UNITED NA TI ONS
1 1
NA TI ONS UNIES
INSTITUT AFRICAIN DE DEVELOPPEI\1ENT ECONOMIQUE ET DE PLANIFICATION AFRICAN INSTITUTE FOR ECONOMIC DEVELOPI\1ENT AND PLANNING .
(IDEP)
EXAMINING THE IMPACT OF EXTERNAL DEBT ON . ECONOMIC GROWTH IN THE COMESA REGION (1990-2004)
By
Esther NAKA YIMA
Submitted in partial fulfilment of the requirements for the award of Master of Arts degree in Economie Policy and Management of the United Nations African Institute
for Economie Development and Planning (IDEP)
Supervisor: Professor Aloysius A. Amin
April2008
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UNITED NATIONS
AFRICAIN INSTITUTE
FOR ECONOMIC DEVELOPMENT AND PLANNING
IDEP
This is to certify that
Esther NAKA YI MA
Identification No 070711
has successfully defended the M.A. thesis entitled
EXAMINING THE IMPACT OF EXTERNAL DEBT ON ECONOMIC GROWTH IN COMESA REGION
(1990- 2004)
Approved by the Thesis Committee: /
Medou DIAKHATE ...
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· Externaf
:,;;;;i·~er
~
Dipo BUSARI. ...
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............ .Member 1
Prof. Aloysius A. AMIN ..
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-"~--rs~·~~~·i~·~r ....... ..Aloysius A. AMIN ... ..
ep y Director/
Chief, Training Division
DEDICATION
This work is dedicated to the Bagwana Family, .for the ir prayers and support du ring my entire study period in Dakar Senegal. The Lord has blessed us once again.
ACKNOWLEDGEMENT
1 am very thankful to the almighty Lord for blessing me throughout the eighteen months study at IDEP.
1 am also grateful to UNIDEP for awarding me a scholarship to pursue this master degree programme. My heartfelt thanks go out to the Director, Dr. Diery Seck and the entire IDEP staff for their encouragement and understanding. My sincere appreciation to the Ministry of Education and Sports Uganda for giving me the opportunity to apply for the scholarship and for 'the ir logistical support.
1 am greatly indebted to Professer Aloysius Ajab Amin, Deputy Director and Head of Training Division for supervising this work and for his significant comments and guidance.
My sincere thanks to Dr. Dipo Busari the M.A coordinator and the entire training division for their support during my training at IDEP. The interpretation section, Library and information technology staff you did a commendable job thank you so much. My sincere thanks to ali the professors who provided quality training during the M.A programme your contribution is highly appreciated.
To Dr. Bagwana and family especially Dad and Mum, who made me believe 1 would accomplish my dream amidst ali the tribulations. The sacrifices you made during my stay in Dakar have been rewarded. Eng. Aaron Kabirizi and Mrs. Kabirizi for your persistent encouragement to take up the challenge and financial support may the almighty continue to bless in ali your endeavors. To Albert Byaruhanga thanks for your prayers, care, encouragement and patience.
To the "centenaire ladies" Martha, Susan,. ireen and Jackie thanks for your hospitality and for coming into my life. To my colleagues Angela, Evans, Sheriff, Kossi, Amadou, Layty, Karim, Conde, Sàdio, Motamra , Diop and Kwesi thank you ali for your support.
My sincere thanks go to lreen Musonda who tirelessly commented and edited this work. Lastly thanks to you ali that played a part in this achievement. May the Almighty Bless you ali.
ABSTRACT
The Common Market for East and Southern Africa (COMESA) as one of the regional blocs_ is still plagued with heavy external debt burden. This study seeks to investigate the impact of external debt on Economie growth in 15 selected countries belonging to the Common Market for East and Southern Africa (COMESA) using the pooled least squares method of estimation and Arellano -Bond. The madel is based on the aggregate production function and a madel by Pattillo et al (2002). The results suggest that external debt impedes economie growth. This is illustrated by the negative coefficient and significance of the external debt to exports which is used to capture debt overhang. The results are in conformity with those of Pattillo et al (2002). The study will contribute in giving policy direction particularly in the bid to bring debt ratios in the COMESA region to sustainable levels.
RESUME
Le marché commun de l'Afrique de l'Est et de l'Afrique Australe (COMESA), en tant qu'un des blocs régionaux, est toujours dominé par le lourd fardeau de la dette extésieure. Cette étude cherche à analyser l'impact de la dette extérieure sur la croissance économique dans 15 pays choisis du marché Commun de l'Afrique de l'Est et de l'Afrique Australe (COMESA) en utilisant la méthode des estimations des moindres carrés combinés. Le modèle est basé sur la fonction de production agrégée et un modèle de Patti llo et al (2002). Les résultats empiriques montrent que la dette extérieure entrave la croissance économique. Cela est illustré par les coefficients négatifs et significatifs de la dette extérieure et des exportations utilisés pour capter le fardeau de la dette. Les résultats sont cohérents avec ceux de Pattillo et al (2002). L'étude contribue à donner des orientations politiques particulièrement dans le but d'amener les niveaux de la dette du COMESA à des niveaux soutenables.
EXECUTIVE SUMMARY
ln the past three decades, developing countries especially African countries have borrowed large amounts from a board hoping that that these loans wou Id put them on a faster development path through increased investment and faster growth. But as debt ratios reached very high levels in the 1980s, it was realized that for many of these countries, repayment would not only hamper economie performance but it also was practically impossible. Ever since, the issye of external debt and debt servicing has assumed critical importance which has resulted in what is referred to as the 'debt crisis' debate.
About 34 out of 42 countries in Sub-Saharan Africa are classified as Heavily lndebted Poor Countries by the World Bank. The debt burden has resulted into these economies to divert resources from social sectors such as health and education, to debt servicing. By the year 2001 the total debt for sub-Saharan African countries was US $209 billion. ln that same year, the sub-continent borrowed US
$11.4 billion wh ile debt service amounted toUS $14.5 billion of which US $9.8 billion as principal repayment and US $4.7 billion as interest. As a result, the region recorded a negative 'net transfer' (new borrowing minus debt service) of US -$3.1 billion. This continued a trend of negative net transfers in the previous decade ln Sub-Saharan Africa (SSA) as a whole, debt service amounted to 3.8 percent of Gross Domestic Product (GDP) in 2000. By comparison, SSA countries spent 2.4 percent of GDP on health (Boyce and Ndikumana 2002).
The Common Market for East and Southern Africa (COMESA) as one of the regional blocs is still plagued with heavy external debt burden. The debt crisis, compounded by massive poverty and structural weaknesses of most of the member countries economies has made the attainment of rapid and sustainable growth and development difficult. The external debt of COMESA member countries has increased twenty fold si nee 1970 and the debt ratios which in 1970 were insignificant averaged 45 percent of export earnings between 1989 and 1990 making the region one of the most heavily indebted in the world. According to the World Development lndicators (2000), COMESA as an economie body with a present value of debt-to- export ratio of 396%, is one of the world's heavily indebted regions.
