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The Singapore Economic Review
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Article Title: Does foreign aid help or hinder the institutional quality of the recipient
country? New evidence from the OIC countries

Author(s): Mohammad Ashraful Ferdous Chowdhury, Mohamed Ariff, Mansur

Masih, Izlin Ismail

DOI: 10.1142/S0217590819420037

Received: 01 July 2018

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Accepted: 09 September 2019

To be cited as: Mohammad Ashraful Ferdous Chowdhury et al., Does foreign aid help
or hinder the institutional quality of the recipient country? New evi-
dence from the OIC countries, The Singapore Economic Review, doi:
10.1142/S0217590819420037

Link to final version: [Link]

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Does foreign aid help or hinder the institutional quality of the recipient country?

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New evidence from the OIC countries1

Abstract:

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This study examines the impact of foreign aid on the institutional quality of the OIC countries.
Using the data of OIC countries for the three-year average period from 1991 to 2016, the
System GMM finds that aid in general deteriorates the Institutional quality for the aid recipient
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countries. However, Quantile regression suggests that the negative impact of foreign aid on

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institutional quality is relatively greater in the countries where the existing quality of institution
is poor. The findings of the study suggest that improving the existing capacity is essential for
reaping the optimum benefit of foreign aid on institutional development.
Key words: Foreign Aid, Institutional Quality, OIC countries, System GMM, Quantile
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regression

1. Introduction:

Foreign aid is a key ingredient of the foreign capital flows and plays a significant contribution

in the developing countries. Tierney et al (2011) reports that the donors from various countries
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donated more than $ 7 trillion US dollar to developing nations since the World War II. With

the higher aid flows, the recipient countries can develop immensely through the knowledge,

expertise and financial support (see Arandt [Link]. 2015, Juselius [Link] 2014, Hansen and Trap,

2001). A few nations are constantly reliant on external aid. For example ODA represented 40
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percent of the government budget and 6.2 percent of GDP in Burkina Faso amid 1960–1999

and in Mauritania, for 37 percent and 12 percent, respectively (see Dijankov et al. 2008).

Despite a significant flow of foreign aid is coming to developing countries, still a number of
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countries are not been able to grow out of poverty. Collier (2007) identified poor good

governance structure is one of the major traps of why so many millions are still trapped in

extreme poverty. Various investigations have demonstrated that the radical anti-aid view holds
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that foreign aid supplants domestic resources, worsens domestic income inequality and trade
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1
This paper is part of the first author’s successfully completed Ph.D. dissertation. The authors are grateful to
reviewers for their valuable comments which improved the quality of the paper immensely.
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balance, an in general aid makes governments in developing nations inefficient and corrupt

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(Quazi & Alam 2015).

Along with the macroeconomic effect, a fascinating area of research has emerged that

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investigates the connection between foreign aid and the institutional quality in developing

countries (Jones and Tarp, 2016; Asongu & Nwachukwu, 2017; Busse et. al 2017). Some

scholars (Goldsmith, 2001; Dunning, 2004; Ear, 2007; Charron, 2011; Okada & Samreth,
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2012) believe that foreign aid can play a vital role for the institutional development through

the quality of civil administration, boost policy and planning capacity, and strengthen central

institutions, while other scholars consider that the aid weakens the quality of political

institutions (see Deaton 2013, Booth 2011, Rajan and Subramanian, 2007). The opponents of
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foreign aid propose that the aid can hinder the host government’s internal revenue collection

process. As the host government are no longer dependent on the consent of the parliament or

of the population at large, foreign aid are often said to weaken the accountability of the country
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(Moyo, 2009, Moss et al 2008). Likewise, Djankov et al. (2008) remarked aid as ‘curse’ as too

much aid dependence can undermine the institutional quality, weaken the accountability, and

encourage rent seeking and corruption. A number of studies such as Kangoye (2013) confirmed

that aid volatility2 is also associated with more corruptions and more rent seeking activities in

the aid recipient countries, while others have the opposite conclusions (Tavares 2003).
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However, Askarov & Doucouliagos (2015) finds that total aid has no effect on overall quality

of governance. Recent studies such as Feeny et al (2019) and Fielding (2014) argued that the

positive or negative outcome of foreign aid rather depends on the absorptive capacity of the
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recipient countries.

Like many developing nations, a large number of OIC member countries are

precariously dependent on foreign aid or Official Development Assistance (ODA) inflows.

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2
Aid volatility refers the deviation between the aid commitments and disbursement approval or the gap between
what is committed and what is disbursed.
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SESRIC (2018) reports based on UNCTAD estimation, developing countries including OIC

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countries face an annual gap of $2.5 trillion out of $ 3.3 trillion to $4.5 trillion every year for

the infrastructural development, food security, climate change mitigation and adaptation,

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health, and education. The report also claimed that the OIC countries were affected more so

than any other parts of the world by large-scale humanitarian crises and natural disasters and it

causes a huge budget deficit every year in majority Muslim countries. So, foreign aid is
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inherently important to all Muslim majority countries for balancing their budgets. The recent

statistics show that Muslim countries figure prominently in the ranking of funds received for

humanitarian assistance. For the five-year period 2006 to 2010, Muslim majority countries

comprise half of the top 10 recipient nations in terms of Official Development Assistance
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(Clarke & Tittensor 2016). According to OECD statistics (2016), Afghanistan, Indonesia and

Pakistan were among the top 10 recipient countries of humanitarian aid in 2013. In a similar

vein, the recent data from 2012-2017 show that Muslim countries are among the top recipients
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of ODA (International Humanitarian Aid Report 2017). Ishnazarov & Cevik (2017) in their

recent studies found that the OIC countries are the largest aid beneficiary and receiving 50%

of the total ODA from 2002 to 2013.

On the other hand, the institutional quality structures of Muslim countries are

significantly in poor status (Mirakhor et. al 2016). Ideally, Muslim countries should have high
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institutional quality as Islam promotes freedom of choice, property rights, the rule of law, good

governance and a fair economic system. For any country, rule of law is the fundamental pillar

of the sustainable development and poverty reduction (Anjinappa 2015). But along with the
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poor rule of law, the overall existing institutional quality of majority Muslim countries is

unsatisfactory. Alaabed et al (2016) found that the Muslim countries are lagging behind in

terms of the principles of Maqasid Al Shari’ah (Objective of Shari’ah). Mirakhor (2015) found
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Muslim countries are highly deficient in terms of good governance. Rehman and Askari (2010)
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found none of the OIC countries are placed within the first 40 countries in overall Islamicity

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index (Islamicity rankings 2016)3. According to the index, only three countries Malaysia (41)

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and United Arab Emirates (40) and Qatar (45) are within the first 50 of overall Islamicity index.

Having population of 1.79 billion people (23.8% of the total world population), OIC countries

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constitute a considerable part of the developing world and reflect high levels of heterogeneity

and divergence in terms of socio-economic development (SESRIC 2018). Ishnazarov & Cevik

(2017) in their recent studies argued that the OIC countries represent a variety of geographical
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locations, politically and culturally heterogeneous. Amir-ud-Din (2014) and Anto (2011) found

the institutional quality of the OIC differs significantly across each other as 23 countries out of

57 are ranked outside 100.

Too much aid dependency of the Muslim countries on the one hand and the weak
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institutional infrastructure and the intriguing features of social and economic indicators of

Muslim countries on the other hand, makes this study more interesting. So, the objective of this

study is to investigate whether foreign aid contributes to the institutional development of the
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OIC countries. This study examines the impact of foreign aid on institutional quality from three

angles: (a) the aggregate effect of aid on institutional quality, (b) aid volatility and its effect on

governance, and finally (c) the marginal effect and nonlinearity of aid and institutional quality

of the recipient countries4. In detail, the study boils down to the following three objectives:

1. The first objective of this study is to investigate whether aid flows contribute to the
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institutional quality of the OIC countries or not.

2. The second objective of the study is to find out the impact of aid volatility or aid

unpredictability on the institutional quality of the aid-recipient countries.

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3. The third and final objective of the study is to investigate how foreign aid affects the

institutional quality when different countries have different institutional infrastructure.

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3
Islamicity Indices is an index developed for measuring the institutional quality of the Muslim countries with four key
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dimensions: economic islamicity, Legal and governance, Human and policitcal rights,, International relations Islamicity. The
detail is available in this link: [Link]
4
Details is available in section 2.4
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Alternatively, the aim of this research objective is to find out how aid impacts the low

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institutionally developed and the high institutionally developed countries.

