External Debt and Economic Growth: The Role of Institutional Quality in Lower- and Upper-Middle-Income Countries

This study examines the moderating and threshold effects of institutional quality on the relationship between external debt and economic growth using panel data from 39 lower- and upper-middle-income countries over the period of 1996–2023. To address econometric challenges commonly found in previous studies—including endogeneity, cross-sectional dependence, and slope heterogeneity—the analysis employs a dynamic common correlated effect (DCCE) estimator and a dynamic panel threshold model (DPTM). The DCCE results indicate that external debt exerts a negative and statistically significant effect on economic growth, whereas institutional quality has a positive effect. Furthermore, the interaction between external debt and institutional quality is positive and significant, suggesting that stronger institutions mitigate the adverse growth effects of external debt. The threshold analysis reveals significant institutional quality thresholds across income groups. For the full sample, the estimated threshold value of institutional quality is 2.74. Disaggregated results indicate thresholds of 1.80 for lower-middle-income countries (LMICs) and 4.33 for upper-middle-income countries (UMICs). Although external debt continues to exert a negative impact on growth in both regimes, the magnitude of this adverse effect declines once institutional quality surpasses the threshold levels. These findings highlight the critical role of institutional quality in shaping the debt–growth nexus. Strengthening governance structures—including improving transparency, rule of law, and fiscal accountability—can help mitigate the growth-reducing effects of external debt and improve countries’ capacity to manage debt sustainability in developing economies.