External Debt and Economic Growth: Empirical Evidence from Sierra

1.1 Background to the study The generation or mobilization of resources to carry out government development plans is very crucial. The effectiveness of any change management within an economy is contingent upon the development of sound economic policies, backed by the political, social and people will to implement the activities and the available of resources to effect the change. Irrespective of the level of resources within an economy, there are a number of sectors that need to be given high priority on the nations development agenda. Such sectors include the health and agricultural sectors to name a few. Where expenditure in these inevitable sectors weighs heavily on the national budget, ways and means through loan contraction become one of the major options. The governments inability to generate enough resources to finance its domestic and foreign expenditure will result to debt contracting. Sound, realistic and feasible fiscal and monetary policies aimed at increasing the mobilization and availability of domestic resources and reducing the level of expenditure on nonessential budgetary support items would lead to a reduction in the nations debt stock. In establishing a relationship between economic policy and debt contracting, there are two schools of thought: On one hand, it would be safe to say that there is negative relationship between sound economic policy (with the right will of the people to implement them given the level of matching implementation resources) and debt contracting, especially considering the level of developing countries. In other words, the expected change as a result of successfully implementing the policies would lead to less loan contracting and a subsequent reduction in the debt stock. The second school of thought focuses on the fact that because nations do not have sufficient funds to implement whatever sound economic policies they put forward, the need for debt contraction to obtain the needed foreign resources becomes inevitable. For this reason and in this context, it is argued that there is a positive relationship between the economic policy and debt contracting.

In the present country context of Sierra Leone, the pre-war external debt burden, coupled with eleven year war, enervated economic growth is the reason the country is the third least on the human development index. During this period and prior to the establishment of some viable public revenue generating institutions like the National Revenue Authority (NRA) and the National Social Security Scheme (NASSIT), the issue of debt has been and still remains to be critical to the Government of Sierra Leone. All government economic policies over these years, as far back as the 80s, have been addressing the issue of external debt- especially with the IMF, World Bank, the Paris Club and other bilateral nations. Given the above situations, the government still continues to heavily depend on external creditors for both disbursement (to provide the needed foreign currency) and loan cancellation or rescheduling.

1.2 Statement of the problem In most economies, and Sierra Leone in particular, borrowing is essential for financing development and is a fundamental aspect of the global economic system. In ideal circumstances, a country borrows to promote long term productivity and economic output, thereby advancing human development, with the accompanying result of economic growth and a booming export sector that further stimulate the economy and increase the ability to repay lenders the principal and interest owned. As a result of this anticipated overall goal, countries are enticed to enter in huge loan contracts even when they do not have the absorptive capacity to adequately manage the loan and achieve the desired goal. The accumulation of this undesirable situation, over years, of huge loan contract, inability to repay principal and interest, and subsequent mismanagement of the resources with zero or negative impact on the economy lead to debt burden, especially on poor countries who always go hand-in-gloves asking for debt rescheduling and forgiveness. When a countrys debt becomes disproportionately large compared to its gross national product (GNP) and export earnings, instead of stimulating growth and human development, debt begins to weaken the nations economic vitality and divert resources from critical social sectors. To repay such high levels of debt so as not to default or add arrears to the total debt, countries are most times under pressure to divert already scarce resources. In most cases the poor, especially children, pay the highest price of being deprived of basic health care, nutrition and education because a significant proportion of government resources go to servicing debt. In Sierra Leone, total Disbursed and Outstanding External Debt (DOD) stock stood at US$59 million in 1970 but increased to US$433 in 1980. The increase, which was more than 600 percent, was due to the countrys compelling need for foreign exchange to pay for the increase cost of oil imports, a situation caused by the:

