From 1978 to 2007

From 1978 to 2007

Name: Ying Xin Student Number: S1744585 Date: September 2008

Supervisor: dr D.H.M. Akkermans

Abstract

China has become increasingly dependent on external funding over the past years.

The previous empirical results indicate the existence of a positive relationship between economic growth and external debt below a certain threshold level (optimal external debt).

However, once the external debt exceeds this level, its impact on the performance of the economic growth becomes negative. So, it is difficult to say whether external debt has a negative, positive or nonlinear relationship on economic growth. In this paper, I will examine the impact of foreign debt on the performance of the China’s economy. There are some relevant questions: whether debt has a nonlinear effect on economic growth and I want to find out the level of external debt at which the marginal impact of debt on growth becomes negative. In addition, it is important to detect what are the other factors that influence the relationship between foreign debt and economic growth.

Moreover, I use time series data on China for the period of 1978 to 2007. GDP growth rate is used as the dependent variable and Investment over GDP rate, Government expenditure over GDP rate and Foreign Debt over GDP rate as independent variables.

Export over GDP rate, School enrollment rate and Inflation rate will be used as control

variable. In addition, I will bring about one dummy variable as explanation variable to

observe different situations before or after China’s access to WTO.

My results indicate that the effect of external debt on economic growth in China is

positive and significant. In other words, the share of China’s foreign debt to GDP is still

at low level, so foreign debt can stimulate China’s economic growth. Additionally,

investment will take positive and significant effects on the economic growth. There is

negative and significant relationship between inflation rate (government expenditure) and

growth.

Table of Contents

Abstract ……… 2

Table of contents ……….. 4

1. Introduction ……… 5

2. Literature review ……… 8

3. Hypothesis ………..13

4. Methodology………..… 20

4.1 Variable definition ………...…20

4.2 Data source.………..…22

4.3 Economic model .……… …22

4.4 Empirical analysis.………...25

5. Conclusion….……….33

5.1 Conclusion..………..…33

5.2 Limitation ………34

5.3 Further Expansion ………...…34

Reference ………35

1. Introduction

China opened its doors to the outside world and made transition to a market economy at the end of 1978. From then on, China’s new economic development strategy had changed from import orientation to export orientation and focused on the industry investment. Due to the weak domestic savings performance, China couldn’t carry out its economic reforms without massive foreign capital. Therefore, China tried to attract large scale direct foreign investment to achieve desired changes at the beginning of the reform.

Then, it experienced a change in the structure of its utilization of foreign capital in the early 1980s. As a result, the growth rate of direct foreign investment decreased slowly. At the same time, there is a gradual increase of foreign debt growth rate. That directly led to the high growth of foreign debt in the early 1990s. (See Figure 1)

Figure 1:

Foreign Debt and Direct Foreign Investment

0 500 1000 1500 2000 2500 3000 3500

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

100 Million Dollar

Foreign Debt Direct Foreign Investment

Source: China Year Book 1978-2007

Then, China officially became a member of the World Trade Organization (WTO) on the 11th of December 2001. During the transition period (2002-2005), China liberalized its trade regime step by step. The rapid growth of the domestic economy and foreign trade led to the continued increase of foreign debt in this period. As part of the conditions of accession to WTO, China completely opened its financial markets to the world since 11 December 2006. Further development of China’s economy will likely stimulate faster the increase of foreign debt in the future. Over the past three decades, accompanied by China’s policy reforms, the scale of foreign debt have undergone great changes. In 1979, the total volume of China’s external debt amounted to as little as 2.39 billion dollars

. However, it has risen rapidly to reach 331.56 billion dollars at the end of 2007. The average growth rate of foreign debt to GDP was 9% per year from 1978 to 2007.

China has become increasingly dependent on external funding over the past years.

The previous empirical results indicate the existence of a positive relationship between economic growth and external debt below a certain threshold level (optimal external debt).

However, once the external debt exceeds this level, its impact on the performance of the

economic growth becomes negative. So, it is difficult to say whether external debt has a

negative, positive or nonlinear relationship on economic growth. In this paper, I will

examine the impact of foreign debt on the performance of the China’s economy. There

are some relevant questions: whether debt has a nonlinear effect on economic growth and

I want to find out the level of external debt at which the marginal impact of debt on growth becomes negative. In addition, it is important to detect what are the other factors that influence the relationship between foreign debt and economic growth. Therefore, I use the growth model to analyze whether external debt along with other factors such as capital stock, labor force and human capital will have significant impact on the rate of economic growth.

