The effect of external debt on economic growth in sub – saharan africa

ACRONYMS AND ABBREVIATIONS ADF African Development Fund BOP Balance of Payment COC Control of Corruption DEDH Direct Effect of Debt Hypothesis DPD Dynamic Panel Data FONDAD Forum on Debt

THE EFFECT OF EXTERNAL DEBT ON ECONOMIC GROWTH IN SUB – SAHARAN AFRICA

THE CENTER FOR AFRICAN AND ORIENTAL STUDIES

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS

FOR THE DEGREE OF MASTER OF ARTS IN AFRICAN STUDIES (HUMAN AND ECONOMIC DEVELOPMENT IN AFRICA)

ADDIS ABABA UNIVERSITY

ADDIS ABABA, ETHIOPIA

JULY, 2017

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Addis Ababa University

School of Graduate Studies

This is to certify that the thesis prepared by Mahlet Kassaye, entitled: The Effect of External Debt

on Economic Growth in Sub – Saharan Africa and submitted in partial fulfillment of the

requirements for the Degree of Master of Arts in African Studies (Human and Economic Development in Africa) complies with the regulations of the University and meets the accepted standards with respect to originality and quality

Signed by the Examining Committee:

Examiner Signature _ Date

Examiner Signature _ Date

Advisor Signature _ Date

Chair of Department or Graduate Program Coordinator

First and above all, glory to be for the Almighty God for making me complete this thesis successfully and for all the blessings in my life

My heartfelt thanks and gratitude goes to my advisor, Dr Kidist Gebreselasie, for her guidance, constructive and timely comments, unlimited support and welcoming approach in undertaking this study

I am also very grateful to my family, thank you for being very much supportive throughout my life

My sincerest thanks go to my friends and classmates for their encouragement and support Thank you all!

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Contents Pages

Acknowledgements i

Table of Contents ii

List of Tables iv

List of Figures v

List of Acronyms vi

Abstract viii

Chapter One 1

Introduction 1

1.1 Background of the Study 1

1.2 Statement of the Problem 4

1.3 Objective of the study 8

1.4 Significance of the study 8

1.5 Delimitation of the Study 9

1.6 Organization of the thesis 9

Chapter Two 10

Review of the Literature on External Debt and Economic Growth 10

2.1 Theoretical Literature 10

2.1.1 Conceptualizing External Debt, Debt Servicing, Economic Growth and Convergence 10

2.1.2 Historical Roots of SSA‗s External Debt 12

2.1.3 Theories on the External Debt and Growth nexus 13

2.1.4 Theories on the negative effect of excessive debt on growth 19

2.1.5 The Heavily Indebted Poor Countries Initiative 24

2.2 Empirical Literatures 26

Chapter Three 32

Research Method 32

3.1 Model Specification 32

3.1.1 Theoretical Model 32

3.1.2 Empirical Model 37

3.2.1 Variables and their expected signs 45

3.3 Data description and source of data 46

3.4 Estimation Method 46

3.4.1 The General Method of Moments (GMM) 46

3.4.2 Testing for Stationarity 50

3.4.3 Testing for Consistency 51

3.4.4 Testing for Multicollinearity 52

3.4.5 Testing for Heteroskedasticity 52

Chapter Four 53

4 Results and Discussion 53

4.1 Descriptive Statistics and trends in per capita GDP growth and Debt 53

4.1.1 Trends in Per capita GDP growth across the HIPCs SSA 54

4.1.2 Trends in External Debt Stock across the HIPC, SSA 56

4.1.3 Trends in debt servicing across the HIPC of SSA 58

4.2 Test Results 60

4.2.1 Levin-Lin-Chu test for Stationarity 60

4.2.2 Arellano - Bond test for Autocorrelation 61

4.2.3 Pairwise test for Multicollinearity 62

3.2.4 Test for Heteroskedasticity 63

4.3 Econometric Results 63

4.3.1 The Effect of Debt Stock on Growth across the HIPC of SSA 65

4.3.2 The Effect of Debt Servicing on Growth across the HIPC of SSA 66

4.3.3 Evidence of Convergence/Divergence in Growth across the HIPC of SSA 68

4.3.4 Other variables affecting growth across the HIPC of SSA 68

Chapter Five 70

Conclusion 70

References 72

Appendices 79

iv

List of Tables

Table 3.1 Variable description and their expected signs 45

Table 4.1 Descriptive statistics of the variables included in the estimation (1996-2015) 53

Table 4.2 unit root test result for Levin-Lin-Chu (LLC) test 61

Table 4.3 Arellano –Bond test for autocorrelation 62

Table 4.4 Pairwise test for multicollinearity 62

Table 4.5: dynamic panel –data estimation, two - step GMM results 64

List of Figures

Figure 2.1.The Debt Laffer curve 21

Figure 4.1 Average per capita GDP growth rate during 1996-2015 55

Figure 4.2 Average per capita GDP growth rate among HIPC-SSA (1996-2015) 56

Figure 4.3 External debt stocks (% of GNI) for HIPC of SSA during 1996-2015 57

Figure 4.4 External debt stocks (% of GNI) among HIPC-SSA during (1996-2015) 58

Figure 4.5 Total debt servicing (% of GNI) for HIPC of SSA during (1996-2015) 59

Figure 4.6 Total debt servicing (% of GNI) among HIPC-SSA during (1996-2015) 60

ACRONYMS AND ABBREVIATIONS

ADF African Development Fund

BOP Balance of Payment

COC Control of Corruption

DEDH Direct Effect of Debt Hypothesis

DPD Dynamic Panel Data

FONDAD Forum on Debt and Development

GDP Gross Domestic Product

GMM General Method of Moments

GNI Gross National Income GNP Gross National Product

HIPC Heavily Indebted Poor Countries

ICOR Incremental Capital - Output Ratio

IDA International Development Agency

IFIs International Financial Institutions

IMF International Monetary Fund

LDCs Least Developed Countries

LLC Levin-Lin-Chu

MDGs Millennium Development Goals

MDRI Multilateral Debt Relief Initiatives

OLS Ordinary Least Square

OPEC Organization of Petroleum Exporting Countries

PRGF Poverty Reduction and Growth Facility

PRSP Poverty Reduction Strategy Paper SAPs Structural Adjustment Programs SOEs State Owned Enterprises

