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DOI: http://dx.doi.org/10.25115/eea.v39i3.4108

Volumen:39-3 // ISSN: 1133-3197

Foreign Aid and Economic Growth in Nigeria: The Role of

Institutional Quality
ADEWALE SAMUEL HASSAN
Trade research entity, NORTH-WEST UNIVERSITY, SOUTH AFRICA. E-mail: [email protected]

ABSTRACT

This study examined the moderating effect of institutional quality on the foreign aid-economic growth nexus in
Nigeria from 1984 to 2018 through the use of Johansen and canonical cointegration regression. Findings from
the study indicate that while foreign aid has a separate positive effect on economic growth, the quality of
institutions in the country diminishes and leaks out this positive effect. To this end, fiscal authorities in Nigeria
need to review the existing institutional framework guiding the sourcing, disbursement and utilization of foreign
aid with a view to detecting any loopholes and lapses that encourage diversion of fund and institutionalized
corruption which prevent it from promoting growth.
Keywords: Foreign aid; economic growth; institutional quality; cointegration
JEL Classification: E00:E02; F3:F35

Recibido: 10 de Noviembre de 2020

Aceptado: 25 de Febrero de 2021
 Adewale Samuel Hassan

1. Introduction

Foreign aid has continually grown in importance as a major source of capital inflow for developing
countries of the world for several decades. Its evolution and development over time have been
justified and prescribed on the basis that it can solve the problem of inadequate capital for investment
and economic growth for these countries in their quest to attain development (Baldé, 2011; Todaro
and Smith, 2009; Lipsey, 1999). In his neoclassical growth model, Solow (1956) had theorized the
important role of saving in the formation of physical capital accumulation needed to drive growth;
however, the level of domestic saving in developing countries is grossly inadequate for capital
formation and economic growth (Drine and Nabi, 2010). Moreover, given the heavy dependence of
most developing countries on primary product export and weak technology in production, foreign
exchange earnings from export, and consequently, government revenue greatly fall short of required
funds to import capital goods that are necessary to reduce the economies’ dependence on primary
products (Sethi, 2014; Simplice and Jellal, 2016). Therefore, as a way of mobilizing capital for these
countries, foreign aid has been advocated for a number of reasons. First, according to Baldé (2011),
foreign aid can stimulate physical capital accumulation by contributing to domestic saving in countries
with low saving. Lipsey (1999) also emphasized its importance by asserting that foreign aid closes the
saving-investment gap in developing countries. Second, it bridges the gap between the realizable
government revenue/foreign exchange earnings and the capital requirements for technology,
management and entrepreneurial skills through foreign aid-sponsored and transfer programs (Todaro
and Smith, 2009). Third, foreign aid could serve as a mechanism for propelling aggregate consumption,
which is a major proposition of the Keynesian model for driving economic growth. It is therefore not
surprising that the size of foreign aid released to developing countries has risen significantly since the
1970s. It has grown from only 6.84 billion US dollars in 1970 to 49.67 billion US dollars in 2000, and by
2019, it had increased to 152.8 billion US dollars (OECD, 2020; World Bank, 2019).
The nature of the relationship between foreign aid and economic growth in developing countries,
and particularly in sub-Saharan Africa has generated a controversy among researchers over the years.
While some previous researches (Easterly, 2003, 2005; Goh et al., 2017; Gunby et al., 2017; Kanbur,
2000; Nowak-Lehmann et al., 2012; Ranis, 2010; Rajan and Subramanian, 2008; Sothan, 2018) reported
that foreign aid has failed to enhance economic growth, some others (Albulescu, 2015; Arndt et al.,
2015; Clist, 2016; Dalgaard et al., 2004; Tarp, 2006) have advocated the need for increased inflow of
foreign aid into African economies based on their research findings of positive impact of foreign aid on
economic growth. Although both arguments have been supported empirically, the debate on the
nature of the contribution of foreign aid to African economies continues unabated as no clear
conclusion has been reached on the issue.
For Nigeria, the need to investigate the contribution of foreign aid to the economy cannot be
ignored given the pressing need for massive capital expenditure, arising from different problems in the
country such as large infrastructural deficit, high incidence of poverty among its high and fast-growing
population, vulnerability of the economy to the volatility in crude oil prices in the world market, high
level of unemployment, very underwhelming industrial capacity utilization, just to mention a few. Over
time, foreign aid has been canvassed and attracted as a way of stimulating physical capital needed to
drive the economy towards the path of sustainable growth. For decades, Nigeria has benefited from
huge amount of foreign aid which has increased over time. The net official development assistance
(ODA) received far back in 1970 constituted 0.89% of GNI, while in 2018, it still constituted as much as
0.87% of the country’s GNI (World Bank, 2020). In terms of the total ODA received in recent years,
World Bank (2019) puts it at an average of USD2.7 billion between 2012 and 2018. However, despite
the humongous inflow of ODA into the economy over the decades, there are no convincing signs that
the underlying economic issues that formed the basis for attracting the aids are being resolved to
satisfaction. The World Poverty Clock showed that in 2018, Nigeria overtook India as the country with
the highest number of people living in extreme poverty, and as at September 2020, the figure stood at
over 105 million, representing 51% of the total population (World Data Lab, 2020). Furthermore, the

