The Real Effect of Government Debt: Evidence from the Malaysian Economy

(ProQuest: denotes formulae omitted.)1. IntroductionThere are several lessons to be learnt from the recent sovereign debt crisis that has affected most of the European economies. A rise in public debt and country specific problems are among the factors behind the European Financial Crisis. Ireland is facing a banking crisis while Spain is experiencing a housing bubble. In addition, Greece, Italy and Portugal are involved in fiscal mismanagement. Thus, they have drawn their economies into sovereign debt crises and are still in the process of recovery four years after the crisis erupted in 2008. On the other hand, current development shows that Japan, Greece, Italy, Portugal and Ireland are among the top listed countries with very high levels of public debt (IMF 2012) As at the end of 2011, Japan held a public debt of about 229.77 per cent of gross domestic product (GDP) and this was expected to hit almost 240 per cent of its growth. In addition, Greece, Italy, Portugal and Ireland held public debts (as percentages of GDP) of about 160.81 per cent, 120.11 per cent, 106.79 per cent and 104.95 per cent respectively. Furthermore, in response to this issue, the Organisation for Economic Cooperation and Development (OECD) has called on countries to cut their public debts to prudent levels of around 50 per cent of GDP in order to cope with future challenges including health, long term care and pensions.2Looking at the roots of the problem, it can be seen that persistent large deficits, used primarily to finance public sector operating expenses, have resulted in high ratios of debt to GDP, thus driving Greece and other European countries into debt overhang problems. In the midst of this phenomenon, some developing countries are showing signs or symptoms of the debt overhang problem; this highlights the question of whether government debt has benefited economies (Cecchetti, Mohanty and Zampolli 2011; Baum, Checherita Westphal and Rother 2012; Presbitero 2010; Caner, Grennes and Koehler Geib 2010) Thus has underlined the urgency of investigating the issue of the heavy stock of public debt in developing economies, since neither developed nor developing countries are immune to the public debt sustainability issue.Malaysia, a small open economy, has recorded a fiscal deficit position since its independence in 1957 except for the period 1993 1997. Furthermore, the country has recorded 13 consecutive years of fiscal deficits since the year 1997. This condition was leading Malaysia to accumulate a stock of indebtedness regardless of domestic or international capital markets since, by continuing to run budget deficits, the country would have a high stock of debt (as depicted in Appendix 1) In addition, the federal government debt was financed from domestic and foreign funding, which constituted approximately 96.2 per cent and 3.8 per cent of the gross borrowing respectively.3 As at the end of 2011, total federal government debt was recorded at RM 455,745 million, which is equivalent to 53.8 per cent of Gross Domestic Product (GDP) (Malaysia Economic Planning Unit 2011) This position has already been reached and is slightly higher than the prudent cut off point of public debt holding that has been set for developed economies. However, no one size fits all. This highlighted the importance of analysis on a country by country basis before it was too late and the country had already passed its optimal level, becoming trapped in a debt overhang situation, being in default and, to a lesser extent, witnessing the eruption of a sovereign debt crisis.In principle, if borrowing has been allocated efficiently, a country will benefit from it since debt financing of public spending can make a positive contribution to productive investment and ultimately to economic growth (Miller and Foster 2012) In contrast, a country with high levels of debt will face the probability of a debt overhang problem, to a lesser extent, or default or bankruptcy.