From Raj Nallari and Breda Griffith's lecture notes.
Studies investigating the link between external debt and growth place a strong emphasis on the role of investment. In effect, large debt stocks are expected to lower growth by hindering investment (debt overhang hypothesis). Under this channel, outstanding debt ultimately becomes so large that investment will remain inefficiently low without sizable debt or debt service reduction, with ever larger shares of a country’s resources transferred abroad for debt servicing.
Another strand of the debt overhang theory emphasizes the point that large debt stocks increase expectations that debt service tends to be financed by distortionary measures (inflation or other punitive taxes or arbitrary expenditure cuts). Under such uncertainty, private investors will prefer to exercise their option of waiting and may choose to invest less, or divert their resources towards quick, financial returns with high risk, or resort to transfer their money abroad (capital flight).
Another important component of the debt overhang theory is the so-called Laffer debt curve. This graphs shows expected debt repayment against the face value of debt service. It shows that as outstanding debt increases beyond a threshold level—to “debt overhang” levels—even as the debt stock rises, a country’s expected repayments begin to fall as governments begin to default on debt so as to avoid the damaging impacts of very high debt service. (See Patillo et al. (2002), who discuss the possible nonlinear relationship between debt and growth, for details).
Debt "Laffer Curve"
Source: Pattilio, Poirson and Ricci, 2002
The crowding-out effect of debt service payments on social spending is another plausible channel through which high debt impacts growth. Underlying the debt relief debate is the belief that fiscal resources released by the debt relief will be channeled towards social sectors, including health, education, water, sanitation and other essential services to the poor. It is also believed that social spending increases lead to better social outcomes, as supported by a wide-ranging study on 48 Sub-Saharan African countries for the period 1980-99, which found that absolute social spending allocations are paramount in determining social outcomes. Thus a key component of poverty reduction strategies in low-income countries is for countries to focus on “investing in people.” Increased pro-poor spending is widely regarded as crucial for low-income countries to achieve the Millennium Development Goals (MDGs), which includes goals for reducing child and infant mortality rates and improving education enrollment rates. In this context, high levels of indebtedness, due to the attendant high debt service, is assumed to lead to a reduction in available resources to meet the needs of the poor.
Finally, high-debt countries are often perceived by international financial markets and donors as exhibiting problems of economic mismanagement and bad governance, and therefore to be especially risky for investment. High indebtedness could then lead to a decline in new flows of external resources, leading in turn to a reduction in poverty-related spending.
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