ABSTRACT

Several studies on external debt have solely focused either on its causes or how it affects the macroeconomic variable in a country (or a group of countries). This study investigates the causes and consequences of external debt in Pakistan. Therefore, the annual time series data has been obtained on external debt and macroeconomic variables, spanning from 1976 to 2022 to fully capture the interaction between the two. In this study, the system of equations is being developed for exploring the causes and consequences of external debt. To tackle the problem of simultaneity bias associated with the system of equation, the study utilizes the Three Stage Least Squares (3SLS) technique. The 3SLS is only appropriate when there is a correlation between error term across equations in the system. While analyzing the causes of external debt indicator, government expenditure and current account balance have a negative relationship with external debt, thus decreasing their foreign borrowings and improving the trade balance situation. However, Real GDP and Foreign Exchange reserves cause accumulation of external debt in Pakistan. Thus, the study shows that external debt has a significant adverse effect on government expenditure, balance on current account, and investment, meaning that high external debt levels discourage domestic investment and exports and government spendings. On the contrary, economic growth, foreign exchange reserves, and real effective exchange rate are positively affected by the accumulation of external debt. The significant correlation of the residuals of different equations in a system justifies the application of 3SLS model instead of the Two Stage Least Squares (2SLS) model since 3SLS gives more efficient estimates.