Why do so many countries remain poor? The culprit may be aid with certain eligibility criterion. The paper's focus is on the incentive effect of a cutoff, an income level above which the recipient country is ineligible for aid in the form of concessional loans or grants. The key result is that concessional loans are better than grants, provided that the loan scheme's perverse incentive effects, which induce the country to remain below the cutoff to reap the benefit of the concessional interest rate, are small enough. The paper shows that if the initial debt is high, these perverse effects are greater, thus providing a theoretical rationale for "debt overhang".

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Under what conditions should grants be preferred to loans? To answer this question, we present a simple model à la Krugman (1988) and show that, for any given level of developmental assistance, the optimal degree of loan concessionality is positively associated with economic growth if countries are poor, have bad policies, and high debt obligations. We then test our model by estimating a modified growth model for a panel of developing countries, and find evidence supporting our predictions.

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We perform a Tobit analysis of aid allocation for 1999-2002 accounting for altruistic and selfish donor motives comparing all bilateral, multilateral aid agencies, and nine bilateral donor and also for IDA aid separately. Taking account poverty, governing index CPIA and Kauffman, post conflict resolution and trade interests. Some differences where found with previous studies our estimates do neither suggest that multilateral aid is more poverty and policy oriented than bilateral aid and IDA aid.

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We investigate how indebtedness affects growth in developing countries. We find a highly non-linear debt-growth relation: positive at low levels of debt, negative at intermediate, nil at high. Donors behavior may explain why HIPCs have not shown symptoms of debt overhang in the past. However, after the debt relief initiative, most HIPCs’ debt levels will probably fall in that intermediate region where debt negatively affects growth. These arguments strengthen the case for additional debt relief.

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This paper empirically explores the relationship between debt and growth for a number of developing and industrial economies. For developing countries, we find that lower total external debt levels are associated with higher growth rates, and that this negative relationship is driven by the incidence of public external debt, and not by private external debt. For industrial countries, we do not find any significant relationship between gross government debt and economic growth.

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Between 1989 and 2003, low-income countries received $100 billion in debt relief. The stated objectives for much of this debt relief have been to reduce debt overhang and to free up recipient government resources for development spending that would otherwise have been used for debt service. In this paper we empirically assess the extent to which debt relief has been successful in meeting these objectives, using a newly-constructed database measuring the present value of debt relief for 62 low-income countries. We find little evidence that debt relief has affected the level and composition of public spending in recipient countries. We also do not find evidence that debt relief has raised growth, investment rates or the quality of policies and institutions among recipient countries. Although we cannot rule out the possibility that our failure to find evidence of positive impacts of debt relief is due to a variety of data and statistical problems, the evidence reported here does suggest that some skepticism is in order regarding the likely benefits of further large-scale debt relief.

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