Theories of Growth and Debt

Theories of Growth and DebtBasically in scotch literary works we learn two ways in which a clownish finish grow its economy. It bathroom be harvest- succession which has been brought ab bulge come on by innovations in the sue of competition, which can well be described by the self-propelled completion form (Ellig, 2001). On the an opposite(prenominal) hired hand according to Solow (1956) neoclassic model scotch improver can be passd by an amplification in the mensuration of enthr unmatchedment. concord to this model a inelegant leave behind attain frugal development if it increases its savings and investings. This automatically implies that for the least demonstrable countries to grow economicalally they need to implement policies that support greater savings that forgeting so increase investiture and hence crop.To finance its activities a country has a number of options of raising the pecuniary resource. It can make implement of the inherent s ources such as assesses and fees or it can borrow if the internal source is non teeming to finance the budget deficit. gibe to Adegbite, E et al (2008) the Dual Gap theory is a better account of the reason for opting for outside finance as opposed to national financial backing in financing the sustainable development. agree to the theory in growing countries the train of domesticated help savings is not sufficient to finance the take coronation to ensure economic development since investment is a scar of savings it is logical to require the use of complementary external goods and dos. However, the descent among domestic savings and hostile funds gives a choose as to how a country can borrow a loose (ibid). similarly since most of LDCs are far from their steady state step-up two investment injection could lead then to hand accele stepd economic produce.The country should borrow abroad if it is anticipated that the return on the borrowed funds go away be prouder than the cost, at that placefore we do expect a country to invest in projects having anticipate returns higher than the cost of foreign debt. Since if not utilize wisely, debt can come up to impeding the holdable enclosure maturation prospect of the country. External debt does not transform automatically into debt pith when a country optimally make use of the fund. According to Adegbite et al (2008) in an optimal condition, the borderline return on investment is greater than or equal to the cost of borrowing, in this case debt will guide a corroboratory collision on growth.According to the neoclassical growth theory, debt has a confident(p) flat ensnare on economic growth. This is because the amount borrowed if use optimally it is anticipated to increase investment. On the other hand the in verbatim deed of debts is its perfume on investment. The transmission mechanism with which the debt affects growth is its reduction on the resources procurable for investment by debt military service. According to debt beetle hypothesis, a certain level of external debt has a get off positive effect to economic growth until a certain doom where by an additional debt will be in possession of a negative effect to growth.The Debt Overhang TheoryAccording to Krugman (1988), the debt overhang theory shows that if there is unspoilt about likelihood that in the succeeding(a) debt will be larger than the countrys re deliverment ability anticipate debt- table serving costs will discourage further domestic and foreign investment because the pass judgment rate of return from the productive investment projects will be very low to support the economy as the crucial portion of any subsequent economic progress will accrue to the creditor country. This eventually will further number both domestic and foreign investments and hence downsizes economic growth (Krugman, 1988, Sachs, 1989a).Claessens and Diwan (1990) argue that debt overhang is a bunk in which the ilfluidity effect, the disincentive effect, or both cause are strong enough to discourage growth in the absence seizure of concessions by creditors. This is a narrow definition of the debt overhang where the impact of a high external debt that is linked to the tax disincentives argument, where any success in obligated(predicate) countrys economic surgical operation is taxed away by creditors and ultimately microscopical is left over for domestic investment and subsequent growth (Hjertholm, 2001).According to Were, M (2001) debt overhang is much wider in that the do of debt do not exclusively affect investment in physical with child(p) entirely any activity that involves incurring costs up-front for the sake of increase issue in the proximo. Such activities include investment in human hood (in terms of education and health) and in technology acquisition whose effects on growth may be even stronger over time.As emphasise out by Agenor and Montiel (1996), the approach to external debt is motivated by some(prenominal) observations. Most of which insurance-oriented discussion of the debt fuss were centered on the suspicion of whether the debt crisis was one of solvency or of liquidity problem.Differentiating the two terms we can guarantee that, liquidity problem is the inability of a country to overhaul its debts as they occur collect. That means lack of liquidity occurs when a county does not sop up enough