LDC Borrowing with Default Risk

Abstract

This paper presents a theoretical model to describe the effects of default risk on international lending to LDC sovereign borrowers. The threat of defaults in international lending is shown to give rise to many characteristics of the syndicated loan market: (1) quantity rationing of loans; (2) LDC policies designed to enhance creditworthiness; (3) prevalence of short maturities on international loans; and (4) a prevalence of bank lending relative to bond-market lending. Daniel Cohen Jeffrey SachsVisiting (6ii) 1L95-I1l2 In competitive markets agents may buy and sell commodities at parametric prices and without quantity contraints. In the "textbook" loan market, for example, it is postulated that individuals may borrow and lend in unlimited amounts at a fixed market interest rate. The implausibility of this assumption has long been granted for the loan market, and economists have generally accepted "the imperfection of capital markets." Because of the difficulties of contract enforcement, and moral hazards in the behavior of debtors, it is recognized that individuals and firms are often constrained in borrowing.Indeed, certain "paradoxes of borrowing" seem to rule out, a priori, the logical possibility of purely competitive borrowing without quantity constraints.Numerous authors have now shown how certain legal and economic institutions may serve to overcome incentive problems in the loan market. Problems of moral hazard in corporate borrowing, for example, may often be reduced through the use of bond covenants, seniority of debt, bankruptcy provisions, etc. The capital structure of the firm may itself be designed to counteract certain incentive effects of loans. The losses in firm valuation that attach to the irreducible moral hazards in the loan market have been termed the "agency cost of debt."The efficiency problems of loan markets are dramatically magnified in the international setting, where problems of contract enforcement become endemic. With international loans, there is no uniform commercial code governing the design and interpretation of contracts, and no international policing power available for contract enforcement. Civil remedies for breach of contract will typically be different under the distinct legal systems of the creditor and debtor, and there may be acute difficulties for a creditor to obtain and enforce a legal judgement against a debtor in the latter's political jurisdiction.-2-For many international loans, repayment depends on the enlightened self-interest of the debtor rather than on legal compulsion. Debtors may have strong incentives to maintain reputation if they make repeated trips to the loan market, and so may have incentives to repay loans even if each individual loan agreement is not directly enforceable. In cases where self-interest for repayment is not strong the loan market may simply collapse, with mutually advantageous opportunities for trade left unexploited.The problems of sustaining international loans are compounded further in the case of LDC debtors. Though t...

Asymmetries of Information and LDC Borrowing with Sovereign Risk

“…As noted by Sachs and Cohen (1982), a long-term loan contract would require a higher rate of interest for a given size loan than a shorter term contract to achieve non-negative profits. Borrowers may prefer debt of shorter maturities at lower rates of interest, so that long.…”

“…AsylTlfTletries of ;~formation about total concurrent indebtedness of borrowers between debtors 3 and creditors are shown to imply the shortened debt maturity structures, predominance of bank over bond lending, relationship between quantity-rationing of credit and rates of investment, and exclusion of the lowest income LDCs from the private international capital market observed in LDC borrowing. Another paper, by Sachs and Cohen (1982), explores the relationship between default risk, the lack of bond covenants and the special features of LDC borrowing. Their approach and explanations differ greatly from those given in this paper, which concentrate on the role of asymmetries of information between creditors and debtors.…”

Does Conditionality on Borrowing Help?

“…Among them were Sachs and Cohen (1982), who modeled default risk on international lending to LDC's. Their study reported how the threat has shaped the international lending landscape.…”

Persistent Gaps, Volatility Types, and Default Traps

“…The difference between the prices that the borrower faces after repayment or default can be viewed as a "default premium". Ex-ante such a "default premium" constitutes a deterrent mechanism that induces countries to pay even in the absence of output penalties featuring elsewhere (e.g., Sachs and Cohen, 1985;Obstfeld and Rogoff, 1996;Alfaro and Kanuzck, 2005). Ex-post, however, the attendant rise in spreads associated with such a "default premium" increases the cost of future borrowing.…”