Debt Sustainability and Economic Growth in the EU : An Empirical Exploration from a Panel Data

Transcription

1 Debt Sustainability and Economic Growth in the EU : An Empirical Exploration from a Panel Data MENBERE WORKIE TIRUNEH Vysoká škola manažmentu, Bratislava Abstract: This paper shows the debt-growth causality in the European Union in the past ten years or so. Using a panel of EU-27 countries for which data was available during the period (a three-period, five-year non-overlapping panel), the paper shows the existence of debt overhang in selected countries of EU, where debt at a higher level deacreases growth rate of GDP per capita. Our results suggest that the truning point of debt to GDP ratio (which serves a barometer for debt sustainability) ranges between 66% and 100% depending on the type of explanatory variables included in the regression. Keywords: Debt overhang. Eeconomic growth. Panel data. European Union. 1. Introduction International debt has become one of the most serious challenges of the Eueopean Union in the recent periods. Inspite of the Maastricht criteria that imposed a maximul level of debt to GDP ratio (at 60% of GDP), most countries have been experiencing mounting external debt and elevating public finance deficit, escpcially since the outset of the global financial and economic crisis. While there is a significant cross-country variation in the level of debt to GDP ratio, the debt position of EU member states has become a significant bottleneck to both economic growth and sustainability of the fiscal balance. Given the high degree of uncertainties about the existing strategies to manage debt crisis, the future of most economies looks gloomy. The objective of this paper add to the existing debt-growth literature by empirically exploring the debt-growth causality in the Euopean Union member states during the past 10 years or so. In this paper I regress the growth rate of real GDP per capita (of a cross-section of economies in the European Union) against the ratio of debt (% of GDP) and its square, controlling for vector of policy and other variables that often appear in the context of the augmented- Solow growth framework (Mankiw, Romer and Weil, 1992, among others). The time period covered is period, allowing to construct a three-period; five-year non-overlapping panel. When it comes to the empirical strategies, a panel data approach with both randonm and fixed effects has been applied as the later helps us to control for country-specific shocks. This is critical given significant variation across countries both in terms of the level of debt as well as determinants of growth. 2. The debt-growth nexus: theoretical presumptions On the theoretical arena, there is a bulk of literature that link the level of debt with the growth dynamics of an economy. The general consensus is that while debt may help underfunded economies (if properly allocated) to achieve accelerated economic growth, however, when debt excceds cetrain threshold values it could turn harmful (see the next chart). In this regard, the economic literature provides a number of channels through which debt could get tralslated into sluggish ecnomic growth. First, excessive debt may hamper future growth through the debt overhang effect (Borenstein, 1990; Sachs, 1986; Krugman, 1988, Checheria and Rother, 2010; among others). The debt overhang effect manifests itself in various ways. One aspect is linked to the degree of uncertainty arising from high debt buildup. Krugman (1988) defined debt overhang as the presence of an existing inherited debt sufficiently large that creditors do not expect with confidence to be fully repaid (p.254). The second transmission channel comes through the incentive mechanism. As argued by Claessens and Diwan (1990) debt overhang is a 1

2 situation in which the illiquidity effect, the disincentive effect, or both effects are strong enough to discourage growth in the absence of concessions by creditors (p. 31). Similarly, Seurieux and Samy, (2001) argue that debt overhang creates a disincentive environment for private investment that, through lower investment spending, leads to a slowdown in the rate of economic growth, which further reduces future investment. As growth slows down, the debt -to-income ratio also increases, and so does the risk-premium in future borrowing, reinforcing the disincentive effect. The second transmission channel that goes from excessive debt to sluggish economic growth is linked with the crowding-out effect (Sachs, 1988)1, where high level debt increases the marginal cost of debt and reduces future investment. This is because higher interest on debt would mean less domestic investment as much of what has been produced in thr debtor economy is confiscated by creditors, which penalized future growth. The results seem to suggest that while there is a positive statistically significant relationship between total government debt and economic growth, in contrast, higher level of debt (taking the square of debt) is negatively related to economic growth, an evidence that signals that there is a growing debt overhang in the European Union. Nonetheless, given significant number of outliers, such as Greece, Spain, Italy, Belgium, and several others), the results should be interpreted with caution and in context of the time. The Debt Laffer curve (Agénor 2000: 599) lny i, t lnyi, t = α0 + β0(lnyi, t 1) + β1 ln( n + g + δ ) ( INV ) + β ln( HCI ) + β ln( Debt) + β ( Debt) + β2 ln 3 / + γ χit + µ i + υt + ε i, t Data and sample 1 For a broader summary of the debt-growth nexus, see Workie (2005; 2007) 2