This study is novel in number of ways: Firstly, a voluminous number of studies considered the

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different countries from different regions. However, as we discussed earlier, the OIC countries

are the highest recipients of foreign aid but no comprehensive study has yet been conducted

to find out its impact on their institutional development. Focusing exclusively on the OIC
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countries, this study makes a unique contribution and enhances our deeper understanding of

aid and institutional quality nexus in the aid literature. Secondly, unlike the previous studies,

our study considered two governance databases i.e., International Country Risk Guide (ICRG)

and World governance Index (WGI), for testing the robustness of the empirical findings.
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Thirdly, our study integrates three disparate strands of literature in one single study by putting

a coherent empirical structure on them. Finally, this study also contributes to the existing

literature regarding the effectiveness of aid on the institutional quality by focusing on the
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distribution of institutional dynamics.

The remainder of the paper is structured as follows. Section 2 addresses the literature

review and hypotheses of the study, section 3 provides the data and methodology of the study

and section 4 summarizes the model estimations and main findings of the study and finally

section 5 outlines the conclusion and policy implications for the decision makers.
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2. Foreign Aid and Institutional Quality---Prior studies and Hypotheses development:

With the higher aid inflows, beneficiary nations gain advantage from the money related

assets as well as from learning, expertise and technical assistance. However, there is no
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evidence of any aid allocation set aside for institutional improvement. Looking into the vast

majority of the investigations of the most recent two decades, this study distinguishes four

unique strands of evidence in this context: (i) aid improves institutional quality; (ii) aid erodes
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institutional quality; and (iii) unpredictability/volatility of aid flows can affect the institutional
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quality; and (iv) the relationship between aid and instuitional quality is nonlinear. Table 1

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summarizes prior literature into four strands.

Table 1: Review of Literature

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Researchers Main findings
First-strand: Aid improves Institutional Quality
Jones and Tarp (2016) Positive but very small effect is found between foreign aid on political institution in
the sampled 104 countries for the period 1983-2010.
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Keresting and Kilby Long run positive but short run impact of aid on democracy uncovers positive
(2014) relationship for bilateral aid but not from multilateral in the sampled 122 countries for
the period 1972-2011.
Dadasov (2017) Based on the data of 103 developing nations, authors found aid can improve
Institutional Quality.
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Dutta and Williamson Using a panel of 108 countries over the period 1971 to 2010, Aid can develop
(2015) economic freedom of the recipient country when it is democratic rather than autocratic.
Quazi and Alam Aid has positive association with the institutional quality of aid dependent countries in
(2015) the sampled south and east Asian countries.
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Gibson et. Al(2015) Technical assistance improves the democratization in the African countries.
Asongu (2012) Using a panel data of 52 African countries over the period 1996 to 2010,
the author found that aid mitigates corruption in the African continent.
Busse et al.(2017) Foreign aid can improve the regulatory quality when the aid is allocated for business
drives in the developing nations.
Inariat (2014) Among six world bank governance indicators, Voice and Accountability (VA) and
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control of corruption (CC) are critical in the aid allocation decision.

Asongu (2015) Foreign aid has positive effect on corruption in African region.
Mohamed [Link] (2015) Foreign aid has reduction effect on the corruption level of sub-Saharan countries
(SSA)
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Carnegie & Marinov Based on the Cingranelli-Richards (CIRI) Human Rights Dataset, authors
(2017) concluded that aid has short term positive effects on human rights and democracy.
Croix & Delavallade Aid is not negatively correlated with corruption across countries.
(2013)
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Asongu SA (2014) The effects of foreign aid on corruption and institution are positive; constitutionally
positive, conditionally positive with the magnitude dependent on initial institutional
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capacity level.

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Second-strand: Aid deteriorates Institutional Quality

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Rajan & Using the data over the period 1980 to 2010 of developing nations, authors concluded
Subramanian(2007) that aid dependence can erode the tax structure and finally it deteriorates the
institutional quality of the host country.

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Asongu (2012) Aid is detrimental to government effectiveness in African sampled countries.
Asongu (2013) Foreign aid is detrimental to Institutional quality in all aspects.
Kalyvitis and Based on the data from 64 aid dependent countries in the period 1967-2002, the study
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Vlachaki (2012) found a negative relationship existing between aid and institutional quality.

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Furthermore, the study found the effect was larger in low democratic status to begin
with.
Booth(2011) Negative and it might offset the exchange rate through Dutch disease.
Busse and Groning Using the three years average data from 1984 to 2004 for 106 countries, authors found
(2009)
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aid has a negative impact on governance.
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Young and Sheehan Aid flows are associated with deterioration in political and economic institutions, legal
(2014) system and property rights.
Wako (2017) Aid affects negatively the growth and institutional quality in the sub-Saharan African
countries.
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Fielding (2014) Negative relationship between the variation in political rights over time and variation
in governance aid.
Djankov et al.(2008) For a sample of 108 countries over the period 1960-1999, authors found aid has
negative impact on democracy.
Isopi, A. (2015). (1) donors do not tend to discriminate between corrupt and non- corrupt recipients; and
(2) foreign aid can fuel corruption without reducing poverty
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Moyo (2009) Foreign aid increases the dependency, poverty and corruption
Third Strand: Mixed/No effect of Aid on Institutional Quality
Asongu & Foreign aid does not have any significant impact on political rights
Nwachukwu (2017)
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Dunning (2004) Aid has no impact on the democratic development in African region before the 1987
but relation becomes positive and significant afterwards.
Menard and Weill No significant causality exists between aid and corruption in either direction.
(2016)
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Ear (2007) Other than voice and accountability, aid has no significant impact on other governance
indicators.
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Fourth Strand: Aid Volatility and Institutional Quality

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Kangoye (2013) Higher aid volatility leads to higher corruption in the sampled 80 recipient countries.
Kathavate & Mallik Based on the data of 78 countries over the period 1984 to 2004, the study found the
(2012) nexus between aid and growth is negative but it depends on the initial institutional

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capacity of the recipient country.
Iulai (2014) Aid volatility shows adverse impacts on the recipient countries.
Afawubo & Mathey Aid is positively associated with savings and investment, its volatility is harmful to
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(2017) savings and investment. However, when higher quality institutions exist, the volatility

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of aid has a less negative impact on savings and investment.
Asongu & Aid volatility does reduce democracy of the recipient countries.
Nwachukwu (2017)
Fifth Strand: Nonlinearity of Aid and Institutional Quality

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Brayzs (2016) Aid may simultaneously improve and hinder governance. So, relationship between
aid and governance could be positive and negative.
Asongu SA (2014) The effects of foreign aid on corruption and institution are positive; constitutionally
positive, conditionally positive with magnitude dependent on the initial institutional
capacity level of the recipient countries in the African region.
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Okada and Using quantile regression, the study found aid reduces the corruption level at different
Samreth(2012) percentiles in 120 developing countries.
Asongu(2015) Using panel quantile, foreign-aid is more negatively correlated with countries of higher
institutional quality than with those of lower quality in African region.
Mohamed [Link] (2015) Based on the data from sub-Saharan countries over the period 2000 to 2010, the study
found that the impact of foreign aid on corruption is likely to be more noteworthy in
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countries that experience a higher level of corruption.

2.1 Aid Literature on Muslim-majority OIC Countries:

Although Majority Muslim countries are the top recipients of foreign aid but aid literature
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relating to Muslim majority countries is extremely scarce. A few studies such as Alterman and

von Hippel (2007), Harrigan and Said (2009) examined the political economy of foreign aid

and found that aid allocations are substantially influenced by the donors’ domestic political
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considerations, including commercial advantage and foreign policy objectives such as

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migration and terrorism. An earlier work by Harrigan and Said (2004) found that the allocations
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of US aid to Israel and Jordan are much higher than the aid allocation to Iran, Sudan and

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Yemen. Bellers (1993) examined the financial development assistance practices of Saudi

Arabia and found that the aid practice of Saudi Arabia to be highly politicized and lacking

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transparency. Neumayer (2003) found that poor Arab, Sub-Saharan African and Muslim

countries and nations that support Saudi Arabia in the UN general assembly, were more likely

to get aid. Likewise, Villanger (2007) who showed that Muslim aid tends to be very generous
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and at the same time very volatile as it is driven by political, commercial and religious interests.

