Foreign Aid and the Real Exchange Rate in the West African Economic and Monetary Union

This paper aims to re-examine the relationship between foreign aid and the real exchange rate, using the recent econometric methods developed for non stationary dynamic panels and an estimator that imposes a weaker homogeneity assumption on the slope coefficients. The investigation shows that foreign aid led to an appreciation of the real exchange over the period 1975-2005. In addition, the paper finds that other variables, such as labour productivity (a proxy for Balassa-Samuelson effect), terms of trade improvement, and government consumption of non-tradable goods are also associated with an appreciation of the real exchange rate. To avoid an appreciation of the real exchange rate and a decline in competiveness, we recommend that WAEMU countries use foreign exchange from aid inflows to import capital goods, which will not only lead to export expansion, but also to faster economic growth.