The structure of this paper is organized as follows. Section 2 provides related literature of the relationship between the foreign debt and economic growth. Section 3 will propose some hypotheses. Section 4 uses the econometric model to thoroughly investigate the relationship between the foreign debt and economic growth in China’s economy, presents the empirical results and describes the main findings of the paper.

Section 5 concludes this paper, presenting the limitation of the research.

2. Literature review

From the literature, I want to investigate what’s the relation between the foreign debt and economic growth, and whether debt has a nonlinear effect on the growth? In this section, I will outline the existing literature related to these issues from two perspectives.

First, there are contradictory views on debt and growth, foreign debt maybe takes a positive or negative effect on growth. Second, maybe both effects are true, because a few models have combined them to explain that debt may have nonlinear effects on growth.

At first, the reasonable level of foreign debt as a capital inflow takes a positive effect

on economic growth. The early post- Keynesian growth models have emphasized the

importance of investment in economic growth. Domestic savings, foreign debt and FDI

are three main resources for investment. Therefore, with foreign debt going up, the GDP

growth rate increases (See Figure 2 Part A). In fact, some countries with abundant foreign

debt will experience faster economic growth. Moreover, country must repay debt and

repayment of foreign debt is composed of principal and interest. In the area A, the

earnings are more than the repayments that bring about economic growth. This can be

explained for capital scarce countries to borrow and invest since the marginal

productivity of capital exceeds interest rate on capital. That indicates the efficient

utilization of foreign debt and investment can lead to the increase of exports and taxes,

the continued growth earnings can be associated with positive economic growth.

Figure 2:

Source: own drawing

From the other side, over-borrowing can lead to the decrease of economic growth (See Figure 2 Part B). That can be explained by debt overhang theory: If debt will exceed the country’s repayment ability in the future, the expected debt service

will be an increasing part of its output. Thus the returns from investing in the domestic economy are effectively taxed away by existing foreign creditors and this might discourage investment by domestic and foreign investors

. In other words, debt overhang is a significant factor influencing slowdown in investment. When earnings are less than repayments, the debtors’ country has to increase taxes to pay their debt obligations. Too heavy taxes will affect real returns on investment, so that causes less investment and decrease of economic growth. Moreover, exports revenue is another important component of repayment in debtors’ country. Higher taxes lead to too expensive export goods. As a result, the drop of export trade will generate fewer earnings to pay back. That will have a vicious circle of

2 Debt service includes principal and interest.

3 This is the definition of debt overhang by Claessen in 1996.

higher growth taxes and fewer exports.

Krugman (1989) provides empirical evidence support a negative relationship between foreign debt and economic growth. This paper showed that large scale of foreign debt is limit to stimulate investment and debt overhang is the main reason for slowing economic growth in indebted countries. The debtor country cannot benefit fully from an increase of production because of the debt service obligation. They must pay a part of the production to creditor countries. Therefore, this paper justifies the existence of the debt overhang theory.

In addition, more recent studies have attempted to reconcile the above conflicting views by developing models with non-linear effects of debt on growth. At first, in the area A (See Figure 2), GDP growth rate is stimulated to increase step by step because of accumulated foreign capital. Due to too heavy tax on investment and too expensive price on export, the peak of curve is point C where large scale of foreign debt stock begins to take a negative effect and becomes a burden on economic growth. In the area B, over borrowing leads to the continued decrease of economic growth.

Calvo (1998) showed that the higher debt regime would be associated with low

growth since a higher tax burden on capital was required to service debt, therefore, a

lower rate of return on capital and lower investment would result. However, in the area

with lower debt have high economic growth rates that will reduce the tax rate needed to service the debt. Thus, the effect of debt on growth could become negative when foreign debt becomes excessive. Therefore, when examining the relationship between debt and economic growth, it is necessary to consider whether there is non-linear effect and what level the effect of external debt on growth become negative. Maghyereh and Kalaji (2002) used the AK models

to examine the relationship between external debt and the performance of the Jordanian economy after taking into account the possibility of the existence of a threshold effect. They tried to explain at what level external debt has a negative impact on economic performance. The empirical results indicate the existence of a positive relationship between economic growth and external debt below a certain threshold level (optimal external debt). This level is found to be equal to about 53 percent of GDP. In other words, once the external debt exceeds this level, its impact on the performance of the Jordanian economy growth becomes negative and statistically significant.

