International Journal of Economics and Empirical Research

http://www.tesdo.org/Publication.aspx
Debt Accumulation and Economic Growth: Empirical Evidence from Pakistan Economy
Zeshan Arshad, Sana Aslam, Mehak Fatima, Ayesha Muzaffar
Department Of Economics. GC Women University Sialkot, Pakistan.
Highlights
External debt function is applied for Pakistan.
The unit root and causality tests are applied for empirical purpose.
Military spending is positively linked with external debt.

Abstract
Purpose: The study analyzes the contribution of external debt on the economic growth of

Pakistan. To investigate whether the external debt has contributed to the economic growth
in the long run, extended Solow growth model is used. Methodology: To test model Johnson
co-integration is applied on time series data for the years1970-2014. ADF is also being
applied to check the stationarity. Results disclosed, there exist negative relation between
external debt and economic growth of Pakistan. With the justification of Nigerian economy
in which ordinary least square method is used to establish a simple relationship between
variables under study, Granger Causality test was also applied to check relation between
GDP, external debt and domestic debt. Findings: Results showed that external debt has a
negative impact on growth and domestic debt has a positive impact on economic growth.
Domestic debt, if managed can lead to higher level of growth. Recommendations: Focus
should be made on efforts to manage the debt by using them in productive activities so that
the level of output will increase in the country.
Keywords: External debt, Economic growth
JEL Classification: H6, O4

Corresponding Author Email: zeshan_chohan@yahoo.com

Citation: Zeshan, A., Aslam, S., Fatima, M. and Muzaffar, A. (2015). Debt Accumulation and Economic Growth:
Empirical evidence from Pakistan Economy. International Journal of Economics and Empirical Research. 3(8), 405410.

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International Journal of Economics and Empirical Research. 2015, 3(8), 405-410.

