EFFECTS OF EXTERNAL FINANCIAL DEBT ON VARIOUS ECONOMIC SECTORS IN LATIN AMERICA. A thesis. Presented to the faculty

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1 EFFECTS OF EXTERNAL FINANCIAL DEBT ON VARIOUS ECONOMIC SECTORS IN LATIN AMERICA A thesis Presented to the faculty of Financial Economics programme at ISM University of Management and Economics In Partial Fulfillment of the requirements for the Degree of Master in Financial Economics by Aurimas Matelis May 2014 Vilnius

2 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 2 Abstract Matelis A. Effects of External Financial Debt on Various Economic Sectors in Latin America: Master thesis, Financial Economics. Vilnius, ISM University of Management and Economics, This study aims to investigate the external debt effect on different economic sectors in Latin America a region highly dependent on external factors and having a history as a region that tends to have a high external debt. In literature, the researches in most cases suggest and focus on negative external debt effects on economy with rare inquiries concerning effect on sectors another ankle to look at economy conditions. Using secondary macroeconomic data in time horizon from 1980 to 2011, the panel data analysis is adopted to capture the external debt effect on agriculture, manufacturing and services sectors in the countries members of the Union of South America nations representatives of Latin America. The findings suggest an existing negative effect on agriculture and manufacturing sectors indicating an unfavorable pressure on these sectors while a positive effect on services sector with an affirmative input on this sector as external debt level increases. Findings also suggest that debt servicing indicates for crowding out effect of investment from agriculture and services sectors and contradicting results for manufacturing sector. However, limitations of this study plays a big role in a perfect interpretation and perception. Keywords: External debt, economic sectors, agriculture, manufacturing, services, macroeconomic, panel data

3 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 3 Contents INTRODUCTION Literature review External Debt External debt contribution to economy Economic sectors contribution to economy Effects of external debt on economic sectors Literature review inference Problem definition Research methodology Panel data Dynamic panel data Research design Region Economic Sectors Data Empirical research Region Analysis Economic sectors Effect on agriculture sector Effect on manufacturing sector Effect on services sector Dynamic panel data External debt effect on agriculture External debt effect on manufacturing External debt effect on services External debt curvilinear relationship with sectors Discussion Main findings Findings in the light of theory Findings that fail to support hypothesis Limitations of the study Implications for further research... 76

4 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Policy implications of the study CONCLUSION Bibliography Appendixes List of figures Figure 1. Debt indicators. Trend Figure 2. Debt indicators of HIPCs decline since Figure 3. The debt-laffer Curve Figure 4. Debt Relief and output Figure 5. Stylize shape of non-linear relation between debt and Figure 6. The changing structure of employment during economic development Figure 7. Gross domestic product Figure 8. Economic and trade balance Figure 9. Current account (% of GDP) Figure 10. Average agriculture value added Figure 11. Average manufacturing value added Figure 12. Average service sector value added Figure 13. Scatterplot of agriculture value added Figure 14. Scatterplot of manufacturing value added Figure 15. Scatterplot of services value added List of tables Table 1. Dynamic panel data output results (agriculture) Table 2. Dynamic panel data output results (manufacturing)... 61

5 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 5 Table 3. Dynamic panel data output results (services) Table 4. Dynamic panel data (SYS-GMM) output results (agriculture) Table 5. Dynamic panel data (SYS-GMM) output results (manufacturing) Table 6. Dynamic panel data (SYS-GMM) output results (services) Table 7. Main findings from variables in interest for three sectors

6 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 6 INTRODUCTION A usage of external debt for countries does not at once imply an economic stagnation or a clear future recession. Total external world debt has increased by 4.67% from $69.6 trillion in 31 December 2011 to $72.85 trillion in 31 December 2012, and had a higher than total world product. To the gross world product at the same time ($ trillion, in 31 Dec and $72.69 trillion in 31 Dec. 2012) grew at 2.07% (CIA world Factbook). It shows a need of source of finance for a future development or to cover existing liabilities. Nevertheless more developed countries can cope with the external debt better that the developing ones. A negative external debt burden arises from weak macroeconomic and structural adjustment policies, a risk of price volatility in terms of a non-diversified export base and a bad debt management and servicing policy. Even so, as long as the external debt is managed well - the return is higher than cost of borrowing - it gives possibilities for the economy to grow (Brook, Cortes, Francesca, Ketchekmen, Metzgen, Powell, Eizavi, D. Ross and K. Ross, 1998). In this research it will be tried to investigate how the external debt in different countries has affected different economics sectors. For this research three sectors were chosen: agriculture, manufacturing and services sectors. The effect of external financial debt on these sectors will be investigated in Latin America. Previous similar analysis of the external debt effect on Latin America economic showed negative relationship, indicating that lower external debt levels are associated with higher rates. After the 80 s external debt crisis, Latin America has improved its debt managements and in fact it has started lowering external debt s levels. Compared to Europe or North America distribution of the total share of external debt is different. The biggest amount of the external debt belongs to the government (35%), banks (16%) and an intercompany direct debt (10%) that represents the total public external debt (61%), while the rest 39% is private external debt.

7 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 7 All three sectors are very important to all Latin America in many aspects: An agriculture sector is one of the key player in all developing regions as well as in Latin America. It shows an increase in food export at ~8% annually since 90's. The World Bank sees a high potential in Latin America food supply in later years, in 2050 there will be a need to feed 2 billion more people (The World Bank Group, 2013). For now at a global level 13% of the agricultural trade belongs for Latin America. All facts support the importance of the agriculture sector to Latin America s economy. Manufacturing is second sector that will be analyzed in this paper. This sector s importance grew together with countries developing process. In a decade since 1990, there can be noticed a solid for high-tech manufacturing due to more open economies for trade, foreign investment and privatization of state owned enterprises (Hill, 2002). Other branches of manufacturing also are important, and various studies found whole manufacturing to be part of economic incentives (Libanio, 2011). The third sector is services one, also influential and significant for Latin America. Services sector in Latin America is experiencing good trends. Firms in this sector is being requesting for innovations, as sector is huge employer in the region, innovation help to increase not only the sector s productivity but also aggregate productivity level. However, the risk increase as well (Tacsir, 2011). Nevertheless, the services sector is becoming more and more important in the region. Since all three sectors show good future trends and expectations in Latin America, an additional financing plays an important role as well in case. In this research it will be investigated how external debt affects these sectors if any. As for the problem of this research: what is the impact of the external debt on the chosen economic sectors. The goal of the paper is to identify the external debt s effect on economic sectors within Latin America. The objectives helping to achieve the goal are: 1. Debt analysis in

8 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 8 region of Latin America; 2. Compare different countries; 3. Sectors evaluation, its importance and contribution to economy; 4. Find relationship between external debt levels and sectors performance; Hypotheses to be tested are as follow: 1. High level of external debt has a significant negative effect on the agriculture sector ; 2. High level of external debt has a significant negative effect on the manufacturing sector ; 3. High level of external debt has a significant negative effect on the services sector. With an econometric model it will be tried to identify how different variables have affected economic sectors. The relationship between debt and economic sectors performance is going to be identified. In many previous works on topics like effect of external debt on economics or manufacturing it was used econometric models with exogenous and endogenous variables and certain relationship was determined. First the static relationship between variables will be tested using correlation, and panel data analysis for selected countries will be applied. The secondary data from different data bases will be collected to perform analysis. The analysis is considered to include countries members of union of South American Nations over 30 years starting from This paper is aimed to determine the effect of external debt on different economic sectors within Latin America. The sequence in which the research is going to be presented is as follow: in the first part the theoretical aspects and analysis will be introduced, leading to research problem and question, in the second section the methodology issues will be presented including data collection and analysis. The next section is intended for the research itself, findings and answer to research question. Lastly the insights, drawback and conclusions will be delivered.

9 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 9 1. Literature review This part will introduce the external debt from various sides and its different effects. First of all the general idea about the external debt will be presented including different operations in different regions, initiatives for the burden of the debt management. Then it will move to the external debt effect on. It will be discussed on several cases how external debt affects economic. Often a deeper understanding of economy is showed by looking into the economy by sectors. The next section of this part is intended to present how different economic sectors contribute to economic performance. And lastly, the effect of the external debt on economic sectors in previous researches will be presented. Literature review help to specify on the problem area and to flesh out the external debt effect on the whole economy to more specific and deeper look using economic sectors External Debt The external debt by definition represents money borrowed by a country from foreign lenders with a liability to pay back the debt plus interest on the debt in a currency in which the loan was made. A country witch borrowed money may have to export its goods to country, which lend, to earn that currency (Panizza, 2008, p. 1). The external debt presents the outstanding amount of its actual or current liabilities that require a certain payment of principal some time in future. It includes debt securities, bonds, notes, money market instruments, loans, deposits, currency and etc. (Dias, 2010, p. 3) The external debt is often met as a source of finance, giving a new access to recourses. The level of debt should be sustainable that allows a debtor country to fully meet its current and future debt service obligations, without a recourse to further debt relief or rescheduling (Sanmun Economical and Financial Committee Forum, 2012, p. 1). It is important what is the attitude of countries governments towards a development strategy and its relation to a trade policy and capabilities that external debt could be beneficial not a burden. The external debt gives ability

10 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 10 to use internal debt for other purposes if needed. It allows various entities to finance opportunities that it would not be able do that with their own funds and resources, it plays a role for financing investments and imports, enabling the developing country to reach economic and increase its consumption (Pradhan, 2009, p. 2). However the other side of the external funding sometimes leads to loosing ownership, come of a required return on investment like interest on lend money. In recent years, developing countries have borrowed big amounts of money in international markets and have been constantly increasing its external debt levels. The total amount of external debt in developing countries rose from $4.4 trillion in 2010 to $4.9 trillion at the end of 2011 (World Bank database). Diverse effects of debt on economy itself and sectors performance (such as or stagnation) will be discussed in the following sections of literature review. In eight year period from 2000 to 2008 external debt indicators, such as Gross National Income and export earnings, showed a good and concentrated performance -in the graph (see Graph 1.) the downward slope can be seen. In this period ( ) the ratio of the external debt stock to GNI in developing countries has decreased by 15.8% (from 37.9% in 2000 to 22.1% in 2008). Even a higher decrease can be noticed in the external debt to export earnings. In the same period it decreased almost double (129% in 2000, 63.9% in 2008). A solid performance, a steep jump in export volumes, leaded to increase in export earnings, growing prices for primary commodities in the international markets and a shift from debt to equity financing in many developing countries can be mentioned as reasons for visible improvements (International Debt Statistics, 2013, p. 10). However the previous global financial crises influenced the trend negatively. An increase in borrowing was mainly used to stimulate a fiscal environment and finance current account deficits. Exports earnings shrink in parallel to decrease in volumes of GNI. Both indicators went up and reached level of The external debt to GNI

11 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 11 in 2009 was 24.2%, while the external debt to export earnings increased to 85%. Nonetheless, developing countries faced a recovery during years and the corresponding rations decreased to almost lowest levels (external debt to GNI 21.5%, external debt to export earnings 69.3%). Figure 1. Debt indicators. Trend Adapted from World Bank Reporting system and IMF, 2013, p. 10. Latin America and Caribbean external debt to GNI did not show huge movements in latest years and stayed almost at the same level ( %; %; %; %), only Europe and Central Asia with Sub-Saharan Africa had the higher ratios. The external debt to export earnings has increased from 87.2% in 2008 to 115.3% in 2009 facing a contraction in export and an increase in borrowing, but in the following years it managed to lower its ratio to 99% in 2011, and still managed to keep it the second highest after Europe and Central Asia (111.8% in 2011). Since many countries are still facing many difficulties after taking too much of the external debt, the World Bank and International Monetary Fund launched Heavily Indebted Poor

12 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 12 Countries (HIPC) initiative in 1996 an intention for all creditors to provide a debt relief to the poorest and most indebted countries (Staffs of the World Bank and IMF, 2003). More than 40 countries are included in this program. The external debt amount of HIPC exiting point for countries was reduced effectively with long-term prospects and structural reforms that might be a key factor for poor countries helping not to get back to debt level that is harming again, if managed correctly. Structural reforms carefully look after the debt sustainability and feel that it is very important not only for poor and developing countries but for economically strong ones as well. A policy and institutional architecture, a debt management content, an export diversification, a fiscal revenue assembly all of them are important in ensuring to obtain a sustainable debt allowing debtor countries to meet their total current and future debt obligations (Sun, 2004). Figure 2. Debt indicators of HIPCs decline since Adapted The World Bank spring meeting report, Nevertheless, the HIPC initiative attracts and negative opinions from academics, various society groups about funding, usage of recourses, but this initiative has already made positive effects on heavily indebted poor countries (see Figure 2.). It started the policy toward the goal ensure deep, broad and fast debt relief and thereby contribute toward, poverty reduction, and debt sustainability in the poorest, most heavily indebted countries (The World Bank, 2012 spring meeting report).

13 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 13 Additionally to the HIPC initiative the Multilateral Debt Relief Initiative (later MDRI) was first established in 2006 with the aim to provide an additional support for HIPC to reach its own goals (Weiss, 2012). It was created with an offer of IMF, the World Bank and African Development Bank. The impact of MDRI is not that significant. MDRI debt relief does not increase the total level of resources available to poor countries. Debt relief that a country receives will be felt in a net decrease in future multilateral aid resources allocated. Moreover, the amount of debt relief provided by MDRI is small. As an example 15 African HIPC countries on average paid $19 million for debt service to the World Bank in In the same year, they received $197 million as a new aid from the World Bank and $946 million in total aid. A debt relief can provide not a significant increase in domestic resources even adding it to existing foreign assistance. It appears that debt relief can have its largest impact if it is situated as part of a broader package of reforms that include an increased debt management capacity, and targeted enhancing changes in national policy as it was discussed earlier in HIPC structural reforms case (Weiss, 2012) External debt contribution to economy A steady is one of the most important goals of all economic systems. The higher the GDP the more easily external debt level can be managed increased or reduced because a country looks more attractive to investors and is able to find financing more easily. But when talking about the opposite situation, when country tries to increase its GDP by increasing the external debt stock, not all the time it happens in the best scenario. The external debt is associated with lower GDP (some neoclassical models suggest a positive relationship between debt and GDP ). However, borrowing in foreign countries can increase the by using debt without reducing consumption levels. The governments can use debt for a lending to increase the sectors productivity, and investments to infrastructure, health care, education (Sanmun Economical and Financial Committee Forum, 2012).

