What is Debt Overhang
Debt overhang is a debt burden that is so large that an entity cannot take on additional debt to finance future projects. This includes entities that are profitable enough to be able to reduce indebtedness over time. Debt overhang serves to dissuade current investment, since all earnings from new projects would only go to existing debt holders, leaving little incentive and ability for the entity to attempt to dig itself out of the hole.
BREAKING DOWN Debt Overhang
In the context of sovereign governments, the term refers to a situation in which the debt of a nation exceeds its future capacity to repay it. This can occur from an output gap or economic underemployment, repeatedly plugged by the creation of additional credit. A debt overhang can lead to stagnant growth and a degradation of living standards from reduced funds to spend in critical areas, such as healthcare, education, and infrastructure.
Examples of Debt Overhang
To solve the debt overhang in many developing nations, debt cancellation programs are occasionally implemented by intergovernmental organizations, such as the World Bank, and international organizations, such as the International Monetary Fund (IMF). Recent programs have covered Côte d’Ivoire, the Democratic Republic of the Congo, Gabon, Namibia, Nigeria, Rwanda, Senegal and Zambia. The Jubilee 2000 campaign was an international movement by 40 countries, which called for canceling the debt in developing nations by the year 2000.
A debt overhang can also trap companies as a greater proportion of revenues or cash flow simply goes toward service existing debt. This widening deficit can only be filled through incremental debt, which only increases a company's burden. A debt overhang is particularly difficult as it straps companies aiming to take advantage of new opportunities with positive net present value (NPV). Although under more normal conditions, these potential projects would repay themselves over time, a ballooning existing debt position in a company could likely turn off would-be investors in the project. Given that the company’s debt-holders can reasonably be expected to lay claim to a portion or all of the new project’s profits, the NPV would, in effect, be negative.
Eventually, ways out of a debt overhang include: the forgiveness of part or most of the debt by creditors (as with debt cancellation programs, described above), debt default (by a nation), through bankruptcy (for a company), or repurchasing some existing debt and turning it into equity.