Journal Issue

High debt levels hurt economic growth by hampering investment and productivity

International Monetary Fund. External Relations Dept.
Published Date:
October 2004
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We know that at low levels, external debt has positive effects on growth but, above a certain threshold, this effect turns negative. In a recent study, Catherine Pattillo, Hélène Poirson, and Luca Ricci build on their research in this area by asking how exactly debt affects growth. Is it mostly through an effect on the accumulation of the factors of production (investment in capital and labor) or on factor productivity growth? They find that high debt levels have a strong negative effect on both.

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 relief advocates argue that high debt severely constrains low-income countries’ abilities to provide social services, such as education. For their part, individuals view the decision to acquire human capital as an investment decision, which might be negatively affected if individuals expect most of the anticipated return on their investment (in the form of higher future wages) to be taxed away. High debt levels could thus lower growth by slowing human capital accumulation. This effect may be very difficult to detect, however, as it would affect human capital stocks only with long time lags.

What the data show

Theory, thus, suggests that debt could have negative effects on growth, either through capital accumulation or productivity growth. But what do the data show? Using a data set for 61 developing countries spanning sub-Saharan Africa, Asia, Latin America, and the Middle East over 1969–98, Pattillo, Poirson, and Ricci find that, consistent with their previous study, the impact of debt on growth is very different at low and high levels of debt. At high levels, debt has a large negative impact: on average, doubling debt from any initial debt level at or above the threshold where the impact of further debt accumulation starts to turn negative will reduce per capita growth by about 1 percentage point. At low levels, the effect is generally positive but often not significant.

In terms of the channels through which debt affects growth, the data show that the impact of high debt operates both through a strong negative effect on physical capital accumulation and on total factor productivity. The size of the effects is similar to that of the effect on output growth: on average, for countries with high debt levels (around 65 percent of exports), doubling debt will reduce output growth by about 1 percentage point and reduce growth in both per capita physical capital and total factor productivity by almost as much. In terms of the contributions to growth, approximately one-third of the effect of debt at high levels of indebtedness occurs via physical capital accumulation and two-thirds via total factor productivity growth. In contrast, the impact of high debt on human capital accumulation is not significant. At low debt levels, the effect of debt tends to be positive for total productivity growth and negative for capital (on average) but generally not significant.

These results are consistent with the speculation that high debt reduces the incentive to invest and to undertake good policies, since the return on such actions can be expected to accrue partly to lenders rather than to citizens and politicians of a highly indebted country. In contrast, the impact of debt on human capital accumulation could not be detected, say the authors, perhaps because it operates with very long time lags.

What about reverse causality?

Does high debt actually lower growth (and its components), or does low growth increase indebtedness? Both directions of causality have been argued in the literature. William Easterly of New York University, for example, contends that low growth does increase indebtedness. He maintains that the worldwide slowdown in growth after 1975 contributed to the debt crises of the middle-income countries in the 1980s and the heavily indebted poor countries (HIPCs) in the 1980s and 1990s. In this view, lower growth reduces tax revenues and primary surpluses and, without adjustment, debt ratios explode. The authors explore this reverse causality. Their evidence suggests that both the effect of indebtedness on growth and the effect of growth on indebtedness are significant.

Policy implications

Based on the study’s finding, for the average country in the sample, reducing debt levels would contribute to growth by boosting both capital accumulation and productivity growth. But reducing debt may not have the desired effect on capital or productivity growth (and therefore output growth) if other macroeconomic and structural distortions or political constraints bind.

High debt reduces the incentive to invest and to undertake good policies, since the return on such actions can be expected to accrue partly to lenders rather than to citizens and politicians of a highly indebted country.

It is important to note, say the authors, that although the findings are relevant for current policy debates on the potential impact of the HIPC Initiative and forward-looking assessments of debt sustainability in low-income countries—suggesting that some of these countries may be caught in a low-growth debt trap—the economic and political situations of these countries make them an atypical sub-sample. Lowering debt alone may not be sufficient to jump-start growth in these countries in the absence of structural reforms that address the key bottlenecks to growth (such as lack of human capital, institutional weaknesses, and inadequate financial intermediation). In addition, HIPCs experience worse macroeconomic and institutional conditions than the average country in the sample. And, in that aid flows to them exceeded their debt service, several HIPCs received a positive net transfer of resources throughout the 1980s and 1990s (as have many other low-income countries). Further research would be necessary to determine the extent to which the findings of this study hold specifically for HIPCs.

Copies of IMF Working Paper No. 04/15, “What Are the Channels Through Which External Debt Affects Growth?” by Catherine Pattillo, Hélène Poirson, and Luca Ricci, are available for $15.00 each from IMF Publication Services. See page 308 for ordering information. The full text of the paper is also available on the IMF’s website (

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