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8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 1/22
Topic 2
Sovereign Debt
and the Pattern of Capital Flows
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 2/22
Debt Overhang (O&R 6.2)
• In the 1980s, many countries struggled with debtservicing burdens. Latin America, Africa
•
Is the causality between debt problems andgrowth bi-directional? Sachs/Krugman – a largestock of pre-existing foreign debt acts as a tax oninvestment.
• More generally, do we refinance loans to a debtorin trouble or offer debt forgiveness?
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 3/22
Krugman (JDE, 1989)
• Small open economy, 2 periods
• Country has pre-existing debt, D, all due inperiod 1. It can transfer an maximum of x1 inperiod 1.
• Period 2 resource transfers unknown anddepend on state of nature (s) and adjustmenteffort (z)
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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•
Consumption in period 2 is simply
• Where P is payment to creditors
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Country cares about period 2 consumption
and dislikes adjustment effort
• (Defensive) new money lending to avoid a
default is
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 6/22
• Payment in period 2
• Creditors first choose interest rate on newmoney lending and then debtor chooses
adjustment effort. Solve backwards
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 8/22
• How does adjustment effort respond to the
interest rate charged?
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 9/22
• Creditors maximise the expected value of new
lending
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 10/22
• Term 1: New money bias in the face of
uncertainty. Here rollovers are preferable to
keep the option of cashing in on potential
good fortune alive.
• Term 2: Debt forgiveness bias due to problem
of incentives for the debtor. Take losses up
front instead.
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Krugman – choice between refinance andforgiveness is less about issues of liquidity vsolvency but more about the option value of alarge nominal debt and the incentive effects of
debts unlikely to be repaid.
• Tension between these forces makes the issue adifficult one to resolve practically.
• Link payments to measures of economicconditions outside the country’s control
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 12/22
Risk Sharing and Moral Hazard
(O&R 6.3)
• Suppose a country has (random) output whichcannot be observed perfectly (it can lie)
•
It would like to share output risk with others viaan Arrow-Debreu contract. – Make (insurance) payments to others when output is
high
– Receive (insurance) payments when output is low
• But if it can cheat, then it can claim insurancepayments that it does not deserve
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
http://slidepdf.com/reader/full/lecture-6-debt-forgiveness-and-moral-hazard-in-international-lending 13/22
• Two date model. A continuum of small countries,
receiving an endowment each period.
• At date 1, half receive Y – and half Y+ so that
average output in the world economy is
Y=(Y –+Y+)/2
• At date 2, everyone receives Y (the average), so
only date 1 carries output risk.
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Notice that world output is the same every period – thereis no aggregate endowment risk
• Now let countries write contracts to diversify output risk.
• If each country knows it will have high (low) output with
probability ½, then expected utility is
• In an ideal world, each country delivers Y+-Y to insurers ifoutput high, Y-Y – if output low. And everyone consumesC1=Y with certainty
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• What if output cannot be observed?
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Now allow trade in riskless bonds (these areenforceable). We can get to point B on thecontract curve.
• Now the high output country lends out anamount at date 1 and receives it back in date 2
•
But the two types end up with unevenconsumption – consumption risk is not smoothedout
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Can we do better than B? We need incentive
compatible contracts that remove thetemptation to deceive.
• High output types would wish to lie. By doingso, they get a positive payment on date 1,
taking them to “D”.
• Suppose now we can penalise countries
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Rule - if a country reports low output, it mustmake a payment at date 2
• If the gain from reporting low output is smallenough, and penalty large enough, then ahigh output type is deterred from cheating.
• Let H type make payments (P1, P2) and L typemake payments (-P1, -P2)
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Expected utility
•
Incentive compatibility constraints mean thatH types do not gain from posing as L types
(and vice versa)
8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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8/12/2019 Lecture 6 Debt Forgiveness and Moral Hazard in International Lending
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• Punishments can be empty. A corrupt country
can always turn to the capital markets to
smooth consumption.
• Can we monitor and control other financial
trades? Is a country able to undo the effects of
penalties and sanctions?