The size of the debt relative to the size of the economies is extensive and debt servicing is using up the resources that could have been allocated to investment which will lead to increased growth. When the above is combined with the reality of high poverty levels in the region in which three quarters of the population live on less th an US 1$ per day , the desperate and damaging nature of the debt overhang becomes more evident. Given this gloom situation, a question that may arise is can a country meet bath its debt obligations and grow fast enough at the same time.
The objective of this study is to examine the impact of external debt on economie growth in the COMESA region in the period of 1990-2004. Based on the empirical findings the study will help in designing policies for COMESA member states, so as to bring the debt to sustainable levels. The findings of this study will add to the
knowledge and studies undertaken by researchers and development partners in this area, and hence serve as an input to policy making. The tact that most of the countries in the region are classified as heavily indebted (see annex 1) and literature suggests that external deb.t would have both positive and negative impact on economie growth warrants a study to examine the impact of external debt on economie growth in the COMESA region.
The Common Market for Eastern and Southern Africa (COMESA) came into existence in 1981 and was formerly known as the Preferential Trade Area (PTA).The region is comprised of the following countries: Burundi, Comores, Djibouti, Democratie Republic of Congo, Eritrea, Ethiopia, Egypt, Kenya, Libya, Mauritius, Malawi, Madagascar, Rwanda, Seychelles, Sudan, Swaziland, Uganda, Zambia and Zimbabwe. COMESA member countries have diverse structures with different levels of development with only two countries falling in the category of upper middle group wh ile the majority is in the low income group
The economie performance of the COMESA region has been rather disappointing over the last two to three decades, with overall economie growth of the COMESA region averaging 3.2 percent per · annum. The average GDP growth rate for COMESA between 1990 and 2004 was positive despite
a
sharp fall in 1994.The sharp fall in 1994 was attributed to the drought experienced in the region and civil wars in sorne of the member states particularly Rwanda and Burundi. Nonetheless there were strong signs of improvement when the growth rates went up to 4.91 percent in 1995.Since then the growth rates have been fluctuating yearly with 2004 recording a growth rate of 4.06 percent.COMESA as one of the sub-regions in Africa is faced with the problem of large debt burden. According to a 2005 classification of indebtedness by the World Bank, of the 19 CO MESA member States, 10 countries are severely indebted, 5 moderately indebted and only 3 economies are categorized as less indebted (WDI 2005). The COMESA region's total external debt stock in ·2001 was estimated at US$83 billion which was 6 percent higher than the level in 2000. External debt to GDP ratio was 55.67 percent in 2001 for COMESA as compared to 50.42 percent for the whole of Africa.
The debt crisis in the COMESA region and Africa as a whole is a combined result of a number of factors both domestic and external. The states promoted lmport Substitution Industries (ISI) and subsidized consumption with an intention that the emerging industries would be supported through a system .of grants, subsidies and protection from foreign competition, there was poor economie management, as weil as mismanagement of borrowed funds by inefficient public enterprises, Oil shocks of 1973 and 1979 and tightening of American monetary policy to curb inflation among others.
The theoretical literature on the relationship between the stock of external debt and growth has largely focused on the adverse effects of debt overhang. Krugman
(1989) defines debt overhang as a situation in which the expected repayment on external debt falls short of the contractual value of debt. . If a country's debt level is expected to exceed the country's repayment ability with sorne probability in the future, expected debt service is likely to be an increasing function of the country's output level. Thus, sorne of the returns from investing in the domestic economy are effectively taxed away by existing foreign creditors and investment by domestic and foreign investors and thus economie growth is discouraged. The debt overhang hypothesis has, however, been questioned on both theoretical and empirical grounds. Bulow and Rogoff (1991) suggested that the borrowers' underdevelopment was due more to their own economie mismanagement than to the burden of external debt and thus debt overhang was a symptom rather than a cause of low economie growth in the indebted countries.
ln investigating the impact of external debt on economie growth the study uses
· pooled series data .The study builds on empirical work by Pattillo et al (2002) and in this regard economie growth in COMESA is tunction of lag of growth of GDP per capita, population growth rate, human capital development, debt service to exports of goods and services, total external debt to exports of goods and services, gross capital formation, degree of openness and government expenditure. Eviews software version 6 and Stata 8 were utilized for estimation of the results. The pooled least squares and Arellano-bond techniques were used to estimate the coefficients of the variables.
The empirical results show that external debt has a negative impact on economie growth evidenced by the negative and significance of ratio of external debt to exports which was used to capture debt overhang. The findings suggest that the main channel through which external debt affects economie growth is through total factor productivity, this was supported by the increase in the coefficients of the debt indicators when a regression is carried out excluding investment. The study recommends the following basing on the empirical findings: reduction in the debt stock, diversification of the export base, Exportation of value added commodities so as to fetch higher priees and Government expenditure in productive investments that will accrue higher returns to be used in debt service.