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

economy is still languishing under the weight of overdependence on crude oil and also struggling to
find a way out of high unemployment conundrum that has held sway over the years.
Figure 1: Trend of Institutional quality in Nigeria (1984-2018)

Trend of institutional quality

3,5
3
2,5
2
Score

1,5
1
0,5
0
1980 1985 1990 1995 2000 2005 2010 2015 2020
Year

CORR LAWO

Notes: CORR = Corruption index; LAWO = Law and order index

Source: Author’s computations

While the socio-economic conditions in Nigeria have continued to deteriorate despite the
continuous inflow of huge amounts of foreign aid, there have been success stories elsewhere.
Countries in the Western Europe (under the Marshall Plan after World War II), as well as China, Japan,
Singapore, South Korea and Taiwan had benefited from foreign aid in the past, and today many of
them are foreign aid donors, despite the fact the aids lasted only a few years (O’Connell and Soludo,
2001). The failure of foreign aid in Nigeria has been attributed to a number of factors such as
macroeconomic instability, socio-political upheavals and weak governance (Salisu, 2007). Cooksey
(2003) had opined that corruption could diminish the efficacy of foreign aid, while it has also been
argued that foreign aids perform best in countries with high institutional quality (Burnside and Dollar,
2000). Despite the obvious controversy from various studies on the exact impact foreign aid on
economic growth in Nigeria, none of them considered the moderating role of institutions as a
transition mechanism in the foreign aid-economic growth nexus for the country, and this is the gap
that this study intends to fill. Vitola and Senfelde (2015) described institutions as both formal (state-
order rules) and informal (private-order beliefs, norms and conventions) restrictions that affect
economic activities; while Acemoglu et al. (2002) underscored the importance of good institutions by
concluding that institutions, not geography, are responsible for the reversal of fortunes of several poor
colonised countries which were relatively rich before colonisation. This study is necessary in the
context of Nigeria because the quality of institutions in the country appears to be one of the weakest
in sub-Saharan Africa. An examination of the International Country Risk Guide (ICRG) data for Nigeria
shows that from 1984 to 2018, the average scores in corruption and law and order stand at 1.60 and
2.02 respectively out of possible 6 points. The trends of the two measures of institutional quality as
presented in Figure 1 also show that quality of institutions oscillated between 1.00/6.00 and 2.00/6.00
for corruption and between 1.00/6.00 and 3.00/6.00 for law and order. With these lacklustre scores,
it appears the institutions in the country might allow loopholes that could hamper the effectiveness of
foreign aid in stimulating economic growth as intended. To this end, this study would again contribute
to the literature on the subject by determining the minimum quality of institutions required for foreign
aid to enhance economic growth in Nigeria, as this has not been considered by any previous study.
Determining the threshold of institutional quality in the foreign aid-economic growth nexus would
certainly guide the policy makers on the minimum level of quality they need to pursue in order to turn
foreign aid to an effective driver of growth in the country.

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 Adewale Samuel Hassan

The rest of the paper is as follows. Section 2 captures a review of relevant literature on the subject,
while Section 3 is devoted to a discussion on issues that bother on methodology, as well as description
and sources of data. In Section 4, the empirical findings of the study are presented and discussed, while
the study is concluded in the last section.

2. Literature review

The effectiveness of foreign aid has been massively debated in the literature and these debates
have generated different forms of findings. While some conclude that foreign aid is effective in
stimulating economic growth, others opine that it is ineffective. There are also those that suggest that
its effectiveness is contingent on some factors, while some assert that it is deleterious to the
attainment of sustained growth in the recipient countries. In a study of the effect of foreign aid on
economic growth in Cambodia from 1980 to 2014, Sothan (2018) employed the ARDL technique and
found that foreign aid affects economic growth positively in the short run. In the long run however,
the results indicated that foreign aid affects economic growth and investment negatively. In a related
study on the relationship between foreign capital inflows and economic growth in Nigeria covering the
period 1980-2015, Ehigiamusoe and Lean (2019) also employed the ARDL technique. They suggested
that Nigeria should not rely on foreign aid to drive economic growth, as estimates from their models
indicated that foreign aid has no significant impact on economic growth. Similarly, Adebayo and
Kalmaz (2020) investigated the link between foreign aid and economic growth in Nigeria with a
Wavelet analysis for the period 1980-2018. They equally concluded that increasing foreign aid to
Nigeria depresses economic growth, indicating a negative effect from the former to the latter.
Meanwhile, in another investigation of Nigeria on the subject for 1984-2016, Fashina et al. (2018)
tested the validity of the medicine model in Nigeria and employed the VECM technique on the
extended model in their study. Estimates from their regression indicated that there exists a tipping
point beyond which persistent foreign aid inflows could have a negative impact on economic growth.
Corroborating these results are findings from previous similar studies that foreign aid on its own has
no impact on economic growth (Burnside and Dollar, 2000; Easterly et al., 2004). For Southeast Asian
economies of Indonesia, Thailand and the Philippines, Burke and Ahmadi-Esfahani (2006) found that
foreign aid does not promote economic growth, while Khan and Ahmed (2007) concluded that foreign
aid depresses economic growth in Pakistan. Several other studies are in support of these results as
they concluded that foreign aid affects economic growth negatively (Mallik, 2008; Rajan and
Subramanian, 2008; Ang, 2010; Adams and Atsu, 2014; Herzer and Morrissey, 2013).
On the contrary, there are studies which have concluded that foreign aid is an ancillary to economic
growth. Fasanya and Onakoya (2012) investigated the effect of foreign aid in Nigeria from 1970 to
2010 using the error-correction modelling and found that foreign aid affects economic growth
positively, but this positive effect vanishes once the policy variables are accounted for. Furthermore,
in a panel study of 80 less developed countries from 1971 to 1990, Fayissa and El-Kaisy (1999)
concluded that foreign aid enhances economic growth. Similarly, in a study of five African countries
including Nigeria, Irandoust and Ericsson (2005) found that foreign aid is an important driver of
economic growth. In the same vein, a panel study of 40 African countries was conducted using the
fixed effects method by Loxley and Sackey (2008). They concluded that foreign aid enhances economic
growth in Africa, though they cautioned on the need to work towards putting plans in place towards
easing out of foreign aids over time. Furthermore, in a panel study of the effect of FDI, remittances
and foreign aid on economic growth in 53 African and 34 Caribbean and the Latin American economies.
Nwaogu and Ryan (2015) found from separate regressions that foreign aid enhances economic growth;
however, only FDI was found to impact economic growth when all the three variables were controlled
for. Support for the enhancing effect of foreign aid on economic growth have been reported in other
studies such as Arndt et al. (2015), Moolio and Kong (2016), Mekasha and Tarp (2013) and Moreira
(2005).
There is also a set of studies that investigated the performance of foreign aid in the recipient
economies based on quality of certain important intervening variables, such as macroeconomic policy,

