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S3H Working Paper Series
Number 11: 2016
Public Debt and Economic Growth
Incorporating Endogeneity & Non-linearity
Saira Saeed
Tanweer Ul Islam
December 2016
School of Social Sciences and Humanities (S3H) National University of Sciences and Technology (NUST)
Sector H-12, Islamabad, Pakistan
S3H Working Paper Series
Faculty Editorial Committee
Dr. Zafar Mahmood (Head)
Dr. Najma Sadiq
Dr. Sehar Un Nisa Hassan
Dr. Lubaba Sadaf
Dr. Samina Naveed
Ms. Nazia Malik
S3H Working Paper Series
Number 11: 2016
Public Debt and Economic Growth
Incorporating Endogeneity & Non-linearity
Saira Saeed
Graduate, School of Social Sciences and Humanities, NUST [email protected]
Tanweer Ul Islam
Assistant Professor, School of Social Sciences & Humanities, NUST [email protected]
December 2016
School of Social Sciences and Humanities (S3H) National University of Sciences and Technology (NUST)
Sector H-12, Islamabad, Pakistan
iii
Contents
Abstract …………………………………………………………………………….. v
1. Introduction ………………………………………………………………………… 1
2. Literature Review …………………………………………………………………… 2
3. Data & Methodology ………………………………………………………………... 4
4. Econometric Methodology ………………………………………………………….. 5
5. Estimation Methodology ……………………………………………………………. 6
6. Results ……………………………………………………………………………… 6
7. Conclusion ………………………………………………………………………….. 9
References ………………………………………………………………………….. 10
List of Tables
Table 1: Unit Root Test Results ……………………………………………. 7
Table 2: Fully Modified Ordinary Least Square …………………………….. 7
Table 3: Threshold Levels ………………………………………………... 8
Appendix Table 1: Panel Co-integration Test Results …………………………………. 13
Appendix Table 2: Endogeneity Test Results ……………………………………….. 13
v
Abstract
It is well established in literature that the public debt and economic growth bear positive and
non-linear relationship. However, in recent literature, evidence of no relationship is found when
accounted for endogeneity in case of advanced economies (Panizza, 2014). This finding provides
the motivation to re-explore the relationship between public debt and economic growth under
non-linearity and endogeneity in context of developing economies of South Asia including
Pakistan, India, Bangladesh and Sri-Lanka for the period 1980-2014. There exists a significant,
positive but nonlinear relationship between the public debt and economic growth for the
selected set of developing countries when accounted for endogeneity and non-linearity. The
negative association between the public debt and economic growth for SAARC region is found
when the debt level is higher than 61% of GDP which is quite lower than developed countries
which have threshold level near to 90% of GDP (Reinhart and Rogoff, 2010). Individual
threshold levels for debt-to-GDP ratio divulge that Sri Lanka, Pakistan and India need to control
their public borrowings as their current debt levels are higher and/or around the respective
threshold levels.
1
1. Introduction
Public debt always remains a concerning issue for most of the developing or less developed
countries in the world because the external borrowing is considered as an important resource for
economic growth (Doğan & Bilgili, 2014). This leads to an important policy question; does high
level of public debt have negative impact on economic growth? The endogenous growth models
support negative relation between government debt and long-run growth. The studies in this respect
reveal that if debt affects the productivity of public expenditure, it negatively influences growth of
the country (Teles and Mussolini, 2014; Ramzan and Ahmed, 2014; and Doğan and Bilgili, 2014).
The major drawback of public debt is that it increases uncertainty and affects future expectations
negatively (Cochrane, 2011). The increased accumulation of debt creates sovereignty problems for
countries. The high sovereign risk leads to high interest rate which in turn creates barriers for private
investment (Tanzi and Chalk, 2000). On the other hand, expansionary fiscal policy leading to debt
accumulation ends up with a positive and stable long run growth if prolonged recessions are avoided
(DeLong and Summers, 2012 and Bakar and Hassan, 2008).
Thus, debt trajectory can be as important as the debt level in understanding future growth prospects
(Pescatori, Sandri, and Simon, 2014). It is found that the economic growth is not a major issue in
high debt countries only if the debt is declining over time. A large strand of literature has found the
evidence of nonlinear relationship between debt and growth (Reinhart and Rogoff, 2009; Reinhart
and Rogoff, 2010; Checherita-Westphal and Rother, 2012; Kumar and Woo, 2010 and Eberhardt
and Presbitero, 2015). The problem of endogeneity got the attention in the recent literature as well
(Kumar and Woo, 2010; Checherita-Westphal and Rother, 2012; and Panizza and Presbitero, 2014).