There are some empirical studies about the nonlinear effects of debt on growth.

Pattillo, Poirson and Ricci (2002) assess the non-linear impact of external debt on growth using a large panel data set of 93 developing countries over 1969-98. Results are across different econometric methodologies (OLS, instrumental variables and fixed effect), regression specifications and different debt indicators. The findings suggest that the average impact of debt becomes negative at about 160-170 percent of exports or 35-40

4 It is known as the endogenous growth models.

percent of GDP. The marginal impact of debt starts being negative at about half of these

values. High debt appears to reduce growth mainly by lowering the efficiency of

investment rather than its volume. Moreover, the authors also found that prospects of the

future tax burden enforce investments asymmetry toward the short-run projects with less

positive on the long-run productivity growth.

3. Hypothesis

In this section, I want to know what other factors that influence the relationship between economic growth and foreign debt. According to the production function model, there are four main factors influence economic growth: capital stock, human capital, labor force and foreign debt. In my study, I will choose GDP growth rate as the dependent variable (representing the China’s economic growth situation), investment to GDP ratio (representing the effect of physical capital accumulation), school enrollment (representing the country’s ability of human capital) and foreign debt as the independent variables to estimate whether these variables take effects on economic growth. In addition, inflation rate, export to GDP ratio and government expenditure to GDP ratio will be used as control variables to examine what effects it will take on economic growth. Next, I will explain my motivation to include this set of variables into my analysis and propose some hypotheses.

Figure 3: Relationship between the economic growth and production variables

At the beginning, it is necessary to explain why I choose GDP (gross domestic product) growth rate to describe China’s economic growth situation. GDP is one of the measures of national and output for a given country’s economy. This variable is defined as the total market value of all final goods and services produced within the country in a given period of time and present level of country’s economic development. (Wikipedia Encyclopedia) The GDP growth rate is the most important indicator of economic health.

As a result, I choose the GDP annual growth rate to evaluate China’s levels of economic growth.

Hypothesis 1: There is a positive and significant relationship between school enrollment rate and china’s economic growth.

The improvement of human capital can be represented by school enrollment rate which

describes the knowledge and skills embodied in individuals are an important source of

economic growth. This interpretation is supported by Pattillo, Poirson and Ricci (2002),

they found school enrollment rate was highly significant and positive with economic

development in all regressions. However, Khanobus and Bari (2000) found insignificant

impact of school enrollment rate on economic growth, claiming growth depend on the

quality, not quantity. It is well known that china has the largest population in the world,

so government does not have sufficient capacity to provide public enough education

opportunity. China’s school enrollment rate even is lower than lots of developing

countries. Although Chinese government tries best to improve education condition, the

slight variation of school enrollment rate whether will be beneficial to economic growth.

At the same time, the education quality of China’s high institution is not very well.

Therefore, I try to test whether there is positive relationship between school enrollment rate and china’s economic growth.

Hypothesis 2: There will be a positive and statistic significant relationship between the investment and economic growth.

Investment can present the effect of physical capital accumulation that is important factor for economic growth. The endogenous growth models have emphasized the positive relationship with between investment and economic growth. Lin and Sosin (2001) used the investment to GDP ratio as independent variable and found higher investment rate results in higher growth. Some empirical studies, Siddiqui and Malik (2001) have proven the hypothesis of a positive relationship between the growth rate and investment to GDP ratio in Asian countries. The countries with a higher level of investment to GDP ratio grew faster than countries with a lower level. Maghyereh et.al (2002) found a one percentage point increase in investment to GDP is associated with a 0.37 percentage point increase in real GDP growth rate in Jordan. Moreover, from Output-Expenditure

, we know domestic savings, foreign debt and foreign investment are three main sources for investment. China’s government makes some policy to stimulate the increase of foreign debt and foreign investment in recent years. As a result, the investment share of GDP rate

5 Output-Expenditure model: Y= GDP = C + I + G + X – M, I = Savings + Foreign debt + FDI

has arrived at 55.6% at the end of 2007. Thus, I try to explore whether the rapid increase of investment can stimulate China’s economic development.

Hypothesis 3: There will be a positive and statistic significant relationship between export and economic growth in China.

