International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 44 (2010)

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm

External Debt and Economic Growth: Empirical

Evidence from Pakistan

Shahnawaz Malik
Chairman Department of Economics, Bahauddin Zakaryia University, Multan, Pakistan
Tel: + 92 (0) 61 9210052, 54; Fax: + 92 (0) 61 9210098

Muhammad Khizar Hayat

Corresponding Author Department of Economics, Bahauddin Zakaryia University, Multan, Pakistan
Tel: + 92 (0) 61 9210052, 54; Fax: + 92 (0) 61 9210098
E-mail: theeconomistbzu@gmail.com

Muhammad Umer Hayat

Graduate Student (International relations & Political Security)
University Science Sociale Toluse, France

Abstract

Foreign Aid or External debt is considered a significant source of income for

developing countries. Pakistan has relied much on foreign debt to finance its balance of
payments deficit and saving investment gap. This heavily dependence on external resources
became uncontrollable in late 1980s. Primary objective of this paper is to explore the
relationship between external debt and economic growth in Pakistan for the period of 1972-
2005, using time series econometric technique. We took a point of glance of external debt
and economic performance of Pakistan. The paper shows that External Debt is negatively
and significantly related with economic growth. The evidence suggests that increase in
external debt will lead to decline in economic growth. Debt servicing has also significant
and negative impact on GDP growth. As the debt servicing tends to increase, there will be
less opportunities for economic growth.

Keywords: External Debt, Economic Growth, Ordinary Least Square

I. Introduction
Foreign aid and external debt was considered a significant source of income for developing countries.
From the late 1950’s current account deficit was considered normal. The countries facing current
account deficit were encouraged to borrow from international community to boost their economic
growth. During the last fifty years the external debt problem is one of the main challenges faced by the
developing countries like Pakistan. External debt and its repayments act as a hindrance to the economic
growth and development of developing countries. In the past three decades it has been observed that
external debt has been the main cause of decline in investment and the growth performance of many
nations. This external debt is like an unfavorable tax on future generations, which they have to pay for
nothing.
International Research Journal of Finance and Economics - Issue 44 (2010) 89

According to Chenery (1996) the basic reason of external debt in developing counties is to
fulfill lack saving investment gap. Foreign debt affects not only investment but also economic growth.
The literature shows that besides fulfilling the saving investment gap, the external debt has adversely
effect the growth of the developing countries. The basic reason of this adverse effect is the restrictions
of the donor agencies.
According to World Bank, the total external debt of the developing countries has increased
from US $ 411.4 billion to US $ 523.4b billion over the period 1990-2002(WDI 2004). This creates a
great hindrance in the economic growth of a country due to high interest payments on the external debt,
heavy public expenditures and foreign exchange to repay that debt.
The objective of the paper is to examine the impact of External Debt on Economic Performance
of Pakistan for the period 1972-2005. The organization of the paper is as follows. Next session has
brief explanation of external debt and economic growth in Pakistan. Section III deals with the related
work towards the topic. Section IV deals with Data and Methodology. Results of the estimations are
reported and discussed in section V. Final section deals with concluding remarks and some policy
suggestions based upon the study.

II. An Overview of External Debt and Economic Growth in Pakistan

Since independence Pakistan is facing serious problems in balance of payments deficit. To finance this
balance of payments deficit the country adopted to rely on external debt. World Bank classified
Pakistan as severely indebted country of South Asia in 2001. External debt compromises round about
50% 0f total GDP of Pakistan. (Table1). Pakistan has to reschedule its external debt two times between
1998 and 2001 because the country was unable to serve its external debt. Table 2 shows external debt
as percentage foreign exchange earnings. The data shows that external debt is more than 100 % of
foreign exchange earnings. Graph shows a continuous decline in external debt as percentage of foreign
exchange earnings.

External Debt and Liabilities as a Percentage of GDP

Table 1:

Year ED as a % of GDP
1996-97 46.9
1997-98 55.4
1998-99 54.9
1999-00 53.5
2000-01 51.7
2001-02 52.1
2002-03 50.9
2003-04 43.1
2004-05 36.7
2005-06 32.7
90 International Research Journal of Finance and Economics - Issue 44 (2010)
Figure 1:

External Debt as a % of GDP

60
ED as % of GDP

50
40
30
20
10
0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2005-
97 98 99 00 01 02 03 04 2004- 06
05
Years

Source: State Bank of Pakistan Annual Reports various issues

Table 2:

Year ED as a % of FEE
2000-01 297.2
2001-02 259.5
2002-03 236.8
2003-04 181.2
2004-05 165.0
2005-06 134.3

Figure 2:

ED a s % of FEE

350
300
EDas%of FEE

250
200
150
100
50
0
2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
Ye ars

Source: State Bank of Pakistan Annual Reports various issues

Gross Domestic Product

Pakistan has experienced a fluctuated economic growth. In the early 1970,s there is a downward trend
in the economic growth of Pakistan due to political instability and aftereffects of 1971 war. Then
Pakistan experienced a respectable growth rate in the late 1970,s and till 1988, due to consistent
economic policies and afghan War. After 1988 again there is a declining trend in GDP growth rate,
which is due to political instability, inconsistent economic policies of political governments and the
International Research Journal of Finance and Economics - Issue 44 (2010) 91

preference of personal political interests over national interest. After 2000 there is an increasing trend
in GDP Growth Rate.

