Paradoxical Pathways: How Foreign Aid, Fiscal Policy, and Governance Shape Inclusive Growth in East African Economies

Abstract

This paper examines the intricate interactions among foreign aid, fiscal policy, governance quality, and inclusive growth in East African countries between 2008 and 2023. Using a panel of 11 countries (Burundi, Kenya, Madagascar, Malawi, Mauritius, Mozambique, Rwanda, Tanzania, Uganda, Zambia, and Zimbabwe) as a mixed integration order and a cross-sectional dependence (also known as the Pooled Mean Group) estimator, we address the methodological problems associated with mixed integration orders and cross-sectional dependence in estimating the short-run and long-run relationships between equilibrium variables. An initial screening of diagnostic tests shows that there is a clear dichotomy as macroeconomic variables are highly cross-sectionally interdependent, whereas the governing indicators develop comparatively autonomously across national lines, implying the existence of country-specific institutional pathways in common macroeconomic shocks. The empirical findings have affirmations and contradictions with the existing literature on development. Political stability proves to have the largest positive impact on inclusive growth in the long-run (β = 0.1057, p = 0.000), which is consistent with the views of institutional economics regarding the fundamental significance of foreseeable political settings. Nevertheless, government effectiveness demonstrates a considerable negative relationship (β = -0.1979, p = 0.000), which disrupts the usual governing orthodoxy and indicates a possibility of measurement problems or situational circumstances in which governance technical efficiency may not result in inclusive performance. Foreign aid is negatively correlated with inclusive growth, with a significant negative long-run relationship (β = -0.0184, p = 0.000), supporting critical views of aid dependency and Dutch disease impacts, and productive government spending has moderate positive results (β = 0.0131, p = 0.000). The cointegration is confirmed by the error correction mechanism, and the adjustment to equilibrium is quite fast, with an estimated 111 percent of the disequilibrium being corrected within a single period.