metadata: authors: 0: author: Cordella,Tito
1: author: Powell,Andrew P.
count: World
docna: 0: docna: Preferred and Non-Preferred Creditors
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,External Debt,Debt Relief and HIPC,Debt Markets,International Law,Legal Reform,Regulatory Regimes,Legislation,Social Policy,Legal Products,Judicial System Reform,Capital Flows,Capital Markets and Capital Flows
teratopic: Social Development,International Economics and Trade,Law and Development,Governance,Public Sector Development,Finance and Financial Sector Development
abstracts: cdata!: International financial institutions
            (IFIs) generally enjoy preferred creditors treatment (PCT).
            Although PCT rarely appears in legal contracts, when
            sovereigns restructure bilateral or commercial debts they
            normally pay IFIs in full. This paper presents a model where
            a creditor, such as an IFI, that can commit to lend limited
            amounts at the risk-free rate and can refrain from lending
            into arrears is always repaid and adds value. The analysis
            suggests that IFIs should not mimic commercial lenders, but
            exploit their complementarity, even if banning commercial
            borrowing can sometimes be optimal. IFIs should also focus
            on countries with limited market access and should not be
            forced into debt restructurings.
repnme: repnme: Preferred and Non-Preferred Creditors
display_title: Preferred and Non-Preferred Creditors
listing_relative_url: /research/2019/07/31265289/preferred-non-preferred-creditors
topicv3: Debt Relief m1326505 452,Multilateral Debt Relief Initiative
            m1326708 1138,Trade m1326924 698,Capital Markets m1326967 332,International Law m1327532 962
publishtoextweb_dt: 2019-07-22T00:00:00Z
historic_topic: Social Development,International Economics and Trade,Law and Development,Governance,Public Sector Development,Finance and Financial Sector Development
no_of_pages: 28
author_keys: 0: author_key: 879396
1: author_key: 428666
model_extractions: Policy Research Working Paper 8941 Preferred and Non-Preferred Creditors _Tito Cordella Andrew Powell_ Development Economics Vice Presidency Knowledge and Strategy Team July 2019
Policy Research Working Paper 8941

# **Abstract**

International financial institutions (IFIs) generally enjoy preferred creditors treatment (PCT). Although PCT rarely appears in legal contracts, when sovereigns restructure bilateral or commercial debts they normally pay IFIs in full. This paper presents a model where a creditor, such as an IFI, that can commit to lend limited amounts at the risk-free rate and can refrain from lending into arrears is always repaid and adds value. The analysis suggests that IFIs should not mimic commercial lenders, but exploit their complementarity, even if banning commercial borrowing can sometimes be optimal. IFIs should also focus on countries with limited market access and should not be forced into debt restructurings.

This paper is a product of the Knowledge and Strategy Team, Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted attcordella@worldbank.org and andrewp@iadb.or.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Preferred and Non-Preferred Creditors<sup>�</sup>

Tito Cordella<sup>y</sup> and Andrew Powell<sup>z</sup>

**JEL Classification Numbers:** F34, H63, O19, P33

**Keywords:** Preferred Creditor Treatment, Preferred Creditor Status, Sovereign Debt, Sovereign Defaults, International Financially Institutions, Emergency Financing.

> �We would like to thank Shanta Devarajan, Aitor Erce, Paolo Garella, Bernardo Guimaraes, Aart Kraay, Leonardo Martinez, Alessandro Missale, Andrew Neumeyer, Ugo Panizza, Anushka Thewarapperuma, Harold Uhlig, as well as participants at the 2018 ESM Workshop on “Debt sustainability: Current Practices and Future Perspectives,” at the DebtCon3 conference at Georgetown University, at the 2019 World Bank ABCDE conference, and at seminars at the University of Milan and at the Research Department of the IDB for constructive comments and suggestions. The usual disclaimers apply.

> yThe World Bank, tcordella@worldbank.org

> zInter-American Development Bank, andrewp@iadb.org
# 1 Introduction

The role of international ...nancial institutions (IFIs) in the global ...nancial architecture has been widely analyzed both by academics and by the international policy community.<sup>1</sup> Much has been discussed about their role as providers of emergency funding but a long-standing central puzzle remains. Namely, the International Monetary Fund (IMF) and the main multilateral development banks (MDBs) enjoy Preferred Creditor Treatment (PCT) in relation to their sovereign lending, meaning that they are expected to be repaid even if the borrower restructures private or bilateral debt. And yet, while PCT is critical for the operating model of IFIs, and the Paris Club Agreed Minutes exonerate IFIs from a “comparability of treatment”clause, their preferred standing is not strongly backed in international law.<sup>2</sup> At times, the preferred treatment of IFIs has been called into question. Perhaps, the most emblematic of such discussions to date has been when Greece fell into arrears with the IMF in July 2015.<sup>3</sup> On the other hand, during the prolonged “trial of the century” following Argentina’s 2002 default, IMF liabilities were paid early and in full. While there were many attempts from hold-outs to disrupt payments to creditors that accepted the 2005 restructuring and subsequent o¤ers, there was virtually no mention of Argentina’s preferred lenders in those cases, nor any serious attempt to crowd them in.<sup>4</sup> Similarly, in many recent bond restructurings, private creditors su¤ered changes in contracts and present-value haircuts but IFIs were eventually paid in full.<sup>5</sup> The persistence of IFIs’ preferred-standing is intriguing, especially given that it is a market practice, which is not backed by any contractual clause. The resilience of PCT, together with the lack of any strong legal foundation, suggests that it should be understood as an “equilibrium outcome.”And yet we know of no economic model to date that shows this to be the case. Sovereign debt models that focus on “willingness to pay” do not consider seniority,<sup>6</sup> while those that focus on seniority<sup>7</sup> assume it, without explaining its origin. Despite the vast literature on international ...nancial architecture and sovereign debt restructuring, and despite the critical nature of PCT to the operations of the main IFIs, to our knowledge there is no model that explains why sovereign borrowers treat such lenders as preferred. This paper attempts to ...ll this gap. Our contribution is to develop a model that endogenizes the repayment decision of both commercial and IFI creditors,<sup>8</sup> to show how such decisions are interdependent, and to describe the potential advantages and