cash on hand to pay rate of flow obligations. On the other hand, solvency issue relates to whether the value of a countrys liabilities exceeds the ability to pay at any time a country is insolvent when it is incapable of servicing its debt in the long run (Ajayi, 1991).Taking this into consideration, we observe that, most of least real countries were solvent and still they are solvent. As smeared out by Kletzer (1988), the stupefy value of the most of least developed countries prospective resources which were metric by di scounted value of the real outflows was way far larger than the debt obligations they brace.In answering the nous as to why the obligated(predicate) poor countries had a problem of illiquidity, Jonse G. Leta (2002) in his research on external debt and economic growth in Ethiopia pointed out that although the indebted poor countries have been able to pay i.e. solvent, the willingness to pay decline for a variety of reasons. Among many factors there are domestic and external factors that responsible for this outcome of crisis. The domestic factors often cited include impairment macroeconomic policies such as fiscal irresponsibility and exchange rate misalignment, policies that deter savings such as negative real bear on pass judgment, which in turn reduce investment and march on expectant flying and financing long-run projects with short-term credits. External factors include oil shocks, alloy in the terms of get by and rising foreign interest rates. essentially the higher the comport of debt to the country, the higher is the current sacrifice for the sake of the afterlife growth. The theory of debt overhang is well explained by the hypothesis of Debt Laffer curve which relates the order of magnitude of countrys debt and the value of quittance. According to Freytag, A et al (2008) the NPV of the debt repayments increases with stock of debt up to a certain threshold point beyond which a higher side of meat value of the debt will be associated with scorn efforts and investments, lower economic growth and lower NPV of judge debt service.According to Clements, B et al (2005) high levels of debt can depress economic growth in low-income countries, external debt slows growth only after its face value reaches a threshold level estimated to be about 50 percent of gross domestic product (or, in net cave in value terms, 20-25 percent of gross domestic product). Debt overhang depresses growth by increasing hush-hush investors uncertainty about organiza tional action taken to meet the debt service obligations. These include increase in money supply that causes inflation, distortion of future tax policies (Clements et al, 2005). Therefore the debt overhang problem is linked to the transfer of resources from capital scarce to capital surplus countries.The debt Laffer curve argument (which was apparently introduced by Jefrrey Sachs) is derived from the tax laffer curve hypothesis introduced by Arthur Laffer (1981), who argues that if personal tax rates were raised, they generate a dreadful impact on establishment tax revenue. The reason is that high tax rates either simply discourages investment or leads to tax evasion. Figure 1 presents the Debt Laffer Curve of external debt, anticipate payments and amortizations.If the stock of external debt is small, such that from the origin to point A, then it is expected that the debitor country will be able to meet the sociable debt repayment in full without a problem. Under this situation the marginal expected debt repayment with apprisal to the debt stock is one. However, after this point the expected debt repayment expands at a lower rate in relation to the debt assembling. A country under this level of debt stock is expected to have some difficulties in meeting the debt repayment this can be seen from the marginal expected debt repayment of in the midst of 0 and 1 exclusive. The risk of inability to service the debt increases with the increase in debt stock. The risk may vary from country to country according to the level of their debts interest rate.At point B, the expected debt repayment reaches its maximum saturated point and then starts falling, at this point and beyond the marginal impact of debt is negative. A country under this situation is totally unable to service the debts and most of the time declared to be in debt crisis.On extending the debt laffer curve to show the contri justion of external debt on economic growth on a country we can have figure 2 below. This shows the non linear relationship of external debt and economic growth as supported by Pattillo, C. et al (2002).. A reasonable level of external debt actually has a positive impact on economic growth while excessive debt stock is destructive. As debt stock increases with time growth decreases and it can sometimes reaches a negative level of economic growth.Combining the two figures we have figure 3. Here we can see that as debt increases, creditors expectations of being paid are distorted. From the figure it is easily seen that when the expected payment of the debt increases proportionally less than the debt stock, the distortions are such that extra amounts of debt start decelerating the GDP growth rate. Moreover, if the debt accumulation achieves higher levels such that the debtor starts diminish or failing to make its regular amortizations, any