External shocks and persistence of external debt in open vulnerable economies: The case of Africa Stella Muhanji a,b , Kalu Ojah a, ⁎ a University of Witwatersrand, Private Bag 98, Wits, Johannesburg 2050, South Africa b Kabarak University, Private Bag 20157, Kabarak, Kenya abstract article info Article history: Accepted 10 February 2011 JEL classification: D58 F30 F34 G01 Keywords: World interest rates shocks World commodity price shocks DSGE model Business cycles External debt We examine the extent to which two external shocks, the world interest rate shock and the commodity price shock, lead to external debt accumulation in Africa. We begin by estimating a dynamic stochastic general equilibrium model of external debt burden, and solve the linear equations using the quadratic method of undetermined coefficients. Consequently, we run simulations of 50 time periods. Our results show that both world commodity price and world interest rate shocks impact external debt accumulation in the majority of our sample African countries. Interestingly, world commodity price shocks lead to an increase in external debt while world interest rate shocks appear to discourage accumulation of external debt. © 2011 Elsevier B.V. All rights reserved. 1. Introduction African economies have economic structures that are characteris- tically susceptible to external shocks in the sense that they rely heavily on primary commodities for their export earnings, have relatively small manufacturing and service sectors, and conversely large agricultural sectors. They are thus vulnerable to external shocks such as world commodity price and world interest rates shocks. Relevant economic literatures have documented mixed results about the extent to which both of these shocks affect small open economies (e.g., Deaton and Miller, 1995; Glenn, 1997; Senhadji, 1997; Kose, 2002; and others). World interest rate has been identified as a potential conduit for transmitting international shocks to small open economies. Glenn (1997) notes that when the marginal cost of borrowing increases after an adverse world interest rate shock, consumers put off current consumption to the future. He further notes that debt is an increasing function of the marginal cost of borrowing and posits that over- borrowing will occur if a permanent increase in world interest rate is perceived to be transitory or if a transitory decline in world interest rate is believed to be permanent. Conversely, Blankenau et al. (2001) find that world interest rates have little effect on output, domestic investments, net exports and net foreign assets. Their results buttress Mendoza's (1991) finding that world interest rate fluctuations contribute minimally to fluctuations in macroeconomic variables. Kose and Riezman (2001) similarly find that world interest rates account for less than 1% of the output fluctuations in Africa. In fact, they note that world interest rate results only in a shift from domestic savings to foreign assets, and a decrease in investment. Regarding commodity prices, Senhadji (1997, 2003) notes that commodity boom contributes to the indebtedness of African countries through over-borrowing. Deaton and Miller (1995) analyze the importance of international commodity prices in economic fluctua- tions in African countries by using vector autoregression analysis. They find that while a sudden 10% increase in commodity prices results in a 6% increase in output, the price shocks most heavily affect investment dynamics among African economies. These findings are supported by Kose (2002) who finds that world price shocks are important in driving business cycles in small open developing economies: that roughly 88% of aggregate output fluctuations and 90% of investment variation can be explained by world price shocks. Our study analyzes simultaneously the extent to which world price and world interest rate shocks affect debt accumulation in eleven African economies. 1 It is in the spirit of Senhadji (1997, 2003) which Economic Modelling 28 (2011) 1615–1628 ⁎ Corresponding author. Tel.: + 27 11 717 3764; fax: + 27 11 717 3849. E-mail address: Kalu.ojah@wits.ac.za (K. Ojah). 1 These sample countries are Cote d'Ivore, Ghana, Kenya, Malawi, Nigeria, Senegal, South Africa, Tanzania, Uganda, Zambia and Zimbabwe. 0264-9993/$ – see front matter © 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2011.02.020 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod