Local government debt and regional growth in Indonesia

Abstract

This study analyses the impact of local government debt on growth and attempt to determine the threshold level of local debt-to-GRP for 33 regions in Indonesia over the period of 2008 to 2013. To investigate the impact of the level of local debt-to-GRP (Gross Regional Product) on growth, we utilized a generalized economic growth model augmented with the debt variable. The empirical growth model is generally based on an equation that relates the real GRP per capita growth rate to the initial level of income per capita augmented with the variable of local government debt-to-GRP and a squared term of local government debt-to-GRP. There are five control variables in this study. The first control variable is population growth rate to capture the effect of population in the region on local economic growth, which is expected to have a positive coefficient. A higher population creates higher aggregate demand in the region; therefore it is expected to have a positive effect on local growth. The second variable is the Human Development Index (HDI). The HDI is a composite index consisting of life expectancy, education and income indicator. The higher value of HDI represents better quality of life and education; thus it is expected to have positive sign. The third control variable is total investment of domestic and foreign investment. A higher value of investment would have a positive impact on infrastructure development as well as on the local growth, thus it is expected to have a positive coefficient. We also consider including fiscal capacity ratio (FISCI) as a control variable as it is used to assess the health status of local finance to take domestic and foreign loan. Even though, region with higher fiscal capacity ratio would have better ability to borrow and repay loan, we expect the sign of FISCI to be negative as region with higher fiscal capacity ratio is usually a more matured region with stable and lower local economic growth. The fifth control variable is the customer price index (CPI) to capture the impact of price level dynamics at the regional level. We expect the sign of CPI is negative, as rapid increase in the price level of goods and services will generally hamper local growth. We first apply Ordinary Least Square (OLS) regression to examine the linear impact of the local debt-to-GRP variable on growth. We take into account of linear form of the local government debt-to-GRP ratio into equation. The coefficient of local debt-to-GRP is significant at the level of 1 per cent. To evaluate the nonlinear relationship between local debt and growth, we estimate a nonlinear regression model augmented with a squared term of debt variable. The coefficient of the debt variable and a squared term of debt variable are both significant at the level of 1 per cent and 5 per cent respectively. The sign of a squared term of debt- to-GRP variable is also negative as we expect. The negative sign of a squared term of debt variable reflects the concavity or the inverted U-shape relationship between local government debt level and growth. The Hausman test is used to determine the preferred panel model between Fixed Effect (FE) and Random Effect (RE). The results show that FE model is preferred over the RE. In the linear FE model, the coefficient of debt-to-GRP variable is significant at the level 1 per cent. In the nonlinear FE model, the debt-to-GRP variable is all significant at the level of 1 per cent and a squared term of debt-to-GRP is significant at the level of 10 per cent. Our results suggest that there is a nonlinear relationship between local government debt and growth. The turning point or debt threshold ranges from 57 to 75 per cent. The coefficient of the quadratic form of local debt-to-GRP is a negative, indicating a concave or inverted U-shaped relationship between local debt and growth. The results confirm the theoretical assumption that at low debt levels the impact on growth is positive, but beyond the debt threshold an adverse effect on growth prevails.