Working Paper: NBER ID: w2172
Authors: Jonathan Eaton
Abstract: Significant amounts of private capital have flowed out of several of the more heavily indebted developing countries. This outflow, often called "capital flight ," largely escapes taxation by the borrowing-country government, and has generated concern about the prospects for future servicing of the debt. Imperfect contract enforcement may lead to implicit or explicit government guarantee of foreign debt. The model developed below demonstrates that a government policy of guaranteeing private debt can, in turn, generate more than one outcome. One such outcome replicates the allocation under perfect contract enforcement: national savings is invested domestically and foreign debt is repaid. The tax obligation implied by potential nationalization of private debt, however, can also lead to another outcome in which national capital flees and foreign debt may not be repaid.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government guarantees of private debt (H81) | Capital flight (F21) |
| Default by one borrower (G33) | Increased expected tax obligations for other borrowers (H29) |
| Increased expected tax obligations for other borrowers (H29) | Incentive to invest abroad (F21) |
| Contagion effect (E44) | Likelihood of capital flight increases (F21) |
| Potential nationalization of private debt (H63) | Risk of capital flight (F21) |
| Risk of capital flight (F21) | Deter domestic investment (F21) |
| Expectation of increased tax obligations (H26) | Diminish incentive for borrowers to manage investments (G51) |
| Diminish incentive for borrowers to manage investments (G51) | Contribute to capital flight (F21) |
| All borrowers choose to invest abroad (F21) | Flight equilibrium characterized by default on foreign loans (F34) |