> 1 We review relevant academic literature in the next section. As examples of the policy discussion, see Council of Foreign Relations (2018) and the section on the global ...nancial safety net in G20 Eminent Persons Group on Global Financial Governance (2018).

> 2 “The Paris Club Agreed Minutes ‘comparability of treatment’ clause aims to ensure balanced treatment of the debtor country’s debt by all external creditors. In accordance with this clause, the debtor country undertakes to seek from nonmultilateral creditors, in particular other o¢ cial bilateral creditor countries that are not members of the Paris Club and private creditors (mainly banks, bondholders and suppliers), a treatment on comparable terms to those granted in the Agreed Minutes.” See: http://www.clubdeparis.org/en/communications/page/what-does-comparability-of-treatment-mean On the other hand, see Martha (1990) and Schadler (2014) on the lack of strong legal standing for PCT in international law.

> 3 See, for example, “Defaulting on the IMF: A stupid idea whose time has come,” Financial Times, Alphaville, July 1st, 2015.

> 4 For example, in Cruces and Samples (2016) account of Argentina’s “trial of the century” there is virtually no mention of Argentina’s senior creditors.

> 5 Such cases include Belize, the Dominican Republic, Jamaica and Uruguay. A set of low income countries also obtained debt relief under the Multilateral Debt Relief Initiative (MDRI). Broadly speaking these countries did not have market access and, as we are most interested in understanding why countries may treat IFIs as preferred in relation to market lending, they are special cases. Still one interpretation is that IFIs extended loan volumes greater than those consistent with risk-free lending. Moreover, there have been cases of arrears with IFIs. Still, with just three countries in long-standing arrears to the IMF, Oeking and Simlinski (2016) argued that persistent arrears to that organization may be a thing of the past. At the time of writing, the República Bolivariana de Venezuela is accumulating arrears with the Inter-American Development Bank (IDB). In keeping with the expectation of being paid both capital and interest in full, the IDB is making provisions solely on interest on interest payments, which is not charged. Five countries are currently in arrears with the World Bank: Eritrea, Somalia, Sudan, the Syrian Arab Republic, and Zimbabwe.

> 6 See, for instance, the classic papers by Eaton and Gersovitz (1981), Bulow and Rogo¤ (1989), Kletzer and Wright (2000) or, for a more up-to-date discussion, Aguiar and Amador (2014).

> 7 See, e.g., Bolton and Jeanne (2009), Boz (2011), Chaterterjee and Eyigungor (2015), Gonçalves and Guimaraes (2015), Hatcheondo et al (2017), Corsetti et al (2018).

> 8 Throughout the paper we use IFIs and multilateral lenders/debt interchangeably. We thus ignore the fact that some

1
trade-o¤s faced by countries that may borrow from both the market (commercial lenders) and IFIs.

In what follows, we develop a relatively simple model of emergency ...nancing<sup>9</sup> that allows us to obtain a set of analytical results. This contrasts with much of the recent literature, which tends to rely on numerical simulations. To keep things straightforward, our model abstracts from several important real-world features such as liquidity and creditor coordination issues as well as reforms and conditionality. Our aim is to understand the fundamental di¤erences between IFIs and private lenders, focusing on the underlying incentives for a country to borrow and to repay each type of creditor. We show that IFIs are preferred because their bylaws allow them to commit to (i) lend limited amounts at close to the risk-free rate under most circumstances, and (ii) refrain from lending until any unpaid arrears are cleared. This avoids the possibility of debt dilution, sets IFI lending aside from private lenders, and explains why, in many instances, the presence of IFIs adds value. However, we also ...nd that preferred lending may be constrained by a country’s willingness to honor the commitments made, with the constraint depending on the probability and the severity of future shocks, on repayment costs and on the country’s access to private lenders, which, in turn, depends on similar parameters.

