UNITY UNIVERSITY

COLLEGE OF BUSINESS, ECONOMICS AND SOCIAL SCIENCE

DEPARTMENT OF ECONOMICS

Title: Impact of Public External Debt on Economic Growth of Ethiopia

Section: BE1R1N2/12
Members ID Number
1. Hawi Mesfin UU81101R
2. Meklit Tsegaye UU79422R
3. Michael Gezahegn UU79527R
4. Yafet Gezahegn UU79422R
5. Yeabsira Getachew UU79910R

Submitted to: Urgaia Rissa (PhD)

Submission date: May 28, 2023
 Table of Contents
CHAPTER ONE ...................................................................................................................................................................... 5
INTRODUCTION .................................................................................................................................................................... 5
1.1. Background of the study............................................................................................................................................... 5
1.2. Statement of the Research Problem ............................................................................................................................ 6
1.3 Research Questions ........................................................................................................................................................ 6
1.4 Objectives of the Study .................................................................................................................................................. 6
1.4.1. General Objectives ..................................................................................................................................................... 6
1.4.2. Specific Objectives ..................................................................................................................................................... 6
1.5 Scope and Limitation of the Study ............................................................................................................................... 7
1.6 Significance of the Study ............................................................................................................................................... 7
1.7 Organization of the Study ............................................................................................................................................. 7
CHAPTER TWO ..................................................................................................................................................................... 8
LITERATURE REVIEW ........................................................................................................................................................ 8
2.1 Theoretical Literature.................................................................................................................................................... 8
2.1.1. Debt overhang Theory ............................................................................................................................................. 8
2.1.2. Traditional view on Domestic Debt (Tax cut or Deficit)............................................................................................ 9
2.1.3. Ricardian View on Domestic Debt (Tax cut or Deficit) ............................................................................................. 9
2.1.4. Keynesian view on consumption.............................................................................................................................. 9
2.2 Empirical literature review ......................................................................................................................................... 10
2.3 Conceptual Framework ............................................................................................................................................... 11
CHAPTER THREE ............................................................................................................................................................... 12
RESEARCH METHODOLOGY ......................................................................................................................................... 12
3.1. Research Approach and Design ................................................................................................................................. 12
3.2. Data Type, Source and Hypothesis ............................................................................................................................ 12
3.3. Data Analysis Technique ............................................................................................................................................. 12
3.5. Regression Model ........................................................................................................................................................ 12
CHAPTER FOUR .................................................................................................................................................................. 13
RESULT AND DISCUSSION ............................................................................................................................................... 13
4.1 Econometric Analysis ................................................................................................................................................... 13
4.1.1 Unit Root Test Results........................................................................................................................................ 13
4.1.2 Johansson test ......................................................................................................................................................... 14
4.2 Econometric Tests ........................................................................................................................................................ 14
4.2.1 Autocorrelation ....................................................................................................................................................... 14
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 4.2.2 Multicollinearity test ............................................................................................................................................... 15
4.2.3 Heteroskedasticity test............................................................................................................................................ 15
4.3 Vector Error Correction Model (VECM) .................................................................................................................. 16
4.3.1 Regression Results..................................................................................................................................................... 16
CHAPTER FIVE.................................................................................................................................................................... 18
CONCLUSION AND POLICY RECOMMENDATION ................................................................................................... 18
5.1 Conclusion..................................................................................................................................................................... 18
5.2 Policy Recommendations ............................................................................................................................................. 19

List of figures

Figure 2.2. 1 ...................................................................................................................................................................... 11

Table 4.1. 1 Dickey Fuller test for Unit Root ................................................................................................................... 13

Table 4.1. 2 Johansen tests for co-integration................................................................................................................. 14

Table 4.2. 1 multicollinearity test ..................................................................................................................................... 15

Table 4.2. 1 Heteroskedasticity Test ................................................................................................................................. 15

Table 4.3. 1 Regression Result ........................................................................................................................................ 16

