THE RELATIONSHIP BETWEEN EXTERNAL DEBT AND ECONOMIC GROWTH: EMPIRICAL EVIDENCE FROM ETHIOPIA

The study analyzed the relationship between external debt and the level of Economic Growth in Ethiopia for the period 1981/82 – 2014/15. Johansen co-integration test and Vector Error Correction Econometric Technique was applied by using data obtained from the National Bank of Ethiopia and Ministry of Finance and Economic Cooperation. Empirical results revealed that there was an indication of the “debt over-hang” problem and ‘crowding out’ effect of debt service, while the current external debt had a positive impact on real GDP growth during the study period. This is because the high accumulated debt would act as a dis-incentive to capital formation and the low level of domestic investment in the real sectors of the economy was not able to made positive impact on growth. Moreover, the payment on external debt soaked up resources obtained from loan and other sectors of the economy that otherwise channeled to development purpose, to serve pressing debt as returns from investment took a long time.

Nevertheless, to the extent that there is high resource gap between domestic saving and domestic investment in the country, to achieve some growth target, government may be forced to finance the gap by borrowing. However, as dependency on foreign resource is both risky and unreliable, the government should strengthen policies that encourage increased domestic saving, raise export earnings and create conducive environment for the inflow of foreign direct investment to finance the development activities. To reduce the “debt overhang” problem and crowding out effect of debt service on investment the government should pay debt on time and there should also be wise and proper utilization of foreign resources by investing on selective and productive investment.