Effects of foreign aid on human development and poverty: evidence from Pacific Island Countries

To address diverging human development and poverty trends across Pacific Island Countries (PICs), this study investigates the effects of Official Development Assistance (ODA) on multidimensional welfare outcomes over 2000–2023. Using two-stage least squares (2SLS) estimation, findings show that total and social-sector assistance significantly improve the Human Development Index (HDI), standard of living, and schooling, whereas only total aid reduces poverty. Additionally, economic and production aid effectively increase standard of living and education, respectively. However, two counterintuitive results emerge: overall and social aid correlate with lower life expectancy, and economic aid increases poverty—outcomes likely driven by aid fungibility and Dutch disease dynamics. Specifically, economic aid leads to real exchange rate appreciation that depresses agricultural output and exports, while social aid can cause recipient governments to reallocate domestic spending away from key public sectors, such as health. For small, open economies, these findings explain, in part, why aid-dependent nations struggle to grow and mitigate poverty. Overall, aid effectiveness hinges on sectoral allocation and recipient income levels. These findings highlight the need to reform aid architecture, strengthen domestic health systems, and actively implement macroeconomic stabilization measures.