Ahmed (2006) in his doctoral thesis found that local NGOs are often used by a political party

to preach their political ideals in Bangladesh. By using time series data from 1972- 2010, Nasir

et. al. (2012) found a positive association between foreign aid and terrorism in Pakistan.
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Based on the literature review in the previous section, this study clearly found that the

relationship between aid and institutional quality of the recipient country is vague and

inconclusive. Some researcher are proponent of aid on institutional development, some are
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completely opposite. There are a few studies which found the relationship between aid and

institutional quality is conditional and it is subject to the existing capacity of the recipient

countries. The following sub-sections explain the theoretical underpinnings and hypotheses

development of aid and institutional quality nexus:

2.2 Positive effects of ODA:

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Beginning with the mid-1990s, researchers, for example, Brautigam (1992) and

Lancaster (2000) started to conjecture on the potential of using foreign aid to foster better

governance which in turn would facilitate economic development. Degnbol & Martinussen
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(2002) argued aid can be utilized to encourage better administration in three ways: first,

‘enhancing state capacity’ to increase the efficiency of utilizing the public resources and the

quality of public administration; second, ‘strengthening state–society linkage institutions and

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procedures' to incorporate judicial reform and strengthening the rule of law; and third,

‘empowerment of civil society organizations’ to engage with the decision making process with
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their government with lower cost. Each of these channels can play a positive role of foreign

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aid on the institutional quality of the aid recipient countries.

There are a few channels through which aid can influence decidedly specific properties

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of institutions and can play an impetus role for change. For instance, Knack (2001) and Freytag

and Heckleman (2012) contend that aid flows may make an imperative commitment to change

by serving to finance improvements in institutions. Knack (2004) contends again that aid can
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add to the democratization of a nation through technical assistance in the electoral process and

fortifying legislature and judiciaries. Aid can also work indirectly thorough income, training

and education. By enhancing education level and training, aid may expand the beneficiary's

capacity for open and transparent government and educated citizens’ cooperation. High levels
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of aid can possibly enhance the quality of governance through improving the legal system,

improving the quality of civil administration, strengthening policy and planning capacity and

accountability. Furthermore, aid conditionality from the donors to recipient countries triggers
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to initiate specific reforms to improve the quality of governance prior to receiving aid packages.

It may also enhance the accountability of recipient governments. A good example can be South

Korea and Taiwan and Botswana which have utilized foreign aid for socio-economic

development (Bräutigam & Knack, 2004).

2.3 Adverse effects of ODA:

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While there are solid reasons behind the positive impact of aid on institutional quality,

there are also some reasons that aid can undermine institutional quality. Busse and Groning

(2009) note that the ‘moral hazard’ and rent seeking associated with high levels of aid could
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prompt a negative effect of aid on governance. Likewise, Moss et al (2006) claims that aid can

erode the quality of institution through rent seeking and corruption. Skill (2001) takes note in

that aid reliance can undermine institutional quality, hinder responsibility, and encourage rent
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seeking and corruption. Thus, over time, the institutions of recipient countries are likely to
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become geared towards unproductive activities.

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Svensson (2000) finds foreign aid is associated with increased corruption and this

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impact is more prominent in ethnically heterogeneous nations. There are conceivable reasons

why aid flows may be adverse to a beneficiary's institutional quality. For instance, aid

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beneficiary government might not have the motivation or inclination to or undertake tax

reforms or to be responsive and responsible to its nationals. William J. Baumol (1990) and

Djankov et. al (2008) consider aid to be a "curse" for the beneficiary nation as it applies and
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exerts a corrupting influence on its institutions. Rajan and Subramanian (2007), Kalyvitis and

Vlachaki (2012), Heckelman and Knack (2008) find aid can hinder (rather than encourage)

market-oriented reforms.

Prasad and Nikow (2016) remarked the aid as a curse for the developing countries as it
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destroys the economies in the following three ways: Firstly, a large inflow of aid can disrupt

the growth due to the corruption and temptation. Secondly, aid may weaken bureaucratic

institutions by placing heavy external demands on them, and by poaching staff away from the
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state. Thirdly, aid may undermine advancement by debilitating the force for setting up strong

tax administration. In the event that aid is given as credits which increment the nation's

obligation load, absence of reliable tax administration will prompt an ever bigger part of the

budget setting off to the overhauling of obligation, which thus may obstruct improvement

(Bräutigam and Knack, 2004; Moore, 2004). Foreign aid can disrupt the political stability of
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the non-democratic regime of the naturally resourceful countries. For example, Ravetti et. al

(2018) found that the foreign aid and natural resources can act as a double curse on autocratic

regime. It reduces the accountability and increases the returns to corruption and moral hazard,
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engendering looting and sudden departures of political leaders.

H1 Foreign aid can help improve the institutional quality of the recipient.
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2.4 Aid volatility and Institutional Quality:

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The volatility of aid flows is measured as the deviation of actual aid flows from the expected

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aid flows. The aid volatility arises either because of the policy changes by the donor or external

shocks in the global economy. In either case, aid vulnerability may adversely affect government

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expenditure, and specifically investment. A diminishment of public investment may thus

prompt lower private speculation, and eventually additionally to bring down development.

Bulíř and Haman (2008) identified that the effect of aid volatility is particularly severe when
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the shortfall of aid and domestic revenue deficit coincidentally happens simultaneously in the

aid dependent country. Lensink and Morrissey (2000) investigate the impact of volatile aid

flows and found that aid in itself contributes to higher growth, but that the effectiveness of aid

is diminished when aid flows are more volatile.

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In addition to the economic consequences of the aid volatility, there are some studies

which found that the aid volatility can affect the political environment of the recipient country.

For example, Kangoye (2013) explored the political economy of 80 developing countries over
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the period 1984 to 2004 and compared the political power and rent seeking behavior of the

corrupted leaders with the aid volatility. The author argued that the politicians aim to increase

the rent they capture and where they have inter temporal smoothing considerations, greater

volatility of aid can lead them to engage more than proportionally (compared with the optimal

path) in rent seeking since they face a shortfall risk of aid. Likewise, Robinson [Link] (2006)
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used the resource curse theory for explaining the aid volatility and its impact on the political

institution of the recipient countries. Ventelou (2001) found that the greater the aid volatility,

the greater the incentives for kleptocrat leaders to engage in rent seeking in countries where
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institutional quality is poor. Likewise, Arellano et al. (2009) examined the aid volatility and its

effect on welfare. They found that lower aid volatility is beneficial for consumption (welfare

enhancing), whereas higher aid volatility leads to consumption volatility (welfare impeding).
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However, a recent study of Asongu & Nnanna (2019) found that aid unpredictability or
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instability improves government standards especially political and general governance.

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H2: Foreign aid volatility has adverse effect on the institutional quality of the recipient.

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2.5 Marginal effect and Nonlinearity of foreign Aid on Institutional Quality:

Following the comparative thinking, another branch of research has contended that a vital piece

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of the story is disregarded by not considering the absorptive limit of the aid-getting nations.

Brayzs (2015) first introduced the Laffer curve to find the relationship between aid and

governance structure of the aid recipient countries. They argued that aid and governance need
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not be linear always and they found too much of foreign aid can lead to counterproductive

result in the governance. This branch of research infers that the aid and development

relationship may demonstrate diminishing returns (Feeny and McGillivray 2011). Some studies

applied quadratic functions to examine the nonlinearity between aid and growth relationship
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(e.g., Hansen and Tarp, 2000; Dalgaard and Hansen, 2001; Lensink and White, 2001). These

studies argue that aid is effective in increasing growth with diminishing returns and many aid

recipient countries may have limited capacity to absorb foreign resources and, hence, aid
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beyond a certain threshold may actually harm the economic growth.

In a similar vein, recent studies such as Mohamed et al. (2015), Okada and Samreth

(2012), Askarov and Doucouliagos (2015) found that aid-institution relationship is

heterogeneous and it is contingent on the initial level or absorption capacity of the aid recipient

country. Brazys (2015) asserted that aid-governance relationship need not be linear, but rather
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aid may simultaneously improve and hinder governance. So, relationship between aid and

governance could be positive or negative. By using quantile regression, they investigated the

effect of aid at different levels of institutional quality and they found that the aid-institution
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nexus is not symmetric; rather it has a marginal effect. Mohammed et al. (2015) results suggest

that generally aid has a mitigating effect on corruption. The effect is bigger in countries with

low corruption perception index (CPI) scores (i.e. in more corrupt countries). Okada and
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Samreth (2012) found that aid reduces the corruption level but the reduction effect is greater in
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less corrupt countries. So, this study will test the non-linearity or marginal effect of the OIC

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countries with the following hypothesis:

H3: The relationship between increased aid and institutional quality (IQ) is nonlinear and

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depends on the "initial level" of IQ.

