Strategic side payments: preferential trading agreements, economic reform, and foreign aid

We propose that major powers give foreign aid to developing countries to facilitate politically costly economic reforms that preferential trading agreements mandate. Only democratic developing countries can credibly commit to using fungible revenue in ways that benefit the donor, so a side payment for deeper reforms should only apply to democracies. A quantitative test lends support to the theory. Fully democratic developing countries that form a preferential trading agreement obtain a threefold increase in foreign aid in the short run. Additional tests show that this increase is not driven by macroeconomic difficulties and that the increase in foreign aid is temporary. The theory implies that donors have used foreign aid to magnify the effect of preferential trading agreements on the economic reforms that they expect to benefit from.