Evidence of Economic Imbalance: The Presence of Dutch Disease in the Developing Nations

Abstract

Objective: The present study employs the Dutch Disease paradigm to evaluate the macroeconomic and structural impacts of foreign aid in the developing nations. It considers the issue of inflows of foreign assistance whether it leads to real exchange rate appreciation and reallocates resources between non-tradable services sectors at the expense of industrial value addition.

Research Gap: The literature extensively examines the growth effects of foreign aid in developing economies, yielding mixed evidence. However, the presence of Dutch Disease remains insufficiently explored, particularly with respect to sector-specific value-added responses between non-tradable services and tradable industrial goods. This study investigates Dutch Disease by assessing the impact of foreign aid on the exchange rate and complements the analysis with a sectoral evaluation for deeper insight.

Design/Methodology/Approach: In this analysis, data of 74 developing countries during the period of 2000-2022 are used. The paper is based on System GMM that manages endogeneity and dynamic interactions.

The Main Findings: Foreign aid significantly appreciates the real exchange rate in developing countries. This appreciation shifts resources toward non-tradable services and reduces industrial value added. The results provide strong evidence of Dutch Disease, indicating both macroeconomic impacts and structural distortions.

Theoretical / Practical Implications of the Findings: It emphasizes the impact of foreign aid as a non-neutral macroeconomic agent on the productive structure in developing countries in the long run, putting greater weight on the theoretical association between capital inflows, real exchange rate behavior, and structural change.

Originality/Value: Value of the paper lies in its empirical evidence on identifying Dutch Disease as a channel explaining the ineffectiveness of foreign aid in developing economies and consequently explains contribution of foreign aid to sectoral distortions in developing economies.