FOREIGN AID AND FINANCIAL SECTOR DEVELOPMENT IN AID-DEPENDENT ECONOMIES: THE ROLE OF IMF–WORLD BANK COORDINATION

Abstract

This paper examines whether concessional foreign aid in low‑income and fragile economies primarily finances long‑term development expenditures or is redirected toward short‑term macroeconomic stabilization, and how that allocation affects financial‑sector development. Using a mixed‑methods approach qualitative analysis of institutional reports and case studies combined with quantitative analysis of cross‑country panel data and guided by political‑economy, financial‑sector, and principal‑agent frameworks the study assesses aid’s effects on revenue mobilization, sovereign bond issuance, and capital‑market formation. The analysis shows that foreign aid is associated with substitution effects, lower revenue mobilization, and reduced sovereign bond issuance, which together can delay the development of domestic capital markets; aid surges can also induce real exchange‑rate appreciation and greater volatility, complicating monetary policy in economies with underdeveloped (shallow) financial markets. The findings imply that policymakers and donors should prioritize alignment of concessional finance with domestic financial development strategies, invest in institutional capacity for tax mobilization, and design aid modalities that incentivize sovereign bond market development and prudent macroeconomic management to foster resilient, inclusive financial systems. The empirical strategy combines panel regressions with instrumental variables to address endogeneity concerns and complements quantitative results with illustrative country case studies that trace institutional pathways; robustness checks include alternative aid measures, sub‑sample analyses by fragility status, and tests for heterogeneous effects across different stages of financial development, ensuring that the conclusions are not driven by outliers or measurement choices. Policy recommendations emphasize phased reforms, capacity building, and donor coordination to sustain long‑term market development effectively.