Project Contingent Repudiation Risk in the Model of North-South Lending

P ojec Con ingen Repudia ion Risk in he Model o No h-Sou h Lending. Cons an in T. Gu dgie Depa men o Economics T ini y College, Dublin Depa men o Economics, Na ional Uni e si y o I eland, Maynoo h Open Republic Ins i u e, Dublin. [email p o ec ed] 1s D a : Ap il 2002. 2nd D a : Augus 2002 Abs ac . P esen esea ch p oposes he ex ension o he Ge le -Rogo -Lane model o in e na ional lending unde he isk o epudia ion wi h mo al haza d o encompass he possibili y o he p ojec con ingency in he epudia ion isk i sel . By linking he le el o epudia ion isk o he size o he p ojec we show ha in es men p ojec s unde aken can be biased in a di ec ion a ou ing la ge p ojec s. Al e na i ely, we show ha smalle in es o s a e equi ed in he ma ke place, unde ce ain condi ions, o p o ide g ea e gua an ees o highe colla e al in o de o ob ain unds needed o in es men . In oduc ion. In ecen yea s, he ole o isk and in pa icula epudia ion isk as a de e minan o in es men decisions and capi al lows has been highligh ed by a ple ho a o models. A he same ime, adi ional models o epudia ion isk ha e in a iably a oided endogenising he isk-p ojec ela ionship ou side he gene al amewo k o he mo al haza d and agency p oblems. Ye , wi h de elopmen o democ a ic ins i u ions and he opening o na ional bounda ies o ade and capi al lows, in o ma ion lows ha e come o he o e on o he eal in es men p ojec s assessmen wi h espec o bo h he inhe en isk in ol ed and he ole ha he na u e o he p ojec plays wi hin he cons ain s o such ins i u ions on he le el o o e all isk. While he o me aspec o he epudia ion isk is co e ed ex ensi ely in he exis ing li e a u e, he la e emains la gely unexplo ed. Ye as he esul o hese di e en ace s o he same phenomena, bo h he inhe en isk o he in es men s and he epudia ion isk in pa icula a e o en endogenous o he en i onmen o he p ojec . Ano he aspec wo h conside ing is he ela ionship be ween he p ojec cha ac e is ics, such as size, and he o e all a ailabili y o in o ma ion. In he socie ies wi h de eloped democ a ic ins i u ions, such as cou s, media and poli ical campaigning, la ge p ojec s enjoy g ea e public isibili y and elec o al sc u iny. Thus such p ojec s may be na u ally associa ed wi h he lowe epudia ion isk. On he o he hand, in he socie ies wi h se e e deg ees o ma ke dis o ions and co up ion, la ge p ojec s may be associa ed wi h go e nmen in ol emen and hus may be linked o a highe deg ee o epudia ion isk. In wha ollows, we e m hese e ec s p ojec -con ingen na u e o epudia ion isk and o he sake o b e i y deal wi h he i s ype o ela ionship be ween he na u e o he p ojec and he inhe en le el o isk in ol ed. The majo i y o epudia ion isk li e a u e ocuses on he open economy side o he mac oeconomic models, while he la ge sha e o mo al haza d models is conce ned wi h he closed economies. Fo example, he seminal pape by Ge le and Rogo de elops a 2 model o in es men unde unce ain y in he p esence o mo al haza d ha igno es he possibili y o epudia ion isk. As such, his model, acco ding o au ho s’ admission, canno be used o dis inguish in es men lows be ween wo s a es wi hin he US and he wo so e eign coun ies. Lane (1998, 1999) ex ension in oducing epudia ion isk mo es his model in o he open economy mac oeconomics, while lea ing he conside a ion o p ojec -speci ici y o isk no add essed. Simila ly, an impo an pape by Holms om and Ti ole (1998) ocuses on he closed economy aspec o agency isk wi hou p o iding an analysis o he epudia ion isk, o he link be ween he na u e o he p ojec and he epudia ion isk. Fu he mo e, adi ional li e a u e on epudia ion isk and in es men lending a ely deals wi h he implica ions o he p ojec na u e o size linkages o he o e all iskiness o he p ojec . In so a as epudia ion isk is ela ed o he limi ed liabili y and bank up cy liquida ion laws, his implies ha mos heo e ical models o