Impact of Public Debt On Economic Growth: Evidence From Indian States
Impact of Public Debt On Economic Growth: Evidence From Indian States
Impact of Public Debt On Economic Growth: Evidence From Indian States
States
Abstrac
t
This study examines the impact of public debt on economic growth by taking other
control
14 major (non-special category) States in India for the period 1980-81 to 2013-14.
After
establishing long-run relationship among the variables, panel long-run estimates are
drawn
using both DOLS and FMOLS methods. Results from both the methods suggest
positive and
statistically significant impact of all the variables on economic growth. To test causal
One way causality is revealed from economic growth to electricity consumption and
from
India should not think public debt as a burden but expand it for productive spending
to reap
higher economic
growth.
1
Prof. Asit Ranjan Mohanty is Professor in Finance, Xavier University and Chair Professor of Centre of
1.
Introduction
The impact of public debt on economic growth has remained a key issue in the
academia. Over the
past decade and especially after the financial crisis in 2008, the level of public debt is
expanding
in international, national and sub-national level. Heavy dependence on public debt could
retard
investment and economic growth. The ‘debt overhang’ hypothesis mentions that if the
anticipated
external debt of a country is more than it’s repayment ability, then the increased cost of
servicing
debt can impede investment (Krugman, 1988). If a major chunk of foreign capital is
used for
interest payments, then a meagre amount will remain to finance for investment that
could constrain
However, another school of thought states that, if public debt is used in productive
activities, then
the economy may expand without creating any macroeconomic instability (Burnside and
Dollar,
2000). As far as public debt is concerned, broadly it could be divided into types, one is
external
debt and the other is domestic debt. The two types of debt may have distinct impact on
economic
growth. The rationale behind dependence on domestic debt is that it saves the home
country from
the adverse external shocks and foreign exchange risk, and helps in the progress of
domestic
financial markets (Barajas and Salazar, 1999, 2000). But, Beaugrand et al. (2002) are
of the view
Most of the recent literature on public debt and growth nexus centered on non-linear
(inverted U-
shape) relationship between the two and estimation of the threshold limit of public debt
share to
GDP (See Smyth and Hsing, 1995; Blavvy, 2006; Reinhart and Rogoff, 2010; Reinhart
et al., 2012;
Kumar and Woo, 2010; Cecchetti et al., 2011; Checherita-Westphal and Rother, 2012;
Furceri and
Zdzienicka, 2012; Herndon et al., 2013; Chen et al., 2016). However, for a developing
country like
India and its underdeveloped states, our hunch is that the optimum level of public debt
has not yet
been reached. The average public debt to gross domestic product ratio across the
major 14 states
for different periods from 1980-81 to 2013-14, varies from 19.1% to 35.3%. Therefore, a
positive
Earlier studies mainly focused on the impact of external debt in economic growth and
therefore
neglected the role of domestic debt. Further, the analysis is limited to cross-country
analysis or
time series analysis. Hence, this study will explore on the impact of domestic debt on
economic
growth along with other control variables by using a panel data set of 14 major states
in India.
The present study tries to assess the impact of public debt on economic growth using a
production
function approach where other relevant inputs like credit and electricity are also taken
as
explanatory variables. Inclusion of the other relevant variables also helps in removing
omitted
variable bias. Using Dynamic OLS (DOLS) and Fully Modified OLS (FMOLS) the study
gets
positive and statistically significant impact of public debt, institutional credit and
commercial
The remainder of this study is as follows. Section 2 gives a brief overview of literature.
Section 3
outlines the theoretical framework and data used in the study. Econometric
methodology applied
in the analysis is presented in Section 4. Section 5 outlines the results and finally
section 6 provides
2. Brief overview of
Literature
Recent studies dealing with nexus between external debt and growth found that, the
relationship
between the two could be non-linear (inverted-U type shape). This means there could
be threshold
limit up to which debt can induce growth and thereafter higher debt can reduce growth.
