Debt overhang and investment: An international perspective

When firms issue risky debt, equity holders have less of an incentive to invest because the proceeds of that investment are more likely to accrue to the debt holders if the firm defaults (Myers, 1977). That is, debt overhang arises when a firm financed with risky debt passes up investment opportunities that could increase the market value of the firm. Investment spending by nonfinancial corporations around the world has declined significantly since the global financial crisis (GFC), while leverage and debt overhang has increased. For most regions, capital expenditures are at their lowest levels in decades. To what extent has the increase in debt overhang contributed to the decline in private investment since the GFC?

Recent studies have found evidence that debt overhang reduces investment by households (Melzer, 2012), and that debt overhang in the public sector is typically associated with slower economic growth (Reinhart et al. 2012). Only a few studies, however, have tried to empirically quantify the effects of debt overhang on investment by corporates. Using fixed-effects regressions, we examine the effects of debt overhang on investment using a panel of S&P Global's Capital IQ data of roughly 36,000 nonfinancial firms across 58 developed and emerging market economies (EMEs) from 2000-2016. To control for unobserved firm-specific factors which may influence investment, we include firm-level fixed effects. Following Kalemli-Ozcan, Laeven, and Moreno (2015), we also control for changes in credit demand and in aggregate demand conditions by including industry-country-year fixed effects.

We find that debt overhang exerts an economically and statistically significant drag on investment, and that the effects of debt overhang on investment are more pronounced for the EMEs. We also find that debt overhang is less of a drag on investment for corporations that are nationally owned, as they have easier acess to financing from state-owned banks, and likely also enjoy lower borrowing costs because of perceived government support.