Effect of Governance on the Relationship between External Debt Financing and Economic Growth among East Africa Community Member Countries

Abstract

Governments borrow to finance budget deficits. Public debt and growth relationships can be both positive and negative. The main proponents of public borrowing to bridge the domestic financial resources gap confirm that debt contributes to economic growth through capital accumulation. In the last two decades, the EAC member countries have witnessed unexplained disparities between rise in public debt levels and economic growth levels. Research studies conducted on the relationships between debt and economic growth have however remained inconclusive as some studies allude to positive, negative, U-shaped and dual causality relationships respectively. This study used a lagged multiple linear regression model to establish the effect of governance on the relationship between external debt financing and economic growth in the EAC member countries using the Baron and Kenny moderation testing approach. Premised on the Keynesian, balanced growth and institutional corruption theories, the study embraced a panel longitudinal research design to examine the relationships. The study finds that 80.70% of variations in sustainable economic growth are explained by variations in external debt, governance index and the interaction term between external debt and governance index. The relationship between external debt and sustainable economic growth is positive but not statistically significant implying that a unit increases in external debt necessitates increase in sustainable economic growth by up to 0.043 units. The relationship between governance and sustainable economic growth is positive and statistically significant inferring that a unit increase in governance raises sustainable economic growth by up to 11 units. The interaction term between governance and external debt exhibits a statistically significant relationship with sustainable economic growth which is however negative due to the negative governance indices in the region. The finding implies that a unit increase in external debt and governance decreases sustainable economic growth by up to 0.509 units. To benefit from the envisaged positive debt and growth nexus, Government policy makers should put in place efforts to improve the domestic debt market infrastructure and encourage domestic investor participation so as to benefit from the long term effects of debt finance. This should be reinforced with sound Country governance framework. Policy makers and external development partners should relook at the terms of the specific external borrowings channeled for development in the region. As a contribution to further research, a study should be modelled on the optimal mix of debt and the turning point (threshold) at which the positive effects of public debt reverts to negative effects. Also, since governance indicators in the region are negative though the EAC member countries continue to attract external financing for development. A study should be designed to undertake a review on the effectiveness of the external debt covenants especially on clauses on governance and the consequences thereon on flouting the covenants. The study should review the types of covenants and the compliance by the governments