Foreign aid and sovereign credit worthiness

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.