Debt Relief for Poor Countries: Conditionality and
University of Konstanz
Final version received 2 September 2016.
This paper studies the eﬀectiveness of debt relief to stimulate economic growth in the most heavily
indebted poor countries. We develop a neoclassical framework with a conﬂict of interest between the
altruistic donor and the recipient government, and model conditionality as an imperfectly enforceable
dynamic contract. In contrast to the recent practice of fully cancelling debt, optimal incentive-compatible
conditionality is accompanied by a concessionality level that implies a combination of subsidized loans
and outright grants. The optimal concessionality level depends on the recipient’s access to international
ﬁnancial markets and on the strength of the conﬂict of interest. Incentive-compatible transfers with
optimal concessionality levels generate substantial welfare gains. If the donor does not implement the
optimal concessionality level and provides subsidized loans only, then the eﬀectiveness of transfers
decreases in the long run with severe welfare implications. In contrast, transfers are less eﬀective in the
short run if the donor oﬀers outright grants only.
The most heavily indebted poor countries (HIPCs) in the world have been suﬀering from
low income levels, stagnating economic growth and high external public debt for many
years. In 1996, motivated by the concern to stimulate growth and reduce poverty, the
International Monetary Fund (IMF) and the World Bank founded the Initiative for
Heavily Indebted Poor Countries that was supplemented by the Multilateral Debt Relief
Initiative in 2005. The objective of the initiative is to provide substantial debt
cancellations so that the recipient governments have free resources to ﬁnance eﬃcient
growth-enhancing economic policies. In 2007, total costs of debt relief were estimated at
$71 billion (IMF 2010).
In their seminal contributions, Krugman (1988) and Sachs (1988, 1989) show that
debt relief may facilitate new lending, investment and growth if a country suﬀers from a
However, as argued by Arslanalp and Henry (2004, 2006) and Eaton
(1990), it is questionable whether HIPCs are characterized by a debt overhang since they
have continuously received positive net loans on concessional terms, and face debt
obligations to oﬃcial creditors rather than commercial banks.
To emphasize this point, Figure 1 shows the components of public external debt as
well as the components of oﬃcial development assistance (ODA). Since positive ODA
net loans have replaced market debt by oﬃcial debt, Easterly (2002) argues that debt
relief has been implicitly granted to the HIPCs over the past three decades. Concern
about the unsustainability of external debt burdens motivated the recommendation made
by the Meltzer Commission (Meltzer 2000) that development assistance should be
provided through outright grants rather than subsidized loans.
This paper studies the question of how debt relief should be provided in order to be
an eﬀective instrument to stimulate economic growth in HIPCs. Our theoretical
framework builds on the macroeconomic literature on economic development and takes
into account that the main economic problem of HIPCs is the lack of functional
economic institutions rather than debt overhang.
Instead of implementing eﬃcient
© 2016 The London School of Economics and Political Science. Published by Blackwell Publishing, 9600 Garsington Road,
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Economica (2018) 85, 626–648