14 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 14 Nevertheless, a large external debt stock leads to capital flights, an increase in tax rates. A wrong management of relationships between the external borrowing and trade, and a continuous over borrowing has a negative effect on (Arnone, Bandiera and Presbitero, 2005). Authors present some effects of external debt. First, the debt overhang effect creditors are not expecting to be fully repaid because of existence of a huge debt. A country has a debt overhang problem when the expected present value of potential future resource transfers is less than its debt (Krugman, 1989, p. 255). On the one hand a lender stays at lending position not to face loses and hope that the borrowing party improves economically and manages to payback all obligations. On the other hand, the borrower is not in that good position anymore, knowing that all good investments made and gains earned will be used for those obligations and taxed in any case. Therefore, lowering the total amount of the debt could benefit both sides a lender will have a higher possibility to get back the assets and the borrower will decrease the debt burden. The operative move with gains for both sides is represented by the debt Laffer curve the expected repayment as a function of the face value of debt (see figure 3). The debt-laffer curve presents the idea behind that while stock of the debt is higher that critical value D*, both sides gain from lowering the debt.

15 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 15 Figure 3. The debt-laffer Curve. Adapted from External Debt Sustainability by M. Arnone, L. Bandiera and A. F. Presbitero, 2005, p. 18. Jeffrey D. Sachs (2002) points out poverty traps that poor countries can easily fall in due to debt burden. The idea behind his statement is that nonlinearities in savings, investment and production can lead low-income countries to face low or declining Gross National Product per capita even though that there is an interflow of the economic intensity such as a capital inflow into capital-scarce countries from capital-intense one and spreading of the technology from developed to developing countries. The author shows that the of output can be graphed in a relationship to capital stock (see Figure 4.) for given parameters (saving rate, rate of depreciation, population ), level of debt service and foreign aid. As long as k*<k economy grows, in additions saving rate is greater that the resources needed to replace capital per worker, at k* - stagnation, k*>k economy declines and faces a poverty trap because saving rate is low, output and capital stock decrease to level when savings is equal to zero. Figure 4. Debt Relief and output. Adapted from Adapted from External Debt Sustainability by M. Arnone, L. Bandiera and A. F. Presbitero, 2005, p. 20. There were many investigations whether the debt has an impact on the specifically through a factor accumulation (according to Economic Glossary it is four main

16 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 16 factors used to produce goods and services in the economy labor, capital, land and entrepreneurship) or a total factor productivity am efficiency of all inputs to a production process (Kohli, 2004, p. 5). Increase in a factor accumulation leads to a more powerful economy thus it is able to make more goods and services leading to a long run expansion of the economy the. In addition to a factor accumulation, an increase in total factor productivity arises due to technological innovations and improvements leading to better economic performance (Poirson, Pattillo, Ricci, 2004, p. 15). The presence of nonlinearities in the effect of the debt on different sources of were tested as well (Poirson, Pattillo, Ricci, 2004, p. 5). The result might seem not very surprising. Panel date of 61 developing countries and 29 years time horizon was used. The dynamic panel data models include per capita as dependent variable and as control variable lagged income per capita, the investment rate, the secondary school enrollment rate, the population rate, openness, fiscal balance and terms of trade as exogenous shocks. The findings show that a low level of the debt have positive but often not a significant effect on however high level of the external debt within a country has a negative impact on economic through a negative impact on both and a physical capital accumulation as well as a total factor productivity. As they stated in their findings, on average for countries having high debt, doubling it will decrease output by around 1%, accordingly it will lower a physical capital accumulation and a total factor productivity at a similar but lower rate. The finding on a nonlinear relationship between the debt and gives us a shape of inverted V line. According to the working paper, the average impact of debt becomes negative at the intercept of the function on the horizontal axis (see point B in Figure 5), while the marginal affect of debt becomes negative at the turning point of the function (see point A in Figure 5).

17 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 17 Figure 5. Stylize shape of non-linear relation between debt and. Adapted from What are the Channels through Which External Debt Affects Growth by Hélène Poirson, Catherine Anne Pattillo, Luca Antonio Ricci, 2004, p. 30. The findings suggest that the average impact of debt becomes negative at about % of exports or % of GDP. Results indicate that the marginal impact of the external debt starts to have a negative impact at around half of these values on average. The quantitative effects of high debt were found to be quite substantial: for a country with an average indebtedness, doubling the debt ratio would reduce annual per capita by between half and a full percentage point. While for countries that are to benefit from debt reduction under the current Heavily Indebted Poor County (HIPC) initiative, per capita might increase by 1 percentage point, unless constrained by other macroeconomic and structural distortions. In many attempt to find relationship between the stock of external debt and a country s opportunity findings show contradicting results. However, in literature relationship between debt and economic is largely focus on negative effect such as debt overhang when too large debt makes problem to repay countries past liabilities and at the same time creating bad image of a country for positional lenders (Clements, Bhattacharya and Nguyen,

18 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA ). As authors show in their work, the empirical literature tests mixed the debt overhang hypothesis. First in many models of the determinants of have presumed that the level of debt affects directly by reducing government s determination to undertake certain structural reforms and indirectly by lowering investment. On the other hand, few studies have investigated such effect of the debt on and investment in low-income countries so further analysis would be an appropriate addition. The empirical analysis they presented in working paper used 55 low-income countries and 29 years time horizon. Countries were classified by IMF s Poverty Reduction and Growth Facility with an incentive to determine the key factors for the of real per capita income. In the standard model, they used most widely employed variables the face value and the net present value of the stock of external public debt, each as a share of GDP and as a share of export of good and services. Findings support debt overhang hypothesis and suggest a threshold of about 30-37% of DGP. Crossing the threshold implies higher external debt is linked to lower rates per capita income. Moreover findings has no strong support to show that debt service has direct effect on but in latter research it was found out that debt services tend to crowd out public investment. The relationship is nonlinear, showing that one percentage point of GDP increase in debt services decreases public investment at around 0.2% of GDP. However, the authors agree that decreasing ratio of debt service to GDP from 8.7 % (the average in 2000 of the seven most heavily indebted poor countries) to 3% (roughly the average debt service-to-gdp ratio for all highly indebted poor countries in 2002) would increase public investment by approximately 0.75 % point of GDP and indirectly raise real per capita GDP by 0.15% point annually. Still, this small backing to is roughly equal to the actual in per capita incomes achieved by heavily indebted poor countries during the 1990s. Moreover, if half of this debt service relief were channeled to public investment, annual per capita would rise quite significantly (about 0.5% point a year). However, the positive

19 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 19 impact of greater public investment on will be offset if financed through larger budget deficits. To conclude the findings it can be stated that high level of debt can harm economy in low-income countries after its face value crosses the threshold level. Findings imply that the substantial reduction in external debt projected for the countries participating in the HIPC initiative would directly add % to their per capita GDP rates. The external debt affects indirectly as well through its effect on the public investment. Although the level of public debt does not appear to depress public investment, the cost of servicing the debt does and they show that reducing debt service by around 6 % points of GDP would raise public investment by % point of GDP, which in turn would result in a small increase of about 0.2 % point in. A research intended to evaluate the nonlinear relationship between external debt and using panel data set of 93 developing countries in 29 years ( ) showed the that results are robust among different econometric methodologies, regression specifications, and different debt indicators (Pattillo, Poirson, Riccil, 2002). According to the findings, a country having an average indebtedness can lead to a decrease in per capita at around 0.5-1% if debt ratio will double. The differential in per capita, between countries with external indebtedness (debt net present value) below 100 % of exports and above 300% of exports can be in excess of 2% annually. Countries benefit from the debt reduction under the current HIPC initiative, per capita might increase by 1%. However if any constrains are imposed on the macro economy or structural economy it can lead to certain distortions. Authors in their findings also agree and suggest that the average impact of debt becomes negative at about % of exports or 35-40% of GDP. The impact of debt starts being negative at about half of these values. On the strength of analysis, a high debt seems to reduce by lowering the efficiency of investment rather than its volume itself.

20 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 20 Anyway, authors assume that in many theoretical models, valid levels of current debt inflows are expected to have a positive effect on. In traditional neoclassical models, allowing capital mobility, or the ability for a country to borrow and lend, increases transitional. There is an incentive for capital-scarce countries to borrow and invest since the marginal product of capital is above the world interest rate (Pattillo, Poirson, Riccil, 2002). A quite sound debt effect has two sides. On the one hand an appropriate level of the external debt inflows tend to have a positive effect on, on the other hand large, disproportionate level of debt inflows will harm the economy. Three very important key elements for the high debt and a low rate were analyzed. First of all the consideration of political economy might bring to high borrowing and low, it often goes together with a capital flight. Such capital flights can lead to money movements form one investment opportunity to another one trying to find the optimal. Often these investment movements arises between countries having specific internal risks political instability, inflation risk etc. Capital flows usually are huge and easily affects the whole country s financial system. The second reason mentioned in working paper was discussed earlier a debt overhang problem. They support idea that returns from investments in the country can face a high marginal tax by external creditor and new possibilities for domestic and foreign investments can be not attractive any more. A debt overhang problem not only creates difficulties with debt management, repayment, ability of but also leading to lower investment incentives. Keeping the debt growing and not having a solid export performance in the country can lead to even deeper debt overhang problem. Finally in literature, it is presented that negative effect of high debt can arise from uncertainty about not knowing exactly what part of the debt will be serviced using the countries internal recourses. Uncertainties leads to investors delays pointing out the trend that such investments will rather be made in liquid environment offering fast return rather than in high debt one. Such uncertainties creates misallocation of investments that later on

21 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 21 lower the efficiency capital accumulation leading to through investment efficiency and yield. However, a big stock of the external debt is not a burden and a big problem for some economies. As example, the U.S. had no problems with increasing external debt in purpose to finance ongoing current account deficit. The interest payments on external debt were not a problem for economy as well because U.S. has many external assets together with liabilities. In 2003, U.S. assets had higher rate of return than liabilities leading to higher earnings compare to expenditures on liabilities (Roubini and Setser, 2004, p. 3). Comparatively U.S. has the highest stock of the external debt while EU takes the second place leaded by UK and Germany (Sanmun Economical and Financial Committee, 2012). It shows that economically strong countries have high amount of external debt and can deal with it in proper manner. The gross external debt has increased in many advanced economies since 2003, due to need of financing, and a replacement from equity to debt after financial crisis (Dias, 2010, p. 3) 1.3. Economic sectors contribution to economy Historically, sectors contribution to GDP has changed over time, moving from an agricultural sector to a services one. The inter and intra sectorial factors leads to different sectors contribution to national income (Swamy, 1967). According to Central Intelligence Agency, The World Factbook in all countries around the world contribution to GDP is made mainly by two big sectors - more than 60% contribution by industry and services leaving only small share for agriculture. Only few countries have agriculture contribution to GDP more than 20% and those countries are in developing phase (Zambia 20.5%, Sudan 27.7%, Solomon Islands 51.8%, Papua New Guinea 28.2% and few other having a high agriculture sector s contribution). An increase in the power of economy has strongly influenced the sectors distribution and importance. It has influenced the movement from primary sectors such as agriculture to more sophisticated ones like manufacturing, requiring skills and technology improvements. Reasons

22 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 22 like these made urbanization process working at high rates, creating more jobs available along with income. Since year 1945, industrialization process started to run very fast involving developing economies and making manufacturing sector higher than mining or agriculture. Author argues that Latin America had benefits entering industrialization process early in 1930s and had economic in all countries until 1980s when industrial output started to decrease together with external debt crisis. Nevertheless since 1970s service sector jumped in front of all sectors and turn into a dominant one (Memedovic, 2009). A sectorial structure of world economies has changed but a trend still can be noticed. In low income countries all three main sectors have more or less similar contribution to economy (agriculture ~25%, Industry ~ 38% and Services ~35%), moving to richer middle income countries the change can be seen in agriculture sector (lower by ~14%) and services sector (higher by ~20%), while industry in quite the same. However, the dramatic changes in agriculture and services sectors can be noticed in high-income countries (agriculture ~2%, industry ~32%, and services ~66%). The changes can be seen in economic development phases (see Figure 6). As countries have more and more per capita income they tend to lower the agriculture sector, while leaving the industry sector significant and making the services sector the biggest one creating intangible products health care, education, business services, IT and moving relatively more on human based capital than natural one, creating demand for labor having specific knowledge and skills.

23 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 23 Figure 6. The changing structure of employment during economic development. Adapted from Growth of service sector, The World Bank, n.d., p. 51. The agriculture sector is very important field in all countries that gives essential contribution to economy. Roe T. L. (2001) investigates the agriculture s contribution to economy through two fundamental characteristics a size of the industrial sector is a function of an agriculture productivity and special fixity of agriculture tends to make it vulnerable to concentrated downstream industries. Findings show that an agricultural sector s not expensive products (like food) is very important for overall development. For countries having high transportations costs, not developed agriculture production supply chain, can make joining into world trading expensive. What author finds is that an increasing agricultural productivity is relevant for development. An increase in productivity makes the cost of food lower leading to a savings increase and a capital formation. In turn, the capital formation helps to increase productivity in non-agricultural sectors moving the labor from agriculture in parallel with decreasing food prices. Nevertheless, as a production of capital good steps up, capital deepening in agriculture evolves as well increasing productivity of labor in agriculture and raising land rental rates. This path depends on many countries specifics population, initial capital stock, trade policies, land scares or abundant country is etc. Talking about the second assumption Roe T. L. (2001) finds that oligopsonistic competition small number of buyers - does not use capital in appropriate way, decrease the return to land and lower the capital benefit for the sector itself. Increasing capital often leads to a decrease and negative effect on the economy. Well-managed taxes and trade tariffs have significant positive effect on economy. In more general, it is stated that for poor countries themselves it is difficult to develop, so foreign capital attraction and agriculture openness plays important role reaching oliopsonistic market structure. Construction is other very important sector for all countries. Construction sector is not only important as economic sector or income generator it provides shelter as well. It also

24 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 24 contributes to economy, employs many workers, provides socio-economic development, infrastructure and in world term shows good long-term prospects along with increasing urbanization. In 2013 the biggest construction market by company was seen in Africa (35%) leaving behind US/Canada (28%), Middle East (22%), Mexico/Central America/South America (11%), Australia (11%), CEE countries 9%, and Western Europe and India/Eastern Asian both with 8% (KPMG international Construction Survey, 2013). Regions like India that barely felt an economic slowdown is expecting construction sector to surge significant and become a key contributor together with finance services, infrastructure, telecommunications (EC Harris, 2011). Seeking for additional financing Indian Government even made possible 100% foreign direct investment in real estate with expectations to produce and gain more and showing for a need of additional capital in this field. Raza Ali Khan (2008) analyzing role of construction sector in economy in Pakistan finds that there is positive impact off construction on real GDP leading to countries development taking into account the fact that this sector in Pakistan is quite small (2.3% of GDP as for 2008) and showing the importance of construction industry. Patrick Achitabwino (2009) states that construction industry make a huge impact on countries GDP, earning and workplaces. Byoungki Kim (2006) points out that good infrastructure raises productivity and decreases costs in the directly productive activities of the economy, however it has to be expanded quickly to be able to meet the demand for the infrastructure in the early stage of development. Expenses for construction like energy, transportation are huge and construction period tends to be quit long. Forecasts of demand trends and investment allocation have to be based on a long-term economic development trend and precisely predict the country s demographics and economic structure. Moving on the other sector it is important to mention that sectorial analysis gives a deeper understanding of a countries economy s condition. Banking sector is not an exception

