The poor investment and growth performance of the highly indebted countries in the past few years is frequently attributed to the burden of their foreign debt (a high ratio of external debt to GDP), a phenomenon known as the “debt overhang.” According to the debt overhang hypothesis, the accumulated debt acts as a tax on future output, discouraging productive investment plans of the private sector. This is because increases in production or exports of the indebted country generate revenues that must be used to repay current debt obligations; that is, creditors receive a significant portion of the future returns from investment.
Despite the appealing theoretical arguments put forward for the debt overhang hypothesis, there has been surprisingly little empirical work on the subject. This article, based on a recent study, attempts to test the existence of a debt overhang effect directly for one heavily indebted country—the Philippines—which is in the process of carrying out foreign debt reduction operations with its commercial bank creditors. The Philippines appears to be an appropriate country to study because of the relative stability of the investment and growth performance until the early 1980s, and the apparent severity of the debt problem.
The study uses a standard neoclassical approach to estimate investment demand—which is a function of general macroeconomic variables—and then adds some tentative indicators of debt overhang to the equation to determine the significance of the direct impact of the debt overhang on investment. The magnitude of the direct debt overhang effect is of critical importance in guiding policy measures to reactivate investment.
While the results reported in the article apply only to the Philippines, the methodology is generally applicable to other indebted countries. The empirical findings reveal a significant disincentive effect of foreign debt on private investment, calling attention to the importance of debt reduction schemes that have been put forward in both academic and policy-making circles to help promote the economic recovery of debtor countries.
Growth and debt
The Philippine economy had shown steady growth and high investment rates in the post-war period, comparable to several of its successful Asian neighbors. Foreign debt accumulated rapidly, however, and by 1982-83, the country ran into economic difficulties and had to suspend its debt payments. Simultaneously, private and public investment collapsed, with the ratio of total investment to GDP falling by as much as ten percentage points.
The overall ratio of investment to GDP had increased steadily, up from under 15 percent in the 1950s to nearly 25 percent in the late 1970s, before collapsing to an average of 13.5 percent in 1985-87 (see Table 1 and charts). Not counting the surge in investment of the late 1970s—a result of dubious public investment projects—the level of investment in 1988 was still fairly low relative to the more normal levels of the 1960s and early 1970s. Although GDP growth rates have returned to historical levels since 1986, investment only appeared to recover in 1989, coincidentally with the improvement in the debt situation.
|Period||Investment GDP||GDP growth rate|
Early in 1990, the Philippines concluded a debt buyback operation with its commercial creditors, under the auspices of the Brady initiative, in which about $1.3 billion of its foreign debts were repurchased at a 50 percent discount of face value. This was the first stage of an envisioned two-stage operation and it included both the cash buyback and loan commitments from commercial banks. A second round of debt reduction operations will take place at a later stage. The total resources made available by multilateral and bilateral agencies for cash buyback and “enhancements” of new debt securities were an estimated $1.5 billion, and the amount of medium-and long-term debt of commercial banks eligible for the debt reduction operations was about $7 billion. Total external debt, including debt to official and international sources as well as short-term debt, reached nearly $30 billion.
For a detailed, analysis, see “Debt Overhang, Debt Reduction, and Investment: The Case of the Philippines” by Eduardo Borensztein, IMF Working Paper, WP/90/77, available from the author.
In the secondary market for Philippine debt, the reaction to the debt reduction plan was very positive. The price of the Philippine debt, which was about 36 cents per dollar in early March 1989 (before the announcement of the Brady initiative), climbed to 46 cents by mid-April, and to about 50 cents by mid-May, where it stabilized. What explains this positive development? First, the $1.5 billion provided by third parties (i.e., international financial institutions and bilateral sources) should increase, to some extent, total expected payments by the Philippines to its commercial creditors, as perceived by market participants. Second, the reduction in total contractual obligations of the Philippines resulting from the debt buyback would, by generating more favorable expectations, help increase investment and improve economic performance, thereby enhancing the debt-servicing capacity of the country. While it is possible that markets may associate the granting of debt reduction with a less firm commitment to service obligations in the future, the favorable effects of debt reduction seem to outweigh this consideration. It must be noted, however, that the mere observation of secondary market developments is not sufficient to establish causality between debt problems and economic performance.
To verify the disincentive to investment created by the debt overhang, private investment demand was econometrically estimated for the Philippines using postwar data. In this framework, investment is essentially determined by its expected profitability, expected real interest rates, and the cost of capital goods. Although the results prove to be both plausible and statistically significant, the various statistical tests carried out suggest that an important variable may have been absent. The effect of the debt overhang is most likely to be the missing variable.
The main difficulty lies in finding the proper way of accounting for the effect of foreign debt on private domestic investment. There are several indirect channels through which a large foreign debt curbs productive investment: high domestic real interest rates resulting from limited access to international credit, low profitability due to a downturn in economic activity, declines in public investment projects that involve private participation, and so on. Most of these effects are already captured by the variables included in the analysis, such as the domestic real interest rate and the expected marginal profitability of investment. However, the direct effect of the debt overhang on investment may not be reflected in the empirical analysis, because it is, in large measure, associated with expectations about future events.