The
threshold limit of external debt is estimated to be 38.4 percent of GDP by Smyth and
Hsing (1995);
Westphal and Rother (2012); and 90 percent by Chen et al. (2016). On the other hand
the study by
Reinhart and Rogoff (2010) concludes that in advanced and emerging market
economies (EMEs),
debt to GDP ratio of about 90 percent is growth reducing. If the ratio is below 60 percent
then it
can retard economic growth in only EMEs. Subsequently, Herndon et al. (2013) try to
replicate
the study by Reinhart and Rogoff (2010). By making some correction they find that the
relationship
between debt ratio and economic growth is similar in the two situations. So far as
causality between
public debt and economic growth is concerned, Panizza and Presbitero (2014) do not
find any
causality between the two, whereas Puente-Ajovín and Sanso-Navarro get bi-directional
causality
between public debt and economic growth. Lof and Malinen (2014) get support of one
way
It is well known that financial deepening results in higher growth through different
channels like
more credit with financial liberalization promotes investment and innovation resulting in
more
efficient investment and thereby growth. In the literature various studies are done to
explore the
financial development and economic performance. Others try to identify the channels
through
which the two are related. Pioneering work of McKinnon (1973) and Shaw (1973)
reflects that
higher economic growth. Later on various papers using the endogenous growth models
take
efficiency in investment (See Bencivenga and Smith, 1991; Greenwood and Jovanovic,
1990). But
not all economists are convinced with the role of credit in generating growth. Robinson
(1952)
states that ‘where enterprise leads, finance follows’ which means economic growth
creates the
Early papers find a positive relationship between financial development and economic
growth
using cross-country analysis (See King and Levine, 1993; Demirguc-Kunt and
Maksimovic, 1996;
Levine and Zervos, 1998; among others). But these studies do not deal with causality
analysis and
do not pays any attention to time series properties of the data. Ram (1999) gets
evidence of weak
negative relationship between financial development and economic growth and opines
that cross-
country studies have various limitations like heterogeneity issue in slope coefficients of
various
countries. Moreover, the results based on these type of analysis is sensitive to the
sample of
(2004), and Hassan et al. (2011) etc. Most of the time series studies get evidence of
causality
between credit and economic growth with no consensus on the direction of causality
(See
Demetriades and Hussein, 1996;; Luintel and Khan, 1999; Bell & Rousseau, 2001;
Calderon and
Liu, 2003; Bhattacharya and Sivasubramanian, 2003 and Liang and Teng, 2006 among
others).
3
See Levine for a detailed survey on financial development-growth
nexus.
Few studies get no evidence of causality between the two (see Eng and Habibullah,
2011 and
Mukhopadhyay et al.,
2011).
To overcome the limitations of time series and cross-section analysis, various studies
use panel
data to assess the nexus between the financial development and economic growth (See
Levine et
al., 2000; Christopoulos and Tsionas, 2004; Beck and Levine, 2004; Hassan et al.,
2011, Gaffeo
and Garalova, 2014. etc.). Recent study by Kar et al. (2011) could not get any clear cut
relationship
between financial development and growth as the results are country specific in Middle
East and
North African (MENA) countries. However, two studies by Arestis et al. (2014) and
Valickova et
al. (2014) find evidence of positive relationship between financial development and
economic
growth by employing
meta-analysis.
variables electricity is most flexible form and a key infrastructural input for development.
