Political Institutions and Debt Dynamics in Developing Countries: Centralization of Power is a Double-Edged Sword

Abstract

While international and domestic economic factors influence a governments willingness and ability both to accrue and to pay off sovereign debt, political institutions also play an important role. We present an analysis of the effects of political institutions on foreign-debt buildup and reduction in developing countries. Our findings show that the degree of centralization of power, whether through presidential systems, unified governments, or the lack of a federal or otherwise decentralized system, is a double-edged sword. On the one hand, governments in such systems are more likely to indulge in debt expanding spending sprees, particularly left leaning governments, during election years, in more democratic states. On the other hand, governments with more centralized power are better able to cut spending and reduce debt, particularly those operating within more authoritarian political institutions. Overall, our findings imply that centralized power in the hands of a national executive in a highly democratic setting is more likely to lead to rapid foreign debt buildup, yet executives in such settings are often unable to take the drastic measures needed to reduce debt in times of imminent crisis. In short, political institutions impact both debt buildup and debt reduction.