LDC Debt
Incentives to borrow

While numerous studies of the 1982 debt crisis have focused on the roles of distorted incentives to lenders or irrational `herd behaviour' by banks, there has been little or no analysis of the borrowing countries' incentives. Yet some developing countries incurred costs that were too large for their actions to be easily reconciled even with ex ante optimality. In Discussion Paper No. 582, Sule Ozler and Research Fellow Guido Tabellini examine the effects of domestic political instability and polarization on borrowing countries' incentives. Intuitively, instability and polarization should increase borrowers' myopia, thus increasing their demand for loans and reducing their willingness to invest. The authors examine the equilibrium effects of these political factors under `moral hazard' and `credit-rationed' regimes. In the first, there is a binding incentive constraint on the equilibrium loan contract, and lenders will accommodate borrowers' increased demand for loans. In the second, the reduction in investment will tighten the credit constraint and hence reduce equilibrium borrowing.
Ozler and Tabellini test their model on panel data for 55 countries for 1972-81 a period of rapid debt accumulation by regressing each country's annual new borrowings from Eurocurrency markets on political variables chosen as proxies for instability and polarization as well as conventional economic variables such as real GDP per capita, the penalty for defaulting, the interest rate and the variability of future income. They use the probability of an imminent change in government (as perceived by the incumbent) as a proxy for political instability, estimating this probability for each country over 1972-81 using a probit model. They use various proxies for political polarization: whether or not the country was a democracy; the percentage of its population resident in urban areas; and the occurrence of political assassinations, strikes and riots.
Ozler and Tabellini classify the sample countries as `credit-rationed' for years in which they had neither an extended fund facility nor a stand-by agreement with the IMF; the `moral hazard' regime applies in all other cases. They find that political instability had a major positive effect on external borrowing in the moral hazard regime, but no effect in the credit-rationed regime. Their empirical results on polarization are ambiguous, however, perhaps because it is harder to measure.

External Debt and Political Instability
Sule Ozler and Guido Tabellini

Discussion Paper No. 582, October 1991 (IM)