External Debt and Growth

• Author: Catherine Pattillo, Hélène Poirson and Luca Ricci
• Position: Economists in the IMF's Research Department, African Department, and Asia and Pacific Department, respectively

Reasonable levels of external debt that help finance productive investment may be expected to enhance growth, but beyond certain levels additional indebtedness may reduce growth. An IMF study estimates two critical turning points: when additional debt slows growth and when it contributes negatively to growth, making the country worse off.

Over the past three decades, developing countries have borrowed large amounts, often at highly concessional interest rates (Chart 1). The hope was that these loans would put them on a faster development path through higher investment and faster growth. But as debt ratios reached very high levels in the 1980s, it became clear that for many of these countries, repayment would not just constrain economic performance but be virtually impossible. Thus, in the 1980s, several middle-income countries-particularly in Latin America-faced severe debt crises and, in the mid-1990s, the IMF and the World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative to bring the debt of low-income countries-most of which are in sub-Saharan Africa-to sustainable levels.

Despite the importance of this issue and the public attention it has received, including from the Pope and rock stars, policymakers and economists around the world still have only a partial understanding of fundamental questions, such as

* Beyond what level does external debt impair economic performance?

* What is the quantitative effect of debt on economic growth for the typical developing country?

* Is the effect of debt on growth nonlinear-in other words, does the effect on growth of additional debt vary, depending, for example, on the level of the debt stock?

* What are the channels through which debt affects growth?

* What effect on growth can we expect from the debt reduction associated with the HIPC Initiative?

We conducted a study that examined these questions, looking at nearly 100 developing countries over a 30-year period. Countries heavily dependent on oil exports, countries with populations of less than 400,000, and countries in transition are excluded from the analysis.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

What theory tells us

Economic theory suggests that reasonable levels of borrowing by a developing country are likely to enhance its economic growth. Countries at early stages of development have small stocks of capital and are likely to have investment opportunities with rates of return higher than those in advanced economies. As long as they use the borrowed funds for productive investment and do not suffer from macroeconomic instability, policies that distort economic incentives, or sizable adverse shocks, growth should increase and allow for timely debt repayments. These predictions hold up even in theories based on the more realistic assumption that countries may not be able to borrow freely because of the risk of debt repudiation.

Why do large levels of accumulated debt lead to lower growth? The best-known explanation comes from "debt overhang" theories, which show that if there is some...