DEBT CRISES & INDEPTH DETAIL ANALYSIS

RELATED TO PAKISTAN

PRESENTED TO PROF ILYAS

BY HURMAT FAIZA
FINANCIAL ECONOMICS
DEPARTMENT
SUPERIOR UNIVERSITY LAHORE

1
Thesis Title:
Affect of rising LT-DEBT on the
economic growth of country & overall
productivity impact in Pakistan

Research By:
Hurmat Faiza

Research Supervisor:
Signature: _________________________ Date:
__________________
• Prof. Muhammad Ilyas,

2
Submitted as the requirement of MSC Economics
Department of economics
Superior University Lahore

Impact of Inflation and unemployment on

poverty in Pakistan

(An analytical approach from 1993 - 2008)

3
My teachers who have inspired me
through my path of education & my
Parents.

It is certified that the research work contained in this thesis

titled “Impact of the rising debt burden on the
economy caused by rising liabilities & loans from
the IMF & World Bank in Pakistan" has been carried out
under my supervision by Hurmat Faiza and is approved for

4
submission in the partial fulfillment of the requirement for
the degree of Masters in Economics.

Supervisor:

Prof. Muhammad Ilyas

Dated:
Submitted Through
Prof. Muhammad Zia-Ullah-Khan
Program Manager of Economics
Superior University, Lahore

5
Hurmat Faiza Roll number 9107 MBA Economics, session:
2008-2010, hereby declare that matter printed in the thesis
titled “Impact of the rise in LT-debt on the economic
growth & national productivity in Pakistan” is my own
Research work under kind supervision of our supervisor
Prof. Muhammad Ilyas and has not been printed, and
published and submitted as research work thesis or
publication in any form in any university research institute
etc. in Pakistan or abroad. I also declare that this thesis
work has not been used for any benefit or advantage
elsewhere.

Dated
Deponent

6
First of all I acknowledge ALMIGHTY ALLAH whose
blessings lead us towards successes accomplishing
in every sphere of life. All respects for HAZARAT
MUHAMMAD (peace be upon him), who is forever a
torch of knowledge and guidance to humanity and
enable us to shape our lives according to the
teachings of Islam.
It is matter of great pleasure and honor for us to
express our deep sense of gratitude for the continues
guidance , indispensable advice and precious time
devoted to us by our advisor and teacher
MUHAMMAD ILLYAS of economics department ,
superior university , Lahore.
I also offer a very sincere note of thanks to our
honorable program manager PROF. ZIA-ULLAH-
KHAN, all our teachers, all administrative staff and
library staff of superior university Lahore for
providing us the necessary information when
required.
Finally, I extend my cordial and my special regards to
my most respectful affectionate and loving parents,

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 who have always prayed for my success and
betterment.
Hurmat Faiza

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9
Table of contents

Chapter Description Page #

0 Abstract 9

1 Introduction 12

2 Literature Review 23

3 Theoretical Frame work 43

4 Data and Methodology 46

5 Results analysis 60

6 Conclusion 67

7 References 71

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CHAPTER 1
Abstract to
thesis
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Abstract to Thesis

This study undertakes the long-run and short-run relationships between

a) External debt
b) Economic growth of Pakistan.
By fitting production function model to annual data for the period 2000-2010, the study
examines the dynamic effect of
a) GDP,
b) debt service,
c) capital stock
d) labour force on the economic growth of the country.
By following Cunningham (1993), I have to identify the long-run and short-run causal
relationships among the included variables. The results will show whether that debt

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servicing burden has a negative effect on the productivity of labor and capital? Thereby
affecting economic growth adversely. Results will also show whether debt service ratio
tends to affect GDP negatively and thereby the rate of economic growth in the long-run,
which, in turn, will cause to reduce the ability of the country to service its debt. Similarly,
the estimated error correction term will show the existence of a significant long-run
causal relationship among the specified variables. Overall, the results may or may not
point to the existence of short-run and long-run causal relationship running from debt
service to GDP of country.

Chapter 2
Introduction to
Thesis

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Introduction
To
Thesis

Like many other countries of the world, Pakistan has accumulated

large external debt. External borrowing is ought to accelerate
economic growth especially when domestic financial resources are
inadequate and need to be supplemented with funds from abroad.

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Postulation of economic theory:
Economic theory postulates that reasonable levels of borrowing
promote economic growth through factor accumulation and
productivity growth.
Reason:
This is because the countries at the initial stages of their development
usually tend to have smaller capital stocks and their investment
opportunities are limited, which promise high rates of returns in them.
Pros & Cons of borrowing by a govt:
If the borrowing countries channel the borrowed funds into productive
investments and they enjoy macroeconomic stability, they will be able
not only to accelerate their economic growth but also to settle their
debt obligations comfortably. The external debt also has a dark side.
Foreign debt does not remain a blessing after it gets accumulated
beyond a certain limit. In fact, too much of debt can dampen growth by
hampering investment and productivity growth.
Reason of reduced growth in debts:
The obvious reason is that when greater percentages of reserves
(foreign currency) are consumed in meeting debt service,
creditworthiness erodes causing reduction in access to external
financial resources. It is known that increase in external debt is
invariably accompanied by a concomitant increase in debt-service
requirement, which has unfavorable133 implications for economic
growth and thereby for country’s ability to settle debt and debt-service
obligations.
Pakistan’s external debt reached an unprecedented level during the
1990s. Main causes of rapid growth in external debt include a) inept
use of borrowed resources in the form of wasteful government
spending, and b) financing of current expenditure, and c) investing in
low priority development projects, and d) poor implementation of
foreign aided projects. Because of an injudicious utilization of

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foreign loans debt carrying capacity of the country weakened due to its
reduced real revenues and exports, leading ultimately to increased
real cost of government borrowing, both domestic and foreign.
In order to protect its future credit-worthiness, Pakistan like many
other countries of the world has initiated certain restraining measures
to limit inflationary pressures and to protect the competitiveness of its
exports. However, since there is a substantial time-lag for these
measures to work their way through the economy, its growth gets
affected negatively from delays in their effectiveness (Afxentiou and
Serletis, 1996).
Some attempts have already been made in analyzing the effect of debt
on economic growth of Pakistan (Siddiqui and Malik, 2001; Chaudhary
and Anwar, 2000, 2001; Burney, 1988). The quantitative estimates of
these studies are based on cross-sectional analyses. To the extent the
previous researchers used cross-sectional data for analyses; they have
not been bale to take into account the non-stationary properties of the
macroeconomic time series. As such, their results are of doubtful
validity because they suffer from spurious regression problem. In this
study, I have therefore, analyzed the impact of external debt service
on economic growth of Pakistan with a method that has modeled the
non-stationary behaviour of the included variables via E-views
software. More specifically, by following Cunningham (1993), this study
has employed a vector error correction framework (VECM) for
analyzing the short-run and long-run effects of external debt service on
gross domestic product taken as a surrogate of economic growth.

Researched Figures involving latest Debt Figures added in thesis work

Support material to thesis work & literature review explanation & working

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As reported by business recorder taken on Friday, June 25, 2010.

External debt-to-GDP ratio

The country’s external debt-to-GDP ratio has hit 30 percent, while domestic debt-to-
GDP ratio has mounted to an alarming level of 31 percent.

Pakistan’s outstanding stock of domestic debt: Rose by 19.04% to Rs4.633 trillion by

May from Rs3.892 trillion during the corresponding period last year, the central bank
said.

Reason for the rise in Domestic debt [the State Bank of Pakistan (SBP) said]:
The rise in domestic debt is attributed by the economists to the

a) “net external financing”

b) Due to “lower-than-expected disbursement” of the “pledged foreign financing”
c) Increase in the “external debt repayment” on maturing stocks of the foreign
currency bonds.

Reason of the higher deficit:

The virtual halt with the budgeted external finances put pressure on the domestic
source of financing to finance the budget deficit.

Over all impact :

“Consequently, the structure of domestic debt has changed significantly with

increasing share of scheduled banks and non-bank debt in the total domestic debt.”

Rise in Outstanding stocks (permanent debt):

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 The outstanding stocks of permanent debt went up by 16.79% to Rs789 billion
during July-May 2009/10 against Rs675.6 billion during the corresponding period last
year.

Share of the PIBs:

Pakistan Investment Bonds (PIBs) retained its dominant share in the outstanding
stocks of permanent debt with Rs505.3 billion against Rs441 billion.

Rise in the floating debt:

The head of floating debt rose by 22.66 % during the first 11 months of FY10 to Rs2.397
trillion against 1.954 trillion during the corresponding period last year.

Rise in the unfunded debt:

The overall unfunded debt showed an increase of 14.89 per cent to reach Rs1.44 trillion
against Rs1.253 trillion.

Overall national domestic debt surge:

Domestic debt surges by 19.04pc in 11 months

“Overall public debt, thereby, remains a strong source of vulnerability to the economy
and mounting domestic debt is also strongly suggesting an interest rate rise in the
offing,” Farhan Bashir Khan, an economist at Invest Cap Securities.

Amount of govt revenue used to pay interest:

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Almost 46 percent of government revenue was used for interest and principal payments
on public debt during first nine months of fiscal year 2009-10 aggregating Rs 640.2
billion.

% of projected GDP

Percentage of the projected GDP for 2009-10, the public debt servicing stood at 4.4
percent.

Payments for debts by govt:

Interest payments of Rs 428 billion went to domestic debts and Rs 45 billion payments
was on account of foreign debt, while Rs 166.7 billion was paid to retire the maturing
foreign currency debt. According to Finance Ministry statistics, almost 46 percent of
government revenue had been used for interest and principal payments on public debt
during during July 2009 to March 2010.

Debt servicing cost of permanent debt

A further break up shows that debt servicing cost of permanent debt rose sharply and
mounted to Rs 57 billion in July-March as compared to Rs 40 billion in same period of
previous fiscal year. Current increase was largely due to interest payment on 10-year
Pakistan Investment Bonds (PIBs). Interest payment on floating debt registered a decline
of 7.1 percent to Rs 160.7 billion.

Debt servicing cost of permanent debt

Debt pressure faced by Pakistan:

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Pakistan has been facing the burden of mounting debt pressure. The same stems from
escalating fiscal deficit of the country as compared to the budgetary estimates. During
FY10, the fiscal deficit rose to 5.2 percent of the GDP against the budgeted 4.7
percent. The domestic side remained a prominent source of financing fiscal deficit.

The IMF:

In between, a differentiating factor came in the form of the International Monetary

Fund’s (IMF) budgetary support under its augmented funding plan for Pakistan.
The contribution of the IMF funding in the overall external financing of the country has
risen. The IMF’s total share in external debt has risen from four percent in FY06 to 14
percent till the third quarter of FY10. The burden of borrowing sis overburdening the
govt with the debts.

Overall situation that Pakistan is going through since past 3 years:

A debt sustainability analysis by the government and the IMF shows that Pakistan’s debt
position worsened significantly in 2008.

EDL:

The External debt and liabilities (EDL) as a percentage of foreign exchange receipts
(exports, services receipts, and private transfers) increased to 127.2% in 2008 from
121.6% in 2006.

Overall result of rise in EDL:

It indicates that the stock of EDL is growing at a faster rate than foreign exchange
earnings.

Surging figure of SDL:

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The EDL as a percentage of official foreign exchange reserves surged to 407.3 pc in
2008 from 267.5 pc in 2007, reflecting a deteriorating ability to meet external debt
obligations.

Situation of Pakistan’s external debt portfolio:

This indicates that Pakistan’s external debt portfolio is highly vulnerable to shocks that
might lead to a deterioration of the balance of payments position.

Overall impact:

This could include

a) Another spike in international commodity prices,
b) A decline in exports
c) Slowdown in foreign exchange inflows into Pakistan.
There is a real risk that such shocks are in the pipeline given the collapse in external
demand amid the global recession and the rapid slowdown of forex inflows into all
emerging economies due to the turmoil in the international financial markets.

Total debt-to-GDP ratio

Pakistan’s total debt-to-GDP ratio has crossed 61 percent this fiscal year,
breaching the 60 percent limit set under the Fiscal Responsibility and Debt Limitation
Act.

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Introduction to the general concept:

Govt Debt:

Therefore whatsoever has been borrowed by govt in he past is known as public or govt
debt.

Note:
Whether any country is rich or poor its debt burden goes on increasing.

2 views regarding public debt:

1) Traditional view regarding the public debt which states that “due to public debt the
national savings decrease.”

2) Alternate theory of public debt which was presented by prof. Ricardo. Known as
“Ricardian Equivalence.”
Ricardian Equivalence: The public debt does not affect national savings & capital-
accumulation.

Budget Deficits:

When ever the govt spends more than the revenues earned through taxes, govt has to face
the budget deficits. To meet such deficits govt borrows from the private sector.
Budget deficit = change in assets – change in debts.

