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LDC Debt: Forgiveness, Indexation, and Investment Incentives

Authors

  • KENNETH A. FROOT,

  • DAVID S. SCHARFSTEIN,

  • JEREMY C. STEIN

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    • Affiliations: MIT, Harvard, and NBER (Froot); MIT and NBER (Scharfstein); Harvard and Council of Economic Advisers (Stein). We thank Geoff Carliner, Sue Collins, Martin Feldstein, Kala Krishna, Greg Mankiw, Kathy Mann, Ken Rogoff, and Jeff Sachs for helpful comments and Kathryn Dominguez for help in obtaining data. All errors remain our own.


ABSTRACT

We compare different indexation schemes in terms of their ability to facilitate forgiveness and reduce the investment disincentives associated with the large LDC debt overhang. Indexing to an endogenous variable (e.g., a country's output) has a negative moral hazard effect on investment. This problem does not arise when payments are linked to an exogenous variable such as commodity prices. Nonetheless, indexing payments to output may be useful when debtors know more about their willingness to invest than lenders. We also reach new conclusions about the desirability of default penalties under asymmetric information.

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