THE EFFECTS OF INSTITUTION ON DEBT SUSTAINABILITY FOR LONG RUN ECONOMIC GROWTH AND DEVELOPMENT: EVIDENCE FROM LOW AND MIDDLE INCOME COUNTRIES

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UNIVERSIT

À

DI PISA E SCUOLA SUPERIORE SANT’ANNA

LAUREA MAGISTRALE IN ECONOMICS

The Effects of Institutions on Debt-Sustainability for

long run economic growth and development: Evidence

from Low and Middle-Income Countries

Candidato

Relatore

Ismaila Y. Jammeh Prof. Neri Salvadori

This dissertation is submitted in partial fulfillment of the requirements for a Master of Science degree in Economics

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Abstract

This study seeks to understand the effect of institutions on debt sustainability in low- and middle-income countries (LMICs). This is motivated by rising government debt levels due to the COVID-19 pandemic and China’s Debt-Trap Diplomacy which has undermined the sovereignty of many LMICs.

The study proposed a dynamic debt model which relates the ratio of debt-to-GDP as a function of interest rates, exchange rate, primary budget balance, institutions and a vector of controls such as inflation and foreign currency reserves, whereby the ratio of debt-to-GDP measures debt sustainability and the interest rate measures the cost of debt. It also includes the lag of the ratio of debt-to-GDP to capture the debt dynamics in LMICs. To estimate the model, I used an annual data from the WDI from 2005 to 2018 for a total of 135 countries which gives a total of 1890 observations to estimate the effects of institution on debt sustainability in LMICs. To check the robustness of the effects of institutions on debt sustainability in LMICs, I also used institutional data from the WGI.

Moreover, I also make a pre-estimation analysis to understand the nature and distribution of the collected data so as to identify the most appropriate estimation for accurate and reliable result for statistical inference.

The results show that having institutions is not enough to achieve debt sustainability, these institutions must be active in controlling corruption and improving transparency and accountability in the public sector. In the absence of active and strong institutions to ensure transparency in contracts, debt statistics and allocation, public debt are more likely to be embezzled and use for non-productive programs especially during election cycles.

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Keywords: Institutions, Debt sustainability, Low- and middle-income countries, Debt distress,

Economic growth and development, Pairwise correlation, Private property rights, Human capital development.

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Dedication

In greatest honors, I dedicate this piece of work to my siblings; Isatou, Kebba, Samba, Omar, Yunus, the late Sirreh and my parents; Muhammed and Amie Jammeh for their tremendous efforts to make sure that I have the privilege to be educated, which most children of my age in Africa do not have and Gambia in particular, and their sacrifices in making sure that I have quality education. which make it possible to excel in the academics.

Acknowledgement

I would thank my supervisor Prof. Neri Salvadori for his valuable time and efforts in reading and commenting on the draft of the entire dissertation and thus providing step by step guidance and extensive feedbacks which greatly helped to improve the quality of this dissertation.

Am also grateful to all my Professors at the University of Pisa and Sant’Anna School of Advanced Studies, University of Aveiro and the University of the Gambia for giving me the academic knowledge to write this dissertation.

Special thanks to Prof. ssa. Elizabeth Pereira and Prof. ssa Anabela Botelho of the University of Aveiro (Portugal) during my Erasmus studies, gave me the knowledge to independently conduct research and thanks to the University of Pisa and the European Union for making it possible. My appreciation also goes to William Gomez for his valuable time, efforts and help in statistical computing knowledge in making sure that I have accurate results. And to all my friends at the University of Pisa and Sant’Anna School of Advanced Studies for giving me the confidence and their contributions to improve the quality of this dissertation.

I am highly indebted to my brother Dr. Kebba Jammeh, who encourage me to study economics during my undergraduate studies then in many ways supported and financed my undergraduate

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I will not do justice if I do not thank the Agenzia Regionale Diritto allo Studio Universitario-DSU Toscana for the accommodation, meals, tuition fees and stipends which make it possible to complete my studies.

Finally, I thank Allah (SWT) for giving me life, health, strength, patience and the non-visible skeletal system that makes me agile. Agile enough to climb mountain of snows, having intensities equivalent to that of six feet of snow.

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List of abbreviations

CIA Central Intelligence Agency DSA. Debt Sustainability Analysis DSF Debt Sustainability Framework

EU European Union

GDP Gross Domestic Product

HIPC Heavily indebted Poor Countries IMF International Monetary Fund LICs Low-Income Countries

LMICs Lower and Middle- Income Countries MICs Middle-Income Countries

OECD Organisation for Economic Co-operation and Development R & D Research and Development

SMEs Small and Medium Enterprises WDI World Bank Development Index WGI World Bank Governance Indicators

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CHAPTER ONE

INTRODUCTION

1.1 Background

Borrowing, both by governments and private entities, is widely used to make up for short-term revenue shortfalls and to finance investment projects needed to support sustainable growth. Governments also borrow to conduct countercyclical fiscal policy and cushion the economy from internal and external shocks. Sustaining growth and development has been a fundamental policy objective for governments, international development organization and policy makers around the world. Government borrowings to finance development projects and programs are crucial drivers of long-run economic growth and development by creating jobs and smoothening consumption across generations. At the same time, economic growth increases governments’ revenue base to finance current and future expenditure requirements and to meet debt obligations. Despite its importance, high debt burdens can hinder growth and development if debt is not well and properly managed.

Many policy makers and researchers believe that public debt sustainability is a necessary condition to achieve sustainable development.1_{Unsustainable debt accumulation affects government’s}

ability to finance productivity and social projects and programs in education, health and needed infrastructure due to rising cost of debt servicing. It is generally accepted that higher level of debt maybe sustainable and needed to keep the economy in motion as long as the rate of economic growth is more than the rate of interest on debt. This is because the economy can effectively grow its way out of debt at no fiscal cost. However, with the ongoing COVID-19 pandemic, the risk of

1_{“Debt is sustainable if a borrower is expected to be able to continue servicing its debt without an unrealistically} correction to the balance of income and expenditure” (IMF, 2020, p.4).

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debt default is increasing due to low levels of growth registered in many developing and developed countries. Nonetheless, the COVID-19 pandemic has forced countries around the world to borrow and spend in unprecedented rates due to widespread disruption in economic activity and falling government revenue. Thus, the pandemic will keep the economies of many LMIC in debt distress due to growing government borrowing in the face of weak growth to cushion their economies from adverse demand and supply shocks resulting from the pandemic. To reduce the impact of COVID-19 on debt sustainability in low- and middle-income countries (LMIC), the World Bank, International Monetary Fund (IMF) and other multilateral lenders are providing concessional funding to governments to keep their economic activities on track and enhance economic growth. Moreover, G20 creditors have also granted debt moratorium to poor countries due to falling government revenues and private capital inflows to these countries. Bulow et al. (2020) noted that the ability of governments and multilateral lenders to have access to better tools and policies to navigate a wave of restructuring depends on the quality of available institutions.