In a similar vein to the common statement in corporate ...nance that if all ...nancing is debt then none is (it turns into equity), we may quip that if all lending is preferred then no lending is. Preferred lending cannot be unlimited, otherwise it may not be considered as preferred. From a normative standpoint, our analysis suggests that if the capital or resources of preferred lenders are restricted, they may wish to concentrate their activities in countries where there is a signi...cant bene...t to having access to such emergency lending when needed but where that need may be relatively infrequent. If emergency ...nancial assistance is required frequently, or is extremely rare, market solutions may be just as good and private lenders may even dominate IFIs. In addition, we ...nd that there are situations in which a country is better o¤ if it cannot borrow from the market, providing a justi...cation for restrictions on commercial lending under certain speci...c conditions.

In the next section, we review the literature on di¤erent aspects of PCT. In section 3, we introduce the basic model and study the case in which the country borrows from an IFI. In section 4, following the standard sovereign debt literature, we assume that the country relies on private lenders. In section 5, we allow for the simultaneous presence of multilateral and private lenders. Section 6 discusses how a capital constrained IFI should optimally allocate its resources, while section 7 looks at some of the key assumptions of the model and discusses the robustness of the results. Finally, section 8 provides a set of policy implications and concludes.

# 2 On preferred creditor treatment, a brief review

Our paper borrows from several strands of literature on IFIs and PCT. First, a number of papers have discussed potential explanations for why IFIs may enjoy PCT, although none contains a model illustrating how it can be supported as an equilibrium outcome. Among these, Buiter and Fries (2002) suggest countries may confer PCT to IFIs in return for competitive lending rates. Levy Yeyati (2009) argues that PCT is related to an insurance motive–namely the expectation that IFIs will extend credit during a crisis. Humphrey (2015) stresses IFIs mutual ownership structure. Risk Control (2017) collects statistics related to these three potential “drivers”of PCT (favorable rates, countercyclical lending, cooperative nature of the institutions) and ...nds evidence that IFIs do indeed extend funds at lower rates than the market, that they are countercyclical, and that they lend in bad times. The paper also compares the degree of “mutuality” of each institution and discusses how that may a¤ect preferential treatment.

Second, within the large empirical literature on sovereign defaults, a subset of papers consider defaults (and the building up of arrears) on IFIs. Schlegl et al (2015, 2019) claim a hierarchy in seniority with the IMF and MDBs at the top. Their analysis is based on World Bank data and covers 127 countries from 1980 to 2006. Considering arrears, bonds appear below MDBs in the pecking order, and then come bilateral lenders, banks and trade credit. The analysis also shows that not all multilateral lenders are treated equally;

> multilateral lenders such as the IFC (the private sector arm of the World Bank Group) do not generally claim preferred status.

> 9 Focusing on emergency lending (and abstracting from lending for consumption-smoothing motives in normal times) provides a clean way to illustrate how a preferred lender could exist as an equilibrium outcome.

2
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These inequalities are veri...ed for “reasonable”parameter values. For instance, in the numerical simulations we present below, where we assume a = 8, � = :6, k = 3:25, (A1) is met for all � 2 [0; 1].

# 3.1 IFI lending

We start our analysis by considering the case in which the country only has access to an IFI.<sup>15</sup> IFIs are di¤erent from commercial lenders since, according to their internal rules, they normally lend at rates well below market anticipating that they will receive preferential treatment and be repaid during periods of debt distress. Indeed, some MDBs’internal risk models essentially assume a zero probability of default on the loan principal and signi...cant adjustments are required to standard risk models applied by rating agencies to analyze MDB risks.<sup>16</sup> While some IFIs have di¤erent facilities with di¤erent interest rates, to a ...rst approximation these rates are close to the risk-free rate.<sup>17</sup> However, as we investigate below, this means that, in equilibrium, countries should only borrow amounts that they are willing to repay under all possible circumstances. For this risk-free lending to be sustainable in equilibrium,<sup>18</sup> we assume that, in contrast to the market, IFIs can commit to speci...c lending volumes. We also assume that if a country defaults on an IFI it is excluded from borrowing from any IFI until it fully repays the arrears. This re‡ects IFIs’actual rules and working practices.<sup>19</sup> At time t, the value function for the country, assuming that, if ...nancial assistance is needed, it borrows LIt from an IFI at the risk-free interest rate, and it repays both in the high- and in the low-repayment-cost state, is given by: where subscript I denotes IFI. Equating VIt with VIt+1, we can rewrite the value function as For the loan to be risk free and support the speci...cation of this value function, the country must be willing to service the loan in the high-repayment-cost state. This is the case if that is, when the continuation value of the o¢ cial lending relation VI , net of the repayment cost kLI , is 1 greater than the continuation value of defaulting, which is given by � �P=t �<sup>(t��)</sup> C = � 1<sup><u>�</u></sup> �<sup>C</sup> �<sup>.Also,aswe</sup> mentioned above, we rule out the possibility for the country to default on the o¢ cial sector if the highrepayment-cost state materializes and then to clear its arrears in the next draw of a low-repayment-cost state. This is the case when

> 15 While we assume one IFI lender, our analysis would carry through if there were more IFIs assuming that they coordinate, which is usually the case during emergencies.

> 16 As discussed above, arrears and delays to repayment have occurred but in virtually all cases, principal and interest have eventually been repaid in full. Some MDBs do not charge interest on delayed interest.

> 17 Actually, IFIs lend slightly above the risk-free rate to cover their own operational costs.

