Country Risk and Contingencies
The purpose of this paper is to study the role of credit market policies in the presence of country risk from the nationalistic and the global point of view, to address the role of endogenous default penalties that are contingent upon the intensity of default on the part of the borrowing nation, and to evaluate the effects of contingency plans that make the interest rate dependent upon variables that are correlated with the default penalty. This is done by considering an economy where a default will trigger a penalty, in the form of either a trade embargo or effective exclusion of the defaulting nation from future borrowing. Assuming costly enforcement of the penalty we show that the optimal borrowing tax from the global point of view exceed the optimal borrowing tax from the nationalistic point of view. The economic principle guiding the borrowing tax is that in the presence of country risk an activity that changes the probability of default generates thereby an externality, This principle applies also for investment: if a given investment reduces (increases) the probability of default it generates positive (negative) externality. Consequently, the social interest rate associated with this activity is lower (higher) than the private one, calling for a subsidy (tax) on borrowing used to finance that investment. Next, we evaluate the role of endogenous penalties. We design alternative incentive schemes by varying the responsiveness of the penalty to the intensity of default, without changing the total cost applied in case of a complete default. We turn then to an assessment of the welfare effect of plans that make the interest rate contingent upon realization of shocks. We conclude by deriving the optimal borrowing plan for an example where the source of uncertainty is a stochastic terms of trade. It is shown that allowing for contingent payment has the effect of raising the credit ceiling, raising the expected income, and stabilizing income across states.
|Date of creation:||May 1987|
|Publication status:||published as International Economic Journal, Vol. 3, No. 1, pp. 81-102, (Spring 1989).|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Sebastian Edwards, 1983. "LDC's Foreign Borrowing and Default Risk: An Empirical Investigation," NBER Working Papers 1172, National Bureau of Economic Research, Inc.
- Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
- Eaton, Jonathan, 1986.
"Lending with costly enforcement of repayment and potential fraud,"
Journal of Banking & Finance,
Elsevier, vol. 10(2), pages 281-293, June.
- Jonathan Eaton, 1985. "Lending with Costly Enforcement of Repayment and Potential Fraud," NBER Working Papers 1697, National Bureau of Economic Research, Inc.
- Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, vol. 94(374), pages 287-307, June.
- Aizenman, Joshua, 1989. "Country Risk, Incomplete Information and Taxes on International Borrowing," Economic Journal, Royal Economic Society, vol. 99(394), pages 147-161, March. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:2236. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.