De-facto States and Aid Dependence: An Analysis of the Impact of Turkish Aid on the Economy of Northern Cyprus/De facto Devletler ve Dis Yardim Bagimliligi: Turkiye Yardimlarinin Kuzey Kibris Ekonomisi Uzerindeki Etkisinin Analizi.

• Author: Ozyigit, Ahmet

Introduction

For decades, foreign aid has been used as an instrument for poverty reduction and growth stimulation in the less fortunate economies of the developing world. While the degree to which it has achieved this goal is still cause for controversy, the amount of foreign financial assistance has multiplied in value over time. According to the latest World Bank report, while net official development assistance averaged around 71 billion USD per annum in 1997, it reached and exceeded an annual level of 135 billion USD in 2013. (1) Despite the ample literature, the jury is still out on whether foreign aid is a successful tool for any positive long-term economic impact in receiving economies.

Origins of the efficacy of foreign aid as a means of growth promotion can be traced back to early economic growth models. The Keynesian Harrod-Domar growth model stresses the importance of savings as a source of investment and investment as a source of capital accumulation, which, in turn, catalyzes economic growth. The later neoclassical extension to the Harrod-Domar model, known as the Solow-Swan model, also places savings and capital accumulation at the heart of economic growth. By association, in the absence of local savings, foreign aid should act as a compensatory mechanism and contribute to capital accumulation as a means of promoting economic growth. Therefore, it follows that foreign aid should have a positive association with economic growth. (2) However, early work in the aid-savings literature has found a significant negative effect of foreign aid on savings, (3) hence raising skepticism about whether aid can buy growth. (4) A large number of pioneering researchers in the field, including Papanek, Svensson, and Herzer, and Morrissey, independently failed to find a positive association between aid and economic growth in their cross-country empirical work. (5) On the other hand, there are various examples suggesting a positive long-run influence of aid on economic growth, the most comprehensive one being the work of Juselius, Moller and Tarp. (6) Perhaps the answer may not be as straightforward as a linear relationship between these two variables. Several factors such as the conditions of aid, the degree to which aid allocation is overseen, local economic structure, size of government, and political relationships between donors and recipients are a few considerations when assessing the impact of aid.

This paper utilizes an ARDL bounds-test approach in an attempt to discover short-run and long-run associations specifically between Turkish financial assistance, government size, investment, and growth parameters in North Cyprus with a focus on the position of local government in relation to Turkish political ideologies. In the rest of the paper, we provide a general overview of the relevant literature, describe the unique Turkish-North Cyprus relations from a de facto state perspective and lay the foundation for our empirical analysis. The conclusion is preceded by an in-depth discussion of the results to the empirical analysis.

Aid, Aid Effectiveness and Dependence

The Organisation for Economic Co-operation and Development (OECD) defines aid as an official development assistance with at least one-fourth of the sum being unreciprocated. OECD further narrows the scope of aid by leaving military assistance or anti-terrorist activity-related transfers out of the aid parameters. (7) Aid can be seen as an unreciprocated gift when it does not necessitate a formal repayment. (8) Gift-giving is not a new concept. It has been used between groups of people as well as among nations long before formal international exchange and trade practices were put in practice. Mauss defines gift-giving as common practice in primitive trade relations with an implied obligation of reciprocity. (9) An unreciprocated gift would place the recipient in an inferior position in the relationship. From this perspective, one could argue that even when aid is given as a gift, it is likely to have an embedded implication of reciprocity in terms of a hierarchical relationship or a political interest. (10) With this implication, foreign aid can possibly be defined as a government-togovernment resource transfer on concessional terms, hoping to achieve or maintain a foreign policy objective of the donor. (11)

Effective use of aid by recipient nations is one of the most scrutinized facets in the foreign aid literature. While foreign aid is expected to increase government spending, when aid is used to finance non-productive and possibly inefficient public sector practices, it does not only fail to promote economic growth, but can also lead to changes in relative prices, adversely affecting the private sector. (12) Using aid as a means of vote-maximizing behavior is also a concern when aid is being channeled into public sector use. (13) When aid is used for short-term deficit financing or vote-maximizing purposes, it can offer temporary relief but may cause more harm in the long run. Ineffective use of aid for such practices has the potential to promote a vicious cycle of aid dependence in the long run, even when transitory beneficial effects may be observed in the short run. At this point, how aid is structured becomes an important consideration.