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 List of Acronyms/Abbreviations
GDP: Gross Domestic Product
IMF: International Monetary Fund
HIPC: Highly Indebted poor Countries
MDRI: Multilateral Debt Relief Institute
SOE: State owned Enterprises
MOF: Ministry of Finance
DSA: Debt Sustainability Analysis
UNCTD: United Nations
EXIM: Export Import
CBE – Commercial Bank of Ethiopia
DA – Direct Advance
NBE – National Bank of Ethiopia
WB – World Bank

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 CHAPTER ONE

INTRODUCTION
1.1. Background of the study

Developing countries are characterized by poverty and macroeconomic instability, and they have been through
many development programs to boost economic growth, therefore, they have been financially constrained to realize
poverty reduction and other development schemes through domestic savings. Thus, Debt is a key option to consider.

Debt is from both internal and external sources aimed to fill the resource gap between savings and investment.
External debt is the function of low productivity, income and saving in developing countries which have weak
private financial sectors Adepoju et al. (2007); therefore, these countries seek, financial, managerial and technical
assistance from developed ones.

Domestic debt is also another alternative to finance the deficit of government budget. Domestic debt is becoming
significant mode of financing gap replacing external debt and it has crowding out impact on private sector
investment as government use huge share of resources to finance its budget deficits can have a crowding out effect
on private investment since the government will share resources that should have been used by private sectors as
developing countries don’t have enough saving; thus, developing countries borrow from both external and domestic
sources to finance saving and investment gaps to bring about economic growth.

Developmental state ideology followed by public led investment, that state owned enterprises have large
responsibilities regarding high expenditure investments on sugar, chemical, irrigation and Hydropower dams that
could take billions of dollars to implement. The aim was to invest on these productive sectors to produce export
products by borrowing from external sources both bilateral and multilateral so that debt will be paid from export
receipts. Most projects such as sugar, chemical and Great Ethiopian Renaissance Dam failed with their multibillion-
dollar accumulated debt. Therefore, Ministry of Finance and Economic Cooperation cuts state owned enterprises
external borrowing and outstanding non-concessional commercial debt, (IMF country report 2018).

Ethiopia’s risk of debt distress was assessed as “High-risk” in the2018 DSA, but risks have increased so the ability
to pay its accumulated debts will be reduced, that will lead to liquidity and solvency problems, debt overhang, that
is, debt will be beyond country’s repayment ability then expected debt-service costs will reduce further domestic
and foreign investment. Most of the country’s development projects are financed by external borrowing that likely
affect economic growth. To make matters worse, Ethiopia has been paying its external debts taken by SOEs to

5
finance its development projects by borrowing from domestic sources such as CBE that could be a vicious circle
and even unable to further borrow from external sources. Moreover, ministry of finance started coupon bond to
finance SOEs, such as electric power generation, on development projects.

Debt, both external and internal, currently, affecting Ethiopia’s position in debt sustainability and distress IMF
(2018), through, low export performance, delays in high public led development projects.

1.2. Statement of the Research Problem

This study focuses on investigating the recent debt dynamics as the previous studies on “impact of external debt
on Ethiopian economic growth”, found different results and the current issues on debt sustainability issues
regarding external debt accumulation and debt service by government of Ethiopia and IMF &WB coupled with the
demand for financing development projects to boost economic growth and exports by state owned enterprises
rationalize to conduct in-depth study to show which one of the previous studies findings are supported.

The study also focuses on impact of domestic debt on economic growth as domestic debt in recent times is the
issue in making it an alternative financing source, according to (UNCTD, 2008) and 43 % of Ethiopia’s total debt
is financed from domestic debt since demand of domestic debt is growing recently though developing countries
are characterized by low domestic saving , and as far as the researcher’s knowledge is concerned there are no
previous studies conducted in Ethiopia on the effect of domestic debt on economic growth.

1.3 Research Questions

I. Do external borrowing has impacts on the pace of growth of the Ethiopian economy through debt overhang?

II. Do external debt servicing has impact on economic growth through crowding out effect on investment in the
Ethiopia?

III. Does domestic debt impact economic growth through crowding out effect on private investment in the Ethiopia?

IV. Do export and nominal lending rate have impact on economic growth?

1.4 Objectives of the Study

1.4.1. General Objectives
The general objective of the study is to assess the effect of public debt on economic growth of Ethiopia.