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Reason for difference of opinion: It is due to the difference in views regarding
consumption. Justification of the theories is concerned with the way the fiscal policy
affects the consumer expenditures.
Most important factors: To know the affects of the budget deficits on the economy it is
important to know
a) whether the consumers are foresighted or shortsighted
b) Whether they face constraints to borrow or not.
Traditional View of the govt debt:
It is stated that the fall in taxes leads to increase in consumption & decrease in savings.
Result of fall in savings:
The rate of interest increases.
Result: This results in the process of crowding out of the private investment.
Justifications stated in the theories:
IS-LM: This model states that due to fall in taxes the consumption expenditures of
people rise shifting the IS curve to the right in the IS map. If there is no change in the
monetary policy, due to the shift of the IS curve the AD curve will shift towards right.
In case of open economy model it’s clear that when savings fall in economy, deficit in
trade balance rises. This will encourage the inflow of foreign capital.
Mundell -Fleming model:
States that because of fiscal changes the external value of dollar will rise which will make
imported goods cheaper & exported goods expensive in world market.
Overall analysis:
Fall in taxes financed with the public debt give rise to following effects:
Consumption expenditures rise in long run & short run
Short run impact of increase in the consumption:
The demand for goods & services rises pushing the income & employment. The savings
will fall.
Behavior of the producers:
A competition will develop amongst the producers to borrow the funds which will push
interest rates up. Increase in interest rates will cause the investment to be discouraged.
Inflow of foreign capital:

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Rise in interest rates will encourage the inflow of foreign capital.
External value of currency of this country in terms of others will go up. Depressing the
competitive position of that country in the world.
Long run impact:
Due to fall in taxes when national savings fall, stock of capital comes down & amount of
debt rises.
Overall impact:
Production of economy falls & major part of the national output will be owned by
foreigners.
Impact of low taxes:
There will be higher consumption & higher unemployment. Leading to increase in
inflation. It will cause budget deficit & there will be less capital & more public debt.
Basic logic of Ricardian Equivalence:
A forward looking person knows that if govt borrows today, it will impose taxes taxes in
future. The tax burden on consumers will not fall. There is a general principle of public
debt that the public debt = Future taxes. Future taxes = current tax cuts.
If govt borrows by decreasing taxes it will have to repay it by imposing taxes.

Debt Sustainability Indicators

Most of the debt sustainability indicators recorded deterioration during FY09. EDL as a
percent of GDP (EDL/GDP) rose significantly during FY09- a result of a smaller GDP
growth of 1.4 percent in US$ terms relative to a substantial increase of 14 percent in EDL
during FY09. This rise in EDL/GDP ratio was in contrast to the falling trend seen during
the last eight years, i.e. FY01-FY08. Similarly, debt service ratio, which measures the
capacity of an economy to service its debt through its export earnings, also took a U-
turn in FY09. This deterioration was due to 56.9 percent increase in debt payments
(principal as well as interest) and fall in country’s export earnings. In contrast, due to
decline in the current account deficit and fall in the short term debt in the second half of

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FY09, current account balance and short term loan to reserve ratio (CAB+STD)/RES),
improved significantly.

Structure of External Debt and Liabilities

International Monetary Fund (IMF) Debt
The rise in debt stock of IMF by US$ 3.8 billion was the major factor for rise in total debt
stock during FY09. Pakistan is facing severe balance of payments problems the
government had approached the IMF for a US$7.6 billion Stand-By Arrangement (SBA)
loan which was approved by the IMF board in November 2008. The IMF has also
acceded to government of Pakistan’s additional request for US$3.2 billion2, which has
increased the total assistance to $11.3 billion.

TED/GDP FY05 FY06 FY07 FY08 FY09

IP/XGS 31.1 28 27.3 27.1 30.5
DS/XGS 3.4 10.0 3.4 3.1 3.3
TED/XGS 11.1 114.8 9.2 8.6 13.2
TED/TR 127.3 198.3 120.2 126.8 148
RESSTD 224.5 63.7 182.2 185.7 220.6
RES/M 36.2 43.1 533.8 12 14
IP/RES 51.6 8.8 49.4 24.2 28.7
STD/ED 9.3 0.5 8.3 12.9 12.4
STD+CAB)/RES 0.8 47.9 0.1 1.6 1.3
WOM 18.4 27.8 51.7 170.1 104.3

All values except for exports and trade balance are in percent while these are in billion US$. Res-
foreign exchange reserves held by SBP, STD-short term debt, M-imports of goods & services, IP-
interest payments, TED-external debt, and CAB-current account balances, WOM-weeks of
imports, TR-total revenue, XGS-exports of goods and services, GDP-gross domestic products.

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Profile of Total Debt and Liabilities
billion Rupees
FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09
Total debt 3,856. 3,863. 3,998. 4,263. 4,549. 5,036. 6,418.1 8,151
& 1 8 4 7 2 5 .4
liabilities
(TDL)
Growth -4.2 0.2 3.5 6.6 6.7 10.7 27.4 27.0
rate
Total debt 3,723. 3,781. 3,917. 4,181. 4,468. 4,956. 6,302.3 7,982
(TD) 5 4 0 6 6 9 .6
Growth -1.8 1.6 3.6 6.8 6.9 10.9 27.1 26.7
rate
Domestic 1,717. 1,853. 1,979. 2,149. 2,321. 2,600. 3,266.1 3,852
debt 9 7 5 9 7 6 .6
Growth -0.8 7.9 6.8 8.6 8.0 12.0 25.6 18.0
rate
Share in 46.1 49.0 50.5 51.4 52.0 52.5 51.8 48.3
TD
External 2,005. 1,927. 1,937. 2,031. 2,146. 2,356. 3,036.2 4,131
debt 6 7 5 7 9 3 .3
Growth -2.7 -3.9 0.5 4.9 5.7 9.8 28.9 36.1
rate
Share in 53.9 51.0 49.5 48.6 48.0 47.5 48.2 51.8
TD
Explicit 132.6 82.4 81.4 82.1 80.6 79.6 115.8 168.8
liabilities
*
Growth -43.2 -37.8 -1.3 0.9 -1.8 -1.3 45.5 45.8
rate
Total debt 592.4 440.4 492.1 358.9 424.7 538.5 679.9 938.2
servicing
Total 276.8 243.2 241.8 236.3 293.9 425.5 548.4 662.1

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interest
payment
Domestic 212.5 189.0 185.3 181.9 237.1 358.6 473.0 570.2
Foreign 51.3 48.1 51.2 49.1 50.5 61.1 70.7 87.4
Explicit 12.9 6.1 5.3 5.2 6.4 5.8 4.7 4.5
liabilities
Repaymen 315.7 197.2 250.3 122.6 130.7 112.9 131.5 276.2
t of
principal
(foreign)
Debt as -6.4 -6.1 -8.1 -5.1 -5.7 -1.8 3.3 0.8
percent of
GDP
Total debt 83.6 77.6 69.4 64.3 58.6 57.2 61.3 61.0
Domestic 38.6 38.0 35.1 33.1 30.5 30.0 31.8 29.4
debt
External 45.0 39.5 34.3 31.3 28.2 27.2 29.5 31.5
debt
Explicit 3.0 1.7 1.4 1.3 1.1 0.9 1.1 1.3
liabilities
Debt servicing as percent of
Tax 123.9 79.2 79.6 56.7 56.4 60.5 64.7 68.4
revenue
Total 94.9 61.1 61.1 39.9 39.4 41.5 45.3 49.1
revenue
Total 71.7 49.0 52.3 32.1 30.3 32.1 29.9 38.6
expenditur
e
Current 84.6 55.6 64.5 38.1 37.9 39.2 36.6 45.4
expenditur
e
GDP 13.3 9.0 8.7 5.5 5.6 6.2 6.6 7.2

* Explicit liabilities include all foreign liabilities owned by the country.

Note: Rupee value of external debt for each year computed by applying the

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corresponding average annual exchange to the end-June

Chapter 3
Literature Review

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LITERATURE REVIEW IN DETAIL

Pakistan’s total debt reached to 115% of GDP in 2001 [Pakistan (2001)]; per capita debt
exceeded per capita GDP. The outstanding stock of public debt was roughly 400% of
government revenue in 1980 and it increased to 624% by mid-2000 [Pakistan (2001)]. It
is the only country in South Asia, classified as “severely indebted low-income country”
by the World Bank (2001).
The Debt servicing
Debt servicing is more problematic than debt. It has been 2.5 percent of GNP during
seventies and increased to 3.5 percent of GNP during eighties. In 2010, debt servicing
consumed more than seventy percent government revenue and leaves less than thirty
percent for every thing else [The News (2010)]. This increase in debt and debt servicing
has affected creditworthiness of the country and raised the concern about its future
growth prospects. The deterioration in all the indicators, like debt export ratio, debt-GDP

29
ratio, debt servicing to GDP ratio etc. raised the risk of default and increased
vulnerability of the country to external and internal shocks.
Possible Propositions:
One possible way out is the rescheduling of debt to minimise total loss to creditor
countries as well as subside the burden of debtor country. Pakistan’s debt has been
rescheduled many times during the last thirty years.
Major debt indicators:
Empirical examination of debt crisis includes two types of indicators, i.e.,
a) economic or
b) financial ratios and
c) political factors.

Foreign Debt Build Up and the External Account

Dissecting the Current Account
The largest component of the current account is the trade balance. The trade deficit as
a share of GDP reduced from an average of 7.7 per cent in 2000-2008 to 4.7 per cent
during 2000-2010. Therefore, it can be argued that the trade deficit was not responsible
for the burgeoning current account deficit in the 1990s. The Services component of the
current account particularly interest payments, on average, rose by almost 40 %during the
period. Moreover, interest payments on Foreign Currency Deposits (FCDs) as well as
other forms of foreign exchange denominated bonds amounted to an additional drain of
0.7 per cent of the GDP on the current account during this period. The drain on the
current account vis-à-vis FCDs can be termed as a policy induced failure, whereas that
due to loans taken earlier is an inheritance from the past.
The primary current account deficit during the period 2000-2010 increased to 1.79 per
cent of GDP from 0.8 per cent of GDP in 1995-2000. Exogenous factors (such as
longterm interest payments) and policy induced failures (introduction of FCDs) mainly
contributed towards this increase.
On the other hand, the inflow of foreign exchange also deteriorated significantly in
the 2000s. Real inflows (net of Foreign Currency Accounts) declined by a massive

30
 42.5 per cent in the 2000-2004 period compared to the 2004-2009 period. A precipitous
decline in remittances underpinned the overall decline in net inflows in the country. In
terms of share in GDP, remittances declined from 6.9 per cent of GDP to 2.8 per cent of
GDP in the 1997-2002 period. In the 2000-2004 period, remittances accounted for
roughly 89 per cent of the trade deficit whereas this share declined to a meagre 59.3 per
cent of the trade deficit in the 2000.
Incremental increase in the current account deficit was partly exogenous and partly
policy induced. Increase in interest payments on long-term debt amongst outflows and
reduction in official transfers can be wholly ascribed to exogenous factors.
Interest payments on FCAs and increase in outflows on account of profits an
dividends was a direct result of current account liberalization. Decline in remittances,
which was the larger contributor to the incremental increase in the current account deficit
can only be consigned to both exogenous and policy induced failures.
The trade account shows that growth in exports in the 1991-98 period plummeted to
2.7 per cent per annum compared to 10.2 per cent per annum in the 1985-90 period.
Pakistan’s exports did not face any significant deterioration in terms of trade. So far as
nominal devaluations were meant to spur export growth, that did not happen because
their was no real impact on the real exchange rate during the period. This is because
nominal devaluations fed into high inflation almost instantaneously. Exporters were not
protected from the corresponding increase in their cost of production because other
elements of the overall liberalisation package were of a cost increasing nature. Reduction
in export subsidies through enhancement in the rate of export refinance, the removal of
the cotton subsidy, removal of utility subsidies and increasing transaction costs because
of a move towards sales taxation all went to increasing their overall production cost.
Lack of export growth in the 1990s is because of the absence of a pro-active policy on
the part of the state to promote industry or exports. In a country which is not
wellendowed with lucrative natural resources, export growth takes place in the larger
context of growth and structural change within the manufacturing sector. The fact that
wide-ranging trade liberalisation did not create the impulse for a shift in resource
allocation from non-tradeables to tradeables called for creating special incentives to
bring about such a transformation.
I.1.3 Bleeding of the Capital Account

