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