External debt and growth: An econometric study

1. External debt and growth: An econometric study Marianna KoliIDPM, University of Manchester ESDS International Conference London, 3 December, 2007

2. Research objectives • To assess the significance of debt as a determinant of growth • To test the debt overhang hypothesis • To find the critical debt ratios where the impact of debt on growth becomes negative

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

4. Debt overhang hypothesis GDP per capita growth Growth-maximising debt level Debt/GDP

5. 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

6. 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

7. 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?

8. 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

9. 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

10. Methodology • Regression with fixed effects • chosen through logical method and OLS/FE/RE diagnostic statistics comparison • Robustness tested through country groups

11. 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

12. 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

13. Results: Cubic Laffer curve Lagged variables Non-lagged variables GDP per capita growth Debt/GDP Growth-maximising debt level

14. 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)

15. 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

16. 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

17. 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

18. Critical debt ratios(90% confidence interval)

19. 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

20. 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?

21. 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

22. 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%)

23. Conclusions • Crisis avoidance and growth objectives are equally important • “Infant institutions” argument is valid, particularly in SICs • Policies should be tailored to country circumstances • Model may be specific to conditions where debt is important