External debt or Foreign Aid is considered a significant source of income for developing countries. Pakistan has relied much on foreign debt to finance its balance of payments (BOP) deficit and saving investment gap. This heavily dependence on external resources became uncontrollable in late 1980s. Primary objective of this paper is to explore the relationship between external debt and economic growth in Pakistan using time series econometric technique. We took a point of glance of external debt and economic performance of Pakistan from 1947 to till now. The paper shows that External Debt is negatively and significantly related with economic growth Pakistan. The evidence suggests that increase in external debt will lead to decline in economic growth of the country. Debt servicing has also significant and negative impact on GDP growth rate. As the debt servicing tends to increase, there will be fewer opportunities for economic growth.
Keywords: External Debt, Economic Growth, Debt Servicing
Accumulation in debt stock has been the prime problem faced by both developing and developed countries. Developing countries face this problem more often as they need to borrow to facilitate their development process and accelerate the growth pace. However, the borrowed funds required to be allocated properly for the productive expenditures and in accordance to their repayment ability. Though debt is useful for the growth of the economy however dependence on debt must be closely monitored and proper strategy should be adopted for enhancing the repayment capability of the country. High and unsustainable levels of debt have serious repercussions for the economy in terms of heavy debt servicing and decreased developmental expenditures, essential to carry on the growth process. Besides, availability of lesser funds for investing in the economy and increase in taxes for repayment, hampers growth as it limits the productive investment, resulting in shrinking of the debt repayment capacity of the economy. It creates crowding out effect as well as has negative impact on the foreign and domestic investment and development plans of the government.
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The external debt exerts significant negative impact on economic growth. This confirmed the existence of debt overhang in Pakistan in both long and short run. Labour force affect GNP negatively in long run and short run as well, but in short run impact is insignificant. Pakistan faces serious debt problem, which threaten the economic future of the country. Burden of external debt and debt servicing have continued to grow over time.
Central to the economic reforms process is a clear progression towards deregulation of the economy. Prices of petroleum products, gas, energy, agricultural commodities and other key inputs are mostly determined by market. Imports and domestic marketing of petroleum products have been deregulated and opened up to the private sector. More importantly, taxation reforms have been prominently on the government’s agenda, with no real reforms undertaken.
There are different indicators of debt service burden such as;
I) Debt servicing as percentage of export receipts measures the ability of debt repayment and creditworthiness of a country. According to the World Bank, when debt servicing of a country go beyond 20 percent of its export earnings then its debt becomes unsustainable.
II) Debt servicing as a percentage of foreign exchange earnings is another important indicator of indebtness of a country.
III) The most important indicator determining long-run results is the ratio of debt service to GDP which determines the burden of debt service burden on the country’s income. As this ratio goes up, increases the burden. As a research by Chris Nagassam (1992) employed a logit model and indicated that higher the debt service ratio will be, the lower the GDP will be and it will develop constraint for external debt servicing capacity of African Nations.
The fiscal and real sectors of the economy are strongly linked to internal and external debt through certain economic variables. On one hand, it appears that the budget deficit is the major cause of domestic debt. While, on the other hand, it turns out that the deficiency in savings and its effects on the balance of payments is the basis of foreign debt. Notwithstanding the rationale behind the occurrence of debt, the level and rate of growth of public debt should not unduly limit the country’s monetary, fiscal and exchange rate flexibility.
Pakistan’s debt dynamics has undergone substantial changes since FY2007. Higher fiscal deficit led to accumulation of huge debt both in absolute and relative terms. Due to non availability of sufficient funds from the external sources, the financing focus shifted towards domestic sources that led to shortening of maturity profile of public debt. A confluence of unfavourable factors including lower GDP growth, devastating floods, severe energy shortages, haemorrhaging PSEs (public sector enterprises), high inflation, weak security situation and global economic recession resulted in higher fiscal deficits in the recent past.
The level of debt depends on the debt servicing capacity of the economy i.e. export earnings and revenue generation. The debt burden can be expressed in terms of stock ratio i.e. Debt to GDP, external Debt to GDP or flow ratios i.e. Debt to revenue, external Debt to Foreign exchange Earnings. It is common practice to measure public debt burden as a percentage of GDP; however, it makes more sense to measure debt burden in terms of flow ratios because earning potential reflects more accurately on repayment capacity as GDP changes do not fully translate in to revenues particularly in case of Pakistan where taxation systems are inelastic and taxation machinery is weak.
