the impact of external debt on economic growth in sierra leone

8/4/2019 The Impact of External Debt on Economic Growth in Sierra Leone

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External Debt and Economic Growth:

Empirical Evidence from Sierra

1.1 Background to the study

The generation or mobilization of resources to carry out government development plans is very

crucial. The effectiveness of any change management within an economy is contingent upon the

development of sound economic policies, backed by the political, social and people will to

implement the activities and the available of resources to effect the change. Irrespective of the level

of resources within an economy, there are a number of sectors that need to be given high priority on

the nations development agenda. Such sectors include the health and agricultural sectors to name a

few. Where expenditure in these inevitable sectors weighs heavily on the national budget, ways and

means through loan contraction become one of the major options. The governments inability to

generate enough resources to finance its domestic and foreign expenditure will result to debt

contracting. Sound, realistic and feasible fiscal and monetary policies aimed at increasing the

mobilization and availability of domestic resources and reducing the level of expenditure on non-essential budgetary support items would lead to a reduction in the nations debt stock.

In establishing a relationship between economic policy and debt contracting, there are two schools

of thought: On one hand, it would be safe to say that there is negative relationship between sound

economic policy (with the right will of the people to implement them given the level of matching

implementation resources) and debt contracting, especially considering the level of developing

countries. In other words, the expected change as a result of successfully implementing the policies

would lead to less loan contracting and a subsequent reduction in the debt stock. The second school

of thought focuses on the fact that because nations do not have sufficient funds to implement

whatever sound economic policies they put forward, the need for debt contraction to obtain theneeded foreign resources becomes inevitable. For this reason and in this context, it is argued that

there is a positive relationship between the economic policy and debt contracting.


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In the present country context of Sierra Leone, the pre-war external debt burden, coupled with

eleven year war, enervated economic growth is the reason the country is the third least on thehuman development index. During this period and prior to the establishment of some viable public

revenue generating institutions like the National Revenue Authority (NRA) and the National Social

Security Scheme (NASSIT), the issue of debt has been and still remains to be critical to the

Government of Sierra Leone. All government economic policies over these years, as far back as the

80s, have been addressing the issue of external debt- especially with the IMF, World Bank, the Paris

Club and other bilateral nations. Given the above situations, the government still continues to

heavily depend on external creditors for both disbursement (to provide the needed foreign

currency) and loan cancellation or rescheduling.

1.2 Statement of the problem

In most economies, and Sierra Leone in particular, borrowing is essential for financing development

and is a fundamental aspect of the global economic system. In ideal circumstances, a country

borrows to promote longterm productivity and economic output, thereby advancing human

development, with the accompanying result of economic growth and a booming export sector thatfurther stimulate the economy and increase the ability to repay lenders the principal and interest

owned. As a result of this anticipated overall goal, countries are enticed to enter in huge loan

contracts even when they do not have the absorptive capacity to adequately manage the loan and

achieve the desired goal. The accumulation of this undesirable situation, over years, of huge loan

contract, inability to repay principal and interest, and subsequent mismanagement of the resources

with zero or negative impact on the economy lead to debt burden, especially on poor countries

who always go hand-in-gloves asking for debt rescheduling and forgiveness.

When a countrys debt becomes disproportionately large compared to its gross national product

(GNP) and export earnings, instead of stimulating growth and human development, debt begins toweaken the nations economic vitality and divert resources from critical social sectors. To repay such

high levels of debt so as not to default or add arrears to the total debt, countries are most times

under pressure to divert already scarce resources. In most cases the poor, especially children, pay

the highest price of being deprived of basic health care, nutrition and education because a

significant proportion of government resources go to servicing debt.

In Sierra Leone, total Disbursed and Outstanding External Debt (DOD) stock stood at US$59 million in

1970 but increased to US$433 in 1980. The increase, which was more than 600 percent, was due to

the countrys compelling need for foreign exchange to pay for the increase cost of oil imports, a

situation caused by the:


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1973 and 1974 oil price shocks; Collapse of commodity prices; and

Exorbitant expenses incurred in hosting the Organization of African Unity (OAU) summit in 1980

By 1990, a year after an IMF/World Bank programme was agreed, external debt rose to US$ 1.2billion, and further US$1.5 billion in 1994 but averaged around US$1.2 billion by the end of 2000.

