Public Debt and Economic Growth: Is

There a Causal Effect?

Ugo Panizza Andrea F. Presbitero∗
April 2, 2012
SUMMARY:
Do high levels of public debt reduce economic growth? This is an important policy question. A positive
answer would imply that, even if effective in the short-run, expansionary fiscal policies (Expansionary
fiscal policy is a form of fiscal policythat involves decreasing taxes, increasing government expenditures
or both in order to fight recessionary pressures. A decrease in taxes means that households have more
disposal income to spend. Higher disposal income increases consumption which increases GDP) that
increase the level of debt may reduce long-run growth, and thus partly (or fully) negate the positive effects
of the fiscal stimulus. Most policymakers do seem to think that debt -run economic growth. This view is in
line with the results of a growing empirical literature which shows that there is a negative correlation
between public debt and economic growth in advanced and emerging economies, and finds that this
correlation becomes particularly strong when public debt approaches 100 percent of GDP.

Correlation, however, does not imply causation. The link between public debt and economic growth could
be driven by the fact that it is low economic growth that leads to high levels of debt. Alternatively, the
observed correlation between debt and growth could be due to a third factor that has a joint effect on these
two variables. Establishing the presence of a causal link going from debt to growth requires finding an
instrumental variable that has a direct effect on debt but no direct (or indirect, except for the one going
through debt) effect on economic growth. It was also found that changes in a country’s exchange rate have
a direct and mechanical effect on the debt-to-GDP ratio.

The fact that we do not find a negative effect of debt on growth does not mean that countries can sustain
any level of debt. There is clearly a level of debt which is unsustainable (for instance, when the interest bill
becomes greater than GDP) and a debt-to-GDP ratio at which debt overhang, with all its distortionary
effects, kicks in.

It would be true that debt reduces growth, but only because high levels of debt lead to contractionary
policies. While such an interpretation would justify long-term policies aimed at reducing debt levels, it also
implies that countries should not implement restrictive policies in the middle of a crisis. These policies are
the reason for the negative effect of debt on growth. Of course, policymakers under pressure from market
participants might not have an alternative. This is why we need prudent fiscal policies and lenders of last
resort that can rule out multiple equilibria.
Impact of Domestic and External Debt on
the Economic Growth of Pakistan
Rabia Atique and Kamran Malik
SUMMARY:

This paper examines the determinants of economic growth for Pakistan, the impact of domestic debt and
external debt on the economic growth of Pakistan separately.

 The findings suggested an inverse relationship between domestic debt and economic growth and
also the relationship between external debt and economic growth was found to be inverse. These
relationships were found to be significant as well.
 The results also concluded that external debt amount slows down economic growth more as
compared to domestic debt amount. The reason behind this could be that as the debt servicing of
external debt has to be paid in foreign currency and the value of Pakistani rupee is weak as
compared to the creditor countries currency. So external debt is slowing down the economy more
as compared to domestic debt.
 The negative effect of external debt is stronger on the economic growth in comparison to domestic
debt.
 Especially the developing nations face the phenomenon stated by the debt overhang (a situation in
which a country can not borrow more money, even when that new borrowing is actually a good
investment) hypothesis. As developing nations face other economic issues as well which the
developed nations don’t have to face, the debt management becomes more difficult for the
developing nations like Pakistan
 As foreign exchange reserves are very important for paying back foreign debt the revenue generated
from exports can help Pakistan from bankruptcy.
 Good relations with other countries should be established and with mutual consents trade
barriers should be reduced so that the products of Pakistan can be exported to many
countries.
 The government should promote local industries so that high quality goods can be produce in
Pakistan.
 The agricultural sectors should also be given importance as Pakistan is famous for its rich
agricultural lands and premium quality crops.

Revisiting the role of external debt in

economic growth of developing countries
Siti Nurazira Mohd Daud & Jan M. Podivinsky
SUMMARY:
 Foreign direct investment: A foreign direct investment (FDI) is an investment in the form of a
controlling ownership in a business in one country by an entity based in another country.
 Debt service ratio: The debt service coverage ratio, also known as "debt coverage ratio", is the ratio
of cash available for debt servicing to interest, principal and lease payments. It is a popular
benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt
payments.
 The aim of this paper is to analyze the debt-growth nexus, particularly the debt-growth and the
debt-investment relationship with reference to 31 developing countries in the sample.
 The accumulation of external debt is associated with a slowdown in the economies of the
developing countries.
 Apart from this, we find evidence that the debt service ratio does not crowd out the investment rate
in developing countries. Crowding out is an economic concept that describes a situation where
personal consumption of goods and services and investments by business are reduced because of
increases in government spending and deficit financing sucking up available financial resources
and raising interest rates.
 Thus, there are convincing results to support the negative effect of external debt on economic
growth but there is no evidence that debt service payment squeezes the investment rate. This could
imply that the likelihood of a country being able to service its repayment (principal and interest
payment) through investment is still high. In addition, the gross investment and fiscal balance as
well as the trade openness (at 5 percent significance level) were found to have a positive and
significant impact on economic growth.
 There is no evidence that the debt Laffer curve (The curve is used to illustrate Laffer's main
premise that the more an activity — such as production — is taxed, the less of it is generated.)
relationship exists in the debt growth model, which reflects that the negative relationship of debt
with economic growth is robust. Debt- Laffer curve which indicates negative relationship between
the stock of external indebtedness and expected of repayment.
 Furthermore, among the countries that have downward-sloping debt curve have the potential of
being in the debt overhang situation. This situation is explained by a positive growth in debt service
and negative growth in investment.
 The country becomes involved in a debt overhang situation or, to a lesser extent, is in default. As
external debt is important as a source of capital, the government could play an important role in
utilizing the public debt to improve and provide an environment conducive to investment incentive.
 In other words, a well-built infrastructure for investment could help boost domestic investment as
well as attract more foreign direct investment into the country. In addition, policy that could
generate earnings, especially in foreign revenue, should be formulated wisely. Policies such as an
export-led growth strategy (export-led growth is a trade and economic policy aiming to speed up
the industrialization process of a country by exporting goods for which the nation has a
comparative advantage) could benefit a country, since countries use their foreign earnings to service
the external debt.
 Impact of Public Debt on the economic
growth of Pakistan
By Naeem Akram
SUMMARY:
Heavy indebtedness of the developing economies is one of the major challenges at the beginning of 21st
century. Needless to point out, government can finance its budget and development efforts by borrowing
or taxing the output. However, taxes tend to distort the structure of relative prices, borrowing, if pushed
beyond the carrying capacity of an economy, creates problems of intergenerational equity, and it can cause
a transfer of resources that tends to be undermining growth. Yet borrowing has to be done to finance public
expenditure to increase social welfare and promote economic growth. Over the years Pakistan has failed to
collect enough revenues to finance its budget. Consequently, it has been facing the problem of twin deficits
and resultantly to finance their developmental activities government has to rely on public external and
domestic debt.

