**Policy, Research, and External Affairs**

# **Debt and International Finance**

## WPS 441

T his papcr - a prodxuct ol the Debt and International Finanice Division, Intcrnationai Fconomiics Department - is part ot a larger effort in PRE to determirie the conditions un(der which debtor countries benefit froin debt aund debt service reduction operations. Copies are available free fromii **the** World Banik, lXIX H SLrect NW. Washington DC 2(433. Please contact Sheilah King-WaLtson, room S8-025, extension 31(Q47 (57pages}.

The negotiation of sovereign debt repayments and ol new loans after default may yield inefficicnt outcomes that justify intervention by creditor country governments and international financial institutions, **Kletzer** analyzes possible distortions arising in renegotiations between private creditors and sovereign bon3wers. Hc argues that legal privileges accorded to existing creditors in their home jurisdictions can distort the flow of resources lor capital lormation abroad. Seniority privileges for old lenders convey to them some of thc social returns iromii new lending, reducing thc potential rewards for those who might provide the new lunds.

unattalinlblc lor the coalition of lenders due to institutional distortions. The importance of legal institutions within and across creditor countries for eflficicnc y of renegotiations is discussed at length.

Informational asymmetries are an additional source of distortions in the resource allocation sustained through hargaining over repayments and new loans. Because a borrower may be able to conceal that shc would be willing to rcpay as contracted, she **may** be able to renegotiate debt-service obligations to her advantage. In an cquilibrium with imperfect inlormiiation about debtor characteristics, the loan and renegotiation offers made by lenders anticipate this possibility leadling to less initial lenidinig and a faster build-up of a debt overhang.

**A** simple dynamic model is presented in which the motivation for borrowing from abroad is to smooth consumption over timTle when national income is subject to ran(lom fluctuations. The borrower cannot comiti to make IftIure repayments to creditors due to sovereig,n immunity. Payments are ma(de by) the borrower to avoid credible suspecnSions of access to consumiption-smi(x)thing opportunities. hlese arc imposed in the f'uture, in contrast to a repeated static mo(icl in which sanctions are tra(id i lor **pa\** contemnporaneou sly.

Thei paper also presents a mo(icl of strategic bargaining with asy immetric information about the debtor government' **s** oc:ial prclercnces to capture the constrairnL\ that the domiestic political environnicnt imnposes oi debt-servicing. Creditors may dclay agreem ent to clicit private information, and the 1onscqUe1nt ccr suspenSion of inflows leads to a socially ineflicienit capital accumulation path in this dynamic ollo(1t .

Time inconsistency arises because lenders cannot commit to accept luture net resource transk'rs Ahich, in some contingencics, they will wish to renegotiate. Therefore, renegotiation of' simple dcbt contracts **(cx** _post_ need not lead to thc Cquilibrium path achieved usilng state-contingent contracts when comimlitmtiiue is possible. Ncw capital inflows to heavily-indebted countries will not be forthcomiling w\hen luriher lendiing is socially elficient. Thc bargaining cond(Lct in renegotiations of a long-terrm relationship hbet cen lenders and a borrower dcpends on thc commiitmeint opportunities of lcnders and their legal privileges * isa-vis other lenders. Cooperative equilibria can be The anakis stresses the distinction between cxpli,it contracts w ith statc-continigent repa\ ment scheduleS ail long-terimi relationships created by simple contracts that exchange resources ior an ability to imposC sanctions w hose value is ncgotiated cx post, Because institutions created bhy crcditor country governments conv e _legal_ privileges that distort the allocatiorn of resources in the bargaining process, the paper urges investigation of oflicial alienation of these privileges, regulatory relorit, and intr(xouction of alternative financial instrumeints that cmtxxiy op urtUnitics forcrc(itor comm1litment.

The PRE Working lap-r Series disseminates the Findings of \Aork unrder **Aa\** in th. Bank's Potlicy Research. and External Affairs Comptex. An objective of the series is to get these lindings out quickly. csen if presentittions are less than fully polished. The findings. interpretations, and conclusions in these papers do iot necessarily represent official Bank policv P"roduCd h\ the PR _E_ 'einter