©The Pakistan Development Review

51:4 Part II (Winter 2012) pp. 51:4, 79–96

External Debt Accumulation and Its Impact on

Economic Growth in Pakistan
RIFAQAT ALI and USMAN MUSTAFA*

1. INTRODUCTION
The accumulation of external debt is common phenomenon of the developing
countries and it has become a common feature of the fiscal sectors of most of the
economies. A country with lower saving rate needs to borrow more to finance the given
rate of economic growth. So external debt is obtained to sustain the growth rate of the
economy, which is otherwise not feasible with the given domestic resources. Pakistan is
one of the developing countries and faces serious debt problems, according to World
Bank Report 2000-2001, Pakistan is among the Highly Indebted Countries (HICs);
because Pakistan’s present and future debt situation is very grim.
According to the World Bank total external debt may be defined as debt owed to non-
resident repayable in terms of foreign currency, goods or services. External debt is the
composition of long term debt (public and publicly guaranteed debt plus private non
guaranteed debt), short term commercial debt and International Monetary Fund (IMF) loans.
Prior to early 1970s the external debt of developing countries was primarily small and official
phenomenon, the majority of creditors being foreign governments and international financial
institutions offer loan for development project [Todaro (1988)]. At the same time current
account deficit was common which increased the external indebtedness of the developing
countries, until when Mexico, despite an oil exporter, declared in august, 1992 that it could
not services its debt ever since, the issue of external debt and its servicing has assumed critical
importance and introduced the debt crises debate [Were (2001)].
Several factors have contributed to high rate of debt accumulation in developing
countries. These factors are wide-ranging and interconnected. The major factor was the
1973-74 oil price increased by Organisation of Petroleum Exporting Countries (OPEC)
led to general deterioration in the external payments position of the oil importing
developing countries and forced many of them to borrow heavily. Like other oil
importing countries, Pakistan also suffered from these international events of exceptional
nature. These events which imposed severe strains on its Balance of Payments (BOP)
position hampered its development efforts and led to a marked increase in the volume of
international indebtedness as well as its debt servicing liabilities. While improper
implementation of macro economic policies, political instability, corruption and poor law
and order situation are the main internal factors for rapid growth of external debt.

Rifaqat Ali <rifaqatss786@gmail.com> is Subject Specialist (Economics), Education Department,

Punjab. Usman Mustafa <usman@pide.org.pk> is Chief Training Programme/Head, Department of Business
Studies, Pakistan Institute of Development Economics, Islamabad.
51:4, 80 Ali and Mustafa

Effects of external debt accumulation on investment and economic growth of the

country are always remaining questionable for policy-makers and academicians alike.
There is no consensus on the role of external debt on growth. It has both positive and
negative aspect, different experts are in view that external debt will have favourable
effect on economic growth because external debt will increase capital inflow and when
used for growth related expenditures can accelerates the pace of economic growth. It will
not only provide foreign capital for industrial development but will also give managerial
know how, technology, technical expertise as well as access to foreign markets for the
mobilisation of a nation’s human and material resources for economic growth. On the
other hand when external debt accumulated beyond a certain limit, it will contract the
economic growth by hampering investment. A leading explanation for this negative
relationship is the so-called debt overhang hypothesis, which states that high level of
indebtedness discourage investment and negatively affect growth as future higher taxes
are expected to repay the debt.
Pakistan faces serious debt problem, which threaten the economic future of the
country. Burden of external debt and debt servicing have continued to grow over time.
According to the World Bank report 2000-2001, Pakistan is among the HICs; because
Pakistan’s present and future debt situation is quite dismal. In 1970 the value of external
debt in absolute term was $ 3.4 billion which went to $ 9.93 billion in 1980. The external
debt approximately doubled over from 1981 to 1990 and reached to $ 20.66 billion.
External debt showed rising trend during 1990-99 as it increased from $ 20.66 billion to $
33.89 billion. It declined to $ 32.78 billion in 2000 due to debt rescheduling. Then
external debt was $ 35.74 billion in 2003, in the last few years external debt increased at
an unprecedented rate and reached to $ 54.60 billion in 2010 [Pakistan (2010) and World
Bank (2007)].
Comparison of indicators of indebtedness to geographically and income related
countries signify that Pakistan is severely indebted as compare to South Asian and Low
Income Countries (LICs) during the last four decades. External debt as a percentage of
Gross National Product (GNP) was 45.20 percent in Pakistan as compared to 24.17
percent of South Asian countries and 36.78 percent in LICs. Total reserves as percentage
of external debt was 13.93 percent in Pakistan as compared to 30.94 percent of South
Asian countries and 24.67 percent in LICs. Foreign debt has been a major disbursement
item in Pakistan’s exports earnings budget. External debt to export of goods and services
was 356.83 percent in Pakistan as compared to 256.80 percent of South Asian countries
and 243.72 percent in LICs (these figures are the average of study period i.e. 1970–2010).
All these indicators signify the severity of debt crises that Pakistan is facing.
The study is organised as follows, chapter one is introduction of the study. Chapter
two gives a review of the theoretical and empirical literatures related to the study.
Chapter three presents methodology where methods and techniques to test the hypothesis
have been discussed, chapter four is econometric analysis of the study, last chapter is
conclusions. References are given at the end of the study.

