Journal of Post Keynesian Economics / Summer 2013, Vol. 35, No.

4 599
2013 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 01603477 (print) / ISSN 15577821 (online)
DOI: 10.2753/PKE0160-3477350405
MARCOS ROCHA AND JOS LUIS OREIRO
Capital accumulation, external
indebtedness, and macroeconomic
performance of emerging countries
Abstract: This paper aims at presenting a nonlinear post Keynesian growth
model to evaluate at the theoretical and empirical levels the relationship between
external indebtedness and economic growth in emerging countries. To this end, a
post Keynesian endogenous growth model is presented, in which: (1) the desired
rate of capital accumulation is assumed to be a nonlinear function of external
indebtedness as a share of capital stock; (2) an endogenous country risk premium
is assumed to be an increasing (linear) function of external indebtedness (as
a share of capital stock); (3) there is a xed exchange rate regime and perfect
capital mobility in the sense of Mundell and Fleming. The main theoretical
result of the model is the existence of two long-run equilibrium positions, one
of which has a high level of external indebtedness (as a ratio of capital stock)
and a low prot rate and the other has a low level of external indebtedness
and a high prot rate. This means that excessive external indebtedness can
result in stagnant growth due to its negative effect on the rate of prot. To test
the effects of external indebtedness on the rate of economic growth in emerging
economies, a dynamic panel is estimated to evaluate whether external debt has
an effective negative inuence on economic growth in emerging countries. An
empirical test of demand-led growth equations with a dynamic panel for fty-
ve emerging countries conrms the potential negative effects of external debt
on long-term growth rates in the sample countries.
Key words: External debt, balance of payments, and capital accumulation.
JEL classications: F3, F4, O2
The proponents of capital account liberalization argue that one of the
main benets of free convertibility is that it gives emerging countries
Marcos Rocha is an assistant researcher at the Institute for Applied Economic Re-
search (IPEA). Jos Luis Oreiro is a professor in the Economics Department at
Universidade de Braslia and a researcher of National Council for Scientic and Tech-
nological Development (CNPq).
600 JOURNAL OF POST KEYNESIAN ECONOMICS
greater access to international capital markets and gives greater inows
of external savings to these countries. An increase in the savings rate
(internal + external) will produce an increase in the gross domestic
product (GDP) per capita of these economies in the long run, accord-
ing to neoclassical models such as SolowSwan. It is then obvious that
emerging countries should open capital accounts as a means to increase
the level of income per capita and catching up with income levels of the
developed countries.
This view in favor of free convertibility of the current account is mainly
founded on the hypothesis that economic growth can be stimulated or
induced by external savings. Since external savings are the counterpart of
current account decit, it follows that growth in the developing countries
should necessarily be linked to large current account imbalances. The ac-
cumulation of current account decits over time results in growing levels
of external debt. This means that the view pro free convertibility of the
current account also states the existence of a positive relation between
economic growth and external debt (see, among others, Eaton, 1993).
More recently this naive view of external debt and growth has been
criticized at the theoretical and empirical levels by a growing body of
economic literature about the nonlinear effects of external debt on growth.
Pattillo et al. (2002) argue that although for low levels of external debt,
economic growth can be stimulated by foreign savings, there are compel-
ling reasons to believe that external debt may depress economic growth
after some threshold level. One reason for a negative effect of external
debt on growth is the debt overhang theory. According to this theory,
if there is some likelihood that in the future debt will be larger than the
countrys ability to repay it, then expected debt service will be an increas-
ing function of the countrys output level. In that case, the returns from
investing in the country face high marginal taxes from external creditors,
and new domestic and foreign investment is discouraged, depressing
economic growth (Krugman, 1988; Sachs, 1989).
Clements et al. (2003) also argue that for low-income countries a high
level of external debt has an indirect but negative effect on economic
growth due to the effect of a higher level of debt service over public in-
vestment. Indeed, a higher level of debt service reduces the current scal
position of government in low-income countries, imposing a contraction
of public investment in order to restore scal balance.
The empirical evidence on the existence of a nonlinear relation between
external debt and economic growth is, however, mixed. Patillo et al.
(2002) based on a sample of ninety-three developing countries in the pe-
riod 196398 found a nonlinear effect of external debt on growth, and also
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 601
that the average effect of debt on per capita growth became negative for
debt levels above 16070 percent of exports and 3540 percent of GDP.
These ndings are corroborated by Clements el al. (2003), who, based
on a sample of fty-ve low-income countries for the period 197099,