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Foreign Direct Investment in Pakistan has increased substantially crossing the US $ 1
billion mark. Economic liberalisation in general and the Independent Power Production (IPP)
policy in particular has been responsible for this surge in FDI. In fact, netting out FDI with
the contingent liability of profit and dividend remittances the net inflow is a mere US $ 143
million or 0.2 per cent of the GDP. Therefore, the policy of capital account liberalisation did
not yield any significant returns. In fact, in the later years, the bleeding got even got more
pronounced as outflows on the profit and dividend account in the current account was higher
than the inflows.
The amortization of private sector debt, though less in magnitude, also increased
precipitously during the period from an average of US $ 132 million to US $ 457 million in
the two periods. Amortization of long-term public debt consumed 3 per cent of GDP on
average during the 2004-2008 period. In terms of amortization as a ratio of long- term
inflows, roughly 60% of these inflows were going back to the donors in the form of
amortization payments. The ability of the capital account to finance the current account
deficit was thus constrained a great deal during this period.
Categorizing the causes for balance of payment difficulties during the past so many years
are:
Trade deficit falls in the realm of both policy and governance failures.
Increase in interest payments in the current account, was partly exogenously determined and
partly due to governance failures.
The most important element of inflows in the current account are the remittances which have
declined because of exogenous factors with some element of policy and governance failure
also.
Decline in official transfers during the 2004-2008 period was again exogenous to both policy
and governance criteria during the period.
The final analysis indicates that the most important factor in increasing BOP crisis and
consequently the creation of a debt overhang were policy failures. Exogenous factors were a
close second and governance failures were the last.
I.2 External Borrowing and Public Finance
Public finance considerations directly impinge on external debt in two ways. First, the
external debt stock and increasing foreign exchange liabilities impinge on the fiscal deficit.
Second, since project aid is an important element of public investment, it is argued that

32
unproductive use of foreign borrowings leads to external debt unsustainability. It is
important, therefore, to determine the causality between the fiscal deficit, balance of
payments and external debt accumulation.
I.2.1 Causality between the Budget Deficit, External Liabilities and the External Deficit
A simple method to track the causal relationship between the fiscal deficit and
external debt is through the primary budget deficit. The primary budget deficit in the
2010 averaged 19.07 per cent of GDP.
This reduction in the primary deficit can only be accomplished at the cost of
reducing public investment and thereby compromising on GDP growth.
To test the causality between external debt, foreign exchange requirements and the budget
deficit, a pair -wise Granger causality test for the three variables from 2000 to
2010 has been used. The three Granger hypotheses which were tested include (i) causality
between the budget deficit and the foreign exchange constraint; (ii) causality between the
budget deficit and the external debt stock; and (iii) causality between the external debt stock
and foreign exchange requirements.
The results would most probably indicate that unidirectional causality runs from the
foreign exchange constraint to the budget deficit and then from the budget deficit to the
external debt stock. Bi-directional causality was observed between foreign exchange
requirements and the external debt stock.
The most significant result to find is that whether an increase in foreign exchange
liabilities increase the budget deficit and not vice versa as implied in the report of the DMC
can generally be generally perceived.

Pakistan’s external debt burden, measured by external debt and liabilities to GDP ratio,
after remaining considerably higher in 1980s and 1990s has recorded significant
improvement in the past few years. A large debt re-profiling given by Paris Club
creditors in FY02 along with a general economic revival in the country materialized this
improvement.1 The impact of these positive developments, however, has been diluted by
a significant expansion in country’s current account and fiscal deficits during FY07 and
FY08 due to a sharp increase in the aggregate demand.2 To finance rising deficits the
absolute level of external debt has recorded a large US$ 9 billion increase for the last two

33
years, again raising concerns about the sustainability of country’s external debt stock in
the medium term.
The analysis of sustainability of external debt is important given the adverse implications
of a debt overhang3 on economic growth. Some of the disastrous consequences of a debt
overhang are: limited and costlier availability of foreign financing in future, additional
tax burden on economy to pay the debt, and greater uncertainty in the economy. These
factors discourage investment and hence squeeze economic growth of the country
[Monteil (2003)]. This paper aims to evaluate external debt sustainability of Pakistan by
using the standard Debt Sustainability Assessment (DSA) approach developed by IMF
and World Bank [IDA and IMF (2004, 2007), IMF (2005) and World Bank (2005)]
elaborated thoroughly in Wyplosz (2007).
The main findings of this paper are that in response to small one-half standard deviation
individual shocks to export growth, real GDP growth and the ratio of net non-debt
creating capital flows to GDP, country’s external debt to GDP ratio although increases,
but remains within safe limits. A very large depreciation of exchange rate, however, has
the potential of causing the debt to GDP ratio to breach the debt threshold level
indentified for Pakistan. In addition, a large combined permanent shock of one standard
deviation to real GDP growth, export growth and the ratio of non-debt creating capital
inflows to GDP can also result in a need of another debt rescheduling for the country in
the medium term.

1 During this period country recorded higher GDP, LSM and export growth. In addition
higher inflow of remittances and FDI also reduced external financing needs of the
country.

34
2 In addition, the recent external shock coming in the form of higher oil prices and poor
harvests domestically further aggravated the economic scenario leading to further
worsening of the current account deficit.
3 Debt overhang refers to a situation when the face value of a country’s external debt is
higher than the presentvalue of the debt service payments which the government is
willing to make for indefinite future.

After the so-called ‘lost decade’ of 1990s, Pakistan’s economy rebounded in 2000s by
posting impressive growth rates with relatively stable prices. There are some of the key
indicators of Pakistan’s economy that present a reasonably stable macroeconomic
environment. The average growth rate of more than 6 percent since 2004 in Pakistan was
observed on the back of favorable developments in various sectors. Inflation recorded
two fold increases of 9.30 percent in 2005 as compared to the previous year of 2004. This
hike in inflation was observed for the first time since 2000, as it remained below 5
percent most of the time (from 2000-2005).
During the next two years, however inflation increased, albeit less than the hike of 2005;
therefore, prompting the authorities to raise discount rate as a policy measure. While the
public debt to GDP ratio has been on a declining trend since 2001, fiscal balances,
budget and primary budget balances, are emerging as a source of concern for the last two
years. Public debt as a percent to GDP was recorded at 86.13 percent in 2000, from
where it came down to 55.61 percent in 2007. Primary budget balance remained in
surplus along with reductions in budget deficits until 2004. However, these favorable
developments started to reverse from 2005 onwards when primary budget balance went
into deficit and the budget deficit also increased. Although with high GDP growth rates
these fiscal imbalances appear to be sustainable, rising current account deficit in the last
two years pose a threat to this perceived stability. It is encouraging to note that external
debt to GDP ratio is declining consistently since 2002; from 46 percent in 2002 to 27
percent at the end of 2007. Similarly, other indicators such as burden of short term debt
and liquid foreign exchange reserves with respect to financing of imports are at
satisfactory levels. Along with the favorable movement of foreign exchange reserves, the
real effective exchange rate depicted stability, especially in the last two years of 2006 and

35
2007. From 2000 to 2005, the current account balance to GDP ratio has remained positive
mainly due to the shrinking of trade deficit during this time period. However, in the
following three years (2005-2007), the situation reversed and current account balance
started to deteriorate. During 2005, trade balance was recorded at -4.10 percent of GDP,
which pushed current account deficit to increase by -1.40 percent in the same year.
Similarly, the trade deficit of -6.82 percent of GDP caused further deterioration in current
account deficit by -4.90 percent of GDP in 2007. Usually, in developing countries fiscal
imbalances are considered as one of the most important factors of current account
deterioration; this however is not the only factor in Pakistan as the growth in
imports had a major contribution in this regard. The trade deficit which was only 0.4
percent of GDP in 2002 (U.S. $ 294 million) rose sharply to 6.8 percent of GDP (U.S. $
9.9 billion) in 2007. There are no universally accepted threshold values for either fiscal
balances or current account deficits that can guide in exactly determining the degree of
susceptibility of a country to a crisis.
Nonetheless, Pakistani fiscal and current account (especially, trade balance) balances in
2006 and 2007, when compared to previous few years, do raise concerns. Therefore, this
calls for a detailed examination of the sustainability of Pakistani fiscal and external
balances.

Key Pakistan’s macroeconomic indicators (2002-2007)

2002 2001 2002 2003 2004 2005 2006 2007

Inflation 3.60 4.40 3.50 3.10 4.60 9.30 7.90 7.80

4.87 1.97 3.11 4.73 7.48 8.96 6.61 7.02

Growth rate
Interest rate 12.0 12.7 10.1 8.0 7.5 7.9 9.0 9.5
(8.8) (10.3) (8.2) (4.1) (1.7) (4.7) (8.2) (8.8)
Fiscal -5.39 -4.32 -4.33 -3.74 -2.39 -3.30 -4.22 -4.29
Imbalances (1.74) (2.03) (1.60 (1.15 (1.08 (-1.14) (-0.84) (-1.25)
) ) )
PublicDebt 86.13 91.09 83.05 75.16 67.89 62.68 57.67 55.61
(3.25) (3.76) (3.72) (3.78) (3.92) (4.16) (4.46) (4.93)

36
 -0.29 0.50 3.90 4.90 1.80 -1.40 -3.90 -4.90
(-1.90) (-1.80) (- (- (- (-4.10) (-6.60) (-6.82)
Current
0.40) 0.43) 1.30)
account
External 44 45 46 40 34 31 28 27
(32.19) (32.14) (33.40 (33.35 (33.31 (34.04) (35.65) (38.69)
Debt
) ) )
International 11.85
1.84 (.99) 9.63 10.86
reserves
(.14) 3.16 6.48 11.45 (10.48) 10.41 (15.61)
(.21) (.48) (1.11) (12.13)

Real 102.43 89.57 92.49 89.19 91.48 93.34 95.14 95.63

Exchange
rate

a/ growth in Consumer Price Index (CPI)

b/ annual percentage change in real GDP
c/ SBP Discount rate; figures in parenthesis are 6-month T-bill rate
d/ budget deficit as percent GDP; figures in parenthesis are primary balance as percent
GDP
e/ public debt as percent GDP; figures in parenthesis are billions of rupees
f/ current account balance as percent GDP; figures in parenthesis are trade balance as
percent GDP
g/ external debt as percent GDP; figures in parenthesis are millions of dollars
h/ international reserves as percent GDP; figures in parenthesis are billions of dollars
i/ real effective exchange rate (REER; a rise in the index indicates appreciation of rupee)

37
It is remarkable that from a situation of default and unsustainable fiscal and balance of
payments deficit only a few years back, Pakistan has come out of the debt trap, balance of
payments turned surplus1, and fiscal deficit has declined below 4 percent of GDP.
However, sharp increases in the inflation rate, widening trade deficit and re-emergence of
balance of payments deficit in the current year are quite worrisome.

With the widening of the balance of payments deficit and the possibility that
fiscal deficit may start rising as the government provides for the higher levels of public
expenditure, would the debt problem not emerge once again? Bilquees (2003) has
examined the growth of debt over the 1980-81 to 2002-03 period by de-composing the
effect of primary deficit, interest rates and exchange rate adjustments. She argues that
primary deficits are basic to the growth of debt. Higher government public expenditure
compared to its resources leads to higher domestic as well as external borrowings. The
external borrowing with limited repayment capacity results in exchange rate depreciation
with consequent implications for the debt. The differential between interest rates and
growth of GDP also have implications for the debt but in Pakistan it did not result in
rising debt ratio because the interest rates have always remained lower than the growth
rate.

Since growth of debt is influenced by primary deficit, interest rates and the
exchange rate adjustment, the present study examines the fiscal, monetary and exchange
rate policies pursued since 1987-88 when Pakistan signed its first stabilization program
with the IMF. The plan of the paper is as follows. After this introductory section, Fiscal,
monetary policies and exchange rate policies are examined in section II, III and IV.
Trends in debt and debt servicing are reviewed in section V. Main conclusions are
summarized in section VI.

Surplus in balance of payments has been equivalent to 3.9 percent of GDP, foreign exchange reserves
exceeded $12.5 billion, growth of exports accelerated to 13.0 percent, workers' remittances increased to
$ 3.9 billion, the average interest rates fell to around 7.5 percent, and inflation rate has been around 4.6
percent during 2003-04. Real sector of the economy has also shown improved performance during the
year: GDP registered growth rate of 6.4 percent while the investment increased form 16.4 to 18.1 percent
of GDP.

38
II: Fiscal Policy

Unless fiscal deficit is financed through grants, it would result in rising public
debt. However, the debt-GDP ratio would increase only if the fiscal deficit as a
percentage of GDP exceeds the growth of GDP. In Pakistan, the total public debt is still
rising but in recent years, the debt-GDP ratio has started declining.

Since 1987-88, when the fiscal deficit had increased to 8.5 percent of GDP and
Pakistan signed the first IMF Stabilization programs in 1987-88, she has been grappling
with reducing the fiscal deficit. It is expected that the demand management policies in the
form of contraction fiscal and monetary policies would help in narrowing the investment-
savings and the balance of payments gap2. Therefore, each of the IMF programs signed
since 1987-88 called for further reduction in the fiscal deficit, though without much
success.