There
economic growth. In studying the relationship between the two, the prime focus was on
the
causality issue since the publication of Kraft and Kraft (1978). The causality analysis is
important
strategy to reduce electricity consumption may reduce growth. The causality from
growth to
electricity could be justified on the ground that demand for electricity will increase with
upsurge
and an input for production. Causality from economic growth to electricity is supported
by many
studies (see Kraft and Kraft, 1978; Ghosh, 2002; Narayan and Smyth, 2005; Mozumder
and
Marathe, 2007; and Jamil and Ahmad, 2010; Ciarreta and Zarraga, 2010; and Shahbaz
and Feridun,
2012 etc.). On the other hand, the reverse causality from electricity consumption to
growth is
revealed by other empirical papers (see Hsiao, 1981; Stern, 1993; Aqeel and Butt,
2001; Shiu and
Lam, 2004; Altinay and Karagol, 2005; Lee and Chang, 2005; Narayan and Singh,
2007; Yuan et
al., 2007; Tang, 2008, Odhiambo, 2009; and Chandran et al., 2010 etc.). Some other
find
bidirectional causality between electricity consumption and growth (See Yang, 2000;
Jumbe,
2004; Zachariadis and Pashourtidou, 2007; Lean and Smyth, 2010; Tang et al., 2013;
Osman et
al., 2016 among others). Some studies report no causality between the two (e.g. Ozturk
and
Acaravci, 2011; Yoo and Kwak, 2010; and Wolde-Rufael, 2006; etc.). Thus, the
relationship
government borrows today, then, it has to repay this borrowing, in future by raising
taxes above
the normal level and the impact of debt on growth will be neutralized (Ricardo, 1817). In
the
gap (Todaro and Smith, 2003). Solow (1957) maintained that in the short-run fiscal
policy can
have some impact on level of per-capita income but in the long-run the impact is
neutral. In a neo-
classical set up Diamond (1965) formally brought the public debt as a variable
explaining growth.
He opines that internal debt reduces the available capital stock due to substitution of
public debt
for physical capital. As per the endogenous growth models, both fiscal and monetary
policies play
a crucial part in determining potential economic growth. Public debt can result in
technical
progress and thereby can influence growth (Villanueva, 1972). But Saint-Paul (1992)
using the
endogenous growth caveat states that higher debt is always associated with lower growth. The
recently
developed new growth theories explore the relationship of public debt and growth nexus
by
bringing utilization and governance aspects of public debt (See Zak and Knack, 2001
and
The study employs annual data for the period 1980-81 to 2013-14 for 14 major
non-special
category states in India. The key variables in the study include Gross State Domestic
Product
(GSDP) proxy used for real income, real public debt, real institutional credit to private
sector, and
commercial consumption of electricity (in Gigawatt). All the variables are transformed
into natural
logarithms prior to estimation and respectively denoted as LRY, LRD, LRC, and LCCE.
As State
wise data on private investment is not available for India, commercial bank credit to
private sector
is taken as a proxy for private investment. Nominal values of public debt and credit to
private
sector by commercial banks are deflated by the GSDP deflators of the respective states
to obtain
real values of the concerned variable. All variables except electricity are in Rs. crore at
2004-05
prices. Real GSDP data is collected from National Account Statistics published by
Central
Statistical Organization. Public debt and Credit variables are collected from State
Finance: A Study
of Budgets, published by the Reserve Bank of India and electricity data is taken from
EPWRF and
Table 1. Descriptive
Statistics
LRY LRD LRC LCCE Cross-section 14 14 14 14
Time Series 34 34 34 34 Observation 476 476 476 476 Mean 11.57 10.12 10.12 6.72
Median 11.53 10.05 9.97 6.70 Maximum 13.71 11.86 13.89 9.55 Minimum 10.04 8.22
7.58 3.86 Std. Dev. 0.74 0.80 1.18 1.15 Skewness 0.32 0.13 0.59 -0.02 Kurtosis 2.49
2.25 3.07 2.46 Note: Variables are in Natural Log.
Table 2. Correlation
Matrix
LYR LRD LRC LCCE LYR 1.000
----
-
----
-
Table 1 depicts the descriptive statistics of all the logarithmic transformed variables. The
standard
deviation of all the variables are revealing that the data of all the series are dispersed
around the
mean. It permits us to move forward and use the data for further
estimation.
Table 2 presents the correlation matrix. The correlation coefficient between all variables
are very
high and they are intertwined which provides us the clue to estimate their
relationship.
4. Econometric
Methodology:
4.1.The
Model
LRYit =
β0 +
β1LRDit +
β2LRCit +
β3LCCEit +
εit (2)
Where, εit =
μi +
θit,
μi ∼ (0,σμ2) and θit ∼ (0,σθ2) are assumed to be independent of each other and among
themselves. μi and
θitsignify country specific fixed effects and time variants effects,
respectively. The subscripts i and t denote state (i = 1...14) and time period considered(t
= 1980/
81......2013/14), respectively.