 The positive effects of public debt relate to the fact that in resource-starved economies debt
financing if done properly leads to higher growth and adds to their capacity to service and repay
external and internal debt.
 The negative effects work through two main channels--i.e., “Debt Overhang” and “Crowding Out”
effects.
 Study finds that public external debt has negative relationship with per capita GDP and investment
confirming the existence of “Debt Overhang effect”. However, due to insignificant relationships of
debt servicing with investment and per capita GDP, the existence of the crowding out hypothesis
could not be confirmed. Similarly, domestic debt has a negative relationship with investment and
per capita GDP.
 Public debt can be classified as sum of external debt and domestic debt. As far as the relationship
between external debt and economic growth is concerned, a reasonable level of borrowing is likely
to enhance economic growth, through capital accumulation and productivity growth (Chowdhury,
2001).
 External borrowing for productive investment creates macroeconomic stability (Burnside, 2000),
external debt is also been seen as capital inflow having positive effect on domestic savings,
investment and economic growth.
 However, high level of accumulated debt has an adverse effect on rate of investment and economic
growth. Most broad rationalization of the adverse effect of debt is “debt overhang” effect. If there
is some likelihood that in future, debt will be larger than the country’s repayment ability then
anticipated debt-service costs will depress further domestic and foreign investment.
 The other channel through which debt obligations affect economic growth is known as “crowding
out” effect. If a greater portion of foreign capital is used to service external debt, very little will be
available for investment and growth. Debt-servicing cost of public debt can crowd out public
 investment expenditure, by reducing total investment directly and complementary private
expenditures indirectly.
 On the other hand, only in the short run debt servicing has a negative and significant relationship
with per capita GDP. But from this evidence we cannot infer the existence of the “crowding out
effect” because debt servicing does not seem to significantly affect investment.
 Domestic debt has a negative and significant relationship with investment, suggesting that it has
tended to crowd out private investment. However, domestic debt does not have significant
relationship with per capita GDP; and that investment has a positive and significant relationship
with per capita GDP. Therefore, the policy makers should not use the domestic debt to finance the
fiscal deficit (A fiscal deficit occurs when a government's total expenditures exceed the revenue
that it generates, excluding money from borrowings) rather there is a dire need to enhance efforts
to stimulate the revenue or reduce the current expenditures.

External Debt & Economic Growth

By Diego R. Calvo Johannes H. Stefanoudakis Juan Marcelo
Tames Blanc
SUMMARY:
In this report we examine several factors that affect the gross domestic product (GDP) and their levels of
impact with the sole purpose of inferring the relationship between debt and GDP. In addition, we will
propose a cut-off point from which additional debt results in negative growth.

o GDP per capita (current $US) (dependent variable)

o ssDebt service to exports (Debt Service-to-exports has a positive coefficient implying that the
higher the amount of debt serviced the better GDP per capita ends up.)
o Population increase (an increase in population combined with less or fixed capital sources would
result in negative GDP growth. The negative coefficient in front of population increase sustains
that theory.)
o Investments (The positive coefficient of Investments verifies the assumption that new investments
will result in higher GDP growth one year later. There is strong evidence that the channel through
which debt affects growth is investment and by reducing the investment flow there is a direct
negative effect over growth; causing less efficient investments since investors tend to assign
resources to short-term projects.)
o Openness to trade (The openness’ coefficient has a negative sign which can be explained by two
main theories. The first one suggests that long term economic openness might cause productivity
reduction. The reason is that no additional investments are made (seen as a flat rate over most of
the countries) and innovations turn to be usual inputs. Alternatively we could imply that
 governments might try to protect the domestic production in cases of high openness, thus harming
the GDP growth.)
o Debt-to-GDP ratio (The debt-to-GDP ratio is the ratio of a country's public debt to its gross
domestic product (GDP). Often expressed as a percentage, this ratio can also be interpreted as
the number of years needed to pay back debt if GDP is dedicated entirely to debt repayment.)s

To sum up we strongly support the theory that external debt can be beneficial for a country but only up to
certain levels. After those levels additional debt results in negative contribution on economic growth. There
we can imply that the relationship between external debt and growth is not linear and that reasonable levels
of debt actually contribute to the economic growth of a country while excessive levels turn out to be
destructive. This means that too much debt would lead to zero or even negative economic growth.