External Debt and Economic Growth in India: Error Correction Model Estimation of the Causal Relationship

Abstract

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External debt is essential for economic growth; however, high levels of public debt adversely affect growth via debt overhang, crowding-out of domestic private investment, and constraining countercyclical fiscal policy. This paper estimates the causal relationship between external public debt and economic growth in India, along with other macroeconomic variables, using annual time series data for 41 years, from 1980 to 2020, and applying the error correction mechanism estimation method. The debt burden is segmented into two parts – external debt stock and external debt service – and are measured as the percentage share to external debt to GDP and percentage share of total external debt service to total foreign exchange earnings, respectively. The estimated results show a significant positive impact of external debt stock on economic growth in the long run. There is no evidence of a debt overhang problem, but evidence of external debt service potentially affects growth by crowding out private investment. The effect of debt stock is less noteworthy, as the negative effect of debt service exceeds the positive debt stock effect. The adverse effect of debt service, both in the long and short run, is significant. The short-run disequilibrium is corrected at a reasonably good speed, providing the sanguinity of the external public debt in India.

Keywords: External Debt, Economic Growth, Debt Overhang, Crowding Out, ECM Estimation

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