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

financial development, quality of institutions and so on. However, in the case of institutional quality,
majority of the studies focused on the impact of increased aids on the quality of institutions, rather
than the moderating effect of institutional quality on the foreign aid-economic growth nexus which is
the aim of this study. In a study of 90 countries from 1975 to 2000, Ali and Isse (2005) found a nonlinear
relationship between foreign aid and economic growth with the conclusion that more and more aids
are deleterious to economic growth. In addition, they claimed that a good policy environment is pivotal
for aids to be effective. Furthermore, in a study of the interconnectivity between foreign aid, economic
growth and quality of institutions in 43 SSA countries with the use of panel ARDL technique and DCCE
estimator for the period 1980-2013, Wako (2018) considered disaggregated data for both donors and
recipients. Regression estimates showed that the impacts are not the same for all donors/recipients;
however, aids from majority of the donors neither enhanced economic growth nor strengthened the
quality of institutions. This result was corroborated by Bräutigam and Knack (2004) who investigated
the link between foreign aid and institutions in SSA who implemented the OLS and 2SLS in their
analysis. They concluded that there is a link between increasing levels of foreign aid and declining
quality of institutions; however, a positive relationship was found between GDP per capita and
institutional quality. In a similar study of 74 developing countries covering Africa, Asia and South
America from 1980 to 2016 with the use of panel 2SLS, Maruta et al. (2020) investigated foreign aids
into the agriculture, education and health sectors. Regression results show that the impact of foreign
aid on differs along the regional lines and it is also contingent on the level of institutional quality.
Corroborating this finding was a previous study by Svensson (1999) for 58 foreign aid recipient
economies from 1970 to 1994. Results from the study showed that the higher the level of political and
civil liberties in the countries, the better the growth impact of foreign aid. In another study on
developing countries, Islam (2003) found very little impact of aid on growth in tin pot countries, while
a positive influence was found in respect of totalitarian countries.
While findings on the relationship between foreign aid and economic growth still remain largely
controversial, it is clear that studies on the moderating effect of institutional quality on the relationship
are few and far between. Hence, this study.

3. Methodology and data

As already stated, the study investigates how the quality of institutions influence the foreign aid-
economic growth nexus in Nigeria. This objective is achieved through the use of the Johansen and
canonical cointegration technique. Both the neoclassical and endogenous growth theories had
advocated the need for foreign capital inflows such as foreign aid into capital-deficient economies as
a way of driving capital accumulation and technological progress for long-term economic growth and
development. According to Lipsey (1999), foreign capital drive capital accumulation in developing
countries by closing the saving-investment gap, thus improving the marginal productivity of capital. In
the same vein, foreign aid is reputed as an important channel via which transfers of technology,
managerial skills, technical skills, innovation and knowledge spill-over, which are very key to long-run
economic growth are accessed by developing countries (Grossman & Helpman, 1991; Mankiw et al.,
1992). Another important contribution of foreign aid in developing economies comes in the form of
filling the gap between the targeted foreign exchange requirements and those derived from net export
earnings (Todaro & Smith, 2009). Meanwhile, the intervening role of institutional quality in the foreign
aid-economic growth nexus is conceptualised based on the hypothesis that weak institutions depress
economic growth even when macroeconomic variables are favourable (Ben Ali & Krammer, 2016).
Thus, the empirical model is inspired by the empirical work of Maruta et al. (2020) and it is expressed
as follows:

ln𝐺𝐷𝑃𝑡 = 𝛽0 + 𝛽1 ln𝐹𝐴𝑡 + 𝛽2ln(𝐹𝐴 ∗ 𝐼𝑄)𝑡 + 𝛽3 ln𝐼𝑄𝑡 + 𝛽4 ln𝐶𝐴𝑃𝑡 + 𝛽5 ln𝑇𝑂𝑃𝑡 + 𝜖𝑡 (1)

where 𝛽0 is the constant term, 𝛽1 , 𝛽2 , 𝛽3 , 𝛽4 and 𝛽5 are coefficients to be estimated, GDP
represents real GDP per capita, FA represents foreign aid, IQ represents measure of institutional
quality, CAP is capital stock, TOP is trade openness and 𝜖 is the error term. The variables in the model

