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Policy Implications of a nonlinear relationship between aid, debt and GDP growth

Raj Nallari's picture

Aid and Growth Nexus.  Dollar and Burnside (2000) argue that aid positively influences long term growth in countries with good policy environment.  This is intuitively correct because we all accept that humanitarian assistance by averting crises and human suffering is generally considered.  In addition, no one can deny that building schools, hospitals, roads and power plants and paying teachers, doctors, nurses and engineers under aid projects complements private investment and contributes to overall human development, growth and development.  But, there are complementarities involved in aid-growth nexus – building schools has to be accompanied by teachers who are present regularly to reach, hospitals need pharmaceuticals and doctors as well as nurses simultaneously for health care to improve.  Further, country absorptive capacity, aid management, including project implementation and recurrent budget availability, have differential aid impact on growth. While some countries utilize aid inflows effectively, most countries do not and the aid effectiveness and growth relationship is very complex, possibly nonlinear in relationship, and its quality cannot be captured by indices such as Bank’s CPIA (country policy and institutional assessment).

Aid could hurt growth through two channels.  First, aid inflows push the price of goods and services, such as aid managers, engineers that work on roads, power, and school building, doctors and nurses, and building contractors because of demand for such services.  These goods and services are needed by both traded and non-traded sectors.  For example, aid projects that utilize such services will drive up the wages of such service workers.  If wages are pushed up for these qualified personnel, non-tradable sector is likely to increase prices of its output to compensate for the higher costs so as to maintain its profitability.  On the other hand, the tradable sector because it faces external competition and the price for its output is fixed will run into a loss-making situation and is likely to lose its competitive edge because of the higher wages for the same qualified personnel.

Second, in a flexible exchange rate regime, aid inflows will push up the nominal exchange rate, thereby reducing the tradable sector’s competitiveness if wages do not adjust downwards.  Third, large aid inflows are likely to create a ‘Dutch Disease’ phenomenon. Aid inflows by pushing up wages of certain goods and services, put upward pressure on all other sectors to increase wages.  There is likely to be a generalized rise in wages through out the country.  These effects of aid inflows on growth are not mutually exclusive but the loss of competitiveness, especially in the tradable sector.  Fourth, aid inflows do not provide any incentive for a country to improve its tax collection and administration and perpetuate a culture of aid dependency.  Aid inflows by relaxing the resource constraint of the government could weaken institutions of tax and expenditures, and allow for lack of transparency and corruption in the use of such resources.

To counter this, aid inflows have to be spent for the benefit of tradable sector (imported capital and machinery, intermediate goods etc) rather than non-tradable sector accompanied by fiscal adjustment.  Only then will wages not rise and appreciate the exchange rate. 

Resources are not everything.  While construction of classrooms and hospitals will spur growth in the short term, in the longer term, the critical ingredients for contribution of human capital and physical capital to economic growth may be the right incentives to  avoid absentee teachers and doctors, for availability of teaching materials and pharmaceuticals, and for ensuring adequate supply of power and water. 

Aid inflows have some adverse effects on growth of tradable sector, overall wages, and employment, especially in labor intensive, low skilled, exporting sectors. Remittances, which are private-to-private transfers, do not generate adverse effects on competitiveness.  Aid inflows go through recipient government to the final beneficiaries (i.e. citizens) and this could have a distortionary effect in the economy as described above.  In contrast to aid inflows, inflows of worker remittances directly reach the beneficiaries and do not appear to have a distortionary effect. 

While a scaling-up of aid promotes the transfer of real resources from rich to poor countries, beyond a certain threshold (of about 5 percent of GDP per year), a surge in aid poses macroeconomic problems and could have a negative impact on growth in the long term, particularly if aid is channeled more towards consumption and less towards investment.  There is also evidence that revenue collections are lower in highly-aided countries. 

Debt, Debt Relief and Growth.  Studies investigating the link between external debt and growth place a strong emphasis on the role of investment. Large debt stocks are typically expected to lower growth through the channel of reduced investment which is usually described by the debt overhang hypothesis. Outstanding debt ultimately becomes so large that investment will be inefficiently low without sizable debt or debt service reduction. The burden of large debt sooner or later can lead to extreme scarcity in liquidity, negatively impacting upon capital formation, growth, and consumption.  The incentive effect of this hypothesis refers to the low public and private investment because a larger and larger share of resources is transferred abroad for debt servicing. In other words, some of the returns from investing in the domestic economy are effectively taxed away. 

Another strand of the debt overhang theory emphasizes the point that large debt stocks increase expectations that debt service tends to be financed by distortionary measures (inflation tax or cuts in public investment). Under such  uncertainty,  private investors will prefer to exercise their option of waiting and may choose to invest less, or divert their resources towards quick, financial returns with high risk, or resort to transfer their money abroad (capital flight).

The original Laffer-Debt curve graphed the expected repayment against the face value of debt service. It shows that as outstanding debt increases beyond a threshold level, the expected repayment begins to fall due to the adverse effects mentioned above. Patillo et al. (2002) discuss the possible nonlinear relationship between debt and growth.

