Debt Reduction, Adjustment Lending, and Burden Sharing

We argue that the disincentive effect of a debt overhang is generally small and consequently that debt reduction does not lead to important efficiency gains on this account. Instead, we develop a framework that highlights the inefficiency created by the liquidity constraint faced by over-indebted countries. Often, adjustment/investment opportunities that are profitable at the world interest rate cannot be undertaken for lack of sufficient funds. New creditors are deterred from investing as they expect to be 'taxed" by the old creditors who stand to gain disproportionately. This leads to an inefficient situation when a class of new creditors have a comparative advantage relative to the old creditors. We focus on the time inconsistency introduced by the shortage of liquidity. 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 between the debtor, the old creditors, and the new creditors. The role of debt reduction then is to create the "headroom" needed for these new and more efficient creditors to step in