Debt Relief for Poor Countries: Conditionality and Effectiveness

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.