SSA Sub - Saharan African

USD United States Dollar

WB World Bank

WDI World Development Indicators WGI Worldwide Governance Indicators

ABSTRACT

The Effect of External Debt on Economic Growth in Sub – Saharan Africa

Mahlet Kassaye

Addis Ababa University, 2017

The effect of external debt on economic growth continuous to be a debatable issue among scholars, policy makers and advocates This study examines the impact of excessive debt accumulation on economic growth in the heavily indebted poor countries (HIPC) found in Sub – Saharan Africa (SSA) during the period (1996 – 2015) using two – step GMM estimation technique It also assesses weather the debt cancellations under the HIPC initiative contributes for growth in SSA Results show that excessive external debt accumulation is adversely affecting the growth rate of per capita GDP possibly through its overhang and crowding out effects, whereas debt forgiveness under the HIPC initiative is found to have a significant and positive effect on the growth rate of per capita GDP in SSA Debt coming as a package with a relief initiative can positively contribute to growth in HIPC

- SSA In other words, if debt is to benefit SSA, it should be accompanied by cancellation which is uncertain since it is a decision in the hands of the creditors

Key Words: Debt cancellation, Economic growth, External Debt, HIPC initiative, SSA

Chapter One

Introduction

1.1 Background of the Study

Most Sub - Saharan African (SSA) countries obtained their independence in 1960s.By 1966, 75% of the region was free from the colonial rules (Crowder, 1987) Following the global hike up of commodity prices, the growth performance of many countries in the region improved till early 1970s According to Collins et al., (1996), the political independence and economic growth goes hand in hand and this is manifested by the more rapid growth in SSA during the period 1960 – 1972 than the first half of the 20thcentury with a growth structure better than southern Asian countries

Starting from early 1970s, SSA countries started to face a deteriorating economic performance and a declining social and human development records which were even worse than the colonial times The region observed a rising poverty, inequality, deteriorating terms

of trade, lack of social service provision and most of the countries were unable to continue the huge infrastructural projects which they were building with a dream of attracting future investment opportunities (Moyo, 2009) In 1980s things became worse with social unrest and springing protracted civil wars and as a result the economy of SSA became totally dependent

on external debt and foreign aid with, the external debt burden reached US$235.94 billion making up 71.95% of the GDP by 1995 (Fiagbe, 2015)

Scholars gave various international, regional as well as country specific explanations for SSA‘s indebtedness though they fail to point out the exact factors and remedies For

example, Fosu(1996, 1999), Iyoha(1999), Fole (2003) and Ayadi (2008) indicated that the major factors for Africa‘s indebtedness are: the oil price shocks of the 1970s and their aftermath which includes high interest rates, recession in industrial countries and the subsequent commodity price fall and high inflation rates in Africa Many also argue that a rise in public expenditure, low institutional development/quality and unwise policy measures

by African governments contributed to the situation (Todaro et al., 2012)

According to Elbadawi (2000), the lack of capital faced by African nations pushed them for borrowing He argues that entrepreneurship and capital do not actually exist in Africa and when many states needed a good push to move their economies they went towards the developed countries to borrow capital In many instances, the countries failed to pay back both the debt and its arrears which eventually led to a serious and severe disaster termed as debt crisis

According to Fole (2003), Africa‘s debt crisis has to do with the cumulative effect of the negative trade balances the continent has registered since the time of European conquest and industrial revolution, which through process created a dependent, easily vulnerable and fragile economy He argues that before the conquest, the continent had full autonomy in its economic ties and was capable of producing world class products and fulfilling the basic needs of the African society, but colonialism created a dependent Africa with no bargaining power In the process, African countries were pushed to specialize in providing a single commodity to the world market which worsened the scale of their debt burden Supporting this argument FONDAD (1992), states that protectionism on agricultural and low technology

products made it double difficult for African countries to come out of the debt trap since it made it difficult to earn sufficient hard currency from export

Others blame the political landscape of Africa and its tyrant leaders who practice unlimited power and unaccountable leadership for Africa‘s debt crisis It is believed that majority of the money incurred by SSA as debt is odious and went to the pocket of leaders, affiliated political officials and their close relatives either for personal use or huge army building rather than state building For instance only two African leaders, Mobutu of former Zaire and Abacha of Nigeria looted an estimated sum of US$10 billion from their respective countries (Transparency International (2007) cited in Moyo, 2009)

Still others blame the loose administration of the international financial system as well as the influence of the developed world in using International Financial Institutions (IFIs) to pursue their own agenda through channeling huge funds (Moyo) As a result, African countries ended up getting huge funds even to service their debts and the IFIs were providing debt knowing it has no positive returns and used for non-development purposes The institutions were providing huge sum of money and floating concessional loans through different stabilization policies and Structural Adjustment Programs (SAPs) without considering the countries‘ repaying ability; further impacts on growth, and sustainability of the continent‘s overall development (Todaro et al., 2012)