25 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 25 from significant and revealing countries economic sectors. A. Abubakar and I. Musa Gani (2013) stressed out that in the long-run liquid liabilities of commercial banks and trade openness make significant positive effect on economic, however credit to the private sector, interest rate spread and government expenditure make significant negative influence. According to findings credit to the private sector consist of the identified several problems, government borrowing, and high interest rate are crowding out investment and. The authors find the following implications: financial reforms in Nigeria should focus more on deepening the sector in terms of financial instruments so that firms can have alternatives to banks credit which proved to be inefficient and detrimental to, moreover, government should inculcate fiscal discipline so as to reduce excessive borrowing from the financial sector and thereby crowding out private investment (p. 47). All sectors have their place and importance in the economy environment. Depending on the country itself, the inside policy sectors make different contribution. As I.B. Abdullahi (2008) states sectors contribute to the economy development, but it is very important to improve and monitor allocation of sectors and be able to get all benefits from it. According to Pete Roythorne report financial sector can become even more influential in near future and by 2020 in United Kingdom create additional jobs. In more general for economic sectors, it is important to not only survive and keep the same level, but also to use all source of finance in good way to accelerate and increase its contribution to economy development Effects of external debt on economic sectors Maureen Were (2001) stresses out that in Kenya during oil crisis the external indebtedness increased significantly ( ) and made the effect on agriculture output leading to increase in food imports through growing borrowing. Moreover Rodolphe Blavy (2006) analyzing debt and productivity issues in Jamaica finds that high debt is linked to a macroeconomic uncertainty and an output structure that basically relays just on major sectors

26 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 26 leaving low space for productivity. In addition, public investment tends to be crowded out by debt service and it negatively affects productivity even more. Additionally Abdul Wahab Bangkona (2010) points out that economic and financial reforms that also takes into account lowering external debt level helps for sectors productivity. After these reforms Indonesia economy had a nearly 5% with leading trading sector (services, finance, agriculture etc.) Brownson, Vincent, Emmanuel and Etim (2012) investigated agricultural - one of the most important sector in Nigeria in terms of contribution to GDP and employment productivity. Findings suggests that the external debt has a significant negative effect on agricultural productivity in the country in both short and long term. Reasons for negative relationship arises from countries internal position. An increase in external debt affects budget deficit, which in turns under allocate recourse for other sectors cutting share of finance part from real sectors like agriculture. Agricultural sector in Nigeria is getting subsidies from government, however even with subsidies or external borrowing funds it is difficult for agriculture in Nigeria to have stable productivity mainly because of low level of technological innovations and dominance of small farms. Jackeline Velazco (2001) in case of Peru and all Latin America investment in agriculture shows that in times of high debt in the region have a direct effect on lower agriculture output and performance with decreased ability to import necessary equipment like fertilizers also rigorous monetary policy tend to reduce supply of credit to agriculture sector. In a research on the financial sector and debt crisis Carmen M. Reinhart and Kenneth S. Rogoff (2010) investigate if banking crises can be linked to sovereign debt crises. As they affirm banking crises in many cases either precede it coincide with sovereign debt crisis. As a banking sector faces the crisis it automatically affects currency value negatively making unfavorable situation in terms of borrowers solvency who have big amounts of debt in foreign currencies. In opposite situation when sovereign debt leads to banking crisis authors also finds solid arguments.

27 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 27 After inconvenient situations in financial field and international capital control could lead to government making healthy banks to buy government debt in huge quantities and including bank in the chain. If the chain faces a collapse in any stage banks balance sheets can be affected directly and easily. Okosodo Lawerence (2013) implemented another case analysis. He made a research on the impact of external debt burden on the of agriculture and manufacturing sectors of the Nigerian economy. After applying co-integration test, he finds out that agriculture sector s production has an inverse relationship with debt servicing, suggesting that the higher debt amount leads to higher debt servicing and negatively affecting agriculture sector. However talking about manufacturing sector s output, author finds direct relationship with external debt and contributing to Nigeria economy s. It was also offered that any increase in external borrowing have to be maintained very carefully to provide the use of additional money in appropriate way. Analyzing relationship between external debt and economic sectors, many authors find different effects depending on many specific things. Obademi Olalekan Emmanuel (2013) analyzing the impact of external debt on banks performance in Nigeria finds a negative external debt affect banks performance but different directions on two chosen banks. One of the bank was most affected on return on capital while other one on the earnings per share. The differences were expected to arise due to different internal environment in the banks. Moreover, Augustin Kwasi Fosu (2007) analysis of African economies points out that the external debtservicing problem negatively affects social sector as well as education and health sectors. He argues that external debt burden also might lower the public investment. Nevertheless, findings show that the debt relief would have intersectional outcomes leading to a positive fiscal response to social sectors of debt relief. Imed Drine and Sami Nabi (2010) find non-linear relationship between external public debt and production efficiency with a turning point of 82%. Bellow this

28 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 28 point any increase in external debt can be linked to production productivity increase, however above turning point private sector size starts to decrease. According to the authors, the indirect effect of increasing external debt stock is higher taxation. Nevertheless, the external debt is met as a source of finance for sectors in a country that is able to manage it internal and external needs and abilities. Authors mention China as example. Strong economy since 1980 with adopted market economy policy, left import substitution, and if at the period of policy adaption economy slowed down; in long run, it had a good trend. External debt was and is not a big issue for China s economy and sectors as it has high export rates and external debt mainly is used for developing all spheres of economy and for export oriented sectors, leading to efficient sectors usage of debt making it as big advantage (Cetin and Kalayci, 2010) Senay Agca and Oya Celasun (2009) stress out that external debt increase in developing countries have an effect on increase in borrowing costs of domestic corporate sector. According to findings huge amounts of the external debt lowers foreign funds to the private sectors and possessing the risk of sovereign debt crisis. However, Ribeiro, Vaicekauskas, Lakštutienė (2012) in their working paper state that economic and better sectors performance can be achieved using additional money from foreign investors as external debt Literature review inference It is clear that additional funds and access to new recourses is very important for all countries, especially for developing ones to manage all operations and create a better economic environment within a country. The external debt providing this opportunity becomes a tool that that might create both and a positive and a negative effect. Developing countries showing high demand for funds usually tend to fall into the external debt trap inability to cover obligations without taking more obligations and creating positions without solutions. For poor countries, many initiatives (like HIPC) come with a purpose to help. While the high external debt is linked

29 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 29 to a lower economic, a decrease in public investment, well managed it can become a useful additional factor allowing an acceleration of development process. Various economic sectors performance contributes to an overall countries development level. In many cases in literature, an increase in external debt usually leads to decrease in sectors performance. However, in some cases sectors can use this source of finance, which is vital in corresponding to external debt beneficial and harmful sides. Countries that mange the external debt correctly, do not start over borrowing policies, tend to gain from external debt more than lose for paying, can achieve good results and allow a better sectors performance and creates a better economic environment.

30 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Problem definition Increasing external debt not only stands as additional funds but also creates difficulties arising from both an inside and outside the country factors leading to countries insolvency and further problems. Many studies analyzed the external debt effect in terms of economic and countries performance. Findings suggest that in countries that are able to use external financing the problems arise after the external debt reaches some point of gross domestic product value. Afterwards the additional borrowing abroad is linked to lower performance of the country. Only limited number of studies have been intended to capture external debt effect on specific economic sectors performance. The findings mainly offer the idea of a negative effect on difference sectors performance, leading to lower sectors contribution to economy as external debt increases. However, countries that can manage external debt in a proper way and show signals of beneficial usage of foreign debt usually can add some funds for improving the sectors. Literature review part showed that external debt in most cases becomes an unfavorable factor. Debt overhang problem, capital flight risk, borrowing traps etc. are issues that might become very difficult to overcome for most of the countries. Historically the most significant problems with external debt is met in low-income countries. International debt relief initiatives has positively contributes in lowering the debt burden, however the risk is still visible and external debt crisis have not been a good lesson for many developing countries. In this research, the developing region Latin America or more precisely the Union of South American nations - will be analyzed. Region faced huge external debt crisis in 1980s and been dependent on external factors for a long time. It has affected whole countries in many aspects - from trade policies to political issues and it has translated to the sectors and economy. The effect of external debt in this region will be analyzed in context of economic sectors components of the economy. The study considers how external debt can influence economic sectors. The hypothesis to be checked are as follow:

31 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA High level of external debt has a significant negative effect on services sector 2. High level of external debt has a significant negative effect on manufacturing sector 3. High level of external debt has a significant negative effect on agriculture sector

32 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Research methodology In this part, the research methodology is going to be presented and reasoned why the chosen method is suitable for investigation of the proposed research question and achievement of the research goals. In most of the cases, the critical examining of different aspects in the corresponding field is being applied. On this research, it will be done in purpose to determine the existence of relationship between set of macro-economic variables and its effects. It is going to be performed by collecting, analyzing and interpreting the final information. The research itself refers to a process with a framework indicating a specific approach leading the exploitable findings. In this specific research the quantitative approach will be used by including models development, methods of data measurement, data collection, simulation and analysis. Moreover, quantitative research gives ability to test specific hypothesis, it is associated with credible and quantifiable outcomes that are widely used in practice. However, it is difficult to present whole picture of any event and some variables are just ignored or not included in the model because of human behavior s role it is too complicated to collect all details on everything - and the result might be distorted (Hendry, 1980, p. 399) For this research, methods that were already presented and tested for validity will be used in order to get as accurate and reliable results as possible. Methods is going to be designed in unbiased and objective way, trying to prevent the researches interest to influence the outcome. Macro-economic variables interconnection between each other are in interest of researches that try to determine its different effects. Macroeconomic analysis is involved in a creation of multiple variables statistical models to examine the phenomena and relationship between chosen variables. In order to determine the existence of relationship between different macro-economic variables the econometric research is widely applied. Econometric analysis in general helps to measure the economic and leads to economic theories by empirical verification. This research is intended to explore if there is a relationship between external debt and economics sectors

33 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 33 performance, thus one of the econometric researches tool will be discussed in more detailed in later chapters and applied practically Panel data Regression analysis and time series analysis are two very important and widely used statistical methods to analyze and interpret data. While a regression analysis assesses one certain measurement as a response and is classified as type of multivariate analysis that examine data from a cross-section perspective. Using time series analysis it is possible to examine one or several subjects over time with ability to find relationship in time or dynamic side. However, it has a limitation of subjects having high number of observation in time. Panel data analysis (or longitudinal data analysis) allows examining data from the perspective of both regression and time series analysis. Having many regression data sets, panel data is set from cross-section perspective and allows observing and examining many subjects over time unlike regression and time series analysis alone. Incorporating cross section of subjects over time gives ability of examining a dynamic together with cross sectional aspects of problems (Frees, 2004, Ch. 1). Seeing that the goal of this research is to identify the effect of external debt of economic sectors within Latin America counties over time, panel data provides ability to do that by allowing investigation of cross section of counties over certain period. Panel data as a method have started to be used in many fields of science and developed, as more databases were available. Using panel data, it allows to study dynamic relationships and to model the differences or heterogeneity (Frees, 2004, p. 4). These two factors are big advantages compared to cross sectional or time series analysis being used separately. However, it is linked to an attrition bias, which is associated with models of selection bias and the applicability of the selection bias or more specifically problems in designing the sample (Fitzgerald, Gottschalk, Moffitt, 1997, p. 7). As data collection become natural phenomena and the availability of it has increased, panel data started to attract more and more researches due to its benefits. Panel data possesses

34 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 34 more degree of freedom, sample variability and reduced problems of data multicolinearity compared to cross sectional analysis. It has a higher ability to convey the complexity of human behavior, and power to control the impact of omitted variables. Moreover it reveal the dynamic relationships, lovers or eliminates the estimation bias, gives a chance to create more accurate predictions, identifies economic models, tend to differ between interacting economic hypothesis and provides micro foundations for aggregate data analysis. Panel data as an analysis method gives simpler calculation s way together with statistical findings (Hsiao, 2006, p.7). However, there are drawbacks that have to be taken into consideration. First of all the idea of heteroscadastisity arises due to different behavior of different variables. Spatial correlation is linked to effect of values to show similar trends within certain location. Other problems can be associated with serial correlation, non-stationary data, unit-heterogeneity and slope heterogeneity due to different inside politics and attitude towards regulations, taxes, social securities, etc. (Plumer and Troeger, 2004, p. 7). Regression analysis is very common and widely used in social science trying to determine the relationship between variables. A simple linear regression form can be seen in equation 1. It is used to describe linear dependence, for prediction value of one variable in terms of other and correcting the linear dependence. However, linear regression can cope with cross sectional and time series analysis, so it is not compatible with this type of research. Nevertheless, in equation 2, the panel data model is presented and applicable for observing subjects over time. Y i = β 0 + β 1 X i + ε i, where ε i ~N(0, σ 2 ) (1) Y it = x it β + Z i α + ε it = x it β + c i + ε it (2) In equation 2, the notion Y it is dependent variable, whereas the x it presents number of independent variables, not including the constant term. Parameter β shows the corresponding change of Y it as x it change by unit. The Z i α present the heterogeneity or individual effect, as

35 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 35 Z i is a constant term and set of individual variables, ε it is a random disturbance term, and indicators i,t presents subjects (country, region, etc.) and time (Greene, 2010, p. 345). There variety of models for panel data possible to apply for specific situations. Pooled regression when Z i holds a constant term only, then ordinary least squares can be applied. Fixed effects versus random effects are other models used for panel data estimator as well as balanced and unbalanced panels together with more extension in models. (Greene, 2010, p. 348). In this research, it is trying to determine the external debt effect on specific sectors within pool of countries. Dynamic panel data model will be used to examine this relationship as it become popular in many empirical works, which are related to economic issues (Khadraoui, 2012, p. 96). Compared to static panel data analysis, dynamic one provides more reliable results (Faustino and Leitao, 2008, p. 2) Dynamic panel data An interest in long-run and macro-economic data availability for large panels of countries has influenced researches to use dynamic models with panel data for estimations. Using macroeconomic panel data sets it important to consider the fact that often a time dimension is quite huge compare to subject dimension. That leads to importance in choosing the right technique (Judson and Owen, 1996, p. 2). Bias or contradicting results are not the final outcome wanted by researches. As time dimension increases the bias tend to significantly decrease (Nickell, 1981, p. 1422). For dynamic panel, generalized method of moment s estimator using available lagged values increase estimation efficiency (Owen, 1996, p. 3). Dynamic panel specifications are estimated using fixed effects to allow countries to have different intercepts that might possibly be correlated to independent variables and system of generalized method of movements to correct endogeneity (Pattillo, Poirson and Ricci, 2011, p. 13). Dynamic fixed effect model (equation 3) includes θ i fixed-effect, x it is a (K-1) x1 vector of exogenous variables and ε it is an error term. This model is common with macro-economic data. Firstly, if

