The Impact of External Debt on the Nigerian Economy free essay sample

Prior to 2003, Nigeria’s external debt was greater than its export capacity. As for South Africa, the story is different, with a manageable debt indicator ratio better than that of Nigeria. The ratio of debt stock to GDP is a traditional debt indicator that compares a country’s debt stock with its productive capacities. By implication, the higher a country’s debt stock is, compared with its output, the greater the debt burden or indebtedness of that country. This ratio showed that debt stock was above the productive capacities of Nigeria in the year 1995, whereas the South Africa indicator ranges between 12. 3 and 22. 59 from 1994 to 2007. Nigeria’s ratio did not decline substantially until the debt relief was granted by the Paris club in 2006. The importance of this is that South Africa’s management of its debt, as well as its productive capacities, is better than that of Nigeria. The above point is well supported when one observes the debt service payment as a proportion of export, and as a proportion of GDP. We will write a custom essay sample on The Impact of External Debt on the Nigerian Economy or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page South Africa had continued to honor its external obligations regularly while Nigeria accumulated service arrears. This ratio is identical for both South Africa and Nigeria, despite the huge disparity between debt stock to exports of the two countries, because South Africa had been honoring its service obligations as and when due. In Nigeria however, there is a wide disparity between service due and payments, which further exerts substantial pressure on its debt stock due to recapitalization of arrears. 239 There are limitations to the aforementioned anecdotal comparative analysis because they have not been able to ascertain existence of a debt trap facing either of the two countries. Debt stock as well as debt service indicators, mostly serve as warnings of potential danger of excessively large debt stock. Based on Van Der Merwe (1993) even though the ratio of government debt to GDP has increased relatively sharply in South Africa, there is still no â€Å"explosion† in the growth of debt. Whether or not the same argument holds water for Nigeria prior to 2005 is a different story. From Tables 1 and 2, it is extremely difficult to draw any definite conclusions alone from our international comparisons thus necessitating for additional comparative analysis on the possible impact of huge debt on growth. The thesis of this paper is to apply some econometric approaches to investigate the presence of linear or non-linear effect of debt on economic growth. Literature Review Increases in savings and investment in an economy lead to economic growth (Hunt, 2007). Sachs (2002) argues that growth will not take-off until capital stock has risen to a given threshold. As capital rises, and investment and output rise, in a virtuous circle, the saving level will also continue to rise. After a given level, the rise in both capital and savings will be sufficient to engender self-sustaining growth. The reason for opting for external finance, as a means of ensuring sustained development rather than utilizing only domestic resources, is provided by the ‘dual gap’ theory. The theory postulates that investment is a function of savings, and that in developing countries, the level of domestic savings is not sufficient to fund the needed investment to ensure economic development. Thus, it is logical to seek the use of complementary external goods and services. The acquisition of external 240 funds, however, depends on the relationship between domestic savings, foreign funds, investment, and economic growth. A guiding principle on when to borrow is a simple one. Borrow abroad so far as the funds acquired generates a rate of return that is higher than the cost of borrowing the foreign funds (Ajayi Khan, 2000). In essence, by following this guiding principle, a borrowing country is increasing capacity and expanding output with the aid of foreign savings. External debt does not automatically transform into debt burden when funds are optimally utilized. In an optimal condition, the marginal return on investment is greater than or equal to the cost of borrowing. According to Edelman (1983), the critical factors affecting debt service capacity are returns on investment, the cost of borrowing, and the rate of savings. The benefits of external borrowing have been emphasized in the literature to the neglect of the costs. Ubok-Udom (1978), enumerates the costs of external borrowing to include debt service burden which incorporates costs implied by the term structure of external loans, costs of resultant liquidity crisis, costs of the viciously cumulative debt, the manageability of the debt, costs of debt rescheduling, and costs of import substitution among others. Colaco (1985) explains debt service vulnerability in developing countries using three contexts. First, the size of external loans has reached a level that is much larger than equity finance, resulting in an imbalance between debt and equity. Secondly, the proportion of debt at floating interest rates has risen dramatically, so borrowers are hit directly when interest rates rise. Thirdly, maturities have shortened considerably in large, part because of the declining share of official flows. All the above factors are relevant to Nigeria and South Africa. Mehran (1986) argues that adequate debt management is essential in an increasingly 241 complex financial environment. Mehran also identifies the critical components of debt management as policy co-ordination, regulatory environment, accounting, and statistical analysis. The aforementioned is true since the effectiveness of measures to reach a balanced level of debt supportive of development, depends on the debtor nation adopting fiscal adjustment and structural reform. Other features are transparency and anticorruption olicies, creation and/or improvement of debt management structures, and decision making processes among others. The next issue in debt acquisition and management is the determination of a sustainable level of debt. According to Ajayi and Khan (2000), sustainable foreign borrowing is measured by several ratios, such as debt to export, debt service to export, debt to GDP (or GNP), and external debt to Gross National Income among others. However, the determination of the sustainable level of these ratios is indeterminable and their usefulness is reduced to a warning of potential explosive growth in the stock of foreign debt. For instance, if the acquisition of additional foreign debt increases the debt servicing burden more than it increases the country’s capacity to bear the burden, such an acquisition becomes undesirable and the situation must be reversed through export expansion. If export is not expanded, more borrowing will be necessitated for servicing debt and external debt will pile up above the country’s capacity to bear. According to Omotoye et al. (2006), Nigeria is the largest debtor nation in the SubSaharan Africa. They also observe, in a comparative study with Argentina (Latin America’s most severely indebted nation), that Nigeria’s external debt, as a percentage of gross national income, has been continuously higher than that of Argentina since 1985 and continued to follow an upward pattern, unlike that of Argentina. The problem is compounded, according 242 to Greene (1989), by inability of the economy to generate the requisite resources to meet repayment obligations, especially since the early 1980s.