In effect, most SSA countries became so burdened and overwhelmed by huge external debt stocks and debt-service obligations that their overall economies and particularly the financial

systems are seriously damaged as they struggle to come out of the debt trap According to the World Bank (1999), out of the 39 Heavily Indebted Poor Countries (HIPC), 33 are found in SSA Poverty is also becoming irreversible in SSA and even after providing the so called debt relief and cancellations more than 50% of SSA remains to live below the poverty lines, earning less than $1.25 a day (World Bank)

1.2 Statement of the Problem

Growth theories have established the role of saving and investment for stimulating growth Historical records also proved that countries that achieved and sustained growth in the long run are those that maintained high domestic saving rates sufficient to support their domestic investment (Todaro et al., 2012) Similar with other developing regions, SSA regularly faces capital shortage and widening gap between the amount of savings and investment needs According to Elbadawi (2000) private and public savings have been declining as a share of GDP in SSA Based on the success stories of the developed world, developing countries are advised to fill the saving – investment gap through foreign aid and/or borrowing since they have a very poor record of domestic capital formation which causes SSAs dependency on external capital (Ndikumana, 2014)

Indebtedness is considered as one of the contemporary development problems faced by the developing world This issue attracted many researchers although the focus was more on assessing the causes of indebtedness for Latin American countries especially after Mexico defaulted on its debt obligations (Fiagbe, 2015).The level of external debt in SSA has been steadily increasing for the last couple of decades The external debt stock of SSA countries

reached US$360 billion in 2013 from US$67 billion in 1980,UD$168 billion in 1990, US$206 billion in 2000 and US$268 billion in 2010 respectively (IMF 2015;cited in Hamid, 2015)

The level of debt notwithstanding, the growth performance of SSA has been deteriorating with GDP growth rates kept at minimum or even below zero in some cases Real GDP growth was 5.32 % on average between 2000 and 2010 which started to decline afterwards, registering only a 4.22 % and 4.07 % growth in 2011 and 2013 respectively (Fiagbe,2015) Accompanied by low growth performances poverty continues to be an immense challenge for SSA with the poor increasing from 217 million in 1987 to 384 million in 2005 which is the highest percentage in the world for any region, and it is also with the greatest increase in the number of poor people both numerically and proportionally (WB cited in Todaro et al., 2012)

Debt-driven capital flights continue to be a bottleneck for growth in SSA According to Ndikumana et al., (2011) the borrowed funds have not been financing the development projects as intended; in contrast, the money ended up in private pockets of government officials with the support of the financers and banks They found that33 SSA countries that have debt arrears of US$177 billion in 2008 had an estimated capital flight record of about US$944 billion in between 1970-2008 This situation highly burdened African people with servicing debt

External debt can affect the economy through debt overhang and crowding out effects Based

on the debt overhang hypothesis debt has a negative impact on the economy after it reaches a certain threshold level (Nguyen et al., 2003).This threshold level is estimated at around 50 %

of GDP for the face value of external debt, 20–25 % of GDP for its estimated net present value or 100–105 % as a ratio to exports (Nguyen et al.,) On the other hand, paying for external debt took the money away from public service investments and other development projects According to Ndikumana et al.,(2011) the costs of reckless lending-borrowing practices in SSA are beyond financial problems where an additional dollar of debt servicing implies to 29 fewer cents spent on public health and a reduction of US$ 40,000 through debt servicing leads to one additional infant death Based on this, the African debt service payments are estimated to be equivalent to more than 75,000 infant deaths each year (Ndikumana et al.,)

Many countries fall into debt crowding out effect as public investment is adversely affected

by servicing external debt Since debt servicing is mostly done by using foreign currencies and particularly the dollar, it drains the foreign exchange reserves of the debtor country through capital flights SSA countries engaged in exporting primary products so their export earnings is too small even to finance their imports and provide social services under normal conditions let alone to paying the debt arrears (Moyo,2009) According to Ndinkumana and Boyce (2003), for every dollar of external borrowing by a SSA country in a given year, on average 80 cents left the country as capital flight and will continue to cause an increment in capital flight for consecutive years This indicates that the capital flight exceeds the debt stock itself as it causes investment to flow out of the country

On the other hand finding physical capital through borrowing from different sources has a tendency to boost economic growth in different parts of the world Some of the literature considers the development successes of war torn Europe, South Korea and Japan‘s economic performance as borrowing – led Moyo (2009) It is believed that these countries have

benefited a lot from foreign borrowing in becoming leading economics of the world According to Fiagbe (2015), theoretically this phenomenon is supported since capital generated from domestic sources is very scarce to sufficiently meet the investment targets of the countries at their early stages of growth also ample empirical evidences supporting the theories Uzun et al., (2012), found out that external debt has a positive impact on boosting investment in emerging economies of the world Similarly, Warner (1992), Khan and Kumar (1997), Bhatto (2010), Zaman and Arslan (2014), and many others argue that external debt has a positive contribution for economic growth

In general even if the issue of debt and debt servicing seems to be only financial problems its effects are multi-dimensional touching economic, political and social spheres Although there

is a significant difference among the debt positions of individual countries in SSA, it is very difficult to address the growth and development issues the region is facing without properly addressing the questions raised concerning external debt and growth in the region Although there are many researches conducted on the debt growth nexus almost all are focused on assessing the channels through which debt influences growth, none of them examined the effect of HIPC initiatives on growth for SSA aggregate This research will try to see the impact of external debt on economic growth through assessing the contributions of debt treatments done under the HIPC initiatives for HIPC of SSA