36 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 36 the individual effect stands for omitted variables, it is highly possible that country specific characteristics are correlated with other independent variables, moreover there is less chance for typical macro data bases to contain all of the certain countries, not just a random samples of them (Judson and Owen, 1996, p. 3).` y it = γy i,t 1 + x it β + θ i + ε it, where ε it ~N(0, σ 2 ε ) (3) However equation 3 holds country specific fixed effect that have to be removed by taking first differences of equation 3 and the following equations is derived: (y i,t y i,t 1 ) = γ(y i,t 1 y i,t 2 ) + (x i,t x i,t 1 ) β + (ε i,t ε i,t 1 ) (4) In the above equation the errors (ε i,t ε i,t 1 ) are now correlated with the one of the dependent variables(y i,t 1 y i,t 2 ), the recommendation is instrument for (y i,t 1 y i,t 2 ) with y i,t 2 or(y i,t 2 y i,t 3 ), which are not correlated with error, but are correlated with(y i,t 1 y i,t 2 ). The general method of moments estimator for the dynamic panel model include the two moment conditions (by Arellano and Bond): E[y i,t s (ε i,t ε i,t 1 )] = 0, for s 2; t = 3,, T (5) E[x i,t s (ε i,t ε i,t 1 )] = 0, for s 2; t = 3,, T (6) Arellano and Bond (1991) proposed two set up general methods of moments estimators, using these conditions of moments first of all errors are assumed to be independent and homoscedastic through countries and time, and residuals obtained in the first stage are used to build a coherent estimation of variance-covariance matrix, so relaxing suppositions of independence and homoscedasticity. Country specific effect should not be correlated as well, so additional conditions of moments for level regression are: E[(y i,t s y i,t s 1 )(θ i + ε it )] = 0, for s = 1 (7) E[(x i,t s x i,t s 1 )(θ i + ε it )] = 0, for s = 1 (8)

37 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 37 As there are four moment conditions (equations 5-8) employed the system panel estimator the consistent and efficient parameters are more likely to be estimated. The consistency of the general methods of moments estimator depends on the validity of the assumption that the error terms do not exhibit serial correlation and on the validity of the instruments (Khadraoui, 2012, p. 97). Most of dynamic panel specifications are estimated using simple ordinary least squares technique, instrumental variables for endogeneity problem abolition, fixed effect in order to allow countries to have different intercepts, and system of general methods of moments to fix endogeneity and biases (Pattillo, Poirson, Ricci, 2002, p. 9). However, the first two methods do not have ability to present a country effect and might be influenced by omitted variables bias. The fixed effect model gives consistent estimates in the presence of country specific effects that are correlated with explanatory variables, while general method of movements reduces endogeneity problem Research design Following the earlier studies, where the standard model is extended with debt variables to determine the effect of external debt on. There are four indicators widely used as external debt indicators. The face value of stock of external debt as a share of GDP, the net present value of the stock of external debt as a share of GDP, the face value of stock of external debt as a share of export of goods and services, and net present value of debt as a share of exports of goods and services (Clements, Bhattacharya and Nguyen, 2003, p. 7). Using fixed effect and system of general method of moments the following model will be applied: (ECO_SECT i,t ECO_SECT i,t 1 ) = α i ECO_SECT i,t 1 + α 1 RCI i,t + α 2 TOT i,t + α 3 GSE i,t + α 4 GDI i,t + α 5 CA i,t + α 6 OI i,t + α 7 TD i,t + α 8 EXD i,t + μ i,t Where: ECO_SEC one of economic sectors (agriculture, manufacturing, services) in terms of GDP;

38 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 38 RCI per capita income, lagged one period, measured in natural logs; TOT percentage change in terms of trade; GSE secondary school enrollment rate; GDI domestic investment in terms of GDP; CA Current account in terms of GDP; OI country s openness as export plus impost in terms of GDP; TD external debt service in terms of export of goods and services; EXD one of external debt indicators, measured in natural logs; α i Individual specific effect; α Measure of quantitative effect; μ Error term; i,t countries and time period. Per capita income stands for measure of countries output for number people in the region. It not only states how wealthy or high living standards are in the country. Authors, comparing two countries argue that a country having higher per capita income tend to have lower price elasticity, higher markup and higher price level. Moreover, there are assumptions that if highincome elasticity goods are differentiated then countries with high per capita income will have higher volume of intra-industry trade, and trades with other high per capita income countries (Markusen, 2010). Terms of trade is a relationship between exports and imports prices. Positive change in terms of trade means that for the same level of exports country is able to buy more imports. Terms of trade fluctuations create a huge impact for industries. For developing countries being very open to foreign trade, and volatility in terms of trade is much higher compared to develop. The main reasons are high dependence on commodity exports and low impact on prices of goods they export (Broda and Tille, 2003).

39 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 39 Secondary school enrolment rate is the next independent variable in the model. Most of low-income countries for a long time have a very low economic. Analysts mention many reasons for this trend. Education is one of them. It is assumed that higher education leads to work that is more productive and progress in this field can boost economic through higher productivity in different industries (Glewwe, Maiga and Zheng, 2007). Domestic investment is other variable in the model. Despite the fact that growing economies has a tendency to highly use foreign direct investment, however there are many cases analyzed and domestic investment took an important role. After Asia crisis, for example, domestic investment was key element in economic afterwards. Findings show policies leading to increase in domestic investment are followed by economic, attraction of foreign capital and export expansion (Al khatib, Altableb and Alokor, 2013) Current account balance stands for difference between value of import of good and services plus return on investments abroad minus value of export of good and services. Net lenders for the rest of the worlds has a positive balance while net borrower negative. Current account deficit has an increase in external liabilities of the economy (and vice versa). However as long as current account deficit is not too high for a long time it is not harmful with requirements for a positive capital and financial account (Milesi-Ferretti and Razin, 1996). Countries openness in literature is often referred to a sum of exports and imports. More open countries are linked ti higher prospect, however if trades are not diversified it can possibly possess a high volatility. Countries that are more open are able to better perform periods of lower capital flows, currency crashes; a larger trading sector can help for a country in contractionary periods to perform better (Haddad, Lim, Pancaro and Saborowsi, 2012, and Frankel and Cavallo, 2004). As external debt comes not free, it has to be serviced. External debt servicing for developing countries usually arises as one more problem leading to insolvency. It is widely

40 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 40 arguing that difficulties in debt servicing influence public spending due to functional sectors of government, budget movement away from different sectors and in more general influence crowding out effect. Partially increasing burden of debt servicing arises because of the government expenditure decrease due to debt induced liquidity constraints (Fosu, 2007). In many previous studies, four indicators for external debt were used. Value of external debt and present value of external debt in terms of GDP, and value of external debt and present value of external debt in terms of exports. Value of external debt present the outstanding amount of liabilities and is a typical measure. According to World Bank, present value of external debt is referred to the sum of short-term external debt plus the discounted sum of service payments due on public, publicly guaranteed and private non-guaranteed long-term debt over the existing loans. For present value calculations, the Heavily Indebted Poor Countries method will be used incorporating commercial interest reference rate (CIRR) as a discount rate (HIPC capacity building program, 2009). In this research the CIRRs six-month average of U.S. dollar will be used (IMF, 2013). Lagged per capita income, tests for convergence across countries over time towards a common level of per capita income, as in standard Barro model. It is expected to be a negative coefficient. Terms of trade is associated with an external shock to economy measure, with expected positive value. Population and secondary school enrolment rates reflects to quality of human labor and capital with expected negative and positive values respectively. Gross domestic investment is linked to future economy capacity and is expected to be positive. Current account is intended to measure of country s transactions with rest of the world and is expected to be negative. Country s openness is expected to be positive with link to a productivity increase. Both total debt service and one indicator of external debt stock will separate crowding out and overhang effects with expected negative values (Clements, Bhattacharya and Nguyen, 2003, p. 7; and Pattillo, Poirson, Ricci, 2002, p. 10).

41 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Region The analysis explores 12 countries members of union of South America Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Guyana, Paraguay, Peru, Suriname, Uruguay and Venezuela. There are many common problems that is being in open position for some time including strengthening political, economic, and social, together with environmental and infrastructure areas. It is aimed to develop identity of South Latin America and improve overall wealth within the union with other countries integration and first was introduced on May 23, 2008 (UNASUR). The Union is intended develop and improve conditions of nations with common history of economic instability and external dependence (Bolanos, 2012, p. 1). This Union was established in similar model to European Union while 12 countries in this union is a regional body representing Latin America states. Nevertheless, Nahuel (2012) points out that whole Latin America region remains peripheral, very sensitive and dependent to external factors since independence and in global level it is rules taker rather than maker. Regional integration seemed a good way for implementation of new development model. Frist two regional institutions were the Bolivarian Alliance for the Peoples of our America and the Union of South American Nations with not only political aims but with purpose for better economic integration and elimination of the global economic crisis consequences (Nahuel, 2012). The Union of South American nation first of all allows for institutional bodies greater monetary, financial and fiscal cooperation among the South American countries, and second, for policymakers and international institutions to agree on the restructuring of the global economic order and the acceleration of the economic regional integration process (Filho, 2013). Despite many communities of nations in Latin America that were trying to reach stability, however they have not succeeded due to many difficulties in political and economic environment. Nevertheless, authors point out that Union of the South America nations for the

42 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 42 first time has made socio-economic equality a goal of integration at the core of its institutional processes. It has proposed monetary integration; at global level, union is trying to get negotiation power, global political and economic relevance. The fact that most of the countries are highly indebted possess challenges as decreasing intrastate trade for the last decade. The Union is trying to impose regional policies to reduce this issue. In more general view the countries of the Union and whole region is linked to a huge potential in overall situation, good usage of natural recourses (Sanchez, 2011) Economic Sectors For this analysis three sectors will be investigate. Agriculture, manufacturing and services industries are very important for all economies. Despite the fact the share of GDP of the sectors are changing as countries developed the contribution to GDP by all sectors is significant. Most of developing countries have a trend of significant decrease in agriculture and increase in manufacturing and services. Employment moves from agriculture to manufacturing and later to services. Since 18 th manufacturing was important industry fro economy, for now services became a clear leader in advanced economies (Szirmai, 2009). Usually in literature economic sectors are divided into primary (agriculture), secondary (manufacturing) and tertiary (services). Agriculture sector plays important role in development process. It provides not only food, but source of livelihood, contributes to economy, incorporates transportation, employs huge workforce, provides income for government, and takes important role in trade (Diao, Hazell, Resnick and Thurlow, 2007). Manufacturing sector was important all the time. It provides employment for many people, it contributes not only directly to economy but to other sectors as well. Manufacturing is a source of productivity. It is assumed a high relationship between manufacturing and economy - high slowdown in manufacturing can easily damage whole economy. Services sector contributes more and more to GDP in most of the countries. It

43 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 43 provides jobs, inputs and public services for the economy, trading services can improve economy, providing a wide range of traditional and new export opportunities (Cali, Ellis and Willem te Velde, 2008). Sectors performance will be indicated by value added and in terms of GDP. Sectors value added refers to the net output of sectors after adding up all outputs and subtracting intermediate inputs. Value added indicator is widely used in researches and is a good and accurate measure for indication of sectors contribution to economy. As value added increases it makes a positive impact on the Gross Domestic Product (Tiffin and Irz, 2005). Other measure used in this research is sectors in terms of GDP is widely used indicator not only measuring the performance of sectors alone but also reflecting industrialization process earlier discussed in literature review part Data The data covers period This research follow the latter authors assumption on calculating three years averages to net out the effect of short run fluctuations. Latin America falls in a pool with countries that faced big 1980s external debt crisis of developing world. Nevertheless, country managed to recover from the crises with several plans including HIPC initiative and lessons learned play a crucial role in further external debt management. Various databases will be used including: World Bank, Inter-American Development Bank, International Monetary Fund, Global Development Finance, World Economic Outlook, World Development Indicators, NYU Development Research Institute, Development Data.

44 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Empirical research In this part, the empirical analysis will be performed in order to investigate the research problem. At first, the analysis of the countries and sectors will be analyzed and presented, and later the econometric analysis results will be identified. In this part the problems of the research is going to be investigated and the hypothesis will be checked whether true or false Region Analysis The analysis is intended to capture the external debt effect on various economic sectors in Latin America, to be more precise, in the block of countries representing the whole Latin America region. The 12 countries members of The Union of South American nations has a constantly growing gross domestic product in period (Chile and Uruguay are leader of the union in term of DGP per capita (see the right side Figure 7). Looking at the gross domestic product of whole Latin America and Caribbean (see appendix 1 left side) has the same trend and the increase from around $900 billion in 1980 to more than $6 thousands billion in The union that is going to be investigated later tends to follow all the trends of whole Latin America (see appendixes 1-4). Despite the fact that now GDP is in the peak there were and noticeable downturns during this research period. Several years starting from 1980 were difficult in all aspects. GDP started to fall in from 40% in 1980 to -50% in 1983 in year-to-year change (see figure 7 left side). GDP and total GDP decreased a lot of due to many factor. Economically it was a lost decade for all Latin America with moving one step forward and two steps back (Hayes, 1988). It happened mainly due to wrong macro economy management and significant foreign borrowing leading to countries insolvency problems that influenced one of the most unfavorable Latin America debt crisis of 1980s. All of this started back around 20 years before 1980s with criticism on Latin America s State-led industrialization model with drawback in weak macroeconomic discipline, inefficiencies generated by high tariffs, quantitative imports

45 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 45 restrictions and moreover high external dependence leaded to balance of payment crisis one upon another caused by external shocks (Bertola, Ocampo, 2012). Oil crisis at the end of 1970s also contributed to this crisis a lot. It affected food prices and the terms of trade with resulted in huge deficit in Latin America that was finance using external debt (Miranda, Molina, 2010). Figure 7. Gross domestic product (persentage change) ( ) and gross domestic product per capita as for 2012 (U.S. dollars) (on the right side) by countries, calculated using IMF database. There were not only external factors like worldwide inflation, recession or very high level of interest rate due to U.S. monetary policy change (see appendix 3) but as well as internal currency overvaluation, debt trap, intensive borrowing for current consumption (Ocampo, 2003). As in literature is referred, 1970s for Latin America were -led debt while 1980s debt-led debt. However after debt crisis spread all over the region the IMF, United Stated played a role of the last resort with the aim to stop developing the crisis imposing stabilization plans, giving loans with conditionality, adding it to total debt or postponing debt service and payback period (Sims and Romero, 2013). Despite all the actions to eliminate external debt negative effects from the crisis it can be noticed and nowadays. The next 1990s decade seemed to be promising for the economy. Lessons learned from the last crisis created better regulations and system to prevent downturns in Latin America. However, Latin America regions faced new challenges. First of all in Mexico faced

