Academic journal article Research in Applied Economics

Determining Optimal Public Debt and Debt-Growth Dynamics in the Caribbean

Academic journal article Research in Applied Economics

Determining Optimal Public Debt and Debt-Growth Dynamics in the Caribbean

Article excerpt

Abstract

This study (i) investigates the debt-growth nexus and the non-linearity issue using panel dynamic ordinary least squares estimations and threshold dynamics in 13 Caribbean countries, (ii) calibrates an optimal debt/GDP ratio for each country using a modified Blanchard (1983) exercise, and (iii) tests the crowding out hypothesis by examining the debt-investment link. The empirical results support the view that there is a non-linear relationship between debt and growth. The findings suggest that there is a global tipping point for the debt/GDP ratio of 61 percent beyond which debt adversely impacts growth and investment. At the country level, the results show marked divergence between actual debt/GDP ratios and the calibrated optimal ratios. The empirical findings have policy relevance for Caribbean countries that are challenged by persistent high debt and low growth in the context where development is financed largely by debt accumulation.

Keywords: Optimal Debt, Economic Growth, Investment, Caribbean

JEL Number: C23, F34, H63, O54

(ProQuest: ... denotes formulae omitted.)

1. Introduction

It is widely acknowledged that most developing countries face high debt burdens and the attendant growth and well-being effects are of deepening concern to both researchers and policymakers (Pattillo, et al 2002; Scharlarek and Ramon-Ballester 2005; Reinhart and Rogoff 2010; Kumar and Woo 2010; Cheherita and Rother 2010). A less widely established view is the optimal debt/ gross domestic product (GDP) ratio a country can maintain. In an optimization framework, an optimal debt/GDP ratio is defined as one that maximizes social welfare and economic growth without reducing private investments or increasing sovereign credit risks or raising overall development costs (Blanchard 1983; Stein 2004; Alfaro and Kanczuk 2006; and Rochet 2006). In reality, an optimal debt/GDP can be viewed as one that is consistent with debt sustainability.

In perhaps one of the most influential studies that investigated the debt-growth nexus, Reinhart and Rogoff (2010) found that debt is a drag on growth when the ratio exceeds a 90 percent threshold. In a postwar sample, they found that the average annual growth rate of countries with a debt/GDP ratio above 90 percent drops from 3 percent to -0.1 percent. Reinhart and Rogoff went further and divided countries with debt to GDP ratios above 90 percent into two groups: those below 120 percent and those above 120 percent, showing that those above 120 percent had a lower growth rate. Reinhart and Rogoff's study came under scratching criticism from the economics fraternity when a new study by Herndon et al (2013) found mathematical errors in Reinhart and Rogoff's dataset in trying to replicate their results. Herndon et al reported that in the same postwar sample, average annual growth rate simply eases down from 3 percent to 2.2 percent when the debt to GDP ratio exceeds the 90 percent threshold. Although neither study answered the causality question, the empirical findings of both imply a negative association between debt and growth when debt exceeds a certain threshold. Irrespective of the unsettled causality question, and perhaps the causality question will never truly be answered, concerns about high indebtedness for growth and socioeconomic development more broadly are well placed. This concern is particularly acute in the Caribbean context, where countries are challenged by heavy debt burdens, low economic growth and unacceptably high poverty.

This research is an empirical inquiry into the validity of the debt overhang and the crowding-out theories in 13 Caribbean countries(Note 1). The debt overhang proposition asserts that in the early stages of development, a country needs to boost its capital stock and in turn, economic growth, by borrowing. However, as debt accumulates, resources go to debt servicing, diverting what would have otherwise gone to finance the development needs of the country. …

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