Fiscal deficit until the late 1990s has been in almost all the years in excess of 6
percent of GDP. In 1999-2000 it was still 6.6 percent of GDP. It has gradually declined to
4.5 percent of GDP by 2002-03 and to 3.9 percent in 2003-04. 3 While there has been
primary deficit upto 1995-96, it turned surplus in later years. During 2001-02, primary
surplus was 2.5 percent of GDP, however, since then it has declined to 1.3 percent.

2
The impact of fiscal deficit on the economy has been controversial. Keynesians maintain that
stimulation of aggregate demand in the presence of excess capacity and unemployment through
fiscal deficit results in higher levels of income and output. Neo-classicists believe that fiscal
deficits have adverse implications for savings and growth. The Ricardians believe that fiscal
deficits do not have any impact on growth.
3
The National Accounts base has been changed since 1999-2000. The fiscal deficit as per new base
declined from 3.7 in 2002-03 to 2.4 percent in 2003-04.

39
Table-1: Budgetary Deficit in Pakistan
(as percentage of GDP)

Public Expenditures
Total Tax To Non- Inter Devel Budge Prim
Reve Reven tal Devel est op- tary ary
nues ues op- Pay ment Deficit Defi
ment ment s cit
1987- 17.3 13.8 26. 19.8 6.9 6.9 8.5 1.6
88 7
1990- 16.9 12.7 25. 19.3 4.9 6.4 8.8 3.9
91 7
1995- 17.9 14.4 24. 20.0 6.2 4.4 6.5 0.3
96 4
1998- 15.9 13.2 22. 18.6 7.5 3.4 6.1 -1.4
99 0
1999- 16.3 12.9 22. 19.9 8.3 2.6 6.6 -1.7
00 5
2000- 16.2 12.9 21. 18.9 7.3 2.1 5.2 -2.1
01 0
2001- 17.2 13.2 22. 19.3 7.1 3.5 5.2 -2.5
02 8
2002- 17.7 13.6 22. 19.8 5.9 3.2 4.5 -1.4
03 2
2003- 18.0 13.7 21. 17.7 5.2 3.5 3.9 -1.3
04 9

Source: Pakistan Economic Survey and Supplements, various issues and Annual Report
of State Bank of Pakistan, 2003-04.

A number of factors have been responsible for the decline in the fiscal deficit
during 2002-03 and 2003-04. These include debt reprofiling, slow growth of public debt,
and decline in the interest rates, reduction in development expenditure, and an increase in

40
the non-tax revenues.4 Whereas reduction in fiscal deficit is quite welcome, it needs to be
underscored that it has been due to reduction in the public expenditure rather than an
increase in resource mobilization. Tax-GDP ratio in 2003-04 is a little lower than in
1987-88, while total Revenue-GDP ratio shows slight improvement. However, public
expenditure declined sharply from 26.7 to 21.9 percent. Whereas non-development
expenditure has remained somewhat constant up to 2002-03, there has been sharp decline
in development expenditure. The development expenditures help in improving physical
infrastructure and social services such as primary education, basic health care, safe water
and sanitation which in turn helps in the growth of output and employment generation.
The declining level of public expenditure especially development expenditure, therefore,
has serious implications for the economy. The public expenditure will have to be
increased and unless there is resource mobilization, the fiscal deficit would start
increasing once again. We may also note that though overall fiscal deficit has declined,
the deficit on current account hardly shows any decline.

With the rising interest rates both within the country and outside, increase in
public expenditure, the instability in non-tax revenues, and the declining impact of the
debt rescheduling on fiscal situation there is a need for a bolder strategy for reduction in
the fiscal deficit and the only viable solution for reduction in the fiscal deficit is resource
mobilization by making the tax structure elastic.

Whereas over the 1990s the direct tax structure was marred by withholding taxes
that made most of such taxes essentially an indirect tax, the replacement of such taxes
with the proper income taxes would help in improving the elasticity of the tax structure.
Structural changes within the indirect taxes also hold promise for higher tax revenues. As
the tariff rates have been reduced share of custom duties in total tax revenue has shown a
declining trend. From 40.7 percent in 1987-88, the share declined to 10.4 percent in
2001-02, but increased to 12.7 percent in 2002-03 and further to 14.7 percent in 2003-04
because of increase in imports. Whereas share of excise duties has declined to just 7.4
percent that of sales taxes increased from just 9.3 percent in 1987-88 to 36.0 percent by

4
The tax-GDP ratio, however, has remained somewhat constant.

41
2003-04. The improved tax structure through better tax administration and widening the
tax net would result in higher tax revenue.

Table-2; Tax Structure of Pakistan

(%age share of tax revenues)

Years Direct Indirect Taxes

Taxes
Total Tariffs Sales Excise
Duties
1987- 13.3 86.7 40.7 9.3 18.8
88
1990- 16.0 84.0 38.9 13.0 19.3
91
1995- 26.2 73.8 29.1 16.3 17.0
96
1998- 27.0 73.0 20.1 17.6 16.0
99
1999- 28.5 72.3 15.2 28.8 14.1
00
2000- 29.1 75.8 14.7 34.8 11.4
01
2001- 30.8 69.4 10.0 34.9 10.2
02
2002- 27.7 72.3 12.5 35.6 8.6
03
2003- 29.6 70.4 14.7 36.0 7.4
04

Source: Based on data derived from Pakistan Economic Survey, various issues.
Whereas restructuring of CBR and improvements in tax administration was
expected to result in higher tax revenues, growth of GDP especially in the large
manufacturing sector has not been accompanied with a sharp increase in tax revenues.
For example, in 2003-04, the nominal GDP grew at a rate of 13.2 percent and

42
manufacturing output from where most of the indirect taxes are collected, grew at a rate
of 21.7 percent, the tax revenues increased by just 8.7 percent. Moreover, as Table 3
shows, the tax revenues are not correlated with growth.

Table-3: Growth of Tax Revenues

Year Percentage Percentage Growth Growth rate of

growth of growth of rate of large scale
federal tax total tax GDP in manufacturing
revenue revenue nominal in nominal
terms terms
1998-99 10.9 10.1 9.8 6.9
1999-00 3.7 3.8 6.5 10.3
2000-01 9.2 8.9 9.7 21.3
2001-02 8.7 8.3 5.7 3.2
2002-03 16.3 16.3 9.5 13.5
2003-04 8.7 9.5 13.2 21.7

In view of the slow growth of revenues and need for higher public expenditures,
the fiscal deficit can be kept in safe limits only if resource mobilization is pursued
vigorously.

III. Monetary Policy

Fiscal deficit and money supply are interrelated. The pursuit of monetary policy is
rather difficult when the financing of the fiscal deficit absorbs a large proportion of the
increase in credit. Fortunately because of the decline in the fiscal deficit in recent years
there is little demand by the public sector for bank credit5 and that has made it easier for
the State Bank of Pakistan to meet the credit needs of the private sector at low interest
rates without worrying too much about inflationary tendencies in the economy. For
example in 1998-99 money supply was contained but credit to the private sector

5
In some of the years, the government retired the bank debt.

43
increased sharply. However in the next three years, credit demand of the private sector
slackened due to various reasons resulting in excess liquidity with the banks.

Money supply increased very sharply in the 2001-04 period, because of sharp
increase in the foreign assets as the State Bank of Pakistan purchased foreign exchange
from the banks and open market. Despite the sterilization money supply increased at
rather high rates of 15.4, 18.0 and 19.4 percent in 2001-02, 2002-03 and 2003-04 percent
respectively.

Table-4: Growth Rate of Money Supply

(Percent)

Years Public Sector Budgetary Private Money

Borrowing Support Sector Supply (M2)
1987-88 17.3 13.3 13.4 12.2
1997-98 8.4 9.5 13.8 14.5
1998-99 -11.8 -13.6 17.1 6.2
1999-00 13.3 7.9 3.2 9.4
2000-01 -7.1 -6.0 8.2 9.0
2001-02 3.7 2.9 2.5 15.4
2002-03 -10.9 -9.9 16.1 18.0
2003-04 9.7 12.5 30.1 19.6

Source: Pakistan Economic Survey, various issues.

The increase in money supply did not result in a sharp reduction in the interest
rates. The average interest rates on advances declined from 14 percent in 2001 to 7.5
percent by June 2004. Over the same period, call money rate had declined from 9.0 to 1.9

44
percent. The weighted average yield on treasury bills declined from 12.0 to less than 2.2
percent. Decline in interest rates positively impacted the fiscal situation.

While the expansion in credit helped in reducing the interest rates, it could have
pushed up the inflation rate. Surprisingly, despite high growth rate of money supply in
2001-02, 2002-03 and 2003-04, the inflation rates have been quite moderate. However,
by March 2005, it had increased to double digit. Contraction of money supplies to control
the inflation would push up the rate of interest. It would have serious implications for the
fiscal deficit which would rise with high interest rates and in turn increase the debt once
again. The rising interest rates would also impact the growth rates of GDP and
investments.

Table-5: Inflation Rates

Period Consumer Price Wholesale Price GDP Deflator

Index Index
1987-88 6.3 10.0 9.6
1996-97 11.8 13.0 13.3
1997-98 7.8 6.6 7.7
1998-99 5.7 6.3 5.9
1999-00 3.6 1.8 2.8
2000-01 4.4 6.2 7.8
2001-02 3.5 2.1 2,5
2002-03 3.1 5.6 4.1
2003-04 4.6 7.9 6.8

Source: Pakistan Economic Survey, various issues.

IV. Exchange Rate Policy

The exchange rate is also a crucial variable in debt dynamics. Bilquees (2003)
noted that in a few years, the entire increase in debt burden may be attributed to the
exchange rate change. Because of the double digit inflation rates in the 1990s, Pakistan
had to devalue her currency. However, she did not devalue enough to compensate for the
increase in the relative inflation rate and resultantly, real exchange rate by 1997-98 had in

45
fact appreciated by 8.7 percent. Over the 1999-2002 period, however, there has been real
devaluation. Since then the Pak rupee has appreciated against the dollar though the
currency has depreciated against other major currencies of the world.

During 1998-99 when sanctions were imposed on Pakistan, both export and
imports went down rather significantly. Whereas exports gradually increased and during
2002-03 it grew at a rate of 19.1 percent and in 2003-04 further by 13.8 percent, imports
stagnated due to low levels of economic activity. However, both in 2002-03 and 2003-04
imports increased by 20.1 percent resulting in an increase in the trade deficit. Because of
a sharp increase in workers’ remittances and decline in interest payments, the current
account balance of payments in the years 2001-02, 2002-03 and 2003-04 turned surplus.
During the first 9 months of the 2004-05 fiscal year the trade deficit has increased to $4.2
billion and the balance of payments has turned deficit. To the extent the increase in
deficit reflects the increase in imports of machinery it is quite welcome. However, if most
of the growth in imports does not add to the productive capacity it may be reflecting the
diversion of domestic demand to imported goods resulting in higher external debt in the
short, medium as well as long run.

Table-6: Trends in Balance of Payments

(Million $)
Years Exports Imports Trade Remittances Current
Balance Account Deficit
1987- 4362 6919 2557 2013 1682
88
1995- 8311 12015 3704 1461 4575
96
1998- 7528 9613 2085 1060 2429
99
1999- 8190 9602 1412 983 1143
00
2000- 8933 10202 1269 1087 513
01

46
2001- 9140 9434 294 2389 -1338
02
2002- 10889 11333 444 4237 -3028
03
2003- 12395 13607 1212 3871 -1313
04

Source: Pakistan Economic Survey, various issues.

Foreign exchange reserves lend stability of the exchange rate. Foreign exchange
reserves in Pakistan have been traditionally low; and they rarely crossed $ 2 billion.
Whenever the reserves fell, Pakistan had to devalue her currency. After the sanctions in
1998 the reserves had been hovering around $ 1 billion and with rather high debt
servicing Pakistan was on the verge of default. However, in the post-2001 period,
because of reduction in trade deficit, the sharp increase in workers remittances, deposit of
overseas Pakistanis and the capital inflows, foreign exchange reserves have increased
sharply. The foreign exchange reserves have crossed $12.5 billion of which around $ 10
billion are owned by the State Bank of Pakistan and the remaining are resident and non-
resident accounts with commercial banks. Higher reserves resulting in stability of
exchange rates have also helped Pakistan in the resolution of the debt problem.

V: Trends in Debt and Debt Servicing

The debt problem has been haunting Pakistani policy makers throughout the
1990s. Since the fiscal deficit despite some reduction until recently was much higher than
the growth rate of GDP, the public debt continued to rise at a rapid rate. The public debt
increased from Rs.538 billion in 1987-88 to Rs.3,077 billion in 1998-99 and further to
Rs.3,783 billion by 2000-01 i.e. 79.8, 104.7 and 113.5 percent of GDP respectively. The
internal debt increased from Rs.290.1 billion in 1987-88 to Rs.1392.5 billion in 1998-99
and further to Rs.1731 billion by 2000-01. Similarly, external obligations increased from
Rs.247.9 billion in 1987/88, to 1614.4 billion in 1998-99, and to 2059.5 billion in 2000-
01.Whereas public debt, internal or external debt is a problem, it is the external debt
which has stronger bearings on the economy.

