Relationship between external debt and economic growth in selected developing countries

UNIVERSITY OF ECONOMICS
STUDIES
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

RELATIONSHIP BETWEEN EXTERNAL DEBT
AND ECONOMIC GROWTH IN SELECTED
DEVELOPING COUNTRIES

BY

NGUYEN THANH THAI CHAN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, December 2014


UNIVERSITY OF ECONOMICS
STUDIES
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL

THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

RELATIONSHIP BETWEEN EXTERNAL DEBT
AND ECONOMIC GROWTH IN SELECTED
DEVELOPING COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN THANH THAI CHAN

Academic Supervisor:
Ph.D Pham Khanh Nam
HO CHI MINH CITY, December, 2014


TABLE OF CONTENT
Chapter 1: INTRODUCTION .................................................................................. 1
1. Problems statement ....................................................................................... 1
2. Research objectives ...................................................................................... 2
3. Scope of study ............................................................................................... 2
4. Structure of thesis .......................................................................................... 4
Chapter 2: LITERATURE REVIEWS .................................................................... 5
1. Theorectical reviews ..................................................................................... 5
1.1. External debt’s concept ....................................................................... 5

1.2. Economic Growth Theories and Models ............................................ 7
1.3. Theories and hypothesis on the relationship between external debt and
economic growth ............................................................................... 9
2. Empirical Literature Reviews ..................................................................... 14
Chapter 3: RESEARCH METHODOLOGY ......................................................... 20
1. Overview of external debt and economic growth in developing countrieS
..................................................................................................................... 20
2. Analytical Framework................................................................................. 23
3. The Econometric Model.............................................................................. 25
4. Data ............................................................................................................. 27
4.1.

Data Description .............................................................................. 27

4.2.

Summary table of variables and data source ................................... 27

5. Estimation Approach................................................................................... 29
Chapter 4: RESULTS ............................................................................................. 30
1. Descriptive Statistic Data ............................................................................ 30
2. Econometric Results ................................................................................... 31
3. Results Expression ...................................................................................... 33
3.1.

Linear equation: Yi,t = αXi,t + γDi,t + ui,t ...................................... 33

3.1.1. All coefficients are constant across time and individual ........... 33
3.1.2. Using Fixed-effects Technique .................................................. 34

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3.1.3. Using Random-effects Technique .............................................. 34
3.1.4. Choosing between Fixed –effects (FEM) and Random-effects
Model (REM) ............................................................................. 35
3.2.

Quadratic equation: Yi,t = αXi,t + γDi,t + δD2i,t + ui,t ................. 36

3.3.

Tests for correcting the chosen model – FEM ................................. 37

3.4.

Analyzing the estimation results and economic meanings of chosen
model - FEM (eq3).......................................................................... 38

3.5.

Discussion ...................................................................................... 42

Chapter 5: CONCLUSIONS .................................................................................. 46
1. Conclusions ................................................................................................. 46
2. Policy Implications ..................................................................................... 48
3. Limitation of thesis ..................................................................................... 50
REFERNCES .................................................................................................... 51-54
APPENDIX ............................................................................................................ 55

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TABLES & FIGURES
Figure 1.1. Solow Model Production Function .......... ………………………………….8
Figure 1.2. Laffer Debt Curve ............... ………………………………………………13
Figure 1.3. Debt Threshold Curve................................................................................. 18
Table 3.1. External debt and GDP in main areas of developing countries ...... ……...20
Figure 3.1. Extenal Debt and Economic Growth Framework ........ ……………..........24
Table 3.2. Summary of Descriptive Variables ............. ………………………………28
Table 4.1. Summary Statistics of Variables ........... …………………………………..30
Table 4.2. Summary of Regresssion Result ............................................................... 32

