Sustainable economic growth is of predominant concern for all economies, especially for the developing economies which commonly face burgeoning fiscal deficits mainly driven by higher levels of debt servicing, particularly external debt servicing and widening current account deficits. Economists have, therefore, focused to explore the channels through which external debt can possibly hamper economic growth, and came up with two competing hypothesis, i.e. debt overhang theory and liquidity constraint hypothesis. Over the time, various studies tried to explore the validity of these hypotheses, using different data sets and different methodologies. Some of these studies confirmed these hypotheses, while others could not. This paper is also an attempt to explore whether external debt has any direct effect on economic growth, and, does the external debt stock in developing countries affect the level of private investment. In addition this paper investigates the effectiveness of private investment for the economic growth.
Since developing countries are striving for sustainable economic growth, they need to control their escalating fiscal deficit. In order to bring it down, these countries are confronted with the challenges of increasing revenues, curtailing unessential public expenditures and expanding avenues for new investment that can derive these economies to higher growth trajectory path while limiting the current account deficit to sustainable levels. A part from that, as majority of these economies heavily rely on foreign borrowings, the international donor agencies commonly demand fiscal prudence, economic and political stability, sound banking system, lower cost of doing business, and an environment conducive for investment to ensure further assistance. To address these internal and external concerns, countries often take counterproductive measures by slashing essential capital expenditures that have a large damaging impact on long-run economic growth. Therefore, it is imperative for such economies to provide investment opportunities for the private sector while reducing the cost of doing business that can help them to progress and achieve a higher level of income with improved living standards.
Heavy external debt does not necessarily imply a slow economic growth. It is a country’s inability to meet its debt obligations compounded by the lack of information on the nature, structure and magnitude of the external debt (Were 2001). Countries may have heavy external debt along with relatively higher level of exports that can help them to sustain their level of external debt. But external debt, if not sustainable, imposes higher risk to the economic prosperity, as its servicing which is also an indicator of higher current account deficit, may lead to debt overhang in a country. For any economy, debt either public or publically guaranteed, which also includes the contingent liabilities, plays a crucial role towards overall economic progress. Developing economies typically have limited sources to fetch revenues. If they fail to utilize their debt productively, mobilize investment and create new employment opportunities; they will eventually get stuck up with the dilemma of lower revenue base which will affect their spending capacity, thereby leading to higher debt servicing. Inability to service debt on time not only makes it harder for the developing countries to get aid at concessional rates with less conditionalities from the donor agencies but it also increases the country risk. That not only reduces the overall level of foreign direct investment but forces a country to rely on domestic borrowing. This higher domestic borrowing increase the domestic interest rate which leads to crowding out that further slows down the economic growth.
Traditionally, while assessing the external debt vulnerabilities and risk factors that can hamper economic growth, economists’ give emphasis on two types of indicators, namely external debt indicators and macroeconomic indicators. External debt indicators include the assessment of external debt to GDP ratio, external debt to exports ratio that helps in analyzing the burden of debt services, and short-term debt to total debt ratio, that gauges the liquidity problems associated with external debt. In case of macroeconomic indicators, focus lies on a number of variables mainly comprising the level of net international reserves, real effective exchange rate, level of inflation, GDP, openness of trade, lending and borrowing rates, domestic credit, level of investment and fiscal deficit. Following the basic pattern of conventional studies, this paper analyzes a relatively small sample of 24 developing countries over a period of 1976-2003, employing all the leading variables of external debt indicators and macroeconomic indicators. Furthermore, apart from the above mentioned economic variables, this paper attempts to evaluate the affect of private investment on economic growth, and also endeavors to determine the factors that affect the overall level of private investment in developing economies. The results of the paper are consistent with both the theories of debt overhang and the liquidity constraint hypothesis, and therefore, conclude that external debt does hamper economic growth, and affects through the channel of private investment.
Contents
I. Introduction
II. Literature Review
III. Data Description
IV. Empirical Analysis
- A. Effect of External Debt on Growth
B. External Debt and Private Investment
V. Conclusion and Policy Recommendations
References
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