Introduction:

A situation of fiscal deficit refers to a state wherein revenue

collection of government including tax and foreign grants
together with other receipts is less than government expenditure.
In less developed countries and emerging economies,
government use public debt as an imperative tool to finance its
expenditure. There is lots of debate whether to finance internally
or externally. Historically, external debt received much attention.
Until the late 1990s, developing countries did not address the
risks and challenges of internal debt.

The trend of deficit financing has changed profoundly. The recent

indication is toward the domestic financing. Most of developing
countries are focusing on domestic financing. There are some
logical reasons behind this trend. The sudden stop of foreign
capital inflows creates a greater uncertainty, means an inability to
even rollover existing government foreign debt. It may be a major
reason in the currency depreciation, external defaults and costly
crises.

On the other hand, issuing domestic debt whether to finance the

fiscal deficit or to roll over existing debt involves a complex
evaluation of the costs and benefits to the economy. Domestic
debt and domestic debt servicing enhance the price level. The
interest rate i.e. cost of domestic borrowing or debt servicing is
one of the major reasons for the budget deficit. Generally
domestic debt is short term and costly instrument than foreign
financing. Frequent servicing of domestic debt absorbs a major
part of government revenues. So government has fewer resources
to spend on development projects. In this way, internal debt
servicing is more harmful for the economic growth than the stock
of internal debt. High yielding government debt induces

commercial banks to invest in government instruments. In turn,

the smaller residual pool of loan able funds in the market raises
the cost of capital accumulation, growth and welfare and it
creates crowding out effect for private investment. If the
government finances through central bank printing currency it
creates inflationary pressure in the economy.
Only domestic or foreign financing is not a solution. Any debt
policy should balance the risks to its debt stock by focusing on a
mix of both domestic and external sources while borrowing funds.
Because optimum level of domestic and foreign financing

Literature Review:
Generally, there is substantial literature on this topic for the
developed countries. However, the evidence is quite limited for
developing countries, in particular, the Asian developing countries.
Various studies on the relationship of domestic debt and economic
growth in context of developed and developing countries are
presented. I have reviewed some important empirical studies on
domestic debt and economic growth.
Checherita and Rother (2010) determine the average impact of
government debt on per capita GDP growth for twelve euro area
countries over a period of about 40 years from 1970-2009. The
channels through which government debt impact the economic
growth are private savings, public investment, total factor
productivity and real interest rates. The study shows non-linear
negative impact of government debt on economic growth.

Habibullah, Cheah, Baharom (2011) attempt to determine the

long run relationship between budget deficit and inflation in

thirteen Asian developing countries. Using annual data for the

period 1950-1999 Granger Causality within the error-correlation
model (ECM) framework suggest that all variables involved
( budget deficits, money supply and inflation) are integrated of
order one. The result indicates long run inflationary relationship of
budget deficits in Asian developing countries.
Sheikh, Faridi and Tariq (2010) investigate the impacts of
domestic debt on economic growth in Pakistan applying OLS
technique for the period of 1972 to 2009. The study indicates that
the stock of domestic debt affects the economic growth positively
in Pakistan. But the negative impact of domestic debt servicing on
economic growth is stronger than positive impact of domestic
debt on economic growth.

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 level of
marketable domestic debt as a percentage of GDP have
significant positive, non-linear impacts on economic growth, but
debt levels exceeding thirty percent of total bank deposits have
negative impact on economic growth.

Manna, Owino and Mutai (2008) analyses the development in

public domestic debt in Kenya and its impact on the economy for
the period 1996 to 2007. The study found no evidence that the
growth in domestic debt crowds-out private sector lending in
Kenya. They also examine the effect of domestic debt on real
output by using a Modified Barro growth regression. The result
indicates that domestic debt expansion had a positive but not a
significant effect on economic growth during the period.

Christensen (2004) discusses the role of domestic debt markets

in sub-Saharan Africa (SSA) based on a simple panel data model
of regressing private sector lending on domestic debt for 27 SSA
countries during the 20 year period 1980-2000. The result from
this regression found significant support for the crowding out
hypothesis; on average across countries; an expansion in
domestic debt of 1 percent relative to broad money causes the
ratio of lending to the private sector to broad money to decline by
0.15 percent.

The above mentioned studies show a mixed impact of domestic

debt on economic growth. Some studies are of view that domestic
debt impedes the economic growth but some are in the opinion
that domestic debt positively affects the economic growth.