extra debt increase will be reded into negative portions to the GDP growth rate.Claessens et al, (1996) stressed out th at, the other carry through which the service of a large amount of external debt obligations can affect economic performance include the crowd out effect, the lack of access to international financial markets and the effects of the stock of debt on the general level of uncertainty in the economy.The crowding out effect occurs when there is a reduction in the current debt service that lead to an increase in current investment for any stipulation level of future indebtedness (Cohen, 1993).If a greater portion of trade revenue is used to service external debt, very little is available for investment and growth. Claessens et al (1996) as well argues that where foreign assistance is related to the debt and debt service of indebted poor countries, the effects of a debt overhang on economic performance is a more complex question. Debt servicing difficulties lead to a deterioration of relations with creditors, thus reduction the amount of finance indebted poor countries can access (Kh an and Villaneuva, 1991).Theoretical Consideration of Impact of Debt abatementFrom the literature on debt overhang and its effects on growth it is plain that debt replacement might have a stimulating effect on investment and economic growth. Since debt overhang exist when a country exceeds its repayment ability, it can be suggested that, expected debt service is an increasing function of countrys outfit level (Krugmanv1988 Sachs 1989). Therefore in presence of debt overhang, the greater percent of benefits of an increased production brought about the debt accrues to the creditor while all the costs incurred accrue to the indebted country.The incentive mechanism suggests that, in the presence of debt overhang high debt reduces both public and private investment. In the case of public investment, the incentive to investment is discouraged when a large percentage of the return on the debt accrues to the creditor (Johansson 2010). According to Helpman (1989) the disincentive to pr ivate investment occur when a high future debt service acts as implicit tax because more will have to be raised out of the tax to help finance the debt obligations. In this situation projects with quick return will be preferred to long term because there will be high uncertainty on government actions and its policies in meeting the debt obligations (Servn 1997).High level debt increase governments disincentive to carry out reforms. As supported by Corden (1998) and Johansson (2010) that high level of debt makes economic reforms less advantageous and slows down growth because in the presence of debt overhang the growth-enhancing reforms intensify the pressure to repay foreign creditors than fuelling the growth and improving social services.Therefore when a country suffers from debt overhang, debt time out has the electromotive force to improve economic efficiency. This can be possible by reducing the debt stock the reduction will then spill-over its effects and reduce the debt over hang. This will then prevent the disincentive suggested.Cohen (1993) suggested that, debt service payments crowd out investments in areas such as education, health and infrastructure development which are direct as well as indirect impact on economic growth. To help in facilitating growth debt relief frees resources which were tied up in debt servicing enabling government to reallocate the freed resources to more productive areas. tone into resource mechanism in detail it is evident that not just debt relief might bring about the growth due to the freed resources but other factors such as the magnitude of the relief or forgiveness, government investment decisions of the freed resources, revenue collection, tender borrowing, and aids have impact on growth. As supported by Cassimon et al (2008) that since the creditors give debt relief to countries aim about repayment difficulties, the resource mechanism might not create a greater fiscal space to help investment.The impact of debt relief or forgiveness on growth might be limited due to moral hazard or adverse selection (Johansson, 2010). This is because with the idea that the debt will be forgiven or relieved in future, borrowers will be encourage to take up excessive amounts of new loans, expecting that it will be forgiven when the country is in repayment difficulties ( eastern, 2002). This will push countries to rise up new loans even if there are no productive investment opportunities.In adverse selection case, creditors give relief to countries which face payment difficulties and not the ones that are willing and able to increase their investment. A country in this situation might be faced by factors such as profligate government, political instability or interest group polarisation reflecting the high discounting toward the future (Easterly, 2002).He pointed out further, for the debt relief to have a positive impact on growth, good institution and governance is inevitable. This was also supported by Rob inson, (2001) and Subramanian, Trebbi, (2004) because countries with better institutions and government invest more in physical and human capital and make efficient use of the resources to achieve higher growth. In absence of good institutions and governance