2. LITERATURE REVIEW
Traditional studies on the external debt problem have focused mainly on the
development of the magnitude and trends of the external debt in the LICs and then
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 81

followed by other studies which have examined the debt burden indicators and severity of
the debt problem [Ahmed (2008)]. Academic research on external debt and its impact on
economic growth have only exploded after the debt crises that hit many developing
countries in the early 1980’s. However, recently many empirical studies have been
conducted to assess the impact of external debt on economic growth but the results are
ambiguous.
Oleksandr (2003), divided the existing literature on the related topic into three
groups. A first group of theories suggest that because poor countries are far away from
steady states any investment injection in form of foreign debt could lead them to have
accelerated economic growth through capital accumulation and productivity growth
[Pattillo, et al. (2004)]. Therefore foreign debt has a positive impact on growth up to
certain threshold level. Second group of theories, stress that high accumulated debt stock
have negative impact on growth. A leading explanation for this negative relationship is
the so called debt overhang hypothesis of Krugman (1988), and Sach (1989), then
advocated by Cohen (1993). Third group of theories combines these two effects and
argued that the impact of debt on growth is nonlinear.
The relationship between foreign debt and economic growth has mainly focused
on the negative effect of “debt overhang”. Krguman (1988), defined the debt overhang as
a situation in which the expected repayment on foreign debt falls short of the contractual
value of the debt. Likewise, Borensztein (1990), defined the debt overhang as a situation
in which the debtor country benefits very little from the return to any additional
investment because of the debt service obligations.
The review of existing empirical studies of external debt and economic growth
relationship indicated that it an inadequate to make any generalisation of the relationship
between economic growth and external debt. Therefore, it is necessary to consider the
case of each country or group separately.
Shabbir (2009) investigated the impact of external debt on economic growth in 24
developing countries from 1976 to 2003. The study applied random effect and fixed
effect estimation. The results showed that debt servicing to GDP negatively affect the
economic growth and may leave less funds available to finance private investment in
these countries leading to a crowding out effect.
Adosla (2009) examined the effect of external debt service payments on the
economic growth in Nigeria by using ordinary least square multiple regression method
for his analysis. It was found out that debt service payments have negative impact on
economic growth.
Abu Baker and Hassan (2008), focused to analyse the impact of external debt on
economic growth in Malaysia. The analysis was conducted both at aggregate and
disaggregate level. The empirical results indicated that total external debt positively
affect the economic growth at aggregate and disaggregate level. In the short run, total
external debt had positive effects on economic growth. It also revealed that Malaysia had
not suffered from debt overhang problem.
On a Similar line Cholifihani (2008), analysed the short run and long run
relationship between external debt and income in Indonesia from 1980 to 2005. The
findings showed that GDP, DSR, capital stock, labour force and human capital inputs
have a long run equilibrium relationship. External debt servicing showed a significant
51:4, 82 Ali and Mustafa

negative relationship with GDP, which indicated that debt overhang phenomenon, has
occurred in Indonesia in the long run. While labour force and human capital was main
supporting variables of GDP in the long run; however capital stock is significant variable
in boosting economic growth.
Hasan and Butt (2008) explored the association between external debt and
economic growth in Pakistan for the period of 1975-2005 using Auto Regressive
Distributed Lag (ARDL) approach to cointegration. Results indicated that labour force
and trade both in the long run and the short run mainly determined economic growth in
Pakistan. Total debt was not to be an important determinant of economic growth either in
the short-run or the long run mainly due to inefficient use of external debt.
Boopen, et al. (2007), investigated the relationship between external public debt
and the economic performance for state of Mauritius over the period 1960–2004. The
results suggested that external debt have been negatively associated with the output level
of the economy in both short and long run. Bicausality between public debt and economic
development was also reported. Moreover, there were also evidences that public debt
have negative impact on both private and public capital stock of the country thus
confirming the debt overhang and crowding out hypotheses.
Patenio and Tan-Curz (2007), studied the relationship between external debt
servicing payments and economic growth in Philippines for period 1981 to 2005. Results
showed that economic growth was not very much affected by external debt servicing.
This was probably because external debt servicing in Philippines was not yet a threat in
economic growth and thus, Philippines should not fear of experiencing debt overhang in
the near future.
Clements, et al. (2003), examined the channels through which external debt affect
economic growth in 55 LICs over the time 1970-1999. The study suggested that beyond a
certain threshold, higher external debt is associated with lower rates of growth of per
capita income. The results indicated a threshold level of around 30–37 percent of GDP or
around 115–120 percent of exports. The study observed that the negative effect of debt
on growth works not only through its impact on the stock of debt, but also through the
flow of service payments on debt, which are likely to ‘crowd out’ public investment. This
is so because service payments and repayments on external debt soak up resources and
reduce public investments. The damaging impact of debt servicing on economic growth
is attributable to the reduction of government expenditure resulting from debt induced
liquidity constraints.
It is worth mentioning that the majority of existing empirical literature report that
external debt adversely affects economic growth. Cunningham (1993), Afxentiou (1993),
Deshpande (1997), Were (2001), Karagol (2002), Cholifihani (2008), Hameed, et al.
(2008), reported that the external debt negatively affect the economic growth. Whereas
Warner (1992), Cohen (1993), Afxentiou and Serletis (1996) and Patenio and Tan-Curz
(2007), concluded that external debt did not affect the economic growth. While Omet and
Kalaji (2003), and Abu Baker (2008), report the positive impact of external debt on
economic growth. The theoretical literature has summarised the following channels
namely debt overhang, liquidity constraint, fiscal effect, productivity suppression and
reduction in human capital accumulation along which external debts affects negatively
growth [see Krugman (1988) and Savvides (1992)].
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 83

Table 1
Summary of Literature Review of External Debt and Economic Growth Relationship
Date Author Time Period Sample Findings
2008 Abu Baker 1970-2005 Malaysia External debt positively affect economic growth
2008 Ayadi and Ayadi 1970-2007 Nigeria and Confirm the negative impact of external debt on
South Africa economic growth.
2008 Hameed, et al. 1970-2003 Pakistan Debt service burden inversely affect economic
growth.
2008 Colifihani 1980-2005 Indonesia External debt payment has significant negative
relationship to GDP.
2007 Patenio and Tan- 1981-2005 Philippines Economic growth was not affected by external debt
Curz servicing.
2005 Mohamad 1978-2001 Sudan External debt works against economic growth
2003 Clements 1970-1999 55 low income Beyond certain threshold levels external debt
countries negatively affect economic growth.
2003 Omet and Kalaji 1970-2000 Jordan External debt positively affect economic growth
below optimal debt level i.e. 53 percent of GDP
2002 Wijeweera, 1952-2000 Sri Lanka Debt overhang had not exist in Sri Lanka.
et al.
2002 Karagol 1956-1996 Turkey Debt service is negatively correlated to economic
growth.
1997 Deshpande 1971-1991 13 Severely The relationship between external debt and
Indebted investment is negative.
Countries
1992 Warner 1960-1981 13 Less External debt does not reduce investment.
and 1982- Developed
1989 Countries

