External Debt, Growth and Investment for Developing Countries: The Role of Government Effectiveness

We investigate the effect of total, public and private external debt stocks on the growth rate and also on total, government, and private investment by using data for more than sixty developing countries with the system GMM. We find a significant and negative growth effect of total external debt stock, lending evidence for the debt overhang argument. Moreover, our results importantly indicate that external debt lowers growth only in countries with ethnically fractionalized and ineffective governments. On the other hand, our empirical findings don’t support the existence of a non-linear or threshold relationship between external debt and growth. Similar to the growth effects of external debt, significantly and negatively estimated coefficients on the three measures of external debt stocks imply that external debt reduces investment, again providing a robust evidence for the debt overhang argument. We also find that the investment effects of external debt vary with the level of government effectiveness of the countries. Finally, our estimations show that private investment level is sensitive to the government external debt rather than the private external debt.