Export to GDP ratio is regarded as important standard of one country’s external competitiveness. Export is the main source for country’s foreign exchange income. More export can bring about more foreign exchange revenue that can strongly stimulate economic growth. Siddiqui and Malik (2001) used the share of volume of export in GDP as independent variable and found that the export to GDP was positively related to the growth rate of GDP. That means export growth will improve competitiveness and productivity of economy, thus lead to the increase of GDP. China officially became a member of the World Trade Organization (WTO) on 2001, its foreign trade experienced huge changes in recent years. The increase of export is always at the high level from 2001 to 2007. Therefore, I try to research whether high speed growth of export will have good influence on China’s economy.

Hypothesis 4: There is a negative relationship between government expenditure and economic growth.

Government expenditure is classified by economists into three main types: government

consumption, government investment and transfer payments. In the growth literature, this

variable is highlighted as quite important variable in determining economic growth. From the previous empirical studies, the effect of government expenditure on economic growth is disputable. Oleksandr (2003) highlighted government expenditure is quite important variable in determining economic growth. In his empirical study, he found that this variable negatively affected growth in its growth regression. Tax is main source for government expenditure, so the higher taxes will reduce the efficient allocation of resources and the level of output. However, Chadha and Coricelli (1997) found that the importance of this variable in their theoretical model in terms of government should support efficient restructuring of economy. That means the increase of government expenditure can stimulate economic development during economic depression. Over the past 30 years, China’s government expenditure increased from 1122 hundred million yuan in 1978 to 40422 hundred million yuan in 2007

. Due to this rapid growth, I want to know government expenditure will take negative or positive on China’s economic growth.

Hypothesis 5: There will be a negative relationship between inflation rate and economic growth.

Inflation rate can be used to measure the macroeconomic stability that is important factor for the transition economic growth. Higher inflation maybe causes inflationary pressures in the future. Maghyereh et.al (2002) found inflation uncertainty causes the real value of future payments and earnings to be uncertain, and thereby can distort economic agents’

6 From <China Statistical Year Book 1978-2007>.

decisions regarding investment and consumption. Oleksandr (2003) found the lower the rate of inflation would be associated with higher economic growth. From 1978 to 2007, china experienced many policy reforms that strongly lead to macroeconomic instability, the inflation rate has great fluctuation. As a result, I am interested in examining whether there is negative relationship between inflation rate and economic growth.

Hypothesis 6: The foreign debt to GDP ratio has inverted U-shape (See Figure 1) relationship with economic growth in China.

The early post- Keynesian growth models have emphasized the importance of investment in economic growth. Domestic savings, foreign debt and FDI are three main resources for investment. Therefore, foreign capital plays an important role in economic growth. The reasonable level of foreign debt as a capital inflow takes a positive effect on economic growth. However, over-borrowing can lead to the decrease of economic growth. That can be explained by debt overhang theory: If debt will exceed the country’s repayment ability in the future, the expected debt service

will be an increasing part of its output. Thus the returns from investing in the domestic economy are effectively taxed away by existing foreign creditors and this might discourage investment by domestic and foreign investors

. In other words, debt overhang is a significant factor influencing slowdown in investment.

When earnings are less than repayments, the debtors’ country has to increase taxes to pay their debt obligations. Too heavy taxes will affect real returns on investment, so that

7 Debt service includes principal and interest.

causes less investment and decrease of economic growth. As a mentioned above, I try to

test whether the inverted U-shape relationship exist in China’s economic growth and

foreign debt.

4. Methodology 4.1 Variables Definition

I will use GDP growth rate as the dependent variable, and Investment over GDP rate, Government expenditure over GDP rate and Foreign Debt over GDP rate as independent variables. Export over GDP rate, School enrollment rate and Inflation rate will be used as control variable. Moreover, I will bring about one dummy variable as explanation variable to observe different situations before or after China’s access to WTO. Next, I want to explain definition of every variables and how to measure them.

GDP (gross domestic product) growth rate is counted by the annual gross domestic product (100 Million Yuan) minas last year gross domestic product (100 Million Yuan

) then divide last year gross domestic product (100 Million Yuan). It is calculated according to constant price and 1978 (opening year) is seen as initial year.

Investment to GDP ratio (IGR) is the independent variable, which is the share of annual total value of investment (100 Million Yuan) over this year’s GDP (100 Million Yuan). It is calculated according to constant price.