I. Introduction
Accelerating the growth of economy is one of the prime objectives of developing economies. But these economies
normally face the problem of low savings due to the low level of per capita income as well as less developed and
weak financial system. In order to meet their fiscal and trade deficits, these countries then rely on external sources of
finance like IMF, World Bank and other non-financial institutions. They borrowed funds and other resources termed
as external debts. External debt is the foreign currency dominated liabilities issued by public agencies of country
to non-residents. These liabilities imply shift of resources abroad in the form of debt repayment and debt servicing.
Although, external and domestic debt, both help to close the gap between the public sectors income and
expenditures. But their impact on the behavior of macroeconomic variables are different, the long run effect of
public sectors deficit is different, depending on financed. The amount of debt availed from external sources
compiled over the time due to non-payment of debt servicing. Moreover, the additional debt is obtained to pay
previous debt owing to these economies and financing deficits. So, this debt accumulation is one of the main
problems facing by the developing world. Although debt is helpful to play an augmenting role for economic growth,
but debt dependency need to be very closely monitored for which suitable strategy is required to enhance the repayment capacity of the economy.
The level of debt that is unsustainable and highly compared to the economys size has series consequences in the
form of less development expenditures which play pivotal role in economic growth, due to the payment of high debt
servicing. Crowding out is the impact of debt along, with lesser amount of funds availability for investment in
productive and developing projects. Private investors expectation about Government for the high tax rates in future
that will reduce their profits. Both, taxes and Government expenditures have same crowding impact. In context of
Pakistan economy, crucial problem of debt accumulation prevails. The external debts of Pakistan in absolute terms
were $3.4 billion which surge to $9.93 billion in 1980. After 1981 to 1990 the external debt approaches to double
and become $20.66 billion. During 1990-1999 the external increased from $20.66 billion to $33.89 billion. In 2000
due to rescheduled policy of Government this figure decline to $32.78 billion, up to 2010 the external debt of
Pakistan increased to a huge amount of $54.60 billion (Government of Pakistan, 2010; World Bank, 2007). As
compared to south Asian countries and low income economies likewise Pakistan is facing the severe situation of
indebtness. On the basis of % of GNP if we compare the Pakistan economy, 45.20% GNP are external debts while
the situations in South Asian LICs is 24.17% and 45.20% of the GNP, respectively. Total reserve to external debts
ratio was 13.93 in Pak-economy while this figure in South Asian and low income countries was 30.94 and 24.67
accordingly (Mustafa, 2010).
Impact of the external debt on the economic growth and investment level is always questionable for researchers,
academician and policymakers alike. Researchers have no concensus on the role of external debt for economic
growth. Some stated that it hampers growth rate and some argued the positive impact of debt on economic growth.
Researchers who are in the favor of positive impact argued that debt provides capital inflows which used for
productive projects and to improve the technology, skills and required expertise to promote economic growth
activities. On the other hand some researchers concluded that debt effecting the growth negatively in two ways, debt
overhang affect and crowding out of private investment. The present study involves analyzing empirical relationship
between total external debt stock and economic growth rate of Pakistan economy, and to look that either the external
debt effecting the Pakistan economic growth positively or it mere a burden on the economy.
II. Literature Review
Economic growth can be accounted for by two major ways; in first according to Ellig, (2001) economic growth
arises from the dynamic competition model which states that the process of competition results in generating
innovations and strategies which leads economic growth to rise. In second way as described by Solow (1956), is the
neo-classical model followed by the argument that expansion in the scale of investment caused to encourage growth
rate, and according to the neo-classical the policy of low income countries should focus on enhancing the scale of
investment and savings (Hunt, 2007). Growth cant take-off until stock of capital and technology has risen to a
specific threshold level in economy (Sachs, 2002). Developing and low income countries which are facing dual
deficit problem (budget deficit & trade deficit) have a tendency to avail the funds from different sources to meet
their financial needs and accelerate their economic growth. These borrowings of government can be from external or
internal sources but due to insufficient local savings rate to finance the investment needs mostly government borrow
finances from external international financial institutions. This act of borrowing generates the debts for the
countries.
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Debt Accumulation and Economic Growth: Empirical evidence from Pakistan Economy
"Debt refers to the amount of money or resources which are not invested by the owners of an organization,
government or residents of a country in their economy rather the amount belongs to another party and is payable
principal plus interest amounts after a certain period of time (Oyejide et al. 1985)". Funds can be borrow by
government from various domestic as well as external sources, in order to finance the goods and services that are
provided publically and which lead to welfare and economic growth (Ogunmuyiwa, 2011). External debt can affect
the growth rate of an economy in different ways as, Colaco (1985) explains the vulnerability of debt servicing in low
income developing countries and use three different contexts. First, the volume or size of external borrowings is
reached to a level that it becomes much larger than equity finance of the economy, which causes to unbalancing the
debt and equity levels. In second context the interest rate sustainability, as the interest rate raises and exchange rate
changes the borrower directly hit by this increase and borrowings go to rise dramatically. Thirdly, maturity durations
have shortened in a large part because it results in a decline in official flows of funds. Islam, (1992) examines the
issue for the case of Bangladesh using time series data covering the period 1972-1988. His findings suggest a weak
positive link of debt on growth, while in general the domestic resource appears to exert stronger impact than the
foreign resources. In a similar context, Mbeki (1993) tries to investigate the relationship between foreign debt and
growth in Cameroon and the result obtained agree with Islam, (1992) findings. Kemal, (2001) explains the debt
accumulation and its implications for growth and poverty in Pakistan. The study shows that debt accumulation
(domestic and external debt) and debt servicing affect the poor adversely. The findings of the study illustrate that
even though debt burden as a percentage of GDP of Pakistan exceed that of all South Asia countries but it is not still
so high as to go for debt write off. This means that Pakistan has the capacity to service the debt.
Sheikh et al. (2001) explain that Pakistan is surrounded in serious socio-economic problems, due to low tax base and
twin deficits. Pakistan has to rely on both external and internal capital flows. The foreign capital flows are not easily
accessible but domestic capital flows are approachable at all times. The study investigates the impacts of domestic
debt on economic growth in Pakistan applying the OLS technique for the period of 1972-2009 and indicates that the
stock of domestic debt affects economic growth positively. Thus, the resources generated through domestic
borrowings have been used partially to finance that expenditure which contributes to economic growth. It also
observes that there is an inverse relationship between domestic debt and economic growth. The findings of study
reveal that the negative impact of domestic debt servicing on economic growth is stronger than positive impact of
domestic debt on economic growth. Uzochukwu, (2003) investigates the quantitative effect of public debt (domestic
and external) and economic growth on poverty in Nigeria by applying the per-capita income approach using annual
data of 1970 to 2002. The study use growth and debt variables and suggests that these variables have played very
vital role towards poverty acceleration in Nigeria. Bhattacharaya and Nguyen, (2003) this paper examine the
channels through which external debt affects growth in low-income countries. The results suggest that the
substantial reduction in the stock of external debt projected for high indebted poor countries (HIPCS) would
directly increase per capita income growth by about 1 percentage point per annum. Reduction in external debt
services could also provide an indirect boost to growth through their effects on public investment. If half of all debtservice relief were channeled for such purpose without increasing the budget deficit, then growth could accelerate in
some HIPCS by an additional 0.5 percentage point per annum. Schclarek, (2004) observes the relationship between
gross government debt and per capita GDP growth in developed countries. The results of the paper show that there
is no strong evidence of a statistically significant relationship between gross government debt and per capita GDP
growth for a sample of 24 industrial countries with data 1970 to 2002. Abbas and Christensen, (2007) highlight the
impact of domestic debt on economic growth for ninety three low-income countries from the period of 1975-2004
by applying Granger Causality Regression Model. The analysis shows that moderate levels of marketable domestic
debt as a percentage of GDP have significant positive, non-linear impacts on economic growth. Malik et al. (2010)
tried to measure the impact of external debt on economic performance of Pakistan among 1972 to 2005 by using
time series economic techniques. The results showed that external debt is negatively and significantly related with
economic growth it means increase in external debt will lead to decline in economic growth. Debt servicing has also
negative impact on GDP growth.

