From debt crisis to debt relief: A study of debt determinants, aid composition and debt relief effectiveness

Abstract: This thesis explores the external debt situation of developing countries and donor responses in terms of aid composition and debt relief. Primarily, these issues are important for future debt sustainability and therefore for creating beneficial conditions for accelerating growth and reducing poverty. With a focus on domestic factors (e.g. regime type) and exogenous shocks (e.g. terms of trade volatility), Chapter 2 provides empirical evidence about debt accumulation in developing countries over the period 1975–2004. The results show that neither domestic factors nor exogenous shocks explain debt accumulation to a great extent. Instead, the most important factor explaining debt accumulation is initial debt, suggesting that country-specific factors beyond regime type and exogenous shocks are more important. The results, moreover, appear to lend support to a change in the debt regime recently as high debt countries accumulated more debt in the beginning of the sample period but less debt over the period 1995–2004. Chapter 3 studies whether the poorest and most indebted countries receive foreign aid in the form of grants rather than loans. By studying bilateral aid flows to low- and middle-income countries between 1975 and 2004, the chapter provides empirical evidence on the determinants of the grant component of aid flows. While the analysis finds no evidence that more indebted countries receive a higher grant component, it shows that poorer countries tend to receive a significantly higher grant component of aid. The results suggest that the recent grant versus loan debate should focus not only on a total increase in the grant component of aid but also on the actual allocation of the grant–loan mix to recipient countries. Chapter 4 evaluates the effectiveness of debt relief over the period 1989–2004. Using a sample of 118 developing countries, this chapter empirically assesses the impact of debt relief on growth via (1) resources made available for investment from reduced debt service payments and (2) improved incentives to invest from a reduced debt stock. Although the results show no general evidence of a growth effect from debt relief, the study provides certain evidence that it promotes investment and thereby growth in countries not classified as HIPCs. Overall, the thesis suggests that future debt sustainability is possible – mainly because of a changing debt regime and an increase in grant flows. It questions, however, whether debt relief is able to generate what it promises in heavily indebted countries.