The Inverse Relation between Saving and Aid: An Alternative Explanation

A persuasive theoretical justification for extending foreign assistance to developing countries was provided by the now famous ¡®two gap¡¯ theory. It proclaimed that these countries might not in general be able to achieve a target rate of growth because of persistent balance of payments problems and a paucity of investable funds. Both these problems could be dealt with simultaneously by an injection of resources from overseas in the form of foreign aid. An implication of the two gap theory was that foreign aid would be complementary to domestic saving effort: it will raise investment by providing additional resources, and also increase saving by raising the level of income through the multiplier process. However, a number of studies have found that instead of supplementing domestic saving, foreign aid has actually supplanted it in many countries. One explanation, which has attracted some attention, is that by making resources easily available, foreign aid permitted a relaxation in saving effort and encouraged an increase in consumption. This paper takes the view that the observed inverse relationship between foreign aid and domestic resource mobilization could be also explained in terms of an entrepreneurial constraint. Many developing countries like Bangladesh suffer from an acute shortage of entrepreneurial skill. Given the existing stock of entrepreneurial skill, these nations are unable to invest any more than a small proportion of their income. Injection of foreign material and technical aid is, therefore, unlikely to be fully reflected in an increase in investment; part of it will actually replace domestic private investment. This paper develops a theoretical framework to explain this interaction and applies cointegration analysis to test it with time series data of Bangladesh.