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 Adewale Samuel Hassan

are expressed logarithmically in order to align them to the same unit of measurement and to reduce
the likelihood of heteroscedasticity (Ejemeyovwi et al. 2018; Uusitalo, 2012).
The inclusion of an interaction term between foreign aid and institutional quality (𝐹𝐴 ∗ 𝐼𝑄) in
equation (1) suggests that the responsiveness of economic growth to foreign aid is influenced by the
quality of institutions. It therefore sheds light on whether the impact of foreign aid on economic
growth differs with different levels of institutional quality. This is realized by finding the partial
derivative of equation (1) with respect to foreign aid as follows:
𝜕ln𝐺𝐷𝑃𝑡 (2)
𝜃= = 𝛽1 + 𝛽2 ln𝐼𝑄𝑡
∂ln𝐹𝐴𝑡
In equation (2), the magnitude of 𝜃 represents the marginal effect of foreign aid on economic
growth, which indicates the responsiveness of the steady state level of economic growth to foreign
aid. The influence of institutional quality on the foreign aid-economic growth nexus in this model
revolves around the magnitudes of 𝛽1 and 𝛽2 , which can assume any of the following four possibilities:
(a) If 𝛽1 > 0 and 𝛽2 > 0, foreign aid exerts a positive impact on economic growth and the quality
of institutions enhances/improves the positive effect.
(b) If 𝛽1 > 0 and 𝛽2 < 0, foreign aid exerts a positive impact on economic growth and the quality
of institutions restrains/dampens the positive impact.
(c) If 𝛽1 < 0 and 𝛽2 > 0, foreign aid exerts a negative impact on economic growth and the quality
of institutions mitigate the negative impact.
(d) If 𝛽1 < 0 and 𝛽2 < 0, foreign aid exerts a negative impact on economic growth and the quality
of institutions exacerbates the negative impact.
Equation (2) also allows the determination of a threshold of institutional quality beyond which
foreign aid enhances economic growth. This is determined by obtaining the positive effect of foreign
aid on economic growth from the equation:
𝜃>0 ↔ 𝛽1 + 𝛽2 > 0
Thus, it follows that the minimum level of institutional quality beyond which foreign aid enhances
−𝛽1
economic growth is attained when 𝐼𝑄 > .
𝛽2
Annual data for Nigeria from 1984 to 2018 is employed in the study. Economic growth is measured
by real GDP per capita while foreign aid is measured by ODA as a percentage of GNI. Both capital stock
and trade openness are measured by gross fixed capital formation as a percentage of GDP and trade
as a percentage of a GDP respectively. All the variables are obtained from the World Development
Indicators (WDI). Furthermore, the study employs a common measure of institutional quality which is
law and order, in line with Lau et al. (2014) and to test robustness, another measure of institutional
quality, corruption, is employed in a second model. These two measures of institutional quality are
preferred to others for this study as they meet up with all the four criteria of predictability (security),
legitimacy, dynamic efficiency (adaptability) and static efficiency (Alonso & Garcimartin, 2013). While
law and order influences the legitimacy of institutions by affecting the capacity of institutions to
engender a normative framework that shapes the behaviour of agents, the level of corruption
influences institutions by affecting its security and consequently the degree of certainty/uncertainty
in relation to human interaction. The data for both variables is obtained from the International Country
Risk Guide (ICRG) of the Political Risk Services (PRS) Group. Williams and Siddique (2008) had described
ICRG dataset as the most reliable and widely used measure of institutional quality in recent time. Law
and order ranges from 0 to 6, and it measures how strong, independent and impartial a country’s legal
system is. It also measures how strongly the law is followed. Corruption, which also ranges from a score
of 0 to 6 measures the extent to which office is abused for personal gains. For each measure of
institutional quality, higher scores indicate stronger institutional quality and vice-versa. For example,
a score of 5 in corruption implies very low level of corruption in the country (and consequently stronger

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

institutional quality), while a score of 1 implies that corruption is pervasive in the country (and
consequently very weak institutional quality).