The coefficients β1, β2 and β3 are the long-run elasticity estimates of gross income with
respect to public debt, credit, commercial electricity consumption, respectively. The
coefficient of all the
regression. Therefore, unit-root testing and co-integration analysis are useful tools for
empirical
cointegration relationship can be established among the variables. Testing for unit-roots
and
Wu (1999) mention that testing unit-root and cointegration in panel data increases the
power of
the test as compared to the respective tests done in Time series data. This paper uses
four steps in
its analysis: 1. Check for stationary properties of the data using panel unit root test; 2. if
the series
are stationary then test for the cointegration relationship, 3. in case the series are
cointegrated,
FMOLS and DOLS Methods are applied to measure the elasticity of income with
respect to public
Panel unit-root test can be done with two types of specification, one with a common or
process. The former specification can be implemented by Levin, Li and Chu (2002)
(LLC),
Breitung (2000), and Hadri (1998) panel unit root tests, while the latter specification can
be
fulfilled by Im, Pesaran and Shin (2003) (IPS), Fisher-ADF and Fisher-PP panel unit
root tests
(Maddala and Wu, 1999). This paper employs four methods of panel unit root tests that
are LLC,
Breitung, IPS and Fisher-PP Test i.e. two tests from each
categories.
k=1
This form allows two-way fixed effects i.e. the intercept varies over state as well as time
period,
counts. Firstly, it removes the autoregressive portion but not the deterministic portion of
the ADF
equation. Secondly, the proxies for standardization are transformed and de-trended. He
considers
IPS (Im, Pesaran and Shin 2003) test allows heterogeneity on the coefficient of the
lagged Yi variable
by extending the work of LLC. The IPS procedure of testing panel unit
root is based on
the following
model.
+ δit + ∅t +
uit (5)
n∆Yit =
αi +
ρiYi,t−1 +
∑ φk∆Yi,t−k
k=1
With H0: ρi = 0 for all i and H1: ρi < 0 for at least one i. The t-statistic, applicable for a
balanced panel can be obtained by t = 1/N∑ Nt=1 tρi . Here, tρi denotes an individual ADF
t-
Another alternative method of panel unit root tests applies Fisher’s (1932) results to
develop tests
which combine the p-values from individual unit root tests. This Method is suggested by
Maddala
and Wu, and by
Choi.
If πi is defined as the p-value from any individual unit root test for cross-section i, then
under the null of unit root for all N cross section, the asymptotic result would be,
N−2∑log(πi)
(6)
i=1
In the present paper we have reported the asymptotic χ2 statistics using Phillips-Perron
individual
unit root tests. Choi’s result of standard normal statistics are not reported due to
similarity of
results. The null and alternative hypothesis for the Fisher-PP test are same as
the IPS test.
The tests are done with model with intercept for all tests except the Breitung test. AIC
criteria is
Kernel spectral
technique.
4.3.Panel co-integration
Test:
Two varieties of co-integration test is done by following Pedroni (1999, 2004) and Kao
(1999).
m=1
In this model the X and Y are assumed to be stationary at first difference or I(1). Pedroni
test is a
residual based test where the residual obtained from equation (6) is tested for
stationarity by
εit =
ρiεi,t−1 +
uit (8)
for each
cross-section.
Co-integration statistics given by Pedroni is divided into two categories. The first
category consists
across the different sections of the panel for the unit-root test on the residuals. The
second category
member of the panel for the unit-root test of the residuals. The Kao cointegration test is
also a
residual based test. It distinguishes from the Pedroni test in specifying cross-section
specific
Therefore a number of alternative estimators are proposed such as DOLS and FMOLS
among
others. The major weakness of DOLS estimator is that it does not take care of the
cross-sectional
heterogeneity issue. Therefore, Pedroni (2000) suggested to use the FMOLS estimator
that deals
with the cross sectional heterogeneity, endogeneity and serial correlation problems. In
small
samples the FMOLS is believed to give consistent estimates. First we estimated the
DOLS
estimator and then to check the robustness of the results FMOLS estimator is applied.