APPENDIX

EXTERNAL DEBT OVERVIEW ........................................................................... 55-59
DETAILED POLICIES ON EXTERNAL DEBT ISSUE ....................................... 60-64
TABLE 1: OLS RESULT ........ ………………………………………………………65
TABLE 2: OLS WITH DUMMY VARIABLE .......... ………………………………..66
TABLE 3: FIXED-EFFECTS MODEL RESULT.......... ……………………………..67
TABLE 4: RANDOM-EFFECTS MODEL RESULT.......... ……………………........68
TABLE 5: HAUSMAN TEST ......... ………………………………………………….69
TABLE 6: FIXED-EFFECTS MODEL RESULT FOR EQUATION 2 .......... ………70
TABLE 7: TESTING FOR MULTICOLLINEARITY ......... …………………….......71
TABLE 8: TESTING FOR HETEROSKEDASTICITY ......... ……………………….72

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Chapter 1 INTRODUCTION

1.

Problems statement
During three last decades from 1950s, the issue of financial deficit remained

its normal level of acceptance and debts from external sources were considered as
an indispensable solution for the national shortage of capital. Many countries in the
world had different motivation to borrow the foreign source of capital to enhance
their economy. For developing countries, the deficit in current account due to a big
lack of “savings and investment” has approached the foreign capital and become
external

indebted

inevitably.

However,

in

1982,

Mexico

claimed

the

unserviceableness of its debt and remarked the time of severe debt crisis in the
history (Buffie, 1989). This is the condition when the external debt of one country

exceeds the capability of repaying the interest and the principal of its loans. Up till
now, the issue of external debt as well as its serving has become critical and
widespread in the world, which has made its impact on economic growth more and
more questionable and catchy.
Policy makers and economists have paid a great attention to investigate the
relationship between external debt and economic growth to evaluate the impact of
external debt on economic growth and find out the reasons. Under the present
economic

circumstances,

the

more

developing

countries

approach

their

globalization and interrogation, the higher risk of debt crisis they have to bear due
to the easy accession to the external sources of foreign loans. Khan and Ul Haque
(1985) considered this risk as an explosive one to emphasize its potential threat to
the whole economy. Therefore the issue of external debt has always kept a
significant concern related to development economics and become the never old
topic of various researches from the economists to policy makers.
Any economy which experienced a fiscal deficit can finance the public

deficit by borrowing domestically from a private sector through financial
institutions or from other international sources. For developing countries, due to

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the lack of the strong private sectors and well-established banking system, the
available source of domestic capital input are almost insufficient all the time.
Facing the nonstop demands for investment and development, many developing
countries have no way but borrowing extensively from international lenders and
other external sources. This is also the reason why the relationship between external
debt and economic growth has an outstanding correlation in developing countries
and many studies also choose developing countries as main object of research. If the
government or policy makers do not have a correct and comprehensive evaluation
on this relationship as well as its impact, the issue of economic growth can be a big
puzzle.
Some countries believe in the positive impact of external debt on economic
growth and easily get trap in the debt crisis. As Amoateng and Amoako-Adu (1996)
found that GDP growth shared a positive relationship with debt service. Otherwise,
the others are scare of debt burden and minimize the external loans but they cannot
generate the economic growth due to the shortage of capital. According to Maureen
(2001), external debt has a negative impact on private investment and hinders the
economic growth as a result. Practically, the external debt issue which has been
widely known for the debt overhang theory and crowding out effect can definitely
affect the economic growth in some ways by imposing the threats and vulnerability
for the developing economies. Specifically, external debt which is larger than the
economy scale of borrowing countries can certainly lead to a risky capital deficit to
hinder private investment channels, which can result in a retrograde economic
growth rate. Besides, using export to service the debt of developing countries may
make a negative impact on economic growth through drawing the income from the

service activities. But it cannot be denied that external debt can provide the physical
capital input that helps to boost the economic growth rate. Therefore, finding the
linkage between external debt and economic growth can give best tool for
developing countries to adjust and boost their economic growth with the reasonable
policies.

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2.

Research objectives
The study aims to explore whether there is a relationship between the

external debt and economic growth or not by using the panel data of selected
developing countries in the fixed period. Focusing on the tests to answer the
question if there is a linkage, how the relationship can turn out. Under the specific
collected data, this study aims to answer the questions if the relationship is positive
or negative. This relationship is expected to be linear but with reference to previous
empirical researches, this study also attempts to find out whether a nonlinear
relationship exists or not.
3.

