Impact of Debt Servicing on Economic Growth

Abstract

The external debt has become a key problem for Pakistan. Pakistan has huge debt to pay, which also entails interest payment on the loan borrowed. It adds burden to the economy of Pakistan. Government through different means try to pay these loans. In this paper we have analyzed the impact of debt servicing on economic growth, i.e. whether debt servicing positively or negatively affect the economic growth. The data collected for this purpose ranges from 1982 to 2008. We have use regression test and find out that debt servicing is positively effecting the growth of Pakistan.

Key Words: Debt Servicing, Economic Growth, GDP, Human Capital, Labor Force

Introduction

Many researchers have focused on the relationship between external debt and growth, and what is the impact of external debt on economy. It also persists to attract considerable interest from economists and policymakers. A large amount of research has been carried out on this topic and substantial literature is also available, but few have conducted research on the impact of debt servicing on economic growth. The conditions and the interest rates on which the loan is provided can vary from donor to donor.

Weak economies due to low revenue generation cannot meet their expenses and have to gain loan from international financial institutions or have to issue Treasury bills. Once they obtain loan they utilize it in the development projects and generate revenue, however on maturity, Government does not have to repay only the principal amount of loan but also have to pay amount of interest on it. International Financial Institutions like World Bank, International Monetary Fund, Asian Development Bank are the leading donor agencies. They give loan on hard and soft conditions depending upon the credit rating of the country.

The discussion is going on for a passage of time, whether debt acquired by the loaner country, helps it in boosting the economic growth or the conditions implied by the donor lowers the economic growth. The higher debt service payments can also have negative effects on the composition of public spending by minimizing the amount of resources available for infrastructure and human capital, which have negative effects on growth. If external debt service is minimized it could increase growth through public investment. (Clemets et al, 2003).

(Cholifihani, 2008) discuss the relationship between Public debt service and GDP. He used a production function model which measured GDP as a function of debt service, capital stock, labor and human capital in which all data are represented by constant local currency unit. He comes up with the result that Indonesia faces a debt overhang problem in the long run since increasing the public external debt service slows economic growth.

The objective of this research paper is to determine the impact of debt servicing on the economic growth of Pakistan; which needs to be reviewed as these dimensions are not studied before especially in the context of Pakistan. Research study will be carried on the basis of data available of the debt servicing and economic growth.

Literature Review

Developing countries face the problem of debt-servicing on the economic growth which creates extra burden on the economies. For countries who do not want to print money and have lo generation of tax revenue will opt for borrowing money. Like many other LDCs, Pakistan being one of developing country has accumulated large debt burden and continuously made debt-servicing payments to the lenders which ultimately affects the fiscal position of the country. Debt Borrowing have to speed up the economic growth particularly when domestic financial resources are not enough to meet and need the extra funds. Theory of Economic also states that reasonable levels of loan accelerate economy and beyond a certain level it affects the economy negatively.

The key factor is that countries in early years of development have low levels of capital stock and also the investment chances are lower. Many researchers have often argued that borrowing countries if invest the funds into productive development programs, they certainly would enjoy Macroeconomic stability. This results in lowering the debt obligations and increase in the economic growth. (Blavy, 2006) conduct a research over Jamaica, in which he emphasis on channeling the debt into productive investment. He also states that high level of debt is directly related to low level of growth.

(Krugman 1988) define debt overhang a situation in which the expected repayment on external debt falls short of contractual value of debt. If a country’s debt level is anticipated to increase the country’s repayment ability with some probability in the future, expected debt service is likely to be a boosting function of the country’s output level. Investment from domestic and foreign investors is depressed which results in slowing of the economic growth. In other words, Krugman hypothesis states that debt overhang is partly due to the burden of foreign debt and that investment will be slow resulting in poor growth performance.

The most widely used indicator to express debt is percentage of GNP or debt servicing as a percentage of exports and fiscal deficit for both external and internal (S.P Gupta, 1994). Rising debt limits the ability of a country to finance vital imports and to initiate new development projects. Paper focuses on some countries because of their low per capita income dependence heavily on few primary commodities for export earnings. Most of the projects were designed to improve domestic industry rather than increasing exports directly, concept was that national economies would grow over time and also the export production, and reasonable trends in export prices would allow the debt service obligations (Joshua Greene, 1989).

.Most of the low income countries that face the problem of budget deficit have weak domestic structure. They get loan through International Financial Institutions like World Bank, International Monetary Fund and Asian Development Bank and through developed countries. IMF providing the debt on certain conditions also asks them to export primary commodities. Due to the excess supply of primary commodities, prices gets low and revenue generated is low, which can cause problems like debt overhang for the debtor’s nation (Michael, 1998). (William Easterly 2002) states the reasons of poor countries becoming heavily indebted poor countries. He states that Governments who does not change discount rates have to obtain more loans to get debt relief for long term. The major issue faced by the countries while paying debt is the increasing inflation and low growth. Repayment of external debt has shown to entail a tradeoff between growth and inflation (Beatriz et al, 1994).

