1) The document discusses Francis Fukuyama's 1989 theory of "the end of history" and the optimism about the global triumph of liberal democracy and free market economies after events like the fall of the Berlin Wall. 2) It then discusses theories of sovereign risk in international lending, including why countries lend to other countries despite the inability to rely on legal recourse for repayment. Key factors that influence lending decisions are the ability to inflict penalties on defaulters through trade embargoes or other means. 3) A theoretical model is presented of the lending decision between a monopolistic lender and borrowing country, taking into account the borrower's utility from consumption and the lender's goal of profit maximization balanced

1. International Indebtedness
&
Theories of Sovereign Risk
International Finance-II, 2014
Department of Commerce
North Bengal University

2. EXORDIUMEXORDIUM

3. Few Historical Events of Late Eighties of the last century which led Fukuyama to
conclude ‘the end of history’:
a)Crumbling of Berlin Wall, 1989 (Germany)
b)Dissolution of the Soviet Union, 1989
c)Confrontations in China (captured best in Tiananmen Square), 1989
“A wave of optimism engulfed the Western democratic States. This contagious
optimism was best exemplified by the confidence and popularity of Francis
Fukuyama's claim that the end of history was at hand, that the future - if that
word could still be said to have the same meaning - was to become the global
triumph of free market economies.”
Bernd Magnus And Stephen Cullenberg in the Introduction to a Jacques Derrida’s
book “Specters of Marx: The State of the Debt, the Work of Mourning and the
New International”.
EXORDIUMEXORDIUM

4. “The twentieth century saw the developed world descend into a paroxysm of
ideological violence, as liberalism contended first with the remnants of absolutism,
then bolshevism and fascism, and finally an updated Marxism that threatened to
lead to the ultimate apocalypse of nuclear war. “
But the century that began full of self-confidence in the ultimate triumph of
Western liberal democracy seems at its close to be returning full circle to where it
started: no to an "end of ideology" or a convergence between capitalism and
socialism, as earlier predicted, but to an unabashed victory of economic and
political liberalism.” (page-1)
“What we may be witnessing in not just the end of the Cold War, or the passing of
a particular period of post-war history, but the end of history as such: that is, the
end point of mankind's ideological evolution and the universalization of Western
liberal democracy as the final form of human government.” (Page-2)
Francis Fukuyama said in his article ‘The End of History”
EXORDIUMEXORDIUM

5. “The ruins of the Reich chancellory as well as the atomic bombs dropped on
Hiroshima and Nagasaki killed this ideology on the level of consciousness as
well as materially, and all of the proto-fascist movements spawned by the
German and Japanese examples like the Peronist movement in Argentina or
Subhas Chandra Bose's Indian National Army withered after the war.” (page-
10)
EXORDIUMEXORDIUM
Francis Fukuyama said in his article ‘The End of History”
But the situation of liberal democracy and also free market economy since early eighties of
the last century has not been free from economic crisis, social injustice, inequality,
starvation and other perennially persisting ills which are causes of human tragedy. Though,
according to Fukuyama, those are because of incomplete implementation of basic
principles of liberal democracy, we feel, however, that there exist some inherent
fundamental contradictions even in liberal democracy and free market economy for which
we have to wait to declare final triumph of free market economy and the ‘end of history’.
Loan pushing by developed countries to LICs leads to Indebtedness and that compounds
to sovereign risk which may be fatal for the existence of present international financial
system.

6. Theories of Sovereign Risk
If one agents lends money to another within same country and the borrower refuses to
repay, the lender can in principle resort to the nation’s laws. Such recourse to the law, so
goes the standard argument, is not usually possible when the government of country-A (or
some agent in A) lends to country-B (or some agent in B).
This phenomenon gives rise to a kind of risk which is called sovereign risk different from
business risk or financial risk.
Why then Country-A would lend to Country-B?
It seems widely agreed that country-A will lend to B only when A has the ability to hurt B.
First: the lender can threaten to refuse loans to defaulting borrower. This Contingent
Renewal is effective only if the borrower has a cyclical need for credit.
Second: the lender can embargo trade with the borrower.
Third: a lender can intervene militarily.
Two aspects distinguish international from domestic credit markets.
First: sovereign risk can be different from the risk of lending within a country,
Second: repayment can not always be made in the debtor’s currency.
SOVEREIGN RISK

7. An incident on August 13, 1982
“a bombshell that shook an entire universe”-Kraft Joseph, ‘The Mexican Rescue’, 1984
What was that incident?
Finance Minister of Mexico announced on August 13, 1982 that Mexico
could no longer service its enormous external debt.
This date is considered by the academicians and other concerned people as the start
of current international debt crisis.
What are the consequences (or fall out) of this announcement?
i)Lenders cut back their lending to other Latin American countries who in
turn became incapable of continuing with their repayment schedule
ii) Imports fell by 42 percent in mexico
iii) Wage bill dropped by 32 percent
Theories of Sovereign Risk

