Haircut, Overborrowing, and Growth

Author

A. M. Muhib Morshed Ami, Southern Illinois University CarbondaleFollow

Date of Award

5-1-2023

Degree Name

Doctor of Philosophy

Department

Economics

First Advisor

Morshed, AKM Mahbub

Abstract

This dissertation consists of three chapters and is centered on the issues of external debt default and growth. In the first chapter, we develop a macrodynamic model of a small open economy that incorporates the effects of haircut and external debt default on the borrowing cost of a debtor country. We argue that the ability to impose a substantial haircut, a reduction in external debt in the face of a sovereign default can work as a strong enough incentive for a debtor country to borrow heavily even when it faces an increased default risk. Calibrating our model to real world data and employing numerical simulations we show that the observed overborrowing and consequently multiple external debt defaults by many countries around the world are equilibrium outcomes in the presence of the haircut induced benefit of sovereign default. Chapter two empirically investigates how debt default affects growth in low-income countries that have a high debt burden. We adopt Rose’s (2005) methodology of using dummy variables to examine both the contemporaneous and lagged effects of debt default on growth in countries that received debt relief assistance under the Heavily Indebted Poor Countries Initiative (HIPC). An inflow of capital is expected to affect these economies differently than other countries which are not eligible for the HIPC initiative. Our findings indicate that initiation of an external debt default leads to a downturn in growth, possibly due to the uncertainty created by such an event. However, debt renegotiation marking the conclusion of a default spell helps to revive growth and contributes to about 1 percentage point increase in growth for these countries. This positive growth effect of successful completion of a default episode is robust to different specifications and is pertinent even in the long run. In the third chapter, we examine the differential impacts of debt renegotiation on the various sectors within an economy. We analyze more than fifty years of data for ten broadly defined sectors from twenty-four mostly developing countries around the world. Our results indicate that debt rescheduling is associated with five to nine percent growth in sectoral productivity in countries outside of sub-Saharan Africa. This positive impact of debt renegotiation is particularly significant in the sectors of mining, construction, trade services, transport services, business services and personal services. Our findings provide support to the postulations of the debt overhang theory and the crowding out theory at sectoral level.