1.3 Objective of the study

The objective of this study is to examine the effect of external debt on economic growth in Sub-Saharan African countries and test the convergence hypothesis for HIPCs of SSA Specifically the study sets out to achieve the following specific objectives:

 examine the trends of external debt stock and debt servicing for SSA

 analyze the effect of indebtedness on the economic growth performance of SSA

 assess the role of HIPC initiative for economic growth in SSA

 investigate the existence of convergence in growth among the HIPCs in SSA

1.4 Significance of the study

The African debt problem is one among the myriads of problems the continent is facing (Fole, 2003).Although there is a significant difference among the debt positions of individual countries in SSA, almost all countries in the region are struggling a lot with debt related issues The SSA region comprises 33 of the 39 HIPC as categorized by the WB and IMF, (1996) Studying the trends of debt stock and debt servicing as well as the debt – growth nexus is necessary and not only because it is one of the contemporary economic issues of the region but also because it has showed direct and indirect long lasting impacts on growth throughout the region

Solving financial constraints using external borrowing did not help in taking the SSA region out of stagnant economic situations for the last couple of decades Scholars, politicians, policy makers and advocates admit that the arrears of debt servicing become a burden for the infant economy of SSA and worked towards debt relief and cancellation since mid-1990‘s to

help SSA achieve the Millennium Development Goals (MDG‘s) and minimize the level of poverty However many countries of SSA continue to remain in unsustainable debt burden having consecutive and severe financial constraints causing economic stagnation and chaos that calls for more empirical research

1.5 Delimitation of the Study

There are 47 countries found in SSA Of which 33 are HIPC This study used –countries of the HIPC SSA by excluding Sao Tome and Principe, Somalia, Sudan and Eritrea Sao Tome and Principe is excluded due to lack of sufficient data on the key variables included in the estimation whereas Somalia, Sudan and Eritrea are excluded as they are not yet eligible for full debt relief and cancellation since they are in the pre – decision stage The study only focuses on countries in the Completion Point in order to get unbiased outcome regarding the guidance of HIPC initiative

1.6 Organization of the thesis

The remaining part of the thesis is organized as follows Chapter two reviews the theoretical and empirical literature concerning the external debt - growth nexus as well as the impact of indebtedness on growth in SSA and developing regions in general Chapter three then presents the theoretical and empirical models as well as the variables and estimation technique for the study Chapter four presents the data analysis and results of the study The last chapter summarizes the main conclusion drawn from the study

2.1.1 Conceptualizing External Debt, Debt Servicing, Economic Growth and Convergence

External debt refers to the total private and public foreign debt owed by a country The WB defines external debt as ―the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy which is repayable

in foreign currency, goods or services in at any given time.‖, External debt is usually owed for two major purposes higher investment or/and higher consumption which domestic resources cannot support which in the long run facilitates economic growth and improves standard of living (Fiagbe, 2015)

Total debt service is the arrear of the debt which includes both the sum of principal repayments and interest actually paid in foreign currency, goods, or services (WB) In most

cases the currency of the lender‘s country serves as the standard currency to service external debt regardless of the exchange rate differences between the currencies However, in a situation where countries involved use same currency, the borrower customarily repays the debt in its own currency (Fiagbe, 2015)

Economic Growth is an increase in the nation‘s productive capacity and shows the rate at which a country‘s economy grows over time It is usually measured as the annual percentage rate of growth of the country‘s major national income accounting aggregates, such as the Gross National Product (GNP) or the Gross Domestic Product (GDP) with appropriate statistical adjustments to discount the potentially misleading effects of price inflation (Johnson, 2000)

The convergence hypothesis states that countries with relatively low levels of initial per capita income grow faster than those with high levels of initial per capita income so that over time income levels converge across countries This hypothesis has led to differences between the two leading economic growth theories – the neoclassical and endogenous growth models The Solow model predicts that growth rates in output and income per capita converge to a constant and identical levels across countries, and regions where as the advocates of endogenous growth models Barro & Sala-I-Martin (1992, 1995), Jones (1995), Mankiw et al., (1992) emphasize that a number of factors may influence growth convergence which includes the existence of diminishing returns to capital within each country or region; spatial capital or/and labour mobility; and the diffusion of innovations across countries and regions

2.1.2 Historical Roots of SSA’s External Debt

It is very difficult to see the SSA debt crises in separation from the global debt crises that occurred since early 1980s Too much borrowing by developing countries combined with liberal lending of foreign commercial banks in 1970s; the fall in commodity prices in the early 1980s, particularly for petroleum products; and the very large increase in international lending rate in 1982 are some of the major factors behind the debt crises in SSA(Todaro et al.,2012) Before the 1982‘s global debt crisis, most non-oil exporting developing countries depended on foreign borrowing to make up for their BOP deficits which is caused by current account deficits and increased from 8.7 billion US$ in 1973 to US$ 42.9 billion in 1974 and US$ 51.3 billion in 1975 due to oil price shocks occurred from 1973 to 1979 (Fiagbe, 2015) Being triggered by the Arab - Israel and the Iraq - Iran war respectively, the quadruple increase in oil prices by the Organization of Petroleum Exporting Countries (OPEC) made huge oil cash available for International Commercial Banks which increased their liquidity to lend abundantly to countries including SSA without any record of creditworthiness (Todaro

1973 to US$ 336billion in 1978 and in SSA alone eleven countries namely Angola,

Cameroon, Congo, Ivory Coast, Gabon, The Gambia, Mozambique, Niger, Nigeria, Tanzania and Zambia defaulted on their debt obligations, Moyo (2009), Ejigayehu(2013)

