UNIVERSITY OF ECONOMICS
STUDIES
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL
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
STUDIES
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL

1.2. Economic Growth Theories and Models ............................................ 7
1.3. Theories and hypothesis on the relationship between external debt and
economic growth ............................................................................... 9
2. Empirical Literature Reviews ..................................................................... 14
Chapter 3: RESEARCH METHODOLOGY ......................................................... 20
1. Overview of external debt and economic growth in developing countrieS
..................................................................................................................... 20
2. Analytical Framework................................................................................. 23
3. The Econometric Model.............................................................................. 25
4. Data ............................................................................................................. 27
4.1.

Data Description .............................................................................. 27

4.2.

Summary table of variables and data source ................................... 27

5. Estimation Approach................................................................................... 29
Chapter 4: RESULTS ............................................................................................. 30
1. Descriptive Statistic Data ............................................................................ 30
2. Econometric Results ................................................................................... 31
3. Results Expression ...................................................................................... 33
3.1.

Linear equation: Yi,t = αXi,t + γDi,t + ui,t ...................................... 33

3.1.1. All coefficients are constant across time and individual ........... 33
3.1.2. Using Fixed-effects Technique .................................................. 34


2


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 2 .......... ………70
TABLE 7: TESTING FOR MULTICOLLINEARITY ......... …………………….......71
TABLE 8: TESTING FOR HETEROSKEDASTICITY ......... ……………………….72

3


Chapter 1 INTRODUCTION

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

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


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.
3.

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,

Next, chapter 3 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 4 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 5 gives a conclusion for what has been found and raises
some policy implications for what to do when determining the relationship as well
as the impact of external debt on economic growth.

4


Chapter 2

LITERATURE REVIEWS

1.

Theoretical reviews

1.1

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

borrowing country to finance its current and up-coming compulsory debt service
fully without restructuring or avoiding the accumulation of arrears but allowing a
reasonable level of economic growth. According to the World Bank and IMF report
"a country can be said to achieve external debt sustainability if it can meet its
current and future external debt service obligations in full, without recourse to debt
rescheduling or the accumulation of arrears and without compromising growth”.
Then, analyzing the external debt sustainability under the circumstances of viewing
the behavior of economics variables and other determinants can shed a light on the
condition in which the level of debt and other indicators can be kept at a stable state
and determine the reasonable adjustments as well as the scale for making the
policies.
There are various indicators for the sustainability of external debt but
typically, external debt to GDP ratio, external debt to exports ratio, government debt
to current fiscal revenue ratio…and their respective service ratio are the most
generally applied ones. In this study, the ratio of external debt on export and total
debt service as the main indicator for debt variable.
Finally, the more detailed issues which are related to the structure, the
classification and the general indicators of external debt can be discussed and found
in the Appendix. Having a glance through these parts is also important because it
can help to approach the external debt more comprehensively and understand the
problem more easily as well as deeply.

6


1.2

Economic Growth Theories and Models
First of all, the theory of growth should be taken into account and some


The Solow diagram can be drawn using the two key equations of the Solow
model in terms of output per worker and capital per worker. These equations are:
Y= kα and
ḱ = sy – (n+d) k
The respective steady state quantity of capital per worker and steady state
quantity of output per worker can be demonstrated by:
k* = (s/n+d) 1/(1-a)
y* = (s/n+d)a/(1-a)
Where: k* = steady state quantity of capital per worker
y* = steady state quantity of output per worker
Looking the diagram of production function, the relationship between the
economic growth and its determinants including the investment rate, population
growth rate and technology can be demonstrated fully. Specifically, if an increase in
investment rate in an economy with its steady value happens, the sy curve will shift
upward to s´y, which also makes the production function shift upward and result in
an economic growth as well as a higher steady value capital per worker. Otherwise,
if population growth rate increases, the (n+d)k curve shifts upward to (n’+d)k. And
this will make a loss in steady state capital stock per worker value.