1973 and 1974 oil price shocks; Collapse of commodity prices; and

Exorbitant expenses incurred in hosting the Organization of African Unity (OAU) summit in 1980 By 1990, a year after an IMF/World Bank programme was agreed, external debt rose to US$ 1.2 billion, and further US$1.5 billion in 1994 but averaged around US$1.2 billion by the end of 2000. The rise in the debt stock in the 1990s was attributed to increased disbursements under the IMF supported Structural Adjustment Programme as well as the acquisition of new loans from the IMF, World Bank and African Development Bank to finance critical imports and development activities. In addition, the increase in debt stock could be attributed to the civil war in Sierra Leone which caused tremendous damage to the economic and social infrastructure, and inflicted extensive suffering on the population. A modest recovery following the restoration of the democratically elected government in March 1998 was sharply reversed by the rebel invasion of Freetown in January 1999. Economic activities shrank, with rebels holding all the mineral rich and export crop production districts. This contributed to a collapse in the fiscal revenue base and to significant increases, in the budget deficit, bank financing, and external payments arrears. Inflation surged, and the exchange rate depreciated sharply. As a result besides the humanitarian assistance that the country received from various sources, it had to go into series of loan contracts and deferred loan repayment. Objective of the study The main aim of the study is to provide an analysis of the external debt services capacity faced by Sierra Leone, and the implication of external debt on economic policy. The study therefore has the following specific objectives: To highlight the macroeconomic performance of the Sierra Leone economy; To highlight Sierra Leones external debt including its structure and composition; To analyze the external debt burden and debt servicing capacity; To analyze the impact of external debt on economic policy and finally to draw policy implications for macroeconomic management.

1.3 Hypothesis of the study External debt is expected to have negative impact on economic policy. This is the case when huge external debt overhang and increasing domestic political paralysis have now combined to not only prevent current development opportunities but also endanger the domestic autonomy and direction of economic policy. In the present context of global economic adjustment, excessive external debt always entails the danger of the imposition of international policy prescriptions that often overlook critical domestic economic, social, and human development concerns. This has already been experienced in most African and other developing countries, where the persistence of external debt crises in the two decades has facilitated the enforcement of international economic policy regimes that have failed in large part to last protect human and socioeconomic development. This negative influence of external debt crisis on the domestic control of economic policy is not homogeneous across countries. This issue will be discussed in detail under literature review.

1.4 Methodology, Data Source and Limitation of the study To pursue this analysis- adopting from the Chowdhury (1994) model- we used simultaneous equation using Two Stage Least Squares. The study relies on secondary data for the period 1980 to 2005. The major sources of data are Ministry of Finance and Economic Development, Bank of Sierra Leone, and Statistics Sierra Leone. Moreover, International Financial Statistics (IFS) of the IMF and various World Debt Tables will be used. The limitation arises from the problem of inconsistency of data as reported by different institutions. Even data from the same institution shows different figures for the same year. Proxy variable will also be used as need arise. The paper will be organized as follows: Section one is introduction and background of the study. Section two gives a review of the theoretical and empirical literatures. Section three provides an overview of the performance of the Sierra Leone economy over the period under review. Section four is model specification and economic analysis of the study and section five is conclusion and policy recommendation of the study.

III. Literature Review

Perasso (1992) using data from twenty middle-income severely indebted countries for the 1982-1989 period investigated the relationship between economic growth and external debt. The study shows that appropriate domestic policies have stronger impact on increasing investment and growth in highly indebted countries than decreasing debt-servicing obligation. Cohens (1993) investigated the relationship between external debt and investment of developing countries for 1980s. The study shows that there is a little effect of level of stock of debt on investment. The author argued that an actual flow of net transfers affects investment. The study further reveals that actual service of debt crowded out investment. Cunningham (1993) investigated the relationship between debt burden and economic growth for sixteen countries for the period of 1971-2007. The study shows that growth of a countrys debt burden has a negative effect on the economic growth. He also argued that when a country is significantly to foreigners, this adversely affects both labor and capital productivity. Chowdhury (1994) investigated the relationship between indebtedness and economic growth for Bangladesh, Indonesia, Malaysia, Philippines, South Korea, Sri Lanka and Thailand for the period of 1970-1988. They explored that external debt leads to mismanagement in exchange rate. The study

