Design of the Optimal Loan Contract and its Implicit Contingencies in the Case of Developing Countries

Abstract

This paper argues that LDC loans contain implicit contingent features that provide insurance to the borrowing country against unfavorable economic circumstances. The motivation for, and optimality of, the implicit features of LDC loans are analyzed. Two policy implications to reduce the cost of default in LDC contracts are derived. First, if parties can make some of the implicit contingencies explicit, or countries can be insured against commodity price fluctuations, some sources of default would be eliminated and costs avoided. Since agents may be unable to include all contingent provisions explicitly, the second implication, therefore, is that default and rescheduling costs may be reduced if the parties submit to arbitration.