Scope of study
Since developing countries are striving for sustainable economic growth,

they likely need to deal with the problem of debt most of the time, especially the
level of external debt. There are many researches on the impact of the external debt
on economic growth of a specific country with time series or a group of countries in
the same area but there are few ones covering the range of many areas. Moreover,

many existing researches have focused on evaluating the impact of external debt on
investment and saving levels rather than the analysis of the relationship between the
external debt and economic growth itself.
Although there are many studies on this topic with sample of different
developing countries in previous period far back then, there are still few researches
focusing on this issue at the recent time with detail. This is the reason why this
study chooses to explore the nature of relationship and cover the sample of 2
representative developing countries which are equally distributed in Africa; Latin
America and Asia as: South Africa, Nigeria; Mexico, Brazil; Vietnam and India for
the period of 20 years from 1990 to 2009.
4.

Structure of thesis
This thesis will consist of 5 chapters and each chapter will cover the

following content. Chapter 1 gives the general introduction about the research topic

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including the problem statement to explain the importance of external debt in
relationship with economic growth; the main research objectives to find out what
should be studied in this relationship and the scope of study to limit the research
sample.
Then, chapter 2 which is named literature review presents two main parts. As
the first part, theoretical review covers the theories and hypothesis about
relationship between external debt and economic growth. Some models or citation
can be used to illustrate for the theories and the determinants. The second part
mainly focuses on empirical reviews on this relationship as well as the related
determinants with the citation and brief findings drawn from the previous researches.

Next, chapter 3 aims at explaining the methodology of research. A brief
overview of practical problem can be reminded, then the main part focuses on the
building of econometric model. The data is then described in detail and the
variables in function can be clarified.
Chapter 4 presents the results from regression with a descriptive statistic
dataset. Some discussions can be generated in the process of looking back and
comparing with the literature review.
And finally, chapter 5 gives a conclusion for what has been found and raises
some policy implications for what to do when determining the relationship as well
as the impact of external debt on economic growth.

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Chapter 2

LITERATURE REVIEWS

1.

Theoretical reviews

1.1

External debt’s concept
Before entering the literature review focusing on relationship between the

economic growth and external debt, a brief definition of external debt should be
included to present a clear overview. External debt which is also called as foreign
debt is known as the part of the total debt in a country that is owed to creditors

outside the country. The governments, corporations or private households are able
to become the debtors under the circumstance. In the other ways, “total external
debt is a debt owed to non-residents repayable in foreign currency, goods or
services” (World Bank World Indicators Definition, 2000).
To sum up, total external debt is the sum of public, publicly guaranteed, and
private nonguaranteed long-term debt, use of IMF credit, and short-term debt.
Short-term debt includes all debt having an original maturity of one year or less and
interest in arrears on long-term debt. Total external debt is the debt at any given
time, as total loans of liabilities at that time, not including debt service reserve,
requires the borrower to pay the original debt with or without interest, in the future,
and this debt is owed by residents with no residence in the country, according to the
definition of eight international statistical analytical organizations of external debt,
including Bank for International Settlements, the Commonwealth Secretariat, the
European Statistical Organization, International Monetary Fund, the Organization
for Cooperation and Development Economics, Secretariat of the Paris Club,
Conference on Trade and Development United Nations. The external debt of the
country's balance comprise of all current liabilities (excluding debt service reserve)
to pay the principals and interest in respect of external debt in the country.
Besides,eExternal debt can also be defined by national loans for creditors who
reside outside the country (including the national debt by a non-resident in that
country holds). According to the Glossary of banking and Finance Peter Collin