Institutions have important role on debt sustainability for long-run economic growth and development. Public debt spurs economic growth and become more sustainable if debt is used to fund productivity investments that benefit citizens. In the absence of good institutions to ensure transparency in contracts, debt statistics and allocation, public debt are more likely to be embezzled and use for non-productive programs especially during election cycles. Gunduz (2017) explained that the lack of good and stable institutions has a greater probability of causing debt crisis as a result of low productivity growth creating adverse shocks in the economy. In order to achieve a sustainable debt, the availability of proper institutions will determine the formulation of effective policies and act as a driving factor that will manage the allocation and distribution of the debts in sectors that will yield greater productivity, promote investment and innovation. Public debt is

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sustainable if institutions ensure that public officials respect government intertemporal budget constraint.

This study seeks to understand the effects of institutions on debt sustainability in low- and middle-income countries (LMIC). The study will provide empirical evidence on the role of economic institutions in the sustainability of debts to support economic growth and development in the long run. I will give special attention to the role of institution on debt sustainability in Africa given the development challenges that the continent has been facing despite rising debt levels. Africa still cannot achieve an economic growth and development that is sustainable even though the amount of debt is still raising. African leaders have been accused of using the

COVID-19 pandemic as way to borrow in order to enrich themselves. Others have argued that multilateral lenders and foreign governments should put in more efforts to promote transparency in debt statistics and contracts, if they aim to promote growth in these countries. This has been particularly important in China’s Debt-Trap Diplomacy, a concept used by Chellaney (2017). This refers to loans provided by China to developing countries to finance their infrastructural development and when these countries are unable to pay the loans obligations, China can demand economic or political concessions in exchange for debt relieve.

which is becoming a major problem for many developing countries especially African countries, which are in a high risk of debt distress creates unsustainable debt and undermines their sovereignty.

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1.2 Purpose and Significant of the study

The management of debt, both domestic and external, is a very important topic in both developed and developing countries. As a result, the IMF and the World Bank jointly developed a framework for conducting public and external debt sustainability analysis (DSA) in low-income countries in 2005. The aim of the framework is to guide the borrowing of low-income countries, guide creditors lending and grants allocation decision and thus improve the World Bank and IMF assessment and policy advice when crisis is about to occur (DSF, 2005). A similar debt sustainability analysis model was developed for middle income and emergent market economies.

Nonetheless, debt stock and debt service have been increasing in low- and middle-income countries. Figure 1 shows that public debt stock as a share of GDP has increased from 40 percent to 50 percent in 2018. Debt service burden also increased by five percentage points during the same period.

Figure 1: Debt and Debt Service in Low- and Middle-Income Countries (in percentage)

Source: World Bank Development Indicators

0 2 4 6 8 10 12 14 16 0 10 20 30 40 50 60 70 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 De bt S er vi ce (% ) De bt S to ck (% )

Total Public Debt (% GDP) External debt stocks (% of GNI)

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In addition to increasing debt stocks, the composition of public debt has also been changing in LMIC countries. The composition of public debt in LMIC countries has been changing due to the growing importance of commercial debts in the form of Eurobonds and loans from non-Paris club members such as China. China’s Debt-Trap Diplomacy increases the risk of debt distress in LMIC countries and undermines the sovereignty of countries such as Zambia, Sri Lanka, and Djibouti. Sri Lanka handed over part of its port to state-owned Chinese companies and Zambia is in negotiation for Chinese companies’ takeover of owned electricity company, airport, state-owned television and radio stations due to the government’s inability to pay the high debt stock and increasing cost of debt servicing.

One of the most contributing factors to the debt crisis is LMIC countries is institutional factors such as corruption, poor education, political instability and lack of private property rights causing an uncertainty for foreign direct investment and establishment of SMEs which are the drivers of competitiveness, innovation, economic growth and development. Easterly (2001) examined the role lack of economic growth will play in developing countries debt crisis and found that a lack of economic growth reduces the incentives for further investment. Mauro (1995) and Barro (1997) argue that investment and long run sustainability growth is possible if there are good economic institutions. The quality institutions will formulate good economic policies that will promote human and physical capital accumulation which increases the

efficiency of the production inputs and thus leading to larger production and employment. As the production level and employment increases, the consumers will have enough income to spend (i.e., their marginal propensity to consume will increase). This increasing in consumers spending will act as incentives for further investment by firms and the government will collect more tax

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revenues than its expected expenditures and pay it creditors with the remaining revenue collected.

The purpose of this dissertation is to empirically examine the impact of quality institutions on debt sustainability. This is very important since it will help us understand how the quality of institutions will affect debt sustainability in order to achieve a long run economic growth and development. Over the past decade, the amount of debt has been increasing in many developing and emerging market economies faster than the rate of poverty reduction in these countries. Understanding the institutional requirements to stabilize the level of public debt is very important to better understand how debt can be utilized to spur economic growth and reduce poverty. This is particularly important during and post COVID-19 given the rising public debt and the growing importance of debt sustainability for economic growth and development. A similar path was observed in the aftermath of the Global Financial Crisis, when advanced countries faced a tremendous increase in Public Debt- to- GDP level by approximately 30 percentage point from 2007 to 2012 (IMF, 2017). This significant increase of Public Debt-to-GDP ratio in advanced countries started at the end of the stagflation period of 1970s where most advanced economics Central Banks engaged in disinflationary policies which implies a severe increase in interest rates while the growth rate of real GDP remains stagnant/slow down. As a result, institutional requirements to stabilize the level of Public Debt became a significant research agenda by Economists and Policymakers in macroeconomics to better understand economic growth and development.

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1.3 Objectives of the study

The main objective of this study is to show empirically that the quality of institutions plays a pivotal role in the sustainability of debt in order to achieve a sustainable economic growth and development. To achieve this, I will empirically examine

• the contributions of public sector management and institutions to debt sustainability.

• how transparency, accountability, and corruption in the public sector impact on debt sustainability.

• How debt sustainability can be achieved by proper management of public resources.

• the importance of good and stable macroeconomic environment on debt sustainability.

• the fundamental impact of economic growth on the sustainability of debt; and • how changes in the prices of debt, measured by real interest rate and exchange rate fluctuations, affects debt sustainability in low- and middle-income countries.

1.4 Research Hypothesis

The research hypothesis is a statement about the prediction of the outcome of the study which is used to test the relationship between two or more variables. This research will use two types of hypotheses: the null and the alternative hypotheses. Our Null Hypothesis is denoted by H0 and the Alternative Hypothesis is denoted by H1. These two hypotheses will be used to answer my research questions by testing the hypothesis. If the null hypothesis is rejected, then the alternative hypothesis will be accepted, and vice versa.

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1. H0: Improved transparency and accountability, and lower corruption in the public sector do not affect debt sustainability

H1: Improved transparency and accountability, and lower corruption in the public sector affect debt sustainability

2. H0: Public sector management and institutions, do not affect debt sustainability.

H1: Public sector management and institutions, do not affect debt sustainability.

1.5 Contribution

This study is geared toward understanding how institutions can affect debt-sustainability, focusing on low- and middle-income countries. Several researchers have studied the effects of debt on economic growth. Studies such as Vanlaer et al. (2015), Baum et al. (2013), Reinhart and Rogoff (2010), and Cecchetti et al. (2014) focus on OECD countries while Checherita and Rother (2010) examines the effect of debt on GDP per capita in the EU area. Similarly, Essl et al. (2019) investigated the evolution of debt in low-income countries and Arnone et al. (2005) studied the different channels to achieve external debt sustainability in highly indebted poor countries (HIPC). Several studies have shown than increasing the amount of debt is not a tangible solution to achieve a debt-sustainability. Cecchetti et al. (2014) argued that if poor institutions adversely affect economic growth because government have limited revenue to finance development projects and to meet its debt servicing obligations due to corruption. Furthermore, Matemilola et al. (2016) focused on how legal origin affect debt in developing countries and many researchers such as Acemoglu and Robinson (2010), Beck and Laeven (2006), and Berggren et al. (2015) investigated the impact of institution on economic growth. Nonetheless, only a handful of researchers studied

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the effects of institutions on debt sustainability. For example, Gunduz (2017) studied the causes of debt distress and the role of institutions in low-income countries and found that weak institutions will increase the probability of debt distress by formulating weak economic policies which will result to external shocks in the economy.

To the best of my knowledge, none of these researchers conducted a study on how institutions affect debt sustainability by comparing countries from different income gaps. This needs to be done and explained to have a clear understanding of the divergencies between countries across different income level in term of the role of institutions on debt sustainability. In that regard, this research will focus on both low-income and middle-income countries using a sample of countries from each income group across continent in order to control geographical/cultural factors. Countries in the same continent might have similar institutions, and/or cultures, so that we can isolate how differences in institutions across income levels affect debt sustainability.

Debt and institution have been a major obstacle for the growth and development in many African countries, which is endowed with vast natural resources. This debt distress is major setback for the increasing in savings and investment in the continent without which economic growth and poverty cannot be overcome and this lack of sustainability especially in low-income countries will cause lenders to be skeptical to lend and/or at a higher interest rate.

CHAPTER TWO

LITERATURE REVIEW

There have been remarkable contributions on the impact of institutions on debt sustainability and growth; how debt sustainability can be achieved and the impacts of not fulfilling debt conditions. However, no researcher has conducted a study on how institutions affect debt sustainability by

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comparing countries from different income gaps. To fully understand the effects of institutions on debt sustainability across income groups, I start by giving a comprehensive view on different perspectives on debt sustainability and the impact of institutions on debt sustainability.

2.1 Theoretical Background

Borrowing is fundamental to development and it is one of the ways of raising funds for development. However, too much of borrowing can harm the economy and the future generation by sacrificing development projects to pay its debt obligations. Debt may arise when a government receive revenue less than what it supposed to spend, which causes a budget deficit. Deficit spending can be financed by borrowing from banks, private bonds holders, foreign countries and multilateral lenders such as the World Bank. The more the government runs a budget deficit, the more it will be willing to borrow in order to finance its expenditure, thereby accumulating more debt. This has a negative impact on the long-run performance of the economy if the government is unable to pay its debt on the stipulated time. Thus, increasing default risk and the interest rate on the debt. Hakura (2020) explained that countries that default from debt payment obligations often loss market access and suffer higher borrowing cost which in turn affects their ability to borrow, harm growth and investment.

There are two concepts in the debt sustainability literature that deserve to be clarified: the concept of solvency and liquidity. Whereas solvency means a debtor can have enough funds in the future to cover its debt without accumulating more debt, liquidity implies that a debtor will be able to have enough funds to finance each period to close its financing gap without disruptive adjustment (Wyplosz C., 2011).

There are several factors that determine a country’s ability to carry debt i.e., the amount of debt a country can hold before it becomes unsustainable. These factors include the quality of institutions,

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primary deficits, nominal interest rate payment, exchange rate, inflation, and GDP growth, macroeconomic conditions and debt management capacity.

Rangarajan and Srivastava (2003) found that primary deficit and the difference between growth and interest rate are contributing factors to changing debt-to-GDP ratio. Increasing in public deficit increases public debt which will crowd-out private investment creating more deficits thereby reducing access to foreign borrowing and at a higher interest rate.

An increase in exchange rate also cause a fall in real GDP due to the fall in net export, domestic goods will be expensive to foreigner and raise import. This will affect GDP growth causing a primary deficit and accumulation of debt.

A country’s capacity to carry debt is also influenced by the global economic environment, which is exogenous, uncertain and changes over time. However, this dissertation will focus on the quality of institution on debt sustainability. Institutional qualities are factors that can determine the possibilities of paying its debt obligations by promoting productivity and economic growth. Using the funds borrowed in their productive uses such as investment will spurs growth, because the convergency theories postulated that countries with small initial capital stocks will yield higher returns from those investment projects which all lies on the quality of institutions. Gunduz (2017) mentioned that institutions which governs government activities in managing its economic and social resources, formulated good policies will increase efficiency within the economy and reduces the probability of adverse shock. Countries that have a better and quality institutions are more likely to promote innovation and boost productivity thereby creating employment opportunities for its people. Thus, increasing consumers spending and raise revenue for the government to finance its spending preventing future deficit in the economy.

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North (1991) postulated that institutions can be subjected to two constraints: informal and formal constraints. Informal constraints include code of conducts, tradition, taboos etc. while formal constraints include constitutions, laws, and property rights which are created by man in order to reduce uncertainty and promote order within the society. He further argued that these institutions create incentives structures in the economy. The more they evolve, the more they direct the economy towards growth, stagnation or deterioration. For instance, if there were no competitive laws that prevents collusion of firms in the market, firms would cooperate in fixing prices, which leads to higher prices, prevent other firms from entering the market, decrease product choice, discourage innovation and limits productivity in the economic. Hence, affecting consumers’ welfare and impede economic growth.

The importance of institutions on debt sustainability can be traced back to the argument that geography or culture are the reasons why some countries are rich while others are poor. For example, the path breaking studies by Acemoglu and Robinson (2001, 2002) make remarkable explanations why manmade institutions are the causes of divergences between countries. For instance, in 1944, South and North Korea where the same country with the same people, the same cultures, history, languages and geography. But in 1945, when they split, each took different economic system. North Korea took a centrally planned economic system where there is no private property right, no free press and isolated economy. On the other hand, South Korea took the capitalist economic system where there are property rights, democracy, open economy and a dependable legal system. After the political strife of 1961, which led to 10%-13% annual inflation rate and over US$300 million annual trade deficit when General Pak Chung-hue took office, he instituted development policies and institutions that emphasis on foreign trade and promote foreign investment which increases industrial output by 17% more than North Korea (CIA, 1972). After

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50 years, there is a big difference between them, South Korea’s GDP per capita is far more than North Korea’s GDP per capita and the standards of living in South Korea is equal to most western countries. In contrast, North Korea is still considered a developing country and it still cannot provide enough food to its people.

Their differences in institutions clearly explain their different growth path, and consequently debt carrying capacity. The present of property rights, free press, open economy and democracy creates incentives for investment in human and physical capital accumulation which create a high technological advancement and promote rapid economy development. An educated workforce helps to formulate and implement policies that promote international trade making them seventh largest exporter in the world, according to data from the International Trade Statistics. Due to quality institution, South Korea was able to grow faster than North Korea who has weaker institutions. From this study, Acemoglu et al. (2005) argued that a good institution creates effective property rights which promote incentives for people to invest, innovate and take part in economic activities. It also promotes investment in physical and human capital accumulation, and the more human capital develops, the more they will create better political institutions that will benefit the people and spread information about government misconducts thereby holding them accountable. Private property rights and dependable legal system protect citizens against the powerful elites which creates incentives for investment in the economy. Expectation plays a vital role in the economy, if people have the expectation that their private property rights are been preserved and protected, they will be willing to invest in the economy. All these factors contribute significantly to increasing a country’s debt carrying capacity and debt sustainability.

Political stability also plays a role in economic growth and development which is also in the World Bank’s governance indicators. Stable countries and economies create confident for both foreign

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and domestic investors to invest in the economy. Political instability also weakens institutions such as lack of rule of law and democracy, which have adverse effects on growth and development. Furthermore, even distribution of political power creates incentives for people to have interest in creating public goods and services. This is because people have the same opportunities of getting jobs and hold public officials accountable for embezzlement and mismanagement of public resources. This has far-reaching implications on the transparent use and allocation of a country’s debt funds. In the African continent where leaders create institutions that favors the elites, the distribution of political power among its people is not evenly distributed. This creates avenues to misuse public funds and funds from government borrowing. Low educational attainment is an important part of this story because the more the population are educated, the more likely they will demand the creation of proper institutions that benefit every member of the society.

On the impact of debt on growth, the Saltwater economists also known as the Traditional view of government debt argue that increasing in public debt will boost aggregate output in the short run but in the long run investment will reduce. The main tenet of the Saltwater economists is that when government lower taxes today, and faces a budget deficit, consumers’ disposable income will increase. By the Keynesian theory of consumption, household consumption will increase. By increasing aggregate demand, firms produced more and employed more workers. As a result, as investors compete for the small savings available, the rate of interest will also increase which increases the cost of borrowing. As interest rates increases, investment will decline due to the increasing cost of borrowing. In the long run, the low national savings as a result of government tax cuts lead to a lower capital accumulation in the economy. Thus, in the long run, debt offsets the short run increased in output. In this view, current generation would benefit from the tax cut

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consuming more and higher employment while the future generation faces the burden of the tax cut.

In contrast, the proponents of the Ricardian equivalent theory, which is based on Milton Friedman Permanent Income Hypothesis (PIH) and rational behavior of economic agents, believe that people think about the future burden of public debt and care about future generations. Thus, they will save some amount of money thus investment and economic growth will not be affected. They believed that economic agents are rational and forward looking, they will base their spending on their expected future income (from Friedman’s PIH the permanent income) and not on their transitory income only. Agents know that government tax cut today means that there will be higher taxes in the future. Therefore, the overall government tax cut in order to finance its debt will not affect the tax burden.

2.2 Relevant Empirical Evidence

The neoclassical growth literature (Solow,1956; Cass, 1965; Koopman, 1956) explain that difference in economic growth (and hence debt carrying capacity) between countries is due to the difference in factor accumulation which is trigger by differences in savings rate. Hall and Jones (1999) reveal that differences in institutions and government policies between countries is the cause of large variation in the accumulation of capital, education attainment and productivity growth leading to a large income disparity. Gunduz (2017) stressed that quality institutions help in formulating effective policies which will enhance productivity. Again, saving is a function of productivity and economic growth, if productivity increase consumers will have more income to consume and save. Similarly, Olson et al. (1998) found out that institutional factors have positive impact on productivity: countries with better institutions always have higher productivity while weak institutions increase transaction cost.

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Moreover, Acemoglu et al. (2002) and Moer (1999) found that the quality of institutions has larger effect on short-run than long-run economic growth. Mauro (1995) and Barro (1997) found that institutions are the key drivers of investment and long-term sustainable growth. Acemoglu et al. (2006) quantified that institutional components such as private rights institutions, which is a component of rule of law in the World Bank’s governance indicator, are the major drivers of long run economic growth, investment and financial development. Similarly, Rodrik et al. (2004) found that the rule of laws indicator has a positive effect on economic growth (and hence debt carrying capacity).

Besides, private property rights are not sufficient because those that have the power to enact those laws can also abuse those powers to expropriate property too. In the Gambia and many other African countries, governments excessively use theirs power to confiscate private properties such as lands for their own benefits. Therefore, independent judiciary and parliament systems are needed to provide checks and balance.

Rodrik (2000) mentioned that the existence of these democratic institutions will strongly contribute to the process of enforcing rule of law. The absence of such institutions may have negative impact on debt sustainability given that political authorities can misuse their power without accountability. This may lead to a conflict of interest and the use of government borrowed resources for their political gains. Voting them out will also be tedious due to the lack of institutional factors such as free press, civil liberties or public access to information, information sharing and freedom to protest.