Table 2:

YEARS GDP YEARS GDP YEARS GDP YEARS GDP

I972-73 49784 1981-82 247831 1990-91 759851 1999-00 2735943
1973-74 61414 1982-83 292153 1991-92 908374 2000-01 3529345
1974-75 81690 1983-84 328412 1992-93 1077943 2001-02 3876025
1975-76 103557 1984-85 374349 1993-94 1200129 2002-03 4095212
1976-77 119736 1985-86 425064 1994-95 1412858 2003-04 4481412
1977-78 135982 1986-87 466319 1995-96 1688126 2004-05 5142610
1978-79 159840 1987-88 515431 1996-97 1929891 2005-06 6129676
1979-80 177844 1988-89 601025 1997-98 2226580
1980-81 210253 1989-90 683138 1998-99 2480884
Source: Hand Book of Statistics, State Bank of Pakistan

Figure 2:

GDP

7000000
6000000
5000000
GDP

4000000
3000000
2000000
1000000
0
3

5
-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0
72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04
19

19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
Years

Source: Hand Book of Statistics, State Bank of Pakistan

External Debt
Pakistan has experienced serious debt problems in the through out the period which lead to worsening
in macroeconomic indicators like economic growth and investment which ultimately lead to high
incidence of poverty. In 1972-73 external debt was 4385 US Million Dollars which rose to 29630 US
Million Dollars in 2005-06. The data shows a continuous increase in the external debt. The Graph
shows that there was a jump in a 1979 which was due to Afghan War. The downward rigidity of
budgetary expenditures and lack of buoyancy in revenues have generated persistently large fiscal
deficits which cause a heavy reliance on external debt. Pakistan’s external debt rose over time which
can be seen in table 3.

Table 3:

YEARS ED YEARS ED YEARS ED YEARS ED

I972-73 4385 1981-82 8766 1990-91 15190 1999-00 26735
1973-74 4468 1982-83 8772 1991-92 15541 2000-01 26531
1974-75 4683 1983-84 9312 1992-93 17512 2001-02 26966
1975-76 4795 1984-85 6469 1993-94 19284 2002-03 27773
1976-77 5730 1985-86 9732 1994-95 20604 2003-04 28487
92 International Research Journal of Finance and Economics - Issue 44 (2010)

1977-78 6341 1986-87 10948 1995-96 22246 2004-05 28847

1978-79 7131 1987-88 12022 1996-97 22484 2005-06 29630
1979-80 7792 1988-89 12913 1997-98 22678
1980-81 8710 1989-90 14189 1998-99 23609
Source: Hand Book of Statistics, State Bank of Pakistan

Figure 3:

External Debt

100000
80000
60000
ED

40000
20000
0
3

5
-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0
72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04
19

19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
Years

Source: Hand Book of Statistics, State Bank of Pakistan

Debt Servicing
High debt generally leads to high debt service liability. However, the severity of the debt service
liability of a country depends on the relationship of its GDP and on the level of debt in relation to its
debt service obligation. The absolute volume of volume of dent of the country is not matter of concern
as the extent of debt service liability. There is a fluctuated trend in debt servicing in Pakistan. The
figure shows an increasing trend in debt servicing till 1979, than there was sharp decline in debt
servicing. After 1979 again there is an increasing trend in debt servicing till 1999. Figure shows more
fluctuations in debt servicing of the country which is result of policies of Pervaz Musharaf.

Table 4:

YEARS DS YEARS DS YEARS DS YEARS DS

I972-73 506 1981-82 365 1990-91 771.5 1999-00 464.6
1973-74 547 1982-83 288.1 1991-92 782.4 2000-01 892.3
1974-75 916 1983-84 388.6 1992-93 920.6 2001-02 973.1
1975-76 695 1984-85 451.7 1993-94 998.6 2002-03 753
1976-77 1340 1985-86 511.6 1994-95 1077.9 2003-04 810.3
1977-78 1810 1986-87 601.6 1995-96 1293.6 2004-05 2362.7
1978-79 2261 1987-88 732.2 1996-97 1346.4 2005-06 871
1979-80 233.8 1988-89 691.1 1997-98 1520.2
1980-81 350.2 1989-90 684.1 1998-99 1623.2
Source: Hand Book of Statistics, State Bank of Pakistan
International Research Journal of Finance and Economics - Issue 44 (2010) 93
Figure 4:

Debt Servicing

2500
2000
1500
DS

1000
500
0
19 3

19 5

19 7

19 9

19 1

19 3

19 5

19 7

19 9

19 1

19 3

19 5

19 7

20 9

20 1

20 3

5
-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0
72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04
19

