External Debt and Political Instability

Abstract

This paper studies theoretically and empirically the role of domestic political incentives in the accumulation of large external debts by developing countries during 1972-81. The theoretical model characterizes two equilibrium regimes. In one regime the borrower is on its demand curve and changes in the loan size demand are accommodated by the lenders. In the other regime the borrower is credit rationed, and the loan size is determined by the perceived country risk. Higher political instability increases the equilibrium loan size in the first regime and decreases it in the second. Using out-of-sample of evidence, we identify the two regimes in the data. We then find that in the unconstrained regime political instability has a significant positive effect on the loan size, whereas it has no significant effect in the credit rationing regime. Hence the evidence indicates a positive effect of political instability on the demand for sovereign loans, as predicted by the theory.