further states that External debt does not affect the GNP growth rate. Metwally and Tamaschke (1994) employed Two Stage Least Square (2SLS) and Ordinary Least Square (OLS) method to investigate the relationship between debt servicing, capital inflows and economic growth for Algeria, Morocco and Egypt during 1972-2002. The results of the study show that capital inflows have a significant impact on the growth debt relationship. Sawada (1994) used annual time series data for sample period from 1955-1990 has shown that heavily indebted countries have debt overhang problems. Since their current external debts are above the expected present value of the future gains. Elbadawi et al. (1996) used cross-section data for ninety-nine countries to investigate the relationship also investigated the same relationship i.e. external debt and economic growth. The authors are of the view that current debt inflows as a ratio of GDP, past debt accumulation and debt service ratio have affected economic growth adversely. Amoateng and Amoako-Adu (1996) using the data pooled into time series and cross sectional form examined the relationship between external debt servicing, economic growth and exports for thirty-five African countries during 1971-1990. The study shows that that there is a unidirectional and positive causal relationship between foreign debt service and GDP growth after excluding exports revenue. Fosu (1996) examine the relationship between economic growth and external debt for the sample of sub-Saharan African countries for the period 1970-1986. The study reveals that on average a high debt country faces about one percentage reduction in the GDP annually. Deshpande (1997) investigated the relationship between external debt and investment 13 severely indebted countries for the period of 1971-1991 by using OLS method. The study shows that there exists negative relationship between external debt and investment. Olgun et al. (1998) employed 2SLS and 3SLS methods to investigate the relationship between capital inflows, foreign debt stock, investment and economic growth during the 1965-1997 period for Turkey. The study shows that there exists a two-way relationship between debt stock and debt service. The authors also pointed out that debt service does not affect economic growth. Iyoha and Milton (1999) investigated the relationship between external debt and economic growth for Sub-Saharan countries during the period 1970-1994. The study shows that external debt has adversely effect investment. The study also pointed out that reduction in debt stock would lead to

improvement in investment and economic growth. The authors stressed that debt of these countries should be forgiven to stimulate economic growth. Fosu (1999) has employed an augmented production function to investigate the impact of external debt on economic growth in sub-Saharan Africa for the 1980 -1990 period. The study reveals International Research Journal of Finance and Economics - Issue 44 (2010) 100 that there is a negative relationship between debt and economic growth. The study also shows that a rather weak negative impact of debt on investment levels. Karagl (2002) examined relationship between economic growth and external debt service for turkey during 1956-1996. The author used multivariate co-integration techniques. The study shows that there exists a negative relationship between external and economic growth in the long run. Granger causality test results showed a uni-direction causality running from debt service to economic growth. Abdelmawla and Mohamed (2005) investigated the impact of external debt on economic growth during 1978-2001 of Sudan. The study reveals that external debt and inflation adversely affected the countrys economic performance. The study also shows that export earnings have significantly positive impact on economic growth. Chaudhary (1998) investigated that whether Pakistan will accumulate a heavy burden of foreign debt if the present tendency of borrowing is to continue. The author has evaluated the impact of trade and saving on the external debt. The study reveals that if Pakistan has to reduce its debt burden than trade policy is more favorable than saving policy. Ahmed (1997) used three-gap model to investigate the external debt problem of Pakistan. The author suggested that if Pakistan has to reduce its debt burden that it has to focus on fiscal policy measures. These fiscal policy measures can be changes in tax rate, government consumption and public expenditure expenditures Ahmed (2001) used three-gap dynamic model of macroeconomic model of macroeconomic equilibrium to analyze the external debt problem of Pakistan. The author is of the view that if the pattern of external debt continues than Pakistans foreign debt position will further deteriorate in the future. Like the above mentioned studies on the relationship between external debt and growth in Pakistan, several economists have tried to find out the role of foreign aid in economic development of

Pakistan. As, Shabbir & Mahmood (1992) and Khan & Rahim (1993) concluded that the aid has accelerated the rate of growth of GDP. Aslam (1987) examined that the public FCI did not affect the domestic investment significantly, while the private FCI covered the domestic savinginvestment gap. Some other studies were carried out to analyze the impact of aid on savings in Pakistan. Khan, Hasan and Malik (1992) estimated that the FCI caused to decline national savings in Pakistan during the period of 1959-60 to 1987-88. Shabbir and Mahmood (1992) also found the negative impact of foreign capital on the national savings in Pakistan for the same period. Mahmood (1997) found that country may caught in a sever debt problems due to macroeconomic mismanagement, misutilization of aid and inappropriate policies.

