Country Risk and Contingencies

This paper investigates the role of credit market policies in the presence of country risk. We show that if a given investment reduces (increases) the probability of default it generates positive (negative) externality calling for a subsidy (tax) on borrowing used to finance that investment. We demonstrate that variable default schemes that tie the penalty to the default rate are disadvantageous, whereas a contingency plan that make the interest rate contingent upon realization of shocks is advantageous. Allowing for contingent payment has the effect of raising the credit ceiling, raising the expected income, and stabilizing income. [023].