For developed economies, Panizza and Presbitero (2014) found no relationship beteween economic
growth and public debt when accounted for endogeneity. This is an interesting finding which
motivated us to explore the relationship beteween economic growth and public debt in context of
major economies of SAARC (South Asian Association for Regional Cooperation) countries
including India, Pakistan, Bangladesh & Srilanka. This study investigates the existence of a
significant negative/positive long run relationship between public debt and economic growth when
the problem of endogeneity is catered by calling in the Fully Modified OLS (FMOLS) technique and
further examines the presence of a common or country specific thresholds beyond which debt is not
sustainable.
2
2. Literature Review
This study focuses on the public debt and economic growth relationship while catering for
nonlinearity and endogeneity for the major economies of SAARC viz. India, Pakistan, Bangladesh
and Sri Lanka. The contribution of these four economies to the total GDP of the region is 99%
(Mahmood, Arby, & Sherazi, 2014).
Mahmood, Arby, and Sherazi (2014) conclude that all the aforementioned economies are
experiencing episodes of unsustainable debt burden due to large fiscal and current account
imbalances by comparing the traditional debt ratios to the threshold levels. The study emphasizes to
address the long standing issue of twin deficit through credible policy measures to achieve debt
sustainability.
Siddiqui and Malik (2001) cater for nonlinearity while analyzing the impact of various debt indicators
on economic growth for three south asian countries including Pakistan, Bangladesh and Sri Lanka
for the period 1975-1993. The study confirms the nonlinear relationship between debt indicators
and economic growth. The study highlights the mismanagement of resource, macroeconomic
imbalances and international uncompetitiveness as the main factors behind the high external debt
and its negative impact on growth.
Ramzan and Ahmed (2014) analyze the effecitveness of economic polices in utilizing the external
debt for productive pursposes over the period 1970-2009. They develop a composite policy index
comprising of monetary policy, fiscal policy and trade policy by using principle component analysis
and conclude that the low economic growth in Paksitan is due to the lacking of sound economic
polices despite continous resort to foreign debt.
Akram (2011) finds a negative and significant relationship between external debt and GDP per
capita for the period 1972-2009. This study applies the ARDL approach to conclude the existance of
debt overhang effect in Pakistan however, no evidence is found in favour of crowding out effect.
Shah and Pervin, (2012) analyze the impact of external debt stock and external debt servicing on
Bangladesh’s economy for the period 1974-2010. They do not find any evidence of debt overhang
3
but the crowding out effect orginates from the fact that debt servicing has an adverse effect on
growth for the period. The study concludes that the debt stock has positive relation with growth but
more debt stock implies more debt service payment in future. This can be growth retarding in future
if debt stock is accumulated or increased at very high rate.
Another study by Hassan and Akhter (2012) analyzes the relationship of public debt with other
variables like total consumption, manufacturing sector growth, tax revenue, subsidy, net export &
total government stock and the impact of public debt on economic growth of Bangladesh through
public-debt and growth models respectively. This study finds a significant positive relationship of
public debt with investment and government’s reserves. However, the external debt has a negative
impact on economic growth of Bangladesh with little statistical significance for the time period
1980-2012.
India is proved to be a fast growing economy of South Asia with a huge human capital which can be
explored with right investment. Singh (1999) finds the support for Ricardian equivalence hypothesis
between debt and economic growth in India by using cointegration and Granger causality tests over
the period 1959-95. Barik (2011) and Kaur and Kaur (2015) find the indirect positive impact of debt
on economic growth through investment channel suggesting that the Indian public debt is
intensively used for investment purpose to achieve sustainable growth. However, Bal and Rath,
(2014) find a negative impact of both domestic and external debts on economic growth of India in
the longrun by using an ARDL approach.
There are serious concerns regarding the impact of accumulation of public debt and interest
payments on the Sri Lankan economy (Kumara & Cooray, 2013). The study by Kumara and Cooray
(2013) establishes nonlinear relationship between public debt and economic growth of Sri Lanka and
computes the threshold levels of debt-to-GDP ratio as 59.42 and 68.22 percent for two year non-
overlapping and simple time series data sets from 1960 to 2010. The study uses the lagged values of
variables as instruments to cater for endogeneity problem. Kumarasinghe and Purankumbura (2015)
also reveal that the debt has a non-linear relationship with economic growth in Sri Lanka with a 61
percent threshold level of debt-to- GDP over the period 1964-2012.
