Debt service channel for external debt and growth in developing countries

This paper investigates the relevance of the “debt service channel” for external debt in developing countries, arguing that this channel exerts a distinct impact on economic activity beyond the effects of external debt levels. To characterize this mechanism, the paper first develops a small open economy real business cycle model featuring an external debt service mechanism. Specifically, the model incorporates a random maturity structure for external debt to demonstrate how debt burden shocks function as a distinct mechanism, independent of credit shocks. The impulse responses show that a rise in the debt service burden is associated with declines in employment, investment, consumption, and output, as economic agents are unable to fully smooth out these shocks due to prevailing budget constraints and risk premia. Empirical analysis for a large sample of developing countries covering the last five decades also produces supportive evidence. Namely, higher levels of external debt service lead to a contraction in output for an extended period, a finding that remains robust across various model specifications. Therefore, this paper establishes the significance of the “debt service channel” and shows its importance for external debt dynamics in developing countries.