Reducing Developing Country Debt

Abstract

This paper offers a brief primer on the economics of debt reduction for developing countries. It begins by considering the case of unilateral debt forgiveness; such forgiveness is only in the mutual interest of creditors and debtors if the country is on the wrong side of the "debt Laffer curve". Current empirical estimates suggest that problem debtors are in a very flat region of the debt Laffer curve where large changes in face value of debt have only small effects in expected payments. The paper then considers a variety of market-based debt reduction schemes. It shows that the widespread belief that the market offers a cheap way to reduce debt is incorrect; unless new market instruments can be made credibly senior to existing debt, debt reductions that impose only small costs to creditors would be very expensive if achieved through buybacks.