Moreover, there has been contrasting views on the macroeconomic impacts of public debt. Some economists believe that a high public debt will lead to a higher long-term interest while others believe that a higher public debt will increase tax. Aizenman et al. (2007) found that higher public

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debt reduces public expenditures in the infrastructure. Vanlaer et al. (2015) conducted a study by observing the total debt levels of 26 countries in the short, middle and long term. They found a negative correlation between high levels of debt and short run economic growth but the effect of high debt on economic growth diminishes in the medium and long term. They also found that, fast increasing debt levels reduce economic growth in the short term but in the medium term they have a less impact while in the long term will not have an impact. Cecchetti et al., (2011) also conducted a similar study by using dataset on government, households and non-financial debt in 18 OECD countries for a period of 30 years. They found that a moderate level of debt will improve welfare and growth but if it’s too high will be damaging to the economy. They estimated that a threshold of around 85% of GDP on government and household debt and a threshold of 90% of GDP on corporate debt and beyond these thresholds, debt may be detrimental to economic growth if policy makers do not address their fiscal problem and keep debt below their estimated thresholds. Moreover, Sargent and Wallace (1981) and Barro (1974) pointed out that an increasing in public debt will lead to a higher inflation which lower economic growth by increasing the volatility in the economic. While Krugman (1988) found that increasing in external debt will affect private investment. He believed that debt would act as disincentive for foreign and domestic investor to supply more capital in the economy because they will expect financial instability government will likely raise taxes in the long run.

Checherita and Rother (2010) also argue that government debt can affect the economic growth rate through private savings, public investment, total productivity and sovereign long-term nominal and real interest rate. Their tenet is that it will affects private saving because the accumulation of public debt using the view of the saltwater economist as explained earlier affect the future generation by reducing the flow of income of economic agents and since the flow of income falls,

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private capital accumulation will also fall and decreases investment. Therefore, the increasing in the long run interest rate as a result of the fall in private investment lowers GDP growth resulting to a further increasing in debt.

Majority of the empirical studies conducted on public debt has concluded that higher public debt has a negative effect on economic growth. Checherita and Rother (2010) estimated that a 10% increase in the ratio of debt to GDP will reduce annual growth to 0.1-0.2 in percentage point on average. They found that the impact of government debt to GDP growth is a statistically significant non-linear relationship between government debt ratio and GDP per capita and there is a turning point which will occurs between 90 and 100% and if debt to GDP increases beyond this turning point it will have a negative impact on the long run economic growth.

Moreover, there are some researchers who believed that public borrowing could help stimulate the economic if it used for public investment which according to the golden rule of public finance borrowing is unfavorable only if the funds are used for current expenditures instead of investing in the accumulate public capital for the future generation which other economists such as (Blanchard and Giavazzi, 2004; Modigliani et al.,1998) supported the view. In contradiction to this above view, this may not be the case for most African and other low-income countries public borrowing can be invest in private investment but if there are poor institutions then will not be able to stimulate economic growth. The MRW model, explained that production is not determine only by the amount of capital but also on the accumulation of human capital and knowledge which governed the efficient use of the investment to produce a greater quantity of output and recently, technology and innovation are major cause of growth in the more advanced countries therefore there must be well establish institutions that will promote investment in human capital and innovation to achieve a growth that is sustainable.

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Dort et al. (2014) give evidence that investment will boost economic growth in countries which has strong institution. For instance, in the African countries, the Gambia as an example, were they are high rate of corruption those who are responsible for employing mostly employed family members, friends or relatives who are not competent and do not have the education and skill in executing their jobs leading to a lower aggregate output thus affect the economy performance in both the short and long run. This level of corruption can significantly have a positive impact on the increasing public debt as this politician can also use this borrowed fund to finance their flamboyant lives styles without nothing holding them accountable for their behaviors. Shleifer and Vishny (1993) argued that if the level of corruption is high in a country, it will lead to shifting of the funds borrowed away from the high value projects such as education and health and spend on defense and thus borrowing more than what is needed to spend in the economy. Paleologou (2013) military expenditure has significant effect on the growing government debt on 25 EU countries. Therefore, reducing military expenditure will be effective in lowering the growing government debt in this EU countries.

In the Gambia in 2014, the former government borrowed about millions of GMB dalasis to celebrate the day it took office which is unproductive and unaccountable spending with the lack of economic growth, the amount of debt exceeded total GDP growth leading to the accumulation of more debt in the economy which will harm the future generation development. The divergence between North and South Korea can also be explain by unproductive spending between the two countries. Where the former focus on spending in national defense while the later spend in R&D which stimulate innovation and economic growth.

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The increasing interest rate and debt has the tendency to increase the interest on debt (cost of debt). which often happen when the economy is growing, and this become problematic if debt grow relative to GDP. Institutions and policies that promote GDP growth will reduce the amount of debt. Therefore, to investigate the effects of institutions on debt sustainability, primary balance, exchange rate, GDP growth, interest rate and other control variables (such as inflation rate, foreign reserve, macroeconomic environment) on debt will significantly help to better understand debt sustainability as they have impact on productivity which promote growth in the economy.

CHAPTER THREE

RESEARCH METHODOLOGY

This chapter of the dissertation posits the empirical model, methods and data that were used to estimate the effects of institutions on debt sustainability. It thus includes the estimation procedures, tools and techniques, type of data and data collection sources as well as a description of the variables used in this study.

3.1 Model Specification

This section discusses the empirical model that is used to estimate the effects of institutions on debt sustainability in low- and middle-income countries. I propose a dynamic fixed effect debt model which relates debt sustainability as a function of interest rates, exchange rate, primary budget balance, institutions and a vector of controls such as inflation and foreign currency reserves.

The dynamic nature of the model (including a lag of debt-to-GDP) will help to understand how previous debt affect current debt. Ignoring the dynamic nature can lead to potential loss of

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important information, model misspecification bias in our estimation and the lagged of the dependent variable can also help control for many omitted variables.

This lag of the dependent variable might not be the main interest of the studies, but it is significant in order to obtain a consistent estimate of other parameters of interest.

The model can be econometrically presented as:

𝑫𝒆𝒃𝒕𝒋𝒕 𝑮𝑫𝑷_𝒋𝒕 = 𝝑𝟎+ 𝛀𝒋+ 𝝑𝟏.𝒓𝒋𝒕− 𝒈𝒋𝒕2 + 𝝑𝟐𝒆𝒋𝒕+ 𝝑𝟑 𝑷𝑩𝒋𝒕 𝑮𝑫𝑷_𝒋𝒕+ 𝝑𝟒𝑰𝒏𝒔𝒕𝒊𝒕𝒋𝒕+ 𝚷𝒄𝒁𝒋𝒕+ 𝜹𝒍 𝑫𝒆𝒃𝒕𝒋𝒕A𝟏 𝑮𝑫𝑷_{𝒋𝒕A𝟏} + 𝜺𝒋𝒕

where 𝑫𝒆𝒃𝒕_𝒋𝒕 refers to the total stock of gross public debt measured in the local currency of country 𝒋 at the end of period 𝑡; 𝒓_𝒋𝒕 and 𝒈_𝒋𝒕 are the real interest rates and growth rate on public debt country 𝒋 during period 𝒕, respectively; 𝒆𝒋𝒕 is average exchange rates (local currency per unit

of foreign currency) of country 𝒋 at period 𝑡; 𝑷𝑩_𝒋𝒕 refers to the primary balance (i.e., primary government revenues minus primary government expenditures) of country 𝑗 during period 𝑡; 𝑰𝒏𝒔𝒕𝒊𝒕_𝒋𝒕 is a measure of the quality of institutions in country 𝑗 at time 𝑡. The CPIA public sector management and institutions cluster and the CPIA transparency, accountability and corruption in public sector rating are used to measure the quality of institutions; 𝑮𝑫𝑷_𝒋𝒕 is the gross domestic product of country 𝑗 in time 𝑡; 𝛀E our country fixed effects; 𝜺𝒋𝒕 is a vector of standard error terms;

and 𝒁_𝒋𝒕 is a vector of controls such as inflation and foreign currency reserves to increase the robustness of our model.

