Is Pakistan in a debt trap? Do domestic and foreign debts crowd-out private investment?

Abstract

Historically, Pakistan remained heavily dependent on domestic and external sources of financing which have strangled economic activities. Excessive public borrowing from domestic sources puts upward pressure on interest rates which crowded out domestic investment. Earlier studies found a linear relationship between debt and private investment. However, these studies overlooked the non-linear behavior of debt. The present study fills the research gap by examining the asymmetric impact of domestic and external debt on private investment. Further, this study attempts to explore whether the domestic and foreign debt crowed-in or crowed-out private investment in Pakistan over the period from 1972 to 2022. To this end, the Non-linear Autoregressive Distributed Lag (NARDL) model has been utilized to capture the positive and negative shocks of domestic and foreign debt on private investment. The empirical outcome confirms the existence of both the long-run and short-run asymmetry between private investment, domestic debt, and external debt in Pakistan. Particularly, the positive shock to domestic debt deters private investment, while the negative shock promotes private investment in the short run. On the other hand, a positive shock to foreign debt enhances private investment in the short-run and the opposite holds for the negative shocks in the long-run. Another important finding is the crowding-out effect of public investment on private investment, which holds true in the short run. Thus, there is a need to curtail the size of domestic debt since its accumulation adversely affects private investment.