The total public debt stood at Rs.10,709 billion as at June 30, 2012, an increase of Rs.1,788 billion or 20 percent higher than the debt stock at the end of last fiscal year. Government borrowed Rs.1, 086 billion from domestic sources and Rs.62 billion from external sources to finance the fiscal operations. Approximately, US$ 3.3 billion were added to the external debt stock owing to depreciation of US Dollar against other major international currencies and around Rs.27 billion was added by depreciation of Pak Rupee against US Dollar by meagre 0.6 percent.
Depreciation of the US Dollar against other major currencies caused the foreign currency component of public debt to increase by approximately US $3,300 million. This capital loss on foreign currency debt, however, is mitigated by the strong concessionality element associated with Pakistan’s external loans. The impact of any currency shock should not be looked at in isolation, but rather be analyzed in the context of interest rate differential.
Developments in TPD (Total Public Debt) during 2010-11 have been driven mainly by a combination of five distinct factors.
Increased demands on the government budget during 2010-11 for purposes of security meant that expenditure was fairly rigid even in the face of a committed effort to rationalize expenditure and curtail the fiscal deficit. Secondly, lower than expected GDP growth, acute energy shortages, and a high cost of doing business led to a revenue shortfall, situation was further complicated by the devastating floods that put additional burden on fiscal operations. Higher international prices for textile products had a positive impact on Pakistan’s trade balance.
Relationship of External Debt with GDP
Malik, Hayat, and Hayat (2010) explored the relationship between external debt and economic growth in Pakistan for the period 1972 – 2009, using time series econometric technique. Their result shows that external debt is negatively and significantly related to economic growth. The evidence suggests that increase in external debt will lead to decline in economic growth.
Hameed et al. (2008) on Pakistan analyzed the long run and short run relationships between external debt and economic growth. Annual time series data from 1970 to 2008 was obtained to examine the dynamic effect of GDP, debt service, capital stock and labour force on her economic growth. The study concludes that debt servicing burden has a negative effect on the productivity of labour and capital, thereby adversely affecting economic growth.
Chaudhary and Ali (2009) analyzed Pakistan’s outstanding external debt up to the year 2009-10 and presented an alternative measure to reduce debt burden. They proposed to increase savings as a policy measures to overcome the debt problem. According to them, Pakistan can increase its savings by 3 percent, and then it can significantly reduce dependence on foreign resources. They focused on projection of Pakistani foreign debt. They projected the foreign debt for the period of 2009-10 to 2014-15. The empirical findings of the study are consistent with economic theory. Pakistan’s foreign dependence will be doubled by the year 2015 as compared to 1992-93. Similarly, its debt servicing as a percentage of GNP will more than double by the year 2015. They gave trade policy as an alternative strategy to debt and suggest that if Pakistan can increase its exports by 2 percent and reduce imports by 2 percent; borrowing can be decreased by a considerable amount.
Patillo et al. (2002, 2008) examined the relationship between the total external debt and the GDP growth rate for 61 developing countries, for the period 1978-2008. They found out a backward bending growth curve with a debt-growth positive relationship at low levels of national debt and negative relationship at high levels. This shows us that the effects of debt-overhang are likely to occur only after a certain threshold has been reached.
Effectiveness of External debt
Khan and Rahim (1993) examined the impact of annual changes in net economic assistance receipts on changes in two indicators of economic development; domestic savings and economic growth of Pakistan. The analysis incorporates regression of OLS using the sample years 1960 to 1988. The estimated regression equations for domestic savings provided negative coefficients of correlation between foreign aid and domestic efforts for resource mobilization. Aid in grant also exhibits a positive effect on economic growth after one year of actual disbursement, but its estimated coefficient is insignificant.
In order to protect its future credit-worthiness, Pakistan like many other countries of the world has initiated certain restraining measures to limit inflationary pressures and to protect the competitiveness of its exports. However, since there is a substantial time-lag for these measures to work their way through the economy, its growth gets affected negatively from delays in their effectiveness (Afxentiou and Serletis, 2006).
Catherine Pattillo, Helene Poirson, and Luca Ricci (January 2004). And Channels through which external debts affects growth, over the period 1970-08. In the second half of the 1990s, policymakers and citizens around the world have been increasingly concerned that high external indebtedness in many developing countries is limiting growth and development. In Pattillo, Poirson, and Ricci (2002) (hereinafter referred to as PPR), we found empirical support for a nonlinear impact of debt on growth: at low levels, debt has positive effects on growth; but above particular thresholds or turning points, additional debt begins to have a negative impact on growth.