3. Data and Methodology:

3.1 Data:
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This study employs the panel data consisting of annual observations of the OIC countries with

the average of every 3 years aggregated from 1991 to 2016. However, a few countries,

including Saudi Arabia, Qatar, Bahrain, and Kuwait, are dropped from the list as they are not

aid recipients, rather they are aid donors. Finally, this study considered annual data of 38
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countries from OIC region. This study uses the official development assistance (ODA) data as

a measure of the amount of foreign aid a country receives. The data of ODA along with the

following variables is collected from the OECD and DataStream database. Since an increase
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in dollar per capita may not be a good measure of aid dependency (because of the changes in

dollar value itself), a look at the foreign aid as a percentage of the GNI is likely to provide a

better picture of the phenomenon (see Moniruzzaman, 2012). For representing the dependent

variable, this study applies two types of dataset of institutional quality: first, the ICRG data set

and second, the world governance indicators (WGI), as suggested by Kaufmann et al. (2010).
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Both datasets have similarities for explaining political and governance structure of the

countries. For example, key indicators like political stability, corruption, regulatory quality,

bureaucratic quality etc. are considered in both datasets. In our study, the ICRG dataset is used
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as a base in the empirical section, while the second dataset is applied for tesing the robustness

of the study. Askarov & Doucouliagos (2013) made a meta-analysis of aid and its effect on

governance and they found that nearly two-thirds (64%) of researchers used these two dataset
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separately. However, in this study both of these datasets are used simultaneously to identify
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the impact of aid on institutions.

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In WGI, the institutional quality variables include: the rule of law, regulation quality,

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corruption-control, government effectiveness, voice and accountability, and political stability.

Kaufmann et al. (2010) illustrated that these six aggregate indicators can be reported in two

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ways: (1) in their standard normal units, ranging from approximately -2.5 to 2.5, and (2) in

percentile rank terms from 0 to 100, with higher values corresponding to better outcomes. For

the ease of interpretation, this study adopts the latter option in all empirical models. The ICRG
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index is composed of 5 components: government stability, corruption, law and order,

democratic accountability and bureaucratic quality. Control variables such as inflation,

unemployment, trade openness, economic growth, population growth are applied in this study.

These control variables are broadly consistent with the causes of institutional quality (Goel and
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Nelson, 2005; Lambsdorff, 2006). Javed (2016) found Trade openness and economic growth

are the significant determinants of the institutional quality.

3.2. Methodologies:
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3.2.1 Static Model (Fixed and Random Effects):

Following the prior studies (Asongou 2015; Dadasov 2016; Askarov and Doucouliagos 2015), this

study adopts following equation using the static panel model to examine the relationship

between the foreign aid and the institutional quality of the host country:

IQ (ICRG) = α + β1 ODA to GNI + β2 POP +β3 TRDO + β4 INF + β5 UEM + β6 EG + ……….(i)

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Here, the dependent variable is the Institutional Quality (IQ) measured by ICRG index

Independent variables:

ODA to GNI (%) = Official development assistance to Gross National Income (%)
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POP = Population growth

TRDO = Trade openness

INF = Inflation rate

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UEM = Unemployment rate

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EG = Economic growth

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= Error term

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Since the sample considers all countries over a particular time period, the fixed effects model

is adopted in the analysis. Furthermore, the opportunity to use a fixed effects rather than a

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random effects model has been tested with the Hausman test.

3.2.2 Dynamic Model-System GMM:

Like recent studies, our study also believes that there should be dynamic relationship
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between aid and institutional quality. That’s why, after the static models, this study considered

the dynamic panel models with the following justifications: i) the dependent variable-

Institutional Quality is very likely to be dependent on the past one (Dadasov, 2017). ii) As

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mentioned earlier aid flow, the main variable of our research interest is endogenous by nature

(see Dutta & Williamson, 2015). The argument for endogeneity is the allocation of aid flow is

dependent on many factors including the institutional quality of the recipient countries. The

same idea is applicable to some of our control variables. iii) Unobserved time invariant factor
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may affect both institutional quality and other independent variables iv) In cross country macro

data, the error terms are subject to heteroskedasticity and serial correlation.

As static panel models suffer from above mentioned problems, ‘difference’ GMM

suggested by Arellano and Bond (1991) can eliminate the fixed effects. However, it fails to

remove the problem of correlation between the lagged dependent variable and the error term
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which requires the use of ‘instruments’. One possible solution is the use of appropriate lags of

the dependent and independent variables as instruments. However, one potential problem with

the ‘differenced’ equation is that the lagged ‘levels’ of regressors may be weak instruments for
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the ‘differenced’ variables (See Yalta & Yalta, 2012).

In order to address the above mentioned problems, this study applied dynamic System

GMM proposed by Arellano and Bond (1991) and Blundell and Bond (1998). Some recent
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studies such as Busse et. al (2017) strongly recommend System GMM as it deals effectively
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with reverse causality by using lagged levels and differences as a set of instruments for the

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endogenous variables. Based on this context, the system GMM is used based on the following

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two equations for addressing our first research objective:

𝐼𝑄𝑖𝑡 = 𝛼𝑖 +𝑏𝑡 + 𝛽1 𝐼𝑄𝑡−1 + 𝛽2 𝐴𝐼𝐷 + 𝛽′3 𝑋𝑖𝑡 + 𝜀𝑖𝑡 (𝑖𝑖)

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∆𝐼𝑄𝑖𝑡 = 𝑏𝑡 + 𝛽1 𝛥𝐼𝑄𝑡−1 + 𝛽2 𝛥𝐴𝐼𝐷𝑖 + 𝛽′3 𝛥𝑋𝑖𝑡 + ∆𝜀𝑖𝑡 (𝑖𝑖𝑖)

Where i indicate the country (𝑖 = 1, … 𝑁)and t indicates the time period (𝑡 = 1 … 𝑇𝑖 ).

IQ indicates Institutional Quality, the dependent variable of our study. AID refers to the official
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development assistance to GNI (%) form. Xit is the set of control variables. αi and bt denotes

country and time effects respectively. Finally, 𝜀𝑖𝑡 is the unobservable error term. Using system-

GMM methodology, equation (ii) is first transformed into equation (iii) using first-differences

(Δ) that eliminates the country fixed effects. Then both equations are estimated simultaneously
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whereby lagged first-differences of all potential endogenous variables are used as their own

instruments in the level equation (ii), and lagged levels of the respective variables are used as

instruments in the first-difference equation (iii). (see Dadasov 2017). However, System GMM
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suffers from the two following problems: a) To make the estimates asymptotically more

efficient, S-GMM uses two-step procedure but standard errors of the estimates tend to be

critically biased. b) Another problem with the two-step GMM is the ‘instrument proliferation’

which results in biases in the coefficient and their standard errors (Roodman, 2009a.).

For addressing the second research objective of the study as to how aid volatility affects
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the institutional quality, we need to measure the aid volatility first. Like some prior studies

(Fielding and Mavrotas, 2008; Asongu, 2014, Kangoye, 2013; Asongu & Jacinta C.

Nwachukwu, 2017), our study applied 4-year rolling standard deviation of the change in the
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foreign aid expressed in logarithmic terms. Finally, after finding the aid volatility, the following

formula for S-GMM will be used to conduct the empirical analysis:

𝐼𝑄𝑖𝑡 = 𝛼𝑖 +𝑏𝑡 + 𝛽1 𝐼𝑄𝑡−1 + 𝛽2 𝐴𝐼𝐷𝑉 + 𝛽′3 𝑋𝑖𝑡 + 𝜀𝑖𝑡 (𝑖𝑣)

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∆𝐼𝑄𝑖𝑡 = 𝑏𝑡 + 𝛽1 𝛥𝐼𝑄𝑡−1 + 𝛽2 𝛥𝐴𝐼𝐷𝑉𝑖 + 𝛽′3 𝛥𝑋𝑖𝑡 + ∆𝜀𝑖𝑡 (𝑣)

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Where i indicate the country (𝑖 = 1, … 𝑁)and t indicates the time period (𝑡 = 1 … 𝑇𝑖 ).

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IQ indicates Institutional Quality, the dependent variable of our study. AIDV refers to the aid

volatility (standard deviation) of the ODA to GNI (%) form. The AIDV variable is measured

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before taking the average of every 3 years aggregated from 1991 to 2016. Xit is the set of control

variables. αi and bt denote country and time effects respectively. Finally, 𝜀𝑖𝑡 is the unobservable

error term.
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3.3.3 Quantile regression:

Due to the diversity of the income level, political structure and institutional quality of the

sampled OIC countries in our study, the dataset of our study is highly skewed (heavy tailed

distribution). So, OLS estimation is inappropriate in such a situation because of the normality
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problem of the distribution. This is why, this study adopts the Quantile regression suggested

by Koenker and Bassett (1978) for examining the third research question. While OLS

regression focuses on mean, quantile regressions are able to describe the entire conditional
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distribution of the dependent variable (Coad & Rao, 2006). Unlike OLS, the error term and

dependent variable in QR need not be distributed normally. So, quantile regression technique

allows us to examine if the relationship among institutional dynamics and foreign-aid differs

throughout the distributions of the institutional dynamics (Asongu 2015). Like Mohamed et.

al. (2015), Asongu (2013), this study would be able to carefully assess the incidence of
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development assistance throughout the conditional distribution with particular emphasis on

countries with strong and worst weak institutions by using the following quantile formula:

𝑦𝑖𝑡 = 𝑥́ 𝑖𝑡 𝛽0 + 𝜀𝜃𝑖𝑡 𝑤𝑖𝑡ℎ𝑄𝑢𝑎𝑛𝑡𝜃 ((𝑦𝑖𝑡 |𝑥𝑖𝑡 ) = 𝑥́ 𝑖𝑡 𝛽0 , (𝑣𝑖)

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Where i denotes country, t denotes time, 𝑦𝑖𝑡 denotes institutional quality, 𝑥́ 𝑖𝑡 is a vector
of regressors, 𝛽 is the vector of parameters to be estimated, 𝜀 is vector of residuals.
𝑄𝑢𝑎𝑛𝑡𝜃 ((𝑦𝑖𝑡 |𝑥𝑖𝑡 ) denotes 𝜃 𝑡ℎ conditional quantile of 𝑦𝑖𝑡 given 𝑥𝑖𝑡 . 𝜃𝑡ℎ regression quantile,
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0 < 𝜃 < 1, solves the following problem:

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𝑚𝑖𝑛 1

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{ ∑ 𝜃 │𝑦𝑖𝑡 − 𝑥́ 𝑖𝑡 𝛽│ + ∑ (1 − 𝜃) │𝑦𝑖𝑡 − 𝑥́ 𝑖𝑡 𝛽│}
𝛽 𝑛
𝑖,𝑡:𝑦𝑖𝑡 >𝑥́ 𝑖𝑡 𝛽 𝑖,𝑡:𝑦𝑖𝑡 <𝑥́ 𝑖𝑡 𝛽
𝑛
𝑚𝑖𝑛 1
= ∑ 𝜌𝜃 𝜀𝜃𝑖𝑡 (𝑣𝑖𝑖)
𝛽 𝑛

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𝑖=1

Where 𝜌𝜃 (∙), which is known as the ‘check function’, is defined as:

𝜃𝜀𝜃𝑖𝑡 𝑖𝑓𝜃𝜀𝜃𝑖𝑡 ≥ 0
𝜌𝜃 (𝜀𝜃𝑖𝑡 ) = { } (𝑣𝑖𝑖𝑖)
(𝜃 − 1)𝜀𝜃𝑖𝑡 𝑖𝑓𝜃𝜀𝜃𝑖𝑡 ≤ 0
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According to Buchinsky (1998), as one increases 𝜃 continuously from 0 to 1, one traces

the entire conditional distribution of yit, conditional on xit. Since the quantile regression is more

appropriate than the OLS and other static models for testing our hypothesis, this study

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considered the 20th, 40th, 60th, 80th and 90th quantiles as shown here:

𝑄0.20 (𝐼𝑄) = 𝛼0.20 + 𝛽0.20,1 𝑋 + 𝛽0.20,2 𝑂𝐷𝐴 𝑡𝑜 𝐺𝑁𝐼 + 𝜀0.20𝑖𝑡 (ix)

𝑄0.40 (𝐼𝑄) = 𝛼0.40 + 𝛽0.40,1 𝑋 + 𝛽0.40,2 𝑂𝐷𝐴 𝑡𝑜 𝐺𝑁𝐼 + 𝜀0.40𝑖𝑡 (x)
𝑄0.60 (𝐼𝑄) = 𝛼0.60 + 𝛽0.60,1 𝑋 + 𝛽0.60,2 𝑂𝐷𝐴 𝑡𝑜 𝐺𝑁𝐼 + 𝜀0.60𝑖𝑡 (xi)
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𝑄0.80 (𝐼𝑄) = 𝛼0.80 + 𝛽0.80,1 𝑋 + 𝛽0.80,2 𝑂𝐷𝐴 𝑡𝑜 𝐺𝑁𝐼 + 𝜀0.80𝑖𝑡 (xii)

𝑄0.90 (𝐼𝑄) = 𝛼0.90 + 𝛽0.90,1 𝑋 + 𝛽0.90,2 𝑂𝐷𝐴 𝑡𝑜 𝐺𝑁𝐼 + 𝜀0.90𝑖𝑡 (xiii)
Here, IQ denotes Institutional Quality, X is set of control variables and ODA to GNI (%) refers

to foreign aid flows.

4. Models Estimation and Discussions:

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4.1 Descriptive Statistics:

Table 2 which presents some basic descriptive statistics for the main variables used in the

empirical analyses (data are averaged over 1991-2016), shows that the values of aid as a
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percentage to GNI is around 7 percent. Based on the ICRG dataset, the institutional quality of

the sampled country is only 52 out of 100, which is relatively lower, compared to that of the

developed countries. WGI, another dataset of governance, shows the score is even less than
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one-third of the total score. These results are consistent with the findings of Askari [Link]. (2017)
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that made an index called Islamicity Index where he found that none of the Muslim countries

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are in the top 40 and the score ranges between 40 percent to 44 percent.

Table 2: Descriptive statistics

WGI

CR
ODA to
ICRG GNI POP TRDO INF UEM EG

Mean 52.407 29.29 7.040 2.1760 70.062 22.954 9.730 4.171

Median 53.962 24.454 3.500 2.2666 63.056 5.283 8.250 4.350

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Max. 74.428 40.030 66.780 6.690 255.850 1000.00 27.66 24.560

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Min. 0.0000 11.713 0.003 -1.570 15.410 -7.166 1.63 -19.283

Std. Dev. 11.618 5.699 9.176 1.173 36.099 91.34 5.59 4.147

Skewness -1.5563 0.108 2.589 -0.039 2.041 7.956 0.90 -0.514

Kurtosis 7.697 2.594 12.620 4.565 8.718 71.493 3.324 11.899

Obs. 304 248 304 304 304 304 304 304

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Source: Author’s estimation

Notes: The dependent variable is IQ and is measured by the ICRG and WGI index . ODA to GNI(%) Official development
assistance to Gross National Income (%); POP refers to the population growth, TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers Unemployment rate and finally EG is the Economic growth

From the macroeconomic perspectives, the average annual economic growth of the

sampled countries is 4.17 percent. The unemployment rate and inflation rate of the sampled
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countries are 9 percent and 22 percent, respectively. This study also reveals that the

considerable variation exists in the inflation rate of the sample countries, as few countries like

Syria and Yemen are in under the war crisis. The standard deviation of ICRG and WGI is found

11.61 and 5.69 respectively and these figures indicate that the existing level of institutional
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quality is varied among the OIC countries.

4.2 Correlation Matrix:

For understanding the basic relationship between our dependent and independent variables, a
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correlation matrix is constructed in Table 3. The results show that the impact of aid and aid

volatility are negatively correlated with the institutional quality of the aid dependent countries.

For example, the ratio of ODA to GNI and aid volatility is negatively and statistically
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significant to ICRG by 0.22 and -0.15, respectively.

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Table 3: Correlation Matrix

IP
ODA to
ICRG LAIDV GNI(%) POP TRDO INF UEM EG

ICRG 1

CR
LAIDV -0.1557* 1

ODA to GNI -0.2267* 0.0783 1

POP 0.0408 0.1782* 0.2083* 1

TRDO 0.1469* -0.1168 -0.0212 -0.2046* 1

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INF -0.5779* 0.0623 -0.0349 -0.1962* 0.0347 1

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UEM 0.0343 -0.0692 -0.0268 -0.1391 0.1525 0.0232 1

EG 0.2826* -0.0102 0.0400 0.1739* -0.0166 -0.3900 0.0209 1

Source: Author’s estimation
Notes 1: The dependent variable IQ is measured by the ICRG and WGI index; ODA to GNI(%) Official development
assistance to Gross National Income (%); POP refers to the population growth, TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers to Unemployment rate and finally EG is the Economic growth

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Note 3: .*, **and***indicate significance at the 10%, 5% and 1% levels, respectively

In addition to the aid variable, there are some macroeconomic factors, such as inflation

and unemployment which are negatively related with the institutional quality. However, as

expected, the trade openness, economic growth are positively and significantly related with the
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institutional quality of the aid dependent countries. This result can be a primary source of

evidence that the aid and institutions are negatively correlated. Another purpose of making

correlation matrix is to see issues resulting from over parametization and multicollineraity.