1.4.2. Specific Objectives

I. To assess the effect of external debt on economic growth in Ethiopia.

II. To examine the effect of domestic debt on economic growth in Ethiopia

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III. To find out impact of external debt servicing on economic growth of Ethiopia.

1.5 Scope and Limitation of the Study

The study pursues analysis of Ethiopia debt and its impact on its economic Growth. In order to fully capture its
effect on the economy, a thorough empirical investigation was conducted with data covering a period of 28 years
that is from (1991-2018). Moreover, only government and government guaranteed debt is considered in this
research as it focuses on public debt. The study focuses on selected variables only; since the data collected from
different sources had some inconsistency and lack of data to use time series data longer than 28 years.

1.6 Significance of the Study

The burden of debt has been a matter of great concern to the Government of Ethiopia and the nation as a whole
which has resulted in embarking upon drastic actions like dividing the nation’s scarce resources in servicing of
debts annually, one of the ways to service its external debt is exporting sesame to EXIM bank of China and using
domestic debt to buy hard currency to service its external debt.

This action has thus led to disinvestment in the economy, and as a result a fall in the domestic savings and the
overall rate of growth. The study seeks to investigate the direct impact of domestic and external debt” debt
overhang; and crowding out effect” aspect, by finding a long and short run causal relationship with economic
growth.

This study is significant as it includes additional sample amount of debt data of State-Owned Enterprises total taken
debt, both from domestic and external sources to finance its findings will provide a basis which will aid policy
makers in proffering polices aimed at managing the debt crisis situation in Ethiopia. More over the scope of the
study will also differ from previously conducted researches as it focuses on 28years’ time series data (1991-2018),
since it is difficult to use 30 years or more time series data due to data inconsistency, that enables us to define our
paper in terms of scope and in-depth analysis and domestic debt is becoming an issue of alternative financing for
development, therefore it has significance to know its relationship with economic growth.

1.7 Organization of the Study

This study is structured as follows: Chapter one provides the research background, research objectives, and
significance of the study, scope and the limitation of the study. Chapter two comprises of theoretical and literature
studies on impact of public debt on economic growth and in Ethiopia and a conceptual framework. Chapter three
covers the methodology. Chapter four covers the findings and finally chapter five covers the Conclusions, policy
recommendations, and areas for further research.

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 CHAPTER TWO

LITERATURE REVIEW
2.1 Theoretical Literature
Developing economies are characterized by low income, saving and expenditure management system that leads to
have low domestic investment as a result of poor resource mobilization capacity due to mentioned reasons above.
Solow (1956) neoclassical model asserts that economic growth can be brought by expansion of investment. The
model emphasizes that to achieve economic growth by increasing the amount of savings and investment. To realize
this, countries have two options to mobilize resources, domestic and external, that can be generated through taxes,
non-tax revenue sources, grant, remittances and debt. In case of developing countries, governments finance their
deficit using taxes, non-taxes and domestic borrowing, however, realistically low saving make it difficult to fill the
finance gaps, and to seek alternative finance from abroad in terms of external debt for financing development
projects and consumption.

2.1.1. Debt overhang Theory

Krugman (1988) debt overhang theory states that there is probability in the future debt will be larger that countries
repayment ability, debt servicing costs will be discouraging to further investment as the expected rate of return will
be very low since it will be shared by the creditors. This gradually discourage both domestic and foreign investment
so does economic growth (Krugman, 1988, Sachs, 1989a).

Were (2001) debt overhang even gets worse that debt not only affect investment in physical capital but education,
health and technology in the long run. Debt Countries can have both liquidity and insolvency problems; liquidity
is the current phenomena where countries fall short of money to pay debts currently, but overhang is a situation
where counties are unable to service their debts in the long run termed as insolvency; according to (Ajayi, 1991) a
country is insolvent when it is incapable of servicing its debt in the long run.