found even lower levels for the threshold level of external debt. Accord-
ing to them, external debt had a negative effect on economic growth for
debt levels above 3037 percent of GDP and 11520 percent of exports.
Schclarek and Ramon-Bellester (2005) reached different results. Based
on a sample of twenty Latin American and Caribbean countries for the
period 19702002, these authors found evidence of a negative effect of
total external debt on economic growth, but no evidence whatsoever of
a nonlinear relationship between these variables.
Post Keynesian economists are also skeptical regarding the effects of
capital account liberalization on long-term growth. Although the balance-
of-payments constraint is considered to be the ultimate constraint to
output expansion in the post Keynesian literature of demand-led growth
(Kaldor, 1977; Thirwall, 1979, 2002), external saving can only produce
a temporary increase in the growth rate that is compatible with balance-
of-payments equilibrium. In fact, a current account decit nanced by
capital ows allows a higher growth rate of importsand, consequently, a
higher rate of growththan would be the case if the current account was
balanced. However, current account decits increase the level of external
debt, increasing the ow of debt services (interest and amortization),
thereby reducing the rate of growth that is compatible with equilibrium
in the balance of payments. It can be shown that in the long-run equi-
librium, where the ratio of current account decit to domestic income is
constant, the balance-of-payments equilibrium growth rate is unlikely
to be substantially affected by the growth of capital ows (McCombie
and Roberts, 2002, p. 95).
Another issue regarding capital account liberalization is the nancial
fragility induced by this movement. Since emerging economies are, in
general, incapable of borrowing in domestic currency on international
capital markets, capital inows produce a currency mismatch between
assets and liabilities of these economies. This problem can worsen if li-
abilities are of short-term maturity and assets are of long-term maturity,
that is, if short-term capital ows are used to nance long-term assets
such as real estate. These problems increase the economys level of ex-
posure to a currency crisis in the case of a sudden stop of capital ows
(Davidson, 2002, ch. 13; Palma, 2002). A sudden stop can be the result
of self-fullling prophecies if short-term external debt is higher than
the countrys international reserves (Rodrik and Velasco, 1999). In this
602 JOURNAL OF POST KEYNESIAN ECONOMICS
case, an expectation of currency devaluation will trigger larger outows
of capital, producing greater exchange rate depreciation (independent of
the exchange rate regime), which will force the Central Bank to increase
interest rates (mainly in ination-targeting countries) in order to avoid a
huge increase in ination rates due to the pass-through effect of exchange
rate to ination. The monetary contraction will result in output loss and
a substantial reduction in growth rates.
The link between external saving and economic growth was also ana-
lyzed by Bresser and Nakano (2003). For them, external nancing tends
to generate a reduction in the long-term growth rates of emerging coun-
tries due to an excessive increase in external debt. In fact, an external
debt increase makes the emerging countries even more susceptible to a
balance-of-payment crisis, which, to resolve, demands signicant devalu-
ations of nominal and real exchange rates, in turn increasing ination
rates and inducing tight monetary and scal policies as a way to control
ination. This dynamic makes a huge trade surplus necessary to resolve
the balance-of-payments crisis, usually through cutting domestic absorp-
tion by means of very tight scal and monetary policies.
Up to now, however, little effort was made by post Keynesians in
order to analyze in a systematic way the relation between external debt
and economic growth. In fact, the post Keynesian literature presented
above does not show any precise mechanism by which accumulation of
external debt through a succession of current account decits can depress
economic growth. We can obtain only some imprecise analysis of the
effects of nancial liberalization on nancial fragility and long-term
growth. The post Keynesian literature has developed no formal model to
show the effects of external debt on economic growth and the channels
by which external indebtedness can depress long-term growth.
The objective of the present paper is to ll this gap and develop a post
Keynesian growth model to evaluate, at the theoretical and empirical
levels, the hypothesis that external debt may have a negative impact on
economic growth after some threshold level of external indebtedness.
This nonlinear effect of external debt on long-term growth will be shown
to be a consequence of the existence of a kind of decreasing returns
of capital ows over domestic investment together with a country risk
premium that is an increasing function of the level of external debt.
Indeed, for low levels of external debt, an increase in external indebt-
edness by means of foreign savings will result in a signicant increase
in desired investment by capitalists, since investment expenditure is re-
stricted, in an open emerging economy, by the capacity to import capital
goods from developed economies. This means that external borrowing
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 603
can ease the foreign exchange restriction on capital goods imports,