4
It is well established in debt and economic growth literature that the nonlinearity and endogeneity
are the key issues in econometric modeling. It has been shown in literature that the relationship
between debt and economic growth becomes insignificant in case of advanced economies if
corrected for endogeneity. The evidence of non-linearity is also found which give the idea of
threshold level and it is proven that up to certain level the debt accumulation does have positive
impact on growth. However, except for Sri Lanka, there is hardly any study catering for nonlinearity
and endogeneity problems simultaneously while exploring the debt-growth nexus for major
economies of the SAARC. This study is an attempt to bridge this literature gap.
3. Data & Methodology
We develop an augment Solow, (1956) neoclassical model of economic growth by following
Mankiw, Romer, and Weil, (1992). Assuming the Cobb-Douglas production function for country i,
production at time t is given as
------------- (1)
where, Y is output, W is technological progress and other institutional factors, K and H are the
stocks of physical and human capital and L is the labor respectively. Assuming that the technological
progress can be disaggregated into exogenous technological progress and direct effect of public debt
on economic growth, we may define W as
-------------- (2)
where, A is exogenous technological progress and other institutional factors and D is the public
debt. Following Kumara and Cooray, (2013), quadratic form of debt is used to test the existence of a
nonlinear impact of public debt on growth. To avoid model specification bias in debt-growth
relationship control variables including inflation, human capital (Govt. expenditure on education as
percentage of GDP), dependency ratio (ratio of population aged 0-14 and 65 above to total
population) and trade openness are introduced in the model. The data on the aforementioned
variables are taken from the World Development Indicators and Penn tables for the time period
1980-2014.
5
4. Econometric Methodology
Due to regional integration, economic variables start depending on each other and a shock
happening in a particular country may have large impact on its neighboring country if integration is
very high (Pesaran, 2004). This study is based on panel data which requires the testing for cross-
sectional dependence in the error terms. Pesaran (2004) has proposed the following diagnostic
statistic for cross sectional dependence in panel models
√
{∑
∑ ̂ } ------ (3)
with null hypothesis and ̂ is the sample estimate of pair-wise
correlation of disturbances.
Im, Pesaran, and Shin, (2003) propose panel unit root tests based on the mean of individual unit
root test statstistics with less restrictive alternative hypothesis (i.e. some of the individual series are
unit root processes instead of all) in comparison to panel unit root test proposed by Levin, Lin, and
Chu, (2002). Averaged Dickey-Fuller statistic converges in probability to a standard normal variate
with T followed by N where T and N represent the time series dimensions and cross
section dimensions respectively.
Literature suggests several panel data cointegration tests such as Pedroni (1995, 1997), Kao (1999)
and McCoskey and Kao (1998) however, their null and alternative hypothesis require either all
relationships are cointegrated or all the relationships are not cointegrated. But, the Fisher test allows
for some relationships to be cointegrated and others not. Based on the less restrictive hypothesis,
this study uses the Fisher’s test for panel cointegration suggested by Maddala & Wu (1999). If the
observed significance levels (p-values), , from individual cointegration tests, are
independent uniform (0,1) variables, then Fisher’s test statistic, ∑ has a
distribution with 2N degrees of freedom.
6
5. Estimation Methodology
Although, Ordinary Least Squares (OLS) estimates are super-consistent under cointegration but, still
it contain a second order bias in the presence of endogeneity. This bias can’t be eliminated even
asymptotically and leads to size distortions even when the sample size grows large in panel
dimension (Pedroni, 2000). To deal with the endogeneity problem in debt and economic growth
relationship, this study utilizes the approach developed by Pedroni (2000) for cointegrated panels
based on the principle of FMOLS.
6. Results
The cross sectional dependency test proposed by Pesaran (2004) divulges to accept the null
hypothesis of cross sectional independence (p-value=0.1032). This leads us to the panel unit root
test proposed by Im, Pesaran, and Shin (2003) with the assumption of cross sectional independence.
It is evident from the results summarized in Table 1 that growth rate of GDP, human capital, labor
growth and inflation are stationary at levels while the other variables are integrated of order one.
Fisher’s cointegration test proposed by Maddala and Wu (1999) is the most suitable choice due to its
less restrictive alternative hypothesis and mixed order of integration of variables. Both the Fisher’s
cointegration statistics, trace and maximum eigen value tests, confirm the existance of cointegration
among the varaibles (see, Appendix, Table 1).
Durbin–Wu–Hausman test (augmented regression test) is applied to test the existence of
endogeneity issue in the model. The data do not provide enough evidence (p-value=0.049) to
support the null hypothesis of exogeneity (see, Appendix Table 2). This leads to the inconsistency of
OLS. Thus, FMOLS is applied to estimate the empirical model and results are summarized in Table
2.
