Relationship between external debt and economic growth in selected developing countries

INSTITUTE OF SOCIAL UNIVERSITY OF ECONOMICS STUDIES HO CHI MINH CITY VIETNAM 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 INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY VIETNAM 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 TABL Chapter 1: INTRODUCTION 1.Problems statement 2.Research objectives 3.Scope of study 4.Structure of thesis Chapter 2: LITERATURE REVIEWS 1.Theorectical reviews 1.1.Exter 1.2.Econo 1.3.Theor economic growth 2.Empirical Literature Reviews Chapter 3: RESEARCH METHODOLOGY 1.Overview of external debt and economic growth 2.Analytical Framework 3.The Econometric Model 4.Data 4.1 Data Description 4.2 Summary table of variables and data source 5.Estimation Approach Chapter 4: RESULTS 1.Descriptive Statistic Data 2.Econometric Results 3.Results Expression 3.1 Linear equation: Yi,t = αXi,t + γDi,t + ui,t 3.1.1 All coefficients are constant across time an 3.1.2 Using Fixed-effects Technique 3.1.3 Using Random-effects Technique 3.1.4 Choosing between Fixed –effects (FEM) a M 3.2 Q 3.3 T 3.4 A m 3.5 D Chapter 5: CONCLUSIONS 1.Conclusions 2.Policy Implications 3.Limitation of thesis REFERNCES APPENDIX 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 .………70 TABLE 7: TESTING FOR MULTICOLLINEARITY …………………… .71 TABLE 8: TESTING FOR HETEROSKEDASTICITY ……………………….72 Chapter INTRODUCTION 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 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 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 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 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 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 Structure of thesis This thesis will consist of chapters and each chapter will cover the following content Chapter gives the general introduction about the research topic 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 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 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 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 gives a conclusion for what has been found and raises some policy implications for what to when determining the relationship as well as the impact of external debt on economic growth Chapter 1.1 LITERATURE REVIEWS Theoretical reviews 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 because it relates not only to the economic situation, but also the ability to pay debts related to attract financial resources from outside to serve the objectives of macro state The indicators of external debt are built into the system to determine the severity of the foreign debt to finance national security Also need to redefine the criteria to assess the overall external debt, namely assessment of the level of debt, thereby implicitly said repayment capacity of each country in medium and long term There are many indictors for external debt Generally speaking, the developing countries often appreciate the value of the domestic currency or use the multi-rate regime leading to reduce the severity of the debt Therefore, the debt situation cannot be underestimated and choosing the appropriate criteria to assess the level of external debt as well as the the repayment capacity of the country in the medium and long term is very important The criteria which is used popularly in many empirical research is the ratio between total external debt and total exports of goods and services This indicator can demonstrate the performing external debt including private debt, government debt underwritten by the exports of goods and services The idea of using this indicator is to reflect commodity export revenues and services means that a country can use to pay external debt This indicator in the East Asia Pacific showed decreasing ability to repay debts in export income is difficult, need to have other sources of income to offset with the following simple formula: Criteria = (Total external debt / Total export turn over in goods and services) Another indicator which cannot be apart from the above one is total external debt service This indicator is the sum of principal repayments and interest actually paid in currency, goods, or services on long-term debt, interest paid on short-term debt, and repayments (repurchases and charges) to the IMF (World bank definition in World Development Indicator) Both indicators can combine each other to give a full-sided look on external debt in the relationship with economic growth 59 DETAILED POLICIES ON EXTERNAL DEBT ISSUE Policies on improving the efficiency in using external debt 1.1 Tightening the management of external debt from gov External debt is rising rapidly in many developing countries mainly the weak debt management from the approriate authourities, especially the government Government has the most powerful tool to control the whole flow of external debt including the regulation, fiscal plan and other tools Strict control of external debt, especially short-term loans limit is very important to developing countries in the complicated context of globalization interogation nowadays It should be emphasized that one of the causes of the 1997 financial crisis mainly in Asian countries like Thailand, Indonesia, Singapore, Korean….as well as the global economic crisis in 2008 which has been confirmed by many developing countries is due to the lack of management from government and the other authorities To manage the external debt source better, government should control it on the principle of priority and identify the specific using objectives based on its necessity External debt with preferential source will be a better choice for developing countries than the one with high commercial interest rate Accordingly, commercial loans of Government should only use for the purpose of lending for key development programs or projects