stimulating capital accumulation. However, the increase in investment
rate will not be proportional to the increase in external indebtedness
since capital ows will not be fully used to nance domestic investment,
but a share of this increase in external debt will be used, for instance, to
nance government decits or speculation in nancial markets. Hence,
external indebtedness will not result in a proportional increase in the
investment rate. On the other hand, the domestic interest rate will be an
increasing function of the level of external debt due to its effect on the
country risk premium in a setting of free capital mobility in the sense of
Mundell (1963) and Fleming (1962).
The combined effects of increasing levels of external debt over invest-
ment expenditure and domestic interest rate will produce a hump-shaped
relation between the rate of prot (and the rate of capital accumulation)
and external debt: for low levels of external debt, an increase in external
debt will result in an increase in the rate of capital accumulation and
hence in the rate of prot; after some threshold level of external indebt-
edness, however, an increase in the level of external debt will produce
a decrease in the rate of capital accumulation and in the rate of prot
since the positive effect of external debt on investment will be more than
offset by the negative effect on domestic investment of the increase in
the domestic interest rate.
When this hump-shaped relation between investment (and prot rate)
and external debt is combined with the requirement for a nonexplosive
ratio between external debt and capital stock (a necessary condition for
balanced growth in the model to be developed in this study), then it is
possible to show the existence of multiple long-run equilibrium positions
for the economic system, one characterized by a low level of external
debt (as a ratio to capital stock) and a high rate of prot, and the other
characterized by a high level of external debt and a low prot rate. This
means that excessive external indebtednessrelative to the threshold
level of external indebtednesscan result in stagnant growth due to its
negative effect on the rate of prot.
To empirically evaluate the predictions of the model about the rela-
tion between external debt and economic growth, we will also build an
empirical model of growth in the second part of the paper. The empirical
test of demand-led growth equations with a dynamic panel for fty-ve
emerging countries conrms the potential negative effects of external
debt on the long-run growth rates of the sample countries. Indeed, our
empirical results show that the threshold level of external indebtedness
is negative, so that the optimal policy for an emerging country is to
604 JOURNAL OF POST KEYNESIAN ECONOMICS
become a net creditor in international markets. In order to do so, emerging
countries may adopt policies that allowed them to run persistent current
account surpluses.
Capital accumulation and external borrowing
In this section we present a demand-led growth model for a small open
economy that operates with a xed exchange rate and a fully convert-
ible capital account. Investment and exports are assumed to be the au-
tonomous component of aggregate demand, which is in sharp contrast
to the standard balance-of-payments constrained growth models where
exports are considered to be the only source of autonomous demand for
the economy as a whole (Thirwall, 2002, p. 55).
1
For the sake of sim-
plicity, there are no government activities, so government expenditures
and taxes are set at zero.
The fundamental blocks of the model
We assume an economy in which the rms produce a homogeneous
good using labor and imported raw materials. The production technol-
ogy of the economy is represented by means of a Leontief technology,
in a way that the technical parameters of labor and commoditiesthat
is, the amounts of labor and raw materials required to produce a unit of
outputare independent of the production level of the rms. For sim-
plicity, we assume an economy without technological progress so that
labor productivitydened as the reverse of the unitary requirement of
laboris constant over time.
Just as is assumed in most post Keynesian growth models, here we
assume that the rms of this economy have market power and set the
prices of their goods based on a constant markup over the variable unitary
costs of production. Hence, the price equation of this economy is given
by (Taylor, 1989, p. 21):
p = (1+ )[wb + ep
*
0
a
0
], (1)
1
According to Kaldor (1988), in the long run the sources of autonomous demand
for the economy as a whole are given only by government expenditures and exports,
since investment is supposed to be determined by the Harrodian accelerator, so that
it is a fully endogenous variable in the long run. According to our understanding of
Keynesian investment theory, however, investment has a purely autonomous part,
even in the long run, due to its dependence on entrepreneurs animal spirits. This
means that it is theoretically unacceptable to treat investment as a purely endogenous
variable, as is assumed in balance-of-payments constrained growth models.
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 605
where p is the domestic price level, w is the nominal rate of wages, p*
is the international price level, e is the nominal exchange rate, b is the
unit requirement of labor, a
0
is the unit requirement of imported input
commodities, and is the rate of markup.
Let r be the prot rate and u the level of capacity utilization. It can be
shown that the prot rate is given by:

r u =
+

1
.
(2)
Hence, it can be seen that protability is an increasing function of
markup and of the degree of capacity utilization.
2
The goods market is cleared when the aggregate demand equals the
production level of the rms:
pC + pI + pE = pX, (3)
where pC is the nominal value of consumption expenditure, pI is the
nominal value of investment expenditure, pE is the nominal value of net
exports, and pX is the nominal value of the production level.
Additionally, also assumed is the existence of two social classes (capi-
talists and workers), which differ by the type of income they earn (prots
and wages) and by their propensity to consume out of the disposable
income. As in Kaldor (1956), it is assumed that the workers consume
all they get so their consumption propensity is equal to one (i.e., its
propensity to save is equal to zero), and, at the same time, capitalists
consume a constant fraction of their income (which is solely made of
prots), saving a fraction s
c
of their income. Hence, the nominal value
of the consumption expenditure is given by:
pC = wbX + (1 s
c
)rpK. (4)
By substituting (4) in (3):

I
K
E
K
s r qa mr
c
+ =
0
0, (5)
where q
ep
p
=
*
is real exchange rate and
m =
+

1
is prot share of income.
2
The markup rate is taken as given since it depends upon structural factors such as
(1) the degree of monopoly of the rms in the economy; (2) the level of entry barriers
to new rms in the industry; and (3) the degree of substitution between the products of
a given industry.
606 JOURNAL OF POST KEYNESIAN ECONOMICS
In this model, the rate of growth of capital stock (I/K = g) that is de-
sired by capitalists is a positive function of an autonomous component
(
0
),
3
of the difference between prot rate and interest rate (
1
[r i])
4

and of a component that depends upon the external indebtedness g as a
share of the capital stock (
2
z

).
5
It is assumed that an increase in the
external borrowing as a share of capital stock will result in a less than
proportional increase in I/K, that is, < 1.
6

I
K
r i z = + + < <

0 1 2
0 1 [ ] .
(6)
Equation (6) assumes a conventional Keynesian hypothesis that in-
vestment decisions are positively inuenced by the difference between
the current prot ratewhich is a proxy of the expected rate of return
for new planned investment (Possas, 1987)and the nominal interest
rate.
7
The new element in the investment function here is the inclusion of
external debt as a share of capital stock. This addition to the investment
function is intended to formalize the existence of an external constraint
to economic growth and capital accumulation.
8
In fact, as emphasized in
Bresser and Nakano (2003, p. 14), investment expenditure is restricted,
in an open emerging economy, by the capacity to import capital goods
from developed economies. According to this line of reasoning, external
borrowing can ease the foreign exchange restriction to capital goods
3
This refers, for instance, to the capitalists animal spirits. To get an understand-
ing of this concept, see Keynes (1936, ch. 12).
4
The rst two components of the investment demand function are the standard
formulation of investment decisions according to the so-called neo (post) Keynesian
approach to growth and distribution (Marglin, 1984, pp. 8195).
5
z = D/K is external indebtedness as a share of capital stock.
6
This happens because we are assuming, in accordance with the experience of
emerging countries, that part of foreign capital ows is used to acquire nonreproduc-
ible assets such as land.
7
For the sake of simplicity, we assume that the expected rate of ination is equal to
zero.
8
We introduce the external constraint to economic growth in a manner that is dif-
ferent from the conventional balance-of-payments constrained growth models, such as
that developed by Moreno-Brid (199899). In fact, Moreno-Brid analyzed the effect of
capital ows on the balance-of-payments constraint, but left open the question of the
determinants of effective growth rate. This means that in the long-run equilibrium, it is
possible that the effective growth ratelargely determined by the desired rate of capital
accumulationis lower than the balance-of-payments equilibrium growth rate. In this
case, capital accumulation and economic growth will be independent of capital ows,
which seems to be in contradiction to the empirical evidence of emerging economies.
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 607
imports, stimulating capital accumulation. In Equation (6), we use the
stock of external debt as a proxy for the inow of capital to the economy
at hand.
9
It can also be seen in Equation (6) that the external borrowing effect on
the investment rate is nonlinear. More specically, it is assumed that an
increase in external indebtedness as a share of capital stock will generate
a less than proportional increase in the investment rate. This hypothesis
can be justied by the idea that capital ows are not fully devoted to
nancing xed capital investment, but are also used, for instance, to
nance government debt or real estate. Hence, the external indebtedness
will not result in a proportional increase in the investment rate.
Net exports are a positive function of an autonomous component (
0
)
10

and a negative function of the level of capacity use, since it is assumed
that an increased level of economic activity implies increased imports,
which reduces the trade balance. Hence, the following equation can be
written:
11

E
K
u =
0 1
.
(7)
The country risk premium is assumed to be endogenous and given by
the following equation:
=
0
+
1
.z (8)
where:
0
> 0; e
1
> 0.
Equation (8) shows that the country risk premium is an increasing
function of the level of the ratio of external debt to capital stock. The
implicit idea in this reasoning is that the larger the external indebtedness
the greater the ow of external nancial commitments of the country,
increasing the risk of default on external debt (Oreiro, 2004).
To complete the model, it is necessary to specify the determinants of
domestic interest rate. In order to do that, it is assumed that the economy
9
This will happen if lenders in international capital markets desire a constant rate
of growth for assets denominated in currencies of emerging economies. In fact, let
d be the rate of growth of capital ows for a specic emerging economy. Then d =
FKF/D, where FKF is foreign capital ow. This means that D = FKF/d and z = D/K =
(1/d)*(FKF/K).
10
This depends upon the real exchange rate, among other variables. Since we as-
sume the existence of a pegged currency regime and price rigidity at the domestic and
international levels, it follows that the real exchange rate can be treated as a constant
and hence be incorporated in the autonomous component of the net export function.
11
In this model, the nominal and real exchange rate are assumed to be constant and
captured by the term
0
.
608 JOURNAL OF POST KEYNESIAN ECONOMICS
at hand has full convertibility of its capital accountthat is, it is assumed
that there is free capital mobility in the sense of Mundell (1963) and
Fleming (1962). We will also assume the existence of a xed exchange
rate regime. In this setting, the nominal interest rate is determined using
the uncovered interest rate parity theorem, which is given for the fol-
lowing equation:
i = i
*
+ . (9)
Substituting (8) and (9) into (6), we obtain an equation that denes
investment as a ratio to capital stock as a function of the external indebt-
edness and protability of the economy:

