Easing the Pain of Adjustment? Preferential Trading Agreements, Foreign Aid, and Credible Commitment to Economic Reform

Baccini, Leonardo and Urpelainen, Johannes Easing the Pain of Adjustment? Preferential Trading Agreements, Foreign Aid, and Credible Commitment to Economic Reform. Working Paper (Submitted)

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Abstract

In this article, we propose that wealthy donors give foreign aid to developing countries to facilitate political adjustment, such as compensation for losers and side payments to influential elite constituencies, towards mutually profitable economic reform. Only democratic developing countries can credibly commit to using fungible revenue in ways that benefit the donor, so the adjustment effect only applies to democracies. A quantitative test against data on preferential trading agreements lends strong support to the theory. Strikingly, fully democratic developing countries that form a preferential trading agreement obtain a threefold increase in foreign aid in the short run. Additional tests show that this increase is not driven by macroeconomic difficulties and that the beneficial effect on foreign aid is temporary. Both findings are consistent with the theory. An important implication of these results is that if foreign aid facilitates economic reform through preferential trading agreements, previous research could have underestimated the benefits thereof.

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