with utmost needs Besides, the using of ODA is also considered more carefully and tightly in order to avoid the excessive low interest debt which can easily leads to debt crisis in public sector and leave the heavy debt burden on nest generation of one country In particular, the developing countries including Vietnam should resolutely refuse ODA loans if the project is estimated ineffective or inefficient because of many binding factors and clauses Furthermore, Government should build a sound regulation system for managing sector debt, including loans and repayment of foreign and domestic from the provincial government, central cities, or public enterprises Building the Government’s Decree on Government bonds issued to international capital markets 60 can help to control the condition Then, planning the medium-temporary program and warning system for debt risk in form of montly or quarterly reports to provide the most adequate information of debt condition to all the participant objects in debt cycle In addition to management, the inspection for the use of external debt loans should also be enhanced Each country’s Government should conduct an audit requirements mandatory for all projects implemented by borrowing funds to ensure that the external debt will be used for the right purpose with the highest effectiveness Depending on a specific types of external debt, the further details can be discussed as follows: 1.1.1 Loans from official development assistance (ODA) Making use of ODA must be in accordance with the investment demand for development and absorptive capacity of the economy in general and of each sector, in particular localities ODA should be a priority focus on investment in industries and specific areas to suit the requirement for each development period For the construction project infrastructure unconditional withdrawal of funds directly, the use of which should be based on economic efficiency for the society Setting the orientation for using ODA is of great important to increase the efficiency and limit the loss as well as the potential risk for debt crisis To attract ODA for development goal at a reasonable level requires the good correspondences between the capital usage and distribution 1.1.2 Loans from foreign government – Public external debt This external debt which comes from Governments should only be applied in the exceptional or urgent cases and when they cannot immediately mobilized an amount of capital from other sources effectively Government should prepare the necessary conditions and issue government bonds abroad to gradually penetrate the international financial markets and raise additional capital for investment and development Researching and applying the management solutions suitable as restructuring debt, convertible debt, buy back debt, debt swap, in order to ensure 61 reasonable structure and reduce debt obligations from the external debt of the Government 1.1.3 External debt from the enterprise – Commercial external debt This external debt has a competitive interest rate on the financial market Thus, a close monitoring of using the debt and servicing it from the corporate sector, especially state enterprise loans short term loans is a necessary step to ensure a good dent management Instead of borrowing the capital from foreign source, promotion for domestic capital rise such as indirect issuing the shares or bonds from corporate enterprises to sell for foreign investors with target of gaining the additional capital investment As a result, the external debt reduces in total while the domestic capital can be ensured at the same time Building the stategy for borrowing and repaying external debt Each country should plan a strategy for dealing with external debt problem including the borrowing and repaying scheme This strategy will play a role as an orientation tool to adjust the economic deviation to help one country to achieve its goal for economic development Understanding that both external debt to export turn over and total debt service are negative correlated with GDP growth of one country, the importance of planning a strategy for borrowing and repaying debt is more emphasized A typical strategy for external debt and debt service should focus on main points including the requirement on management and repayment of external debt; then the legal framework and institutional management of external debt; and the collection, aggregation, reports, shares, published information as well as training on the management of external debt Government should exploit its active central role in defining each specific job; assigning the Ministries and Agencies such as the Ministry of Planning and Investment, Ministry of Finance…to serve the process of building a strategic plan 62 Policies on downsizing external debt and the others One of the best ways to deal with the external debt is to stop borrowing the capital from foreign sources However this solution is hard to carry out because all developing countries are always in the regular shortage of capital Thus, the loan to invest in developing and small parts to consumers is inevitable in poor countries is growing as our country, but it is important to restrict the lending for the capability of repayment (the principal and interest) by maturity and avoidance of debt burden as well as dent crisis Therefore, these countries can reduce the level of debt and apply the innovation as well as the improvement of policies and mechanisms to manage the external debt on the basis of complete construction process and appraise projects using foreign loans The relevant Ministries in the process of issuing documents and policies related to external debt issues should ensure consistency with the principles of the current legislation on the management of foreign borrowing and repayment Then, organizing the structure of external debt in the ministries, branches and localities, including