Domestic debt on the other hand is the alternative source of financing which recently developing countries have
been shifting towards domestic debt to finance government investment gaps, both budget deficit and project
financing by State owned enterprises. Domestic debt is the financing government budget gap and demand from
development project by SOEs, in Ethiopia case, by internal sources.

The major instruments of government domestic borrowing are treasury bills, bonds and DA that is borrowing from
central bank. Currently Ministry of finance started coupon bond to finance State Owned Enterprises, particularly,
to EPPCO to implement power generation projects. Since domestic debt market is not well developed to get money
8
through treasury bills, direct advance is the major component of domestic debt. Government Bonds, with longer
term maturity (10 years and more); have been issued for special purposes rather than as a means of raising money
to fill the budget gap. The major holders of government securities in Ethiopia are the National Bank of Ethiopia
and the Commercial Bank of Ethiopia followed by government and private banks and insurance companies, Public
Servants Social Security Agency and other public enterprises.

Domestic debt can be a base for both primary and secondary market if there is a free market activity with market
interest ratee

2.1.2. Traditional view on Domestic Debt (Tax cut or Deficit)

The traditional views, on the effect of public budget deficit to encourage consumption by cutting taxes argues that,
cutting taxes and encourage consumption to stimuli aggregate demand will have positive effect in the short run but
negatively affect economic growth in the long run. This view explains Government budget deficits financed by
borrowing make consumers relatively richer than they would be without borrowing; then Consumption increases
that will be a stimulus aggregate demand to increase output in the short run.

2.1.3. Ricardian View on Domestic Debt (Tax cut or Deficit)

Consumers are modern, and know that a debt-financed tax cut today is equal to an increase in future taxes that is
equal in present value to the tax cut or deficit. Thus, the tax cut does not make consumers better off, so they do not
spend or raise consumption. Thus, according to this view, consumers save the full tax cut in order to repay the
future tax liability. As a result, private saving rises by the amount public saving falls, magnitude of national saving
remains unaffected. Therefore, there is no change in consumption and aggregate demand to push out put any further.

2.1.4. Keynesian view on consumption

Following Great depression "depression economics," as Keynes' eminent book The General Theory of
Employment, Interest, and Money was written 1936 book was informed by directly observable economic
phenomena arising during the Great Depression, which could not be explained by classical economic theory that
glorifies market economy. Keynes asserted government intervention is mandatory during the time of economic
crisis and it was of great acceptance.

9
The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Its concept is
simple: Spending from one consumer becomes income for another worker. That worker's income can then be spent
and the cycle continues. Keynes and his followers believed individuals should save less and spend more, raising
their marginal propensity to consume to effect full employment and economic growth. In this sense if tax cut results
in increase in consumption, using Keynesian multiplier spending will boost aggregate demand then output (GDP).

In Ethiopia case, tax revenue is not growing as desired to finance huge public investments, Tax to GDP ratio stood
at 7%, where it is below sub-Saharan average of 15%, weak tax administration, low tax base and diversity in tax
items are major reasons for low performance in tax revenue collection, thus, consider this a tax cut then financing
the gap of growing budget deficit through domestic debt.

2.2 Empirical literature review

Domestic debt is the government’s fiscal deficit financing mechanism when there is no enough capital from external
sources due to default or inability to discharge obligations to pay external debt by many reasons ,some reasons of
insolvency is that, decline in export earnings, low economic growth , and in Ethiopia case failure or untimely
completion of export oriented development projects ,thus lenders become curious on the future loan disbursement
to these 13 countries but most researchers focus on external debt thus empirical researches on the relationship
between domestic debt and economic growth is limited in this regard.

Hana (2013) only used data up 10 years to 2010, found that external debt stock does not affect economic growth
but does debt service positively, Hana explained the reason why debt servicing has positive effect on economic
growth it was due to debt relief and rescheduling but it deviated from theory.