A simple approach can, however, be followed to incorporate the debt overhang effect in any analysis of foreign debt. From the point of view of a private investor, the debt overhang can be translated into the potential increase in (the present value of) taxation that will become necessary to repay foreign debt. Although such an increase in taxation is uncertain, due to the relative irreversibility of investment projects, many investors would prefer to wait until the debt situation clears. Therefore, the ratio of debt to GDP, being an approximate measure of the maximum magnitude of (the present value of) taxation that would be necessary to obtain the required resources to service debt, can be used as a measure of the reduction in net expected profits generated by the overhang effect.
But what is the appropriate concept of foreign debt in measuring the debt overhang? This depends on the interpretation of the debt problem. First, there is the problem of whether debt with official creditors (governments and international financial institutions) should be included in the relevant debt concept. Official debt is a substantial fraction of total debt in the Philippines, but its actual importance in creating a debt overhang problem is not obvious for several reasons. One can conceive situations in which refinancing of official debt payments would be much easier than private debt payments. For instance, if a debtor country was affected by negative external shocks (such as a deterioration in the terms of trade) but made satisfactory policy adjustments, it might still maintain access to refinancing of official debts; private flows, by contrast, would dry out if the creditworthiness of the country became questionable. In this sense, a dollar of official debt may represent less of a burden than a dollar of private debt. More important, if private investors anticipate that official credit would not be tightened as much as private credit in the event of unfavorable shocks, they would give less weight to official debt in their computation of the debt overhang.
Second, a more refined measure of foreign debt overhang—the amount by which debt exceeds the level that can be normally serviced—is perhaps appropriate. Arguably, not every dollar of foreign debt creates a disincentive to investment; at moderate levels of indebtedness, investors will believe that existing taxes and tax rates will suffice to service debt, but at higher levels, the government’s need for extra revenue would threaten the return to private investments. Therefore, it is only when debt surpasses a certain level that the debt overhang effect is present.
Source: Same as Table 2.
Two approaches were taken in the analysis: 1) the debt overhang was measured as the excess of current debt over its level as of 1982, assuming that the level of indebtedness up to 1982 was a normal one and not problematic; and 2) the discount applied to transactions on the Philippine debt in the secondary market was used to measure the debt overhang (by multiplying the discount by the face value of private debt). For example, if Philippine debt were trading at 40 cents on the dollar, debt overhang would be measured as 60 percent of the contractual value of debt. A problem with the latter measure is that, because data on prices on secondary market transactions are available only since 1986, the price had to be assumed to be unity before that year, that is, there was no discount. The demand for investment was estimated using all these different debt variables.
All results show a significant negative relationship between foreign debt and investment (see Table 2). The econometric tests reveal the first measure of debt overhang (the excess over the level of 1982) to be the most appropriate. The findings indicate that the median effect of a $1.3 billion debt reduction operation would be to increase investment demand by about one percentage point of GDP. The highest effect of debt reduction occurs when the second measure of debt overhang (based on the secondary market discount) is used, with an expected increase in investment of 2.3 percent of GDP. The impact on investment is smallest when the relevant concept of debt included both official and private creditors, with an estimated increase in investment of only 0.22 percent of GDP.
|Variable||Eslimaled coefficient||Effect of $1.3 billion debt reduction on (he ratio of investment to GOP|
|Debt with private banks||-0.136|
|Private bank plus official debt’||-0.062|
|Private bank debt in excess of 1982 level||-0.313|
|Private bank plus official debt in excess of 1982 level1||-0.183|
|Private bank “debt overhang” (discount times face value)||-0.195|
|Private and official debt separately2||-0.146|
$0.65 billion of debt reduction.
Coefficient corresponds to private debt.Note: Figures in brackets are the standard error of the cosfficient.
$0.65 billion of debt reduction.
Coefficient corresponds to private debt.Note: Figures in brackets are the standard error of the cosfficient.
In addition, when the significance of the effects on investment of debt from private and from official sources is statistically tested, the results support only the existence of an effect from private bank debt. There is no evidence that debt with official creditors (both international and bilateral) has any adverse effects on private investment. As noted above, the fact that financing from official sources might be available even under adverse circumstances helps explain this result.
The increase in the investment-to-GDP ratio reported in Table 2 represents an increase in investment demand only. For an increase in investment to take place, a concomitant increase in domestic (and/or foreign) savings is required. Thus, the expansion in investment would actually be somewhat lower than the values reported, but the higher level of investment should persist over time, because the debt reduction removes the disincentive to investment in a permanent way.
The relative scarcity of empirical work on the relationship between foreign debt and investment is symptomatic of the difficulties implicit in attempting such an evaluation. Two key elements cannot be observed: the perceptions about the determination of future repayments from a heavily indebted and nonperforming debtor country, and the sources from which the debtor country government can finance such payments. But both economic reasons and casual evidence on investment and growth make the case for the debt overhang effect, a priori, a strong one.
In the case of the Philippines at least, econometric results have shown foreign debt to be among the factors depressing private investment after 1982. The estimation of the debt overhang effect identifies a direct effect, over and above the effect that foreign debt may have on domestic interest rates or current profitability, although the exact mechanism through which this debt overhang effect operates is not identified. In conclusion, debt reduction in the Philippines will have a beneficial effect on investment and growth. Of course, this stimulus might be overwhelmed by other factors affecting the Philippine economy currently, such as political turmoil, natural disasters, and the rise in energy prices.