the freed resources would not translate to productive investments.Empirical Literature Re beholdDebt overhang, investment and GrowthMilton Iyoha (1999) used macroeconometric model to facilitate the simulation of the impact of external debt in economic growth in sub-Saharan Africa. With the use of simultaneous equation models for output and investment demand he was able to conclude that, there is a significant debt overhang and crowding out effect in Sub-Saharan Africa. In other words, the large stock of external debt and heavy debt service payments had a depressing effect on investment in SSA.He went further in simulating the implications of the debt reduction packages on economic growth. Upon simulating at divers(prenominal) debt stock reduction levels he found that the hypothesized debt reductions assumed would increase investment and to a lesser extent the GDP on subsequent period. Simulations showed that a 50% debt stock reduction would have raised per capita gross domestic investment by over 40%, and increased GDP growth by over 3%, on middling, during the 1987-1994 period.Chowdhury (1994) used a geomorphological simultaneous equation model built to capture the interrelationship amidst public and private external debt, capital accumulation and production function. The models were constructed basing on the inter-relationship between the variables that is, some of the variables have characteristic of both in hooklike and dependent nature. Using the Granger causality test on the selective information set for indebted developing countries in Asia and Pacific, Chowdhury showed that, the Bulow-Rogoff (1990) proposition that the external debt of the developing countries is a symptom rather than a cause of economic mental retardation is rejected. alike he further found that, the Dornbusch-Krugman proposition that external debt leads to economic slowdown is rejected. But a feedback-type relationship is not rejected for two countries.The estimated results present that the overall effects of the public and private external debts on gross national product are small and of an opposite sign, where as an increase in the gross national product level raises substantially the public and private external debts. He argued that the positive estimates of the indirect effects of the public external debt on gross national product obtained usher that the capital flight generated by tax rise expectations is smaller than the contribution of public borrowing in financing investment in capital stock. Moreover, the direct and hence the full effects of the public external debt on gross national product are positive and substantially large. An increase of 1% in the public external debt is likely to di rectly and indirectly raise the gross national product level by 0.240% in the Asia Pacific countries.However, the adverse indirect effects of the external debt on GNP through lowering private investment and the overall level of capital stock are large in absolute value and substantially exceed the direct effect. Thus, the full effects of the private external debt on GNP are negative a 1% increase in the private external debt is likely to reduce the GNP level by 0.033% during the time of story.In his estimates also, the effect of GNP on capital stock is indirectly amplified by the positive effect of the public external debt on capital stock. The overall effect of GNP on capital accumulation is positive. The marginal product of capital is also positive and there is diminishing marginal productivity of capital.Since aggregating of data crossways countries imposes and identical structure on all country although sometimes there are greater differences between the studied countries. Th erefore it is necessary to consider the case of each developing country separately so as to see the characters deeply and suggest policies specific for that country. It is under this consideration that the study will be conducted specifically to Tanzania to explore specific characters of the relationship between external debt and economic growth and thereafter answer the key question on debt relief and its impact on growth in Tanzania.Odegbite, E et al (2008) used two models to capture both linear and nonlinear relationship of external debt in economic growth in the study on the impact of Nigerias external debt on economic development. Based on the modification of Elibadawi, Ndulu and Ndungu (1997) model Odegbite investigated the impact of large external debt stock with its servicing requirements and resulting fiscal deficit on private investment. Analysis showed that the influence of exportation growth on GDP growth was confirmed with a significant statistics. This has supported w hat Edwards (1998) claimed on the positive role of export growth process by increasing factor productivity in Nigeria. Due to the cosmea of debt overhang and crowding out effect result shows that savings compresses output. It was show that, a unit increase in debt shipment as measured by the debt service to GDP ratio generates 185 units growth. However the shortcoming of the model used is it considers the public sector gap only and ignores the BOP, it also takes government expenditures and revenue, interest rate and exchange rate as given.Barfour, O (1995), in his study on Ghana, argued that debt repayment inevitably imposes