Abbas and Christensen (2010) on their research in low-income countries (including 40 sub-Saharan Africa
countries) analyzed optimal domestic debt levels in and emerging markets between 1975 and 2004 then investigate
moderate levels of marketable domestic debt as a percentage of GDP have significant positive effects on economic
growth. The study indicated that debt levels that exceed 35% of total bank deposits have negative impact on
economic growth.

Akram (2015) in is research conducted in Philippines found that domestic debt has a negative relationship with
investment because of crowding out effect and positive relationship with economic growth. However, external debt
has negative and significant relationship with economic growth and investment confirming the existence of “Debt
Overhang effect” except insignificant relationships of debt servicing with investment and economic growth,
therefore it did not have crowding out effect. 14 Optimal domestic debt should be analyzed since external debt
cannot be obtained when needed, in such cases; governments look for domestic options to finance the budget
10
deficit, however they should critically look at all angels of the economic dimensions, investment and inflation, and
other factors to be affected as optimal points are surpassed.

Ogunbiyi et.al (2015) investigated the impact of external debt burden on capital accumulation of Nigeria using
time series data 1980-2012, using Gross fixed capital formation as proxy variable for capital accumulation and
GDP, using OLS method to estimate the impact and found eternal debt has positive effect on economic growth
about 68%, this means that, 1-million-dollar debt can induce 680-thousand-dollar capital in the country with curious
recommendation for further borrowing.

Sami et. al2018), researched the relationship between government external borrowing and economic growth, to
finance Oman’s government annual budget. 1990-2015 time series data was used and the ARDL co integration
deployed and error correction model to ascertain the short-run dynamic nature of external debt and economic
growth, and found negative and significant influence of external debt on economic growth in Oman, thus,
recommended a more productive use of the external debt fund in order to affect positive growth.

2.3 Conceptual Framework

Figure 2.2. 1

Positive
Debt stock Investment & impact on
External debt Consumption Economic
Growth

Debt

Debt overhang Consumpion&

servicing Investmnt

Negative Crowding out

Crowding out impact on
effect on Domestic Debt
Economic Private (stock)
investment growth Investment

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 CHAPTER THREE

RESEARCH METHODOLOGY
3.1. Research Approach and Design
This study deployed time series data of 28 years, co integration approach to examine the short and long run
relationship between dependent and independent variables considered in the study, Vector Error correction Model
(VECM) were used to find out the relationship.

3.2. Data Type, Source and Hypothesis

The study used 28 years annual time series data of the variables to be deployed from 1990/91- 2017/18; the data
sources used were NBE, MOF, and Plan and Development Commission of Ethiopia.

3.3. Data Analysis Technique

The data was collected and checked, edited and organized then got ready for second stage of pre analysis. The
variables to use in the analysis are, Real GDP, domestic and external debt.

Diagnostic tests such as; Augmented Dickey-Fuller stationery test to test and prevent spurious regression, and the
presence of long run relationship were tested using Johansson for co-integration using Trace and Max statistics was
used and VECM model was deployed to determine whether there is the long and short run relationship between
dependent and independent variables.

3.5. Regression Model

Vector Error Correction Model (VECM) of Real Gross Domestic Product Initially, VECM was devised to describe
a relationship between the short-run dynamic and the long-run equilibrium. If two variables are co integrated at the
first difference order, their relationship can be expressed as the VECM. This approach enables the long run
equilibrium relationship and the short-run dynamics to be estimated simultaneously. This type of technique helps
to correct the potential bias in the estimation of the coefficients in models with differences.

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 CHAPTER FOUR

RESULT AND DISCUSSION

4.1 Econometric Analysis
4.1.1 Unit Root Test Results
Table 4.1. 1 Dickey Fuller test for Unit Root
5%

Variables Test Critical 5%Critical

Statistic Value Test Statistic Value Conclusion
At First
At Level Difference
PCGDP Intercept 2.401 -2.994 -3.173 -2.997 Stationary at FD
Trend & Intercept -1.016 -3.592 -4.9 3.596 Stationary at FD
DDO Intercept 3.398 -2.994 -3.138 -2.997 Stationary at FD
Trend & Intercept -0.064 -3.596 -5.548 3.596 Stationary at FD
EDO Intercept 1.893 -3.592 -3.203 -2.997 Stationary at FD

