The World Bank Economic Review Advance Access published online on February 7, 2008
The World Bank Economic Review, doi:10.1093/wber/lhm024
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Foreign Aid, the Real Exchange Rate, and Economic Growth in the Aftermath of Civil Wars
JEL codes: F5, F3, F43
Foreign aid, the real exchange rate (RER), and economic growth are three key variables that shape the aftermath of civil wars in many developing countries. Panel estimations drawn from a sample of 39 conflict and 44 nonconflict countries between 1970 and 2004 indicate that although postconflict countries receive larger aid flows and exhibit moderate RER overvaluation after peace is attained, overvaluation cannot be traced to aid. Yet foreign aid is among the significant determinants of the equilibrium RER. Aid is also an important determinant of economic growth, particularly after peace is reached. Aid exhibits decreasing returns, however, and interacts negatively with RER overvaluation. RER overvaluation reduces growth, but this effect is ameliorated by financial development. Postconflict policies should therefore aim to use aid prudently, avoid RER misalignment, and support financial and capital market development to achieve high and stable growth in the aftermath of war and beyond.
Ibrahim Elbadawi (corresponding author) is a lead economist in the Development Economics Research Group of the World Bank; his email address is ielbadawi{at}worldbank.org. Linda Kaltani is an economist at the International Monetary Fund; her email address is lkaltani{at}imf.org. Klaus Schmidt-Hebbel is professor of economics at the Catholic University of Chile; his email address is kschmidt{at}bcentral.cl. A preliminary version of this article was presented at the first collaborative research project workshop, "Political Institutions, Development and a Domestic Civil Peace," held in Oslo, June 19–20, 2006. The conference was organized by the Development Economic Research Group of the World Bank; the Centre for the Studies of African Economies, at the University of Oxford; and the International Peace Research Institute (PRIO), Oslo. The authors thank Majak d'Agoot, Paul Collier, Jim de Melo, and workshop attendants for valuable comments and suggestions. Ibrahim Elbadawi and Linda Kaltani also thank Aart Kraay and Norman Loayza for helpful discussions. The authors acknowledge the valuable research support of Nahla Hilmi and Marcelo Ochoa. They are indebted to the editor and three anonymous referees for valuable comments and suggestions.