Impact of External Debt on Economic Growth

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Department of Banking and Finance, University of Abuja
Debt is borrowing that is either for the purpose of smoothening the consumption path in the face of transitory shocks or as a means of supplementing domestic savings in order to expand productive capacity and raise the long – run growth rate. The objective of this work is to link foreign borrowing with growth. Whether debt could be used as a development strategy especially among low-income countries is the question of interest in this research. By using a simple open macro-economic model and focusing on the external balance of payment of a developing economy with rigidities, this work derives an empirically testable condition to show the impact of foreign borrowing on growth, i.e. as factor of growth and its negative impact on growth or when acting as a burden on growth. It concluded that foreign debt could have negative relationship with growth if not managed prudently. It is recommended that for external debt to be of positive impact on growth there is the need for a comprehensive and effective debt management strategy.

Foreign debt is a situation of the indebtedness of one country to another or institutions of the world. Many developing countries have used the instrument of foreign borrowing for the purpose of promoting or meeting their economic growth. It is a fact that many of today’s advanced industrial economies also resorted to foreign borrowing at one time or the other, especially after the Second World War (Farzin, 1988). The difficulties faced by many indebted developing countries led to a widespread and frequent debt reschedule which in turn raise serious concerns among policy makers culminating in clamours for debt cancellation for the poor indebted countries (World Bank, 2002). This work focuses particularly on the consequence of external debts on Nigeria’s economic growth. Similar works have been going on for decades, especially since the 1980s where the happening in the Latin American countries became a global issue. The resultant stand that materialized from the crisis was the assertion that external debt can act as a “factor of growth” and sometimes as a “burden on growth” of a certain country (Farzin, 1988). This was later seen to be an argument that might not necessarily hold valid for a low income country, particularly the highly indebted poor ones which could face an entirely different debt crisis and which might be affected differently by large external debts (Schclarek, 2004). 2.0 LITERATURE REVIEW

There was the traditional school view point which believed that an optimal balance between long term debt and equity existed and that at this optimal point share price (or equity) would be minimized and cost of capital minimized. Here the argument is stating that debt especially long term has a positive impact on the growth of an organization or the net worth of the borrower (Brigham, 1975). The arguments of two other renowned financial academics in the persons of Modigliani and Miller which was published (1958) earlier disputed the so-called arguments of the traditional school and argued that the so called optimal capital structure did not exist at all. Impliedly the total value of the borrowing body remains constant with any level of change in leverage. Given the argument above it is very important to see how phenomenon of debt impact on a borrowing nation. The question that arises out of this situation is, could debt have any positive impact on a country’s economic growth as held by the traditional school or zero impact as postulated by Modigliani and Miller? And hence the thrust of this work.

Presbitero (2005) argues that contrary to recent empirical studies there was no evidence...
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