Public Debt and Firm Performance: A Love-Hate Relationship?

To show how public debt impacts performance for a sample of 79,746 formal private firms located across 72 developing economies, we impose a heteroscedastic covariance restriction and construct internal instruments following \cite{lewbel2012using}. In contrast to conventional wisdom, we find that, on average, a 10-percent increase in the debt-to-GDP ratio raises the firm average annual growth rate of sales by around 0.23 percentage points. This effect becomes even larger—reaching around 0.45–0.46 percentage points and statistically significant—when internal instruments are combined with a conventional external instrument based on valuation effects. By contrast, when the external instrument is used alone, the coefficient remains positive but loses statistical significance. We then explore the heterogeneity of this effect in a two-step process. First, we test whether public debt benefits more (or less) firms facing particular constraints—such as finance, infrastructure deficiencies or institutional barriers. To assess the relative importance of these constraints, we combine opinion-based survey questions with hard-data, assuming that objective measures can help mitigate potential biases inherent in subjective perceptions. Second, we explore how firms are impacted by debt based on the structural characteristics of their particular industry. To this end, we construct exogenous sector-specific input intensities using the U.S. input-output matrix (2000–2014).