Domestic verses foreign borrowing: Does the mode of fiscal deficit financing matter for inflation in Sub-Saharan African countries?

Abstract

The aim of this study was to analyze the relationship between fiscal deficit financing and inflation in sub-Saharan African countries and determine whether the mode of fiscal deficit financing selected in the economy matters for inflation. The panel data sourced from 45 sub-Saharan African countries from 2005 to 2020 was used for analysis with domestic and foreign borrowing as the main independent variables and the consumer price index as the dependent variable. The study used two-step GMM econometric analysis as the main econometric model with a scaling quantity analysis model to test for the relative effect of the deficit financing tools on inflation. The results show that deficit financing through foreign and domestic borrowing positively influences inflation among sub-Saharan African countries and the severity of the effect on inflation differs between the two modes of deficit financing. This is shown by the domestic borrowing's scaling quantity analysis value of 0.12 against 0.08 for the foreign borrowing. The practical implication of this study is that fiscal deficit financing is inflationary and domestic borrowing causes more inflation than foreign borrowing. Sub-Saharan African governments must therefore make efforts to reduce the fiscal deficit because of the increasing impact of the budget deficit on inflation whenever it is funded. However, foreign borrowing should be preferred to domestic borrowing because it achieves the macroeconomic goal of financing the budget deficit with a lower inflationary effect in cases where deficit financing is unavoidable.