TABLE OF CONTENTS
DEDICA TION ... i
ACKNOWLEDGEMENT ... ii
ABSTRACT ... iii
RESUME ... iii
EXECUTIVE SUMMARY ... v
ACRONYMS AND ABBREVIA TI ONS ... x
CHAPTER ONE: BACKGROUND TO THE STUDY ... 1
1.1 Introduction ... 1
1.2 Statement of the problem ... 2
1.3 Objective of the study ... 2
1.4 Significance of the study ... 3
1.5 Justification of the study ... 3
1.6 Organization of the study ... 3
CHAPTER TWO: ECONOMIC PERFORMANCE AND EXTERNAL DEBT SITUATION IN COMESA REGION ... 4
2.1 Background of the COMESA Sub region ... 4
2.2 Economie Performance of COME SA Region ... 6
2.4 Overview of Externat Debt situation in the COMESA region ... 9
2.4.1 Structure ofCOMESA's Externat Debt.. ... 9
2.4.2 Trends and Magnitude ofCOMESA's Externat Debt.. ... 11
2.5 Causes ofthe Debt Crisis ... 15
2.6 Initiatives to bring Externat Debt Burden to Sustainable Levels ... 18
CHAPTER THREE: REVIEW OF LITERA TURE ... 20
3.1 Introduction ... 20
3.1 Theoretical studies ... 20
3.2 Empirical Literature Review ... 25
CHAPTER FOUR: METHODOLOGY ... 30
4.0 Introduction ... 30
4.1 Methodology ... 30
4.2 The Theoretical Framework ... 30
4.3 Mode! Specification ... 31
4.4 Justification of Variables ... 32
4.5 Scope and Data sources ... 34
4.6 Estimation Procedures ... 35
4. 7 Regression Results ... 36
4.9 Interpretation ofResults ... 37
CHAPTER FIVE: PO LICY IMPLICATIONS AND CONCLUSION ... 40
5.1 Summary ofFindings ... 40
5.2 Policy Implications ... 41
5.3 Conclusion ... 42
REFERENCE ... 44
ANNEXES ... 49
LIST OF FIGURES, TABLE AND ANNEXES
A: TABLES
Pages
Table 2.1: The lncome Classification of the COMESA Member States ... 5
Table 2.2: The lndebtedness Classification of COMESA member States ... 11
Table 2.3: lnterest payments/GNP for Different Regions (Percentage) ... 17
Table 4.1: Unit Roots Tests at Levels lntercept and Trend ... 35
Table 4.2: Estimation Results ... 36
B: FIGURES Figure 2.1: Average GDP growth Rates for the CO MESA region ... 7
Figure 2.2: External debt to GDP (%)for the COMESA region and Africa ... 12
Figure 2.3: Trends in debt ratios for 16 countries in COMESA (1990-2003) ... 14
Figure 2.4: Total Net Transfers on Debt for 16 Selected COMESA countries 1990- 2003 (Millions$) ... 15
C: ANNEXES Annex 1: HIPC countries in COMESA (WDI 2005) ... 49
Annex 2: Debt lndicators in selected 16 COMESA member countries ... 50
Annex 3: The structure of External Debt in 16 selected COMESA member countries ( 1990-2003) ... 50
Annex 4: Pooled Least Squares Results ... 51
Annex 5: Estimation Excluding lnvestment.. ... 52
Annex 6: Time Aggregation of 3 sub-samples ... 53
ADF AfDB AGOA COME SA EGLS FDI GDP
GNP HIPC IDA IMF LDCs MD RI OPEC PTA PLS SSA UNIDEP
UNCTAD WDI WEO
ACRONYMS AND ABBREVIATIONS
African Development Fund African Development Bank African Growth Opportunity Act
Common Market for East and Southern Africa Estimated Generalized Least Squares
Foreign Direct lnvestment Gross Domestic Product Gross National Product
Heavily lndebted Poor Countries International Development Association International Monetary Fund
Low Developed Countries Multilateral Debt Relief Initiative
Organization of Petroleum Exporting Countries Preferential Trade Area
Pooled Least Squares Sub Saharan Africa
United Nations African lnstitute for Economie Development and Planning
United Nations Conference on Trade and Development World Development lndicators
World Economie Outlook
CHAPTER ONE:
BACKGROUNDTOTHESTUDY
1.1 Introduction
According to World Bank (2006), total external debt is the debt owed to non residents repayable in foreign currency, goods and services. Total external debt is sum of public, publicly guaranteed and private non-guaranteed long-term debt, use of International Monetary Fund (IMF) credit and short -term debt. ln the past three decades, developing countries especially African countries have borrowed large amounts from aboard hoping that that these loans would put them on a faster development path through increased investment and faster growth. But as debt ratios reached very high levels in the 1980s, it was realized that for many of these countries, repayment would not only hamper economie performance but it also was practically impossible. Ever since, the issue of external debt and debt servicing has assumed critical importance which has resulted in what is referred to as the 'debt crisis' debate.
Against this background in the 1990s, the IMF and the World Bank launched the Heavily lndebted Poor Countries (HIPC 1) Initiative in 1996 and HIPC Il initiative in 1999 to bring the aebt of low-income countries most of which are in sub-Saharan Africa to sustainable levels which will enable debt service through export earnings and capital inflows without compromising long term poverty reducing growth. The eligibility criteria for HIPC was based on a good track record of implementation of reforms, pursuance of sound policies and ability to translate the resources into better prospects for the poor.
About 34 out of 42 countries in Sub-Saharan Africa are classified as Heavily lndebted Poor Countries by the World Bank. The debt burden has resulted in these economies to divert resources from social sectors such as health and education, to debt servicing. By the year 2001 the total debt for sub-Saharan African countries was US $209 billion. ln that same year, the sub-continent borrowed US $11.4 billion while debt service amounted toUS $14.5 billion of which US $9.8 billion as principal repayment and US $4.7 billion as interest. As a result, the region recorded a negative 'net transfer' (new borrowing minus debt service) of r.JS -$3.1 billion. This continued a trend of negative net transfers in the previous decade. ln
Sub-Saharan Africa (SSA) as a whole, debt service amounted to 3.8 percent of gross domestic product (GDP) in 2000; by comparison SSA countries spent 2.4 percent of GDP on health (Boyce and Ndikumana 2002).
The Common Market for East and Southern Africa (COMESA) as one of the regional blocs is still plagued with heavy external debt burden. The debt crisis, compounded with poverty and structural weaknesses of most of the member · countries' economies has made the attainment of rapid and sustainable growth and development difficult. The external debt of COMESA member countries has increased twenty- fold since 1970 and the debt ratios which in 1970 were insignificant averaged 45 percent of export earnings between 1989 and 1990. According to the World Development lndicators (2000), COMESA as an economie body with a present value of debt-to-export ratio of 396%, is one of. the world's most heavily indebted regions. If the NPV of debt to experts exceeds the critical value of 150% then this signais imminent debt difficulties.
1.2 Statement of the problem
The size of the debt relative to the size of the economies in COMESA sub region is large and increased debt servicing is using up the resources that could have been allocated to investment which will lead to increased growth. When this is combined with the reality of high poverty levels in the region in which three quarters of the population live on less than US 1$ per day, the damaging nature of the debt overhang becomes more evident. Given this gloom situation, can a country meet both its debt obligations and grow fast enough at the same time. Thus the study seeks to examine the impact of external debt on economie growth in the COMESA region over the period 1990-2004.
1.3 Objective of the study
The objective of the study is to examine the impact of the external debt on economie growth in the COMESA region.
1.4 Significance of the study
Based on the empirical findings the study will help in designing policies for COMESA member states, so as to bring the debt to sustainable levels-. The findings of this study will add to the knowledge and studies undertaken by researchers and development partners in this a rea, and hence serve as' an input to policy making.
1.5 Justification of the study
The tact that most of the countries in the region are classified as heavily indebted (see annex 1) and th at lite rature suggests th at external debt would have bath positive and negative impact on economie growth warrants a stu~y to examine the impact of external debt on economie growth in the COMESA region.
There is no study on external debt in COMESA as a regional group; hence this study seeks to till that gap.
