Foreign Debt and Economic Growth: The Role of Institutional Quality and Financial Development in Asian Developing Countries

Muhammad Dawood, Zhao Rui Feng, Mingxing Li, Fayaz Hussain Tunio, Noah Cheruiyot Mutai and Zhong Hua Li

Economics of Transition and Institutional Change, 2026, vol. 34, issue 1, 161-182

Abstract: The dual role of foreign debt as both a stimulus for growth and a driver of fiscal fragility remains a critical challenge for developing economies. Although existing literature emphasises static debt‐to‐GDP thresholds, this study contributes to a paradigm shift by examining how institutional quality (IQ) and financial development (FD) dynamically moderate the debt–growth nexus across 32 developing Asian countries (1997–2022). Employing advanced second‐generation econometric techniques, system GMM, dynamic common correlated effects (DCCE) and dynamic panel threshold models (DPTM), we address the issues of endogeneity, cross‐sectional dependence and heterogeneity that have been pervasive in prior studies. Results reveal that foreign debt exerts a baseline adverse effect on economic growth, consistent with the debt overhang hypothesis. However, strong institutional structures and developed financial systems reduce these adverse effects, enabling debt to act as an impetus for growth beyond the identified thresholds. For the full sample, institutional quality and financial development thresholds are 0.93 (on a −2.5 to +2.5 scale) and 38.35% (on a 0 to 100 scale) of GDP, respectively. Disaggregated analyses show that lower‐middle‐income countries (LMICs) benefit at thresholds of 0.91 (IQ) and 37.33% (FD), whereas upper‐middle‐income countries (UMICs) require stricter thresholds of 0.85 (IQ) and 55.94% (FD) to leverage debt for innovation‐driven growth. These findings challenge the universality of debt‐to‐GDP ‘danger zones’, emphasising context‐dependent thresholds shaped by governance and financial maturity. This study underscores that institutional reforms—such as enhancing transparency, strengthening the rule of law, improving fiscal accountability, deepening financial systems and advancing credit allocation and risk intermediation—are essential prerequisites for the sustainable utilisation of external debt. By bridging institutional economics and debt sustainability frameworks, this work offers policymakers actionable benchmarks to navigate debt's dual role as a developmental tool and fiscal liability in emerging Asia.

Date: 2026
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Persistent link: https://EconPapers.repec.org/RePEc:wly:ectrin:v:34:y:2026:i:1:p:161-182

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