Effect of external debt on economic growth economics essay

This is just one of many economic findings included in CBO's latest Long-Term Budget Outlookwhich shows very clearly that rising debt could be detrimental to the American economy. While CBO's standard long-term projections are based on "benchmark" economic projections which generally assume no major changes in fiscal policy, they also warn of the limits of such projections. As CBO explains, rising debt can have feedback effects by crowding out private investment in favor of public debt and ultimately slowing economic growth.

Effect of external debt on economic growth economics essay

An IMF study estimates two critical turning points: Over the past three decades, developing countries have borrowed large amounts, often at highly concessional interest rates Chart 1. The hope was that these loans would put them on a faster development path through higher investment and faster growth.

But as debt ratios reached very high levels in the s, it became clear that for many of these countries, repayment would not just constrain economic performance but be virtually impossible. Thus, in the s, several middle-income countries—particularly in Latin America—faced severe debt crises and, in the mids, the IMF and the World Bank launched the Heavily Indebted Poor Countries HIPC Initiative to bring the debt of low-income countries—most of which are in sub-Saharan Africa—to sustainable levels.

Despite the importance of this issue and the public attention it has received, including from the Pope and rock stars, policymakers and economists around the world still have only a partial understanding of fundamental questions, such as Beyond what level does external debt impair economic performance?

What is the quantitative effect of debt on economic growth for the typical developing country? Is the effect of debt on growth nonlinear—in other words, does the effect on growth of additional debt vary, depending, for example, on the level of the debt stock?

What are the channels through which debt affects growth?

This paper will be limited to the study of impact of external debt only on Pakistan’s economic growth. Theoretical framework Shahrukh Rafi Khan in examined the terms on which Pakistan receives aid and the impact of foreign aid and debt on economic growth. Abstract This paper would discuss the effect of external debt on economic growth with four areas, the effect on private local investment, foreign direct investment, government expenditure and export growth. v THE RELATIONSHIP BETWEEN EXTERNAL DEBT AND ECONOMIC GROWTH IN THE WEST AFRICAN MONETARY ZONE: A PANEL DATA ANALYSIS Prepared by: Ismaila Jarju, Edward Nyarko, Kormay Adams, Ozolina Haffner and Olukayode S.

We conducted a study that examined these questions, looking at nearly developing countries over a year period. Countries heavily dependent on oil exports, countries with populations of less than , and countries in transition are excluded from the analysis.

What theory tells us Economic theory suggests that reasonable levels of borrowing by a developing country are likely to enhance its economic growth. Countries at early stages of development have small stocks of capital and are likely to have investment opportunities with rates of return higher than those in advanced economies.

As long as they use the borrowed funds for productive investment and do not suffer from macroeconomic instability, policies that distort economic incentives, or sizable adverse shocks, growth should increase and allow for timely debt repayments.

Effect of external debt on economic growth economics essay

These predictions hold up even in theories based on the more realistic assumption that countries may not be able to borrow freely because of the risk of debt repudiation.

Why do large levels of accumulated debt lead to lower growth?

Public Debt and Economic Growth: Is There a Causal Effect?

The best-known explanation comes from "debt overhang" theories, which show that if there is some likelihood that, in the future, debt will be larger than the country's repayment ability, expected debt-service costs will discourage further domestic and foreign investment and thus harm growth.

Potential investors will fear that the more a country produces, the more it will be "taxed" by creditors to service the external debt, and thus they will be less willing to incur costs today for the sake of increased output in the future.

This argument is represented in the debt "Laffer curve" Chart 2which posits that larger debt stocks tend to be associated with lower probabilities of debt repayment.

On the upward-sloping or "good" section of the curve, increases in the face value of debt are associated with increases in expected debt repayment, while increases in debt reduce expected debt repayment on the downward-sloping or "bad" section of the curve.

Although the debt overhang models do not analyze the effects on growth explicitly, the implication is that large debt stocks lower growth partly by reducing investment. But in addition, the incentive effects associated with debt stocks tend to reduce the benefits to be expected from policy reforms that would enhance efficiency and growth, such as trade liberalization and fiscal adjustment: Thus, some considerations suggest that, at reasonable levels of debt, further borrowing would be expected to have a positive effect on growth.

Others stress that large accumulated debt stocks may be a hindrance to growth. Both these elements together imply that debt is likely to have nonlinear effects on growth. Although the debt overhang theories have not explicitly traced the effect on growth, it may be possible to extend and translate the debt Laffer curve posited by these models into a Laffer curve for the effect of debt on growth.

Since the peak of the debt Laffer curve shows the point at which rising debt stocks begin acting as a tax on investment, policy reforms, or other activities that require up-front costs in exchange for future benefits, the peak may relate to the point at which debt begins to have a negative marginal impact on growth.

How are debt and growth linked? In our study, we tried to find out if this type of curve exists, essentially asking, what is the link between debt and growth? To do this, we used various debt stock indicators, including a recent World Bank data set that measures the net present value of debt—a measure that takes into account the fact that a significant part of the external debt is contracted at an interest rate below the prevailing market rate.

This is important because most studies have simply considered debt ratios to exports and to GDP in nominal terms, whereas most countries sampled have contracted debt at concessional rates—meaning that the actual amount they will have to repay in the future is less than the face value of the debt.

To properly identify the debt overhang effect through the above debt stock indicators, we also include the ratio of debt service to exports to control for any crowding-out effects arising from resources being spent on debt service instead of investment or growth-enhancing domestic spending.

We found that debt does indeed seem to have an inverted-U relationship with growth Chart 3, next page. When countries open up to foreign capital and start borrowing, the impact on growth is likely to be positive moving from zero indebtedness to point A in Chart 3.

As debt ratios increase beyond point A, additional debt eventually slows growth down even though the overall debt level continues to make a positive contribution to growth. Thus, point A can be considered as the growth-maximizing level of debt.

When debt reaches point B, however, the overall contribution of debt turns negative: Besides confirming this inverted-U relationship between debt and growth, our study also quantifies the two critical turning points.

The one we can identify with more confidence is point B: The marginal impact appears to become negative point A at about half these levels, although our results do not allow us to estimate those levels precisely.

The results also indicate that the growth differential between countries with low indebtedness less than percent of exports or 25 percent of GDP and those with the highest indebtedness more than percent of exports or 95 percent of GDP is, on average, in excess of 2 percent a year.

Our results were found to be robust across the many specifications, methodologies, and debt indicators employed see box.The relationship between economic growth and public debt is a very controversial issue by economists.

According to Elmendorf and Mankiw () state debt is important for effects that it brings itself, directly or indirectly, in the country's economy. Firstly, the state debt could affect monetary policy. Debt-driven Growth?

Wealth, Distribution and Demand in OECD Countries Abstract: The paper investigates the effects of changes in the distribution of income and in wealth on aggregate demand and its components. We extend the Bhaduri and Marglin ().

Search form


External debt accumulation has been rising over the years with debt burden indicators increasing steadily in the early s. Using time series data for the period , the empirical results indicated that external debt accumulation has a negative impact on economic growth and private investment.

debt-growth nexus literature by analyzing the causal nexus between debt and growth and also examining the effect of debt on economic growth. The rest of the present paper is set out as follows. External Debt and Domestic Debt Impact on the Growth of the Nigerian Economy 71 it is important to investigate the effect of public debt on economic growth in Nigeria.

Apart External Debt and Domestic Debt Impact on the Growth of the Nigerian Economy.