External public debt, economic growth, and welfare gains from debt relief for HIPCs

We undertake theoretical and empirical investigations of the impact of external public debt on economic growth and welfare of the Heavily Indebted Poor Countries (HIPCs). The theoretical model shows that at a lower level of external public debt ratio, the relationship between the long run growth rate and external public debt ratio is positive. However, if external public debt ratio exceeds a certain critical value, then it has a deleterious effect on growth. This implies that the critical external public debt ratio is the growth maximizing level. Calculations used to calibrate the average growth performance of the HIPCs reveal that the growth maximizing external public debt to GDP ratio is about 28 percent. We also investigate the impacts of external public debt on welfare and growth maximizing fiscal policies.; Using panel data from HIPCs and other non-HIPC developing countries, we empirically examine the implication of the simple theoretical model that external public debt has a non-linear effect on growth. The recent threshold estimation method employed in this dissertation demonstrates that the threshold external public debt-to-GDP ratios for the HIPCs and full sample of developing countries are 22 and 31 percent, respectively. We find that while low external public debt (below the threshold value) has a positive effect on the growth rate, excessive external pubic debt (above the threshold value) hinders growth. The empirical result also suggests that high external public debt ratio affects the growth rate adversely through the productivity and investment channels.; We also conduct a simulation analysis of the effects of the current debt relief initiative on the HIPCs' growth and welfare. The simulation results suggest that the proposed two-third reduction in the external debt of HIPCs increases their per capita GDP growth rate, on average, by about 1.6 percentage points. This significant growth gain is the result of both the direct and indirect effects of debt relief on growth. The results also show that debt relief has a substantial welfare gain for debtor countries.