Debt Overhang and Sovereign Debt Restructuring

Debt overhang is defined as a situation where a large amount of debt distorts the optimal investment decisions and discourages the government's efforts of the debtor country to undertake the necessary "adjustment policies". In this paper I study some different strategies that can be used to solve the sovereign debt overhang problem. In particular, I consider two strategies based on a debt restructuring process, via haircut or rescheduling, and a third one based on conditional-additional lending. This strategy relies on the idea that the debtor country can get new lending from the existing creditors, in order to undertake investments that can affect the productivity shock distribution in a positive way (or reduce the probability of default). The aim of this paper is to study the consequences, deriving from the three strategies described, on the incentives to invest in a "troubled country". According to these consequences and under some specific conditions, I rank the three strategies in order to see which is the most effective one. In particular, I find that if the change in investments due to the conditional-additional lending makes the probability of default low in this scenario, the conditional lending strategy will be the most effective one. Basically, this paper might help the policy-makers to implement the right intervention according to the specific scenarios considered.