High debt levels hurt economic growth by hampering investment and productivity

• Pages: 304-305

Page 304

Economic theory suggests that "reasonable" levels of borrowing are likely to enhance economic growth, both through factor accumulation and productivity growth. Countries at early stages of development have small stocks of capital and are likely to have investment opportunities with higher rates of return than 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-economic growth should increase and allow for timely debt repayments.

What the theories say

But too much debt does create problems. "Debt overhang" theories, for example, argue that if there is some likelihood in the future that debt will be larger than the country's repayment ability, expected debt- service costs will discourage further domestic and foreign investment. Potential investors will fear that the more is produced, the more will be "taxed" by creditors to service the external debt and, thus, they will be less willing to incur investment costs today for the sake of increased output in the future. The expectation that some portion of the debt will have to be forgiven can also at some point discourage private foreign investors from providing new financing, thus lowering capital accumulation.

The channel for the debt overhang's effect on growth may be through productivity growth as well as the volume of investment. The anticipation of future debt relief may, for example, reduce governments' incentives to pursue difficult policy reforms that would strengthen their repayment capacity, and this disincentive will have a negative impact on productivity growth.

Similarly, the literature stressing the uncertainties created by high debt stocks seems to imply also that debt constrains growth through either the capital accumulation or the productivity channel. In highly uncertain and unstable environments, even if the fundamentals are improving, investors may hesitate to invest in costly, irreversible projects though they may have higher rates of return in the long run and have beneficial consequences for productivity growth. Instead, investment decisions are made on the basis of short-run rates of return. As a result, productivity growth will tend to be slower in a highly uncertain environment.

Finally, debt...