All the conventional variables carry the expected signs and significance. For instance, labour, capital,
human capital and trade openness have positive and significant impact on growth. On the other
hand, dependency ratio and inflation are growth retarding. The coefficient for capital is positive and
significant which show that increase in capital accelerate economic growth. The increase in capital
7
formation will enhance the production capacity of an economy. The increase in overall output level
of country induces positive effect on growth. The estimated coefficient on labour is slightly larger
than one would expect to predict from neoclassical theory. The possible explanation could be the
rise in labour reduces the rate in technological progress. These results are in line with the findings in
Shahzad and Javed (2015); Salotti and Trecroci (2012); and Panizza and Presbitero (2014).
Table 1: Unit Root Test Results
Variable Level First Difference
GDP Growth -3.04148 (0.0012)
Capital Growth 0.93442 (0.8250)
-5.10051 (0.0000)
Labor Growth -3.05048 (0.0011)
Human Capital
-2.39392 (0.0083)
Debt/GDP -1.20834 (0.1135)
-3.45493 (0.0003)
Inflation -3.37978 (0.0004)
Trade Openness 2.27268 (0.9885)
-6.37398 (0.0000)
Dependency Ratio 3.70669 (0.9999)
-11.3786 (0.0000)
P-values are in the parenthesis
Table 2: Fully Modified Ordinary Least Square (FMOLS)
Variable Coefficients Standard Error t-values Prob.
Capital Growth 0.007897 0.003112 2.537477 0.0124 Labor Growth 0.696475 0.148292 4.696642 0.0000 Human Capital 0.017182 0.008989 1.911413 0.0582 Debt/GDP 0.258933 0.020798 12.44971 0.0000 Debt/GDP^2 -0.002069 0.000163 -12.66404 0.0000 Dependency Ratio -0.054461 0.009907 -5.496966 0.0000 Inflation -0.057829 0.021281 -2.717459 0.0075 Trade Openness 0.022279 0.006296 3.538805 0.0006
R-squared 0.232839
Adjusted R-squared 0.190885
Long-run Variance 1.073117
Durbin-Watson stat 1.772961 Dependent Variable: GDP Growth
8
Statistical significance and the opposite signs of debt to GDP ratio and its squared form prove the
existence of nonlinear relationship between debt and growth. This is in line with the finding in
Kumara and Cooray (2013) and Panizza and Presbitero (2014). The positive sign of debt to GDP is
indicative of the fact that debt helps to accelerate the growth however; the negative sign of its square
form divulges the existence of a threshold point beyond that the debt will bring deleterious impacts
on the economy. Differentiating the growth model with respect to debt to GDP variable allows us
to compute the threshold levels for the selected set of countries. Results are summarized in Table 3.
Table 3: Threshold Levels
Country Threshold level Current Level (2014)
SAARC 61% -- Pakistan 62% 64% India 66% 66% Bangladesh 40% 19% Sri-Lanka 66% 75%
In case of Pakistan, the level of debt sustainability is 62% of GDP which is in line with the findings
in Saqib (2014). The debt sustainability level for Sri-Lanka is 66% of GDP which is slightly lower
than the findings in Kumara and Cooray (2013) which was 68% of GDP. This difference of two
percentage points may be due to the use of non-overlapping growth spells by Kumara and Cooray
(2013) and the difference in time period. The threshold level for India is 66% of GDP which is
equal to the current debt level of country. In case of Bangladesh, the level is lowest that is 40% of
GDP, which can be backed by the fact that overtime the heavy reliance of economy on debt has
decreased in Bangladesh and the statistics show that the debt to GDP share remain lower than 50%
of GDP during the selected time period.
While comparing with the current situation, India and Pakistan, has debt levels approximately equal
to their respective threshold levels which reveals that further debt will bring negative impacts on
economy. In case of Sri-Lanka the situation is a worst as the threshold level is 66% of GDP and
current level is 75% of GDP which mean that the government need to take steps to lower down
overall debt of country to avoid its negative impacts.
9
7. Conclusion
The hypothesis of nonlinear relationship between debt and economic growth has got its due
attention in the literature however; the endogeneity issue has not been addressed in case of
developing economies. In the recent literature, in case of developed economies, it has been
established that debt and economic growth bear no relationship when controlled for endogeneity
(Panizza and Presbitero, 2014). We explore the relationship between economic growth and public
debt under the assumptions of endogeneity and nonlinearity and the results reveal the significant
dependence of economic growth on public debt for the selected developing countries of the SAARC
region.