3. MODEL SPECIFICATION AND EMPIRICAL STRATEGY

This study employed the extended model of production function originally applied
by Cunningham (1993), to investigate the effect of debt burden on economic growth in
sixteen heavily indebted nations. Cunningham (1993), presumed that the production
function only consist of physical capital, labour and debt service.
The model assumed that there is no human capital. Romer (1986), investigated that
physical capital is important for the production function but the human capital is vital.
Therefore, Karagol (2002), extended the Cunningham model to incorporate Romer’s
conceptualisation of human capital. Human capital consists of skill, abilities and
knowledge of particular workers therefore, to investigate the relationship between
external debt burden and economic growth the study insert variable of human capital that
can be proxied by annual government education expenditures.
Karagol (2002), covered data of Turkey and Wijeweera, et al. (2005), used data of
Sri Lanka employed education expenditures representing human capital in the model.
Karagol suggested that education expenditures may not be a suitable proxy for human
capital in case of Turkey. In contrast, in case of Sri Lanka, the results suggested that
education expenditures may have been an appropriate proxy for human capital.
This study used external debt as a percentage of GDP to capture the effect of
external debt because external debt as a percentage of GDP signifies the indebtness
relative to economic strength of the country.
51:4, 84 Ali and Mustafa

The model of this study was:

Y= f (HK, K, L, EDY)
The production function used the following specification:
Yt= β0+ β1HK +β2K+ β3LF+ β4 EDY + εo … … … … (1)
Yt = Gross National Product (GNP)
HK = Human capital, It consists of the skills and knowledge of particular workers
(Annual education expenditures of Pakistan used as a proxy of human capital)
K = Capital stock (Capital formation)
LF = Total labour force
EDY = External debt as a percentage of GDP
εo = White noise error term
By applying natural logs, the model was
LYt= β0+ β1LHK + β2LK+ β3 LLF + β4 LEDY + εo … … … (2)
It has now become a standard practice to check the univariate time series of
variable by using a unit root test in each series before estimating any equation. If there is
a unit root, then the particular series is considered to be non-stationary. Moreover,
estimation based on non stationary variables may lead to spurious results which produce
high R2 and t-statistics, but without any coherent economic meaning [Granger and
Newbold (1974)]. In accordance with standard practice it was checked whether the
variables are stationary or not.
In this study Augmented Dicky Fuller (ADF) test was carried out for checking unit
roots. ADF has three different specifications, the first excludes both the trend and the
intercept, second specification includes the intercept but excludes the trend term and the
third specification includes both the trend and the constant term. The study used the third
specification. The purpose to use the ADF to testing the null hypothesis that a series does
contain a unit root (i.e., it is non stationary) against the alternative hypothesis of
stationarity.
ΔYt= β1+ β2t+ δYt–1+ α Σi=1ΔYt–i +εt … … … … … (3)
Where Yt is relevant time series, t is time trend and εt is white noise error term.
It is also important to select an appropriate lag length; too few lags may result in
rejecting the null hypothesis when it is true (i.e., adversely affecting the size of the test),
while too many lags may reduce the power of test [Harris and Sollis (2003)]. The study
used the Schwarz criterion (SC) and Hannan-Quinn information criterion (HQ) to choose
the appropriate lag length.

3.1. Cointegration Analysis

After checking univariate of all time series variables, the study test cointegration
among the variables of the model (GNP, human capital, capital, labour force and external
debt). The reason of the cointegration test was to determine whether a group of non
stationary series is cointegrated or not.
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 85