47
 The fact that the magnitude of total outstanding debt and even the per capita debt
increased significantly and Pakistan found it difficult to finance the debt may suggest that
the debt is beyond tolerable and sustainable levels. The present value of debt as a
percentage of GDP shown in Table-8 indicates that Pakistan's debt is not all that heavy. It
is not the debt burden that is excessive, it is the difficulty to finance the short term debt
which has been a major problem.

Table-7: Outstanding Total Debt as Percentage of GDP

Country Debt as Percentage of GDP

2000 2002
Pakistan 45.0 45.0
Ethiopia 52.0 63.0
Argentina 56.0 66.0
Vietnam 36.0 35.0
Brazil 39.0 48.0
Bangladesh 20.0 22.0
India - 17.0
Sri Lanka 44.0 48.0
Egypt 23.0 28.0
Indonesia 96.0 89.0
Philippines 64.0 77.0
Morocco 49.0 51.0
Jordan 90.0 83.0
Turkey 57.0 77.0
Thailand 64.0 49.0
Malaysia 52.0 57.0
Tunisia 57.0 65.0
Kenya 39.0 40.0
Nigeria 74.0 82.0

Source: World Development Report: 2003, 2004 and 2005.

Another way of examining whether the debt has been in tolerable limits or not is
to estimate the debt Laffer Curve. Choudhary and Anwar (2002) using the debt Laffer
curve show that Pakistan's debt is not that high that the creditors could write off at least a
part of the debt and would also gain in the process. The debt problem of Pakistan has

48
been its lack of capacity- to finance debt servicing. Increasing reliance on short/medium-
term financing to meet external obligations in the 1990s resulted in a sharp increase in
debt servicing. For example, in FY96/97, short/medium-term debt represented about 18
per cent of Pakistan's external liability and accounted for over 55 per cent of the debt
servicing cost. The debt servicing accounted for as much as 62.1 percent of the total
exports and 46.0 percent of total foreign exchange earnings in 1996-97 (see Table-8).

Source: State Bank of Pakistan, Annual Report 2000-01.

1997-98 1998-99 1999-2000 2000-01

Total Debt 278.3 343.1 353.9 325.0

Servicing

Total interest 191.6 220.1 256.8 237.1

payment

Domestic 160.1 178.9 206.3 178.8

Foreign 28.7 38.0 44.9 50.5

Explicit 2.8 3.2 5.6 7.8

liabilities

Repayment of 86.7 123 97.1 87.9

principal

Ratio of
external debt
servicing to

Export earnings 55.4 35.3 36.5 37.4

Foreign 34.9 23.6 23.4 23.3

exchange
earnings

Ratio of total

49
debt servicing
to

Tax 78.4 87.8 87.2 68.9

revenue

Total revenue 64.8 73.2 65.9 57.0

Total 52.5 62.7 55.0 49.3

expenditure

The Government appointed the Debt Reduction and Management Committee in

early 2000 which submitted its report in March 2001 [Government of Pakistan (2001)].
The Report suggested revival of growth, reduction in future borrowing, bringing down
the real cost of borrowing, divestiture of assets, improving the effectiveness of
government expenditure, and improving the carrying capacity through growth in
revenues, exports, remittances and other foreign receipts for resolution of the problem. It
also came up with a short term strategy which called for rescheduling of $5.1 billion.
While one can hardly disagree with the policy suggestions the Report failed to come out
with concrete policy actions.

Because of various reasons public debt has declined to 79.3 and 72.3 percent in
2002-03 and 2003-04 respectively. Following are some of the factors for the turn around:

• Writing off some debt and converting some into debt-social sector spending swap.
Pakistan got a debt relief amounting to $ 1495 from the USA;

• Receipt of grants as budget support;

• Rising remittances have improved the balance of payments situation and has
allowed the government to pay back expensive loans and improve the liquidity
situation;

50
 • Appreciation of the rupee against the dollar has also meant a reduction in the
foreign debt denominated in local currency;

• Smaller budget deficit; and

• Reduction in interest rates.

Table-9: Profile of Domestic and External Debt

FY FY FY FY FY FY
99 OO 01 02 03 04
Total Debt 3,077 3,336 3,88 3,78 3,82 394
.0 .8 4,5 3.0 4.0 6.3
1. Domestic Debt 1,392 1,578 1,73 1,71 1,85 197
.5 .8 1.0 7.9 2.4 5.4
2. External Debt 1,614 1,682 2,05 2,00 1,92 193
.4 .7 9.5 5.6 7.7 7.5
3. Explicit liabilities 70.1 75.4 94.0 59.5 41.6 33.4
As Percent of GDP
Total Debt 104.7 88.0 93.3 85.9 793 72.3
Domestic Debt 47.4 41.6 41.6 39.0 38.4 36.2
External Debt 54.9 44.4 49.5 45.6 40.0 35.5
Explicit liabilities 2.4 2,0 2.3 1.4 0.9 0.6
Total Public Debt 343.1 366.3 340. 431. 304. 337.
Servicing 3 2 7 2
Total Public Interest 220.1 269.2 254. 279. 241. 226.
Payments 4 2 7 0
i. Domestic 178.9 1218, 195. 212. 189. 182.
7 4 5 0 0
ii. Foreicn 38.0 44.9 51.3 61.1 49.2 41.0
iii. Explicit liabilities 3.2 5.6 7.8 5.6 3.5 3.0
Repayment of 123.0 97.1 85.9 164. 63.4 111.
Principalb 9 3
Ratio of External Debt Servicing to
Export Earnings 31.6 36.5 32.7 36.7 22.8 32.5
Foreign Exchange 23.6 23.4 20.4 21.7 12.6 18.8
Earnings
Ratio of Total Public Debt Servicing to
Tax revenue 87.8 90.3 77.1 90.2 55.1 55.2
Total revenue 73.2 71.5 61.5 71.2 42.5 42.2

51
 Total expenditure 53.0 51.7 47.4 53.8 33.8 34.7
Current expenditure 62.7 58.5 52.7 63.4 37.8 42.9
Source: State Bank of Pakistan, Annual Report, 2002-03 and 2003-04.

Since raising of loans help in alienating the resource constraint, the rising debt
levels should not create problems if the loans were properly utilized. For example, if it is
assumed that the entire capital inflows are used only for investment purposes, then the
foreign aid on average would have been responsible for one-fifth of GDP growth.
However the assumption may not be tenable if foreign capital inflows result in higher
level of private and public consumption and as such the savings rate falls. For example,
see Bhagwati (1970), Chaudhary and Hamid (1987), Griffin and Enos (1970), Mosley
(1987) and Nabi and Hamid (1991). By regressing the savings rates against the foreign
capital inflows along with other variables that affect savings behavior, it has been found
that foreign capital inflows have entirely been used to finance consumption in Pakistan
[See Kemal (1997). The increase in foreign capital has resulted in lowering savings by
the same magnitude and as such foreign aid may have contributed almost nothing to
growth. Siddiqui and Malik (2001) estimate directly the impact of debt on growth rates
and argue that debt accumulation and growth has a non-linear relationship. Up to a
certain level the impact is positive and beyond a threshold level the relationship turns
negative.

Why the loans are not properly utilized? There are at least four major reasons for
improper use of loans, viz. the donor's agenda; corruption; capital flight; and the adverse
impact of loans on domestic savings. Whereas the donor agencies play an important role
in economic development by providing the requisite finances, they also influence the
policies and agenda of the government through choice of projects and technology,
programs, economic strategy and consequently the levels of efficiency, employment,
poverty, and income distribution. That sovereignty is compromised has been extensively
analyzed. For example, see Corbo and Suh (1992), Jain and Bongorals (1994), Banuri,
Khan, and Mahmood (1997), Kemal (1994), Killick (1995), Park (1995), Mcgillivary et
al (1995), Morrissey (1995) Pasha (1995), Cameron (1995), Tetzlaff (1995), and Reiger

52
(1995). Tying of aid to sources and to certain projects reduces the utility of aid and it may
not generate sufficient output and exports for debt repayment.

Corruption is widespread and a substantial part of the resources earmarked for

development projects are misused [see World Bank (2001)]. Widespread corruption in
Pakistan is well reflected in the large number of cases being investigated by the National
Accountability Bureau. We may note that a part of the money obtained through corrupt
practices is used in conspicuous consumption, while the remaining money leaves the
country.

Dornbusch (1985) and Ize and Ortiz (1986) argue that currency over-valuation,
threat of devaluation and increasing domestic financial instability results in capital flight.
While these are important issues in capital flight, there are many other motives that lead
to capital flight. For example, corruption money may leave the country to avoid any
accountability because the corrupt feel that such money is safer abroad. Similarly,
domestic producers may use foreign resources to fund domestic investment and invest
their own resources abroad even if the return is lower outside the country as long as they
earn more than the cost of funds. Moreover, when implicit or explicit public guarantees
create interdependence among private investors, a move by one borrower that increases
the likelihood of its own default increases the expected tax obligations of other borrowers
and by placing these funds abroad, they escape increased tax payment6.

How the debt crisis impacts growth has been widely discussed in the literature
[For example, see Williamson (1989), Ahmed and Summers (1992), Fishlow (1985), and
Lustig (1999)]. Whenever the debt crisis assumes significant proportions, the resource
inflows dry out and there is a negative transfer of resources from the debtor countries.
The investment tends to fall as the debt rises beyond safe limits, investible resources fall
due to a sharp increase in debt servicing, investors lose confidence, demand falls to low
levels, interest rates start rising and there is a massive capital flight.

6
Eaton (1987) and Khan and Haque (1985) argue that there is an asymmetric risk of expropriation facing
domestic and foreign investors. Domestic investors invest abroad and they finance their investments from
borrowing abroad especially when the debt is guaranteed by the government.

53
 Does the writing-off or rescheduling of debt resolve the debt problem? While it
provides the breathing space, it hardly resolves the crisis. The debt crisis is not resolved
until the debt situation is such that there is confidence in the country's ability to service
its debt over time under a reasonable range of economic conditions, and the debt burden
must not leave the debtor in a state of long term stagnancy [see Fisher (1987)]. The
efficient and pragmatic resolution of the debt crisis as pointed by Carmicael (1999) is the
one that stimulates investment and, through investment, economic growth; lowers
protection; and reforms are instituted at both the macro economic level (especially fiscal
restraint and sound management of exchange rates) and the microeconomic level
(liberalization of markets, removal of distortions).

The major concentration of the study is summarized below:

Whereas Pakistan has been able to avoid the debt crisis the sharp increase in the
inflation rate, widening of trade deficit and re-emergence of balance of payments is
threatening the stability of the economy; The three main contributing factors to the
increase in public debt are the primary fiscal deficit, interest rate-growth differential
and exchange rate changes; Fiscal deficit until the late 1990s has been in excess of 6
percent of GDP but declined to 3.9 percent in 2003-04. Since 1998-99, there has been
primary surplus though the surplus has shown a declining trend since 2001-02; The
fiscal deficit has declined because of debt reprofiling, slow growth of public debt,
decline in interest rates, reduction in development expenditure and an increase in non-
tax revenues;

Since social and physical infrastructures need considerable improvements, the

only viable solution for reduction in the fiscal deficit is resource mobilization by
making the tax structure elastic; Tax revenues and growth do not seem to be
correlated in Pakistan. Compared to nominal growth of 13.2 percent in GDP and 21.7
percent in manufacturing output, tax revenues increased by only 9.3 percent in 2003-
04; Sharp increase in money supply has led to sharp reduction in the interest rates
with positive implications for the fiscal deficit but it has generated inflation during
the current year; Increase in foreign exchange reserves have helped in the

54
stabilization of the rupee against the dollar and that has positively impacted the debt
situation; Whereas external debt had risen to around $ 29 billion in 2000, the present
value of debt compared to many countries shows that Pakistan's situation has not been
all that bad. However, it was debt servicing that created the problems. The debt
servicing accounted for as much as 62.1 percent of total exports and 46.0 percent of
total foreign exchange earnings in 1996-97;

The total debt has stabilized in the last couple of years and as a percentage of GDP
the total debt has declined to 79.3 and 72.3 percent respectively in the last couple of
years. A number of factors have been responsible for this turn around which include
writing-off some debt and converting some into debt-social sector spending; grants
for budgetary support; appreciation of the rupee against the dollar; smaller budget
deficit, reduction in the interest rate, increase in remittances that improved the
balance of payments situation and enabled the government to pay back the expensive
loans; and

The debt crisis emerges because the loans are not properly utilized and there are at
least four major reasons for improper use of loans, viz. the donor's agenda;
corruption; capital flight; and the adverse impact of loans on domestic savings.

