External Debt and Political Instability

This paper provides a theoretical and empirical analysis of the role played by domestic political incentives in the accumulation of large external debts by developing countries between 1972 and 1981. The theoretical model characterizes two equilibrium regimes. In one the borrower is on its demand curve and changes in the loan size desired by the borrower are accommodated by lenders. In the other regime the borrower is credit rationed, and the loan size is determined by the perceived country risk. Increased political instability increases the equilibrium loan size in the first regime and decreases it in the second. Using out-of-sample evidence, we identify the two regimes in the data. We then find that in the unconstrained regime political instability has a significant effect on the loan size, whereas it has no significant effect in the credit rationing regime. Hence the evidence indicates a positive effect of political instability on the demand for sovereign loans, as predicted by the theory.