| IPES | CHAPTER 10 | Box 10.1

Debt Overhang

The term “debt overhang” originated in the corporate finance literature and indicates a situation in which a firm’s debt is so large that any earnings generated by new investment projects are entirely appropriated by existing debt holders, and hence even projects with a positive net present value cannot reduce the firm’s stock of debt or increase the value of the firm (Myers, 1977). The concept of debt overhang migrated to the international finance literature in the mid-1980s, when the debt crisis motivated a series of influential papers by Krugman (1988, 1989) and Sachs (1989). These authors argued that, as sovereign governments service their debt by taxing firms and households, high levels of debt imply an increase in the private sector’s expected future tax burden. Debt overhang characterizes a situation in which this future debt burden is perceived to be so high that it acts as a disincentive to current investment, as investors think that the proceeds of any new project will be taxed away to service the pre-existing debt.a A weaker version requires only uncertainty by investors as to whether the government will expropriate the return on their investment, or even uncertainty on the part of lenders to investors who may not be sure whether their claims will take precedence over—or be superseded by—the government’s taxing power.b Lower levels of current investment, in turn, lead to lower growth and, for a given tax rate, lower government revenues, lower ability to pay, and lower expected value of the debt. Countries that suffer from debt overhang will have no net resource flows because, by definition, any new loan that might be issued would be worth less than its nominal value, and no new creditor will be willing to lend when a loss is certain.

Countries that suffer from debt overhang may be located on the wrong side of the “Debt Laffer curve” described in the figure on the facing page and are characterized by a situation in which partial debt cancellation that reduces the expected tax burden can make both lenders and borrowers better off by increasing investment and growth and thus tax revenues and the value of debt. Even if creditors could be better off by canceling debt, debt cancellation requires a coordination mechanism that forces all creditors to accept some nominal losses. In the absence of such a coordination mechanism, each individual creditor will prefer to hold out while other creditors cancel part of their claims.

The key question is, at what level does debt become a debt overhang? It is easy to find this level in a theoretical model with the help of convenient assumptions (Borensztein, 1990). But it is harder to find debt overhang in the data. There is also an important distinction between emerging markets (which economists had in mind in the 1980s when the issue was first debated) and developing countries, where there is little borrowing from private sources and repayment obligations on official debt tend to be soft, as debt is often rolled over continually.

a According to Krugman’s (1988) definition, a country suffers from debt overhang when the expected present value of future country transfers is less than the current face value of its debt.

b Corden (1989) extended the concept of debt overhang to explain a lack of motivation on the part of governments to implement economic stabilization and policy reforms, in the expectation that any revenues generated by an improvement in the domestic economy will go entirely to servicing debt.