Nber Working Paper Series Country Risk and the Organization of International Capital Transfer

Foreign portfolio investment is threatened by the risk of default and repudiation, while direct foreign investment isthreitened by the risk of expropriation. These two contractual forms of investment can differ substantially in: (I) the amount of capital they can transfer from abroad to capital-importing countries; (2) the shadow cost of capital and (3) their implications for the tax policy of the host. The interaction of public borrowing from abroad with investments abroad by private citizens of the borrowing country can imply multiple equilibria with very different welfare consequences. One equilibrium involves private inflows and repayment of public debt. Another is characterized by capital flight and default. Jonathan Eaton Mark Gersovitz Oepartment of Economics Woodrow Wilson School Rouss Hall Princeton University University of Virginia Princeton, New Jersey 08544 Charlottesville, Virginia 22901 (609) 452-4797 (804) 924—7580