19 In order to identify the debt overhang effect,<sup>a debt-reduction</sup> operation is first computed by ignoring the liquidity effect<sup>which may arise</sup> from the public debt-service reduction. This liquidity effect<sup>will be, anyway,</sup> limited in countries which are running arrears. The short-term<sup>and medium-term</sup> simulation results indicate that the real private investment<sup>is significantly</sup> responsive to external debt changes. To illustrate, an initial<sup>20% debt-</sup> reduction leads to an increase in private investment and in<sup>the GDP level of</sup> 11.7 % and 1.16% respectively (5 years impact). More<sup>precisely, a debt-</sup> reduction will affect positively the level of private<sup>investment through three</sup> different incentive channels. First, as private investors see<sup>the foreign debt</sup> burden decrease, they anticipate reduced future tax burden<sup>for its servicing</sup> and more stability of the economy. Second, the portfolio<sup>shift from foreign</sup> assets into domestic bank deposits reduces interest rates. Third,<sup>the banking</sup> system extends more domestic credit to the private investors<sup>since a reduction</sup> 27 in the price level increases real money supply . Note, however, that the increase in international reserves reduces simultaneously the flow supply of domestic credit.

The second shock assumes not only an incentive effect<sup>but also a</sup> liquidity effect. The incentive effect is similar to the<sup>one described in the</sup> first policy and the liquidity effect arises from the reduction<sup>in the foreign</sup> 28 debt service paid by the public sector . The release of the budget constraint of the public sector leads simultaneously to an increase in public investment and a reduction in public borrowing from<sup>the domestic financial</sup> system, therefore lowering the crowding out of domestic credit to the private sector. Higher domestic credit relaxes the private sector<sup>budget constraint</sup> and increases domestic assets demands and private investment.<sup>Note that the</sup> positive short-run effect on the production level is<sup>relatively weak because</sup> the short-run link between public investment and production<sup>is negative due to</sup> the existence of adjustment costs. However, as the<sup>costs of adjustment</sup> disappear, the increase in the GDP level becomes<sup>progressively higher over</sup> time. To illustrate, the estimated total impact of a<sup>20 % debt-reduction is</sup> 1.62 % oni GDP growth for the first year and 3.60 % for the fifth<sup>year. These</sup> simulated results are more favorable to debt-reduction operations than those obtained with single-equation approaches. Indeed, the direct and the total effects (in terms of elasticities) on private investment is 0.124<sup>and 1.129</sup> 29 respectively . This comparison suggests that the variations in interest rates and in domestic credits constitute indirect crucial<sup>channels through</sup> which a debt-relief influences investment and growth in Argentina.

27The decline in the price level comes from the reduction in domestic interest rates, thereby increasing the demand for national<sup>liquidities (ml).</sup> 28We supposed that only the public debt-service is reduced by the debtrelief operation and, therefore, there is no direct liquidity<sup>effect in the</sup> private sector. Furthermore, we assumed that the public<sup>external debt-service</sup> is equal to 5 % of the total stock of debt. That<sup>means that the reduction in</sup> the public debt-service is : -dfds8 = 0.05*(-deD$) 29source: Schmidt-Hebbel, 1990 p.299, case 6a.