Trend & Intercept 1.595 -2.994 -4.372 -3.596 Stationary at FD

EDS Intercept -4.914 -2.994 -8.365 -2.997 Stationary at FD
Trend & Intercept -4.836 -3.596 -8.196 -3.596 Stationary at FD
NLR Intercept -3.543 -2.994 -5.585 -2.997 Stationary at FD
Trend & Intercept -5.612 -3.956 -5.579 -1.95 Stationary at FD
EXP Intercept -0.071 -2.994 -2.947 -1.95 Stationary at FD
Trend & Intercept -3.22 -3.596 -3.378 -2.997 Stationary at FD
Source: STATA Output, 2023 G.C
From the ADF criterion, all variables except External debt Service were found to contain unit root at level, in
both with intercept and Trend & Intercept, but at first difference all variables in the table were found to not contain
a unit root at 5% level of Significance. This means that, all variables are stationary at first difference with intercept
and with Trend & Intercept at 5% level of significance. If the calculated statistics is greater than the critical values
in absolute terms, the null hypothesis that say the series contains unit root was rejected and the series said to be
stationary. Therefore, all variables are stationary at first difference, and there is no spurious results situation.

13
4.1.2 Johansson test

If the time series variables have the long run relationship, suppose we can say the variables are integrated
and going together in the long run, Johansson Tests for co integration using trace and max statistics
deployed and found that there are three co integrating equations between time series between dependent
Variable (Per Capita GDP) and independent variables.

Table 4.1. 2 Johansen tests for co-integration

Eigen 5%Critical
Rank Parms LL value Trace Stat value
0 6 -1076 - 125.43 94.15
1 17 -1055 .79 83.01 68.52
2 23 -1038 0.70 50.29 47.21

3 33 -1026 0.6 25.27* 29.68

4 38 -1018 0.43 9.9 15.4
5 41 -1013 0.28 .85 3.76
6 42 -1013 0.03 - -
Null: rank -0there is no Co integration
Source: STATA Output, 2023 G.C
As shown in the Table, rank –at value-o means the Null hypothesis which states there is no co integration
and Null hypothesis is rejected where trace Statistics is greater than 5% critical value, and at Rank-3 we
found co-integrating equations. Therefore, there is co integration between variables per Capita and
independent variables; this means that, there is a long run relationship. The author also used max-
statistics to test the presence of long-run relationship between the variables and found that there is co
integration.
4.2 Econometric Tests

4.2.1 Autocorrelation

The Durbin-Watson d-statistic was used to check for auto correlation between the error terms of different periods.
Durbin-Watson d-statistic (7, 27) = 1.705298
While testing the autocorrelation the value should be closer to 2 than 0 and 4 meaning that it should be between 1
and 3. The result was successful.

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4.2.2 Multicollinearity test

Multicollinearity is a problem that occurs in a regression analysis when two or more of the
independent/explanatory/predictor variables are highly correlated with each other. This makes it difficult to
identify the effect of one individual independent variable to the dependent variable. The effect of the presence of
multicollinearity are unreliability of the coefficient estimate, loss of predictive accuracy of the estimates,
misleading statistical and goodness of fit tests and the like. There are a number of tests that can be used to identify
multicollinearity and this paper uses the Variance Inflation Factor (VIF) test. The VIF test states that if the VIF
of a model exceeds 10 or if the Tolerance (1/VIF) is less than 0.1 there is a multicollinearity problem, if not there
isn’t.
Table 4.2. 1 multicollinearity test

Variable VIF 1/VIF

DDO 11.71 0.085409
EXP 6.77 0.147706
EDS 5.76 0.173753
EDO 4.48 0.223190
NLR 1.43 0.700326
Residual 1.18 0.848716
Mean VIF 5.22
Source: STATA Output 2023G.C.
As observed from the table above, by using STATA to compute the VIF test, the mean VIF was found to be
5.22 which is less than 10. This signifies that there is no multicollinearityproblem in the model.

