Journal Article

No. 2008-30 | October 07, 2008
The Debt-Growth Nexus in Poor Countries: A Reassessment PDF Icon

Abstract

The paper investigates the relationship between external debt and economic growth, focusing on the role played by the policy and institutional framework. Results for a panel of 114 developing countries show that the debt-growth nexus depends on institutions and policies. The Debt-Laffer curve looses statistical significance once institutional quality is controlled for and debt overhang seems to be at work exclusively in countries with sound institutions. On the contrary, external debt proves to be irrelevant for countries with weak institutions. A policy implication is that efficient debt relief policies should be tailored to country-specific characteristics and conditional to a certain level of institutional quality.

JEL Classification

C33 F34 H63 O11

Citation

Andrea F Presbitero (2008). The Debt-Growth Nexus in Poor Countries: A Reassessment. Economics: The Open-Access, Open-Assessment E-Journal, 2 (2008-30): 1—28. http://dx.doi.org/10.5018/economics-ejournal.ja.2008-30

Assessment

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Comments and Questions


Wasseem Mina - Comments on "The Debt-Growth Nexus in Poor Countries: A Reassessment"
November 07, 2008 - 17:59

Comments on
The Debt-Growth Nexus in Poor Countries: A Reassessment

by

Wasseem Mina
UAE University

This is an interesting paper that aims to empirically examine the interesting issue of whether and the extent to which domestic institutions and policies affect the debt-growth nexus. Results show that domestic ...[more]

... policies and institutions affect this relationship. The paper has an important policy implication for debt relief initiatives, which follow a one-size-fits-all approach: Efficient debt relief policies should be tailored to country-specific characteristics and conditional on institutional quality levels.

I have few conceptual comments on this paper. The first comment relates to the relationship between institutions and the debt-growth nexus. Underlying the posited relationship there exist a series of interconnected relationships between a) debt and growth, b) institutions and debt, c) and institutions and growth. I briefly summarize what is in the literature on these relationships.

Debt influences growth through investment. Pattillo et al (2002, 2004) argue that investment, domestic and foreign, is the channel through which external debt influences growth directly through efficiency and productivity or indirectly through the level of investment.

Institutions also matter for debt. Better institutions increase the level and lengthen the maturity of international lending, and reduce the probability of crisis. Kraay and Nehru (2004) find that improvement in policies and institutions largely reduces the probability of debt distress, and is roughly of the same order of magnitude as reductions in debt burdens. Mina (2006) and Mina and Martinez-Vazquez (2006) show that better contract enforcement and institutional stability increase the level and lengthen the maturity of international lending a country can attract.

There is an arguable association between institutions and growth. Many studies argue that institutions are associated with growth (Dollar and Kraay 2003; Hall and Jones 1999; Knack and Keefer 1995; Kaufmann et al 2007; Mauro 1995). Yet Glaeser et al (2004) are skeptical about the nature of this relationship.

Building on the above relationships, one can argue that institutions matter for investment, which in turn influences growth. From private investment perspective, Aysan et al (2007) find that institutions, in particular administrative quality, political stability, and public accountability matter for private investment decisions. Gwartney et al (2006) find that countries with better institutional quality have higher private investment rate and investment productivity. Dawson (1998) empirically examines the relationship between institutions, investment and growth and finds that economic freedom affects growth though both a direct effect on total factor productivity and an indirect effect on investment.

From an FDI perspective, Asiedu (2006) finds that less corruption, political stability, and legal system reliability promote FDI in Africa, a result that Naude and Krugell (2007) share. In examining FDI in host OECD and Asian countries, Mishra and Daly (2007) reached similar results: The strength and impartiality of the legal system, popular observance of law, strength and quality of bureaucracy, and government stability have a direct effect on FDI. For developing countries, Busse and Hefeker (2007) find that institutions, namely government stability, internal and external conflict, corruption and ethnic tensions, law and order, democratic accountability of government, and quality of bureaucracy, are highly significant determinants of FDI inflows.

Therefore one can argue that better institutions help attract higher level and more long term debt, which finances domestic and foreign investment and encourages growth. This conclusion takes me to the second comment. If sound institutions encourage domestic and foreign investment, which investment source matters more for the debt-growth nexus? It would be interesting to explore which investment matters more.

The third comment relates to the type of (formal) institutions that matter most for the debt-growth and whether informal institutions also matter. The paper uses the World Bank’s Country Policy and Institutional Assessments (CPIA) indicator. I wonder if there are specific component(s), which matter more than others for the debt-growth nexus.

