Countries that have a high international debt face what is called the debt overhang. The prospect of having to service a large debt from investment returns discourages investment. In such situations, some amount of debt forgiveness can help. To see this, consider the following example:

A country needs to make $2 billion of service payments on its debt. To do so, its government can attempt to raise additional resources, say by extra taxation or reduced expenditures, in order to make investments of $10 billion dollars. Only an investment with a net return of 10% or more (to the government) will be undertaken. These investments pay off $2.5 billion dollars in additional revenue: a 25% return.

(a) Show that if debt service payments have to be made from the returns, these investments will not be undertaken.

(b) Show that a certain amount of forgiveness (or postponement) of the debt service will make both the government and the creditors better off. Calculate the minimum amount of forgiveness that’s necessary.

(c) Suppose a whole range of investments (at different levels) are available. Creditors might forgive some of the debt in order to induce these investments (as above) or might participate more actively in the investments themselves, asking for a fixed percentage of the returns as debt service. That is, debt is converted into equity. Compare these two options. Ideas from the theory of land tenancy (see Chapter 12) may be relevant here.