More foreign aid, less financial development

We examine whether foreign aid substitutes domestic finance. A simple theoretical model is presented to show that foreign aid might raise private consumption but reduce private borrowing, which could be consistent with undermining financial development. The results of empirical tests of the foreign aid–financial development relationship reported employing crosssectional and panel data sets of 96 developing countries for the period 1971-2015. The results indicate that foreign aid inflows have a negative and highly significant impact on financial development in aid-recipient countries. The results are not affected by model specification, different control variables, variation in country sample, or estimation technique. To our knowledge, this is the first paper to test the foreign aid–financial development linkage.