4. Results and interpretations

4.1 Descriptive statistics and correlation matrix

Table 1 presents a summary of descriptive statistics of variables. The figures show that Nigeria
received foreign aid that amounts to 0.69/GNI on the average for the period under study, while the
minimum and maximum aid received amounts to 0.04/GNI for 1985 and 4.94/GNI for 2006
respectively. This points to the increasing trend of foreign aid into the country. The average real GDP
per capita is $1756.890; the standard deviation is $446.89, while the minimum and maximum values
are recorded as $1324.30 for 1984 and $2563.90 for 2014. For institutional quality variables, the
average scores are 2.019/6 and 1.60/6 for law and order and corruption respectively; the standard
deviations are 0.71 and 0.36, while the minimum scores are 1.00 between 1984 and 1990 for law and
order and 1.00 between 1999 and 2004 for corruption. The maximum score of 3.00 was recorded for
law and order for the period 1993-2000, while for corruption, a maximum score of 2.00 was achieved
for 1985-1997. This indicates that Nigeria has continually ranked lower than 2.00/6.00 for corruption
index since 1997 till date.
It is also necessary to observe the correlation coefficients of the variables which are presented in
Table 2 in order to verify that the model is free from the problem of multicollinearity. From the Table,
all the coefficients are low in values, indicating that multicollinearity is unlikely in the model. The pair
of variables that have the highest correlation coefficient- (-0.3957) is corruption and trade openness.
The coefficient is low and does not suggest multicollinearity. It is also observed that there is a positive
correlation between the dependent variable and each of the explanatory variables.
Table 1. Descriptive statistics of variables
Std.
Variable Mean Deviation Minimum Maximum Observations
Real GDP per capita 1756.887 446.285 1324.297 2563.900 35
Foreign aid/GNI 0.695 0.973 0.044 4.939 35
Law and order 2.019 0.711 1.000 3.000 35
Corruption 1.600 0.362 1.000 2.000 35
Capital stock 32.151 14.072 14.169 58.956 35
Trade openness/GDP 33.819 11.789 9.136 53.278 35
Notes: RGDPC=real GDP per capita; FAID/GNI=foreign aid/GNI; LAWO=law and order; CORR=corruption; CAP=capital stock;
TOP=trade openness/GDP.
Source: Author’s computations.

Table 2. Correlation matrix

RGDPC FAID/GNI LAWO CORR INV TOP
RGDPC 1.0000
FAID/GNI 0.1611 1.0000
LAWO 0.0689 0.0171 1.0000
CORR 0.3218 -0.0871 -0.0869 1.0000
CAP 0.2869 -0.1921 -0.1797 0.2617 1.0000
TOP 0.0997 0.1470 0.2269 -0.3957 -0.3781 1.0000
Source: Author’s computations.

4.2 Unit root tests

In order to avoid spurious results in regression analysis, it is appropriate to establish that the series
in the model do not contain unit root. To this end, all the variables in the model are subjected to test
of stationarity by means of the Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) methods. Each

7
 Adewale Samuel Hassan

test operates under the null hypothesis that a series is non-stationary, in which case the null can be
rejected if the test statistic is statistically significant; otherwise, the null is accepted. Table 3 presents
the results of the stationarity tests which establish that all the variables are stationary at first difference
with 1% statistical significance.
Table 3. Unit root tests
Variables ADF PP Decision
1st
Level Difference Level 1st Difference
Real GDP per capita -0.319 -3.867*** -0.314 -3.796*** I(1)
Foreign aid -0.307 -5.302*** -0.293 -4.992*** I(1)
FAID_LAWO -0.598 -4.999*** -0.562 -4.804*** I(1)
FAID_CORR -0.809 -5.187*** -0.713 -4.823*** I(1)
Capital stock -1.238 -6.442*** -1.233 -6.434*** I(1)
Trade openness -1.409 -7.313*** -1.187 -7.286*** I(1)
Note: *** indicates statistical significance at 1%.; FAID_LAWO=interaction term between foreign aid and law and order;
FAID_CORR=interaction term between foreign aid and corruption.
Source: Author’s computations

4.3 Cointegration analysis

The confirmation of stationarity at first-difference for all the variables indicates the appropriateness
of the Johansen and canonical cointegration regression as the estimation technique for the model and
this begins with the investigation of the existence of long-run association among the variables. Tables
4 and 5 report the results of the Johansen cointegration test for both models with law and order and
corruption as the institutional quality variables respectively. Judging from the Mackinnon et al. (1999)
probability values in the test for model with law and order as the institutional quality variable, the null
hypothesis of three cointegrating relationships and one cointegrating relationship cannot be rejected
according to the Trace test and Maximum Eigenvalue respectively. Similarly, in the case of the model
with corruption as the institutional quality variable, both Trace test and Maximum Eigenvalue agree
that the null of one cointegrating relationship among the variables cannot be rejected. Thus, the
existence of long-run relationship among all the variables in each of the two models is established.
With these results, we can proceed with the estimation of the long-run parameters in the models by
means of canonical cointegration regression.
Table 4. Johansen cointegration results (Institutional quality variable: Law and order)
Cointegrating
Rank Trace Test Maximum Eigenvalue
Critical Critical
Statistic value p-value Statistic value p-value
None 94.53862* 69.81889 0.0002 36.97373* 33.87687 0.0206
At most 1 57.56489* 47.85613 0.0047 26.01578 27.58434 0.0783
At most 2 31.54911* 29.79707 0.0311 16.90847 21.13162 0.1764
At most 3 14.64065* 15.49471 0.0670 12.77350 14.26460 0.0848
At most 4 1.867143 3.841466 0.1718 1.867143 3.841466 0.1718
Note: * denote rejection of null hypothesis of no cointegration.
Source: Author’s computations

