Optimal Sovereign Debt Write-Downs

Abstract

At present, the enhanced HIPC initiative and the Gleneagles Proposal for debt write-downs by the G8 are the main mechanisms used to reduce indebtedness of low-income countries. In these countries where poor governance is a key issue, it is naïve to believe that the Millennium Development Goals can be achieved if the current debt relief mechanisms fail to address such problem. In this paper, we develop a model of sovereign debt write-downs, where governance problems reflect domestic distributive conflict between two classes in the society and intertemporal conflict. The main policy issue is how to design the optimal form of debt write-downs and the conditionality requirements attached to it with such governance problems in mind. To deal with the domestic distributive conflict, it is crucial that the conditionality requirements target both provision of public goods and private consumption level of the poor citizens. Addressing the intertemporal conflict problem requires the use of long-run conditionality requirements. Against such a benchmark, we then evaluate the efficacy of the current debt relief initiatives and discuss some policy implications.

Keywords: Debt Relief, Conditionality, HIPC Initiative

JEL Classification: O19, O11, F34, F35, I38