On Overborrowing

A central question in emerging-market macroeconomics is what factors lead countries to accumulate excessive levels of external debt. It is often argued by economic observers and policymakers that emerging markets tend to overborrow when the lending decisions of foreign financial institutions are guided by rough indicators of the emerging country’s macroeconomic performance, and not by careful assessment of individual borrowers’ abilities to repay. This is because individual agents fail to internalize the effect their own borrowing decisions have on the country’s aggregate credit conditions. Overborrowing, it is argued, makes emerging countries prone to balance-of-payments crises, or sudden stops, and calls for government policy aimed at putting sand in the wheels of external finance. The purpose of this paper is to investigate whether the type of lending practices described above indeed lead emerging countries to overborrow. To this end, I characterize the equilibrium dynamics of a small, open-economy subject to an aggregate borrowing constraint. I have in mind a situation in which foreign lenders lack the ability or the incentives to monitor individual investment projects in the emerging country, and instead base their lending decisions on observation of a few macroeconomic indicators, such as total external debt or output growth. Individual agents do not internalize the credit constraint. I assume that in this economy credit rationing is implemented through a market mechanism. Specifically, when the aggregate debt limit is reached, an interest-rate premium emerges in the domestic economy that ensures individual borrowing decisions are collectively compatible with the aggregate credit constraint. I compare the equilibrium dynamics of this economy to those of an economy in which the borrowing limit is imposed at the level of each individual agent. The specific question that my investigation aims to address is whether the economy with the aggregate debt limit tends to overborrow relative to the economy with debt limits imposed at the level of each individual agent. I find there is no overborrowing in equilibrium. The reason is that in the economy with the aggregate credit constraint, market incentives, conveyed by the interest rate, induce individual saving decisions that are identical to those caused by the imposition of agent-specific debt limits.