It is important to note that we use the debt-to-GDP ratio 𝑫𝒆𝒃𝒕_𝑮𝑫𝑷𝒋𝒕

𝒋𝒕 as a measure of debt sustainability

in low and income countries (LMIC). Discussions of public debt dynamics are often centered around the debt-to-GDP ratio. A country’s GDP is an indicator of its capacity to service its debt. Furthermore, looking at the debt-to-GDP ratio facilitates comparisons of the level of indebtedness

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across countries. For example, if country A has more debt than country B, but country A also has a larger GDP and a lower debt-to-GDP ratio (everything else equal), we may be less concerned about indebtedness in country A. Given the low levels of debt carrying capacity in LMIC countries, higher shares of debt as a percentage of GDP signals higher risk of debt distress. The lag of debt-to-GDP ratio 𝑫𝒆𝒃𝒕_𝑮𝑫𝑷𝒋𝒕F𝟏

𝒋𝒕F𝟏, capture the dynamic nature of debt. Since countries with high debt-to-GDP

ratio in time 𝑡 − 1 are more likely to have high levels of debt-to-GDP ratio in time 𝑡, holding all factors constant. This implies that we expect the value of 𝜹_𝒍 to be positive.

Moreover, we use the interest rate to measure the cost of debt. Therefore, 𝒓𝒋𝒕− 𝒈𝒋𝒕 is the cost of

debt net of growth. This is because high economic growth offsets the load on debt servicing as it signals that debt is being used in productive investments which enhances a country’s ability to payback its debt. Hence, higher rate of interest increases the risk of debt distress and high growth rates lower the risk of debt distress, i.e., we also expect 𝝑𝟏 to be positive. Similarly, we included

exchange rate 𝒆𝒋𝒕 in our debt model because it reflects the cost of foreign debt. Foreign or external

debt are public debts that are denominated in foreign currencies. A depreciation of the local currency relative to foreign currencies, increases the cost of external debt which also increases the risk of debt defaults, i.e., 𝝑_𝟐> 𝟎. In addition, primary balance 𝑷𝑩_𝒋𝒕 measure the resources (or lack of resources) that a country can use to pay back its debt. A country with a primary surplus is more likely to service and payback its debt than a country with a primary deficit. This is because countries with primary deficits need to borrow to finance their budget. It is sometimes useful to evaluate public debt dynamics using the overall balance (primary balance minus interest payments) as a stand-alone component affecting debt. For example, many countries have written fiscal rules limiting the size of government’s overall balance, and one may want to know the implications of

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In this study however, the parameter of interest in the debt model specified above is 𝝑_𝟒 which measures the effect of institution 𝑰𝒏𝒔𝒕𝒊𝒕_𝒋𝒕 on debt sustainability. If 𝝑_𝟒< 𝟎, this means that quality institutions contribute to reducing debt distress in low- and middle-income countries. In contrast, 𝝑_𝟒> 𝟎, imply that institutions do not play meaningful roles in reducing debt problems in low- and middle-income countries. Rather, countries with higher quality of institutions tend to borrow more to finance government activities. Finally, 𝝑_𝟒= 𝟎, means that institutions have no impact of debt management in low- and middle-income countries, after controlling for the cost of debt, government financing needs and other macroeconomic variables such as inflation and foreign currency reserves.

There are no restrictions about which variables to use as an independent variable in studying debt but variables that’ll have impact on debt sustainability are ideal for accurate results.

Traditional debt sustainability analysis also focusses on how primary deficit respond to the amount of debt and other exogenous parameters such as growth, exchange rate and interest rate dynamics. Growth forecast are taken to be either constant or stochastic and do not depend on the amount borrowed unless if not use in investment purposes (Berg et al., 2012).

This dynamic debt model is similar dynamic debt model of Morsy et al., (2019). They studied debt sustainability by using variables such as nominal GDP, primary deficit, primary deficit to GDP ratio, nominal interest on debt, nominal GDP growth rate while neglecting the role of exchange rate and inflation. They believe that the ratio of debt to GDP depends on the dynamics interest and GDP growth rate which is also used in my debt model. Inflation, foreign reserve and the macroeconomic environment are used as control variables for robustness of our estimates.

Paleologou (2013) used military expenditure, real GDP per capita and the lag of debt to study the relationship between military expenditure and government debt. While Ahmed (2012) uses a

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system of two equations real external debt as a function of real expenditure, real domestic income, real export, real import and also express real domestic income as a dependent variable to investigate the relationship between external debt and economic growth in a sample of 25 Sub-Sahara African countries. Real export and import can be capture in the official exchange rate variable this is because an appreciation in the exchange rate reduces net export by slowing down real GDP growth. while military expenditures depend on the available institutions which determines the use of resources in their most productive sectors.

Therefore, the variables included in the econometric model above are significant in the study as they have direct or indirect impact on debt sustainability.

3.2 Data and Source of Data

To empirically estimate our debt model, we need data from low- and middle-income countries. The panel dataset used in this study was obtained from the World Bank’s World Development Indicators (WDI). The variables used are total government debt (% of GDP); lending interest rate (%); GDP growth (%); official exchange rate (local currency per US$, period average); net national savings (% of GNI); total reserves (% of total external debt); inflation as measured by GDP deflator (%); national expenditure (% of GDP).

The CPIA2_{public sector management and institutions cluster average (1=low to 6=high); and}

CPIA transparency, accountability, and corruption in the public sector rating (1=low to 6=high) are taken from the World Bank Development indicators (under policy and institutions).

According to the World Bank, the CPIA public sector management and institutions cluster average measures the quality of budgetary and financial management, efficiency in revenue mobilization, quality of public administration, accountability, property rights and rule-based governance and

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corruption in the public sector. While CPIA transparency, accountability, and corruption in the public sector rating measures the extent to which executive and public official are held responsible for misusing public funds and employees within the executive are required to account for administrative decision, use of resources and result obtain through electorate and by legislative and judiciary.

