External Debt, Capital Flight and Political Risk

Abstract

This paper provides an explanation of the simultaneous occurrence of large accumulation of external debt, private capital outflow and relatively low domestic capital formation in developing countries. We consider a general equilibrium model in which two types of government with conflicting distributional goals randomly alternate in office. Uncertainty over the fiscal policies of future governments generates private capital flight and small domestic investment. This political uncertainty also provides the incentives for the current government to over accumulate external debt. The model also predicts that left wing governments are more inclined to impose restrictions on capital outflows than right wing governments. Finally, we examine how political uncertainty affects the risk premium charged by lenders and how debt repudiation may occur after a change of political regime.