Debt Hold Up and International Lending
Are lending contracts between international financial institutions (IFIs) and sovereign borrowers optimal? To address this question this paper builds on two ideas. First, the prospect of future debt relief can make it profitable for an IFI to continue lending even if lending contracts are currently violated. Second, some policy makers may prefer not implement reform contract and this preference remains unobserved to the IFI. Hence, some governments may strategically implement contracts in order to accumulate debt. When the debt stock becomes sufficiently large, it can be used as an â€œhold upâ€ instrument, enabling the government to implement its preferred policy, assured that lending will continue. To mitigate the risk of â€œhold upâ€, the IFI may use lending contracts to screen such borrowers, leading to distorted reform contracts.
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