Investment Incentives and Renegotiation in International Lending
GEORGE C. ANAYIOTOS
Debt finance creates incentives for underinvestment when a country does not precommit its investment decision. This is partly the result of inefficient risk sharing between the debtor and the creditor in international lending. Considering the fact that international debt contracts have not been written to delegate risks to the two parties efficiently, it is not a surprise that a debt crisis would arise when adverse developments affect either debtors or creditors. In addition to these problems of risk sharing, we consider incentive problems that are present in international lending. The distortion of investment incentives in a country where there is a need for repayment of external debt arises in a one-period model. It is a well-established result in agency theory that when some aspect of investment (level, riskiness, productivity) is a private decision of the country-agent and is not observed or monitored by the lender, the country has incentives to underinvest by tive net present value projects. Even if the international loan contract is designed to provide incentives for high levels of investment, risk sharing between lenders and borrowers will typically be inefficient. It is difficult to avoid this trade-off between optimal risk sharing and incentives in international lending. To achieve efficient risk sharing along with high incentives for investment, we need more complex financial contracting and more complete international financial markets.
This chapter addresses the problem of underinvestment that arises when countries do not precommit their investment level at the time of signing a loan agreement. The issue that precommitments by countries are not generally credible is analyzed together with the fact that international debt contracts are not enforceable. In the presence of sovereign risk and because it is costly for lenders to impose various penalties on countries that default, there is a strong incentive for both parties to act cooperatively and renegotiate their initial agreement when default is likely.