5


Publish (1997), external debt is the debt of a country from another country
including the debt on the domestic debt market, but creditors are non-residents in
the domestic market.
Another issue which needs to be considered carefully is the debt
sustainability. This concept covers represents the level of debt which permits the

borrowing country to finance its current and up-coming compulsory debt service
fully without restructuring or avoiding the accumulation of arrears but allowing a
reasonable level of economic growth. According to the World Bank and IMF report
"a country can be said to achieve external debt sustainability if it can meet its
current and future external debt service obligations in full, without recourse to debt
rescheduling or the accumulation of arrears and without compromising growth”.
Then, analyzing the external debt sustainability under the circumstances of viewing
the behavior of economics variables and other determinants can shed a light on the
condition in which the level of debt and other indicators can be kept at a stable state
and determine the reasonable adjustments as well as the scale for making the
policies.
There are various indicators for the sustainability of external debt but
typically, external debt to GDP ratio, external debt to exports ratio, government debt
to current fiscal revenue ratio…and their respective service ratio are the most
generally applied ones. In this study, the ratio of external debt on export and total
debt service as the main indicator for debt variable.
Finally, the more detailed issues which are related to the structure, the
classification and the general indicators of external debt can be discussed and found
in the Appendix. Having a glance through these parts is also important because it
can help to approach the external debt more comprehensively and understand the
problem more easily as well as deeply.

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1.2

Economic Growth Theories and Models
First of all, the theory of growth should be taken into account and some

typical models should be employed to get a better view of the factors affecting the
ecomomic growth to find the answer for the question whether a relationship
between economic growth and external debt exists or not. One of the best-known
models of growth which can give a general look on determinants is Neoclassical
Growth model developed by Solow-Swan (1956). This model explained the long
run economic growth clearly by considering the basic inputs including the labor (L),
the capital (K) and other factors. Specifically, a linkage between economic growth
rate and

capital accumulation, labor or population growth, and increases

in productivity, commonly referred to as technological progress can be found.
Cobb–Douglas type, a neoclassical core production function has shown those above
relationship clearly:
Y = F (K, L) = Lα.Kα
Where:
Y = out put ; K = Capital input; L = Labor input α and 1-α

are output

elasticity’s of capital and labor respectively. Thus economic growth is proved to
be enhance by the capital input and the accumulation of capital related closely to the
motivation for approaching the debt from any sources, especially the external ones.
A quick glance through the Solow diagram will present a clear look into these
relationship:

7


Figure 1.1. Solow Model Production Function

The Solow diagram can be drawn using the two key equations of the Solow
model in terms of output per worker and capital per worker. These equations are:
Y= kα and
ḱ = sy – (n+d) k
The respective steady state quantity of capital per worker and steady state
quantity of output per worker can be demonstrated by:
k* = (s/n+d) 1/(1-a)
y* = (s/n+d)a/(1-a)
Where: k* = steady state quantity of capital per worker
y* = steady state quantity of output per worker
Looking the diagram of production function, the relationship between the
economic growth and its determinants including the investment rate, population
growth rate and technology can be demonstrated fully. Specifically, if an increase in
investment rate in an economy with its steady value happens, the sy curve will shift
upward to s´y, which also makes the production function shift upward and result in
an economic growth as well as a higher steady value capital per worker. Otherwise,
if population growth rate increases, the (n+d)k curve shifts upward to (n’+d)k. And
this will make a loss in steady state capital stock per worker value.

8


Finally, this model also figures out a significant points that a sustainable
economic growth will be only ensured when being accompanied by a progress in
technology which occurs when there is an increase in “A” which is a new
coefficient called “labor augmenting” or “Harrod –neutral” labeled by Solow in the
respective function: Y = F (K, AL) =A.Kα.Lα. And the progress in technology will
be only achieved if there are the sufficient sources of capital input and the
productivity of a labor unit. All will lead to the undeniable correlation between
economic growth and the accumulation of capital as an important input factor of

Growth model in general, decides the Total factor productivity (TFP) factors.
Therefore, in specific view, a definite relationship between economic
growth and external debt can be expected due to the fact that not all countries,
especially the developing ones can have enough the sound saving and investment
rate, so the alternative capital input comes from the external sources will be
inevitable. Or in the other ways, considering all the factors affecting economic
growth, a link between it and external debt can be found definitely but the fact that
how this relationship would like to turn out has a different approach drawn from the
various existing researches.
1.3

Theories and hypothesis on the relationship between external debt and

economic growth
There are various theories and hypothesis relating to the relationship between
external debt and economic performance, which can be approached under the
different point of view. It is hard to identify clearly the impact of external debt on
economic growth since it will depend on the level of debt. Positive relationship
between the external debt and economic growth will be determined if an acceptable
level of debt can compensate the capital deficit and improve the social welfare.
Whereas a negative relationship will be likely to happen if an excessive level of
external debt can affect economic growth through debt overhang and crowding out
effect.

