The impact of tied aid on trade flows between donor and recipient countries

This paper aims to contribute to the current debate on aid effectiveness and suitability by examining a specific aspect of the problem: the theoretical and empirical relationship between tied aid and trade flows. In the first part, we evaluate the theoretical implications of the use of tied aid as a hidden trade policy. The possibility that aid flows directly benefit the donor country (especially its exporters) can make aid more viable from the domestic point of view, but since it also might affect foreign competitors, international conflicts can arise. These issues are examined in a framework adapted from the well-known strategic trade policy literature, showing that tied aid cannot be considered equivalent to an export subsidy. The second part of the paper is empirical and tests some propositions suggested by the theory. We estimate the impact of tied aid on total imports of recipient countries in order to examine whether the distortionary impact of tied aid overcomes the trade generating effect. We also look at the consequences of tied aid on the donor's market share in the recipient country in order to evaluate the effectiveness of this policy in supporting domestic exporters. The (preliminary) evidence shows that tied aid does not necessarily generate trade flows and that the donor's export shares are not correlated to the degree of tying.