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Ministry of Finance Report 2011
The modern theory for public debt sustainability discerns a fundamental relationship between economic stability and debt sustainability in a country. The inadequate debt management and a permanent and unlimited growth of debt to GDP ratio may result in some negative tendencies and changes in main macroeconomic indicators, like crowding out of investment, financial system instability, inflationary pressures, exchange rate fluctuations etc. There are also social and political implications of unsustainable debt burden. Persistent and high public debt calls for a large piece of budgetary resources for debt servicing. Ergo, the conventional wisdom focuses the management of debt, rather debt itself.
Debt is not a stigma in itself, yet the management of debt is important. Debt is an important measure of bridging the financing gaps. Prudent utilization of debt leads to higher economic growth and it also helps the government to accomplish its social and developmental goals.
As a rule of thumb, as long as the real growth of revenue is higher than the real growth of debt, the Debt to Revenue ratio will not increase. Crucially, future levels of debt hinge around the primary balance of the government.
Dr Yannos Papantoniou said the sovereign debt crisis, originating in the Eurozone immediately after the eruption of the global financial crash, highlights the dangers surrounding the globalisation process. The integration of product and financial markets, and services to a lesser extent, coupled with enormous technological progress in communications and transport has diffused growth to regions and continents, which were left behind previously. “At the global level the huge current account imbalances that have been built up over the last decades have produced an unusual pattern of savings flows,” Dr Yannos said. He said that resolving the crisis inevitably includes action on the causes of the persistent imbalances with structural reforms focusing on liberalising markets. Saving the euro will provide evidence of the extent to which modern nations can impose self-discipline and transfer policy tools to supranational authorities so as to ensure stability and maintain the necessary equilibrium for steady growth, he added.
Some attempts have already been made in analyzing the effect of debt on economic growth of Pakistan (Siddiqui and Malik, 2001; Chaudhary and Anwar, 2001; Burney, 1996). The quantitative estimates of these studies are based on cross-sectional analyses. To the extent they have used cross-sectional data for analyses; they have not been able to take into account the non-stationary properties of the macroeconomic time series. As such, their results are of doubtful validity because they suffer from spurious regression problem. The present study has, therefore, analyzed the impact of external debt service on economic growth of Pakistan with a method that has modelled the no stationary behaviour of the included variables.
More specifically, by following Cunningham (1993), this study has employed a vector error correction framework (VECM) for analyzing the short-run and long-run effects of external debt service on gross domestic product taken as a surrogate of economic growth.
An impressive analysis is made by Reinhart and Rogoff (2010) who selected 44 countries over around 200 years, collecting about 3,700 yearly observations. They found out that the relationship between government debt and real GDP growth is weak for debt-GDP ratios below a threshold of 90% of GDP, while, above 90%, median growth rates fall by 1%, and average growth falls considerably more. As regards the emerging markets, there are lower thresholds for public and private external debt: when external debt reaches 60% of GDP, annual growth decreases by about 2%; for higher levels, growth rates are roughly cut in half.
As mentioned above, this analysis of the relationship between debt and economic growth is based on theoretical framework design after Cunningham (1993) who argues that the effect of debt burden affects on the productivity of capital and labour is similar to that of exports on the productivity of non-export sector in the Feder’s (1982) model. The model used relates the economic growth to debt burden, labour and capital in the form of a neo-classical production function. In, as much as, a nation has significant debt burden, the need to service its debt will affect how labour and capital will be employed in the production function. More specifically, if the gains of the productivity increase are transferred to foreign creditors and not to domestic agents; little incentive will be left to increase the productivity of capital or labour. This, in turn, means that increase in debt burden will decrease economic growth. It is further pointed out that when a nation suffers from heavy debt burden, the need to service that debt determines the manner in which labour and capital are exploited in the production process. More specifically, if the foreign creditors benefit more from the rise in productivity than domestic agents, the latter are discouraged from increasing the application of capital or labour.
This neo-classical production function presented by Cunningham purports the existence of a possible long-run relationship between economic growth and three inputs (debt burden, labour, capital). The possibility of the long-run relationship is tested by using a co integration technique. For this purpose, it is hypothesized that external debt service has a negative impact on economic growth.
The main focus of this study is to analyze the effect of rising debt on economic growth. The increasing dependency of Pakistan on foreign resources is evident from the magnitude of the debt burden and the accompanying debt-servicing liability.
Soundness of Pakistan’s debt position, as given by various sustainability ratios, while deteriorating slightly in the previous fiscal year, remains higher than the internationally accepted thresholds. Total Public debt levels around 3.5 times and debt servicing below 30 percent of government revenue are generally believed to be within the bounds of sustainability. Total public debt in terms of revenues has increased to 4.7 times during 2010-11, as opposed to 4.3 times in the previous fiscal year whereas the debt serving to revenue has declined to 37.7 percent in 2010-11 from 40.4 percent in 2009-10. Regardless, the widening gap between the real growth of revenues and real growth of Total Public Debt needs to be aggressively addressed to reduce the debt burden and improve the debt carrying capacity of the country to finance the growth and development needs.
