Effect of Gross Capital Formation on the Relationship between Debt Financing and Economic Growth among East Africa Community Member Countries

Abstract

The main proponents of public borrowing to bridge the domestic financial resources gap confirm that debt contributes to economic growth through capital accumulation. Public debt and growth relationships can be both positive and negative. In the last two decades, the EAC member countries have witnessed unexplained disparities between economic growth and debt levels rise. Studies on debt and economic growth relationships have remained inconclusive. The studies allude to positive, negative, U-shaped and dual causality relationships. This study used a lagged multiple linear regression model to establish the effect of gross capital formation on the relationship between debt financing and economic growth in the EAC member countries using the Baron and Kenny four steps approach. Premised on the Keynesian and balanced growth theories of public debt, the study embraced a panel longitudinal research design to examine the relationships. The study finds statistically significant strong positive relationships between total debt and sustainable economic growth, domestic debt and sustainable economic development, external debt and sustainable economic development, domestic debt and total debt, external debt and total debt, domestic debt and external debt and gross capital formation and external debt. Gross capital formation has statistically significant weak positive relationships with sustainable economic growth, total debt and domestic debt. The study establishes that the influence of gross capital formation on the relationship between sustainable economic growth and debt finance components are statistically significant. Specifically, 53.05% of changes in sustainable economic growth are attributed to changes in debt financing and gross capital formation and the model is statistically significant. The study finds a statistically significant positive relationship between the interaction term of total debt financing, gross capital formation and sustainable economic growth. It also finds a statistically significant positive relationship between sustainable economic growth and the interaction of gross capital formation and domestic debt financing. Also, it finds a statistically significant negative relationship between the interaction terms of external debt financing with gross capital formation and sustainable economic growth. To benefit from the 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. Policy makers and external development partners should relook at the terms of the specific facilities channeled for development in the region. An enabling macro-economic environment with good governance should be put in place in order to benefit from the debt stock. 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 gross capital formation mediate the debt economic growth nexus. A study on what are the comfortable levels of gross capital formation for the diverse debt regimes is desirable.

Key Words: Debt Financing, Total Debt, External Debt, Domestic Debt, Economic Growth, Sustainable Economic Growth, Gross Capital Formation