The rise in the debt stock in the 1990s was attributed to increased disbursements under the IMF

supported Structural Adjustment Programme as well as the acquisition of new loans from the IMF,

World Bank and African Development Bank to finance critical imports and development activities. In

addition, the increase in debt stock could be attributed to the civil war in Sierra Leone which

caused tremendous damage to the economic and social infrastructure, and inflicted extensive

suffering on the population.

A modest recovery following the restoration of the democratically elected government in March

1998 was sharply reversed by the rebel invasion of Freetown in January 1999. Economic activitiesshrank, with rebels holding all the mineral rich and export crop production districts. This contributed

to a collapse in the fiscal revenue base and to significant increases, in the budget deficit, bank

financing, and external payments arrears. Inflation surged, and the exchange rate depreciated

sharply. As a result besides the humanitarian assistance that the country received from various

sources, it had to go into series of loan contracts and deferred loan repayment.

Objective of the study

The main aim of the study is to provide an analysis of the external debt services capacity faced by

Sierra Leone, and the implication of external debt on economic policy. The study therefore has the

following specific objectives:

To highlight the macroeconomic performance of the Sierra Leone economy; To highlight Sierra Leones external debt including its structure and composition; To analyze the external debt burden and debt servicing capacity; To analyze the impact of external debt on economic policy and finally to draw policy

implications for macroeconomic management.

1.3 Hypothesis of the study

External debt is expected to have negative impact on economic policy. This is the case when hugeexternal debt overhang and increasing domestic political paralysis have now combined to not only

prevent current development opportunities but also endanger the domestic autonomy and direction

of economic policy. In the present context of global economic adjustment, excessive external debt

always entails the danger of the imposition of international policy prescriptions that often overlook

critical domestic economic, social, and human development concerns. This has already been

experienced in most African and other developing countries, where the persistence of external debt

crises in the two decades has facilitated the enforcement of international economic policy regimes

that have failed in large part to last protect human and socioeconomic development. This negative

influence of external debt crisis on the domestic control of economic policy is not homogeneous

across countries. This issue will be discussed in detail under literature review.


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1.4 Methodology, Data Source and Limitation of the study

To pursue this analysis- adopting from the Chowdhury (1994) model- we used simultaneous

equation using Two Stage Least Squares.

The study relies on secondary data for the period 1980 to 2005. The major sources of data areMinistry of Finance and Economic Development, Bank of Sierra Leone, and Statistics Sierra Leone.

Moreover, International Financial Statistics (IFS) of the IMF and various World Debt Tables will be

used.

The limitation arises from the problem of inconsistency of data as reported by different institutions.

Even data from the same institution shows different figures for the same year. Proxy variable will

also be used as need arise.

The paper will be organized as follows: Section one is introduction and background of the study.

Section two gives a review of the theoretical and empirical literatures. Section three provides an

overview of the performance of the Sierra Leone economy over the period under review. Section

four is model specification and economic analysis of the study and section five is conclusion and

policy recommendation of the study.

III. Literature Review

Perasso (1992) using data from twenty middle-income severely indebted countries for the

1982-1989

period investigated the relationship between economic growth and external debt. The study

shows that

appropriate domestic policies have stronger impact on increasing investment and growth in

highly

indebted countries than decreasing debt-servicing obligation.

Cohens (1993) investigated the relationship between external debt and investment of

developing countries for 1980s. The study shows that there is a little effect of level of stock

of debt on

investment. The author argued that an actual flow of net transfers affects investment. The

study further

reveals that actual service of debt crowded out investment.

Cunningham (1993) investigated the relationship between debt burden and economicgrowth

for sixteen countries for the period of 1971-2007. The study shows that growth of a

countrys debt

burden has a negative effect on the economic growth. He also argued that when a country is

significantly to foreigners, this adversely affects both labor and capital productivity.

Chowdhury (1994) investigated the relationship between indebtedness and economic

growth

for Bangladesh, Indonesia, Malaysia, Philippines, South Korea, Sri Lanka and Thailand for the

period

of 1970-1988. They explored that external debt leads to mismanagement in exchange rate.The study


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further states that External debt does not affect the GNP growth rate.

