Asymmetries of Information and LDC Borrowing with Sovereign Risk

Abstract

The dramatic rise in the amount and extent of private lending to the lessdeveloped countries following I973 has received widespread attention. During the current recession, the Western press has often reported that creditors were unaware of the total amount of lending to individual LDCs, thereby incorrectly assessing the risk of default. This paper presents a theoretical model of international lending with sovereign risk which emphasises the role of asymmetric information about total debt-service obligations between creditors and debtors. The model is used to explain how sovereign risk leads to important special features observed in LDC borrowing. The characteristics of borrowing by the LDCs on international capital markets have been investigated and described in several recent studies (see, for example, Eaton and Gersovitz (I98I b); Fleming (I98I); Hope (I98I); IMF (I98I and I980); O'Brien (1 98 I) and Wellens (I 977)). Eaton and Gersovitz (1 98 I b), in particular, argue that the threat of possible repudiation of debt by a sovereign country is responsible for the salient differences between market outcomes for LDC borrowing and the nature of loan contracts observed in lending between developed nations and in domestic corporate finance. Access to long-term loans on the Eurobond market is limited to very few non-OPEC LDCs, and most LDCs which receive loans on the private credit market obtain medium-term commercial credit from the major U.S. and European banks. Therefore, LD C debt is typically of shorter maturity than most developed country corporate debt. The lowest income LDCs almost never gain access to the private loan market and rely upon long-term borrowing from official creditors and international agencies. Private creditors are also reported to analyse individual countries' credit-worthiness, that is, their ability, or proclivity, to absorb capital inflows and repay debts. Therefore, the adoption of policies intended to signal credit-worthiness by LDC governments is often observed. Credit on international markets is typically quantity-rationed, with countries having higher rates of saving and investment receiving larger loans at lower rates of interest. Because lenders are often unable to obtain legal remedies for breach of contract in a debtor's political jurisdiction, mutually advantageous contracts common in domestic corporate bond-finance are unenforceable in the international credit market. In the presence of sovereign risk, lenders must rely upon the threatened denial of future credits and the disruption of a debtor's commodity trade or access to trade-finance to discourage the repudiation of debt. In the case of corporate finance, bond convenants and bankruptcy provisions protect creditors from increases in their exposure to default risk created by subsequent borrowing