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International Journal of Economics and Empirical Research. 2015, 3(8), 405-410.

Naeem, (2011) argued that over the year Pakistan has failed to collect enough revenues to finance its budget, facing
the problem of twin deficits and resultantly to finance their developmental activities government has to rely on
public external and domestic debt. The positive effect of debt relates to resource-starved economics debt financing
leads to higher growth and repays external and internal debt. Negative effects work through two main channels,
Debt Overhang and Crowding Out effects. The study examines the consequences of public debt for economic
growth and investment in Pakistan for the period 1972-2009. The study finds that public external debt has negative
relationship with per capita GDP and investment confirming the existence of Debt Overhang effects. Thus
domestic debt has a negative relationship with investment and per capita GDP. In other words, it seems to have
crowded out private investment. Muhammad, (2014) examines the impact of external debt on economic
performance of Pakistan based on the analysis of the historical data about the economy of Pakistan. Foreign debts do
not improve the state of foreign direct investment in Pakistan. Far from improving, they have caused decline in most
of the occasions, the investor feel that with the increase in the external borrowings, the problems of debt overhang
and crowding out effect will emerge, resulting in the shrinkage of the government funds for the development of
economic and social infrastructure. Thus, they remain reluctant to bring funds from their native countries to Pakistan
for investment due to which private investment as percentage of GDP decreases in Pakistan. Ayyoub et al. (2014)
explore the core purpose of this study is to investigate the impact of debt on overall GDP, manufacturing sector
growth and unemployment situation of Pakistan. By applying OLS technique for analysis on the secondary data for
period 1989-90 to 2009-10, the study result that these are actual expenditure on debt servicing which are mainly
responsible for the worst situation of less productivity, increasing unemployment and less contributing
manufacturing sector. Whereas the external debt and liabilities to GDP ratio is found positively related with the
growth of manufacturing sector. External debt and liabilities to GDP ratio has been found to have positive and
statistically significant relationship with the overall GDP levels of the economy. The study strongly suggests
reducing the expenditures on debt servicing, to utilize the external debt on more productive expenditures, to reduce
the population growth rate to control the hyper inflation, and to reduce the overall government deficit in the
economy. Chaudhury, (2001); Siddiqui and Malik, (2001); Easterly, (1999, 2001, 2002) and Sen, (2007) come to the
same conclusion that external debt negatively affect economic growth. Impact of high debt on growth appears to
operate through both a strong negative effect on physical-capital accumulation and on total factor productivity (TFP)
growth. In addition, neither TFP nor private savings rates are affected by external debt levels (Patillio, 2004). Fosu,
(1996) argues that GDP growth is negatively influenced via a diminishing marginal productivity of capital. It was
also estimated that on average a high debt country faces about one percentage reductions in GDP growth rate
annually. Latter on Fosu, (1999) comes to the conclusion that negative relationship between economic growth and
debt might be due to poor performance of recipient country.
III. Model Formation, Variables Selection and Empirical Work
We are using Solow growth model for empirical analysis. The empirical Solow growth model is stated as:

ln GDP 1 ln ED 2 ln GCF

(1)

Where ED stands for external debt and GCF stands for gross capital formation. is the error term.
We use time-series data for our analysis from 1970 to 2014, and we check long run relation between variables. The
data source is world development indicators (CD-ROM, 2015). To check contribution of external debt on economic
growth of Pakistan we are applying Johnson co-integration and Granger causality. We also used ADF test to check
whether our data is stationary or not. It is necessary condition for co-integration that all variables should be
integrated at same order. Following Table-1 shows the ADF results.