> 18 As will become clearer, we are here referring to the case in which risk-free lending is not a market equilibrium.

> 19 For instance, the IMF’s ability to lend to a country is (at least in principle) a multiple of the country’s IMF quota. The IBRD lending envelope to any particular country is approved by the World Bank board every 4 years in the Country Partnership Strategy and is a function of each country’s size, needs and ability to repay. As per the no-lending into arrears clause, there is indeed a mutual understanding between IFIs that arrears to di¤erent institutions have to be cleared simultaneously. For instance, according to IMF (2013), “The Fund maintains a policy of non-toleration of arrears to o¢ cial creditors. Fund supported programs required the elimination of existing arrears and the non-accumulation of new arrears during the program period with respect to o¢ cial creditors,” (p.48).

6
where (k � 1)LI is the amount the country “saves” by repaying the creditors in the low-repayment-cost states, and 1�(1���)�<sup>(aLI�</sup><sup><u>1</u></sup> 2<sup>L</sup> I<sup>2)theexpectedcostofthelackofaccesstocredit.20Whenthisisthecase,</sup> we have that Proposition 1 The optimal amount of IFI lending is given by and the associated utility by

## Proof : In Appendix.

According to Proposition 1, if the probability of requiring emergency ...nancial assistance is su¢ ciently low, � � <u>�I</u> , then risk-free IFI lending is not supported in equilibrium and the country cannot improve on �C in that case. The reason is that, given the low probability of requiring assistance, the borrower will default in the bad state when repayment costs are high as the value of the relationship with the o¢ cial lender is insu¢ cient to outweigh such costs. On the other hand, when the probability of requiring assistance is su¢ ciently large, � � b�I , the lending relation is valuable enough to allow the IFI to lend the optimal unconstrained amount. For intermediate values of � (b�I > �> <u>�I</u> ), IFI lending is supported in equilibrium, but the participation constraint (ensuring that the IFI is repaid in the bad state) binds. This constraint then determines the amount of IFI lending.

The optimal amount of IFI lending, as a function of �, is illustrated in Figure 4. In Proposition 1, we have expressed the three regimes as a function of �, the probability of requiring ...nancial assistance. However, the critical values <u>�I</u> and b�I , also depend on the other parameters. More precisely, <u>�I</u> and b�I both increase in a and in �, and decrease in k. As discussed above, a is a measure of the value of emergency lending and thus, the higher is a, the higher is the opportunity cost of defaulting. So higher values of a support larger amounts of IFI lending. Similarly, the higher is � and the lower is k, the lower is the expected cost associated with servicing the debt in the high-repayment-cost state, which may be written as (1 � �)k, and thus the higher is the value of maintaining the relationship with the IFI and being able to borrow in the future. This, in turn, implies that higher values of �, or lower values of k, also support larger volumes of IFI lending.

# 4 Market lending

Consider now the case in which the country only borrows from private lenders, which we refer to as the market. The key di¤erences between market and IFI lenders are that private lenders are willing to extend credit even in the presence of default risks and that, being unable to commit to a maximum amount of lending, they may face a dilution problem. Private lenders are competitive and risk neutral and to break even they must charge an interest rate commensurate with the risk-free interest rate adjusted for the probability of default. Loans are short term as before. As mentioned above, we assume that if the country defaults it cannot regain access to credit from the market.<sup>21</sup>

> 20 The expected cost of the lack of access to credit is the cost of lacking access to credit in the next period should there be a need for emergency assistance (with probability �), and in the period after should there be a further need and the country again faces a high-repayment-cost state (with probability �<sup>2</sup> (1 � �)) and so forth. Hence it is equal to (� + (1 � �)�<sup>2</sup> + (1 � �)<sup>2</sup> �<sup>3</sup> + :::)(aLI � 2<sup><u>1</u>L</sup> I<sup>2) =</sup> 1�(1���)�<sup>(aLI�</sup> 2<sup><u>1</u>L</sup> I<sup>2).</sup>

> 21 Had we assumed that, after a default, the borrower could borrow again from the market with a certain probability in the subsequent period, the qualitative results of the paper would remain the same.

7
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To solve for the optimum amount of market lending, we start by assuming that the borrower always defaults in the high-repayment-cost state so that the gross interest rate is 1=�. Again, we assume that in each period � , loans are short term and must be repaid at the end of the period. In the initial period t, the value function for the country–assuming it borrows LMDt from commercial lenders at the risk-adjusted interest rate and pays the total due amount LMD� <u>t</u> in the low-repayment-cost state, which occurs with probability �, is given by where superscript MD denotes market (M ) lending when repayment occurs in the low-repayment-cost state and default (D) in high-cost-repayment state. Again, � 1<sup><u>�</u></sup> �<sup>C</sup> �<sup>isthecontinuationvalueassumingdefaultin</sup> the bad state and no lending. Equating VMDt with VMDt+1; the value function can be written as For the market to be willing to o¤er loans at this interest rate, the country must be willing to repay the debt in the low-repayment-cost state. This condition can be written as The optimal amount of borrowing is then found by maximizing (8) subject to the constraint (9). The results are summarized in Lemma 1.

