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 sairasaeed1@yahoo.com

Tanweer Ul Islam

Assistant Professor, School of Social Sciences & Humanities, NUST tanweer@s3h.nust.edu.pk

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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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.