The Effects of Public Debt on Economic Growth and Gross Investment
in India: An Empirical Evidence
Amanpreet
Kaur
Research
Scholar,
Punjab
School of Economics, GNDU, Amritsar, Punjab (India)
Dr.
Baljit Kaur
Assistant
professor,
Punjab
School of Economics, GNDU, Amritsar, Punjab (India)
Abstract
Public borrowing is one of the major
instruments of resource mobilization which divert the flow of resources into
right channels, especially in case of developing economies. Given
the current drive towards government borrowings there is a need to have an
understanding of the factors which influence public debt. The aim of the
present paper is to analyze the empirical relationship between public debt and
economic growth in India. The present study covers the period of 32 years
(i.e., from 198182 to 201213). To achieve this objective, the trends in
public debt, investment and GDP for a period of 32 years’ regular time series
have been analyzed. Granger’s causality analysis has been carried out in order
to examine the cause and effect relationship between economic growth and public
debt. Furthermore, Multiple Regression has been worked out to investigate the
indirect relationship between economic growth and public debt. The present
study provides us the evidence of positive, but indirect relationship between
public debt and economic growth via investment. The results show the positive
and statistically significant relationship between public debt and investment
and also Public debt effects the economic growth significantly.
Keywords: Public
Debt, Economic Growth, Outstanding Liabilities, Debt Sustainability
1. Introduction
A developing economy needs to tap all
possible resources to mobilize required financial resources for the
implementation of its developmental plans. Public borrowing is one of the major
instruments of resource mobilization which diverts the flow of resources into
right channels, especially in case of developing economies, as they lack
resources required for development. The study of public debt is not of recent
origin. Therefore, India after independence decided to go for economic
development that was based on centralized planning which assigned a great role
to public debt. Shoup (2006) defines Public Debt or
government borrowings as “the receipt from the sale of financial instruments by
the government to individuals or firms in the private sector to induce the
private sector to release manpower and real resources; and to finance the
purchase of those resources or to make welfare payment or subsidies”.
Public debt may be acquired from both internal as
well as external sources. An internal debt involves only transfer of wealth
within the borrowing community. In case of external loans, it involves firstly,
a transfer of wealth from the lending to the borrowing community, when the loan
is raised and secondly, a transfer in the reverse direction, when the interest
on principal is repaid (Meade, 1958). Public debt includes domestic and
external liabilities excluding small savings and total liabilities. Internal
debt includes market loans and bonds, treasury bills and special securities
issued to RBI etc. Other liabilities include Small Savings, Provident Funds,
Reserve Funds and Deposits.
How public debt is affecting the macroeconomic variables
like income, interest and investment etc., is an issue which has not been
considered much. The relationship between public debt and various economic
policy indicators is well discussed in international research studies; but in
Indian context, it is not much focused.
Central governments’ financial status which the
present study aims to address is of significant concern as it has a greater
potential to affect macroeconomic instability. Given the current drive towards
government borrowings, there is a need to have an understanding of the factors
influencing public debt. The relationship between public debt and economic
growth is a debatable issue as there has been contrasting views of the
economists on the relationship between public debt and economic growth. The
present paper aims at analyzing the empirical relationship between economic
growth and public debt.
2. Review of Literature
Various studies being conducted in the recent past
have mainly concentrated on the direct relationship between debt & growth
by considering debtGDP ratio only and have given less emphasis on the indirect
effects of debt on economic growth through investment and output.
Traditionalists viewed negative relationship between public debt and economic
growth whereas Ricardian viewed neutrality of debt to growth. Keynesian new
theory of public debt (or ‘no burden’ thesis) relied on positive aspects of
public borrowings; according to which, through debt creation, the government
can tap savings streams, put the resources thus raised to productive use and
bring out an increase in national income.
Singh (1999) investigated recent trends in domestic
debt, economic growth and their relationship covering the period from 1959 to 1995
and examined both the variables in the light of previous literature considering
two views  one is traditional view point depicting negative relationship and
other is Ricardian equivalence hypothesis implying the neutral relationship. The
author tested the hypothesis by using the concept of cointegration and the
causal relationship between debt and growth. The granger causality test
indicated that there is no causal relationship between unanticipated domestic
debt and growth, supporting the Ricardian equivalence hypothesis.
Reinhart and Rogoff (2009) examined the economic
growth at different levels of government debt for a period of about two hundred
years in a sample of forty four countries. Their empirical analysis provided
the evidence of negative link between economic growth and public debt.
Kumar and Woo (2010) studied the impact of high
public debt on long run economic growth for advanced and emerging economies
during 19702007. The empirical results suggested an inverse relationship
between initial debt and subsequent growth. On an average, it was estimated
that a 10 percentage point increase in initial debt to GDP ratio is associated
with 0.2 percentage point fall in growth of annual real per capita income per
year.
Presbitero (2010) studied the comprehensive analysis