9


Firstly, some hypothesis and theoretical models have shown the support for
the positive relationship between external debt and economic growth at a reasonable
level of debt to improve the social welfare and encourage the investment. The

general core point in those views can be drawn to the fact that economic growth
would be explained and booted by the accumulation of capital. Typically, the
Harrod-Domar model (1946) which was used widely in development economics put
an effort to show the direct linkage between economic growth and capital
accumulation and indicated that if the debt can supply the capital accumulation, the
economic growth will be targeted. This model was developed initially by Sir Roy
Harrod in 1939 and then, Evsey Domar continued developing it in 1946 to find the
explanation for economic growth rate in terms of the level of saving and
productivity of capital. The Harrod–Domar model had the implications for the root
of generating the economic growth which can be explained through the quantity of
labor and capital input. The more capital stock is accumulated, the more easily the
economic growth target can be achieved. The main function Y=f(K) implies the
capital is necessary for output. This is the key issue to the developing countries
where the labor is abundant but the physical capital stock is always in condition of
shortage, so the economic growth has been slowed down.
Dealing with this question, many developing countries have approached the
external debt with the motivation of making the positive impact to finance the
national economic growth for a long time. These external debts can definitely help
to generate the economic growth of that country in turn if they do not exceed the
acceptable limit to become a debt burden. According to the model of Growth, it can
not be denied that the external debt can definitely help the countries, especially the
developing ones, to fill the gap of capital shortage for growth as long as the external
debt is controlled at a reasonable point.
Consequently, a positive relationship between external debt and economic
growth can be achieved at some level since the critical function of external debt is
to supply the adequate source of capital for the domestic demand in wide range of

10

investment and transformation to boost the economy as mentioned by Chenery and
Strout

(1966). Then a stimulated economic growth can bear a higher output

because it can finance the productivity of labor. And this good performance can
help a country to service its own external debt as long as the level of debt is
correspondent to its pay-back capacity.
On the other hand, some theories has supported the idea that a certain
amount of external debt can affect the economic growth negatively on through the
debt overhang effect on investment channel. It can be said that “debt obverhang”
theory is one of the most well-known ones to demonstrate the adverse impact of
external debt on growth. According to (Myers, 1977), the term “debt overhang” was
originally stemed from the corporate finance literature which portrays a situation in
which a firm’s debt is larger than any earnings generated by new investment
projects, even projects with a positive net present value. Therefore, both the current
stock of debt and the present value of a firm cannot be improved by any ways under
that circumstance as the beginning of “debt crisis” in microeconomic view. Then
the concept of “debt overhang” was developed in the international finance literature
by many economists.
According to Krugman’s (1988), debt overhang condition happens in one
country when the face value of its debt is larger than the expected present value of
its future transfers. The “debt overhang” theory is also characterized by Sachs
(1989) as the excess of the expected repayment on external debt over the contractual
value of debt. This theory emphasizes the negative impact of external debt on
economic growth through the channel of investment and the physical capital
accumulation.
Specifically, when a country, especially the developing one, bears a high
level of external debt, it can easily discourage the domestic and foreign investment
for physical capital accumulation, then slow down the economic growth as a whole.