8


Finally, this model also figures out a significant points that a sustainable
economic growth will be only ensured when being accompanied by a progress in
technology which occurs when there is an increase in “A” which is a new
coefficient called “labor augmenting” or “Harrod –neutral” labeled by Solow in the
respective function: Y = F (K, AL) =A.Kα.Lα. And the progress in technology will
be only achieved if there are the sufficient sources of capital input and the
productivity of a labor unit. All will lead to the undeniable correlation between
economic growth and the accumulation of capital as an important input factor of

general core point in those views can be drawn to the fact that economic growth
would be explained and booted by the accumulation of capital. Typically, the
Harrod-Domar model (1946) which was used widely in development economics put
an effort to show the direct linkage between economic growth and capital
accumulation and indicated that if the debt can supply the capital accumulation, the
economic growth will be targeted. This model was developed initially by Sir Roy
Harrod in 1939 and then, Evsey Domar continued developing it in 1946 to find the
explanation for economic growth rate in terms of the level of saving and
productivity of capital. The Harrod–Domar model had the implications for the root
of generating the economic growth which can be explained through the quantity of
labor and capital input. The more capital stock is accumulated, the more easily the
economic growth target can be achieved. The main function Y=f(K) implies the
capital is necessary for output. This is the key issue to the developing countries
where the labor is abundant but the physical capital stock is always in condition of
shortage, so the economic growth has been slowed down.
Dealing with this question, many developing countries have approached the
external debt with the motivation of making the positive impact to finance the
national economic growth for a long time. These external debts can definitely help
to generate the economic growth of that country in turn if they do not exceed the
acceptable limit to become a debt burden. According to the model of Growth, it can
not be denied that the external debt can definitely help the countries, especially the
developing ones, to fill the gap of capital shortage for growth as long as the external
debt is controlled at a reasonable point.
Consequently, a positive relationship between external debt and economic
growth can be achieved at some level since the critical function of external debt is
to supply the adequate source of capital for the domestic demand in wide range of

10



It can be easy to recognize the risk with harmful effect when a large accumulation
of physical capital coming from the external sources exceeds the ability of one

11


county to repay both its past and current debt. In turn, the investment activities have
to bear many losses when potential lenders and investors will be steered away due
to the uncertainties and instabilities of repayment. Even if not in the present time
but in the probability of future, can the estimated level of debt unserviceable also
impose the similar negative impact on the economic performance through the level
of output. Then, the returns from the domestic investments are "taxed away" by
existing foreign creditors to service the debt and this will discourage the incentives
to invest in both domestic and foreign sectors and affect negatively on economic
growth, according to Claessens et al(1996).
The impact of debt overhang to illustrate for the relationship between
external debt and economic performance can be tracked through the “crowding out”
effects. It means that the increase in external debt service will strike down the level
of investment in turn. The main measures of external indebtedness are the indicators
over GDP and exports, so “crowding out effect” emphasizes the negative impact of
the fact that the income from export has to be taken away to repay the external debt.
As a result of this, the lack of capital for stimulating the investment activities to
escort the economic growth is inevitable. According to Hansen (2004), the debt
payment service can become the severe restriction to economic growth by such that
crowding out effect.
Then Cohen (1993) found the empirical evidence to oppose the “debt
overhang” hypothesis and support the “crowding out” effect. Besides, when a
county is in the debt overhang condition, the government can take some actions
which may depress the investors like the distortionary measures including the fiscal
and restructural reforms to finance the debt –service obligations. These changes in

in debt stock can be accompanied with an increase in repayment capability but after
reaching a critical point called peak, any increases in debt stock means a decrease in
expected repayment. However, it is not easy to figure out that critical point and it
can be different depending on each countries. Any countries on the right side of that
point have to bear the condition “debt overhang” with negative impacts on the
economic growth rate.

13


2.