1.6 Organization of the study
The rest of the study is organized as follows; chapter two provides background to the COMESA region; its economie performance, overview of external debt, causes and initiatives to curb external debt burden. Chapter three deals with review of relevant theoretical and empirical literature. Chapter four is madel specification and econometrie analysis of study. Chapter five contains the main findings, policy implications and conclusion resulting from the study.
CHAPTER TWO:
ECONOMIC PERFORMANCE AND EXTERNAL" DEBT SITUATION IN COMESA REGION
This chapter examines the background of COMESA region, the macroeconomie environment and external debt situation in the region.
2.1 Background of the COMESA Sub region
The Common Market for Eastern and Southern Africa (COMESA) came into existence in 1981 and was formerly known as the Preferential Trade Area (PTA). PTA was initially established with the aim of promoting cooperation and integration covering ali areas of economie activities in particular trade and customs, industry, transport and communications, agriculture and moneta'ry affairs. The transformation to COMESA was in the fulfillment of the requirements of the Preferential Trade Area treaty which provided for the transformation of the PTA into a common market. The Member States of COMESA set out a vision to establish a tully integrated, internatiç>nally competitive regional economie community; a community with economie prosperity as evidenced by high standards of living
~or its people, political and social stability and peace, and a community within which goods, services; capital and labor are free to move across international borders. Currently the COMESA region is the largest African economie grouping with 19 member states.1
ln 2006, the region had a population of over 400 million and a combined GDP of US$ 285 billion. ln 2004, Egypt had the highest population of about 73 million followed by Ethiopia with a population of about 70 million while Seychelles had the lowest population of 84,000 (World Bank Africa database 2007).COMESA member countries are at different levels of development with only two countries falling in the category of upper lower group while the majority are in the low in come group (See table 2.1 ).
1 Burundi, Comoros, Democratie Republic Of Congo, Djibouti, Egypt, Ethiopia, Eritrea, Kenya, Libya, Madagascar, Malawi, Mauritius, Rwanda, Seychelles, Sudan, Swaziland, Uganda, Zambia, Zimbabwe.
Table 2.1: The Incarne Classification of the COMESA Member States
INCOME GROUP COUNTRY
Low Burundi
Comoros
Democratie Republic of Congo Ethiopia
Eritrea Kenya
Madagascar Malawi Rwanda Sudan Uganda Zambia Zimbabwe
Middle lower Djibouti
Egypt Swaziland
Upper lower Mauritius
Seychelles
. . . .
Source: The World Bank. 'Ciasstftcatton of economtes by mcome and reg ton, 2006' COMESA member states nevertheless have sorne similarities like reliance on a few primary export commodities, small domestic markets· and weak infrastructure links among others.
lntra-COMESA trade has significantly increased especially in the period 2000-2005 and this was attributed to the Free trade area in the region which was initiated in 2000.1ntra- COMESA as a whole grew at an average rate of 9 percent over 2000-2005 while intra-FTA trade growth averaged at 13.9 percent (a growth of 20 percent was recorded in 2005 alone)2. During 2003 and 2004, despite the slowdown in the expansion of world trade, intra- COMESA trade continued to increase at record rates. Total intra-COMESA trade increased from US$ 4.2 billion in 2002 to US$ 4.8 billion in 2003 and to US$ 5.4 billion in 2004 and estimated at over US$ 7 billion in 2005. Comores, Egypt, Eritrea and Madagascar achieved especially high growth rates of experts to the region, though other countries such as Kenya,
2 Intra-FT A re fers to trade between member countries that have eliminated duties and tariffs on CO MESA originating products whereas Intra- CO MESA trade refers to trade between CO MESA member countries.
Malawi, Rwanda, Uganda, Zambia and Zimbabwe also achieved significantly high growth rates of exports to the region. On the import side, Burundi, Democratie Republic of Congo, Eritrea, Rwanda and Zambia had substantial increases in their imports from the region. The top intra-COMESA export products include tea, sugar, beverages, and cement and petroleum oils substances. The value of total trade (import and export) by COMESA Member States reached US$ 91.8 billion in 2004, up from US$ 64 billion in 2002. However, total exports out of COMESA Member States amour,lted to US$ 43.8 billion in 2004. The major export market for the region is the European Union, United States of America under
\he African Growth and Opportunity Act (AGOA) and Asia. The major export commodities for the region are cotton, textiles, tea, coffee, tobacco, fish and minerais including copper, diamond and gold (COMESA 2004).
2.2 Economie Performance of COMESA Region
The economie performance of the COMESA region has been rather disappointing over the last two to three decades, with overall economie growth of the COMESA region averaging 3.2 percent per annum. The region has also experienced, over the last few years, unprecedented droughts, leading to widespread food shortages and famine. There is growing and widespread poverty in the COMESA region, especially among the rural communities. This has been aggravated by the decline in expenditures on social services such as health, education and public utilities while l1utrition has worsened and mortality continues to increase. Unemployment is another major crisis especially among the youth in mban areas.
On average GDP growth rate for COMESA between 1990 and 2004 was positive despite a sharp fall in 1994.The sharp fall in 1994 was attributed to the dr~ught experienced in the region and civil wars in sorne of the member states particularly Rwanda and Burundi.
Nonetheless there were strong signs of improvement when the growth rates went up to 4.91 percent in 1995.Since then the growth rates have been fluctuating yearly with 2004 recording a growth rate of 4.06 percent (see figure 2.1 below).The significant improvement in economie performance was due to creation of suitable macroeconomie environment
appropriate for growth like fiscal austerity and restrictive monetary policies. Notwithstanding this improvement, economie performance in the region is-still unsatisfactory due to the constraints in law productivity, inefficient management, poorly devised and implemented government policies as weil as failure to diversify the narrow export base (World Bank 2006).
Figure 2.1: Average GDP growth Rates for the COMESA region
A\.erage GDP Growth Rates (const 2000 US$)
6.00 - - . - - - , 5.00 +---~---~
4.00 +---4---~---~
3. 00 -·~---=:---J---~--t'-'1
2. 00 +--\----+--1--1---__,_--+--...:z;_-~
1.00 +-~r-+-4-~---~
0. 00 -1--r---.----.----rl--h---,---,----,---,---.--.----,---,----,~
-1.r#-
-2.00 -'---~---'
Source: World Development lndicators (2006)
----+--- A\.erage GDP Growth Rates (const 2000 US$)
Inflation has been a problem in the region with many of the member states having inflation levels way above the regional threshold of 5. percent per annum. Dispersion of inflation across the region has reduced such that Uganda, Egypt, Ethiopia, Comores, Djibouti and Seychelles have managed to keep their inflation rat~s within the COMESA target. Other single digit inflation nations (Madagascar, Kenya, Mauritius, Rwanda, Sudan and
$waziland) are barely above target. Though still high (21.8 percent), Zambia has sharply corrected inflationary pressures, which were degenerating early 1990s. Over the last 2 years, there has been a build up of inflationary pressures especially with inflation levels going above 1000%. High inflation cou Id be associated with monetary expansion for example, in Democratie Republic of Congo and Zimbabwe average· inflation of 191 percent
and 197 percent between 2000 and 2004 could be attributable to the respective triple-digit monetary expansions of 141 percent and 217 percent Rising inflation in Comores could be in response to higher money growth (Mutoti and Kihangire 2006).
