International Business & Economics Research Journal – November 2013 Volume 12, Number 11 2013 The Clute Institute Copyright by author(s) Creative Commons License CC-BY 1389 Foreign Aid, Domestic Savings, And Economic Growth In South Asia Hem C. Basnet, Chadron State College, USA ABSTRACT The role of foreign aid in promoting growth by complimenting domestic savings has been an issue of considerable controversy. This study examines the role of foreign aid on domestic savings and economic growth in South Asian countries - Bangladesh, India, Nepal, Pakistan, and Sri-Lanka - by using simultaneous equation system in which growth and savings are jointly determined. The results indicate that aid has a positive and significant effect on the growth rates of the five nations studied during 1960 to 2008. However, foreign aid appears to crowd out domestic savings rather than complementing it. Keywords: Foreign Aid; Domestic Savings; Investment, Growth I. INTRODUCTION hile there are many reasons for giving foreign aid, the most notable argument is to bridge the gap between domestic saving and domestic investment and therefore, to accelerate growth. A fundamental assumption made by the supporters of aid is that it helps poor countries in achieving higher levels of economic growth. In the absence of such aid internal resources of the poor countries will not be able to take off (Dowling and Hiemenz, 1983). Additionally, since less developed countries are constrained by low foreign currency reserves aid can fill the foreign exchange gap as well as saving gap (Papanek, 1973). Hence, foreign aid is crucial in the process of economic development in developing countries. Even though, most of foreign aid has been targeted to promote economic growth and improve the well being of their citizens in developing countries, there has been significant debate over the effectiveness of aid in the recipient countries. Empirical studies related to foreign capital flow and economic growth show evidence for and against the theoretical arguments regarding the impact of foreign capital. Griffin (1970), for instance, argues that foreign aid does not contribute to economic growth and that it fails to foster democratic political regimes. Instead, foreign economic assistance could retard economic development by lowering the domestic saving rate. Rajan and Subramanian (2008) also documents a similar conclusion to that of Griffin (1970). However, Papanek (1973), in a cross-country regression analysis of 34 countries in the 1950s and 51 countries in the 1960s, treating foreign aid, foreign investment, other flows and domestic savings as explanatory variables, finds that foreign aid has a substantially greater effect on growth than on the other variables. He explains that aid, unlike domestic savings, can fill the foreign exchange gap as well as the savings gap. He also finds a strong negative correlation between foreign aid and domestic savings. Fayissa and El-Kaissy (1999), in a study of 77 countries over sub-periods 1971-1980, 1981-1990 and 1971- 1990, show that foreign aid positively affects economic growth in developing countries. This is consistent with theory of foreign aid, which asserts that overseas development assistance accelerates economic growth by supplementing domestic capital formation (Chenery and Strout, 1966; Hatemi-J and Irandoust, 2005). Studies that found negative associations between foreign aid and growth argue that government receiving aid generally do not raise taxes but expand consumption from money coming from external sources. That results in lower savings and thereby low growth. If capital inflow is high then domestic saving tends to decrease or even go negative if the foreign capital inflow is very high. In other words, domestic savings is not only the function of national income but also the function of foreign capital. In the literature some studies argue that the negative relation W