THEORETICAL LITERATURE
2.1.1 Debt Crisis and its Origin
Debt crisis refers to a situation where a country announces that it could not meet its forthcoming debt repayments on its outstanding debt to international creditors. That means announcing it would be unable to continue servicing (paying interest and amortization payments on its debt). For instance, for the first time on 12 August 1982, the Mexican government announced that it could not meet its forthcoming debt repayment on its US$ 80 billion of outstanding debt to international banks. This was the first sign of the international debt crisis. Soon after the Mexican announcement, a number of other Less Developed Countries (LDCs) announced that they too were facing severe difficulties in meeting forthcoming repayments. Therefore, through out the 1980s and 1990s the problem faced by LDCs in servicing their debts has been one of the major international policy issues (Keith Pilbeam, 1998). According to Keith Pilbeam, the origin of this debt crisis dates back to the oil price shock following the Egypt-Israel war of October 1973. The quadrupling of the oil price was
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particularly harmful to the non-oil producing developing countries who experienced an enormous increase in their import expenditure on top of which resulting in recession severely curtailed their export earnings. As a result, the current account deficit of most LDCs rose from US$ 8.7 billion in 1973 to US$ 42.9 billion in 1974, and US$ 51.3 billion in 1975. Their

terms of trade also deteriorated substantially between 1973 and 1975 from 100 to 40, which meant that in 1975 they needed two and a half times the export volume for every unit of imports than they had in 1973. Although LDC indebtedness rose substantially from US$ 130 billion in 1973 to US$ 336 billion in 1978, they were relatively experiencing healthy rates of economic growth and not having any particular difficulties in servicing their debts. However, over the following four years, a number of unfavorable factors led to a rapid deterioration of their indebtedness and ability to service their repayments. Some of those factors are: In 1979 the Organization of Petroleum Exporting Countries (OPEC) cartel more than doubled the price of oil, from US$ 13 per barrel to US$ 32 per barrel. Industrialized countries' response to this second oil shock was more uniform since they were determined to reduce the inflationary consequence even if this meant an increase in their unemployment levels. At the end of 1979 the US authorities adopted a tight monetary policy designed to control inflation, with the UK, Germany, France, Italy and Japan adopting similarly tough policies. While, by contrast, LDCs preferred to borrow further funds and their outstanding debt nearly doubled from US$ 336 billion in 1978 to US$ 662 billion in 1982.

IV. Methodology and Data Issues

The impact of external debt on economic growth has been explored in the context of Pakistan for the period 1972-2005. The data has been obtained from International Financial Statistics, World Bank, Pakistan Economic Survey (various issues), and World Development Indicators (WDI 2005) First of all, the problem of stationarity has been solved through employing the unit root test. In this case Augmented Dickey-Fuller test has been applied to variables. This test has been performed at level as well as at first difference. If the all the series are found to be integrated of same order, test for co-integration can be employed and if the series are not found to be integrated of same order, the relationship can be checked through employing usual Ordinary Least Square method. The model has the following form: GDP= 0+ 1(ed) + 2 (ds) + i (1) Where GDP is Gross Domestic Product at factor cost, ed is external debt and ds is debt servicing. Augmented Dickey-Fuller (ADF) test is carried out to test for the stationarity of the variables. In implementing ADF unit root test, each variable is regressed on a constant, a linear deterministic trend, a lagged dependent variable and q lags of its first difference. 101 International Research Journal of Finance and Economics - Issue 44 (2010)

The ADF test for unit root tests the null hypothesis Ho: = 0 against the one-sided alternative H1: < 0 in equation above. The optimal lag length for conducting ADF tests is usually picked with the help of various information criteria e.g. Schwartz Information Criteria (SIC).

V.