Public debt to GDP ratio declined by a 0.8 percentage point to stand at 59.3 percent during FY2011, below the ceiling of 60 percent envisaged in the FRDL Act 2005. Fiscal control and a limit on borrowing from SBP facilitated this reduction. However, public debt to GDP may be understated as this ratio does not include any estimates of contingent liabilities, which might materialize in future. Unfortunately, government has not installed any system to quantify and manage the fiscal impact of these contingent liabilities, rather these liabilities are created essentially on an ad hoc basis and without regard to fiscal consequences. Pakistan’s external debt and debt servicing in terms of foreign exchange earnings stood at 1.3 times and 11.4 percent during 2011-12 compared to 1.5 times and 16.5 percent respectively in 20010-11, within the acceptable threshold of 2 times and debt servicing below 20 percent of foreign exchange earnings. However, repayment of IMF debt starting from 2HFY2013 will put pressure on external debt servicing in coming years, therefore it is imperative for the government to take measures for attracting both debt and non-debt foreign currency flows. In the current global economic scenario it will be uphill task for the government to manage external account solvency.
Excessive debt affects a country’s economic development in a number of ways. Firstly, the large debt service requirements dry up foreign exchange and capital, because they are transferred to lenders to payback principal and interest. A country benefits only partially from an increase in output or exports because a growing fraction of the increase gets used to service the accrued debt. Secondly, when the debtor countries are unable to fulfil their debt service obligations promptly, the debtor countries are considered high risk countries and they find it difficult to borrow. As a result, debtor countries have to pay high interest rates to obtain new credit. Thirdly, the accumulation of debt causes a reduction in an economy’s efficiency, since it is difficult to adjust efficaciously to some shocks and international financial fluctuations. Finally, to save more foreign exchange so as to meet debt obligations many debtor countries cut down on imports and restrict trade which leads to poor trade performance.
Overall, the results of the study suggest that debt overhang is an important factor in overall debt scenario of Pakistan. The high debt burden has stemmed from mismanagement of resources, macroeconomic imbalances and loss of competitiveness in the international market. The existence of negative relationship between GDP and debt service may indicate the fact that borrowed resources were misallocated or wasted on consumption. The continued negative effects of debt burden on productivity will reduce the country’s ability to service its debt in future. On the downside, though, a broad expansion in domestic debt poses significant negative connotations for private investment, fiscal sustainability and ultimately economic growth and poverty reduction in case of thin financial markets and poor debt management capacity.
Divergent trends between growth in foreign exchange earnings and government revenues on one hand, and foreign exchange payments and expenditure on the other hand, point towards underlying structural issues which need to be addressed. Export receipts and other foreign currency non-debt creating flows need to be increased above and beyond the growth of foreign exchange payments and growth of external debt and liabilities. By doing so, the government will be able to restrict the non-interest current account deficit, and ensure the sustainability of present levels of external debt. Failure to arrest the widening gap between foreign exchange inflows and outflows will severely hamper the government’s room to manoeuvre in case of future external shocks and may possibly lead to a balance of payment crisis and explosive debt path. Additionally, given access to cheap external finance, in the form of concessionary loans and grants from international financial institutions, governments preferably avoid seemingly expensive domestic borrowing. To limit the growth of public debt burden and to avoid future debt traps, it is essential that significant real growth in revenues is achieved while undertaking a simultaneous rationalization of expenditure.
On the basis of given theoretical and econometric analysis, the study strongly suggests the following future remedies to the policy makers:
1) To try to reduce the expenditures on debt servicing. It can be achieved with the better professional and skilled negotiation with the donor agencies and countries.
2) To efficiently allocate and to develop constraints to utilize the amount of external debt on more productive and development expenditures. So that it might be a source of increase in net investment in the country and, hence, to increase the exports of the economy and, further, to reduce the trade deficit and overall government deficit.
3) To reduce the population growth rate, since it has been found to have significant positive correlation with unemployment rate in the economy. This reduction in growth rate of population will not only cause to improve per capita income of Pakistan, but also be helpful to improve the living standard of the people.
4) To control the hyper inflation, and to make price stability sustainable with GDP growth rate of the economy.
5) The external debt must be allocated to increase the technical skill and professional capabilities of the people. So that they might be able to increase the manufacturing sector growth rate of the economy.