Debt Overhang and the Effects on Developing and Developed Economies

This paper explores the connection between debt, future payments and investments which is part of the debt overhang hypothesis. The purpose of the paper is to expand the understanding of debt overhang and to examine its effects on developing and developed countries. The study begins with a theoretical discussion of the incentives on investment together with the relationship between debt and debt-servicing. The theory follows with a deeper analysis of capital flight and austerity measures which further affect the debt overhang. Empirically the paper covers 19 severely indebted developing countries and 5 indebted developed countries during two different crises, the LDC-crisis in the 1980s and the PIIGS-crisis of the late 2000s. For the developing countries external debt exercised a negative influence on investments during the whole LDCcrisis which supports the theory of debt overhang. The outcome for the developed countries was ambivalent, only Greece and Portugal showed a significant negative relationship between external debt and investments. For the rest of the PIIGS the effects were either mitigated or positive once country specific variables were accounted for.