy, most of which came during
the military rule. Finally, due to weak political and economic institu-
tions, the potential gain of foreign assistance has not been potentially
harvested. However, the miss-utilization decreased in military regimes
because of its strict management.
However, unlike the long run, in the short run the democratic regimes
are not significantly affecting the impact of foreign aid on economic
growth in the case of Pakistan. The short-run dynamics are given in

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Table 6. These results indicate that physical capital, human capital and
financial development enter the model significantly and with their

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expected positive signs. Like the long run, foreign aid is adversely affect-
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ing economic growth even in the short run. The interactive term of for-
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eign aid and democratic regimes has a negative sign; however, it is not
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statistically significant.
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Table 6. Short Run Dynamics: An Error Correction Model_2. Dependent

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Variable: Real GDP

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Variables Coefficients t-Statistics P-Value

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Constant –0.225 –3.06 0.004

FO

D(Ky)t–1 0.320 1.97 0.053

DlnHt–1 0.097 2.06 0.045
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D(FD)t–1 0.281 2.92 0.006

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DlnAyt–1 –1.002 –2.04 0.045

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Dln(Ay)t –0.009 2.05 0.006

Dln(Ay)2t–1 0.019 1.84 0.071
Dln(A*D)t–1 –0.190 –1.65 0.110
ECt–1 –0.023 3.23 0.002
R2 0.64
Adjusted R2 0.55
DW-Stat 2.20
F-Statistics 7.50
(0.000)
White Heteroscedasticity Test 12.24
(0.58)
Serial Correlation LM test 2.13
(0.34)
Source: Authors.
Luqman et al. 133

Conclusion
The key objective of the study is to analyze the role of political regimes
as far as the effectiveness of foreign aid is concerned. To meet our
objective, we use an interactive term of democratic regime and foreign
aid as one of the regressors in the growth equation. Our analysis show
that democratic regimes have adverse consequences as far as the impact
of foreign aid on economic growth is concerned. Thus, we conclude that
the democratic regimes affect the growth effectiveness of foreign aid
adversely in the case of Pakistan. Additionally, we find that, in Pakistan,
there are diminishing returns to the scale of foreign aid as the assumption

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of a linear relationship between foreign aid and economic growth is
relaxed. The other control variables like physical capital and human

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capital enter the model significantly and with their expected positive
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signs in both the short and the long run. Financial development has an
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unexpected negative sign, which is statistically significant in the long
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run; however, its significance vanishes in the short run. As the study
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found no evidence about the growth effectiveness of foreign aid in the

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long run and in democratic regimes, its effect is negative; hence it directs
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public policy for endogenous resource mobilization.

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Acknowledgements
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The authors thank an anonymous reviewer of this journal for comments that
improved the paper significantly. The usual disclaimer applies.
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Appendix 1. Variables Description

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Variable Description Source

Yt Gross Domestic Product, at
Constant Prices of 2000–01
Kyt Gross Fixed Capital Formation,
at Constant Prices of 2000–01
(Percent of GDP)
Ayt Foreign Assistance (Foreign
Grants + Foreign Debt), at
Constant Prices of 2000–01
(Percent of GDP)
Handbook of Statistics on
Pakistan Economy 2005, and
State Bank of Pakistan
Handbook of Statistics on
Pakistan Economy 2005,
and State Bank of Pakistan
Handbook of Statistics on
Pakistan Economy 2005,
and State Bank of Pakistan
(Appendix 1 continued)
134 South Asian Journal of Macroeconomics and Public Finance 4(1)

Variable Description Source

Ht High School Enrolment in
thousands
FDt Financial Development Index
constructed using indicators of
M2 to GDP, Private Sector
Credit to GDP and Stock
Market Capitalization to GDP
D D = 1 for Democratic
Government and 0 otherwise
Handbook of Statistics on
Pakistan Economy 2005,
and State Bank of Pakistan
Handbook of Statistics on
Pakistan Economy 2005,
and State Bank of Pakistan
Authors own construction

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Appendix 2. CUSUM and QUSUMQ for Structural Stability
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2A: Role of Political Regime in Long Run
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T
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Luqman et al. 135

2B: Role of Political Regime in Short Run

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