With the aim of determining long run relationship between variables cointegration
technique is adopted. Two main cointegration techniques are generally used; Engle and Granger
(1987), technique and Johansen (1988), approach. In order to test cointegration among variable
the study applied the Johansen cointegration technique. This technique depends on direct
investigation of cointegrating Vector Auto Regressive (VAR) representation.
Yt = α1Yt-1 + α2Yt-2 + ………. + αkYt-k + εt
Where, Yt is n  1 vector of I (1) endogenous variables (GNP and its determinants) in the
VAR system εt is a vector of white noise error terms.
The Johansen procedure is designed to statistically determine the number of
cointegrating vectors in the VAR. In order to determine the number of cointegrating
vector Johansen (1988), provides two different likelihood ratios tests to determine the
value of cointegrating vector. These are the Trace test:
LR= TΣ ni=r+1 ln( 1–λi)
And the Maximum Eigenvalue test statistics:
LR= T ln(1–λr+1)
Trace statistic is a joint test where the null is that the number of cointegrating
vectors is less than or equal to r against an alternative that there are more than r.
Maximum Eigenvalue test conducts separate tests on each Eigenvalue and has its null
that the number of cointegrating vectors is r against an alternative of r+1. The null
hypothesis was tested sequentially from low to high values of r. The testing procedure
ends when a null hypothesis fails to be rejected for the first time [Rusike (2007)].

3.2. Short Run Dynamics

The final step of the analysis involved the estimation of short run relationship between
external debt and GNP. The short run model was used to identify whether the effect of
external debt is permanent or transitory. If the responses are significant in the short run only,
then the impacts of change in external debt is transitory. On the other hand, if the impacts are
significant in both short and long run, then there will be temporary and permanent effect. If
there is an equilibrium or cointegration relationship among non stationary variables there has
to be an error correction representation [Engle and Granger (1987)]. Relationship between Yt
and Xt with an error correction specification as;
∆Yt= β0+ β1∆Xt – π êt-1 + εt
β1 will have the short run effect, that measure the immediate impact that a change in Xt
will have on change in Yt. On the other hand is the adjustment effect and shows how
much of disequilibrium is being corrected, i.e. the extent to which any disequilibrium in
the previous period effects any adjustment in the Yt period.
The error correction mechanism integrates the short run dynamics with the long
run equilibrium without losing long run information. This term captures the short run
relationship. It attempts to correct deviations from the long run equilibrium path and its
coefficient can be interpreted as the speed of adjustment or the amount of disequilibrium
transmitted each period to economic growth [Ndung’u (1993)].
51:4, 86 Ali and Mustafa

3.3. Data Collection and Data Definitions

The empirical analysis of this study used the time series data coverd the period
from 1970 to 2010. All the data obtained from Government publication, Annual
Economic Surveys of Pakistan (various issues), World Development Indicators [CD
(2007)], Federal Bureau of Statistics and State Bank of Pakistan. Besides this,
International Financial Statistics (IFS) of IMF has also been used to supplement the
information.

Table 2
Variables Names and Description
Variable Name Variable Description
LY Log of GNP

LHK Log of human capital

LK Log of capital

LLF Log of labour force

LEDY Log of external debt as a percentage of GDP

4. ESTIMATIONS AND ANALYSIS OF RESULTS

This section provides graphical analysis and test the existence of unit roots of
each series using the Augmented Dickey Fuller (ADF) test. The optimal lag length
for the unit root and Johansen’s cointegration tests are decided by the Schwartz
Criterion (SC) and Hannan-Quinn information criterion (HQ). Then the study detects
the number of cointegrating vectors by employing Trace statistics and Max
Eigenvalue test. After that the cointegration analysis was employed using the
Johansen (1988), cointegration technique and calculate the normalised long run
equilibrium equations. Finally the study estimated the Vector Error Correction
Modeling (VECM) for short run dynamics.

4.1. Results for Unit Root Test

Non-stationarity of time series data has often been considered as a proble m in
empirical analysis. Working with non-stationary variables leads to spurious
regression results, from which further inference is meaningless. Therefore, it is
important to test the stationarity of all series entering in the model. The ADF test was
used to test the stationarity of the series. The null hypothesis was that the variable
under investigation has a unit root, against the alternative that it does not. The results
of the test for the variables are presented in Table 3. In addition to the ADF test, the
study also attempted to examine the trend of the variables graphically. The graphical
illustration of the variables demonstrates the similar characteristic of the variables as
the ADF test.
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 87

Fig. 1. Graphical Plots for Unit Roots

Table 3
Results of ADF Test for Non Stationarity
ADF Test in Level ADF Test in First Difference
Variables Calculated Lags Calculated Lags
LY –2.50 1 –4.52** 1
LHK –2.29 1 –4.46** 1
LK –2.73 1 –4.20* 1
LLF –2.06 1 –6.92** 1
LEDY –2.75 1 –5.67** 1
Note: The asterisks (*) and (**) indicates statistical significance at the 5 percent and 1 percent significance
level.
51:4, 88 Ali and Mustafa

