lecture 6 debt forgiveness and moral hazard in international lending

8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending

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Topic 2

Sovereign Debt

and the Pattern of Capital Flows



Debt Overhang (O&R 6.2)

• In the 1980s, many countries struggled with debtservicing burdens. Latin America, Africa

•

Is the causality between debt problems andgrowth bi-directional? Sachs/Krugman – a largestock of pre-existing foreign debt acts as a tax oninvestment.

• More generally, do we refinance loans to a debtorin trouble or offer debt forgiveness?



Krugman (JDE, 1989)

• Small open economy, 2 periods

• Country has pre-existing debt, D, all due inperiod 1. It can transfer an maximum of x1 inperiod 1.

• Period 2 resource transfers unknown anddepend on state of nature (s) and adjustmenteffort (z)



•

Consumption in period 2 is simply

• Where P is payment to creditors



• Country cares about period 2 consumption

and dislikes adjustment effort

• (Defensive) new money lending to avoid a

default is



• Payment in period 2

• Creditors first choose interest rate on newmoney lending and then debtor chooses

adjustment effort. Solve backwards



• How does adjustment effort respond to the

interest rate charged?



• Creditors maximise the expected value of new

lending



• Term 1: New money bias in the face of

uncertainty. Here rollovers are preferable to

keep the option of cashing in on potential

good fortune alive.

• Term 2: Debt forgiveness bias due to problem

of incentives for the debtor. Take losses up

front instead.



• Krugman – choice between refinance andforgiveness is less about issues of liquidity vsolvency but more about the option value of alarge nominal debt and the incentive effects of

debts unlikely to be repaid.

• Tension between these forces makes the issue adifficult one to resolve practically.

• Link payments to measures of economicconditions outside the country’s control



Risk Sharing and Moral Hazard

(O&R 6.3)

• Suppose a country has (random) output whichcannot be observed perfectly (it can lie)

•

It would like to share output risk with others viaan Arrow-Debreu contract. – Make (insurance) payments to others when output is

high

– Receive (insurance) payments when output is low

• But if it can cheat, then it can claim insurancepayments that it does not deserve



• Two date model. A continuum of small countries,

receiving an endowment each period.

• At date 1, half receive Y – and half Y+ so that

average output in the world economy is

Y=(Y –+Y+)/2

• At date 2, everyone receives Y (the average), so

only date 1 carries output risk.



• Notice that world output is the same every period – thereis no aggregate endowment risk

• Now let countries write contracts to diversify output risk.

• If each country knows it will have high (low) output with

probability ½, then expected utility is

• In an ideal world, each country delivers Y+-Y to insurers ifoutput high, Y-Y – if output low. And everyone consumesC1=Y with certainty



• What if output cannot be observed?



• Now allow trade in riskless bonds (these areenforceable). We can get to point B on thecontract curve.

• Now the high output country lends out anamount at date 1 and receives it back in date 2

•

But the two types end up with unevenconsumption – consumption risk is not smoothedout



• Can we do better than B? We need incentive

compatible contracts that remove thetemptation to deceive.

• High output types would wish to lie. By doingso, they get a positive payment on date 1,

taking them to “D”.

• Suppose now we can penalise countries



• Rule - if a country reports low output, it mustmake a payment at date 2

• If the gain from reporting low output is smallenough, and penalty large enough, then ahigh output type is deterred from cheating.

• Let H type make payments (P1, P2) and L typemake payments (-P1, -P2)



• Expected utility

•

Incentive compatibility constraints mean thatH types do not gain from posing as L types

(and vice versa)



• Punishments can be empty. A corrupt country

can always turn to the capital markets to

smooth consumption.

• Can we monitor and control other financial

trades? Is a country able to undo the effects of

penalties and sanctions?

lecture 6 debt forgiveness and moral hazard in international lending

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