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and suffering the consequences of the resulting penalty. A ssum ing, for exam ple, that

the penalty from defaulting consists in the exclusion from future access to capital

m arkets, the country w ill repay only if the utility from doing so is higher than the

utility from defaulting now and consum ing its autarkic o u tp u t thereafter. That is, the

country w ill have the incentive to repay if:

The left-hand side of the incentive com patibility constraint represents the present

value of the utility accruing from following some specific repaym ent path (m arked

by the sign ~), and the right-hand side expresses the utility associated w ith

consum ing the autarkic o u tp u t at any tim e subsequent to the period of default,

denoted by r. W ithout a perfect enforcem ent m echanism , the country has no

incentive to repay, since after p eriod r, consum ption w o u ld have to fall below the

level of current output, for all t > r. W ithout a strong enforcem ent m echansim at the

disposal of the c red ito r7, the country w ould therefore be strictly better off by

breaching the contract an d consum ing the full level of o u tp u t thereafter.

The central analytical question is thu s to identify enforcem ent m echanism s that m ake

the com pliance w ith sovereign debt contracts incentive-com patible. The m ost

influential literature has p roposed the answ er in term s of p un itive enforcem ent,

relating to the reputational argum ent m entioned in the above ex am p le.8 The

argum ent w as first introduced in a sem inal pap er by Eaton an d G ersow itz (1981)9,

based on sim ple intuition: rather than facing the stick of som e other punitive action

by creditors, a sovereign is rew arded w ith the carrot of increasing its reputational

asset if it does repay debt, thereby assuring continued access to foreign loans in the

7 It should be noted that the term 'creditor' is used here interchangeably w ith 'creditors'. For the sake of simplicity of the exposition of the key arguments, w e therefore abstract from the important collective action problems affecting creditors' decisions as a group. Furthermore, the term 'creditor' may be thought of as including also the group of concessional creditors, or the donor community as a whole, with regard to its loan (not grant) disbursements.

8 Without counting elem ents such as honour, national pride, or guilt, as enforcement mechanisms, given that they are based on a debtor's ethical values, rather than on coercion. Nevertheless, this is not to argue that such elements may not play a decisive role in determining a country's decision to repay (honour) its debts.

9 It was further elaborated, among others, by Kletzer (1984), Eaton, Gersowitz and Stiglitz (1986), Grossman and Van Huyck (1988), Eaton (1990, 1993), Atkeson (1991), Cole, Dow , and English (1995), Cole and Kehoe (1996).

00 0C

(incentive com patibility constraint) (4)

future too. 10 Technically, this quid-pro-quo m echanism requires both repeated

interaction (i.e. a repeated game) to be effective, and the ability by creditors to

cooperate in carrying o u t the p un ish m en t in the event of default (Fafchamps, 1996).

M oreover, it w o u ld be ineffective if a defaulting debtor w ere able to b uy insurance

contracts, so as to allow for consum ption sm oothing (Bulow and Rogoff, 1989a).11

Also, this m echanism is not suited to inducing continued p ay m en t by countries

progressing along their developm ent path, from a low -capital and low -grow th period,

to a period of capital abundance. For in the period of relative capital abundance, the

carrot of continued access to external capital m ight offer too w eak an incentive for

inducing repaym en t (Eaton, G ersowitz, and Stiglitz, 1986). W hile such a scenario is

still out of reach for m ost sub-Saharan African countries12, a m ore relevant argum ent

in the context of LIC debt is the v arian t of the reputation arg um ent p u t forw ard in

relation to these countries' strong incentive to ensure continued access to aid flows.

Indeed, Fafcham ps (1996) show s that the threat of reduced aid flows to non­

com plying debtors has usually represented a sufficiently strong (binding) incentive

to ensure rep ay m ent in this group of countries.

Ultimately, the presence of som e sort of enforcem ent m echanism ensures th at a

defaulting country at least faces the possibility of penalties. International lending is

thus m ade possible to the extent that the expectation of penalty costs provides the

debtor w ith the incentive to repay. A t the same time, how ever, as long as the

possibility of default persists, total credit to a country is constrained, and the

effectiveness of the enforcem ent m echanism determ ines the level of constraint.

Clearly, if bo th lenders and borrow ers knew the costs of default w ith certainty, full

10 If the reputational asset is assumed to increase with every loan repaid, the terms of lending should