The results reported in Table 3 are carried out with trend and intercept. Results
indicated that all series exhibit non stationary in levels. In other words, the null
hypothesis that each of the time series has a unit root cannot be rejected. However, there
is no evidence of a unit root when the series are first differenced. The no stationary
hypothesis was dismissed in all cases. It means that all the variables under investigation
are stationary at first difference at 1 percent level of significance except LK which was
stationary at 5 percent level of significance, as can be inferred from Table 3.

4.2. Optimal Lag Selection

After analysing the result of unit root test next step is to find out the lag order for
cointegration. One must determine the optimal lag structure of the model, i.e. the number
of lags that will capture the dynamics of the series. Results of two different criterions for
optimal lag selection are presented in Table 4. Both SC and HQ statistics suggested one
lag as optimal lag.

Table 4
Optimal Lag Selection
Lag SC HQ
0 –5.149482 –5.29265
1 –11.64190* –12.50092*
2 –10.59315 –12.16803
3 –9.409976 –11.70071
* Indicates lag order selected by the criterion
SC: Schwarz criterion
HQ: Hannan-Quinn information criterion

4.3. Results from the Conitegration Analysis

The results from the unit root test indicated that the entire variables entered in the
model are non-stationary at level and became stationary at first difference. While the
optimal lag length criteria suggested one as optimal lag.

Table 5
Unrestricted Cointegration Rank Test (Trace Statistics)
Hypothesised No of Eigenvalue Trace 5 percent
Cointegration Equation Statistics Value Critical Value Prob**
None * 0.62436 75.461 69.818 0.0165
At most 1 0.48028 39.233 47.856 0.2511
At most 2 0.22607 15.017 29.797 0.7790
At most 3 0.13767 5.5350 15.494 0.7497
At most 4 0.00147 0.0545 3.8414 0.8154
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 89

Table 6
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesised No. of Eigenvalue Trace 5 percent
Cointegration Equation Statistics Value Critical Value Prob**
None * 0.62436 36.228 33.876 0.0257
At most 1 0.48028 24.215 27.584 0.1273
At most 2 0.22607 9.4822 21.131 0.7917
At most 3 0.13767 5.4805 14.264 0.6803
At most 4 0.00147 0.0545 3.8414 0.8153
Trace test and Max-eigenvalue test indicate 1 cointegrating eqn(s) at the 0.05 level
*denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

The next procedure was to test the existence of long run relationship among the
variables in the model. This study applied Johansen (1988), cointegration test to examine
whether there is more than one single cointegration relationship.
Johansen’s cointegration procedure mainly focused to find out the number of
cointegrating vectors in the system. If the number of cointegrating vector (0≤r≤n) is zero,
it would imply that there is no long run relationship among the variables. On the other
hand, if there are r cointegrating vectors, it suggests that there are (n-r) common
stochastic trends among the variables that link them together.
Tables 5 and 6 revealed the results of Johansen cointegration test based on Trace
statistics and Max Eigenvalue respectively. These tests statistics help to evaluate whether
there exist a long run relationship exist among LY, LHK, LK, LLF and LEDY. Both of
these tests showed the long run equilibrium relationship among non stationary variables
entering in the model. The null hypothesis of no cointegration was rejected therefore, the
alternative hypothesis that at least one cointegrating vector was accepted by both test at 5
percent level of significance. According to the results of Johansen’s test, it can be argued
that a long run relationship exist among LY, LHK, LK, LLF and LEDY and there exist
precisely one cointegrating vector in the estimated model.
Variables considered in the determination of economic growth have expected signs
except labour force. Human capital and capital positively affect the economic growth
where as external debt and labour force affects it negatively.