It can be easy to recognize the risk with harmful effect when a large accumulation
of physical capital coming from the external sources exceeds the ability of one

11


county to repay both its past and current debt. In turn, the investment activities have
to bear many losses when potential lenders and investors will be steered away due
to the uncertainties and instabilities of repayment. Even if not in the present time
but in the probability of future, can the estimated level of debt unserviceable also
impose the similar negative impact on the economic performance through the level
of output. Then, the returns from the domestic investments are "taxed away" by
existing foreign creditors to service the debt and this will discourage the incentives
to invest in both domestic and foreign sectors and affect negatively on economic
growth, according to Claessens et al(1996).
The impact of debt overhang to illustrate for the relationship between
external debt and economic performance can be tracked through the “crowding out”
effects. It means that the increase in external debt service will strike down the level
of investment in turn. The main measures of external indebtedness are the indicators
over GDP and exports, so “crowding out effect” emphasizes the negative impact of
the fact that the income from export has to be taken away to repay the external debt.
As a result of this, the lack of capital for stimulating the investment activities to
escort the economic growth is inevitable. According to Hansen (2004), the debt
payment service can become the severe restriction to economic growth by such that
crowding out effect.
Then Cohen (1993) found the empirical evidence to oppose the “debt
overhang” hypothesis and support the “crowding out” effect. Besides, when a
county is in the debt overhang condition, the government can take some actions
which may depress the investors like the distortionary measures including the fiscal
and restructural reforms to finance the debt –service obligations. These changes in

the policy of government can set a barrier or build the hesitation to hinder the
investing activities and result in a loss of output as well as a negative economic
growth rate at last. This effect can be demonstrated by the the Debt Laffer curve
which was introduced by Sachs (1998) through the theory of “debt overhang” as
below:

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45o
Expected
Repayment

Figure 1.2. Laffer Debt Curve

Debt Stock

Source: Sachs(1998)
Initially, the Laffer Debt Curve was used to illustrate the adverse relationship
when the tax rate increases, the total tax revenue of the government ac initially
increase but have a downing trend after exceeding a certain point because the labors
do not have any incentives to work more when they have to bear a larger tax for that
at all. Similarly, the Debt Laffer Curve demonstrates clearly the situation when a
high level of debt is accompanied with a loss in the capability of expected
repayment because of the discouragement effect and sabotage impact.
Specifically, it means that when the external debt stock rises, the indebted
country is discouraged by the lack of investment from foreign investors and has no
incentives to produce more due to the fact that the output will be used to service the
existing external debt. Thus, a loss in economic growth is inevitable and clear.
Looking at the Debt Laffer Curve, if a country is on along its left side, an increase

in debt stock can be accompanied with an increase in repayment capability but after
reaching a critical point called peak, any increases in debt stock means a decrease in
expected repayment. However, it is not easy to figure out that critical point and it
can be different depending on each countries. Any countries on the right side of that
point have to bear the condition “debt overhang” with negative impacts on the
economic growth rate.

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2.

Empirical Literature Reviews
Besides a number of theoretical literature on this issue, many empirical

studies has been done to find out the relationship between external debt and
economic growth. There are various existing results but they can be divided into
three groups. The first group belongs to the empirical evidence that has supported
the positive effect of external debt on economic growth at the certain level. The
second group relates to those which have indicated the negative relationship of high
level of external debt with economic growth; then the third one combines two above
effects to argue that there is a nonlinear relationship between external debt and
economic growth by nature. Besides, there are some empirical studies have found
no relationship between external debt and growth.
Firstly, a few studies have found the positive relationship between the
external and economic growth at the certain level. Chowdhury (1994) attempted to
shed a light in the debate of determining the causes and relationship between
external debt and economic growth, by conducting granger causality tests for
Asian and Pacific Countries over a period of 1970-88. With the dependent
variable is GDP, a set of independent variables including debt payment (negative),

inflation (negative), interest rate (positive), agricultural labor (negative), it has been
found that any increase in GDP is followed by a higher level of external debt
and the overall external debt does not have any negative impact on economic
growth.
A simple neo-classical model was employed to find out the relationship
between external debt and economic growth and the capability of external debt
servicing with the cross sectional data of 31 Sub-Saharan African countries by
Gerald Scott(1994). This study used the dependent variables of GNP per capita in
log and a set of independent variables including exports (positive), domestic Capital
(positive), technology (negative), imports (positive), exchange rate (positive). It has
been concluded that there is positive evidence of the impact of external debt on
growth at the certain level. Employing data from 59 developing and 24 industrial

