their very limited ability to absorb income shocks. Approximately half of all households in emerging and advanced economies lack sufficient liquid assets to sustain consumption and debt payments for more than three months in the event of an income loss —40% in advanced economies, 50% in emerging economies (Badarinza et al., 2019).<sup>3</sup> This figure is practically identical at the one-year mark and highlights the importance of effective debt resolution mechanisms, given the rapidly increasing participation of low-income households in the formal credit market.

Our conceptual framework explores how differences in the type and extent of debt relief available to households shape credit market outcomes and borrower expectations. In the model, we contrast the effects of rules-based debt relief with those of discretionary debt relief policies. Because personal bankruptcy institutions are largely absent in developing economies, most debt resolution occurs through _ad hoc_ debt relief programs initiated by governments, regulators, or financial institutions, rather than rules-based relief through an established legal bankruptcy process. While such one-off policies may be preferable to the alternative of no debt relief, they have a number of drawbacks relative to an institutionalized bankruptcy process. When debt relief is governed by discretion rather than rules, debt relief policies can distort credit markets by altering expectations about the availability of relief in the future. Such expectations can create moral hazard, depending on who ultimately bears the cost of debt relief. When creditors anticipate compensation from the government for forgiving or restructuring debt, this weakens incentives to lend judiciously. Credit supply may increase in anticipation of future debt relief. These increases can be inefficient when creditors do not internalize costs borne by taxpayers who end up subsidizing risky lending. When anticipated debt relief instead reduces penalties for default, and creditors bear the costs of default, moral hazard on the part of borrowers can increase ex ante demand for credit and ex post default. However, anticipating more default motivates creditors to restrict lending ex ante, thus limiting access to credit. Our review of the literature explores to what extent the predictions of our simple model match the empirical evidence on debt relief, borrower expectations, and moral hazard.

The remainder of the paper proceeds as follows. Section 2 lays out a stylized model of debt relief and presents comparative statics describing the effects of debt forbearance and debt restructuring under alternative model assumptions. In section 3, we discuss the various types of debt relief programs implemented in practice and review the existing evidence on the effect of these programs. Section 4 presents evidence on the effects of debt relief on borrower expectations, using survey data from a population of microfinance borrowers with recent exposure to debt relief. Section 5 discusses promising directions for future research and concludes.

# **2 The Costs and Benefits of Debt Relief: Conceptual Framework**

This section presents a simple model of consumer borrowing, default, and debt relief policies that builds on Indarte (2022, 2023). We use the model to highlight differences in the costs and benefits of different debt relief policies.

> 3 See also Badarinza et. al. “How has the pandemic affected household finances in developing economies?” Economics Observatory Blog, June 2021.

4