of debt and growth in developing countries covering the period 19902007 and
found that rising debtGDP ratio has negative and monotonic effect on growth in
case of developing countries. Further, debt is a constraint for the economies
with sound macroeconomic policies and institutions. In these economies, public
debt has real effects and the economies where debt sustains for a long time and
the volume of debt is large, macroeconomic policies are worse and volatile.
Thus, various studies show mixed results regarding
the impact of public debt on growth. But growth is not the only economic factor
that is being affected by public debt; growth also affects the debt dynamics
and fiscal policy variables. There is a vicious cycle of budget deficits,
inflation and private capital share which widens the fiscal gap and results in
rising public debt (Easterly, 2004).
3. Database and Methodology
The aim of present paper is to analyze the empirical
relationship between public debt and economic growth. Therefore, the present
study covers the period of 32 years (i.e., from 198182 to 201213). To fulfill
this objective, the data on the various policy variables like public debt,
Gross Domestic Product, Gross Fixed Capital Formation, Population Growth rate has
been compiled from various issues of government publications like Indian Public
Finance Statistics, Economic Surveys, Handbook of Statistics on Indian Economy
(Reserve Bank of India) and various reports of the Ministry of Statistics and
Programme Implementation.
The study confines only to the central government
debt and excludes the debt of state governments, union territory governments,
central public sector undertakings and public financial institutions. The
reason behind this exclusion is that the central government is a major borrower
among all the government entities within the economy. In the paper, the words
government debt and public debt has been used interchangeably. The government
debt is defined as the total liabilities of Government of India and it
comprises both internal and external liabilities.
Central governments’ finances are of significant
concern as it has a greater potential to affect macroeconomic instability,
therefore, the trends in public debt, investment and GDP have been analyzed over
a period of 32 years. Before analyzing the causal relationship between gross
state domestic product and education expenditure, trend stationary, which is a
basic assumption in case of time series data analysis, has been checked by
applying Augmented Dickey Fuller (ADF) test. This test is conducted by adding
the lagged values of the dependent variable and it consist of estimating the
regression equation as:
Y_{t
}= β_{1 }+ β_{2}t + δY_{t1 }+ _{i}ΔY_{t1
}+ ε_{t}
For examining causal relationship between Gross
Domestic Product and Public Debt, Granger’s causality analysis (1969) was
performed. As per Granger’s causality theorem, a time series {Y_{t}} is
said to be caused by a time series {X_{t}}, if forecasts of variable Y
using both the lagged values of Y and the lagged values of some other variable
X are superior to the forecasts obtained by using past values of Y alone. In
the same way, if past values of Y improve the forecasts of X in the presence of
past values of X, then Y is said to Granger cause X. The test involves the
estimation of following two regression equations:
Y_{t = } +
+
……………… (1)
Y_{t} = +
+
……………... (2)
Where the disturbance terms u1t and u2t are assumed
to be stochastically independent. Now four alternative cases could be
distinguished:
1.
If σ^{ 2 }(Y_{t} X_{t1}, Y_{t1}) <
σ^{2 }(Y_{t }Y_{t1}), then X is said to cause Y
(abbreviated as X Y). Here σ^{ 2} (Y_{t }X_{t1},
Y_{tj}) is the prediction error variance of Y based on past values of
X and Y, and σ^{ 2 }(Y_{t} Y_{t1}) is the
prediction error variance of Y based on its past values alone;
2.
If σ^{ 2 }(X_{t }X_{t1, }Y_{t1}) <
σ^{ 2 }(X_{t} X_{t1}) then Y is said to cause X
(abbreviated as Y X);
3.
If both the above outcomes occur simultaneously, there is feedback or bilateral
causality (abbreviated as X Y); and
4. If σ^{ 2 }(Y_{t} Y_{t1})
< σ^{ 2} (X_{t }X_{t1}) > σ^{ 2 }(X_{t
}X_{t1, }Y_{tj}), then the two series are not
temporally related (abbreviated as X ~ ~ ~ Y), meaning stochastic independence
among the series.
3.
If both the above outcomes occur simultaneously, there is feedback or bilateral
causality (abbreviated as X Y); and
4. If σ_{t} +β_{2}D+β_{3}V+u_{i} …
(2)
Where, G_{t }is gross domestic product, I_{t
}is gross investment, D_{ }is public debt or outstanding
liabilities of government, V is population growth and u_{i} is error
term.
4. Results and Discussion
4.1 Trends in Public Debt and Economic
Growth
It is first required to understand the behavior of
public debt before going for further analysis. Therefore, the trends in
government debt and gross domestic product have been analyzed. Table1 depicts
the trends in DebttoGDP ratio.
The continuous increase in the ratio implies
unsustainability of debt. Debt sustainability at the sub national level is much
more complicated due to the legislative mandates of central and state
governments. Many policies that effect economic growth & fiscal policy are
designed largely by central governments. Further, it depends upon macroeconomic
& financial market developments that are uncertain by nature. In the
literature of public finance, the issue of fiscal health of state governments
has been a priority area of concern. Borrowing being an easier alternative to
raising taxes or cutting expenditures; states have continued to borrow to a
greater extent. This has given rise to the problems of state’s indebtedness and
fiscal imbalances.
Sustainability of debt is an important tool to
assess the macroeconomic health of a country. Sustainability is a situation
when debttoGDP ratio reaches an excessive proportion. This ratio signifies
the fiscal health and sustainability of debt as it is clearly stated in the
previous literature that the declining trend of debt to GDP ratio implies
sustainability. For the present investigation this ratio has been calculated
from 198081 to 201213. The perusal of the table reveals that the debt/GDP
ratio in 2012 is higher than the initial level.
Table
1: Ratio of Public Debt to Gross Domestic Product during different years
Year

