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International lending with moral hazard and risk of repudiation

The author examines the optimal pattern of lending in an environment in which there are two impediments to contracting. The first impediment is that lenders cannot observe whether borrowers invest or consume borrowed funds. This impediment leads to a moral hazard problem in investment. The second impediment is that the borrower may choose to repudiate his debts. The optimal contract is shown to specify that the borrowing country experience a capital outflow when the worst realizations of output occur. This seemingly perverse pattern of capital outflow forms a necessary part of the optimal solution to the moral hazard problem in investment. Copyright 1991 by The Econometric Society.