The debt overhang and the disincentive to invest

This paper is an attempt to explore the debt overhang hypothesis by an empirical examination of the investment experience of 13 severely indebted countries. It begins with a discussion of the disincentive effect of debt overhang, which is linked to some aspects of the adjustment measures that these countries are undergoing, viz. devaluation and reduction in public sector deficits. This is followed by empirical analysis, which demonstrates that first, in countries with a debt overhang, external debt captures many of the effects of other explanatory variables that traditionally explain investment. Second, through 1971-1991, the relationship between external debt and investment is consistently a negative one; however, the first half of the period has strong time influences that exercise a positive influence on investment. In the second half of the period, time effects turn negative too, thus explaining the fall in investment levels observed after 1982.