lending unde mo al haza d lead o a conclusion ha cos s o such isk a e ei he e enly bo n by all en ep eneu s, o bene i small in es o s in excess o he la ge ones. Howe e , as shown by many s udies, see o example G oop e al (1996) and Be kowi z and Whi e (2002), empi ically such cos s ac o edis ibu e c edi away om small en ep eneu s in a ou o he la ge p ojec s. This empi ical con adic ion o heo e ical models o lending unde mo al haza d isk appea s o be un esol ed in he mode n li e a u e. Cu en s udy is designed o ill hese gaps by ex ending he Ge le -Rogo -Lane amewo k o include conside a ion o he p ojec con ingen epudia ion isk. In he ollowing we assume ha he impo ance o epudia ion isk in in es men decisions es s in pa on he di e ences amongs a ious p ojec s. Fo simplici y, we assume ha his endogenei y o epudia ion isk is linked o a speci ic cha ac e is ic o he p ojec , namely i s size. Howe e , he model p esen ed below can be easily ex ended o co e many con ingencies wi hin he ealm o he p ojec en i onmen ’s desc ip ion. 3 Pa 1. Model. The e a e wo ypes o isk-neu al agen s, each li ing wo pe iods and +1: en ep eneu s and lende s. Lende s a e in e es ed in maximising he expec ed a e o epaymen on he p ojec , while en ep eneu s maximise hei expec ed u ili y o e he choices o consump ion and in es men (assumed o be p opo ional o he capi al ou lay o he p ojec ), subjec o budge cons ain . Li e- ime u ili y is gi en by: E UC ,C 1,klog C   E logC 1  alog k (1) whe e in gene alU, U U C0 1 C0, CC,U  1 CC  0  and U k  0, U k k 0. The income a ailable o en ep eneu s a ises om wo sou ces. O iginal, pe iod endowmen o weal h, W , can be in es ed in isky p ojec wi h s a e con ingen payo s desc ibed below, and he isk ee asse , , yielding he g oss a e o e u n, R. Risky in es men echnology is gi en as ollows. A da e en ep eneu uses he own unds, B W C , oge he wi h he bo owed amoun o b o inance capi al o ma ion in he amoun o k. This capi al is hen applied o he isky in es men p ojec and en ep eneu chooses he le el o e o o be applied o he p ojec . The esidual unds a e au oma ically deposi ed in o bond holdings. The p ojec yields a da e +1 a e u n  G wi h p obabili y  k   co esponding o he ‘good’ s a e o na u e, o a e u n  B wi h p obabili y 1   k   co esponding o he ‘bad’ s a e o na u e. We assume ha 0   B    G . Le el o e o (capi al ou lay o he p ojec ) unde he possibili y o in es ing he bo owed unds in he isk- ee asse is p i a e in o ma ion a ailable o he en ep eneu bu no o an in es o . A da e upon bo owing unds o in es men , en ep eneu commi s o epay s a e-con ingen a e o e u n Z G  Z B. Howe e , in es o aces an addi ional isk o de aul due o limi ed liabili y ( epudia ion). A e ealisa ion o he p ojec , in es o s may exp op ia e only a sha e o inal ou pu . This sha e is p ojec -size-con ingen , so ha  k  iZi iG,B (2) 4 We shall conside only one case:  'k  0 , co esponding o he si ua ions in which epudia ion isk is dec easing (so ha epaymen sha e is inc easing) in he size o a p ojec . In a democ a ic socie y wi h de eloped media and socio-poli ical checks and balances on co po a e and public bu eauc acy, high p o ile (la ge k) in es men p ojec s a e associa ed wi h highe deg ee o isibili y. The esul ing educ ion o in o ma ion cos s makes la ge p ojec s cheape o moni o han smalle ones. In addi ion, wi h high deg ee o public exposu e, such p ojec s a e less subjec o co up ion (media exposu e in democ a ic se ing inc eases cos o co up ion) and he e o e a e associa ed wi h lowe epudia ion isk han smalle , less isible ones. This si ua ion can wa an he a o emen ioned link be ween he size o he p ojec and he epudia ion isk in ol ed. As was men ioned in he in oduc ion, in case o se e e co up ion p oblems a he op o he go e nmen appa a us, we can speci y he opposi e di ec ion o he ela ionship be ween he p ojec size and epudia ion isk in ol ed. Such ex ension o he model would equi e e e