The Mouse that Roars Gets the Cheese: LDC Debt Forgiveness and Political Instability

Traditional models of sovreign debt and default focus on the purely economic costs and benefits of borrowing and default. The model developed in this paper shows that political importance, in the face of possible political instability, is also important when determining the amount of privately funded loan a developing country can command. This paper presents a model where a politically important LDC near the point of political instability is able to extract its full political value to the U.S. by engaging in a loan agreement. This agreement consists of a loan equal to the present value of a stream of payments so large that after payments are made, aid from the U.S. is needed to fund a level of consumption that keeps the LDC politically stable. In this way, the U.S. is induced into funding a portion of the loan. This type of loan is only made to countries who do not have sufficient aggregate production to meet domestic consumption demand, and the size of the loan is proportional to the political importance of the LDC. Further, though the size of the loan is determined by a Rubenstein bargaining process, the impatience of the LDC and bank for making an agreement does not affect the outcome - it is the willingness of the U.S. to provide aid in the case of default that determines the size of the loan.