Conditionality and Sovereign Debt

We study the incentive role of international conditional lending in sovereign debt markets with private information and limited commitment. Without conditionality, sustaining repayment incentives requires ex-post inefficient penalties that compress imported inputs and depress output. We show that conditionality strictly expands the Pareto frontier even when modeled as a pure deadweight loss with no reform benefits. By acting as an endogenous, non-pecuniary penalty, conditionality decouples incentive provision from productive distortions, preserving imports and sustaining output during crises. The constrained optimal allocation can be decentralized through a portfolio of private defaultable bonds with active maturity management, complemented by conditional official lending during default episodes. Our framework rationalizes conditionality through its incentive role alone, independent of its contested efficacy in delivering any additional benefits.