Table 7
Long Run Equilibrium Equation Dependent Variable (Log GNP)
Independent Variable Coefficient t-statistics
Constant –1.3227 4.2378
Log (Human Capital)* 0.31277 4.6239
Log (Capital Stock)* 0.52918 6.4832
Log (Labour Force)* –0.16823 –10.3901
Log (External Debt as Percentage of GDP)* –0.42394 –8.24052
Note: The asterisks (*) indicates the statistical significance at 5 percent level of significance.
51:4, 90 Ali and Mustafa

In the context of LDCs, economic theory suggests that human capital is an

important determinant of economic growth. Various theoretical models include human
capital as a factor of production and consider the accumulation of human capital as an
element of the growth process. Empirical evidence for number of countries also
confirmed this relationship. Lucas (1993), argued that accumulation of human capital
serve as an engine of economic growth. Mankiw (1992), further extended the theory and
consider human capital as an additional accumulatable factor. He provided evidence that
changes in human capital ultimately translates into significant changes of growth rates.
Barro and Lee (1993) and Benhabib and Spiegel (1994), provided evidence that human
capital accumulation promotes economic growth.
Empirical findings indicated that human capital has a positive effect on economic
growth and have the second most substantial effect on GNP i.e. 0.31. This means that 1
percent increase in annual education expenditure (used as proxy of human capital) leads
to increase GNP by 0.31 percent. This relationship was significant at 5 percent level of
significance. This indicates the low level of government expenditure on education in
Pakistan.
The results also indicated a positive relationship between capital and economic
growth. This in line with the general assertion that the capital is a key factor of
production hence it is positively associated to economic growth. Since capital is one of
the major determinants of GNP therefore, according to estimation it reports the positive
effect on economic growth. On this estimates 1 percent increase in capital leads to
increase GNP by 0.53 percent. This association was significant at 5 percent level of
significance. The relationship was consistent with economic theory. This indicates the
scarcity of capital in Pakistan.
Labour force showed the negative impact on economic growth; where as the study
hypothesised the positive effect of labour force. Firstly, it can be argued that Pakistan is
labour abundant country. More unskilled labour having low productivity is unlikely to
increase the level of output in the country. Secondly, agriculture is the largest sector of
the economy and 45 percent of total employed labour force is working in this sector
[Pakistan (2010-11)]. Agriculture sector suffer from disguised unemployment, majority
of the people belong to this sector seem to be actively participated in economic activities,
but having zero marginal productivity. Therefore, labour was negatively related to
economic growth. These results were conflict with Hameed, et al. (2008), who found the
positive impact of labour force and economic growth in Pakistan. While Wijeweera, et al.
(2005), found the same result for Sri Lanka. Positive impact of education expenditures
also indicated that there may be scope of improving labour efficiency by increasing
education expenditure in Pakistan.
Results reported in Table 7 indicated that external debt has negative long run
relationship with economic growth. The rationale is that high ratio of external debt as
percentage of GDP leads to lower the rate of economic growth i.e. an increase in 1
percent in external debt as percentage of GDP will reduce the GNP by 0.42 percent.
These results confirmed the existence of debt overhang problem. This hypothesis
hypothesised that having heavy debt burden the government will have to increase taxes in
the future to finance the high debt service payments. That increase in taxes means a lower
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 91

after tax return on capital and a reduced incentive to invest. Lower investment leads to
slower growth [Krugman (1987 and 1985); Sachs (1984 and 1986)].
However in the long run repayments of principal and interest payment absorb the
significant portion of foreign reserves making it difficult to launch new investment
projects. This implies that rising external debt deter economic growth. The findings were
consistent with the literature with Geiger (1990), Cunningham (1993), Afexientue (1993),
Sawada (1994), Deshpande (1997), Karagol (2002), and Hameed, et al. (2008), (in case
of Pakistan) found negative relationship between debt burden economic growth.
Among the variable capital stock and human capital contributed to boost the
economic growth in the country during the period of the study. While being a labour
abundant nation labour contributed negatively. Heavy external debt act like a future tax
therefore, it verified the occurrence of debt overhang situation in Pakistan during the
period of the study. All these associations are statistically significant at 5 percent level of
significance.

4.4. Short Run Dynamics

Short run dynamic equation has two important objectives. Firstly, it can be used to
investigate whether the impact of any external debt burden is stable or temporary. If the
responses are significant both in long run and short run, it can be said that changes are
permanent as well as transitory. Finally, the Error Correction Term (ECT) provides
information about the speed of adjustment in response to a deviation from the long run
equilibrium. The short run results of the model are depicted in Table 8.