4.2.3 Heteroskedasticity test

Heteroskedasticity is a violation of one of the OLS (Ordinary Least Square) regression assumption which states
that the residuals/error terms have a constant variance. The effect of this heteroskedasticity is that the OLS
estimates are no longer BLUE (Best Linear Unbiased Estimators) because they are no longer efficient, which will
make any predictions made using those estimates inefficient. Additionally, because of this inefficiency, the
statistical teste like t-testand F-test will become invalid. There are many ways to test this heteroskedasticity and
this studyused the Breusch-Pagan / Cook-Weisberg test for heteroskedasticity. This test states that if the Prob >
chi2 is greater than 0.05, the model had a heteroskedasticity problem but if not, there is homoskedasticity.
Table 4.2. 1 Heteroskedasticity Test

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

Ho: Constant varianc
Variables: fitted values of P
Chi2(1) 3.45
Prob > chi2 0.0633
Source: STATA Output, 2023 G.C
15
As we can see from the table above, by using STATA to compute the Breusch-Pagan/ Cook-Weisberg test for
heteroskedasticity, the Prob > chi2 was found to be 0.0633 which is greaterthan 0.05 indicating that there is no
heteroskedasticity problem in the model (i.e., there is homoskedasticity).

4.3 Vector Error Correction Model (VECM)

Vector Error Correction Model is used when there is co integration or long-run relationship between
time series variables, since, according to Johansson test there is a long run relationship. Furthermore,
VECM can also show the short run dynamics. Firstly, the researcher identified the appropriate co
integrating equation, ce1, co-integration equation one is both significant and has negative sign. The
Vector Error correction term is-0.299 and significant at 5% level of significance, then it can be
concluded that there is a long run relationship running from dependent variable, per Capita GDP,
to the independent variables. The term -0.229 is also called the speed of adjustment towards the long-
run equilibrium or steady state.
Regarding the short run dynamics, there is no short run causality running from explanatory variables to
Per Capita GDP since the coefficients of Domestic and External debt are notstatistically significant at
5% of level of significance. The speed of adjustment tells, 29.9% is adjusted every year towards
equilibrium which is a slow adjustment.

4.3.1 Regression Results

Table 4.3. 1 Regression Result
Number of obs. = 28

F(5, 22) = 194.7R-squared =0.977

Prob > F = 0.0000 Adj R-squared = 0.972

PCGDP Coef Std.Err t P>(t) (95% Conf.Int)
DDO 0.029 0.00046 6.31 0.000 .019 .038
EDO 0.0053 0.0026 1.97 0.62 -0.0028 0.019
EDS -.003 0.0089 -0.4 0.0694 -0.0221 0.014
NLR .229 4.57 0.05 0.96 -9.225 9.7
EXP .046 0.019 2.34 0.028 0.0053 0.195
_CONS 2.09 50.09 0.04 0.967 -101.79 105.98

Source: STATA Output, 2023 G.C

From the estimation results, there was evidence of statistical significance of domestic debt and exports,
in explaining economic growth in the long-run; however, the external debt stock& external debt service
had insignificant long run and short run relationship with economic growth.
16
 The signs of the estimated coefficients were also consistent with the expectation from economic theory;
Export and domestic debt were found to affect economic growth positively, whereas Nominal Lending
rate and external debt stock had positive but insignificant effect on economic growth. Furthermore,
external debt servicing had negative but insignificant effect on Per Capita GDP.

The signs of their corresponding coefficients show consistency with expectation from economic theory.
The coefficient of determination, Adj-R-squared (0.972) indicated that the independent variables
accounted for around 97.2 percent of the variations in Per Capita GDP, on the. Similarly, the p-value
(0.000) of the F-statistic indicated that the overall model was significant in explaining the relationship.

Moreover, the confidence intervals of Domestic debt, and export has non-zero value at 95%, therefore,
there is 95% confidence of these variables stated above to have non-zero value estimates of the
population parameters. The external debt servicing has negative confidence interval, holds zero value at
5% significance level.

