Domestic Creditor Rights and External Private Debt

Abstract

This paper unbundles institutions protecting domestic and foreign creditors' rights. We estimate a negative relation between the degree of domestic rights protection and the external stock of private nonguaranteed debt in 85 developing countries. A supply-side explanation is that strong domestic protection supports reliable outside financing options for potential external debt defaulters; foreign investors anticipating this would tighten credit constraints ex ante. Then we formalise the argument in a private borrowing and default model, and show that centralisation is no longer necessarily welfare superior.Creditor rights protection is a critical determinant of developing countries' capacity to accumulate external debt. This is especially the case in the private-sector debt market, where repayment enforcement relies more on third-party institutions than self-enforcing arrangements. However, the literature has overlooked the role played by institutions protecting domestic creditors' rights. Instead, it had naturally concentrated on foreign creditor rights protection in debtor countries. Using variations in institutional quality, this paper examines the effects of domestic creditor rights on external private debt and the consequent welfare implications.Domestic creditor rights were seldom contemplated in prior studies for two reasons. First, external debt of developing countries used to be comprised mostly of sovereign debt, where legal enforcement of rights is minimal. Hence theorists have focused on the economic incentives to repay. 1 Broadly defined measures of institutions suffice to proxy for sovereign creditworthiness. 2 Second, research on external private debt documented only the importance of foreign creditor rights. The * The authors are grateful to the editor Morten Ravn and two anonymous referees. We also thank ) provide a literature review on newly-written theoretical contributions on this topic. 2 Faria and Mauro (2009) construct an index from the World Bank's Worldwide Governance Indicators (WGI) to show that better institutions tilt countries' external capital structures toward equity and away from debt. Lane (2004) and Qian (2012) construct another broad assessment by averaging International Country Risk Guide's (ICRG) IRIS-3 variables from the Political Risk Services group. Lane (2004) emphasises the role of institutions in determining the stock of external public debt and Qian (2012) examines how institutions affect the likelihood of sovereign defaults.

Sovereign debt assistance and democratic decision‐making

“…Djankov et al (2007) find that improved legal rights of creditors and information sharing increase private credit. Similarly,Anyanwu et al (2017) find that better institutional quality increases private credit andFan and Gao (2017) demonstrate how protection of creditor's rights affects private external debt. 5 https://www.worldbank.org/en/results/2022/08/01/stepping-up-immediate-support-to-tonga-after-a-once-in-amillennium-natural-catastrophe…”