Although investment disincentives associated with an external debt overhang have become a popular explanation for the collapse in investment in heavily indebted countries, the conditions required by previous authors for efficiency-enhancing debt reduction appear not to be satisfied for most of these countries. In addition, market-based debt-reduction instruments, such as buybacks, have been criticized on the grounds that they are unlikely to improve the welfare of the debtor, who is forced to pay the average value of outstanding claims for a reduction in the buybacks’ marginal value. Despite these considerations, however, several countries have moved ahead with debt reduction and restructuring under the Brady initiative.
This paper models an economy with an external debt overhang. The model captures two types of investment inefficiency—a disincentive effect caused by the existence of the future debt burden and a liquidity effect arising from a shortage of current resources. Two types of relief schemes are considered: debt reduction, which involves reducing current resources in exchange for a reduction in future obligations; and liquidity relief, which increases current liquidity and the stock of debt.
The appropriate relief scheme depends on which of the two effects dominates. It is shown that, except under special circumstances, mixed policy packages involving both debt and liquidity relief are not worthwhile. Furthermore, debt reduction is shown to be Pareto-improving even when the debtor country is not on the “wrong side” of the debt Laffer curve. This result widens the scope for debt reduction on efficiency grounds.
The paper also discusses the price of a concerted debt-reduction operation, finding that its price must be above the marginal value of outstanding claims but may or may not exceed their average value. Hence, even if a concerted debt-reduction operation improves welfare, a market buyback may not.