PD/GDP

Year

PD/GDP

198182

27.29

200102

41.79

198586

30.81

200506

40.18

199192

31.12

201011

37.24

199596

29.27

201213

38.78

Source: Author’s own calculations by
using data available in Indian Public Finance Statistics, 201213.
Furthermore, the figure 1 shows the clear picture of
volume of central government debt over a period of 32 years i.e., from 1981 to
2012. There has been continuous increase in the volume of government debt in
India. It is 39 percent of Gross Domestic Product during 201213. India’s
public debt has been increasing since 1980s. As per RBI statistics, India’s public
debt increased from 32.1 percent of GDP in 1952 to 71.4 percent in 200102. The
major increase in public debt was due to the increase in domestic debt which
increased from 30.8 percent in 1952 to 68.2 percent in 200102.
Figure
1
Source: Author’s own calculations by
using data available in Indian Public Finance Statistics, 201213.
4.2. Economic Growth, Public Debt and
Investment
Various studies
available in literature show a mixed impact of public debt on economic growth. How
public debt is affecting the macroeconomic variables like income, interest and
investment etc; is an issue which has not been considered much. The various
factors that affect economic growth are (1) Private saving (2) Public
investment (3) Total Factor Productivity (TFP) and (4) Sovereign long term
nominal and real interest rates.
For the present paper,
Granger’s Causality analysis and Regression analysis has been carried out. Both
the tests are based on times series data. Time series data analysis has the underlying
assumption of stationary data. Therefore, the testing of stationarity is the
basic requirement for time series data. In the present analysis, Augmented
Dickey Fuller test is applied for all the variables by taking Null hypothesis
as ‘presence of unit root’ (i.e, presence of non stationarity). If the absolute
computed value exceeds the absolute critical value, then, we reject the null
hypothesis. And conclude that series is stationary and vice –versa. The
variables under study are public debt, gross domestic product, gross investment
and population growth. All the variables are expressed in logs. Here, log_PD_
is the log value of Public debt, GDP is the gross domestic product, and INV is
the gross domestic capital formation. The variables are not stationary in
levels at 5 percent level of significance. Therefore, all the variables are
differenced once and Augmented Dickey Fuller test is conducted. The results of
the test are shown in the Table no. 2
Table
no 2. Result of Unit Root Test
First difference and Intercept alone

Variables

Absolute Computed value

Absolute Critical value (5% level of
significance)

log__PD_

5.715

(2.963)**

log_GDP

3.077

(2.963)**

log_INV

6.161

(2.963)**

Pop_growth_rate

5.197

(2.967)**

Source:
Author’s Estimation using Eviews 7.0. Note:
* indicates the significance at 5 %.
The table reveals that
all the variables are stationary at first difference and intercept. Therefore,
it can be concluded that the variables are stationary.
To analyze the relationship between economic growth
and public debt Granger’s causality analysis has been carried out which
provides us the evidence of no causal linkage between the two variables.
However, the correlation coefficient is 0.99.
4.2.1 Public Debt and Investment
In case of developing economy like India where
Public debt is an important source used for planned investment. It will be
imperative to first go for analyzing the relationship between public debt and
investment. For this it is hypothesized that investment is determined by the
economic growth of the economy, population growth and public debt.
I_{t }=
β_{0}+β_{1}G+β_{2}D+β_{3}V+u_{i
}…. (1)
Where, I_{t }is investment, G is economic
growth, D is the government debt and V is the population growth rate and u_{i}
is the error term. The variables have been expressed in log terms. To estimate
the relationship between public debt and investment, the equation has been
estimated using the principle of ordinary least squares.
Table
no.3: Regression results
(Heteroskedasticitycorrected,
using observations 19812012, (T = 32) Dependent variable: log_INV_)
Variables