School Enrollment rate (SER) is independent variable, which is the share of annual

amount of the high institution education number of people (million) over this year’s total

population (million).

Foreign Debt to GDP ratio (FDG) is independent variable, which is the share of annual foreign debt (100 Million Yuan) over this year’s GDP (100 Million Yuan). It is calculated according to constant price.

Government expenditure to GDP ratio (GGR) is the control variable, which is the share of annual total value of government expenditure (100 Million Yuan) over this year’s GDP (100 Million Yuan). It is calculated according to constant price.

Export to GDP ratio (EGR) is the control variable, which is the share of annual total value of export (100 Million Yuan) over this year’s GDP (100 Million Yuan). It is calculated according to constant price.

Inflation rate (IR) is used as control variable to measure inflation (the rate of increase of a price index). It is calculated by the current average price level minus the price level of last year, and then divided the price level of last year.

Dummy variable is explanation variable to distinguish time before or after China’s access to WTO. My study use data from 1978 to 2007 china economy. I divide this period into 2 sub-periods. The first is from 1978(opening year) to 2001(access to WTO). The second is from 2002 to 2007 (China opened completely the market to all over the world).

I want to utilize this dummy variable to observe the different relationship between the

every variables and economic growth in two periods.

4.2 Data Source

The data of GDP, GDP growth rate, investment, export, school enrollment, government expenditure, inflation rate and foreign debt from 1978 to 2007 are from

“China Statistical Year Book” and “People's Republic of China - national economic and social development of statistical bulletin.” that are published by China Statistical Bureau.

Other relevant data are taken from the National Statistics Office and other website such as the China Institution fro development studies.

4.3 Econometric Model and Choosing Methodology

In order to explore the impact of foreign debt on economic growth, it will be used

econometric method to estimate this relationship. At first, I want to know whether foreign

debt has a nonlinear effect on china’s economic growth and to what extent it influences

economic growth. As above mentioned, there are some theories to support that the linear

specification might be inadequate to identify the influence of debt on growth, so it is

necessary to employ a following specification to find out the level of external debt at

which the marginal impact of debt on growth becomes negative (taking into account the

possibility of the existence of a threshold effect which maybe show up nonlinear

relationship):

The linear specification:

Y

= α

+ α

IGR

+ α

SER + α

D

+ α

Dummy + γ

X

+ μ

(1)

t = 1978-2007; i = 1-3; Z t=0 Dummy=0(1978-2001), Dummy =1(2002-2007)

The quadratic specification:

Y

= α

+ α

IGR

+ α

SER + α

D

+ α

D

+ α

Dummy + γ

X

+ μ

(2)

t = 1978-2007; i = 1-3; Z _t=0 Dummy=0(1978-2001), Dummy =1(2002-2007)

The spline specification:

Y

= α

+ α

IGR

+ α

SER + α

D

+ α

Z

(D

– D*) + α

Dummy + γ

X

+ μ

(3)

t = 1978-2007; i = 1-3; Z _t=0(if D _t< D* ), Z _t=1(if D _t> D* );Dummy=0(1978-2001), Dummy =1(2002-2007) The idea of this specification is from “External Debt and Economic Growth in Jordan: The threshold effect”

(Maghyereh, Omet and Kalaji, 2002) and “External Debt and Growth”(Pattillo, Poirson and Ricci, 2002).

Y is dependent variable GDP growth rate. IGR (investment to GDP ratio) and SER (school enrollment rate) are independent variables. X

is control variables that contain export over GDP ratio, inflation rate and government expenditure to GDP ratio. D represents the debt to GDP indicator, D* is the threshold level of external debt, Z is a dummy variable that is equal to one if debt is above D* and zero otherwise and μ is the random error term.

At the beginning, I will make a regression of linear and quadratic equations and

choose one that is good enough to capture the relation between foreign debt and

economic growth in China. Firstly, the value of the Adjusted R

, F-test and the coefficient

of all variables will be calculated in two equations

. If the Adjusted R

of linear equation (1) is higher than of quadratic equation (2), the F-test’s p-value of equation (1) is significant and smaller than equation (2) and more coefficient of variables of equation (1) are significant than equation (2), we can say that a linear relationship explains more than a quadratic relationship and vice versa.

