There is little doubt that reducing public debts would help heavily-indebted low-income countries (Martin, 1997, Box 1). However, if debt reduction consumes resources that would otherwise have been made available as aid then there is a trade-off. In considering this trade-off, it is necessary to assess:
the costs of any resulting reduction in aid on the recipient countries.
A distinction must also be made between debt reduction which simply reduces the level of scheduled debt repayments to the level which the country would otherwise have paid (that is, it merely prevents the build up of arrears by cancelling debt which would not have been paid anyway) and debt reduction which reduces debt repayments beyond this level and therefore frees up government resources for other uses.
Debt has essentially two types of effect on the economy.
a. Servicing debts takes resources away from alternative uses, particularly in terms of imports, government spending and investment.
b. Anticipation of the economic effects of debt (slower market growth, higher taxation, uncertainty in policy making, etc) discourage private investment.
Reducing debts to the level which would otherwise be repaid will only reduce the debt overhang effect (b), since actual debt-service payments are not reduced. Further debt reduction beyond this level will have both types of effect.
Debt reduction can also have a beneficial effect from the point of view of new aid flows by reducing or eliminating the need for defensive lending. If, for example, IDA resources are being used in effect to service existing debts (as they are in many cases), then reducing the debts should release at least part of this money for other, more productive, uses - for example to relieve pressure on recurrent spending for health, education and administration, or investment in infrastructure. This could add significantly both to economic growth and to human development.