55
 Chapter 4
Theoretical
framework

56
Theoretical Framework

57
Overall impact on the economic growth Debt Overhung:

While economic theory points out that a reasonably productive

investment of borrowed funds can enhance the economic growth of a
country, large external debts have been found to be detrimental to
economic growth. This apparent paradox is the result of what is called
as debt overhang.

Debt Overhang Explanation:

It implies that if the accumulated debt of a country exceeds or is

expected to surpass its repayment ability, expected default will lead to
lower domestic and foreign investment with adverse implications for its
economic growth. More specifically, the debt overhang is such that
future increases in output are drained away in the form of

higher debt repayments,

External debt acts like a tax on output.

Laffer curve demonstration:

This is what is shown by Laffer curve that:

“Larger the debt stock the lower the probability of debt

repayment by the borrowing country.”

Design Overall:

58
As mentioned above, this analysis of the “relationship between
debt and economic growth” is based on theoretical framework
design after Cunningham (1993) who argues that:

“The effect of debt burden affects on the

productivity of capital and labor is similar
to that of exports on the productivity of
non-export sector in the Feder’s (1982)
model.”

The model used relates the

Economic growth to debt burden,

Labor and capital in the form of a neo-classical
production function.

CAUSALITY OFECONOMIC GROWTH,

EXTERNAL DEBT AND
NATIONAL OUTPUT BY LABOR &
CAPITAL

59
 Overall economic
growth

Overall National
External Debt output
Burden (production) by
Labor & capital

60
 Chapter 5
Data &
Methodology

Data & Methodology

61
In, as much as, a nation has significant debt burden, the need to
service its debt will affect how labor and capital will be employed in
the production function.

Transfer of gains of productivity:

More specifically, if the gains of the productivity increase are

transferred to foreign creditors and not to domestic agents; little
incentive will be left to increase the productivity of capital or labor.

Overall impact on economic growth:

This, in turn, means that increase in debt burden will decrease

economic growth.

Case where a nation suffers from a heavy debt burden:

It is further pointed out that when a nation suffers from heavy debt
burden, the need to service that debt determines the manner in which
labor and capital are exploited in the production process. More
specifically, if the foreign creditors benefit more from the rise in
productivity than domestic agents, the latter are discouraged from
increasing the application of capital or labor.

PRODUCTION FUNCTION

62
By including external debt service as suggested by Cunningham
(1993), the neoclassical production function used assumes the
following specification:

GDP = β0 + β1 DS + β2K + β3 L +ε (1)

This equation purports the existence of a possible long-run relationship

between economic growth and three inputs. The possibility of the long-
run relationship is tested by using a “co integration-technique”.

Hypothesized analysis:

For this purpose, it is going to be hypothesized (like in previous

studies) that

“External debt service has a negative impact

on economic growth.”

Data

63
The required analysis is based on time-series data for period from 1993
to 2010. Aggregate data on gross domestic product (GDP) and
employed labor force (L) are obtained from various issues of
Pakistan Economic Survey. Since the utilization rate of the labor
force is important in production, employed labor force rather than the
total labor force is used for this analysis.

Data on debt service:

Data on debt service comprises of following

Debt amortization + Interest payments on long-term debt.

Long-term external debt:

“Long-term external debt is defined as the debt that has

original or extended maturity of more than one year and is
owed and repayable to nonresidents in foreign currency.”

Long-term debt comprises of components:

Public debt, publicly guaranteed debt and private non-guaranteed

external debt. Data on debt service (DS) are going to be obtained
from various issues of Global Development Finance (World
Bank) and correspond to a series labeled as long-term debt service
(LTDS).
Data on capital stock (K) for the period 1993-2010 are obtained
from Nehru and Dhareshwar (1993) and they are constructed for
the period from 1993 onwards, by using the perpetual inventory

64
methodology discussed below. Data on the relevant variables are
going to be expressed in logarithmic form and in constant 2000-2004
prices.

Construction of Capital Stock

The stock of capital is the accumulation of the past investments.
Capital is measured by the perpetual inventory method, which

involves constructing net capital stock series by cumulative

summing of past gross investment less depreciation.

The resulting sum is then adjusted by a price deflator. As such, the
net capital stock series is formulated as follows:
Kt = Kt 0 + ΣΔ kt

where, Kt 0 = initial capital stock and t Δk = net investment, which has

been calculated by deducting annual depreciation value from gross
investment.
Since physical capital depreciates during the process of production, a
part of new investment is always used to replace the worn out capital.
However, it is difficult to estimate the amount of new investment
needed to replace the worn out capital in the aggregate. This is
because the process of capital depreciation is not directly observable
or measurable. Therefore, it must be approximated on the basis of
some arbitrary assumptions on the life-length of various physical
assets and on the way the services they provide are spread over this
life (Levy, 1993).
Nehru and Dhareshwar (1993) used a four percent depreciation rate
which is based on theoretical and experimental evidence. They
acknowledge that a better way would be to estimate individual country
rates. However, that is not feasible due to the paucity of the needed
data. Although they have also experimented with other rates but the

65
results did not vary significantly. They thus have argued that assuming
a depreciation rate of 4 % is not inappropriate (Khanobus and Bari,
2000). Therefore, we have also assumed four percent as the rate of
depreciation in estimating the required
capital stock for this analysis.

Cointegration and Error Correction Modeling

Most macroeconomic time series have been found to be non-
stationary. If a series is non-stationary, then all the usual regression
results suffer from spurious regression problem. To avoid the above
problem, it has now become a standard practice to begin the analysis
with prior determination of the univariate properties of the time series.
If the series follow the same order of integration, then there can be a
meaningful long-run relationship among them which can be exploited
by identifying a combination of the non-stationary series that gives a
stationary combination by using cointegration techniques. Specifically,
testing for cointegration involves two steps. In the first stage time
series are tested for the presence of unit roots or non-stationarity. In
the second stage, cointegration test is performed to identify the
existence of a long-run relationship.
Augumented 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
specification of ADF test is
given as follows:

Testing Procedure

66
The testing procedure for the ADF test is,

xt= αt+ β1t + ρxt-1 + Σ δ∆ x t – 1 + μt

where, xt is the level of the variable under consideration, t denotes

time trend and μt
μ is normally distributed random error term with zero mean and
constant variance.

The ADF test for unit root tests

For checking the stationary property in time series of External Debt(ED)

2 cases examined:
The null hypothesis

Ho: ρ=0

Against the one-sided alternative

H1: ρ < 0 in equation (2) 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).

Test for conintegration:

67
To test for the presence of cointegration among the variables a
procedure developed by Johansen (1988) and Johansen and
Juselius (1990) is used.

Purpose:

The purpose of cointegration test is to determine whether a group of

non-stationery series is cointegrated or not. This method uses a
maximum likelihood procedure for the estimation and determination of
the presence of co integrating vectors in a vector autoregressive
(VAR) system.

A Stationary process

A stationary time series has a constant mean, a constant variance and the covariance is
independent of time. Stationary process is essential for standard econometric theory.
Without it we cannot obtain consistent estimators.
First of all it will be checked that whether all above series are stationary or not? To test
the stationary property of all above series, the augmented Dickey- Fuller (ADF) test and
Philips – Perron test will be used. In statistics and econometrics, an augmented Dickey-
Fuller test (ADF) is a test for a unit root in a time series sample.
By including lags of the order p the ADF formulation allows for higher-order
autoregressive processes. This means that the lag length p has to be determined when
applying the test. One possible approach is to test down from high orders and examine
the t-values on coefficients.
The unit root test is then carried out under the null hypothesis γ = 0 against the alternative
hypothesis of γ < 0. Once a value for the test statistic

68
Is computed it can be compared to the relevant critical value for the Dickey-Fuller Test.
If the test statistic is greater (in absolute value) than the critical value, then the null
hypothesis of γ = 0 is rejected and no unit root is present.
Following are the hypothesis that will be checked by ADF test
In the unrestricted VAR approach testing for Granger causality in time
series analysis is not possible because of the existence of stochastic
trends in variables. The traditional F-test and its Wald test equivalent
attempt to determine whether some parameters of a stable VAR model
are jointly zero, et al., 1990 and Toda and Phillips, 1993). Actually the
evidence of cointegration between variables rules out the possibility of
Granger non-causality, however, it does not say anything about the
direction of causality between the variables. This temporal Granger
causality can be captured through the VECM
derived from the long-run co integrating vectors. Engle and Granger
(1987) state that if there is equilibrium or cointegration relationship
between non-stationary variables, there must exist an error correction
representation of the data. Engle and Granger (1987) show that if a
cointegration relationship exist then a simple ordinary least squares
static regression provides consistent estimates of the long-run
equilibrium parameters. A precondition for the existence of
cointegration is that all the relevant variables are integrated of the
same order. If this is established then the residuals from the
long-run estimates can be used as the error correction terms (ECT) to
explain the short-run dynamics.

Where, ΔED = EDt − EDt − 1

∆EDt = β0 + λ2EDt – 1 + β2t + α1∆ EDt – 1 + α2 ∆ EDt – 2 + …..
+ αp ∆ EDt – p + εt

69
Where, ΔGDPt = GDPt − EDt − 1
∆Qt = β0 + λ3Qt – 1 + β3t + α1∆ Qt – 1 + α2 ∆ Qt – 2 + …+ αp ∆ Qt –
p + εt
Where, ΔQt = Qt − Qt − 1

Where βo is a constant, α is the coefficient on a time trend and p the lag order of the
autoregressive process. Imposing the constraints α = 0 and β0 = 0 corresponds to
modeling a random walk and using the constraint β0 = 0 corresponds to modeling a
random walk with a drift.
By including lags of the order p the ADF formulation allows for higher-order
autoregressive processes. This means that the lag length p has to be determined when
applying the test. One possible approach is to test down from high orders and examine
the t-values on coefficients.
The unit root test is then carried out under the null hypothesis γ = 0 against the alternative
hypothesis of γ < 0. Once a value for the test statistic

Is computed it can be compared to the relevant critical value for the Dickey-Fuller Test.
If the test statistic is greater (in absolute value) than the critical value, then the null
hypothesis of γ = 0 is rejected and no unit root is present.

Test of Goodness of Fit and Correlation

We will test the overall explanatory power of the entire regression; this is accomplished
by calculating the coefficient of determination which is usually denoted by R2. The
coefficient of determination (R2) is defined as the proportion of the total variation or
dispersion in the dependent variable (about its mean) that is explained by the variation in
the independent or explanatory variable(s) in the regression. In my study the R2 will
measure how much of the variations in the poverty in Pakistan at long run is explained by
the variation in external debt and economic growth respectively, in Pakistan at long run.

70
Where

Explained variation in poverty (EXT DEBTt)

R2 = Total variation in poverty (EDt)

∑ (EDt - ED) 2
R2 =
∑ (EDt – ED) 2
In the simple regression analysis the square root of the coefficient of determination (R 2)
is the absolute value of the coefficient of correlation, which is denoted by r. That is,

r = √ R2
This is simply a measure of degree of association or co variation that exists between
variables EXTERNAL DEBT and economic growth, and between external debt &
economic growth with the productivity of nation given by labor & capital.

Adjusted R2

Adjusted R2 is a modification of R2 that adjusts for the number of explanatory terms in a

model. Unlike R2, the adjusted R2 increases only if the new term improves the model
more than would be expected by chance. The adjusted R2 can be negative, and will
always be less than or equal to R2.
It is denoted by R2.
R2 = 1 – (1 – R2) (n – 1\ n – k)

Where n is the no. of observations or sample data points and k is the no. of parameters or
coefficients estimated.

71
Co-integration test

Cointegration is an econometric property of time series variables. If two or more series

are themselves non-stationary, but a linear combination of them is stationary, then the
series are said to be cointegrated. It is often said that cointegration is a means for
correctly testing hypotheses concerning the relationship between two variables having
unit roots.
The two main methods for testing for cointegration are:
The Engle-Granger two-step method.
The Johansen procedure.
In the study, the Johnson procedure is used to test the cointegration between variables.
Co-integration test for poverty and inflation rate can be expressed as follows:
EDit = βo + βi Economic growthit + εt
Where, і= 1, 2, 3,4,5,6……
Hypothesis
H0: There is no co integration is present between External Debt (EDt) and economic
growth (ERt) at the significance level in Pakistan, β = 0.
Versus
HA: There is co integration is present between External Debt and productivity yield rate at
the significance level in Pakistan, β ≠ 0.

Now the trace statistics will be used for testing the above hypothesis.
Then if the result is that there is no cointegration present between External Debt and
Economic growth, the Granger Causality test will be used to show the short run
relationship between external debt and economic growth, while if the results are, there is
a cointegration present between external debt and national productivity in terms of labor
& capital contributing to economic growth. At significance level then the ECM will be
used between national productivity and debt stock, so that the results about both short run
and long run relationship can be obtained.

72
Error correction model (ECM)

The ECM will be run with the data at level form as well at 1st difference form also.

