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

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.