Essays on external borrowing by less developed countries

It is often observed that loans extended to sovereign borrowers in international financial markets are not fully repaid. The purpose of this work is to analyze from a theoretical standpoint the effects of default risk in this particular market.

The first and third chapters look at the effects of asymmetric information in a model in which default risk causes credit rationing. It is shown that when lenders ignore the correct credit ceilings to apply, total or partial default can work as a signal and reveal to the market the hidden information. A round of default, therefore, is followed by new loans. Borrowers who repay get larger loans, since they are identified as being creditworthy, while borrowers who default are punished by severe rationing in the future. It is also shown that for some parameter values the equilibrium is "pooling": Very little lending takes place, and no default is ever observed.

The second essay compares different types of loan indexation in a model in which the borrower's default decision is explicitly analyzed. The main focus is on the comparison between fixed-interest rate loans, which prevailed in international credit markets until the mid '70s, with floating-interest rate loans, which are now largely adopted in lending to LDCs. In a stochastic model in which import prices, export revenues, and the international interest rate are random variables, the two types of loan contracts give rise to different default probabilities. If states of the world with low export revenues for LDCs tend to occur when world interest rates are also low, as evidence from recent years suggests, then at the same level of lending the probability of default is smaller with a floating interest rate than with a fixed one. Consequently, a rationale for the observed contractual arrangements is provided.

It is also shown that fully contingent contracts involving indexation on the both export revenues and the import prices of the borrowing country can usually improve upon both fixed and floating-rate loans, but they may give rise to moral hazard problems when the country can influence export production.