When highly indebted poor countries suffer from debt overhang, it becomes difficult for them to service their debt. In this case, debt reliefs can help them by reducing a part of the debt stock which in turn reduces the debt overhang or in some cases relieve the indebted country from their debts. Debt reliefs are beneficial especially in the case of poor countries with a high debt burden in which the debt service payments crowd out private investments and affect the economic growth. Debt relief can help through the expansion in public spending relieving some of the constraints on the government’s budget and promoting investments. However, in other situations it may be a reason of the deterioration of relations between countries.
Johansson (2010) argued that debt relief creates a situation of moral hazard or adverse selection as Easterly (2002) argued that borrowers will be encouraged to take new loans expecting that it will be forgiven or relieved in future when the country is in repayment difficulties as in debt overhang situations even when they are not willing or able to repay their debts and not the ones that are willing and able to increase their investment and elevate economic development.Easterly (2002) noted that these countries might be faced by political instability, corrupted governments or interest group polarization reflecting the high discount for the countries’ political and economic position.
So Easterly (2002), Robinson (2001), Subramanian (2004) and Trebbi (2004) all argue that for debt reliefs to have a positive impact on growth, good institution and governance are necessary in order to increase investments, reduce poverty, improving unemployment rates and make efficient use of the resources to achieve the intended economic growth.
There is still an argument by Arslanap and Henry (2003) that these highly indebted poor countries have a very limited access to the international capital markets as a result of their poor government policies and institutions which is one of the reasons of their increasing share of debt .In this case, there is no guarantee even with debt reliefs that private investments would flow to these countries. They used this argument to support their view that the concept of debt relief works better with highly developed indebted emerging economies that have an infrastructure ready for a profitable economic growth.