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Debt Accumulation and Economic Growth: Empirical evidence from Pakistan Economy

Variables
LNGDP
LNED
LNGCF
LNED
LNGCF

Table-1. ADF Unit Root Test Analysis

PROB
T-statistics
Critical
First diff
Value at 5%
0.9383
0.0001
0.3848
0.0044
0.8219
0.0012
0.3848
0.0044
0.8219
0.0012

RESULTS

-5.227

-2.938

I(1)

-3.929

-2.941

I(1)

-4.395

-2.9389

I(1)

-3.929

-2.941

I(1)

-4.395

-2.9389

I(1)

Table-1 shows that at level all variables are non- stationary, the probability value is greater than 5% level that is
variables are insignificant. At first difference variables are stationary; the critical value at 5% level is greater than
probability value so we reject our null hypotheses and declared our variables are integrated at first difference which
means that they are integrated at order 1. And at first difference variables are significant.
The Table-2 result shows that there is one co-integration equation, also the trace statistics value is
greater than critical value i.e. (34.8847 > 29.7970) in our results and the probability value is less than 5% level that
is the value is significant so we reject our null hypothesis and declare that there exists long run relation between
variables.
Table-2. Unrestricted Co-integration Rank Test (Trace)
Hypothesized
No. of CE(s) Eigenvalue
None *
0.409932
At most 1
0.294963
At most 2
0.017308

Trace
Statistic
34.88478
14.31160
0.680908

0.05
Critical Value
29.79707
15.49471
3.841466

Prob.**
0.0119
0.0748
0.4093

Trace test results indicates 1 co-integrating equation(s) at the 0.05 level. Note: *
denotes rejection of the hypothesis at the 0.05 level.

Long run Results

Co-integrating coefficients (standard error in brackets)
LGDP
LED
LGCF
1.000000
-0.379868
1.367506
(0.20768)
(0.17093)
In our analysis we use gross capital formation because we considered the blood of the economy it can enhance the
productive capacity of the country, as we see in our model capital is positively affecting economic growth. Elasticity
of GDP regarding GCF is 1.367 i-e 1% changes in GCF will increase GDP by 1.367 %. Our main purpose is to find
long run relation between gross domestic product and external debt, elasticity of GDP regarding ED is -0.3798
which is negative that is 1 % increase in ED will decrease economic growth by -0.379868 or 1 % changes in ED will
leads to -0.37 % change in GDP but in opposite direction. Debt is not bad but its use determines its consequences.
Most of the time Pakistan got external debt to maintains its reserves but due to huge expenditures on its imports it
could not maintain. To maintain reserves and debt servicing Pakistan got more quantity of debt over the time. Hence
a large amount of debt is accumulated which is hampering economic growth. Debt should be utilized to enhance
productive capacity of the country. For checking causality we first find out that whether our variables are integrated
at same order. We already found that variables are integrated at order 1.

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International Journal of Economics and Empirical Research. 2015, 3(8), 405-410.

Table-3. Pairwise Granger Causality Tests

Lags: 2
Null Hypothesis:
LED does not Granger Cause LGDP
LGDP does not Granger Cause LED
LGCF does not Granger Cause LGDP
LGDP does not Granger Cause LGCF
LGCF does not Granger Cause LED
LED does not Granger Cause LGCF

Obs
39
39
39

F-Statistic
3.11046
2.43368
0.71899
1.12044
2.48827
6.06610

Prob.
0.0575
0.1028
0.4945
0.3379
0.0981
0.0056

The results in Table-3 explain that there exists unilateral causality between external debt of Pakistan and gross fixed
capital formation because the probability value is significant (0.0056 < 0.05) so we reject this null hypotheses that
LED does not Granger Cause LGCF. But the rest of probabilities are insignificant, so we accept null hypotheses.
Our objective variables GDP and ED however, does not cause to each other.
IV. Concluding Remarks
The study analyzed to find out the long run impact of external debt on Pakistans economic growth over the period
of 1970-2014, we considered GDP as a function of capital and the external debt. Long run relationship is empirically
tested by applying Johansen co integration test. Empirical results showed that external debt has a negative impact on
economic growth which indicates that an increase in external debt decreases economic growth. We took capital as a
factor of production, which positively affects the growth of the economy. This verifies that investment in capital
accelerate the economic growth. Co-integration confirmed the long run relationship in the policy point it is stated
that increase in domestic saving and increase in domestic earnings could also increase the growth rate and decrease
the dependence of the economy on external debt. It is very important to create an environment for capital
investments and policy focus should be on the inflow of Foreign Direct Investment (FDI), while the debts inflows
should be minimized. There should be close monitoring and consistent debt management policies should be formed
to reduce the unproductive utilization of external debt.
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