The Debt Overhang Hypothesis: Evidence from Pakistan

Abstract

This study investigates the debt overhang hypothesis for Pakistan in the period 1960-2007. The study examines empirically the dynamic behaviour of GDP, debt services, the employed labour force and investment using the time series concepts of unit roots, cointegration, error correlation and causality. Our findings suggest that debt-servicing has a negative impact on the productivity of both labour and capital, and that in turn has adversely affected economic growth. By severely constraining the ability of the country to service debt, this lends support to the debt-overhang hypothesis in Pakistan. The long run relation between debt services and economic growth implies that future increases in output will drain away in form of high debt service payments to lender country as external debt acts like a tax on output. More specifically, foreign creditors will benefit more from the rise in productivity than will domestic producers and labour. This suggests that domestic labour and capital are the ultimate losers from this heavy debt burden.