Sovereign debt buybacks as a signal of creditworthiness

To solve the puzzle of attitudes toward debt buybacks, the authors use a model that combines considerations of debt overhang with the possibility of asymmetrical information between debtor countries and their creditors. In this environment, a debt overhang may create disincentives for a country to undertake a worthwile investment, and debt relief may induce the country to invest and to increase its output, raising future debt repayments. The authors show that debt buybacks can credibly reveal a debtor country's willingness to invest and to repay in the future when offered relief today. In equilibrium, countries that buy back debt get debt relief and those that do not buyback debt do not get debt relief. The authors tested and failed to reject two implications of their model : 1) that banks grant debt relief to countries that have a swap program in place, and 2) that the secondary market price of country debt, conditional on a swap, is higher than the debt price, conditional on no swap.