Sovereign Debt Relief Schemes and Welfare

IMF Working Papers, March 1, 1992

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Concerted debt reduction may be welfare-improving even when the investment disincentive effect of a debt overhang is not large enough to place the debtor country on the wrong side of the debt Laffer curve.
Whether the appropriate relief scheme involves debt reduction or new money depends on whether investment disincentives or liquidity constraints dominate.
Except under very special circumstances, mixed policy packages involving both debt and liquidity relief may not yield the desired results.

Debt reduction can improve welfare even without large investment disincentives that would push a country past the debt Laffer curve.
Choice of relief instrument should be driven by the dominant constraint:
- If investment disincentives dominate, debt reduction may be preferable.
- If liquidity constraints dominate, provision of new money may be preferable.
Mixed packages (debt relief + liquidity relief) are generally unlikely to yield desired outcomes except in very special circumstances.

Subjects: Asset and liability management, Debt burden, Debt buyback arrangements, Debt reduction, Debt service, External debt, Financial crises, Liquidity
Keywords: competitive market debt buyback, Debt burden, Debt buyback arrangements, debt buyback scheme, debt claim, debt Laffer curve, debt obligation, debt overhang effect, Debt reduction, debtor country, debtor country government, disincentive effect, Liquidity, liquidity effect, WP