Lemma 1 If the country defaults in the high-repayment-cost state, and it repays its debt in the low-repaymentcost state, the optimal amount of borrowing is given by and the associated utility is given by Proof : In Appendix Thus, also in the case in which the country borrows from the market (and defaults in the high-repaymentcost state) there are three di¤erent regimes. If the probability of requiring ...nancial assistance is low, � � <u>�M</u> , the market cannot lend as it will not be repaid: the value of the borrowing relationship is so low that the country always ...nds it in its interest to default (even in the low-repayment-cost state). On the other hand, if the probability of requiring emergency lending is high, � � b�M , then maintaining the relation with private lenders is very valuable and the unconstrained optimal amount of market lending can be supported in equilibrium. In intermediate cases, <u>�M</u> < �< b�M , the private sector is willing to lend, but the constraint that the lender must be repaid in the low-repayment-cost state binds. This repayment constraint then determines the amount of market lending.

In the above, we derived the optimal amount a country can borrow from the market when there is default in the high-repayment-cost state and when the country repays in the low-repayment-cost state. For 9
this to be an equilibrium, it should indeed be the case that it is in the country’s interest to default in the high-repayment-cost state, that is, where VND is the value of borrowing from the market L<sup>�</sup> MD<sup>whenthemarketchargestheriskadjustedrate,</sup> but the country never defaults. Of course, this condition is always veri...ed if � � b�M : if the non-default constraint is binding in the low-repayment-cost state, it is a fortiori binding in the high-repayment-cost state. In the Appendix, we show that, when �> b�M the country has no incentives in deviating from the MD strategy if with If, instead, �> �<sup>c</sup> , and �<sup>c</sup> < 1 then the country will not default in any state<sup>22</sup> and the market is thus willing to o¤er the very same loan the IFI o¤ers at the risk-free rate.<sup>23</sup> Hence, it follows that Proposition 2 If <u>�M</u> � � � �<sup>c</sup> , L<sup>�</sup> M<sup>=L�</sup> MD<sup>istheequilibriumlevelofmarketborrowing,andthecountry</sup> defaults in the high-repayment-cost state, while if �> �<sup>c</sup> , L<sup>�</sup> M<sup>=L�</sup> I<sup>istheequilibrium,themarketcharges</sup> the risk-free rate, and there is no default in either state.

Proposition 2 con...rms the intuition that, when the need for ...nancial assistance is rare, the incentives of a country to repay are lower and market lending cannot be risk free. In contrast, if there is a more frequent need for ...nancial assistance and so the country would like to borrow from the market in the future, then this implies that the value of keeping the borrowing relation in good standing may be high enough that the market can mimic the o¢ cial sector and also lend risk free.<sup>24</sup>

# 4.1 Comparison between market and IFI lending

Looking at Figure 4, which compares market and IFI lending, it is evident that, for low values of �, no lending, IFI nor market, can be supported in equilibrium. When � is too small, the value of the lending relationship is low so that the country will have the incentive to default, even if the cost of repayment is low. At higher values of �; �> <u>�M</u> , market lending is supported, the country will repay in the low-repayment-cost state and default in the high-repayment-cost state. At somewhat higher values of �; �> <u>�I</u> ; the IFI can lend and, as the value of the relationship is higher, it can expect to be repaid even in the high-repayment-cost state.<sup>25</sup> At still higher values of �, the market can replicate the IFI and also lend risk free. The comparison between market lending and IFI lending is most interesting for intermediate values or �; when � is high enough to support both types of lending but not so high to eliminate the di¤erence between the two. We can then show that Proposition 3 For low values of �, �< e�, the utility level associated with market lending is higher than that associated with IFI lending. For intermediate values of �, � 2 [e�; �<sup>c</sup> ], the utility associated with IFI lending is higher than that associated with market lending. For su¢ ciently high values of �, �> �<sup>c</sup> > b�I , the utility value of market and IFI lending is the same.

> 22 Notice that �c < 1 () �> a+22kk�1<sup>,aconditionthatweassumeholdstruetosimplifythediscussionofthedi¤erentcases.</sup>

> 23 This follows directly from the fact that if the country has no incentive in defaulting on L�MD<sup>inthehigh-repayment-</sup> cost state, a fortiori it will have no incentives in defaulting on the optimal amount of borrowing L<sup>�</sup> I<sup>.</sup> The argument is so straightforward that we omit the formal proof.

> e� 24is Noticethe valuethatofthe�, equilibriumsuch that �>characterizede� () VI<sup>�</sup> above,> VMD<sup>�</sup> is<sup>.</sup> not<sup>There</sup> necessarily<sup>canbe</sup> the<sup>another</sup> only market<sup>equilibrium</sup> equilibrium<sup>inthis</sup> in<sup>interval</sup> the interval<sup>where</sup> (e�; �<sup>the</sup> c)–where<sup>market</sup> believes that the country always repays creditors and thus charges the risk-free rate. However, we can show that Propositions (2), and (3) below hold true if we had selected the other equilibrium.

> 25 Condition (A1) implies that <u>�M</u> < <u>�I</u> < b�M < b�I :

10
## Proof: In Appendix.