46 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 46 currency crisis due to devaluations of Mexico peso against U.S. dollar by 14% (Whitt, 1996). Then Brazil faced exchange rate crisis in 1999 followed by Argentina default crisis in 2001 influenced by the combination of internal and external factors (Saxton, 2003 and Evangelist and Sathe, 2006). The underemployment and excessive current account deficit in Brazil and difficult political and economic regimes in Argentina together with financial crisis in East Asian in 1997 and Russian crisis 1998 that spilled over first of all to Brazil, Argentina and later to all Latin America. The GPD has contracted by a significant level. The whole economy faced many difficulties starting with firms insolvency, banking system downturn, increase in unemployment and decrease of a purchasing power. This spillover effect was transmitted through a trade and finance channels (economic commission for Latin America and the Caribbean, 1998). For the last decade, Lain America is having a continuous only hit in The latest downturn is linked to global economic crises that affected Latin America in 2009 through the export market by influencing trade to fall by 31% in one year ( ) (exports have a - 10% year to year change in 2009, see appendix 6). However, the recover was different from other developed countries because the crisis did not started in the countries of Latin America. The region was affected externally so they had capacity to use fiscal stimulus and expansionary monetary policy in order to prevent further crisis (Blanco, 2009). In period , the average annual rate was 4% that was driven by good and conductive international conditions, world trade, increasing commodities prices making positive terms of trade impact for whole region (Latin America economic outlook 2014). However, the near future does not possess the same favorable conditions with decreasing external demand. As developing countries tend to rely on external factors, Latin America is not exception in this case. Latin America had a tendency to run an eternal deficit influenced by behavior of trade balance and increasing demand for investment while domestic saving rates are low. Trade policy is one of them that incorporates food, raw materials or as the level of development in the

47 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 47 country increases the export diversification increases as well, providing some risk management (Hanson, 2010). As Latin America many time faced external debt difficulties at the same time the export from the region increased leading to a positive balance of trade position. Figure 8. Economic and trade balance, retrieved from The Latin American debt crisis in historical perspective by Ocampo, 2003 While Latin America had a small trade surplus and GDP it was able to manage moderate level of external debt and it was not a very big problem. However, 1980s significant level of external borrowing influenced economic downturn and aims to cover it with increased export base (see figure 8). The negative impact of external borrowing was influenced by cost of imported capital, superficial attitude towards export, government investment using borrowed money and many other reasons influenced Latin America to face growing burden of the external debt since 1960s. Latin America is closely related to U.S. not only geographically but economically as well. U.S. trade with Latin America compose 58% of its trade with developing countries. Latin America region is important for U.S. also giving a market for export and providing area of raw materials (Quiliconi, 2005). Even though U.S. made a huge impact in saving and helping during downturns, the various changes in United States economic, political environment had a direct effect to Latin America due to close relationships. Latin America and Caribbean region is the

48 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 48 largest foreign supplier of oil to the U.S. and strong development partner and make strong economic, strategic and cultural connection that stands for the merit as well as a big concern. Nevertheless, during the latest years Latin America diversified it position by expanding relationships with new area including new strong patterns India and China. As Latin America faced latest downturn, China played a huge role in Latin America s interest. China, a very fast growing economy, had a big demand for raw materials from Lain America influencing an activation of export base and not that crucial effect of the crisis (Barshefsky and Hill, 2002). Six countries from the union of South America nation (Argentina, Brazil, Colombia, Chile, Peru and Venezuela) are biggest economies conducting more than 90% of total exports and imports of countries members (see appendix 7) and a majority of all Latin America. As for now biggest trade regions for Latin America are U.S., EU countries and Asia region. The most aggressive moves towards partnership with Latin America are between U.S. and China. As 1980s and 1990s were tough decades for Latin America region the sharp drop in current account can be seen (see figure 9). As Latin America then to rely on external financing it was not a huge problem as it used borrowed funds for investment with higher return compared to the interest payments on debt and still managed to be solvent. However external debt crisis possessed many problem including negative total sales abroad.

49 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 49 Figure 9. Current account (% of GDP), members of the union of South America nations ( ), calculated using IMF database. As for now situation in international markets are not stable with weak euro zone economic performance, slowdown in Chinese economy, its effect on raw materials prices as metal and mineral, the U.S. impact on international capital markets directly affect Latin America region. As globe trade is considered having a moderate, it decreases the demand for exports, leaving the prices for imports the same leading to negative trade balance in later years (see figure 9) ( Latin America Economic Outlook, 2014). Any U.S. monetary policy restriction or tightening will increase cost of external borrowing for Latin America and again can easily influence a risk to increase Economic sectors All economic sectors are important for countries. Well-managed sectors can contribute and influence economic. Each country or region depending on their development differ on sectors contribution to overall economy. In the following sections, the analysis of Latin America sectors under the investigation will be presented.

50 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Effect on agriculture sector. An agriculture in Latin America is very important sectors in many aspects. In makes significant influence for economic development and social welfare. Having enough natural resources, rural work force and enough potential to increase technological level the sector contributed a lot for Latin America in early stages. The 12 member countries represent more than 99% of total Latin America agricultural output and population (Trindade, 2012). Since 1980 to 2011 total agriculture value added has increased a lot. In the region in concern it has increased more than 4 time (see figure 10 right side). While the levels were volatile and changed over time, but it remained positive except for early 1890s and 1990s (see figure 10 left side). The main factors that affected this trend were from the inside the region and from the rest of the world. In both cases the economy in the world was facing quite difficult times spreading its effect over all sectors and making them less productive. In 1980s case Latin America situations was unfavorable in many terms. External debt crisis, reduced government expenditures in infrastructure and technology, elimination of marketing and price support programs that were benefiting many farms had a direct impact. In addition, devaluation of currency made imports more expensive, excessive macroeconomic stabilization programs reduced credit to agriculture by the private and public banking sectors. Crisis negatively affected many industrial sectors players that use agriculture raw materials also adding negative effect on agriculture (Diaz- Bonnila, 1999). The further slow in the world and the region had a negative effect on agriculture in Latin America in 1990s as well. Despite many factors directly negatively affecting agriculture, real exchange rates has increased in many countries in Latin America that represent the price of tradable good over non-tradable making increase in export and import substitution with agriculture production. Policies linked to trade liberalization, devaluation of real exchange rates helped to prevent huge

51 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 51 losses in agriculture and leaded to downturns effects less harmful compared to rest of the world (Diaz-Bonnila, 1999). Figure 10. Average agriculture value added annual percentage (left side) and agriculture value added (U.S. dollars) ( ), members of the union of South America nations, calculated using World Bank data base. Until 1998 region quite successfully managed to raise agriculture production level. However, the crisis in Asia that started in 1997 and global economic crisis in 2008 created many problems and the effect can be seen until nowadays, including drop in exports, sales prices. The latest slowdown was influenced by several countries significant contraction in. Paraguay faced huge difficulties with agriculture due to adverse weather condition and making the biggest country s sector shrink by more than 48%, having in mind that Paraguay is among leaders of agricultural raw material exporter and world s fourth exporter of soy (Paraguay economic outlook, 2013). Argentina also faced significant drop in agriculture - a fall from 28% in 2010 to 5% in 2011 due to unfavorable conditions. In Latin America and Caribbean region agriculture sector in terms of GDP has been constantly decreasing and in period 1980 to 2012 it changed from 10.37% to 5.43% (see appendix 9) following the trend and moving more to service and manufacturing sectors as it was discussed earlier in literature review. In general, agriculture in Latin America has been rising in small amount only by 1.9% compared to 2.4% in OECD countries in period Nevertheless, Latin America

52 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 52 is expected to grow by 80% to 2050 to meet the needs of expected 35% population increase (Inter-American Development Bank) together with South Asia (see appendix 8) Effect on manufacturing sector. Manufacturing sectors is another important sector in Latin America. According to Kaldor s law there is a positive relationship between of manufacturing and economic. As output increases, productivity increases as well leading to drop in price level that makes competitiveness stronger, exports higher and output growing (Pacheco-López and Thirlwall, 2013). In the 12 countries members of the union of South America nation manufacturing sector has increased more than 5 times with a permanent in period (see figure 11). As agriculture sector, this one also faced difficulties at the similar times. First of all manufacturing sector decelerated in early 1980s for obvious reasons link to crisis situation and overall situation in economy and connections with outsiders. Despite the fact that Latin America had the largest average annual GDP from 1900 to 1990, the early 1990s started with social, political and economic asperities, negatively influencing all sectors including manufacturing as well (Pintasilgo, 1992). However the situation stabilized, attraction of foreign direct investment helped for sectors to recover and continue the latest path. Manufacturing sector alone had a good trend in attracting foreign direct investment, and trying to recover in 1990 the FDI from US in manufacturing almost doubled -from $16 billion in 1990 to $ billion 28 in 1993 (Grosse, 1997).

53 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 53 Figure 11. Average manufacturing value added annual percentage (left side) and manufacturing value added (U.S. dollars) ( ), members of the union of South America nations, calculated using World Bank data base. Crisis in Asia region contributed to negative performance of manufacturing sector in this region. The sector contracted by 2% mainly affected by spillover effect from Asia region to Latin America due to close relationships directly affecting and reflecting all changes. A drop in the capital inflows, world s products prices, lower export revenue and other reasons made a sector to contract (Loser, 1998). Quite significant drop in early 2000s was influenced by very unfavorable weather conditions that influenced huge rage of production to loss as well as big losses in agriculture sector. Since then the sector was contributing a lot to Latin America development, workforce usage, new investments attraction, export base extension. However, the global financial crisis hit for this sector also, leading to a small contraction. Nevertheless, it managed to recover quickly and continue to grow.

54 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Effect on services sector. Services sector is vital for all countries. It is common that services sector is the biggest one in the country. In Latin America services sector value added in terms of GDP consist a big part around 60% and has a growing trend (see appendix 11). In period of interest countries members of the Union of South America nation has significantly increased services sector value added from $25 billion in 1980 to almost $220 billion in 2011 with a constant except for periods when whole Latin America faced huge difficulties including downturns influencing all sectors as mention earlier (see figure 12). However, the productivity remain relatively low. Services sector stronger position as well as in other regions was influenced by increase in knowledge, technology and efficiency leading to huge contribution of the sector towards economic. A positive effect for Latin America services sector is made by China and India that creates new production and services possibilities. Figure 12. Average service sector value added percentage (left side) and services sector value added (U.S. dollar) ( ) for members of the union of South America nations, calculated using World Bank database. In early 1980s, sector s contribution has not increased drastically. For 10 years period it remained at the same level because of no capacity to expand due to difficult economic environment in the region and scarcity of additional funds. Since 1994 sector started to as investment spur, however the Asia crisis, Russian crisis and other internal and external problems were followed by a sector s drop for 5 years. Since 2002 services sectors has found a good path

55 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 55 and the increase in value added is noticeable. Increase in labor productivity, access to external funds, new investments made sectors to develop significantly. Innovations and services sector is very important for Latin America for not only direct contribution for economy as a whole, but and for increase in agriculture and manufacturing competitiveness as well. Looking at the period from 1980 to 2002 the overall agriculture, manufacturing and service sectors value added has not changed significantly comparing to what happened later starting from These two decades for Latin America were difficult in many aspects. Economic reforms, poverty, terms of trade shocks, changing capital flows, and unstable global economy leaded to modest and volatile (Salimano and Soto, 2005). All three sectors in terms of value added has not improved a lot. However, since 2003 the started to make significant moves. Favorable external conditions (except crisis), new markets, products, good overall conditions influenced very solid performance of the sectors and overall economy. If in period sectors (in terms of value added) increased by 1.1 times for agriculture, no change in manufacturing and 2.1 times in services sector, so the changes in are: more than 3 times bigger agriculture, 5 time bigger manufacturing and more than 4 times services sector Dynamic panel data In this part the results of dynamic panel date will be reviewed and check whether the hypothesis true or false and analyzed in context of literature. The stated hypothesis are as follow: 1. High level of external debt has a significant negative effect on agriculture sector ; 2. High level of external debt has a significant negative effect on manufacturing sector ; 3. High level of external debt has a significant negative effect on services sector. The tables here present sectors from two perspectives. The first model is used in terms of valued added presenting nominal value, and the second one sectors in terms of GDP the

56 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 56 real value. Nevertheless, there arises a chance of multicolinearity problem due to strong relationship between independent variables. So first of all the results will be presented for data as it is, while later in the model with data after transformation in order to reduce level of multicolinearity External debt effect on agriculture. For analysis two types of agriculture sector data will be used value added and share of GDP. In both cases there is a positive relationship between sector and external debt (% of GDP) while data vary and has just a minimum upward trend in value added case, a stronger positive trend can be seen in second cases, however the dispersion is big and the trend is mostly approximation (see figure 13). The tendency is almost the same with all debt indicators, however agriculture share of GDP with other debt indicators has a positive relationship while value added presents negative linear relationship (see appendixes 13-14). The correlation alone did not show a high value, but it is expected that in multiple regression together with other variables it is going to show its impact. Figure 13. Scatterplot of agriculture value added (left) and agriculture % of GDP (right) with stock of external debt as % of GDP. The panel data was strongly balanced using 11 cross-sections and 11 time series in 3 years not moving averages model. Real per capita variable differ across the models. However, there is a contradicting tendency that it makes a negative effect on sector s value added, while positive on share of GDP. It shows significance on half of models. As it was expected, it is negative coefficient on valued added indicated for a sector s contraction,

57 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 57 less importance when income raises, and an expansion when income decreases toward common level of real income per capita in the region (Clements, Bhattacharya and Nguyen, 2003). Moving on the models on sector s in terms of GDP all coefficients are positive indicating an affirmative trend. This can be traced to increased real income, urbanization, usually changing lifestyle and food preferences tend to highly increase agricultural products demand (Dias Avila, Romano and Garagorry 2010). The change in terms of trade confirmed the expectation of a positive value. Despite the positive coefficient only in the second type models, the variable was significant. It stands for idea of positive impact of terms of trade shocks have a significant effect on investment, consumption (Spatafora and Warner, 1995). The indicator for human labor quality - secondary education again gives contradicting results. For value added models, in all cases it shows a negative significant coefficient. It is expected that more year of schooling tend to increase agriculture productivity. However, higher education leads to bigger usage of innovative production. A relationship between year of schooling and innovation behavior tends to significantly negative (Weir, 1999). Moreover Latin America all region struggles with education levels. In this region primary education is a clear leader compared to secondary and tertiary in labor force, while in OECD countries situation is very different (see appendix 19), supporting the ideology that in low income countries labor force in agriculture tend to have low education level. Nevertheless, the agricultural sector in terms of GDP holds for expected positive coefficient, suggesting that higher rate of secondary school enrolment leads to higher sector s, contributing the hypothesis the positive education impact on agriculture productivity and (Reimers and Klasen, 2011).