Figure 4:

Source: own drawing

If I choose the equation (1) as the econometric model, when α

is positive and significant, the relationship between the growth and debt will be in Area A, (See Figure 1) when α

is negative and significant, the relationship between the growth and debt will be in Area B. (See Figure 1) If I choose the equation (2) as the econometric model, when α

is positive and significant, α

is negative and significant, there will be inverted U-shaped

curve (See Figure 4) relationship between the foreign debt and economic growth. When

α

is negative and significant, α

is positive and significant, there will be U-shaped curve (See Figure 4) relationship between the foreign debt and economic growth.

If U-shaped curve relationship between the foreign debt and economic growth can be proved, I will try to calculate the optimal level of foreign debt in China’s economy. In this spline equation (3), we can know that the effect of debt on GDP growth rate is given by α

when foreign debt is less than or equal to the optimal external debt level (D*), and by α

+α

when external debt is higher than the optimal one. The best debt threshold D*

can be determined by the residual sum of squares (RSS) for different threshold level of foreign debt from D

to D

. The optimal threshold level is which the regression products minimize the sequences of RSSs. Last, I will apply WLS regression to test the relationship between each variable and China’s economic growth.

In my study, I want to investigate whether threshold effect will exist in the

relationship between foreign debt and economic growth. In my opinion, different

countries may have different situations about their foreign debt, so it is not necessary to

explore general statement across several countries. In other words, case-by-case methods

can be used to consider about every country’s unique characteristics. As a result, I choose

the time series data from 1978 to 2007 in China and try to find out feasible method to

resolve the issue.

4.4 Empirical Analysis

In order to obtain a better understanding of the situation of foreign debt on growth in China, I will bring about some figures that have good view of these variables. At first, have a look two figures (See Figure 5 and 6), it is easy to find that the GDP growth rate increase rapidly in China and the average growth rate is 9.4% from 1978 to 2007. In addition, the total volume of China’s external debt amounted to as little as 2.39 billion dollars in 1979. However, it has risen rapidly to reach 331.56 billion dollars at the end of 2007. The average growth rate of foreign debt to GDP was 9% per year from 1978 to 2007.

Figure 5: GDP of China

Figure 6: Foreign Debt of China

FOREIGN DEBT OF CHINA

0 500 1000 1500 2000 2500 3000 3500

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

year

100 million dollor

FOREIGN DEBT OF CHINA GDP(China)

0 50000 100000 150000 200000 250000 300000

1978197919801981198219831984 19851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007

year 100 million yuan

GDP(China)

The descriptive statistics are provided to enhance the understanding of the data set.

This contains standard descriptive statistics such as minimum, maximum and standard deviation. (See Table 1)

Table1: Descriptive Statistics

As mentioned above, I choose time series data to study the topic. Therefore, prior to applying the estimation procedure, I must test whether the data is stationary. I apply the unit root test of ADF test, the results indicate there is a unit root in all variables (the results of ADF test are bigger than critical value). In other words, the null hypothesis that each of the time series has a unit root cannot be rejected and data is nonstationary. But when I apply on the first difference level, there is no a unit root (the results of ADF-test are smaller than critical value). As a result, I try to transfer the variables of interest by taking their first difference operator to achieve stationary.

Table 2 present the correlation matrix among the variables, I will test for multicollinearity through it. As we can see, the coefficient of all variables is between -0.8 and 0.8, so there is no multicollinearity. In addition, the coefficient of foreign debt to GDP ratio is positive with GDP growth rate. However, from the previous studies and

GDP GR FDG IGR SER EGR GGR IR

Observations 30 30 30 30 30 30 30

Mean 0.094 0.15 0.342 0.026 0.271 0.2 0.058

Median 0.096 0.146 0.341 0.02 0.278 0.183 0.037

Maximum 0.152 0.247 0.556 0.056 0.395 0.354 0.241

Minimum 0.039 0.034 0.199 0.009 0.178 0.117 -0.014

Std. Dev. 0.026 0.057 0.090 0.014 0.057 0.055 0.065

related theories, over borrowing foreign debt maybe lead to the negative effect on the economic growth. Maghyereh (2005) studied the relationship between debt and growth in Jordan. They found part of the correlation is wrong and can’t reflect the nonlinear relationship between debt and growth posited by theory. Therefore, I will examine whether there is nonlinear relationship between debt and growth firstly.