Breaking down the definition of these indicators according to the World Bank, corruption is measuring the ability by which public powers are used for private interest and not public interest and it includes both minor and major corruptions by elites. Corruption can range from trade restriction, embezzlement, illegal employment, price control and any rent-seeking behavior that benefits private individuals which reduces efficiency, loss and wastage of revenue and discourage investment; and thus, retard economic growth and debt sustainability. Public sector management includes the quality of public and civil services, government formulation and implementation of policies and the credibility of their commitment to the policies created as well as the degree of its independent from political pressures. Financial management and effective revenue mobilization are the effective and efficiency use of public resources in there most productive sectors.

Likewise, the rule-based governance captures the ability in which agents have confident and fairness in the judiciary system and abide by the rule of the society. In particularly, this includes intellectual property protection, property rights, equal treatment of foreigners before the law, and the existence of law and order and enforceability of contracts. Moreover, accountability measure the ability of citizens to participate in selecting government, holding public officials to accountable, political rights, open government and stable democratic institutions.

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All variables are in annual frequencies, stretching from 2005 to 2018 for a total of 135 countries. This gives a total of 1,890 observations to estimate the impact of institutions on debt sustainability in low- and middle-income countries.

These institution indicators are expected to have impact on long-term economic performances and the ability of governments to formulate sound and effective policies that have potentials to benefit debt sustainability. Kraay and Nehru (2006) found that policies and quality institutions that positively affect real GDP growth are likely to reduce the probability of debt distress. This is because poor institution will result to the formulation of weak macroeconomic institutions leading to adverse shocks in the economy. Easterly (2001) also argued that the lack of growth in low-income countries (LICs) also plays an important role in their debt problems. LICs and MICs differs in their policies and quality of institutions which makes LICs more vulnerable to debt distress. Poor governance systems in many LICs discourage investment and the lack of investment adversely affects sustainable economic growth due to low private and foreign investors. In the absence of solid institutions, increasing debt levels may lead to tax hike which negatively affects private investment.

The use of panel datasets will help to estimate the effects of institutions on debt sustainability in LMICs which will help to overcome endogeneity problem, since the fixed effect estimator will be able to control cross country and time series dimension of the data and it will also provide efficiency in the estimation by providing more informative data, more degree of freedom and more sample variability to make an accurate inference about the estimated parameters of the model (Hsiao, 2007).

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Moreover, a problem of using panel data is, it reduces efficiency if the time series dimension is small and if we consider countries from different geographic region, social and economic development (Paleologou, 2013).

But since this study focus on Low-and-Middle-income countries which have almost the same level of economic development and many of the LMICs are found in the same geographic region. Therefore, the study will not suffer from such weakness.

It is important to note that most of the studies conducted on institution and debt sustainability focus on low-income countries (Gunduz Y.B., 2017) and Euro Area (Checherita C. and Rother P., 2010). According to the World Bank, low-income countries are countries with GNI per capita of $1,035 or less. Lower middle-income countries are those countries that have GNI per capita between $1,036 to $4,045 while upper middle-income countries are those with GNI per capita between $4,046 to $12,535. The World Bank provides accurate, reliable and up-to-date data for both academic research and business research for all countries. These data help us to estimate our debt model in order to answer the research question: does institutions affect debt sustainability in low- and middle-income countries?

3.3 Estimation Method

Estimating the dynamic econometric model by OLS can be problematic since there are many country specific effects that cannot be observe and putting them in the error term would cause biased and inconsistent to our estimates if it correlated to any of the explanatory variables.

Therefore, dynamic fixed effect estimation allows to overcome this endogeneity problem, since the within group estimator is able to remove the country specific effect and the availability of yearly data will also provide more instruments to solve the problem.

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Moreover, estimating the dynamic panel model with fixed effect (subtracting each variable from its mean) may also lead to endogeneity problem since the idiosyncratic error may not be

correlated with the explanatory variables but the demean version can correlated with the lag of the dependent variable which will cause a downward biased in the coefficient of lag dependent variable which is called the Nickel bias (Nickel,1981).

There has been a contracting view in the existing literatures about which type of estimation technique to use in a dynamic panel model.

Anderson and Hsiao (1981) propose that taking the first difference transformation of the model and use a lag of the dependent variable at 𝑡 − 2 as an instrumental variable for the first difference. Arellano and Bond (1991) opposed that this technique will produce consistent estimate, but it will not be efficient because its failure to use all moment conditions. They use the differenced Generalized Method of Moment to remove the time invariant effect and use all feasible lagged values of the variables as an instrument which obtain more efficient and asymptotically consistent than the Anderson and Hsiao method. Blundell and Bond (1998) show that if the parameter of the lag dependent variable is persistent and close to being a random walk ( 𝛿L > 1).

Then the difference-GMM will be downward biased which happen when time period is small due to weak instrument, since the lagged of the dependent variable can be weakly correlated with the first difference. Therefore, they propose the system-GMM, which is a system of two simultaneous equations, one in level with lag of the first difference as instrument and the other first difference with lagged levels as instrument which produce better results than the Arellano and Bond estimator. The properties of GMM estimators are valid asymptotically because they are for micro data where spatial dimension is large which make them problematic.

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Since this study uses a dynamic fixed effect model with small sample, I used the estimation technique proposed by Kiviet (1995).

He proposed an approximation of small sample bias for LSDV estimators in balanced panel where N is small. The within group estimator in this method is more efficient than the GMM and Anderson and Hsiao techniques for small T and N.

Bruno (2005) solve the problem of Kiviet estimator by analyzing the performance of bias in unbalanced panel. By using the LSDV estimation method will be able to account for cross country specific effects that do not varies with time.

In order to estimate the effects of institutions on debt sustainability, the estimation strategy will involve three steps:

1) I performed a descriptive/summary statistic of the variables used in the study in understanding the effects of institutions on debt sustainability.

2) I also performed a correlation analyzing to know the relationship between the variables of interest.

3) Moreover, in estimating the model, I used both Total public debt and external debt as a dependent variable on the same explanatory variables to know the impact of these variables especially institution on external debt.

Total public debt is the total amount of debt owed by a government (same as national debt) which can be categorized into Domestic debt and external/foreign debt. The domestic debt is the amount of debt which the government owed to lenders within the country such as commercial banks while, the external debt is the total amount of debt owed to foreign lender.