The significant positive effect of domestic debt stock in Ethiopia (0.029) on economic growth concurs
with Keynesian hypothesis on tax cut that states there is influence both in the short and long run
consumption to boost aggregate demand and economic growth. Moreover, the result concurs with
empirical studies done by, Mohammed (2010) who found domestic debt has positive relationship with
economic growth and PETER N. MBA et.al (2013).

Negative but statistically insignificant effect of external debt servicing on economic growth showed that
there is no evidence to explain crowding out effect on Ethiopian investment.Possible reasons to explain
its insignificance result might be debt relief from lenders and the characteristics of loan provided which
was concessional that might have reduced the impact of debt on the economy. External debt has
insignificant positive impact on economic growth so both its positive effect or negative effect
characterized by debt overhang cannot be confirmed. Moreover, must of the studies in developing
countries have shown both negative and positivesignificant impact. Export has significant positive
impact on economic growth in which 100 USD export bill willinduce 4.6 USD on economic Per Capita
GDP.

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 CHAPTER FIVE

CONCLUSION AND POLICY RECOMMENDATION

5.1 Conclusion
The study's ultimate goal is to analyze the impact of public debt on the Ethiopian economy throughout the specified
time period 1990-2021. Following the completion of the relevant statistical tests, the Vector Error Correction Model
was used to determine the short and long run relationship.

According to the empirical data, debt servicing has a negative but minor impact on Ethiopian economic growth,
which raises questions about how this occurs. Ethiopia's economy has been growing despite low exports and taxes,
which have an impact on the amount of money required to support the ambitious government-led investment plan.
Low exports have an impact on debt servicing, and recently, export bills have dropped, making it difficult to service
foreign debt.

An increased demand for external financing due to reliance on capital goods to construct projects, along with a low
export bill utilized for both project implementation and debt servicing, has placed the country in a tough
macroeconomic predicament. According to the IMF's debt sustainability analysis report (2019), the government is
a high-risk borrower due to poor export performance and a drop in the timely completion of SOE export-oriented
projects.

Before the HIPC and other debt relief initiatives were stopped, Ethiopia had been considering debt reduction and
debt restructuring. Furthermore, Ethiopia's debt is distinguished by a low interest rate and a longer maturity period,
allowing the country to pay less money, allowing the country to transfer its resources toward economic activities
that may be beneficial.

This result differed from the work of Iyoha (1999), came to the conclusion that debt servicing has a negative impact
on economic growth and most researchers in developing countries came to the same conclusion. Furthermore,
external debt 41 outstanding was statistically insignificant to explain Per capita GDP, making it difficult to confirm.

Domestic debt has also had a good and large impact on economic growth, and this is the first outcome in the case
of Ethiopia, and it can be argued that there is a crowding out effect on private investment because the majority of
government funding sources were its own institutions and banks, its good impact on growth, and its favorable
conclusion are primarily due to government poverty-oriented and welfare schemes, which account for more than
60% of total expenditure on average.

Domestic debt was determined to be significant in terms of positively affecting economic growth in general.
However, foreign debt and debt servicing have had little influence, presumably because a large amount of money
was written off under the HIPC program and diverted to the government budget. Ethiopian loans are mostly
concessional, which means they have a low interest rate and a longer maturity period, allowing the country to pay
a little amount of debt each year. Furthermore, rescheduling could be another explanation for the lessened economic
impact.

5.2 Policy Recommendations

Following the findings below are the policy implications arising from this study;

• The government should minimize external borrowings since it impacts the economy negatively
• Government needs to utilize external debt effectively and efficiently
• Domestic debt was found to have positive impact on the economy and is now becoming an alternative
financing government
• Internal debt, efforts should be made to repay past ones, so as to increase the money supply in the economy
• Funds for capital and recurrent expenditure purposes should be used expedient
• Because exports are dropping, debt servicing should be at its optimal level so as not to drive out investment.
This is especially important when there is no debt reduction or restructuring related to policy sovereignty.
• Financial markets where investors can invest more in government securities and also ensure a smooth
channel of funds of national savings from deficit to surplus users should be established.

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