8. A Theoretical Frame Work:
Discussion is based on the following three papers:
(i)Eaton, Gersovitz, Stiglitz (1986), “The Pure Theory Of Country Risk”, EER
(ii) Krugman (1985), “International Debt Strategies In An Uncertain World” in Smith
& Cuddington (Ed.) “International Debt and the Developing Countries”
(iii) Basu (1991), ‘The International Debt Problem, Credit Rationing and Loan
Pushing: Theory and Experience’, Princeton Studies In International Finance No- 70
Theories of Sovereign Risk
World Bank data revealed that in 1970s developing country debt grew at an alarming
annual rate of 21 percent and the Debt-to-GNP ratio rose from 18 to 28 percent. This
explains the extent of sovereign risk in international finance market existed at that time
and the incident of Mexico was not an unexpected one.

9. Theories of Sovereign Risk
However, here we are considering a two-period model following Eaton et el (1986):
Lender lends L units in period-1 and charges an interest rate i.
Repayment in period-2 is R= Loan amount (L) + interest (at the rate i) on L = L+ iL = (1+i)L
Non-repayment cost or penalty = b (the amount of cost that can be inflicted on borrower
is positively related to the amount L). Thus we have,
(1)),( Lbb =
We postulate Monotonicity here, hence
Disadvantage of Finite-horizon Model:
(2)000 =>′ )(,)( bLb
aboveboundedandconcaveis(.)b
But, penalty can not be made infinitely large and hence the slope of penalty function
must be downwards after a certain point. Therefore, the function
Finite-horizon or Infinite-horizon?The Monopolistic Lender Model

10. Theories of Sovereign Risk
Borrower’s Problem:
Borrower country’s utility is if consumption in period i is Ci
Utility function is continuous, convex and strictly increasing in each of its argument.
),( 21 CCU
Let )ˆ,ˆ( 21 CC be consumption streams if it does not borrow from abroad
and use the loan package ),( iL
])(ˆ,ˆ[ LiCLCUU R
+−+= 121
Then utility under three situations may be considered:
i.Loan borrowed in period-1 and repaid
in period-2
ii.Loan borrowed in period-1 but caused
default in period-2 and paid penalty
iii.Loan is not borrowed
)](ˆ,ˆ[ LbCLCUU D
−+= 21
)ˆ,ˆ( 21 CCUU O
=
LiLb )()( +≥ 1Borrower will, therefore, repay if

11. Theories of Sovereign Risk
Lender’s Problem:
Supposing Lender’s opportunity cost of lending to the borrower is r, then the
lender’s problem is to maximize the profit π as follows:
and(2)i)L(1b(L)
subject to
(1)
Maximize
+≥
−=π ,)(),(
),(
LriiL
iL
(3)121
O
ULiCLCUU ≥+−+= ])(ˆ,ˆ[
It is quite rational to suppose that the utility of borrowing is greater than the utility of
not borrowing, otherwise there is no incentive to borrow. Hence the second constraint
(equation-3).
It is quite rational to suppose that the utility of borrowing is greater than the utility of
not borrowing, otherwise there is no incentive to borrow. Hence the second constraint
(equation-3).

12. Slope = 1+i*
b(L)
(1+r)L
B
A
L* L
The Monopolistic Lender Model
Theories of Sovereign Risk

13. Theories of Sovereign Risk
Competition and Credit RationingCompetition and Credit Rationing
The standard model of the International Credit Market is one in which lenders compete with
one another and push their monopolistic profits to zero.
Following Eaten et el (1986) we have that profit is zero when i=r in the profit function π= (i-r)L in
our model. Then from (2), we can compute the maximum loan amount without causing default:
LrLb ˆ)()ˆ( += 1
)(
)ˆ(ˆ
r
Lb
L
+
=
1

14. Default Frontier
Lˆ
r
E
L
i
C
O
Theories of Sovereign Risk

15. Theories of Sovereign Risk
Demand Curve under the assumption of no default:
))(ˆ,ˆ()( LiCLCUiD +−+= 1argmax 21
L
Demand curve is the locus of the peak points of all iso-utility curve drawn in (L,i)-space
kLiCLCU =+−+ ))(ˆ,ˆ( 121

16. Demand Curve for LoanDefault Frontier
Iso-utility Curve
Lˆ
r
E
L
i
C
O
Theories of Sovereign Risk
Excess Demand
D

17. Demand Curve for LoanDefault Frontier
Iso-utility Curve
r
E
L
i
C
O
Lˆ
Theories of Sovereign Risk
Competitive Lender: Demand Equals Supply

18. Next
STRATEGY
OF
LOAN PUSHING