Metwally and Tamaschke (1994) employed Two Stage Least Square (2SLS) and Ordinary

Least Square (OLS) method to investigate the relationship between debt servicing, capital

inflows and

economic growth for Algeria, Morocco and Egypt during 1972-2002. The results of the study

showthat capital inflows have a significant impact on the growth debt relationship.

Sawada (1994) used annual time series data for sample period from 1955-1990 has shown

that

heavily indebted countries have debt overhang problems. Since their current external debts

are above

the expected present value of the future gains.

Elbadawi et al. (1996) used cross-section data for ninety-nine countries to investigate the

relationship also investigated the same relationship i.e. external debt and economic growth.

The

authors are of the view that current debt inflows as a ratio of GDP, past debt accumulationand debt

service ratio have affected economic growth adversely.

Amoateng and Amoako-Adu (1996) using the data pooled into time series and cross

sectional

form examined the relationship between external debt servicing, economic growth and

exports for

thirty-five African countries during 1971-1990. The study shows that that there is a

unidirectional and

positive causal relationship between foreign debt service and GDP growth after excluding

exportsrevenue.

Fosu (1996) examine the relationship between economic growth and external debt for the

sample of sub-Saharan African countries for the period 1970-1986. The study reveals that on

average a

high debt country faces about one percentage reduction in the GDP annually.

Deshpande (1997) investigated the relationship between external debt and investment 13

severely indebted countries for the period of 1971-1991 by using OLS method. The study

shows that

there exists negative relationship between external debt and investment.

Olgun et al. (1998) employed 2SLS and 3SLS methods to investigate the relationshipbetween

capital inflows, foreign debt stock, investment and economic growth during the 1965-1997

period for

Turkey. The study shows that there exists a two-way relationship between debt stock and

debt service.

The authors also pointed out that debt service does not affect economic growth.

Iyoha and Milton (1999) investigated the relationship between external debt and economic

growth for Sub-Saharan countries during the period 1970-1994. The study shows that

external debt has

adversely effect investment. The study also pointed out that reduction in debt stock wouldlead to


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improvement in investment and economic growth. The authors stressed that debt of these

countries

should be forgiven to stimulate economic growth.

Fosu (1999) has employed an augmented production function to investigate the impact of

external debt on economic growth in sub-Saharan Africa for the 1980 -1990 period. The

study revealsInternational Research Journal of Finance and Economics - Issue 44 (2010) 100

that there is a negative relationship between debt and economic growth. The study also

shows that a

rather weak negative impact of debt on investment levels.

Karagl (2002) examined relationship between economic growth and external debt service

for

turkey during 1956-1996. The author used multivariate co-integration techniques. The study

shows that

there exists a negative relationship between external and economic growth in the long run.

Grangercausality test results showed a uni-direction causality running from debt service to

economic growth.

Abdelmawla and Mohamed (2005) investigated the impact of external debt on economic

growth during 1978-2001 of Sudan. The study reveals that external debt and inflation

adversely

affected the countrys economic performance. The study also shows that export earnings

have

significantly positive impact on economic growth.

Chaudhary (1998) investigated that whether Pakistan will accumulate a heavy burden of

foreigndebt if the present tendency of borrowing is to continue. The author has evaluated the

impact of trade

and saving on the external debt. The study reveals that if Pakistan has to reduce its debt

burden than

trade policy is more favorable than saving policy.

Ahmed (1997) used three-gap model to investigate the external debt problem of Pakistan.

The

author suggested that if Pakistan has to reduce its debt burden that it has to focus on fiscal

policy

measures. These fiscal policy measures can be changes in tax rate, governmentconsumption and public

expenditure expenditures

Ahmed (2001) used three-gap dynamic model of macroeconomic model of macroeconomic

equilibrium to analyze the external debt problem of Pakistan. The author is of the view that

if the

pattern of external debt continues than Pakistans foreign debt position will further

deteriorate in the

future.

Like the above mentioned studies on the relationship between external debt and growth in

Pakistan, several economists have tried to find out the role of foreign aid in economicdevelopment of


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Pakistan. As, Shabbir & Mahmood (1992) and Khan & Rahim (1993) concluded that the aid

has

accelerated the rate of growth of GDP. Aslam (1987) examined that the public FCI did not

affect the

domestic investment significantly, while the private FCI covered the domestic saving-

investment gap.Some other studies were carried out to analyze the impact of aid on savings in Pakistan.