Foreign aid can follow a military intervention in order to meet the intervening nation's political and economic goals. Once these goals are met, aid can continue to secure them for the long haul. (14) In this sense, aid can be perceived as a means of achieving and maintaining a status quo that would serve the interests of the intervening party. Nevertheless, maintaining a status quo does not have to follow a military intervention. It can also be a means of securing power dynamics in a geographical setting. China's generous aid packages to finance North Korea's large trade deficits is perhaps one such strategy. By financing North Korea's rather unstable economy, China keeps North Korea afloat and can, therefore, avoid a massive influx of refugees. (15) Keeping the North Korean peninsula stable also helps avoid the formation of a power vacuum that can potentially bring South Korea or the United States to fill the vacuum. (16)

If not well-defined or managed, budgetary supports are prone to corruption when transparency is an issue. (17) Even when funds are used effectively for a project, there remains the issue of fungibility. While the funds would be used for the intended projects and not raise any red flags from a transparency point of view, the receipt of foreign assistance can free up the funds, which would have been used for the specific project, for other corrupt practices. (18) This can easily be overlooked if the donor's main interest rests with maintenance of the status quo. This does not only reduce the quality of local governance, (19) but significantly undermines the credibility and accountability of local leaders. (20) With larger volumes of financial aid, the recipient government becomes accountable to the donor rather than local citizens when it comes to how money is spent, (21) further diminishing local credibility. Brautigam and Knack study 32 sub-Saharan African economies and find evidence for a worsening quality of governance related to the receipt of foreign aid. (22) The authors also find that when aid becomes persistent over long periods of time and enters in large amounts, institutions tend to get weaker and provide even more incentives for aid agencies.

Large volumes of aid tend to grow the size of the government. This is often attributed to the incumbent leaders' propensity to create jobs for their relatives or people from their birth place as a means of securing votes, all to improve their chances of remaining in the office. (23) Similarly, aid can be used by donor countries to keep certain local political actors in power. There are reports suggesting a causal relationship between increased financial aid and incumbent re-election when aid is increased in the year before an election. (24) Yuichi Kono and Montinola observe that both democratic and dictatorship regimes tend to enjoy leader survival in elections, which can be explained by patterns of foreign aid. (25) Aid can also be perceived as the incumbent government's success when it is directed into projects that promote public satisfaction. Even when the government or its leaders have no influence on how aid is distributed and what it targets, they are still likely to claim credit for political gains. (26)

When aid becomes a normal part of fiscal policy, it has failed as a temporary relief instrument and has turned into a chronic problem of dependence. This is partly because foreign aid is often seen as a potential source of rents. (27) Rent-seeking activity can take the form of public sector employment as a means of cronyism or vote-seeking behavior. Even in the absence of rent-seeking behavior, generous aid packages are known to have hindered private sector investment by supporting parastatal and state establishments in several investments that would have been made by private sector establishments otherwise. (28)

First suggested by the World Bank as an observation, negative returns to higher volumes of aid have been reported in empirical studies. (29) Because foreign aid increases the availability of public funds, it may also negatively influence taxation capabilities. Governments may intentionally fail to collect taxes effectively to gather political support in upcoming elections. This would provide a possible explanation for the empirical evidence provided by Brautigam and Knack, (30) suggesting a significant negative relationship between foreign aid and the share of taxes in GDP. Benedek et al. also find a statistically significant negative relationship between foreign assistance and domestic tax revenues. The authors estimate a ten-cent reduction in tax revenues for every dollar received in financial assistance. (31)

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