There is enough evidence that external debt slows growth beyond a certain level (of about 50 percent of GDP or 20-25 percent of GDP in net present value terms).  This is the so-called ‘Debt Laffer Curve.’  Therefore, substantial reduction in external debt as under the HIPC Initiative is estimated to add about 1 percent in per capita GDP growth (e.g. annual GDP growth of HIPC countries averaged about 1.2 percent per year during 2000-02 compared with 0.2 percent during 1990-99.

External debt also affect GDP growth indirectly through its effect on public investment.  One reason is that the cost of servicing debt decreases fiscal revenues and tends to depress public investment.  The crowding-out of investment intensifies with rising debt service to GDP ratio, thereby suggesting a non-linear relationship between debt, debt-service and growth.  Policymakers are urged to use the resources released by HIPC debt relief for raising public investment, without increasing budget deficits, in an effort to increase growth.

Reducing the stock of debt alone, rather than immediately reducing debt service, is unlikely to induce governments to increase their allocation to public investment.  Front-loading of debt relief and topping-up relief makes eminent sense if poorer countries are to be assisted through debt relief, but every one percent in debt relief by itself raises public investment, on an average, by only 0.2 percent.

In sum, on an average poorer countries, have to learn to manage with aid flows of about 5 per cent of GDP per year, while ensuring that the debt stock is maintained below the 50 percent of GDP threshold, and that the borrowing is on concessional terms to ensure low debt service obligations each year.  Beyond these thresholds, aid and debt will negatively impact upon GDP growth.  The above discussion points to prudent external borrowing strategy and maximizing aid effectiveness for ensring  long term growth.

Comments

Submitted by Andrea Presbitero on

I am very happy to read this interesting post on the relationship between debt and growth. However, I would like to add some comments on the so-called Debt Laffer curve.

In a couple of papers (available on http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=415104) I have investigated the debt-growth nexus, finding evidence in support of a linear relationship. In fact, controlling for the role of institutions and using past values of the debt ratios make the quadratic specification no more significant.

In the most recent paper (The Debt-Growth Nexus in Poor Countries: a Reassessment, the most recent version is available on request) I investigate the relationship between external indebtedness and economic growth, with a particular attention to LICs, for which I guess that the theoretical arguments of debt overhang and liquidity constraint should be reconsidered. The estimation of a growth model, with a panel of 121 developing countries, supports a negative and linear relationship between past values of the NPV of external public debt and current economic growth. This is due to the “extended debt overhang”, according to which a large indebtedness leads to misallocation of capital and discourage long-term investment and structural reforms.

The first contribution of this work is that there is no evidence of an inverse U-shaped curve representing the debt-growth relation. External public debt in the previous period is negatively associated with current economic growth, even controlling for policies and institutions. However, we recognize that this link could become less strong or even not significant when debt is too large, so that there might be a debt irrelevance zone. The upward sloping part of the Debt Laffer curve, instead, is not validated by the data, coherently with the reasonable assumption that rich and industrialized countries are the ones which occupy that portion of the bell curve.

A previous reduction in the discounted debt ratio from 50 to 30, similar to what happened in Bolivia in the last decade, is associated with an increase of almost half percentage point in current GDP growth.

A further step aims to disentangle the negative debt effect in Low and Middle Income countries, on the ground that debt overhang could be reduced or avoided in LICs thanks to the continuous external borrowing. Results are not conclusive, but they suggest the possibility that the negative effect of debt on growth is lower in the poorest countries.

The second contribution of the paper concerns the discussion on the channels through which external debt affects economic growth. The estimation of a total investment and a public investment equations does not find any relationship between external debt and investment rate, providing additional support to the extensive interpretation of debt overhang.

With respect to the crowding out effect, it is limited to total investment in LICs (on average, a one percent increase in the debt service to GDP ratio reduces the total investment rate by almost 0.4 percentage points), where, even considering the concessionality of external lending, interest payments on external debt are a constraint in the poorest because of their weak fiscal system.

Eventually, the paper underlines the great relevance of macroeconomic management and market oriented policies to trigger economic growth. Therefore, in order to reap of the benefit from a reduction in external debt, it is necessary that governments have the incentives to keep on pursuing structural adjustments and reforms. On the contrary, without conditionality, moral hazard issues could prevent these improvements and hinder economic growth.

Submitted by Phillip on
Debt will put a stanglehold on an individual, a company, or a nation. Debt levels must be put in check. Aid can not flow in to rapidly but must be infused carefully into an economy to avoid inflation.

Submitted by Suchmaschinenmarketing - Suchmaschinenoptimierung on
I argue that the institutional view is not so strong as it may appear: different specifications and different institutional indicators undermine the exclusive importance of institutions.

Submitted by alon on
Reducing the stock of debt alone, rather than immediately reducing debt service, is unlikely to induce governments to increase their allocation to public investment. i agree with that

Submitted by Anonymous on
Are there any classifications/ debt stock to GDP thresholds to indicate when the country becomes heavily indebted...

Submitted by eddie on
It is had to make it without debt however, debt contracts and management is critical

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