Author Description

Because the disincentive effect of a debt overhang is generally small, debt reduction does not lead to important efficiency gains on this account. This study develops, instead, a framework that highlights the inefficiency created by the liquidity constraint faced by over-indebted countries. Adjustment and investment opportunities that are profitable at the world interest rate often cannot be undertaken for lack of sufficient funds. New creditors are deterred from investing, because they expect to be "taxed" by the old creditors who stand to gain disproportionately. This leads to inefficiency when a class of new creditors have a comparative advantage over old creditors. The shortage of liquidity introduces a time inconsistency. New (unconditional) loans will be consumed rather than invested. In this context, conditional lending can release the liquidity constraint in a time-consistent way and lead to efficiency gains that can be shared among the debtor, the old creditors, and the new creditors. The role of debt reduction is, thus, to create the "headroom" needed for these new and more efficient creditors to participate.