The average savings as a percentage of GDP for COMESA member states has been fluctuating. The average savings rate in 2004 stood at 12.6 percent, compared to 25 percent in 2003 while in 2001 and 2000 it was 17 percent and 18 percent respectively. The disparity in savings ratios is high, with sorne countries having savings ratios of above 20 percent and others had ratios of less th an 10 percent. For instance Mauritius had a savings ratio of 28 percent in 1992, 26 percent in 2000 and 27 percent in 2003 compared to Zambia which had saving ratios of -11 percent in 1992, 3 percent in 2000 and 15 percent in 2003(
World Bank Africa Database 2005).
The investment performance of the region declined from 20.4 percent of GDP in. 2000 to 19.2 percent in 2001.1nvestment in the region v.aried considerably with Democratie Republic of Congo, Egypt, Eritrea, Mauritius and Seychelles recording rates of above 20
~ercent in 2000 while others recorded much lower rates. The low investment performance of the region as a whole underscores the challenges facing COMESA policy makers to implement a set of policies that will move the economies into higher investment and growth (COMESA 2002).
COMESA current account deficit standing at about 11 percent may be considered low, and has been attributed to improvements in external positions of Democratie Republic of Congo, Madagascar, Angola, Egypt, Ethiopia, Kenya, Mauritius, Sudan, Swaziland, Comores and Swaziland. While Uganda and Seychelles barely exceed 12 percent, current account deficits are on the rise in Malawi, Burundi, Rwanda, Zambia, Djibouti and Eritrea (Mutoti and David 2006).
ln Zimbabwe experts and imports are both collapsing with current account deficit falling to under 1 percent as external finance is withdrawn (World Economie and Financial Surveys, October 2007).
2.4 Overview of External Debt situation in the COMESA region
Africa as a whole has been faced with huge economie, social and political challenges and paramount among these is the large debt burden and reducing levels of Official Development Assistance (ODA). ln actual tact, for every US$1 of US aid to Africa, US$3 is taken back in debt repayments. The implication of this is illustrated by, for example Zambia which spends twice as much on debt repayment as 'on education or in Malawi where the government spends more on debt repayment than on health (New African, November 2007).
2.4.1 Structure of COMESA's External Debt
The Analysis of external debt in the COMESA region shows that the bulk of external loans are from official sources bath bilateral and multilateral. The share of multilateral debt has been increasing since 1980s as a result of large disbursements of lending from the World Bank, IMF and Africa Development Bank (AfDB) to finance structural adjustment program (see annex 2).The multilateral debts are debts owed to regional and international financial organizations such as the World Bank, particularly the International Development Association (IDA}, IMF and the AfDB. These are long term loans for infrastructural development or project-tied loans from multilateral institutions.
The group of official bilateral creditors consists of Paris club creditors and non Paris club creditors. The Paris club creditors represent only government guarantee creditors or official government creditors. The major Paris creditors are United Kingdom, United States of America, France, Canada, Germany, Netherlands, Japan, Sweden, ltaly and Belgium among others. The non Paris creditors group includes Israel, China and lndia among others.
lt is also important to look at the terms and conditions by which countries in the COMESA region acquired loans. ln this regard the maturity period increased from 27.13 years in 1990 to 29.38 years in 1992 and then went dawn to 26.69 years in 1994. The average interest rate on debt outstandlng declined from 3.50 percent in 1990 to 2.31 percent in 2002 with sorne fluctuations in between. The average grace period which was 7.12 years in 1990
dropped to 6.56 years in 1994, went up to 7.625 years in 2000 and feil to 5.81 years in 2002 (See annex 3).
Since the early 1990s the proportion of concessional debt as a percentage of total external debt has been rising. The proportion of concessional debt rose from 53.875 percent in 1990 to 60.25 percent in 1995, 65 percent in 2003 and went down to 60.026 in 2004 (see annex 2). ln general, loans with a grant element of 25 percent are defined as concessional. The loans contracted by COMESA member countries are highly concessional with the average grant element varying between 47 percent to 58 percent during the study period. This therefore gives the COMESA region an advantage of contracting loans on soft terms. Short term debt has also remained relatively low over the years with most of the loans having a maturity period of more than one year (see annex 3).
Sorne of the COMESA member countries have rescheduled their debt with Paris Club creditors. After reaching the completion point in April 2005, Paris Club creditors met in May 2005 to discuss the case of Rwanda. The country's debt was treated under Cologne terms, equivalent to the cancellation of $82.7 million of external debt. Furthermore, Paris Club creditors agreed to cancel and additional $7.7 million of external debt on a bilateral basis.
The two treatments led to the cancellation of ali the Paris Club debt of Rwanda. Zambia also reached the completion point in April 2005, and the Paris Club meeting to provide debt relief under the HIPC Initiative took place in May 2005. Official bilateral creditors provided a debt cancellation on Cologne Terms, equivalent to $1.403 billion. As in the case of Rwanda, on a bilateral basis, creditors decidèd to go beyond the Cologne Terms, and pledged to cancel another $393 million of Zambia's external debt. The Paris Club also
~greed to re-profile 50 per cent of the payments due on the remaining debt over the period 2005-2007. ln September 2005, Burundi reached the decision point, and was granted interim relief under the Cologne Terms.
2.4.2 Trends and Magnitude of COMESA's Extern·al Debt
COMESA as one of th,e sub-regions in Africa is faced with the problem of large debt
·,·!
burden. According to a 2005 classification of indebtedness by the World Bank, of the 19 COMESA member States, 10 countries are severely indebted, 5 moderately indebted and only 3 economies are categorized as less indebted (See table 2.2).
Total external debt showed an increasing trend over the period 1990-1995 from US$ 53 billion in1990 to US$81 billion in 1995.1t then declined from US$80 billion in 1996 to US$69 billion in 2001. lt further reduced to US$49 billion in 2004 (World Bank Africa database 2006).