Coefficient

Std. Error

tratio

pvalue***

Const

1.02999

0.169483

6.0773

<0.00001**

log__PD_

0.309234

0.119157

2.5952

0.01488***

log_GDP_

0.809615

0.125785

6.4365

<0.00001***

pop__Grwth_rate

0.0724246

0.0340747

2.1255

0.04250**

(Source: Author’s
calculations using Gretl software)
A perusal of the results of first regression
equation provides us with the econometric estimates where public debt is
associated with investment. The results show the positive and statistically
significant relationship between investment and public debt (at 3 percent level
of significance). One percent point increase in public debt is associated with
0.30 percent increase in investment. The results indicate that public debt
effects investment in a positive manner i.e., if the resources generated
through public debt is used for productive purposes then it will not affect the
investment harmfully. Other variables like GDP and Population Growth also
affect investment significantly. But the relationship is negative in case of
population growth (at 5 percent level of significance). However, the
relationship of GDP with Investment is positive and significant.
4.2.2 Public Debt and Growth
Next step is to analyze the effect of public debt on
economic growth. We found evidences from the previous theoretical literature
for the effect of public debt on economic growth. Here it is hypothesize that
the economic growth or GDP will be determined by the public debt, investment
and population growth rate.
G_{t} =
β_{0}+β_{1} I_{t} +β_{2}D+β_{3}V+u_{i
}.... (2)
All the variables are expressed in log terms. Here
OLS method has been applied to investigate the relationship between economic
growth and public debt.
Table
no. 4: Regression results
(Heteroskedasticitycorrected,
using observations 19812012, (T = 32) Dependent variable: log_GDP_)

Coefficient

Std.
Error

tratio

pvalue

Const

0.936642

0.0698313

13.4129

<0.00001***

log__PD_

0.394279

0.0348957

11.2988

<0.00001***

pop__Grwth_rate

0.0557864

0.0165394

3.3729

0.00219***

log_INV_

0.515598

0.0314635

16.3872

<0.00001***

(Source:
Author’s calculations using Gretl software)
Now the interpretation of second regression equation
gives us the estimates where public debt is associated with economic growth.
Here also results depict the positive and significant relationship between
public debt and economic growth. All the three independent variables have
positive and significant association with economic growth. One percent point
increase in public debt is associated with 0.39 percent increase in GDP. Public
debt and investment have positive and significant relationship with economic
growth (at 0.1 percent level of significance) and population growth rate has
positive and statistically significant relationship with economic growth (at 1
percent level of significance).
5. Conclusions and Policy Implications
In the present paper, an attempt has been made to
investigate the empirical relationship between economic growth and public debt
in India. The relationship between public debt and various economic policy
indicators is well discussed in international research studies; but in Indian
context, it is not much focused. There has been contrasting views of the
economists on the relationship between public debt and economic growth.
From the analysis of the trends in public debt and
Debt/GDP ratio it is very much clear that there has been continuous rise in
Public debt. As far as relationship between economic growth and public debt is
concerned, no causal relationship was found between them. But there was an
evidence for the indirect relationship between public debt and economic growth through
investment. Public debt was detected to be affecting the economic growth
significantly. Also a statistically significant relationship between public
debt and investment was found. The relationship of public debt turned out to be
positive with both the variables. The positive relationship indicates that the resources
being generated through debt have been used productively. It is clear from the
fact that debt affects the investment positively; and investment and debt both
affect GDP positively.
The positive and significant relationship implies
that with rise in public debt there will be increase in investment and thus through
investment it will lead to economic growth indirectly. However, it does not
imply that there should be a substantial rise in the government debt because it
may lead to various financial problems if the debt is not used productively. Another
side of the story is the cost of servicing debt. It is also an important aspect
and no government can go for raising debt to an unlimited extent as it poses
the problem of financial instability for the economy. The rapid building up of
public debt of central government may give rise to the emergence of several
critical issues.
It has already been discussed that there are
contrasting views regarding the impact of public debt on economic growth, the
present study provides us the evidence of positive indirect relationship
between public debt and economic growth via investment. Keynesian theory of
public debt also relies on the positive aspect of public borrowings. Thus, the
present study supports the Keynesian ‘no burden’ thesis. But the complete
reliance on public debt for the investment is not a good alternative.
Therefore, there is a need to take measures not to raise debt but to channelize
the resources in the productive direction too.
References
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(2006). Public Finance, Transaction publishers, 2006.
Easterly,W.
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(2010). Total public debt and growth in developing countries. European
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