clearly defining the functions, tasks, powers and strengthen coordination mechanisms in research for development, strategic planning and executive management policies of external debt Firstly, to strengthen debt management apparatus in the integrated management, the agencies such as the Ministry of Finance, Ministry of Planning and Investment and the State Bank of one developing country, should have analyzed and prepared a planned scheme for the approriate level of loan soon Secondly, training and re-training to enhance the professional qualifications of the staff on external debt management need the cooperation from both state management and personnel management to meet the immediate needs and long term goal Besides, organizing the information networks on external debt smoothly from central to local units are very important Another policy on dealing with external debt is to try to develop internal capital resources instead of loans The capital mobilization of all economic sectors in the country can be mde used of to maximize the potential of total investment implementation efficiently without getting stuck in the unnecessary external debt 63 Besides, to developing countries, export oreientaion is one of the most important policies which should be implemented quickly due to the direct relationship with external debt’s repayment capability This policy can be carried out by accelerating the export and importing only essential equipment, materials, fuel and supplies to ensure that domestic production cannot be produced or produced ineffectively (using comparative advantage), then limiting the imports of consuming goods to narrow the gap between export and import Then, in the future, the indicators for evaluating debt as the ratio of external debt to export can be downsized and have a better value In addition to, the politic stability should also be taken into account to create a favourable environment for policy implementation Anti-corruption is also a point to get not only in the project, the work that foreign loans from other sources If there is the corruption, the favourable external debt source which are necessary for the development like ODA will be limited or even if the ODA is received, its disbursement will be in trouble or get the hiatus Finally, promoting the foreign direct investment (FDI) instead of getting the foreign loans like ODA is not only long-term orientation in the developing countries, but also developed countries as well nowadays To this policy, developing countries should prepare the supporting documents from the Law, to the Decree, to create an attractive market for FDI, such as the Law on Investment effected from 1/7/ 2006 in Vietnam 64 TABLE 1: OLS RESULT regress loggdp logexternaldebt realgdp investment inflation schooling openess expenditure savings totaldebtservice populationgr > owth Source Model Residual Total loggdp logexterna~t realgdp investment inflation schooling openess expenditure savings totaldebts~e population~h _cons 65 TABLE 2: OLS RESULT W regress loggdp logexternaldebt > wth dummy_brazil dummy_mexico Source Model Residual Total 66 TABLE 3: FIXED-EFFECTS MODEL RESULT xtreg loggdp logexternaldebt realgdp investment inflation schooling openess expenditure savings totaldebtservice populationgrowth > , fe Fixed-effects (within) regression Group variable: country R-sq: within between = 0.2951 overall F(10,103) corr(u_i, Xb) logexterna~t totaldebts~e population~h sigma_u sigma_e F test that all u_i=0: 67 TAB loggdp logexternaldebt realgdp xtreg > wth , re Random-effects GLS regression Group variable: country R-sq: within Random effects u_i ~ Gaussian = corr(u_i, X) loggdp logexterna~t realgdp investment inflation schooling openess expenditure savings totaldebts~e population~h _cons sigma_u sigma_e 18278728 rho 68 b = consistent under Ho and Ha; obtained from xtreg B = inconsistent under Ha, efficient under Ho; obtained from xtreg Test: Ho: difference in coefficients not systematic chi2(10) = (b-B)'[(V_b-V_B)^(-1)](b-B) = 2875.82 Prob>chi2 = 0.0000 69 TABLE 6: FIXED-EFFECTS MODEL RESULT FOR EQUATION xtreg loggdp externaldebttoexport totaldebtservice investment inflation schooling populationgrowth openess expenditure savings E > xternalDebt_Squared , fe Fixed-effects (within) regression Group variable: country R-sq: within between = 0.0005 overall F(10,102) corr(u_i, Xb) externalde~t totaldebts~e population~h ExternalDe~d sigma_u sigma_e F test that all u_i=0: 70 TEST TABLE 7: TESTING FOR MULTICOLLINEARITY cor loggdp logexternaldebt realgdp investment inflation schooling openess expenditure savings totaldebtservice populationgrowth (obs=119) loggdp logext~t realgdp invest~t inflat~n school~g openess expend~e savings totald~e popula~h loggdp logexterna~t realgdp investment inflation schooling openess expenditure savings totaldebts~e population~h vif Variable schooling openess logexterna~t expenditure population~h realgdp investment totaldebts~e savings inflation Mean VIF Mean VIF = 2.6 No multicollinearity exists 71 TABLE 8: TESTING FOR HETEROSKEDASTICITY Fixed-effects (within) regression Group variable: country R-sq: within between overall corr(u_i, Xb) logexterna~t totaldebts~e population~h F test that all xttest3 Modified Wald test for groupwise heteroskedasticity in fixed effect regression model H0: sigma(i)^2 chi2 (6) Prob>chi2 Prob>chi2 = 0.00122 => There is no heteroskedascity Therefore the data is fit and the model is correct 72 ... not find any empirical relationship between external and debt servicing on economic growth as well 19 Chapter RESEARCH METHODOLOGY Overview of external debt and economic growth in developing countries. .. relationship between external debt and economic growth needs considering and put into the right place Next, the external debt issue can also be found in developing countries of Latin-America Debt crisis... 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