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Journal of Economics and Finance

10-05-2024

The effect of external debt on greenhouse gas emissions

Authors: Jorge Carrera, Pablo de la Vega

Published in: Journal of Economics and Finance

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Abstract

We estimate the causal effect of external debt on greenhouse gas emissions in a panel of 78 emerging market and developing economies over the 1990-2015 period. Unlike previous literature, we use external instruments to address the potential endogeneity in the relationship between external debt and greenhouse gas emissions. Specifically, we use international liquidity shocks as instrumental variables for external debt. We find that dealing with the potential endogeneity problem brings about a positive and statistically significant effect of external debt on greenhouse gas emissions: a 1 percentage point (pp.) rise in external debt as a percentage of GDP causes, on average, a 0.5% increase in greenhouse gas emissions. One possible mechanism of action could be that, as external debt increases, governments are less able to enforce environmental regulations because their main priority is to increase the tax base to pay increasing debt services or because they are captured by the private sector who owns that debt and prevented from tightening such regulations.

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It is worth bearing in mind that the nexus between debt and growth has been extensively studied, but even today no definitive conclusion on the direction of causality between the two variables has been made (Modigliani 1961; Bernheim 1987; Lyoha 1999; Aschauer 2000; Reinhart and Rogoff 2010; Carrera and de la Vega 2021; Law et al. 2021)

Katircioglu and Celebi (2018) and Akam et al. (2021) discuss other plausible channels such as external debt financing energy imports in energy deficit economies. However, from a money fungibility perspective, this may be hard to assess and we consider the economic growth channel to include this case well.

This is in fact related to the increasing, although yet low, relevance of green bonds (Ehlers and Packer 2017; Flammer 2020; Tolliver et al. 2020)

Notwithstanding, having climate change-related policies in place is increasingly becoming a prerequisite for governments and firms to receive funding (Wire 2021; Rankin 2021). Therefore, it is likely that reverse causality may be also an issue in the future.

In order to increase sample size, for each country i, we use all j countries with information on financial openness and calculate weights as the inverse of the simple distance between most populated cities, which is constant, obtained from CEPII GeoDist Database (Mayer and Zignago 2011)

This instrument is similar to the one used in Habib et al. (2017) for estimating the causal impact of real exchange rate on economic growth. However, they use global capital flows as a proxy of international liquidity and the i country’s financial openness instead of the time-averaged financial openness of the \(i's\) neighbors countries.

Note that the FE estimates are the same if we include GDP growth and net capital inflows as in the IV estimates. These results are available upon request.

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Title: The effect of external debt on greenhouse gas emissions
Authors: Jorge Carrera
Pablo de la Vega
Publication date: 10-05-2024
Publisher: Springer US
Published in: Journal of Economics and Finance
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI: https://doi.org/10.1007/s12197-024-09674-x