The threshold levels for individual countries indicate that the Sri Lanka’s current level of debt (75%
of GDP) is far beyond the benchmark level (66% of GDP). Pakistan and India are also around their
respective threshold levels (62% & 66% of GDP). Further borrowing will bring negative impacts on
their economies. However, Bangladesh’s current debt level (19% of GDP) is well below the
threshold level (40% of GDP). Reinhart and Rogoff (2010) conclude that the low level of debt
seems to have very small impact on growth rate as compare to countries that have accumulated high
amount of debt. But, accumulation of debt is only sustainable when it is kept under the threshold
level.
Reinhart and Rogoff (2010) find the negative association between the public debt and economic
growth when the public debt-to-GDP ratio is higher than 90% of the GDP for emerging and
developed economies. However, in case of developing economies of SAARC region, we find the
negative association between public debt and economic growth when the public debt-to-GDP ratio
is higher than 61% of the GDP.
10
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13
Appendix:
Table 1: Panel Co-integration Test Results
Hypothesized No. of CE(s)
Fisher Stat.* (from trace test)
Prob. Fisher Stat.* (from max-eigen test)
Prob.
None 131.7 0.0000 200.1 0.0000 At most 1 206.7 0.0000 76.87 0.0000
At most 2 119.0 0.0000 60.37 0.0000
At most 3 70.51 0.0000 25.71 0.0012
At most 4 48.03 0.0000 20.01 0.0103
At most 5 31.34 0.0001 12.48 0.1309
At most 6 23.38 0.0029 12.76 0.1204
At most 7 17.68 0.0237 15.34 0.0528
At most 8 12.68 0.1233 12.68 0.1233
Table 2: Endogeneity Test results
Null hypothesis: Debt/GDP is exogenous
Coefficient Std. Error t-Statistic Prob.
2SLS Residuals Stats -0.018911 0.011516 -1.982178 0.0489
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Peru and Vietnam by Mina Zamand and Asma Hyder (2015), 27 pp.
08: 2015 Energy Related Carbon Dioxide Emissions in Pakistan: A Decomposition Analysis
Using LMDI by Arslan Khan and Faisal Jamil (2015), 20 pp.
09: 2015 Decomposition Analysis of Energy Consumption Growth in Pakistan during 1990-
2013 by Arbab Muhammad Shahzad and Faisal Jamil (2015), 24 pp.
10: 2015 Economic Rationality and Early Age Work-Education Choice: Rethinking the Links
by Zahid Sidique, Faisal Jamil and Ayesha Nazuk (2015), 22pp.
11: 2015 Trade Costs of Pakistan with its Major Trading Partners: Measurement and its
Determinants by Saba Altaf and Zafar Mahmood (2015), 32 pp.
01: 2016 The Statistical Value of Injury Risk in Construction and Manufacturing Sector of
Pakistan by Ahmad Mujtaba Khan and Asma Hyder (2016), 15 pp.
02: 2016 Socio-economic Determinants of Maternal Healthcare Behavior: Evidence from
Pakistan by Sadaf Munir Ahmad and Asma Hyder (2016), 19 pp.
03: 2016 Rising Debt: A Serious Threat to the National Security by Ashfaque H. Khan (2016),
31 pp.
04: 2016 Long-run Pricing Performance of Initial Public Offerings (IPOs) in Pakistan by
Muhammad Zubair Mumtaz and Ather Maqsood Ahmed (2016), 38 pp.
05: 2016 When Enough is Not Enough: An Exploratory Analysis of Corruption Behavior in
Select Urban Populations by Kh. Ayaz Ahmed and Ather Maqsood Ahmed (2016),
43 pp.
06: 2016 Determinants of Income Inequality among the Earners in Pakistan by Saira Naseer
and Ather Maqsood Ahmed (2016), 38 pp.
07: 2016 Natural Resource Dependence and Human Capital Accumulation – An Analysis for
the Selected SAARC, ASEAN and OPEC Countries by Rabia Qaiser and Zafar
Mahmood (2016), 31 pp.
08: 2016 Horizontal and Vertical Spillover Effects of Foreign Direct Investment on Sectoral
Productivity in Selected SAARC Countries by Noreen Kasi and Zafar Mahmood
(2016), 34 pp.
09: 2016 Technology Transfer, Development, Deployment, and Productivity Performance in
Pakistan by Irfan Ali and Zafar Mahmood (2016), 35 pp.
10: 2016 Welfare Impact of Electricity Subsidy Reforms: A Micro Model Study by Syed
Adnan Khalid and Verda Salman (2016), 31 pp.
Chinese Studies:
CS-01: 2016 China’s Development Experience by Syed Hasan Javed (2016), 15 pp.
Development Studies:
DS-01: 2016 Rehabilitation of 2010 Flood Affected People in Pakistan: Role of Development
Partners by Sheeba Farooq (2016), 39 pp.