Although there is a large body of literature on the effects of public debt on capital accumulation and growth in industrialized countries—dating to Diamond (1965) on the welfare effects of national debt, and Barro (1974) on debt neutrality—the study of public debt and growth in lower-income countries (LICs) and emerging markets (EMs) has mostly happened in the narrower context of external debt.1 The debt Laffer curve literature a la Sachs (1989) and Husain (1997), and empirical investigations thereof—including most recently, by Pattillo, Poirson, and Ricci (2002)—have all concentrated on the growth impact of “external” debt. Even here, the focus has been the country’s total external debt, rather than its publicly owed counterpart.
Indeed, little formal academic or policy interest has been shown in understanding the possible relationship(s) between public “domestic” debt and economic growth in LICs and EMs.2 Although some work on local bond markets has been initiated by EMs and international financial institutions of late, this predominantly reflects a response to the East Asian financial crisis, which was seen as stemming from, inter alia, weak financial markets and an excessive reliance on bank-intermediated external finance. The arguments made in this literature focus on the benefits of local bond markets generally and, while the role of government bond markets is stressed, the implications for domestic debt, as a whole, and/or fiscal financing strategies are neither clearly derived, nor highlighted.
Consequently, surprisingly basic fiscal and public debt policy questions have remained unanswered to date, such as: Is there a causal link between domestic debt and growth in general, and, in LICs and EMs specifically? Controlling for endogeneity, does domestic debt contribute to economic growth? If yes, what are the relevant channels: financial development, capital accumulation, investment efficiency or institutional? Is the impact linear or nonlinear? If nonlinear, can a notion of an optimal (growth-maximizing) domestic debt share in GDP or deposits be developed? To what extent might such “optimal share” calculus depend on the quality of the underlying debt, or the macroeconomic, financial sector and institutional environment obtaining in a country?
Such questions are more pertinent than ever given the increased scope for expanding domestic debt in many LICs and EMs following external debt reduction initiatives and a surge in international portfolio interest in local currency bond markets. A meaningful policy response, however, remains constrained by a dearth of comprehensive empirical studies that examine domestic debt’s impact on savings, investment, financial deepening, institutions and, hence, growth.
The lack of interest in formally studying the impact of domestic debt on growth could be attributed to (1) data unavailability—reliable datasets on domestic debt either do not exist or are not amenable to empirical analysis; (2) a wide-spread perception that domestic debt is “endogenous” rather than an exogenous policy choice variable that governments can tweak to affect macro-financial outcomes: countries’ domestic debt issuance capacity is “determined” entirely by their level of income, pool of savings and institutional quality; and (3) the relatively small size of domestic debt relative to external public debt in most LICs and EMs. These factors have, arguably, combined over the years to “crowd out” the amount of attention paid to domestic debt.
The aforementioned “attention deficit” has, however, not prevented policymakers from taking a strong view on the desirability, or otherwise, of domestic debt in developing countries. In most cases, policy advice from international financial institutions has sought to limit the accumulation of domestic debt through zero or negative net domestic financing conditionalities. Shallow financial markets, financial repression propensities and poor debt management capacity, which are found in many LICs and even some EMs, have led to the belief that domestic debt expansion will have significant negative implications for private investment, fiscal sustainability and, ultimately, economic growth and poverty reduction. In addition, given that many LICs have access to very cheap external finance, in the form of concessionary loans and grants, the idea of borrowing domestically at market rates appears expensive. In summary, low domestic debt issuance has been generally considered beneficial for economic development.
In recent years, however, some researchers have begun to echo the positive view of many market participants regarding the importance of domestic debt instruments for monetary and financial systems, as well as the development of political institutions. Compared to other forms of budgetary finance, market-based domestic borrowing is seen to contribute more to macroeconomic stability—low inflation and reduced vulnerability to external real and domestic monetary shocks—domestic savings generation and private investment. This seems to be supported by the experience of fast growing EMs such as China, India and Chile, which have maintained relatively low external indebtedness and avoided major financial or fiscal crises.3
The objective of this paper is to fill this void in the literature by bringing together the various arguments for and against domestic debt issuance currently scattered across the literatures on capital markets, public finance, debt management and fiscal sustainability (Section I); compiling a new domestic debt database spanning the period 1975–2004 for 93 LICs and EMs, as well as consolidating existing databases on domestic debt (Section II); using panel econometric techniques to examine the endogeneity of domestic debt and its impact on growth with a view to obtaining a sense of the optimal size and quality of domestic debt (Section III); and presenting empirically-grounded policy conclusions on domestic debt to guide macro-financial practitioners, especially in LICs (Section IV).