External debt, planning horizon, and distorted credit markets

The purpose of this paper is to study the behavior of the credit market and the role of policies in the presence of country risk with underdiscounting by the policy maker. The underdiscounting may reflect political uncertainty, where the effective planning horizon of the centralized government is shorter than that of the private sector. The consequence of underdiscounting is to shift the supply curve facing the economy leftwards. The role of optimal borrowing policies in the presence of country risk is to discourage borrowing for consumption purposes, encourage investment in openness, and discourage investment in activities that reduce openness. The effect of underdiscounting by the policy maker is to increase the values of the optimal policy instruments (i.e., to increase the magnitude of the borrowing taxes and subsidies). Increasing the relative importance of open activities can be viewed as a way to reduce the harmful consequences of underdiscounting. Underdiscounting may rationalize various conditionality clauses that will induce the economy to follow the desired credit market policies.