External debt and growth: An econometric

studyMarianna Koli

IDPM, University of Manchester

ESDS International ConferenceLondon, 3 December, 2007

Research objectives

1. To assess the significance of debt as a determinant of growth

2. To test the debt overhang hypothesis

3. To find the critical debt ratios where the impact of debt on growth becomes negative

Context

Growth• Mainstream variable• Often proxy for developmentDebt• Instrument of public dev. discourse• Need hard evidence of real situation• Little research into exact critical ratios• Debt overhang hypothesis (Krugman)

Debt overhang hypothesis

GDP per capita growth

Debt/GDPGrowth-maximising debt level

Previous literature

• A wealth of studies on determinants of growth– Large country samples (100+)

• Some studies on debt/growth and debt overhang hypothesis– Pre-2000 papers 10-30 countries– Recent papers 20-100 countries

Original contributions of this study

• Middle-income countries only• Smaller subgroups of countries

– Lat Am/non-Lat Am– Severely/moderately/less indebted

• Determination of “critical debt level”• New data compared to previous

literature on same topic

Sample

• 25 middle-income countries as classified by UN based on GDP pc

• Middle-income versus low-income:– Lower levels of absolute poverty, HIV

and other urgent wide-scale problems– Better possibilities for strategic planning– Better institutions– Better government?

Sample

• Exclusions: – Population less than 1 000 000 (islands)– Independence after 1960 (EECA, SSA)– China excluded for poor data availability

• 85 data points of 7700 (1.1%)had to be estimated using combination method: two moving averages and two econometric techniques, with equal weights

Subgroups

• Indebtedness– Severely/moderately/less indebted– Effect of debt level on debt/growth

relationship

• Latin America– Endemic debt crises in 1980s– To find out whether debt/growth

relationship is different in Latin America

Methodology

• Regression with fixed effects – chosen through logical method and

OLS/FE/RE diagnostic statistics comparison

• Robustness tested through country groups

Results

• Significance in several subgroups: debt/GDP, debt service/X, short-term debt/total debt, budget balance/GDP, terms of trade, investment/GDP and economic openness

• Results reflect the current theories about financial crises in middle-income countries

Results: debt variables

• External debt/GDP is highly significant in all groups except non-Latin America

• External debt without lag gives U-shaped Laffer curve

• External debt with lag gives inverted U-shaped curve

• All sub-samples give same shape for curve

Results: Cubic Laffer curve

GDP per capita growth

Debt/GDP Growth-

maximising

debt level

Non-lagged variables Lagged variables

Results: insignificant variables

• Education, population growth, tax revenue/GDP, economic freedom

• Solow model variables found insignificant, possibly because of heavy focus of model on debt

• Taxes and economic freedom possibly neutralised by other variables (budget balance, investment)

Results: Being in Latin America

• Small number of significant variables• Significant variables: external debt,

budget balance and short-term debt• Debt service is insignificant• Different causes of growth slowdowns:

– Lat Am: debt overhang– Non-Lat Am: debt service crowds out

investment, reducing growth

Results: Indebtedness level

• SICs: debt, stability, openness (negative!)

• LICs: debt, investment and stability• MICs: debt, ST debt, terms of trade,

education, economic openness, investment rate

• Conclusion: debt is significant in all groups, but reasons may be different

Results for debt overhang

• Mixed evidence for DOH (total of 24 squared coefficients, of which 12 significant, of which 6 negative)

• Some evidence for DOH found in all subgroups except Less Indebted Countries

Critical debt ratios(90% confidence interval)

Pattillo et al (2002)

Debt/GDP 15-20%

Pattillo et al (2002)

DS/X 80-85%

Elbadawi (1997) Debt/GDP 97%

This study Debt/GDP (All) 300-5260%

This study Debt/GDP (MICs) 110-820%

This study Debt/GDP (Lat Am) 120-320%

This study DS/X (MICs) 20-35%

This study DS/X (non-Lat Am) 32-38%

Explanation of critical ratios: debt/GDP

• High error margins in some groups, but all critical debt/GDP ratios over 100%

• Higher thresholds than earlier research – improved debt tolerance?

• Previous studies included 1970s and included both low- and middle-income countries

• Latin America shows lower tolerance than whole sample of 25 countries

Explanation of critical ratios: DS/X

• We find lower critical ratios than Pattillo et al (2002)

• Possibly explained partly by sample composition: high exporters give low DS/X ratios (e.g. Thailand, Philippines)

• No clear statistical explanation for lower ratios – does this mean debt service tolerance has fallen?

Laffer curve findings: debt/GDP

• Four countries found on “wrong side of the Laffer curve” during 1980-2001:– Bolivia (1986-87)– Jordan (1987, 1989-1995)– Panama (1988-1989)– Syria (1983-2001)

• All but Bolivia are still severely indebted

Laffer curve findings: DS/X

• Seven countries exceed the 30% mark for longer periods of time, mostly Lat Am:– Argentina (range: 25-80%)– Bolivia (30-60%)– Brazil (20-80%)– Chile (15-70%)– Hungary (20-50%)– Mexico (20-50%)– Peru (10-50%)

Conclusions

1. Crisis avoidance and growth objectives are equally important

2. “Infant institutions” argument is valid, particularly in SICs

3. Policies should be tailored to country circumstances

4. Model may be specific to conditions where debt is important