this may be the case. Our contribution is to provide a relatively simple model that illustrates how IFIs can lend at close to the riskless interest rate and expect to be repaid in all states of nature (as it is always in the country’s interest to repay) and how the existence of preferred creditors, in addition to private lenders (which may su¤er default), may be valuable. Existing papers that consider sovereigns’willingness to pay do not include seniority and those models that include seniority do not appear to consider willingness to pay. We believe that this is the ...rst paper that attempts to provide a theoretical justi...cation for both the existence of preferred lenders and how they may improve welfare.

From the standpoint of the country, borrowing from a private creditor is more expensive, but repayments are ex-post state contingent. In contrast, preferred lenders are in a position to o¤er cheaper more competitive ...nancing but countries must be prepared to repay in all states. In our model, preferred lenders may limit the amount of ...nancing that is o¤ered. The potentially binding constraint for the preferred lender is that it must be repaid in bad states of nature, where the cost of repayment is high, while the potentially binding constraint for private lenders is that they must be repaid in the good state where that cost is low. Hence, while both lenders o¤er loans with the same fair ex-ante returns, ex post outcomes may di¤er.

Our results may also be considered in a more normative fashion as IFIs consider their role in sovereign lending versus that of the market. As the two types of lenders play di¤erent roles, there is no reason to think that IFIs should mirror the behavior of private lenders. Indeed, IFIs add value precisely because they behave di¤erently. If IFIs priced loans to risk, as private lenders do, then this would be tantamount to admitting that their lending is risky and that borrowers may then default. Taking this logic to the limit, IFIs would then become just one more (defaultable) lender among many, and lose their PCT. Rather, we suggest that IFIs should consider where they may add most value given that they can o¤er loans at low rates but subject to the restriction that they expect to be repaid in all states.

We conclude that IFIs should focus their ...repower where the probability of requiring ...nancial assistance is in an intermediate zone. This result holds if preferred lenders are unconstrained in terms of capital and is strengthened if preferred lenders are constrained. Indeed, if the overall lending constraint is very tight, then preferred lenders should refrain from lending to countries with a very high probability of requiring ...nancial assistance in the future, even if ...scal volatility is quite high (and leave this to the market), and concentrate their activities to an even greater degree on the group of countries in an intermediate range regarding the probability of requiring ...nancial assistance in the future. This would maximize the impact of IFI lending.

We also discussed a number of caveats to our results given our relatively simple model. In addition to those, it is worth noting that, as it is common in the sovereign debt literature, we assumed that the market and IFIs cannot o¤er state-contingent contracts, where repayment depends on the realization of the state of nature. Were this the case, it could be possible to improve on the current allocation and countries could be able to borrow more and avoid costly defaults. There are various reasons why such contracts do not exist. Some argue that a ...nance minister is generally not blamed if there is a slump in the global market for an important commodity export but that if a costly hedge is purchased and not needed then there may be an ex-post inquiry as to why resources were “wasted.”There have been various proposals for GDP-indexed debt but here there are concerns that statistics might be manipulated and/or such contracts may be di¢ cult to price. A further intriguing reason, more related to our model, is that, if a state-contingent contract takes the form of requiring lower payments in bad states but higher repayments in good states, then the willingness to repay in the good state may be threatened. In the comparison of the continuing value of the lending relationship versus the cost of repayment, this may actually restrict lending.<sup>34</sup> We also assumed that loans should be repaid at the end of each period and hence we ruled out the possibility that countries might roll-over debt with IFIs and borrow more to avoid repayment when it is most costly to do so. This discussion is closely related to the restriction maintained by the main IFIs that they should not “evergeen”–extend new loans to repay old loans. Had we allowed this, the o¢ cial sector could lend to help countries repay market loans. However, this would go against the principle of “private

> 34 Anderson, Gilbert and Powell (1989) suggest that the World Bank may wish to guarantee such state contingent contracts. The argument is that markets can manage price risks while multilaterals may have a comparative advantage in controlling “performance risks.”This argument depends on the multilateral having some other power of persuasion on the country perhaps coming from its governance structure.

18