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

Table 5. Johansen cointegration results (Institutional quality variable: Corruption)

Cointegrating
Rank Trace Test Maximum Eigenvalue
Critical Critical
Statistic value p-value Statistic value p-value
None 79.25075* 69.81889 0.0073 34.23156* 33.87687 0.0454
At most 1 45.01920 47.85613 0.0902 18.60003 27.58434 0.4460
At most 2 26.41917 29.79707 0.1167 13.06432 21.13162 0.4463
At most 3 13.35485 15.49471 0.1024 7.382911 14.26460 0.4449
At most 4 2.170244 3.841466 0.1119 2.971941 3.841466 0.4145
Note: * denote rejection of null hypothesis of no cointegration.
Source: Author’s computations

Results of the canonical cointegration regression for the model with law and order as the
institutional quality variable are presented in Table 6, while those of the model with corruption as the
institutional quality variable are presented in Table 7. Each of the two models is estimated based on
three different specifications with no trend, linear trend and quadratic trend and the results for the
three specifications are presented in columns [1], [2] and [3] respectively in Tables 6 and 7. The results
from the law and order model in Table 6 show that foreign aid has a positive and statistically significant
coefficient across the three models at 1%. It indicates that foreign aid has a positive impact on
economic growth in Nigeria. For instance, a percentage increase in foreign aid is associated with about
0.15%, 0.14% and 0.12% increase in economic growth in the long run. These results are also consistent
with those of corruption model in Table 6. The result also suggests that foreign aid provides the much-
needed fund for closing the saving-investment gap, thereby expanding the allocation of investible
funds for economic growth (Baldé, 2011; Drine and Nabi, 2010; Lipsey, 1999). In addition, this finding
supports the theoretical postulation of Solow (1956) who emphasized the need to mobilize saving as
a way of generating sufficient physical capital formation for economic growth. Along the same line,
this finding corroborates the research outcomes of previous studies (Albulescu, 2015; Arndt et al.,
2015; Clist, 2016; Dalgaard et al., 2004; Fasanya and Onakoya, 2012; Irandoust and Ericsson, 2005;
Mekasha and Tarp, 2013; Moolio and Kong, 2016; Moreira, 2005; Tarp, 2006) which established the
growth-enhancing effect of foreign aid in developing countries. Furthermore, results from the Table 6
show that law and order yields positive and significant coefficients at 1%. Judging from the magnitudes
of the coefficients, the positive impact of institutional quality on economic growth can be said to be
strong, as a percentage increase in institutional quality is associated with approximately 0.32%, 0.23%
and 0.31% increase in economic growth. These results are also corroborated by those in Table 7 where
institutional quality is measured by corruption. This result which indicates that improvement in the
quality of institutions enhances economic growth is expected as institutional quality has been clearly
established as an important ancillary to growth (Berhane, 2018; Effiong, 2015; Arminen and Menegaki,
2019; Vitola and Senfelde, 2015). It is also in agreement with the theorization of Acemoglu et al. (2005)
and Alexiou et al. (2018) that differences in level of economic development observed for different
countries is mainly caused by varying qualities of their institutions.
While the separate impacts of foreign aid and institutional quality on economic growth have been
established, it is also important to determine the intervening effect of institutional quality on the
foreign aid-economic growth nexus, which is the main objective of this study. In the models, this is
represented by the interaction terms between law and order and foreign aid (FAID_LAWO) and
between corruption and foreign aid (FAID_CORR). The coefficient of the interaction term between law
and order and foreign aid is negative and statistically significant at 1%, 5% and 10% for the models with
constant, linear trend and quadratic trend respectively. The implication of these estimates is that
institutions in the country do not support foreign aid in the fulfilment of its growth-enhancing
potentials; rather, it exerts a dampening effect on growth-increasing efforts of foreign aid. Put
differently, institutions in the country give room to leakages from the positive impacts of foreign aid
on economic growth, thereby preventing foreign aid from being an effective driver of growth as

9
 Adewale Samuel Hassan

intended. Another implication of these estimates is that institutional quality and foreign aid fail to be
complementary in the growth process as posited by Johnson et al. (2002) with respect to several
transition economies. For the model with corruption as the institutional quality variable presented in
Table 7, the interaction term (FAID_CORR) is equally negative and statistically significant at 5%, 10%
and 5% for the models with constant, linear trend and quadratic trend respectively. This result
reinforces the results from the model with law and order by indicating that institutions in the country
do not drive foreign aid to impact positively on economic growth in Nigeria. Rather, it slows down the
growth-enhancing impact foreign aid. This finding conforms to some earlier results (Maruta et al.,
2020; Slesman et al., 2015; Svennson, 1999) which showed that the impact of foreign aid and foreign
capital inflows on economic growth is contingent on the level of institutional quality in the country.
Table 6. Canonical cointegration results (Institutional quality variable: Law and order)
Variable [a] [b] [c]
Constant 9.565*** (0.129) 9.284*** (0.411) 9.175*** (0.257)
Foreign aid 0.151*** (0.034) 0.143** (0.072) 0.122*** (0.024)
Law and order 0.317*** (0.084) 0.228*** (0.081) 0.307*** (0.075)
FAID_LAWO -0.107*** (0.031) -0.099** (0.051) -0.085* (0.047)
Capital stock 0.519*** (0.022) 0.492*** (0.129) 0.506*** (0.081)
Trade openness 0.075** (0.030) 0.073** (0.036) 0.030 (0.035)
Linear Trend 0.002 (0.006) -0.023*** (0.007)
0.0006***
Quadratic trend (0.00017)
Observations 35 35 35
R-squared 0.939 0.941 0.961
Notes: ***, ** and * represent significance at 1%, 5% and 10% respectively; All variables are in logarithm form; FAID_LAWO
= interaction term between foreign aid and law and order; values in parentheses are standard errors; Dependent variable = real
GDP per capita.
Source: Author’s computations

