Does External Debt Service Devalue Local Currency in the Long Run? Empirical Evidence from Egypt

The aim of this study is to identify the extent to which there is an effect of external debt service on the exchange rate in Egypt in the long run, where the change in the exchange rate has great importance in changing currency value and thus affecting its function as a store of value and a standard for forward payments and then in the redistribution of income and wealth, It also has an effect on some macroeconomic variables, such as inflation, exports, imports, and thus the current account. The study examines the estimation of the long-run relationship between the external debt service and the exchange rate in Egypt in the period 1980-2019 and relies on the exchange rate of the dollar against the Egyptian pound as a dependent variable, while the explanatory variables were the external debt service, gross capital formation, broad money growth, deposit interest rate, household final consumption expenditure, gross savings, and terms of trade adjustment. The methodology is based on Vector Error Correction (VEC) and the study concluded that there is a significant long-term relationship between the value of the Egyptian pound and all the variables explained in the study, as the error correction coefficient is negative and significant. Also, there is an inverse statistically significant relationship between the value of the Egyptian pound and each of the external debt service, the deposit interest rate, and gross savings; any change of 1% in the external debt service, the deposit interest rate, and gross savings leads to a devaluation of the Egyptian pound against the dollar by 4.8%, 0.04%, and 0.05%, respectively. The study also concluded that there is a positive, statistically significant relationship in the long term between the value of the Egyptian pound and each of gross capital formation, broad money growth, households' and NPISHs' final consumption expenditure, and terms of trade adjustment, as any change of 1% in these variables leads to an increase in the value of the Egyptian pound by 0.16%, 0.05%, 0.27%, and 6%, respectively. This study recommends that decision makers consider all the reasons that would reduce the external debt service in order to preserve the value of the Egyptian currency in the long run.


Introduction
There is extensive literature on the benefits of public debt in foreign currencies. The most important potential benefits of foreign currency debt include access to a larger investor base, reduced crowding out of private sector lending in domestic markets or repeat inflationary financing (Bua, Juan, & Andrea, 2014), lower returns on foreign currency issuance, access to longer maturities, ability to build official foreign currency reserves and improved short-term stability term longevity in difficult times. Also, in developing countries, the state resorts to external borrowing to provide the private sector's needs of foreign exchange, whether by lending where companies cannot access foreign money markets or by guaranteeing loans. Moreover, external borrowing in foreign currencies may lead to more discipline fiscal and monetary, whereby the government's incentive to create inflation decreases to reduce the value of the local currency. But foreign currency financing is risky and tends to be volatile, cyclical and subject to sudden stops (Cavallo & Tavella, 2013).The issuance of foreign currency on a large scale can increase the external vulnerability of a country as seen by investors and credit rating agencies. The presence of foreign currency debt, along with real exchange rate volatility increases the volatility of GDP growth and capital inflows (Eichengreen, Hausmann, & Panizza, 2005a). exposure to external conditions, especially when debt is contracted at a variable rate and with rising global interest rates, which leads to an increase in debt service costs. A depreciation also leads to increased debt service (in terms of the domestic currency), and when the country borrows to cover the growing deficit, external borrowing leads to an unsustainable level of debt, an excessive share of debt service in total government spending, and a significant use of foreign currency to service debt which may lead to a debt crisis in the long term (Beaugrand, Loko, & Mlachila, 2002). As for external borrowing for the purpose of formation of foreign exchange reserves. If foreign money is sterilized, it leads to the same effects of domestic loans as increasing interest rates and excluding private investment. If money is not sterilized, external financing is accompanied by increased domestic demand and thus results in pressure on inflation or the balance of payments (Beaugrand, Loko, & Mlachila, 2002). The rest of this study is organized as follows: Section 2 gives the Empirical Review. Section 3 presents the methodology and model estimation. Finally section 4 gives the results and conclusion.

Empirical Review
Most of the empirical studies agreed on the existence of an inverse significant relationship between the value of the currency and the service of the external public debt, despite covering different periods of time and different explanatory variables and their application to different countries. The following table 1 shows a summary of the results of some of these studies. The results of this study showed that debt, in addition to the usual variables such as money supply and interest rates, has a largely significant and negative impact on the external values of most of the countries' currencies.
This paper proposes a structural model that is an aggregation of an asset and a monetary model of exchange rates along the Frankel Line (1983), modified to include external debt. Estimate this model for a sample of 18 LDCs. Ajayi, R. A.,& Jongmoo, J.C. (1993).
External debt as a means of financing the budget deficit which has been discouraged in Nigeria in the short term because its servicing and repayment especially puts pressure on the foreign exchange market in the short term and thus leads to exchange rate fluctuations in terms of depreciation of nairan in Nigeria.
This study used an Autoregressive Distribution Lag model (ARDL), and the variables used exchange rate fluctuations as dependent variables, and external debt, debt service payment, and foreign reserves as independent variables. Aderemi, Timothy Ayomiunde et al. (2020). study checked The relationship between external debt and exchange rate fluctuations in Nigeria during the period from 1981 to 2018.
The results showed a positive relationship between the external public debt, the budget deficit, the current account deficit, and the exchange rate depreciation.
In model, the benefit of autoregressive (dynamic) modeling has been taken as granted for using the option of lagged value(s) of the regress and as explanatory variable. Alam, Noor and Fauziah Md. Taib (2013). this study designs a model wherein the relationship of external public debt with budget deficit, current account deficit, and exchange rate depreciation are empirically tested. The study is dichotomy that covers empirical analysis of panels of a group of six "Debt Trap Countries (DTC)" namely as, India, Indonesia, Nepal, Pakistan, Sri Lanka, and Thailand and eight "Non Debt Trap Countries (NDTC)" as Bangladesh, Fiji, Korea, Malaysia, Myanmar, Papua New Guinea, Philippines, and Singapore, of Asian Pacific Developing Countries (APDC).The study period of thirty years (1971 to 2000).
The external debt service had a negative impact on the exchange rate in the short-run in Kenya.
The Vector Autoregression model was estimated using first difference of the variables. The Impulse Response Functions and variance decomposition were estimated. Mutua et al. (2020). The research examined the impact of external debt service on the exchange rate in Kenya. Times series data was used for the period 1982 to 2016.
The results of the study showed that foreign debt receipts and foreign debt service have short and long-term positive relationships with exchange rate fluctuations in Niran. The study concluded that while the receipts of the external public debt positively affect the exchange rate, the service of the external public debt negatively affects the exchange rate.
The variables were used in this study included external public debt receipts, external public debt servicing, and exchange rate Fluctuations. This study used multiple regressions (Ordinary Least Square) and Co-integration to establish the short-run and long-run relationship.