Proposition 3 implies that, as shown in Figure 4, when the probability of requiring emergency ...nancial assistance is low, market lending dominates IFI lending. The intuition is that, given the existence of a high-repayment-cost state, market lending de facto o¤ers a state-contingent contract. Given that ...nancial assistance will only be needed again with a low probability, the costs associated with losing market access are limited, when compared with the gains associated with state-contingent repayments/defaults. Hence, for low values of �, the utility associated with market lending is higher than that associated with IFI lending. When the probability of requiring ...nancial assistance in the future is large, the market and IFIs o¤er the very same volume of lending, at the same price, and thus they bring the same utility levels. For intermediate values of �, however, the utility associated with IFI lending is higher. It is more valuable for the country to obtain a lower rate of interest and to be assured continued access than to pay a higher rate, default and lose access. IFIs are able to o¤er this contract (and maintain preferred creditor status), as they can limit their lending to volumes that are consistent with repayment in all states. In our model, preferred creditors do not price risk, by de...nition they lend risk free. Instead, they manage risk by restricting credit volumes, if, and when, it is necessary to do so.

# 5 Market and IFI lending-The blended case

In the previous section, we discussed IFI and market borrowing separately and independently of each other. However, in general, countries may borrow both from the market and from IFIs; in such a situation, the volume of market lending will a¤ect optimal IFI lending and vice versa. In addition, even if the market does not lend, the very possibility that it can lend may a¤ect the volume of lending extended by a preferred creditor. In this section, we thus allow the country to borrow both from a set of competitive private lenders and from an IFI. Once again we will investigate feasible and optimal lending allocations imposing the restriction that the preferred lenders should be repaid in all states. We refer to this as the blended case, denoted by the subscript B.

An important assumption is that there are no cross-default clauses between IFIs and private creditors so that, if the country defaults on the market, it can continue to borrow from IFIs and vice versa. Indeed, we work under the premise that IFIs o¤er the same terms when the country is in good standing with the market as when it is in default. As we do not want to load the results in one direction or another we also assume, in symmetric fashion, that the market can o¤er the same terms whether the country defaults on IFIs or not. Assuming that the country always repays the IFIs, that the country repays the market in the low-repayment-cost state and defaults in the high-repayment-cost state, the value function can be written as

## where

and where (16) denotes the value of the relation with the IFI, in similar vein to (1), and (17) represents the additional utility associated with borrowing LMB from the market at an interest rate of 1=�.

As discussed previously, IFIs di¤ers from the market in that they can commit to the amounts they lend, while there can be no such commitment from commercial lenders. It is natural therefore to solve the blended case assuming that the IFI moves ...rst (as a Stackelberg leader) and decides how much to lend anticipating the volume of loans that the country would then choose to take from the market, with the interest rate charged by private lenders re‡ecting the default risk. When we solve for the optimal amount of market lending for a given level of IFI lending, we obtain 11
Lemma 2 If the country defaults on the market in the high-repayment-cost state, and honors its debt in the low-repayment-cost state, for any given amount of risk-free IFI lending LIB, the optimal amount of market borrowing is given by and the associated utility by Proof : In Appendix.

Once again, there are three di¤erent regimes and, in this case, we choose to di¤erentiate them by the amount of IFI lending o¤ered, so that (18) can be thought of as a reaction function–how market lending responds to the chosen volume of lending by the IFI.<sup>26</sup> Such a reaction function has a di¤erent speci...cation in each regime. In the ...rst regime, the volume of IFI lending is low and the volume of market lending is unconstrained. This means that, for each additional dollar of o¢ cial lending, market lending is reduced one to one. In the second regime, the volume of IFI lending is higher, and the market-repayment constraint in the low-repayment-cost state is now binding. Here, for each additional dollar of IFI lending, market lending must thus fall more steeply. In the third regime, IFI lending is higher still and no market lending is supported.

The constraint that the private sector must be repaid in the low-repayment-cost state is embedded in these reaction functions but, so far, the fact that preferred creditors must be repaid in all states has been ignored. A necessary and su¢ cient condition for the IFI to always be repaid is that, in the high-repaymentcost state, the country is better o¤ repaying, rather than defaulting and relying henceforth solely on the market.<sup>27</sup> Formally: De...nition 1 LI is risk free i¤ and the set L<sup>�</sup> IB<sup>whereIFIlendingisriskfreeis</sup> Let us now start investigating under which conditions IFI lending is risk free and how the di¤erent variables a¤ect the set L<sup>�</sup> IB<sup>.Webeginbyprovingthat</sup>

> Lemma 3 If k<sup>a</sup> �<sup><u>a</u></sup> 1�<sup>�</sup> �<sup><u>�</u>>k>�(�</sup> 4(1<sup><u>(a�</u></sup> �<sup>1</sup> �<sup><u>)</u></sup> )<sup>�2)</sup> � k<sup>b</sup> ; for a su¢ ciently high probability of requiring ...nancial assistance (�> �<sup>a</sup> > <u>�I</u> ) the set L<sup>�</sup> IB<sup>whereo¢ciallendingisriskfreeisnonempty.</sup>

> 26 Note that we do not allow IFIs to re-optimize should the country default on the private sector. A justi...cation for this is that countries’lending envelopes with IFIs tend to be relatively ...xed. Moreover, re-optimization would imply greater lending from IFIs, but this is generally frowned upon as it may be seen as rewarding a country that had defaulted on the market. Technically, the continuation value of only being able to borrow from IFIs is like a constant outside option and so this assumption has little bearing on the overall nature of most of the results. See also the discussion below.