With the impact of foreign aid on economic growth established to be contingent on the level of
institutional quality, it becomes necessary to investigate the minimum level of institutional quality that
needs to be attained for foreign aid to enhance economic growth. This can be obtained as any level of
−𝛽1
institutional quality where 𝐼𝑄 > 𝛽2
, in line with extant studies (Ehigiamusoe et al., 2020; Hassan et
al., 2019; Law et al., 2018a; Law et al., 2018b; Gazdar and Cherif, 2015). The threshold for law and
order is obtained by differentiating the estimated equation in Table 6 with respect to foreign aid, and
𝜕𝑙𝑛𝐺𝐷𝑃 𝜕𝑙𝑛𝐺𝐷𝑃
setting the resulting outcome to zero to obtain ( 𝜕𝑙𝑛𝐹𝐴 = 0.151 − 0.107𝐼𝑄), ( 𝜕𝑙𝑛𝐹𝐴 = 0.143 −
𝜕𝑙𝑛𝐺𝐷𝑃
0.099𝐼𝑄) and ( 𝜕𝑙𝑛𝐹𝐴 = 0.122 − 0.085𝐼𝑄) for models [a], [b] and [c] respectively. Thus the threshold
0.151 0.143 0.122
is computed at 4.10/6 (𝑒 0.107 = 4.10) , 4.24/6 (𝑒 0.099 = 4.24) and 4.20/6 (𝑒 0.085 = 4.20) for models
[a], [b] and [c] respectively. This result implies that for foreign aid to effectively drive economic growth
in Nigeria, a minimum level of law and order of 4.10/6 must be attained and maintained consistently.
Turning to the threshold for corruption index, it is computed by differentiating the estimated equation
in Table 7 with respect to foreign aid, and setting the resulting outcome to zero to obtain
𝜕𝑙𝑛𝐺𝐷𝑃 𝜕𝑙𝑛𝐺𝐷𝑃 𝜕𝑙𝑛𝐺𝐷𝑃
( = 0.084 − 0.070𝐼𝑄), ( = 0.076 − 0.067𝐼𝑄) and ( = 0.113 − 0.103𝐼𝑄) for
𝜕𝑙𝑛𝐹𝐴 𝜕𝑙𝑛𝐹𝐴 𝜕𝑙𝑛𝐹𝐴
0.084
models [a], [b] and [c] respectively. The threshold is computed at 3.32/6 (𝑒 0.070 = 3.32),
0.076 0.113
3.83/6(𝑒 0.067 = 3.83) and 3.00/6 (𝑒 0.103 = 2.995) for models [a], [b] and [c] respectively. This also
bespeaks the need for Nigeria to attain a minimum score of 3 out of 6 in corruption measure of
institutional quality, for foreign aid to enhance economic growth. Put differently, institutions may not
be able to energize foreign aid to drive economic growth when the country operates below these
thresholds. It is clear from the earlier analysis that institutions do not enable foreign aid to enhance

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

economic growth in the country, rather, it constrains it by playing a substituting role to it in the growth
process. This situation may have arisen due to the fact that the levels of institutional quality in Nigeria
falls below the thresholds. For instance, as reported in Table 1, the average score of law and order and
corruption measures of institutional quality for the country stand at 2.0/6 and 1.6/6 respectively.
Moreover, the highest scores of 3/6 (law and order) and 2/6 (corruption) and the lowest scores of 1/6
(law and order) and 1/6 (corruption) are attained. These score are quite below the threshold of
institutional quality required for foreign aid to enhance economic growth.
Table 7. Canonical cointegration results (Institutional quality variable: Corruption)
Variable [a] [b] [c]
Constant 9.558*** (0.209) 9.769*** (0.923) 10.119*** (0.689)
Foreign aid 0.084** (0.041) 0.076*** (0.021) 0.113*** (0.043)
Corruption 0.240*** (0.086) 0.161*** (0.031) 0.157*** (0.036)
FAID_CORR -0.070** (0.033) -0.067* (0.037) -0.103** (0.049)
Capital stock 0.534*** (0.037) 0.583*** (0.205) 0.695*** (0.154)
Trade openness 0.096** (0.047) 0.096* (0.050) 0.037 (0.064)
Linear Trend -0.003 (0.011) -0.042** (0.016)
0.00084**
Quadratic trend (0.00033)
Observations 35 35 35
R-squared 0.936 0.933 0.961
Notes: ***, ** and * represent significance at 1%, 5% and 10% respectively; All variables are in logarithm form; FAID_CORR
= interaction term between foreign aid and corruption; values in parentheses represent standard errors; Dependent variable = real
GDP capita.
Source: Author’s computations

The coefficient of capital stock and trade openness are positive and statistically significant in line
with a priori expectations. By implication, this result underscores the important role of capital in the
growth process in line with the proposition of the endogenous growth theory that capital is a major
input in the growth function (Romer, 1990; Lucas, 1988; Frankel, 1962). It also indicates that opening
up the economy more to trade improves the level of economic growth.

