FUERZA A APLICAR A LA TUBERÍA AL FIJAR EL ANCLA

Central to any contract is the enforcem ent m echanism th at punishes non-com plying

behaviour. The various enforcem ent m echanism s discussed in the debt-literature will

be recalled from ou r discussions in Section 2.2 above. C onsider now th at any

com bination of reputational an d/or coercive p un ish m ent m easures constitute the cost

of default to the non-com plying party. A rational debtor fulfils all contractual

obligations if the costs (or, equivalently, the benefits) of doing so are sm aller than the

costs (benefits) of breaching the contract and suffering the penalties. That is, applying

the m ost general notation:35

Cc(D, t, n) < Cb( t, n) te{T}; ne{N} (15)

W here the cost to com ply Cc is the cost to repay debt of am ou nt D, as a function of

the characteristics of the debtor m aking up its typology, t, an d the state of nature, n.

Cb denotes the costs associated w ith the breach of contract obligations. These costs

are also a function of type an d nature. Clearly, penalties w ill d ep en d on the specific

state of nature, such as the occurrence of shocks, since the latter affect a d ebtor's

likelihood of compliance. They also dep end on the debtor's characteristics, such as a

sovereign's ruling class time horizon of staying in pow er determ ining its valuation of

reputational capital; the strength of ethical self-enforcem ent mechanisms; the

structure of the debtor economy, for exam ple in relation to pro duction

m ethodologies and exporting capacity.

Incapacity, as opposed to unw illingness to pay, can be th o u g h t of as an infinite level

of Cc. T constitutes the set of all possible types the debtor can belong to, including

any characteristic th at is of relevance in the lender-borrow er relationship (e.g.

national pride, productivity, quality of the bureaucracy, etc). The cost of com pliance

varies w ith the debto r's type. N constitutes the set including any possible

contingency, therefore any exogenous shock that could possibly influence the

debtor's com pliance w ith contractual obligations. M ore generally, it is assum ed that

the d ebtor's type influences its resilience, i.e. the degree to w hich exogenous shocks

(the state of nature) affect compliance. For example, a w ell-run finance m inistry is

likely to fulfil the technical requirem ents better in the w ake of a crisis; export

diversification m ay p u t an econom y in a position to cope better w ith a su d d en drop

in the export prices of prim ary com m odities.

The m ost crucial set of assum ptions in contract-theoretic m odels relate to the

distribution of inform ation. Clearly, sym m etric and com plete inform ation about the

set of possible an d actual realisations of both t and n w ould pose few problem s in

35 Borrowing and adapting from Tirole (1999), and Freixas and Rochet (1997).

w riting optim al contracts. The typical problem s arise from asym m etric inform ation,

inducing adverse selection and m oral hazard problem s in relation to the type and

actions of the debtor, against the background of a state of n atu re th at is neither

observable by the creditor no r verifiable by an outside court (or som e arbitrator).

A ssum ing th at the debtor generally has a m ore com plete set of inform ation relating

to both t and n than does any other p arty to the contract, the dynam ic relationship

betw een the parties to a debt contract will be extrem ely complex, starting w ith the ex

ante-conditions necessary for both the creditor and the debtor to even agree to a debt

contract in the first place.

To see the im plications, consider that a rational creditor, assum ed to have no prior

inform ation about the debtor's type, gathers all inform ation abo ut t and n it can, so as

to form its beliefs about the likelihood of default no t occurring (i.e. for condition (15)

to be fulfilled). A ssum ing the sets T and N to be finite, to allow for analytical

tractability, the creditor can be th o u g h t of as form ing and orderin g its beliefs about

the expected value of repaym ent across all possible types and contingencies.

Som ew hat abusing notation, this is m ost easily expressed by equalling the expected

value of repay m en t conditional on the creditor's belief, E(D\B), to the space

delim ited by the low er and u p p e r delim itations to the sets of possible types and

states of nature (Ti - Th, and Ni - Nn, respectively).

The creditor will then accept the contract u n d er the condition th a t the expected value

of repaym en t is higher than the opp ortu nity cost of D, at the time of m aking the

contract. That is, w ith j3 denoting the subjective time discount betw een the period of

investm ent and expected return:

Similarly, the bo rrow er accepts the contract only if the expected benefits from doing

so exceed the expected costs. In contrast to the lender, how ever, the b orrow er know s

its type, t'. Clearly, this m akes the bo rrow er's m axim isation problem a far easier task

th an the lender's:

(16)

T, N,

N m

N„

E(D11') > J c c ( ^ » # ( / 7 | f ) + \ C B( t \ n ) d f ( n \ t ' ) (18)

N, N „

W here Nm denotes the state of nature, draw n from an o rdered set of states of nature,

an d w hich m arks the po int of indifference by the debtor betw een com plying and

breaching the contract, conditional on being of a certain type. Inequality (18)

therefore expresses the ex-ante condition that the expected benefits from entering the

contract be greater than the expected costs w hen com pliance occurs (the first right-

h an d term), plus the expected costs associated w ith the breach of the contract (the

second right-hand term).