2.1.3 Theories on the External Debt and Growth nexus

Economic theories suggest that reasonable levels of borrowing by a developing country can enhance economic growth since countries at early stages of development face capital shortage According to these theories developing countries have better returns on investment when compared with developed countries and as long as they use the borrowed funds for productive investment purposes and as far as they face no economic distortions they would not face a debt burden since the increase in growth allows them for timely debt servicing (Pattillo et al., 2004) The positive growth effect of debt is implicitly embedded on theories supporting the positive growth effect of capital accumulation Some of these theories which directly or implicitly acknowledge the role of debt for growth are the Harrod – Domar growth model, The Solow- Swanson model, The Keynesian model and the endogenous growth model which are discussed in what follows

The Harrod-Domar growth model is the simplest and most known production function used

in the analysis of economic development, which is developed by Harrod (1939) and Domar (1946), primarily to explain the relationship between growth and unemployment in an advanced capitalist society The model has been used extensively in LDCs to examine the relationship between capital requirements and growth The model, assumes that economic growth is a direct result of capital accumulation in the form of saving and has been

intensively used to estimate the financing gap of a developing economy By assuming abundant labor supply this theory claims capital scarcity as the only growth constraint for developing countries (Effendi, 2001)

The Harrod – Domar model asserts that growth is proportional to the rate of investment, which depends on the level of national saving and the productivity of capital investment (the capital output ratio), (Todaro et al., 2012) The model helps to find the saving investment gap which is mathematically calculated by multiplying the targeted growth rate with the capital output ratio This model advocates the use of imported foreign capital to stimulate growth (Suma, 2007)

The model also articulates that the growth rate of national income is directly related to the saving ratio and inversely related to capital-output ratio On theoretical grounds, the Harrod-Domar growth model suffers a shortcoming, by which the equilibrium is unstable since it requires the equalization of warranted and natural growth rates and for using production function with little suitability among inputs (Scarfe, 1977) As described by, Foday (2007) the production function used in this model is of Leontief type with fixed proportion and no substitutability of factors Although the huge capital injection saved the war torn Europe, empirical evidences do not, however, support this theory in the context of developing countries since the massive external debt that has accumulated in developing countries since the 1960s was accompanied by neither economic growth nor investment

ii The Solow – Swan Model

The Solow – Swan (1956) model was developed independently by Robert Solow and Trevor Swan in 1956 The model targets to address the question of why rich countries are so rich and why the poor ones are so poor? This model which is developed based on Cobb – Douglass production function reveals constant returns to scale, diminishing returns to each input, and positive substitutability to inputs The production function is assumed to be a function of capital, labor and technology and states that economies will conditionally converge to the same level of income if they have the same rates of savings, depreciation, labor force growth, and productivity growth This model serves as the basic framework for the study of convergence across countries (Todaro et al., 2012)

The model states that an increase in saving, which is reflected in investment, will generate additional growth in the short run However, as the ratio of capital to labor increases, the marginal product of capital will decline and the economy will go back to a steady state which makes output, capital, and labor grow at the same rate Hence growth in per capita income continues and equals the annual rate of productivity improvements (Suma, 2007)

Based on this model total capital accumulation depends on the change in capital per worker which is a function of investment per worker, depreciation per worker and population growth (Ejigayehu,2013).Total capital stock grows when saving is greater than depreciation, and capital per worker grows when saving is greater than what is needed to equip new workers with the same amount of capital as the existing workers and as we increase the capital accumulation by raising the rate of savings, there exists a temporary increase in the rate of

output growth, although at a higher level of output per worker we return to the original steady-state growth rate in each consecutive year (Todaro et al., 2012)

The model states that an increase in saving will not increase growth in the long run That is, once the economy gets time to adjust, both capital-labor ratio and the output-labor ratio increases, but not their rates of growth In the Solow – Swan model, an increase in saving raises equilibrium output per person and growth rate increases temporarily as the economy moves up to a higher equilibrium, saving definitely increases and the economy may not return even halfway to its steady state for decades Despite the model‘s advocacy for technology in bringing growth in the long run, it emphasizes that capital accumulation is necessary for growth since convergence between countries can only be achieved through increasing the capital output ratio Considering the reality in the developing world including SSA, there have been efforts to increase capital accumulation by mobilizing foreign saving but convergence, productivity, growth or innovation and technological advancement never occurred in the region (Suma, 2007, Todaro et al., 2012) This situation warrants further investigation to identify the underlying factors

iii Keynesian Economic Theory

The bases of Keynesian economic theories were first presented by John Maynard Keynes during the great depression occurred in the industrial world in1930s.Keynesian economists generally argue that, aggregate demand is volatile and unstable in a market economy which often experience inefficient macroeconomic outcomes According to these theorists government intervention and active monetary policy responses can mitigate and help

stabilize the economy especially in the short run (IMF, 2014) Keynesian economists often advocate an active role for government intervention during recessions In this theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy Keynesian economics served as the standard economic model

in the developed world during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the oil shock of the 1970s

Although this theory does not have a direct link and application regarding the developing world, in principle the theory advocates financial support through borrowing since less investment brings less growth and make the economy work less than its potential growth levels According to Keynes (1936), government spending is necessary to increase economic activities which can regulate the economy Thus, indebtedness does not create charges either

on current or future generations since indebtedness stimulates demand and leads to a more proportionate rise in investment via the accelerator principle or effect and as interest rates decline and become favorable for borrowing they promote investment through increasing debt supported consumptions Based on this theory, foreign debt is likely to have a favorable effect on total investments in a country because most of the foreign borrowing is done on the claim that domestic savings are not sufficient to finance the planned investment expenditures

iv Endogenous Growth Models

The endogenous growth theory which is first developed by the work of Romer (1986) and Lucas (1988) modeled an extended production function that includes human capital and the investment made on human capital as sources of economic growth The theory states that the

rate of returns to capital both physical and human determines growth in the long run The augmented Solow models developed by Romer et al., (1992) and Lucas (1988) implied that technology is not exogenous rather it is determined by economic activities like innovation