Credibility of the country is also a key factor in obtaining the loan on soft conditions and low interest rates. Countries with the less creditworthiness had to pay large spread on external debt and also have to face harsh conditions for obtaining loans. The increase in debt will add to the country loss of credibility (Gupta, 1994). The credit rationing effect arises, when debtors are not able to repay the debts. Countries increase their interest rates to enhance savings which lead to shorten the saving investment gap, which negatively affect investment and hurts economic growth. (Wijeweera et al, 2005).

Like every country Pakistan also took measures to limit the inflationary pressure and to protect the competitiveness of its exports. In fact there is a time frame to work their way through economy, growth can be effected if the effectiveness is not done on time (Afxentiou and Serletis, 1996). Ogunmuyiwa, 2011 carry out a research in Nigeria, in which he measures the relationship between external debt and growth. He comes up with the result that causation between debt and growth in Nigeria is weak and insignificant, and changes in GDP cannot be forecast with changes in external debt

Methodology

The equation has been adopted by the Indonesian paper, in this equation we will be taking GDP as a function of Human Capital, labor force and Capital stock.

Y=A+B1x1+B2x2+B3x3

Y (GDP) = α + B1 (Human Capital) +B2 (Capital Stock) + B3 (Labor Force) + €

At first, we will be checking the relation of the variables to the GDP. How much they are explaining and are affecting GDP. In Second equation, we will be checking the relationship between GDP and external debt servicing. Equation is;

Y=A+B1x1

Y (GDP) = α + B1 (External Debt Servicing) + €

For this study, we have covered a period of 1982 to 2008. The data has been collected from World Bank Catalog. The variables used in this study are GDP, Capital stock, labor force, human capital and debt servicing.

Data sources are taken from key indicators of Asian Development Bank, World Development Indicators published by the World Bank. Almost all monetary units of variables are in US dollars, while labor is expressed by number of people. Gross Domestic Product (GDP) is a dependent variable, whereas, capital stock, labor force, human capital are determinant factors of GDP (Cholifihani, 2008). Variable of income is represented by real GDP at 2000 constant prices as GDP better reflects the independent productive capacity of the country (Cordella, 2005). Capital stock is represented by real fixed capital stock. GDP and fix capital stock are taken from World Development Indicators (WDI) published by the World Bank. Labor force is defined as employed people. Total people working i.e. employed labor force in jobs are collected from key indicators published by Asian Development Bank (ADB). Human capital in this case is represented by education expenditure per year. Human capital is important as it enhances the economy since this variable includes general skills and ability of labor to do a job. External debt service is defined as Total the sum of principal repayments and interest actually paid in foreign currency, goods, or services on long-term debt, interest paid on short-term debt and repayments (repurchases and charges) to the IMF (World Bank Catalog).

Results

Model Interpretation

Significance

R Square

Standardized Co-efficient

BETA

Significance

.000

.98

.163

Human Capital

.104

Human Capital

-.193

Capital Stock

.038

Capital Stock

1.014

Labor Force

.000

Labor Force

In first equation we want to check the effect of all variables on GDP. -47090.6 is a fixed value which will come in each scenario. The coefficient of Human Capital is .163, means that increase in human capital will lead to increase in GDP. In other words it can be said that one unit change in human capital, GDP would also be increased by .163 units. The result is 0.104 which means it is less significant. The coefficient of capital stock is -.193, that if there is an increase in capital stock then GDP would be decreased. In other words we can say that Capital stock does not play a significantly role. The result is 0.00 which means it is negatively significant. The coefficient of labor force is 1.014, meaning if there is increase in labor force then GDP will be increased. The result is 0.00 which means it is positively significant.

The R Square tells us about the model fitness. In our case the model is fit i.e. 98.08 %, hence we can conclude that all variables used in this model explain it by 98.08 % and around 2% is not explained by these variables. We can conclude that the other variables which explain the equation are external and are not included.

Model Interpretation

Significance

R Square

Standardized Co-efficient

BETA

Significance

.000

.45

.675

Debt Servicing

.000

Debt Servicing

In the second equation, we have investigated the relationship between external debt servicing and GDP. The R square is 0.455, which means that only 45% is explained by this variable and rest of 55% was explained by external factors. The coefficient of debt servicing is .675 that if there is an increase in debt servicing then GDP would also increase. The result is 0.00 which means it is significant.

Limitations

The limitation of this study is that data of debt servicing includes only represents external debt servicing and the internal debt servicing was not included due to non availability of data. The result could have given a exact picture of the impact of debt servicing on economic growth if both internal and external debt service would have been added. In start we try to collect data from 1970 to 2008, but data was available from 1982 to 2008.

Conclusion

The main focus of this study was to analyze the effects of debt servicing on economic growth.

Within limited indicators we find out that debt servicing has positively affected the economic growth of Pakistan. Theoretically it is not possible because a big amount form received borrowings is used for debt return and its interest and it should negatively affect the economy But in case of Pakistan the amount of debt circulating in the economy is high. Estimated about 70% of the economy of Pakistan consists of debt. With the passage of time, the debt should have reduced but it has increased. It can be said that the debt should be invested in productive areas rather than wasted on less productive projects.