14


countries over a period of 1970-2002, Schclarek (2004) found no proof of the
fact that external debt can affect total factor productivity (TFP) but got the
evidence that a low level of external can accompany with a favorable rate of
economic growth. This also hinted a positive relationship between low debt and
economic growth.
Secondly, the empirical studies which favor the negative relationship
between external debt and economic growth account for substantial number and
become the trendy and attentive hardcore on this topic. This study will also focus on
this direction in the process of find out how this relationship can be. For instance,
Iyoha (1999) used a small macro-econometric model with the simulation approach
with both Growth equation and Investment Equation to look into the impact of
external debt on economic growth in sub-Saharan African countries in the period
1970-1994. A negative relationship came out the light with the consistent
hypothesis with the debt overhang theory and crowding out effect.

Besides, Sachs (1984, 1988), Cohen and Sachs (1986), and Krugman (1988),
Adepoju et al. (2007) studied that relationship in the context of debt crisis in 1980s
and employed the debt overhang theory models to find out the negative impact of
external debt on economic growth rate. For the case of Nigeria over a period of
1962 to 2006, by using the simultaneous model with time series data, Adepoju
(2007) jumped to the conclusion that the accumulation of external debt really held
the economic growth back for times in Nigeria. Another case in Pakistan, Hameed
et al.(2008) investigated the dynamic effect of external debt servicing, capital stock
and labor force on the economic growth for a period of 1970-2003 and found an
adverse relationship of external debt and economic growth through the channel of
capital productivity and labor productivity. Maureen Were (2001) used dependent
variable of GDP growth rate and a set of independent variables including inflation
(negative), lagged inflation (positive), real public investment as a ratio of GDP
(positive), private investment (positive), fiscal deficit/GDP (negative), Human
Capital Development (positive), Debt/GDP(negative), Debt Service to export

15


(positive) with time series data of Keyna. A negative relationship between external
debt and economic growth was found as final result.
Then, the panel data of 14 Pacific Island Countries from 1988–2004 was
analyzed by T.K. Jayaraman, Evan Lau (2008) to do tests for finding a linkage
between external debt and economic growth rate. Real GDP was set as dependent
variable with a set of independent variables as follows: External Debt (negative),
Exports (positive), Budget Deficit (negative). And one of the most popular
empirical study, "What Are the Channels Through Which External Debt Affects
Growth?", Pattillo(2004) used the data of a group of 61 developing countries in the
period of 1969–98 to build a growth-accounting framework and found that the
average level of external debt slow down the economic growth by holding back the

physical capital accumulation and the growth of total factor productivity (TFP).
Thirdly, many existing empirical researches which support the nonlinear
relationship between external and economic growth have caught the attention more
and more. Typically, by using fixed and random effects panel data to estimate the
regression model, Elbadawi et al. (1997) found out the nonlinear impact of external
debt on economic growth. The relationship was characterized and consistent with
the debt Laffer curve with a critical threshold. This research showed both in linear
and quadratic form of debt-to-GDP ratio in the regressions and found the growth
maximizing debt to GDP ratio of 97 percent.
Then, Patillo et al. (2002, 2011) used many methods of estimation including
OLS, Fixed effects, and GMM system to come to conclude a nonlinear relationship
between external debt and economic growth with the panel data of 93 developing
countries. Patillo et al. (2004) continue to research in detail about the channels
through which external debt can make a non-linear impact on growth in developing
countries, and found that the physical capital accumulation accounted for one-third
of the negative effect of debt on growth and two-thirds were stemmed from total
factor productivity growth (TFP). This study of 93 developing countries in the
period of 1969-1998 found that the negative impact of external debt on growth