Table 2.2: The lndebtedness Classification of COMESA member States
INDEBTEDNESS LEVEL COUNTRY
Seve rely Burundi
Comoros
'' Democratie Republic of Congo
Eritrea Malawi Rwanda Seychelles Su dan Zambia Zimbabwe
Moderately Ethiopia
Kenya Mauritius Madagascar Uganda
Less Egypt
Djibouti Swaziland Source: The World Development lnd1cators 2005
External debt to GDP ratio was 55.67 percent in 200j for COMESA as compared to 50.42 percent for the whole of Africa (see figure 2.2)
The severity of COMESA's debt problem can better be appreciated by examining sorne debt indicators such as External DebUExport of goods and services ratio, External DebU GDP ratio and Total Debt Service/Experts of goods and services ratio. These debt indicators are relevant because they help to assess a country's external debt situation and its ability to meet its debt obligations. The debt to export ratio is defined as the ratio of total outstanding debt at the end of the year to the economy's experts of goods and services for any one year. This ratio shows the number of years of export earnings, at current levels, which are required to repay the whole of the debt stock. COMESA's Debt Export ratio rose from 573.5 percent in 1990 to 803.4 percent in 1993 with the lowest in the period 1990- 2003 being 457.60 percent in 2004 due to the HIPC initiative which started in 1996 (See annex 2).This illustrates that in 1990 COMESA regioo at current levels required more than 5 years of export earnings to service its debt.
Figure 2.2:
120.00
-
~ ~ 100.00
c (!)
0 80.00
....
:0 ~ 60.00
iü 1:
~ 40.00
C1l
]9 20.00
~
External debt to GDP (%) for the COMESA region and Africa
-+-Ali Africa - cOMESA
Source: World Bank Africa Database 2005.
The total debt to GDP is defined as the ratio of the total outstanding external debt at the end of the year to GDP. This ratio had an increasing trend in the period of study implying that the debt stock is growing more than what the country is producing and in addition it suggests that over time the task of restructuring the economy and reducing foreign borrowing is becoming difficult (see figure 2.3). ln ·1990 the ratio was 79.13 percent it further increased to 112.63 percent in 1994, 101.67 percent in 2000, feil to 92.13 percent in
~002 and then went up again to 95.73 percent in 2003 (Annex 2).
Further evidence of debt distress is fou nd in the debt service as a ratio of experts of goods and services which had a fluctuating trend. The debt service ratio is defined as the ratio of external debt service payments of principal and interest on total ~ebt to experts of goods and services for any one year. An increasing debt service ratio indicates that debt service payments are increasing faster than the export earnings and this may lead to liquidity problems. The debt service ratio is also an indicator of debt sustainability as it shows how much of a country's export earnings will be used up in debt servicing.
The ratio reduced from 24.60 percent in 1990 to 15.67 percent in 1994 and it then went up again in 2002 to 37.89 percent due to a reduction in the priee of main experts but dropped to 12.84 percent in 2003( Annex 2). For example in 1990, 24.60 percent of the region's export earnings were being used to finance debt. Although for the period 1993-2001 the Total Debt Service to experts of goods and services was ranging between 13.06 to 18.38 percent and appeared low in relation to the critical value of 20-25 percent, debt relief reduced the payments. Although debt-service. ratios have remained relatively low because of the highly concessional nature of exterrial financing provided to many countries in the region have been unable to service their debt without recourse to rescheduling under Paris Club arrangements or by accumulating arrears. The total debt service to GNP ratio has also been fluctuating which implies that many of the economies in the region are using much of their in come to service the ir debts (Annex 2).
Figure 2.3: Trends in debt ratios for 16 countries in COMESA (1990-2003) Trends in debt ratios For the COMESA (1990-2003)
120.00 w 100.00
(!)
<t: 80.00
1-z 60.00
(.) w
40.00 0::
-+--EDT/GDP -11-TDS/XGS a. w 20.00
0.00
R>C)
"Q)
9:>'~-
"Q)
#
"Q)
R>(Q
"Q)
R>co ...._Q)
~ ~C) ~ ~'1-
YEARS
Source: Global Development Finance 2006
ln the recent years, resources have been flowing from Africa to the developed World and COMESA as a region in Africa has also been hit by this phenomenon as shawn by the negative net transfers. Net negative transfers refer to net borrowing minus debt service.
The region has recorded negative net transfers implying that it is paying more in debt servicing than the actual amount it borrows. ln the period of study, the region had a positive net transfer only in 1991 which was US$6.125million, in 1992 it went up to US$-40.56 millions and US$-126.187millions in 2000 (See figure 2.4).
lndeed, ali indications are that the excessive stock of external debt and debt service burden is slowing down the growth and hampering socio-economic development in the COMESA region. Debt servicing in the face of inadequate foreign exchange earnings leads to severe import reduction. The later holds back export growth because it limits the inflow of capital goods and raw materials that are needed for production. The debt overhang and other uncertainties created by the debt situation further depress investment. When the fall in investment is combined with shortages of essentiC!I imports it results in declining real output. Declining output and increasing current account deficits lead to increasing debt and
~ising debt service obligations. Given the structural weakness of most COMESA
economies, their law incarne, law savings and law investment, the current high levels of debt and debt servicing would work against rapid economie growth and development.
Figure 2.4: Total Net Transfers on Debt for 16 Selected COMESA countries 1990- 2003 (Millions $)
Net transfers on debt, total (NTR, US$)
20 0
-2~-
"
en -40
...J -60
:iil
-80 -100 -120 -140
Source: Global Development Finance 2006
2.5 Causes of the Debt Crisis
-+-Net trans fers on debt, total (NTR, US$) (mill)
The debt crisis in the COMESA region and Africa as a whole is a combined effect of a riumber of factors bath domestic and external.
Up until the late 1980s and early 1990s most COMESA countries followed an economie system which involved the state in ali aspects of production, distribution and marketing thus denying the private sector to play a role in the economy. The states promoted lmport Substitution Industries (ISI) and subsidized consumption with an intention that the emerging industries would be supported through a system of grants, subsidies and protection from foreign competition. The states anticipated that these industries would grow to a level where they would compete against foreign firms. However, this did not happen as the domestic markets were tao small to compete internationally. lnitially the ISI were being financed from domestic earnings through sale of primary commodities and minerais. Later the levels of revenue from these commodities declined and the countries resorted to
borrowing on western capital markets, IMF and World Bank so as to maintain the previous levels of consumption. The borrowed funds were usually not used to improve production so levels of real GDP continued to decline while expenditure levels which had risen significantly as a result of higher debt servicing payments continued to rise.
There was poor economie management, as weil as mismanagement of borrowed funds by inefficient public enterprises. This is partly because the borrowed funds were · used to finance consumption, excessive hiring of government employees, purchasing military equipment and investing in projects with low returns. However, even in circumstances where funds were wisely invested unforeseen adverse movements in interest rates and unfavorable terms of trade made the rates of return on. investments inadequate. ln addition the growing fiscal deficits and surging private credit demand as a result of expansionary fiscal policy and borrowing for consumption, there was a rapid ~xpansion of the money supply in Sub Saharan Africa (SSA). Most of these policies increased borrowing needs and lowered export earnings, thus reducing the ability of SSA to meet debt service obligations (Obadan 2004).