Following, Mark and Sul (1999), the study applies a simple weighted DOLS estimator
that permits
for heterogeneity in the long-run variances. Similarly, feasible pooled (weighted)
FMOLS
estimator developed by Pedroni (2000) and Kao and Chiang (2000) is used which
considers
heterogeneous cointegrated panels with differences in long-run variances across
cross-sections.
4.5.Dumitrescu-Hurlin causality test:
After getting long-run coefficient of three explanatory variables determining the real
income, it is
useful to draw information on the causal link between them which can have greater
policy
implications. Therefore, this study also attempts to explore on the causal link between
the variables
by applying Dumitrescu-Hurlin test. This test has two advantages over the Granger
(1969)
causality test in that in addition to the fixed coefficient accounted in Granger causality
test, it
considers two dimensions of heterogeneity. One for the regression model used to test
Granger
causality and the other is heterogeneity in the causal relationship. The detailed
derivation of the
Dumitrescu-Hurlin test can be found in Dumitrescu and Hurlin (2012).
5. Results and Implications
5.1. Panel Unit Root Test:
The empirical analysis starts with the testing of panel unit root in log-levels of real
income, real
public debt, real credit and electricity consumption by following four varieties of panel
unit root
tests viz. LLC, Breitung, IPS and Fisher-PP panel unit root test.
Table 3. Panel Unit Root Test
Variable
LLC Breitung IPS Fisher-PP
(Chi-square
(t-statistics) (t-statistics) (W-Statistics)
Statistics)
Levels LRY 7.7235 2.9181 11.6800 0.0736
LRD -2.2760** 1.0919 1.7309 19.4651
LRC 4.4096 1.6611 9.0721 0.4573 LCCE 2.4438 3.6317 5.6921 20.6416 First Differences
LRY -14.0529* -3.3658* -14.2520* 344.643* LRD -6.8155* - 7.2473*
-7.5748* 137.297* LRC -6.0747* -5.4904* -5.4913* 186.949* LCCE
-16.1223* -5.2121* -17.1570* 337.172*
Note. 1. All tests are done on the model with an intercept except the Breitung test which is
done for a model of intercept with trend. 2. Lag Lengths are set based on the AIC criterion. 3.
For LLC and PP- Fisher test Barlet Spectral Method with Newey-West Bandwidth is applied.
4. * and ** depicts statistical significance at 1% and 5% level, respectively.
The results of panel unit root tests are reported in Table 3. It demonstrates that for the
log-level
series, the null of non-stationarity in variables could not be rejected for all the variables
except the
real debt variable. Real debt is found to be stationary in level by only the LLC test,
which is refuted
by other Panel Unit root tests. First difference of the log-levels variables are found to be
stationary
at 1 percent level of significance. Thus, the results indicate that the four variables
contain a panel
unit root in
level.
5.2. Panel
Co-integration:
As the panel unit root test results reveal that all the variables are difference stationary,
we proceed
to check the cointegration or long-run association of the variables by using Kao test and
Pedroni
Test. The model for Kao Test assumes no deterministic trend, while model for Pedroni
Test
assumes deterministic trend with intercept.4 Lag length is set by AIC criteria and Barlett
spectral
the Kao and Pedroni Test of cointegration suggest long-run relationship among the four
variables
Pedroni
test.
Table 4. Panel Co-integration Tests: Kao Test and Padroni Test Method Statistic Kao
Residual Cointegration Test ADF Stat. - 6.645*
Pedroni residual cointegration test Panel v-Statistic 8.151* Panel rho-Statistic -2.410*
4
We could also reject the null of no cointegration by Panel ADF-test (with-in dimension) and Group ADF
statistics (between-dimension)
using Pedroni cointegration test with the assumption of no deterministic
trend.