Years

Source: Hand Book of Statistics, State Bank of Pakistan

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.
Cohen’s (1993) investigated the relationship between external debt and investment of
developing countries for 1980’s. 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 economic growth
for sixteen countries for the period of 1971-2007. The study shows that growth of a country’s 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
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 show
that 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 accumulation and 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 exports
revenue.
94 International Research Journal of Finance and Economics - Issue 44 (2010)

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 relationship between
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 would lead to
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 reveals
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.
Karagöl (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. Granger
causality 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 country’s 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 foreign
debt 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, government consumption 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 Pakistan’s 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 economic development of
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 and
inappropriate policies.
International Research Journal of Finance and Economics - Issue 44 (2010) 95

IV. Methodology and Data Issues

The impact of external debt on economic growth has been explored in the context of Pakistan 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= α0+ α1(ed) + α2 (ds) + εi (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.
The ADF test for unit root tests the null hypothesis Ho: ρ = 0 against the one-sided alternative
H1: ρ < 0 in equation above. The optimal lag length for conducting ADF tests is usually picked with
the help of various information criteria e.g. Schwartz Information Criteria (SIC).

V. Empirical Results
Augmented Dickey-Fuller test has performed to test the unit root hypothesis to all variables. The
results are reported in table 5 and 6. According to the results, all variables are not integrated of same
order. DS is stationary time series at level when checked with intercept and with trend and intercept.
All GDPFC and Ed are integrated of order one i.e. I (1) when checked with intercept and with trend
and intercept both.

Table 5: Augmented Dickey-Fuller Test with Intercept

Variables Level 1st Difference Conclusion

LNGDPFC -2.40 -4.10 I(1)
LNED -1.79 -4.63 I(1)
LNDS -3.34 - I(0)
Source: Authors calculations using E-views 3.1

Table 6: Augmented Dickey-Fuller Test with Trend and Intercept

Variables Level 1st Difference Conclusion

LNGDPFC -4.22 - I(0)
LNED -0.68 -5.14 I(1)
LNDS -3.50 - I(0)
Source: Authors calculations using E-views 3.1

OLS methodology has been used to check the impact of external debt and debt servicing on
economic growth. Results of estimations are reported in table 7. ED is negatively and significantly
related with economic growth. The evidence suggests that increase in external debt will lead to decline
in economic growth. Debt servicing has also significant and negative impact on GDP growth. As the
debt servicing tends to increase, there will be fewer opportunities for economic growth. Moreover, the
model is good fit as indicated by the value of F-statistics. In addition, the problem of autocorrelation
has been removed by using Auto Regressive Moving Average (1, 1).
96 International Research Journal of Finance and Economics - Issue 44 (2010)
Table 7: Estimation Results Dependent Variable: LNGDP (1)
Sample: 1972-2005

Variables Coefficients Standard Error t-statistics

Constant 32.07473 11.31345 2.835098*
∆LNED -0.325619 0.086374 -3.769893*
LNDS -0.038329 0.005891 125.0644*
AR(1) 0.989206 0.007910 -1.9698*
MA(1) 0.908743 0.085796 12.59196*
R-squared 0.999374 F-statistics 10779.10
Durbin-Watson stat. 1.959221 Prob. (F-statistics) 0.000000*
Source: Authors calculations using E-views 3.1
Note: *, ** and *** indicate the level of significance at 1%, 5% and 10% respectively.

VI. Conclusion and Policy Implications

The primary objective of the study was to analyze the effect of external growth on the economic
performance of Pakistan. Pakistan has relied much on foreign debt to finance its balance of payments
deficit and saving investment gap. This heavily dependence on external resources became
uncontrollable in late 1980s. It is assumed that external debt can help the developing countries to meet
developing needs of those countries. But external debt did not contribute its due role in case of
Pakistan. This was due to mismanagement of the external debt. Now the external debt has become one
of the major hurdles in the economic development of the country. The country has to spend his major
portion of its Balance of Payments to serve its external debt. Pakistan has to agree upon many
unfavorable conditions posed by IMF and World Bank. Pakistan has to narrow down its international
trade because the country has to save its BOP to meet debt servicing needs of the country
Primary objective of external debt in case of Pakistan was to boost development activities. .
This could also be financed through increased export earnings spearheaded by an export-led growth
strategy. Availability of external finance should be consistent with a policy framework that is credibly
maintained (fiscal stance, exchange rate policy, interest rate policy, pricing policy, etc.). The policy
makers should create credibility including political will in order to spur investor confidence for both
local and foreign investments. Pakistan is facing many problems like political instability, terrorism etc
because of which the country has lost its confidence for investors. The need of the day is to re-build
that confidence so that the investor may invest in the country and the country can get rid of heavy
reliance on external debt. Pakistan still has a chance of overcoming its external debt problems by
cultivating the right policies, but will need considerable support through debt relief/reduction
initiatives.

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