Since the pair correlation of variables is less than 0.80, there does not appear to be any serious
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concerns in terms of mulitcollinearity. (see Gujrati et. al. 2009).

4.3 Results of Static Panel Models:

The descriptive statistics in the earlier section found the negative correlation between the
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changes in foreign aid and institutional quality of the host country. For better understand of the

nexus between foreign aid and institutional quality, the basic empirical models have been

estimated using the fixed effects method and the random effects method, results are shown in
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Table 4. To check which method is more appropriate, Hausman test is applied and found that

the fixed effects method is more acceptable compared to the random effects.
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Table 4: Static Models Estimations
(1) (2) (3) (4)

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Dependent Variable: ICRG
VARIABLES Fixed Fixed effects-lag Random Effects Random Effect-lag
[Link] -------- -.00784** ------- -.00759***
(.00288) (.0028)
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ODAGNI -0.0303*** -0.0254*** -0.0273*** -0.0235***

(0.00844) (0.00801) (0.00754) (0.00722)

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EG -0.00565 0.187 -0.0182 0.172
(0.0959) (0.124) (0.0939) (0.122)

INF -0.0637*** -0.0584*** -0.0662*** -0.0601***

(0.00616) (0.00615) (0.00596) (0.00596)

UEM -0.280 -0.362 -0.0345 -0.0771

(0.276) (0.254) (0.160) (0.156)

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TRDO -0.0443 -0.0376 0.0155 0.0160

(0.0316) (0.0306) (0.0223) (0.0222)

POP -.00018 -.000249 .0000647 .000016

(.00029) (.0002853) (.0002456 ) (.0002394)

Constant 55.13*** 58.31*** 56.09*** 61.50***

(14.02) (13.28) (11.78) (11.31)
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Observations 294 287 294 287
R-squared 0.406 0.422
Number of idc 38 38 38 38
Notes 1: The dependent variable IQ is measured by the ICRG and WGI index; ODA to GNI(%) Official development
assistance to Gross National Income (%); POP refers to the population growth, TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers to Unemployment rate and finally EG is the Economic growth
Notes 2: this study tested the Hausman test and found P-value 0.017 meaning fixed effects model is more valid
Note 3: .*, **and***indicate significance at the 10%, 5% and 1% levels, respectively

The first and foremost important variable of interest of our study is the coefficient of
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aid flows and the impact on the institutional quality of the aid dependent countries. It is found

that the ratio of ODA to GNI has a negative and statistically significant impact on the ICRG

index at 1 percent level of significance. This study employed static panel methods such as fixed
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effects and random effects for hypothesis testing. However, the study accepted the fixed effects

model as the p-value found is 0.017 in the Hausman test. By using the fixed effects method, it

is found that a 1 percent increase in the ODA to GNI ratio decreases the ICRG index -.030%.
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The similar result exists when we use the random effects method.

Theoretically, foreign aid flows should discharge governments from restricting income
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requirements and empower them to focus enforcing good governance. The financial and
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tecnnical support enables developing countries to ensure proper institutional quality (see Busse

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[Link], 2017; Sachs, 2005). However, our results reveal that aid flows erode the governance

quality of the receipient countries. One possible explaination could be: due to moral hazard

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problems and rent seeking, high levels of aid could delay or block necessary domestic reforms

to improve regulations (Bräutigam & Knack, 2004; Heckelman and Knack, 2008). The other

possible reason could be the presence of weak institutions and rent seeking practices of the
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corrupt government of the aid recipient countries.

Among the macroeconomic variables, inflation has an adverse effect on the institutional

quality of the aid dependent countries. In a similar vein, the other financial liberalization

variables, such as the trade openness has negative but statistically insignificant relationship
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with the institutional quality of the OIC countries. This study also examined whether there is

any dynamic relationship existing or not in the model. The results found that the dynamic

relationship exists in the model since the lag dependent variables are statistically significant.
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4.4 Results of Dynamic Models- System GMM:

Although this study relied on the results of the ‘System’ GMM result but for the

robustness and consistency of the findings, this study also applied ‘difference’ GMM. Column

2 and 4 are for the ‘difference’ GMM estimation. The result of the difference GMM is also

consistent with System GMM. The system GMM tries to deal with weak instrument problem
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by augmenting these instruments. System GMM does not require the panel data to be normally

distributed. However, System GMM of any assumption on the panel distribution is only

consistent when there is no second-order autocorrelation within the error term and second,
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when the model is not over-identified (i.e. when the instruments are valid). Therefore, Table 5

reports two tests: the Arrelano and Bond test of first- and second-order autocorrelation in the

residuals and the Hansen test of over-identification. The P-value of AR(2) suggest that there is
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no second order autocorrelation in the residual within all models in the table 5. Furthermore,
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the number of instruments is less than the number of groups (i.e., countries).

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Table 5: Dynamic Model Estimation- System GMM

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Variables Dynamic Models Dynamic Models Dynamic models with aid volatility
(2) (3) (4) (5) (6) (7)
D-GMM S-GMM D-GMM S-GMM S-GMM S-GMM

Dependent Variable: Institutional Quality measured by ICRG

ICRG ICRG WGI WGI ICRG WGI

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[Link] 0.488*** 0.484*** 1.252*** 1.116*** 0.568*** 1.050***
(0.0778) (0.0905) (0.281) (0.102) (0.0872) (0.0585)

Aid ------ ------ ------ ------- -0.0257** -0.0725**

volatility ------ ------ ------ ------- (0.013) (0.033)
ODA to GNI -0.175** -0.134** -.4367* -0.377 -0.114** -0.0205**
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(0.0824) (0.0601) (2.350) (0.369) (0.0557) (0.00874)

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INF -0.029*** -0.0367*** 0.00851 0.0120 -0.0290*** 0.00156
(0.00463) (0.00569) (0.00888) (0.0183) (0.00379) (0.0131)

UEM -0.292 -0.117 0.00733 -0.0109 -0.0201 -0.0285***

(0.598) (0.120) (0.148) (0.0164) (0.0890) (0.0107)

EG 0.0424 0.0841 0.0364 0.0302* 0.101 0.121

(0.145) (0.109) (0.0267) (0.0174) (0.138) (0.118)

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TRDO -0.0135 0.0390* -0.0124 -0.00366 0.0232* -0.00501

(0.0592) (0.0230) (0.00990) (0.00692) (0.0140) (0.00482)

POP 0.780** -0.106 -0.354 -0.260* 0.0637 -0.231***

(0.391) (0.396) (0.528) (0.156) (0.338) (0.0857)
Obs. 213 251 229 223 254 213

No. of instr. 18 24 12 23 19 13
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No. of 38 38 31 31 38 31
Groups
AR(1) 0.018 0.032 0.006 0.002 0.018 0.024

AR(2) 0.404 0.716 0.972 0.488 0.138 0.098

Hansen J- 0.334 0.301 0.345 0.349 0.351 0.254

test (p-
value)
Notes 1: The dependent variable is IQ is measured by the ICRG and WGI index . ODA to GNI (%) Official development
assistance to Gross National Income (%); POP refers to the population growth; TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers to unemployment rate and finally EG is the economic growth
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Notes 2: Two-step system GMM results by using robust standard errors corrected for finite samples (by using Windmeijer's,
2005, correction) and Hansen J tests never reject the validity of the over-identifying restrictions.
Notes 3: If p-value > .05, we confirm the validity of instruments. AR (2) is a test for the second-order serial correlation and is
asymptotically distributed as N(0,1) under the null of no serial correlation. If p-value >0.05, we confirm no serial correlation
at order two in the first-differenced errors and the model is well specified.
Note 4: *, **and***indicate significance at the 10%, 5% and 1% levels, respectively
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On the whole, the validity of the instruments used as a necessity for System-GMM is

confirmed, as indicated by the p-values of the Hansen J test. In all the models in table 4, the p-

value of Hansen’s J test for over identification restrictions are higher than the critical level of
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0.05 and even 0.10 meaning that the joint validating of instruments is not rejected. Like

Dadasov (2017), this study also follows another ‘rule of thumb’ and assuring that the number
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of instruments is not exceeding the number of countries. So, considering all test statistics of

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these models we can conclude that the estimated models are adequately specified.