As stated by Romer (1994) economic growth is not the result of forces that impose from outside but it is the results of economic activities that create new technological knowledge According to this model output can be increased by increasing resource inputs and productivity of these inputs

As stated by Todaro et al., (2012), the frequently abnormal behavior of capital flows from poor to rich nations helped provide the motivation for the development of endogenous/the new growth theory This theory provides a theoretical framework to analyze growth from within Assuming investments in human capital improve productivity that offsets the natural tendency for diminishing returns these theorists seek to explain the existence of increasing returns to scale

Endogenous growth models well explained the causes of anomalous international flows of capital that exacerbate wealth disparities between developed and developing countries According to them though developing countries potentially have high rate of return on investment, this is eroded by lower levels of complementary investments in human capital, infrastructure, or research and development As a result ,developing countries benefit less from broader social gains associated with each of these alternative forms of capital expenditure thus they suggest an active role for public policy in promoting economic

development through direct and indirect investment in human capital formation and foreign private investment (Todaro et al.,)

According to them individuals involve in capital flight because they receive no personal gain from the positive externalities created by their own investments since the free market leads to the accumulation of less than the optimal level of complementary capital Arrow et al., (1970) introduced the concept of productive public capital in growth model, where growth is determined exogenously Barro (1990) used same approach to present a model that assumes government spending as a flow variable enters the macroeconomic production function

Futagam et al., (1993) presents an endogenous growth model where the stock of public

capital has positive effects with regards to the marginal product of private capital which leads

to endogenous growth Ewijk et al., (1993) analyze the impact of different budgetary regimes for the dynamics of growth and public debt in a conventional growth model and find out that government that keeps the budget deficit constant is less favorable with regarding productivity growth as compared to a regime where the government tries to cut the budget deficit through borrowing In this model external borrowing is expected to have a positive impact on economic growth in a belief that an expansion in public debt leads to an increase

in public expenditure which increases economic growth through the government expenditure multiplier

2.1.4 Theories on the negative effect of excessive debt on growth

Holding excessive external debt is expected to have adverse effect on economic growth (Elbadawi et al., 1996) There are several theories supporting the adverse effects of

indebtedness including debt overhang, debt crowding out, Dutch disease ,foreign exchange liquidity constraint and so on, which Fosu ,(1996) termed as the Direct Effect of Debt Hypothesis (DEDH)

i The Debt Overhang Hypothesis

The debt overhang hypothesis is one of the dominant theories regarding the adverse consequence of holding excessive debt stock Debt overhang is a situation in which the expected repayment of external debt falls short of the contractual value of debt For Krugman (1988), if a country‘s debt level exceeds the nation‘s repayment ability, expected debt servicing is likely to be an increasing share of the country‘s future output level Thus, investment and growth will be discouraged expecting high future tax rates on the returns from the domestic economy issued for the existing foreign creditors

Debt overhang is a primary cause of stunted economic performance: in heavily indebted countries As discussed by Sachs (1990) in the context of poor countries the required debt service payments are so large that the prospects for a return to growth path are dim, even if the countries adopt strong adjustment programs The existence of large debt overhang inhibits private investment programs by virtue of uncertainty and adverse incentive effects it creates along the way Theoretically, literatures suggests that foreign borrowing has a positive impact on investment and growth up to a certain threshold level but beyond this level it affects growth that can easily be shown using the Debt Laffer curve given in Figure 2.1

Source: Krugman (1989)

Figure 2.1.The Debt Laffer curve

The Debt Laffer Curve in Figure 2.1 shows the relationship between debt accumulation and

economic growth At all points to the left of D* on the X-axis, increasing levels of debt increases economic growth However, after growth level A on the curve, economic growth begins to increase at a declining rate until the peak level E, which corresponds to debt stock,

D*, where additional levels of debt decreases economic growth Therefore point, D* is the

limit at which further debt accumulation starts to impact negatively on growth The expectation that some portion of the debt will have to be forgiven can also discourage private foreign investors from providing new financing, thus lowering capital accumulation and growth (Helpman & Krugman, 1989)

Other thoughts imply that high debt levels may also constrain growth by lowering the growth

of total factor productivity Governments will be less willing to undertake difficult and costly policy reforms if it is perceived that the future benefit in terms of higher output will accrue

partly to foreign creditors The poorer policy environment, in turn, is likely to affect the efficiency of investment and productivity In addition, high levels of uncertainties and instabilities related to debt overhang are likely to hinder incentives to improve technology or

to use resource efficiently Thus investment may be misallocated to activities with quick returns, rather than long-term, higher-risk irreversible investment which would be more conducive to long run productivity growth Misallocated resources and less efficient investment projects could thus contribute to slower productivity growth (Pattillo et al., 2004)

ii Debt Crowding out Effect

According to the debt crowding out hypothesis, external debt servicing creates liquidity constraint on the debtors and as a result servicing external debt potentially affects growth by crowding out private investment through shifting the direction of public spending Nguyen et al., (2003) states that higher debt service can raise the government‘s interest bill and the budget deficit but reduces public savings; which raise interest rates and crowd out credit available for the private investment and there by harming economic growth Higher debt service payments can also have adverse effects on the composition of public spending by squeezing the amount of resources available for infrastructure and human capital development and posting a setback to meeting basic human needs and social services in developing countries (OXFAM international, 1995)

