erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

The Role of Lender Behavior in International Project Finance

Sumru Altuğ (University of Durham and CEPR, UK)
Şule Özler (University of California, Los Angeles, USA)
Murat Usman (Koç University)

Abstract

We consider a sovereign borrower who is seeking to raise funds in international capital markets to finance a fixed-size project, which no single lender can finance alone. There İstanbul Üniversitesi private information about the endowments of lenders, which determines the extent of debt that they can finance. We show that it is in the interest of the lenders not to communicate prior to lending. Because of that, a coordination failure between the lenders arises, which leads to a type of moral hazard behavior on the part of the borrower government: The government implements a private benefits project if it cannot raise sufficient funds for the productive investment. As a result, some socially desirable projects will not be financed, even if ex post feasible. The coordination problem also causes multiple equilibria, and a conflict of interest emerges between lenders about which equilibrium to coordinate on. When endowments are volatile, some lenders prefer the equilibrium where the project is financed with probability p < 1, even if ex post feasible. The government eliminates such equilibria by offering a sufficiently high return, but only if endowment volatility is small.

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