58 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 58 Value added Agriculture ( t-1 ) -0.58*** (3.3e- 0.31) Constant 1.38* (0.09) Per capita income (natural logs) (0.41) Change in terms of trade 1.97 (%) (0.8) Secondary school -0.21* enrolment (rate) (0.07) Domestic investment (% 1.36** of GDP) (0.033) Current account (% of GDP) (0.69) Countries' oppeness (% of GDP) Total debt services (% of export) -1.3e-07 (0.98) 0.15 (0.15) % GDP (0.72) -5.4 (0.11) 38.3* ( ) 111.4*** (0.007) 0.59 (0.18) (0.13) -1.5*** (0.007) -6.8e-05** (0.04) -1.08** (0.02) Value added -0.59*** (6.5e- 029) 1.6* (0.08) (0.23) 2.8 (0.73) -0.21* (0.065) 0.46*** (0.007) (0.91) 3.6e-06 (0.59) 0.15 (0.14) % GDP 0.02 (0.66) -4.6 (0.10) 11.1 (0.51) 117.1** (0.01) 0.74* (0.08) (0.12) -1.79*** (0.003) -1.6e-05 (0.63) 0.82 (0.133) Value added -0.59*** (4.1e- 03) 1.5* (0.07) -3.9* (0.09) 2.8 (0.72) -0.2* (0.08) 0.37** (0.03) (0.63) 3.07e06 (0.62) 0.17 (0.15) % GDP 0.02 (0.73) -3.3 (0.26) 24.9 (0.1) 116.4*** (0.006) 0.55 (0.17) -1.3 (0.18) -0.96* (0.05) -3.8e-05 (0.2) -1.06** (0.04) Value added -0.5*** (8.3e- 034) 1.2 (0.15) -3.7* (0.09) 2.5 (0.74) -0.19* (0.073) 0.37** (0.02) (0.66) 1.7e-06 (0.82) 0.15 (0.1) % GDP 0.01 (0.75) -6.6 (0.1) 18.7* (0.07) 111.2*** (0.008) 0.65 (0.14) -1.9 (0.15) -1.6*** (0.009) -4.5e-05* (0.07) -1.1** (0.03) Value of stock of external debt (% of GDP) (logs) (0.29) 20.4 (0.19) PV of the stock of external debt (% GDP) (logs) 1.78 (0.58) -4.6 (0.82) Value of stock of external debt (% of exports) (logs) (0.96) 17.5 (0.32) Present value of the stock of external debt (% exports) (logs) -1.8 (0.47) (0.27) Table 1. Dynamic panel data output results (dependent variables: agriculture value added and % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10%. Domestic investment measuring future economic capacity has an expected positive and significant value for sector s value added. It refers to more self-supporting economy, more attractive to foreigners. As domestic investment increase agriculture value added increase as well leading to a better position and even capitalize more using foreign direct investment (Lautier and Moreaub, 2012). Despite the fact that in model with agriculture sector in terms of GDP has negative values, all of them are insignificant. Current account holds for expectations as well with a negative coefficient in all cases and for second model is significant. Current account deficit does not necessarily mean a problem. As Latin America is highly dependent on external factors, indicating that running higher current account deficit leads to higher borrowing abroad (Ickes, 2008). In this specific case an increase in current account deficit leads to increase in agriculture sector. For countries productivity increase, the country s openness indicator (export + import) was expected to be positive. However, the

59 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 59 significant coefficients show a negative impact on agriculture sector in terms of GDP indicating that increase in region openness would negatively affect of an agriculture sector in terms of GDP in Latin America. However, it is against all prediction of future Latin America agriculture sector importance and capacities. As the negative impact is very small, it could be explained in terms of negative effect of imports, leading to less usage of domestic agriculture production. Indicators for debt have not showed the true expected outcome. Total debt service was negative and significant in three cases, in model with sectors in terms of GDP satisfying the expectations and implying the higher debt service leads to crowding out effect and contraction of agriculture sector. Unfortunately all four debt indicators did not show any significance in any of models, but in most cases showing negative value, while present value of the stock of external debt (% of exports) shows negative coefficient in both models External debt effect on manufacturing. Value added and in term of GDP is going to be analyzed. Form scatterplots (see figure 14) it is noticeable a weak linear relationship between sectors indicators and face value of stock of external debt in terms of GDP. For value added relationship is negative while for in terms of GDP it is positive. The same trend is for all four indicators negative linear relationship with value added and positive with in terms of GDP (see appendixes 15-16). Figure 14. Scatterplot of manufacturing value added (left) and manufacturing % of GDP (right) with stock of external debt as % of GDP.

60 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 60 Per capita income in two models showed expected significant results, indicating that a negative trend in per capita income would have a positive effect on manufacturing sector s while an increase in income negative effect. Situation is similar to the previous one, when value added has an expected coefficient, while in terms of GDP contradict indicating that higher per capita income would lead to higher demand for manufacture sector s output leading to its in terms of GDP. Change in terms of trade did not show any significance for value added, nevertheless in terms of GDP it did have a significant coefficient in all models, confirming that external shock to economy has a positive impact on manufacturing sector. The further indicator contributing to quality of human also indicates the higher of sector as education level increases. Domestic investment plays a role for sector value added with significant expected coefficients, pointing out that increase in domestic investment creased value added in manufacturing sector. Current account and countries openness did not show any significance in this model. Surprisingly, no debt indicators followed the expectation again. They have not showed any direct impact on sectors in both cases. From these result it is difficult to make any conclusion on external debt effect on manufacturing sectors performance.

61 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 61 Manufacturing ( t-1 ) -0.58*** (2.11e- 014) Constant 0.9 (0.49) Per capita income (natural logs) (0.11) Change in terms of trade -1.3 (%) (0.91) Secondary school enrolment (rate) (0.84) Domestic investment (% 1.29*** of GDP) (0.091) Current account (% of 0.33 GDP) (0.43) Countries' oppeness (% of GDP) Total debt services (% of export) Value of stock of external debt (% of GDP) (logs) PV of the stock of external debt (% GDP) (logs) Value of stock of external debt (% of exports) (logs) Present value of the stock of external debt (% exports) (logs) Value added % GDP 1.5e-05 (0.41) (0.97) -6.6 (0.4) 0.13* (0.06) -6.8*** (0.006) 22.3 (0.14) 73.49*** (0.0005) 0.79** (0.03) 0.51 (0.48) 0.16 (0.81) -1.3e-05 (0.75) 0.33 (0.66) (0.97) Value added -0.58*** (6.5e- 029) 0.74 (0.58) 0.2 (0.97) -4.4 (0.63) (0.83) 1.3*** (0.0013) 0.44 (0.34) 9.6e-06 (0.58) (0.82) 9.37 (0.14) Table 2. Dynamic panel data output results (dependent variables: manufacturing value added and % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10% External debt effect on services. % GDP 0.12* (0.068) -6.3* (0.05) 36.1*** (0.004) 70.9*** (0.001) 0.79** (0.02) 0.55 (0.49) 0.16 (0.83) -1.4e-05 (0.64) Value added -0.58*** (4.1e- 014) 0.34 (0.82) -10.9*** (0.004) -2.2 (0.83) (0.93) 1.08*** (0.0013) 0.13 (0.77) 9.8e-06 (0.53) % GDP 0.12** (0.04) -6.3** (0.03) 32.3*** (0.008) 69.9*** (0.001) 0.68* (0.05) 0.78 (0.32) 0.76 (0.31) -4.18e-05 (0.34) Value added -0.58*** (2.66e- 013) 1.4 (0.33) -9.2** (0.015) (0.99) (0.87) 1.36** (0.02) 0.38 (0.34) 1.47e-05 (0.4) Services sector will be analyzed from two perspectives also. From scatterplots, the negative linear relationship between a sector and debt indicators can be seen. All of the indicators showed the same tendency (see figure 17-18), except for present value of stock of external debt in terms of GDP and face value of stock of external debt in terms of exports (0.66) 15.5 (0.37) 0.03 (0.73) -5.8 (0.22) 0.22 (0.75) 11.8 (0.18) 0.03 (0.74) 8.12 (0.36) % GDP 0.13** (0.04) -4.4* (0.074) 16.8* (0.05) 79.1*** (0.0002) 0.74** (0.049) 0.58 (0.46) (0.94) 1.e-05 (0.72) 0.43 (0.57) (0.13) Figure 15. Scatterplot of services value added (left) and services % of GDP (right) with stock of external debt as % of GDP.

62 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 62 In case of services sector, in models with significant coefficient for per capita income, satisfied the expectations indicating the opposite directions of per capita income and services sectors value added. Change in terms of trade shows the significant coefficients for value added, but different trend as it was expected. For Latin America, negative change in terms of trade is linked to service sectors supporting the latter researches that found positive impact of negative change of terms of trade implying change in comparative advantage leading to new sectors opportunities in medium term and reducing number of inefficient firms (Funke, Granziera and Imam, 2008). Value added Services ( t-1 ) -0.39*** (1.57e- 011) Constant (0.6) Per capita income 7.2 (natural logs) (0.51) Change in terms of trade (%) Secondary school enrolment (rate) Domestic investment (% of GDP) Current account (% of GDP) Countries' oppeness (% of GDP) Total debt services (% of export) -64.3*** (0.003) (0.77) 1.94 (0.39) 1.39** (0.011) 2.12e-05 (0.52) (0.31) % GDP -0.42*** (0.0021) -1.8 (0.41) (0.42) (0.21) (0.16) 0.32 (0.59) (0.86) 2.8e-06 (0.82) (0.2) Value added -0.4*** (3.96e- 013) 1.4 (0.45) 6.1 (0.56) -62.4*** (0.005) (0.92) 1.19 (0.28) 1.2** (0.02) 5.5e-05* (0.06) (0.36) % GDP -0.4*** (0.0025) -2.8 (0.2) -4.2 (0.48) (0.17) (0.49) 0.02 (0.96) (0.73) 5.19e-06 (0.71) (0.33) Value added -0.42*** (2.19e- 015) 0.26 (0.9) -18.9*** (0.007) -56.4** (0.012) (0.88) 0.72 (0.56) 0.72 (0.34) 6.3e-05* (0.04) (0.42) % GDP -0.42*** (0.0013) -1.3 (0.43) 11.9 (0.22) (0.19) -0.2 (0.19) 0.41 (0.53) (0.99) -5.7e-06 (0.34) -0.3 (0.14) Value added -0.41*** (2.8e- 014) (0.73) -12.3** (0.04) -60.6*** (0.0044) (0.92) 0.96 (0.4) 1.15** (0.04) 5.5e-05* (0.08) (0.33) % GDP -0.42*** (0.002) -3.1 (0.26) 11.5 (0.21) (0.17) 0.16 (0.16) 0.16 (0.75) (0.84) 7.6e-06 (0.61) 0.4 (0.15) Value of stock of external debt (% of GDP) (logs) 16.6* (0.053) 2.6 (0.7) PV of the stock of external debt (% GDP) (logs) 26.9*** (0.009) *** (0.006) Value of stock of external debt (% of exports) (logs) (0.46) 6.01 (0.46) Present value of the stock of external debt (% exports) (logs) -6.4 (0.49) (0.19) Table 3. Dynamic panel data output results (dependent variables: services value added and % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10%. The secondary school enrolment rate and domestic investment unexpectedly were not significant. Current account and countries openness coefficients showed positive significant effect on valued added. As for current account trade balance is largest component, positive net sales abroad generated by exports lead service sector s. However, external

63 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 63 debt services indicator failed to support crowding out effect of investment and did not show any significance. From all four debt indicators value of stock of external debt and present value of stock of external debt (both in terms of GDP) showed significant coefficients. Both indicators showed positive impact on service sectors in terms of value added implying that source of new funds helps to grow for these sectors. However, sector s in terms of GDP showed negative impact of external debt, contributing to expectation that higher level of external debt negatively affect sector s compared to GDP. As external debt increases, it makes positive effect on nominal value; however, its real value tends to decrease. The finding of all three sectors has not contributed to a clear view on how the external debt affects sectors. Exception is for a negative debt service effect on agriculture in terms of GDP, positive effect of face value and present value of stock of external debt (both in terms of GDP) on service sector while negative present value of stock of external debt (in terms of GDP) effect on service sector as share of GDP. Moreover, most of models failed to accept Sargan over-identification test, leading to possibility of residual correlation to instrumental variables and biased and inconsistent results (Murray, 2006). In the next sections, with reference to other authors attention to laffer-curve, the curvilinear relationship is going to be analyzed. However, omitting the countries openness coefficient as the effect of external debt is already encountered into exports they increase as external debt increase in order to be sustainable (Shabbier, 2004) (Also lowering the level of multicolinearity) and adding squared values of all four debt indicators External debt curvilinear relationship with sectors The dynamic panel model findings, including equation of generalized method of moment system (SYS-GMM) suggest that for agriculture sector in region positive change in terms of trade has a significant positive effect on sectors in terms of GDP (see table 4) ( also see appendix for fixed effect). Again per capita income showed significant positive effect on sector s

64 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 64 share of GDP matching the first model as well as current account. The coefficient debt service once again conclude a negative effect on agriculture sector (% of GDP) and leaving the crowding out effect significant negative for this sector. Moving on debt indicator, face value of external debt in terms of GDP did not show any significance, but three other indicators found significant negative effect on sector s value added, stating that increase in external debt lead to agriculture sector contraction. Curvilinearity indicator stand for inverted U shape, however as both linear and curvilinear indicators are negative it is more possible that it contains only a one - descending part, as it did not show an inverted V shape form. For dynamic panel model, including SYS-GMM estimates Sargan over identification passed the test for validity of instrument set. In the table 5, the results for manufacturing sectors can be seen. For manufacturing sector, per capita income indicator showed significant negative effect on value added, indicating the same trend as previous model, toward common level of income across region. Change in terms of trade differ between models. As for value added, it showed significant negative effect while for in terms of GDP significant positive. Result are opposing, and while positive change in term of trade shows that economy is getting better, and more money comes into economy, driving manufacturing sector in terms of, however the developing countries often face difficulties as it exports cheaper goods and services compared to imported ones.