sing he sign o  'k o  'k    0. Gi en he expec ed a e o e u n o he isky in es men p ojec , we speci y he in e - empo al budge cons ain as: C C 1 R  k R    BB  RWbk (3) Deno e by Z  Z G  Z B and    G   B. To con ol o he p esence o mo al haza d p oblem in e ms o in es men p ojec choice, we impose he s anda d incen i e compa ibili y cons ain acco ding o which isky p ojec s mus yield a leas he same a e o e u n as isk- ee bonds:  'k  ZR (4) We u he assume ha nei he u u e income, no he expec ed epudia ion unds can be le e aged in he deb ma ke s, so ha W bkB C 0 (5) Fu he mo e, in es o s mus be gua an eed a epaymen le el a leas in he amoun o he oppo uni y cos o isky in es men , i.e. R:  kZZBRb (6) 5 We a e now eady o pos ula e he p oblems aced by en ep eneu who chooses consump ion o e wo pe iods, capi al in es men , deb le el, and he le el o he s a e- con ingen epaymen o o e so as o: max C ,C 1,k,b,ZG,ZB  E UC ,C 1,k  subjec o (1)-(6). Deno e by  i,  ,  ,  ,  he mul iplie s on cons ain s (2)-(6) espec i ely. Then he i s o de condi ions o he gene al p oblem a e gi en by: U CR  U 1 C  1 C R  C 1 (7a) R  U 1 C  R  C 1 0 (7b) U k   ' R  Z1        'Z  ''  Z  '  G  G  B  B    a k  ' R  Z1        'Z  ''  Z  '  G  G  B  B   0 (7c)      R (7d)    R        '    G (7e) 1      R        '    B (7 ) F om (7a) i is clea ha we ha e wo cases o conside : Case 1: R  C C 1U C  R  U  1 C which implies ha   0 wi h (5) sa is ied a inequali y. This is a case when bo owe s will hold non-ze o le el o bonds and colla e al ese e, so ha mo al haza d applies. As shown below he esul ing op imal le el o capi al alloca ion is below he ull in o ma ion i s -bes solu ion in Ge le -Rogo -Lane. Case 2: U CR  U 1 C which implies ha  0 and (5) is sa is ied a equali y. This is a case when bo owe s will hold no bonds and cola e al, so ha mo al haza d does no cons ain he op imal le el o capi al a ailable o bo owe s. Repudia ion isk alone ma e s. As shown below he esul ing op imal capi al alloca ion is de e mined by i s e ec on epudia ion isk. 6 Pa 2. Case-Speci ic Solu ions. 2.1. Case 1: Mo al Haza d in Absence o E ec i e Repudia ion Risk. Conside Case 1. Since  0, hen he op imal solu ion o he p oblem is gi en by he ollowing equa ions:  kZZBRb (8a) MR cu e bC k  W B B 0 IC cu e  'k  ZR (8c) ZZ cu e  k    k  ii iG,B (8d) Equilib ium le el U kU C R  'k  R  (8e) k1 *a C R  '   R Compa ing in e cep IC wi h le el, k1 *k1 *  k0 IC . The eason o his is ha unde he assump ions o Case 1 mo al haza d applies and bo owe s ha e o se aside a ce ain amoun o ese es in o m o bonds o supply colla e al o he loans. This limi s he le el o capi al in es men ha can be unde aken. Howe e , since ne e u n o bo owe s a e epaymen o he loan is highe han he isk- ee a e o e u n, IC cons ain does no bind a he op imum. Hence k1 *˜ k , whe e ˜ k deno es he solu ion o s anda d G-R-L p oblem wi hou epudia ion isk bu wi h mo al haza d. In p esence o colla e al, bo owe s can gua an ee highe epaymen a e Z1 *˜ Z han in case o G-R-L. Thus, lende s a e compensa ed o he added isk by ob aining he expec ed e u ns in excess o isk- ee a e o e u n. The epudia ion isk does no ma e in his case because i is e ec i ely o se by he bond holdings, which can be epudia ed unde he assump ions o (2), (3) and (5). Figu e 1 below shows hese esul s. 7 Figu e 1. Equilib ium Le els o Capi al In es men and Repaymen Pledge. Benchma k Case o No Repudia ion Risk. Z MR Z1 * ˜ Z isk-p emium o lende IC k ˜ k k k1 * 0 IC B>0 No e ha in his case wel a e analysis conduc ed in Ge le (1992) ully applies. Thus inc ease in weal h endowmen o en ep eneu s will shi bo h IC and MR cu es igh wa d he eby inc easing he c edi a ailabili y. Al e na i ely inc ease in pe sonal weal h will educe he isk-p emium equi ed by he lende s. 2.2. Case 2: Mo al Haza d in P esence o Repudia ion Risk. Nex we conside Case 2. In gene al, assump ions o his case imply ha  0, so ha ou side he bond holdings colla e al ese es a e ze o and cons ain (5) holds a equali y. I is s aigh o wa d o show ha equali ies in cons ain s (3) and (6) will ollow as well. Finally, simpli ying (7c) we can summa ise he main equa ions o he model as ollows: 8 MR cu e  kZZBRb (9a) bC k  W IC cu e  'k  ZR (9b) ZZ cu e  k    k  ii iG,B (9c) E-le el U k  'k  U 1 C  ZU C RZ        ''  ZU C  'k  G  G  B  B  (9d) As in G-R-L we can conside wo cases o applica ion o epudia ion isk. Case 2.A.: epudia ion isk does no bind in ‘good’ s a e, i.e.  