Revisiting the Role of External Debt in Economic Growth of Developing Countries

Daud, Siti Nurazira Mohd, Podivinsky, Jan M., Journal of Business Economics and Management

1. Introduction

The issues related to capital flight through foreign direct investment and the importance of external debt has started to gain the concern of policy-makers, investors and academics. Several studies that have analyzed the impact of foreign direct investment in stimulating growth are ambiguous, with mixed results (Choong et al. 2010) while the impact of external debt on economic growth remains an important and compelling debate with no clear consensus emerging. In retrospect, the high stock of external indebtedness held by some of the developing countries that are associated with a high incidence of default and poverty has underlined the importance of research to investigate this debatable issue. Thus, the role played by external debt in generating economic growth can be questioned since there has been a high incidence of default.

As has been enlightened by the capital market imperfection view, there is no effective mechanism to prevent the borrower from being in default to the lenders. Even with a high level of indebtedness where debt service could "crowd out" investment or, to a lesser extent, cause stagnant or declining economic growth, being in default is not the best option. This is because the incidence of default could have incurred or imposed costs such as reputational costs (exclusion from the international capital market for future borrowing), international trade exclusion costs, costs to the domestic economy through the financial system, and political costs to the authorities (Borensztein, Panizza 2008). As such, being neither in default nor in a debt-overhang position is not the best way for a country to maintain a sustainable economic position. Thus, by analyzing the effects and relationship between external debt and economic growth, this paper will try to shed light on whether countries have gained from external borrowing over the past 20 years.

Thus, this paper aims to investigate the relationship between external debt and economic growth in developing economies. Furthermore, this paper also aims to analyze the debt-investment relationship for the developing countries. This could provide evidence on the "disincentive effects" of high debts, due to the debt overhang and to macroeconomic instability, as well as the liquidity constraint which could refer to the adverse effect of debt-servicing on investment and growth. This paper is also concerned with the importance of considering spatial dependence among developing countries in the growth model. This analysis is important since any results found from the linkages between external borrowing and economic growth would be useful for policy formulation that could prevent countries from being in default or in a debt-overhang situation. In this case, debt could boost or impede economic growth. Besides that, this paper might give an indirect signal to creditors regarding a country's ability to service its debt in the future. This paper is distinct from past studies in several aspects. Firstly, this paper contributes to the small but growing body of empirical literature on the debt-growth nexus. Furthermore, this analysis investigates in more detail whether the relationship between debt and growth is robust for all the developing countries in the sample. This paper also investigates the existence of the debt-Laffer curve relationship. Thirdly, this is the first attempt to analyze the relationship of the debt-growth nexus by using a spatial correlation approach. Moreover, no empirical study has been carried out to determine whether location matters for the debt-growth model. An analysis of the contribution of external debt to economic growth using a panel spatial econometric approach rather than a cross-sectional or time series (country-specific) analysis could provide a valuable addition to existing empirical studies. Thus, this study attempts to fill this gap in the literature. This paper is organized as follows. Section 2 reviews the theoretical model and empirical literature on the debt-growth nexus. The model, procedure of the estimation and the dataset that has been used in the analysis are explained in section 3. The empirical results are presented in section 4, and section 5 concludes the paper.

2. Literature review

In recent decades there has been a scarcity of literature studying the significant roles that external debt plays in long-term economic growth. As an extension of the Harrod-Domar growth model, the dual-gap theory has highlighted the motivation for the introduction of external debt in a growth model. Furthermore, in the era of high mobility of

resources, the interdependence among countries has inspired Otani and Villaneuva (1989), Agenor (2000), Villaneuva (2003), and Mariano and Villaneuva (2006) to develop a growth model for the open economy that incorporates a global capital market role. Otani and Villanueva (1989), who initiated the study of this area, have developed a simple aggregate growth model that is capable of assessing the impact of macroeconomic policies on the long-term performance of a developing country where the model analyzes the accumulation of capital and the dynamic of external debt. Meanwhile, the aggregate capital stock is defined as the accumulated sum of domestic saving, global capital market, and net external borrowing (Villaneuva 2003). In addition, the difference between the expected marginal product capital, net of depreciation, and the marginal cost of funds in the international capital market determine the proportionate rate of change in the external debt-capital ratio. Furthermore, Villaneuva (2003) added that, when the expected net marginal product of capital matches the marginal cost of funds at the equilibrium capital-labour ratio, the proportionate increase in net external debt is fixed by the economy's steady-state output growth and the external debt-to-output ratio stabilizes at a constant level. Meanwhile Mariano and Villaneuva (2006) correct the shortcomings of the Villanueva (2003) model which is unable to settle the steady-state external debt ratio that is consistent with maximum consumer welfare. As such, on the balance-growth path, Mariano and Villanaeuva (2006) choose the domestic savings rates that maximize social welfare by maximizing long-run consumption per unit of effective labour (1).

Theoretically, a country will benefit from the positive effect of external debt if it has been efficiently allocated to domestic investment, resulting in a higher rate of growth. In addition, a well-functioning financial institution that supports the investment environment climate will result in a positive impact of private capital flow (which includes foreign direct investment, portfolio investment and foreign debt) on economic growth (Choong et al. 2010). Furthermore, a country could improve its capability to service debt without crowding out investment. However, empirical studies have sought to provide evidence of the negative effect of external debt on economic growth (Chowdhury 2001; Clements et al. 2003; Wijeweera et al. 2005; Sen et al. 2007). A high level of indebtedness incorporated with a low level of economic growth and low capability to repay external debt has highlighted the symptoms of a country in the debt overhang problem (2). A country with a debt overhang problem would be burdened with a high level of indebtedness; it would not be able to generate growth, its investment would be squeezed, it would fail to repay its debts and its economic growth would be reduced. Besides that, high debts have a negative impact on the rate of investment and economic growth because of disincentive, cash flow and moral hazard effects (Claessens et al. 1997). At the other end of the spectrum, at a reasonable level of foreign borrowing, a country might possibly experience both effects: a positive effect (when the debt benefits the country's growth), followed by a negative effect (when a country is burdened with a heavy external debt) as represented by a "Laffer Curve". In other words, if the outstanding debt increases beyond a threshold level, the required repayments begin to fall as a consequence of adverse effect (3).

According to Krugman (1988), high debts have adverse effects on economic growth, and this situation could be related to the debt-overhang theory. If there is some likelihood that, in the future, debt will be larger than the country's repayment ability, the expected debt-service cost will discourage further domestic and foreign investment (Pattillo et al. 2002). However, at a reasonable level of foreign borrowing, external debt could have a positive impact on investment and growth. The relationship between the face value of debt and investment can be represented by a "Laffer Curve". If the outstanding debt increases beyond a threshold level, the expected repayment begins to fall as a consequence of adverse effect. Besides that, the uncertain condition of the outstanding stock of external debt could result in a low level of economic growth (4). Pattillo et al. (2004) argue that the main channel through which debt affects economic growth is the quality and efficiency of investment rather than its level, because the exclusion of the investment rate from the growth regression does not significantly change the adverse debt effect.

However, to the best of the authors' knowledge, there have been few empirical studies carried out to analyze the linkages between debt and economic growth, and most of the empirical studies have investigated the period 1969-1999. Furthermore, in all the above-mentioned studies, none of the analyses considered spatial factors as factors that contribute to economic growth. Published studies on the effect of external debt on economic growth have found mixed results to support the debt-overhang hypothesis. Clements et al. (2003), Mohamed (2005), Chowdhury (2001), Wijeweera, Dollery and Pathberiya (2005) and Sen et al. (2007) found evidence that the external debt has a negative impact on a country's economic growth. Meanwhile, a study by Pattillo et al. (2004) indicates that the negative impact of high debt on growth mainly operates through a strong negative effect on physical capital accumulation and on total productivity growth. In a case-study of Sri Lanka, Wijeweera et al. (2005) found a negative but insignificant long-run relationship between debt and economic growth. On the other hand, the stock of external debt has an indirect effect on growth through its effect on public investment (Clements et al. 2003).

Pattillo et al. (2002, 2004), Cordella, Ricci and Ruiz-Arranz (2005) and Imbs and Ranciere (2005) found evidence of non-linearity in the debt-growth relationship. Furthermore, Pattillo et al. (2002) found that the average impact of debt on per capita growth appears to become negative for debt levels above 160-170 percent of exports and 35-40 percent of GDP. Furthermore, Clements et al. (2003) found that, above the threshold of 20-25 percent of GDP and 101-105 percent of exports, external debt is associated with lower rates of growth for 55 low-income countries. In contrast, the study conducted by Schclarek (2004) found …

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Publication information: Article title: Revisiting the Role of External Debt in Economic Growth of Developing Countries. Contributors: Daud, Siti Nurazira Mohd - Author, Podivinsky, Jan M. - Author. Journal title: Journal of Business Economics and Management. Volume: 13. Issue: 5 Publication date: November 2012. Page number: 968. © 2009 Vilnius Gediminas Technical University. COPYRIGHT 2012 Gale Group.

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