Panel PP-Statistic -6.315* Panel ADF-Statistic -6.625* Group rho-Statistic -0.223 Group
PP-Statistic -4.881* Group ADF-Statistic -6.676* Note: 1. Trend assumption [Kao: no
deterministic trend, Pedroni: Deterministic trend with intercept]; H0: No Co-integration; 2.
Newey–West automatic bandwidth selection and Bartlett kernel. 2. * depicts statistical
significance at 1% level.
long-run elasticity using DOLS and check the robustness by applying FMOLS method.
In the
DOLS method one lead and one lag is taken. Trend specification is set with no
deterministic trend
and the panel option is set as Pooled (weighted) in both the methods. The long-run
variance
Table 5 depicts the results from DOLS estimates. It reveals that public debt, institutional
credit
variables are elasticity. The coefficient for public debt in explaining income is found to
be 0.33
which can be interpreted as a 1% rise in public debt will increase the income by 0.33%.
The
positive relationship between the public debt and economic growth could be explained
by the fact
that, at State level, the threshold limit of debt to GSDP is not yet been reached. The
coefficient for
credit and electricity variables are found to be 0.34 and 0.07 respectively. It is
noticeable that the
impact of public debt and institutional credit on income is similar and the impact of
electricity
consumption is very low. This is due to the fact that the share of electricity consumption
to GSDP
Table 5. Results from DOLS Estimation (Dependent variable LRY) Variable Coefficient
Std. Error t-Statistic Prob. LRD 0.3306 0.0346 9.5419 0.0000 LRC 0.3390 0.0320 10.6031
0.0000 LCCE 0.0729 0.0198 3.6836 0.0003 R-squared 0.9893 Mean dependent var.
11.5894 Adjusted R-squared 0.9841 S.D. dependent var. 0.7076 S.E. of regression 0.0891
Sum squared resid. 2.3111
Long-run variance 0.0129
Table 6 gives the estimated results obtained from FMOLS estimate. The results fairly
resemble
with the DOLS Method though the coefficients of various explanatory variables slightly
differ. As
compared to the DOLS, FMOLS assigns a slightly low coefficient to public debt variable
and in
turn the coefficients of the credit variable in explaining income has increased. All the
explanatory
variables are affecting income positively and significantly. In this case also the elasticity
of income
Table 6. Results from FMOLS Estimation (Dependent variable LRY) Variable Coefficient
Std. Error t-Statistic Prob. LRG 0.2626 0.0097 26.9531 0.0000 LRC 0.3615 0.0115 31.4851
0.0000 LCCE 0.0734 0.0070 10.5364 0.0000 R-squared 0.9805 Mean dependent var
11.5950 Adjusted R-squared 0.9798 S.D. dependent var 0.7331 S.E. of regression 0.1041
Sum squared resid 4.8253 Long-run variance 0.0085
The result of pairwise Dumitrescu-Hurlin panel causality test is reported in Table 7. The
result
suggests that bi-directional causality exists between public debt and economic growth
which is in
from economic growth to credit at 10% level of significance. One way causality from
economic
This study uses panel data of 14 major (non-special category) States in India during the
period
1980-81 to 2013-14 to examine the influence of public debt on economic growth by
controlling
other relevant variables like institutional credit and commercial electricity consumption.
After
applied to derive the elasticity of size of the economy (income) on public debt, credit
and
consumption of electricity. The study finds that economic growth is significantly and
positively
affected by public debt and credit. The impact of public debt and institutional credit are
high and
FMOLS (pooled weighted) estimates are also reported which give similar results.
Dumitrescu-
Hurlin pairwise causality test reveals existence of bi-directional causality between public
debt and
economic growth. One way causality is revealed from economic growth to electricity
consumption
The analysis reveals that at State level, expansionary debt policy will be helpful for the
economy
in generating higher economic growth. High economic growth will further increase the
provision
of institutional credit to private sector and increase the demand for energy consumption
for
commercial purpose. One can expand the paper by exploring on the composition of
public debt
and its impact on economic
growth.
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