Other People’s Money: External Debt, Disequilibrium Exchange Rate and Economic Growth, A Kenyan Case (1963-2015)

Abstract

External debt is found to be a driver of economic growth if properly managed but its servicing rather than repayment is an inhibiting factor to economic growth. This paper examined the relationship between external debt and economic growth in Kenya. The paper also examines the control effect of exchange rate for the period between 1963 and 2015. Through Vector Error Correction model, Variance decomposition and causality, the findings reveal that economic growth and disequilibrium exchange rate is negatively and significantly related to economic growth. However, there is absence of bidirectional causality between the variables. The negative effect of exchange rate on economic growth is a signal to the central bank and Policy makers that they need to stabilize the local currencies for instance by improving exports. A reduction in borrowing will enable the country to use a greater proportion of their tax revenues for investments rather than repaying loans, thereby increasing economic growth. Furthermore, real exchange depreciation raises the debt burden and negatively relates to GDP. There is thus the need to ensure that exchange is not over-devalued in order to balance the two effects.

Key Words: External Debt, Disequilibrium Exchange Rate, Economic Growth, Kenya