Exogenous factors beyond African countries control played a pervasive role in the debt crisis. According to Pilbeam (1998) the origin of the debt crisis dates back to the oil priee shock of 1973-197 4. The quadrupling of oil priee was particularly harmful to the non-o il producing countries that experienced an enormous increase in their import expenditure. ln addition, recession in the developed countries severely reduced the export earnings of less Developed Countries (LDCs). As a result, the current account deficit of most LDCs rose from US$8.7 billion in 1973 to US$42.9 billion in 1974 and US$51.3 billion in 1975.
The ir terms of trade deteriorated significantly between 1973 and 1975 from 100 to 40, which meant th at in 197 4 they needed two and a half times the ex~ort volume for every unit of imports than they had in 1973.
The second oil shock of 1979-1980 occurred when the Organization of Petroleum Exporting Countries (OPEC) cartel more than doubled the priee of oil from US$ 13 per barrel to US$
32 per barrel and this led to the oil shock of 1979-1980.This occurred at a time when there
were sharp increases in real interest rates. Consequently, the global recession of 1981- 1982 further aggravated the problem by reducing demand for developing countries exports and this ~orsened the balance of payment crisis not ?nly for the ail importing countries but also for the ail exporters. Nonetheless, based on the assumption that the global recession would be short-lived and that the priees of the non- fuel commodities would increase, most countries resorted to external borrowing to finance fiscal and external imbalances (UNCTAD 2004).
The financial and economie policies of the industrialized countries such as the tightening of American monetary policy in 1979-1980 so as to curb rampant inflation tao aggravated the debt crisis in Africa. The dollar interest rate rose leading to an increase in debt service payments, due to the global recession the demand for their exports feil and as commodity priees feil they faced lower terms of trade. According to the United Nations Conference on Trade and Development (UNCTAD1988), commodity priees (for essentially foodstuffs, fuels, minerais, and metals) dropped 28 percent in 1981-82, and between 1980 and 1982 interest payments on loans increased by 50 percent in nominal terms and 75 percent in real terms.
Table 2.3 shows the interest payments that developing countries paid on their external debt, expressed as a fraction of GNP in the different regions. These figures reflect periods of early 1980s when the debt crisis first exploded.
Table 2.3: lnterest payments/GNP for Different Regions (Perçentage)
Year SSA East Asia Europe North Latin South
And and Africa & America & Asia Pacifie Central Middle Caribbean
Asia East
1980 1.7 1.5 2.2 2.1 3.5 0.6
1983 2.1 2.0 2.8 2.1 5.6 0.9
1985 2.7 2.2 1.4 1.5 5.5 1.0
1987 2.5 2.1 1.3 1.6 4.1 1.2
1989 3.0 1.7 1.4 2.4 2.9 1.3
Source: World Bank, World Debt Table, 1992-93 w·ashington .D.C.
Latin America had the highest ratios in the peri ad 1980-1987. The interest payments increased from 3.5 percent to 5.6 percent in 1983 and then 4.1 percent in 1987, implying it dedicated a large share of its GNP to interest payments for its debt. The ratios for SSA also increased significantly and this is linked to the failure of many of the developing countries in the region to service their debts thus the debt crisis.
2.6 Initiatives to bring External Debt Burden to Sustainable Levels
There is no straightforward response to the current LOC debt crisis. A combination of corrective measures by the IMF, changes in the nature of economies of LOCs, effective debt reconstruction through debt rescheduling, and appropriately forgiving LOC debt will ensure satisfactory recovery of LOCs from the burden of debt.
ln July 2005 at the Gleneagles, UK summit, the G8 Heads of State and Government agreed to provide 100 percent debt relief on multilateral debt of countries th at have reached their HIPC completion point (African Oevelopment Bank 2005).
ln relation to the above, the Multilateral Oebt Relief initiative (MORI) adopted by the IMF in the late 2005 puts into action a debt relief proposai advanced by the G8 in July 2005.
However, the IMF executive board modified the G8 proposai to meet the requirement specifie to the IMF, that the institution's resources be used across its membership consistent with the principle of uniform treatment. lt was agreed that ali member countries with per capita incarne of US$ 380 a year or less will be eligible for MORI debt relief from the IMF resources. On 6 January 2006 IMF delivered MORI relief amounting to US$ 3.4 billion to an initial group of 19 countries and among these were Ethiopia, Rwanda, Madagascar, Uganda and Zambia. The total debt relief by IMF under MORI is expected to be over US$ 5 billion.3As a result of HIPC and later MORI relief has helped keep Uganda's debt sustainable with debt to GOP ratio at 14 percent (World Economie and Financial Surveys 2007).
3 http://www.imf.org/extemal/np/exr/mdri/eng/index.htm (accessed on December 11, 2007).
ln recent years, the movement for debt forgiveness has drawn much attention. A special interest group dedicated to debt forgiveness, Jubilee 2000, managed to attract significant support throughout the developed world for widespread debt forgiveness. As a result of their efforts, by the end of 2000, a total of twenty four countries qualified for international debt relief (Stig litz 2002). Jubilee-Zambia has participated in the formation of a government HIPC Expenditure Monitoring Team, to look at the disbursements of funds under HIPC.
NEPAD as an African initiative focuses on debt reduction and Official Development Assistance as complementary external resources required in the short to medium term and addresses private capital flows as a longer term conc~rn. The debt initiative put in place by NEPAD is where the African initiative seeks to extend debt relief beyond its current levels based on the interim debt strategy. The African initiative leadership called for the establishment of a forum in which African countries will exchange experiences and mobilize for the improvement of debt relief strategies in Africa.4
4 http://www.nepad.org/2005/files/docwnents/anewafi·icanintiative.pdf(accessed on December 11,2007
CHAPTER THREE:
REVIEW OF LITERA TURE
3.1 Introduction
This section will review theoretical and empirical studies that have investigated the impact of external debt on economie growth. There seems to be an agreement that external debt has significantly negative effects on economie growth, however sorne studies have revealed mixed results.
3.1 Theoretical studies
According to the Keynesian capital accumulation is important for investment and economie growth. Capital accumulation translates into economie growth via the savings- investment linkage. The ability of a country to grow depends on adequate savings mobilization. The problem arises when domestic savings are inadequate to meet the required rate of investment. Thus external borrowing has been resortéd to fill such gaps.
fn traditional neoclassical models, allowing for capital mobility, or the ability of a country to barrow and lend, increases transitional growth. There is an incentive for capital-scarce countries to barrow and invest as the marginal product of capital exceeds the world interest rate. The assumption is that countries at the early stages of development have small capital stock and are likely to have investment opportunities higher returns than those in developed countries. As long as they use the borrowed funds for productive investment and do not suffer from macroeconomie instability, then growth will increase and allow for timely debt repayment.