Fosu (2009) stated that servicing external debt takes the scarce hard currency away from the poor and highly indebted economics which makes governments shorthanded towards providing sufficient public investment that can stimulate growth According to the debt

crowding out hypothesis debt servicing takes the small export gains of poor economies which are dependent on exporting cheap raw materials there by eroding the major sources of revenue for providing social services

iii Dutch Disease

Dutch Disease describes the apparent causal relationship between the increase in the growth

of a specific sector and a decline in other sectors caused by increasing revenues from the growing sector or through foreign capital inflows This situation makes, the given nation's currency become stronger/ appreciate as compared to currencies of other nations which makes the nation's other exports becoming more expensive for other countries to buy, and

imports becoming cheaper, making those sectors less competitive (IMF,2003)

Initially Dutch Disease was used to explain the relationship between exploitation of natural resource and decline in the manufacturing sector The theory emphasizes that increase in revenues from natural resources will deindustrialize the nation‘s economy by appreciating the real exchange rate, which makes the tradable sector less competitive As Corden & Neary (1982) explained the situation creates adverse effect on non- booming agricultural and manufacturing sectors due to the booming of the mining sector As stated by many literatures the term ―Dutch Disease‖ is also used to describe the situation where an economy suffers from an increase in inflation and unemployment and a decline in the competitiveness of export sector which leads the economy towards lower growth rate

Several factors can cause appreciation in real exchange rates Geda (1997) asserts that, external finance can led to Dutch Disease if part of it is spent on non-tradable goods, which

in turn leads to a real appreciation (i.e., a rise in relative price of non-tradable goods) This, in turn, leads to resource movement out of the non-booming tradable sector in to the non-traded

sector (Hjertholm et al., 2000)

According to Fosu(1996) nations may increasingly rely on relatively short term investment projects in order to service their debt thus, loans would probably be used for generating short term export proceeds in order to be able to meet repayment obligations rather than for long term improvements in the infrastructure whose returns are larger in the future Burdensome debt service levels will remove the cash away from relatively productive investment requiring expensive imported materials critical to the growth process

2.1.5 The Heavily Indebted Poor Countries Initiative

The Heavily Indebted Poor Countries (HIPC) initiative was launched in 1996 by a coalition

of the World Bank (WB), International Monetary Fund (IMF) and other bilateral and multilateral creditors with the aim of making debt levels sustainable and manageable for the HIPC that fulfills the initiative‘s criteria This initiative which is the outcome of the different networks influencing the multilateral creditors and the G-8 governments to transform the international debt regime particularly in SSA officially started to operate since 1999(Gautam, 2003).The initiative marked significant advancement from traditional debt relief mechanisms for eligible low-income countries since it transformed the debt regime towards more open and accountable norms, and introduced some key innovations, including, a systematic treatment of multilateral debt, the notion of debt sustainability, and the focus on poverty reduction (Callaghy,2002)

According to the WB being eligible for HIPC debt relief requires to fulfill two sets of criteria which are literally known as the decision point and the completion point A country must: a) eligible to borrow from the World Bank‘s International Development Agency(IDA), which provides interest-free loans and grants to the world‘s poorest countries, and from the IMF‘s Poverty Reduction and Growth Trust, which provides loans to low-income countries at subsidized rates: b) face an unsustainable debt burden that cannot be addressed through traditional debt relief mechanisms; c) have established a track record of reform and sound policies through IMF and WB support programs; and d) develop a Poverty Reduction Strategy Paper (PRSP)through a broad-based participatory process in the country Once a country has made sufficient progress in meeting the above criteria, it become eligibility for debt relief and may immediately begin receiving interim relief on its debt service

The second set of criteria is known as the completion point At this stage countries must: a) establish a further track record of good performance under programs supported by loans from the IMF and the World Bank; b) implement satisfactorily key reforms agreed at the decision point; and c) adopt and implement its PRSP for at least one year in order to receive full and irrevocable reduction in debt available under the HIPC Initiative, and once a country has met these criteria; it can reach its completion point, which allows it to receive the full debt relief committed at the decision point

In July 2005, the G8 leaders announced the inauguration of the multilateral debt relief initiatives (MDRI) and pledged to cancel the debt of the world's most indebted countries, most of which are located in SSA Through this program debt cancellation was provided by

IDA of the World Bank, the IMF and the African Development Fund (ADF) to countries that have graduated/ reaching the "completion point" under the HIPC Initiative, IMF (2016)

According to the WB initially there were 39 countries which were potentially eligible for HIPC initiative assistance program Out of which 33 are found in SSA whereas the other 6 are located in Asia and Latin America Of these 36 countries are receiving full debt reliefs from the IMF and other creditors after reaching their completion points Three countries namely Eritrea, Somalia and Sudan though identified as potentially eligible for HIPC Initiative assistance, have not yet reached their decision points According to the IMF,(2016) the total cost of providing assistance to the 39 countries is estimated to be about $75 billion

in end-2014 net present value terms of which US$41.6 billion was covered through MDRI

2.2 Empirical Literatures

In this section empirical literature which focuses on the impact of external debt on growth is presented Although there are several researches conducted in analyzing the impact of external debt on economic growth, they come up with different results depending on the geographical area and the time covered as well as difference in estimation techniques and measurement of external debt The following empirical literatures give a highlight on how external debt is affecting the economy of SSA and the developing world in general