Furthermore, in the light of Table 5, we explore our main conjecture about the aid

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impact on the institutional quality of the sample countries. First we explore the role of aid on

the institutional quality (column 2-4) and then we examine the dynamic effects of aid volatility

on the institutional quality. The coefficient of system GMM indicates that there is a negative
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and statistically significant association between aid and IQ – for both WGI and ICRG - at 5

percent level of [Link] result is consistent with our earlier static model results. By

using the differenced and system GMM for the ICRG dataset, it is found that if there is 1

percent increase in the ODA to GNI ratio; the institutional quality will be decreased by -0.17
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and -0.13 percent, respectively. A similar result has been found in our second data set of

institutional quality i,e world governance index (WGI). Both differenced GMM and system

GMM found a negative impact of aid on the institutional infrastructure of the sampled OIC
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countries.

Among all the control variables, inflation, population growth and the unemployment

rates are negatively associated with the institutional quality. Like the static models, Trade

openness (TO), another proxy variable of financial liberalization (the ratio of exports and

imports to GDP), has a negative but insignificant association with the institutional quality of
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the sampled OIC countries. However, the effect of inflation rate and institutional quality is

relatively higher and statistically significant. Based on the ICRG dataset in differenced GMM

and system GMM, it is found that 1 percent increase in inflation will erode institutional quality
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by -0.029 percent and -0.036 percent. These results are consistent with prior studies such as

Busse and Groing (2009), Djankov et al (2008), Wako (2017) who argued that the aid can

impact negatively on the institutional quality. With regards to the population growth, our results
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found a negative association with the institutional quality. Like Busse, M., & Gröning, S.
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(2009), we also believe that the higher population growth can pose information asymmetry

25
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problems and higher transaction costs which financially impede institutional developments.

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Finally, as expected our study also reveal that the unemployment problem can also erode he

institutional quality.

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Aid volatility, another research question of this study, concludes with similar findings.

By using the System GMM the coefficient between aid volatility and institutional quality is

negative. For instance, by using the ICRG and WGI index, if there is 1 percent increase in aid
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volatility, the institutional quality will decrease by 0.025 percent and 0.0725 percent,

respectively. The ODA to GNI ratio is also negatively associated with institutional quality of

the recipient countries in all models. Our result is consistent with Kangoye (2013) who found

1% increase in the aid volatility leads to 0.32% corruption in the aid recipient countries. A
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possible reason advanced by the author is that the greater the aid volatility the greater incentive

of kleptocrat leaders to be involved in rent seeking practices especially in the countries where

institutional quality is weak. Likewise, Afawubo & Mathey (2017) found when higher quality
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institutions exist, the volatility of aid has a less negative impact on savings and investment.

Other than the direct institutional impact of aid volatility on the aid recipient countries, few

studies such as Hudson and Mosley (2008), Iulai (2014) found that aid can negatively impact

initially on the macroeconomic performance of the aid recipient countries which indirectly

hamper the different components of the institutional quality of the host country.
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4.5 Results of Quantile regression:

Form our earlier static and GMM results, we found that institutional quality in the recipient

countries is negatively associated with aid inflows and aid volatility. However, it is yet to
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explore the heterogeneous effect of aid effects on our institutional quality meaning that we are

not sure yet how does the aid impact on the country where existing institutional quality is good

or bad. For this purpose, this study employs Quantile regression (QR) to investigate the
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relationship among institutional dynamics and foreign-aid flows throughout the distributions
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of institutional dynamics (Koenker & Hallock, 2001). For the purpose of our result

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interpretation, it is important to note that the lower quantiles (in conditional distributions) of

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the dependent variable denote less institutional quality index of the recipient countries.

Alternatively, the upper quantile indicates the high institutional quality of the aid recipient

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countries (see Asongu (2015).

Table 6: Quantile regression at different percentiles when ICRG is dependent variable

(1) (2) (3) (4) (5) (6)
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Variables OLS q25 q40 q60 q80 q90

Dependent Variable: ICRG

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ODAGNI -0.0257*** -0.0329*** -0.0196*** -0.0147 -0.0107 -0.0132*
(0.00729) (0.00906) (0.00675) (0.00914) (0.0125) (0.00783)

EG -0.118 -0.0994 -0.0852 -0.0142 -0.201 -0.144

(0.108) (0.203) (0.219) (0.252) (0.297) (0.398)

INF -0.0754*** -0.0993*** -0.0848*** -0.0803*** -0.0698*** -0.0742***

(0.00658)
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UEM 0.0109 -0.0200 -0.00868 -0.0440 -0.0524 -0.0219

(0.103) (0.172) (0.125) (0.132) (0.112) (0.195)

TRDO 0.0515*** 0.0758 0.0582** 0.0588** 0.0460*** 0.0167

(0.0172) (0.0494) (0.0279) (0.0254) (0.0151) (0.0174)

POP -0.0628 -0.751 -1.045 -0.563 -0.687 -1.332

(0.508) (1.394) (0.739) (0.517) (0.467) (0.860)
DM

Const. 43.80*** 42.56* 39.63** 52.51*** 59.54*** 78.28***

(10.40) (25.01) (19.29) (17.35) (16.93) (20.57)

Notes 1: The dependent variable is IQ measured by the ICRG and WGI index. ODA to GNI(%) Official development
assistance to Gross National Income (%); POP refers to the population growth, TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers to Unemployment rate and finally EG is the Economic growth

Note 2: *Denotes significance at 10% level; ** Denotes significance at 5%; *** Denotes significance at 1%

As shown in the quantile regression in Table 6, the aid-institutional quality (IQ) nexus
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is negative in terms of magnitude across distributions and specifications. However, the

marginal negative effect of aid on IQ decreases in the upper quantile of the distribution. This

implies the low-IQ countries are more affected than the high-IQ countries. Alternatively, the
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high-IQ countries are more likely to benefit from development assistance (in terms of general

economic growth) than their low-IQ counterparts. Foreign aid is more negatively correlated

with countries of lower quantiles than those of higher quantiles, meaning that aid impacts the
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institutional quality badly when the country has poor institutional quality at the initial stage.
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From the summary in Table 6, it is noticeable that the negative nexuses are not

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significantly different across specifications and distributions. However, the magnitude of

negative incidence of ODA on institutional quality statistically significantly decreases from the

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bottom (0.25 and 0.40 quantiles) to the top distributions (0.80 and 0.90 quantiles). This suggests

the positive aid correlations are more present in top quantiles of the institutional quality

distribution. Alternatively, the negative impact of aid is more evident in the low-IQ countries.
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This finding is consistent across specifications with the slight exception of the 0.90 quantile in

Table 6.

For robustness, WGI data is used to examine the effect of aid on institutional quality at

different distributions. The results of WGI are in line with the findings of ICRG data. In Table
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7, it can be seen that the aid is negatively related with the institutional quality at different

percentiles. For example, aid is negatively related at the Q20, Q40 Q60, Q80 Q90; however, the

lower quantile is more statistically significant than the upper quantile. So, it can be said that
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aid is more challenging to the low-IQ countries in comparison with the high-IQ countries. This

finding of marginal effect of aid on institutional quality is consistent with Okada and Samreth

(2012) and Mohamed et al. (2015) who concluded that the marginal effect is bigger in countries

with low institutional quality.

Among all control variables, most of them are significant with the right signs since
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inflation and population growth seriously infringe on institutional quality, while investment

(public, domestic and private) improves it. Estimates of fixed effects, controlling for the

unobserved heterogeneity in legal origins, trade openness and income-levels, also have the
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expected signs. Based on WGI data, Income indicated by GDP per capita is positively related

to the institutional quality of the sampled countries at various distributions. The results imply

that higher income can improve the institutional quality of all countries irrespective of its initial
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level of institutional quality. Similar to earlier findings, inflation is negatively correlated with
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institutional quality of the OIC countries. These findings are consistent with the OLS results.