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happened when its net present value (NPV) exceeded 160–170 percent of exports
and 35–40 percent of GDP.
Reinhart and Rogoff’s (2010) set the first step in orientating the research
tendency in estimating the debt thresholds and threshold effects of debt on growth.
Both linear and non-linear effects of external debt on growth were investigated
through the model specifications by employing different econometric techniques.
The linear estimations directly indicated a negative relationship between debt and
initial growth, while the nonlinear estimations found a threshold of 90% debt-toGDP ratio at that level external debt to make a significant negative impact on

growth. Therefore, unlike a low and reasonable limit, a high external debt is likely
to have the definite negative impact on the economic growth. Or in the other ways,
there is a threshold of level debt at which the external debt can impose the two
opposite effects on the economic performance of one country. This implies that a
relationship between external debt and economic growth also has an inverted U
shape with a critical point called the threshold beyond which the initial positive
impact of external debt on economic growth will turn out the negative one
completely. That is beginning from zero up to the thresh hold, any increases in
external debt or its net present value can make the expected repayment reliable, then
increase its contribution to economic growth through accumulating the physical
capital. However, after reaching the threshold, any further increases in external debt
only results in the risk of debt unserviceableness. In other words, the negative
effects of debt overhang theory occur only after a certain threshold level has been
reached. The debt threshold curve can be inspired by the shape of Debt Laffer
Curve like this:

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Contribution of external
debt to economic growth
rate

Net Present Value
(NPV) of external
debt to export

Figure 1.3. Debt Threshold Curve
Source: Patillo et al. (2004)
Looking at the debt threshold curve, A is determined as debt threshold and

keeps role to divide the impact of external debt on economic growth into two
distinguished ones. On the left side of A, external debt bears a positive relationship
with economic growth or in other words the marginal productivity of each available
external debt is greater than or equal with the principal and the interest payment,
according to Cline (1985). However, on the right side of A, one country has to
suffer the negative influence of external debt on economic growth due to that fact
that the payment of interest and repayment of principal can discourage the private
investment or make the changes in public expenditure. Higher external interest
payments can increase a country's budget deficit, thereby reducing public savings.
And when reaching the point B of net present value (NPV) of external debt, its
contribution to economic growth not only has downward trend but also keeps a
negative value.
It can be seen that there are three different flows of main ideas on
relationship between external debt and economic growth which has been based on
various empirical studies. However, there are still some researches on external debt

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and growth which cannot find any relationship. Focusing on one of the Heavily
Indebted Poor Countries (HIPC), Kenya, Were (2001) focused on analyzing the
debt overhang and tried to find out any relationship between external debt and the
present low economic growth rate. Using time series data from 1970-1995, this
study could not find any evidence to favor for the negative or positive impact of
debt servicing on economic growth; instead of it, some crowding-out effects on
private investment were confirmed. While employing 13 developing countries
data for a period of 1960-1981 and 1982-1989, Warner (1992) could also not
find any empirical relationship between external and debt servicing on economic
growth as well.

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Chapter 3 RESEARCH METHODOLOGY
1.

Overview of external debt and economic growth in developing countries
Before entering the methodology of research, some main points about

condition of external debt and economic growth in developing countries are going
to be briefly scanned through. An overview picture can be summarized in the
following table to make clear of the current situation of external debt
Table 3.1: External debt and GDP in main areas of developing countries
Unit: Billion USD

Area
Pacific and
East Asian
countries
European and
Middle Asian
countries

External
debt

GDP

Debt / GDP

Export Turn
over

Debt / Export
Turn over

741

4.438

0,16

1783

41.56

1.214.

3.155

0,35

874.

138.88

.
Latin
American and
Caribean

countries
Middle, East
and North
African
countries

825

3.444

0,25

750

110.07

136.

828.

0,17

297

45.83

South Asian
countries

304.

1.438

0,22

184

164.71

South Sahara
African
countries

195

842.

0,23

261.

74.64

Source: World Bank and IMF Indicators and Data (2010)
Recently, the issue of external debt has risen globally at high speed.
Developing countries in three areas: Asia, Latin –America and Africa are facing
with this problem and struggling for the target of achieving the sustainable
economic growth at the same time. This has pushed these countries into a dilemma

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