Kamiru Mohammed, University of International Business and Economics, Beijing
According to the World Economic Forum, the African investment gap in infrastructure (electricity, roads, water, and telecommunications) hinders nearly 40% of Africa's production. With limited savings, many developing countries lack the capital needed for investment. While countries can borrow capital domestically, heavy domestic borrowing can raise interest rates and crowd out private investment. To mitigate the latter, African countries have increased their external borrowing to fund their development projects and meet their infrastructure needs.
Evidence on the impact of external debt on economic growth is mixed. For example, a study of Ethiopia found that external debt supported long-term growth up to an optimal threshold. In contrast, a study of Oman found that external debt servicing had a significant negative effect on economic growth. Across 31 sub-Saharan African countries, researchers found that foreign debt harmed growth where public sector management was weak and helped growth where it was strong. Overall, evidence suggests that external borrowing can fund investment and infrastructure and so increases economic growth. Still, others also find that heavy debt can crowd out private investment, divert revenue into interest payments, and cut social spending, which in turn slows economic growth.
The missing link in the current body of literature may be the role of government effectiveness. Indeed, a country's ability to turn borrowing into productive investment depends on its institutions and on government effectiveness. By government effectiveness, we mean the quality of public services, the competence of the civil service, its independence from political influence, and policy reliability. An open, accountable government that delivers services well is more likely to invest borrowed money in ways that boost growth.
Using World Bank World Development Indicators data, this study examines Botswana, Burundi, Cameroon, Côte d'Ivoire, Ethiopia, Ghana, Lesotho, Mauritius, South Africa, and Zambia from 2000 to 2022 to assess the effect of external debt on economic growth, highlighting the effectiveness of government.
The study measured Economic growth using GDP per capita in constant 2015 US dollars, which ranged from about US$255 to nearly US$11,000 across the 10 countries. Other variables included the total external debt stock, the official exchange rate, consumer price inflation, debt service as a share of gross national income, and government effectiveness as a percentile rank.
The results indicate that both external debt and government effectiveness have a positive and significant effect on economic growth. Here, effective governance serves as a mediator and can positively influence the relationship between external debt and economic growth. In other words, government effectiveness has a significant effect on external debt, which in turn has a significant effect on growth. The results also show that the exchange rate and debt service had positive and significant effects on economic growth, while inflation had a negative effect.
This is in line with the literature: countries with strong institutions tend to adopt cautious fiscal policies and to put borrowed capital into investments that earn enough to service the debt. Transparent, accountable governments can build investor confidence and attract more foreign capital. Where governance is poor, defaults become more likely and borrowing costs rise.
What should governments do?
Governments should reform financial management and public administration so that external loans stimulate economic growth. The government could set up a Development Debt Fund to direct external borrowing to sectors with a track record of fostering growth, such as renewable energy, infrastructure, healthcare and education, and that support the Sustainable Development Goals. There should be accompanying legislation to define the fund's objectives, governance and operating guidelines, as well as adequate evaluation and monitoring of the projects.
To ensure the Development Debt Fund is effective, governments should also enact anti-corruption measures and strengthen their financial institutions. They can stabilize their currencies through monetary policy reform, fiscal discipline, and structural economic reform.
By using external loans strategically, African countries can stimulate economic growth and achieve sustainable development. Still, more research is needed across the continent, including indicators such as export volumes and corruption control.
Main photo: Flickr
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