Foreign debt, sanctions and investment: a model with politically unstable Less Developed Countries
✍ Scribed by Alberto Dalmazzo; Giancarlo Marini
- Publisher
- John Wiley and Sons
- Year
- 2000
- Tongue
- English
- Weight
- 180 KB
- Volume
- 5
- Category
- Article
- ISSN
- 1076-9307
No coin nor oath required. For personal study only.
✦ Synopsis
Foreign debt works as a 'poison pill'. When a domestic entrepreneur borrows from abroad to finance a project, he obtains funds today against the promise of a future repayment. As a consequence, if the government expropriates the investment project, it will have either to bear the burden of debt repayment or suffer sanctions. By reducing the gains from expropriation, foreign debt can therefore shelter domestic entrepreneurs from political risks. We also show that external debt may be the most effective tool to increase the investor' share and promote physical capital accumulation.
The novel implications of our model are consistent with existing empirical evidence. The result that external debt financing can be more effective than foreign direct investment in reducing underinvestment in LDCs can explain why the stocks of foreign direct investment are much lower than total debt claims. Also, consistent with empirical observation, our model predicts that LDCs' debt trades at a discount, and capital flights can coexist with large foreign debts. Further, political instability does not deter foreign institutions from lending large amount of funds. Finally, the advantages of borrowing from abroad push LDCs towards high openness to international trade.