Articles on Islamic Economics

Negative Effects of Interest Based Loans on Development


Salman Ahmed Shaikh

Most developing countries are going through a perpetual debt trap which takes away resources that could have been used on development, but instead are used to service compounded debt.

More money goes out in debt servicing than what comes in as aid in many countries. On a net basis, even after receiving aid, outflow is more than inflow. If this trend persists in future, one can see how it will perpetuate the debt trap.

UN predicts that the Corona Virus could add an additional 29 million people to the more than 400 million Africans living in extreme poverty. Progress on debt relief is slow as private lenders fear about reaction to their portfolio performance and ratings.

There is some empirical literature which supports the negative effect of external debt servicing on economic growth and development. Easterly (2002) presented empirical evidence which shows a negative effect of indebtedness on growth. Explaining the evidence, he stated that the paradox of debt is that heavily indebted poor countries (HIPCs) became more heavily indebted after two decades of debt relief efforts. He stated that even concessional financing, a form of debt relief also failed to reduce net present value of debt. According to him, the record is not encouraging for the success of current debt relief efforts.

From Africa, Fosu (2010) finds that the implied debt service burden adversely affects the share of public spending in the social sector, with similar impacts on education and health. For Zimbabwe, Saungweme and Mufandaedza (2013) find that external debt servicing adversely affects short run income per capita and is associated with worsening infant mortality rates.

Furthermore, Adegbite et al. (2008) confirm the negative impact of debt (and its servicing requirements) on growth in Nigeria. Non-linearity in their results show that external debt may have a positive impact for sometime, but as debt servicing increases beyond a threshold point, it starts to negatively affect the economic growth. Problem is that reversal becomes all the more difficult for HIPCs who struggle to service current debt and require more resources to sustain their economies. Thus, they fall in debt trap and find it immensely difficult to get out of it when the economic growth is also negatively affected. Ajayi and Oke (2012) found in an empirical study for Nigeria that external debt burden had an adverse effect on the per capita income and led to devaluation of the currency, increase in unemployment, social strife and poor educational system.

Cunningham (1993) collecting evidence for the period 1971-1987 from 16 HIPCs found a significant negative relationship between the growth of debt burden and economic growth in these countries. It is not just Africa that is suffering from the debt crisis. Other developing regions are also having the same negative impacts. Malik et al. (2010) provided the empirical evidence for Pakistan’s economy which shows negative and significant relationship of external debt with economic growth. Currently, Pakistan pays around half of its tax revenues in debt servicing. Karagol (2012) shows that even a relatively developed economic like Turkey has experienced negative effect of external debt servicing on economic growth.

References

Adegbite, E. O., Ayadi, F. S., & Ayadi, O. F. (2008). “The Impact of Nigeria’s External Debt on Economic Development”. International Journal of Emerging Markets3(3), 285 – 301.

Ajayi, L. B. & Oke, M. O. (2012). “Effect of External Debt on Economic Growth and Development of Nigeria”. International Journal of Business and Social Science, 3 (12), 297 – 304 .

Cunningham, R. T. (1993). “The Effects of Debt Burden on Economic Growth in Heavily Indebted Developing Nations”. Journal of Economic Development. 18 (1), pp. 115-126.

Easterly, W. (2002). “How Did Heavily Indebted Poor Countries Become Heavily Indebted? Reviewing Two Decades of Debt Relief”, World Development, 30 (10), pp. 1677-1696.

Fosu, A. K. (2010). “The External Debt‐servicing Constraint and Public‐Expenditure Composition in Sub‐Saharan Africa”. African Development Review22(3), 378-393.

Malik, S., Hayat, M. K., & Hayat, M. U. (2010). “External Debt and Economic Growth: Empirical Evidence from Pakistan”. International Research Journal of Finance and Economics, Issue 44, pp. 88 – 97.

Saungweme, T., & Mufandaedza, S. (2013). “An Empirical Analysis of the Effects of External Debt on Poverty in Zimbabwe: 1980–2011. International Journal of Economics and Research4(6), 20 – 27.

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