The success story of the Marshall plan in lifting up the economy of the war - torn Europe after the Second World War confirmed the significant role of physical capital for economic growth Adequate physical capital and its positive contribution for growth is indubitable

However the main concern in empirical studies lies on measuring its rate of return when external debt become major source of capital to finance the overall economy of a nation

Fosu (1996) in studying the impact of external debt on economic growth for SSA used augmented production function and OLS techniques He employed data over the period 1970-1986 for 29 SSA countries of which 21 of incurred arrears or rescheduling during 1984 – 1986 and found out that the burden of debt whether measured as debt service or debt outstanding has on average been deleterious to growth in SSA According to his estimation countries which are in high debt face a reduction of 1.1 percentage points in annual economic growth In examining the effect of external debt on the developing countries‘ of Africa, he tasted for the Direct Effect of Debt Hypothesis (DEDH) and find out that debt adversely influenced economic growth in SSA nations over the long run According to his (2009) findings debt negatively influenced GDP growth by reducing public service provision especially education and basic health care

Pattillo et al., (2002) used multiple regression analysis to test whether debt and per capita growth are related The analysis used panel data for 93 developing countries including SSA over the period 1969 - 1998 According to them reasonable levels of external debt that help finance productive investment may enhance growth, but beyond certain levels additional indebtedness may reduce growth Using various non-linear specifications to identify the levels of debt at which the average and marginal impact of debt on growth becomes negative, other growth determinants remaining constant and addressing major debt related questions, they ratify that the overall contribution of debt becomes negative at about 160-170 percent of

export and 35-40 percent of GDP in net present value terms Their results also indicate that the marginal impact of debt starts being negative at about half of the above values on average They concluded that for a country with average indebtedness doubling the debt ratio would reduce the annual per capita growth by between half and one percentage points, while countries that are to benefit from debt reduction under the HIPC might increase 1% in per capita growth, unless constrained by other macroeconomic and structural distortions

Ejigayehu (2013) using panel data analyzed the effect of external debt on economic growth for eight HIPC in SSA for the period 1991-2010 He examined the debt overhang and debt crowding out hypothesis by employing the random effect approach and found out that debt affect growth of the selected regions by the debt crowding out effect rather than debt overhang According to him, the impact of debt on economic growth is significant in terms of debt crowding effect for the selected countries in particular and for the overall HIPC in general Based on his findings the debt overhang effect has not been discovered in the selected countries The study also published that the total amount of debt relief the countries

in the study received is negligible and did not help them towards a better economic growth

Nguyen et al.,(2003) conducting a study on 55 low –income countries that are classified as eligible for the IMF‘s Poverty Reduction and Growth Facility (PRGF) covering the period 1970–99 ,found out that high levels of debt can depress economic growth in low-income countries According to them debt appears to affect growth via its effect on the efficiency of resource use, rather than through its depressing private investment Their results imply that the substantial reduction in external debt projected for the HIPCs will directly add 0.8–1.1

percent to their per capita GDP growth rates by the completion point, ceteris paribus They

showed that external debt also has indirect effects on growth through its effects on public investment since debt servicing depress public investment and on average, every 1 % increase in debt service as a share of GDP reduces public investment by about 0.2 % which implies that a reduction in debt service of about 6 percentage points of GDP would raise investment by 0.75–1 % of GDP, which raises growth by about 0.2 %

The debate towards the convergence hypothesis has captured the attention of mainstream economists in the last decades According to Sala-I-Martin, (1996) the reasons for the sudden increase is because since it serves as the main test for the validity of modern economic growth theories and as a distinguishing feature between the earlier Solow model and the endogenous growth models and due to availability of data specially the GDP, which make it easy and possible to test for it

Mankiw et al., (1992), studying convergence in 98 countries over a 25-period assuming a common rate of technological progress Grossman and Helpman (1994) pointed out the failure of per capita output to equalize across developed and developing countries and proof that there is little observable tendency for poorer economies to catch-up with the richer ones Lee et al., (1995) found no evidence of convergence among 102 non-oil producing countries over the period 1960-1989 However, Baumol, Blackman and Wolf (1989) argue that if low-income, middle-income and high-income countries are examined separately, there is evidence of convergence within each group

The prediction of absolute convergence is tested by a number of growth theorists For example, Baumol (1986) examined the absolute convergence for 16 industrial countries and found out a high degree of growth convergence However, DeLong (1988) adding seven countries in the previous sample found out that the rate of convergence falls to about half the estimate obtained by Baumol Barro and Sala-I-Martin (1995) examine growth convergence across US states for nine periods from 1880 to 1988 and found evidence of convergence They find that the gap between the rich and poor states decreases by 2 percent per year Most studies conclude that there appears unconditional convergence among richer countries of the world, but little evidence of convergence is found in poorer countries (Barro, 1991; Mankiw

et al 1992) Quah (1993) and Ben-David (1995) argue that unconditional convergence is not only a trait of the richest countries but also common among the poorest countries

The recent literature on the growth convergence debate has contributed significant theoretical explanations on the circumstances how convergence in income levels takes place According

to them there are two main reasons for the occurrence of convergence of per capita income across countries: the first is the assumption of diminishing marginal returns to physical capital as stated in the neoclassical model (Solow, 1956; Koopmans, 1965).where the higher marginal product of capital in poor countries attract foreign capital thus through time, the capital-labour ratios and factor prices will equalize Likewise, because of the inflow of capital from rich to poor countries, income in poor countries would grow faster than incomes

in rich countries and the two would eventually convergence because of decreasing returns as stated in the classical theory However, although there has been considerable transfer of capital to poorer countries, the inflow is by far less than the size predicted by the standard