Does high external debt predict lower economic growth? Role of sovereign spreads and institutional quality

Abstract

There has been a lengthy debate regarding the relationship between external borrowing and macroeconomic fragility. This paper investigates the predictive power of external debt as an indicator for economic growth to examine the argument that there is a dynamic relationship between external debt and growth. We conduct a panel regression using data from low- and middle-income countries (LMCs) between 1970 and 2018. The results indicate that an increase in total, long-term, or external public debt consistently predicts slowdowns in short- and medium-run growth. Limited evidence on non-linear external debt-growth relationship highlights the fact that external borrowing, especially by the public sector, significantly contributes to macroeconomic fragility. Proxy vector autoregressive (PVAR) estimation also confirms the dynamic causal effect of external sovereign debt expansion on economic slowdowns. Further evidence suggests that even the countries have high borrowing costs, better institutional quality can help mitigate the negative impact of external borrowing on growth.