The crowding-out effect of public debt on private investment in developing economies and the role of institutional quality

Public spending is a crucial instrument of fiscal policy in running the economy. Most governments use public spending actively to overcome the cyclicality of the economy. However, the increase in government spending financed by public debt can negatively contribute to the private sector investment. This study raises two research questions: (i) Does public debt in developing countries crowd out private investment? (ii) What is the role of governance in public debt-private investment relationship in these countries? For the answers, we apply the two-step difference generalized method of moments Arellano-Bond estimator to empirically investigate the effects of public debt, governance, and their interactions on private investment for a sample of 98 developing countries from 2002 to 2019. We then employs the pooled mean group estimator to check the robustness of estimates. Results show that public debt crowds out private investment, whereas governance stimulates it. Notably, the crowding-out effect of interaction on private investment seems counterintuitive. Furthermore, economic growth and trade openness enhance private investment. These findings suggest policy implications for governments in developing countries for controlling and managing public debt to promote the private sector investment.