3 The data includes 24 EU member states (EU_27 minus Romania, Bulgaria and Luxembourg). Romania and Bulgaria have been excluded because data problem and Luxembourg has been excluded due its size. The time period includes (a three non-overlapping four-years panel) The results of the resgression are included in table 1. The dependent variable is average growth rate of GDP per capita. The indeendent variables include education (measured as school attainment), inflation (a measure of macroeconomic stability), government consumption (a proxy for the behavior and size of the government sector), labor force growth (a proxy for population dynamics and labor market), research and development expenditure (a proxy for innovation) and openness (a measure of trade liberalization and a proxy for competitiveness). Our variable of interest in this paper is debt (measured as the total government debt-to-gdp ratio and its square). Our hyothesis is that debt to some level should be helpful to increase capital deepening in the economy. In contrast, excessive debt may hamper growth through debt overhang and crowding out effects. With the exception of investment, initial values of independent variables used (to minimize endogeneity problem) 4. Results The results seem to suggest debt at lower level actually helps economies to grow as indicated by a ositive and statistically significant relationship between debt and growth. However, once debt reaches excessive level (in our case it ranges between % of GDP, it truns out to be more harmful than helpful. Most of the coefficients on control variables show right signs though not always statistically significant. The results also suggest that controlling for debt and other variables in the resgression, there is conditional convergence in the European Union as indicated by a negative and statistically significant relationship between the growth rate of real GDP per capita and its intial level (GDP t-1 ). The policy implication of this paper and previous similar studies is straightforward: excessive external debt is at the expense of future growth. The experiences of most developing countries in Latin America and Africa also show that high debt buildup is an irrational policy that could lead to problems with debt sustainability and susequently hamper future growth Table 1 Regression results from a fixed effects model * Reg. 1 Reg. 2 Reg. 3 CONSTANT (4.8) *** (5.3) *** (3.5) *** GDP t (-9.17) *** (-9.5) *** (-11.7) *** SCHL (0.67) (0.35) (0.33) LFG (1.66) * (1.21) (1.79) R&D (1.5) (2.6) ** INV (2.7) *** OPEN (0.94) (0.76) GGC (-0.36) (0.32) 3

4 CPI (-2.8) ** (-4.8) *** DEBT (2.19) ** (2.1) ** (2.5) ** DEBT_SQ (-1.65) * (-1.85) * (-1.7) * No. of obser R Turning point The asterisk s *, **, *** indicate level of significance at 10%, 5% and 1% respectively The dpendent variable is growth rate of real GDP Per Capita The asterisk s *, **, *** indicate level of significance at 10%, 5% and 1% respectively. 4

5 References (1) CHECHERITA, C., ROTHER, P The impact of high and growing government debt on economic growth : An empirical investigation for the Euro Area. NO 1237 / AUGUST The European Central Bank. (2) BORENSZTEIN, E Debt overhang, credit rationing and investment. In Journal of Development Economics, 32(2), (3) CLAESSENS, S., DIWAN, I. Investment Incentives : New Money, Debt Relief, and the Critical Role of Conditionality on the Debt Crisis. In World Bank Econ. Review, 4 (1): 21-41, (4) KRUGMAN, P Financing vs. forgiving a debt overhang. In Journal of Development Economics, 29, (5) AGÉNOR, P. R The economics of adjustment and growth. San Diego,CA: Academic Press. (6) SERIEUX, J. E., SAMY, Y The debt service burden and growth : Evidence from low-income countries. The North-South Institute : Ottawa, Canada. (7) SACHS, J The debt overhang and the developing countries. In Calvo, G., Fundlay, R., Kouri, P. and de Macedo J.B. (eds): Debt, Stabilization and Development. Basil Blackwell : Cambridge, MA. (8) WORKIE, M Why Have Indebted Countries Failed to Pay Back Their External Debt? An Empirical Investigation. In Czech Journal of Economics and Finance (Finance a uver) 55, vol. 3-4, May 2005, p (9) WORKIE, M From Debt Crisis to Growth Crisis: Is External Debt the Cause or the Effect of Africa's Marginalization", VDM Verlag Dr. Muller, Dec. 2007, Germany. ISBN ISBN: Contact: Menbere Workie Tiruneh Vysoká škola manažmentu/city University of Seattle Panónska cesta Bratislava mworkie@vsm.sk ; menbere.workie@savba.sk 5