4.4 Diagnostics

Some diagnostic tests were carried out on the regression results in order to verify how reliable they
are. Table 8 presents the results of the diagnostic tests conducted on models [a], [b] and [c] of the
equation with law and order as the institutional quality variable, while Table 8 presents those of
models [a], [b] and [c] of the equation with corruption as the institutional quality variable. As shown
in both tables, all the six models passed the normality, autocorrelation and heteroscedasticity tests, as
the probability values of all the tests exceed the 5% level. This serves to confirm the reliability of the
estimates in the study.
Table 8. Diagnostic tests results (Institutional quality variable: Law and order)
Test Statistic p-value Statistic p-value Statistic p-value
[a] [b] [c]
Jarque-Bera 14.2566 0.1407 14.2079 0.1172 19.2573 0.2047
Autocorrelation test (LM) 8.3785 0.2273 12.7122 0.3417 9.5724 0.1533
Heteroscedasticity test 83.5504 0.4618 92.5044 0.2055 77.5901 0.3728
Source: Author’s computations

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 Adewale Samuel Hassan

Table 9. Diagnostic tests results (Institutional quality variable: Corruption)

Test Statistic p-value Statistic p-value Statistic p-value
[a] [b] [c]
Jarque-Bera 16.1132 0.2513 12.5682 0.2355 18.3751 0.1117
Autocorrelation test (LM) 11.5107 0.1057 10.3370 0.3157 9.6370 0.1671
Heteroscedasticity test 88.3762 0.4933 75.3052 0.5619 81.0073 0.4229
Source: Author’s computations

5. Conclusion

The role of institutions in the relationship between foreign aid and economic growth has not
received adequate attention in the literature despite the persistence of various macroeconomic issues
in the countries that have been the beneficiaries of the huge amount of foreign aid over the decades.
One such country is Nigeria, which has continually received increasing amount of aids with very little
to show for it in terms of macroeconomic stability, poverty reduction, quality health care delivery,
reduction of illiteracy and so on. Interestingly, one major characteristic of Nigeria and other seemingly
perpetual beneficiaries of foreign aid is weak institutions. Up till date, there is no known study that has
investigated the intervening effect of quality of institutions on how foreign aid impacts economic
growth in Nigeria and this is the primary objective of this study. Moreover, the study set out to also
determine the threshold of institutional quality beyond which foreign aid becomes an effective driver
of economic growth. To achieve the study’s objectives, the Johansen and canonical cointegration
technique was employed based on two equations with two different measures of institutional quality
(law and order and corruption). All the variables in the models were found to be cointegrated based
on the Johansen cointegration test. Furthermore, results from the canonical cointegration regression
showed that foreign aid has a separate positive effect on economic growth in Nigeria, but this positive
effect is diminished and leaked out by the quality of institutions in the country. What this indicates is
that institutions in Nigeria are characterised by loopholes and weaknesses that allow subversive and
sharp practices which often divert foreign aid funds meant for growth-enhancing projects into self-
serving and unproductive activities. The study also found that the minimum level of institutional
quality required for Nigeria to attain in order for institutional quality to propel the growth-enhancing
prospect of foreign aid, rather than dampening it, is 4.10 out of a possible score of 6 for law and order
index, as well as 3 out of a possible score of 6 for corruption index, based on the ICRG data. A survey
of Nigeria’s scores for the two indexes over the years (Table 1) shows that Nigeria falls far below this
threshold. This may likely be responsible for the failure of institutions to support foreign aid to enhance
economic growth.
These results have some key policy implications. First, the fiscal authorities in Nigeria need to
review the existing institutional framework guiding the sourcing, disbursement and utilization of
foreign aid with a view to finding out any loopholes and lapses that encourage diversion of fund and
institutionalized corruption which prevent it from promoting growth. Second, policies should be put in
place by international donors to the effect that a minimum level of institutional quality that is based
on generally agreed criteria and definition of institutions should be attained by any country before it
can qualify as a beneficiary of a particular amount of aid. Third, Nigeria should endeavour to generally
improve her institutional architecture, especially as regards corruption and rule of law, as the country
is currently operating below the minimum level required for institutions to support the growth-
enhancing capabilities of foreign aid. Lastly, there is a need for an improvement in the quality of
governance provided by the political class in the country, as the quality of institutions in a country
cannot be divorced from the state of governance (Acemoglu et al., 2002; Alesina & Weder, 2002). Thus,
attention should be paid to issues of strict adherence to the tenets of democracy, freedom of the press,
enforcement of fundamental human rights and reduction of electoral fraud/violence.

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 Foreign Aid and economic Growth in Nigeria: The Role of Institutional Quality

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