Empirical Literature Reviews
Besides a number of theoretical literature on this issue, many empirical

studies has been done to find out the relationship between external debt and
economic growth. There are various existing results but they can be divided into
three groups. The first group belongs to the empirical evidence that has supported
the positive effect of external debt on economic growth at the certain level. The
second group relates to those which have indicated the negative relationship of high
level of external debt with economic growth; then the third one combines two above
effects to argue that there is a nonlinear relationship between external debt and
economic growth by nature. Besides, there are some empirical studies have found
no relationship between external debt and growth.
Firstly, a few studies have found the positive relationship between the
external and economic growth at the certain level. Chowdhury (1994) attempted to
shed a light in the debate of determining the causes and relationship between
external debt and economic growth, by conducting granger causality tests for
Asian and Pacific Countries over a period of 1970-88. With the dependent
variable is GDP, a set of independent variables including debt payment (negative),

Besides, Sachs (1984, 1988), Cohen and Sachs (1986), and Krugman (1988),
Adepoju et al. (2007) studied that relationship in the context of debt crisis in 1980s
and employed the debt overhang theory models to find out the negative impact of
external debt on economic growth rate. For the case of Nigeria over a period of
1962 to 2006, by using the simultaneous model with time series data, Adepoju
(2007) jumped to the conclusion that the accumulation of external debt really held
the economic growth back for times in Nigeria. Another case in Pakistan, Hameed
et al.(2008) investigated the dynamic effect of external debt servicing, capital stock
and labor force on the economic growth for a period of 1970-2003 and found an
adverse relationship of external debt and economic growth through the channel of
capital productivity and labor productivity. Maureen Were (2001) used dependent
variable of GDP growth rate and a set of independent variables including inflation
(negative), lagged inflation (positive), real public investment as a ratio of GDP
(positive), private investment (positive), fiscal deficit/GDP (negative), Human
Capital Development (positive), Debt/GDP(negative), Debt Service to export

15


(positive) with time series data of Keyna. A negative relationship between external
debt and economic growth was found as final result.
Then, the panel data of 14 Pacific Island Countries from 1988–2004 was
analyzed by T.K. Jayaraman, Evan Lau (2008) to do tests for finding a linkage
between external debt and economic growth rate. Real GDP was set as dependent
variable with a set of independent variables as follows: External Debt (negative),
Exports (positive), Budget Deficit (negative). And one of the most popular
empirical study, "What Are the Channels Through Which External Debt Affects
Growth?", Pattillo(2004) used the data of a group of 61 developing countries in the
period of 1969–98 to build a growth-accounting framework and found that the
average level of external debt slow down the economic growth by holding back the

growth. Therefore, unlike a low and reasonable limit, a high external debt is likely
to have the definite negative impact on the economic growth. Or in the other ways,
there is a threshold of level debt at which the external debt can impose the two
opposite effects on the economic performance of one country. This implies that a
relationship between external debt and economic growth also has an inverted U
shape with a critical point called the threshold beyond which the initial positive
impact of external debt on economic growth will turn out the negative one
completely. That is beginning from zero up to the thresh hold, any increases in
external debt or its net present value can make the expected repayment reliable, then
increase its contribution to economic growth through accumulating the physical
capital. However, after reaching the threshold, any further increases in external debt
only results in the risk of debt unserviceableness. In other words, the negative
effects of debt overhang theory occur only after a certain threshold level has been
reached. The debt threshold curve can be inspired by the shape of Debt Laffer
Curve like this:

17


Contribution of external
debt to economic growth
rate

Net Present Value
(NPV) of external
debt to export

Figure 1.3. Debt Threshold Curve
Source: Patillo et al. (2004)
Looking at the debt threshold curve, A is determined as debt threshold and

19


Chapter 3 RESEARCH METHODOLOGY
1.

Overview of external debt and economic growth in developing countries
Before entering the methodology of research, some main points about

condition of external debt and economic growth in developing countries are going
to be briefly scanned through. An overview picture can be summarized in the
following table to make clear of the current situation of external debt
Table 3.1: External debt and GDP in main areas of developing countries
Unit: Billion USD

Area
Pacific and
East Asian
countries
European and
Middle Asian
countries

External
debt

GDP

Debt / GDP


countries
Middle, East
and North
African
countries

825

3.444

0,25

750

110.07

136.

828.

0,17

297

45.83

South Asian
countries

304.