The Political Economy of Sovereign Debt Overhang

Developing economies have heterogeneous experiences with growth and openness. This research starts by documenting a core empirical fact: The countries that grow relatively fast do so while reducing sovereign liabilities and accumulating foreign reserves. Standard economic models state that a capital-poor country can benefit from openness by importing financial capital. However, in practice, countries that accumulate foreign liabilities tend to stagnate, while fast-growing economies provide capital to the rest of the world. The private sector, on the other hand, tends to borrow in high-growth economies. This project proceeds to build an economic framework to understand this phenomenon and provide policy guidance. The first building block is limited commitment on the part of the government. That is, governments cannot guarantee debt or tax promises that future governments are unwilling to implement. In this environment, investment is similar to sovereign debt, as it can be taxed or expropriated after the capital is in place. This similar vulnerability creates a “debt overhang” effect in which high debt positions deter investment. Governments with large outstanding debt positions have an incentive to tax capital income after an investment is in place. Investors therefore avoid making large commitments in high-debt environments. High growth economies require significant investment in both capital and technology. These investments can only occur in a low debt environment. What explains the heterogeneity across countries in debt policy? The answer is that paying down sovereign debt requires political stability as the cost of retiring debt is borne by the current incumbent, while the benefits accrue primarily to future politicians. A high-growth, low-debt fiscal policy is feasible if political parties agree on core priorities or if political parties have a high probability of returning to power conditional on losing office. This latter point indicates that political turnover per se is not detrimental, as long as turnover occurs as part of a regular cycle. The research also relates to policy design: How should the government policy be set when both the household and the government itself may face a limited ability to commit to promises of repayment of debt and taxation. The research shows that if it is the government’s commitment that is lacking, then it is best for the government to run surpluses, at least in the medium run. Such a policy allows the economy to borrow as much as possible, but does so in a way in which the private sector holds the debt, rather than the government. We show that the economic reasoning behind this is that this policy minimizes tax distortions in the long run. Hence, a conservative fiscal policy allows the economy to operate efficiently when the debt is due. Only in such an environment are bond markets willing to allow the economy to borrow. Such a policy can be implemented by allowing private agents to borrow from abroad (perhaps with a tax), or to borrow from a government agency that in turn borrows from abroad. The key element of the policy is that the private sector is ultimately liable for the debt, not the fiscal authority. We also study how policy differs when the main friction arises from the households’ inability to commit to debt repayment.

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