Impact of Debt Relief on Economic Growth in Heavily Indebted Poor Countries

Abstract

The launch of the Heavily Indebted Poor Countries Initiative (HIPCs) in 1996, the enhanced HIPC in 1999 (The enhanced HIPC initiative) and the beginning of the Multilateral Debt Relief Initiative in 2005 following the G7 decision to further provide debt relief for eligible poor countries has raised the question whether these programs are effective in helping to boost economic growth of the participating countries and only few studies have assessed the direct effects of debt relief on economic growth of HIPC countries per se.

Based on the Debt Overhang hypothesis this study finds econometric and statistically significant evidence that debt relief has a positive impact on economic growth and growth of GDP per capita income of HIPC countries. For each percentage point increase of debt relief both GDP and per capita income of Heavily Indebted Countries will rise by 0.3 percentage points. We also conducted a case study analysis on the effects of debt relief initiatives in Tanzania, and found that before the HIPC initiatives, Tanzanias growth was relatively low and at times even negative, but upon joining the HIPC Initiatives and receiving debt relief, Tanzanias economy grew, increasing financial allocation to health, education, roads, water and agriculture. These findings are very much consistent with the theoretical baseline on fiscal space gained through debt relief initiatives that releases financial resources which would otherwise have been spent on meeting foreign debt servicing obligations.

In addition, this study demonstrates that debt overhang is negatively correlated to economic growth and GDP per capita growth of HIPC countries. This could be due to the fact that higher external debt depresses growth by either discouraging investment or creating disincentives for governments to take necessary reforms that are critical for long-term growth. Therefore, debt relief provides an incentive for reforms, increasing investor as well as potential lenders confidence to invest and thereby contributing to economic growth. Furthermore, through debt relief, HIPCs countries were able to increase their social and economic expenditures which have long term impacts on economic growth.