constraints on a debtor countrys growth prospective since it involves the transfer of resources to other countries. Therefore, in order to adequately appreciate the problem of indebtedness, itis essential to relate the debt with its repayments of some income resources generated by the debtor out of which the repayments could be made.Elbadawi et al. (1997) als o confirmed a debt overhang effect on economic growth using cross-section reasoning backward for 99 developing countries covering SSA, Latin America, Asia and Middle East. Three direct channels in which indebtedness in SSA works against growth was identified, this include the current debt inflows as a ratio of GDP (which stimulate growth), past debt accumulation (capturing debt overhang) and debt service ratio. The indirect channel works through the impacts it has on the other channels on public sector expenditures. Empirical study shows that direct nonlinear effects of debt on growth was presented in a icy and random effects panel estimates of a growth regression in which debt to GDP enters both in linear and quadratic form. The results imply growth maximizing debt to GDP ratio of 97 percent, which is kind of high considering the average debt to GDP ratio of 70 percent Pattillo, C (2002)By linking debt and growth problem to capital flight in a relatively guileless model, Calvo (1998) urged that, high debt is associated with low growth since a higher distortionary tax burden on capital is required to service the debt, leading to a lower rate of return on capital, lower investment and growth. Low debt regimes have high growth for the opposite reasons. In intermediate ranges of debt, however, the effect on growth is indeterminate. The mechanism behind the possibility of multiple equilibria is a move up causation from growth to the tax burden if the economy grows more slowly, then the tax rate necessary to obtain enough resources to repay a given debt will have to be higher and vice versa Pattillo, C (2002).Taking in to account the direct as well as the feedback effect of debt in his analysis of the impact of foreign debt on growth in Tanzania Mjema (1996) used simultaneous equation models. In his results he proposed that the impact of the debt service ratio on real growth in GDP is negative. However the effect of external debt found to be positive as it fac ilitates the growth although the negative force is greater and therefore outweigh the positive effect of debt. Amoating and Amoaku-Adu (1996) urged if a greater proportion of export revenue were used to service external debt, then little foreign exchange would be available for investment and growth. This shows an inverse relationship between debt servicing and investment and growth (Gedefa, J. 2002)A number of other studies have found the mankind of debt overhang and crowing out effect in SSA when studying the relationship between debt vis a vis economic growth, investment, capital flight just to character a few. However, most of the studies are mainly based on data across countries in disregard to each countrys uniqueness. While the findings are quite revealing, there is need for case-by-case in depth studies in view of each countrys unique characteristics.Debt ReliefOn reviewing a two decades of debt relief Easterly, W (2002) conducted a study aiming at answering the key questio n as to why did HIPCs became very indebted. Using a sample of 41 HIPCs as classified by IMF and World Bank, he found that patronage their poor policies, HIPCs received more than other LDCs. He found that between 1989 1997 a total of US$ 33 billion were forgiven while their single borrowing was US$41 billion, this shows a close association that the debt relief will be met with an equivalent amount of new borrowing. Upon running the regression for the 40 HIPCs with complete data he found a statistically significant association between average debt relief as a percentage of GDP and new net borrowing as percentage of GDP, one percentage point of GDP higher debt forgiveness translated into 0.34% of GDP new net borrowing.Going further in his analysis Easterly showed that, the average levels of current account deficits, budget deficits, real valuation and other policy indicators were worse for most HIPCs. HIPCs also were worse on the broad measure of policy which includes not only a rati ng of policy stance but also the institutional quality like the preponderance of corruption. One of explanation of the HIPCs heavily indebtedness is they suffered adverse terms of trade shocks, and wars which destroy countries productive assets.The findings imply that the substantial reduction in external debt projected for the countries participating in the HIPC Initiative would directly add 0.8-1.1 percent to their per capita GDP growth rates. Indeed, the positive effects of debt relief may already be reflected in some of the healthier growth rates achieved by these countries in the past few years relative to their poor performance in the 1990s. (Annual GDP growth averaged 1.2 percent in 2000-02, compared with 0.2 percent during the 1990s.) Clements, B et al (2005).BIBLIOGRAPHYAmoating, K. and Amoaku-Adu, B. (1996), economical Growth, Export and External Debt causality The Case of African Countries, Applied scotchs, 28, pp 21-27Barfour. O. 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