65 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 65 Agriculture ( t-1 ) Constant Per capita income (natural logs) Change in terms of trade (%) Secondary school enrolment (rate) Domestic investment (% of GDP) Current account (% of GDP) Total debt services (% of export) Value of stock of external debt (% of GDP) (natural logs) Value of stock of external debt (% of GDP) (natural logs)^2 Present value of the stock of external debt (% GDP) (natural logs) Present value of the stock of external debt (% GDP) (natural logs)^2 Value of stock of external debt (% of exports) (natural logs) Value of stock of external debt (% of exports) (natural logs)^2 Present value of the stock of external debt (% exports) (natural logs) Present value of the stock of external debt (% exports) (natural logs)^2 Value added % GDP -0.48*** (5.83e- 0.16) (0.15) 0.7 (0.37) (0.83) (0.78) 0.16 (0.19) (0.54) 0.06 (0.35) 4.42 (0.4) (0.54) (0.27) 0.13 (0.99) 4.48 (0.4) 116.2*** (0.009) (0.96) -0.6 (0.58) -1.3*** (0.0016) -0.52** (0.06) -8.5 (0.75) 0.65 (0.84) Value added -0.47*** (4.11e- 017) -4.8 (0.16) -0.2 (0.7) -1.6 (0.83) (0.64) 0.19* (0.06) -0.1 (0.24) 0.11 (0.32) -4.01* (0.1) -2.11* (0.05) % GDP (0.2) (0.14) 5.3 (0.2) 113.4** (0.01) (0.97) (0.57) -1.4*** (0.009) -0.49* (0.07) (0.4) (0.42) Value added -0.49*** (3.44e- 018) -42.2** (0.047) (0.86) (0.91) (0.86) 0.16* (0.07) -0.09*** (0.008) % GDP (0.33) (0.66) 8.1* (0.05) 115.2*** (0.006) (0.77) -0.5 (0.58) -1.14** (0.01) 0.09 (0.36) -0.7 (0.14) -15.6* (0.05) -1.5* (0.06) (0.49) 5.1 (0.49) Value added -0.48*** (2.45e- 017) -6.2 (0.11) 0.55 (0.44) (0.77) (0.23) 0.14 (0.34) (0.96) 0.15 (0.14) -2.8* (0.07) 1.6 (0.66) % GDP -0.1 (0.15) (0.35) 3.7 (0.45) 114.5** (0.011) 0.03 (0.74) (0.79) -1.23** (0.009) -0.5** (0.04) -0.1 (0.98) (0.28) Table 4. Dynamic panel data (SYS-GMM) output results (dependent variables: agriculture value added and agriculture as % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10%. Secondary school enrollment rate as it was expected increase quality of human capital and has a significant positive effect on valued added. Domestic investment also contribute significant and positive effect on manufacturing. Current account counts for significant positive effect on value added. As for developing regions it is common to run a deficit import more to increase productivity, however the results say that for this region positive change in current account leads to higher value added for manufacturing possibly leading to benefit from higher level of manufacture production exports. Total debt service showed significant positive effect very different from the expectations. As the debt service is significant while any of debt indicators did not show any significance at the same time, it does not make a clear idea of how strong it can affect sector. However face value and present value of stock of external debt (both as share of exports) did show a negative significant effect

66 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 66 on both models (value added and share of GDP ) while the latter showed and a U shape curvilinear relationship. Again, Sargan over identification passed the test for validity of instrument set. Manufacture ( t-1 ) Constant Per capita income (natural logs) Change in terms of trade (%) Secondary school enrolment (rate) Domestic investment (% of GDP) Current account (% of GDP) Total debt services (% of export) Value of stock of external debt (% of GDP) (natural logs) Value of stock of external debt (% of GDP) (natural logs)^2 Present value of the stock of external debt (% GDP) (natural logs) Present value of the stock of external debt (% GDP) (natural logs)^2 Value of stock of external debt (% of exports) (natural logs) Value of stock of external debt (% of exports) (natural logs)^2 Present value of the stock of external debt (% exports) (natural logs) Present value of the stock of external debt (% exports) (natural logs)^2 Value added % GDP -0.5*** (4.45e- 07) (0.42) -2.6* (0.09) -16.4*** (0.004) 0.1* (0.059) 0.65** (0.047) 0.41** (0.01) 0.094*** (0.0031) 4.26 (0.55) (0.7) 0.17* (0.08) 12.1 (0.85) (0.9) ** (0.016) (0.32) 1.44*** (0.005) (0.43) 0.12 (0.73) (0.75) 0.06 (0.97) Value added -0.5*** (7.7e (0.66) -2.9** (0.01) ** (0.011) 0.11** (0.016) 0.66** (0.017) 0.38** (0.04) 0.07 (0.15) 1.9 (0.29) 0.45 (0.69) % GDP 0.16** (0.05) -49** (0.03) 3.4 (0.33) 122.4** (0.012) (0.18) 1.29** (0.014) (0.69) 0.17* (0.66) (0.71) 0.36 (0.95) Value added *** (8.9e- 08) 26.8 (0.61) -2.7*** (0.0087) -15.1** (0.01) 0.1** (0.01) 0.73** (0.016) 0.48** (0.042) 0.03 (0.7) -12.6* (0.058) 1.4 (0.39) % GDP 0.17* (0.07) (0.24) 6.3** (0.05) 120.1** (0.05) (0.35) 1.38*** (0.0005) 0.11 (0.8) (0.71) * (0.07) 10.2* (0.06) Value added -0.52*** (2.44e- 06) (0.93) -2.15** (0.02) -16.7*** (0.003) 0.07 (0.12) 0.52*** (0.006) 0.36** (0.04) 0.13* (0.06) -2.3 (0.18) 6.5** (0.03) % GDP 0.19* (0.07) -43.8* (0.06) 1.9 (0.35) 126.8** (0.025) (0.61) 1.6*** (0.0036) (0.57) (0.78) 7.5 (0.4) * (0.07) Table 5. Dynamic panel data (SYS-GMM) output results (dependent variables: manufacture value added and manufacture as % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10%. As for service sector (see table 6) per capita income showed significant negative (for value added ) and positive (as for % of GDP ), indicating that increase in income per capita tend to lower service sector value added but stimulates it in terms of GDP. The result a similar to manufacturing sector s change in terms of trade did not make value added higher but in terms of GDP. Secondary school enrolment did show contradicting result with negative value, while domestic investment as expected positive.

67 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 67 Current account as for manufacturing, here as well had significant positive value on service sector s value added, while in terms of GDP had expected negative value. Service ( t-1 ) Constant Per capita income (natural logs) Change in terms of trade (%) Secondary school enrolment (rate) Domestic investment (% of GDP) Current account (% of GDP) Total debt services (% of export) Value of stock of external debt (% of GDP) (natural logs) Value of stock of external debt (% of GDP) (natural logs)^2 Present value of the stock of external debt (% GDP) (natural logs) Present value of the stock of external debt (% GDP) (natural logs)^2 Value of stock of external debt (% of exports) (natural logs) Value of stock of external debt (% of exports) (natural logs)^2 Present value of the stock of external debt (% exports) (natural logs) Present value of the stock of external debt (% exports) (natural logs)^2 Value added % GDP -0.32*** (3.55e- 013) (0.54) -1.9 (0.55) -73.8*** (6.63e- 05) 0.08 (0.51) (0.97) 0.65 (0.11) (0.18) 24.1 (0.42) -1.9 (0.57) -0.39*** (0.0025) -1.6 (0.97) 1.7 (0.4) (0.22) (0.16) (0.89) -0.75* (0.09) (0.12) 3.9 (0.89) -0.8 (0.76) Value added -0.34*** (5.8e- 020) 34.3*** (0.003) (0.17) -68.9*** (0.0004) 0.14 (0.16) (0.98) 0.68* (0.08) (0.14) 14.4** (0.03) 3.88 (0.3) % GDP 0.16** (0.05) -49** (0.03) 3.4 (0.33) 122.4** (0.012) (0.18) 1.29** (0.014) (0.69) -0.17* (0.66) (0.71) 0.36 (0.95) Value added -0.33*** (1.88e- 019) (0.4) -6.7*** (0.0015) -69.7*** (0.0001) 0.11 (0.27) 0.05 (0.91) 0.49 (0.3) -0.2 (0.48) 44.7 (0.15) -4.3 (0.17) % GDP -0.4*** (0.002) (0.8) 4.1** (0.02) (0.16) -0.2*** (0.007) (0.6) (0.33) (0.11) 1.3 (0.96) (0.99) Value added (2.72e- 017) 36.4** (0.016) -4.2 (0.13) -68.*** (0.003) 0.1 (0.3) (0.66) 0.45 (0.28) (0.24) 1.72 (0.61) 17.38*** (0.005) % GDP -0.41*** (0.002) -19.5** (0.04) 5.8*** (0.0005) (0.13) -0.22*** (0.0002) (0.22) (0.27) -0.27* (0.08) 2.75 (0.3) 14.9*** (3.63e- 06) Table 6. Dynamic panel data (SYS-GMM) output results (dependent variables: service value added and service as % of GDP ). P-value significant *** at 1%, ** at 5%, * at 10%. Moving on debt servicing issue it showed a significant negative effect on service, showing an investment crowding out effect, negatively influencing service sector in terms of GDP. From four indicator one showed significant positive effect on service sector value added. Present value of stock of external debt showed positive significant curvilinear relationship for both models. Sargan over identification passed the test for validity of instrument set.

68 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Discussion In this part, the main findings will be discussed in the light of existing as it was presented in literature review in terms of external debt effect on the region s economic sectors (agriculture, manufacturing, services). Discussion part includes checking of stated hypotheses, theoretical and practical implications, also discussion on limitation that might be affecting validity and generalizability of the results.

69 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Main findings In the table (see table 7) the outcome of indicators in interest can be found. It presents the expected outcome in comparison with the obtained outcome. The expected outcome was that the external debt has significant negative effect on three selected sectors; however, the results did not show the expected outcome for all models. The model suggested that the agriculture sector was negatively affect by both and debt servicing and external debt, but the external debt servicing was negative for sector s in term of GDP, while external debt indicator showed a negative impact for value added. The negative values reflect the crowding out and debt overhang assumption, leading to sector s contraction as external debt increases. For the manufacturing sector, a model suggested that the external debt indicator was significantly negative, again supporting debt overhang idea, yet debt servicing showed positive impact, going against crowding out effect. However, it showed a positive effect only when external debt indicator was insignificant, not showing a contradicting result. As for services sector a model suggested that the external debt indicator had a positive impact for sector s value added, suggesting the need and benefit of external fund for this sectors. Still, the sectors in terms of GDP faces a negative impact from debt servicing supporting crowding out statement in previous researches. External debt Agriculture Expected value Obtained value Value added negative negative % of GDP negative no effect External debt Manufacture Expected value Obtained value Value added negative negative % of GDP negative negative External debt Services Expected value Obtained value Value added negative positive % of GDP negative no effect

70 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 70 Table 7. Main findings from variables in interest for three sectors. According to the hypothesis held: Hypothesis 1. High level of external debt has a significant negative effect on agriculture sector. Outcome 1. Hypothesis is partially confirmed. External debt seems to have a negative effect on agriculture sectors ; one indicator showed a negative effect of external debt on sector s, while none of them had any impact on in term of GDP. Hypothesis 2. High level of external debt has a significant negative effect on manufacturing sector. Outcome 2. Hypothesis is accepted. External debt indicator showed a significant negative effect on manufacture in both cases. Hypothesis 3. High level of external debt has a significant negative effect on service sector. Outcome 3. Hypothesis is rejected. External debt indicator presented a positive significant effect with no effect on in term of GDP Findings in the light of theory Latin America region had a very intensive and hard 1980s and 1990s, filled with crisis due to internal and external reasons. However early 2000s started with significant. The Union of South America nations seeking for strong fiscal, monetary and financial integration. The region was at moderate until 2002, influenced by different economic and political reasons. An agriculture sector in this region has decrease in terms of GDP; manufacturing also has a downward trend, while services sector was improving, making economy composition, which implies for economic development, as it was discussed in literature review. In the context of this study, it was expected that agriculture, manufacturing and services sector is significantly negative affected by external debt. The findings presented a negative external debt

71 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 71 indicators effect on agriculture as well as manufacture sectors supporting the big field of literature argues for negative external debt effect. Latin America having and holding a very high level of debt in time under investigation, increases risk of not being sustainable in medium term and making country exposed to interest rates risk. Too high level of debt not only harm sector separately but also slows down economy taking funds for various investments to debt servicing (Krueger, 2006). Rodolphe Blavy (2006) adds that even major sectors can feel the downward pressure as external debt cost increase a lot. Brownson, Vincent, Emmanuel and Etim (2012) state that in developing countries labor intense sectors usually tend to have much lower productivity when external debt increases too much. The whole Latin America and Caribbean region faced a harmful external debt crisis, due to overbrowning and inability to repay. It managed to significantly lower its external debt in terms of GDP. Latin America as well as other developing regions use external debt as instrument to fulfill the missing fund between domestic and desired investment and export-import gap to increase financing for economic development, poverty reduction, however often countries fall into borrowing trap when external debt and its servicing becomes damaging (Bankura, Kitabire and Powell, 2000). For Latin America, negative effect of external debt was felt due to many reasons. Rauser, Maejorie and Rose (1992) stress out interest rate importance. As around 80% of low developing countries were under variable-rate agreements and when interest rates went up in 1980s the debt services increased accordingly. Latin America is highly dependent on commodities export. The authors point out that the higher the share of exports in total output, the higher share of exports are from primary commodities leading to a higher damage from deterioration in terms of trade. Nevertheless during low developing countries, that tend to borrow massively abroad, faced increase of 5.3% to gross national income, however agricultural exporters from low developing countries faced 8-41% decline of their gross national income. It can be assumed that even if sector is increasing its export it does not at once imply an

72 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 72 overall economy, there is still a chance that money from exports is used to finance it current liabilities. As example, Argentina even took a policy of lowering export taxes in order to increase export supply in However, despite the net trade and external debt position, as real exchange rate of the dollar appreciates, stocks increased together with interest rates and made commodities prices to decrease, negatively affecting sector (Rauser, Maejorie and Rose, 1992). Adverse terms of trade and bad weather conditions are mentioned as exogenous factors increasing debt s problem. Low developing countries not having a diversified export base can easily face huge difficulties after a certain shock or negative World market trend. Sharp drop in export base can influence inability to repay debt liabilities and further problems (Boote, 1998). Many authors suggest that low level of external debt is not harmful. Latin America tended to increase external debt level to abnormal level and still has a high one. Moreover, it has tried to cover the existing liabilities with revenues from export of natural recourses. In addition, it makes real exchange rate to increase making manufacturing sector very sensitive to any event. Natural recourse with high amount of stock of eternal debt not only lower the of manufacturing sector, but also the national industrialization process (Gurbanov and Merkel, 2012). Findings also support the ideas presented in literature review when a high external debt leads to negative effect on sectors productivity influencing its (Were, 2001). Crowding out effect is strongly felt when huge amount of money are assigned for debt servicing. However, this study finds suggestions that not all three sectors face the external debt as a negative factor. The biggest, services sector s can be linked to positive effect of the external debt. A different reaction can be explained in support to previous analysis findings, when different sectors take the effect of external borrowing differently due to internal factors (Emmanuel, 2013). Service sector showed positive relationship between external debt and its, confirming Ribeiro, Vaicekauskas, Lakštutienė (2012) findings that using additional money

73 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 73 economy and its sectors can achieve better performance. In Latin America, agriculture and manufacturing in general have a negative trend in term of GDP while service sector has a positive. However all three sectors has a solid value added in last decade. Latin America is strengthening the regional services industry. In terms of outsourcing and offshoring (strategic business decisions of transferring a certain process to a foreign country, aiming for operating efficiency, lower costs, and qualified human recourses) increased the of this sector. According to World Trade Organization Argentina, Brazil, Chile were among leader of high level of outsourcing services exports for the last decade (Inter-American Development Bank). Analysts agree that global services sector gives ability for higher diversification in exports. This helps for a sector, using external financing, easier cover the liabilities. External debt influence cannot be assumed as the only one factor affecting sectors performance. Adding from literature, the strongest and most important sectors can live crisis easily as it contributes a lot to a whole economy in many aspects. Change in terms of trade tended to show similar results on all three sectors. Latin America, as a region, where commodity-exporting policy is very important has benefited in the last decade as commodities prices increased. Commodities price boom, improved macroeconomic situation allowed Latin America to improve in all perspectives (Adler and Magud, 2013). Sectors felt significant positive effect in in terms of GDP. Domestic investment is significantly positive for Latin America allowing sectors to improve. However, other capital flows tend to crowed out domestic investment. Studies aimed to find out if external debt have impact on domestic investment find that higher external debt is linked to lower domestic level, and external debt without domestic investment has even higher effect (Clements, Bhattacharya and Nguyen, 2003).