It is now possible to see the ex-ante problem s of w riting the optim al, incentive-

com patible contract: in the extrem e case, creditors adjust penalties to a level that

raises Cbto a point w here it will alw ays be too costly to breach the contract. That is,

they set Cb> Cc Vn, t. By low ering the expected benefits from agreeing to the contract

below the penalties, there will exist for every type of debtor the possibility th at some

states of n ature occur th a t will m ake com pliance im possible. H ence, no contract will

be m ade. Similarly, if the creditor sets penalties at a level too low to create incentives

to repay, say equal to zero to take the extrem e case, the expected retu rn to its

investm ent w ill fall to zero, and therefore no contract comes into existence. For all

other levels of penalties, w hich fall betw een the two extrem e cases, contracts could be

m ade on the basis of ex-ante incentives, b u t all of them are fraug ht w ith the problem s

of adverse selection and m oral h azard arising from asym m etric inform ation about n

and f. In the ex-ante context, the adverse selection problem arises w hen the type of

the debtor is unobservable to the creditor. 'B ad' type debtors have the incentive to

apply for the loan even w hen they know they will not be able to repay it. As a result,

if creditors cannot distinguish 'g o o d ' from 'b a d ' type borrow ers, credit rationing will

occur, for exam ple along the lines of the m odel by Stiglitz and Weiss (1981).

Similarly, debtors have an incentive to m isrepresent their type w hen filing for debt

relief, in order to induce an increase in the am ount offered. In contrast, m oral h azard

concerns the incentive problem affecting the actions of the debtor after the contract

has been signed (i.e. ex post). To the extent that rep aym en t capacity is affected by

debtor's actions, the creditor's retu rn on investm ent is d eterm in ed by the latter's

ability to identify actions th at low er retu rn s and credibly enforce penalties. H owever,

w hile h igher penalties partially alleviate m oral h azard problem s ex post, they

exacerbate the adverse selection problem ex ante, thereby tightening the credit

constraint (Froot et al., 1989). M oreover, the threat of enforcing the penalty, although

m aking lending possible ex ante, m ay not be credible ex post, after the actual breach

of contract. Indeed, if im posing the penalty is costly to the creditor, the debtor will

exploit the strategic situation and offer to renegotiate the contract, for exam ple by

offering a side-paym ent th at leaves the creditor indifferent b etw een accepting the

paym ent and enforcing the penalty (Gale and Hellwig, 1989). M ore generally, the

optim al contract solution does not concern the optim isation of ex-ante efficiency, b u t

rather its ex-post efficiency, once the true type of debtor (t) has been revealed and the

state of natu re (n) h as been realised, an d incentives have changed accordingly.

Therefore, w hen w riting the initial contract, lenders an d borrow ers foresee

renegotiation, and the ensuing sub-gam e equilibrium , w hich w ill be different from

the equilibrium envisioned in the original contract. Rationally, the contracting parties

will then consider the outcom e of the sub-gam e equilibrium w h en calculating

expected benefits. If, how ever, the renegotiation gam e has m ultiple equilibria, and

the parties typically cannot pre-com m it strategies due to the tim e-inconsistency

problem , the outcom e of the initial contract is essentially indeterm inate.

Gale and H ellw ig (1989) note in this respect th at contract theory solves this

indeterm inacy by assum ing th at the parties w ill select the sub-gam e equilibrium that

Pareto-dom inates all others, at the tim e of w riting the initial contract. It will be

further show n below, in the discussion of the specific m odels, how such an

assum ption is typically im plem ented. H ere, the key point relates to the insight that in

order to alleviate adverse selection and m oral h azard problem s, creditors w ould

optim ally distinguish excusable default, due to unanticipated events, from

inexcusable breach of contract d ue to negative characteristics of the debtor. From a

theoretical p oint of view, this essentially leaves tw o options to allow for the necessary

contractual flexibility in high-risk or uncertain environm ents. If, in the period of

scheduled repaym ent, inform ation about the type of borrow er and the realisation of

the state of natu re is observable by both parties and verifiable by the court, the

optim al contract is m ade contingent on the state of nature. If, in contrast, inform ation

about t and /o r n is asym m etric, a com plete contract cannot be w ritten, and the

function of the contract is essentially to influence the bargaining p o w er of each party

in the bargaining process d u rin g the renegotiations of the original contract. The key

contributions in relation to the tw o options are now outlined in turn.