Methodology and Model Estimation
This study examines the estimation of the relationship between Exchange rate and Debt service on external debt in Egypt in the period 1980-2019 in long run.   Figure 1. The graph of the study variables

Unit Root Test
The following Table 3 shows the results of the time series stability test will use the breakpoint unit root test will be use. It is clear that all the variables are stable in the first difference with a constant enabling us to carry out Co-integration of study variables.

Co-Integration Test
From

Vector Error Correction (VEC)
The results of the long-term relationship between Exchange rate, Debt service on external debt, Gross capital formation, Broad money growth, Deposits interest rate, Household final consumption expenditure, Gross Savings and Terms of trade adjustment were estimated in the equation (2) and in Table 5.
From the equation 2 and Table 5 bellow, it is clear to us through the estimated relationship in the model that: First: There is a significant long-term relationship between the value of the Egyptian pound against the dollar and all the variables explained in the study, as the error correction coefficient is negative and significant. Second: There is an inverse statistically significant relationship between the value of the Egyptian pound and each of the debt service on external debt, the deposit interest rate and Gross savings, as any change of 1% in the debt service on external debt, the deposit interest rate and Gross savings leads to a devalue of the Egyptian pound against the dollar by 4.8 %, 0.04%and 0.05% respectively. Third: There is a positive statistically significant relationship in the long term between the value of the Egyptian pound against the dollar and each of Gross capital formation, Broad money growth, Households and NPISHs final consumption expenditure and Terms of trade adjustment, as any change of 1% in these variables leads to an increase in The value of the Egyptian pound against the dollar by 0.16%, 0.05%, 0.27% and 6%, respectively.
The value of coefficient R 2 reached 87.5%, meaning that the independent variables in the model explain an amount of 87.5% of the change in the value of the Egyptian pound against the dollar.

Test the Quality of the Model
In order to test the quality of the model, the researcher tested the normal distribution of the Residual, which is shown in Table 6, where it was found that the Residual is distributed naturally. The null hypothesis is assumed that the Residual follow the natural distribution. The researcher tested the residual serial correlation; the results of this test in the table 7 indicated that there is no residual serial correlation between the errors in order to accept the null hypothesis that suggests the independence of random errors. The Heteroskedasticity test presented in Table 8 has been accepted for the null hypothesis, which assumes the homoscedasticity of the study variables and rejects the Heteroskedasticity. Also Wald Test results in table 9 illustrate the significance of all study variables. From previous model quality tests, it is clear that the model is acceptable and can be relied on.

Conclusion
This study examines the estimation of the long-run relationship between the external debt service and the exchange rate in Egypt in the period 1980-2019 and relies on the exchange rate of the dollar against the Egyptian pound as a dependent variable, while the explanatory variables were the external debt service, gross capital formation, broad money growth, deposit interest rate, household final consumption expenditure, gross savings, and terms of trade adjustment. This study methodology is based on Vector Error Correction (VEC) and concludes that there is a significant long-term relationship between the value of the Egyptian pound and all the variables explained in the study, as the error correction coefficient is negative and significant. Also, there is an inverse statistically significant relationship between the value of the Egyptian pound and each of the external debt service, the deposit interest rate, and gross savings; any change of 1% in the external debt service, the deposit interest rate, and gross savings leads to a devaluation of the Egyptian pound against the dollar by 4.8%, 0.04%, and 0.05%, respectively. The study also concluded that there is a positive, statistically significant relationship in the long term between the value of the Egyptian pound and each of gross capital formation, broad money growth, households' and NPISHs' final consumption expenditure, and terms of trade adjustment, as any change of 1% in these variables leads to an increase in the value of the Egyptian pound by 0.16%, 0.05%, 0.27%, and 6%, respectively. This study recommends that decision makers consider all the reasons that would reduce the external debt service in order to preserve the value of the Egyptian currency in the long run. ijef.ccsenet.org International Journal of Economics and Finance Vol. 14, No.2;2022