G  0 Case 2.B.: epudia ion isk does bind in ‘good’ s a e, i.e.  G 0 2.2.1. Case 2.1: Repudia ion Risk in ‘Bad’ S a e Alone Fi s suppose epudia ion isk cons ain does no bind in case o ‘good’ s a e ealisa ion. This implies ha  k  G  G and he e o e,  B0 unambiguously. The go e ning equa ions a e: MR cu e  kZ  k  BRk  C  W   (10a) IC cu e  'k  ZR (10b) ZZ cu e  k   (10c) E-le el a ki *AZ  '   ''  '  Z  '  B      1 C    '  C 1 A1 RC   C 1 (10d) As be o e, MR cu e slopes up in k,Z   space, howe e , equa ion (10a) gi es a la e slope han co esponding equa ion in Case 1, since now epudia ion cons ain does no bind in ‘good’ s a e. In addi ion, MR has non-ze o in e cep a k0 M R. 9 puzzle a ises in so a as adi ional heo e ical models o lending in p esence o mo al haza d imply he e e se e ec s o limi ed liabili y on he abili y o he en ep eneu s o aise c edi ela i e o he size o he p ojec s. In ou model la ge p ojec s a e a ou ed by in es o s due o he link be ween he size o he p ojec and he le el o he epudia ion isk. The smalle (less weal hy) en ep eneu s and p ojec s a e less likely o bene i om he epudia ion isk linkage. This implies ha in so a as limi ed liabili y and bank up cy liquida ion clauses ha e he same e ec on lowe ing he expec ed abili y o en ep eneu s o epay he lende s in case o bad ou come, i is he la ge in es o s who ha e g ea e access o he c edi ma ke s. Thus ou model con i ms he empi ical egula i ies obse ed in he li e a u e. In so a as he p esen s udy o e s a way o endogenising he epudia ion isk by linking he le el o isk wi h he cha ac e is ic o he p ojec i sel , he model p esen ed abo e o e s an in e es ing case o he u u e empi ical analysis. Fi s ly, i con i ms he gene al hypo hesis ha democ a ic ins i u ions o checks and balances can ac in asymme ic ashion on he deg ee o epudia ion isk. Wi h la ge in es men p ojec being subjec o he g ea e sc u iny in local and in e na ional media, cos s o moni o ing he p ojec de elopmen and he h ea o po en ial public exposu e o he loan aiding en ep eneu s ac o amelio a e he epudia ion isk and lowe he equi emen s on epaymen pledge and colla e al. Secondly, he s udy de elops an explici ela ionship be ween he es able hypo heses conce ning he obse able en i onmen and he ex an e analysis o he po en ial in es men p ojec s. Thi dly, we show ha he model can be easily in e p e ed in he con ex o he o ce majeu epudia ion isk (bad s a e only case) and he gene al epudia ion isk. Bo h ypes can be sepa a ed wi hin he cons ain s o he model and he e ec s o hei di e ences can be aced back o he abili y o he en ep eneu s o aise unds. O e en g ea e impo ance is he ac ha he size o he p ojec unde he assump ions o he democ a ic 16 17 ma ke -d i en ins i u ions, can be in insically linked o hese di e ences as well. While o ce majeu causes may apply o he epudia ion aid whe eby in he bad s a e o na u e, especially when such bad s a e is mac oeconomic (down cycle, coun y-wide shock, e c) e en in democ a ic ma ke -o ien ed socie ies, he gene al epudia ion isk mos ce ainly mee s no app o al om he gene al elec o a e. Thus he ex e nal en i onmen di e ences be ween hese wo o ms o epudia ion isk mus be kep clea ly dis inguished in any model o in es men unde unce ain y wi h he possibili y o capi al unds exp op ia ion. Ou model sa is ies his c i e ion. Bibliog aphy. Be kowi z, J. and M. 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