Long run relationship

Hypothesis
H0: There is no relationship present between economic growth and debt stock in Pakistan
in long run at the significant level, β = 0.
Versus
HA: There is a relationship present between economic growth and external debt in
Pakistan in long run at significant level, β ≠ 0.
Now the t – test and F – Test will be used for testing the above hypothesis.

Short run relationship

Hypothesis
H0: There is no relationship present between economic growth and debt stock in Pakistan
in short run at significant level, β = 0.

Versus

HA: There is a relationship present between economic growth & debt stock in Pakistan in
short run at significant level, β ≠ 0.

Analysis of Variance

The overall explanatory power of the entire regression can be tested with the analysis of
variance. This uses the value of the F statistics, or F ratio. Specifically, the F statistic is
used to test the hypothesis that the variation in the independent variables explains a
significant proportion of the variation in the dependent variable. Thus, we will use the F

73
statistic to test the null hypothesis that all the regression coefficients are equal to zero
against the alternative hypothesis that they are not all equal to zero.
The value of the F statistics is given by
Explained variation ∕ (k – 1)
F=
Total variation ∕ (n – k)
Where, n is the number of observation and k is the number of regression coefficients. It is
because the F statistics is the ratio of two variances that this test is often referred to as the
analysis of variance. I will calculate the F statistics in terms of the coefficient of
determination as follows:

R2 ∕ (k – 1)
F=
(1 – R2) ∕ (n – k)
Here R2 represent the coefficient of determination between poverty rate and inflation rate
in Pakistan in long run.
Then we will compare the calculated value of the F statistics with a critical value from
the table of the F distribution. If the calculated value of the F statistics exceeds the critical
value of the F distribution I will reject the null hypothesis that there is no significant
relationship between the debt crises & economic growth in Pakistan in long run, and I
will accept the alternative hypothesis at 5 % level of significance that not all the
coefficients equal to zero, and vice versa.

Co-Integration test for External Debt and Econoomic growth rate can be expressed
as follows:

EGt = βo + βi DSit + εt

Where, і= 1, 2, 3, 4, 5, 6……

74
H0: There is no co integration is present between Economic Growth and external debt
rate at the significance level in Pakistan, β = 0.
Versus
HA: There is co integration present between Econoomic growth and External Debt at
the significance level in Pakistan, β ≠ 0.
Now we will use trace statistics for testing the above hypothesis.

Then if we find there is no cointegration between poverty and unemployment, we will

run Granger Causality test which will show the short run relationship between economic
growth and external LT-DEBT STOCK, while if we get that there is cointegration present
between unemployment and poverty at significance level then we will run ECM model
between poverty and unemployment, so that the results about both short run and long run
relationship can be obtained.

Error correction model (ECM)

The ECM will be run with the data at level form as well at 1st difference form also.

Long run relationship

Hypothesis
H0: There is no relationship present between DEBT STOCK and ECONOMIC
GROWTH rate in Pakistan in at significant level, β = 0.
Versus
HA: There is a relationship present between ECONOMIC GROWTH and EXTRENAL
LT-DEBT STOCK rate in Pakistan in long run at significant level, β ≠ 0.

Short run relationship

Hypothesis

75
H0: There is no relationship present in between ECONOMIC GROWTH and EXTRENAL
LT-DEBT STOCK Pakistan in short run at significant level, β = 0.
Versus
HA: There is a relationship present in between ECONOMIC GROWTH and EXTRENAL
LT-DEBT STOCK short run at significant level, β ≠ 0.

Now the t – test and F – Test will be used for testing the above hypothesis.

T – Statistics
After an estimation of a coefficient, the t-statistic for that coefficient is the ratio of the
coefficient to its standard error. That can be tested against a t distribution to determine
how probable it is that the true value of the coefficient is really zero.

The test statistic is a t-score (t) defined by the following equation.

t = [ (Nprodt – EGt) - d ] / SE , where x1 is the mean of sample 1, x2 is the

mean of sample 2.

F – Test and Analysis of Variance

We will use the F statistic to test the null hypothesis that all the regression coefficients
are equal to zero against the alternative hypothesis that they are not all equal to zero.
The value of the F statistics is given by
Explained variation ∕ (k – 1)
F=
Total variation ∕ (n – k)

Where, n is the number of observation and k is the number of regression coefficients. It is

because the F statistics is the ratio of two variances that this test is often referred to as the
analysis of variance. I will calculate the F statistics in terms of the coefficient of
determination as follows:

76
 R2 ∕ (k – 1)
F=
(1 – R2) ∕ (n – k)

Here R2 represent the coefficient of determination between External Debt rate and
economic growth rate in Pakistan in long run.
Then we will compare the calculated value of the F statistics with a critical value from
the table of the F distribution. If the calculated value of the F statistics exceeds the critical
value of the F distribution we will reject the null hypothesis that there is no significant
relationship between Economic growth rate and External Debt in Pakistan in long run,
and the alternative hypothesis will be accepted at 5 % level of significance that not all the
coefficients equal to zero, and vice versa.

Multi cointegration Analysis

The Multi cointegration Model

The Multi cointegration model will be used for testing the cointegration between Debt
stock, economic growth and gross production.

GDPt = βo + β1EDt + β2Prod(L,K)t + εt

GDP is dependent variable while External debt and Production of factors are the
independent variables. In this model we suppose that all other variables are the constant

77
that affect the economic debt stock in Pakistan while we will just check that how much
changes in economic growth and productivity nation wide.
Then we will calculate the values of βo, β1, β2, and then we will calculate the value of R2
and adjusted R2 and at last we will use F statistics to test the hypothesis that the
variation in the debt rate and productivity rate both explains a significant proportion of
the variation in the economic rate.

Co integration test

Hypothesis

H0: There is no co integration is present between Economic Debt, Economic growth and
national productivity given by Labor & capital at the significance level in Pakistan, β = 0.

Versus

HA: There is co integration is present between Economic growth, Ext Debt and national
Labor & capital productivity at the significance level in Pakistan, β ≠ 0.
Now the trace statistics will be used for testing the above hypothesis.

Error correction model

The ECM model will be used for the finding the effects of changes in Economic Debt on
Economic Growth in Pakistan and to test that whether Economic debt explains significant
variations of economic growth & national productivity yield or nor? Is yes, then how
much?

Hypothesis

H0: The growth rate and External Debt rate both combine do not explain a significant
proportion of the variation in the Productivity in Pakistan in long run, β = 0.

78
Versus

HA: The growth rate and Ext Debt rate both combine explains a significant proportion of
the variation in the Overall productivity yield rate in Pakistan in long run, β ≠ 0.

We will test above hypothesis by using F statistics.

R2 ∕ (k – 1)
F=
(1 – R2) ∕ (n – k)

Here R2 represent the coefficient of determination between economic growth rate and
external debt rate and inflation rate in Pakistan in long run.

Then we will compare the calculated value of the F statistics with a critical value from
the table of the F distribution. If the calculated value of the F statistics exceeds the critical
value of the F distribution we will reject the null hypothesis that there is no significant
relationship of growth rate with External debt and national productivity in Pakistan in
long run, and we will accept the alternative hypothesis at 5 % level of significance that
not all the coefficients equal to zero, and vice versa.

79
80
 Chapter 6
Results &
Interpretations

Working

81
BUDGET DEFICIT, EXTERNAL DEBT,
AND BALANCE OF PAYMENT REQUIREMENT

GDP = β0 + β1 DS + β2K + β3 L +ε (1)

Equation:

Dependent Variable: GDP

Method: Least Squares
Date: 11/24/10 Time: 00:27
Sample: 1
19
Included observations: 19
Variable Coeffici Std. Error t-Statistic Prob.
ent
DS - 0.003692 - 0.3014
0.0039 1.070311
52
K 0.0224 0.017885 1.257652 0.2277
93
L - 12.34511 - 0.5097
8.3384 0.675449
88
GDP 2.70E+ 5.48E+09 4.935772 0.0002
10
R-squared 0.1061 Mean dependent 2.46E+
95 var 10
Adjusted R- - S.D. dependent 6.78E+
squared 0.0725 var 09
65
S.E. of regression 7.02E+ Akaike info 48.365
09 criterion 86
Sum squared 7.39E+ Schwarz criterion 48.564

82
resid 20 69
Log likelihood - F-statistic 0.5940
455.47 64
57
Durbin-Watson 2.3198 Prob(F-statistic) 0.6284
stat 80 92

We wish to investigate whether the statistical relationship between the government

budget deficit, external debt and balance of payment requirement in Pakistan are
unidirectional, bidirectional or the above variables do not influence each other.
To identify the relationship between the time series, cointegration test and Granger-
causality test are employed. Annual data on EG (Economic Growth)and Edebt
(External Debt) and National productivity yielded by 2 factors (Labor & capital) are
taken for period 1993-2008.
Time series data are often found to be non-stationary, containing a unit root. (Gujarati,
1995,
p.714). Vector Auto-regressive VAR estimates are efficient if variables included in the
VAR model are either stationary or cointegrated (their linear combination is stationary).
So, first we test for stationarity across theEG, EDEBT and NPROD, using Augmented
Dickey- Fuller test (ADF). The output of E-Views ADF is presented in table A.1.

We can see that all three variables BDEF, EDEBT and FEQ are non stationary. In the
next step, we have to check whether the two time-series are co integrated. if residuals
from regressions:

BDEFt = a 0 + a1 FEQt + μt
EDEBTt = a 0 + a1 BDEFt + μt .... ..... ..... ..... [E.1]

83
 Government Budget deficit
External Debt Balance of Payment
Deficit
ADF Test Statistics 2.145 ADF Test Statistics ADF Test Statistic 0.133
2.223
1% Critical Value-3.808 1% Critical Value* -2.565 1% Critical Value -3.734
-2.565

5% Critical Value -2.979 -2.979 5% Critical 5% Critical Value -2.990

Value -1.954
10% Critical Value -2.629 10% Critical Value 10% Critical Value -2.634
-1.622

We can see that all three variables Economic growth, EDEBT and overall
productivity of labor & capital are non stationary. We have to check whether the two
time-series are co integrated. if residuals from (Gujarati, 1995, pp. 726-727are stationary.
(Gujarati, 1995, pp. 726-727). E-views estimation output of regression (E.1) is presented
in table A.2(a) and A.2(b) and ADF test for residuals, μt, is presented in table A.3(a) and
table A.3(b).). E-views estimation output of regression (E.1) is presented in table A.2(a)
and A.2(b) and ADF test for residuals, μt, is presente d in table
A.3(a) and table A.3(b). regressions:

1) BEco-Gt = a 0 + a1 Productivity Qt + μt

2) EDEBTt = a 0 + a1 BDEFt + μt .... ..... ..... ..... [E.1]

84
Table A.2(a):
Dependent Variable: B (Economic Growth)
Sample(adjusted): 1993-2008
Included observations: 25 after adjusting endpoints
Sample: 1993 2008

Variable Coefficient Std. Error Prob.

t-Statistic
C -58436.92 0.967496 -2.089168 0.0466
BDEF 8.664964 0.311474 27.81922 0.0000

R-squared 0.967496

Table A.3(a)

ADF Test Statistic -3.642 1% Critical Value* -3.749

5% Critical Value -2.996
-2.638
10% Critical Value
*MacKinnon critical values for rejection of hypothesis of a unit root.

Table A.3(b)

ADF Test Statistic -2.802592 1% Critical Value* -3.707

5% Critical Value -2.979
10% Critical Value -2.6290

85
*MacKinnon critical values for rejection of hypothesis of a unit root.

We can see that these residuals are stationary, so Economic growth (EG) and National
overall productivity (NPROD) are cointegrated, and also EDEBT and Economic growth
are negatively cointegrated, therefore, we can conduct Granger- causality test in levels.

Our specification for Granger-causality test is as follows:

1) yt = a0 + a1 yt -1 + a2 yt-2 + ................ + a 1 yt-1 + ß1 xt -1 + ß2 xt-2 + .......... + ß

1 xt-1

2) xt = a0 + a1 xt -1 + a2 xt-2 + ................ + a 1 xt-1 + ß1 yt -1 + ß2 yt-2 + .......... + ß

1 yt-1

The lag length is taken to be equal to 2 in our case. It is desirable to trace the longer lag
period, maybe 5 or so, but in case of short time series it is impossible to do so. In case of
short time series, however, a lag length that is longer than 2 will consume a lot of degrees
of freedom and estimation becomes impossible (Gujarati, 1995, p.632). E-Views runs
Grangercausality test by automatically testing four hypotheses:
1. Y Granger- causes X;
2. X Granger- causes Y;
3. Causality goes in both directions;
4. X and Y are independent.

