Lecture 7 Moral Hazard in International Lending

8/12/2019 Lecture 7 Moral Hazard in International Lending

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International lending,

credit imperfections,

and the flow of capital



Some questions

• Why does capital flow the wrong way, i.e fromrich to poor nations? – physical rates of return are in favour of poor countries

– Default and expropriation risk?

– Perhaps not, many countries were colonies andsubject to rich country law

• Lucas (1990) – fundamentals forces, externalities

in human capital formation may favourinvestment in rich countries. A “new growththeory” explanation



• What about credit market imperfections? – Reputational and sanctions model suggest that weak

contract enforcement prevents capital flows from headingthe right way.

• Gertler and Rogoff consider an “in-between”explanation – Even with identical institutions and contract enforcement

technology, capital can go the wrong way.

– The net worth of the borrower is a key factor, andwealthier regions can work around credit marketimperfections since they can more easily rely on self-finance



Gertler-Rogoff Model

• Small open economy, 2 periods, 1 good.

• Risk-neutral individual only cares for period 2

consumption,c, so that U(c)=c

• Endowment of the good is W1 and W2 in each

period

•

Individuals can save W1 two ways: – Lend abroad at interest rate, r

– Invest at home in a risky project



• Projects yield stochastic ex post returns

• Note that investment raises the probability that project yields high output



• If the individual wants to invest more than W1,she needs to tap funds from the world capitalmarket

• And in return for borrowing b, she issues astate-contingent security that pays creditors Zg if the project is a success and Zb if it fails



• Her creditors must be at least indifferent to

accepting this security and investing the fundson a riskless (US) treasury bill:

• And expected period 2 consumption will be



• But investment is unobservable. What our borrowerdoes with the funds is private information

– Secretly lend abroad (Swiss bank account), or consume thefunds (palace) instead of investing in the project!

• Contracts can only be conditioned on realised outputs,not actual investment.

• So – given any output contingent payout (Z) specifiedby the contract, borrower chooses k to maximiseexpected consumption



• This amounts to equating expected marginal

gains from investment with the opportunity

costs of (secretly) investing overseas

•

Observe that this decision depends on themarginal gain in expected output, and change

in obligation to the lenders



• Notice

– The borrower cannot have negative consumption,

so Zb≤W2

– If the borrower could promise a fixed payment

across states, Zg=Zb, and so



• We want to minimise the gap between Zg andZb, as this will take us closer to the efficientoutcome

• Define the present value of the output stream:V=W1+W2/r

• Since the project yields nothing in the bad

state, the borrower has to offer her ownassets,W2, in the bad state so the constraintZb=W2 is binding



• In equilibrium, the borrower should also not

be investing secretly overseas, so W1+b=k is

also binding.

– So she will use all borrowing to fund the project.

– And borrowing more than is essential to finance

the project raises the Zg-Zb gap

• So problem can be simplified



• The incentive compatibility constraint is

downward sloping in (Z^, k) space

– A rise in Z^, greater appropriation, lowers the

marginal gain from investing, and k is lower

– At Z^=0, we recover optimal capital, k*

• Lenders are subject to a zero profit condition,

which is upward sloping. Recall



• Equilibrium investment is below the sociallyoptimal level in this world with moral hazard

•

Per capita investment depends on per capitawealth – Raising V shifts MR downwards, IC unchanged, so k

rises, and Z^ falls.

– A rise in borrower net worth stimulates investment

• If the rise is due to increased W1, then borroweris less reliant on external funds (lowers Z^)



• If the rise in V is due to W2 increasing, theborrower is able to guarantee a bigger payout inthe bad state. Also lowers Z^

• A rise in world interest rates shifts both curvesand overall investment declines.

– IC moves left – the opportunity cost of investing rises,

so k declines for all values of Z^. – MR moves left also – some combination of a rise in Z^

and a fall in k will be needed to compensate creditors.



• In this model, the riskless rate is the same

everywhere – the world capital market is

perfectly integrated

• But expected marginal products of capital will

be bigger than the risk free rate and will differ

between countries

– Wealth of nations matters



A two country version

• We can endogenise the world interest rate in atwo country version of the model

– We can now make statements about the direction ofcapital flows

– The uneven distribution of wealth across nationsmatters

• Suppose there are two countries with equal

populations (rich and poor) – In each, a fraction, α, are entrepreneuers

– And a fraction 1-α, are lenders



• Endowments are such that WR1>WP

1 and

similarly for period 2.

• Suppose the poor country starts off owing a

debt, D, to the rich country.

• The debt is financed by a period 2 tax on

entrepreneurs and lenders.

• First consider a world with no asymmetries:



• Equation 15 is a resource constraint, the right

hand side shows the supply of investmentfunds available to the α entrepreneuers

• The world interest rate depends on

technology (π), and the supply of investmentfunds

• Identical technology means that kp*=kr*



• The existence of debts and taxes modifies theentrepreneur’s problem. Now Zg is replaced byZg

i+t, i=p, r.

• We now need analogous IC, MR curves for thetwo countries



• Need to ensure that total demand for

investment capital equals world supply, so

• Which gives us the locus of investment pairs

along which poor and rich nations face a

common risk free interest rate



• Key point is that since the rich country has higher wealth in period 1and 2, then kr>kp

• Savings flow from poor to rich because of the imperfections anddifferent initial wealth conditions



• Pattern of capital flows determined by “agency

costs” of lending in one country relative toanother. These, in turn, depend on the net assetpositions of entrepreneurs across countries.

• Fewer funds flow from rich to poor than underfull information

• Notice entrepreneurs can rely on self-finance if

rich, so even if contract enforcement is identical,high wealth countries suffer less from creditmarket imperfections

Lecture 7 Moral Hazard in International Lending

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