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Foreign aid and sovereign credit worthiness

Pedersen, Karl Rolf
Working paper
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URI
http://hdl.handle.net/11250/163124
Date
2007-12
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  • Discussion papers (SAM) [578]
Abstract
International financial markets are far from perfect. Because of problems related to contract enforcement borrowers often end up being rationed; the lenders tend to constrain the amount lent ex ante in

order to motivate the borrowers to fulfil their obligations and not default ex post. In this paper we take as

our point of departure a relationship like this between a lender (or consortium of lenders) and the government

of a poor country and ask: How is this relationship affected by the fact that the borrowing country also

receives foreign aid? The answer depends on how the aid is given. If the aid inflow

is exogenous we show

that some types of aid are effective in the sense that the aid has a positive effect on the credit obtained and

aggregate welfare. Other types are directly counterproductive. If the aid inflowow is endogenous, supplied by

altruistic donors as part of a safety-net, serious incentive distortions arise, crowding out private credit. Such

aid may actually be welfare-reducing in the recipient country. The paper also contains a discussion of how aid will influence lenders' incentives to give relief if the initial debt is not sustainable.
Publisher
Norwegian School of Economics and Business Administration. Department of Economics
Series
Discussion paper
2007:41

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