Revisited the role of foreign aid in capital formation: experience of South Asian countries

Abstract This study contributes to the aid-development literature by examining the role of host country factors in conditioning the investment effect of foreign aid, covering a panel of six South Asian countries over the period 1990–2019. The study uses second-generation panel unit root, cointegration, and causality methods to control for endogeneity, cross-section dependency, and structural breaks. The study further applies the panel autoregressive distributed lag (ARDL) method of Pooled Mean Group (PMG) and the Common Correlated Effect Pooled Mean Group (CCEPMG) to estimate the long and short-run effects. The study results suggest that in the long run, foreign aid reduces or crowds out domestic investment directly but promotes domestic investment from the complementarity between aid and trade, human and financial development, and FDI. The causality result provides evidence of bi-directional causality between the two, supporting the crowding-out effect.