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Table 7: Quantile regression at different percentiles when WGI is dependent variable

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Q20_res
OLS_res Q40_res Q60_res Q80_res Q90_res

Dependent Variable: WGI

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ODA to GNI -.078950* -.0898*** -.109503** -.1188524** -0.000276 -0.0214
(.0316714) (.02705) (0.03648) (0.04471) (0.02981) (0.01513)

.25681*** .3238*** .33382*** .220120*** .172518*** .146925***

(.067831)
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EG (.037653) (0.04337) (0.05315) (0.03544) (0.01799)

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UEP -.0018626 -.0035513 -0.00371 -0.00129 -0.00085 0.000694
(.0020251) (.003648) (0.00233) (0.00286) (0.00191) (0.00097)

-.00985**
INF -.00866*** -.00942*** -.011417*** -.0048667** -.003362***
(.003330)
(.001848) (0.00213) (0.00261) (0.00174) (0.00088)

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.0219193 .0096396 .0353835* 0.020941 .0273662* .033202***

POP (.0141169) (.025431) (0.01626) (0.01993) (0.01329) (.00675)

.00231**
TRDO .00155*** (.000743) .001489** .0014842* 0.000301 0.000159
(.0004128) -0.00048 -0.00058 -0.00039 -0.0002
DM

-1.159911
Constant -1.75332 -.8922958* -0.63051 1.036787** 1.34847***
Notes 1: The dependent variable is IQ is measured by the ICRG and WGI index . ODA to GNI (%) Official development
assistance to Gross National Income (%); POP refers to the population growth, TRDO indicates Trade openness; INF is the
Inflation rate, UEM refers to Unemployment rate and finally EG is the Economic growth
Note 2: *Denotes significance at 10% level; ** Denotes significance at 5%; *** Denotes significance at 1%

This study conjectures a comparative non-linear connection for the impact of aid on

institutions. Aid may positively affect institutional quality up to a certain level, beyond which
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aid’s marginal contributions would decline and may even turn negative. This would happen

when there is excessive aid flowing into the nation exceeding the ‘absorption’ limit, so much

so that it becomes relatively easier to divert aid to non-productive channel. Without increasing
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the absorption capacity, the excessive amount of foreign aid cannot be consumed legitimately

and in this manner ends up having a negative impact. Similar to our findings, Fielding (2014)

concluded that the outcome of aid depends on the existing institutional characteristics of the
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recipient countries.
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For the validity of the findings of the quantile regressions, the bootstrap procedure is

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employed to construct a joint distribution allowing us to devise F-statistics to test for the

equality of the estimated coefficients across various pairs of quantiles. Table 8 reports the F-

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tests and the related p-values for the uniformity of quantile slope coefficients over the different

sets of quantiles. This test is based on the bootstrapped standard errors utilizing 1000

replications. The F-tests reject the null hypothesis of homogeneous coefficients at the 1 percent
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significance level for all pairs of quantiles meaning that the effect of the explanatory variables

is different across the different parts of the distribution.

Table 8: F test results of quantile regression

Quantile regression results based on ICRG
H0= Q20=Q40
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Test whether Test whether Test whether Test whether

coefficient are equal coefficient are equal coefficient are equal coefficient are equal
between Q20 and Q40 between Q40 and Q60 between Q60 and Q80 between Q80 and Q90

F(1913)= .12 F(1,283)=1.78 F(1, 283) = 0.14 F (1, 283) = 1.34

Probability>F=0.000 Probability>F=0.000 Probability>F=0.000 Probability>F=0.000
Quantile regression results based on WGI
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H0= Q20=Q40 H0= Q40=Q60 H0= Q60=Q80 H0= Q80=Q90

Test whether Test whether Test whether Test whether
coefficient are equal coefficient are equal coefficient are equal coefficient are equal
between Q20 and Q40 between Q40 and Q60 between Q60 and Q80 between Q80 and Q90

F(1,477)= 1.50 F(1,477)=.12 F(1,477)=8.14 F(1,477)=3.10

Probability>F=0.000 Probability>F=0.000 Probability>F=0.000 Probability>F=0.000
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Furthermore, this study employs the graphical evidence of nonlinearity and marginal

effect between aid and institutional quality by applying ICRG data and WGI data in Figures 1

and 2, respectively. Both figures depict the QR estimates and the OLS estimates and found
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that the QR estimates varies widely when the level of institutional quality increases.

Furthermore, both figures ratify that the OLS estimates fail to estimate the nexus between

aid flows and institutional quality for the institutionally developed countries and poor
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institutionally developed countries separately.

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Figure 1: Quantile graphs based on ICRG

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300.00

0.00

8.00
200.00

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-0.10

6.00
ODAto GNI
Intercept

-0.20

4.00
100.00

EG
-0.30

2.00
0.00

-0.40

0.00
-100.00

-2.00
-0.50
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0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Quantile Quantile Quantile

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20.00

[Link]

[Link]
10.00

TRDO
-2.00UEM
POP
0.00

- 0.10
-10.00

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-0.20
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-20.00

-4.00

0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Quantile Quantile Quantile
0.40

0.30
0.30

0.20
INCOME

0.20

0.10

DM -0.10 INF
0.10

0.00
0.00
-0.10

-0.20

0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Quantile Quantile
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Figure 1 presents the regression lines derived by the QR against the OLS methods. According

to the ICRG dataset in Figure 1, there is marked variability between institutional quality

across quantiles (0.20 to 0.90), suggesting that previous research on institutional quality, which
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is based on the approximation of the mean function of the conditional distribution, delivers an

incomplete picture of the efficiency dispersion across countries. In particular, the nexus

between aid and IQ is clearly different from conditional mean (OLS) critical level at the lower
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quantile (before 0.20) and upper quintile (after 0.80).

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Figure 2: Quantile graphs based on WGI

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0.00 0.01 0.02

0.20
30.00
25.00

0.10
ODAGNI
Intercept

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20.00

0.00
EG
15.00

-0.10
10.00

-0.20
5.00

-0.01

-0.30
0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
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Quantile Quantile Quantile

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[Link]

[Link]

0.10
0.08
0.06
UNEM

TRDO
-1.00POP

0.04
-0.10

0.02
-2.00

-0.20

0.00
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0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Quantile Quantile Quantile
0.00

0.00
- 0.10
0.00
INCOME

0.00

0.20
-INF
0.00

- 0.30

DM
0.000.00

-0.40

0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Quantile Quantile

In Figure 2, the same trend is depicted where the nonlinearity is found before 0.20 quantile and
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after 0.80 quantile. This suggests that the quantile regression analysis clearly provides a more

comprehensive picture of the underlying range of disparities in institutional quality that the

classical estimation would have missed out.

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5. Conclusions and Policy Implications:

The nexus between aid and institutional quality is multifaced (Dijkstra, 2018). This

study reviews the aid practices and institutional quality of Muslim countries. This study
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analyses the nexus between the aid and institutional quality from three perspectives: firstly,

the aggregate impact of foreign aid on institutional quality, secondly, the aid volatility and its
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effect on governance, and finally the nonlinearity of aid and institutional quality of the

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recipient countries. For the aggregate effect of aid on institutional quality, this study with help

of system GMM tends to find that the overall impact of aid flows on institutional quality is

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negative. Specifically, aid flows appear to be associated with a deterioration in the political

stability, corruption, government stability and other governance indicators. Aid volatility, the

second focal point of this study has adverse effect on the institutional quality of the aid
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dependent countries. The negative effect of aid volatility on institutions may increase through

rent seeking and corruption. Finally, this study examines the nonlinear or heterogeneous

relationship between aid and institutional quality by using Quantile regression. The results

tend to indicate that the nexus of aid and institutional development is contingent on the existing
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institutional capacity of the aid dependent countries. The findings of this hypothesis suggest

that a heterogeneous relationship exists between the strong and weak countries in terms of

institutional quality. In most of the cases, the results suggest that the effect or magnitude of
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the negative impact of aid on institutional quality is manifest especially in countries with weak

institutions rather than in countries with strong institutions. Most precisely, the findings

broadly tend to indicate that the best and worst countries in terms of institutions respond

differently to development assistance. The findings of this study contribute to the following

policy implications: firstly, since the institutional impact of aid is not homogenous to all aid
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recipient countries and also, the nexus between the aid and institutional quality depends on the

absorptive capacity of the countries, taking too much aid without improving the existing

institutional quality may not be useful. Secondly, the donor and aid-receiving government or
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authority should try to maintain that aid flows are fairly steady so that the aid volatility is

reduced. Government and policy makers should make sure a proper coordination and

harmonization between the donor and the recipient parties for the aid distribution and
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management. Finally, as low institutionally developed countries are too weak or unscrupulous
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to judicially handle large aid flows, the donors and the governments should devote a high

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amount of support and resource to oversight and controls.

Although the findings of the study have a significant contribution to the literature of

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foreign aid and policy making but still this study is subject to some limitations. For example,

this study concludes with the policies based on an overall impact of the foreign aid on the

institutional structure of the recipient countries. As foreign aid is not evenly distributed across
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all parts of a recipient country, the clear-cut conclusion of its impact on institutional

development may not be always accurate. In regard to this limitation, the reasoning, however,

could be better established if the field survey data could be adopted. The future research could

further explore and shed lights on it.

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Acknowledgement:

We would like to acknowledge the financial support kindly provided by MOHE-UM-INCEIF

Islamic Finance Research Grant RPIF10-17INCEIF

References:
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