I
K
g r i z z = = + + + +

0 1 0 1 2
[ ( )] .
*
(10)
Hence, the relationship between the growth rate of capital stock and
the external indebtedness can be seen in Figure 1.
Taking the total derivative of (10), it can be shown that:

( )

I
K
z
z

2
1
1 1
.
(11)
Solving for u in Equation (2) and substituting the resulting equation
into (7), we arrive at:
Figure 1 Growth rate as a function of external indebtedness
g = I /K
z*
z
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 609

E
K
r =
+ ( )

0 1
1
.
(12)
By substituting (10) and (12) into (5), we dene the locus r = 0 by the
following equation:
0
1 2 1 0 1 1
1
0
= + + + +

r z i z m r s r qa mr
c
( ) ,
*
(13)
where:
0
+
0
.
Equation (13) shows the value of the rate of prot for which aggregate
demand is equal to the level of production. This is the short-run equilib-
rium value for the prot rate.
Solving for r in Equation (13) and taking the rst derivatives in regard
to r and z, we obtain the following expression:

=

( )
+ +

r
z
m z
s m qa m m
r c 0
2
1
1 1
1 0
2
1

.
(14)
The sign of

=
r
z
r 0
will depend upon
2
z
1

1

1
, which varies with z. Hence, as z be-
comes larger, the sign of r/z changes from positive to negative. This
behavior characterizes a nonlinear relationship between protability and
external indebtedness. It can also be observed that the threshold level of
external debt as a ratio of capital stock is given by:

2
1 1
1
1

z
*
.
The relationship between external indebtedness and protability can
be seen in Figure 2.
External indebtedness and multiple equilibrium: the long-run
dynamics of the model
The dynamic behavior of external indebtedness is given by the following
differential equation (Simonsen and Cysne, 1995):
D = i
e
D H, (15)
610 JOURNAL OF POST KEYNESIAN ECONOMICS
where D is the stock of total external debt, H is the net resources transfer to
abroad, and i
e
is the nominal interest rate of the external debt. The nominal
interest rate of the external debt is given by the following equation:
i
e
= i
*
+
0
+
1
z. (16)
By taking the time derivative of z, we get the following expression:

& z
D
K
K
K
D
K
=

,
(17)
where K/K is the growth rate of capital stock (g).
12
By substituting (15) and (16) into (17), we get the following
expression:

& z i g z
H
K
e
= ( ) .
(18)
The net foreign transfer of resources is nothing more than the net value
of exports H/K = E/K.
13
By substituting (10) and (12) into (18), we obtain
the nal expression of external debt dynamics:

z i z r i z z z m r

= + + + +
( )
+
* *
[ ( )] .

0 1 0 1 0 1 2 0 1
1
(19)
Figure 2 Protability as a function of the level of external indebtedness
12
Assuming that the capitaloutput rate is constant over time, it follows that the
rate of real output growth is equal to the rate of growth of the capital stock.
13
We assume that the balance of nonfactor services is equal to zero.
r
z*
z
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 611
Solving for r in Equation (9) and differentiating with respect to r and
z, we get the locus z = 0:

=
+

r
z
z
z z z
zm
m
i
& 0
0 1 2
1
2
1 1
1
2
0

pp p p
z i z i z z
zm
+ +

1 1 2
1
1 1
2
( )
( )
,
(20)
where:

0
= i
*
+
0

0

1
r + i
*
+
1

0

1
i
*

0

1
> 0;

1
= (2
1
+ 2
1

1
2
1

1
) > 0
i
p
= i
*
+
0
+
1
z > 0.
Equation (20) shows that the effect of an increase in external borrow-
ing over the economys protability depends on the level of external
borrowing. Assuming that
1
zm
1
> 0; the sign of