E-Views output is shown in table A.4. The Granger- causality test shows that
unidirectional

86
causality goes from Economic growth variable to EDEBT and National productivity Q.
While the bidirectional causality exist between EDEBT and annual productivity given by
Labor & capital. F-test is used to test the hypothesis that collectively the lagged
coefficients are zero. We discovered that there is statistical dependence between
movement in Economic growth and EDEBT. In particularly, past movements of
Economic growth contribute to an explanation of movements in EDEBT. Similarly, there
is statistical dependence between movement in Economic growth and Productivity given
by the factors of economy Labor & capital. While in case of EDEBT and NPROD, past
movements of EDEBT contribute to an explanation of movements in NPROD and vice
Versa.

TABLE A.4
GRANGER CAUSALITY TESTS FOR Economic Growth (EG),
EXTERNAL DEBT (EDEBT), AND Annual productivity [given by
2Factor inputs Labor & capital (NPROD)]

Null Obs F-Statistic Probability

Hypothesis
EDEBT 26 21.2514 9.0
does not
Granger
Cause
NPROD
EDBET 0.108
does not 2.47000
Granger
Cause EG
NPROD 24 12.6418 0.000
does not
Granger

87
Cause
EDEBT
EDEBT 7.9930 0.00303
does not
Granger
Cause
NPROD(Q)

EDEBT 24 0.01966
does not 4.84372
Granger
Cause EG
EDEBT 1.94192
does not
Granger
Cause EG

Results
5.1. Testing for Unit Roots
It is necessary to verify the stationarity properties of variables included
prior to attempting the multivariate cointegration analysis. To
determine the order of integration, ADF unit root test has been carried
out on levels and differences of the relevant variables by estimating
Equation (2).

Specification of Equation (2) & its assumption:

88
The specification of Equation (2) assumes an intercept and a linear
time trend. Capital stock variable is tested for a unit root by
employing Dickey-Fuller GLS approach with an intercept term.
The null hypothesis underlying unit root testing is that the variable
under investigation has a unit root and the alternative is that
it does not. The results reported in Table show that all the variables
have a unit root in their levels and are stationary in their first
differences, implying that they are integrated of order one i.e., I (1).

Results of Unit Root Test

Variable Level Differenc Order of

Order of e Integrati
Integration on
GDP -2.899181 I (1) - I (0)
5.566849**
DS -3.076925 I (1) - I (0)
8.866624**
K -0.017044 I (1) -2.303440* I (0)
L -2.142838 I (1) - I (0)
5.398021**

* significant at 5% level of significance

** significant at 1% level of significance

Results From the Cointegration Test

The results from unit root testing imply that all the variables are non-
stationary and are integrated of the same order, giving rise to the

89
possibility of the existence of a long-run relationship among the
variables. To identify the long-run relationship among the included
variables, Johansen’s (1988) multiple cointegration test has been
employed, by using a lag length of one year suggested by Schwarz
Information Criterion (SIC) criteria.

Analysis via E-views software:

Trend assumption: Linear

deterministic trend
Series: DS GDP K L
Lags interval (in first differences): 1
to 1
Unrestricted Cointegration Rank
Test (Trace)
Hypothesized Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Prob.**
Value
None * 0.952414 74.3762 47.8561 0.0000
6 3
At most 1 0.551955 22.6076 29.7970 0.2659

90
 8 7
At most 2 0.405796 8.95903 15.4947 0.3692
7 1
At most 3 0.006448 0.10997 3.84146 0.7402
5 6
Trace test indicates 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
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized Max- 0.05
Eigen
No. of CE(s) Eigenvalue Statistic Critical Prob.**
Value
None * 0.952414 51.7685 27.5843 0.0000
8 4
At most 1 0.551955 13.6486 21.1316 0.3945
4 2
At most 2 0.405796 8.84906 14.2646 0.2989
3 0
At most 3 0.006448 0.10997 3.84146 0.7402
5 6
Max-eigenvalue test indicates 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

Trace Test

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.952414 74.37626 47.85613 0.0000
At most 1 0.551955 22.60768 29.79707 0.2659
At most 2 0.405796 8.959037 15.49471 0.3692
At most 3 0.006448 0.109975 3.841466 0.7402
Trace test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level

91
**MacKinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized Max-Eigen 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.952414 51.76858 27.58434 0.0000
At most 1 0.551955 13.64864 21.13162 0.3945
At most 2 0.405796 8.849063 14.26460 0.2989
At most 3 0.006448 0.109975 3.841466 0.7402
Max-eigenvalue test indicates 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

Results from Cointegration Test

H0 H1 Maximum Critical Trace Critical

Eigenvalu values values
e
r= 0 r 34.66990* 32.11832 83.44172* 63.87610
congruent *
to 0
r≤ 1 r 28.70102* 25.82321 48.77182* 42.91525
congruent
to 2
r≤ 2 r 14.94124 19.38704 20.07080 25.87211
congruent
to 3
r≤ 3 r 5.129561 12.51798 5.129561 12.51798
congruent
to 4

* Significant at 5% level of significance

** Significant at 1% level of significance

92
The results given in Table denote maximum eigenvalue and trace test
statistics and their associated critical values. These test statistics help
evaluate the null hypothesis of r = 0 against the general alternatives of
r = 1, 2, 3, or 4. These tests make us accept that there are two
cointegrating vectors since both the trace and maximum eigenvalue
statistics do not lead to the rejection of the null hypothesis of r ≤ 2 .
Based on these results, it can be argued that a long-run relationship
exists among GDP, debt service, capital and labor.
It is a standard practice to normalize the cointegrating vectors with
respect to the variables of interest to get a better interpretation. Since
we are interested in analyzing the impact of debt service on output,
the cointegrating vector is normalized with respect to GDP. Also, we
dropped one of the cointegrating vector as it was found to be
associated with a sign inconsistent with prior expectations.

The normalized cointegrating vector is

reported in Table.

Normalised Cointegrating Vector

93
 GDP DS K L Trend
GDP 1.000000 0.150891 - -3.78080 0.049032
0.341254

One can write the above cointegrating vector in the form of an

equation as shown below:

Equation form:

GDP = - 0.150891 DS + 0.341254 K + 3.780807 L - 0.049032

Trend (7)

This equation shows that debt service affects GDP negatively in the
long-run, whereas, capital and labour have a positive effect on output.
The individual coefficients represent respectively, elasticities of debt
service, capital, and labor with respect to output. The negative sign
associated with the debt service variable suggests that increase in
debt service leads to decreased economic growth in the long-run. The
positive coefficient on the capital variable shows that increase in it
affects GDP positively which helps to boost economy’s growth potential
and generate employment opportunities.
However, accelerated growth is accompanied by increases in income
and domestic savings. This, in turn, reduces the need for foreign
borrowings to finance investment projects. It then implies that if
growth of the stock of debt slows down, it will reduce debt service
ratio. Like capital, labour force also has a positive effect on GDP, and
therefore has the same implications for economic growth and debt
service reduction. The results reported in Table lend support to the
debt overhang hypothesis. This hypothesis posits that when foreign

94
debt becomes excessive the performance of the debtor country gets
linked to actual payments due for the creditors. Therefore, potential
increases in debt payments depress returns to productive investment
and discourage capital formation. In such circumstances, the debtor
country benefits only partially from any increase in output and/or
exports because significant portions of that increase gets committed to
service foreign debts. From this point of view, incentives of the
borrowing country to undertake new investments are considerably
weakened. Needless to say this will happen only when a larger
percentage of reserves (foreign currency) go towards meeting debt
servicing. It is unfortunate that when the debt service payment
increases as a percentage of the additional these difficulties, it
becomes nearly impossible for a country under heavy external debt to
continue with large infrastructure, new projects and old investments
(Afxentiou and Serletis, 1996).

Results from Granger Causality Tests Based on VECM

In this section, an error correction model is formulated. Co

integration tests carried out earlier indicate the existence of a long-
term relationship between variables but say nothing about the
direction of the causal relationship. Estimation of VECM makes it
possible both to separate the long-term relationship between the
economic variables from their short-term responses and to determine
the direction of the Granger long-term causality. Causality in co
integrated systems is established if the lagged ECT term, which
captures the long-term dynamics, and the sum of lagged coefficients of

95
the other variables, which captures short-run dynamics, are both
significant. While the significance of the ECT term, in turn, is checked
with an ordinary t-test, the joint significance of the lagged
coefficients is detected by employing χ2-test.

Granger Causality Results Based on VECM

Variabl ΔGDP ΔDS ΔK ΔL Σχ 2 ECTt-1

es
ΔGDP - 4.48 8.61 8.16** 14.87* -3.74* -3.74*
ΔDS 0.01 - 0.39** 0.98 2.90 -0.95 -0.95

ΔK 0.10 0.08 - 6.71** 9.32 -3.46* -3.46*

ΔL 0.002 0.146 1.74 - 1.80 1.30 1.30

* Significant at 5% level of significance

** Significant at 1% level of significance

Results from Granger causality test are presented in Table .

Number of variables involved:

A four variable VECM is estimated and t-values for the ECT terms
are reported.

The co integrating vector identified:

Since one unique co integrating vector was identified earlier only one
lagged ECT term is included in the specification of the VECM. Based

96
on the reported t-value, the ECT term appearing in the GDP equation is
significant.

Resultant Long run causality:

This implies that the long run causality is running from debt
servicing to output.

Short Run causality:

Concerning short-run causality, the first four columns of the above

table report χ2 values for individual and joint significance of other
variables i.e., Σχ 2 , with three degrees of freedom.

Overall observation:

Based on these results, it is concluded that the null hypothesis of the

joint significance of other variables is rejected for the output equation.
However, the null hypothesis of joint significance is not rejected for the
debt service equation. This further confirms that there is uni-
directional causality running from debt service to output.

Impact of causality:

Evidence of short-run and long-run causality running from debt service

to output coupled with our earlier finding of debt service entering the

97
long-run relationship with a negative impact on output, leads us to
conclude the occurrence of a strong debt overhang in Pakistan.

98
 CHAPTER # 7
CONCLUSION

CONCLUSION

99
The main focus of this study is to analyze the effect of rising debt on
economic growth. The increasing dependency of Pakistan on foreign
resources is evident from the magnitude of the debt burden and the
accompanying debt-servicing liability. Pakistan has also resorted to
borrowing heavily from foreign and domestic sources to finance its
development plans and large fiscal deficits in the past, which became
virtually unsustainable in the late 1990s. Stagnant export and foreign
exchange earnings,
together with heavy reliance on foreign resources, were the main
factors contributing to the worsening of the external debt indicators.
Pakistan’s external debt towards the end of the 1990s reached
alarming proportions, which posed a serious danger to the economic
future of the country.

This paper has analyzed the dynamic behaviour of GDP, debt service,
labor and the capital with a view to identifying the long-run and short-
run effect of debt service on economic growth of Pakistan for the
period 1993-2008. ADF unit root tests are conducted to establish
stationarity properties and multiple cointegration procedure is
employed to identify long-run relationship among the included
variables. The long-run relationship shows that debt service affects
GDP negatively, whereas capital and labor affect it positively. It is
argued that debt service burden has a negative impact on labor and
capital productivity, which adversely effects economic growth.
Although cointegration implies the presence of Granger causality, it
does not necessarily
identify the direction of causality between the included variables. This
temporal Granger causality can be captured through a VECM. Results
from the Granger causality tests indicate that the short-run and long-
run causality runs from debt service to GDP, which indicates that debt
overhang was operational for the period under review.

100
Overall, the results of the study suggest that debt overhang is an
important factor in overall debt scenario of Pakistan. The high debt
burden has stemmed from mismanagement of resources,
macroeconomic imbalances and loss of competitiveness in the
international market. The existence of negative relationship between
GDP and debt service may indicate the fact that borrowed resources
were misallocated or wasted on consumption. The continued negative
effects of debt burden on productivity will reduce the country’s ability
to service its debt in future. Excessive debt affects a country’s
economic development in a number of ways. Firstly, the large debt
service requirements dry up foreign exchange and capital, because
they are transferred to lenders to payback principal and interest. A
country benefits only partially from an increase in output
or exports because a growing fraction of the increase gets used to
service the accrued debt. Secondly, when the debtor countries are
unable to fulfill their debt service obligations promptly, the debtor
countries are considered high risk countries and they find it difficult to
borrow. As a result, debtor countries have to pay high interest rates to
obtain new credit. Thirdly, the accumulation of debt causes a reduction
in an economy’s efficiency, since it is difficult to adjust efficaciously to
some shocks and international financial fluctuations. Finally, to save
more foreign exchange so as to meet debt obligations many debtor
countries cut down on imports and restrict trade which leads to poor
trade performance.
There is need to improve the competitiveness of the economy in order
to improve macro imbalances and to help mobilize the domestic
resources so as to lessen economy’s dependence on external debt.
Also, provision of a favorable macroeconomic environment is needed
to reduce mismanagement so as to promote economic growth. Further,
it is pertinent that a viable monitoring system be put in place that can
ensure proper and systematic utilization of the external borrowings for

101
the developmental projects. There is also a need for reducing the
external debt, as it will contribute to economic growth by boosting
capital accumulation and productivity improvement.

102
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