Lecture 7 Moral Hazard in International Lending
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Transcript of Lecture 7 Moral Hazard in International Lending
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International lending,
credit imperfections,
and the flow of capital
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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
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• 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
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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
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• Projects yield stochastic ex post returns
• Note that investment raises the probability that project yields high output
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• 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
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• 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
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• 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
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• 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
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• Notice
– The borrower cannot have negative consumption,
so Zb≤W2
– If the borrower could promise a fixed payment
across states, Zg=Zb, and so
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• 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
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• 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
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• 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
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• 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^)
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• 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.
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• 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
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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
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• 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:
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• 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*
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• 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
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• 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
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• 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
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• 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