=
r
z
z 0
will depend upon the external borrowing. For a low level of z, the slope
is positive, whereas for high levels of z, the slope is negative. One of the
possible congurations of the locus at hand is shown in Figure 3.
In the steady-state equilibrium, the prot rate and the external indebt-
edness are constant over time. This allows us to dene the locus r = 0
and the locus z = 0; their slopes are given, respectively, in Equations
(14) and (20).
Hence, as given in Equations (14) and (20), it can easily be shown
that one of the possible congurations of the long-run equilibrium of the
economy under study corresponds to what can be seen in Figure 4.
Figure 4 shows the existence of two long-run equilibrium positions.
The rst one is characterized by the existence of a high protability (r1)
and a low level of external indebtedness (z1). We will call this position
equilibrium with low external indebtedness. The second position is
characterized by a situation of low protability (r2) and a high level of
external indebtedness (z2), which we will call equilibrium with high
external indebtedness. From this result we can conclude that capital
inows may cause an excessive level of external indebtedness (equilib-
rium with a high level of external indebtedness) with a negative effect
on prot rates and the degree of capacity utilization, which determines a
612 JOURNAL OF POST KEYNESIAN ECONOMICS
situation of economic stagnation. This happens because in this model, an
equilibrium in which the prot rate is low congures a situation where the
degree of productive capacity utilization is also low due to the supposed
constancy of the rate of markup. Since the capital accumulation rate is a
positive function of the degree of productive capacity utilization and a
negative functionbeyond a critical level of external borrowing z*of
external indebtedness, the growth rate of capital stock will be lower than
the one that would prevail if the economy were operating with a lower
level of external indebtedness.
Figure 3 Equilibrium locus of external debt
Figure 4 Long-run multiple equilibrium
z*
z
r
r
r
1
r
2
z
1
z
2 z
z = 0
r = 0

MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 613
Empirical evidence
We have seen in the theoretical model that the foreign capital inow can,
through accumulating external indebtedness, have negative consequences
for performance growth in emerging countries.
The aim of this section is to test the hypothesis that the external debt
has any effect on the macroeconomic performance of emerging countries,
based on panel analysis of a sample set of data for fty-ve emerging
countries,
14
according to the World Bank classication of countries by
income, covering the period 19802000. The sample is constituted by
low-middle income and high-middle income countries. The data comes
from Penn World Tables of Heston et al. (2006) and from the series of
World Banks World Development Indicators.
Empirical model
The idea here is to build a demand-led empirical growth model in a
Keynesian/Kaldorian fashion. In this framework, growth is determined
by the investment rate, which, in turn, is dependent not only upon the
dynamicity and competitive capacity of the export sector of the economy,
but also upon the level of external debt due to the effects presented in
the theoretical model. The external dynamicity here is a proxy for the
real exchange rate behavior of emerging countries.
To create an index of the competitive capacity of the external sector,
a real exchange rate devaluation index is estimated.
15
This index is the
difference between the actual values of the real exchange rate and its long-
run values, which is assessed by the predicted values of a PPP (purchasing
power parity) exchange rate equation, corrected for Balassa-Samuelson
effects. The properties of growth stimulus of devalued real exchange
rates are empirically consolidated. The real exchange devaluation index
is as described in Rodrik (2008). The author creates an exchange rate
misalignment index corrected for Balassa-Samuelson effects. According
14
The sample is composed of Albania, Algeria, Angola, Argentina, Armenia, Belize,
Botswana, Brazil, Bulgaria, Cameroon, Cape Verde, Chile, China, Colombia, Congo,
Costa Rica, Croatia, Cuba, Djibouti, Dominica, Dominican Republic, Ecuador, El
Salvador, Honduras, India, Indonesia, Iran, Iraq, Jamaica, Kazaquistan, Kiribati,
Latvia, Lebanon, Lesotho, Libya, Lithuania, Macedonia, Maldives Island, Mexico,
Mongolia, Morocco, Palau, Paraguay, Poland, Romania, Russia, Saint Lucia, Serbia,
South Africa, Sri Lanka, Sudan, Turkey, Ukraine, Uruguay, and Venezuela.
15
The theoretical vehicles of propagation of the effects of real exchange devaluation
on growth can be accessed in detail in Gala (2008) and, in a more conventional fashion,
in Rodrik (2008).
614 JOURNAL OF POST KEYNESIAN ECONOMICS
to Rodrik, this measure, which has the advantage of being comparable
between countries over time, is obtained in three steps. First, we use the
XRAT nominal exchange rate series from the Penn World Tables and the
PPP series to calculate the real exchange rate of a country i in period t.
Equation (21) shows the equation in logs:
ln
it
= ln(e
it
/PPP
it
). (21)
When the real exchange rate measured is larger than 1, it indicates
that the money value is lower than what is predicted by PPP. However,
in practice, nontradable goods are cheaper in poorer countries (Balassa-
Samuelson effect), so a correction is needed. Hence, in the second step,
we regress the real exchange rate over the RGDPCH Penn World Tables
series, as shown in Equation (22), where f
t
is the xed effect for the period
of time and u
it
is the error term.
ln
it
= +
0
lnRGDPCH
it
+ f
t
+ u
it
. (22)
Finally, in the last step we construct the real exchange rate devaluation
index measured according to Equation (23) as the difference between the
actual exchange rate and the predicted values of the model estimated:
ln(RealDevaluation)
it
= ln
it
ln
it
. (23)
This index of devaluation of the real exchange rate can be compared
between countries, and it is used in the following empirical model esti-
mates as a proxy variable of external competitiveness of the economy.
Fixed effect panel regression estimates of the long-run exchange rate are
reported in Table 1. The coefcient estimate of beta is 0.133, which
suggests a relatively strong Balassa-Samuelson effect: when income
increases by 10 percent, the real exchange rate appreciates by approxi-
mately 1.3 percent.
The empirical growth equation to be estimated is:

ln( / ) ln( / ) ln( / )
( / ) (
Y P Y P I Y
Debt GDP Debt
it it it
it
= + + +
+

1 1
2 3
// ) ( )
, ,
GDP CEX
OPENK SCHOOLING Desval
it it
i t i t
+ +
+ + + +

4
5 6 7 iit
,
(24)
where:
ln(Y/P)
it
is the log of GDP per capita based on the Laspeyres index in
1996 from the Penn World Tables 6.2 series;
ln(Y/P)
it1
is the log of GDP per capita with the Laspeyres index in 1996
basis, lagged in one period, from the Penn World Tables 6.2 series;
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 615
ln(I/Y)
it
is investment as a share of GDP, from the Penn World Tables
6.2 series;
ln(Debt/GDP)
it
is a proxy of the foreign savings and external indebt-
edness, dened as the net foreign assets position of a country with data
drawn from Lane and Milesi-Ferretti (2007);
ln(CEX)
it
is an index of external competitiveness of a country i, built
from XRAT and lnRGDPCH from the Penn World Tables 6.2 series. The
construction of the index was detailed above.
OPENK
it
is an index of the economys trade openness (exports + imports/
GDP), from the Penn World Tables 6.2 series;
SCHOOLING
it
is a human capital index given by primary school enroll-
ment, with series drawn from the World Development Indicators 2008;
Desval
it
is an index of relative depreciation of the real exchange rate.
is a year dummies vector, with one dummy for each period covering
every ve-year sequence;