> 27 To simplify the analysis and to focus on the policy relevant cases, we rule out the possibility for the country to default on the IFI, to borrow from the market, and use the lending proceeds to repay its IFI arrears and resume IFI borrowing.

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feasible and the optimum consists of solely borrowing from the market. At ...rst the market is constrained by the repayment constraint in the low-repayment-cost state. In this region, the optimal amount of market lending rises with �. As the probability of negative shocks rises, the value of the relationship with private lenders also rises and so does optimal market lending. As � rises further, the constraint becomes irrelevant– this is the part of the red line that is horizontal, and market lending is at the optimal level and independent of �. As � continues to rise, risk-free IFI lending becomes feasible and becomes part of the optimal allocation. As noted above, as IFI lending rises, with higher �, market lending falls in the blended optimum.

To understand the interaction between the market and IFI schedules fully (the red and the green lines) it is useful to note (comparing Figure 5 with Figure 4 or considering Figure 6 below) that when both the market and IFI lenders are present, preferred IFI lending is feasible only for values of � that are higher than those for which, absent market borrowing, IFI lending is feasible. The reason is that the very presence of a market alternative increases the incentives to default on IFI loans. Intuitively, when the VI and the VMB e schedules cross, at � = �, the value of market and IFI lending are the same. Hence, it would be in the country’s interest to default on the IFIs (saving on debt service) and borrow from the market; this makes preferred lending infeasible. For higher values of �, the advantages of IFI lending vis-à-vis market lending are greater and a positive volume of both IFI and market lending may be sustained in equilibrium. But then, at a higher value of � (� = �<sup>c</sup> ), the market is able to also o¤er risk-free loans, and this undermines IFIs’ability to lend risk free and being repaid in equilibrium. Formally, we can prove that Proposition 4 If k 2 [k<sup>b</sup> ; k<sup>a</sup> ] and � 2 (�<sup>a</sup> ; �<sup>c</sup> ), L<sup>�</sup> IB<sup>> 0andthepresenceofIFIsstrictlyimproveswelfare.</sup>

## Proof : In Appendix

As IFI safe lending becomes feasible, it is at ...rst constrained (the optimum is at the frontier of the feasible set) and as � rises, the optimal level of IFI lending increases and market lending falls. At higher values of �, IFI lending becomes unconstrained and the market becomes constrained–this is where the optimum for IFI lending leaves the frontier of the feasible set. In this region, the IFI o¤ers loans at lower interest rates, but which may become onerous to repay in the high-repayment-cost state; in contrast, the market o¤ers loans at higher interest rates but will face default should the high-repayment-cost state materialize. Of course, the higher the probability of requiring emergency lending �, the higher is the appeal of relying on IFI vis-à-vis market lending so that, as � rises, optimal IFI lending also rises, while optimal market lending falls.

In order to better understand the welfare implications of the three di¤erent types of lending, in Figure 6, we plot the value of the di¤erent lending relation (6a), the lending volumes (6b), and the welfare associated with the blended case with that of only the market and only IFI lending–to assess the welfare contribution of IFI lending (6c and 6d).

As discussed, for low values of � (�< e�), market lending is preferred. Things become more interesting in the interval [e�; �<sup>b</sup> ] where IFI lending is optimal but not feasible in the blended case. This is because the very presence of market lenders would induce the country to default on IFIs and thus to be able borrow (solely) from the market. In this region, it would be in the country’s self-interest to be barred from borrowing from private creditors and only borrow from IFIs. The existence of the market reduces welfare in this region and so, if private lending can be barred, in the interval [e�; �<sup>b</sup> ] the country can borrow larger amounts from IFIs and this strictly improves welfare–see Figure 6d. Note that having the possibility of blended lending adds most value (relative to just market) in the intermediate region for �–see Figure 6c.

# 6 Optimal “capital allocation”

Until now, we have assumed that IFIs always have the necessary resources to lend to any particular country as much as they want, provided the amount is compatible with maintaining PCT. However, there may well be quantitative restrictions on the total amounts IFIs can lend. Indeed, greater lending implies larger capital and overhead costs and, while the IMF and MDBs have di¤erent ...nancial models, in the end lending is 14
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value of the lending relationship.<sup>33</sup> In addition, in the case of a high probability of requiring assistance but where such assistance had a relatively low value, then we ...nd that the market could provide lending with a similar value than IFIs. This could be considered as akin to normal business-cycle lending, perhaps more common in some advanced economies.

As per the intensity of the emergencies, we assumed that it is equal to a ...xed parameter C. We did not vary that parameter in our analysis. Instead, we paid more attention to the parameter a, the marginal value of lending. One way to think about the parameter a is as a measure of the severity of these emergencies. Following the above discussion, the value of the lending relation should depend not only on the values of a and �, but also on their correlation.