Table 2: Correlation Matrix of Variables

GDP GR FDG IGR SER EGR GGR IR

GDP GR 1

FDG 0.01676 1

IGR 0.29131 0.12236 1

SER 0.051852 -0.09636 0.69962 1

EGR 0.04268 -0.17304 0.069739 0.10799 1

GGR -0.01625 -0.50759 -0.44569 -0.36778 0.44432 1

IR 0.21215 0.36567 -0.014406 -0.28826 -0.15904 -0.24762 1

It is also important to check the heteroscedastic and autocorrelation problem of

my data. At first, I use the White heteroscedastic test and find that p-value of Obs*R is

greater than the significance level, there is no heteroscedastic. Moreover, the traditional

test for the presence of autocorrelation is the Durbin–Watson statistic test, the result

(1.9684) is approximates 2, so there is no autocorrelation.

Figure 7: Economic growth and Foreign debt in China

Econom ic Grow th and Foreign Debt

0 5 10 15 20 25 30

1978 1980

1982 1984

1986 1988

1990 1992

1994 1996

1998 2000

2002 2004

2006 Year

GDP GROW TH RATE(% ) (Y) FOREIGN DEBT TO GDP RATIO(% ) (X7)

From Figure 7, we see the foreign debt to GDP ratio has peaked in the early of 1990s.

It is easy to find that economic growth rate is positive with foreign debt. As mentioned

above, I make a regression of equation (1) and (2), and calculate the value of the Adjusted

R

, F-test and the coefficient of all variables.(See Table 3) I can find that the Adjusted R

of linear equation (1) is higher than of quadratic equation (2), the F-test’s p-value of

equation (1) is significant and smaller than equation (2) and more coefficient of variables

of equation (1) are significant than equation (2). Therefore, I can say that a linear

relationship explains more than a quadratic relationship. There is no threshold effect in

China’s economy from 1978 to 2007. I choose the equation (1) and use WLS to make a

regression.

Table 3: Estimation Results

△ Y

= α

+ α

△ IGR

+ α

△ SER + α

△ D

+ α

Dummy + γ

△ X

+ △ μ

WLS(Linear) WLS(Quadratic) D(IGR) 0.40708*** 0.40504**

D(SER) 1.45126 1,26703

D(FDG) 0.19659* 0.15271*

D(FDG)² --- 0.37399

D(EGR) 0.12577 0.12954

D(GGR) -0.43649* -0.42243*

D(IR) -0.04959** -0.04059

Dummy -0.56354 -0.54832

C -0.00841 -0.00753

D-W test 1.9684 1.9911

F-statistic 1.5062* 1.5126 Adjusted-R² 0.4369 0.4283

* Implies a significance at the 10 percent level

** Implies a significance at the 5 percent level

***Implies a significance at the 1 percent level

From the above table 3, we know that the investment to GDP ratio is positive and statistically significant relationship with china’s economic growth. A one-percentage point increase in investment to GDP is associated with 0.4 percentage point growth in GDP. This result is consistent with the hypothesis. That indicates the higher lead to the faster economic growth. Moreover, there is also positive and significant relationship between the export to GDP ratio and economic growth. These results agree with the hypothesis and illustrate the increase of export can stimulate the economic growth. In addition, the school enrollment rate is positive, but not significant with economic growth.

The possibility explanation of this result can be found that there are too many people in

China and government can’t provide enough education opportunities, so the slight improvement of school enrollment rate is not important to boost China’s economic development.

In addition, the government expenditure to GDP ratio has negative and significant relationship with economic growth at 10% level. The possibility explanation of this result can be found that tax is main source for government expenditure, so the higher tax reduce investment incentive, the efficient allocation of resources and the level of output. The result of inflation rate is consistent with theory and has negative and significant relationship with GDP growth rate. Inflation uncertainty causes the real value of future payments and earnings to be uncertain, and thereby can reduce investment rate and distort economic growth.

The most important result is the relationship between foreign debt and economic

growth, but it is not consistent with hypothesis. From Table 3, I can see that there is

positive and statistical significant relationship between growth and external debt. This

result indicates that China’s foreign debt is still at the low level now, so the foreign debt

will not take bad effects on economic growth. China opened the doors to the outside

world from 1978. From then on, China began to utilize the external debt to stimulate

economic growth. Over the past 30 years, although the amount of foreign debt increased

year by year, the share of debt over GDP is still at the lower level. Therefore, I can

conclude that the relationship between the debt and growth in China is in A region (See

Figure 2). In other word, the increase of external debt can stimulate China’s economic

growth.