Khan, Hasan

and Malik (1992) estimated that the FCI caused to decline national savings in Pakistan

during the

period of 1959-60 to 1987-88. Shabbir and Mahmood (1992) also found the negative impact

of foreign

capital on the national savings in Pakistan for the same period. Mahmood (1997) found that

country

may caught in a sever debt problems due to macroeconomic mismanagement, misutilization

of aid andinappropriate policies.

THEORETICAL LITERATURE

2.1.1 Debt Crisis and its Origin

Debt crisis refers to a situation where a country announces that it could not meet its

forthcoming debt repayments on its outstanding debt to international creditors. That means

announcing it would be unable to continue servicing (paying interest and amortization

payments on its debt).

For instance, for the first time on 12 August 1982, the Mexican government announced that

it

could not meet its forthcoming debt repayment on its US$ 80 billion of outstanding debt to

international banks. This was the first sign of the international debt crisis. Soon after the

Mexican announcement, a number of other Less Developed Countries (LDCs) announced

that

they too were facing severe difficulties in meeting forthcoming repayments. Therefore,

through out the 1980s and 1990s the problem faced by LDCs in servicing their debts has

been

one of the major international policy issues (Keith Pilbeam, 1998).

According to Keith Pilbeam, the origin of this debt crisis dates back to the oil price shock

following the Egypt-Israel war of October 1973. The quadrupling of the oil price was12

particularly harmful to the non-oil producing developing countries who experienced an

enormous increase in their import expenditure on top of which resulting in recession

severely

curtailed their export earnings. As a result, the current account deficit of most LDCs rose

from US$ 8.7 billion in 1973 to US$ 42.9 billion in 1974, and US$ 51.3 billion in 1975. Their


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terms of trade also deteriorated substantially between 1973 and 1975 from 100 to 40,

which

meant that in 1975 they needed two and a half times the export volume for every unit of

imports than they had in 1973.

Although LDC indebtedness rose substantially from US$ 130 billion in 1973 to US$ 336

billion in 1978, they were relatively experiencing healthy rates of economic growth and nothaving any particular difficulties in servicing their debts. However, over the following four

years, a number of unfavorable factors led to a rapid deterioration of their indebtedness

and

ability to service their repayments. Some of those factors are:

In 1979 the Organization of Petroleum Exporting Countries (OPEC) cartel more than doubled

the price of oil, from US$ 13 per barrel to US$ 32 per barrel. Industrialized countries'

response to this second oil shock was more uniform since they were determined to reduce

the

inflationary consequence even if this meant an increase in their unemployment levels.

At the end of 1979 the US authorities adopted a tight monetary policy designed to controlinflation, with the UK, Germany, France, Italy and Japan adopting similarly tough policies.

While, by contrast, LDCs preferred to borrow further funds and their outstanding debt

nearly

doubled from US$ 336 billion in 1978 to US$ 662 billion in 1982.

IV. Methodology and Data Issues

The impact of external debt on economic growth has been explored in the context ofPakistan for the

period 1972-2005. The data has been obtained from International Financial Statistics, World

Bank,

Pakistan Economic Survey (various issues), and World Development Indicators (WDI 2005)

First of all, the problem of stationarity has been solved through employing the unit root test.

In

this case Augmented Dickey-Fuller test has been applied to variables. This test has been

performed at

level as well as at first difference. If the all the series are found to be integrated of same

order, test for

co-integration can be employed and if the series are not found to be integrated of same

order, the

relationship can be checked through employing usual Ordinary Least Square method.

The model has the following form:

GDP= 0+ 1(ed) + 2 (ds) + i (1)

Where GDP is Gross Domestic Product at factor cost, ed is external debt and ds is debt

servicing. Augmented Dickey-Fuller (ADF) test is carried out to test for the stationarity of the

variables. In implementing ADF unit root test, each variable is regressed on a constant, a

linear

deterministic trend, a lagged dependent variable and q lags of its first difference.

101 International Research Journal of Finance and Economics - Issue 44 (2010)


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The ADF test for unit root tests the null hypothesis Ho: = 0 against the one-sided

alternative

H1:

the impact of external debt on economic growth in sierra leone

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