The theoretical literature on the relationship between the stock of external debt and growth has largely focused on the adverse effects of debt overhang. Krugman (1989) defines debt overhang as a situation in which the expected repaynient on external debt falls short of the contractual value of debt. If a country's debt level is expected to exceed the country's fepayment ability with sorne probability in the future, expected debt service is likely to be an increasing function of the country's output level. Th us, sorne of the returns from investing in
the domestic economy are effectively taxed away by existing foreign creditors and investment by domestic and foreign investors and thus economie growth is discouraged.
Claessens and Diwan (1990) classifies debt overhang into three different degrees: liquidity trap, weak debt overhang and strong debt overhang: A weak debt overhang exists where the outstanding debt is so large that the situation cannot be resolved by issuing further financing or new money for the country. Rather the situation is improved by using commitment mechanism to ensure allocation of loans for investment. Commitment mechanism is form of a solution to debt overhang through a clear commitment from lenders that the amount they will ask a debtor to repay in any period will _take into account of the country's economie situation.
ln case of a strong debt overhang, the debtor postpones the implementation of profitable projects until at least part of the debt is forgiven. The leaders of the debtor country have no incentives to participate in extensive structural adjustment program because the benefits of increased growth would end up in the creditor's pocket while the short term cost will rest solely on the debtor's shoulders. The provision of large amou nt of liquidity cannot improve the debt overhang problem. Thus the solution to the strong debt overhang is debt and debt service reduction, commitment to large investment program, commitment to structural economie adjustment and provision of new money.
Lastly the debt overhang is considered as a liquidity trap, if external debt accumulation is not too large, but the indebted country has to struggle with allocati_ng the scarce resources between consumption, investment and external transfer to service existing debt. Since extensive eut downs in funds used for consumption are hard to make, then consumption
n>
expenditure takes a large part of the debtor country's income driving down investment and discouraging future output. Thus the resolution to liquidity
~ct
of debt overhang calls for injections of substantial new money facilities. However, the provision of small amounts of new loans will become un profitable because new resources cou Id be largely · used for consumption purposes.Krugman (1989) and Froot (1989) conceptualize the mode! of deb~ overhang of developing countries by applying the theory of Laffer curve to obtain the relationship between debt stock and the levels of expected repayment (debt Laffer curve). Theory supposes that larger debt stocks tend to be associated with lower probabilities of debt repayment. The curve sloped like an !nverted U shaped, it graphs expected repayment as a function of the face value of the outstanding debt (Figure 3.1 ). On the upward sloping of the curve, increases in the face value of debt are associated with increases in expected debt repayment; while increases in debt reduce expected debt repayment on the doWn ward sloping side of the curve.
The Laffer curve shows that there is a limit at which debt accumulation stimulate economie growth and investment. When a country opens up for foreign capital and start borrowing, the impact of debt on growth is likely to be positive (moving from zero indebtedness to point A in figure 3.1 ). However as the debt ratios increases beyond point A, additional debt eventually slows growth. Therefore point A can be considered as the growth maximizing leve! of debt. When debt reaches point B the contribution of debt to growth turns negative and the contribution becomes worse off than in the case of no indebtedness, thus confirming the inverted U-shaped relationship.
According to Cohen (1993) and Diaz-Alejandro (1981), the liquidity constraint is captured as a 'crowding out' effect, by which the requirement to service debt reduces funds available for investment and growth. A reduction in the current debt service should, therefore, lead to an increase in current investment for any given leve! of future indebtedness.
Savvides (1992) asserts that if a debtor country is unable to pay its external debt, debt payments become linked to the country's economie performance. The country benefits only partially from an increase in output or experts because a fraction of the increase is used to service the debt and accrues to the creditors. Thus, from the perspective of the debtor country as a whole, the debt overhang acts like a high marginal tax rate on the country, thus lowering the return to investment and providing a disincentive to domestic capital
formation. The disincentive effect of the debt overhang may have repercussions on private saving and investment, even when ali exterrial debt is held by the government
Figure 3.1: Debt Laffer curve
Expected debt repayment
0 Zero probability of default
A
Source: Krugman (1989)
Debt overhang
B
Debt stock
Literature points out how debt may have negative effects on economie growth because of the uncertainty about what portion of the debt will actually be serviced with the countries own resources. lt may not be clear at what terms debt will be rescheduled, whether there would be additional lending and what change in government policies the rescheduling will entail. The investment under uncertainty literature ~as stressed that in highly uncertain environments, even if the fundamentals are improving, investors continue to exercise their
?Ption of waiting. The investment that does take place in high debt environments will likely be in trading activities with quick returns, rather than long-term, high-risk, irreversible investment, as in ether high uncertainty environments (Serven, 1997). This misallocation of investment in turn will lower the efficiency of overall capital accumulation.
Agenor and Montiel (1996) focus on the fiscal aspects of the debt problem. As the size of the public debt increases, there is growing uncertainty about what actions and policies the
government will resort to in arder to meet its debt servicing obligations with adverse effed:
on investment hence reduced growth. ln particular as the stock of public sector debt increases, there may be expectation that the government's debt service obligation will be financed with distortionary types of taxation or with cuts in public spending.
Ndulu (1991) and Moran (1990) argue that external debt can affect growth through the external account. External debt service payments require foreign currency that is eamed from exports or capital inflows or from drawing down from reserves. ln the absence of substantial reserves, sizeable experts or capital inflows then higher debt servicing means reducing the import capacity. The heavy debt burden effect through the external account is known as "import compression". lmport compression is effected through currency devaluation or import restrictions and it results in reduction of imports of capital goods thal can lead to lower investment and thus slow growth.
The debt overhang hypothesis has, however, been questioned on both theoretical and empirical grounds. Bulow and Rogoff (1991) suggested th at the borrowers•
underdevelopment was due more to their own economie mismanagement than to e burden of external debt and th us debt overhang was a symptom rather than a cause of lo economie growth in the indebted countries. Arslanalp and Henry (2004) have claimed that the highly indebted poor countries do not suffer from debt overhang. Also, Cordelia
et
al.(2005) are unable to rule out the possibility that debt does not matter.
ln conclusion, theoretical literature on external debt and economie growth suggests several channels through which debt burden impedes growth. This can be through debt overhan disincentive effect and crowding out public investment. Furthermore the debt burden a growth the external account in that it limits the amount of foreign exchange that coul used to import capital goods necessary for economie development. Lastly e mal affects economie growth through the fiscal account as its not certain what acti n
11
taken by government to meet its debt servicing.
