External debt and economic growth nexus in Iran: Role of macroeconomic polices

Foreign or external debt is a tool that governments can use to encourage the investments and economic growth through the development of infrastructures. It plays an important role especially in the developing countries, as most of these countries suffer from the investment shortages and also budget deficits. In addition, in these countries, the savings and export revenues are not enough to finance new investments and import expenditures of the country. In recent years, borrowing has become an important economic problem not only for the developing countries but also for the developed countries as well. In many countries, global crisis and expansionary public policies have caused a rapid increase in the external borrowing.
It is widely known that the wise use of the external debts is necessary to enjoy the benefits of these debts. Otherwise, it will increase the burden on the country in the future and will harm the economy, when the time comes to pay the debts back. In other words, it is necessary to take into account the sustainability and also the efficient allocation of these funds. If the funds that have been raised through debt can be channeled to the investments, they will increase the growth rate of the country and also will make the country capable of paying them back in the future. Otherwise, these funds would reduce the economic growth rate, as a large portion of the government revenues will be used to pay back the debts. Several theories are introduced to link the debt to the growth. Debt overhang hypothesis is one of the theories that anticipates a negative relationship between the external debt and the economic growth. According to this hypothesis, when the external debt increases in a country, investors anticipate that the government will raise the tax rates in the future to gather enough funds to pay the debts back. Therefore, they will invest less, which will reduce the growth rate.
Liquidity constraint hypothesis is another theory that predicts a negative link between the debt and growth. According to this hypothesis, the country will need a large amount of credits in the future to pay the debts back and this will reduce the growth. The accumulation of debt is the third theory that states a negative effect of debt on growth. Based on this theory the government's investment on new technologies, human capital, and financial system will decrease over time. At the same time, a higher debt will increase the uncertainty in the economy which will raise the interest rate and will result in a lower investment.
Considering all these issues, this paper examines the impact of external debt on the economic growth in Iran over the period 1980–2013. To that end, the ARDL approach to co-integration is used. This paper differs from the other papers on this issue in two aspects. First, the effect of the external debts on the economic growth is examined taking into account the presence of different macroeconomic policies. Second, the external debt is divided into bilateral and multilateral debts and their effect on the growth is examined separately.
The impact of external debt on growth is analyzed allowing external debt to interact with the macroeconomic policy index. In addition, the ratio of the external debt to the GDP, the ratio of debt service to the export, and the ratio of multilateral external debt to total external debt also included in the model to examine their effect on the economic growth in Iran.
The results show that external debt has a negative impact on growth, but this adverse effect can be reduced or even reversed in the presence of sound macroeconomic policy. Moreover, the bilateral component of the total external debt is the part that retards the economic growth.