CONNECTION BETWEEN ECONOMIC GROWTH, PUBLIC DEBT AND LONG-TERM BOND YIELDS

The issue of public debt sustainability and its potential impact on economic growth in the future is becoming increasingly important in the context of the recession caused by the COVID-19 pandemic and the strong public debt growth that followed in EU member states, including Croatia. The aim of this paper is to examine the relationship between public debt and GDP growth rates, and their impact on the cost of government borrowing. The paper uses a panel vector autoregression model to examine the relationship between variables: GDP growth rate, public debt as a percentage of GDP and government borrowing cost (yield on ten-year government bonds) in nine countries of New Europe, after which a VAR model with the same variables is estimated for Croatia in order to examine whether there are differences in the relation between the variables in Croatia. The results of the estimated models indicate that the GDP growth rate has a significant negative impact on public debt as well as on long-term government bond yields. On the other hand, public debt does not have a significant impact on the GDP growth rate in the short run in the basic panel model and in the VAR model for Croatia. However, this finding is not robust, because in a different specification, public debt has a positive effect on the GDP growth rate. The implication that public debt growth has no impact on economic growth or has a positive impact in the short term is that strong public debt growth caused by the pandemic won’t necessarily have a negative impact on growth rates after the recession, if monetary policy is not normalized in the short run. Therefore, the increase in public debt amid the last recession is not a problem for economic growth in the short run, but in the medium term it is necessary to decrease the public debt to GDP ratio in order to free fiscal space, so that Croatia can react to possible interest rate hikes in the future and the next recession.