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

By Daud, Siti Nurazira Mohd; Podivinsky, Jan M. | Journal of Business Economics and Management, November 2012 | Go to article overview

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. …

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