it
is a stochastic residual.
Following Arellano and Bond (1991) and Blundell and Bond (2000)
we used the generalized method of moments (GMM) for a dynamic
panel. These estimators attempt to deal with unobservable temporal
effects by including time-specic intercepts. Dealing with these effects
is not a trivial task. As a result, the model is dynamic and may include
endogenous regressors that are controlled by means of the instruments
of the difference variables.
The instruments that correspond to moment conditions are lagged both in
terms of level and difference of the independent and dependent variables.
Because moment conditions typically overidentify the models regression,
the dynamic panel method allows for testing different specications with
Sargans or Hansens test. Using Arellano and Bond (1991) estimators,
Blundell and Bond (2000) developed a system estimator (System-GMM)
Table 1
Long-run real exchange rate with Balassa-Samuelson correction
Ln Coefcient Standard error P > t
ln(RGDPCH) 0.1333 0.0503 0.0080
Constant 1.9592 0.4195 0.0000
Notes: Fixed-effects (within) regression: no. of observations = 1,195; group variable (i):
countries: no. of countries = 55.
616 JOURNAL OF POST KEYNESIAN ECONOMICS
that uses additional moment conditions. The ArellanoBond (1991) and
BlundellBond (2000) estimators were considered suitable for the analy-
sis conducted here because they enable dynamic specication (allowing
a lagged dependent variable) and because they appropriately instrument
potentially endogenous variables. For a more detailed description of these
econometric techniques, see Baltagi (2005).
Table 2 presents the results of the empirical growth model. Specica-
tions (1)(4) test the robustness of the coefcients to different types
of variables coordination. The Hansen test checks the validity of the
overidentication of instruments for SYS-GMM, and is as expected.
The ArellanoBond test indicates rst-order correlation, but rejects the
null hypothesis for the second order.
The positive and signicant coefcients for the lagged dependent
variable in all specications indicate the persistence of the GDP per
capita series. The competitiveness index of exports shows a positive
and signicant relationship with the macroeconomic performance of the
sample countries. This result may suggest that the effects of a relatively
undervalued real exchange rate are an important matter for the growth
of countries in the sample. The investment variable, which is crucial to
growth models in the post Keynesian tradition, appears with positive and
signicant values for its coefcients. The Trade openness variable,
which is traditionally incorporated in growth regression, also appears
positive and signicant.
The Debt/GDP shows a negative correlation with GDP per capita
growth. The negative sign for Debt/GDP signals a hump-shaped re-
lationship as indicated in the theoretical model of the previous section.
Both effects are conrmed for the sample countries in all specications.
However, the positive effect of external debt on economic growth will
occur only for negative values of this variable.
16
This means that, accord-
ing to the empirical model, any positive level of external debt is harmful
for the economic growth of emerging countries. Economic growth can
be maximized only for a negative value of external debtthat is, only if
a country becomes a net creditor in international markets. This requires
running persistent current account surpluses.
This result is in opposition to the results presented in the literature
about external debt and growth. In fact, this literature showed that a posi-
tive, although small, level of external debt can have positive effects on
economic growth. Our empirical model showed that this happens only
16
Consider the following equation: y = a bx cx
2
. It can easily be shown that dy/
dx > 0 if and only if x < (b/2c).
MACROECONOMIC PERFORMANCE OF EMERGING COUNTRIES 617
for negative values of external debt. But it is important to note that this
result is not incompatible with the structure of our theoretical model.
In fact, this result can be derived from Equation (10) of the theoretical
model if we set = 2 and
2
< 0, which makes the threshold level of
external debt, z
*
, negative.
Table 2
Growth equations
(1) (2) (3) (4)
Ln(GDP/Per Capita) 0.683*** 0.669*** 0.553*** 0.630***
(0.0109) (0.0138) (0.0443) (0.0407)
Debt/GDP 0.0103*** 0.0283***
(0.00394) (0.00203)
Debt/GDP 0.007***
(0.0016)
Trade openness 0.0020*** 0.0028*** 0.0023***
(9.65e05) (8.19e05) (0.0002)
Government expenditure 0.0097*** 0.010*** 0.0023***
(0.0006) (0.0004) (0.0002)
Schooling 0.00230*** 0.00110*** 0.00478* 0.0071***
(0.0001) (0.0001) (0.002) (0.0021)
ln(Investment) 0.00426 0.00411** 0.0793*** 0.0662***
(0.0031) (0.0019) (0.0136) (0.014)
Real devaluation 0.887*** 0.826*** 0.800*** 0.827***
(0.207) (0.142) (0.143) (0.200)
Constant 2.505*** 2.690*** 2.965*** 2.247***
(0.100) (0.126) (0.546) (0.468)
AR(1) test 0.0100 0.0070 0.0070 0.0020
AR(2) test 0.782 0.551 0.576 0.559
Hansen test 0.902 0.314 0.513 0.456
Observations 551 551 551 805
Countries 55 55 55 75
Notes: Standard errors are given in parentheses. ***, **, and * denote signicant at the 1 per-
cent, 5 percent, and 10 percent levels, respectively.
Debt/GDP, Debt/GDP, the index of competitiveness of exports and schooling are treated
as endogenous variables in SYS-GMM.
Additional moments conditions were used with the level instrument variables foreign direct
investment and consumer price index, which prove to be good instruments for capital account
variables in several trial specications.
618 JOURNAL OF POST KEYNESIAN ECONOMICS
Final remarks
This paper presented a nonlinear post Keynesian growth model in order
to evaluate, at theoretical and empirical levels, the relationship between
external indebtedness and economic growth in emerging countries. The
main theoretical result of the model is the existence of two long-run
equilibrium positions: one has a high level of external indebtedness (as
a ratio of capital stock) and a low prot rate, and the other has a low
level of external indebtedness and a high prot rate. This means that
excessive external indebtedness can result in stagnant growth due to
its negative effect on the rate of prot.
To test the effects of external indebtedness on the rate of economic
growth in emerging economies, a dynamic panel is estimated to evaluate
whether external debt has an effective negative inuence on economic
growth in emerging countries. The empirical test of demand-led growth
equations with a dynamic panel for fty-ve emerging countries conrms
the potential negative effects of external debt over the long-run rate of
growth of the sample countries.
In particular, a hump-shaped relation was detected between external
debt and economic growth for the sample countries, but the positive
effect of external debt on economic growth occurs only for negative
values of this variable. This means that, according to the empirical model,
any positive level of external debt is harmful for the economic growth
of emerging countries. Economic growth can be maximized only for a
negative value of external debt, that is, only if a country becomes a net
creditor in international markets. This requires emerging countries to run
persistent current account surpluses.
Since persistent current account surpluses are required to foster eco-
nomic growth in emerging countries, we can conclude that capital ac-
count liberalization and the attraction of foreign savings are harmful for
growth performance in these countries.
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