Flying dragon in the Eagle's sky: Is Chinese and US aid a vanguard of their FDI flows to the developing world?

The objective of this study is to assess whether foreign aid from China and the United States facilitates foreign direct investment (FDI) from the same donor country in developing economies—the ‘vanguard effect’. The paper examines corresponding and competing aid flows. Based on donor and recipient specific costs and benefits, it introduces an aid identification model that conceptualizes aid allocation as a simultaneous optimization problem. Empirical results reveal that while Chinese aid shows positive, though inconsistent, association with Chinese FDI, this pattern is less evident for the US. Notably, higher US aid correlates with increased Chinese FDI, but higher Chinese aid does not lead to more US FDI. Improving trade balances with the US attracts FDI from both countries, whereas similar improvements with China may crowd out Chinese FDI. Chinese aid boosts FDI via increased state involvement but may deter it when state capacity and productivity rise. The findings suggest recipient countries may face a trade-off between the Eagle and the Dragon: attracting US FDI may require openness, stronger institutions, and export growth, while courting Chinese FDI in the presence of Chinese aid may come at the expense of these very factors.