74 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Findings that fail to support hypothesis However, this study has not find everything to support the held hypothesis perfectly. Each sector was separated into two measures value added and in terms of GDP. Only for manufacturing sector both measures suggested expected negative values. However, agriculture and services sectors obtained values differ from the expected partially and totally. Frist of all suggested positive impact on services sectors holds for ideas of previous analysis when external debt at some level has a positive effect on sectors. As Latin America a developing region massively borrowing abroad and having an increasing trend of services sector additional funds seems to have a positive effect. External debt corresponds to no effect on two sectors value added in terms of GDP. One explanation is linked to a sectors contribution to GDP change over the last years. As for Latin America agriculture and services sectors share of GDP is moving to opposite directions, level of external debt does not create a specific effect. In some cases, other variables did not show the expected values. Specific countries effects lead to some different outcomes than expected or no effect at all. Human labor is often associated with economic improvements. However, in Latin America in period of the study the high poverty still exists and even if bigger countries started urbanizations process, rural regions are facing big problems, and sectors such as agriculture or even services sector development due to improvement of local human labor is quite difficult. Domestic investment also has not showed a very influential effect. For services sector in Latin America it is can be linked to high influence of foreign investment in this area, nevertheless agriculture sector faces the same trend. Foreign direct investment increase leads to higher productivity and higher salaries in foreign firms in this way crowding out domestic ivestment (Gallagher & Lopez, 2008).

75 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Limitations of the study Multicolinearity issue between independent variables. External debt effect is not direct to dependent variable; however, it has an influence to all the independent variables as well as all independent variables between each other. However, multicolinearity does not highly affect result as model, but more affect individual result (Schober and Weber, 2009). It might have an influencing effect on result. External debt was not separated into public and private, due to calculation of indicators. The independent variables present value of stock of external debt as consist of short-term external debt plus discounted value of debt service payments. There was a lack of data to separate short-term debt into public and private. For this, the result might be influenced. For real value of sectors, an industry-specific price index is more preferable than GDP. However, the data for index is not easily made using secondary data resources. Time period includes many downturns and crisis in the period Latin America and region in concern faced many difficulties, which might reflect to countries specific effects. Three years average computation was include in order lowering short-term fluctuations. Suriname was excluded from the 12 countries member of the Union of South America nation due to lack of data on external debt, leaving 11 countries as a representative block Grouping countries does not account for individual country outliers that might have specific effect overall countries block. Moreover, the countries have formed the union in 2005, in earlier year the goal of the countries were possibly different that might have affected the economic performance before the union started. Many studies analyze this Union as Latin America representative block later than Limitation of methodology. For the fixed effect, the models failed to accept null hypothesis in Sargan over-indentification as well as possible incorporation of endogeneity. After including equation of SYS-GMM, Sargan over-identification and no autocorrelation hypothesis

76 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 76 failed to be rejected. However, at some point the significance level was low indicating for possible countries heterogeneous issues. In the models outcome, not all the debt indicators showed significant meaning, failing to confirm any effect. In the model, different variables showed opposing results occurring due to country specific factors. The model itself is captured to find effect of external debt on overall economic rather than sectors separately. Additional variables possible could be included. However, in this research it was done following the earlier studies. All missing data for variables were collected using several different databases. That might include some minor inaccuracies Implications for further research For further studies model s improvements should be considered, including additional variables or exchanging the existing ones. In similar analysis Mexico should be strongly considered to be incorporated into union of South American nations as it is a huge economy, strong partner for all countries in the region. In this study only limited number of cases showed a significant results from the main variables. The further studies could separate the sectors even more, adding more sector s specific variables in the model for better and more accurate results. As for other studies the comparison between developed and developing countries also could be incorporated, including time scope that is not overlapping with deep crisis. Further analysis could be intended to capture not only the direct effect of external debt on sectors or economic but also the indirect effect that is probably more realistic. For this purpose, the identification of macroeconomic variables through which external debt affects sectors or economic indirectly could be performed

77 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA Policy implications of the study This study was aimed to identify the effect of external debt on various sectors in Latin America. The findings have not suggested just the expected outcome. For the agriculture and manufacturing the increasing stock of external debt is associated with sectors contractions while for the biggest sector services, increase in external debt has a positive impact on. Findings support existing literature implying that external debt can have a negative and positive effect on economy and sectors depending on right management of external factors as well as good internal economic policies. For sectors, using right fund at right time is very important. At slowdowns of world economy using external financing and not having diversified export base can create more damage than befit, while strong economic environment diversification of export can provide benefit from external debt. Empirical results suggest the importance of correct policies management of terms of trade, domestic investment and current account. The findings reveal that external debt can possibly be beneficial in low income countries that are trying to create a stable macroeconomic environment, have diversified export base and use intense exports not only when the burden of debt arises but as well as permanent process. Moreover, the corresponding debt management and its servicing play a huge role in countries attitude towards the effect of external debt o sectors transferring to whole economy s processes.

78 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 78 CONCLUSION In many cases, the external debt is determined as a new source of finance. However, developing countries tend to over borrow in international markets and possess risk of a negative effect of the external debt. In the literature, it is referred that low-income countries fall in the trap when additional amount of external debt is used to cover existing liabilities, not the investment opportunities. When too high level of stock of the external debt starts to harm economy it can be seen in many fields. The debt overhang problem when creditors are not expecting to be fully repaid because of a huge debt existence. Crowding out effect when a country has big debt servicing cost and it influence investment contraction. Capital flight due to unfavorable conditions and increase in taxes, wrong external debt management are issues leading to difficulties that countries might face using external funds. Only in cases when countries are able to mage external debt correctly and cope with amount they are borrowing in beneficial way it can be expected that the external debt has a positive effect and is defined as a debt-led-, not a debt-led-debt. This research analyzed countries economy from three important sectors (agriculture, manufacturing, services) perspective in a region having history of big usage of external debt Latin America. The time scope entailed 32 years starting from 1980, transforming it into 3 years not moving average. Following the literature, this study assumes that external debt has a negative effect on all three sectors. The main goal of the study was to identify how external debt affects the economic sectors in Latin America, for this purpose Latin America was transformed into a representative block of countries, members of the Union of South America Nations. Alongside with the main goal, the other macroeconomic measures that might possibly affect sectors were included (such as terms of trade, secondary school enrolment, domestic

79 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 79 investment etc.). As a most appropriate and widely used method panel data analysis was chosen. The suggested empirical results are as follow: An increasing external debt seems to be negatively affecting agriculture and manufacturing sectors possibilities in the region. The effect is not directly through investment base but rather through recourses used for sectors. However, findings also suggest that using external debt, as a source of finance can be beneficial for a services sector, supporting the previous cases when increasing sectors role is important for the whole economy and additional funds are used in a proper way. The findings suggest the need for a good external debt management in order to keep the balance between sectors, not depressing one to keep growing other. External debt has an effect on sectors through the indirect effect on investment. As in literature, it is common that external debt does not lower investment itself; even so, debtservicing costs can do it. Empirical results suggest a negative debt servicing effect on agriculture and services sectors implying for crowding out effect. Accordingly, funds used to service debt pull back the amount of possible investment into the sectors. Behavior of macroeconomic variables other to external debt follow the theory. A big role was for change in terms of trade that positively influenced sectors in terms of GDP as well as domestic investment referred to higher economic capacity. Current account showed significant effect on sectors as well. Suggested contradicting results are mainly due to specific internal countries factors and study limitations. Findings of the study suggest that for developing countries the need of optimizing the usage of external debt is important for solid and stable sectors performance. Certain macroeconomic and structural adjustment policies, diversified export base, solid domestic investment, correct management system are factors important for region to keep the sectors and whole economy growing. It is necessary to keep the optimal recourses level in the country to be

80 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 80 able to pay the debt services on time and with specific requirements, not only to be attractive for debtors but to be able to manage private investment as well. As external debt becomes a burden for a country it possesses the risk and intensive usage of resources to cover the arising problem while using external in a proper manner can become an additional recourse in the process of economic development.

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94 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 94 Appendixes List of appendixes Appendixes 1 Gross domestic product (U.S. dollars) Latin America and Caribbean Appendixes 2 External debt, total (U.S. dollars) Latin America and Caribbean Appendixes 3 External debt, total debt service Appendixes 4 External debt, total (% of GDP) Appendixes 5 U.S. Fed Funds Rate ( ) Appendixes 6 Export volumes of goods and services (percentage change) Appendixes 7 The countries member of the union of South America nation imports (upper graph) and exports (lower graph) for Appendixes 8 Share of total agricultural production, by region and groups of countries Appendixes 9 Agriculture value added (% of GDP) Appendixes 10 Manufacturing value added (% of GDP Appendixes 11 Service sector value added (% of GDP) Appendixes 12 Correlation matrix of all variables Appendixes 13 Scatterplots of agriculture value added with all debt indicators Appendixes 14 Scatterplots of agriculture % of GDP with all debt indicators Appendixes 15 Scatterplots of manufacture value added with all debt indicators Appendixes 16 Scatterplots of manufacture % of GDP with all debt indicators Appendixes 17 Scatterplots of service sector value added with all debt indicators Appendixes 18 Scatterplots of service sector % of GDP with all debt indicators Appendixes 19 Labor force by education for Latin America and Caribbean Appendixes 20 Dynamic panel data (fixed effect) output (dependent variable agriculture value added and agriculture as share of GDP)

95 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 95 Appendixes 21 Dynamic panel data (fixed effect) output (dependent variable manufacture value added and manufacture as share of GDP) Appendixes 22 Dynamic panel data (fixed effect) output (dependent variable service value added and service as share of GDP)

96 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 96 Appendixes 1 Gross domestic product (U.S. dollars) Latin America and Caribbean (left side) and members of the South America nation (right side), calculated based on IMF database. Appendixes 2 External debt, total (U.S. dollars) Latin America and Caribbean (left side) and members of the South America nation (right side), calculated based on IMF database

97 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 97 Appendixes 3 External debt, total debt service (Percent of exports of goods and services) Latin America and Caribbean (left side) and members of the South America nation (right side) calculated based on IFM data base Appendixes 4 External debt, total (% of GDP) Latin America and Caribbean (left side) and members of the South America nation (right side), calculated based on IMF data base Appendixes 5 U.S. Fed Funds Rate ( ), retrieved from Penzo, 2012.

98 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 98 Appendixes 6 Export volumes of goods and services (percentage change), calculated using World Bank database. Appendixes 7 the countries member of the union of South America nation imports (upper graph) and exports (lower graph) for 2012, calculated based on World Bank database.

99 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 99 Appendixes 8 Share of total agricultural production, by region and groups of countries, retrieved form A changing global harvest by Fuglie and Nin-Pratt, 2012 Appendixes 9 Agriculture value added (% of GDP) for Latin America and Caribbean, calculated using World Bank database.

100 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 100 Appendixes 10 Manufacturing value added (% of GDP)for Latin America and Caribbean, calculated using World Bank database. Appendixes 11 Service sector value added (% of GDP) for Latin America and Caribbean, calculated using World Bank database.

101 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 101 Agriculture sector (value added ) Agriculture sector (% GDP) Manufacturing sector (value added ) Manufacturing sector (GDP) gowth Services sector (Value added ) Services sector(% GDP) Real per capita income (natural logs)(-1) Change in terms of trade (%) Secondary school enrolment rate Gross domestic investment (% GDP) Curent account (% GDP) Export + Import ($mill.) Agricultur e sector (value added ) 1.00 Agricultur e sector (% GDP) Manufact uring sector (value added ) Manufact uring sector (GDP) gowth Services sector (Value added ) Services sector(% GDP) Real per capita income (natural logs)(-1) Change in terms of trade (%) Secondar y school enrolmen t rate Gross domestic Curent investme account nt (% (% GDP) GDP) Export + Import ($mill.) Debt service (%Exp) VSGDPnlog Debt VSGDPnl PVSGDPnl VSEXPnlo PVSEXPnl service og og g og (%Exp) PVSGDPnlog VSEXPnlog PVSEXPnlog Appendixes 12 Correlation matrix of all variables Appendixes 13 Scatterplots of agriculture value added with all debt indicators Appendixes 14 Scatterplots of agriculture % of GDP with all debt indicators Appendixes 15 Scatterplots of manufacture value added with all debt indicators

102 EFFECTS OF EXTERNAL DEBT IN LATIN AMERICA 102 Appendixes 16 Scatterplots of manufacture % of GDP with all debt indicators Appendixes 17 Scatterplots of service sector value added with all debt indicators Appendixes 18 Scatterplots of service sector % of GDP with all debt indicators Appendixes 19 Labor force by education for Latin America and Caribbean compared to OECD countries, calculated using World Bank database.