In our analysis, the key parameter that di¤erentiates the value of IFI and market lending is k, the cost of repayment in the high-repayment-cost state. The higher is k, the more valuable is market lending because of the state contingency. Notice that, having normalized the cost of repayment in the low-repayment-cost state to one, k can be thought of as a “measure”of the volatility of the cost of servicing the debt, and hence as a measure of the volatility of ...scal revenues or of ...scal needs.

With the aim of simplifying the analysis, we assumed that k could only assume two values which we can think of as high or low. In such a world, to o¤er loans at the risk-free interest rate, IFIs need to limit their lending to be repaid in both states. The market may then o¤er contracts that will be paid only in the low repayment cost state and where there is default in the high-repayment-cost state. Notice, however, that if we had a continuum of values of k, IFIs may not wish to be constrained to only lend expecting to be repaid in absolutely all states. Consider, for example, the aftermath of a major ...nancial crisis, a con‡ict, or a large natural catastrophe. Probably, in such states, the country will either enter into arrears with IFIs, or its obligations will be “evergreened.”Strictly speaking, totally risk-free lending may not exist. Hence, in a more general set-up it may be optimal for IFIs to o¤er loans that are repaid in full in almost all states, while the market will o¤er loans that are repaid less often. Our qualitative results would carry through. Countries may fall into arrears with IFIs in such states and may repay capital and interest at a later date.

In our analysis, we also assumed that if a country defaulted on one type of lender (market or IFI), this would not a¤ect its ability to borrow from the other type. This, however, is generally not necessarily the case. The credit rating of a country would normally be severely a¤ected if arrears were built up with IFIs, which would then curtail the ability to borrow from the market. Had we incorporated this into the model, the value of the IFI lending relation would have increased as would the ability of IFIs to lend risk free.

We solved for the optimal amount of IFI and market lending and we illustrated the parameter region where IFIs can lend and are expected to be preferred–the preferred lender feasibility set. It is interesting to note that as � rises and preferred lending becomes feasible, the optimum amount of preferred lending is constrained. Optimal IFI lending is on the frontier of the preferred lender feasibility set. In this region, it might be argued that IFIs should be cautious. An error in the sense of the IFI lending a bit more than the optimum would imply straying from the feasibility set with the consequent danger that the country would not treat the IFI as preferred. In our analysis, it is assumed that all parameter values are known with certainty but in the real world this may not be the case. On the other hand, for higher values of �, the IFI becomes unconstrained as the optimum is inside the feasibility set for preferred lending. At these higher values of �; straying some little way from the optimal amount would not endanger being considered as preferred.

# 8 Conclusion and policy discussion

One of the most persistent puzzles regarding the global ...nancial architecture has been in relation to the preferred status of the main IFIs. While PCT is critical to the operations of the IMF and the major MDBs, it is not generally stated in legal contracts, and it is normally described as a market custom. This suggests that it should be understood as an endogenous outcome of the relation of a country with its creditors rather than something that is imposed. And yet we know of no paper to date that provides an explanation of why

> 33 It is worth noting that in a more general model the relative weight of the two might also depend on risk aversion.

17
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
sector involvement”in periods of debt distress or, in other words, against the principle that the private sector should su¤er losses as, presumably, it had lent at rates precisely re‡ecting such risks. If “evergreening” of o¢ cial loans and additional borrowing more to “bail out”private creditors were allowed, then this would add even greater value to o¢ cial lending (from the standpoint of the country) and make it easier and cheaper for the country to borrow from the market. However it is unlikely that such practices would be consistent with maintaining PCT, a AAA credit rating, and a low cost of ...nancing for those multilaterals that borrow on global capital markets.

A further interesting result is that, for some parameter values, it would be in a country’s own best interest to not be able to borrow from private markets. This is an important issue that is discussed at length in IFIs and even merits an acronym, NCBP, which stands for non-concessional borrowing policy, and applies to countries that received debt relief under the Multilateral Debt Relief Initiative (MDRI). More precisely, IFIs sought to restrict the amount of commercial debt such countries could contract, both to avoid the repeat of the build-up of unsustainable levels of debt and in order to preserve PCT. IFIs have tried to implement NCBPs with the threat that future concessional resources might be curtailed if countries did not abide. But it is not easy to enforce such a rule. Countries have many ways to contract debt. For example, public companies may provide an indirect way of borrowing that is hard to monitor. Another is that investment needs in the developing world are large so that, in many instances, IFIs may be tempted to o¤er NCPBs’waivers. Indeed, despite the NCBP, public debt in low income countries that obtained debt relief has increased in the last decade and is now close pre-MDRI levels. Still, this is an issue that deserves further thought and consideration.

To conclude, our fundamental result is that creditors that expect to be paid in all states of nature are very di¤erent animals to commercial lenders. While commercial lenders price loans according to risk and should therefore expect restructuring if unfavorable states materialize, IFIs that expect loans to be risk free play by di¤erent rules. But in order to play by those rules their behavior must be consistent. Considering carefully the constraints and ensuring that preferred lending is complementary to market lending should help maximize the bang for each buck of preferred creditors’capital.

19