Table 8
Short Run Results of the Model
Independent Variable Coefficient t-statistics
Log (Human Capital)* 1.500092 3.65554
Log (Capital Stock)* 1.231827 3.15180
Log (Labour Force)* –0.116589 –1.63426
Log (External Debt as Percentage of GDP)* –0.482802 –4.92390
Error Correction Term* –0.328 –3.21314
Note: The asterisks (*) indicates the statistical significance at 5 percent level of significance.

The results reported in Table 8 indicate that the short run results of first difference
of log-level variables are similar to long run. Short run dynamics indicated that the short
run impact of human capital and capital is positive and statistically significant. External
debt exerts negative effect on economic growth in short run and the size of negative
impact is stronger than long run. GNP will increase 1.23 and 1.50 percent as a result of 1
percent increase in capital and human capital respectively. While the short run estimates
show the insignificant negative association between labour force and economic growth.
Relationship between external debt and economic growth is found to be negative
and significant in short run. This indicated that external debt effect in Pakistan during the
period of study is permanent as well as transitory and debt overhang occurs both in short
and long run. Negative impact of external debt in short run is stronger than long run, 1
percent increase in external debt as a percentage of GDP will cause 0.48 percent decrease
51:4, 92 Ali and Mustafa

in GNP in short run. Mismanagement of external debt is the main contributing factor of
this negative effect in the short run.
After determining the existence of cointegrating relationships, disequilibrium may
exist in the short run. If a long run relationship between different variable exists then an
error correction process is also taking place. The coefficients of the ECT provide
information about the speed of adjustment toward the long run equilibrium after a short
run shock. The speed of adjustment coefficient is correctly signed. The ECT is
significantly different from zero, indicating the existence of error correction mechanism
and implying that the D(LY), D(LHK), D(LK), D(LLF) and D(LED/Y) converge to the
long run equilibrium relationship. The speed of adjustment of the equilibrium error term
suggest that if a shock inserted into the model 33 percent deviation is rather corrected
with in the first year. The ECT is negative and significant with high t-values of 3.21,
confirms that findings of the study are regarding the cointegration relationship.

5. CONCLUSIONS
The study attempted to examine the long run and short run impact of external debt
on economic growth in Pakistan over the period of 1970-2010, considering GNP as a
function of annual education expenditures (proxy of human capital), capital, labour force
and the external debt. Then long run equilibrium equation was obtained by applying
Johansen cointegration test while short run results were obtained through Vector Error
Correction Modeling. Finally Error Correction Term was measured to capture the speed
of adjustment.
Empirical evidence revealed that external debt exerts a negative impact on
economic growth; clearly indicate that higher external debt discourages economic
growth. Therefore it verified the occurrence of debt overhang situation in Pakistan during
the period of the study. Capital as a key factor of production, positively affects the
economic growth. This indicates that capital investment has a lot of potential to
accelerate the pace of economic growth. Human capital has positive impact on economic
growth signified that an educated and highly productive labour force can lead to speed up
the growth process. Labour force showed the negative impact on economic growth
indicated that more unskilled labour having low productivity is unlikely to increase the
level of output in the country.
Short run results also confirmed the significance of capital formation and human
capital to generate national income. Short run results showed the similar sign of variable
entering in the model as in the long run but significant negative association of labour
force and economic growth exist only in the long run.
A significant adjustment parameter obtained from the cointegration equation
confirmed the long run relationship. An estimation of adjustment parameter suggested
that 33 percent of any deviation to the long run equilibrium corrected in one year.
From the policy prospective it is recommended that increased domestic saving and export
earnings could also raise the estimated growth rate and reduce the reliance of the economy on
external debt. It is very important to create conducive environment for investment and much
focus of the policies should be on the inflow of Foreign Direct Investment (FDI), while the
inflow of debts should be minimised. There is severe need of close monitoring and consistent
debt management strategies to avoid the misutilisation of external debt.
 External Debt Accumulation and Its Impact on Economic Growth in Pakistan 51:4, 93

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