Interestingly the institutions literature seems to focus mostly on the influence of formal institutions on capital flows, investment, and growth. But in poor HIPC countries, would we expect to find formal institutions really sound? I rather think that in these countries informal institutions (customs, traditions, and beliefs) as well as education play a stronger role than formal institutions. I would therefore argue that we are not certain if the formal institutions that matter for growth are the same ones that matter for debt.

The fourth comment relates to the relevance of the dependent variable to the analysis. The paper does not explain the rationale behind using public and publicly guaranteed debt as the dependent variable. It is understandable from the debt overhang literature that HIPC countries do not have access to international capital markets, and rely on concessional lending from official creditors and international organizations. But the sample countries used in the analysis go beyond HIPC countries. So the use PPG debt may not be the most relevant debt measure in this case.

The fifth comment relates to the likely presence of moral hazard and its impact on the analysis. The presence of government guarantees may encourage international lending to poor countries. But at the same time it is known that governments extend guarantees to overcome institutional weaknesses and ascertain international lenders about loan repayment. These guarantees may generate creditor moral hazard. In addition official creditors extend loans at concessional terms likely generating borrower moral hazard. It would be useful if the paper addresses the moral hazard issue conceptually and empirically.

The sixth and final comment relates to the policy implication of the paper. The paper argues that “debt relief could trigger economic growth exclusively in countries with a sound economic and political infrastructure” (page 4). I wonder what the implication of this for war-afflicted poor economies.

References
Asiedu, Elizabeth. 2006. “Foreign Direct Investment in Africa: The Role of Natural Resources, Market Size, Government Policy, Institutions and Political Instability.” World Economy. 29 (1): 63-77.

Aysan, Ahmet Faruk, Mustapha Kamel Nabli, and Marie Ange Veganzones-Varoudakis. 2007. “Governance Institutions and Private Investment: An Application to the Middle East and North Africa.” Developing Economies, 45 (3): 339-77.

Busse, Matthias and Carsten Hefeker. 2007. “Political Risk, Institutions and Foreign Direct Investment.” European Journal of Political Economy. 23 (2): 397-415.

Dawson, John W. 1998. “Institutions, Investment, and Growth: New Cross-Country and Panel Data Evidence.” Economic Inquiry, 36 (4): 603-19.

Dollar, David, and Aart Kraay. 2003. “Institutions, Trade and Growth.” Journal of Monetary Economics, 50 (1): 133-162.

Glaeser, Edward L., Rafael La-Porta, Florencio Lopez-de-Silanes, Andrei Shleifer. 2004. “Do Institutions Cause Growth?” Journal of Economic Growth, 9 (3): 271-303

Gwartney, James D., Randall G. Holcombe, and Robert A. Lawson. 2006. “Institutions and the Impact of Investment on Growth.” Kyklos, 59 (2): 255-73.

Hall, Robert E., and Charles I. Jones. 1999. “Why Do Some Countries Produce So Much More Output Per Worker Than Others?” Quarterly Journal of Economics, 114 (1), 83-116.

Kaufmann, Daniel , Aart Kraay, Massimo Mastruzzi. 2007. Governance matters VI: Aggregate and Individual Governance Indicators 1996-2006. World Bank Policy Research Working Paper 4280.

Knack, Steven, and Philip Keefer. 1995. “Institutions and Economic Performance: Cross Country Tests Using Alternative Measures.” Economics and Politics, 7 (3): 207-227.

Kraay, Aart, and Vikram Nehru. 2004. “When is External Debt Sustainable?” World Bank Policy Research Working Paper 3200.
Mauro, Paulo. 1995. “Corruption and Growth.” Quarterly Journal of Economics, 110 (3): 681-712.

Mina, Wasseem. 2006. “Does Contract Enforcement Matter for International Lending?” Applied Economics Letters, 13 (6): 359-364.


Mina, Wasseem, and Jorge Martinez-Vazquez. 2006. “Contract Enforcement, Institutional Stability and the level and Maturity of International Lending.” International Studies Program Working Paper 06-17, Andrew Young School of Policy Studies, Georgia State University.

Mishra, Anil, and Kevin Daly. 2007. “Effect of Quality of Institutions on Outward Foreign Direct Investment.” Journal of International Trade and Economic Development, 16 (2): 231-44.

Naude, W. A., and W. F. Krugell. 2007. “Investigating Geography and Institutions as Determinants of Foreign Direct Investment in Africa Using Panel Data.” Applied Economics, 39 (10-12): 1223-33.

Pattillo, Catherine, Helene Poirson, and Lucca Ricci. 2002. “External Debt and Growth.” IMF Working Paper 02/69.

Pattillo, Catherine, Helene Poirson, and Lucca Ricci. 2004. “What Are the Channels Through Which External Debt Affects Growth?” IMF Working Paper 04/15.