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CHAPTER FOUR

ANALYSIS OF ESTIMATED RESULTS

This study is geared towards understanding the effect of institutions on debt sustainability. Before estimating the impact of institutions on debt sustainability, it is important to start by having a general understanding of the data by conducting some pre-estimation analyses. This is useful because a proper understanding of the nature and distribution of the collected data is needed to identify the most appropriate estimation technique to obtain accurate and reliable results for statistical inference and policy recommendations.

4.1 Pre-Estimation Analyses

Table 1 presents the descriptive statistics of the variables used in this study. The results show that the average total public debt-to-GDP ratio stands at 46 percent in low- and middle-income countries. Given the diverse nature of countries grouped within the LMIC classification, there exist huge differences among these countries in their debt loads. Some LMICs such as Algeria, Botswana and Nigeria have very low debt-to-GDP ratios while others such as Jamaica, Lebanon, Mozambique and Mongolia have high debt-to-GDP ratios in excess of 100 percent. This is captured by the huge standard deviation, which is more than half of average debt-to-GDP ratio in LMIC. The same trend is observed when I focused on total external debt as a percentage of GDP. Most importantly, the share of total public debt as a percentage of GDP, has been increasing in low- and middle-income countries. This is evident in Figure 1.

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Table 1: Descriptive/Summary Statistics of the variables

Variable Obs. Mean Std. Dev. Min Max

Total Public Debt (% of GDP) 369 46.43 26.828 4.577 137.935 Total External Debt (% of GDP) 1618 46.075 36.112 1.035 497.93 Exchange rate (LCY per US$) 1757 986.856 3432.183 .214 40864.33 Annual GDP growth (%) 1823 4.251 5.551 -62.076 123.14 Interest rate (%) 1404 13.876 8.37 2.696 67.718 Inflation rate (%) 1823 7.204 9.458 -29.691 100.627 Total reserves (% of Total external debt) 1483 86.547 271.564 .252 3840.105 National expenditure (% of GDP) 1583 110.965 21.103 45.28 261.428 Primary Balance (% of GDP) 1440 9.607 13.903 -87.148 74.476 CPIA Transparency, Accountability and

Corruption in the public sector rating (1=low to 6=high).

1061 2.874 .675 1 4.5 CPIA public sector management and institutions

rating (1=low to 6=high)

1061 3.075 .485 1.4 4.1 Note: CPIA denotes Country Policy and Institutional Assessment.

Table 1 also shows that average public sector management and institutions rating in LMICs is higher than the average ratings of LMICs when it comes to transparency, accountability, and corruption in the public sector. This is very interesting as it signals that although LMICs have been making efforts to improve public sector management and institutions, these efforts have not yet translated to improved transparency, accountability, and corruption within the public sector. Thus, attention should not only be focused on setting institutions but to also make sure these public institutions become more effective and efficient in ensuring transparency, accountability, and corruption within the public sector.

Moreover, Table 2 presents a pairwise correlation matrix of the relationship between our variables of interest at ten percent significance level. The results show that, in LMICs, public debt-to-GDP ratio is positively and significantly correlated with government spending and our measures of public sector management and institutions and transparency, accountability, and corruption. This means that governments that spend more tend to borrow more to finance public spending requirements. Moreover, countries with higher institutional quality tend to borrow more to finance

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development projects. Since this is a simple correlation analysis, we will further examine the relationship between institutions and debt sustainability in the following section. Furthermore, Table 2 shows that public debt-to-GDP ratio is negatively and significantly correlated with GDP growth, foreign currency (FOREX) reserve and government’s primary balance. This is consistent with what we expected since high growth rates and FOREX reserve increase a country’s ability to service and pay back its loans thereby lowering its debt-to-GDP ratio.

Table 2: Pairwise correlations analysis between the variables

Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (1) Debt-to-GDP 1.000 (2) External Debt 0.482* 1.000 (3) Exchange rate -0.072 -0.041 1.000 (4) GDP growth -0.215* -0.101* 0.054 1.000 (5) Interest rate 0.084 0.041 0.068 0.022 1.000 (6) Inflation rate -0.119 -0.026 0.051 0.064* 0.295* 1.000 (7) FOREX reserve -0.223* -0.213* -0.048 0.002 -0.116* -0.043 1.000 (8) Fiscal spending 0.231* 0.315* -0.084* -0.038 -0.006 -0.133* -0.084* 1.000 (9) Primary balance -0.199* -0.340* -0.017 0.204* -0.078* 0.093* 0.298* -0.290* 1.000 (10) Transparency, accountability, and corruption rating 0.481* 0.091* -0.145* 0.003 -0.288* -0.185* -0.003 0.181* 0.175* 1.000 (11) Public sector management and institutions rating 0.399* 0.070 -0.028 0.080 -0.209* -0.132* -0.114* 0.068 0.120* 0.835* 1.000 * shows significance at the .01 level

For the inverse relationship between debt-to-GDP and primary balance, this confirms that countries with primary surplus (i.e., countries that spend less than their revenue) have more resources to pay back loans (leading to lower debt-to-GDP rations) while those with primary deficit borrow more to finance government financing needs.

4.2 Impact of Institutions on debt sustainability: Empirical Evidence

We now proceed to quantitatively estimate the effect of institutions on debt sustainability. Given the results of the covariance analyses above, my next step is to estimate how the debt sustainability

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exchange rate, primary deficit and institutions. I used real effective interest rate net of real GDP growth.𝑟_EN− 𝑔_EN2 as a measure of solvency. The econometrics result of the estimated debt model is shown in Table 3. The most important coefficients of the estimated debt sustainability model are consistent with a prior expectation and they are mostly statistically significant. The result shows that a percentage increase in the difference between the rates of return and economic growth will increase the total public GDP ratio by 0.51 percent and increase the external debt-to-GDP ratio by 0.697 percent. This implies that the response of domestic public debt to changes in the cost of debt net of growth is lower compared to the share of foreign debt, and this is statistically very significant. In other words, when domestic interest rates increase relative to growth, the government borrow more from foreign source than from domestic debt. This makes economic sense because an increase in domestic interest rates reflect an increase in the cost of domestic debt compared to foreign debt. Similarly, exchange rate and inflation rate have insignificant positive and negative effects on debt sustainability, respectively. For foreign exchange reserve, an increase in foreign exchange reserve reduces total public debt-to -GDP by 0.237 percent while reduces external debt-to-GDP by 0.529 percent, which is a statistically significant effect on LMICs.

This is because countries with high FOREX reserves tend to have more resources to service and payoff their loans compared to those with lower reserve. Likewise, our primary balance ratio has a negative and statistically significant effect on debt sustainability in LMICs. As explained above, countries will primary surplus are more likely to use those excess government resources to service and payoff their debts comparing to those that run fiscal deficits. Countries that register primary deficits will have to borrow more to finance their budget thereby increasing their debt-to-GDP ratio, holding all other factors constant.