The Short and Long Run Effects of Debt Reduction: Evidence From Debt Relief Under the Enhanced HIPC and MDR Initiatives

High levels of government debt depress productive investment in a number of ways. High outstanding debt keeps market interest rates high crowding out private investment. Risk of default reduces incentives to invest or creates adverse selection in the mix of investments. Government revenue must service debt at the expense of investment in infrastructure and education. `Debt overhang' exists when the level of debt is so high that it discourages additional investments to be undertaken. This paper estimates benefits to debt reduction by using the natural experiment provided by the debt relief programs: the Heavily Indebted Poor Countries (HIPC) Initiative launched by the IMF and World Bank in 1996 and the Multilateral Debt Relief Initiative (MDRI) extension in 2005. We apply a time-shifted difference-in-differences strategy to evaluate the effects of this intervention. We found that debt relief increased capital investment as much as 1.63% in the short run and 5.79% in the long run. However, there was no effect on foreign direct investment. Output and school enrollment increased both in the short and long run.