5. Conclusion 5.1 Conclusion

The most important results indicate that the effect of external debt on economic growth in China is positive and significant. In other words, the increase of external debt can stimulate China’s economic growth. China opened the doors to the outside world from 1978. From then on, China began to utilize the external debt to improve economic growth. Over the past 30 years, China experienced several policies reforms about foreign debt are to succeed in creating a dynamic economy. Although the amount of foreign debt increased year by year, the share of debt over GDP is still at the lower level. As a result, the reasonable foreign debt gives good impacts on China’s economic growth. Increased real GDP can help to reduce poverty, unemployment and external debt overhang, national power and people’s living standard will be improved.

Additionally, the investment to GDP ratio is positive and statistically significant

relationship with the china’s economic growth. A one-percentage point increase in

investment to GDP is associated with 0.4 percentage point growth in GDP. Moreover,

there is also positive and significant relationship between the export to GDP ratio and

economic growth. The school enrollment rate is positive, but not significant with

economic growth. In addition, the government expenditure to GDP ratio has negative and

significant relationship with economic growth. The result of inflation rate is negative and

significant with GDP growth rate.

5.2 Limitation

In my study, I only test the relationship between the foreign debt and economic growth. It is well known that there are different kinds of government finance such as foreign debt, domestic debt and taxes. It is desirable to distinguish different kinds of government finance’s effects on economic growth. Another limitation of this paper is that I choose the total government expenditure as the control variable. The total government expenditure includes education expenditure, infrastructure expenditure and capital expenditure and so on. I expect to investigate the relationship among foreign debt, different kinds of government expenditure and economic growth.

5.3 Future research expansion

In future research, I will investigate the different relationship between debt and

growth in more countries. In this study, I have only research on China. Therefore, I am

interested to study this problem on some developed countries or some other developing

countries in the future. In addition, I try to find out the answer that whether the effect of

debt on growth and its sources depends on the policy environment.

References:

Calvo, A. (1998). “Debt Growth and Economic Transformation: The Capital Flight Problem”, New Theories in Growth and Development, St. Martin’s press.

China Statistics Year Book (1978-2007). “National Bureau of Statistics of China”

http://www.stats.gov.cn/

Chadha, B and Coricelli, F. (1997) “Fiscal constraints and the speed of transition”, The Journal of Development Economics, vol 52, pp.221-249

Claessens, S. Wickham, P. Detragiache, E and Kanbur, R. (1996). “Analytical aspects of the debt problems of Heavily Indebted Poor Countries”, World Bank Policy Research Working Paper Series, SSRN_ID636121code384013

Khasnobis, B and Bari, F. (2000). “Sources of Growth in South Asian Countries”, Unpublished Study Prepared for Global Research Project of World Bank

Accessed at 01/06/2008, http://www.saneinetwork.net/pdf/grp/Basudeb.PDF

Karagol, E. (2002) “The Causality Analysis of External Debt Service and GNP: The Case

of Turkey”, Department of Economics and Related Studies Heslington, York, Y010 5DD,

UK

Accessed at 01/06/2008, http://www.tcmb.gov.tr/research/cbreview/jan02-3.pdf

Krugman, P. (1988). “Financing vs. Forgiving a Debt Overhang”, Quarterly Journal of Economics, Vol.110, No.4, pp.1127-70

Lin, SL and Sosin, K. (2001). “Foreign debt and economic growth”, Economics of Transition, volume 9 (2), 635-655

Maghyereh, A. Omet, G and Kalaji, F. (2002). “External Debt and Economic Growth in Jordan: The Threshold Effect”, SSRN_ID364300_code030115500,

Oleksandr, D. (2003). “Nonlinear impact of external debt on economic growth: the case of post-soviet countries”. Accessed at 09/04/2008

http://www.eerc.kiev.ua/research/matheses/2003/Demchuk_Oleksandr/body.pdf

Pattillo,C. Poirson,H and Ricci,L. (2002). “External Debt and Growth”. International Monetary Fund, WP/02/69

Sachs, J. (1989). “The debt overhang of developing countries”, in Ronald Findlay, Debt,

Stabilization and Development, Essay in Memory of Carlos F. Diaz Alejandro.

Siddiqui, R and Malik, A. (2001) “Debt and Economic Growth in South Asia”, the

Pakistan Development Review, 40:4 Part 2 pp. 677-688