Does Foreign Aid Increase External Debt Burden in Bangladesh? A Dynamic Causality and Cointegration Analysis

Abstract

This paper investigates the impact of foreign aid, amongst other
determinants, on the long-term external debt of Bangladesh using time series data.
Long-run causality from external debt to foreign aid is observed. Bidirectional
causalities exist between external debt and government spending, between external
debt and trade openness, and between government spending and economic growth.
Unidirectional causalities are observed from government spending to domestic
investment, trade openness to government spending, and economic growth to
external debt, foreign aid and trade openness. The short-run and the long-run
effects of foreign aid on external debt are positive which indicate that massive aid
inflows in Bangladesh increase the external debt trap but significantly increase in
the short-run. The long-run and short-run effects of domestic investment on
external debt are significantly positive while trade openness and economic growth
are insignificantly negative. It is found that when external debt level is above or
below its equilibrium level it adjusts by almost 18.98% within the first year. The full
convergence process to its equilibrium level takes about 5.27 years.